UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


 

FORM 10-K


 

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

 

For the Fiscal Year Ended December 31, 20032005

 

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

 

For the Transition Period Fromto            to


 

Commission File Number 001-13533

 


NOVASTAR FINANCIAL, INC.

(Exact nameName of registrantRegistrant as specifiedSpecified in its charter)Charter)


 

Maryland 74-2830661

(State or other jurisdictionOther Jurisdiction of

incorporationIncorporation or organization)Organization)

 

(I.R.S. Employer

Identification No.)

8140 Ward Parkway, Suite 300, Kansas City, MO 64114
(Address of principal executive office)Principal Executive Office) (Zip Code)

 

Registrant’s telephone number, including area code:Telephone Number, Including Area Code:(816) 237-7000

 


 

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

 

Title of Each Class


 

Name of Each Exchange on

Which Registered


Common Stock, $0.01 par value

Redeemable Preferred Stock

 

New York Stock Exchange

New York Stock Exchange

 

Securities registered pursuantRegistered Pursuant to Section 12(g) of the Act:

None

None


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

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

 

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

 

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

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

Large accelerated filer  x    Accelerated filer  ¨    Non-accelerated filer  ¨

 

Indicate by check mark whether the registrant is an accelerated filera shell company (as defined in Exchange Act Rule 12b-2).    Yesx    No¨    No  x

 

The aggregate market value of voting and non-voting stock held by non-affiliates of the registrant as of February 29, 2004June 30, 2005 was approximately $1,310,178,823$1,094,898,056, based upon the closing sales price of the registrant’s common stock as reported byon the New York Stock Exchange Composite Transactions on such date.

 

The number of shares of the Registrant’s Common Stock outstanding on February 29, 2004March 10, 2006 was 24,790,517.32,591,228.

 

Documents incorporatedIncorporated by referenceReference

 

Items 10, 11, 12, 13 and 14 of Part III are incorporated by reference to the NovaStar Financial, Inc. definitive proxy statement to shareholders, which will be filed with the Commission no later than 120 days after December 31, 2003.2005.

 



NOVASTAR FINANCIAL, INC.

FORM 10-K

For the Fiscal Year Ended December 31, 20032005

 


TABLE OF CONTENTS

 

PART I

      

Item 1.

  

Business

  2

Item 2.1A.

  

PropertiesRisk Factors

  13

Item 3.1B.

  Unresolved Staff Comments27

Item 2.

Properties27

Item 3.

Legal Proceedings27

Item 4.

  13
Item 4.

Submission of Matters to a Vote of Security Holders

  1328

PART II

      

Item 5.

  

Market For Registrant’s Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities

29

Item 6.

  14
Item 6.

Selected Financial Data

30

Item 7.

  15
Item 7.

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

31

Item 7A.

  16
Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

65

Item 8.

  37
Item 8.

Financial Statements and Supplementary Data

66

Item 9.

  38
Item 9.

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

107

Item 9A.

  68
Item 9A.

Controls and Procedures

107

Item 9B.

  68Other Information109

PART III

      

Item 10.

  

Directors and Executive Officers of the Registrant

109

Item 11.

  68
Item 11.

Executive Compensation

109

Item 12.

  68
Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

110

Item 13.

  69
Item 13.

Certain Relationships and Related Transactions

110

Item 14.

  69
Item 14.

Principal Accountant Fees and Services

  69110

PART IV

      

Item 15.

Exhibits, Financial Statement Schedules, and Reports on Form 8-K

  70Exhibits and Financial Statements Schedules111


PART I

 

Safe Harbor Statement

Certain matters discussed in this annual report constitute forward-looking statements within the meaning of the federal securities laws. Forward-looking statements are those that predict or describe future events and that do not relate solely to historical matters. Forward-looking statements are subject to risks and uncertainties and certain factors can cause actual results to differ materially from those anticipated. Some important factors that could cause actual results to differ materially from those anticipated include: our ability to generate sufficient liquidity on favorable terms; the size and frequency of our securitizations; interest rate fluctuations on our assets that differ from our liabilities; increases in prepayment or default rates on our mortgage assets; changes in assumptions regarding estimated loan losses and fair value amounts; changes in origination and resale pricing of mortgage loans; our compliance with applicable local, state and federal laws and regulations or opinions of counsel relating thereto and the impact of new local, state or federal legislation or regulations or opinions of counsel relating thereto or court decisions on our operations; the initiation of margin calls under our credit facilities; the ability of our servicing operations to maintain high performance standards and maintain appropriate ratings from rating agencies; our ability to expand origination volume while maintaining an acceptable level of overhead; our ability to adapt to and implement technological changes; the stability of residential property values; the outcome of litigation or regulatory actions pending against us or other legal contingencies; the impact of losses resulting from natural disasters; the impact of general economic conditions; and the risks that are outlined from time to time in our filings with the Commission, including this annual report. Other factors not presently identified may also cause actual results to differ. This document speaks only as of its date and we expressly disclaim any duty to update the information herein.

Item 1.Business

 

Overview

 

We are a Maryland corporation formed on September 13, 1996 as a specialty finance company that originates, purchases, invests in and services residential nonconforming loans. We operate through threefour separate but inter-related units—operating segments – mortgage portfolio management, mortgage lending, loan servicing and branch operations. The loan servicing segment was previously reported as part of mortgage lending and loan servicing, mortgage portfolio managementbut it has been separated to more closely align the segments with the way we review, manage and operate our business. Segment information for the years ended December 31, 2004 and 2003 has been restated for this change. Additionally, we are currently winding down our branch operations. operating unit and expect to complete the wind-down by June 30, 2006. See “Branch Operations.”

We offer a wide range of mortgage loan products to borrowers, commonly referred to as “nonconforming borrowers.” Nonconforming borrowers are individuals who generally do not satisfy the credit, collateral, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers, including U.S. government-sponsored entities such as Fannie Mae or Freddie Mac. We retain significant interests in the nonconforming loans we originate and purchase through our mortgage securities investment portfolio. Through our servicing platform, we then service all of the loans, in which we retain interests, in, in order to better manage the credit performance of those loans.

 

We have elected to be taxed as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended.amended (the “Code”). Management believes the tax-advantaged structure of a REIT maximizes the after-tax returns from mortgage assets. We must meet numerous rules established by the Internal Revenue Service (IRS) to retain our status as a REIT. In summary, they require us to:

 

Restrict investments to certain real estate related assets,

 

Avoid certain investment trading and hedging activities, and

 

Distribute virtually all REIT taxable income to stockholders.our shareholders.

 

As long as we maintain our REIT status, distributions to stockholdersour shareholders will generally be deductible by us for income tax purposes. This deduction effectively eliminates corporateREIT level income taxes. Management believes it has and will continue to meet the requirements to maintain our REIT status.

 

Mortgage Portfolio Management

 

We invest in assets generated primarily from our origination and purchase of nonconforming, single-family, residential mortgage loans.

 

We operate as a long-term mortgage securities portfolio investor.

Financing is providedWe finance our investment in mortgage securities by issuing asset-backed bonds, debt and capital stock and entering into reverse repurchase agreements.

 

Earnings are generated from the return on our mortgage securities and spread income on the mortgage loan portfolio.

 

Our portfolio of mortgage securities include AAA- and non-rated interest only,includes interest-only, prepayment penalty, overcollateralization (collectively, the “residual securities”) and other investment-grade rated subordinated mortgage securities.securities (the “subordinated securities”).

 

Earnings from our portfolio of mortgage loans and securities generate a substantial portion of our earnings. Gross interest income in our mortgage portfolio management segment was $170.4$193.2 million, $107.1$140.3 million and $57.9$109.5 million in the three years ended December 31, 2003, 20022005, 2004 and 2001,2003, respectively. Net interest income from thebefore provision for credit (losses) recoveries for our portfolio management segment was $130.1$174.1 million, $79.4$119.2 million and $30.5$92.1 million in the three years ended December 31, 2005, 2004 and 2003, 2002respectively. One of our top priorities going forward is to preserve the favorable returns generated by our mortgage securities portfolio by focusing on the spread between origination and 2001, respectively.funding costs and the coupons of loans in the portfolio. We expect to continue to grow our portfolio but not at the expense of returns or risk management. See Note 16 to our discussionconsolidated financial statements for a summary of interest income under the heading “Resultsoperating results and total assets for our mortgage portfolio management segment. Also, see “Mortgage Portfolio Management Results of Operations” under “Management’s Discussion and “Net Interest Income”.Analysis of Financial Condition and Results of Operations” for further discussion and analysis of the mortgage portfolio management operations.

 

A significant risk to our operations, relating to our mortgage portfolio management segment is interest rate risk - the risk that interest rates on the mortgage loans which underly our assetsmortgage securities will not adjust at the same times or in the same amounts that interest rates on ourthe liabilities adjust. Many of the loans in our portfolio have fixed rates of interest for a period of time ranging from 2 to 30 years. Our funding costs are generally not constant or fixed. We use derivative instruments to mitigate the risk of our cost of funding increasing or decreasing at a faster rate than the interest on the loans (both those on the balance sheet and those that serve as collateral for mortgage securities).

 

In certain circumstances, because2002, we enter intobegan transferring interest rate agreements that do not meetat the hedging criteria set forth in accounting principles generally accepted intime of securitization into the United States of America, we are requiredsecuritization trusts to recordprotect the change in the value of derivatives as a component of earnings even though they may reduce ourthird-party bondholders from interest rate risk. In times where short-term rates drop significantly,risk and to decrease the valuevolatility of future cash flows related to the securitized mortgage loans. We enter into these interest rate agreements as we originate and purchase mortgage loans in our mortgage lending segment. See “Mortgage Lending” for discussion of the impact of these interest rate agreements will decrease. As a result, we recognized losses on our operating results. At the time of securitization, the interest rate agreements are transferred to the securitization trust and removed from our balance sheet. The trust assumes the obligation to make payments and obtains the right to receive payments under these derivatives of $30.8 million, $36.8 millionagreements. Generally, net settlement obligations paid by the trust for these interest rate agreements reduce the excess interest cash flows to our residual securities. Net settlement receipts from these interest rate agreements are first used to cover any interest shortfalls on the third-party primary bonds and $4.0 million in 2003, 2002 and 2001, respectively.

any remaining funds then flow to our residual securities.

Mortgage Lending and Loan Servicing

 

The mortgage lending operation is significant to our financial results as it produces the loans that ultimately collateralize the mortgage securities that we hold in our portfolio. During 2003,2005 and 2004, we originated $5.3and purchased $9.3 billion and $8.4 billion in nonconforming mortgage loans, therespectively. The majority of whichthese loans were retained in our servicing portfolio and serve as collateral for our mortgage securities. The loans we originate and purchase are sold, either in securitization transactions or in outright sales to third parties. We securitized $7.6 billion and $8.3 billion of mortgage loans during 2005 and 2004, respectively. We sold $1.1 billion in nonconforming mortgage loans to third parties during the year ended December 31, 2005. There were no nonconforming mortgage loan sales during 2004. Our mortgage lending segment recognized gains on sales of mortgage assets totaling $144.0$49.3 million, $53.3$113.2 million and $37.3$140.9 million during the three years ended December 31, 2005, 2004 and 2003, 2002 and 2001, respectively. See Table 15 for a summary of the components of our mortgage lending gains on sales of mortgage assets by year, as well as, a reconciliation of our mortgage lending gains on sales of mortgage assets to our consolidated gains on sales of mortgage assets reported in our consolidated statements of income. In securitization transactions accounted for as sales we retain residual securities (representing interest-only securities, prepayment penalty bonds and overcollateralization bonds) and othercertain investment-grade rated subordinated securities, along with the right to service the loans. See Note 16 to our consolidated financial statements for a summary of operating results and total assets for our mortgage lending segment. Also, see “Mortgage Lending Results of Operations” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion and analysis of the mortgage lending operations.

 

Our wholly-owned subsidiary, NovaStar Mortgage, Inc. (“NovaStar Mortgage”), or NovaStar Mortgage, originates and purchases primarily nonconforming, single-family residential mortgage loans. Our mortgage lending operation continues to innovate in loan origination. We adhere to three disciplines which underly our lending decisions:

Originating loans that perform (attractive credit risk profile),

Maintaining economically sound pricing (profitable coupons), and

Controlling costs of origination.

In our nonconforming lending operations, we lend to individuals who generally do not qualify for agency/conventional lending programs because of a lack of available documentation or previous credit difficulties. These types of borrowers are generally willing to pay higher mortgage loan origination fees and interest rates than those charged by conventional lending sources.lenders. Because these borrowers typically use the proceeds of the mortgage loans to consolidate debt and to finance home improvements, education and other consumer needs, loan volume is generally less dependent on general levels of interest rates or home sales and therefore less cyclical than conventional mortgage lending.

 

We have developed aOur nationwide loan origination network ofincludes wholesale loan brokers, and mortgage lenders, who submit mortgage loanscorrespondent institutions and direct to us.consumer operations. Except for NovaStar Home Mortgage, Inc. (“NHMI”) brokers described below, these brokers and mortgage lenders are independent from any of the NovaStar Financial entities. Our sales force, which includes 281 account executives in 3942 states, develops and maintains relationships with this network of independent retail brokers. AsOur correspondent origination channel consists of December 31, 2003, approximately 5,800 brokers are active customers and approximately 13,000 are approved customers.a network of institutions from which we purchase nonconforming mortgage loans on a bulk or flow basis.

 

We underwrite, process, fund and service the nonconforming mortgage loans sourced through our broker network of wholesale loan brokers and mortgage lenders and our direct to consumer operations in centralized facilities. Further details regarding the loan originations are discussed under the “Mortgage Loans” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

 

A significant risk to our mortgage lending operations is liquidity risk – the risk that we will not have financing facilities and cash available to fund and hold loans prior to their sale or securitization. See “Risk Factors – Related to our Borrowing and Securitization Activities.” We maintain committed lending facilities with large banking and investment institutions to reduce this risk. On a short-term basis, we finance mortgage loans using warehouse lines of credit and repurchase agreements. In addition, we have access to facilities secured by our mortgage securities. Details regarding available financing arrangements and amounts outstanding under those arrangements are included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 68 to the consolidated financial statements.

 

For long-term financing, we fundsecuritize our mortgage loans usingand issue asset-backed bonds (ABB)(“ABB”). Primary bonds – AAA through BBB rated – are issuedsold to large, institutional investors and U.S. government-sponsored enterprises. During 2005 and 2004, US government-sponsored enterprises purchased 51% and 55%, respectively, of the bonds sold to the public. Wethird-party investors from our securitizations. The loss of the U.S. government-sponsored enterprises from the market for our bonds could potentially have a materially adverse effect on us.

In 2005, we started to retain the interest only, prepayment penalty, overcollateralization and othercertain of subordinated bonds.securities from our securitizations. We also retain residual securities as well as the right to service the loans. Prior to 1999, our ABB transactionssecuritizations were executed and designed to meet accounting rules that resulted in securitizations being treated as financing transactions. TheAs a result, the mortgage loans and related debt continue to be presented on our consolidated balance sheets, and no gain was recorded. Beginning in 1999, our securitization transactions have been structured to qualify as sales for accounting and income tax purposes. The loans and related bond liability are not recorded in our consolidated financial statements. We do, however, record the value of the residual and subordinated securities and servicing rights we retain.retain on our balance sheet. Details regarding ABBs we issued can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in Notes 3 and 6Note 8 to our consolidated financial statements.

 

As discussed under “Mortgage Portfolio Management,” interest rate risk is a significant risk to our mortgage lending operations as well as our mortgage portfolio operations. Prior to securitization, we enter into these interest rate agreements as we originate and purchase mortgage loans to help mitigate interest rate risk. At the time of securitization, we transfer these interest rate agreements into the securitization trusts and they are removed from our balance sheet. Generally, these interest rate agreements do not meet the hedging criteria set forth in accounting principles generally accepted in the United States of America (“GAAP”) while they are on our balance sheet, therefore, we are required to record their change in value as a component of earnings even though they may reduce our interest rate risk. In times when short-term rates rise or drop significantly, the value of our agreements will increase or decrease, respectively. As a result, within our mortgage lending segment we recognized gains (losses) on these derivatives of $17.9 million, $(8.8) million and $(29.9) million in 2005, 2004 and 2003, respectively.

Loan Servicing

We retain the servicing rights with respect to loans we securitize. Management believes loan servicing remains a critical part of our business operation. In the opinion of management,operation because maintaining contact with our borrowers is critical in managing credit risk and in borrower retention. Nonconforming borrowers are more prone to late payments and are more likely to default on their obligations than conventional

borrowers. By servicing our loans, we strive to identify problems with borrowers early and take quick action to address problems. Borrowers may be motivated to refinance their mortgage loans either by improving their personal credit or due to a decrease in interest rates. By keeping in close touch with borrowers, we can provide them with information about companyNovaStar Financial products to encourage them to refinance with us. Mortgage servicing yields fee income for us in the form of fees paid by the borrowers for normal customer service and processing fees. In addition we receive contractual fees approximating 0.50% of the outstanding balance for loans we service that we do not own. We serviced $14.0 billion loans as of December 31, 2005 compared to $12.2 billion loans as of December 31, 2004. We recognized $21.1$59.8 million, $10.0$41.5 million and $4.9$21.1 million in loan servicing fee income from the securitization trusts during the three years ended December 31, 2005, 2004 and 2003, 2002 and 2001, respectively. See also “Mortgage Loan Servicing”servicing fee income should continue to grow as our servicing portfolio grows. Also, see “Loan Servicing Results of Operations” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion and analysis of the servicing operations.

Branch Operations

 

In 1999, we opened our retail mortgage broker business operating under the name NovaStar Home Mortgage, Inc., or NovaStar Home Mortgage. (“NHMI”). Prior to 2004, many of these NHMI branches were supported by limited liability companies (“LLC”) in which we owned a minority interest in the LLC and the branch manager was the majority interest holder. In December 2003, we decided to terminate the LLCs effective January 1, 2004. As of January 1, 2004 the financial results of the continuing branches, that were formerly supported by LLCs, are included in our consolidated financial statements. Branch offices offer conforming and nonconforming loans to potential borrowers. Loans are brokered for approved investors, including NovaStar Mortgage. The NHMI branches must adhere to a strict setare considered departmental functions of established policies regarding their operations. Net incomeNHMI under which the branch manager (department head) is an employee of NHMI and receives compensation based on the profitability of the branch is returned(department) as bonus compensation. See Note 15 and Note 16 to our consolidated financial statements for a summary of operating results and total assets for our branches. Also, see “Branch Operations Results of Operations and Discontinued Operations” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion and analysis of the branch “owner/manager.” We provide administrative functions, including accounting, payroll and human resources, loan investor management and license management services for each branch under separate contractual agreements and we receive a fee for providing these services. As of December 31, 2003 we had 432 active branches in 39 states as compared to 216 active branches in 35 states as of December 31, 2002.operations.

 

TheWe routinely close branches and branch business provides an additional source for mortgage loan originations that,managers voluntarily terminate their employment with us, which generally results in most cases, we will eventually sell, either in securitizations or in outright sales to third parties. During 2003 and 2002, our branches brokered $6.4 billion and $2.6 billion, respectively, in loans, of which we funded $1.2 billion and $376 million, respectively, in nonconforming loans. While the branches are not required to use NovaStar Mortgage as their nonconforming lender, they more often choose NovaStar Mortgage over external lenders. We believebranch’s closure. In these terminations, the branch personneland all operations are eliminated. Additionally, as the demand for conforming loans declined significantly during 2004 and 2005, many branches were not able to produce sufficient fees to meet operating expense demands. As a result of these conditions, we adopted a formal plan on November 4, 2005 to terminate substantially all of the remaining NHMI branches. We anticipate that all of the remaining NHMI branches will use NovaStar Mortgage so long as NovaStar Mortgage offers a competitive loan product and quality customer service. NovaStar Mortgage is the lender for a significantly higher percent of nonconforming loans initially brokeredbe terminated by the branches as compared to loans brokered by independent retailers.June 30, 2006.

 

Following is a diagram of the nonconforming industry in which we operate and our loan production during 2003 (in thousands).

(A)A portion of the loans securitized or sold to unrelated parties as of December 31, 2003 originated prior to 2003, but due to timing were not yet securitized or sold at the end of 2002. Loans originated in 2003 that we have not securitized or sold to unrelated parties as of December 31, 2003 are included in our mortgage loans held-for-sale.

Market in Which NovaStar Operates and Competes

Over the last ten years, the nonconforming lending market has grown from less than $50 billion annually to approximately $600 billion in 2005 as estimated by Inside Mortgage Finance Publications. A significant portion of nonconforming loans are made to borrowers who are using equity in their primary residence to consolidate installment or consumer debt, or take cash out for personal reasons. The nonconforming market has grown through a variety of interest rate environments. One of the main drivers of growth in this market has been the rise in housing prices which gives borrowers the opportunity to use the equity in their home to consolidate their high interest rate, short-term, non-tax deductible consumer or installment debt into lower interest rate, long-term, often tax deductible mortgage debt. Management estimates that NovaStar Financial has a 1-2% share of the nonconforming loan market. While management cannot predict consumer spending and borrowing habits, nor the future value of the residential home market, historical trends indicate that the market in which we operate is relatively stable and should continue to experience long-term growth.

 

We face intense competition in the business of originating, purchasing, selling and securitizing mortgage loans. The number of market participants is believed to be well in excess of 100 companies who originate and purchase nonconforming loans. No single participant holds a dominant share of the lending market. We compete for borrowers with consumer finance companies, conventional mortgage bankers, commercial banks, credit unions, thrift institutions and other independent wholesale mortgage lenders. Our principal competition in the business of holding mortgage loans and mortgage securities are life insurance companies, institutional investors such as mutual funds and pension funds, other well-capitalized, publicly-owned mortgage lenders and certain other mortgage acquisition companies structured as REITs. Many of these competitors are substantially larger than we are and have considerably greater financial resources than we do.

 

Competition among industry participants can take many forms, including convenience in obtaining a loan, amount and term of the loan, customer service, marketing/distribution channels, loan origination fees and interest rates. To the extent any competitor significantly expands their activities in the nonconforming and subprime market, we could be materially adversely affected.

 

One of our key competitive strengths is our employees and the level of service they are able to provide our borrowers. We service our nonconforming loans and, in doing so, we are able to stay in close contact with our borrowers and identify potential problems early.

Another key competitive strength is our branch operation. While the branches are free to broker loans for any approved investor, frequently NovaStar Mortgage is the lender for the branch loans. During 2003, the branches brokered $6.4 billion in residential mortgage loans.

We also believe we compete successfully due to our:

 

experienced management team;

 

use of technology to enhance customer service and reduce operating costs;

 

tax advantaged status as a REIT;

 

freedom from depository institution regulation;

 

vertical integration – we broker and/or originate, purchase, fund, service and manage mortgage loans;

 

access to capital markets to securitize our assets.

 

Following is a diagram of the industry in which we operate and our loan production including nonconforming and conforming during 2005 (in thousands).


(A)A portion of the loans securitized or sold to unrelated parties during 2005 were originated prior to 2005. Loans originated and purchased in 2005 that we have not securitized or sold to unrelated parties as of December 31, 2005 are included in our mortgage loans held-for-sale.
(B)The majority of the AAA-BBB rated securities from NMFT Series 2005-1, 2005-2, 2005-3 and 2005-4 were purchased by bond investors during 2005. We retained the Class M-11 and M-12 certificates from NMFT Series 2005-3, which were rated BBB/BBB- by Standard and Poor’s and Fitch, respectively and BBB- by Standard and Poor’s. We retained the Class M-9, M-10, M-11 and M-12 certificates from NMFT Series 2005-4, which were rated A/Baa3/BBB+, BBB+/Ba1/BBB, BBB/NR/BBB- and BBB-/NR/NR by Standard and Poor’s, Moody’s and Fitch, respectively.
(C)The excess cash flow and subordinated bonds retained by NovaStar Financial are from the NMFT Series 2005-1, 2005-2, 2005-3 and 2005-4 securitization transactions, which occurred during 2005.

Risk Management

 

Management recognizes the following primary risks associated with the business and industry in which it operates.

 

Interest Rate/Market

 

Liquidity/Funding

 

Credit

 

Prepayment

 

Regulatory

Interest Rate/Market Risk

Risk.Our investment policy setsgoals are to maintain the following general goals:

(1)Maintain the net interest margin between assets and liabilities, and

(2)Diminish the effect of changes in interest rate levels on our market value

Loan Price Volatility. Under our current modeassets and liabilities and to diminish the effect of operation, we depend heavilychanges in interest rate levels on theour market for wholesale nonconforming mortgage loans. To conserve capital, we may sell loans we originate. Financial results will depend, in part, on the ability to find purchasers for the loans at prices that cover origination expenses. Exposure to loan price volatility is reduced as we acquire and retain mortgage loans.value.

 

Interest Rate Risk. When interest rates on our assets do not adjust at the same time or in the same amounts as the interest rates ason our liabilities or when the assets have fixed rates and the liabilities are adjusting,have adjustable rates, future earnings potential is affected. We express this interest rate risk as the risk that the market value of our assets will increase or decrease at different rates than that of theour liabilities. Expressed another way, this is the risk that our net asset value will experience an adverse change when interest rates change. We assess the risk based on the change in market values given increases and decreases in interest rates. We also assess the risk based on the impact to net income in changing interest rate environments.

Management primarily uses financing sources where the interest rate resets frequently. As of December 31, 2003,2005, borrowings under all financing arrangements adjust daily or monthly. On the other hand, very few of the mortgage assets we own adjust on a monthly or daily basis. Most of the mortgage loans contain features where their rates are fixed for some period of time and then adjust frequently thereafter. For example, one of our loan products is the “2/28” loan. This loan is fixed for its first two years and then adjusts every six months thereafter.

 

While short-term borrowing rates are low and long-term asset rates are high, this portfolio structure produces good results. However, if short-term interest rates rise rapidly, earning potential is significantly affected and impairments may be incurred, as the asset rate resets would lag the borrowing rate resets.

 

Interest Rate Sensitivity Analysis.To assess interest sensitivity 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 anda market value and cash flow basis. The following are summaries of the analysis.

 

Interest Rate Sensitivity - IncomeThe following table summarizes management’s estimates of the changes in market value of our mortgage assets and interest rate agreements assuming interest rates were 100 and 200 basis points, or 1 and 2 percent higher or lower. The cumulative change in market value represents the change in market value of mortgage assets, net of the change in market value of interest rate agreements. The change in market value of the liabilities on our balance sheet due to a change in interest rates is insignificant since the liabilities are so short term.

(dollars in thousands)


   

Basis Point Increase (Decrease) in

Interest Rate (A)


 
   (200) (C)

  (100)

  100

  200

 

As of December 31, 2003:

                

Net interest income

  N/A  $15,546  $(11,393) $(20,777)
   
  


 


 


Percent change in net interest income from base

  N/A   5.6%  (4.1)%  (7.5)%
   
  


 


 


Percent change of capital (B)

  N/A   5.2%  (3.8)%  (6.9)%
   
  


 


 


As of December 31, 2002:

            

Net interest income

  N/A  $8,894  $(6,946) $(13,277)
   
  


 


 


Percent change in net interest income from base

  N/A   7.6%  (5.9)%  (11.3)%
   
  


 


 


Percent change of capital (B)

  N/A   4.9%  (3.8)%  (7.2)%
   
  


 


 



(A)Net interest income (income from assets less expense from liabilities and expense from interest rate agreements) in a parallel shift in the yield curve, up and down 1% and 2%.

(B)Total change in estimated spread income as a percent of total stockholders’ equity as of December 31.

(C)A decrease in interest rates by 200 basis points (2%) would imply rates on liabilities at or below zero.

Interest Rate Sensitivity - Market Value

(dollars in thousands)


 

  

Basis Point Increase (Decrease) in

Interest Rate (A)


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

 
  (200) (C)

  (100)

 100

 200

   (200)

 (100)

 100

 200

 

As of December 31, 2003:

      

As of December 31, 2005:

   

Change in market values of:

         

Assets

  N/A  $99,164  $(135,872) $(296,278)  $96,456  $42,327  $(44,254) $(92,483)

Liabilities

  N/A   (5,325)  6,245   12,627 

Interest rate agreements

  N/A   (90,590)  98,484   208,805    (33,502)  (17,365)  20,072   41,616 
  
  


 


 


  


 


 


 


Cumulative change in market value

  N/A  $3,249  $(31,143) $(74,846)  $62,954  $24,962  $(24,182) $(50,867)
  
  


 


 


  


 


 


 


Percent change of market value portfolio equity (B)

  N/A   1.0%  (9.1)%  (21.9)%   11.0%  4.4%  (4.2)%  (8.9)%
  
  


 


 


  


 


 


 


As of December 31, 2002:

      

As of December 31, 2004:

   

Change in market values of:

         

Assets

  N/A  $16,449  $(49,343) $(119,232)  $70,438  $33,198  $(34,045) $(72,840)

Liabilities

  N/A   (2,311)  2,451   4,969 

Interest rate agreements

  N/A   (36,249)  37,930   76,873    (54,085)  (28,046)  27,832   55,113 
  
  


 


 


  


 


 


 


Cumulative change in market value

  N/A  $(22,111) $(8,962) $(37,390)  $16,353  $5,152  $(6,213) $(17,727)
  
  


 


 


  


 


 


 


Percent change of market value portfolio equity (B)

  N/A   (10.9)%  (4.4)%  (18.4)%   3.3%  1.0%  (1.3)%  (3.6)%
  
  


 


 


  


 


 


 



(A)Change in market value of assets liabilities or interest rate agreements in a parallel shift in the yield curve, up and down 1% and 2%.

(B)Total change in estimated market value as a percent of market value portfolio equity as of December 31.

 

(C)A decrease in interest rates by 200 basis points (2%) would imply rates on liabilities at or below zero.

The values under the headings “100”, “200”, “(100)” and “(200)” are management’s estimates of the income and change in market value of those same assets, liabilities and interest rate agreements assuming that interest rates were 100 and 200 basis points, or 1 and 2 percent higher and lower. The cumulative change in income or market value represents the change in income or market value of assets, net of the change in income or market value of liabilities and interest rate agreements.

Hedging.In order to address a mismatch of interest rates on our assets and liabilities, the hedging section of the investment policywe follow an interest rate program that is followed, as approved by theour 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 mortgage assets and the differences between interest rate adjustment indices and interest rate adjustment periods of adjustable-rate mortgage loans and related borrowings.

 

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

 

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

 

Interest rate cap agreements are legal contracts between us and a third partythird-party firm or “counterparty”. The counterparty agrees to make payments to us in the future should the one- or three-monthone-month LIBOR interest rate rise above the strike rate specified in the contract. We make either quarterly or monthly premium payments or have chosen to pay the premiums at the beginning to the counterparties under contract. Each contract has either a fixed or amortizing notional face amount on which the interest is computed, and a set term to maturity. When the referenced LIBOR interest rate rises above the contractual strike rate, we earn cap income. Payments on an annualized basis equal the contractual notional face amount times the difference between actual LIBOR and the strike rate. Interest rate swaps have similar characteristics. However, interest rate swap agreements allow us to pay a fixed rate of interest while receiving a rate that adjusts with one-month LIBOR.

 

The following table summarizes the key contractual terms associated with our interest rate risk management contracts. Substantially allAll of theour pay-fixed swapsswap contracts and interest rate capscap contracts are indexed to one-month and three-month LIBOR.

 

We have determined the following estimated net fair value amounts by using available market information and appropriate valuation methodologies we deem appropriate as of December 31, 2003.2005.

Interest Rate Risk Management Contracts

(dollars in thousands)


 

  Maturity Range

   

Net Fair

Value


  

Total

Notional

Amount


  Maturity Range

 
  Net Fair
Value


 Total
Notional
Amount


 2004

 2005

 2006

    2006

 2007

 2008

 2009

 2010

 

Pay-fixed swaps:

  $(8,648)       

Contractual maturity

   $1,530,000  $265,000  $800,000  $465,000   $3,290  $1,020,000  $390,000  $510,000  $120,000  $—    $—   

Weighted average pay rate

    2.9%  4.9%  2.3%  2.8%      3.9%  2.4%  4.8%  4.8%  —     —   

Weighted average receive rate

    1.1%  (A)  (A)  (A)      4.4%  (A)  (A)  (A)  —     —   

Interest rate caps:

  $6,679        

Contractual maturity

   $805,144  $155,144  $450,000  $200,000   $5,105  $535,000  $200,000  $160,000  $145,000  $20,000  $10,000 

Weighted average strike rate

    1.7%  1.8%  1.6%  2.0%      3.8%  2.0%  4.9%  4.9%  4.9%  4.9%

(A)The pay-fixed swaps receive rate is indexed to one-month and three-month LIBOR.

 

Liquidity/Funding Risk

Risk.See the “Liquidity and Capital Resources” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for afurther discussion of liquidity risks and resources available to us.

 

Credit Risk

Risk.Credit risk is the risk that we will not fully collect the principal we have invested in mortgage loans or the amount we have invested in securities. Nonconforming mortgage loans comprise substantially our entire mortgage loan portfolio and serve as

collateral for our mortgage securities. Our nonconforming borrowers include individuals who do not qualify for agency/conventional lending programs because of a lack of conventional documentation or previous credit difficulties but have considerable equity in their homes. Often, they are individuals or families who have built up high-rate consumer debt and are attempting to use the equity in their home to consolidate debt and reduce the amount of money it takes to service their monthly debt obligations. Our underwriting guidelines are intended to evaluate the credit history of the potential borrower, the capacity and willingness of the borrower to repay the loan, and the adequacy of the collateral securing the loan.

 

UnderwritingOur underwriting staff workworks under the credit policies established by our Chief Credit Officer.Committee. Underwriters are given approval authority only after their work has been reviewed for a period of at least two weeks.time. Thereafter, the Chief Credit Officer re-evaluates the authority levels of all underwriting personnel on an ongoing basis. All loans in excess of $350,000 currently require the approval of an underwriting supervisor. Our Chief Credit Officer or our President must approve loans in excess of $500,000.$1,000,000.

 

TheOur underwriting guidelines take into consideration the number of times the potential borrower has recently been late on a mortgage payment and whether that payment was 30, 60 or 90 days past due. Factors such as FICO score, bankruptcy and foreclosure fillings,filings, debt-to-income ratio, and loan-to-value ratio are also considered. The credit grade that is assigned to the borrower is a reflection of the borrower’s historical credit and the loan-to-value determined by the amount of documentation the borrower could produce to support income. Maximum loan-to-value ratios for each credit grade depend on the level of income documentation provided by the potential borrower. In some instances, when the borrower exhibits strong compensating factors, exceptions to the underwriting guidelines may be approved.

 

KeyThe key to our successful underwriting process is the use of NovaStarIS®. NovaStarIS®NovaStarIS®, which is the second generation of our proprietary automated underwriting system. ISNovaStarIS® provides more consistency in underwriting loans and allows underwriting personnel to focus more of their time on loans that are not initially accepted by the ISNovaStarIS® system.

 

Our mortgage loan portfolio by credit grade, all of which are nonconforming, can be accessed via our website at www.novastarmortgage.com.(www.novastarmortgage.com). References to our website do not incorporate by reference the information on such website into this Annual Report on Form 10-K and we disclaim any such incorporation by reference.

 

A toolstrategy for managing credit risk is to diversify the markets in which we originate, purchase and own mortgage loans. Presented via our website at www.novastarmortgage.com(www.novastarmortgage.com) is a breakdown of the geographic diversification of our loans. DetailReferences to our website do not incorporate by reference the information on such website into this Annual Report on Form 10-K and we disclaim any such incorporation by reference.Details regarding loans charged off are disclosed in Note 2 to the “Financial Statements and Supplementary Data”.our consolidated financial statements.

 

We have purchased mortgage insurance on manya majority of the loans that are held in our portfolio – on the balance sheet and those that serve as collateral for our mortgage securities. Our mortgage insurance provides for coverage to a loan-to-value of 50-55%, which serves to substantially limit our exposure to credit risk. The use of mortgage insurance is discussed under “Premiums for Mortgage Loan Insurance” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

Prepayment Risk

.Generally speaking, when market interest rates decline, borrowers are more likely to refinance their mortgages. The higher the interest rate a borrower currently has on his or her mortgage the more incentive he or she has to refinance the mortgage when rates decline. In addition, the higher the credit grade, the more incentive there is to refinance when credit ratings improve. When home values rise, a borrower has a low loan-to-value ratio, making it more likely that he or she is more likely towill do a “cash-out” refinance. Each of these factors increases the chance for higher prepayment speeds during the term of the loan.

 

The majority of our mortgage securities are “interest-only” in nature. These securities represent the net cash flow – interest income – on the underlying loans in excess of the cost to finance the loans. When borrowers repay the principal on their mortgage loans early, the effect is to shorten the period over which interest is earned, and therefore, reduce the cash flow and yield on our securities.

 

We mitigate prepayment risk by originating and purchasing loans that are originated withinclude a penalty if the borrower repays the loan in the early months of the loan’s life. For the majority of our loans, a prepayment penalty is charged equal to 80% of six months interest on the principal balance that is to be paid in full. As of December 31, 2003, 65%2005, 67% of our loans had a prepayment penalty. Of the loans that serve as collateral for our mortgage securities 74% had a prepayment penalties aspenalty. As of December 31, 2003.2005, 65% of our mortgage loans - held-for-sale had a prepayment penalty. During 2003, 77%2005, 65% of the loans we originated and purchased had prepayment penalties.

Other Risk FactorsRegulatory Risk.As a mortgage lender, we are subject to many laws and regulations. Any failure to comply with these rules and their interpretations or with any future interpretations or judicial decisions could harm our profitability or cause a change in the way we do business. For example, several lawsuits have been filed challenging types of payments made by mortgage lenders to mortgage brokers. Similarly, in our branch operations, we allow our branch managers considerable autonomy, which could result in our facing greater exposure to third-party claims if our compliance programs are not strictly adhered to.

 

Although management considersState and local governing bodies are focused on the risk components set forth abovenonconforming lending business and are concerned about borrowers paying “excessive fees” in obtaining a mortgage loan – generally termed “predatory lending”. In several instances, states or local governing bodies have imposed strict laws on lenders to be its primary business risks, the followingcurb predatory lending. To date, these laws have not had a significant impact on our business. We have capped fee structures consistent with those adopted by federal mortgage agencies and have implemented rigid processes to ensure that our lending practices are other risks that should be considered by our investors. Further information regarding these risks is includednot predatory in our registration statements filed with the Commission.nature.

 

Failure to renew or obtain adequate funding under warehouse facilities and repurchase agreements may harm our lending operations.We are currently dependent upon a limited number of primary credit facilities for funding of our mortgage loan originations and acquisitions. Any failure to renew or obtain adequate funding under these financing arrangements could harm our lending operations and our overall performance. An increase in the cost of financing in excess of any change in the income derived from our mortgage assets could also harm our earnings and reduce the cash available for distributions to our stockholders. In October 1998, the subprime mortgage loan market faced a liquidity crisis with respect to the availability of short-term borrowings from major lenders and long-term borrowings through securitization. We faced significant liquidity constraints which harmed our business and our profitability.

We regularly monitor the laws, rules and regulations that apply to our business and analyze any changes to them. We integrate many legal and regulatory requirements into our automated loan origination system to reduce the prospect of inadvertent non-compliance due to human error. We also maintain policies and procedures, summaries and checklists to help our origination personnel comply with these laws. Our training programs are designed to teach our personnel about the significant laws, rules and regulations that affect their job responsibilities.

An interruption or reduction in the securitization and whole loan markets or change in terms offered by these markets would hurt our financial position. We are dependent on the securitization market for the sale of our loans because we securitize loans directly and many of our whole loan buyers purchase our loans with the intention to securitize. The securitization market is dependent upon a number of factors, including general economic conditions, conditions in the securities market generally and conditions in the asset-backed securities market specifically. In addition, poor performance of our previously securitized loans could harm our access to the securitization market. Accordingly, a decline in the securitization market, the ability to obtain attractive terms or a change in the market’s demand for our loans could have a material adverse effect on our results of operations, financial condition and business prospects.

Financing with repurchase agreements may lead to margin calls if the market value of mortgage assets declines.We use repurchase agreements to finance the acquisition of mortgage assets in the short-term. In a repurchase agreement, we sell an asset and agree to repurchase the same asset at some period in the future. Generally, the repurchase agreements we entered into stipulate that we must repurchase the asset in 30 days. For financial accounting purposes, these arrangements are treated as secured financings. We retain the assets on our balance sheet and record an obligation to repurchase the asset. The amount we may borrow under these arrangements is generally 96% to 98% of the asset market value. When asset market values decrease, we are required to repay the margin, or difference in market value. To the extent the market values of assets financed with repurchase agreements decline rapidly, we will be required to meet cash margin calls. If cash is unavailable, we may be forced to default under the terms of the repurchase agreement. In that event, the lender retains the right to liquidate the collateral to settle the amount due from us.

Limited access to additional capital may ultimately curtail growth.Cash is required to fund loans we originate as financing arrangements allow us to borrow a percentage, typically 98%, of the mortgage note amount. If we are unable to obtain sufficient cash resources, we may not sustain asset growth.

Changes in interest rates may harm our results of operations. Our results of operations are likely to be harmed during any period of unexpected or rapid changes in interest rates. For example, a substantial or sustained increase in interest rates could harm our ability to acquire mortgage loans in expected volumes. This could result in a decrease in our earnings and our ability to support our fixed overhead expense levels. Interest rate fluctuations may harm our earnings as a result of potential changes in the spread between the interest rates on our borrowings and the interest rates on our mortgage assets. In addition, mortgage prepayment rates vary depending on such factors as mortgage interest rates and market conditions. Changes in anticipated prepayment rates may harm our earnings.

Failure to hedge effectively against interest rate changes may harm our results of operations.We attempt to minimize exposure to interest rate fluctuations by hedging. Asset/liability management hedging strategies involve risk and may not be effective in reducing our exposure to interest rate changes. Moreover, compliance with the REIT provisions of the Code may prevent us from effectively implementing the strategies that we determine, absent such compliance, would best insulate us from the risks associated with changing interest rates.

Mortgage insurers may not pay claims resulting in increased credit losses or may in the future change their pricing or underwriting guidelines.We have placed reliance on mortgage insurance to mitigate the risk of credit losses.

However there can be no assurance that the mortgage insurers will continue to have the financial ability to pay all claims presented. In addition, insurers have the right to deny a claim if the loan is not properly serviced or has been improperly originated. We have the risk that mortgage insurance providers will revise their guidelines to an extent where we will no longer be able to acquire coverage on all of our new production. Similarly, the providers may also increase insurance premiums to a point where the cost of coverage outweighs its benefit.

Differences in our actual experience compared to the assumptions that we use to determine the value of our mortgage securities could adversely affect our financial position.Currently, our securitization transactions are structured to be treated as sales for financial reporting purposes and, therefore, result in gain recognition at closing. Delinquency, loss, prepayment and discount rate assumptions have a material impact on the amount of gain recognized and on the carrying value of the retained mortgage securities. Gain on sale accounting may create volatile earnings in certain environments, including when loan securitizations are not completed on a consistent schedule. If our actual experience differs materially from the assumptions that we use to determine the value of our mortgage securities, future cash flows, earnings and equity could be negatively affected.

Changes in accounting standards might cause us to alter the way we structure or account for securitizations. Changes could be made to current accounting standards which would limit the types of transactions eligible for gain on sale treatment. These changes could cause us to alter the way we either structure or account for securitizations.

We face loss exposure due to the underlying real estate.A substantial portion of our mortgage assets consist of single family mortgage loans or mortgage securities evidencing interests in single family mortgage loans. Any material decline in real estate values would weaken our collateral loan-to-value ratios and increase the possibility of loss if a borrower defaults. In such event, we will be subject to the risk of loss on such mortgage assets arising from borrower defaults to the extent not covered by third-party credit enhancement.

Loans made to nonconforming mortgage borrowers entail relatively higher delinquency and loss rates.Lenders in the nonconforming mortgage banking industry make loans to borrowers who have impaired or limited credit histories, limited documentation of income and higher debt-to-income ratios than traditional mortgage lenders allow. Mortgage loans made to nonconforming mortgage loan borrowers generally entail a relatively higher risk of delinquency and foreclosure than mortgage loans made to borrowers with better credit and, therefore, may result in higher levels of realized losses. Any failure by us to adequately address the risks of nonconforming lending would harm our results of operations, financial condition and business prospects.

Current loan performance data may not be indicative of future results.Management uses estimates and assumptions based on actual experience with the mortgage loans. Actual results and the timing of certain events could differ materially from those projected, due to factors including general economic conditions, fluctuations in interest rates, fluctuations in prepayment speeds and fluctuations in losses due to defaults on mortgage loans. These fluctuations could rise to levels that would harm our profitability.

Market factors may limit our ability to acquire mortgage assets at yields that are favorable relative to borrowing costs. Despite management’s experience in the acquisition of mortgage assets and its relationships with various mortgage suppliers, there can be no assurance that we will be able to acquire sufficient mortgage assets from mortgage suppliers which earn interest rates greater than our cost of funds and at levels sufficient to maintain our profitability.

Intense competition in the nonconforming mortgage loan industry may result in reduced net income or in revised underwriting standards that would harm our operations. We face intense competition, primarily from commercial banks, thrifts, other independent mortgage lenders and other mortgage REITs. The government-sponsored entities Fannie Mae and Freddie Mac are also expanding their participation in the subprime mortgage industry. Any increase in the competition among lenders to originate or purchase nonconforming mortgage loans may result in either reduced interest income on such mortgage loans compared to present levels which may reduce net income or revised underwriting standards permitting higher loan-to-value ratios on properties securing nonconforming mortgage loans which may harm our operations.

Our failure to comply with federal, state or local regulation of mortgage lending, of broker compensation programs or of our local branch operations could adversely affect our operations and profitability.As a mortgage lender, we are subject to many laws and regulations. Any failure to comply with these rules and their interpretations or with any future interpretations or judicial decisions could harm our profitability or cause a change in the way we do

business. For example, several lawsuits have been filed challenging types of payments made by lenders to brokers, which payments are similar in type to the payments we make to our independent brokers. Similarly, in our branch operations, we allow our branch managers considerable autonomy which could result in greater exposure to third-party claims if our compliance programs are not strictly adhered to.

New legislation could restrict our ability to make mortgage loans, which could adversely impact our earnings.Several states and cities are considering or have passed laws, regulations or ordinances aimed at curbing predatory lending practices. The federal government is also considering legislative and regulatory proposals in this regard. In general, these proposals involve lowering the existing federal Homeownership and Equity Protection Act thresholds for defining a “high-cost” loan, and establishing enhanced protections and remedies for borrowers who receive such loans. Passage of these laws and rules could reduce our loan origination volume. In addition, many whole loan buyers may elect not to purchase any loan labeled as a “high cost” loan under any local, state or federal law or regulation. Rating agencies likewise may refuse to rate securities backed by such loans. Accordingly, these laws and rules could severely restrict the secondary market for a significant portion of our loan production. This would effectively preclude us from continuing to originate loans that fit within the newly defined thresholds and could have a material adverse effect on our business.

Should we fail to maintain REIT status, we would be subject to tax as a regular corporation. We conduct a substantial portion of our business through our taxable REIT subsidiaries which creates additional compliance requirements. We must comply with various tests to continue to qualify as a REIT for federal income tax purposes. We conduct a substantial portion of our business through taxable REIT subsidiaries, such as NovaStar Mortgage. Despite our qualification as a REIT, our taxable REIT subsidiaries must pay federal income tax on their taxable income. Our income from and investments in our taxable REIT subsidiaries generally do not constitute permissible income and investments for some of the REIT qualification tests. While we attempt to ensure that our dealings with our taxable REIT subsidiaries will not adversely affect our REIT qualification, no assurance can be given that we will successfully achieve that result. Furthermore, we may be subject to a 100% penalty tax, or our taxable REIT subsidiary may be denied deductions, to the extent that our dealings with our taxable REIT subsidiaries (such as our receipt of loan guarantee payments) are deemed not to be arm’s length in nature.

We have a limited operating history and incurred significant net losses in 1999 and 1998.We have not yet developed an extensive earnings history or experienced a wide variety of interest rate or market conditions. Historical operating performance may be of limited relevance in predicting future performance. We incurred significant net losses in 1999 and 1998.

Restrictions on ownership of capital stock may inhibit market activity and the resulting opportunity for holders of our capital stock to receive a premium for their securities.In order for us to meet the requirements for qualification as a REIT, our charter generally prohibits any person from acquiring or holding, directly or indirectly, shares of capital stock in excess of 9.8% of the outstanding shares. This restriction may inhibit market activity and the resulting opportunity for the holders of our capital stock to receive a premium for their stock that might otherwise exist in the absence of such restrictions.

The recent adoption of tax relief legislation could negatively impact the attractiveness of REIT stock as an investment. The recently enacted Jobs and Growth Tax Relief Reconciliation Act of 2003, Pub. Law 108-27, contains a provision to reduce from 38.6% to 15% the maximum rate of income taxation for individuals on dividends paid by most types of tax-paying corporations. Dividends paid by REITs are not eligible for such treatment except in limited circumstances which we do not expect will apply in our case to a material extent. The adoption of this tax relief provision may reduce the appeal of REITs to investors and may have a negative effect on the market value of our stock.

 

U.S. Federal Income Tax Consequences

 

The following general discussion summarizes the material U.S. federal income tax considerations regarding our qualification and taxation as a REIT. This discussion is based on interpretations of the Code, regulations issued thereunder, and rulings and decisions currently in effect (or in some cases proposed), all of which are subject to change. Any such change may be applied retroactively and may adversely affect the federal income tax consequences described herein. This summary does not discuss all of the tax consequences that may be relevant to particular shareholders or shareholders subject to special treatment under the federal income tax laws. Accordingly, you should consult your own tax advisor regarding the federal, state, local, foreign, and other tax consequences of your ownership and our REIT election, and regarding potential changes in applicable tax laws.

General. Since inception, we have elected to be taxed as a REIT under Sections 856 through 859 of the Code. We believe we have complied, and intend to comply in the future, with the requirements for qualification as a REIT under the Code. To the extent that we qualify as a REIT for federal income tax purposes, we generally will not be subject to federal income tax on the amount of income or gain that is distributed to shareholders. However, origination and broker operations are conducted through NovaStar Mortgage and NovaStar Home Mortgage,NHMI, which are owned by NFI Holding, Inc. – a taxable REIT subsidiary (TRS)(“TRS”). Consequently, all of the taxable income of NFI Holding, Inc. is subject to federal and state corporate income taxes. In general, a TRS may hold assets that a REIT cannot hold directly and generally may engage in any real estate or non-real estate related business. However, special rules do apply to certain activities between a REIT and its TRS. For example, a TRS

will be subject to earnings stripping limitations on the deductibility of interest paid to its REIT. In addition, a REIT will be subject to a 100% excise tax on certain excess amounts to ensure that (i) tenants who payamounts paid to a TRS for services are based on amounts that would be charged in an arm’s-length amount by the TRS,transaction, (ii) fees paid to a REIT by its TRS are reflected at fair market value and (iii) interest paid by a TRS to its REIT is commercially reasonable.

 

The REIT rules generally require that a REIT invest primarily in real estate related assets, its activities be passive rather than active and it distribute annually to its shareholders substantially all of its taxable income. We could be subject to a number of taxes if we failed to satisfy those rules or if we acquired certain types of income-producing real property through foreclosure. Although no complete assurance can be given, we do not expect that we will be subject to material amounts of such taxes.

Failure to satisfy certain Code requirements could cause loss of REIT status. If we fail to qualify as a REIT for any taxable year, we would be subject to federal income tax (including any applicable minimum tax) at regular corporate rates and would not receive deductions for dividends paid to shareholders. As a result, the amount of after-tax earnings available for distribution to shareholders would decrease substantially. While we intend to operate in a manner that will enable itus to qualify as a REIT in future taxable years, there can be no certainty that such intention will be realized. Loss of REIT status would reduce the amount of any distributions by taxes due, but the character of such distributions for tax purposes should be unaffected.

 

Qualification as a REIT. Qualification as a REIT requires that we satisfy a variety of tests relating to income, assets, distributions and ownership. The significant tests are summarized below. We will make available more detailed information regarding our compliance with the REIT rules upon request.

 

Sources of Income. WeTo qualify as a REIT, we must satisfy two tests with respect to the sourcesgross income requirements, each of income: the 75% income test, and the 95% income test. The 75% income test requires that we derivewhich is applied on an annual basis. First, at least 75% of our gross income, excluding gross income from prohibited transactions, for each taxable year generally must be derived directly or indirectly from:

rents from certain real estate-related sources. In orderproperty;

interest on debt secured by mortgages on real property or on interests in real property;

dividends or other distributions on, and gain from the sale of, stock in other REITs;

gain from the sale of real property or mortgage loans;

amounts, such as commitment fees, received in consideration for entering into an agreement to satisfymake a loan secured by real property, unless such amounts are determined by income and profits;

income derived from a Real Estate Mortgage Investment Conduit (“REMIC”) in proportion to the 95% income test,real estate assets held by the REMIC, unless at least an additional 20%95% of the REMIC’s assets are real estate assets, in which case all of the income derived from the REMIC; and

interest or dividend income from investments in stock or debt instruments attributable to the temporary investment of new capital during the one-year period following our receipt of new capital that we raise through equity offerings or public offerings of debt obligations with at least a five-year term.

Second, at least 95% of our gross income, excluding gross income from prohibited transactions, for theeach taxable year must consist eitherbe derived from sources that qualify for purposes of income that qualifies under the 75% gross income test, and from (i) dividends, (ii) interest, (iii) certain qualifying hedges entered into prior to January 1, 2005 and (iv) gain from the sale or dividends and interest. other disposition of stock, securities, or, certain qualifying hedges entered into prior to January 1, 2005.

Management believes that income qualified forwe were in compliance with both of the income tests during 2003.for the 2005 and 2004 calendar years.

 

Nature and Diversification of Assets. As of the last day of each calendar quarter, we must meet foursix requirements under the two asset tests. Under the 75% of assets test, at least 75% of the value of our total assets must represent cash or cash items (including receivables), government securities or real estate assets. SecuritiesUnder the 25% of assets test, no more than 25% of the TRS do constitute non-realvalue of our total assets can be represented by securities, other than (A) government securities, (B) stock of a qualified REIT subsidiary and (C) securities that qualify as real estate assets for purposesunder the 75% assets test ((A), (B) and (C) are collectively the “75% Securities”). Additionally, under the 25% assets test, no more than 20% of the value of our total assets can be represented by securities of one or more taxable REIT subsidiaries and no more than 5% of the value of our total assets can be represented by the securities of a single issuer, excluding 75% test. Under the 10% asset test,Securities. Furthermore, we may not own more than 10% of the total voting power or the total value of the outstanding securities of any single non-governmentalone issuer, if these securities do not qualify under theexcluding 75% asset test. There is an exception for electing corporations of which we own at least 35% of the outstanding securities. We intend to make this election. Under the 5% asset test, ownership of any stocks or securities that do not qualify under the 75% asset test must be limited, in respect of any single non-governmental issuer, to an amount not greater than 5% of the value of our total assets. Under the 20% asset test, no more than 20% of our total assets can consist of securities of one or more taxable REIT subsidiaries. The definition of security for this purpose includes financial contracts and instruments that we acquire in the normal course of business.Securities.

 

If we inadvertently fail to satisfy one or more of the asset tests at the end of a calendar quarter, such failure would not cause us to lose our REIT status. We could still could avoid disqualification by eliminating any discrepancy within 30 days after the close of the calendar quarter in which the discrepancy arose. Management believes that we compliedwere in compliance with all of the requirements of both asset tests for all quarters during 2003.2005 and 2004.

 

Ownership of Common Stock. Our capital stock must be held by a minimum of 100 persons for at least 335 days of each year. In addition, at all times during the second half of each taxable year, no more than 50% in value of our capital stock may be owned

directly or indirectly by 5 or fewer individuals. We use the calendar year as our taxable year for income tax purposes. The Code requires us to send annual information questionnaires to specified shareholders in order to assure compliance with the ownership tests. Management believes that we have complied with these stock ownership tests for 2003.2005 and 2004.

 

Distributions. We must distribute at least 90% of our taxable income and any after-tax net income from certain types of foreclosure property less any non-cash income. No distributions are required in periods in which there is no income.

 

Taxable IncomeIncome.. We use the calendar year for both tax and financial reporting purposes. However, there may be differences between taxable income and income computed in accordance with accounting principles generally accepted in the United States of America (GAAP).GAAP. These differences primarily arise from timing and character differences in the recognition of revenue and expense and gains and losses for tax and GAAP purposes. Additionally, taxable income does not include the taxable income of our taxable subsidiary, although the subsidiary’s operating results are included in our GAAP results.

Personnel

 

As of December 31, 2003,2005, we employed 1,4762,032 people. Of these, 1,3631,678 were employed in our mortgage portfolio management, mortgage lending and loan servicing operations and the remainder in our portfolio management and branch administrative functions.operations. Our branches employed 3,122347 people as of December 31, 2003.2005. The remaining employees were employed in our branch administrative functions.

Available Information

Copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to these reports filed or furnished with the SEC are available free of charge through our Internet site (www.novastarmortgage.com) as soon as reasonably practicable after filing with the SEC. References to our website do not incorporate by reference the information on such website into this Annual Report on Form 10-K and we disclaim any such incorporation by reference. Copies of our board committee charters, our board’s Corporate Governance Guidelines, Code of Conduct, and other corporate governance information are available at the Corporate Governance section of our Internet site (www.novastarmortgage.com), or by contacting us directly. Our investor relations contact information follows.

Investor Relations

8140 Ward Parkway, Suite 300

Kansas City, MO 64114

816.237.7000

Email: ir@novastar1.com

Item 1A.Risk Factors

Risk Factors

You should carefully consider the risks described below before investing in our publicly traded securities. The risks described below are not the only ones facing us. Our business is also subject to the risks that affect many other companies, such as competition, inflation, technological obsolescence, labor relations, general economic conditions and geopolitical events. Additional risks not currently known to us or that we currently believe are immaterial also may impair our business operations and our liquidity.

Risks Related to Our Borrowing and Securitization Activities

Our growth is dependent on leverage, which may create other risks.

Our success is dependent, in part, upon our ability to grow our assets through the use of leverage. Leverage creates an opportunity for increased net income, but at the same time creates risks. For example, leveraging magnifies changes in our net worth. We will incur leverage only when there is an expectation that it will enhance returns. Moreover, there can be no assurance that we will be able to meet our debt service obligations and, to the extent that we cannot, our ability to make expected minimum REIT dividend requirements to shareholders will be adversely affected. Furthermore, if we were to liquidate, our debt holders and lenders will receive a distribution of our available assets before any distributions are made to our common shareholders.

An interruption or reduction in the securitization market or our ability to access this market would harm our financial position.

We are dependent on the securitization market because we securitize loans directly to finance our loan origination business and many of our whole loan buyers purchase our loans with the intention to securitize. A disruption in the securitization market could prevent us from being able to sell loans at a favorable price or at all. Factors that could disrupt the securitization market include an international liquidity crisis such as occurred in the fall of 1998, sudden changes in interest rates, a terrorist attack, an outbreak of war or other significant event risk, and market specific events such as a default of a comparable type of securitization. In addition, poor performance of our previously securitized loans could harm our access to the securitization market. In addition, a court recently found a lender and securitization underwriter liable for consumer fraud committed by a company to whom they provided financing and underwriting services. In the event other courts or regulators adopted the same liability theory, lenders and underwriters could be named as defendants in more litigation and as a result they may exit the business or charge more for their services, all of which could have a negative impact on our ability to securitize the loans we originate and the securitization market in general. A decline in our ability to obtain long-term funding for our mortgage loans in the securitization market in general or on attractive terms or a decline in the market’s demand for our loans could harm our results of operations, financial condition and business prospects.

Failure to renew or obtain adequate funding under warehouse repurchase agreements may harm our lending operations.

We are currently dependent upon several warehouse purchase agreements to provide short term financing of our mortgage loan originations and acquisitions. These warehouse purchase agreements contain numerous representations, warranties and covenants, including requirements to maintain a certain minimum net worth, minimum equity ratios and other customary debt covenants. If we were unable to make the necessary representations and warranties at the time we need financing, we would not be able to obtain needed funds. In addition, if we breach a covenant contained in any warehouse agreement, the lenders under all existing warehouse agreements could demand immediate payment of all outstanding amounts because all of our warehouse agreements contain cross-default provisions. Any failure to renew or obtain adequate funding under these financing arrangements for any reason, or any demand by warehouse lenders for immediate payment of outstanding balances could harm our lending operations and have a material adverse effect on our results of operations, financial condition and business prospects. In addition, an increase in the cost of warehouse financing in excess of any change in the income derived from our mortgage assets could also harm our earnings and reduce the cash available for distribution to our shareholders. In October 1998, the subprime mortgage loan market faced a liquidity crisis with respect to the availability of short-term borrowings from major lenders and long-term borrowings through securitization. At that time, we faced significant liquidity constraints which harmed our business and our profitability.

Financing with warehouse repurchase agreements may lead to margin calls if the market value of our mortgage assets declines.

We use warehouse repurchase agreements to finance our acquisition of mortgage assets in the short-term. In a warehouse repurchase agreement, we sell an asset and agree to repurchase the same asset at some point in time in the future. Generally, the

repurchase agreements we enter into provide that we must repurchase the asset in 30 days. For financial accounting purposes, these arrangements are treated as secured financings. We retain the assets on our balance sheet and record an obligation to repurchase the asset. The amount we may borrow under these arrangements is generally 95% to 100% of the asset market value with respect to mortgage loans and 65% to 80% of the asset market value with respect to mortgage securities—available-for-sale. When, in a lender’s opinion, asset market values decrease for any reason, including a rise in interest rates or general concern about the value or liquidity of the assets, we are required to repay the margin or difference in market value, or post additional collateral. If cash or additional collateral is unavailable to meet margin calls, we may default on our obligations under the applicable repurchase agreement. In that event, the lender retains the right to liquidate the collateral we provided it to settle the amount due from us. In addition to obtain cash, we may be required to liquidate assets at a disadvantageous time, which would cause us to incur losses and could change our mix of investments, which in turn could jeopardize our REIT status or our ability to rely on certain exemptions under the Investment Company Act.

We have credit exposure with respect to loans we sell to the whole loan market and loans we sell to securitization entities.

When we sell whole loans or securitize loans, we have potential credit and liquidity exposure for loans that are the subject of fraud, that have irregularities in their documentation or process, or that result in our breaching the representations and warranties in the contract of sale. In addition, when we sell loans to the whole loan market we have exposure for loans that default. In these cases, we may be obligated to repurchase loans at principal value, which could result in a significant decline in our available cash. When we purchase loans from a third party that we sell into the whole loan market or to a securitization trust, we obtain representations and warranties from the counter-parties that sold the loans to us that generally parallel the representations and warranties we provided to our purchasers. As a result, we believe we have the potential for recourse against the seller of the loans. However, if the representations and warranties are not parallel, or if the original seller is not in a financial position to be able to repurchase the loan, we may have to use cash resources to repurchase loans, which could adversely affect our liquidity.

Competition in the securitization market may negatively affect our net income.

Competition in the business of sponsoring securitizations of the type we focus on is increasing as Wall Street broker-dealers, mortgage REITs, investment management companies, and other financial institutions expand their activities or enter this field. Increased competition could reduce our securitization margins if we have to pay a higher price for the long-term funding of these assets. To the extent that our securitization margins erode, our results of operations, financial condition and business prospects will be negatively impacted.

Differences in our actual experience compared to the assumptions that we use to determine the value of our mortgage securities—available-for-sale could adversely affect our financial position.

Currently, our securitizations of mortgage loans are structured to be treated as sales for financial reporting purposes and, therefore, result in gain recognition at closing. As of December 31, 2005, we had mortgage securities – available for sale with a fair value of $505.6 million on our balance sheet. Delinquency, loss, prepayment and discount rate assumptions have a material impact on the amount of gain recognized and on the carrying value of the retained mortgage securities—available-for-sale. It is extremely difficult to validate the assumptions we use in determining the amount of gain on sale and the value of our mortgage securities – available for sale. If our actual experience differs materially from the assumptions that we use to determine our gain on sale or the value of our mortgage securities—available-for-sale, our future cash flows, our financial condition and our results of operations could be negatively affected.

Changes in accounting standards might cause us to alter the way we structure or account for securitizations.

Changes could be made to the current accounting standards, which could affect the way we structure or account for securitizations. For example, if changes were made in the types of transactions eligible for gain on sale treatment, we may have to change the way we account for securitizations, which may harm our results of operations or financial condition.

Risks Related to Interest Rates and Our Hedging Strategies

Changes in interest rates may harm our results of operations.

Our results of operations are likely to be harmed during any period of unexpected or rapid changes in interest rates. Interest rate changes could affect us in the following ways:

a substantial or sustained increase in interest rates could harm our ability to originate or acquire mortgage loans in expected volumes, which could result in a decrease in our cash flow and in our ability to support our fixed overhead expense levels;

interest rate fluctuations may harm our earnings as the spread between the interest rates we pay on our borrowings and the interest rates we receive on our mortgage assets narrows;

mortgage prepayment rates vary depending on such factors as mortgage interest rates and market conditions, and changes in anticipated prepayment rates may harm our earnings; and

when we securitize loans, the value of the residual and subordinated securities we retain and the income we receive from them are based primarily on the London Inter-Bank Offered Rate, or LIBOR, and an increase in LIBOR reduces the net income we receive from, and the value of, these securities.

Any of the foregoing results from changing interest rates may adversely affect our results from operations.

Hedging against interest rate exposure may adversely affect our earnings, which could adversely affect cash available for distribution to our shareholders.

We may enter into interest rate cap or swap agreements or pursue other interest rate hedging strategies. Our hedging activity will vary in scope based on interest rates, the type of mortgage assets held, and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect us because, among other things:

interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates;

hedging instruments involve risk because they often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities; consequently, there are no requirements with respect to record keeping, financial responsibility or segregation of customer funds and positions, and the enforceability of agreements underlying derivative transactions may depend on compliance with applicable statutory, commodity and other regulatory requirements;

available interest rate hedging may not correspond directly with the interest rate risk for which protection is sought;

the duration of the hedge may not match the duration of the related liability or asset;

the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction;

the party owing money in the hedging transaction may default on its obligation to pay, which may result in the loss of unrealized profits; and

we may not be able to dispose of or close out a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an offsetting contract in order to cover our risks.

Any hedging activity we engage in may adversely affect our earnings, which could adversely affect cash available for distribution to our shareholders. Unanticipated changes in interest rates may result in poorer overall investment performance than if we had not engaged in any such hedging transactions.

Complying with REIT requirements may limit our ability to hedge effectively.

We attempt to minimize exposure to interest rate fluctuations by hedging. The REIT provisions of the Code limit our ability to hedge mortgage assets and related borrowings by requiring us to limit our income in each year from any qualified hedges, together with any other income not generated from qualified real estate assets, to no more than 25% of our gross income. The interest rate hedges that we generally enter into will not be counted as a qualified asset for the purposes of satisfying this requirement. In addition, under the Code, we must limit our aggregate income from non-qualified hedging transactions and from other non-qualifying sources to no more than 5% of our annual gross income. As a result, we may have to limit our use of advantageous hedging techniques. This could result in greater risks associated with changes in interest rates than we would otherwise want to incur. In addition, if it is ultimately determined that certain of our interest rate hedging transactions are non-qualified under the

Code, we may have more than 5% of our annual gross income from non-qualified sources. If we violate the 5% or 25% limitations, we may have to pay a penalty tax equal to the amount of income in excess of those limitations, multiplied by a fraction intended to reflect our profitability. In addition, if we fail to observe these limitations, we could lose our REIT status unless our failure was due to reasonable cause and not due to willful neglect.

Risks Related to Credit Losses and Prepayment Rates

Loans made to nonconforming mortgage borrowers entail relatively higher delinquency and default rates which would result in higher loan losses.

Lenders in the nonconforming mortgage banking industry make loans to borrowers who have impaired or limited credit histories, limited documentation of income and higher debt-to-income ratios than traditional mortgage lenders allow. Mortgage loans made to nonconforming mortgage loan borrowers generally entail a relatively higher risk of delinquency and foreclosure than mortgage loans made to borrowers with better credit and, therefore, may result in higher levels of realized losses. Delinquency interrupts the flow of projected interest income from a mortgage loan, and default can ultimately lead to a loss if the net realizable value of the real property securing the mortgage loan is insufficient to cover the principal and interest due on the loan. Also, our cost of financing and servicing a delinquent or defaulted loan is generally higher than for a performing loan. We bear the risk of delinquency and default on loans beginning when we originate them. In whole loan sales, our risk of delinquency and default typically only extends to the first payment but can extend up to the third payment. When we securitize any of our loans, we continue to be exposed to delinquencies and losses, either through our residual interests for securitizations structured as sales or through the loans still recorded on our balance sheet for securitizations structured as financings. We also re-acquire the risks of delinquency and default for loans that we are obligated to repurchase. Any failure by us to adequately address the delinquency and default risk associated with nonconforming lending could harm our financial condition and results of operations.

Our efforts to manage credit risk may not be successful in limiting delinquencies and defaults in underlying loans and, as a result, our results of operations may be affected.

There are many aspects of credit that we cannot control and our quality control and loss mitigation operations may not be successful in limiting future delinquencies, defaults and losses. Our comprehensive underwriting process may not be effective in mitigating our risk of loss on the underlying loans. Further, the value of the homes collateralizing residential loans may decline due to a variety of reasons beyond our control, such as weak economic conditions, natural disasters, over-leveraging of the borrower, and reduction in personal incomes. The frequency of defaults and the loss severity on loans upon default may be greater than we anticipated. Interest-only loans, negative amortization loans, adjustable-rate loans, reduced documentation loans, sub-prime loans, home equity lines of credit and second lien loans may involve higher than expected delinquencies and defaults. Changes in consumer behavior, bankruptcy laws, and other laws may exacerbate loan losses. Expanded loss mitigation efforts in the event that defaults increase could increase our operating costs. To the extent that unforeseen or uncontrollable events increase loan delinquencies and defaults, our results of operations may be adversely affected.

Mortgage insurers may in the future change their pricing or underwriting guidelines or may not pay claims resulting in increased credit losses.

We use mortgage insurance to mitigate our risk of credit losses. Our decision to obtain mortgage insurance coverage is dependent, in part, on pricing trends. Mortgage insurance coverage on our new mortgage loan production may not be available at rates that we believe are economically viable for us or at all. We also face the risk that our mortgage insurers might not have the financial ability to pay all claims presented by us or may deny a claim if the loan is not properly serviced, has been improperly originated, is the subject of fraud, or for other reasons. Any of those events could increase our credit losses and thus adversely affect our results of operations and financial condition.

Our Option ARM mortgage product exposes us to greater credit risk

There has been an increase in production of our loan product which is characterized as an option ARM loan. There have been recent announcements by federal regulators concerning interest-only loan programs, option ARM loan programs and other ARM loans with deeply discounted initial rates and/or negative amortization features. Federal banking regulators have expressed serious concerns with these programs and an intent to issue guidance shortly concerning offerings of these products. In addition, already one rating agency (Standard & Poors) has required greater credit enhancements for securitization pools that are backed by option ARMs. The combination of these events could lead to the loan product becoming a less available financing option and hence this could have a material affect on the value of such products.

Our interest-only loans may have a higher risk of default than our fully-amortizing loans.

For the year ended December 31, 2005, originations of interest-only loans totaled $2.0 billion, or 22%, of total originations. These interest-only loans require the borrowers to make monthly payments only of accrued interest for the first 24, 36 or 120 months following origination. After such interest-only period, the borrower’s monthly payment is recalculated to cover both interest and principal so that the mortgage loan will amortize fully prior to its final payment date. The interest-only feature may reduce the likelihood of prepayment during the interest-only period due to the smaller monthly payments relative to a fully-amortizing mortgage loan. If the monthly payment increases, the related borrower may not be able to pay the increased amount and may default or may refinance the related mortgage loan to avoid the higher payment. Because no principal payments may be made on such mortgage loans for an extended period following origination, if the borrower defaults, the unpaid principal balance of the related loans would be greater than otherwise would be the case for a fully-amortizing loan, increasing the risk of loss on these loans.

Current loan performance data may not be indicative of future results.

When making capital budgeting and other decisions, we use projections, estimates and assumptions based on our experience with mortgage loans. Actual results and the timing of certain events could differ materially in adverse ways from those projected, due to factors including changes in general economic conditions, fluctuations in interest rates, fluctuations in mortgage loan prepayment rates and fluctuations in losses due to defaults on mortgage loans. These differences and fluctuations could rise to levels that may adversely affect our profitability.

Changes in prepayment rates of mortgage loans could reduce our earnings, dividends, cash flows, access to liquidity and results of operations.

The economic returns we expect to earn from most of the mortgage assets we own are affected by the rate of prepayment of the underlying mortgage loans. If the loans underlying our mortgage securities—available-for-sale prepay at a rate faster than we have anticipated, our economic returns on those assets will be lower than we have assumed which would reduce our earnings, cash flows and dividends. Adverse changes in cash flows from a mortgage asset resulting from accelerated prepayments would likely reduce the asset’s market value, which would likely reduce our access to liquidity if we borrowed against that asset and may cause a market value write-down for GAAP purposes, which would reduce our reported earnings. Changes in loan prepayment patterns can affect us in a variety of other ways that can be complex and difficult to predict. In addition, our exposure to prepayment changes over time. As a result, changes in prepayment rates will likely cause volatility in our financial results in ways that are not necessarily obvious or predictable and that may adversely affect our results of operations.

Geographic concentration of mortgage loans we originate or purchase increases our exposure to risks in those areas, especially in California and Florida.

Over-concentration of loans we originate or purchase in any one geographic area increases our exposure to the economic and natural hazard risks associated with that area. Declines in the residential real estate markets in which we are concentrated may reduce the values of the properties collateralizing our mortgages which in turn may increase the risk of delinquency, foreclosure, bankruptcy, or losses from those loans. To the extent that a large number of loans are impaired, our financial condition and results of operations may be adversely affected.

To the extent that we have a large number of loans in an area hit by a natural disaster, we may suffer losses.

Standard homeowner insurance policies generally do not provide coverage for natural disasters, such as hurricanes and floods. Furthermore, nonconforming borrowers are not likely to have special hazard insurance. To the extent that borrowers do not have insurance coverage for natural disasters, they may not be able to repair the property or may stop paying their mortgages if the property is damaged. A natural disaster that results in a significant number of delinquencies could cause increased foreclosures and decrease our ability to recover losses on properties affected by such disasters, and that in turn could harm our financial condition and results of operations.

Uninsured losses due to the Gulf State hurricanes could adversely affect our financial condition and results of operations.

The damage caused by the Gulf State hurricanes, particularly Katrina, Rita and Wilma, has affected the value of our portfolio of mortgage loans held-for-sale and the mortgage loan portfolio we service which underlies our mortgage securities – available-for-sale by impairing the ability of certain borrowers to repay their loans. At present, we are unable to predict the ultimate impact of the Gulf State hurricanes on our future financial results and condition as the impact will depend on a number of factors, including the extent of damage to the collateral, the extent to which damaged collateral is not covered by insurance, the extent to which unemployment and other economic conditions caused by the hurricanes adversely affect the ability of borrowers to repay their

loans, and the cost to us of collection and foreclosure moratoriums, loan forbearances and other accommodations granted to borrowers. Many of the loans are to borrowers where repayment prospects have not yet been determined to be diminished, or are in areas where properties may have suffered little, if any, damage or may not yet have been inspected. We currently have a mortgage protection insurance policy, which protects us from uninsured losses as a result of these hurricanes up to a maximum of $5 million in aggregate losses with a deductible of $100,000 per hurricane. To the extent that losses exceed the $5 million aggregate loss insurance coverage, our financial condition and results of operations could be adversely affected. Additionally, there is no guarantee the insurance company will pay our claims, which could adversely affect our results of operations.

A prolonged economic slowdown or a decline in the real estate market could harm our results of operations.

A substantial portion of our mortgage assets consist of single-family mortgage loans or mortgage securities—available-for-sale evidencing interests in single-family mortgage loans. Because we make a substantial number of loans to credit-impaired borrowers, the actual rates of delinquencies, foreclosures and losses on these loans could be higher during economic slowdowns. Any sustained period of increased delinquencies, foreclosures or losses could harm our ability to sell loans, the prices we receive for our loans, the values of our mortgage loans held for sale or our residual interests in securitizations, which could harm our financial condition and results of operations. In addition, any material decline in real estate values would weaken our collateral loan-to-value ratios and increase the possibility of loss if a borrower defaults. In such event, we will be subject to the risk of loss on such mortgage asset arising from borrower defaults to the extent not covered by third-party credit enhancement.

Risks Related to the Legal and Regulatory Environment in Which We Operate

Various legal proceedings could adversely affect our financial condition or results of operations.

In the course of our business, we are subject to various legal proceedings and claims. See “Item 3 – Legal Proceedings.” The resolution of these legal matters or other legal matters could result in a material adverse impact on our results of operations, financial condition and business prospects.

We are subject to the risk that provisions of our loan agreements may be unenforceable.

Our rights and obligations with respect to our loans are governed by written loan agreements and related documentation. It is possible that a court could determine that one or more provisions of a loan agreement are unenforceable, such as a loan prepayment provision or the provisions governing our security interest in the underlying collateral. If this were to happen with respect to a material asset or group of assets, we could be required to repurchase these loans and may not be able to sell or liquidate the loans, which could negatively affect our liquidity.

We are exposed to the risk of environmental liabilities with respect to properties to which we take title.

In the course of our business, we occasionally foreclose and take title to residential properties and as a result could become subject to environmental liabilities associated with these properties. We may be held liable for property damage, personal injury, investigation, and cleanup costs incurred in connection with environmental contamination. These costs could be substantial. If we ever become subject to significant environmental liabilities, our financial condition and results of operations could be adversely affected.

Regulation as an investment company could harm our business; efforts to avoid regulation as an investment company could limit our operations.

The Investment Company Act of 1940, as amended, or the Investment Company Act, if deemed applicable to us, would prevent us from conducting our business as described in this document by, among other things, substantially limiting our ability to use leverage. The Investment Company Act does not regulate entities that are primarily engaged, directly or indirectly, in a business “other than that of investing, reinvesting, owning, holding or trading in securities,” or that are primarily engaged in the business of “purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” Under the Commission’s current interpretation, in order to qualify for the latter exemption we must maintain at least 55% of our assets directly in “qualifying real estate interests” and at least an additional 25% of our assets in other real estate-related assets or additional qualifying real estate interests. If we rely on this exemption from registration as an investment company under the Investment Company Act, our ability to invest in assets that would otherwise meet our investment strategies will be limited. If we are subject to the Investment Company Act and fail to qualify for an applicable exemption from the Investment Company Act, we could not operate our business efficiently under the regulatory scheme imposed by the Investment Company Act. Accordingly, we could be required to restructure our activities which could materially adversely affect our financial condition and results of operations.

Our failure to comply with federal, state or local regulation of, or licensing requirements with respect to, mortgage lending, loan servicing, broker compensation programs, or other aspects of our business could harm our operations and profitability.

As a mortgage lender, loan servicer and broker, we are subject to an extensive body of both state and federal law. The volume of new or modified laws and regulations has increased in recent years and, in addition, some individual municipalities have begun to enact laws that restrict loan origination and servicing activities. As a result, it may be more difficult to comprehensively identify and accurately interpret all of these laws and regulations and to properly program our technology systems and effectively train our personnel with respect to all of these laws and regulations, thereby potentially increasing our exposure to the risks of noncompliance with these laws and regulations. Also, in our branch operations, we allow our branch managers relative autonomy, which could result in our facing greater exposure to third-party claims if our compliance programs are not strictly adhered to. Our failure to comply with these laws can lead to civil and criminal liability; loss of licensure; damage to our reputation in the industry; inability to sell or securitize our loans; demands for indemnification or loan repurchases from purchasers of our loans; fines and penalties and litigation, including class action lawsuits; or administrative enforcement actions. Any of these results could harm our results of operations, financial condition and business prospects.

New legislation could restrict our ability to make mortgage loans, which could harm our earnings.

Several states, cities or other government entities are considering or have passed laws, regulations or ordinances aimed at curbing predatory lending practices. The federal government is also considering legislative and regulatory proposals in this regard. In general, these proposals involve lowering the existing thresholds for defining a “high-cost” loan and establish enhanced protections and remedies for borrowers who receive such loans. Passage of these laws and rules could reduce our loan origination volume. In addition, many whole loan buyers may elect not to purchase any loan labeled as a “high cost” loan under any local, state or federal law or regulation. Rating agencies likewise may refuse to rate securities backed by such loans. Accordingly, these laws and rules could severely restrict the secondary market for a significant portion of our loan production. This would effectively preclude us from continuing to originate loans either in jurisdictions unacceptable to the rating agencies or that exceed the newly defined thresholds which could harm our results of operations and business prospects.

If lenders are prohibited from originating loans in the State of Illinois with fees in excess of 3% where the interest rate exceeds 8%, this could force us to curtail operations in Illinois.

In March 2004, an Illinois Court of Appeals found that the Illinois Interest Act, which caps fees at 3% for loans with an interest rate in excess of 8%, is not preempted by federal law. This ruling contradicts the view of the Federal Circuit Courts of Appeal, most state courts and the Illinois Office of the Attorney General. In November 2004, the Illinois Supreme Court decided to consider an appeal to this case. If this ruling is not overturned, we may reduce operations in Illinois since it will reduce the return we and our investors can expect on higher risk loans. Moreover, as a result of this ruling, plaintiffs are filing actions against lenders, including us, seeking various forms of relief as a result of any fees received in the past that exceeded the applicable thresholds. Any such actions, if decided against us, could harm our results of operations, financial condition and business prospects.

We are no longer able to rely on the Alternative Mortgage Transactions Parity Act to preempt certain state law restrictions on prepayment penalties, which could harm our earnings.

Certain state laws restrict or prohibit prepayment penalties on mortgage loans and, until July 2003, we relied on the federal Alternative Mortgage Transactions Parity Act, or the Parity Act, and related rules issued in the past by the Office of Thrift Supervision, or OTS, to preempt state limitations on prepayment penalties. The Parity Act was enacted to extend to financial institutions, like us, which are not federally chartered depository institutions, the federal preemption that federally chartered depository institutions enjoy. However, in September 2002, the OTS released a rule that reduced the scope of the Parity Act preemption and, as a result, we are no longer able to rely on the Parity Act to preempt state restrictions on prepayment penalties. The elimination of this federal preemption has required us to comply with state restrictions on prepayment penalties. These restrictions prohibit us from charging any prepayment penalty in certain states and limit the amount or other terms and conditions of our prepayment penalties in several other states. This places us at a competitive disadvantage relative to financial institutions that will continue to enjoy federal preemption of such state restrictions. Such institutions are able to charge prepayment penalties without regard to state restrictions and, as a result, may be able to offer loans with interest rate and loan fee structures that are more attractive than the interest rate and loan fee structures that we are able to offer. This competitive disadvantage could harm our results of operations, financial condition and business prospects.

Changes in Internal Revenue Service regulations regarding the timing of income recognition and/or deductions could materially adversely affect the amount of our dividends.

On September 30, 2004, the IRS, released Announcement 2004-75, which describes rules that may be included in proposed IRS regulations regarding the timing of recognizing income and/or deductions attributable to interest-only securities. We believe the

effect of these regulations, if adopted, may narrow the spread between book income and taxable income on the interest-only securities we hold and would thus reduce our taxable income during the initial periods that we hold such securities. A significant portion of our mortgage securities—available-for-sale consist of interest-only securities. If regulations are adopted by the IRS that reduce our taxable income in a particular year, our dividend may be reduced for that year because the amount of our dividend is entirely dependent upon our taxable income.

If we fail to maintain REIT status, we would be subject to tax as a regular corporation. We conduct a substantial portion of our business through our taxable REIT subsidiaries, which creates additional compliance requirements.

We must comply with numerous complex tests to continue to qualify as a REIT for federal income tax purposes, including the requirement that we distribute 90% of taxable income to our shareholders and the requirement that no more than 5% of our annual gross income come from non-qualifying sources. If we do not comply with these requirements, we could be subject to penalty taxes and our REIT status could be at risk. We conduct a substantial portion of our business through taxable REIT subsidiaries, such as NovaStar Mortgage. Despite our qualification as a REIT, our taxable REIT subsidiaries must pay federal income tax on their taxable income. Our income from, and investments in, our taxable REIT subsidiaries do not constitute permissible income or investments for some of the REIT qualification tests. We may be subject to a 100% penalty tax, or our taxable REIT subsidiaries may be denied deductions, to the extent that our dealings with our taxable REIT subsidiaries are deemed not to be arm’s length in nature.

Our cash balances and cash flows may become limited relative to our cash needs, which may ultimately affect our REIT status or solvency.

We use cash for originating mortgage loans, minimum REIT dividend distribution requirements, and other operating needs. Cash is also required to pay interest on our outstanding indebtedness and may be required to pay down indebtedness in the event that the market values of the assets collateralizing our debt decline, the terms of short-term debt become less attractive or for other reasons. If our income as calculated for tax purposes significantly exceeds our cash flows from operations, our minimum REIT dividend distribution requirements could exceed the amount of our available cash. In the event that our liquidity needs exceed our access to liquidity, we may need to sell assets at an inopportune time, thus adversely affecting our financial condition and results of operations. Furthermore, in an adverse cash flow situation, our REIT status or our solvency could be threatened.

The tax imposed on REITs engaging in “prohibited transactions” will limit our ability to engage in transactions, including certain methods of securitizing loans, which would be treated as sales for federal income tax purposes.

A REIT’s net income from prohibited transactions is subject to a 100% tax. In general, prohibited transactions are sales or other dispositions of property, other than foreclosure property but including any mortgage loans held in inventory primarily for sale to customers in the ordinary course of business. We might be subject to this tax if we were to sell a loan or securitize the loans in a manner that was treated as a sale of such inventory for federal income tax purposes. Therefore, in order to avoid the prohibited transactions tax, we may choose not to engage in certain sales of loans other than through our taxable REIT subsidiaries and may limit the structures we utilize for our securitization transactions even though such sales or structures might otherwise be beneficial for us. In addition, this prohibition may limit our ability to restructure our portfolio of mortgage loans from time to time even if we believe it would be in our best interest to do so.

Even if we qualify as a REIT, the income earned by our taxable REIT subsidiaries will be subject to federal income tax and we could be subject to an excise tax on non-arm’s-length transactions with our taxable REIT subsidiaries.

Our taxable REIT subsidiaries, including NovaStar Mortgage, expect to earn income from activities that are prohibited for REITs, and will owe income taxes on the taxable income from these activities. For example, we expect that NovaStar Mortgage will earn income from our loan origination and sales activities, as well as from other origination and servicing functions, which would generally not be qualifying income for purposes of the gross income tests applicable to REITs or might otherwise be subject to adverse tax liability if the income were generated by a REIT. Our taxable REIT subsidiaries will be taxable as C corporations and will be subject to federal, state and local income tax at the applicable corporate rates on their taxable income, notwithstanding our qualification as a REIT.

In the event that any transactions between us and our taxable REIT subsidiaries are not conducted on an arm’s-length basis, we could be subject to a 100% excise tax on certain amounts from such transactions. Any such tax could affect our overall profitability and the amounts of cash available to make distributions.

We may, at some point in the future, borrow funds form one or more of our corporate subsidiaries. The IRS may recharacterize the indebtedness as a dividend distribution to us by our subsidiary. Any such recharacterization may cause us to fail one or more of the REIT requirements.

We may be harmed by changes in tax laws applicable to REITs or the reduced 15% tax rate on certain corporate dividends may harm us.

Changes to the laws and regulations affecting us, including changes to securities laws and changes to the Code applicable to the taxation of REITs, may harm our business. New legislation may be enacted into law or new interpretations, rulings or regulations could be adopted, any of which could harm us and our shareholders, potentially with retroactive effect.

Generally, dividends paid by REITs are not eligible for the 15% U.S. federal income tax rate on certain corporate dividends, with certain exceptions. The more favorable treatment of regular corporate dividends could cause domestic non-corporate investors to consider stocks of other corporations that pay dividends as more attractive relative to stocks of REITs.

We may be unable to comply with the requirements applicable to REITs or compliance with such requirements could harm our financial condition.

The requirements to qualify as a REIT under the Code are highly technical and complex. We routinely rely on legal opinions to support our tax positions. A technical or inadvertent failure to comply with the Code as a result of an incorrect interpretation of the Code or otherwise could jeopardize our REIT status. The determination that we qualify as a REIT requires an analysis of various factual matters and circumstances that may not be totally within our control. For example, to qualify as a REIT, at least 75% of our gross income must come from real estate sources and 95% of our gross income must come from real estate sources and certain other sources that are itemized in the REIT tax laws, mainly interest and dividends. We are subject to various limitations on our ownership of securities, including a limitation that the value of our investment in taxable REIT subsidiaries, including NovaStar Mortgage, cannot exceed 20% of our total assets at the end of any calendar quarter. In addition, at the end of each calendar quarter, at least 75% of our assets must be qualifying real estate assets, government securities and cash and cash items. The need to comply with these asset ownership requirements may cause us to acquire other assets that are qualifying real estate assets for purposes of the REIT requirements (for example, interests in other mortgage loan portfolios or mortgage-related assets) but are not part of our overall business strategy and might not otherwise be the best investment alternative for us. Moreover, we may be unable to acquire sufficient qualifying REIT assets, due to our inability to obtain adequate financing or otherwise, in which case we may fail to qualify as a REIT or may incur a penalty tax at the REIT level.

To qualify as a REIT, we must distribute to our shareholders with respect to each year at least 90% of our REIT taxable income (determined without regard to the dividends paid deduction and by excluding any net capital gain). After-tax earnings generated by our taxable REIT subsidiaries and not distributed to us are not subject to these distribution requirements and may be retained by such subsidiaries to provide for future growth, subject to the limitations imposed by REIT tax rules. To the extent that we satisfy the 90% distribution requirement, but distribute less than 100% of our taxable income, we will be subject to federal corporate income tax on our undistributed taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our shareholders in a calendar year is less than a minimum amount specified under federal tax laws. We expect in some years that we will be subject to the 4% excise tax. We could be required to borrow funds on a short-term basis even if conditions are not favorable for borrowing, or to sell loans from our portfolio potentially at disadvantageous prices, to meet the REIT distribution requirements and to avoid corporate income taxes. These alternatives could harm our financial condition and could reduce amounts available to originate mortgage loans.

If we fail to qualify or remain qualified as a REIT, our distributions will not be deductible by us, and we will be subject to federal income tax on our taxable income. This would substantially reduce our earnings and our cash available to make distributions. The resulting tax liability, in the event of our failure to qualify as a REIT, might cause us to borrow funds, liquidate some of our investments or take other steps that could negatively affect our operating results. Moreover, if our REIT status is terminated because of our failure to meet a technical REIT requirement or if we voluntarily revoke our election, we generally would be disqualified from electing treatment as a REIT for the four taxable years following the year in which REIT status is lost.

We could lose our REIT status if more than 20% of the value of our total assets are represented by the securities of one or more taxable REIT subsidiaries at the close of any calendar quarter.

To qualify as a REIT, not more than 20% of the value of our total assets may be represented by the securities of one or more taxable REIT subsidiaries at the close of any calendar quarter, subject to a 30-day “cure” period following the close of the quarter and, for taxable years beginning on or after January 1, 2005, subject to certain relief provisions even after the 30-day cure period. Our taxable REIT subsidiaries, including NovaStar Mortgage, conduct a substantial portion of our business activities, including a majority of our loan origination and servicing activities. If the IRS determines that the value of our investment in our taxable REIT subsidiaries was more than 20% of the value of our total assets at the close of any calendar quarter, we could lose our REIT status.

In certain cases, we may need to borrow from third parties to acquire additional qualifying REIT assets or increase the amount and frequency of dividends from our taxable REIT subsidiaries in order to comply with the 20% of assets test.

Risks Related to Our Capital Stock

Investors in our common stock may experience losses, volatility and poor liquidity, and we may reduce or delay payment of our dividends in a variety of circumstances.

Our earnings, cash flow, book value and dividends can be volatile and difficult to predict. Investors should not rely on predictions or management beliefs. Although we seek to pay a regular common stock dividend at a rate that is sustainable, we may reduce our dividend payments in the future for a variety of reasons. We may not provide public warnings of such dividend reductions or payment delays prior to their occurrence. Fluctuations in our current and prospective earnings, cash flow and dividends, as well as many other factors such as perceptions, economic conditions, stock market conditions, and the like, can affect the price of our common stock. Investors may experience volatile returns and material losses. In addition, liquidity in the trading of our common stock may be insufficient to allow investors to sell their stock in a timely manner or at a reasonable price.

Restrictions on ownership of capital stock may inhibit market activity and the resulting opportunity for holders of our capital stock to receive a premium for their securities.

In order for us to meet the requirements for qualification as a REIT, our charter generally prohibits any person from acquiring or holding, directly or indirectly, (i) shares of our common stock in excess of 9.8% (in value or number of shares, whichever is more restrictive) of the aggregate outstanding shares of our common stock or (ii) shares of our capital stock in excess of 9.8% in value of the aggregate outstanding shares of our capital stock. These restrictions may inhibit market activity and the resulting opportunity for the holders of our capital stock to receive a premium for their stock that might otherwise exist in the absence of such restrictions.

The market price of our common stock and trading volume may be volatile, which could result in substantial losses for our shareholders.

The market price of our common stock may be highly volatile and subject to wide fluctuations. In addition, the trading volume in our common stock may fluctuate and cause significant price variations to occur. Some of the factors that could negatively affect our share price or result in fluctuations in the price or trading volume of our common stock include:

general market and economic conditions;

actual or anticipated changes in our future financial performance;

actual or anticipated changes in market interest rates;

actual or anticipated changes in our access to capital;

actual or anticipated changes in the amount of our dividend or any delay in the payment of a dividend;

competitive developments, including announcements by us or our competitors of new products or services;

the operations and stock performance of our competitors;

developments in the mortgage lending industry or the financial services sector generally;

the impact of new state or federal legislation or adverse court decisions;

fluctuations in our quarterly operating results;

the activities of investors who engage in short sales of our common stock;

actual or anticipated changes in financial estimates by securities analysts;

sales, or the perception that sales could occur, of a substantial number of shares of our common stock by insiders;

additions or departures of senior management and key personnel; and

actions by institutional shareholders.

Our common stock may become illiquid if an active public trading market cannot be sustained, which could adversely affect the trading price and your ability to transfer our common stock.

Our common stock’s trading volume is relatively low compared to the securities of many other companies listed on the New York Stock Exchange. If an active public trading market cannot be sustained, the trading price of our common stock could be adversely affected and your ability to transfer your shares of our common stock may be limited.

We may issue additional shares that may cause dilution and may depress the price of our common stock.

Our charter permits our board of directors, without stockholder approval, to:

authorize the issuance of additional shares of common stock or preferred stock without stockholder approval, including the issuance of shares of preferred stock that have preference rights over the common stock with respect to dividends, liquidation, voting and other matters or shares of common stock that have preference rights over our outstanding common stock with respect to voting; and

classify or reclassify any unissued shares of common stock or preferred stock and to set the preferences, rights and other terms of the classified or reclassified shares.

In the future, we will seek to access the capital markets from time to time by making additional offerings of securities, including debt instruments, preferred stock or common stock. Additional equity offerings by us may dilute your interest in us or reduce the market price of our common stock, or both. Our outstanding shares of preferred stock have, and any additional series of preferred stock may also have, a preference on distribution payments that could limit our ability to make a distribution to common shareholders. Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Further, market conditions could require us to accept less favorable terms for the issuance of our securities in the future. Thus, our common shareholders will bear the risk of our future offerings reducing the market price of our common stock and diluting their interest in us.

Past issuances of our common stock pursuant to our 401(k) plan and our Direct Stock Purchase and Dividend Reinvestment Plan may not have complied with the registration requirements of the securities laws.

We maintain a number of equity-based compensation plans for our employees, including a 401(k) plan, and DRIP for our employees and the public. Up to approximately 23,000 shares of common stock under our 401(k) plan and up to approximately 287,000 shares of common stock under our DRIP (collectively, the “Subject Shares”), may have been sold in a manner that may not have complied with the registration requirements of applicable securities laws during the twelve month period ending January 20, 2006, the date the rescission offers were initiated. In connection with sales under our 401(k) plan, the Subject Shares were purchased in the open market and as a result we did not receive any proceeds from such transactions, which may not be deemed to be sales for these purposes. In connection with sales of up to approximately 287,000 Subject Shares that were not registered under our DRIP in May 2005, we received approximately $10.8 million in net proceeds. As a result, we initiated offers to rescind the purchase of the Subject Shares. While we do not expect all eligible purchasers to exercise their rescission rights pursuant to the rescission offers, we have agreed to repurchase the Subject Shares still held by eligible purchasers generally for an amount equal to the original purchase price for the shares plus interest, less dividends, and to compensate eligible purchasers generally for any losses incurred in the sale of the Subject Shares, plus interest, less dividends. The number of eligible purchasers and the amount that we will pay for the shares that are rescinded will be determined by reference to the closing price of our common stock on March 30, 2006, the expiration date of the rescission offers. Furthermore, we could be subject to monetary fines or other regulatory sanctions as provided under applicable securities laws.

Other Risks Related to our Business

Intense competition in our industry may harm our financial condition.

We face intense competition, primarily from consumer finance companies, conventional mortgage bankers, commercial banks, credit unions, thrift institutions, and other independent wholesale mortgage lenders, including internet-based lending companies and other mortgage REITs. Competitors with lower costs of capital have a competitive advantage over us. In addition, establishing a

mortgage lending operation such as ours requires a relatively small commitment of capital and human resources, which permits new competitors to enter our markets quickly and to effectively compete with us. Furthermore, national banks, thrifts and their operating subsidiaries are generally exempt from complying with many of the state and local laws that affect our operations, such as the prohibition on prepayment penalties. Thus, they may be able to provide more competitive pricing and terms than we can offer. Any increase in the competition among lenders to originate nonconforming mortgage loans may result in either reduced income on mortgage loans compared to present levels, or revised underwriting standards permitting higher loan-to-value ratios on properties securing nonconforming mortgage loans, either of which could adversely affect our results of operations, financial condition or business prospects. In addition, the government-sponsored entities, Fannie Mae and Freddie Mac, may also expand their participation in the subprime mortgage industry. To the extent they materially expand their purchase of subprime loans, our ability to profitably originate and purchase mortgage loans may be adversely affected because their size and cost-of-funds advantage allows them to purchase loans with lower rates or fees than we are willing to offer.

If we are unable to maintain and expand our network of independent brokers, our loan origination business will decrease.

A significant majority of our originations of mortgage loans comes from independent brokers. During 2005, 75% of our loan originations were originated through our broker network. Our brokers are not contractually obligated to do business with us. Further, our competitors also have relationships with our brokers and actively compete with us in our efforts to expand our broker networks. Our failure to maintain existing relationships or expand our broker networks could significantly harm our business, financial condition, liquidity and results of operations.

Our reported GAAP financial results differ from the taxable income results that drive our dividend distributions, and our consolidated balance sheet, income statement, and statement of cash flows as reported for GAAP purposes may be difficult to interpret.

We manage our business based on long-term opportunities to earn cash flows. Our dividend distributions are driven by the REIT tax laws and our income as calculated for tax purposes pursuant to the Code. Our reported results for GAAP purposes differ materially, however, from both our cash flows and our taxable income. We transfer mortgage loans or mortgage securities—available-for-sale into securitization trusts to obtain long-term non-recourse funding for these assets. When we surrender control over the transferred mortgage loans or mortgage securities—available-for-sale, the transaction is accounted for as a sale. When we retain control over the transferred mortgage loans or mortgage securities available-for-sale, the transaction is accounted for as a secured borrowing. These securitization transactions do not differ materially in their structure or cash flow generation characteristics, yet under GAAP accounting these transactions are recorded differently. In a securitization transaction accounted for as a sale, we record a gain or loss on the assets transferred in our income statement and we record the retained interests at fair value on our balance sheet. In a securitization transaction accounted for as a secured borrowing, we consolidate all the assets and liabilities of the trust on our financial statements (and thus do not show the retained interest we own as an asset). As a result of this and other accounting issues, shareholders and analysts must undertake a complex analysis to understand our economic cash flows, actual financial leverage, and dividend distribution requirements. This complexity may cause trading in our stock to be relatively illiquid or may lead observers to misinterpret our results.

Market values for our mortgage assets and hedges can be volatile. For GAAP purposes, we mark-to-market our non-hedging derivative instruments through our GAAP consolidated income statement and we mark-to-market our mortgage securities—available-for-sale through our GAAP consolidated balance sheet through other comprehensive income unless the mortgage securities are in an unrealized loss position which has been deemed as an other-than-temporary impairment. An other-than-temporary impairment is recorded through the income statement in the period incurred. Additionally, we do not mark-to-market our loans held for sale as they are carried at lower of cost or market, as such, any change in market value would not be recorded through our income statement until the related loans are sold. If we sell an asset that has not been marked-to-market through our income statement at a reduced market price relative to its basis, our reported earnings will be reduced. A decrease in market value of our mortgage assets may or may not result in a deterioration in future cash flows. As a result, changes in our GAAP consolidated income statement and balance sheet due to market value adjustments should be interpreted with care.

If we attempt to make any acquisitions, we will incur a variety of costs and may never realize the anticipated benefits.

If appropriate opportunities become available, we may attempt to acquire businesses that we believe are a strategic fit with our business. If we pursue any such transaction, the process of negotiating the acquisition and integrating an acquired business may result in operating difficulties and expenditures and may require significant management attention that would otherwise be available for ongoing development of our business, whether or not any such transaction is ever consummated. Moreover, we may never realize the anticipated benefits of any acquisitions. Future acquisitions could result in potentially dilutive issuances of equity securities, the incurrence of debt, contingent liabilities and/or amortization expenses related to goodwill and other intangible assets, which could harm our results of operations, financial condition and business prospects.

The inability to attract and retain qualified employees could significantly harm our business.

We depend on the continued service of our top executives, including our chief executive officer and president. To the extent that one or more of our top executives are no longer employed by us, our operations and business prospects may be adversely affected. We also depend on our wholesale account executives and retail loan officers to attract borrowers by, among other things, developing relationships with financial institutions, other mortgage companies and brokers, real estate agents, borrowers and others. The market for skilled account executives and loan officers is highly competitive and historically has experienced a high rate of turnover. Competition for qualified account executives and loan officers may lead to increased hiring and retention costs. If we are unable to attract or retain a sufficient number of skilled account executives at manageable costs, we will be unable to continue to originate quality mortgage loans that we are able to sell for a profit, which would harm our results of operations, financial condition and business prospects.

The success and growth of our business will depend upon our ability to adapt to and implement technological changes.

Our mortgage loan origination business is currently dependent upon our ability to effectively interface with our brokers, borrowers and other third parties and to efficiently process loan applications and closings. The origination process is becoming more dependent upon technological advancement, such as the ability to process applications over the Internet, accept electronic signatures and provide process status updates instantly and other customer-expected conveniences that are cost-efficient to our process. Becoming proficient with new technology will require significant financial and personnel resources. If we become reliant on any particular technology or technological solution, we may be harmed to the extent that such technology or technological solution (i) becomes non-compliant with existing industry standards, (ii) fails to meet or exceed the capabilities of our competitors’ equivalent technologies or technological solutions, (iii) becomes increasingly expensive to service, retain and update, or (iv) becomes subject to third-party claims of copyright or patent infringement. Any failure to acquire technologies or technological solutions when necessary could limit our ability to remain competitive in our industry and could also limit our ability to increase the cost-efficiencies of our operating model, which would harm our results of operations, financial condition and business prospects.

Our business could be adversely affected if we experienced an interruption in or breach of our communication or information systems or if we were unable to safeguard the security and privacy of the personal financial information we receive.

We rely heavily upon communications and information systems to conduct our business. Any material interruption or breach in security of our communication or information systems or the third-party systems on which we rely could cause underwriting or other delays and could result in fewer loan applications being received, slower processing of applications and reduced efficiency in loan servicing. Additionally, in connection with our loan file due diligence reviews, we have access to the personal financial information of the borrowers which is highly sensitive and confidential, and subject to significant federal and state regulation. If a third party were to misappropriate this information, we potentially could be subject to both private and public legal actions. Our policies and safeguards may not be sufficient to prevent the misappropriation of confidential information, may become noncompliant with existing federal or state laws or regulations governing privacy, or with those laws or regulations that may be adopted in the future.

Our inability to realize cash proceeds from loan sales and securitizations in excess of the loan acquisition cost could harm our financial position.

The net cash proceeds received from loan sales consist of the premiums we receive on sales of loans in excess of the outstanding principal balance, plus the cash proceeds we receive from securitizations structured as sales, minus the discounts on loans that we have to sell for less than the outstanding principal balance. If we are unable to originate loans at a cost lower than the cash proceeds realized from loan sales, such inability could harm our results of operations, financial condition and business prospects.

Market factors may limit our ability to acquire mortgage assets at yields that are favorable relative to borrowing costs.

Despite our experience in the acquisition of mortgage assets and our relationships with various mortgage suppliers, we face the risk that we might not be able to acquire mortgage assets which earn interest rates greater than our cost of funds or that we might not be able to acquire a sufficient number of such mortgage assets to maintain our profitability.

We face loss exposure due to fraudulent and negligent acts on the part of loan applicants, employees, mortgage brokers and other third parties.

When we originate or purchase mortgage loans, we rely heavily upon information provided to us by third parties, including information relating to the loan application, property appraisal, title information and employment and income documentation. If any of this information is fraudulently or negligently misrepresented to us and such misrepresentation is not detected by us prior to loan funding, the value of the loan may be significantly lower than we expected. Whether a misrepresentation is made by the loan applicant, the loan broker, one of our employees, or any other third party, we generally bear the risk of loss associated with it. A loan subject to misrepresentation typically cannot be sold and subject to repurchase by us if it is sold prior to our detection of the misrepresentation. We may not be able to recover losses incurred as a result of the misrepresentation.

Our reliance on cash-out refinancings as a significant source of our origination volume increases the risk that our earnings will be harmed if the demand for this type of refinancing declines.

For the year ended December 31, 2005, approximately 59% of our loan production volume consisted of cash-out refinancings. Our reliance on cash-out refinancings as a significant source of our origination volume increases the risk that our earnings will be reduced if interest rates rise and the prices of homes decline, which would reduce the demand and production volume for this type of refinancing. A substantial and sustained increase in interest rates could significantly reduce the number of borrowers who would qualify or elect to pursue a cash-out refinancing and result in a decline in that origination source. Similarly, a decrease in home prices would reduce the amount of equity available to be borrowed against in cash-out refinancings and result in a decrease in our loan production volume from that origination source. Therefore, our reliance on cash-out refinancings as a significant source of our origination volume could harm our results of operations, financial condition and business prospects.

We may enter into certain transactions at the REIT in the future that incur excess inclusion income that will increase the tax liability of our shareholders.

If we incur excess inclusion income at the REIT, it will be allocated among our shareholders. A stockholder’s share of excess inclusion income (i) would not be allowed to be offset by any net operating losses otherwise available to the stockholder, (ii) would be subject to tax as unrelated business taxable income in the hands of most types of shareholders that are otherwise generally exempt from federal income tax, and (iii) would result in the application of U.S. federal income tax withholding at the maximum rate (i.e., 30%), without reduction for any otherwise applicable income tax treaty, to the extent allocable to most types of foreign shareholders. How such income is to be reported to shareholders is not clear under current law. Tax-exempt investors, foreign investors, and taxpayers with net operating losses should carefully consider the tax consequences of having excess inclusion income allocated to them and are urged to consult their tax advisors.

Excess inclusion income would be generated if we issue debt obligations with two or more maturities and the terms of the payments on these obligations bear a relationship to the payments that we received on our mortgage loans or mortgage-backed securities securing those debt obligations. The structure of this type of CMO securitization generally gives rise to excess inclusion income. It is reasonably likely that we will structure some future CMO securitizations in this manner. Excess inclusion income could also result if we were to hold a residual interest in a REMIC. The amounts of excess inclusion income in any given year from these transactions could be significant.

Some provisions of our charter, bylaws and Maryland law may deter takeover attempts, which may limit the opportunity of our stockholders to sell their common stock at favorable prices.

Certain provisions of our charter, bylaws and Maryland law could discourage, delay or prevent transactions that involve an actual or threatened change in control, and may make it more difficult for a third party to acquire us, even if doing so may be beneficial to our stockholders by providing them with the opportunity to sell their shares possibly at a premium over the then market price. For example, our board of directors is divided into three classes with three year staggered terms of office. This makes it more difficult for a third party to gain control of our board because a majority of directors cannot be elected at a single meeting. Further, under our charter, generally a director may only be removed for cause and only by the affirmative vote of the holders of at least a majority of all classes of shares entitled to vote in the election for directors together as a single class. Our bylaws make it difficult for any person other than management to introduce business at a duly called meeting requiring such other person to follow certain advance

notice procedures. Finally, Maryland law provides protection for Maryland corporations against unsolicited takeover situations. These provisions, as well as others, could discourage potential acquisition proposals, or delay or prevent a change in control and prevent changes in our management, even if such actions would be in the best interests of our stockholders.

 

Item 1B.Unresolved Staff Comments

None

Item 2.Properties

 

Our executive, administrative and loan servicing offices are located in Kansas City, Missouri, and consist of approximately 129,000200,000 square feet of leased office space. The lease agreements on the premises expire in February 2009.January 2011. The current annual rent for these offices is approximately $2.6$3.9 million.

 

We lease office space for our mortgage lending operations in Orange County, California,Lake Forest, California; Independence, Ohio,Ohio; Richfield, Ohio; Troy, Michigan and Columbia, Maryland and Vienna, Virginia.Maryland. Currently, these offices consist of approximately 189,000233,000 square feet. The leases on the premises expire from April 2005December 2009 through September 2010,May 2012, and the current annual rent is approximately $2.8$4.2 million.

 

Item 3.Legal Proceedings

 

We occasionally become involved in litigation arisingSince April 2004, a number of substantially similar class action lawsuits have been filed and consolidated into a single action in the normal courseUntied States District Court for the Western District of business. Management believesMissouri. The consolidated complaint names us defendants and three of our executive officers and generally alleges that anythe defendants made public statements that were misleading for failing to disclose certain regulatory and licensing matters. The plaintiffs purport to have brought this consolidated action on behalf of all persons who purchased our common stock (and sellers of put options on our common stock) during the period October 29, 2003 through April 8, 2004. On January 14, 2005, we filed a motion to dismiss this action, and on May 12, 2005, the court denied such motion. We believe that these claims are without merit and continues to vigorously defend against them.

In the wake of the securities class action, we have also been named as a nominal defendant in several derivative actions brought against certain of our officers and directors in Missouri and Maryland. The complaints in these actions generally claim that the defendants are liable to us for failing to monitor corporate affairs so as to ensure compliance with applicable state licensing and regulatory requirements.

In July 2004, an employee of NovaStar Home Mortgage, Inc. (“NHMI”), a wholly-owned subsidiary of the Company, filed a class and collective action lawsuit against NHMI and NMI in California Superior Court for the County of Los Angeles. Subsequently, NHMI and NMI removed the matter to the United States District Court for the Central District of California and NMI was removed from the lawsuit. The putative class is comprised of all past and present employees of NHMI who were employed since May 1, 2000 in the capacity generally described as Loan Officer. The plaintiffs alleged that NHMI failed to pay them overtime and minimum wage as required by the Fair Labor Standards Act (“FLSA”) and California state laws for the period commencing May 1, 2000 to present. In 2005, the plaintiffs and NHMI agreed upon a nationwide settlement in the amount of $3.3 million on behalf of a class of all NHMI Loan Officers. The settlement, which is subject to final court approval, covers all claims for minimum wage, overtime, meal and rest periods, record-keeping, and penalties under California and federal law during the class period. In 2004, since not all class members will elect to be part of the settlement, we estimated the probable obligation related to the settlement to be in a range of $1.3 million to $1.7 million. In accordance with SFAS No. 5, Accounting for Contingencies, we recorded a charge to earnings of $1.3 million in 2004. In 2005, we recorded an additional charge to earnings of $200,000 as the estimated probable obligation increased to a range of $1.5 million to $1.9 million.

In April 2005, three putative class actions filed against NHMI and certain of its affiliates were consolidated for pre-trial proceedings in the United States District Court for the Southern District of Georgia entitledIn Re NovaStar Home Mortgage, Inc. Mortgage Lending Practices Litigation.These cases allege that NHMI improperly shared settlement service fees with limited liability companies in which NHMI had an interest (the “LLCs”) alleging violations of the fee splitting and anti-referral provisions of the federal Real Estate Settlement Procedures Act (“RESPA”), and alleging certain violations of state law and civil conspiracy. Plaintiffs seek treble damages with respect to such legalthe RESPA claims, disgorgement of fees with respect to the state law claims as well as other damages, injunctive relief and attorney fees. In addition, two other related class actions individually orhave been filed in state courts.Miller v. NovaStar Financial, Inc. et al., was filed in October 2004 in the aggregate,Circuit Court of Madison County, Illinois andJones et al. v. NovaStar Home Mortgage, Inc. et al., was filed in December 2004 in the Circuit Court for Baltimore City, Maryland. In theMiller case,plaintiffs allege a violation of the Illinois Consumer Fraud and Deceptive Practices Act and civil conspiracy alleging certain LLCs provided settlement services without the borrower’s knowledge. In theJones case, the plaintiffs allege the LLCs violated the Maryland Lender Act by acting as lenders and/or brokers in Maryland without proper licenses and allege this arrangement

amounted to a civil conspiracy. The plaintiffs in both theMiller andJones cases seek a disgorgement of fees, other damages, injunctive relief and attorney fees on behalf of the class of plaintiffs. We believe that these claims are without merit and we intend to vigorously defend against them.

In December 2005, a putative class action was filed against NHMI in the United States District Court for the Middle District of Louisiana entitledPearson v. NovaStar Home Mortgage, Inc.Plaintiff contends that NHMI violated the federal Fair Credit Reporting Act (“FCRA”) in connection with its use of pre-approved offers of credit and its failure to make certain disclosures required by federal law. Plaintiff seeks (on his own behalf, as well as for others similarly situated) statutory damages, other nominal damages, punitive damages and attorney’s fees and costs. We believe that these claims are without merit and we intend to vigorously defend against them.

In December 2005, a putative class action was filed against NovaStar Mortgage in the United States District Court for the Western District of Washington entitledPierce et al. v. NovaStar Mortgage, Inc.Plaintiffs contend that NovaStar Mortgage failed to disclose prior to closing that a broker payment would be made on their loans, which was an unfair and deceptive practice in violation of the Washington Consumer Protection Act. The plaintiffs seek a return of fees paid on the affected loans, excess interest charged, and damage to plaintiffs’ credit and finances, treble damages as provided in the Washington Consumer Protection Act and attorney fees. We believe that these claims are without merit and we intend to vigorously defend against them.

In addition to those matters listed above, we are currently a party to various other legal proceedings and claims, including, but not limited to, breach of contract claims, class action or individual claims for violations of the RESPA, FLSA, federal and state laws prohibiting employment discrimination and federal and state licensing and consumer protection laws.

While management, including internal counsel, currently believes that the ultimate outcome of all these proceedings and claims will not have a material adverse effect on itsour financial positioncondition or results of operations, litigation is subject to inherent uncertainties. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on our financial condition and results of operations.

 

In April 2004, we received notice of an informal inquiry from the Commission requesting that we provide various documents relating to our business. We have cooperated fully with the Commission’s inquiry and provided it with the requested information.

Item 4.Submission of Matters to a Vote of Security Holders

 

None

PART II

 

Item 5.Market for Registrant’s Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities

 

a.Market Price of and Dividends on the Registrant’s Common Equity and Related Stockholder MattersMatters.

The Our common stock of NovaStar Financial is traded on the NYSE under the symbol “NFI”. The following table sets forth, for the periods indicated, the high and low sales prices per share of common stock on the NYSE and the cash dividends paid or payable per share of capitalcommon stock.

 

Common Stock Prices


  Cash Dividends

   High

  Low

  Class of
Stock


  Declared

  

Paid or

Payable


  

Amount

Per Share


1/1/01 to 3/31/01

  $3.10  $1.88  Preferred  4/27/01  5/10/01  $0.12

4/1/01 to 6/30/01

   4.20   2.78  Preferred
Common
 
 
 7/26/01
7/26/01
  8/10/01
8/10/01
   
 
0.13
0.065

7/1/01 to 9/30/01

   5.85   4.05  Preferred
Common
 
 
 10/25/01
10/25/01
  11/10/01
11/10/01
   
 
0.36
0.18

10/1/01 to 12/31/01

   8.96   5.24  Preferred
Common
 
 
 12/19/01
12/19/01
  1/10/02
1/14/02
   
 
0.47
0.235

1/1/02 to 3/31/02

   9.70   7.91  Common(A) 4/23/02  5/7/02   0.40

4/1/02 to 6/30/02

   17.88   9.63  Common  7/24/02  8/6/02   0.45

7/1/02 to 9/30/02

   17.00   10.06  Common  10/15/02  11/7/02   0.50

10/1/02 to 12/31/02

   16.34   9.41  Common  12/18/02  1/15/03   0.80

1/1/03 to 3/31/03

   17.93   14.30  Common
Common
 
 
 1/29/03
4/23/03
  2/11/03
5/15/03
   
 
0.165
1.125

4/1/03 to 6/30/03

   29.90   17.15  Common  7/30/03  8/20/03   1.25

7/1/03 to 9/30/03

   37.22   25.30  Common  10/29/03  11/19/03   1.25

10/1/03 to 12/31/03

   45.25   29.87  Common  12/17/03  1/6/04   1.25
         Dividends

 
   High

  Low

  Date Declared

  Date Paid

  Amount Per
Share


 
2004                   

First Quarter

  $67.29  $43.19  4/28/04  5/26/04  $1.35 

Second Quarter

   66.05   30.97  7/28/04  8/26/04   1.35 

Third Quarter

   48.00   37.84  10/28/04  11/22/04   1.40 

Fourth Quarter

   56.82   41.34  12/22/04  1/14/05   2.65(A)
2005                   

First Quarter

  $48.15  $32.40  5/2/05  5/27/05  $1.40 

Second Quarter

   39.98   34.50  7/29/05  8/26/05   1.40 

Third Quarter

   42.19   32.20  9/15/05  11/22/05   1.40 

Fourth Quarter

   33.01   26.20  12/14/05  1/13/06   1.40 

(A)We issued the class B 7% convertible preferred stock in March 1999, which convertedIncludes a $1.25 special dividend related to common stock in February 2002.2004 taxable income.

 

As of February 29, 2004,March 10, 2006, we had approximately 22,000 stockholders held1,576 shareholders of record of our 24,790,51732,591,228 shares of common stock asoutstanding based upon a review of the securities position listing provided by third party brokers andour transfer agent reports.agent.

 

We intend to make distributions to stockholdersshareholders of all or substantially all of taxable income in each year, subject to certain adjustments, so as to qualify for the tax benefits accorded to a REIT under the Code. All distributions will be made at the discretion of the Board of Directors and will depend on earnings, financial condition, maintenance of REIT status and other factors as the Board of Directors may deem relevant.

 

b. Recent Sales of Unregistered SecuritiesSecurities.

 

None.We may have sold up to approximately 23,000 shares of common stock under our 401(k) plan and up to approximately 287,000 shares under our DRIP in a manner that may not have complied with the registration requirements of applicable securities laws. In connection with sales under our 401(k) Plan, the shares were purchased in the open market. As a result we did not receive any proceeds from such transactions, which may not be deemed sales for these purposes. In connection with sales under our DRIP in May 2005, we received approximately $10.8 million in net proceeds.

 

c. PurchasesPurchase of Equity Securities by the IssuerIssuer.

 

None.

Issuer Purchases of Equity Securities

d. Filings with the Securities and Exchange Commission(dollars in thousands)

 

A copy of the filings we have made with the Securities and Exchange Commission (SEC) may be obtained on our website (www.novastarmortgage.com), through the website of the SEC (www.sec.gov) or by contacting us directly. Our investor relations contact information follows.

Investor Relations

8140 Ward Parkway, Suite 300

Kansas City, MO 64114

816.237.7000

Email: ir@novastar1.com

   Total Number of
Shares Purchased


  Average Price Paid
per Share


  Total Number of
Shares Purchased
as Part of Publicly
Announced Plans or
Programs


  Approximate Dollar
Value of Shares
that May Yet Be
Purchased Under
the Plans or
Programs (A)


October 1, 2005 – October 31, 2005

  —    —    —    $1,020

November 1, 2005 – November 30, 2005

  —    —    —     1,020

December 1, 2005 – December 31, 2005

  —    —    —     1,020

(A)A current report on Form 8-K was filed on October 2, 2000 announcing that the Board of Directors authorized the Company to repurchase its common shares, bringing the total authorization to $9 million.

Item 6.

Safe Harbor Statement

Certain matters discussed in this annual report constitute forward-looking statements within the meaning of the federal securities laws. Forward-looking statements are those that predict or describe future events and that do not relate solely to historical matters. Forward-looking statements are subject to risks and uncertainties and certain factors can cause actual results to differ materially from those anticipated. Some important factors that could cause actual results to differ materially from those anticipated include: our ability to generate sufficient liquidity on favorable terms; the size and frequency of our securitizations; interest rate fluctuations on our assets that differ from our liabilities; increases in prepayment or default rates on our mortgage assets; changes in assumptions regarding estimated loan losses and fair value amounts; changes in origination and resale pricing of mortgage loans; our compliance with applicable local, state and federal laws and regulations or opinions of counsel relating thereto and the impact of new local, state or federal legislation or regulations or opinions of counsel relating thereto or court decisions on our operations; the initiation of margin calls under our credit facilities; the ability of our servicing operations to maintain high performance standards and maintain appropriate ratings from rating agencies; our ability to expand origination volume while maintaining an acceptable level of overhead; our ability to adapt to and implement technological changes; the stability of residential property values; the outcome of litigation or regulatory actions pending against us or other legal contingencies; the impact of losses resulting from natural disasters; the impact of general economic conditions; and the risks that are outlined from time to time in our filings with the Commission, including this annual report. Other factors not presently identified may also cause actual results to differ. This document speaks only as of its date and we expressly disclaim any duty to update the information herein.

Item 1.Selected Financial DataBusiness

 

Overview

We are a Maryland corporation formed on September 13, 1996 as a specialty finance company that originates, purchases, invests in and services residential nonconforming loans. We operate through four separate operating segments – mortgage portfolio management, mortgage lending, loan servicing and branch operations. The following selected consolidated financial data is derivedloan servicing segment was previously reported as part of mortgage lending and loan servicing, but it has been separated to more closely align the segments with the way we review, manage and operate our business. Segment information for the years ended December 31, 2004 and 2003 has been restated for this change. Additionally, we are currently winding down our branch operating unit and expect to complete the wind-down by June 30, 2006. See “Branch Operations.”

We offer a wide range of mortgage loan products to borrowers, commonly referred to as “nonconforming borrowers.” Nonconforming borrowers are individuals who generally do not satisfy the credit, collateral, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers, including U.S. government-sponsored entities such as Fannie Mae or Freddie Mac. We retain significant interests in the nonconforming loans we originate and purchase through our mortgage securities investment portfolio. Through our servicing platform, we then service all of the loans, in which we retain interests, in order to better manage the credit performance of those loans.

We have elected to be taxed as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended (the “Code”). Management believes the tax-advantaged structure of a REIT maximizes the after-tax returns from mortgage assets. We must meet numerous rules established by the Internal Revenue Service (IRS) to retain our status as a REIT. In summary, they require us to:

Restrict investments to certain real estate related assets,

Avoid certain investment trading and hedging activities, and

Distribute virtually all REIT taxable income to our shareholders.

As long as we maintain our REIT status, distributions to our shareholders will generally be deductible by us for income tax purposes. This deduction effectively eliminates REIT level income taxes. Management believes it has and will continue to meet the requirements to maintain our REIT status.

Mortgage Portfolio Management

We invest in assets generated primarily from our auditedorigination and purchase of nonconforming, single-family, residential mortgage loans.

We operate as a long-term mortgage securities portfolio investor.

We finance our investment in mortgage securities by issuing asset-backed bonds, debt and capital stock and entering into repurchase agreements.

Earnings are generated from the return on our mortgage securities and mortgage loan portfolio.

Our portfolio of mortgage securities includes interest-only, prepayment penalty, overcollateralization (collectively, the “residual securities”) and other investment-grade rated subordinated mortgage securities (the “subordinated securities”).

Earnings from our portfolio of mortgage loans and securities generate a substantial portion of our earnings. Gross interest income in our mortgage portfolio management segment was $193.2 million, $140.3 million and $109.5 million in the three years ended December 31, 2005, 2004 and 2003, respectively. Net interest income before provision for credit (losses) recoveries for our portfolio management segment was $174.1 million, $119.2 million and $92.1 million in the three years ended December 31, 2005, 2004 and 2003, respectively. One of our top priorities going forward is to preserve the favorable returns generated by our mortgage securities portfolio by focusing on the spread between origination and funding costs and the coupons of loans in the portfolio. We expect to continue to grow our portfolio but not at the expense of returns or risk management. See Note 16 to our consolidated financial statements for the periods presenteda summary of operating results and should be read in conjunction with the more detailed information therein andtotal assets for our mortgage portfolio management segment. Also, see “Mortgage Portfolio Management Results of Operations” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewherefor further discussion and analysis of the mortgage portfolio management operations.

A significant risk relating to our mortgage portfolio management segment is interest rate risk - the risk that interest rates on the mortgage loans which underly our mortgage securities will not adjust at the same times or in this annual report. Operating resultsthe same amounts that interest rates on the liabilities adjust. Many of the loans in our portfolio have fixed rates of interest for a period of time ranging from 2 to 30 years. Our funding costs are generally not necessarily indicativeconstant or fixed. We use derivative instruments to mitigate the risk of our cost of funding increasing at a faster rate than the interest on the loans (both those on the balance sheet and those that serve as collateral for mortgage securities).

In 2002, we began transferring interest rate agreements at the time of securitization into the securitization trusts to protect the third-party bondholders from interest rate risk and to decrease the volatility of future performance.cash flows related to the securitized mortgage loans. We enter into these interest rate agreements as we originate and purchase mortgage loans in our mortgage lending segment. See “Mortgage Lending” for discussion of the impact of these interest rate agreements on our operating results. At the time of securitization, the interest rate agreements are transferred to the securitization trust and removed from our balance sheet. The trust assumes the obligation to make payments and obtains the right to receive payments under these agreements. Generally, net settlement obligations paid by the trust for these interest rate agreements reduce the excess interest cash flows to our residual securities. Net settlement receipts from these interest rate agreements are first used to cover any interest shortfalls on the third-party primary bonds and any remaining funds then flow to our residual securities.

 

Selected Consolidated Financial and Other DataMortgage Lending

(dollars in thousands, except per share amounts)

 

   For the Year Ended December 31,

 
   2003 (A)

  2002 (A)

  2001 (A)

  2000

  1999

 

Consolidated Statement of Operations Data:

                     

Interest income

  $170,420  $107,143  $57,904  $47,627  $66,713 

Interest expense

   40,364   27,728   27,366   34,696   46,758 

Net interest income before credit recoveries (losses)

   130,056   79,415   30,538   12,931   19,955 

Credit recoveries (losses)

   389   432   (3,608)  (5,449)  (22,078)

Gains (losses) on sales of mortgage assets

   144,005   53,305   37,347   (826)  351 

Losses on derivative instruments

   (30,837)  (36,841)  (3,953)  —     —   

General and administrative expenses

   174,408   84,594   46,505   3,017   3,590 

Net income (loss)

   111,996   48,761   32,308   5,626   (7,092)

Basic income (loss) per share (C)

  $5.04  $2.35  $1.61  $0.26  $(0.54)

Diluted income (loss) per share (C)

  $4.91  $2.25  $1.51  $0.25  $(0.54)
   As of December 31,

 
   2003 (A)

  2002 (A)

  2001 (A)

  2000

  1999

 

Consolidated Balance Sheet Data:

                     

Mortgage Assets:

                     

Mortgage loans

  $792,709  $1,133,509  $365,560  $375,927  $620,406 

Mortgage securities

   382,287   178,879   71,584   46,650   6,775 

Total assets

   1,399,957   1,452,497   512,380   494,482   689,427 

Borrowings

   1,005,516   1,225,228   362,398   382,437   586,868 

Stockholders’ equity

   300,224   183,257   129,997   107,919   100,161 
   For the Year Ended December 31,

 
   2003

  2002

  2001

  2000

  1999

 

Other Data:

                     

Loans originated, principal

  $5,994,492  $2,781,539  $1,333,366  $719,341  $452,554 

Loans securitized, principal

  $5,319,435  $1,560,001  $1,215,100  $584,350  $167,176 

Nonconforming loans sold, principal

  $151,210  $142,159  $73,324  $172,839  $390,827 

Loan servicing portfolio, principal

  $7,206,113  $3,657,640  $1,994,448  $1,112,615  $859,938 

Branches, end of year

   432   216   123   63   1 

Loans brokered through branches

  $6,381,432  $2,622,950  $1,087,971  $193,191  $—   

Annualized return on assets

   9.93%  6.05%  6.03%  0.97%  (0.83)%

Annualized return on equity

   58.90%  30.30%  27.04%  5.50%  (6.71)%

Taxable income (loss)

  $136,495  $48,473  $5,242  $(2) $(90)

Taxable income (loss) per share (B) (C)

  $5.58  $2.32  $0.46  $—    $(0.01)

Dividends declared per common share (B) (C)

  $5.04  $2.15  $0.48  $—    $—   

Dividends declared per preferred share

  $—    $—    $1.08  $0.49  $0.37 

Number of account executives

   281   249   112   85   47 

(A)Includes the assets, liabilities, equity and results of operations for NFI Holding Corporation. The common stock of NFI Holding Corporation was acquired on January 1, 2001.

(B)On January 29, 2003, a $0.165 special dividend related to 2002 taxable income was declared per common share.

(C)Per share amounts for all years have been adjusted for the 2-for-1 stock split on December 1, 2003.

Item 7.Management’sThe mortgage lending operation is significant to our financial results as it produces the loans that ultimately collateralize the mortgage securities that we hold in our portfolio. During 2005 and 2004, we originated and purchased $9.3 billion and $8.4 billion in nonconforming mortgage loans, respectively. The majority of these loans were retained in our servicing portfolio and serve as collateral for our mortgage securities. The loans we originate and purchase are sold, either in securitization transactions or in outright sales to third parties. We securitized $7.6 billion and $8.3 billion of mortgage loans during 2005 and 2004, respectively. We sold $1.1 billion in nonconforming mortgage loans to third parties during the year ended December 31, 2005. There were no nonconforming mortgage loan sales during 2004. Our mortgage lending segment recognized gains on sales of mortgage assets totaling $49.3 million, $113.2 million and $140.9 million during the three years ended December 31, 2005, 2004 and 2003, respectively. See Table 15 for a summary of the components of our mortgage lending gains on sales of mortgage assets by year, as well as, a reconciliation of our mortgage lending gains on sales of mortgage assets to our consolidated gains on sales of mortgage assets reported in our consolidated statements of income. In securitization transactions accounted for as sales we retain residual securities (representing interest-only securities, prepayment penalty bonds and overcollateralization bonds) and certain investment-grade rated subordinated securities, along with the right to service the loans. See Note 16 to our consolidated financial statements for a summary of operating results and total assets for our mortgage lending segment. Also, see “Mortgage Lending Results of Operations” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion and analysis of the mortgage lending operations.

Our wholly-owned subsidiary, NovaStar Mortgage, Inc. (“NovaStar Mortgage”), originates and purchases primarily nonconforming, single-family residential mortgage loans. Our mortgage lending operation continues to innovate in loan origination. We adhere to three disciplines which underly our lending decisions:

Originating loans that perform (attractive credit risk profile),

Maintaining economically sound pricing (profitable coupons), and

Controlling costs of origination.

In our nonconforming lending operations, we lend to individuals who generally do not qualify for agency/conventional lending programs because of a lack of available documentation or previous credit difficulties. These types of borrowers are generally willing to pay higher mortgage loan origination fees and interest rates than those charged by conventional lenders. Because these borrowers typically use the proceeds of the mortgage loans to consolidate debt and to finance home improvements, education and other consumer needs, loan volume is generally less dependent on general levels of interest rates or home sales and therefore less cyclical than conventional mortgage lending.

Our nationwide loan origination network includes wholesale loan brokers, mortgage lenders, correspondent institutions and direct to consumer operations. Except for NovaStar Home Mortgage, Inc. (“NHMI”) brokers described below, these brokers and mortgage lenders are independent from any of the NovaStar Financial entities. Our sales force, which includes account executives in 42 states, develops and maintains relationships with this network of independent retail brokers. Our correspondent origination channel consists of a network of institutions from which we purchase nonconforming mortgage loans on a bulk or flow basis.

We underwrite, process, fund and service the nonconforming mortgage loans sourced through our network of wholesale loan brokers and mortgage lenders and our direct to consumer operations in centralized facilities. Further details regarding the loan originations are discussed under the “Mortgage Loans” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

A significant risk to our mortgage lending operations is the risk that we will not have financing facilities and cash available to fund and hold loans prior to their sale or securitization. See “Risk Factors – Related to our Borrowing and Securitization Activities.” We maintain lending facilities with large banking and investment institutions to reduce this risk. On a short-term basis, we finance mortgage loans using warehouse repurchase agreements. In addition, we have access to facilities secured by our mortgage securities. Details regarding available financing arrangements and amounts outstanding under those arrangements are included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 8 to the consolidated financial statements.

For long-term financing, we securitize our mortgage loans and issue asset-backed bonds (“ABB”). Primary bonds – AAA through BBB rated – are sold to large, institutional investors and U.S. government-sponsored enterprises. During 2005 and 2004, US government-sponsored enterprises purchased 51% and 55%, respectively, of the bonds sold to the third-party investors from our securitizations. The loss of the U.S. government-sponsored enterprises from the market for our bonds could potentially have a materially adverse effect on us.

In 2005, we started to retain certain of subordinated securities from our securitizations. We also retain residual securities as well as the right to service the loans. Prior to 1999, our securitizations were executed and designed to meet accounting rules that resulted in securitizations being treated as financing transactions. As a result, the mortgage loans and related debt continue to be presented on our consolidated balance sheets, and no gain was recorded. Beginning in 1999, our securitization transactions have been structured to qualify as sales for accounting and income tax purposes. The loans and related bond liability are not recorded in our consolidated financial statements. We do, however, record the value of the residual and subordinated securities and servicing rights we retain on our balance sheet. Details regarding ABBs we issued can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in Note 8 to our consolidated financial statements.

As discussed under “Mortgage Portfolio Management,” interest rate risk is a significant risk to our mortgage lending operations as well as our mortgage portfolio operations. Prior to securitization, we enter into these interest rate agreements as we originate and purchase mortgage loans to help mitigate interest rate risk. At the time of securitization, we transfer these interest rate agreements into the securitization trusts and they are removed from our balance sheet. Generally, these interest rate agreements do not meet the hedging criteria set forth in accounting principles generally accepted in the United States of America (“GAAP”) while they are on our balance sheet, therefore, we are required to record their change in value as a component of earnings even though they may reduce our interest rate risk. In times when short-term rates rise or drop significantly, the value of our agreements will increase or decrease, respectively. As a result, within our mortgage lending segment we recognized gains (losses) on these derivatives of $17.9 million, $(8.8) million and $(29.9) million in 2005, 2004 and 2003, respectively.

Loan Servicing

We retain the servicing rights with respect to loans we securitize. Management believes loan servicing remains a critical part of our business operation because maintaining contact with our borrowers is critical in managing credit risk and in borrower retention. Nonconforming borrowers are more prone to late payments and are more likely to default on their obligations than conventional

borrowers. By servicing our loans, we strive to identify problems with borrowers early and take quick action to address problems. Borrowers may be motivated to refinance their mortgage loans either by improving their personal credit or due to a decrease in interest rates. By keeping in close touch with borrowers, we can provide them with information about NovaStar Financial products to encourage them to refinance with us. Mortgage servicing yields fee income for us in the form of fees paid by the borrowers for normal customer service and processing fees. In addition we receive contractual fees approximating 0.50% of the outstanding balance for loans we service that we do not own. We serviced $14.0 billion loans as of December 31, 2005 compared to $12.2 billion loans as of December 31, 2004. We recognized $59.8 million, $41.5 million and $21.1 million in loan servicing fee income from the securitization trusts during the three years ended December 31, 2005, 2004 and 2003, respectively. Loan servicing fee income should continue to grow as our servicing portfolio grows. Also, see “Loan Servicing Results of Operations” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion and analysis of the servicing operations.

Branch Operations

In 1999, we opened our retail mortgage broker business operating under the name NovaStar Home Mortgage, Inc. (“NHMI”). Prior to 2004, many of these NHMI branches were supported by limited liability companies (“LLC”) in which we owned a minority interest in the LLC and the branch manager was the majority interest holder. In December 2003, we decided to terminate the LLCs effective January 1, 2004. As of January 1, 2004 the financial results of the continuing branches, that were formerly supported by LLCs, are included in our consolidated financial statements. Branch offices offer conforming and nonconforming loans to potential borrowers. Loans are brokered for approved investors, including NovaStar Mortgage. The NHMI branches are considered departmental functions of NHMI under which the branch manager (department head) is an employee of NHMI and receives compensation based on the profitability of the branch (department) as bonus compensation. See Note 15 and Note 16 to our consolidated financial statements for a summary of operating results and total assets for our branches. Also, see “Branch Operations Results of Operations and Discontinued Operations” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion and analysis of the branch operations.

We routinely close branches and branch managers voluntarily terminate their employment with us, which generally results in the branch’s closure. In these terminations, the branch and all operations are eliminated. Additionally, as the demand for conforming loans declined significantly during 2004 and 2005, many branches were not able to produce sufficient fees to meet operating expense demands. As a result of these conditions, we adopted a formal plan on November 4, 2005 to terminate substantially all of the remaining NHMI branches. We anticipate that all of the remaining NHMI branches will be terminated by June 30, 2006.

Market in Which NovaStar Operates and Competes

Over the last ten years, the nonconforming lending market has grown from less than $50 billion annually to approximately $600 billion in 2005 as estimated by Inside Mortgage Finance Publications. A significant portion of nonconforming loans are made to borrowers who are using equity in their primary residence to consolidate installment or consumer debt, or take cash out for personal reasons. The nonconforming market has grown through a variety of interest rate environments. One of the main drivers of growth in this market has been the rise in housing prices which gives borrowers the opportunity to use the equity in their home to consolidate their high interest rate, short-term, non-tax deductible consumer or installment debt into lower interest rate, long-term, often tax deductible mortgage debt. Management estimates that NovaStar Financial has a 1-2% share of the nonconforming loan market. While management cannot predict consumer spending and borrowing habits, nor the future value of the residential home market, historical trends indicate that the market in which we operate is relatively stable and should continue to experience long-term growth.

We face intense competition in the business of originating, purchasing, selling and securitizing mortgage loans. The number of market participants is believed to be well in excess of 100 companies who originate and purchase nonconforming loans. No single participant holds a dominant share of the lending market. We compete for borrowers with consumer finance companies, conventional mortgage bankers, commercial banks, credit unions, thrift institutions and other independent wholesale mortgage lenders. Our principal competition in the business of holding mortgage loans and mortgage securities are life insurance companies, institutional investors such as mutual funds and pension funds, other well-capitalized, publicly-owned mortgage lenders and certain other mortgage acquisition companies structured as REITs. Many of these competitors are substantially larger than we are and have considerably greater financial resources than we do.

Competition among industry participants can take many forms, including convenience in obtaining a loan, amount and term of the loan, customer service, marketing/distribution channels, loan origination fees and interest rates. To the extent any competitor significantly expands their activities in the nonconforming and subprime market, we could be adversely affected.

One of our key competitive strengths is our employees and the level of service they are able to provide our borrowers. We service our nonconforming loans and, in doing so, we are able to stay in close contact with our borrowers and identify potential problems early.

We also believe we compete successfully due to our:

experienced management team;

use of technology to enhance customer service and reduce operating costs;

tax advantaged status as a REIT;

freedom from depository institution regulation;

vertical integration – we broker and/or originate, purchase, fund, service and manage mortgage loans;

access to capital markets to securitize our assets.

Following is a diagram of the industry in which we operate and our loan production including nonconforming and conforming during 2005 (in thousands).


(A)A portion of the loans securitized or sold to unrelated parties during 2005 were originated prior to 2005. Loans originated and purchased in 2005 that we have not securitized or sold to unrelated parties as of December 31, 2005 are included in our mortgage loans held-for-sale.
(B)The majority of the AAA-BBB rated securities from NMFT Series 2005-1, 2005-2, 2005-3 and 2005-4 were purchased by bond investors during 2005. We retained the Class M-11 and M-12 certificates from NMFT Series 2005-3, which were rated BBB/BBB- by Standard and Poor’s and Fitch, respectively and BBB- by Standard and Poor’s. We retained the Class M-9, M-10, M-11 and M-12 certificates from NMFT Series 2005-4, which were rated A/Baa3/BBB+, BBB+/Ba1/BBB, BBB/NR/BBB- and BBB-/NR/NR by Standard and Poor’s, Moody’s and Fitch, respectively.
(C)The excess cash flow and subordinated bonds retained by NovaStar Financial are from the NMFT Series 2005-1, 2005-2, 2005-3 and 2005-4 securitization transactions, which occurred during 2005.

Risk Management

Management recognizes the following primary risks associated with the business and industry in which it operates.

Interest Rate/Market

Liquidity/Funding

Credit

Prepayment

Regulatory

Interest Rate/Market Risk.Our investment policy goals are to maintain the net interest margin between our assets and liabilities and to diminish the effect of changes in interest rate levels on our market value.

Interest Rate Risk. When interest rates on our assets do not adjust at the same time or in the same amounts as the interest rates on our liabilities or when the assets have fixed rates and the liabilities have adjustable rates, future earnings potential is affected. We express this interest rate risk as the risk that the market value of our assets will increase or decrease at different rates than that of our liabilities. Expressed another way, this is the risk that our net asset value will experience an adverse change when interest rates change. We assess the risk based on the change in market values given increases and decreases in interest rates. We also assess the risk based on the impact to net income in changing interest rate environments.

Management primarily uses financing sources where the interest rate resets frequently. As of December 31, 2005, borrowings under all financing arrangements adjust daily or monthly. On the other hand, very few of the mortgage assets we own adjust on a monthly or daily basis. Most of the mortgage loans contain features where their rates are fixed for some period of time and then adjust frequently thereafter. For example, one of our loan products is the “2/28” loan. This loan is fixed for its first two years and then adjusts every six months thereafter.

While short-term borrowing rates are low and long-term asset rates are high, this portfolio structure produces good results. However, if short-term interest rates rise rapidly, earning potential is significantly affected and impairments may be incurred, as the asset rate resets would lag the borrowing rate resets.

Interest Rate Sensitivity Analysis.To assess interest sensitivity 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 a market value and cash flow basis.

The following table summarizes management’s estimates of the changes in market value of our mortgage assets and interest rate agreements assuming interest rates were 100 and 200 basis points, or 1 and 2 percent higher or lower. The cumulative change in market value represents the change in market value of mortgage assets, net of the change in market value of interest rate agreements. The change in market value of the liabilities on our balance sheet due to a change in interest rates is insignificant since the liabilities are so short term.

Interest Rate Sensitivity - Market Value

(dollars in thousands)

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

 
   (200)

  (100)

  100

  200

 

As of December 31, 2005:

                 

Change in market values of:

                 

Assets

  $96,456  $42,327  $(44,254) $(92,483)

Interest rate agreements

   (33,502)  (17,365)  20,072   41,616 
   


 


 


 


Cumulative change in market value

  $62,954  $24,962  $(24,182) $(50,867)
   


 


 


 


Percent change of market value portfolio equity (B)

   11.0%  4.4%  (4.2)%  (8.9)%
   


 


 


 


As of December 31, 2004:

                 

Change in market values of:

                 

Assets

  $70,438  $33,198  $(34,045) $(72,840)

Interest rate agreements

   (54,085)  (28,046)  27,832   55,113 
   


 


 


 


Cumulative change in market value

  $16,353  $5,152  $(6,213) $(17,727)
   


 


 


 


Percent change of market value portfolio equity (B)

   3.3%  1.0%  (1.3)%  (3.6)%
   


 


 


 



(A)Change in market value of assets or interest rate agreements in a parallel shift in the yield curve, up and down 1% and 2%.
(B)Total change in estimated market value as a percent of market value portfolio equity as of December 31.

Hedging.In order to address a mismatch of interest rates on our assets and liabilities, we follow an interest rate program that is approved by our 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 mortgage assets and the differences between interest rate adjustment indices and interest rate adjustment periods of adjustable-rate mortgage loans and related borrowings.

We use interest rate cap and swap contracts to mitigate the risk of the cost of variable rate liabilities increasing at a faster rate than the earnings on assets during a period of rising rates. Management intends generally to hedge as much of the interest rate risk as determined to be in our best interest, given the cost and risk of hedging transactions and the need to maintain REIT status. Our ability to hedge is limited by the REIT laws.

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

Interest rate cap agreements are legal contracts between us and a third-party firm or “counterparty”. The counterparty agrees to make payments to us in the future should the one-month LIBOR interest rate rise above the strike rate specified in the contract. We make either quarterly or monthly premium payments or have chosen to pay the premiums at the beginning to the counterparties under contract. Each contract has either a fixed or amortizing notional face amount on which the interest is computed, and a set term to maturity. When the referenced LIBOR interest rate rises above the contractual strike rate, we earn cap income. Interest rate swaps have similar characteristics. However, interest rate swap agreements allow us to pay a fixed rate of interest while receiving a rate that adjusts with one-month LIBOR.

The following table summarizes the key contractual terms associated with our interest rate risk management contracts. All of our pay-fixed swap contracts and interest rate cap contracts are indexed to one-month LIBOR.

We have determined the following estimated net fair value amounts by using available market information and valuation methodologies we deem appropriate as of December 31, 2005.

Interest Rate Risk Management Contracts

(dollars in thousands)

   

Net Fair

Value


  

Total

Notional

Amount


  Maturity Range

 
      2006

  2007

  2008

  2009

  2010

 

Pay-fixed swaps:

                             

Contractual maturity

  $3,290  $1,020,000  $390,000  $510,000  $120,000  $—    $—   

Weighted average pay rate

       3.9%  2.4%  4.8%  4.8%  —     —   

Weighted average receive rate

       4.4%  (A)  (A)  (A)  —     —   

Interest rate caps:

                             

Contractual maturity

  $5,105  $535,000  $200,000  $160,000  $145,000  $20,000  $10,000 

Weighted average strike rate

       3.8%  2.0%  4.9%  4.9%  4.9%  4.9%

(A)The pay-fixed swaps receive rate is indexed to one-month LIBOR.

Liquidity/Funding Risk.See the “Liquidity and Capital Resources” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion of liquidity risks and resources available to us.

Credit Risk. Credit risk is the risk that we will not fully collect the principal we have invested in mortgage loans or the amount we have invested in securities. Nonconforming mortgage loans comprise substantially our entire mortgage loan portfolio and serve as collateral for our mortgage securities. Our nonconforming borrowers include individuals who do not qualify for agency/conventional lending programs because of a lack of conventional documentation or previous credit difficulties but have considerable equity in their homes. Often, they are individuals or families who have built up high-rate consumer debt and are attempting to use the equity in their home to consolidate debt and reduce the amount of money it takes to service their monthly debt obligations. Our underwriting guidelines are intended to evaluate the credit history of the potential borrower, the capacity and willingness of the borrower to repay the loan, and the adequacy of the collateral securing the loan.

Our underwriting staff works under the credit policies established by our Credit Committee. Underwriters are given approval authority only after their work has been reviewed for a period of time. Thereafter, the Chief Credit Officer re-evaluates the authority levels of all underwriting personnel on an ongoing basis. All loans in excess of $350,000 currently require the approval of an underwriting supervisor. Our Chief Credit Officer or our President must approve loans in excess of $1,000,000.

Our underwriting guidelines take into consideration the number of times the potential borrower has recently been late on a mortgage payment and whether that payment was 30, 60 or 90 days past due. Factors such as FICO score, bankruptcy and foreclosure filings, debt-to-income ratio, and loan-to-value ratio are also considered. The credit grade that is assigned to the borrower is a reflection of the borrower’s historical credit and the loan-to-value determined by the amount of documentation the borrower could produce to support income. Maximum loan-to-value ratios for each credit grade depend on the level of income documentation provided by the potential borrower. In some instances, when the borrower exhibits strong compensating factors, exceptions to the underwriting guidelines may be approved.

The key to our successful underwriting process is the use of NovaStarIS®, which is the second generation of our proprietary automated underwriting system. NovaStarIS® provides more consistency in underwriting loans and allows underwriting personnel to focus more of their time on loans that are not initially accepted by the NovaStarIS® system.

Our mortgage loan portfolio by credit grade, all of which are nonconforming, can be accessed via our website at (www.novastarmortgage.com). References to our website do not incorporate by reference the information on such website into this Annual Report on Form 10-K and we disclaim any such incorporation by reference.

A strategy for managing credit risk is to diversify the markets in which we originate, purchase and own mortgage loans. Presented via our website at (www.novastarmortgage.com) is a breakdown of the geographic diversification of our loans. References to our website do not incorporate by reference the information on such website into this Annual Report on Form 10-K and we disclaim any such incorporation by reference.Details regarding loans charged off are disclosed in Note 2 to our consolidated financial statements.

We have purchased mortgage insurance on a majority of the loans that are held in our portfolio – on the balance sheet and those that serve as collateral for our mortgage securities. The use of mortgage insurance is discussed under “Premiums for Mortgage Loan Insurance” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

Prepayment Risk.Generally speaking, when market interest rates decline, borrowers are more likely to refinance their mortgages. The higher the interest rate a borrower currently has on his or her mortgage the more incentive he or she has to refinance the mortgage when rates decline. In addition, the higher the credit grade, the more incentive there is to refinance when credit ratings improve. When home values rise, a borrower has a low loan-to-value ratio, making it more likely that he or she will do a “cash-out” refinance. Each of these factors increases the chance for higher prepayment speeds during the term of the loan.

The majority of our mortgage securities are “interest-only” in nature. These securities represent the net cash flow – interest income – on the underlying loans in excess of the cost to finance the loans. When borrowers repay the principal on their mortgage loans early, the effect is to shorten the period over which interest is earned, and therefore, reduce the cash flow and yield on our securities.

We mitigate prepayment risk by originating and purchasing loans that include a penalty if the borrower repays the loan in the early months of the loan’s life. For the majority of our loans, a prepayment penalty is charged equal to 80% of six months interest on the principal balance that is to be paid in full. As of December 31, 2005, 67% of the loans serve as collateral for our mortgage securities had a prepayment penalty. As of December 31, 2005, 65% of our mortgage loans - held-for-sale had a prepayment penalty. During 2005, 65% of the loans we originated and purchased had prepayment penalties.

Regulatory Risk.As a mortgage lender, we are subject to many laws and regulations. Any failure to comply with these rules and their interpretations or with any future interpretations or judicial decisions could harm our profitability or cause a change in the way we do business. For example, several lawsuits have been filed challenging types of payments made by mortgage lenders to mortgage brokers. Similarly, in our branch operations, we allow our branch managers considerable autonomy, which could result in our facing greater exposure to third-party claims if our compliance programs are not strictly adhered to.

State and local governing bodies are focused on the nonconforming lending business and are concerned about borrowers paying “excessive fees” in obtaining a mortgage loan – generally termed “predatory lending”. In several instances, states or local governing bodies have imposed strict laws on lenders to curb predatory lending. To date, these laws have not had a significant impact on our business. We have capped fee structures consistent with those adopted by federal mortgage agencies and have implemented rigid processes to ensure that our lending practices are not predatory in nature.

We regularly monitor the laws, rules and regulations that apply to our business and analyze any changes to them. We integrate many legal and regulatory requirements into our automated loan origination system to reduce the prospect of inadvertent non-compliance due to human error. We also maintain policies and procedures, summaries and checklists to help our origination personnel comply with these laws. Our training programs are designed to teach our personnel about the significant laws, rules and regulations that affect their job responsibilities.

U.S. Federal Income Tax Consequences

The following general discussion summarizes the material U.S. federal income tax considerations regarding our qualification and taxation as a REIT. This discussion is based on interpretations of the Code, regulations issued thereunder, and rulings and decisions currently in effect (or in some cases proposed), all of which are subject to change. Any such change may be applied retroactively and may adversely affect the federal income tax consequences described herein. This summary does not discuss all of the tax consequences that may be relevant to particular shareholders or shareholders subject to special treatment under the federal income tax laws. Accordingly, you should consult your own tax advisor regarding the federal, state, local, foreign, and other tax consequences of your ownership and our REIT election, and regarding potential changes in applicable tax laws.

General. Since inception, we have elected to be taxed as a REIT under Sections 856 through 859 of the Code. We believe we have complied, and intend to comply in the future, with the requirements for qualification as a REIT under the Code. To the extent that we qualify as a REIT for federal income tax purposes, we generally will not be subject to federal income tax on the amount of income or gain that is distributed to shareholders. However, origination and broker operations are conducted through NovaStar Mortgage and NHMI, which are owned by NFI Holding, Inc. – a taxable REIT subsidiary (“TRS”). Consequently, all of the taxable income of NFI Holding, Inc. is subject to federal and state corporate income taxes. In general, a TRS may hold assets that a REIT cannot hold directly and generally may engage in any real estate or non-real estate related business. However, special rules do apply to certain activities between a REIT and its TRS. For example, a TRS will be subject to earnings stripping limitations on the deductibility of interest paid to its REIT. In addition, a REIT will be subject to a 100% excise tax on certain excess amounts to ensure that (i) amounts paid to a TRS for services are based on amounts that would be charged in an arm’s-length transaction, (ii) fees paid to a REIT by its TRS are reflected at fair market value and (iii) interest paid by a TRS to its REIT is commercially reasonable.

The REIT rules generally require that a REIT invest primarily in real estate related assets, its activities be passive rather than active and it distribute annually to its shareholders substantially all of its taxable income. We could be subject to a number of taxes if we failed to satisfy those rules or if we acquired certain types of income-producing real property through foreclosure. Although no complete assurance can be given, we do not expect that we will be subject to material amounts of such taxes.

Failure to satisfy certain Code requirements could cause loss of REIT status. If we fail to qualify as a REIT for any taxable year, we would be subject to federal income tax (including any applicable minimum tax) at regular corporate rates and would not receive deductions for dividends paid to shareholders. As a result, the amount of after-tax earnings available for distribution to shareholders would decrease substantially. While we intend to operate in a manner that will enable us to qualify as a REIT in future taxable years, there can be no certainty that such intention will be realized.

Qualification as a REIT. Qualification as a REIT requires that we satisfy a variety of tests relating to income, assets, distributions and ownership. The significant tests are summarized below.

Sources of Income.To qualify as a REIT, we must satisfy two gross income requirements, each of which is applied on an annual basis. First, at least 75% of our gross income, excluding gross income from prohibited transactions, for each taxable year generally must be derived directly or indirectly from:

rents from real property;

interest on debt secured by mortgages on real property or on interests in real property;

dividends or other distributions on, and gain from the sale of, stock in other REITs;

gain from the sale of real property or mortgage loans;

amounts, such as commitment fees, received in consideration for entering into an agreement to make a loan secured by real property, unless such amounts are determined by income and profits;

income derived from a Real Estate Mortgage Investment Conduit (“REMIC”) in proportion to the real estate assets held by the REMIC, unless at least 95% of the REMIC’s assets are real estate assets, in which case all of the income derived from the REMIC; and

interest or dividend income from investments in stock or debt instruments attributable to the temporary investment of new capital during the one-year period following our receipt of new capital that we raise through equity offerings or public offerings of debt obligations with at least a five-year term.

Second, at least 95% of our gross income, excluding gross income from prohibited transactions, for each taxable year must be derived from sources that qualify for purposes of the 75% gross income test, and from (i) dividends, (ii) interest, (iii) certain qualifying hedges entered into prior to January 1, 2005 and (iv) gain from the sale or other disposition of stock, securities, or, certain qualifying hedges entered into prior to January 1, 2005.

Management believes that we were in compliance with both of the income tests for the 2005 and 2004 calendar years.

Nature and Diversification of Assets. As of the last day of each calendar quarter, we must meet six requirements under the two asset tests. Under the 75% of assets test, at least 75% of the value of our total assets must represent cash or cash items (including receivables), government securities or real estate assets. Under the 25% of assets test, no more than 25% of the value of our total assets can be represented by securities, other than (A) government securities, (B) stock of a qualified REIT subsidiary and (C) securities that qualify as real estate assets under the 75% assets test ((A), (B) and (C) are collectively the “75% Securities”). Additionally, under the 25% assets test, no more than 20% of the value of our total assets can be represented by securities of one or more taxable REIT subsidiaries and no more than 5% of the value of our total assets can be represented by the securities of a single issuer, excluding 75% Securities. Furthermore, we may not own more than 10% of the total voting power or the total value of the outstanding securities of any one issuer, excluding 75% Securities.

If we inadvertently fail to satisfy one or more of the asset tests at the end of a calendar quarter, such failure would not cause us to lose our REIT status. We could still avoid disqualification by eliminating any discrepancy within 30 days after the close of the calendar quarter in which the discrepancy arose. Management believes that we were in compliance with all of the requirements of both asset tests for all quarters during 2005 and 2004.

Ownership of Common Stock. Our capital stock must be held by a minimum of 100 persons for at least 335 days of each year. In addition, at all times during the second half of each taxable year, no more than 50% in value of our capital stock may be owned

directly or indirectly by 5 or fewer individuals. We use the calendar year as our taxable year for income tax purposes. The Code requires us to send annual information questionnaires to specified shareholders in order to assure compliance with the ownership tests. Management believes that we have complied with these stock ownership tests for 2005 and 2004.

Distributions. We must distribute at least 90% of our taxable income and any after-tax net income from certain types of foreclosure property less any non-cash income. No distributions are required in periods in which there is no income.

Taxable Income. We use the calendar year for both tax and financial reporting purposes. However, there may be differences between taxable income and income computed in accordance with GAAP. These differences primarily arise from timing and character differences in the recognition of revenue and expense and gains and losses for tax and GAAP purposes. Additionally, taxable income does not include the taxable income of our taxable subsidiary, although the subsidiary’s operating results are included in our GAAP results.

Personnel

As of December 31, 2005, we employed 2,032 people. Of these, 1,678 were employed in our mortgage portfolio management, mortgage lending and loan servicing operations. Our branches employed 347 people as of December 31, 2005. The remaining employees were employed in our branch administrative functions.

Available Information

Copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to these reports filed or furnished with the SEC are available free of charge through our Internet site (www.novastarmortgage.com) as soon as reasonably practicable after filing with the SEC. References to our website do not incorporate by reference the information on such website into this Annual Report on Form 10-K and we disclaim any such incorporation by reference. Copies of our board committee charters, our board’s Corporate Governance Guidelines, Code of Conduct, and other corporate governance information are available at the Corporate Governance section of our Internet site (www.novastarmortgage.com), or by contacting us directly. Our investor relations contact information follows.

Investor Relations

8140 Ward Parkway, Suite 300

Kansas City, MO 64114

816.237.7000

Email: ir@novastar1.com

Item 1A.Risk Factors

Risk Factors

You should carefully consider the risks described below before investing in our publicly traded securities. The risks described below are not the only ones facing us. Our business is also subject to the risks that affect many other companies, such as competition, inflation, technological obsolescence, labor relations, general economic conditions and geopolitical events. Additional risks not currently known to us or that we currently believe are immaterial also may impair our business operations and our liquidity.

Risks Related to Our Borrowing and Securitization Activities

Our growth is dependent on leverage, which may create other risks.

Our success is dependent, in part, upon our ability to grow our assets through the use of leverage. Leverage creates an opportunity for increased net income, but at the same time creates risks. For example, leveraging magnifies changes in our net worth. We will incur leverage only when there is an expectation that it will enhance returns. Moreover, there can be no assurance that we will be able to meet our debt service obligations and, to the extent that we cannot, our ability to make expected minimum REIT dividend requirements to shareholders will be adversely affected. Furthermore, if we were to liquidate, our debt holders and lenders will receive a distribution of our available assets before any distributions are made to our common shareholders.

An interruption or reduction in the securitization market or our ability to access this market would harm our financial position.

We are dependent on the securitization market because we securitize loans directly to finance our loan origination business and many of our whole loan buyers purchase our loans with the intention to securitize. A disruption in the securitization market could prevent us from being able to sell loans at a favorable price or at all. Factors that could disrupt the securitization market include an international liquidity crisis such as occurred in the fall of 1998, sudden changes in interest rates, a terrorist attack, an outbreak of war or other significant event risk, and market specific events such as a default of a comparable type of securitization. In addition, poor performance of our previously securitized loans could harm our access to the securitization market. In addition, a court recently found a lender and securitization underwriter liable for consumer fraud committed by a company to whom they provided financing and underwriting services. In the event other courts or regulators adopted the same liability theory, lenders and underwriters could be named as defendants in more litigation and as a result they may exit the business or charge more for their services, all of which could have a negative impact on our ability to securitize the loans we originate and the securitization market in general. A decline in our ability to obtain long-term funding for our mortgage loans in the securitization market in general or on attractive terms or a decline in the market’s demand for our loans could harm our results of operations, financial condition and business prospects.

Failure to renew or obtain adequate funding under warehouse repurchase agreements may harm our lending operations.

We are currently dependent upon several warehouse purchase agreements to provide short term financing of our mortgage loan originations and acquisitions. These warehouse purchase agreements contain numerous representations, warranties and covenants, including requirements to maintain a certain minimum net worth, minimum equity ratios and other customary debt covenants. If we were unable to make the necessary representations and warranties at the time we need financing, we would not be able to obtain needed funds. In addition, if we breach a covenant contained in any warehouse agreement, the lenders under all existing warehouse agreements could demand immediate payment of all outstanding amounts because all of our warehouse agreements contain cross-default provisions. Any failure to renew or obtain adequate funding under these financing arrangements for any reason, or any demand by warehouse lenders for immediate payment of outstanding balances could harm our lending operations and have a material adverse effect on our results of operations, financial condition and business prospects. In addition, an increase in the cost of warehouse financing in excess of any change in the income derived from our mortgage assets could also harm our earnings and reduce the cash available for distribution to our shareholders. In October 1998, the subprime mortgage loan market faced a liquidity crisis with respect to the availability of short-term borrowings from major lenders and long-term borrowings through securitization. At that time, we faced significant liquidity constraints which harmed our business and our profitability.

Financing with warehouse repurchase agreements may lead to margin calls if the market value of our mortgage assets declines.

We use warehouse repurchase agreements to finance our acquisition of mortgage assets in the short-term. In a warehouse repurchase agreement, we sell an asset and agree to repurchase the same asset at some point in time in the future. Generally, the

repurchase agreements we enter into provide that we must repurchase the asset in 30 days. For financial accounting purposes, these arrangements are treated as secured financings. We retain the assets on our balance sheet and record an obligation to repurchase the asset. The amount we may borrow under these arrangements is generally 95% to 100% of the asset market value with respect to mortgage loans and 65% to 80% of the asset market value with respect to mortgage securities—available-for-sale. When, in a lender’s opinion, asset market values decrease for any reason, including a rise in interest rates or general concern about the value or liquidity of the assets, we are required to repay the margin or difference in market value, or post additional collateral. If cash or additional collateral is unavailable to meet margin calls, we may default on our obligations under the applicable repurchase agreement. In that event, the lender retains the right to liquidate the collateral we provided it to settle the amount due from us. In addition to obtain cash, we may be required to liquidate assets at a disadvantageous time, which would cause us to incur losses and could change our mix of investments, which in turn could jeopardize our REIT status or our ability to rely on certain exemptions under the Investment Company Act.

We have credit exposure with respect to loans we sell to the whole loan market and loans we sell to securitization entities.

When we sell whole loans or securitize loans, we have potential credit and liquidity exposure for loans that are the subject of fraud, that have irregularities in their documentation or process, or that result in our breaching the representations and warranties in the contract of sale. In addition, when we sell loans to the whole loan market we have exposure for loans that default. In these cases, we may be obligated to repurchase loans at principal value, which could result in a significant decline in our available cash. When we purchase loans from a third party that we sell into the whole loan market or to a securitization trust, we obtain representations and warranties from the counter-parties that sold the loans to us that generally parallel the representations and warranties we provided to our purchasers. As a result, we believe we have the potential for recourse against the seller of the loans. However, if the representations and warranties are not parallel, or if the original seller is not in a financial position to be able to repurchase the loan, we may have to use cash resources to repurchase loans, which could adversely affect our liquidity.

Competition in the securitization market may negatively affect our net income.

Competition in the business of sponsoring securitizations of the type we focus on is increasing as Wall Street broker-dealers, mortgage REITs, investment management companies, and other financial institutions expand their activities or enter this field. Increased competition could reduce our securitization margins if we have to pay a higher price for the long-term funding of these assets. To the extent that our securitization margins erode, our results of operations, financial condition and business prospects will be negatively impacted.

Differences in our actual experience compared to the assumptions that we use to determine the value of our mortgage securities—available-for-sale could adversely affect our financial position.

Currently, our securitizations of mortgage loans are structured to be treated as sales for financial reporting purposes and, therefore, result in gain recognition at closing. As of December 31, 2005, we had mortgage securities – available for sale with a fair value of $505.6 million on our balance sheet. Delinquency, loss, prepayment and discount rate assumptions have a material impact on the amount of gain recognized and on the carrying value of the retained mortgage securities—available-for-sale. It is extremely difficult to validate the assumptions we use in determining the amount of gain on sale and the value of our mortgage securities – available for sale. If our actual experience differs materially from the assumptions that we use to determine our gain on sale or the value of our mortgage securities—available-for-sale, our future cash flows, our financial condition and our results of operations could be negatively affected.

Changes in accounting standards might cause us to alter the way we structure or account for securitizations.

Changes could be made to the current accounting standards, which could affect the way we structure or account for securitizations. For example, if changes were made in the types of transactions eligible for gain on sale treatment, we may have to change the way we account for securitizations, which may harm our results of operations or financial condition.

Risks Related to Interest Rates and Our Hedging Strategies

Changes in interest rates may harm our results of operations.

Our results of operations are likely to be harmed during any period of unexpected or rapid changes in interest rates. Interest rate changes could affect us in the following ways:

a substantial or sustained increase in interest rates could harm our ability to originate or acquire mortgage loans in expected volumes, which could result in a decrease in our cash flow and in our ability to support our fixed overhead expense levels;

interest rate fluctuations may harm our earnings as the spread between the interest rates we pay on our borrowings and the interest rates we receive on our mortgage assets narrows;

mortgage prepayment rates vary depending on such factors as mortgage interest rates and market conditions, and changes in anticipated prepayment rates may harm our earnings; and

when we securitize loans, the value of the residual and subordinated securities we retain and the income we receive from them are based primarily on the London Inter-Bank Offered Rate, or LIBOR, and an increase in LIBOR reduces the net income we receive from, and the value of, these securities.

Any of the foregoing results from changing interest rates may adversely affect our results from operations.

Hedging against interest rate exposure may adversely affect our earnings, which could adversely affect cash available for distribution to our shareholders.

We may enter into interest rate cap or swap agreements or pursue other interest rate hedging strategies. Our hedging activity will vary in scope based on interest rates, the type of mortgage assets held, and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect us because, among other things:

interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates;

hedging instruments involve risk because they often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities; consequently, there are no requirements with respect to record keeping, financial responsibility or segregation of customer funds and positions, and the enforceability of agreements underlying derivative transactions may depend on compliance with applicable statutory, commodity and other regulatory requirements;

available interest rate hedging may not correspond directly with the interest rate risk for which protection is sought;

the duration of the hedge may not match the duration of the related liability or asset;

the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction;

the party owing money in the hedging transaction may default on its obligation to pay, which may result in the loss of unrealized profits; and

we may not be able to dispose of or close out a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an offsetting contract in order to cover our risks.

Any hedging activity we engage in may adversely affect our earnings, which could adversely affect cash available for distribution to our shareholders. Unanticipated changes in interest rates may result in poorer overall investment performance than if we had not engaged in any such hedging transactions.

Complying with REIT requirements may limit our ability to hedge effectively.

We attempt to minimize exposure to interest rate fluctuations by hedging. The REIT provisions of the Code limit our ability to hedge mortgage assets and related borrowings by requiring us to limit our income in each year from any qualified hedges, together with any other income not generated from qualified real estate assets, to no more than 25% of our gross income. The interest rate hedges that we generally enter into will not be counted as a qualified asset for the purposes of satisfying this requirement. In addition, under the Code, we must limit our aggregate income from non-qualified hedging transactions and from other non-qualifying sources to no more than 5% of our annual gross income. As a result, we may have to limit our use of advantageous hedging techniques. This could result in greater risks associated with changes in interest rates than we would otherwise want to incur. In addition, if it is ultimately determined that certain of our interest rate hedging transactions are non-qualified under the

Code, we may have more than 5% of our annual gross income from non-qualified sources. If we violate the 5% or 25% limitations, we may have to pay a penalty tax equal to the amount of income in excess of those limitations, multiplied by a fraction intended to reflect our profitability. In addition, if we fail to observe these limitations, we could lose our REIT status unless our failure was due to reasonable cause and not due to willful neglect.

Risks Related to Credit Losses and Prepayment Rates

Loans made to nonconforming mortgage borrowers entail relatively higher delinquency and default rates which would result in higher loan losses.

Lenders in the nonconforming mortgage banking industry make loans to borrowers who have impaired or limited credit histories, limited documentation of income and higher debt-to-income ratios than traditional mortgage lenders allow. Mortgage loans made to nonconforming mortgage loan borrowers generally entail a relatively higher risk of delinquency and foreclosure than mortgage loans made to borrowers with better credit and, therefore, may result in higher levels of realized losses. Delinquency interrupts the flow of projected interest income from a mortgage loan, and default can ultimately lead to a loss if the net realizable value of the real property securing the mortgage loan is insufficient to cover the principal and interest due on the loan. Also, our cost of financing and servicing a delinquent or defaulted loan is generally higher than for a performing loan. We bear the risk of delinquency and default on loans beginning when we originate them. In whole loan sales, our risk of delinquency and default typically only extends to the first payment but can extend up to the third payment. When we securitize any of our loans, we continue to be exposed to delinquencies and losses, either through our residual interests for securitizations structured as sales or through the loans still recorded on our balance sheet for securitizations structured as financings. We also re-acquire the risks of delinquency and default for loans that we are obligated to repurchase. Any failure by us to adequately address the delinquency and default risk associated with nonconforming lending could harm our financial condition and results of operations.

Our efforts to manage credit risk may not be successful in limiting delinquencies and defaults in underlying loans and, as a result, our results of operations may be affected.

There are many aspects of credit that we cannot control and our quality control and loss mitigation operations may not be successful in limiting future delinquencies, defaults and losses. Our comprehensive underwriting process may not be effective in mitigating our risk of loss on the underlying loans. Further, the value of the homes collateralizing residential loans may decline due to a variety of reasons beyond our control, such as weak economic conditions, natural disasters, over-leveraging of the borrower, and reduction in personal incomes. The frequency of defaults and the loss severity on loans upon default may be greater than we anticipated. Interest-only loans, negative amortization loans, adjustable-rate loans, reduced documentation loans, sub-prime loans, home equity lines of credit and second lien loans may involve higher than expected delinquencies and defaults. Changes in consumer behavior, bankruptcy laws, and other laws may exacerbate loan losses. Expanded loss mitigation efforts in the event that defaults increase could increase our operating costs. To the extent that unforeseen or uncontrollable events increase loan delinquencies and defaults, our results of operations may be adversely affected.

Mortgage insurers may in the future change their pricing or underwriting guidelines or may not pay claims resulting in increased credit losses.

We use mortgage insurance to mitigate our risk of credit losses. Our decision to obtain mortgage insurance coverage is dependent, in part, on pricing trends. Mortgage insurance coverage on our new mortgage loan production may not be available at rates that we believe are economically viable for us or at all. We also face the risk that our mortgage insurers might not have the financial ability to pay all claims presented by us or may deny a claim if the loan is not properly serviced, has been improperly originated, is the subject of fraud, or for other reasons. Any of those events could increase our credit losses and thus adversely affect our results of operations and financial condition.

Our Option ARM mortgage product exposes us to greater credit risk

There has been an increase in production of our loan product which is characterized as an option ARM loan. There have been recent announcements by federal regulators concerning interest-only loan programs, option ARM loan programs and other ARM loans with deeply discounted initial rates and/or negative amortization features. Federal banking regulators have expressed serious concerns with these programs and an intent to issue guidance shortly concerning offerings of these products. In addition, already one rating agency (Standard & Poors) has required greater credit enhancements for securitization pools that are backed by option ARMs. The combination of these events could lead to the loan product becoming a less available financing option and hence this could have a material affect on the value of such products.

Our interest-only loans may have a higher risk of default than our fully-amortizing loans.

For the year ended December 31, 2005, originations of interest-only loans totaled $2.0 billion, or 22%, of total originations. These interest-only loans require the borrowers to make monthly payments only of accrued interest for the first 24, 36 or 120 months following origination. After such interest-only period, the borrower’s monthly payment is recalculated to cover both interest and principal so that the mortgage loan will amortize fully prior to its final payment date. The interest-only feature may reduce the likelihood of prepayment during the interest-only period due to the smaller monthly payments relative to a fully-amortizing mortgage loan. If the monthly payment increases, the related borrower may not be able to pay the increased amount and may default or may refinance the related mortgage loan to avoid the higher payment. Because no principal payments may be made on such mortgage loans for an extended period following origination, if the borrower defaults, the unpaid principal balance of the related loans would be greater than otherwise would be the case for a fully-amortizing loan, increasing the risk of loss on these loans.

Current loan performance data may not be indicative of future results.

When making capital budgeting and other decisions, we use projections, estimates and assumptions based on our experience with mortgage loans. Actual results and the timing of certain events could differ materially in adverse ways from those projected, due to factors including changes in general economic conditions, fluctuations in interest rates, fluctuations in mortgage loan prepayment rates and fluctuations in losses due to defaults on mortgage loans. These differences and fluctuations could rise to levels that may adversely affect our profitability.

Changes in prepayment rates of mortgage loans could reduce our earnings, dividends, cash flows, access to liquidity and results of operations.

The economic returns we expect to earn from most of the mortgage assets we own are affected by the rate of prepayment of the underlying mortgage loans. If the loans underlying our mortgage securities—available-for-sale prepay at a rate faster than we have anticipated, our economic returns on those assets will be lower than we have assumed which would reduce our earnings, cash flows and dividends. Adverse changes in cash flows from a mortgage asset resulting from accelerated prepayments would likely reduce the asset’s market value, which would likely reduce our access to liquidity if we borrowed against that asset and may cause a market value write-down for GAAP purposes, which would reduce our reported earnings. Changes in loan prepayment patterns can affect us in a variety of other ways that can be complex and difficult to predict. In addition, our exposure to prepayment changes over time. As a result, changes in prepayment rates will likely cause volatility in our financial results in ways that are not necessarily obvious or predictable and that may adversely affect our results of operations.

Geographic concentration of mortgage loans we originate or purchase increases our exposure to risks in those areas, especially in California and Florida.

Over-concentration of loans we originate or purchase in any one geographic area increases our exposure to the economic and natural hazard risks associated with that area. Declines in the residential real estate markets in which we are concentrated may reduce the values of the properties collateralizing our mortgages which in turn may increase the risk of delinquency, foreclosure, bankruptcy, or losses from those loans. To the extent that a large number of loans are impaired, our financial condition and results of operations may be adversely affected.

To the extent that we have a large number of loans in an area hit by a natural disaster, we may suffer losses.

Standard homeowner insurance policies generally do not provide coverage for natural disasters, such as hurricanes and floods. Furthermore, nonconforming borrowers are not likely to have special hazard insurance. To the extent that borrowers do not have insurance coverage for natural disasters, they may not be able to repair the property or may stop paying their mortgages if the property is damaged. A natural disaster that results in a significant number of delinquencies could cause increased foreclosures and decrease our ability to recover losses on properties affected by such disasters, and that in turn could harm our financial condition and results of operations.

Uninsured losses due to the Gulf State hurricanes could adversely affect our financial condition and results of operations.

The damage caused by the Gulf State hurricanes, particularly Katrina, Rita and Wilma, has affected the value of our portfolio of mortgage loans held-for-sale and the mortgage loan portfolio we service which underlies our mortgage securities – available-for-sale by impairing the ability of certain borrowers to repay their loans. At present, we are unable to predict the ultimate impact of the Gulf State hurricanes on our future financial results and condition as the impact will depend on a number of factors, including the extent of damage to the collateral, the extent to which damaged collateral is not covered by insurance, the extent to which unemployment and other economic conditions caused by the hurricanes adversely affect the ability of borrowers to repay their

loans, and the cost to us of collection and foreclosure moratoriums, loan forbearances and other accommodations granted to borrowers. Many of the loans are to borrowers where repayment prospects have not yet been determined to be diminished, or are in areas where properties may have suffered little, if any, damage or may not yet have been inspected. We currently have a mortgage protection insurance policy, which protects us from uninsured losses as a result of these hurricanes up to a maximum of $5 million in aggregate losses with a deductible of $100,000 per hurricane. To the extent that losses exceed the $5 million aggregate loss insurance coverage, our financial condition and results of operations could be adversely affected. Additionally, there is no guarantee the insurance company will pay our claims, which could adversely affect our results of operations.

A prolonged economic slowdown or a decline in the real estate market could harm our results of operations.

A substantial portion of our mortgage assets consist of single-family mortgage loans or mortgage securities—available-for-sale evidencing interests in single-family mortgage loans. Because we make a substantial number of loans to credit-impaired borrowers, the actual rates of delinquencies, foreclosures and losses on these loans could be higher during economic slowdowns. Any sustained period of increased delinquencies, foreclosures or losses could harm our ability to sell loans, the prices we receive for our loans, the values of our mortgage loans held for sale or our residual interests in securitizations, which could harm our financial condition and results of operations. In addition, any material decline in real estate values would weaken our collateral loan-to-value ratios and increase the possibility of loss if a borrower defaults. In such event, we will be subject to the risk of loss on such mortgage asset arising from borrower defaults to the extent not covered by third-party credit enhancement.

Risks Related to the Legal and Regulatory Environment in Which We Operate

Various legal proceedings could adversely affect our financial condition or results of operations.

In the course of our business, we are subject to various legal proceedings and claims. See “Item 3 – Legal Proceedings.” The resolution of these legal matters or other legal matters could result in a material adverse impact on our results of operations, financial condition and business prospects.

We are subject to the risk that provisions of our loan agreements may be unenforceable.

Our rights and obligations with respect to our loans are governed by written loan agreements and related documentation. It is possible that a court could determine that one or more provisions of a loan agreement are unenforceable, such as a loan prepayment provision or the provisions governing our security interest in the underlying collateral. If this were to happen with respect to a material asset or group of assets, we could be required to repurchase these loans and may not be able to sell or liquidate the loans, which could negatively affect our liquidity.

We are exposed to the risk of environmental liabilities with respect to properties to which we take title.

In the course of our business, we occasionally foreclose and take title to residential properties and as a result could become subject to environmental liabilities associated with these properties. We may be held liable for property damage, personal injury, investigation, and cleanup costs incurred in connection with environmental contamination. These costs could be substantial. If we ever become subject to significant environmental liabilities, our financial condition and results of operations could be adversely affected.

Regulation as an investment company could harm our business; efforts to avoid regulation as an investment company could limit our operations.

The Investment Company Act of 1940, as amended, or the Investment Company Act, if deemed applicable to us, would prevent us from conducting our business as described in this document by, among other things, substantially limiting our ability to use leverage. The Investment Company Act does not regulate entities that are primarily engaged, directly or indirectly, in a business “other than that of investing, reinvesting, owning, holding or trading in securities,” or that are primarily engaged in the business of “purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” Under the Commission’s current interpretation, in order to qualify for the latter exemption we must maintain at least 55% of our assets directly in “qualifying real estate interests” and at least an additional 25% of our assets in other real estate-related assets or additional qualifying real estate interests. If we rely on this exemption from registration as an investment company under the Investment Company Act, our ability to invest in assets that would otherwise meet our investment strategies will be limited. If we are subject to the Investment Company Act and fail to qualify for an applicable exemption from the Investment Company Act, we could not operate our business efficiently under the regulatory scheme imposed by the Investment Company Act. Accordingly, we could be required to restructure our activities which could materially adversely affect our financial condition and results of operations.

Our failure to comply with federal, state or local regulation of, or licensing requirements with respect to, mortgage lending, loan servicing, broker compensation programs, or other aspects of our business could harm our operations and profitability.

As a mortgage lender, loan servicer and broker, we are subject to an extensive body of both state and federal law. The volume of new or modified laws and regulations has increased in recent years and, in addition, some individual municipalities have begun to enact laws that restrict loan origination and servicing activities. As a result, it may be more difficult to comprehensively identify and accurately interpret all of these laws and regulations and to properly program our technology systems and effectively train our personnel with respect to all of these laws and regulations, thereby potentially increasing our exposure to the risks of noncompliance with these laws and regulations. Also, in our branch operations, we allow our branch managers relative autonomy, which could result in our facing greater exposure to third-party claims if our compliance programs are not strictly adhered to. Our failure to comply with these laws can lead to civil and criminal liability; loss of licensure; damage to our reputation in the industry; inability to sell or securitize our loans; demands for indemnification or loan repurchases from purchasers of our loans; fines and penalties and litigation, including class action lawsuits; or administrative enforcement actions. Any of these results could harm our results of operations, financial condition and business prospects.

New legislation could restrict our ability to make mortgage loans, which could harm our earnings.

Several states, cities or other government entities are considering or have passed laws, regulations or ordinances aimed at curbing predatory lending practices. The federal government is also considering legislative and regulatory proposals in this regard. In general, these proposals involve lowering the existing thresholds for defining a “high-cost” loan and establish enhanced protections and remedies for borrowers who receive such loans. Passage of these laws and rules could reduce our loan origination volume. In addition, many whole loan buyers may elect not to purchase any loan labeled as a “high cost” loan under any local, state or federal law or regulation. Rating agencies likewise may refuse to rate securities backed by such loans. Accordingly, these laws and rules could severely restrict the secondary market for a significant portion of our loan production. This would effectively preclude us from continuing to originate loans either in jurisdictions unacceptable to the rating agencies or that exceed the newly defined thresholds which could harm our results of operations and business prospects.

If lenders are prohibited from originating loans in the State of Illinois with fees in excess of 3% where the interest rate exceeds 8%, this could force us to curtail operations in Illinois.

In March 2004, an Illinois Court of Appeals found that the Illinois Interest Act, which caps fees at 3% for loans with an interest rate in excess of 8%, is not preempted by federal law. This ruling contradicts the view of the Federal Circuit Courts of Appeal, most state courts and the Illinois Office of the Attorney General. In November 2004, the Illinois Supreme Court decided to consider an appeal to this case. If this ruling is not overturned, we may reduce operations in Illinois since it will reduce the return we and our investors can expect on higher risk loans. Moreover, as a result of this ruling, plaintiffs are filing actions against lenders, including us, seeking various forms of relief as a result of any fees received in the past that exceeded the applicable thresholds. Any such actions, if decided against us, could harm our results of operations, financial condition and business prospects.

We are no longer able to rely on the Alternative Mortgage Transactions Parity Act to preempt certain state law restrictions on prepayment penalties, which could harm our earnings.

Certain state laws restrict or prohibit prepayment penalties on mortgage loans and, until July 2003, we relied on the federal Alternative Mortgage Transactions Parity Act, or the Parity Act, and related rules issued in the past by the Office of Thrift Supervision, or OTS, to preempt state limitations on prepayment penalties. The Parity Act was enacted to extend to financial institutions, like us, which are not federally chartered depository institutions, the federal preemption that federally chartered depository institutions enjoy. However, in September 2002, the OTS released a rule that reduced the scope of the Parity Act preemption and, as a result, we are no longer able to rely on the Parity Act to preempt state restrictions on prepayment penalties. The elimination of this federal preemption has required us to comply with state restrictions on prepayment penalties. These restrictions prohibit us from charging any prepayment penalty in certain states and limit the amount or other terms and conditions of our prepayment penalties in several other states. This places us at a competitive disadvantage relative to financial institutions that will continue to enjoy federal preemption of such state restrictions. Such institutions are able to charge prepayment penalties without regard to state restrictions and, as a result, may be able to offer loans with interest rate and loan fee structures that are more attractive than the interest rate and loan fee structures that we are able to offer. This competitive disadvantage could harm our results of operations, financial condition and business prospects.

Changes in Internal Revenue Service regulations regarding the timing of income recognition and/or deductions could materially adversely affect the amount of our dividends.

On September 30, 2004, the IRS, released Announcement 2004-75, which describes rules that may be included in proposed IRS regulations regarding the timing of recognizing income and/or deductions attributable to interest-only securities. We believe the

effect of these regulations, if adopted, may narrow the spread between book income and taxable income on the interest-only securities we hold and would thus reduce our taxable income during the initial periods that we hold such securities. A significant portion of our mortgage securities—available-for-sale consist of interest-only securities. If regulations are adopted by the IRS that reduce our taxable income in a particular year, our dividend may be reduced for that year because the amount of our dividend is entirely dependent upon our taxable income.

If we fail to maintain REIT status, we would be subject to tax as a regular corporation. We conduct a substantial portion of our business through our taxable REIT subsidiaries, which creates additional compliance requirements.

We must comply with numerous complex tests to continue to qualify as a REIT for federal income tax purposes, including the requirement that we distribute 90% of taxable income to our shareholders and the requirement that no more than 5% of our annual gross income come from non-qualifying sources. If we do not comply with these requirements, we could be subject to penalty taxes and our REIT status could be at risk. We conduct a substantial portion of our business through taxable REIT subsidiaries, such as NovaStar Mortgage. Despite our qualification as a REIT, our taxable REIT subsidiaries must pay federal income tax on their taxable income. Our income from, and investments in, our taxable REIT subsidiaries do not constitute permissible income or investments for some of the REIT qualification tests. We may be subject to a 100% penalty tax, or our taxable REIT subsidiaries may be denied deductions, to the extent that our dealings with our taxable REIT subsidiaries are deemed not to be arm’s length in nature.

Our cash balances and cash flows may become limited relative to our cash needs, which may ultimately affect our REIT status or solvency.

We use cash for originating mortgage loans, minimum REIT dividend distribution requirements, and other operating needs. Cash is also required to pay interest on our outstanding indebtedness and may be required to pay down indebtedness in the event that the market values of the assets collateralizing our debt decline, the terms of short-term debt become less attractive or for other reasons. If our income as calculated for tax purposes significantly exceeds our cash flows from operations, our minimum REIT dividend distribution requirements could exceed the amount of our available cash. In the event that our liquidity needs exceed our access to liquidity, we may need to sell assets at an inopportune time, thus adversely affecting our financial condition and results of operations. Furthermore, in an adverse cash flow situation, our REIT status or our solvency could be threatened.

The tax imposed on REITs engaging in “prohibited transactions” will limit our ability to engage in transactions, including certain methods of securitizing loans, which would be treated as sales for federal income tax purposes.

A REIT’s net income from prohibited transactions is subject to a 100% tax. In general, prohibited transactions are sales or other dispositions of property, other than foreclosure property but including any mortgage loans held in inventory primarily for sale to customers in the ordinary course of business. We might be subject to this tax if we were to sell a loan or securitize the loans in a manner that was treated as a sale of such inventory for federal income tax purposes. Therefore, in order to avoid the prohibited transactions tax, we may choose not to engage in certain sales of loans other than through our taxable REIT subsidiaries and may limit the structures we utilize for our securitization transactions even though such sales or structures might otherwise be beneficial for us. In addition, this prohibition may limit our ability to restructure our portfolio of mortgage loans from time to time even if we believe it would be in our best interest to do so.

Even if we qualify as a REIT, the income earned by our taxable REIT subsidiaries will be subject to federal income tax and we could be subject to an excise tax on non-arm’s-length transactions with our taxable REIT subsidiaries.

Our taxable REIT subsidiaries, including NovaStar Mortgage, expect to earn income from activities that are prohibited for REITs, and will owe income taxes on the taxable income from these activities. For example, we expect that NovaStar Mortgage will earn income from our loan origination and sales activities, as well as from other origination and servicing functions, which would generally not be qualifying income for purposes of the gross income tests applicable to REITs or might otherwise be subject to adverse tax liability if the income were generated by a REIT. Our taxable REIT subsidiaries will be taxable as C corporations and will be subject to federal, state and local income tax at the applicable corporate rates on their taxable income, notwithstanding our qualification as a REIT.

In the event that any transactions between us and our taxable REIT subsidiaries are not conducted on an arm’s-length basis, we could be subject to a 100% excise tax on certain amounts from such transactions. Any such tax could affect our overall profitability and the amounts of cash available to make distributions.

We may, at some point in the future, borrow funds form one or more of our corporate subsidiaries. The IRS may recharacterize the indebtedness as a dividend distribution to us by our subsidiary. Any such recharacterization may cause us to fail one or more of the REIT requirements.

We may be harmed by changes in tax laws applicable to REITs or the reduced 15% tax rate on certain corporate dividends may harm us.

Changes to the laws and regulations affecting us, including changes to securities laws and changes to the Code applicable to the taxation of REITs, may harm our business. New legislation may be enacted into law or new interpretations, rulings or regulations could be adopted, any of which could harm us and our shareholders, potentially with retroactive effect.

Generally, dividends paid by REITs are not eligible for the 15% U.S. federal income tax rate on certain corporate dividends, with certain exceptions. The more favorable treatment of regular corporate dividends could cause domestic non-corporate investors to consider stocks of other corporations that pay dividends as more attractive relative to stocks of REITs.

We may be unable to comply with the requirements applicable to REITs or compliance with such requirements could harm our financial condition.

The requirements to qualify as a REIT under the Code are highly technical and complex. We routinely rely on legal opinions to support our tax positions. A technical or inadvertent failure to comply with the Code as a result of an incorrect interpretation of the Code or otherwise could jeopardize our REIT status. The determination that we qualify as a REIT requires an analysis of various factual matters and circumstances that may not be totally within our control. For example, to qualify as a REIT, at least 75% of our gross income must come from real estate sources and 95% of our gross income must come from real estate sources and certain other sources that are itemized in the REIT tax laws, mainly interest and dividends. We are subject to various limitations on our ownership of securities, including a limitation that the value of our investment in taxable REIT subsidiaries, including NovaStar Mortgage, cannot exceed 20% of our total assets at the end of any calendar quarter. In addition, at the end of each calendar quarter, at least 75% of our assets must be qualifying real estate assets, government securities and cash and cash items. The need to comply with these asset ownership requirements may cause us to acquire other assets that are qualifying real estate assets for purposes of the REIT requirements (for example, interests in other mortgage loan portfolios or mortgage-related assets) but are not part of our overall business strategy and might not otherwise be the best investment alternative for us. Moreover, we may be unable to acquire sufficient qualifying REIT assets, due to our inability to obtain adequate financing or otherwise, in which case we may fail to qualify as a REIT or may incur a penalty tax at the REIT level.

To qualify as a REIT, we must distribute to our shareholders with respect to each year at least 90% of our REIT taxable income (determined without regard to the dividends paid deduction and by excluding any net capital gain). After-tax earnings generated by our taxable REIT subsidiaries and not distributed to us are not subject to these distribution requirements and may be retained by such subsidiaries to provide for future growth, subject to the limitations imposed by REIT tax rules. To the extent that we satisfy the 90% distribution requirement, but distribute less than 100% of our taxable income, we will be subject to federal corporate income tax on our undistributed taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our shareholders in a calendar year is less than a minimum amount specified under federal tax laws. We expect in some years that we will be subject to the 4% excise tax. We could be required to borrow funds on a short-term basis even if conditions are not favorable for borrowing, or to sell loans from our portfolio potentially at disadvantageous prices, to meet the REIT distribution requirements and to avoid corporate income taxes. These alternatives could harm our financial condition and could reduce amounts available to originate mortgage loans.

If we fail to qualify or remain qualified as a REIT, our distributions will not be deductible by us, and we will be subject to federal income tax on our taxable income. This would substantially reduce our earnings and our cash available to make distributions. The resulting tax liability, in the event of our failure to qualify as a REIT, might cause us to borrow funds, liquidate some of our investments or take other steps that could negatively affect our operating results. Moreover, if our REIT status is terminated because of our failure to meet a technical REIT requirement or if we voluntarily revoke our election, we generally would be disqualified from electing treatment as a REIT for the four taxable years following the year in which REIT status is lost.

We could lose our REIT status if more than 20% of the value of our total assets are represented by the securities of one or more taxable REIT subsidiaries at the close of any calendar quarter.

To qualify as a REIT, not more than 20% of the value of our total assets may be represented by the securities of one or more taxable REIT subsidiaries at the close of any calendar quarter, subject to a 30-day “cure” period following the close of the quarter and, for taxable years beginning on or after January 1, 2005, subject to certain relief provisions even after the 30-day cure period. Our taxable REIT subsidiaries, including NovaStar Mortgage, conduct a substantial portion of our business activities, including a majority of our loan origination and servicing activities. If the IRS determines that the value of our investment in our taxable REIT subsidiaries was more than 20% of the value of our total assets at the close of any calendar quarter, we could lose our REIT status.

In certain cases, we may need to borrow from third parties to acquire additional qualifying REIT assets or increase the amount and frequency of dividends from our taxable REIT subsidiaries in order to comply with the 20% of assets test.

Risks Related to Our Capital Stock

Investors in our common stock may experience losses, volatility and poor liquidity, and we may reduce or delay payment of our dividends in a variety of circumstances.

Our earnings, cash flow, book value and dividends can be volatile and difficult to predict. Investors should not rely on predictions or management beliefs. Although we seek to pay a regular common stock dividend at a rate that is sustainable, we may reduce our dividend payments in the future for a variety of reasons. We may not provide public warnings of such dividend reductions or payment delays prior to their occurrence. Fluctuations in our current and prospective earnings, cash flow and dividends, as well as many other factors such as perceptions, economic conditions, stock market conditions, and the like, can affect the price of our common stock. Investors may experience volatile returns and material losses. In addition, liquidity in the trading of our common stock may be insufficient to allow investors to sell their stock in a timely manner or at a reasonable price.

Restrictions on ownership of capital stock may inhibit market activity and the resulting opportunity for holders of our capital stock to receive a premium for their securities.

In order for us to meet the requirements for qualification as a REIT, our charter generally prohibits any person from acquiring or holding, directly or indirectly, (i) shares of our common stock in excess of 9.8% (in value or number of shares, whichever is more restrictive) of the aggregate outstanding shares of our common stock or (ii) shares of our capital stock in excess of 9.8% in value of the aggregate outstanding shares of our capital stock. These restrictions may inhibit market activity and the resulting opportunity for the holders of our capital stock to receive a premium for their stock that might otherwise exist in the absence of such restrictions.

The market price of our common stock and trading volume may be volatile, which could result in substantial losses for our shareholders.

The market price of our common stock may be highly volatile and subject to wide fluctuations. In addition, the trading volume in our common stock may fluctuate and cause significant price variations to occur. Some of the factors that could negatively affect our share price or result in fluctuations in the price or trading volume of our common stock include:

general market and economic conditions;

actual or anticipated changes in our future financial performance;

actual or anticipated changes in market interest rates;

actual or anticipated changes in our access to capital;

actual or anticipated changes in the amount of our dividend or any delay in the payment of a dividend;

competitive developments, including announcements by us or our competitors of new products or services;

the operations and stock performance of our competitors;

developments in the mortgage lending industry or the financial services sector generally;

the impact of new state or federal legislation or adverse court decisions;

fluctuations in our quarterly operating results;

the activities of investors who engage in short sales of our common stock;

actual or anticipated changes in financial estimates by securities analysts;

sales, or the perception that sales could occur, of a substantial number of shares of our common stock by insiders;

additions or departures of senior management and key personnel; and

actions by institutional shareholders.

Our common stock may become illiquid if an active public trading market cannot be sustained, which could adversely affect the trading price and your ability to transfer our common stock.

Our common stock’s trading volume is relatively low compared to the securities of many other companies listed on the New York Stock Exchange. If an active public trading market cannot be sustained, the trading price of our common stock could be adversely affected and your ability to transfer your shares of our common stock may be limited.

We may issue additional shares that may cause dilution and may depress the price of our common stock.

Our charter permits our board of directors, without stockholder approval, to:

authorize the issuance of additional shares of common stock or preferred stock without stockholder approval, including the issuance of shares of preferred stock that have preference rights over the common stock with respect to dividends, liquidation, voting and other matters or shares of common stock that have preference rights over our outstanding common stock with respect to voting; and

classify or reclassify any unissued shares of common stock or preferred stock and to set the preferences, rights and other terms of the classified or reclassified shares.

In the future, we will seek to access the capital markets from time to time by making additional offerings of securities, including debt instruments, preferred stock or common stock. Additional equity offerings by us may dilute your interest in us or reduce the market price of our common stock, or both. Our outstanding shares of preferred stock have, and any additional series of preferred stock may also have, a preference on distribution payments that could limit our ability to make a distribution to common shareholders. Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Further, market conditions could require us to accept less favorable terms for the issuance of our securities in the future. Thus, our common shareholders will bear the risk of our future offerings reducing the market price of our common stock and diluting their interest in us.

Past issuances of our common stock pursuant to our 401(k) plan and our Direct Stock Purchase and Dividend Reinvestment Plan may not have complied with the registration requirements of the securities laws.

We maintain a number of equity-based compensation plans for our employees, including a 401(k) plan, and DRIP for our employees and the public. Up to approximately 23,000 shares of common stock under our 401(k) plan and up to approximately 287,000 shares of common stock under our DRIP (collectively, the “Subject Shares”), may have been sold in a manner that may not have complied with the registration requirements of applicable securities laws during the twelve month period ending January 20, 2006, the date the rescission offers were initiated. In connection with sales under our 401(k) plan, the Subject Shares were purchased in the open market and as a result we did not receive any proceeds from such transactions, which may not be deemed to be sales for these purposes. In connection with sales of up to approximately 287,000 Subject Shares that were not registered under our DRIP in May 2005, we received approximately $10.8 million in net proceeds. As a result, we initiated offers to rescind the purchase of the Subject Shares. While we do not expect all eligible purchasers to exercise their rescission rights pursuant to the rescission offers, we have agreed to repurchase the Subject Shares still held by eligible purchasers generally for an amount equal to the original purchase price for the shares plus interest, less dividends, and to compensate eligible purchasers generally for any losses incurred in the sale of the Subject Shares, plus interest, less dividends. The number of eligible purchasers and the amount that we will pay for the shares that are rescinded will be determined by reference to the closing price of our common stock on March 30, 2006, the expiration date of the rescission offers. Furthermore, we could be subject to monetary fines or other regulatory sanctions as provided under applicable securities laws.

Other Risks Related to our Business

Intense competition in our industry may harm our financial condition.

We face intense competition, primarily from consumer finance companies, conventional mortgage bankers, commercial banks, credit unions, thrift institutions, and other independent wholesale mortgage lenders, including internet-based lending companies and other mortgage REITs. Competitors with lower costs of capital have a competitive advantage over us. In addition, establishing a

mortgage lending operation such as ours requires a relatively small commitment of capital and human resources, which permits new competitors to enter our markets quickly and to effectively compete with us. Furthermore, national banks, thrifts and their operating subsidiaries are generally exempt from complying with many of the state and local laws that affect our operations, such as the prohibition on prepayment penalties. Thus, they may be able to provide more competitive pricing and terms than we can offer. Any increase in the competition among lenders to originate nonconforming mortgage loans may result in either reduced income on mortgage loans compared to present levels, or revised underwriting standards permitting higher loan-to-value ratios on properties securing nonconforming mortgage loans, either of which could adversely affect our results of operations, financial condition or business prospects. In addition, the government-sponsored entities, Fannie Mae and Freddie Mac, may also expand their participation in the subprime mortgage industry. To the extent they materially expand their purchase of subprime loans, our ability to profitably originate and purchase mortgage loans may be adversely affected because their size and cost-of-funds advantage allows them to purchase loans with lower rates or fees than we are willing to offer.

If we are unable to maintain and expand our network of independent brokers, our loan origination business will decrease.

A significant majority of our originations of mortgage loans comes from independent brokers. During 2005, 75% of our loan originations were originated through our broker network. Our brokers are not contractually obligated to do business with us. Further, our competitors also have relationships with our brokers and actively compete with us in our efforts to expand our broker networks. Our failure to maintain existing relationships or expand our broker networks could significantly harm our business, financial condition, liquidity and results of operations.

Our reported GAAP financial results differ from the taxable income results that drive our dividend distributions, and our consolidated balance sheet, income statement, and statement of cash flows as reported for GAAP purposes may be difficult to interpret.

We manage our business based on long-term opportunities to earn cash flows. Our dividend distributions are driven by the REIT tax laws and our income as calculated for tax purposes pursuant to the Code. Our reported results for GAAP purposes differ materially, however, from both our cash flows and our taxable income. We transfer mortgage loans or mortgage securities—available-for-sale into securitization trusts to obtain long-term non-recourse funding for these assets. When we surrender control over the transferred mortgage loans or mortgage securities—available-for-sale, the transaction is accounted for as a sale. When we retain control over the transferred mortgage loans or mortgage securities available-for-sale, the transaction is accounted for as a secured borrowing. These securitization transactions do not differ materially in their structure or cash flow generation characteristics, yet under GAAP accounting these transactions are recorded differently. In a securitization transaction accounted for as a sale, we record a gain or loss on the assets transferred in our income statement and we record the retained interests at fair value on our balance sheet. In a securitization transaction accounted for as a secured borrowing, we consolidate all the assets and liabilities of the trust on our financial statements (and thus do not show the retained interest we own as an asset). As a result of this and other accounting issues, shareholders and analysts must undertake a complex analysis to understand our economic cash flows, actual financial leverage, and dividend distribution requirements. This complexity may cause trading in our stock to be relatively illiquid or may lead observers to misinterpret our results.

Market values for our mortgage assets and hedges can be volatile. For GAAP purposes, we mark-to-market our non-hedging derivative instruments through our GAAP consolidated income statement and we mark-to-market our mortgage securities—available-for-sale through our GAAP consolidated balance sheet through other comprehensive income unless the mortgage securities are in an unrealized loss position which has been deemed as an other-than-temporary impairment. An other-than-temporary impairment is recorded through the income statement in the period incurred. Additionally, we do not mark-to-market our loans held for sale as they are carried at lower of cost or market, as such, any change in market value would not be recorded through our income statement until the related loans are sold. If we sell an asset that has not been marked-to-market through our income statement at a reduced market price relative to its basis, our reported earnings will be reduced. A decrease in market value of our mortgage assets may or may not result in a deterioration in future cash flows. As a result, changes in our GAAP consolidated income statement and balance sheet due to market value adjustments should be interpreted with care.

If we attempt to make any acquisitions, we will incur a variety of costs and may never realize the anticipated benefits.

If appropriate opportunities become available, we may attempt to acquire businesses that we believe are a strategic fit with our business. If we pursue any such transaction, the process of negotiating the acquisition and integrating an acquired business may result in operating difficulties and expenditures and may require significant management attention that would otherwise be available for ongoing development of our business, whether or not any such transaction is ever consummated. Moreover, we may never realize the anticipated benefits of any acquisitions. Future acquisitions could result in potentially dilutive issuances of equity securities, the incurrence of debt, contingent liabilities and/or amortization expenses related to goodwill and other intangible assets, which could harm our results of operations, financial condition and business prospects.

The inability to attract and retain qualified employees could significantly harm our business.

We depend on the continued service of our top executives, including our chief executive officer and president. To the extent that one or more of our top executives are no longer employed by us, our operations and business prospects may be adversely affected. We also depend on our wholesale account executives and retail loan officers to attract borrowers by, among other things, developing relationships with financial institutions, other mortgage companies and brokers, real estate agents, borrowers and others. The market for skilled account executives and loan officers is highly competitive and historically has experienced a high rate of turnover. Competition for qualified account executives and loan officers may lead to increased hiring and retention costs. If we are unable to attract or retain a sufficient number of skilled account executives at manageable costs, we will be unable to continue to originate quality mortgage loans that we are able to sell for a profit, which would harm our results of operations, financial condition and business prospects.

The success and growth of our business will depend upon our ability to adapt to and implement technological changes.

Our mortgage loan origination business is currently dependent upon our ability to effectively interface with our brokers, borrowers and other third parties and to efficiently process loan applications and closings. The origination process is becoming more dependent upon technological advancement, such as the ability to process applications over the Internet, accept electronic signatures and provide process status updates instantly and other customer-expected conveniences that are cost-efficient to our process. Becoming proficient with new technology will require significant financial and personnel resources. If we become reliant on any particular technology or technological solution, we may be harmed to the extent that such technology or technological solution (i) becomes non-compliant with existing industry standards, (ii) fails to meet or exceed the capabilities of our competitors’ equivalent technologies or technological solutions, (iii) becomes increasingly expensive to service, retain and update, or (iv) becomes subject to third-party claims of copyright or patent infringement. Any failure to acquire technologies or technological solutions when necessary could limit our ability to remain competitive in our industry and could also limit our ability to increase the cost-efficiencies of our operating model, which would harm our results of operations, financial condition and business prospects.

Our business could be adversely affected if we experienced an interruption in or breach of our communication or information systems or if we were unable to safeguard the security and privacy of the personal financial information we receive.

We rely heavily upon communications and information systems to conduct our business. Any material interruption or breach in security of our communication or information systems or the third-party systems on which we rely could cause underwriting or other delays and could result in fewer loan applications being received, slower processing of applications and reduced efficiency in loan servicing. Additionally, in connection with our loan file due diligence reviews, we have access to the personal financial information of the borrowers which is highly sensitive and confidential, and subject to significant federal and state regulation. If a third party were to misappropriate this information, we potentially could be subject to both private and public legal actions. Our policies and safeguards may not be sufficient to prevent the misappropriation of confidential information, may become noncompliant with existing federal or state laws or regulations governing privacy, or with those laws or regulations that may be adopted in the future.

Our inability to realize cash proceeds from loan sales and securitizations in excess of the loan acquisition cost could harm our financial position.

The net cash proceeds received from loan sales consist of the premiums we receive on sales of loans in excess of the outstanding principal balance, plus the cash proceeds we receive from securitizations structured as sales, minus the discounts on loans that we have to sell for less than the outstanding principal balance. If we are unable to originate loans at a cost lower than the cash proceeds realized from loan sales, such inability could harm our results of operations, financial condition and business prospects.

Market factors may limit our ability to acquire mortgage assets at yields that are favorable relative to borrowing costs.

Despite our experience in the acquisition of mortgage assets and our relationships with various mortgage suppliers, we face the risk that we might not be able to acquire mortgage assets which earn interest rates greater than our cost of funds or that we might not be able to acquire a sufficient number of such mortgage assets to maintain our profitability.

We face loss exposure due to fraudulent and negligent acts on the part of loan applicants, employees, mortgage brokers and other third parties.

When we originate or purchase mortgage loans, we rely heavily upon information provided to us by third parties, including information relating to the loan application, property appraisal, title information and employment and income documentation. If any of this information is fraudulently or negligently misrepresented to us and such misrepresentation is not detected by us prior to loan funding, the value of the loan may be significantly lower than we expected. Whether a misrepresentation is made by the loan applicant, the loan broker, one of our employees, or any other third party, we generally bear the risk of loss associated with it. A loan subject to misrepresentation typically cannot be sold and subject to repurchase by us if it is sold prior to our detection of the misrepresentation. We may not be able to recover losses incurred as a result of the misrepresentation.

Our reliance on cash-out refinancings as a significant source of our origination volume increases the risk that our earnings will be harmed if the demand for this type of refinancing declines.

For the year ended December 31, 2005, approximately 59% of our loan production volume consisted of cash-out refinancings. Our reliance on cash-out refinancings as a significant source of our origination volume increases the risk that our earnings will be reduced if interest rates rise and the prices of homes decline, which would reduce the demand and production volume for this type of refinancing. A substantial and sustained increase in interest rates could significantly reduce the number of borrowers who would qualify or elect to pursue a cash-out refinancing and result in a decline in that origination source. Similarly, a decrease in home prices would reduce the amount of equity available to be borrowed against in cash-out refinancings and result in a decrease in our loan production volume from that origination source. Therefore, our reliance on cash-out refinancings as a significant source of our origination volume could harm our results of operations, financial condition and business prospects.

We may enter into certain transactions at the REIT in the future that incur excess inclusion income that will increase the tax liability of our shareholders.

If we incur excess inclusion income at the REIT, it will be allocated among our shareholders. A stockholder’s share of excess inclusion income (i) would not be allowed to be offset by any net operating losses otherwise available to the stockholder, (ii) would be subject to tax as unrelated business taxable income in the hands of most types of shareholders that are otherwise generally exempt from federal income tax, and (iii) would result in the application of U.S. federal income tax withholding at the maximum rate (i.e., 30%), without reduction for any otherwise applicable income tax treaty, to the extent allocable to most types of foreign shareholders. How such income is to be reported to shareholders is not clear under current law. Tax-exempt investors, foreign investors, and taxpayers with net operating losses should carefully consider the tax consequences of having excess inclusion income allocated to them and are urged to consult their tax advisors.

Excess inclusion income would be generated if we issue debt obligations with two or more maturities and the terms of the payments on these obligations bear a relationship to the payments that we received on our mortgage loans or mortgage-backed securities securing those debt obligations. The structure of this type of CMO securitization generally gives rise to excess inclusion income. It is reasonably likely that we will structure some future CMO securitizations in this manner. Excess inclusion income could also result if we were to hold a residual interest in a REMIC. The amounts of excess inclusion income in any given year from these transactions could be significant.

Some provisions of our charter, bylaws and Maryland law may deter takeover attempts, which may limit the opportunity of our stockholders to sell their common stock at favorable prices.

Certain provisions of our charter, bylaws and Maryland law could discourage, delay or prevent transactions that involve an actual or threatened change in control, and may make it more difficult for a third party to acquire us, even if doing so may be beneficial to our stockholders by providing them with the opportunity to sell their shares possibly at a premium over the then market price. For example, our board of directors is divided into three classes with three year staggered terms of office. This makes it more difficult for a third party to gain control of our board because a majority of directors cannot be elected at a single meeting. Further, under our charter, generally a director may only be removed for cause and only by the affirmative vote of the holders of at least a majority of all classes of shares entitled to vote in the election for directors together as a single class. Our bylaws make it difficult for any person other than management to introduce business at a duly called meeting requiring such other person to follow certain advance

notice procedures. Finally, Maryland law provides protection for Maryland corporations against unsolicited takeover situations. These provisions, as well as others, could discourage potential acquisition proposals, or delay or prevent a change in control and prevent changes in our management, even if such actions would be in the best interests of our stockholders.

Item 1B.Unresolved Staff Comments

None

Item 2.Properties

Our executive, administrative and loan servicing offices are located in Kansas City, Missouri, and consist of approximately 200,000 square feet of leased office space. The lease agreements on the premises expire in January 2011. The current annual rent for these offices is approximately $3.9 million.

We lease office space for our mortgage lending operations in Lake Forest, California; Independence, Ohio; Richfield, Ohio; Troy, Michigan and Columbia, Maryland. Currently, these offices consist of approximately 233,000 square feet. The leases on the premises expire from December 2009 through May 2012, and the current annual rent is approximately $4.2 million.

Item 3.Legal Proceedings

Since April 2004, a number of substantially similar class action lawsuits have been filed and consolidated into a single action in the Untied States District Court for the Western District of Missouri. The consolidated complaint names us defendants and three of our executive officers and generally alleges that the defendants made public statements that were misleading for failing to disclose certain regulatory and licensing matters. The plaintiffs purport to have brought this consolidated action on behalf of all persons who purchased our common stock (and sellers of put options on our common stock) during the period October 29, 2003 through April 8, 2004. On January 14, 2005, we filed a motion to dismiss this action, and on May 12, 2005, the court denied such motion. We believe that these claims are without merit and continues to vigorously defend against them.

In the wake of the securities class action, we have also been named as a nominal defendant in several derivative actions brought against certain of our officers and directors in Missouri and Maryland. The complaints in these actions generally claim that the defendants are liable to us for failing to monitor corporate affairs so as to ensure compliance with applicable state licensing and regulatory requirements.

In July 2004, an employee of NovaStar Home Mortgage, Inc. (“NHMI”), a wholly-owned subsidiary of the Company, filed a class and collective action lawsuit against NHMI and NMI in California Superior Court for the County of Los Angeles. Subsequently, NHMI and NMI removed the matter to the United States District Court for the Central District of California and NMI was removed from the lawsuit. The putative class is comprised of all past and present employees of NHMI who were employed since May 1, 2000 in the capacity generally described as Loan Officer. The plaintiffs alleged that NHMI failed to pay them overtime and minimum wage as required by the Fair Labor Standards Act (“FLSA”) and California state laws for the period commencing May 1, 2000 to present. In 2005, the plaintiffs and NHMI agreed upon a nationwide settlement in the amount of $3.3 million on behalf of a class of all NHMI Loan Officers. The settlement, which is subject to final court approval, covers all claims for minimum wage, overtime, meal and rest periods, record-keeping, and penalties under California and federal law during the class period. In 2004, since not all class members will elect to be part of the settlement, we estimated the probable obligation related to the settlement to be in a range of $1.3 million to $1.7 million. In accordance with SFAS No. 5, Accounting for Contingencies, we recorded a charge to earnings of $1.3 million in 2004. In 2005, we recorded an additional charge to earnings of $200,000 as the estimated probable obligation increased to a range of $1.5 million to $1.9 million.

In April 2005, three putative class actions filed against NHMI and certain of its affiliates were consolidated for pre-trial proceedings in the United States District Court for the Southern District of Georgia entitledIn Re NovaStar Home Mortgage, Inc. Mortgage Lending Practices Litigation.These cases allege that NHMI improperly shared settlement service fees with limited liability companies in which NHMI had an interest (the “LLCs”) alleging violations of the fee splitting and anti-referral provisions of the federal Real Estate Settlement Procedures Act (“RESPA”), and alleging certain violations of state law and civil conspiracy. Plaintiffs seek treble damages with respect to the RESPA claims, disgorgement of fees with respect to the state law claims as well as other damages, injunctive relief and attorney fees. In addition, two other related class actions have been filed in state courts.Miller v. NovaStar Financial, Inc. et al., was filed in October 2004 in the Circuit Court of Madison County, Illinois andJones et al. v. NovaStar Home Mortgage, Inc. et al., was filed in December 2004 in the Circuit Court for Baltimore City, Maryland. In theMiller case,plaintiffs allege a violation of the Illinois Consumer Fraud and Deceptive Practices Act and civil conspiracy alleging certain LLCs provided settlement services without the borrower’s knowledge. In theJones case, the plaintiffs allege the LLCs violated the Maryland Lender Act by acting as lenders and/or brokers in Maryland without proper licenses and allege this arrangement

amounted to a civil conspiracy. The plaintiffs in both theMiller andJones cases seek a disgorgement of fees, other damages, injunctive relief and attorney fees on behalf of the class of plaintiffs. We believe that these claims are without merit and we intend to vigorously defend against them.

In December 2005, a putative class action was filed against NHMI in the United States District Court for the Middle District of Louisiana entitledPearson v. NovaStar Home Mortgage, Inc.Plaintiff contends that NHMI violated the federal Fair Credit Reporting Act (“FCRA”) in connection with its use of pre-approved offers of credit and its failure to make certain disclosures required by federal law. Plaintiff seeks (on his own behalf, as well as for others similarly situated) statutory damages, other nominal damages, punitive damages and attorney’s fees and costs. We believe that these claims are without merit and we intend to vigorously defend against them.

In December 2005, a putative class action was filed against NovaStar Mortgage in the United States District Court for the Western District of Washington entitledPierce et al. v. NovaStar Mortgage, Inc.Plaintiffs contend that NovaStar Mortgage failed to disclose prior to closing that a broker payment would be made on their loans, which was an unfair and deceptive practice in violation of the Washington Consumer Protection Act. The plaintiffs seek a return of fees paid on the affected loans, excess interest charged, and damage to plaintiffs’ credit and finances, treble damages as provided in the Washington Consumer Protection Act and attorney fees. We believe that these claims are without merit and we intend to vigorously defend against them.

In addition to those matters listed above, we are currently a party to various other legal proceedings and claims, including, but not limited to, breach of contract claims, class action or individual claims for violations of the RESPA, FLSA, federal and state laws prohibiting employment discrimination and federal and state licensing and consumer protection laws.

While management, including internal counsel, currently believes that the ultimate outcome of all these proceedings and claims will not have a material adverse effect on our financial condition or results of operations, litigation is subject to inherent uncertainties. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on our financial condition and results of operations.

In April 2004, we received notice of an informal inquiry from the Commission requesting that we provide various documents relating to our business. We have cooperated fully with the Commission’s inquiry and provided it with the requested information.

Item 4.Submission of Matters to a Vote of Security Holders

None

PART II

Item 5.Market for Registrant’s Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Market Price of and Dividends on the Registrant’s Common Equity and Related Stockholder Matters. Our common stock is traded on the NYSE under the symbol “NFI”. The following discussion should be read in conjunction withtable sets forth, for the consolidated financial statementsperiods indicated, the high and low sales prices per share of NovaStar Financialcommon stock on the NYSE and the notes thereto included elsewherecash dividends paid or payable per share of common stock.

         Dividends

 
   High

  Low

  Date Declared

  Date Paid

  Amount Per
Share


 
2004                   

First Quarter

  $67.29  $43.19  4/28/04  5/26/04  $1.35 

Second Quarter

   66.05   30.97  7/28/04  8/26/04   1.35 

Third Quarter

   48.00   37.84  10/28/04  11/22/04   1.40 

Fourth Quarter

   56.82   41.34  12/22/04  1/14/05   2.65(A)
2005                   

First Quarter

  $48.15  $32.40  5/2/05  5/27/05  $1.40 

Second Quarter

   39.98   34.50  7/29/05  8/26/05   1.40 

Third Quarter

   42.19   32.20  9/15/05  11/22/05   1.40 

Fourth Quarter

   33.01   26.20  12/14/05  1/13/06   1.40 

(A)Includes a $1.25 special dividend related to 2004 taxable income.

As of March 10, 2006, we had approximately 1,576 shareholders of record of our 32,591,228 shares of common stock outstanding based upon a review of the securities position listing provided by our transfer agent.

We intend to make distributions to shareholders of all or substantially all of taxable income in this report.each year, subject to certain adjustments, so as to qualify for the tax benefits accorded to a REIT under the Code. All distributions will be made at the discretion of the Board of Directors and will depend on earnings, financial condition, maintenance of REIT status and other factors as the Board of Directors may deem relevant.

Recent Sales of Unregistered Securities.

 

We may have sold up to approximately 23,000 shares of common stock under our 401(k) plan and up to approximately 287,000 shares under our DRIP in a manner that may not have complied with the registration requirements of applicable securities laws. In connection with sales under our 401(k) Plan, the shares were purchased in the open market. As a result we did not receive any proceeds from such transactions, which may not be deemed sales for these purposes. In connection with sales under our DRIP in May 2005, we received approximately $10.8 million in net proceeds.

Purchase of Equity Securities by the Issuer.

Issuer Purchases of Equity Securities

(dollars in thousands)

   Total Number of
Shares Purchased


  Average Price Paid
per Share


  Total Number of
Shares Purchased
as Part of Publicly
Announced Plans or
Programs


  Approximate Dollar
Value of Shares
that May Yet Be
Purchased Under
the Plans or
Programs (A)


October 1, 2005 – October 31, 2005

  —    —    —    $1,020

November 1, 2005 – November 30, 2005

  —    —    —     1,020

December 1, 2005 – December 31, 2005

  —    —    —     1,020

(A)A current report on Form 8-K was filed on October 2, 2000 announcing that the Board of Directors authorized the Company to repurchase its common shares, bringing the total authorization to $9 million.

Item 6.

Safe Harbor Statement

 

“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” that involve risks and uncertainties. Certain matters discussed in this annual report may constitute forward-looking statements within the meaning of the federal securities lawslaws. Forward-looking statements are those that inherently include certainpredict or describe future events and that do not relate solely to historical matters. Forward-looking statements are subject to risks and uncertainties. Actualuncertainties and certain factors can cause actual results and the time of certain events couldto differ materially from those projectedanticipated. Some important factors that could cause actual results to differ materially from those anticipated include: our ability to generate sufficient liquidity on favorable terms; the size and frequency of our securitizations; interest rate fluctuations on our assets that differ from our liabilities; increases in prepayment or contemplated bydefault rates on our mortgage assets; changes in assumptions regarding estimated loan losses and fair value amounts; changes in origination and resale pricing of mortgage loans; our compliance with applicable local, state and federal laws and regulations or opinions of counsel relating thereto and the forward-looking statements dueimpact of new local, state or federal legislation or regulations or opinions of counsel relating thereto or court decisions on our operations; the initiation of margin calls under our credit facilities; the ability of our servicing operations to a numbermaintain high performance standards and maintain appropriate ratings from rating agencies; our ability to expand origination volume while maintaining an acceptable level of factors, includingoverhead; our ability to adapt to and implement technological changes; the stability of residential property values; the outcome of litigation or regulatory actions pending against us or other legal contingencies; the impact of losses resulting from natural disasters; the impact of general economic conditions, fluctuationsconditions; and the risks that are outlined from time to time in interest rates, fluctuations in prepayment speeds, fluctuations in losses due to defaults on mortgage loans,our filings with the availability of nonconforming residential mortgage loans, the availability and access to financing and liquidity resources, and other risk factors previously outlined inCommission, including this annual report on Form 10-K for the fiscal year ended December 31, 2003.report. Other factors not presently identified may also cause actual results to differ. Management continuously updatesThis document speaks only as of its date and revises these estimates and assumptions basedwe expressly disclaim any duty to update the information herein.

Item 1.Business

Overview

We are a Maryland corporation formed on actual conditions experienced. It is not practicable to publish all revisions and,September 13, 1996 as a result, no one should assumespecialty finance company that results projectedoriginates, purchases, invests in and services residential nonconforming loans. We operate through four separate operating segments – mortgage portfolio management, mortgage lending, loan servicing and branch operations. The loan servicing segment was previously reported as part of mortgage lending and loan servicing, but it has been separated to more closely align the segments with the way we review, manage and operate our business. Segment information for the years ended December 31, 2004 and 2003 has been restated for this change. Additionally, we are currently winding down our branch operating unit and expect to complete the wind-down by June 30, 2006. See “Branch Operations.”

We offer a wide range of mortgage loan products to borrowers, commonly referred to as “nonconforming borrowers.” Nonconforming borrowers are individuals who generally do not satisfy the credit, collateral, documentation or contemplatedother underwriting standards prescribed by conventional mortgage lenders and loan buyers, including U.S. government-sponsored entities such as Fannie Mae or Freddie Mac. We retain significant interests in the nonconforming loans we originate and purchase through our mortgage securities investment portfolio. Through our servicing platform, we then service all of the loans, in which we retain interests, in order to better manage the credit performance of those loans.

We have elected to be taxed as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended (the “Code”). Management believes the tax-advantaged structure of a REIT maximizes the after-tax returns from mortgage assets. We must meet numerous rules established by the forward-looking statementsInternal Revenue Service (IRS) to retain our status as a REIT. In summary, they require us to:

Restrict investments to certain real estate related assets,

Avoid certain investment trading and hedging activities, and

Distribute virtually all REIT taxable income to our shareholders.

As long as we maintain our REIT status, distributions to our shareholders will generally be deductible by us for income tax purposes. This deduction effectively eliminates REIT level income taxes. Management believes it has and will continue to be accurate inmeet the future.requirements to maintain our REIT status.

 

Overview of PerformanceMortgage Portfolio Management

 

We invest in assets generated primarily from our origination and purchase of nonconforming, single-family, residential mortgage loans.

During

We operate as a long-term mortgage securities portfolio investor.

We finance our investment in mortgage securities by issuing asset-backed bonds, debt and capital stock and entering into repurchase agreements.

Earnings are generated from the return on our mortgage securities and mortgage loan portfolio.

Our portfolio of mortgage securities includes interest-only, prepayment penalty, overcollateralization (collectively, the “residual securities”) and other investment-grade rated subordinated mortgage securities (the “subordinated securities”).

Earnings from our portfolio of mortgage loans and securities generate a substantial portion of our earnings. Gross interest income in our mortgage portfolio management segment was $193.2 million, $140.3 million and $109.5 million in the three years ended December 31, 2005, 2004 and 2003, we reported netrespectively. Net interest income before provision for credit (losses) recoveries for our portfolio management segment was $174.1 million, $119.2 million and $92.1 million in the three years ended December 31, 2005, 2004 and 2003, respectively. One of $112.0 million, or $4.91 per diluted share, as comparedour top priorities going forward is to $48.8 million, or $2.25 per diluted share in 2002. Our earnings were driven largely bypreserve the incomefavorable returns generated by our mortgage securities portfolio by focusing on the spread between origination and funding costs and the coupons of loans in the portfolio. We expect to continue to grow our portfolio but not at the expense of returns or risk management. See Note 16 to our consolidated financial statements for a summary of operating results and total assets for our mortgage portfolio management segment. Also, see “Mortgage Portfolio Management Results of Operations” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion and analysis of the mortgage portfolio management operations.

A significant risk relating to our mortgage portfolio management segment is interest rate risk - the risk that interest rates on the mortgage loans which increasedunderly our mortgage securities will not adjust at the same times or in the same amounts that interest rates on the liabilities adjust. Many of the loans in our portfolio have fixed rates of interest for a period of time ranging from $178.92 to 30 years. Our funding costs are generally not constant or fixed. We use derivative instruments to mitigate the risk of our cost of funding increasing at a faster rate than the interest on the loans (both those on the balance sheet and those that serve as collateral for mortgage securities).

In 2002, we began transferring interest rate agreements at the time of securitization into the securitization trusts to protect the third-party bondholders from interest rate risk and to decrease the volatility of future cash flows related to the securitized mortgage loans. We enter into these interest rate agreements as we originate and purchase mortgage loans in our mortgage lending segment. See “Mortgage Lending” for discussion of the impact of these interest rate agreements on our operating results. At the time of securitization, the interest rate agreements are transferred to the securitization trust and removed from our balance sheet. The trust assumes the obligation to make payments and obtains the right to receive payments under these agreements. Generally, net settlement obligations paid by the trust for these interest rate agreements reduce the excess interest cash flows to our residual securities. Net settlement receipts from these interest rate agreements are first used to cover any interest shortfalls on the third-party primary bonds and any remaining funds then flow to our residual securities.

Mortgage Lending

The mortgage lending operation is significant to our financial results as it produces the loans that ultimately collateralize the mortgage securities that we hold in our portfolio. During 2005 and 2004, we originated and purchased $9.3 billion and $8.4 billion in nonconforming mortgage loans, respectively. The majority of these loans were retained in our servicing portfolio and serve as collateral for our mortgage securities. The loans we originate and purchase are sold, either in securitization transactions or in outright sales to third parties. We securitized $7.6 billion and $8.3 billion of mortgage loans during 2005 and 2004, respectively. We sold $1.1 billion in nonconforming mortgage loans to third parties during the year ended December 31, 2005. There were no nonconforming mortgage loan sales during 2004. Our mortgage lending segment recognized gains on sales of mortgage assets totaling $49.3 million, $113.2 million and $140.9 million during the three years ended December 31, 2005, 2004 and 2003, respectively. See Table 15 for a summary of the components of our mortgage lending gains on sales of mortgage assets by year, as well as, a reconciliation of our mortgage lending gains on sales of mortgage assets to our consolidated gains on sales of mortgage assets reported in our consolidated statements of income. In securitization transactions accounted for as sales we retain residual securities (representing interest-only securities, prepayment penalty bonds and overcollateralization bonds) and certain investment-grade rated subordinated securities, along with the right to service the loans. See Note 16 to our consolidated financial statements for a summary of operating results and total assets for our mortgage lending segment. Also, see “Mortgage Lending Results of Operations” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion and analysis of the mortgage lending operations.

Our wholly-owned subsidiary, NovaStar Mortgage, Inc. (“NovaStar Mortgage”), originates and purchases primarily nonconforming, single-family residential mortgage loans. Our mortgage lending operation continues to innovate in loan origination. We adhere to three disciplines which underly our lending decisions:

Originating loans that perform (attractive credit risk profile),

Maintaining economically sound pricing (profitable coupons), and

Controlling costs of origination.

In our nonconforming lending operations, we lend to individuals who generally do not qualify for agency/conventional lending programs because of a lack of available documentation or previous credit difficulties. These types of borrowers are generally willing to pay higher mortgage loan origination fees and interest rates than those charged by conventional lenders. Because these borrowers typically use the proceeds of the mortgage loans to consolidate debt and to finance home improvements, education and other consumer needs, loan volume is generally less dependent on general levels of interest rates or home sales and therefore less cyclical than conventional mortgage lending.

Our nationwide loan origination network includes wholesale loan brokers, mortgage lenders, correspondent institutions and direct to consumer operations. Except for NovaStar Home Mortgage, Inc. (“NHMI”) brokers described below, these brokers and mortgage lenders are independent from any of the NovaStar Financial entities. Our sales force, which includes account executives in 42 states, develops and maintains relationships with this network of independent retail brokers. Our correspondent origination channel consists of a network of institutions from which we purchase nonconforming mortgage loans on a bulk or flow basis.

We underwrite, process, fund and service the nonconforming mortgage loans sourced through our network of wholesale loan brokers and mortgage lenders and our direct to consumer operations in centralized facilities. Further details regarding the loan originations are discussed under the “Mortgage Loans” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

A significant risk to our mortgage lending operations is the risk that we will not have financing facilities and cash available to fund and hold loans prior to their sale or securitization. See “Risk Factors – Related to our Borrowing and Securitization Activities.” We maintain lending facilities with large banking and investment institutions to reduce this risk. On a short-term basis, we finance mortgage loans using warehouse repurchase agreements. In addition, we have access to facilities secured by our mortgage securities. Details regarding available financing arrangements and amounts outstanding under those arrangements are included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 8 to the consolidated financial statements.

For long-term financing, we securitize our mortgage loans and issue asset-backed bonds (“ABB”). Primary bonds – AAA through BBB rated – are sold to large, institutional investors and U.S. government-sponsored enterprises. During 2005 and 2004, US government-sponsored enterprises purchased 51% and 55%, respectively, of the bonds sold to the third-party investors from our securitizations. The loss of the U.S. government-sponsored enterprises from the market for our bonds could potentially have a materially adverse effect on us.

In 2005, we started to retain certain of subordinated securities from our securitizations. We also retain residual securities as well as the right to service the loans. Prior to 1999, our securitizations were executed and designed to meet accounting rules that resulted in securitizations being treated as financing transactions. As a result, the mortgage loans and related debt continue to be presented on our consolidated balance sheets, and no gain was recorded. Beginning in 1999, our securitization transactions have been structured to qualify as sales for accounting and income tax purposes. The loans and related bond liability are not recorded in our consolidated financial statements. We do, however, record the value of the residual and subordinated securities and servicing rights we retain on our balance sheet. Details regarding ABBs we issued can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in Note 8 to our consolidated financial statements.

As discussed under “Mortgage Portfolio Management,” interest rate risk is a significant risk to our mortgage lending operations as well as our mortgage portfolio operations. Prior to securitization, we enter into these interest rate agreements as we originate and purchase mortgage loans to help mitigate interest rate risk. At the time of securitization, we transfer these interest rate agreements into the securitization trusts and they are removed from our balance sheet. Generally, these interest rate agreements do not meet the hedging criteria set forth in accounting principles generally accepted in the United States of America (“GAAP”) while they are on our balance sheet, therefore, we are required to record their change in value as a component of earnings even though they may reduce our interest rate risk. In times when short-term rates rise or drop significantly, the value of our agreements will increase or decrease, respectively. As a result, within our mortgage lending segment we recognized gains (losses) on these derivatives of $17.9 million, $(8.8) million and $(29.9) million in 2005, 2004 and 2003, respectively.

Loan Servicing

We retain the servicing rights with respect to loans we securitize. Management believes loan servicing remains a critical part of our business operation because maintaining contact with our borrowers is critical in managing credit risk and in borrower retention. Nonconforming borrowers are more prone to late payments and are more likely to default on their obligations than conventional

borrowers. By servicing our loans, we strive to identify problems with borrowers early and take quick action to address problems. Borrowers may be motivated to refinance their mortgage loans either by improving their personal credit or due to a decrease in interest rates. By keeping in close touch with borrowers, we can provide them with information about NovaStar Financial products to encourage them to refinance with us. Mortgage servicing yields fee income for us in the form of fees paid by the borrowers for normal customer service and processing fees. In addition we receive contractual fees approximating 0.50% of the outstanding balance for loans we service that we do not own. We serviced $14.0 billion loans as of December 31, 20022005 compared to $382.3 million$12.2 billion loans as of December 31, 2003. These2004. We recognized $59.8 million, $41.5 million and $21.1 million in loan servicing fee income from the securitization trusts during the three years ended December 31, 2005, 2004 and 2003, respectively. Loan servicing fee income should continue to grow as our servicing portfolio grows. Also, see “Loan Servicing Results of Operations” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion and analysis of the servicing operations.

Branch Operations

In 1999, we opened our retail mortgage broker business operating under the name NovaStar Home Mortgage, Inc. (“NHMI”). Prior to 2004, many of these NHMI branches were supported by limited liability companies (“LLC”) in which we owned a minority interest in the LLC and the branch manager was the majority interest holder. In December 2003, we decided to terminate the LLCs effective January 1, 2004. As of January 1, 2004 the financial results of the continuing branches, that were formerly supported by LLCs, are included in our consolidated financial statements. Branch offices offer conforming and nonconforming loans to potential borrowers. Loans are brokered for approved investors, including NovaStar Mortgage. The NHMI branches are considered departmental functions of NHMI under which the branch manager (department head) is an employee of NHMI and receives compensation based on the profitability of the branch (department) as bonus compensation. See Note 15 and Note 16 to our consolidated financial statements for a summary of operating results and total assets for our branches. Also, see “Branch Operations Results of Operations and Discontinued Operations” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion and analysis of the branch operations.

We routinely close branches and branch managers voluntarily terminate their employment with us, which generally results in the branch’s closure. In these terminations, the branch and all operations are eliminated. Additionally, as the demand for conforming loans declined significantly during 2004 and 2005, many branches were not able to produce sufficient fees to meet operating expense demands. As a result of these conditions, we adopted a formal plan on November 4, 2005 to terminate substantially all of the remaining NHMI branches. We anticipate that all of the remaining NHMI branches will be terminated by June 30, 2006.

Market in Which NovaStar Operates and Competes

Over the last ten years, the nonconforming lending market has grown from less than $50 billion annually to approximately $600 billion in 2005 as estimated by Inside Mortgage Finance Publications. A significant portion of nonconforming loans are made to borrowers who are using equity in their primary residence to consolidate installment or consumer debt, or take cash out for personal reasons. The nonconforming market has grown through a variety of interest rate environments. One of the main drivers of growth in this market has been the rise in housing prices which gives borrowers the opportunity to use the equity in their home to consolidate their high interest rate, short-term, non-tax deductible consumer or installment debt into lower interest rate, long-term, often tax deductible mortgage debt. Management estimates that NovaStar Financial has a 1-2% share of the nonconforming loan market. While management cannot predict consumer spending and borrowing habits, nor the future value of the residential home market, historical trends indicate that the market in which we operate is relatively stable and should continue to experience long-term growth.

We face intense competition in the business of originating, purchasing, selling and securitizing mortgage loans. The number of market participants is believed to be well in excess of 100 companies who originate and purchase nonconforming loans. No single participant holds a dominant share of the lending market. We compete for borrowers with consumer finance companies, conventional mortgage bankers, commercial banks, credit unions, thrift institutions and other independent wholesale mortgage lenders. Our principal competition in the business of holding mortgage loans and mortgage securities are retainedlife insurance companies, institutional investors such as mutual funds and pension funds, other well-capitalized, publicly-owned mortgage lenders and certain other mortgage acquisition companies structured as REITs. Many of these competitors are substantially larger than we are and have considerably greater financial resources than we do.

Competition among industry participants can take many forms, including convenience in securitizationsobtaining a loan, amount and term of the loan, customer service, marketing/distribution channels, loan origination fees and interest rates. To the extent any competitor significantly expands their activities in the nonconforming and subprime market, we could be adversely affected.

One of our key competitive strengths is our employees and the level of service they are able to provide our borrowers. We service our nonconforming loans and, in doing so, we are able to stay in close contact with our borrowers and identify potential problems early.

We also believe we compete successfully due to our:

experienced management team;

use of technology to enhance customer service and reduce operating costs;

tax advantaged status as a REIT;

freedom from depository institution regulation;

vertical integration – we broker and/or originate, purchase, fund, service and manage mortgage loans;

access to capital markets to securitize our assets.

Following is a diagram of the industry in which we operate and our loan production including nonconforming and conforming during 2005 (in thousands).


(A)A portion of the loans securitized or sold to unrelated parties during 2005 were originated prior to 2005. Loans originated and purchased in 2005 that we have not securitized or sold to unrelated parties as of December 31, 2005 are included in our mortgage loans held-for-sale.
(B)The majority of the AAA-BBB rated securities from NMFT Series 2005-1, 2005-2, 2005-3 and 2005-4 were purchased by bond investors during 2005. We retained the Class M-11 and M-12 certificates from NMFT Series 2005-3, which were rated BBB/BBB- by Standard and Poor’s and Fitch, respectively and BBB- by Standard and Poor’s. We retained the Class M-9, M-10, M-11 and M-12 certificates from NMFT Series 2005-4, which were rated A/Baa3/BBB+, BBB+/Ba1/BBB, BBB/NR/BBB- and BBB-/NR/NR by Standard and Poor’s, Moody’s and Fitch, respectively.
(C)The excess cash flow and subordinated bonds retained by NovaStar Financial are from the NMFT Series 2005-1, 2005-2, 2005-3 and 2005-4 securitization transactions, which occurred during 2005.

Risk Management

Management recognizes the following primary risks associated with the business and industry in which it operates.

Interest Rate/Market

Liquidity/Funding

Credit

Prepayment

Regulatory

Interest Rate/Market Risk.Our investment policy goals are to maintain the net interest margin between our assets and liabilities and to diminish the effect of changes in interest rate levels on our market value.

Interest Rate Risk. When interest rates on our assets do not adjust at the same time or in the same amounts as the interest rates on our liabilities or when the assets have fixed rates and the liabilities have adjustable rates, future earnings potential is affected. We express this interest rate risk as the risk that the market value of our assets will increase or decrease at different rates than that of our liabilities. Expressed another way, this is the risk that our net asset value will experience an adverse change when interest rates change. We assess the risk based on the change in market values given increases and decreases in interest rates. We also assess the risk based on the impact to net income in changing interest rate environments.

Management primarily uses financing sources where the interest rate resets frequently. As of December 31, 2005, borrowings under all financing arrangements adjust daily or monthly. On the other hand, very few of the mortgage assets we own adjust on a monthly or daily basis. Most of the mortgage loans contain features where their rates are fixed for some period of time and then adjust frequently thereafter. For example, one of our loan products is the “2/28” loan. This loan is fixed for its first two years and then adjusts every six months thereafter.

While short-term borrowing rates are low and long-term asset rates are high, this portfolio structure produces good results. However, if short-term interest rates rise rapidly, earning potential is significantly affected and impairments may be incurred, as the asset rate resets would lag the borrowing rate resets.

Interest Rate Sensitivity Analysis.To assess interest sensitivity 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 a market value and cash flow basis.

The following table summarizes management’s estimates of the changes in market value of our mortgage assets and interest rate agreements assuming interest rates were 100 and 200 basis points, or 1 and 2 percent higher or lower. The cumulative change in market value represents the change in market value of mortgage assets, net of the change in market value of interest rate agreements. The change in market value of the liabilities on our balance sheet due to a change in interest rates is insignificant since the liabilities are so short term.

Interest Rate Sensitivity - Market Value

(dollars in thousands)

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

 
   (200)

  (100)

  100

  200

 

As of December 31, 2005:

                 

Change in market values of:

                 

Assets

  $96,456  $42,327  $(44,254) $(92,483)

Interest rate agreements

   (33,502)  (17,365)  20,072   41,616 
   


 


 


 


Cumulative change in market value

  $62,954  $24,962  $(24,182) $(50,867)
   


 


 


 


Percent change of market value portfolio equity (B)

   11.0%  4.4%  (4.2)%  (8.9)%
   


 


 


 


As of December 31, 2004:

                 

Change in market values of:

                 

Assets

  $70,438  $33,198  $(34,045) $(72,840)

Interest rate agreements

   (54,085)  (28,046)  27,832   55,113 
   


 


 


 


Cumulative change in market value

  $16,353  $5,152  $(6,213) $(17,727)
   


 


 


 


Percent change of market value portfolio equity (B)

   3.3%  1.0%  (1.3)%  (3.6)%
   


 


 


 



(A)Change in market value of assets or interest rate agreements in a parallel shift in the yield curve, up and down 1% and 2%.
(B)Total change in estimated market value as a percent of market value portfolio equity as of December 31.

Hedging.In order to address a mismatch of interest rates on our assets and liabilities, we originate. follow an interest rate program that is approved by our 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 mortgage assets and the differences between interest rate adjustment indices and interest rate adjustment periods of adjustable-rate mortgage loans and related borrowings.

We use interest rate cap and swap contracts to mitigate the risk of the cost of variable rate liabilities increasing at a faster rate than the earnings on assets during a period of rising rates. Management intends generally to hedge as much of the interest rate risk as determined to be in our best interest, given the cost and risk of hedging transactions and the need to maintain REIT status. Our ability to hedge is limited by the REIT laws.

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

Interest rate cap agreements are legal contracts between us and a third-party firm or “counterparty”. The counterparty agrees to make payments to us in the future should the one-month LIBOR interest rate rise above the strike rate specified in the contract. We make either quarterly or monthly premium payments or have chosen to pay the premiums at the beginning to the counterparties under contract. Each contract has either a fixed or amortizing notional face amount on which the interest is computed, and a set term to maturity. When the referenced LIBOR interest rate rises above the contractual strike rate, we earn cap income. Interest rate swaps have similar characteristics. However, interest rate swap agreements allow us to pay a fixed rate of interest while receiving a rate that adjusts with one-month LIBOR.

The following table summarizes the key contractual terms associated with our interest rate risk management contracts. All of our pay-fixed swap contracts and interest rate cap contracts are indexed to one-month LIBOR.

We have determined the following estimated net fair value amounts by using available market information and valuation methodologies we deem appropriate as of December 31, 2005.

Interest Rate Risk Management Contracts

(dollars in thousands)

   

Net Fair

Value


  

Total

Notional

Amount


  Maturity Range

 
      2006

  2007

  2008

  2009

  2010

 

Pay-fixed swaps:

                             

Contractual maturity

  $3,290  $1,020,000  $390,000  $510,000  $120,000  $—    $—   

Weighted average pay rate

       3.9%  2.4%  4.8%  4.8%  —     —   

Weighted average receive rate

       4.4%  (A)  (A)  (A)  —     —   

Interest rate caps:

                             

Contractual maturity

  $5,105  $535,000  $200,000  $160,000  $145,000  $20,000  $10,000 

Weighted average strike rate

       3.8%  2.0%  4.9%  4.9%  4.9%  4.9%

(A)The pay-fixed swaps receive rate is indexed to one-month LIBOR.

Liquidity/Funding Risk.See the “Liquidity and Capital Resources” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion of liquidity risks and resources available to us.

Credit Risk. Credit risk is the risk that we will not fully collect the principal we have invested in mortgage loans or the amount we have invested in securities. Nonconforming mortgage loans comprise substantially our entire mortgage loan portfolio and serve as collateral for our mortgage securities. Our nonconforming borrowers include individuals who do not qualify for agency/conventional lending programs because of a lack of conventional documentation or previous credit difficulties but have considerable equity in their homes. Often, they are individuals or families who have built up high-rate consumer debt and are attempting to use the equity in their home to consolidate debt and reduce the amount of money it takes to service their monthly debt obligations. Our underwriting guidelines are intended to evaluate the credit history of the potential borrower, the capacity and willingness of the borrower to repay the loan, and the adequacy of the collateral securing the loan.

Our underwriting staff works under the credit policies established by our Credit Committee. Underwriters are given approval authority only after their work has been reviewed for a period of time. Thereafter, the Chief Credit Officer re-evaluates the authority levels of all underwriting personnel on an ongoing basis. All loans in excess of $350,000 currently require the approval of an underwriting supervisor. Our Chief Credit Officer or our President must approve loans in excess of $1,000,000.

Our underwriting guidelines take into consideration the number of times the potential borrower has recently been late on a mortgage payment and whether that payment was 30, 60 or 90 days past due. Factors such as FICO score, bankruptcy and foreclosure filings, debt-to-income ratio, and loan-to-value ratio are also considered. The credit grade that is assigned to the borrower is a reflection of the borrower’s historical credit and the loan-to-value determined by the amount of documentation the borrower could produce to support income. Maximum loan-to-value ratios for each credit grade depend on the level of income documentation provided by the potential borrower. In some instances, when the borrower exhibits strong compensating factors, exceptions to the underwriting guidelines may be approved.

The key to our successful underwriting process is the use of NovaStarIS®, which is the second generation of our proprietary automated underwriting system. NovaStarIS® provides more consistency in underwriting loans and allows underwriting personnel to focus more of their time on loans that are not initially accepted by the NovaStarIS® system.

Our mortgage loan portfolio by credit grade, all of which are nonconforming, can be accessed via our website at (www.novastarmortgage.com). References to our website do not incorporate by reference the information on such website into this Annual Report on Form 10-K and we disclaim any such incorporation by reference.

A strategy for managing credit risk is to diversify the markets in which we originate, purchase and own mortgage loans. Presented via our website at (www.novastarmortgage.com) is a breakdown of the geographic diversification of our loans. References to our website do not incorporate by reference the information on such website into this Annual Report on Form 10-K and we disclaim any such incorporation by reference.Details regarding loans charged off are disclosed in Note 2 to our consolidated financial statements.

We have purchased mortgage insurance on a majority of the loans that are held in our portfolio – on the balance sheet and those that serve as collateral for our mortgage securities. The use of mortgage insurance is discussed under “Premiums for Mortgage Loan Insurance” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

Prepayment Risk.Generally speaking, when market interest rates decline, borrowers are more likely to refinance their mortgages. The higher the interest rate a borrower currently has on his or her mortgage the more incentive he or she has to refinance the mortgage when rates decline. In addition, the higher the credit grade, the more incentive there is to refinance when credit ratings improve. When home values rise, a borrower has a low loan-to-value ratio, making it more likely that he or she will do a “cash-out” refinance. Each of these factors increases the chance for higher prepayment speeds during the term of the loan.

The majority of our mortgage securities are “interest-only” in nature. These securities represent the net cash flow – interest income – on the underlying loans in excess of the cost to finance the loans. When borrowers repay the principal on their mortgage loans early, the effect is to shorten the period over which interest is earned, and therefore, reduce the cash flow and yield on our securities.

We mitigate prepayment risk by originating and purchasing loans that include a penalty if the borrower repays the loan in the early months of the loan’s life. For the majority of our loans, a prepayment penalty is charged equal to 80% of six months interest on the principal balance that is to be paid in full. As of December 31, 2005, 67% of the loans serve as collateral for our mortgage securities had a prepayment penalty. As of December 31, 2005, 65% of our mortgage loans - held-for-sale had a prepayment penalty. During 2005, 65% of the loans we originated and purchased had prepayment penalties.

Regulatory Risk.As a mortgage lender, we are subject to many laws and regulations. Any failure to comply with these rules and their interpretations or with any future interpretations or judicial decisions could harm our profitability or cause a change in the way we do business. For example, several lawsuits have been filed challenging types of payments made by mortgage lenders to mortgage brokers. Similarly, in our branch operations, we allow our branch managers considerable autonomy, which could result in our facing greater exposure to third-party claims if our compliance programs are not strictly adhered to.

State and local governing bodies are focused on the nonconforming lending business and are concerned about borrowers paying “excessive fees” in obtaining a mortgage loan – generally termed “predatory lending”. In several instances, states or local governing bodies have imposed strict laws on lenders to curb predatory lending. To date, these laws have not had a significant impact on our business. We have capped fee structures consistent with those adopted by federal mortgage agencies and have implemented rigid processes to ensure that our lending practices are not predatory in nature.

We regularly monitor the laws, rules and regulations that apply to our business and analyze any changes to them. We integrate many legal and regulatory requirements into our automated loan origination system to reduce the prospect of inadvertent non-compliance due to human error. We also maintain policies and procedures, summaries and checklists to help our origination personnel comply with these laws. Our training programs are designed to teach our personnel about the significant laws, rules and regulations that affect their job responsibilities.

U.S. Federal Income Tax Consequences

The following general discussion summarizes the material U.S. federal income tax considerations regarding our qualification and taxation as a REIT. This discussion is based on interpretations of the Code, regulations issued thereunder, and rulings and decisions currently in effect (or in some cases proposed), all of which are subject to change. Any such change may be applied retroactively and may adversely affect the federal income tax consequences described herein. This summary does not discuss all of the tax consequences that may be relevant to particular shareholders or shareholders subject to special treatment under the federal income tax laws. Accordingly, you should consult your own tax advisor regarding the federal, state, local, foreign, and other tax consequences of your ownership and our REIT election, and regarding potential changes in applicable tax laws.

General. Since inception, we have elected to be taxed as a REIT under Sections 856 through 859 of the Code. We believe we have complied, and intend to comply in the future, with the requirements for qualification as a REIT under the Code. To the extent that we qualify as a REIT for federal income tax purposes, we generally will not be subject to federal income tax on the amount of income or gain that is distributed to shareholders. However, origination and broker operations are conducted through NovaStar Mortgage and NHMI, which are owned by NFI Holding, Inc. – a taxable REIT subsidiary (“TRS”). Consequently, all of the taxable income of NFI Holding, Inc. is subject to federal and state corporate income taxes. In general, a TRS may hold assets that a REIT cannot hold directly and generally may engage in any real estate or non-real estate related business. However, special rules do apply to certain activities between a REIT and its TRS. For example, a TRS will be subject to earnings stripping limitations on the deductibility of interest paid to its REIT. In addition, a REIT will be subject to a 100% excise tax on certain excess amounts to ensure that (i) amounts paid to a TRS for services are based on amounts that would be charged in an arm’s-length transaction, (ii) fees paid to a REIT by its TRS are reflected at fair market value and (iii) interest paid by a TRS to its REIT is commercially reasonable.

The REIT rules generally require that a REIT invest primarily in real estate related assets, its activities be passive rather than active and it distribute annually to its shareholders substantially all of its taxable income. We could be subject to a number of taxes if we failed to satisfy those rules or if we acquired certain types of income-producing real property through foreclosure. Although no complete assurance can be given, we do not expect that we will be subject to material amounts of such taxes.

Failure to satisfy certain Code requirements could cause loss of REIT status. If we fail to qualify as a REIT for any taxable year, we would be subject to federal income tax (including any applicable minimum tax) at regular corporate rates and would not receive deductions for dividends paid to shareholders. As a result, the amount of after-tax earnings available for distribution to shareholders would decrease substantially. While we intend to operate in a manner that will enable us to qualify as a REIT in future taxable years, there can be no certainty that such intention will be realized.

Qualification as a REIT. Qualification as a REIT requires that we satisfy a variety of tests relating to income, assets, distributions and ownership. The significant tests are summarized below.

Sources of Income.To qualify as a REIT, we must satisfy two gross income requirements, each of which is applied on an annual basis. First, at least 75% of our gross income, excluding gross income from prohibited transactions, for each taxable year generally must be derived directly or indirectly from:

rents from real property;

interest on debt secured by mortgages on real property or on interests in real property;

dividends or other distributions on, and gain from the sale of, stock in other REITs;

gain from the sale of real property or mortgage loans;

amounts, such as commitment fees, received in consideration for entering into an agreement to make a loan secured by real property, unless such amounts are determined by income and profits;

income derived from a Real Estate Mortgage Investment Conduit (“REMIC”) in proportion to the real estate assets held by the REMIC, unless at least 95% of the REMIC’s assets are real estate assets, in which case all of the income derived from the REMIC; and

interest or dividend income from investments in stock or debt instruments attributable to the temporary investment of new capital during the one-year period following our receipt of new capital that we raise through equity offerings or public offerings of debt obligations with at least a five-year term.

Second, at least 95% of our gross income, excluding gross income from prohibited transactions, for each taxable year must be derived from sources that qualify for purposes of the 75% gross income test, and from (i) dividends, (ii) interest, (iii) certain qualifying hedges entered into prior to January 1, 2005 and (iv) gain from the sale or other disposition of stock, securities, or, certain qualifying hedges entered into prior to January 1, 2005.

Management believes that we were in compliance with both of the income tests for the 2005 and 2004 calendar years.

Nature and Diversification of Assets. As of the last day of each calendar quarter, we must meet six requirements under the two asset tests. Under the 75% of assets test, at least 75% of the value of our total assets must represent cash or cash items (including receivables), government securities or real estate assets. Under the 25% of assets test, no more than 25% of the value of our total assets can be represented by securities, other than (A) government securities, (B) stock of a qualified REIT subsidiary and (C) securities that qualify as real estate assets under the 75% assets test ((A), (B) and (C) are collectively the “75% Securities”). Additionally, under the 25% assets test, no more than 20% of the value of our total assets can be represented by securities of one or more taxable REIT subsidiaries and no more than 5% of the value of our total assets can be represented by the securities of a single issuer, excluding 75% Securities. Furthermore, we may not own more than 10% of the total voting power or the total value of the outstanding securities of any one issuer, excluding 75% Securities.

If we inadvertently fail to satisfy one or more of the asset tests at the end of a calendar quarter, such failure would not cause us to lose our REIT status. We could still avoid disqualification by eliminating any discrepancy within 30 days after the close of the calendar quarter in which the discrepancy arose. Management believes that we were in compliance with all of the requirements of both asset tests for all quarters during 2005 and 2004.

Ownership of Common Stock. Our capital stock must be held by a minimum of 100 persons for at least 335 days of each year. In addition, at all times during the second half of each taxable year, no more than 50% in value of our capital stock may be owned

directly or indirectly by 5 or fewer individuals. We use the calendar year as our taxable year for income tax purposes. The Code requires us to send annual information questionnaires to specified shareholders in order to assure compliance with the ownership tests. Management believes that we have complied with these stock ownership tests for 2005 and 2004.

Distributions. We must distribute at least 90% of our taxable income and any after-tax net income from certain types of foreclosure property less any non-cash income. No distributions are required in periods in which there is no income.

Taxable Income. We use the calendar year for both tax and financial reporting purposes. However, there may be differences between taxable income and income computed in accordance with GAAP. These differences primarily arise from timing and character differences in the recognition of revenue and expense and gains and losses for tax and GAAP purposes. Additionally, taxable income does not include the taxable income of our taxable subsidiary, although the subsidiary’s operating results are included in our GAAP results.

Personnel

As of December 31, 2005, we employed 2,032 people. Of these, 1,678 were employed in our mortgage portfolio management, mortgage lending and loan servicing operations. Our branches employed 347 people as of December 31, 2005. The remaining employees were employed in our branch administrative functions.

Available Information

Copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to these reports filed or furnished with the SEC are available free of charge through our Internet site (www.novastarmortgage.com) as soon as reasonably practicable after filing with the SEC. References to our website do not incorporate by reference the information on such website into this Annual Report on Form 10-K and we disclaim any such incorporation by reference. Copies of our board committee charters, our board’s Corporate Governance Guidelines, Code of Conduct, and other corporate governance information are available at the Corporate Governance section of our Internet site (www.novastarmortgage.com), or by contacting us directly. Our investor relations contact information follows.

Investor Relations

8140 Ward Parkway, Suite 300

Kansas City, MO 64114

816.237.7000

Email: ir@novastar1.com

Item 1A.Risk Factors

Risk Factors

You should carefully consider the risks described below before investing in our publicly traded securities. The risks described below are not the only ones facing us. Our business is also subject to the risks that affect many other companies, such as competition, inflation, technological obsolescence, labor relations, general economic conditions and geopolitical events. Additional risks not currently known to us or that we currently believe are immaterial also may impair our business operations and our liquidity.

Risks Related to Our Borrowing and Securitization Activities

Our growth is dependent on leverage, which may create other risks.

Our success is dependent, in part, upon our ability to grow our assets through the use of leverage. Leverage creates an opportunity for increased net income, but at the same time creates risks. For example, leveraging magnifies changes in our net worth. We will incur leverage only when there is an expectation that it will enhance returns. Moreover, there can be no assurance that we will be able to meet our debt service obligations and, to the extent that we cannot, our ability to make expected minimum REIT dividend requirements to shareholders will be adversely affected. Furthermore, if we were to liquidate, our debt holders and lenders will receive a distribution of our available assets before any distributions are made to our common shareholders.

An interruption or reduction in the securitization market or our ability to access this market would harm our financial position.

We are dependent on the securitization market because we securitize loans directly to finance our loan origination business and many of our whole loan buyers purchase our loans with the intention to securitize. A disruption in the securitization market could prevent us from being able to sell loans at a favorable price or at all. Factors that could disrupt the securitization market include an international liquidity crisis such as occurred in the fall of 1998, sudden changes in interest rates, a terrorist attack, an outbreak of war or other significant event risk, and market specific events such as a default of a comparable type of securitization. In addition, poor performance of our previously securitized $5.3 billionloans could harm our access to the securitization market. In addition, a court recently found a lender and securitization underwriter liable for consumer fraud committed by a company to whom they provided financing and underwriting services. In the event other courts or regulators adopted the same liability theory, lenders and underwriters could be named as defendants in more litigation and as a result they may exit the business or charge more for their services, all of which could have a negative impact on our ability to securitize the loans we originate and the securitization market in general. A decline in our ability to obtain long-term funding for our mortgage loans in the securitization market in general or on attractive terms or a decline in the market’s demand for our loans could harm our results of operations, financial condition and business prospects.

Failure to renew or obtain adequate funding under warehouse repurchase agreements may harm our lending operations.

We are currently dependent upon several warehouse purchase agreements to provide short term financing of our mortgage loan originations and acquisitions. These warehouse purchase agreements contain numerous representations, warranties and covenants, including requirements to maintain a certain minimum net worth, minimum equity ratios and other customary debt covenants. If we were unable to make the necessary representations and warranties at the time we need financing, we would not be able to obtain needed funds. In addition, if we breach a covenant contained in any warehouse agreement, the lenders under all existing warehouse agreements could demand immediate payment of all outstanding amounts because all of our warehouse agreements contain cross-default provisions. Any failure to renew or obtain adequate funding under these financing arrangements for any reason, or any demand by warehouse lenders for immediate payment of outstanding balances could harm our lending operations and have a material adverse effect on our results of operations, financial condition and business prospects. In addition, an increase in the cost of warehouse financing in excess of any change in the income derived from our mortgage assets could also harm our earnings and reduce the cash available for distribution to our shareholders. In October 1998, the subprime mortgage loan market faced a liquidity crisis with respect to the availability of short-term borrowings from major lenders and long-term borrowings through securitization. At that time, we faced significant liquidity constraints which harmed our business and our profitability.

Financing with warehouse repurchase agreements may lead to margin calls if the market value of our mortgage assets declines.

We use warehouse repurchase agreements to finance our acquisition of mortgage assets in the short-term. In a warehouse repurchase agreement, we sell an asset and agree to repurchase the same asset at some point in time in the future. Generally, the

repurchase agreements we enter into provide that we must repurchase the asset in 30 days. For financial accounting purposes, these arrangements are treated as secured financings. We retain the assets on our balance sheet and record an obligation to repurchase the asset. The amount we may borrow under these arrangements is generally 95% to 100% of the asset market value with respect to mortgage loans and 65% to 80% of the asset market value with respect to mortgage securities—available-for-sale. When, in a lender’s opinion, asset market values decrease for any reason, including a rise in interest rates or general concern about the value or liquidity of the assets, we are required to repay the margin or difference in market value, or post additional collateral. If cash or additional collateral is unavailable to meet margin calls, we may default on our obligations under the applicable repurchase agreement. In that event, the lender retains the right to liquidate the collateral we provided it to settle the amount due from us. In addition to obtain cash, we may be required to liquidate assets at a disadvantageous time, which would cause us to incur losses and could change our mix of investments, which in turn could jeopardize our REIT status or our ability to rely on certain exemptions under the Investment Company Act.

We have credit exposure with respect to loans we sell to the whole loan market and loans we sell to securitization entities.

When we sell whole loans or securitize loans, we have potential credit and liquidity exposure for loans that are the subject of fraud, that have irregularities in their documentation or process, or that result in our breaching the representations and warranties in the contract of sale. In addition, when we sell loans to the whole loan market we have exposure for loans that default. In these cases, we may be obligated to repurchase loans at principal value, which could result in a significant decline in our available cash. When we purchase loans from a third party that we sell into the whole loan market or to a securitization trust, we obtain representations and warranties from the counter-parties that sold the loans to us that generally parallel the representations and warranties we provided to our purchasers. As a result, we believe we have the potential for recourse against the seller of the loans. However, if the representations and warranties are not parallel, or if the original seller is not in a financial position to be able to repurchase the loan, we may have to use cash resources to repurchase loans, which could adversely affect our liquidity.

Competition in the securitization market may negatively affect our net income.

Competition in the business of sponsoring securitizations of the type we focus on is increasing as Wall Street broker-dealers, mortgage REITs, investment management companies, and other financial institutions expand their activities or enter this field. Increased competition could reduce our securitization margins if we have to pay a higher price for the long-term funding of these assets. To the extent that our securitization margins erode, our results of operations, financial condition and business prospects will be negatively impacted.

Differences in our actual experience compared to the assumptions that we use to determine the value of our mortgage securities—available-for-sale could adversely affect our financial position.

Currently, our securitizations of mortgage loans are structured to be treated as sales for financial reporting purposes and, therefore, result in 2003gain recognition at closing. As of December 31, 2005, we had mortgage securities – available for sale with a fair value of $505.6 million on our balance sheet. Delinquency, loss, prepayment and discount rate assumptions have a material impact on the amount of gain recognized and on the carrying value of the retained mortgage securities—available-for-sale. It is extremely difficult to validate the assumptions we use in determining the amount of gain on sale and the value of our mortgage securities – available for sale. If our actual experience differs materially from the assumptions that we use to determine our gain on sale or the value of our mortgage securities—available-for-sale, our future cash flows, our financial condition and our results of operations could be negatively affected.

Changes in accounting standards might cause us to alter the way we structure or account for securitizations.

Changes could be made to the current accounting standards, which could affect the way we structure or account for securitizations. For example, if changes were made in the types of transactions eligible for gain on sale treatment, we may have to change the way we account for securitizations, which may harm our results of operations or financial condition.

Risks Related to Interest Rates and Our Hedging Strategies

Changes in interest rates may harm our results of operations.

Our results of operations are likely to be harmed during any period of unexpected or rapid changes in interest rates. Interest rate changes could affect us in the following ways:

a substantial or sustained increase in interest rates could harm our ability to originate or acquire mortgage loans in expected volumes, which could result in a decrease in our cash flow and in our ability to support our fixed overhead expense levels;

interest rate fluctuations may harm our earnings as comparedthe spread between the interest rates we pay on our borrowings and the interest rates we receive on our mortgage assets narrows;

mortgage prepayment rates vary depending on such factors as mortgage interest rates and market conditions, and changes in anticipated prepayment rates may harm our earnings; and

when we securitize loans, the value of the residual and subordinated securities we retain and the income we receive from them are based primarily on the London Inter-Bank Offered Rate, or LIBOR, and an increase in LIBOR reduces the net income we receive from, and the value of, these securities.

Any of the foregoing results from changing interest rates may adversely affect our results from operations.

Hedging against interest rate exposure may adversely affect our earnings, which could adversely affect cash available for distribution to $1.6our shareholders.

We may enter into interest rate cap or swap agreements or pursue other interest rate hedging strategies. Our hedging activity will vary in scope based on interest rates, the type of mortgage assets held, and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect us because, among other things:

interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates;

hedging instruments involve risk because they often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities; consequently, there are no requirements with respect to record keeping, financial responsibility or segregation of customer funds and positions, and the enforceability of agreements underlying derivative transactions may depend on compliance with applicable statutory, commodity and other regulatory requirements;

available interest rate hedging may not correspond directly with the interest rate risk for which protection is sought;

the duration of the hedge may not match the duration of the related liability or asset;

the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction;

the party owing money in the hedging transaction may default on its obligation to pay, which may result in the loss of unrealized profits; and

we may not be able to dispose of or close out a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an offsetting contract in order to cover our risks.

Any hedging activity we engage in may adversely affect our earnings, which could adversely affect cash available for distribution to our shareholders. Unanticipated changes in interest rates may result in poorer overall investment performance than if we had not engaged in any such hedging transactions.

Complying with REIT requirements may limit our ability to hedge effectively.

We attempt to minimize exposure to interest rate fluctuations by hedging. The REIT provisions of the Code limit our ability to hedge mortgage assets and related borrowings by requiring us to limit our income in each year from any qualified hedges, together with any other income not generated from qualified real estate assets, to no more than 25% of our gross income. The interest rate hedges that we generally enter into will not be counted as a qualified asset for the purposes of satisfying this requirement. In addition, under the Code, we must limit our aggregate income from non-qualified hedging transactions and from other non-qualifying sources to no more than 5% of our annual gross income. As a result, we may have to limit our use of advantageous hedging techniques. This could result in greater risks associated with changes in interest rates than we would otherwise want to incur. In addition, if it is ultimately determined that certain of our interest rate hedging transactions are non-qualified under the

Code, we may have more than 5% of our annual gross income from non-qualified sources. If we violate the 5% or 25% limitations, we may have to pay a penalty tax equal to the amount of income in excess of those limitations, multiplied by a fraction intended to reflect our profitability. In addition, if we fail to observe these limitations, we could lose our REIT status unless our failure was due to reasonable cause and not due to willful neglect.

Risks Related to Credit Losses and Prepayment Rates

Loans made to nonconforming mortgage borrowers entail relatively higher delinquency and default rates which would result in higher loan losses.

Lenders in the nonconforming mortgage banking industry make loans to borrowers who have impaired or limited credit histories, limited documentation of income and higher debt-to-income ratios than traditional mortgage lenders allow. Mortgage loans made to nonconforming mortgage loan borrowers generally entail a relatively higher risk of delinquency and foreclosure than mortgage loans made to borrowers with better credit and, therefore, may result in higher levels of realized losses. Delinquency interrupts the flow of projected interest income from a mortgage loan, and default can ultimately lead to a loss if the net realizable value of the real property securing the mortgage loan is insufficient to cover the principal and interest due on the loan. Also, our cost of financing and servicing a delinquent or defaulted loan is generally higher than for a performing loan. We bear the risk of delinquency and default on loans beginning when we originate them. In whole loan sales, our risk of delinquency and default typically only extends to the first payment but can extend up to the third payment. When we securitize any of our loans, we continue to be exposed to delinquencies and losses, either through our residual interests for securitizations structured as sales or through the loans still recorded on our balance sheet for securitizations structured as financings. We also re-acquire the risks of delinquency and default for loans that we are obligated to repurchase. Any failure by us to adequately address the delinquency and default risk associated with nonconforming lending could harm our financial condition and results of operations.

Our efforts to manage credit risk may not be successful in limiting delinquencies and defaults in underlying loans and, as a result, our results of operations may be affected.

There are many aspects of credit that we cannot control and our quality control and loss mitigation operations may not be successful in limiting future delinquencies, defaults and losses. Our comprehensive underwriting process may not be effective in mitigating our risk of loss on the underlying loans. Further, the value of the homes collateralizing residential loans may decline due to a variety of reasons beyond our control, such as weak economic conditions, natural disasters, over-leveraging of the borrower, and reduction in personal incomes. The frequency of defaults and the loss severity on loans upon default may be greater than we anticipated. Interest-only loans, negative amortization loans, adjustable-rate loans, reduced documentation loans, sub-prime loans, home equity lines of credit and second lien loans may involve higher than expected delinquencies and defaults. Changes in consumer behavior, bankruptcy laws, and other laws may exacerbate loan losses. Expanded loss mitigation efforts in the event that defaults increase could increase our operating costs. To the extent that unforeseen or uncontrollable events increase loan delinquencies and defaults, our results of operations may be adversely affected.

Mortgage insurers may in the future change their pricing or underwriting guidelines or may not pay claims resulting in increased credit losses.

We use mortgage insurance to mitigate our risk of credit losses. Our decision to obtain mortgage insurance coverage is dependent, in part, on pricing trends. Mortgage insurance coverage on our new mortgage loan production may not be available at rates that we believe are economically viable for us or at all. We also face the risk that our mortgage insurers might not have the financial ability to pay all claims presented by us or may deny a claim if the loan is not properly serviced, has been improperly originated, is the subject of fraud, or for other reasons. Any of those events could increase our credit losses and thus adversely affect our results of operations and financial condition.

Our Option ARM mortgage product exposes us to greater credit risk

There has been an increase in production of our loan product which is characterized as an option ARM loan. There have been recent announcements by federal regulators concerning interest-only loan programs, option ARM loan programs and other ARM loans with deeply discounted initial rates and/or negative amortization features. Federal banking regulators have expressed serious concerns with these programs and an intent to issue guidance shortly concerning offerings of these products. In addition, already one rating agency (Standard & Poors) has required greater credit enhancements for securitization pools that are backed by option ARMs. The combination of these events could lead to the loan product becoming a less available financing option and hence this could have a material affect on the value of such products.

Our interest-only loans may have a higher risk of default than our fully-amortizing loans.

For the year ended December 31, 2005, originations of interest-only loans totaled $2.0 billion, or 22%, of total originations. These interest-only loans require the borrowers to make monthly payments only of accrued interest for the first 24, 36 or 120 months following origination. After such interest-only period, the borrower’s monthly payment is recalculated to cover both interest and principal so that the mortgage loan will amortize fully prior to its final payment date. The interest-only feature may reduce the likelihood of prepayment during the interest-only period due to the smaller monthly payments relative to a fully-amortizing mortgage loan. If the monthly payment increases, the related borrower may not be able to pay the increased amount and may default or may refinance the related mortgage loan to avoid the higher payment. Because no principal payments may be made on such mortgage loans for an extended period following origination, if the borrower defaults, the unpaid principal balance of the related loans would be greater than otherwise would be the case for a fully-amortizing loan, increasing the risk of loss on these loans.

Current loan performance data may not be indicative of future results.

When making capital budgeting and other decisions, we use projections, estimates and assumptions based on our experience with mortgage loans. Actual results and the timing of certain events could differ materially in 2002. adverse ways from those projected, due to factors including changes in general economic conditions, fluctuations in interest rates, fluctuations in mortgage loan prepayment rates and fluctuations in losses due to defaults on mortgage loans. These differences and fluctuations could rise to levels that may adversely affect our profitability.

Changes in prepayment rates of mortgage loans could reduce our earnings, dividends, cash flows, access to liquidity and results of operations.

The increased volumeeconomic returns we expect to earn from most of the mortgage assets we own are affected by the rate of prepayment of the underlying mortgage loans. If the loans underlying our mortgage securities—available-for-sale prepay at a rate faster than we have anticipated, our economic returns on those assets will be lower than we have assumed which would reduce our earnings, cash flows and dividends. Adverse changes in cash flows from a mortgage asset resulting from accelerated prepayments would likely reduce the asset’s market value, which would likely reduce our access to liquidity if we borrowed against that asset and may cause a market value write-down for GAAP purposes, which would reduce our reported earnings. Changes in loan prepayment patterns can affect us in a variety of other ways that can be complex and difficult to predict. In addition, our exposure to prepayment changes over time. As a result, changes in prepayment rates will likely cause volatility in our financial results in ways that are not necessarily obvious or predictable and that may adversely affect our results of operations.

Geographic concentration of mortgage loans we securitized is directly attributableoriginate or purchase increases our exposure to risks in those areas, especially in California and Florida.

Over-concentration of loans we originate or purchase in any one geographic area increases our exposure to the economic and natural hazard risks associated with that area. Declines in the residential real estate markets in which we are concentrated may reduce the values of the properties collateralizing our mortgages which in turn may increase the risk of delinquency, foreclosure, bankruptcy, or losses from those loans. To the extent that a large number of loans are impaired, our financial condition and results of operations may be adversely affected.

To the extent that we have a large number of loans in an area hit by a natural disaster, we may suffer losses.

Standard homeowner insurance policies generally do not provide coverage for natural disasters, such as hurricanes and floods. Furthermore, nonconforming borrowers are not likely to have special hazard insurance. To the extent that borrowers do not have insurance coverage for natural disasters, they may not be able to repair the property or may stop paying their mortgages if the property is damaged. A natural disaster that results in a significant number of delinquencies could cause increased foreclosures and decrease our ability to recover losses on properties affected by such disasters, and that in turn could harm our financial condition and results of operations.

Uninsured losses due to the Gulf State hurricanes could adversely affect our financial condition and results of operations.

The damage caused by the Gulf State hurricanes, particularly Katrina, Rita and Wilma, has affected the value of our portfolio of mortgage loans held-for-sale and the mortgage loan portfolio we service which underlies our mortgage securities – available-for-sale by impairing the ability of certain borrowers to repay their loans. At present, we are unable to predict the ultimate impact of the Gulf State hurricanes on our future financial results and condition as the impact will depend on a number of factors, including the extent of damage to the collateral, the extent to which damaged collateral is not covered by insurance, the extent to which unemployment and other economic conditions caused by the hurricanes adversely affect the ability of borrowers to repay their

loans, and the cost to us of collection and foreclosure moratoriums, loan forbearances and other accommodations granted to borrowers. Many of the loans are to borrowers where repayment prospects have not yet been determined to be diminished, or are in areas where properties may have suffered little, if any, damage or may not yet have been inspected. We currently have a mortgage protection insurance policy, which protects us from uninsured losses as a result of these hurricanes up to a maximum of $5 million in aggregate losses with a deductible of $100,000 per hurricane. To the extent that losses exceed the $5 million aggregate loss insurance coverage, our financial condition and results of operations could be adversely affected. Additionally, there is no guarantee the insurance company will pay our claims, which could adversely affect our results of operations.

A prolonged economic slowdown or a decline in the real estate market could harm our results of operations.

A substantial portion of our mortgage assets consist of single-family mortgage loans or mortgage securities—available-for-sale evidencing interests in single-family mortgage loans. Because we make a substantial number of loans to credit-impaired borrowers, the actual rates of delinquencies, foreclosures and losses on these loans could be higher during economic slowdowns. Any sustained period of increased delinquencies, foreclosures or losses could harm our ability to sell loans, the prices we receive for our loans, the values of our mortgage loans held for sale or our residual interests in securitizations, which could harm our financial condition and results of operations. In addition, any material decline in real estate values would weaken our collateral loan-to-value ratios and increase the possibility of loss if a borrower defaults. In such event, we will be subject to the risk of loss on such mortgage asset arising from borrower defaults to the extent not covered by third-party credit enhancement.

Risks Related to the Legal and Regulatory Environment in Which We Operate

Various legal proceedings could adversely affect our financial condition or results of operations.

In the course of our business, we are subject to various legal proceedings and claims. See “Item 3 – Legal Proceedings.” The resolution of these legal matters or other legal matters could result in a material adverse impact on our results of operations, financial condition and business prospects.

We are subject to the risk that provisions of our loan agreements may be unenforceable.

Our rights and obligations with respect to our loans are governed by written loan agreements and related documentation. It is possible that a court could determine that one or more provisions of a loan agreement are unenforceable, such as a loan prepayment provision or the provisions governing our security interest in the underlying collateral. If this were to happen with respect to a material asset or group of assets, we could be required to repurchase these loans and may not be able to sell or liquidate the loans, which could negatively affect our liquidity.

We are exposed to the risk of environmental liabilities with respect to properties to which we take title.

In the course of our business, we occasionally foreclose and take title to residential properties and as a result could become subject to environmental liabilities associated with these properties. We may be held liable for property damage, personal injury, investigation, and cleanup costs incurred in connection with environmental contamination. These costs could be substantial. If we ever become subject to significant environmental liabilities, our financial condition and results of operations could be adversely affected.

Regulation as an investment company could harm our business; efforts to avoid regulation as an investment company could limit our operations.

The Investment Company Act of 1940, as amended, or the Investment Company Act, if deemed applicable to us, would prevent us from conducting our business as described in this document by, among other things, substantially limiting our ability to use leverage. The Investment Company Act does not regulate entities that are primarily engaged, directly or indirectly, in a business “other than that of investing, reinvesting, owning, holding or trading in securities,” or that are primarily engaged in the business of “purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” Under the Commission’s current interpretation, in order to qualify for the latter exemption we must maintain at least 55% of our assets directly in “qualifying real estate interests” and at least an additional 25% of our assets in other real estate-related assets or additional qualifying real estate interests. If we rely on this exemption from registration as an investment company under the Investment Company Act, our ability to invest in assets that would otherwise meet our investment strategies will be limited. If we are subject to the Investment Company Act and fail to qualify for an applicable exemption from the Investment Company Act, we could not operate our business efficiently under the regulatory scheme imposed by the Investment Company Act. Accordingly, we could be required to restructure our activities which could materially adversely affect our financial condition and results of operations.

Our failure to comply with federal, state or local regulation of, or licensing requirements with respect to, mortgage lending, loan servicing, broker compensation programs, or other aspects of our business could harm our operations and profitability.

As a mortgage lender, loan servicer and broker, we are subject to an extensive body of both state and federal law. The volume of new or modified laws and regulations has increased in recent years and, in addition, some individual municipalities have begun to enact laws that restrict loan origination and servicing activities. As a result, it may be more difficult to comprehensively identify and accurately interpret all of these laws and regulations and to properly program our technology systems and effectively train our personnel with respect to all of these laws and regulations, thereby potentially increasing our exposure to the risks of noncompliance with these laws and regulations. Also, in our branch operations, we allow our branch managers relative autonomy, which could result in our facing greater exposure to third-party claims if our compliance programs are not strictly adhered to. Our failure to comply with these laws can lead to civil and criminal liability; loss of licensure; damage to our reputation in the industry; inability to sell or securitize our loans; demands for indemnification or loan repurchases from purchasers of our loans; fines and penalties and litigation, including class action lawsuits; or administrative enforcement actions. Any of these results could harm our results of operations, financial condition and business prospects.

New legislation could restrict our ability to make mortgage loans, which could harm our earnings.

Several states, cities or other government entities are considering or have passed laws, regulations or ordinances aimed at curbing predatory lending practices. The federal government is also considering legislative and regulatory proposals in this regard. In general, these proposals involve lowering the existing thresholds for defining a “high-cost” loan and establish enhanced protections and remedies for borrowers who receive such loans. Passage of these laws and rules could reduce our loan origination volume. DuringIn addition, many whole loan buyers may elect not to purchase any loan labeled as a “high cost” loan under any local, state or federal law or regulation. Rating agencies likewise may refuse to rate securities backed by such loans. Accordingly, these laws and rules could severely restrict the secondary market for a significant portion of our loan production. This would effectively preclude us from continuing to originate loans either in jurisdictions unacceptable to the rating agencies or that exceed the newly defined thresholds which could harm our results of operations and business prospects.

If lenders are prohibited from originating loans in the State of Illinois with fees in excess of 3% where the interest rate exceeds 8%, this could force us to curtail operations in Illinois.

In March 2004, an Illinois Court of Appeals found that the Illinois Interest Act, which caps fees at 3% for loans with an interest rate in excess of 8%, is not preempted by federal law. This ruling contradicts the view of the Federal Circuit Courts of Appeal, most state courts and the Illinois Office of the Attorney General. In November 2004, the Illinois Supreme Court decided to consider an appeal to this case. If this ruling is not overturned, we may reduce operations in Illinois since it will reduce the return we and our investors can expect on higher risk loans. Moreover, as a result of this ruling, plaintiffs are filing actions against lenders, including us, seeking various forms of relief as a result of any fees received in the past that exceeded the applicable thresholds. Any such actions, if decided against us, could harm our results of operations, financial condition and business prospects.

We are no longer able to rely on the Alternative Mortgage Transactions Parity Act to preempt certain state law restrictions on prepayment penalties, which could harm our earnings.

Certain state laws restrict or prohibit prepayment penalties on mortgage loans and, until July 2003, we relied on the federal Alternative Mortgage Transactions Parity Act, or the Parity Act, and related rules issued in the past by the Office of Thrift Supervision, or OTS, to preempt state limitations on prepayment penalties. The Parity Act was enacted to extend to financial institutions, like us, which are not federally chartered depository institutions, the federal preemption that federally chartered depository institutions enjoy. However, in September 2002, the OTS released a rule that reduced the scope of the Parity Act preemption and, as a result, we originated $5.3 billionare no longer able to rely on the Parity Act to preempt state restrictions on prepayment penalties. The elimination of this federal preemption has required us to comply with state restrictions on prepayment penalties. These restrictions prohibit us from charging any prepayment penalty in certain states and $2.5 billion, respectively,limit the amount or other terms and conditions of our prepayment penalties in nonconforming, residentialseveral other states. This places us at a competitive disadvantage relative to financial institutions that will continue to enjoy federal preemption of such state restrictions. Such institutions are able to charge prepayment penalties without regard to state restrictions and, as a result, may be able to offer loans with interest rate and loan fee structures that are more attractive than the interest rate and loan fee structures that we are able to offer. This competitive disadvantage could harm our results of operations, financial condition and business prospects.

Changes in Internal Revenue Service regulations regarding the timing of income recognition and/or deductions could materially adversely affect the amount of our dividends.

On September 30, 2004, the IRS, released Announcement 2004-75, which describes rules that may be included in proposed IRS regulations regarding the timing of recognizing income and/or deductions attributable to interest-only securities. We believe the

effect of these regulations, if adopted, may narrow the spread between book income and taxable income on the interest-only securities we hold and would thus reduce our taxable income during the initial periods that we hold such securities. A significant portion of our mortgage securities—available-for-sale consist of interest-only securities. If regulations are adopted by the IRS that reduce our taxable income in a particular year, our dividend may be reduced for that year because the amount of our dividend is entirely dependent upon our taxable income.

If we fail to maintain REIT status, we would be subject to tax as a regular corporation. We conduct a substantial portion of our business through our taxable REIT subsidiaries, which creates additional compliance requirements.

We must comply with numerous complex tests to continue to qualify as a REIT for federal income tax purposes, including the requirement that we distribute 90% of taxable income to our shareholders and the requirement that no more than 5% of our annual gross income come from non-qualifying sources. If we do not comply with these requirements, we could be subject to penalty taxes and our REIT status could be at risk. We conduct a substantial portion of our business through taxable REIT subsidiaries, such as NovaStar Mortgage. Despite our qualification as a REIT, our taxable REIT subsidiaries must pay federal income tax on their taxable income. Our income from, and investments in, our taxable REIT subsidiaries do not constitute permissible income or investments for some of the REIT qualification tests. We may be subject to a 100% penalty tax, or our taxable REIT subsidiaries may be denied deductions, to the extent that our dealings with our taxable REIT subsidiaries are deemed not to be arm’s length in nature.

Our cash balances and cash flows may become limited relative to our cash needs, which may ultimately affect our REIT status or solvency.

We use cash for originating mortgage loans, minimum REIT dividend distribution requirements, and other operating needs. Cash is also required to pay interest on our outstanding indebtedness and may be required to pay down indebtedness in the event that the market values of the assets collateralizing our debt decline, the terms of short-term debt become less attractive or for other reasons. If our income as calculated for tax purposes significantly exceeds our cash flows from operations, our minimum REIT dividend distribution requirements could exceed the amount of our available cash. In the event that our liquidity needs exceed our access to liquidity, we may need to sell assets at an inopportune time, thus adversely affecting our financial condition and results of operations. Furthermore, in an adverse cash flow situation, our REIT status or our solvency could be threatened.

The tax imposed on REITs engaging in “prohibited transactions” will limit our ability to engage in transactions, including certain methods of securitizing loans, which would be treated as sales for federal income tax purposes.

A REIT’s net income from prohibited transactions is subject to a 100% tax. In general, prohibited transactions are sales or other dispositions of property, other than foreclosure property but including any mortgage loans held in inventory primarily for sale to customers in the ordinary course of business. We might be subject to this tax if we were to sell a loan or securitize the loans in a manner that was treated as a sale of such inventory for federal income tax purposes. Therefore, in order to avoid the prohibited transactions tax, we may choose not to engage in certain sales of loans other than through our taxable REIT subsidiaries and may limit the structures we utilize for our securitization transactions even though such sales or structures might otherwise be beneficial for us. In addition, this prohibition may limit our ability to restructure our portfolio of mortgage loans from time to time even if we believe it would be in our best interest to do so.

Even if we qualify as a REIT, the income earned by our taxable REIT subsidiaries will be subject to federal income tax and we could be subject to an excise tax on non-arm’s-length transactions with our taxable REIT subsidiaries.

Our taxable REIT subsidiaries, including NovaStar Mortgage, expect to earn income from activities that are prohibited for REITs, and will owe income taxes on the taxable income from these activities. For example, we expect that NovaStar Mortgage will earn income from our loan origination and sales activities, as well as from other origination and servicing functions, which would generally not be qualifying income for purposes of the gross income tests applicable to REITs or might otherwise be subject to adverse tax liability if the income were generated by a REIT. Our taxable REIT subsidiaries will be taxable as C corporations and will be subject to federal, state and local income tax at the applicable corporate rates on their taxable income, notwithstanding our qualification as a REIT.

In the event that any transactions between us and our taxable REIT subsidiaries are not conducted on an arm’s-length basis, we could be subject to a 100% excise tax on certain amounts from such transactions. Any such tax could affect our overall profitability and the amounts of cash available to make distributions.

We may, at some point in the future, borrow funds form one or more of our corporate subsidiaries. The IRS may recharacterize the indebtedness as a dividend distribution to us by our subsidiary. Any such recharacterization may cause us to fail one or more of the REIT requirements.

We may be harmed by changes in tax laws applicable to REITs or the reduced 15% tax rate on certain corporate dividends may harm us.

Changes to the laws and regulations affecting us, including changes to securities laws and changes to the Code applicable to the taxation of REITs, may harm our business. New legislation may be enacted into law or new interpretations, rulings or regulations could be adopted, any of which could harm us and our shareholders, potentially with retroactive effect.

Generally, dividends paid by REITs are not eligible for the 15% U.S. federal income tax rate on certain corporate dividends, with certain exceptions. The more favorable treatment of regular corporate dividends could cause domestic non-corporate investors to consider stocks of other corporations that pay dividends as more attractive relative to stocks of REITs.

We may be unable to comply with the requirements applicable to REITs or compliance with such requirements could harm our financial condition.

The requirements to qualify as a REIT under the Code are highly technical and complex. We routinely rely on legal opinions to support our tax positions. A technical or inadvertent failure to comply with the Code as a result of an incorrect interpretation of the Code or otherwise could jeopardize our REIT status. The determination that we qualify as a REIT requires an analysis of various factual matters and circumstances that may not be totally within our control. For example, to qualify as a REIT, at least 75% of our gross income must come from real estate sources and 95% of our gross income must come from real estate sources and certain other sources that are itemized in the REIT tax laws, mainly interest and dividends. We are subject to various limitations on our ownership of securities, including a limitation that the value of our investment in taxable REIT subsidiaries, including NovaStar Mortgage, cannot exceed 20% of our total assets at the end of any calendar quarter. In addition, at the end of each calendar quarter, at least 75% of our assets must be qualifying real estate assets, government securities and cash and cash items. The need to comply with these asset ownership requirements may cause us to acquire other assets that are qualifying real estate assets for purposes of the REIT requirements (for example, interests in other mortgage loan portfolios or mortgage-related assets) but are not part of our overall business strategy and might not otherwise be the best investment alternative for us. Moreover, we may be unable to acquire sufficient qualifying REIT assets, due to our inability to obtain adequate financing or otherwise, in which case we may fail to qualify as a REIT or may incur a penalty tax at the REIT level.

To qualify as a REIT, we must distribute to our shareholders with respect to each year at least 90% of our REIT taxable income (determined without regard to the dividends paid deduction and by excluding any net capital gain). After-tax earnings generated by our taxable REIT subsidiaries and not distributed to us are not subject to these distribution requirements and may be retained by such subsidiaries to provide for future growth, subject to the limitations imposed by REIT tax rules. To the extent that we satisfy the 90% distribution requirement, but distribute less than 100% of our taxable income, we will be subject to federal corporate income tax on our undistributed taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our shareholders in a calendar year is less than a minimum amount specified under federal tax laws. We expect in some years that we will be subject to the 4% excise tax. We could be required to borrow funds on a short-term basis even if conditions are not favorable for borrowing, or to sell loans from our portfolio potentially at disadvantageous prices, to meet the REIT distribution requirements and to avoid corporate income taxes. These alternatives could harm our financial condition and could reduce amounts available to originate mortgage loans.

If we fail to qualify or remain qualified as a REIT, our distributions will not be deductible by us, and we will be subject to federal income tax on our taxable income. This would substantially reduce our earnings and our cash available to make distributions. The resulting tax liability, in the event of our failure to qualify as a REIT, might cause us to borrow funds, liquidate some of our investments or take other steps that could negatively affect our operating results. Moreover, if our REIT status is terminated because of our failure to meet a technical REIT requirement or if we voluntarily revoke our election, we generally would be disqualified from electing treatment as a REIT for the four taxable years following the year in which REIT status is lost.

We could lose our REIT status if more than 20% of the value of our total assets are represented by the securities of one or more taxable REIT subsidiaries at the close of any calendar quarter.

To qualify as a REIT, not more than 20% of the value of our total assets may be represented by the securities of one or more taxable REIT subsidiaries at the close of any calendar quarter, subject to a 30-day “cure” period following the close of the quarter and, for taxable years beginning on or after January 1, 2005, subject to certain relief provisions even after the 30-day cure period. Our taxable REIT subsidiaries, including NovaStar Mortgage, conduct a substantial portion of our business activities, including a majority of our loan origination and servicing activities. If the IRS determines that the value of our investment in our taxable REIT subsidiaries was more than 20% of the value of our total assets at the close of any calendar quarter, we could lose our REIT status.

In certain cases, we may need to borrow from third parties to acquire additional qualifying REIT assets or increase the amount and frequency of dividends from our taxable REIT subsidiaries in order to comply with the 20% of assets test.

Risks Related to Our Capital Stock

Investors in our common stock may experience losses, volatility and poor liquidity, and we may reduce or delay payment of our dividends in a variety of circumstances.

Our earnings, cash flow, book value and dividends can be volatile and difficult to predict. Investors should not rely on predictions or management beliefs. Although we seek to pay a regular common stock dividend at a rate that is sustainable, we may reduce our dividend payments in the future for a variety of reasons. We may not provide public warnings of such dividend reductions or payment delays prior to their occurrence. Fluctuations in our current and prospective earnings, cash flow and dividends, as well as many other factors such as perceptions, economic conditions, stock market conditions, and the like, can affect the price of our common stock. Investors may experience volatile returns and material losses. In addition, liquidity in the trading of our common stock may be insufficient to allow investors to sell their stock in a timely manner or at a reasonable price.

Restrictions on ownership of capital stock may inhibit market activity and the resulting opportunity for holders of our capital stock to receive a premium for their securities.

In order for us to meet the requirements for qualification as a REIT, our charter generally prohibits any person from acquiring or holding, directly or indirectly, (i) shares of our common stock in excess of 9.8% (in value or number of shares, whichever is more restrictive) of the aggregate outstanding shares of our common stock or (ii) shares of our capital stock in excess of 9.8% in value of the aggregate outstanding shares of our capital stock. These restrictions may inhibit market activity and the resulting opportunity for the holders of our capital stock to receive a premium for their stock that might otherwise exist in the absence of such restrictions.

The market price of our common stock and trading volume may be volatile, which could result in substantial losses for our shareholders.

The market price of our common stock may be highly volatile and subject to wide fluctuations. In addition, the trading volume in our common stock may fluctuate and cause significant price variations to occur. Some of the factors that could negatively affect our share price or result in fluctuations in the price or trading volume of our common stock include:

general market and economic conditions;

actual or anticipated changes in our future financial performance;

actual or anticipated changes in market interest rates;

actual or anticipated changes in our access to capital;

actual or anticipated changes in the amount of our dividend or any delay in the payment of a dividend;

competitive developments, including announcements by us or our competitors of new products or services;

the operations and stock performance of our competitors;

developments in the mortgage lending industry or the financial services sector generally;

the impact of new state or federal legislation or adverse court decisions;

fluctuations in our quarterly operating results;

the activities of investors who engage in short sales of our common stock;

actual or anticipated changes in financial estimates by securities analysts;

sales, or the perception that sales could occur, of a substantial number of shares of our common stock by insiders;

additions or departures of senior management and key personnel; and

actions by institutional shareholders.

Our common stock may become illiquid if an active public trading market cannot be sustained, which could adversely affect the trading price and your ability to transfer our common stock.

Our common stock’s trading volume is relatively low compared to the securities of many other companies listed on the New York Stock Exchange. If an active public trading market cannot be sustained, the trading price of our common stock could be adversely affected and your ability to transfer your shares of our common stock may be limited.

We may issue additional shares that may cause dilution and may depress the price of our common stock.

Our charter permits our board of directors, without stockholder approval, to:

authorize the issuance of additional shares of common stock or preferred stock without stockholder approval, including the issuance of shares of preferred stock that have preference rights over the common stock with respect to dividends, liquidation, voting and other matters or shares of common stock that have preference rights over our outstanding common stock with respect to voting; and

classify or reclassify any unissued shares of common stock or preferred stock and to set the preferences, rights and other terms of the classified or reclassified shares.

In the future, we will seek to access the capital markets from time to time by making additional offerings of securities, including debt instruments, preferred stock or common stock. Additional equity offerings by us may dilute your interest in us or reduce the market price of our common stock, or both. Our outstanding shares of preferred stock have, and any additional series of preferred stock may also have, a preference on distribution payments that could limit our ability to make a distribution to common shareholders. Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Further, market conditions could require us to accept less favorable terms for the issuance of our securities in the future. Thus, our common shareholders will bear the risk of our future offerings reducing the market price of our common stock and diluting their interest in us.

Past issuances of our common stock pursuant to our 401(k) plan and our Direct Stock Purchase and Dividend Reinvestment Plan may not have complied with the registration requirements of the securities laws.

We maintain a number of equity-based compensation plans for our employees, including a 401(k) plan, and DRIP for our employees and the public. Up to approximately 23,000 shares of common stock under our 401(k) plan and up to approximately 287,000 shares of common stock under our DRIP (collectively, the “Subject Shares”), may have been sold in a manner that may not have complied with the registration requirements of applicable securities laws during the twelve month period ending January 20, 2006, the date the rescission offers were initiated. In connection with sales under our 401(k) plan, the Subject Shares were purchased in the open market and as a result we did not receive any proceeds from such transactions, which may not be deemed to be sales for these purposes. In connection with sales of up to approximately 287,000 Subject Shares that were not registered under our DRIP in May 2005, we received approximately $10.8 million in net proceeds. As a result, we initiated offers to rescind the purchase of the Subject Shares. While we do not expect all eligible purchasers to exercise their rescission rights pursuant to the rescission offers, we have agreed to repurchase the Subject Shares still held by eligible purchasers generally for an amount equal to the original purchase price for the shares plus interest, less dividends, and to compensate eligible purchasers generally for any losses incurred in the sale of the Subject Shares, plus interest, less dividends. The number of eligible purchasers and the amount that we will pay for the shares that are rescinded will be determined by reference to the closing price of our common stock on March 30, 2006, the expiration date of the rescission offers. Furthermore, we could be subject to monetary fines or other regulatory sanctions as provided under applicable securities laws.

Other Risks Related to our Business

Intense competition in our industry may harm our financial condition.

We face intense competition, primarily from consumer finance companies, conventional mortgage bankers, commercial banks, credit unions, thrift institutions, and other independent wholesale mortgage lenders, including internet-based lending companies and other mortgage REITs. Competitors with lower costs of capital have a competitive advantage over us. In addition, establishing a

mortgage lending operation such as ours requires a relatively small commitment of capital and human resources, which permits new competitors to enter our markets quickly and to effectively compete with us. Furthermore, national banks, thrifts and their operating subsidiaries are generally exempt from complying with many of the state and local laws that affect our operations, such as the prohibition on prepayment penalties. Thus, they may be able to provide more competitive pricing and terms than we can offer. Any increase in the competition among lenders to originate nonconforming mortgage loans may result in either reduced income on mortgage loans compared to present levels, or revised underwriting standards permitting higher loan-to-value ratios on properties securing nonconforming mortgage loans, either of which could adversely affect our results of operations, financial condition or business prospects. In addition, the government-sponsored entities, Fannie Mae and Freddie Mac, may also expand their participation in the subprime mortgage industry. To the extent they materially expand their purchase of subprime loans, our ability to profitably originate and purchase mortgage loans may be adversely affected because their size and cost-of-funds advantage allows them to purchase loans with lower rates or fees than we are willing to offer.

If we are unable to maintain and expand our network of independent brokers, our loan origination business will decrease.

A significant majority of our originations of mortgage loans comes from independent brokers. During 2005, 75% of our loan originations were originated through our broker network. Our brokers are not contractually obligated to do business with us. Further, our competitors also have relationships with our brokers and actively compete with us in our efforts to expand our broker networks. Our failure to maintain existing relationships or expand our broker networks could significantly harm our business, financial condition, liquidity and results of operations.

Our reported GAAP financial results differ from the taxable income results that drive our dividend distributions, and our consolidated balance sheet, income statement, and statement of cash flows as reported for GAAP purposes may be difficult to interpret.

We manage our business based on long-term opportunities to earn cash flows. Our dividend distributions are driven by the REIT tax laws and our income as calculated for tax purposes pursuant to the Code. Our reported results for GAAP purposes differ materially, however, from both our cash flows and our taxable income. We transfer mortgage loans or mortgage securities—available-for-sale into securitization trusts to obtain long-term non-recourse funding for these assets. When we surrender control over the transferred mortgage loans or mortgage securities—available-for-sale, the transaction is accounted for as a sale. When we retain control over the transferred mortgage loans or mortgage securities available-for-sale, the transaction is accounted for as a secured borrowing. These securitization transactions do not differ materially in their structure or cash flow generation characteristics, yet under GAAP accounting these transactions are recorded differently. In a securitization transaction accounted for as a sale, we record a gain or loss on the assets transferred in our income statement and we record the retained interests at fair value on our balance sheet. In a securitization transaction accounted for as a secured borrowing, we consolidate all the assets and liabilities of the trust on our financial statements (and thus do not show the retained interest we own as an asset). As a result of this and other accounting issues, shareholders and analysts must undertake a complex analysis to understand our economic cash flows, actual financial leverage, and dividend distribution requirements. This complexity may cause trading in our stock to be relatively illiquid or may lead observers to misinterpret our results.

Market values for our mortgage assets and hedges can be volatile. For GAAP purposes, we mark-to-market our non-hedging derivative instruments through our GAAP consolidated income statement and we mark-to-market our mortgage securities—available-for-sale through our GAAP consolidated balance sheet through other comprehensive income unless the mortgage securities are in an unrealized loss position which has been deemed as an other-than-temporary impairment. An other-than-temporary impairment is recorded through the income statement in the period incurred. Additionally, we do not mark-to-market our loans held for sale as they are carried at lower of cost or market, as such, any change in market value would not be recorded through our income statement until the related loans are sold. If we sell an asset that has not been marked-to-market through our income statement at a reduced market price relative to its basis, our reported earnings will be reduced. A decrease in market value of our mortgage assets may or may not result in a deterioration in future cash flows. As a result, changes in our GAAP consolidated income statement and balance sheet due to market value adjustments should be interpreted with care.

If we attempt to make any acquisitions, we will incur a variety of costs and may never realize the anticipated benefits.

If appropriate opportunities become available, we may attempt to acquire businesses that we believe are a strategic fit with our business. If we pursue any such transaction, the process of negotiating the acquisition and integrating an acquired business may result in operating difficulties and expenditures and may require significant management attention that would otherwise be available for ongoing development of our business, whether or not any such transaction is ever consummated. Moreover, we may never realize the anticipated benefits of any acquisitions. Future acquisitions could result in potentially dilutive issuances of equity securities, the incurrence of debt, contingent liabilities and/or amortization expenses related to goodwill and other intangible assets, which could harm our results of operations, financial condition and business prospects.

The inability to attract and retain qualified employees could significantly harm our business.

We depend on the continued service of our top executives, including our chief executive officer and president. To the extent that one or more of our top executives are no longer employed by us, our operations and business prospects may be adversely affected. We also depend on our wholesale account executives and retail loan officers to attract borrowers by, among other things, developing relationships with financial institutions, other mortgage companies and brokers, real estate agents, borrowers and others. The market for skilled account executives and loan officers is highly competitive and historically has experienced a high rate of turnover. Competition for qualified account executives and loan officers may lead to increased hiring and retention costs. If we are unable to attract or retain a sufficient number of skilled account executives at manageable costs, we will be unable to continue to originate quality mortgage loans that we are able to sell for a profit, which would harm our results of operations, financial condition and business prospects.

The success and growth of our business will depend upon our ability to adapt to and implement technological changes.

Our mortgage loan origination business is currently dependent upon our ability to effectively interface with our brokers, borrowers and other third parties and to efficiently process loan applications and closings. The origination process is becoming more dependent upon technological advancement, such as the ability to process applications over the Internet, accept electronic signatures and provide process status updates instantly and other customer-expected conveniences that are cost-efficient to our process. Becoming proficient with new technology will require significant financial and personnel resources. If we become reliant on any particular technology or technological solution, we may be harmed to the extent that such technology or technological solution (i) becomes non-compliant with existing industry standards, (ii) fails to meet or exceed the capabilities of our competitors’ equivalent technologies or technological solutions, (iii) becomes increasingly expensive to service, retain and update, or (iv) becomes subject to third-party claims of copyright or patent infringement. Any failure to acquire technologies or technological solutions when necessary could limit our ability to remain competitive in our industry and could also limit our ability to increase the cost-efficiencies of our operating model, which would harm our results of operations, financial condition and business prospects.

Our business could be adversely affected if we experienced an interruption in or breach of our communication or information systems or if we were unable to safeguard the security and privacy of the personal financial information we receive.

We rely heavily upon communications and information systems to conduct our business. Any material interruption or breach in security of our communication or information systems or the third-party systems on which we rely could cause underwriting or other delays and could result in fewer loan applications being received, slower processing of applications and reduced efficiency in loan servicing. Additionally, in connection with our loan file due diligence reviews, we have access to the personal financial information of the borrowers which is highly sensitive and confidential, and subject to significant federal and state regulation. If a third party were to misappropriate this information, we potentially could be subject to both private and public legal actions. Our policies and safeguards may not be sufficient to prevent the misappropriation of confidential information, may become noncompliant with existing federal or state laws or regulations governing privacy, or with those laws or regulations that may be adopted in the future.

Our inability to realize cash proceeds from loan sales and securitizations in excess of the loan acquisition cost could harm our financial position.

The net cash proceeds received from loan sales consist of the premiums we receive on sales of loans in excess of the outstanding principal balance, plus the cash proceeds we receive from securitizations structured as sales, minus the discounts on loans that we have to sell for less than the outstanding principal balance. If we are unable to originate loans at a cost lower than the cash proceeds realized from loan sales, such inability could harm our results of operations, financial condition and business prospects.

Market factors may limit our ability to acquire mortgage assets at yields that are favorable relative to borrowing costs.

Despite our experience in the acquisition of mortgage assets and our relationships with various mortgage suppliers, we face the risk that we might not be able to acquire mortgage assets which earn interest rates greater than our cost of funds or that we might not be able to acquire a sufficient number of such mortgage assets to maintain our profitability.

We face loss exposure due to fraudulent and negligent acts on the part of loan applicants, employees, mortgage brokers and other third parties.

When we originate or purchase mortgage loans, we rely heavily upon information provided to us by third parties, including information relating to the loan application, property appraisal, title information and employment and income documentation. If any of this information is fraudulently or negligently misrepresented to us and such misrepresentation is not detected by us prior to loan funding, the value of the loan may be significantly lower than we expected. Whether a misrepresentation is made by the loan applicant, the loan broker, one of our employees, or any other third party, we generally bear the risk of loss associated with it. A loan subject to misrepresentation typically cannot be sold and subject to repurchase by us if it is sold prior to our detection of the misrepresentation. We may not be able to recover losses incurred as a result of the misrepresentation.

Our reliance on cash-out refinancings as a significant source of our origination volume increases the risk that our earnings will be harmed if the demand for this type of refinancing declines.

For the year ended December 31, 2005, approximately 59% of our loan production through adding sales personnelvolume consisted of cash-out refinancings. Our reliance on cash-out refinancings as a significant source of our origination volume increases the risk that our earnings will be reduced if interest rates rise and branch offices primarilythe prices of homes decline, which would reduce the demand and production volume for this type of refinancing. A substantial and sustained increase in newinterest rates could significantly reduce the number of borrowers who would qualify or elect to pursue a cash-out refinancing and underserved markets.result in a decline in that origination source. Similarly, a decrease in home prices would reduce the amount of equity available to be borrowed against in cash-out refinancings and result in a decrease in our loan production volume from that origination source. Therefore, our reliance on cash-out refinancings as a significant source of our origination volume could harm our results of operations, financial condition and business prospects.

 

SummaryWe may enter into certain transactions at the REIT in the future that incur excess inclusion income that will increase the tax liability of Operations and Key Performance Measurementsour shareholders.

 

VirtuallyIf we incur excess inclusion income at the REIT, it will be allocated among our shareholders. A stockholder’s share of excess inclusion income (i) would not be allowed to be offset by any net operating losses otherwise available to the stockholder, (ii) would be subject to tax as unrelated business taxable income in the hands of most types of shareholders that are otherwise generally exempt from federal income tax, and (iii) would result in the application of U.S. federal income tax withholding at the maximum rate (i.e., 30%), without reduction for any otherwise applicable income tax treaty, to the extent allocable to most types of foreign shareholders. How such income is to be reported to shareholders is not clear under current law. Tax-exempt investors, foreign investors, and taxpayers with net operating losses should carefully consider the tax consequences of having excess inclusion income allocated to them and are urged to consult their tax advisors.

Excess inclusion income would be generated if we issue debt obligations with two or more maturities and the terms of the payments on these obligations bear a relationship to the payments that we received on our mortgage loans or mortgage-backed securities securing those debt obligations. The structure of this type of CMO securitization generally gives rise to excess inclusion income. It is reasonably likely that we will structure some future CMO securitizations in this manner. Excess inclusion income could also result if we were to hold a residual interest in a REMIC. The amounts of excess inclusion income in any given year from these transactions could be significant.

Some provisions of our charter, bylaws and Maryland law may deter takeover attempts, which may limit the opportunity of our stockholders to sell their common stock at favorable prices.

Certain provisions of our charter, bylaws and Maryland law could discourage, delay or prevent transactions that involve an actual or threatened change in control, and may make it more difficult for a third party to acquire us, even if doing so may be beneficial to our stockholders by providing them with the opportunity to sell their shares possibly at a premium over the then market price. For example, our board of directors is divided into three classes with three year staggered terms of office. This makes it more difficult for a third party to gain control of our board because a majority of directors cannot be elected at a single meeting. Further, under our charter, generally a director may only be removed for cause and only by the affirmative vote of the holders of at least a majority of all classes of shares entitled to vote in the election for directors together as a single class. Our bylaws make it difficult for any person other than management to introduce business at a duly called meeting requiring such other person to follow certain advance

notice procedures. Finally, Maryland law provides protection for Maryland corporations against unsolicited takeover situations. These provisions, as well as others, could discourage potential acquisition proposals, or delay or prevent a change in control and prevent changes in our management, even if such actions would be in the best interests of our stockholders.

Item 1B.Unresolved Staff Comments

None

Item 2.Properties

Our executive, administrative and loan servicing offices are located in Kansas City, Missouri, and consist of approximately 200,000 square feet of leased office space. The lease agreements on the premises expire in January 2011. The current annual rent for these offices is approximately $3.9 million.

We lease office space for our mortgage lending operations in Lake Forest, California; Independence, Ohio; Richfield, Ohio; Troy, Michigan and Columbia, Maryland. Currently, these offices consist of approximately 233,000 square feet. The leases on the premises expire from December 2009 through May 2012, and the current annual rent is approximately $4.2 million.

Item 3.Legal Proceedings

Since April 2004, a number of substantially similar class action lawsuits have been filed and consolidated into a single action in the Untied States District Court for the Western District of Missouri. The consolidated complaint names us defendants and three of our executive officers and generally alleges that the defendants made public statements that were misleading for failing to disclose certain regulatory and licensing matters. The plaintiffs purport to have brought this consolidated action on behalf of all persons who purchased our common stock (and sellers of put options on our common stock) during the period October 29, 2003 through April 8, 2004. On January 14, 2005, we filed a motion to dismiss this action, and on May 12, 2005, the court denied such motion. We believe that these claims are without merit and continues to vigorously defend against them.

In the wake of the securities class action, we have also been named as a nominal defendant in several derivative actions brought against certain of our officers and directors in Missouri and Maryland. The complaints in these actions generally claim that the defendants are liable to us for failing to monitor corporate affairs so as to ensure compliance with applicable state licensing and regulatory requirements.

In July 2004, an employee of NovaStar Home Mortgage, Inc. (“NHMI”), a wholly-owned subsidiary of the Company, filed a class and collective action lawsuit against NHMI and NMI in California Superior Court for the County of Los Angeles. Subsequently, NHMI and NMI removed the matter to the United States District Court for the Central District of California and NMI was removed from the lawsuit. The putative class is comprised of all past and present employees of NHMI who were employed since May 1, 2000 in the capacity generally described as Loan Officer. The plaintiffs alleged that NHMI failed to pay them overtime and minimum wage as required by the Fair Labor Standards Act (“FLSA”) and California state laws for the period commencing May 1, 2000 to present. In 2005, the plaintiffs and NHMI agreed upon a nationwide settlement in the amount of $3.3 million on behalf of a class of all NHMI Loan Officers. The settlement, which is subject to final court approval, covers all claims for minimum wage, overtime, meal and rest periods, record-keeping, and penalties under California and federal law during the class period. In 2004, since not all class members will elect to be part of the settlement, we estimated the probable obligation related to the settlement to be in a range of $1.3 million to $1.7 million. In accordance with SFAS No. 5, Accounting for Contingencies, we recorded a charge to earnings of $1.3 million in 2004. In 2005, we recorded an additional charge to earnings of $200,000 as the estimated probable obligation increased to a range of $1.5 million to $1.9 million.

In April 2005, three putative class actions filed against NHMI and certain of its affiliates were consolidated for pre-trial proceedings in the United States District Court for the Southern District of Georgia entitledIn Re NovaStar Home Mortgage, Inc. Mortgage Lending Practices Litigation.These cases allege that NHMI improperly shared settlement service fees with limited liability companies in which NHMI had an interest (the “LLCs”) alleging violations of the fee splitting and anti-referral provisions of the federal Real Estate Settlement Procedures Act (“RESPA”), and alleging certain violations of state law and civil conspiracy. Plaintiffs seek treble damages with respect to the RESPA claims, disgorgement of fees with respect to the state law claims as well as other damages, injunctive relief and attorney fees. In addition, two other related class actions have been filed in state courts.Miller v. NovaStar Financial, Inc. et al., was filed in October 2004 in the Circuit Court of Madison County, Illinois andJones et al. v. NovaStar Home Mortgage, Inc. et al., was filed in December 2004 in the Circuit Court for Baltimore City, Maryland. In theMiller case,plaintiffs allege a violation of the Illinois Consumer Fraud and Deceptive Practices Act and civil conspiracy alleging certain LLCs provided settlement services without the borrower’s knowledge. In theJones case, the plaintiffs allege the LLCs violated the Maryland Lender Act by acting as lenders and/or brokers in Maryland without proper licenses and allege this arrangement

amounted to a civil conspiracy. The plaintiffs in both theMiller andJones cases seek a disgorgement of fees, other damages, injunctive relief and attorney fees on behalf of the class of plaintiffs. We believe that these claims are without merit and we intend to vigorously defend against them.

In December 2005, a putative class action was filed against NHMI in the United States District Court for the Middle District of Louisiana entitledPearson v. NovaStar Home Mortgage, Inc.Plaintiff contends that NHMI violated the federal Fair Credit Reporting Act (“FCRA”) in connection with its use of pre-approved offers of credit and its failure to make certain disclosures required by federal law. Plaintiff seeks (on his own behalf, as well as for others similarly situated) statutory damages, other nominal damages, punitive damages and attorney’s fees and costs. We believe that these claims are without merit and we intend to vigorously defend against them.

In December 2005, a putative class action was filed against NovaStar Mortgage in the United States District Court for the Western District of Washington entitledPierce et al. v. NovaStar Mortgage, Inc.Plaintiffs contend that NovaStar Mortgage failed to disclose prior to closing that a broker payment would be made on their loans, which was an unfair and deceptive practice in violation of the Washington Consumer Protection Act. The plaintiffs seek a return of fees paid on the affected loans, excess interest charged, and damage to plaintiffs’ credit and finances, treble damages as provided in the Washington Consumer Protection Act and attorney fees. We believe that these claims are without merit and we intend to vigorously defend against them.

In addition to those matters listed above, we are currently a party to various other legal proceedings and claims, including, but not limited to, breach of contract claims, class action or individual claims for violations of the RESPA, FLSA, federal and state laws prohibiting employment discrimination and federal and state licensing and consumer protection laws.

While management, including internal counsel, currently believes that the ultimate outcome of all these proceedings and claims will not have a material adverse effect on our financial condition or results of operations, litigation is subject to inherent uncertainties. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on our financial condition and results of operations.

In April 2004, we received notice of an informal inquiry from the Commission requesting that we provide various documents relating to our business. We have cooperated fully with the Commission’s inquiry and provided it with the requested information.

Item 4.Submission of Matters to a Vote of Security Holders

None

PART II

Item 5.Market for Registrant’s Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Price of and Dividends on the Registrant’s Common Equity and Related Stockholder Matters. Our common stock is traded on the NYSE under the symbol “NFI”. The following table sets forth, for the periods indicated, the high and low sales prices per share of common stock on the NYSE and the cash dividends paid or payable per share of common stock.

         Dividends

 
   High

  Low

  Date Declared

  Date Paid

  Amount Per
Share


 
2004                   

First Quarter

  $67.29  $43.19  4/28/04  5/26/04  $1.35 

Second Quarter

   66.05   30.97  7/28/04  8/26/04   1.35 

Third Quarter

   48.00   37.84  10/28/04  11/22/04   1.40 

Fourth Quarter

   56.82   41.34  12/22/04  1/14/05   2.65(A)
2005                   

First Quarter

  $48.15  $32.40  5/2/05  5/27/05  $1.40 

Second Quarter

   39.98   34.50  7/29/05  8/26/05   1.40 

Third Quarter

   42.19   32.20  9/15/05  11/22/05   1.40 

Fourth Quarter

   33.01   26.20  12/14/05  1/13/06   1.40 

(A)Includes a $1.25 special dividend related to 2004 taxable income.

As of March 10, 2006, we had approximately 1,576 shareholders of record of our 32,591,228 shares of common stock outstanding based upon a review of the securities position listing provided by our transfer agent.

We intend to make distributions to shareholders of all or substantially all of taxable income in each year, subject to certain adjustments, so as to qualify for the tax benefits accorded to a REIT under the Code. All distributions will be made at the discretion of the Board of Directors and will depend on earnings, financial condition, maintenance of REIT status and other factors as the Board of Directors may deem relevant.

Recent Sales of Unregistered Securities.

We may have sold up to approximately 23,000 shares of common stock under our 401(k) plan and up to approximately 287,000 shares under our DRIP in a manner that may not have complied with the registration requirements of applicable securities laws. In connection with sales under our 401(k) Plan, the shares were purchased in the open market. As a result we did not receive any proceeds from such transactions, which may not be deemed sales for these purposes. In connection with sales under our DRIP in May 2005, we received approximately $10.8 million in net proceeds.

Purchase of Equity Securities by the Issuer.

Issuer Purchases of Equity Securities

(dollars in thousands)

   Total Number of
Shares Purchased


  Average Price Paid
per Share


  Total Number of
Shares Purchased
as Part of Publicly
Announced Plans or
Programs


  Approximate Dollar
Value of Shares
that May Yet Be
Purchased Under
the Plans or
Programs (A)


October 1, 2005 – October 31, 2005

  —    —    —    $1,020

November 1, 2005 – November 30, 2005

  —    —    —     1,020

December 1, 2005 – December 31, 2005

  —    —    —     1,020

(A)A current report on Form 8-K was filed on October 2, 2000 announcing that the Board of Directors authorized the Company to repurchase its common shares, bringing the total authorization to $9 million.

Item 6.Selected Financial Data

The following selected consolidated financial data is derived from our audited consolidated financial statements for the periods presented and should be read in conjunction with the more detailed information therein and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this annual report. Operating results are not necessarily indicative of future performance.

Selected Consolidated Financial and Other Data

(dollars in thousands, except per share amounts)

   For the Year Ended December 31,

 
   2005

  2004(A)

  2003

  2002

  2001

 

Consolidated Statement of Operations Data:

                     

Interest income

  $299,772  $224,024  $170,420  $107,143  $57,904 

Interest expense

   80,843   52,590   40,364   27,728   27,366 

Net interest income before credit (losses) recoveries

   218,929   171,434   130,056   79,415   30,538 

Credit (losses) recoveries

   (1,038)  (726)  389   432   (3,608)

Gains on sales of mortgage assets

   68,173   144,950   144,005   53,305   37,347 

Gains (losses) on derivative instruments

   18,155   (8,905)  (30,837)  (36,841)  (3,953)

Impairment on mortgage securities – available for sale

   (17,619)  (15,902)  —     —     —   

Other income, net

   20,880   6,609   412   1,356   1,856 

General and administrative expenses

   215,397   207,730   174,940   84,594   46,505 

Income from continuing operations

   143,597   126,738   111,996   48,761   32,308 

Loss from discontinued operations, net of income tax (B)

   (4,473)  (11,349)  —     —     —   

Net income available to common shareholders

   132,471   109,124   111,996   48,761   32,308 

Basic income per share:

                     

Income from continuing operations available to common shareholders

  $4.61  $4.76  $5.04  $2.35  $1.61 

Loss from discontinued operations, net of income tax (B)

   (0.15)  (0.45)  —     —     —   
   


 


 


 


 


Net income available to common shareholders

  $4.46  $4.31  $5.04  $2.35  $1.61 

Diluted income per share:

                     

Income from continuing operations available to common shareholders

  $4.57  $4.68  $4.91  $2.25  $1.51 

Loss from discontinued operations, net of income tax (B)

   (0.15)  (0.44)  —     —     —   
   


 


 


 


 


Net income available to common shareholders

  $4.42  $4.24  $4.91  $2.25  $1.51 
   As of December 31,

 
   2005

  2004

  2003

  2002

  2001

 
Consolidated Balance Sheet Data:                     

Mortgage Assets:

                     

Mortgage loans

  $1,320,396  $807,121  $792,709  $1,133,509  $365,560 

Mortgage securities – available-for-sale

   505,645   489,175   382,287   178,879   71,584 

Mortgage securities - trading

   43,738   143,153   —     —     —   

Total assets

   2,335,734   1,861,311   1,399,957   1,452,497   512,380 

Borrowings

   1,619,812   1,295,422   1,005,516   1,225,228   362,398 

Shareholders’ equity

   564,220   426,344   300,224   183,257   129,997 
   For the Year Ended December 31,

 
   2005

  2004

  2003

  2002

  2001

 

Other Data:

                     

Nonconforming loans originated or purchased, principal

  $9,283,138  $8,424,361  $5,250,978  $2,492,767  $1,333,366 

Loans securitized, principal

   7,621,030   8,329,804   5,319,435   1,560,001   1,215,100 

Nonconforming loans sold, principal

   1,138,098   —     151,210   142,159   73,324 

Loan servicing portfolio, principal

   14,030,697   12,151,196   7,206,113   3,657,640   1,994,448 

Annualized return on assets

   6.63%  7.08%  7.85%  4.96%  6.31%

Annualized return on equity

   28.09%  31.76%  46.33%  31.13%  24.85%

Taxable income available to common shareholders (D)

   278,750   250,555   137,851   49,511   5,221 

Taxable income per common share (C) (D)

   8.66   9.04   5.64   2.36   0.45 

Dividends declared per common share (C)

   5.60   6.75   5.04   2.15   0.48 

Dividends declared per preferred share

   2.23   2.11   —     —     1.08 

(A)Reclassified to conform to current year presentation in accordance with SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets,as described in Note 15 to the consolidated financial statements.
(B)Discussion and detail regarding the loss from discontinued operations is provided in Note 15 to the consolidated financial statements.
(C)On January 29, 2003, a $0.165 special dividend related to 2002 taxable income was declared per common share. On December 22, 2004, a $1.25 special dividend related to 2004 taxable income was declared per common share.
(D)Taxable income for years prior to 2005 are actual while 2005 taxable income is an estimate. For a reconciliation of taxable income to GAAP income see “Income Taxes” included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The common shares outstanding as of the end of each period presented are used in calculating the taxable income per common share.

Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the consolidated financial statements of NovaStar Financial, Inc. and the notes thereto included elsewhere in this report.

General Overview

We are a specialty finance company that originates, purchases, invests in and services residential nonconforming loans. We operate through four separate operating segments – mortgage portfolio management , mortgage lending, loan servicing and branch operations. The loan servicing segment was previously reported as part of mortgage lending and loan servicing, but it has been separated to more closely align the segments with the way we review, manage and operate our business. Segment information for the years ended December 31, 2004 and 2003 has been restated for this change. Additionally, we are currently winding down our branch operations unit and expect to complete the wind-down by June 30, 2006. See “Business – Branch Operations.”

We offer a wide range of mortgage loan products to borrowers, commonly referred to as “nonconforming borrowers,” who generally do not satisfy the credit, collateral, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers, including U.S. government-sponsored entities such as Fannie Mae or Freddie Mac. We retain significant interests in the nonconforming loans we originate and purchase through our mortgage securities investment portfolio. Through our servicing platform, we then service all of the loans in which we retain interests, in order to better manage the credit performance of those loans.

We have elected to be taxed as a REIT under the Code. Management believes the tax-advantaged structure of a REIT maximizes the after-tax returns from mortgage assets. We must meet numerous rules established by the IRS to retain our status as a REIT. As long as we maintain our REIT status, distributions to shareholders will generally be deductible by us for income tax purposes. This deduction effectively eliminates REIT level income taxes. Management believes it has and will continue to meet the requirements to maintain our REIT status.

Our net income is generated fromhighly dependent upon our mortgage securities portfolio, which is generated from the securitization of nonconforming loans we have originated.originated and purchased. These mortgage securities represent the right to receive the net future cash flows from a pool of nonconforming loans. Generally speaking, the more nonconforming loans we originate and purchase, the larger our securities portfolio and, therefore, the greater earnings potential. As a result, earnings are largely dependent onrelated to the volume of nonconforming loans and related performance factors for those loans, including their average coupon, borrower default rate and borrower prepayment.prepayment rate. Information regarding our lending volume is presented under the heading “Mortgage Loans.”

 

The primary function of our mortgage lending operations is to generate nonconforming loans, the majority of which will serve as collateral for our mortgage securities. While our mortgage lending operations generate sizable revenues in the form of gains on sales of mortgage loans and fee income from borrowers and third party investors, the revenue serves largely to offset the related costs.

 

We also service the mortgage loans we originate and purchase and that serve as collateral for our mortgage securities. The servicing function is critical to the management of credit risk (risk of borrower default and the related economic loss) within in our mortgage portfolio. Again, while this operation generates significant fee revenue, its revenue serves largely to offset the cost of this function.

 

The key performance measures for executive management are:

net income available to common shareholders

 

dollar volume of nonconforming mortgage loans originated and purchased

 

relative cost of the loans originated and purchased

 

characteristics of the loans (coupon, credit quality, etc.), which will indicate their expected yield, and

 

return on our mortgage asset investments and the related management of interest rate riskrisk.

 

Management’s discussion and analysis of financial condition and results of operations, along with other portions of this report, are designed to provide information regarding our performance and these key performance measures.

Known Material TrendsExecutive Overview of Performance

 

Over the last ten years, the nonconforming lending market has grown by approximately $265 billion to a market of approximately $290 billion in 2003 as estimated by the National Mortgage News. A significant portion of these loansThe following selected key performance metrics are made to borrowers who are using equity in their primary residence to consolidate low-balance, installment or consumer debt. Additionally, this market has been very stable and growing through all interest rate environments, meaning that while interest rates have increased and decreased dramatically over that period, the base market for nonconforming loans has not increased or decreased in relationship to interest rates. Management estimates that NovaStar has a 2-3% market share. While management cannot predict consumer spending and borrowing habits, historical trends indicate that the market in which we operate is relatively stable and growing.

We depend on the capital markets to finance the mortgage loans we originate. The primary bonds we issue inderived from our loan securitizations are sold to large, institutional investors. In the short-term, we finance our mortgage loans using “warehouse” lines of credit provided by commercial and investment banks. The equity marketplace provides capital to operate our business. The trend has been favorable in the capital marketsaudited consolidated financial statements for the types of securitization transactions we execute. Investor appetite forperiods presented and should be read in conjunction with the bonds created has been strong. Additionally, commercialmore detailed information therein and investment banks have provided significant liquidity to finance our mortgage lending operations through warehouse facilities. While management cannot predict the future liquidity environment, we are unaware of any material reason to prevent continued liquidity support in the capital markets for our business. See the “Liquidity and Capital Resources” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussionOperations.”

Table 1 — Summary of liquidity risks and resourcesKey Performance Metrics

(dollars in thousands; except per share amounts)

   For the Year Ended December 31,

  

Increase /

(Decrease)


 
   2005

  2004

  
Consolidated Earnings and Other Data:             

Net income available to common shareholders

  $132,471  $109,124  $23,347 

Net income available to common shareholders, per diluted share

  $4.42  $4.24  $0.18 

Net interest yield on assets

   1.64%  1.53%  0.11%

Loans under management

  $13,897,730  $12,130,182  $1,857,548 

Mortgage Portfolio Management:

             

Loans under management (A)

  $12,752,307  $11,410,147  $1,342,160 

Net yield on mortgage securities (B)

   32.3%  27.2%  5.1%

Mortgage portfolio management net interest yield on assets (C)

   1.45%  1.39%  0.06%

Impairment on mortgage securities – available-for-sale

  $(17,619) $(15,902) $1,717 

Mortgage Lending:

             

Nonconforming originations

  $9,283,138  $8,424,361  $858,777 

Weighted average coupon of nonconforming originations

   7.7%  7.6%  0.1%

Weighted average FICO score of nonconforming originations

   632   622   10 

Nonconforming loans securitized

   7,621,030   8,329,804   (708,714)

Nonconforming loans sold to third parties

   1,138,098   —     1,138,098 

Mortgage lending net interest yield on assets (C)

   3.34%  2.61%  0.73%

Costs of wholesale production, as a percent of principal

   2.39%  2.53%  (0.14%)

Net whole loan price used in initial valuation of residual securities

   102.00   103.28   (1.28)

Gains on sales of loans transferred in securitizations, as a % of principal sold

   0.8%  1.7%  (0.9%)

(A)Includes the principal balance of loans in off-balance sheet securitizations as well as the principal balance of loans in the held-in-portfolio category on our balance sheet.
(B)Based on average fair market value of the underlying securities for the period.
(C)Based on average daily balance of the underlying loans for the period.

During 2005, we reported net income available to us.common shareholders of $132.5 million, or $4.42 per diluted share, as compared to $109.1 million, or $4.24 per diluted share in 2004. Our net income available to common shareholders was driven largely by the income generated by our mortgage securities – available-for-sale portfolio, which increased to $505.6 million as of December 31, 2005 from $489.2 million as of December 31, 2004. These securities are retained in the securitization of the mortgage loans we originate and purchase. We securitized $7.6 billion of mortgage loans in 2005 as compared to $8.3 billion in 2004. During 2005 and 2004, we originated or purchased $9.3 billion and $8.4 billion, respectively, in nonconforming, residential mortgage loans.

 

WithinWe feel 2005 demonstrated the past year,value of having both portfolio and mortgage banking businesses for our shareholders. The net yield on our mortgage securities portfolio increased to 32.3% in 2005 from 27.2% in 2004. Additionally, our mortgage portfolio management net interest yield on assets increased to 1.45% in 2005 from 1.39% in 2004. These increases, which primarily resulted from better than expected credit performance as a result of substantial increases in housing prices, helped drive strong portfolio earnings which more than compensated for declining profit margins in our mortgage lending segment. Our portfolio management focus continues to be on managing a portfolio to deliver attractive risk-adjusted returns. Assuming all other factors unchanged, because of industry margin compression, the net yield on our mortgage REIT industry has seen a significant increasesecurities portfolio should generally decrease as our older higher-yielding securities paydown and we add new lower-yielding securities. The growth of our mortgage portfolio is also very dependent upon future widening or tightening of profit margins. If more tightening occurs, yields on new mortgage securities may fall to levels which may not warrant new growth in the desire for raising public capital. Additionally, there have been several new entrants to the mortgage REIT business and other mortgage lender conversions (or proposed conversions) to REIT status. This increased activity may impact the pricing and underwriting guidelines within the nonconforming marketplace. We have not changed our guidelines or pricing in response to this activity nor do we have any plans to make such changes.portfolio.

 

The net interestWe experienced significant profit margin betweencompression driven by the couponhighly competitive mortgage banking environment in 2005. This margin compression can be demonstrated by the fact that short-term rates continued to rise while the coupons on the mortgage loans we originated and purchased remained flat from 2004. One-month LIBOR and the cost of funding, largely tiedtwo-year swap rate increased to one-month LIBOR, provides4.39% and 4.85%, respectively, at December 31, 2005 from 2.40% and 3.45%, respectively, at December 31, 2004 while the cash flow and yieldweighted average coupon on our mortgage securities. Generally, when short-term rates fall, our cash flow and yield is higher. During 2001 and 2002, short-term rates fell dramatically, which correspondingly increased our cash flow and yield. As mortgage interest rates leveled-offnonconforming loans rose slightly in 2003,2005 to 7.7% from 7.6% in 2004. These factors contributed to the spread onwhole loan price used in valuing our mortgage securities has returned to expected or normal levels. Additionally, in 2002 we began transferring interest rate agreements, at the time of securitization to significantly decrease throughout 2004 and into 2005, which is directly correlated to the decrease in gains on sales of mortgage loans as a percentage of loan principal securitized. For the years ended December 31, 2005 and 2004, the weighted average net whole loan price used in the initial valuation of our retained securities was 102.00 and 103.28, respectively, and the weighted average gain on securitization trustsas a percentage of loan principal securitized was 0.8% and 1.7%, respectively.

Additionally, we proactively focused on cost controls and business efficiencies to help reduce interest rate risk. Whilemitigate the interest rate agreements servedimpact of tighter spreads. These efforts resulted in our cost of wholesale production decreasing in 2005 to decrease2.39% from 2.53% in 2004. Cost containment and production efficiencies will continue to be a major focus in 2006.

We continue to sell nonconforming mortgage loans to third parties that we feel do not possess the yieldeconomic characteristics to meet our long-term portfolio management objective of providing attractive risk-adjusted returns. We sold $1.1 billion in 2003, they are expectednonconforming mortgage loans to decreasethird parties during the volatilityyear ended December 31, 2005. We recognized a net gain of $9.9 million from these sales and the weighted average price to par of the future cash flows onloans sold was 102.01 during the year ended December 31, 2005. There were no nonconforming mortgage loan sales to third parties during 2004. We sold $151.2 million in nonconforming mortgage loans to third parties during the year ended December 31, 2003, recognizing net gains of $3.4 million from these sales with a weighted average price to par of the loans sold of 104.10. We expect to continue selling a portion of our mortgage securities. loans which we feel will not provide attractive long-term risk-adjusted returns.

As a result of our interest rate risk management strategies, we utilize interest rate swaps and caps, which have provided gains to partially offset the impact of margins compressing. We recognized gains on derivative instruments which did not qualify for hedge accounting of $18.2 million for the year ended December 31, 2005, compared to losses of $(8.9) million for the same period of 2004. During periods of rising rates, these derivative instruments help maintain the net interest margin between our assets and liabilities as well as diminish the effect of changes in general interest rate levels on the market value of our mortgage assets. Of the $18.2 million in gains on derivative instruments for the year ended December 31, 2005, $18.1 million was related to mark-to-market gains on derivatives transferred into the NMFT Series 2005-1, 2005-2, 2005-3 and 2005-4 securitizations, while $0.7 million was related to mark-to-market gains on derivatives that were still owned by us at December 31, 2005. A majority of the derivatives owned by us at December 31, 2005 will most likely be transferred into securitizations which close in the first quarter of 2006. The remaining difference is attributable to net settlements paid to counterparties, market value adjustments for derivatives used to hedge our balance sheet and mark-to-market valuations for commitments to originate mortgage loans.

Our loss from discontinued operations net of income taxes for the years ended December 31, 2005 and 2004 was $4.5 million and $11.3 million, respectively. On November 4, 2005, we adopted a formal plan to terminate substantially all of the remaining NHMI branches. We had 16 branches remaining at December 31, 2005 and we expect all of these branches to be terminated by June 30, 2006. Note 15 to our consolidated financial statements provides detail regarding the impact of the discontinued operations.

Known Material Trends and Challenges for 2006

We expect another challenging year for the mortgage industry in 2006, but experience also leads us to believe that tough times can create the best opportunities. We enter 2006 in a strong financial position and still focused on the disciplines we have followed for years. Our driving goals are risk-adjusted return, protecting the portfolio and increasing the profitability of loans going into the portfolio.

One of our primary goals is also on maintaining our status as a REIT. We have managed our business as a REIT since we were founded in 1997, which requires we meet certain income and asset tests to preserve our REIT status. See “Item 1 – U.S. Federal Income Tax Consequences,” for discussion of the income and asset tests we must meet to preserve our REIT status. To provide qualifying income and assets to the REIT for purposes of these tests, we may structure certain future interestsecuritizations as financing transactions at the REIT instead of our typical sales transactions at the TRS. The mortgage loans securitized under this structure may come from our normal origination and purchase channels or may come from whole pools of loans purchased specifically for this purpose. These whole pool purchases could be much larger in size as compared to our typical correspondent purchases. We would also expect these purchases to be eligible for financing through our warehouse repurchase agreements until they are securitized. See “Financial Condition—Short-term Borrowings” as well as “Liquidity and Capital Resources” for discussion of our financing facilities and other liquidity sources.

In a securitization structured as a financing, no gain is recognized at the time of securitization, the mortgage loans remain on the balance sheet and the asset-backed bonds issued to third parties are recorded as debt on the balance sheet. These are clearly much different accounting dynamics than our current securitizations structured as sales. In a sale, a gain is recognized at the time of securitization, the mortgage loans are removed from the balance sheet and new mortgage securities (retained interests) are recorded on the balance sheet. Net income for any quarter in which we structure a securitization as a financing generally will be significantly lower than if the securitization was structured as a sale since there is no gain recognition associated with a financing. This initial difference in net income will reverse itself over the remaining life of the securitization resulting in no material difference in net income recognized under either structure over the life of the securitization.

Additionally, the structure of this type of CMO securitization generally gives rise to excess inclusion income. If we incur excess inclusion income at the REIT, it will be allocated among our shareholders. A stockholder’s share of excess inclusion income (i)

would not be allowed to be offset by any net operating losses otherwise available to the stockholder, (ii) would be subject to tax as unrelated business taxable income in the hands of most types of shareholders that are otherwise generally exempt from federal income tax, and (iii) would result in the application of U.S. federal income tax withholding at the maximum rate (i.e., 30%), without reduction for any otherwise applicable income tax treaty, to the extent allocable to most types of foreign shareholders. How such income is to be reported to shareholders is not clear under current law. The amounts of excess inclusion income in any given year from these transactions could be significant. Tax-exempt investors, foreign investors, and taxpayers with net operating losses should carefully consider the tax consequences of having excess inclusion income allocated to them and are urged to consult their tax advisors.

Moving into 2006, we believe the nonconforming market offers a mix of opportunities and challenges. The following trends have become evident in the business environment in which we operate and could have a significant impact on our financial condition, results of operations and cash flows:

Growth in the nonconforming market continued in 2005 but at a much slower pace than 2004 growth. Nonconforming originations grew to an estimated $600 billion in 2005 from $530 billion in 2004, according to Inside Mortgage Finance Publications. Various industry publications predict that growth in the nonconforming origination market will be relatively flat in 2006 with some publications predicting a slight decline. Our ability to increase the size of our securitized mortgage loan portfolio, which drives our mortgage securities is expected toportfolio, at growth rates experienced in recent years could be less volatile.impaired under these tighter conditions. We expect the cash flow and yield to continue to be at these normalized levels. Onpursue opportunities to increase our market share in the other hand,nonconforming market, including the increasedacquisition or new development of businesses.

Interest rate dynamics have put a squeeze on mortgage banking profits. The spread between funding costs and loan origination, leadingcoupons has narrowed by more than 200 basis points in 2004 and 2005. Some relief was evident in late 2005 as the industry began to a larger securities portfolio, will compensate for the decreased yield. See “Net Interest Income” under the “Results of Operations” section for further discussionraise coupons on new originations, but margins remain tight. These margins could continue to tighten if short-term interest rates increase and analysiscompetitive pressures hold coupons on mortgage loans flat. As we sell all of our mortgage asset yields.loans either in whole pools to third parties or in securitizations, we could continue to experience depressed gains on sales of mortgage loans. Additionally, the mortgage securities we are currently adding to our portfolio are yielding much lower returns than our older securities as a result of these compressed margins. Increasing the size of our portfolio is one of our top priorities but not at the expense of long-term risk-adjusted returns or risk management.

Rising home prices have begun to cool after a multiyear boom. Increasing prices have been fueling the volume of home refinancing, as well as, reducing the risk of existing mortgage loans by improving loan-to-value ratios. For 2006, economists are expecting slower home-price growth, perhaps even declines in some markets which had experienced substantial growth. This could have a significant impact on origination growth in our mortgage lending segment , as well as, prepayment speed and credit loss assumptions on the mortgage securities held by our mortgage portfolio management segment.

The mortgage industry is responding with changing strategies. Some lenders have shifted to a mortgage REIT model, some have cut back or exited market segments, and others have pursued market share even with loans that do not appear profitable.

Gulf State Hurricanes

 

The damage caused by the Gulf State hurricanes, particularly Katrina, Rita and local governing bodies are focused on the nonconforming lending businessWilma, has affected our mortgage loans held-for-sale and the feesmortgage loan portfolio we service which underlies our mortgage securities – available-for-sale by impairing the ability of certain borrowers incurto repay their loans. At present, we are unable to predict the ultimate impact of the Gulf State hurricanes on our future financial results and condition as the impact will depend on a number of factors, including the extent of damage to the collateral, the extent to which damaged collateral is not covered by insurance, the extent to which unemployment and other economic conditions caused by the hurricane adversely affect the ability of borrowers to repay their loans, and the cost to us of collection and foreclosure moratoriums, loan forbearances and other accommodations granted to borrowers. Many of the loans are to borrowers where repayment prospects have not yet been determined to be diminished, or are in obtainingareas where properties may have suffered little, if any, damage or may not yet have been inspected. We currently have a mortgage loan – generally termed “predatory lending” withinprotection insurance policy, which protects us from uninsured losses as a result of these hurricanes up to a maximum of $5 million in aggregate losses with a deductible of $100,000 per hurricane. At this time, we believe the mortgage industry. In several instances, states or local governing bodiesoverall financial impact the Gulf State hurricanes will have imposed strict laws on lenders to curb predatory lending. To date, these laws have had an insignificant impact on our business.future financial condition and results of operations will be immaterial.

In accordance with public policy, regulatory guidance and the Pooling and Servicing Agreements which govern the securitized loans we service, we will work with our customers to assess their personal situation and the effect of the Gulf State hurricanes on them. We have capped fee structures consistent with those adopted by federal mortgage agenciesoffered personal financial counseling and have implemented rigid processes to ensure that our lending practices are not predatory in nature.certain moratoriums on collection activities and foreclosures. We may provide extended terms for affected customers depending on their circumstances.

Significance of Estimates and Critical Accounting PoliciesEstimates

 

We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America and, therefore, are required to make estimates regarding the values of our assets and liabilities and in recording income and expenses. These estimates are based, in part, on our judgment and assumptions regarding various economic conditions that we believe are reasonable based on facts and circumstances existing at the time of reporting. The results of theseThese estimates affect reported amounts of assets, liabilities and accumulated other comprehensive income at the date of the consolidated financial statements and the reported amounts of income, expenses and other comprehensive income during the periods presented. The following summarizes the components of our consolidated financial statements where understanding accounting policies is critical to understanding and evaluating our reported financial results, especially given the significant estimates used in applying the policies. The discussion is intended to demonstrate the significance of estimates to our financial statements and the related accounting policies. Detailed accounting policies are provided in Note 1 to our consolidated financial statements. Our critical accounting estimates impact only twothree of our threefour reportable segments; our mortgage portfolio management, and mortgage lending and loan servicing segments. Management has

discussed the development and selection of these critical accounting estimates with the audit committee of our boardBoard of directorsDirectors and the audit committee has reviewed our disclosure.

 

Transfers of Assets (Loan and Mortgage Security Securitizations) and Related Gains. In a loan securitization, we combine the mortgage loans we originate and purchase in pools to serve as collateral for issued asset-backed bonds that are issued to the public.bonds. In a mortgage security securitization (also known as a “Resecuritization”“resecuritization”), we combine mortgage securities retained in previous loan securitization transactions to serve as collateral for asset-backed bonds that are issued to the public.bonds. The loans or mortgage securities are transferred to a trust designed to serve only for the purpose of holding the collateral. The trust is considered a qualifying special purpose entity as defined by SFAS No. 140,Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – a replacement of FASB Statement No. 125. The owners of the asset-backed bonds have no recourse to us in the event the collateral does not perform as planned.planned except where defects have occurred in the loan documentation and underwriting process.

 

In order for us to determine proper accounting treatment for each securitization or resecuritization, we evaluate whether or not we have retained or surrendered control over the transferred assets by reference to the conditions set forth in SFAS No. 140. All terms of these transactions are evaluated against the conditions set forth in these statements.this statement. Some of the questions that must be considered include:

 

Have the transferred assets been isolated from the transferor?

 

Does the transferee have the right to pledge or exchange the transferred assets?

 

Is there a “call” agreement that requires the transferor to return specific assets?

 

Is there an agreement that both obligates and entitles the transferor to repurchase or redeem the transferred assets prior to maturity?

Have any derivative instruments been transferred?

 

Generally, we intend to structure our securitizations so that control over the collateral is transferred and the transfer is accounted for as a sale. For resecuritizations, we intend to structure these transactions to be accounted for as secured borrowings.

 

When these transfers are executed in a manner such that we have surrendered control over the collateral, the transfer is accounted for as a sale. In accordance with SFAS No. 140, a gain or loss on the sale is recognized based on the carrying amount of the financial assets involved in the transfer, allocated between the assets transferred and the retained interests based on their relative fair value at the date of transfer. In a loan securitization, we do retain the right to service the underlying mortgage loans and we also retain certain mortgage securities issued by the trust (see Mortgage Securities below). In a resecuritization, we retain an interest in a subordinated security that represents the right to receive the cash flows on the underlying mortgage security collateral after the senior bonds have been satisfied. As previously discussed, the gain recognized upon securitization (or resecuritization) depends on, among other things, the estimated fair value of the components of the securitization (or resecuritization) – the loans or mortgage securities – available-for-sale and derivative instruments transferred, the securities retained and the mortgage servicing rights. The estimated fair value of the securitization (or resecuritization) components is considered a “critical accounting estimate” as 1) these gains or losses represent a significant portion of our operating results and 2) the valuation assumptions used regarding economic conditions and the make-up of the collateral, including interest rates, principal payments, prepayments and loan defaults are highly uncertain and require a large degree of judgment.

 

We believe the best estimate of the initial value of the residual securities we retain in a whole loan securitization is derived from the market value of the pooled loans. The initial value of the loans transferred in a securitization is estimated based on the expected open market sales price of a similar pool. We occasionally accept bids on our whole loans in order to test the market price. In open market transactions, the purchaser has the right to reject loans at its discretion. In a loan securitization, loans generally cannot generally be rejected. As a result, we adjust the market price for the loans to compensate for the estimated value of rejected loans. The market price of the securities retained is derived by deducting the percent of net proceeds received in the securitization (i.e. the economic value of the loans transferred) from the estimated adjusted market price for the entire pool of the loans.

An implied yield (discount rate) is calculated based onderived by taking the initial value derived above and using projected cash flows generated using assumptions for prepayments, expected credit losses and interest rates.rates and then solving for the discount rate required to present value the cash flows back to the initial value derived above. We ensurethen ascertain whether the resulting implied yielddiscount rate is commensurate with current market conditions. Additionally, this yieldthe initial discount rate serves as the initial accretable yield used to recognize income on the securities.

 

For purposes of valuing our mortgageresidual securities, it is important to know that in recent securitization transactions we not only have transferred loans to the trust, but we have also transferred interest rate agreements to the trust with the objective of reducing interest rate risk within the trust. During the period before loans are transferred in a securitization transaction as discussed under “Net Interest Income”, “Interest Rate/Market Risk” and “Hedging”, we enter into interest rate swap or cap agreements to reduce interest rate risk. We use interest rate cap and swap contracts to mitigate the riskagreements. Certain of the cost of variable rate liabilities increasing at a faster rate than the earnings on assets during a period of rising rates. Certainthese interest rate agreements are then transferred into the trust at the time of securitization. The trust assumes the interest rate agreements and, therefore,Therefore, the trust assumes the obligation to make payments and obtains the right to receive payments under these agreements.

In valuing our mortgageresidual securities, it is also important to understand what portion of the underlying mortgage loan collateral is covered by mortgage insurance. At the time of a securitization transaction, the trust legally assumes the responsibility to pay the mortgage insurance premiums associated with the loans transferred and the rights to receive claims for credit losses. Therefore, we have no obligation to pay these insurance premiums. The cost of the insurance is paid by the trust from proceeds the trust receives from the underlying collateral. The trust legally assumes the responsibility to pay the mortgage insurance premiums and the rights to receive claims for credit losses. Therefore, we have no obligation to pay these insurance premiums. This information is significant for valuation as the mortgage insurance significantly reduces the credit losses born by the owner of the loan. Mortgage insurance claims on loans where a defect occurred in the loan origination process will not be paid by the mortgage insurer. The assumptions we use to value our residual securities consider this risk. We discuss mortgage insurance premiums under the heading “Premiums for Mortgage Loan Insurance”.

 

The weighted average net whole loan market price used in the initial valuation of our retained securities was 103.71102.00 and 103.49103.28 during 20032005 and 2002,2004, respectively. The weighted average initial implied discount rate for the twelve monthsyears ended December 31, 20032005 and 20022004 was 22%15% and 21%22%, respectively. As discussed in “Executive Overview of Performance”, the increase in short-term interest rates has caused the whole loan price used in the initial valuation of our retained securities to decrease. If the whole loan market price used in the initial valuation of our mortgageresidual securities in 20032005 had been increased or decreased by 50 basis points, the initial value of our mortgageresidual securities and the gain we recognized would have increased or decreased by $26.6$38.1 million.

Information regarding the assumptions we used is discussed under “Mortgage Securities” in the following discussion.Securities-Available-for-Sale and Trading” below.

 

When we do have the ability to exert control over the transferred collateral in a securitization, the assets remain on our financial records and a liability is recorded for the related asset-backed bonds. The servicing agreements that we execute for loans we have securitized includes a removal of accounts provision which gives us the right, not the obligation, to repurchase mortgage loans from the trust. The removal of accounts provision can be exercised for loans that are 90 days to 119 days delinquent. We record the mortgage loans subject to the removal of accounts provision in mortgage loans held-for-sale at fair value and the related repurchase obligation as a liability. In addition, we have a “clean up” call option that can be exercised when the aggregate principal balance of the mortgage loans has declined to ten percent or less of the original aggregated mortgage loan principal balance.

 

Mortgage Securities.Securities – Available-for-Sale and Trading. Our mortgage securities – available-for-sale and trading represent beneficial interests we retain in securitization transactions.and resecuritization transactions which include residual securities and subordinated securities. The beneficial interestsresidual securities include interest-only mortgage securities, prepayment penalty bonds and over-collateralization bonds. All of the residual securities retained by us have been classified as available-for-sale. The subordinated securities represent investment-grade rated bonds which are senior to the residual securities but are subordinated to the bonds sold to third party investors. We have classified certain of our subordinated securities in both the available-for-sale and trading categories.

The residual securities we retain in these securitization transactions primarily consist of the right to receive the future cash flows from a pool of securitized mortgage loans which include:

 

The interest spread between the coupon net of servicing fees on the underlying loans, and the cost of financing.financing, mortgage insurance, payments or receipts on or from derivative contracts and bond administrative costs.

 

Prepayment penalties received from borrowers who payoff their loans early in their life.

 

Overcollateralization and other subordinated securities, which areis designed to protect the primary bondholder from credit loss on the underlying loans.

 

The beneficial interestssubordinated securities we retain in resecuritizationour securitization transactions represent the right to receive the remaining cash flowshave a stated principal amount and interest rate and have been retained at a market discount from the stated principal amount. The performance of the securities is dependent upon the performance of the underlying pool of securitized mortgage security collateral afterloans. The interest rates these securities earn are variable and are subject to an available funds cap as well as a maximum rate cap. The securities receive principal payments in accordance with a payment priority which is designed to maintain specified levels of subordination to the obligations to outside bondholders have been satisfied.senior bonds within the respective

securitization trust. Because the subordinated securities are rated lower than AA, they are considered low credit quality and we account for the securities based on the effective yield method. The fair value of the subordinated securities is based on third-party quotes.

 

The cash flows we receive are highly dependent upon the interest rate environment. The cost of financing forinterest rates on the securitized loans isbonds issued by the securitization trust are indexed to short-term interest rates, while the loan coupons on the pool of loans held by the securitization trust are less interest rate sensitive. As a result, as rates rise and fall, our cash flows will fall and rise, which in turn will decrease or increasebecause the cash we receive on our residual securities is dependent on this interest rate spread. As our cash flows fall and rise, the value of our mortgage securities.residual securities will decrease or increase. Additionally, the cash flows we receive are dependent on the default and prepayment experience of the borrowers inof the underlying mortgage security collateral. Increasing or decreasing cash flows will increase or decrease the yield on our securities.

 

We believe the accounting estimates related to the valuation of our mortgage securities – available-for-sale and establishing the rate of income recognition on the mortgage securities – available-for-sale and trading are “critical accounting estimates”, because they can materially affect net income and stockholders’shareholders’ equity and require us to forecast interest rates, mortgage principal payments, prepayments and loan default assumptions which are highly uncertain and require a large degree of judgment. The rate used to discount the projected cash flows is also critical in the valuation of our mortgageresidual securities. We use internal, historical collateral performance data and published forward yield curves when modeling future expected cash flows and establishing the rate of income recognized on mortgage securities. We believe the value of our mortgageresidual securities is fair, but can provide no assurance that future changes in interest rates, prepayment and loss experience or changes in their requiredthe market discount rate will not require write-downs of the residual assets. Write-downsFor mortgage securities classified as available-for-sale, impairments would reduce income ofin future periods.periods when deemed other-than-temporary.

 

We estimate fair valueAs previously described, our mortgage securities available-for-sale and trading represent retained beneficial interests in certain components of the cash flows of the underlying mortgage loans to securitization trusts. Income recognition for theour mortgage securities we retain in a resecuritization transaction– available-for-sale and trading is based on the present value of future expected cash flows estimated using management’s best estimate ofeffective yield method. Under the key assumptions, including credit losses, prepayment speeds, forwardeffective yield curves, and discount rates commensurate with the risks involved.

Asmethod, as payments are received, they are applied to the cost basis of the mortgage related security. Each period, the accretable yield for each mortgage security is evaluated and, to the extent there has been a change in the estimated cash flows, it is adjusted and applied prospectively. The estimated cash flows change as management’s assumptions for credit losses, borrower prepayments and interest rates are updated. The assumptions are established using internally developed models. We prepare analyses of the yield for each security using a range of these assumptions. The accretable yield used in recording interest income is generally set within a range of base assumptions. The accretable yield is recorded as interest income with a corresponding increase to the cost basis of the mortgage security.

 

At each reporting period subsequent to the initial valuation of the retainedresidual securities, the fair value of mortgagethe residual securities is estimated based on the present value of future expected cash flows to be received. Management’s best estimate of key assumptions, including credit losses, prepayment speeds, the market discount rates and forward yield curves commensurate with the risks involved, are used in estimating future cash flows. We estimate initial and subsequent fair value for the subordinated securities based on quoted market prices.

To the extent that the cost basis of mortgage securities – available-for-sale exceeds the fair value and the unrealized loss is considered to be other than temporary, an impairment charge is recognized and the amount recorded in accumulated other comprehensive income or loss is reclassified to earnings as a realized loss.

During the years ended December 31, 2005 and December 31, 2004, we recorded impairment losses of $17.6 million and $15.9 million, respectively. The impairments were primarily a result of the increase in short-term interest rates during 2004 and 2005. While we do use forward yield curves in valuing our securities, the increase in two-year and three-year swap rates during 2004 and 2005 was greater than the forward yield curve had anticipated, thus causing a greater than expected decline in value. Additionally, the impairments on our residual securities in 2004 and 2005 primarily related to the residual securities which were retained during those two years. This demonstrates that as we retain new residual securities during a period when short-term interest rate increases are greater than anticipated by the forward yield curve, we generally are more susceptible to impairments on our newer mortgage securities as they do not have sizable unrealized gains to help offset the decline in value. See Table 6 for a summary of the cost basis, unrealized gain and fair value of our mortgage securities – available-for-sale by year of issue and Table 11 for a summary of the impairments on our mortgage securities – available-for-sale.

During 2003, ourOur average mortgage security yield has decreasedincreased to 34.3%35.6% for the year ended December 31, 20032005 from 42.7%31.4% for the same period of 2002. This decrease2004. The increase is a result inof lower than expected credit losses we experienced on the decline in loan coupon rates of theloans underlying collateral of our newer securities compared with our older securities. Also contributing to the decrease in yield is the fact that in 2002 we began transferring interest rate agreements, at the time of securitization, into the securitization trusts to help reduce interest rate risk. While the interest rate agreements served to decrease the yield in 2003, they are expected to decrease the volatility of the future cash flows on our mortgage securities. As a result, future interest income on our mortgage securities, is expectedwhich has led us to adjust the credit loss assumptions on certain securities. The low credit losses can be less volatile.attributed primarily to the substantial rise in housing prices in recent years. The positive impact of low credit losses has been able to offset the negative impact of the increase in short-term interest rates and prepayment rates. Mortgage securities interest income has increased from $56.5$133.6 million for the twelve monthsyear ended December 31, 20022004 to $98.8$188.9 million for the same period of 20032005 due to the increase in the average balance of our securities portfolio. If the rates used to accrue income on our mortgage securities during 20032005 had been increased or decreased by 10%, netinterest income during the twelve monthsyear ended 20032005 would have increased by $19.5$30.5 million and decreased by $20.6$48.9 million, respectively.

Housing prices have enjoyed substantial appreciation in recent years, which has resulted in increasing prepayment rates. The market discount rates we are using to initially value our residual securities have declined from 2004. As of December 31, 2003 and 2002,2005, the weighted average discount rate used in valuing our mortgageresidual securities was 18% as compared to 22% and 21%, respectively.as of December 31, 2004. The weighted-average constant prepayment rate used in valuing our mortgageresidual securities as of December 31, 20032005 was 2949 versus 4639 as of December 31, 2002.2004. If the discount rate used in valuing our mortgageresidual securities as of December 31, 20032005 had been increased by 500 basis points,5%, the value of our mortgage securitiessecurities- available-for-sale would have decreased by $22.0$24.6 million. If we had decreased the discount rate used in valuing our mortgageresidual securities by 500 basis points,5%, the value of our mortgageresidual securities would have increased by $25.0$25.4 million.

 

Mortgage Loans and Allowance for Credit Losses. Mortgage loans held-for-sale are recorded at the lower of cost or market determined on an aggregate basis. Mortgage loan origination fees and direct mortgage loan origination costs on mortgage loans held-for-sale are deferred until the related loans are sold. Premiums paid to acquire mortgage loans held-for-sale are also deferred until the related loans are sold. Mortgage loans held-in-portfolio are recorded at their cost, adjusted for the amortization of net deferred costs and for credit losses inherent in the portfolio. Mortgage loan origination fees and associated direct mortgage loan origination costs on mortgage loans held-in-portfolio are deferred and recognized over the life of the loan as an adjustment to yield using the level yield method. Premiums paid to acquire mortgage loans held-in-portfolio are also deferred and recognized over the life of the loan as an adjustment to yield using the level yield method.

An allowance for credit losses is maintained for mortgage loans held-in-portfolio.

The allowance for credit losses on mortgage loans held-in-portfolio, and therefore the related adjustment to income, is based on the assessment by management of probable losses incurred based on various factors affecting our mortgage loan portfolio, including current economic conditions, the makeup of the portfolio based on credit grade, loan-to-value, delinquency status, mortgage insurance we purchase and other relevant factors. The allowance is maintained through ongoing adjustments to operating income. The assumptions used by management regarding key economic indicators are highly uncertain and involve a great deal of judgment.

 

Derivative Instruments and Hedging Activities.Activities.Our objective and strategy for using derivative instruments is to mitigate the risk of increased costs on our variable rate liabilities during a period of rising rates (i.e. interest rate risk). Our primary goals for managing interest rate risk are to maintain the net interest margin spread between our assets and liabilities and diminish the effect of changes in general interest rate levels on theour market value of the Company. We primarily enter intovalue. The interest rate swap agreements and interest rate cap agreements to manage our sensitivity to changes in market interest rates. The interest rate agreements we use have an active secondary market, and none are obtained for a speculative nature, for instance, trading. These interest rate agreements are intended to provide income and cash flows to offset potential reduced net interest income and cash flows under certain interest rate environments. The determination of effectiveness is the primary assumption and estimate used in hedging. At trade date, these instruments and their hedging relationship are identified, designated and documented.

 

SFAS No. 133,Accounting for Derivative Instruments and Hedging Activities (as amended), standardizes the accounting for derivative instruments, including certain instruments embedded in other contracts, by requiring that an entity recognize those items as assets or liabilities in the balance sheet and measure them at fair value. If certain conditions are met, an entity may elect to designate a derivative instrument either as a cash flow hedge, a fair value hedge or a hedge of foreign currency exposure. SFAS No. 133 requires derivative instruments to be recorded at their fair value with hedge ineffectiveness recognized in earnings.

 

All of our derivativeDerivative instruments that meet the hedge accounting criteria of SFAS No. 133 are considered cash flow hedges. We also haveAt December 31, 2005, we had no derivative instruments that doconsidered cash flow hedges, as they all had not meetmet the requirements for hedge accounting. However, these derivative instruments alsodo contribute to our overall risk management strategy by serving to reduce interest rate risk on average short-term borrowings used to fundcollateralized by our loans held-for-sale.

 

The fair value of our derivative instruments along with any margin accounts associated with the contracts are included in other assets. Any changes in fair value of derivative instruments related to hedge effectiveness are reported in accumulated other comprehensive income. Changes in fair value of derivative instruments related to hedge ineffectiveness and non-hedge activity are recorded as adjustments to earnings. For those derivative instruments that do not qualify for hedge accounting, changes in the fair value of the instruments are recorded as adjustments to earnings.

 

Mortgage Servicing Rights (MSR)(“MSR”). Originated MSR are recorded at allocated cost based upon the relative fair values of the transferred loans, derivative instruments and the servicing rights. MSR are amortized in proportion to and over the projected net

servicing revenue over the expected life of the related mortgage loans.revenues. Periodically, we evaluate the carrying value of originated MSR based on their estimated fair value. If the estimated fair value, using a discounted cash flow methodology, is less than the carrying amount of the mortgage servicing rights, the mortgage servicing rights are written down to the amount of the estimated fair value. For purposes of evaluating and measuring impairment of MSR we stratify the mortgage servicing rights based on their predominant risk characteristics. The significantmost predominant risk characteristic considered is period of origination. The mortgage loans underlying the MSR are pools of homogenous,homogeneous, nonconforming residential loans.

The fair value of MSR is highly sensitive to changes in assumptions. Changes in prepayment speed assumptions have the most significantgreatest impact on the fair value of MSR. Generally, as interest rates decline, prepayments accelerate due to increased refinance activity, which results in a decrease in the fair value of MSR. As interest rates rise, prepayments slow down, which generally results in an increase in the fair value of MSR. All assumptions are reviewed for reasonableness on a quarterly basis and adjusted as necessary to reflect current and anticipated market conditions. Thus, any measurement of the fair value of MSR is limited by the existing conditions and the assumptions utilized as of a particular point in time. Those same assumptions may not be appropriate if applied at a different point in time.

 

Stock-Based Compensation Prior to 2003, we accounted for our stock-based compensation plan using the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25,Accounting for Stock Issued to Employees and related interpretations. We accounted for stock options based on the specific terms of the options granted. Options with variable terms, including those options for which the strike price has been adjusted and options issued by us with attached dividend equivalent rights, resulted in adjustments to compensation expense to the extent the market price of the common stock changed. No expense was recognized for options with fixed terms.

During the fourth quarter of 2003, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123,Accounting for Stock-Based Compensation. SFAS No. 123 requires that all options be valued at the date of grant and expensed over their vesting period. We use the Black-Scholes option pricing model to value options granted.

Additionally, we selected the modified prospective method of adoption described in SFAS No. 148,Accounting for Stock-Based Compensation-Transition and Disclosure. Under this method, the change is retroactive to January 1, 2003 and compensation cost recognized in 2003 is the same as that which would have been recognized had the fair value method of SFAS No. 123 been applied from its original effective date. The pretax impact of adopting the provisions under the modified prospective method for the nine months ended September 30, 2003 was a decrease to compensation expense of $7.1 million. In accordance with the modified prospective method of adoption, results for prior years have not been restated. SFAS No. 123 states that the adoption of the fair value based method is a change to a preferable method of accounting. We believe that use of the fair value based method to record stock-based compensation expense is consistent with the accounting for all other forms of compensation.

In accordance with the provisions of SFAS No. 123 and SFAS No. 148, $1.3 million was recorded for total stock-based compensation expense in 2003. In accordance with APB No. 25, total stock-based compensation expense was $2.5 million and $0.7 million, respectively, for the years ended December 31, 2002 and 2001.

Financial Condition as of December 31, 20032005 and 20022004

 

Mortgage Loans.Loans.We classify our mortgage loans into two categories: “held-for-sale” and “held-in-portfolio.”“held-in-portfolio”. Loans we have originated and purchased, but have not yet sold or securitized, are classified as “held-for-sale.”“held-for-sale”. We expect to sell these loans outright in third partythird-party transactions or in securitization transactions that will be, for tax and accounting purposes, recorded as sales. We use warehouse lines of credit and mortgage repurchase agreements to finance our held-for-sale loans. As such, the fluctuations in mortgage loans held-for-sale and short-term borrowings between December 31, 20032005 and December 31, 2002 is2004 are dependent on loans we have originated and purchased during the period as well as loans we have sold outright or through securitization transactions.

 

The volume and cost of our loan production isare critical to our financial results. The loans we produce serve as collateral for our mortgage securities and generate gains as they are sold or securitized. The cost of our production is also critical to our financial results as it is a significant factor in the gains we recognize. The following table summarizes our loan production for 20032005 and 2002. We discuss2004. See Table 17 for a summary of our wholesale cost of production under “Generalfor the years ended December 31, 2005, 2004 and Administrative Expenses” under “Results of Operations”.2003. Also, details regarding mortgage loans sold or securitized and the gains recognized during 20032005 and 2004 can be found in the “Gains on Sales of Mortgage Assets and Losses on Derivative Instruments” section of this document.

Table 14.

Table 12 — Nonconforming Loan Originations and Purchases

(dollars in thousands, except for average loan balance)


 

   

Number


  

Principal


  

Average

Loan

Balance


  

Price Paid to

Broker


  Weighted Average

  

Percent with

Prepayment

Penalty


 
         Loan to
Value


  

FICO

Score


  Coupon

  

2003

  36,911  $5,250,978  $142,261  101.2% 78% 638  7.3% 77%
   
  

  

  

 

 
  

 

2002

  18,453  $2,492,767  $135,087  101.1% 79% 628  8.3% 80%
   
  

  

  

 

 
  

 

   Number

  Principal

  

Average

Loan

Balance


  

Price Paid to

Broker


  Weighted Average

  

Percent with

Prepayment

Penalty


 
         

Loan to

Value


  

FICO

Score


  Coupon

  

2005

  58,542  $9,283,138  $158,572  101.1% 82% 632  7.7% 65%
   
  

  

  

 

 
  

 

2004

  55,974  $8,424,361  $150,505  101.3% 82% 622  7.6% 72%
   
  

  

  

 

 
  

 

 

A portion of the mortgage loans on our balance sheet serve as collateral for asset-backed bonds we have issued (that are not accounted for as sales) and are classified as “held-in-portfolio.” The carrying value of “held-in-portfolio” mortgage loans as of December 31, 20032005 was $94.7$28.8 million compared to $149.9$59.5 million as of December 31, 2002.2004. As discussed under “Asset-Backed Bonds” during the fourth quarter of 2005 we exercised our option to repurchase the mortgage loan collateral for two out of the four securitization loan transactions from 1997 and 1998.

 

Premiums to brokers are paid on substantially all mortgage loans. Premiums on mortgage loans held-in-portfolio are amortized as a reduction of interest income over the estimated lives of the loans. For mortgage loans held-for-sale, premiums are deferred until the related loans are sold.sold or securitized. To mitigate the effect of prepayments on interest income from mortgage loans, we generally strive to originate and purchase mortgage loans with prepayment penalties. Prepayment penalties have decreased from 2004 due to increased regulation specifically aimed at reducing prepayment penalties which can be charged by lenders. Because more borrowers can now refinance their mortgages at any time with no penalty, we would expect prepayment speeds to be slightly faster as a result of the reduction in these penalties. Additionally, the value of our prepayment penalty bonds retained in our newer securitizations will generally have a lower value due to the decrease in expected cash flows.

 

In periods of decreasing interest rates, borrowers are more likely to refinance their mortgages to obtain a better interest rate. Even in rising rate environments, borrowers tend to repay their mortgage principal balances earlier than is required by the terms of their mortgages. Nonconforming borrowers, as they update their credit rating and as housing prices increase, are more likely to refinance their mortgage loan to obtain a lower interest rate.rate or take advantage of the additional borrowing capacity in their homes.

 

The operating performance of our mortgage loan portfolio, including net interest income, allowance for credit losses and effects of hedging, are discussed under “Results of Operations” and “Interest Rate/Market Risk.”Operations by our Primary Operating Segments”. Gains on the sales of mortgage loans, including impact of securitizations treated as sales, is also discussed under “Results of Operations.” Additional information relating toOperations by our loans held-in-portfolio and loans held-for-sale can be accessed via our website at www.novastarmortgage.com. Such information includes a summary of our loans held-in-portfolio and loans held-for-sale by FICO score and geographic concentration. For held-in-portfolio loans, loan performance characteristics such as credit quality and prepayment experience are also available.Primary Operating Segments.”

Table 23 — Carrying Value of Mortgage Loans

(dollars in thousands)


 

  December 31,

 
  2005

 2004

 

Held-for-sale:

   

Current principal

  $1,235,159  $719,904 

Net premium

   12,015   6,760 
  


 


   1,247,174   726,664 

Loans under removal of accounts provision

   44,382   20,930 
  


 


Mortgage loans – held-for-sale

  $1,291,556  $747,594 
  


 


Weighted average coupon

   8.1%  7.7%
  


 


Percent with prepayment penalty

   65%  65%
  December 31,
2003


 December 31,
2002


   


 


Held-in-portfolio:

      

Current principal

  $94,162  $149,918   $29,084  $58,859 

Net unamortized premium

   455   1,175 
  


 


  


 


Premium

  $1,874  $2,994 

Amortized cost

   29,539   60,034 

Allowance for credit losses

   (699)  (507)
  


 


  


 


Coupon

   10.0%  10.0%

Mortgage loans – held-in-portfolio

  $28,840  $59,527 
  


 


  


 


Percent with prepayment penalty

   —  %  18%

Weighted average coupon

   9.9%  10.0%
  


 


  


 


Held-for-sale:

   

Current principal

  $687,880  $972,360 
  


 


Premium

  $10,112  $11,273 
  


 


Coupon

   7.7%  8.0%
  


 


Percent with prepayment penalty

   74%  81%
  


 


The following table details the activity in our mortgage loans held-for-sale for the years ended December 31, 2005 and 2004.

Table 4 — Rollforward of Mortgage Loans Held-for-Sale

(dollars in thousands)

   For the Year Ended December 31,

 
   2005

  2004

 

Beginning balance

  $747,594  $697,992 

Originations and purchases

   9,366,720   8,560,314 

Borrower repayments

   (9,908)  (27,979)

Sales to third parties

   (1,166,377)  (63,042)

Sales in securitizations

   (7,693,775)  (8,424,145)

Transfers to real estate owned

   (712)  (2,001)

Repurchase of mortgage loans from securitization trusts

   13,948   —   

Transfers of mortgage loans from held-in-portfolio

   10,614   —   

Change in loans under removal of accounts provision

   23,452   6,455 
   


 


Ending balance

  $1,291,556  $747,594 
   


 


 

Mortgage Securities Available-for-Sale.Since 1998,1999, we have pooled the majority of the loans we have originated or purchased to serve as collateral for asset-backed bonds in securitizations that are treated as sales for accounting and tax purposes. In these transactions, the loans are removed from our balance sheet. However, we retain excess interest,residual securities (representing interest-only securities, prepayment penalty bonds and overcollateralization bonds) and certain investment-grade rated subordinated principal securities. Additionally, we service the loans sold in these securitizations (seesecuritizations. See “Mortgage Servicing Rights” under the header “Financial Condition as of December 31, 2003 and 2002”).below. As of December 31, 20032005 and 2002,2004, the fair value of our mortgage securities – available-for-sale was $382.3$505.6 million and $178.9$489.2 million, respectively. During 20032005 and 2002,2004, we executed securitizations totaling $5.3$7.6 billion and $1.6$8.3 billion, respectively, in mortgage loans and retained mortgage securities with a valuecost basis of $299.8$332.4 million and $92.9$381.8 million, respectively. See TableNote 3 to the consolidated financial statements for a summary of the activity in our mortgage securities portfolio.

 

The servicing agreements we execute for loans we have securitized include a “clean up” call option which gives us the right, not the obligation, to repurchase mortgage loans from the trust when the aggregate principal balance of the mortgage loans has declined to ten percent or less of the original aggregated mortgage loan principal balance. On September 25, 2005, we exercised the “clean up” call option on NMFT Series 1999-1 and repurchased loans with a remaining principal balance of $14.0 million from the trust for $6.8 million in cash. The trust distributed the $6.8 million to retire the bonds held by third parties. Along with the cash paid to the trust, the cost basis of the NMFT Series 1999-1 mortgage security, $7.4 million, became part of the cost basis of the repurchased mortgage loans.

The value of our residual mortgage securities available-for-sale represents the present value of the securities’ cash flows that we expect to receive over their lives, considering estimated prepayment speeds and credit losses of the underlying loans, discounted at an appropriate risk-adjusted market rate of return. The cash flows are realized over the life of the loan collateral as cash distributions are received from the trust that owns the collateral.

In estimating the fair value of our residual mortgage securities – available-for-sale, management must make assumptions regarding the future performance and cash flow of the mortgage loans collateralizing the securities. These estimates are based on management’s judgments about the nature of the loans. The cash flows we receive on our residual mortgage securities – available-for-sale will be based on the net of the gross coupon and theless servicing costs, bond cost lesscosts, trustee administrative costs (servicing and trustee fees) and the cost of mortgage insurance.insurance costs. Additionally, if the trust is a party to interest rate agreements. Ouragreements, our cash flow will include (exclude) payments from (to) the interest rate agreement counterparty. Table 45 provides a summary of the critical assumptions used in estimating the cash flows of the collateral and the resulting estimated fair value of the residual mortgage securities.securities – available-for-sale.

 

DuringWe have experienced periods prior to 2004 when the past two years, interest expense on asset-backed bonds has been unexpectedly low.dramatically declined due to reductions in short-term interest rates. As a result, the spread between the coupon interest and the bond cost has beenwas unusually high. As a result,high and our cost basis in many of our older mortgage securities has beenwas significantly reduced.reduced due to the dramatic increase in cash flows. For example, our cost basis in NMFT Series 2000-2, 2001-1 and 2001-2 has been reduced to zero (see Table 4)5). When our cost basis in the retainedresidual securities (interest only, prepayment penalty and subordinated securities) reaches zero, the remaining future cash flows received on the securities are recognized entirely as income.

 

The operating performance of our mortgage securities portfolio, including net interest income and effects of hedging are discussed under “Results“Mortgage Portfolio Management Results of Operations” and “Interest Rate/Market Risk.Operations. Additional information relating to our loans collateralizing our mortgage securities can be accessed via our website at www.novastarmortgage.com. Such information includes a summary of our loans collateralizing our mortgage securities by FICO score and geographic concentration, as well as, loan performance characteristics such as credit quality and prepayment experience.

Table 3 — Rollforward of Mortgage Securities

(in thousands)


   Cost

  

Net

unrealized

gain


  Estimated fair
value of
mortgage
securities


 

As of January 1, 2002

  $54,594  $16,990  $71,584 
   


 

  


Increases (decreases) to mortgage securities:

             

New securities retained in securitizations

   90,785   2,118   92,903 

Accretion of income

   56,481   —     56,481 

Proceeds from paydowns of securities

   (99,195)  —     (99,195)

Mark-to-market value adjustment

   —     57,106   57,106 
   


 

  


Net increase to mortgage securities

   48,071   59,224   107,295 
   


 

  


As of December 31, 2002

  $102,665  $76,214  $178,879 
   


 

  


Increases (decreases) to mortgage securities:

             

New securities retained in securitizations (A)

   292,675   7,077   299,752 

Accretion of income

   98,804   —     98,804 

Proceeds from paydowns of securities

   (199,582)  —     (199,582)

Mark-to-market value adjustment

   —     4,434   4,434 
   


 

  


Net increase to mortgage securities

   191,897   11,511   203,408 
   


 

  


As of December 31, 2003

  $294,562  $87,725  $382,287 
   


 

  



(A)See Note 3 of the consolidated financial statements for further discussion.

Table 45 — Valuation of Individual Mortgage Securities – Available-for-Sale and Assumptions

(dollars in thousands)


 

            Current Assumptions (B)

  Assumptions at Trust
Securitization (B)


 
   Cost

  Net
Unrealized
Gain (Loss)


  Estimated
Fair Value
of
Mortgage
Securities


  Discount
Rate


  Constant
Prepayment
Rate


  Expected
Credit
Losses
(A)


  Discount
Rate


  Constant
Prepayment
Rate


  Expected
Credit
Losses
(A)


 

December 31, 2003:

                               

NMFT 1999-1

                               

Subordinated securities

  $6,119  $(101) $6,018  17% 39% 5.2% 17% 30% 2.5%

NMFT 2000-1

                               

Interest only

   —     1,942   1,942                   

Prepayment penalty

   —     244   244                   

Subordinated securities

   299   708   1,007                   
   

  


 

                   
    299   2,894   3,193  15  57  1.3  15  27  1.0 

NMFT 2000-2

                               

Interest only

   —     3,074   3,074                   

Prepayment penalty

   —     274   274                   

Subordinated securities

   754   1,993   2,747                   
   

  


 

                   
    754   5,341   6,095  15  63  1.0  15  28  1.0 

NMFT 2001-1

                               

Interest only

   —     6,386   6,386                   

Prepayment penalty

   —     518   518                   

Subordinated securities

   —     1,629   1,629                   
   

  


 

                   
    —     8,533   8,533  20  53  1.1  20  28  1.2 

NMFT 2001-2

                               

Interest only

   —     16,343   16,343                   

Prepayment penalty

   —     1,469   1,469                   

Subordinated securities

   185   3,164   3,349                   
   

  


 

                   
    185   20,976   21,161  25  41  0.9  25  28  1.2 

NMFT 2002-1

                               

Interest only

   8,437   5,285   13,722                   

Prepayment penalty

   550   937   1,487                   

Subordinated securities

   1,183   3,444   4,627                   
   

  


 

                   
    10,170   9,666   19,836  20  35  1.3  20  32  1.7 

NMFT 2002-2

                               

Interest only

   7,093   1,489   8,582                   

Prepayment penalty

   582   678   1,260                   

Subordinated securities

   1,750   1,315   3,065                   
   

  


 

                   
    9,425   3,482   12,907  25  36  1.8  25  27  1.6 

NMFT 2002-3

                               

Interest only

   20,801   5,362   26,163                   

Prepayment penalty

   1,348   1,662   3,010                   

Subordinated securities

   2,225   1,847   4,072                   
   

  


 

                   
    24,374   8,871   33,245  20  32  0.9  20  30  1.0 

NMFT 2003-1

                               

Interest only

   47,352   2,280   49,632                   

Prepayment penalty

   3,949   1,814   5,763                   

Subordinated securities

   6,698   2,877   9,575                   
   

  


 

                   
    57,999   6,971   64,970  20  23  2.8  20  28  3.3 

NMFT 2003-2

                               

Interest only

   58,709   4,863   63,572                   

Prepayment penalty

   3,042   2,513   5,555                   

Subordinated securities

   25   265   290                   
   

  


 

                   
    61,776   7,641   69,417  28  26  2.6  28  25  2.7 

MFT 2003-3

                               

Interest only

   72,637   3,128   75,765                   

Prepayment penalty

   3,098   1,830   4,928                   

Subordinated securities

   1,628   3,535   5,163                   
   

  


 

                   
    77,363   8,493   85,856  20  23  3.4  20  22  3.6 

NMFT 2003-4

                               

Interest only

   41,668   4,107   45,775                   

Prepayment penalty

   4,430   61   4,491                   

Subordinated securities

   —     790   790                   
   

  


 

                   
    46,098   4,958   51,056  20  30  5.3  20  30  5.1 
   

  


 

                   

Total

  $294,562  $87,725  $382,287                   
   

  


 

                   

   Cost (A)

  

Unrealized

Gain

(Loss) (A)


  

Estimated

Fair Value

of

Mortgage

Securities (A)


  Current Assumptions

  Assumptions at Trust Securitization

 
       

Discount

Rate


  

Constant

Prepayment

Rate


  

Expected

Credit

Losses

(B)


  

Discount

Rate


  

Constant

Prepayment

Rate


  

Expected

Credit

Losses

(B)


 

December 31, 2005:

                               

NMFT Series:

                               

2000-1

  $521  $596  $1,117  15% 36% 1.3% 15% 27% 1.0%

2000-2

   —     907   907  15  37  1.0  15  28  1.0 

2001-1

   —     1,661   1,661  20  40  1.3  20  28  1.2 

2001-2

   —     3,701   3,701  20  31  0.7  25  28  1.2 

2002-1

   1,632   2,184   3,816  20  41  0.7  20  32  1.7 

2002-2

   2,415   542   2,957  20  43  1.4  25  27  1.6 

2002-3

   4,127   1,132   5,259  20  44  0.4  20  30  1.0 

2003-1

   30,815   5,941   36,756  20  39  1.3  20  28  3.3 

2003-2

   11,043   8,330   19,373  20  39  0.8  28  25  2.7 

2003-3

   18,261   6,860   25,121  20  37  0.7  20  22  3.6 

2003-4

   11,070   12,191   23,261  20  46  0.8  20  30  5.1 

2004-1

   17,065   13,142   30,207  20  56  1.3  20  33  5.9 

2004-2

   18,368   13,432   31,800  20  55  1.4  26  31  5.1 

2004-3

   36,502   17,287   53,789  19  53  1.5  19  34  4.5 

2004-4

   34,473   16,102   50,575  20  54  1.5  26  35  4.0 

2005-1

   44,387   8,481   52,868  15  53  1.8  15  37  3.6 

2005-2

   37,377   1,296   38,673  13  51  1.5  13  39  2.1 

2005-3

   46,627   —     46,627  15  47  2.0  15  41  2.0 

2005-3 (C)

   45,058   (2,247)  42,811  N/A  N/A  N/A  N/A  N/A  N/A 

2005-4

   34,366   —     34,366  15  43  2.3  15  43  2.3 
   

  


 

                   

Total

  $394,107  $111,538  $505,645                   
   

  


 

                   

(A)The interest-only, prepayment penalty and overcollateralization securities are presented on a combined basis.
(B)Represents expected credit losses for the life of the securitization up to the expected date in which the related asset-backed bonds can be called.called, net of mortgage insurance recoveries.

(B)(C)Includes the Class M-11 and M-12 certificates of NMFT Series 2005-3. The current discount rateM-11 is rated BBB/BBB- and assumptionsBBB- by Standard & Poor’s and those at trust securitization, which were previously disclosed, have been adjusted to reflect management’s revised estimatesFitch, respectively. The M-12 is rated BBB- by Standard and Poor’s. The fair value for volatility and risk associated with the underlying mortgage loan collateral. These revisions do not impact previously recorded amounts.these securities is based upon market prices.

            Current Assumptions (B)

  Assumptions at Trust Securitization
(B)


 
   Cost

  Net
Unrealized
Gain (Loss)


  Estimated
Fair Value
of
Mortgage
Securities


  Discount
Rate


  Constant
Prepayment
Rate


  Expected
Credit
Losses
(A)


  Discount
Rate


  Constant
Prepayment
Rate


  Expected
Credit
Losses
(A)


 

December 31, 2002:

                               

NMFT 1999-1

                               

Subordinated securities

  $5,791  $(1,541) $4,250  17% 26% 4.8% 17% 30% 2.5%

NMFT 2000-1

                               

Interest only

   984   3,089   4,073                   

Prepayment penalty

   273   370   643                   

Subordinated securities

   299   1,041   1,340                   
   

  


 

                   
    1,556   4,500   6,056  15  67  0.7  15  27  1.0 

NMFT 2000-2

                               

Interest only

   1,355   5,331   6,686                   

Prepayment penalty

   379   620   999                   

Subordinated securities

   792   1,629   2,421                   
   

  


 

                   
    2,526   7,580   10,106  15  70  0.7  15  28  1.0 

NMFT 2001-1

                               

Interest only

   1,766   10,263   12,029                   

Prepayment penalty

   311   1,806   2,117                   

Subordinated securities

   324   1,886   2,210                   
   

  


 

                   
    2,401   13,955   16,356  20  68  1.0  20  28  1.2 

NMFT 2001-2

                               

Interest only

   10,295   20,806   31,101                   

Prepayment penalty

   2,007   4,055   6,062                   

Subordinated securities

   1,315   2,658   3,973                   
   

  


 

                   
    13,617   27,519   41,136  25  58  1.0  25  28  1.2 

NMFT 2002-1

                               

Interest only

   14,925   6,306   21,231                   

Prepayment penalty

   2,491   1,053   3,544                   

Subordinated securities

   3,343   1,413   4,756                   
   

  


 

                   
    20,759   8,772   29,531  20  48  1.2  20  32  1.7 

NMFT 2002-2

                               

Interest only

   13,941   3,650   17,591                   

Prepayment penalty

   1,764   462   2,226                   

Subordinated securities

   2,443   639   3,082                   
   

  


 

                   
    18,148   4,751   22,899  25  30  1.6  25  27  1.6 

NMFT 2002-3

                               

Interest only

   31,729   8,947   40,676                   

Prepayment penalty

   3,057   862   3,919                   

Subordinated securities

   3,081   869   3,950                   
   

  


 

                   
    37,867   10,678   48,545  20  30  1.0  20  30  1.0 
   

  


 

                   

Total

  $102,665  $76,214  $178,879                   
   

  


 

                   

   Cost (A)

  

Unrealized

Gain (A)


  

Estimated

Fair Value

of

Mortgage

Securities (A)


  Current Assumptions

  Assumptions at Trust Securitization

 
        

Discount

Rate


  

Constant

Prepayment

Rate


  

Expected

Credit

Losses

(B)


  

Discount

Rate


  

Constant

Prepayment

Rate


  

Expected

Credit

Losses

(B)


 

December 31, 2004:

                               

NMFT Series:

                               

1999-1

  $7,001  $—    $7,001  17% 33% 4.8% 17% 30% 2.5%

2000-1

   681   538   1,219  15  46  1.2  15  27  1.0 

2000-2

   —     2,290   2,290  15  34  1.0  15  28  1.0 

2001-1

   —     3,111   3,111  20  37  1.1  20  28  1.2 

2001-2

   —     8,601   8,601  25  33  0.8  25  28  1.2 

2002-1

   4,978   6,112   11,090  20  42  0.9  20  32  1.7 

2002-2

   5,048   1,642   6,690  25  40  1.4  25  27  1.6 

2002-3

   11,044   3,817   14,861  20  41  0.7  20  30  1.0 

2003-1

   32,062   5,231   37,293  20  39  1.8  20  28  3.3 

2003-2

   21,980   7,923   29,903  28  38  1.5  28  25  2.7 

2003-3

   32,775   9,239   42,014  20  37  1.6  20  22  3.6 

2003-4

   26,460   17,727   44,187  20  44  1.7  20  30  5.1 

2004-1

   42,547   7,303   49,850  20  43  3.5  20  33  5.9 

2004-2

   39,856   5,695   45,551  26  41  3.8  26  31  5.1 

2004-3

   89,442   —     89,442  19  39  3.9  19  34  4.5 

2004-4

   96,072   —     96,072  26  36  3.7  26  35  4.0 
   

  

  

                   

Total

  $409,946  $79,229  $489,175           ��       
   

  

  

                   

(A)The interest-only, prepayment penalty and overcollateralization securities are presented on a combined basis.
(B)Represents expected credit losses for the life of the securitization up to the expected date in which the related asset-backed bonds can be called.

(B)The current discount rate and assumptions and those at trust securitization, which were previously disclosed, have been adjusted to reflect management’s revised estimates for volatility and risk associated withcalled, net of the underlyingimpact of mortgage loan collateral. These revisions do not impact previously recorded amounts.insurance recoveries.

The previous table demonstrates how the increase in housing prices has impacted the assumptions we use to value our individual mortgage securities available-for-sale. The increase in home prices has led to an increase in constant prepayment rate assumptions as well as a decrease in expected credit loss assumptions. The decrease in expected credit loss assumptions has more than offset the increase in constant prepayment rates and increase in short-term interest rates causing the yield on our mortgage securities to increase. Note 3 to the consolidated financial statements provides additional detail regarding the yields on our mortgage securities available-for-sale.

The following table summarizes the cost basis, unrealized gain and fair value of our mortgage securities—available-for-sale grouped by year of issue. For example, under the “Year of Issue for Mortgage Securities Retained” column, the year 2005 is a combination of NMFT Series 2005-1, NMFT Series 2005-2, NMFT Series 2005-3 and NMFT Series 2005-4.

Table 6 — Summary of Mortgage Securities – Available-for-Sale Retained by Year of Issue

(dollars in thousands)

Year of

Issue

for

Mortgage

Securities

Retained


  2005

  As of December 31

  As of September 30

  As of June 30

  As of March 31

  Cost

  

Unrealized

Gain


  Fair Value

  Cost

  

Unrealized

Gain


  Fair Value

  Cost

  

Unrealized

Gain


  Fair Value

  Cost

  

Unrealized

Gain


  Fair Value

1999

  $—    $—    $—    $—    $—    $—    $7,389  $3  $7,392  $7,150  $32  $7,182

2000

   521   1,503   2,024   588   1,760   2,348   672   2,237   2,909   800   2,307   3,107

2001

   —     5,362   5,362   —     6,741   6,741   —     7,169   7,169   —     9,129   9,129

2002

   8,174   3,858   12,032   14,189   6,594   20,783   15,132   10,402   25,534   19,112   12,283   31,395

2003

   71,189   33,322   104,511   73,168   47,050   120,218   79,419   65,301   144,720   91,112   54,209   145,321

2004

   106,408   59,963   166,371   131,885   61,572   193,457   168,908   56,898   225,806   213,694   33,297   246,991

2005

   207,815   7,530   215,345   198,157   244   198,401   130,379   2   130,381   87,453   —     87,453
   

  

  

  

  

  

  

  

  

  

  

  

Total

  $394,107  $111,538  $505,645  $417,987  $123,961  $541,948  $401,899  $142,012  $543,911  $419,321  $111,257  $530,578
   

  

  

  

  

  

  

  

  

  

  

  

Year of

Issue

for

Mortgage

Securities

Retained


  2004

  As of December 31

  As of September 30

  As of June 30

  As of March 31

  Cost

  Unrealized
Gain


  Fair Value

  Cost

  Unrealized
Gain


  Fair Value

  Cost

  Unrealized
Gain


  Fair Value

  Cost

  Unrealized
Gain


  Fair Value

1999

  $7,001  $—    $7,001  $6,818  $—    $6,818  $6,597  $—    $6,597  $6,353  $185  $6,538

2000

   681   2,828   3,509   539   3,046   3,585   412   5,161   5,573   1,298   8,194   9,492

2001

   —     11,712   11,712   —     16,064   16,064   321   20,910   21,231   233   27,579   27,812

2002

   21,070   11,571   32,641   23,978   14,181   38,159   29,202   14,067   43,269   36,201   18,899   55,100

2003

   113,277   40,120   153,397   142,796   28,458   171,254   184,097   8,841   192,938   226,676   16,090   242,766

2004

   267,917   12,998   280,915   218,898   7,709   226,607   118,684   758   119,442   60,961   1,334   62,295
   

  

  

  

  

  

  

  

  

  

  

  

Total

  $409,946  $79,229  $489,175  $393,029  $69,458  $462,487  $339,313  $49,737  $389,050  $331,722  $72,281  $404,003
   

  

  

  

  

  

  

  

  

  

  

  

Servicing Related Advances.Mortgage Securities – Trading.Advances on behalf As of borrowers for taxes, insuranceDecember 31, 2005, mortgage securities – trading consisted of the NMFT Series 2005-4 M-9, M-10, M-11 and other customer service functionsM-12 bond class securities are made by NovaStar Mortgage, Inc.retained from our securitization transactions in 2005. Note 2 and aggregated $19.3 millionNote 4 to the consolidated financial statements provides additional detail regarding these securities. The aggregate fair market value of these securities as of December 31, 2003 compared with $11.9 million as2005 was $43.7 million. Management estimates their fair value based on quoted market prices. As of December 31, 2002. These balances will generally increase as our assets and loan servicing balances increase.2004, this line-item consisted of an adjustable-rate mortgage-backed security with a fair market value of $143.2 million. During the first quarter of 2005, we sold this security.

 

Mortgage Servicing RightsRights.. As discussed under Mortgage“Mortgage Securities – Available for Sale,Sale” above, we retain the right to service mortgage loans we originate, purchase and have securitized. Servicing rights for loans we sell to third parties are not retained and we have not purchased the right to service loans. As of December 31, 2003,2005, we have $19.7had $57.1 million in capitalized mortgage servicing rights compared with $7.9$42.0 million as of December 31, 2002.2004. The carrying value of the mortgage servicing rights we retained in our securitizations during 20032005 and 20022004 was $20.8$43.5 million and $6.1$39.3 million, respectively. Amortization of mortgage servicing rights was $28.4 million, $16.9 million and $9.0 million and $4.6 million for the years ended December 31, 2005, 2004 and 2003, and 2002, respectively. See further discussion of amortization of mortgage servicing rights under “Loan Servicing Results of Operations.

 

Assets Acquired through ForeclosureDerivative Instruments, net.As of Derivative instruments, net decreased to $12.8 million at December 31, 2003, we had 53 properties in real estate owned with a carrying value of $3.22005 from $18.8 million compared to 69 properties with a carrying value of $5.9 million as ofat December 31, 2002. Losses or gains from2004. These amounts include the ultimate disposition of real estate owned are charged or credited to operating income and are detailed under the heading “Gains on Sales of Mortgage Assets and Losses on Derivative Instruments”.

Other Assets. Included in other assets is collateral (margin deposits) required under the terms of our derivative instrument contracts, net of the derivative instrument market values, fixed assets, receivables from securitizations, deferred tax asset and other miscellaneous assets. Deposits with our derivative counterparties were $20.9 million asvalues. Due to the nature of December 31, 2003 compared with $30.3 million as of December 31, 2002. The market value of the derivative instruments offsetwe use, the margin deposits by $2.0 million and $18.2 million as of December 31, 2003 and December 31, 2002, respectively. These balancesrequired will generally increase as interest rates decline and decrease as interest rates riserise. On the other hand, the market value of our derivative instruments will decline as interest rates decline and increase whenas interest rates fall. Also included in other assets at December 31, 2003 and December 31, 2002 are fixed assets, net of accumulated depreciation of $14.5 million and $5.4 million, respectively. Fixed assets have increased primarily due to purchases of furniture and fixtures, computer equipment and office equipment related to the growth in the number of our employees. Our receivables from securitizations were $6.2 million and $0.6 million at December 31, 2003 and December 31, 2002, respectively. These receivables represent cash due to us when we delivered the remaining $479.8 million in loans collateralizing NMFT 2003-4 in January 2004 as well as cash due to us on our mortgage securities. As of December 31, 2003 and 2002, we had a net deferred tax asset of $10.5 million and $2.5 million, respectively. See Note 9 of the consolidated financial statements for details of the deferred tax asset.rise.

Short-term Financing Arrangements.Borrowings.Mortgage loan originations and purchases are funded with various financing facilities prior to securitization. Repurchase agreements are used as interim, short-term financing before loans are transferred in our securitization transactions. The balances outstanding under our short-term arrangementsrepurchase agreements fluctuate based on lending volume, equity and debt issuances, financing activities and cash flows from other operating and investing and other financing activities and equity transactions.activities. As shown in Table 5,7, we have $130.1had $278.8 million in immediately available funds including $118.2 million in cash.as of December 31, 2005. We have borrowed approximately $873 million$1.4 billion of the $2.9$3.5 billion in committed lines of creditmortgage securities and mortgage securities repurchaseloans financing facilities, leaving approximately $2.0$2.1 billion available to support the mortgage lending and mortgage portfolio operations. See the “Liquidity and Capital Resources” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a further discussion of liquidity risks and resources available to us.

 

Table 57 — Short-term Financing Resources

(dollars in thousands)


   

Credit

Limit


  

Lending

Value of

Collateral


  Borrowings

  Availability

Unrestricted cash

              $118,180

Lines of credit and mortgage and securities repurchase facilities

  $2,875,000  $884,438  $872,536  $11,902
   

  

  

  

Total

  $2,875,000  $884,438  $872,536  $130,082
   

  

  

  

   

Credit

Limit


  

Lending

Value of

Collateral


  Borrowings

  Availability

Unrestricted cash

              $264,694

Mortgage securities and mortgage loans financing facilities

  $3,500,000  $1,432,719  $1,418,569   14,150
   

  

  

  

Total.

  $3,500,000  $1,432,719  $1,418,569  $278,844
   

  

  

  

 

Asset-backed BondsAsset-Backed Bonds.. During 1997 and 1998, we completed the securitization of loans in transactions that were structured as financing arrangements for accounting purposes. These non-recourse financing arrangements match the loans with the financing arrangement for long periods of time, as compared to lines of credit and repurchase agreements that mature frequently with interest rates that reset frequently and have liquidity risk in the form of margin calls. Under the terms of our asset-backed bonds we are entitled to repurchase the mortgage loan collateral and repay the remaining bond obligations when the aggregate collateral principal balance falls below 35% of their original balance for the loans in NHESSeries 97-01 and 25% for the loans in NHESSeries 97-02, Series 98-01 and Series 98-02. WeDuring the fourth quarter of 2005, we exercised this option for issues 1997-1 and 1997-2 and retired the related asset-backed bonds which had a remaining balance of $7.8 million. The mortgage loans were transferred from the held-in-portfolio classification to held-for-sale and have not exercisedbeen or will be sold to third party investors or used as collateral in our right to repurchase anysecuritization transactions. As of December 31, 2005 and December 31, 2004, we had asset-backed bonds secured by mortgage loans outstanding of $26.9 million and repay bond obligations.$53.5 million, respectively.

On November 5, 2002During 2005, we resecuritized interest-only and prepayment penalty securities and issued NovaStar CAPS Certificate Series 2002-C1Net Interest Margin Certificates (“NIM”) in resecuritization transactions in the amount of $68 million. On July 2, 2003, we resecuritized interest-only, prepayment penalty$130.9 million, raising $128.9 million in net proceeds. This NIM is secured by the retained securities from NMFT Series 2005-1 and subordinated mortgage securitiesNMFT Series 2005-2 and is a form of NMFT 2003-2 and issued NovaStar NIMS Certificate Series 2003-N1 in the amount of $54 million.long-term financing. The resecuritizations wereresecuritization was structured as a secured borrowingsborrowing for financial reporting and income tax purposes. In accordance with SFAS No. 140,purposes because control over the transferred assets was not surrendered and thus the transaction was considered financing forsurrendered. Therefore, the mortgage securities.

Accounts Payable and Other Liabilities. Included in accounts payable and other liabilities is the provision for removal of loans from securitization trusts, accrued payroll, income taxes payable and other liabilities. A provision within the trust for each of our securitization transactions gives us the right, not the obligation, to repurchase loans from the trust that are between 90 and 119 days delinquent. In accordance with SFAS No. 140, we are required to record the loans that meet this definition and a corresponding liability to the trustsecurities remain on our balance sheet at fair value.as assets and the asset-backed bonds are recorded as debt. As of December 31, 20032005 and December 31, 2002,2004 we had asset-backed bonds secured by mortgage securities available-for-sale outstanding of $125.6 million and $336.4 million, respectively. Note 8 to the consolidated financial statements provides additional detail regarding these transactions.

Junior Subordinated Debentures.During 2005, we issued unsecured floating rate subordinated debt to obtain low cost long-term funds. The junior subordinated debentures are redeemable, at our option, in whole or in part, anytime without penalty on or after March 15, 2010, but are mandatorily redeemable when they mature on March 15, 2035. As of December 31, 2005, our liability related to this provisionthe junior subordinated debentures was $14.5 million and $11.5 million, respectively. This liability should generally increase as we continue to securitize the loans we originate. Our accrued payroll increased from $9.2 million at December 31, 2002 to $18.1 million at December 31, 2003 due primarily$48.7 million. See Note 8 to our growth in number of employees. Our current income tax liability was $7.9 million and $0.9 million as of December 31, 2003 and December 31, 2002, respectively. This increase is attributable to the increase in income before taxes of NFI Holding Corporation.consolidated financial statements for additional detail regarding this transaction.

 

Stockholders’ EquityShareholders’ Equity..The Board of Directors declared a two-for-one split of its common stock, providing shareholders of record as of November 17, 2003, with one additional share of common stock for each share owned. The additional shares resulting from the split were issued on December 1, 2003 increasing the number of common shares outstanding to 24.1 million shares. Prior year share amounts and earnings per share disclosures have been restated to reflect the stock split.

The increase in our stockholders’shareholders’ equity as of December 31, 20032005 compared to December 31, 20022004 is a result of the following:following increases and decreases.

Shareholders’ equity increased by:

 

$112.0139.1 million increase due to net income recognized for the year ended December 31, 2003.2005

 

$15.1145.4 million increasedue to issuance of common stock

$14.7 million due to increase in unrealized gains on mortgage securities classified as available-for-sale.available-for-sale

 

$9.517.6 million increasedue to impairment on mortgage securities – available for sale reclassified to earnings

$2.2 million due to compensation recognized under stock option plan

$0.9 million due to issuance of stock under stock compensation plans

$0.1 million due to forgiveness of founders’ notes receivable, and

$0.1 million due to net settlements on cash flow hedges reclassified to earnings.

Shareholders’ equity decreased by:

 

$2.2171.3 million decrease due to increase in unrealized losses on derivative instruments used in cash flow hedges.

$93.9 million increase due to issuance of common stock.

$1.3 million increase due to compensation recognized under stock option plan.

$1.6 million increase due to exercise of stock options.

$114.3 million decrease due to dividends accrued or paid on common stock.stock

 

$0.16.7 million increase due to forgiveness of founders’ notes receivable.dividends accrued on preferred stock

 

$4.1 million due to dividend equivalent rights (DERs) on vested stock options, and

$0.3 million due to tax benefit derived from stock compensation plans.

Results of Operations

 

During the year ended December 31, 2003,2005, we earned net income available to common shareholders of $112.0$132.5 million, $4.91or $4.42 per diluted share, compared with net income of $48.8$109.1 million, $2.25or $4.24 per diluted share and of $32.3$112.0 million, $1.51or $4.91 per diluted share, for the same periods of 20022004 and 2001,2003, respectively.

 

Our primary sources of revenue are interest earned on our mortgage loan and securities portfolios, fees from borrowersfee income and gains on the sales and securitizations of mortgage loans. Earningsassets. As discussed under “Executive Overview of Performance,” net income available to common shareholders increased during 20032005 as compared to 2002 and 20012004 due primarily toto:

Higher average balance and higher volumes of averagenet yield on our mortgage securities held andin our mortgage loan originations securitized. The effectsportfolio management segment. See “Mortgage Portfolio Management Results of the higher mortgage security volume is displayed in Table 6. Details regarding higher mortgage loan origination volumes and gains on securitizationOperations” for further discussion of these assets are shownfactors.

Growth in Tables 1, 8 and 9.our servicing portfolio as well as increased interest income on servicing funds we hold as custodian driven by higher short-term interest rates in our loan servicing segment. See “Loan Servicing Results of Operations” for further discussion of these factors.

These increases helped offset the decline in net income available to common shareholders of our mortgage lending segment which was driven by declining profit margins within the mortgage banking industry. See “Mortgage Lending Results of Operations.”

 

As discussed under “Significance of Estimates and Critical Accounting Policies,” priorOur net income decreased to 2003, we accounted for stock-based compensation plans under the recognition and measurement provisions of APB No. 25 and related interpretations. During the fourth quarter of 2003, we adopted the fair value recognition provisions of SFAS No. 123. We selected the modified prospective method of adoption described$109.1 million in SFAS No. 148. Under this method, the change is retroactive to January 1, 2003 and compensation cost recognized2004 from $112.0 million in 2003 is the same as that which would have been recognized had the fair value method of SFAS No. 123 been applied from its original effective date. In adopting SFAS No. 123 retroactive to January 1, 2003, we recorded a net credit (reversal of expense) to compensation and benefits expense of $7.1 million relatingdue to the nine months ended September 30, 2003. decline in net yield on our mortgage securities to $27.2% in 2004 from 31.3% and declining profit margins within the mortgage lending segment.

Results for prior years have not been restated.

Net Interest Incomeof Operations by Our Primary Operating Segments

 

Mortgage Portfolio Management Results of Operations

The following table summarizes key performance data for the years ended December 31, 2005, 2004 and 2003 which we use to assess the results of operations of our mortgage portfolio management segment. See also Note 16 to the consolidated financial statements for condensed statements of income by segment.

Table 8 — Summary of Mortgage Portfolio Management Key Performance Data

(dollars in thousands)

   Year Ended December 31,

 
   2005

  2004

  2003

 

Mortgage Portfolio Management:

             

Mortgage Portfolio loans under management (A)

  $12,752,307  $11,410,147  $6,525,093 

Average balance of mortgage portfolio loans under management (A)

   12,052,775   8,503,493   4,432,647 

Net income

   163,823   111,506   98,683 

Mortgage portfolio management net interest income (B)

   174,666   118,350   91,214 

Impairment on mortgage securities – available-for-sale

   (17,619)  (15,902)  —   

Other income

   22,911   16,651   17,185 

General and administrative expenses

   14,450   7,473   6,667 

Net yield on mortgage securities

   32.3%  27.2%  31.3%

Mortgage portfolio management net interest yield on assets

   1.45%  1.39%  2.06%

(A)Includes the principal balance of loans in off-balance sheet securitizations as well as the principal balance of loans in the held-in-portfolio category on our balance sheet.
(B)This metric is based on mortgage portfolio management net interest income as calculated in Table 10 below.

Net Income. Within our mortgage portfolio management segment, we earned net income of $163.8 million, $111.5 million and $98.7 million for the years ended December 31, 2005, 2004 and 2003, respectively. The main factors driving mortgage portfolio management’s net income are explained in detail in the following discussion of its results of operations.

Mortgage Portfolio Net Interest Income. Our mortgage securities primarily represent our ownership in the net cash flows of the underlying mortgage loan collateral in excess of bond expenses and cost of funding. The cost of funding is indexed to one-month LIBOR. As one-month

LIBOR decreased dramatically in 2001 and 2002, the net cash flows we received increased correspondingly. On the other hand,resets monthly while the coupon on the mortgage loan collateral has adjustedadjusts more slowly. Therefore, the accretable yield (interest rate) on our older securities significantly increased during 2001 and 2002. Our older securities continue to experience unusually high yields. The spread on our new mortgage loans has returned to expected or normal levels as the couponslowly depending on the mortgage securities has adjusted downward. Additionally, incontractual terms of the loan. In 2002, we began transferring interest rate agreements at the time of securitization into the securitization trusts to help reduceprovide protection to the third-party bondholders from interest rate risk and to decrease the volatility of the future cash flows on our mortgage securities. As a result, future interest income on our mortgage securities is expected to be less volatile.

While the spreads on the newer securities have decreased, the overall interest income continues to be high due to the sizeable increase in our mortgage securities retained. Based on these factors, as shown in Table 6, we experienced a decrease in the average net yield on our securities from 40.6% for the year ended December 31, 2002 to 31.3% for the same period of 2003. Mortgage security net yield for the year ended December 31, 2001 was 14.5%

The overall dollar volume of interest income has increased primarily because the size of our mortgage securities portfolio has increased significantly during the past year. As shown in Tables 6 and 7, the average value of our mortgage securities increased from $132.3 million and $67.6 million during the years ended December 31, 2002 and 2001, respectively, to $288.4 million during the year ended December 31, 2003. The average balance of mortgage loans collateralizing our securities increased from $2.1 billion in 2002 to $4.3 billion in 2003. We expect to increase the amount of mortgage securities we own as we securitize the mortgage loans we originate.

As previously discussed, the trust that issues our interest-only securities owns interest rate agreements.risk. These agreements reduce interest rate risk within the trust and, as a result, the cash flows we receive on our interest-only securities are less volatile as interest rates change.

Net interest income As discussed under the heading “Mortgage Securities – Available-for-Sale” in the “Critical Accounting Estimates” section, we lowered the credit loss assumptions on certain of our mortgage loans represents income on loans held-for-sale during their warehouse period as well as loans held-in-portfolio, which are maintainedsecurities – available-for-sale because of better than expected credit loss performance, driven by the substantial increases in housing prices. The lowering of these credit loss assumptions was a major factor in the increased average net yield on our balance sheet as a result of the four securitization transactions we executed in 1997 and 1998. Net interest income on mortgage loans before other expense increased from $25.8 million and $20.7 millionsecurities to $32.3% for the yearsyear ended December 31, 2002 and 2001, respectively to $39.9 million2005 from 27.2% for the same period of 2003. Thein 2004, as shown in Table 9.

Also contributing to the increase in overall net interest income fromwas the sizeable increase in our mortgage loans is primarily driven by loan volumesecurities retained. As shown in Tables 9 and 10, the amount of time held-for-sale loans are in the warehouse.

Future net interest income will be dependent upon the size and volumeaverage fair value of our mortgage securities increased to $531.0 million during the year ended December 31, 2005 from $425.4 million during the year ended December 31, 2004, while the average balance of mortgage loans collateralizing our securities increased to $12.0 billion for the year ended December 31, 2005 from $8.4 billion for the same period in 2004.

In our current environment of tight margins, generally, we would expect the net yield on our mortgage securities to decrease in 2006 as our older higher-yielding securities pay down and loan portfolios and economic conditions.are replaced by new lower-yielding securities, assuming all other factors unchanged.

Despite the decline in net yield on our mortgage securities to 27.2% in 2004 from 31.3% in 2003, overall net interest income continued to increase during the year as the increase in the average fair value of our mortgage securities rose to $425.4 million in 2004 from $288.4 million.

 

Table 69 is a summary of the interest income and expense related to our mortgage securities and the related yields as a percentage of the fair market value of these securities for the three years ended December 31, 2003.2005.

 

Table 69 — Mortgage Securities InterestNet Yield Analysis

(dollars in thousands)


   December 31,

 
   2003

  2002

  2001

 

Average fair market value of mortgage securities

  $288,361  $132,250  $67,588 

Average borrowings

   222,653   89,612   37,004 

Interest income

   98,804   56,481   11,706 

Interest expense

   8,676   2,834   1,911 
   


 


 


Net interest income

  $90,128  $53,647  $9,795 
   


 


 


Yields:

             

Interest income

   34.3%  42.7%  17.3%

Interest expense

   3.9   3.2   5.2 
   


 


 


Net interest spread

   30.4%  39.5%  12.1%
   


 


 


Net Yield

   31.3%  40.6%  14.5%
   


 


 


   Year Ended December 31,

 
   2005

  2004

  2003

 

Average fair market value of mortgage securities

  $530,999  $425,400  $288,361 

Average borrowings

   270,109   337,282   222,653 

Interest income

   188,856   133,633   98,804 

Interest expense

   17,398   18,091   8,676 
   


 


 


Net interest income

  $171,458  $115,542  $90,128 
   


 


 


Yields:

             

Interest income

   35.6%  31.4%  34.3%

Interest expense

   6.5   5.4   3.9 
   


 


 


Net interest spread

   29.1%  26.0%  30.4%
   


 


 


Net Yield

   32.3%  27.2%  31.3%
   


 


 


 

All of NovaStar’sOur portfolio income comes from mortgage loans either directly (mortgage loans held-in-portfolio) or indirectly (mortgage securities). Table 710 attempts to look through the balance sheet presentation of the Company’sour portfolio income and present income as a percentage of average assets under management. The net interest income for mortgage securities and mortgage loans held-in-portfolio reflects the income after interest expense, hedging, prepayment penalty income and credit expense (mortgage insurance and credit losses). This metric

allows the Companyus to be more easily compared to other finance companies or financial institutions that use on balance sheet portfolio accounting, where return on assets is a common performance calculation.

 

TheOur portfolio net interest incomeyield on assets was 1.45% for the year ended December 31, 2005 as compared to 1.39% and 2.06% respectively, for the same period of 2004 and 2003. The increase in yield from 2004 to 2005 can be attributed to the lower than expected credit losses due to rising housing prices which resulted in the lowering of our credit loss assumptions on certain mortgage securities available-for-sale as previously discussed. In addition, net settlement expense on non-cash flow hedging derivatives was lower in 2005 compared with 2004 as short-term interest rates have increased in 2005.

We generally expect our net interest yield on portfolio assets to be in the range of 1% to 1.25% over the long term. The decrease in yield from 2004 to 2003 was the result of a significant decline in the spreads on our mortgage loans held-for-sale and mortgage loans held-in-portfolio reflectsecurities because of the income afterincrease in short-term interest expense, hedging, servicing, prepayment penalty income and credit expense (mortgage insurance and provision to loss reserve).rates in 2004. Table 710 shows the net interest yield in bothon assets under management and the return on assets during the three years ended December 31, 2003.2005.

Table 710 — Mortgage Portfolio Management Net Interest Income Analysis

(dollars in thousands)


   Mortgage
Securities


  Mortgage
Loans
Held-for-
Sale


  Mortgage
Loans
Held-in-
Portfolio


  Total

 

For the Year Ended:

                 

December 31, 2003

                 

Interest income

  $98,804  $60,878  $10,738  $170,420 

Interest expense:

                 

Short-term borrowings (A)

   3,450   20,060   —     23,510 

Asset-backed bonds

   5,226   —     2,269   7,495 

Cash flow hedging net settlements

   —     2,871   6,488   9,359 
   


 


 


 


Total interest expense

   8,676   22,931   8,757   40,364 
   


 


 


 


Mortgage portfolio net interest income before other expense

   90,128   37,947   1,981   130,056 

Other expense (B)

   —     (11,507)  (895)  (12,402)
   


 


 


 


Mortgage portfolio net interest income

  $90,128  $26,440  $1,086  $117,654 
   


 


 


 


Average balance of the underlying loans

  $4,316,599  $792,991  $116,048  $5,225,638 

Net interest yield on assets

   2.09%  3.33%  0.94%  2.25%
   


 


 


 


December 31, 2002

                 

Interest income

  $56,481  $33,736  $16,926  $107,143 

Interest expense:

                 

Short-term borrowings (A)

   2,107   10,406   —     12,513 

Asset-backed bonds

   727   —     4,195   4,922 

Cash flow hedging net settlements

   —     1,672   8,621   10,293 
   


 


 


 


Total interest expense

   2,834   12,078   12,816   27,728 
   


 


 


 


Mortgage portfolio net interest income before other expense

   53,647   21,658   4,110   79,415 

Other expense (B)

   —     (11,782)  (1,624)  (13,406)
   


 


 


 


Mortgage portfolio net interest income

  $53,647  $9,876  $2,486  $66,009 
   


 


 


 


Average balance of the underlying loans

  $2,080,955  $395,394  $172,954  $2,649,303 

Net interest yield on assets

   2.58%  2.50%  1.44%  2.49%
   


 


 


 


December 31, 2001

                 

Interest income

  $11,706  $19,507  $26,691  $57,904 

Interest expense:

                 

Short-term borrowings (A)

   1,911   8,546   —     10,457 

Asset-backed bonds

   —     —     14,874   14,874 

Cash flow hedging net settlements

   —     —     2,035   2,035 
   


 


 


 


Total interest expense

   1,911   8,546   16,909   27,366 
   


 


 


 


Mortgage portfolio net interest income before other expense

   9,795   10,961   9,782   30,538 

Other expense (B)

   —     (1,599)  (6,156)  (7,755)
   


 


 


 


Mortgage portfolio net interest income

  $9,795  $9,362  $3,626  $22,783 
   


 


 


 


Average balance of the underlying loans

  $1,037,352  $266,287  $191,972  $1,495,611 

Net interest yield on assets

   0.94%  3.52%  1.89%  1.52%
   


 


 


 


   

Mortgage

Securities


  

Mortgage

Loans

Held-in-

Portfolio


  Total

 

For the Year Ended:

             

December 31, 2005

             

Interest income

  $188,856  $4,311  $193,167 

Interest expense:

             

Short-term borrowings (A)

   1,770   —     1,770 

Asset-backed bonds

   15,628   1,630   17,258 
   


 


 


Total interest expense

   17,398   1,630   19,028 
   


 


 


Mortgage portfolio management net interest income before other expense

   171,458   2,681   174,139 

Other income (expense) (B)

   1,651   (1,124)  527 
   


 


 


Mortgage portfolio management net interest income

  $173,109  $1,557  $174,666 
   


 


 


Average balance of the underlying loans

  $12,006,929  $45,846  $12,052,775 

Mortgage portfolio management net interest yield on assets

   1.44%  3.40%  1.45%
   


 


 


December 31, 2004

             

Interest income

  $133,633  $6,673  $140,306 

Interest expense:

             

Short-term borrowings (A)

   4,836   —     4,836 

Asset-backed bonds

   13,255   1,422   14,677 

Cash flow hedging net settlements

   —     1,558   1,558 
   


 


 


Total interest expense

   18,091   2,980   21,071 
   


 


 


Mortgage portfolio management net interest income before other expense

   115,542   3,693   119,235 

Other income (expense) (B)

   368   (1,253)  (885)
   


 


 


Mortgage portfolio management net interest income

  $115,910  $2,440  $118,350 
   


 


 


Average balance of the underlying loans

  $8,431,708  $71,785  $8,503,493 

Mortgage portfolio management net interest yield on assets

   1.37%  3.40%  1.39%
   


 


 


December 31, 2003

             

Interest income

  $98,804  $10,738  $109,542 

Interest expense:

             

Short-term borrowings (A)

   3,450   —     3,450 

Asset-backed bonds

   5,226   2,269   7,495 

Cash flow hedging net settlements

   —     6,488   6,488 
   


 


 


Total interest expense

   8,676   8,757   17,433 
   


 


 


Mortgage portfolio management net interest income before other expense

   90,128   1,981   92,109 

Other income (expense) (B)

   —     (895)  (895)
   


 


 


Mortgage portfolio management net interest income

  $90,128  $1,086  $91,214 
   


 


 


Average balance of the underlying loans

  $4,316,599  $116,048  $4,432,647 

Mortgage portfolio management net interest yield on assets

   2.09%  0.94%  2.06%
   


 


 



(A)Primarily includes mortgage loan and securities repurchase agreements.

(B)Other expenseincome (expense) includes servicing expense, prepayment penalty income, net settlements on non-cash flow hedges and credit expense (mortgage insurance and provision for credit losses).

Impairment on Mortgage Securities – Available-for-Sale.To the extent that the cost basis of mortgage securities—available-for-sale exceeds the fair value and the unrealized loss is considered to be other than temporary, an impairment charge is recognized and the amount recorded in accumulated other comprehensive income or loss is reclassified to earnings as a realized loss. During the year ended December 31, 2005, we recorded an impairment loss of $17.6 million compared to $15.9 million during the same period of 2004. The impairments were primarily a result of the increase in short-term interest rates during 2005 and 2004. As can be seen by Table 11, the impairments on our residual securities in 2004 and 2005 primarily related to the residual securities which were retained during that respective year. This reflects that as we retain new residual securities during a period when short-term interest rate increases are greater than anticipated by the forward yield curve, we generally are more susceptible to impairments on our newer mortgage securities as they do not have sizable unrealized gains to help offset the decline in value. The following table summarizes the impairment on our mortgage securities—available-for-sale by mortgage security for the years ended December 31, 2005 and December 31, 2004. We did not record any impairments for the year ended December 31, 2003.

Table 11 — Impairment on Mortgage Securities – Available-for-Sale by Mortgage Security

(dollars in thousands)

   For the Year Ended December 31

   2005

  2004

Mortgage Securities – Available-for-Sale:

        

NMFT Series 1999-1

  $117  $87

NMFT Series 2004-1

   —     6,484

NMFT Series 2004-2

   —     7,384

NMFT Series 2004-2

   —     1,947

NMFT Series 2004-4

   1,496   —  

NMFT Series 2005-1

   1,426   —  

NMFT Series 2005-2

   7,027   —  

NMFT Series 2005-3

   7,553   —  
   

  

Impairment on mortgage securities – available-for-sale

  $17,619  $15,902
   

  

Other Income. Other income for our mortgage portfolio management segment represents intercompany fees earned by the mortgage portfolio management segment and, as such, these fees are eliminated in consolidation and therefore have no impact on consolidated earnings. These intercompany fees are detailed in Note 16 of our consolidated financial statements. Other income also includes mark-to-market gains (losses) on our trading securities as well as interest income earned from the short-term investment of corporate funds.

General and Administrative Expenses.Our mortgage portfolio management segment’s general and administrative expenses increased to $14.5 million for the year ended December 31, 2005 from $7.5 million and $6.7 million for the years ended December 31, 2004 and 2003, respectively. The significant increase from 2004 to 2005 is primarily due to the increase in provision for excise taxes, which is discussed under “Income Taxes”.

Mortgage Lending Results of Operations

The following table summarizes key performance data for the years ended December 31, 2005, 2004 and 2003, which we use to assess the results of operations of our mortgage lending segment.

Table 12 — Summary of Mortgage Lending Key Performance Data

(dollars in thousands)

   For the Year Ended December 31,

 
   2005

  2004

  2003

 

Mortgage Lending:

             

Net (loss) income

  $(21,331) $14,029  $11,877 

Mortgage lending net interest income (A)

   44,704   29,107   26,440 

Gains on sales of mortgage assets

   49,303   113,211   140,870 

Gains (losses) on derivative instruments

   17,907   (8,794)  (29,943)

Premiums for mortgage loan insurance

   (5,331)  (3,690)  (2,194)

Other expense

   (7,788)  (6,445)  (12,369)

General and administrative expenses

   128,619   127,063   118,935 

Nonconforming originations

   9,283,138   8,424,361   5,250,978 

Weighted average coupon of nonconforming originations

   7.7%  7.6%  7.3%

Costs of wholesale production, as a percent of principal

   2.39%  2.53%  2.40%

Nonconforming loans securitized

   7,621,030   8,329,804   5,319,435 

Nonconforming loans sold to third parties

   1,138,098   —     151,210 

Net whole loan price used in initial valuation of residual securities

   102.00%  103.28%  104.21%

Mortgage lending gains on sales of loans transferred in securitizations, as a % of principal sold (B)

   0.5%  1.4%  2.5%

(A)This metric is based on mortgage lending net interest income as calculated in Table 13.
(B)The difference between mortgage lending gains on sales of loans transferred in securitizations in this table and the consolidated gains on sales of loans transferred in securitizations as reported in Note 2 to loss reserve).the consolidating financials is related to intersegment eliminations. See Note 16 to the consolidated financial statements for discussion of eliminations between segments. See also Tables 14 and 15 for further details of how these metrics are calculated.

 

Net (Loss) Income. Our mortgage lending segment reported net (loss) income of $(21.3) million, $14.0 million and $11.9 million for the years ended December 31, 2005, 2004 and 2003, respectively. We experienced significant profit margin compression driven by the highly competitive mortgage banking environment in 2005. The details of this margin compression are discussed under “Executive Overview of Performance.”

Even though profit margins were declining in 2004, we were able to increase our net income due to the increase in the volume of loans we securitized to $8.3 billion in 2004 from $5.3 billion in 2003. For the years ended December 31, 2004 and 2003, the weighted average net whole loan price used in the initial valuation of our retained securities was 103.28 and 104.21, respectively, and the weighted average gain on securitization as a percentage of loan principal securitized was 1.4% and 2.5%, respectively.

Loan Originations and Purchases. Our mortgage lending segment reported nonconforming loan production of $9.3 billion for the year ended December 31, 2005 as compared to $8.4 billion and $5.3 billion for the years ended December 31, 2004 and 2003, respectively. The weighted average coupon of the loans originated or purchased increased slightly to 7.7% for the year ended December 31, 2005 from 7.6% and 7.3% for the years ended December 31, 2004 and 2003, respectively. Coupons on loans we originated in 2005 increased only slightly from 2004 originations due to competitive pressures within the industry. Late in 2005, coupons on new originations did increase across the nonconforming mortgage banking industry. However, competitive pressures may not allow us to raise mortgage coupons at a rate commensurate with increases in short-term interest rates, which drive our funding costs.

Mortgage lending Net Interest Income. Mortgage lending net interest income on mortgage loans represents income on loans held-for-sale prior to being sold to a third party or in a securitization. The net interest income from loans is primarily driven by loan volume and the amount of time held-for-sale loans are held prior to being sold to a third party or in a securitization.

ImpactTable 13 — Mortgage Lending Net Interest Yield Analysis

(dollars in thousands)

   For the Year Ended December 31,

 
   2005

  2004

  2003

 

Interest income

  $106,118  $83,757  $60,878 

Interest expense:

             

Short-term borrowings

   58,654   30,013   20,060 

Cash flow hedging net settlements

   180   1,514   2,871 
   


 


 


Total interest expense (A)

   58,834   31,527   22,931 
   


 


 


Mortgage lending net interest income before other expense

   47,284   52,230   37,947 

Other expense (B)

   2,580   23,123   11,507 
   


 


 


Mortgage lending net interest income

  $44,704  $29,107  $26,440 
   


 


 


Average balance of the underlying loans

  $1,344,569  $1,113,736  $792,991 

Mortgage lending net interest yield on assets

   3.32%  2.61%  3.33%
   


 


 



(A)Does not include interest expense related to the junior subordinated debentures and interest expense on intercompany debt. See Note 16 to the consolidated financial statements for discussion of eliminations between segments.
(B)Other expense includes net settlements on non-cash flow hedges and mortgage insurance expense.

Our mortgage lending net interest income before other expense decreased to $47.3 million for the year ended December 31, 2005 from $52.2 million for the year ended December 31, 2004. The decrease was a result of Interest Rate Agreements.the significant rise in short-term rates throughout 2005, which increases our borrowing expense, while the coupons on our mortgage loans we originated and purchased modestly increased from 2004. We were able to offset some of the negative effects of these tighter margins with an increase in our average balance of the underlying loans which was driven by increased nonconforming production in 2005 compared to 2004. Again, the total amount of mortgage lending net interest income will depend on the volume of originations and timing of our sales. The net interest yield will vary depending on the movement in mortgage loan coupons and our funding costs.

Our mortgage lending net interest income before other expense increased to $52.2 million for the year ended December 31, 2004 from $37.9 million for the year ended December 31, 2003. The increase was a result of the 40% increase in the average balance of the underlying loans in 2004 as compared to 2003.

We have executed interest rate cap and interest rate swap agreements designed to mitigate exposure to interest rate risk on short-term borrowings. Interest rate cap agreements require us to pay either a one-time “up front” premium or a monthly or quarterly premium, while allowing us to receive a rate that adjusts with LIBOR when rates rise above a certain agreed-upon rate. Interest rate swap agreements allow us to pay a fixed rate of interest while receiving a rate that adjusts with one-month LIBOR. These agreements are used to alter, in effect, the interest rates on funding costs to more closely match the yield on interest-earning assets. WeOur mortgage lending segment incurred expenses of $9.4$0.2 million, $10.3$1.5 million and $2.0$2.9 million related to thesenet settlements of our interest rate agreements classified as cash flow hedges for the three years ended December 31, 2005, 2004 and 2003, 2002,respectively. Our mortgage lending segment earned (incurred) $2.8 million, $(19.4) million and 2001,$(9.3) million related to net settlements of our interest rate agreements classified as non-cash flow hedges for the years ended December 31, 2005, 2004 and 2003, respectively. These amounts are included in Table 13 above. Fluctuations in these expenses are solely dependent upon the movement in LIBOR as well as our average notional amount outstanding.

 

Credit Recoveries (Losses)

We originate and own loans in which the borrower possesses credit risk higher than that of conforming borrowers. Delinquent loans and losses are expected to occur. Provisions for credit losses are made in amounts considered necessary to maintain an allowance at a level sufficient to cover probable losses inherent in the loan portfolio. Charge-offs are recognized at the time of foreclosure by recording the value of real estate owned property at its estimated realizable value. One of the principal methods used to estimate expected losses is a delinquency migration analysis. This analysis takes into consideration historical information regarding foreclosure and loss severity experience and applies that information to the portfolio at the reporting date.

We use several techniques to mitigate credit losses including pre-funding audits by quality control personnel and in-depth appraisal reviews. Another loss mitigation technique allows a borrower to sell their property for less than the outstanding loan balance prior to foreclosure in transactions known as short sales, when it is believed that the resulting loss is less than what would be realized through foreclosure. Loans are charged off in full when the cost of pursuing foreclosure and liquidation exceed recorded balances. While short sales have served to reduce the overall severity of losses incurred, they also accelerate the timing of losses. As discussed further under the caption “Premiums for Mortgage Loan Insurance”, lender paid mortgage insurance is also used as a means of managing credit risk exposure. Generally, the exposure to credit loss on insured loans is considered minimal. Management also believes the loan servicing operation is an important element to managing credit risk.

During the years ended December 31, 2003, 2002 and 2001 we recognized credit recoveries (losses) of $0.4 million, $0.4 million and $(3.6) million, respectively and incurred net charge-offs of $1.3 million, $2.1 million and $5.7 million, respectively. A rollforward of the allowance for credit losses for the three years ended December 31, 2003 is presented in Note 2 to the consolidated financial statements.

Fee Income

Fee income primarily consists of fees from five sources: broker fees, loan origination fees, service fee income, branch management fees and prepayment penalty income.

Broker fees are paid by borrowers and other lenders for placing loans with third party investors (lenders) and are based on negotiated rates with each lender to whom we broker loans. Revenue is recognized upon loan origination.

Loan origination fees represent fees paid to us by borrowers and are associated with the origination of mortgage loans. Loan origination fees are determined based on the type and amount of loans originated. Loan origination fees and direct origination costs on mortgage loans held-in-portfolio are deferred and recognized over the life of the loan using the level yield method. Loan origination fees and direct origination costs on mortgage loans held-for-sale are deferred and considered as part of the carrying value of the loan when sold.

Service fees are paid to us by either the investor on mortgage loans serviced or the borrower. Fees paid by investors on loans serviced are determined as a percentage of the principal collected for the loans serviced and are recognized in the period in which payments on the loans are received. Fees paid by borrowers on loans serviced are considered ancillary fees related to loan servicing and include late fees, processing fees and, for loans held-in-portfolio, prepayment penalties. Revenue is recognized on fees received from borrowers when an event occurs that generates the fee and they are considered to be collectible.

Affiliated branch management fees are charged to affiliated mortgage brokers to manage their administrative operations, which include providing accounting, payroll, human resources, loan investor management and license management. The amount of the fees is agreed upon when entering a contractual agreement with affiliated mortgage brokers and are recognized as services are rendered.

Prepayment penalty income are the fees we require the borrower to pay if they pay off their loan early in the loan’s life, generally within two years of origination. This income serves to mitigate and offset prepayment risk and the amortization expense of premiums we paid to loan brokers. The penalty is generally six months of interest on

80% of the unpaid principal at prepayment. Prepayment penalty income was $311,000, $432,000 and $790,000 during the years ended December 31, 2003, 2002 and 2001, respectively.

Fee income increased from $36.0 million and $21.0 million for the twelve months ended December 31, 2002 and 2001, respectively, to $68.3 million for the same period of 2003 due to the following reasons:

Loans originated, including conforming loans, increased from $2.8 billion and $1.3 billion for the twelve months ended December 31, 2002 and 2001, respectively, to $6.0 billion for the same period of 2003.

Our servicing portfolio increased from $3.7 billion and $2.0 billion for the year ended December 31, 2002 and 2001, respectively, to $7.2 billion for the year ended December 31, 2003.

The number of NHMI LLC branches increased from 207 and 108 at December 31, 2002 and 2001, respectively, to 423 at December 31, 2003.

Gains on Sales of Mortgage Assets and Losses on Derivative Instruments

.We execute securitization transactions in which we transfer mortgage loan collateral to an independent trust. The trust holds the mortgage loans as collateral for the securities it issues to finance the sale of the mortgage loans. In those transactions, certain securities are issued to entities unrelated to us, and we retain the interest-onlyresidual securities and non-investment gradecertain subordinated securities. In addition, we continue to service the loan collateral. These transactions were structured as sales for accounting and income tax reporting during the three years ended December 31, 2003, 20022005.

As previously discussed, we experienced significant profit margin compression driven by the highly competitive mortgage banking environment in 2005. These factors contributed to the whole loan price used in valuing our mortgage securities at the time of securitization to significantly decrease throughout 2004 and 2001. Wholeinto 2005, which is directly correlated to the decrease in gains on sales of mortgage loans as a percentage of loan principal securitized.

Table 14 — Mortgage Loan Securitizations

(dollars in thousands)

   

Mortgage Loans

Transferred in Securitizations


 
               Weighted Average Assumptions Underlying
Initial Value of Mortgage Securities –
Available-for-Sale


 

For the Year Ended

December 31,


  

Principal

Amount


  

Mortgage
Lending

Net Gain

As a % of
Principal (A)


  

Consolidated

Net Gain

Recognized As a
% of Principal


  Initial Cost Basis
of Mortgage
Securities


  Constant
Prepayment
Rate


  Discount
Rate


  Expected Total
Credit Losses, Net
of Mortgage
Insurance


 

2005

  $7,621,030  0.5% 0.8% $332,420  40% 15% 2.47%
   

  

 

 

  

 

 

2004

  $8,329,804  1.4% 1.7% $381,833  33% 22% 4.77%
   

  

 

 

  

 

 

2003

  $5,319,435  2.5% 2.6% $292,675  26% 22% 3.55%
   

  

 

 

  

 

 


(A)The difference between mortgage lending gains on sales of loans transferred in securitizations and consolidated gains on sales of loans transferred in securitizations as reported in Note 2 to the consolidating financials is related to intersegment eliminations. See Note 16 to the consolidated financial statements for discussion of eliminations between segments.

Table 14 further illustrates the fact that housing prices have enjoyed substantial appreciation in recent years, which has resulted in prepayment rates increasing while credit losses are decreasing. Also illustrated is the fact that profit margins are down as the market discount rates we are using to initially value our mortgage securities have declined from 2004 and 2003.

In 2005, we executed sales have also been executed whereby we sellof whole pools of loans to third parties. In the outright sales of mortgage loans, we retain no assets or servicing rights. We generally will sell loans to third parties which do not possess the economic characteristics which meet our long-term portfolio management objectives. Table 915 provides a summary of gains on mortgage loans sold outright and transferredto third parties. We sold $1.1 billion in securitizations.nonconforming mortgage loans to third parties during the year ended December 31, 2005, recognizing net gains of $9.9 million from these sales with a weighted average price to par of the loans sold of 102.01. There were no nonconforming mortgage loan sales during 2004. We sold $151.2 million in nonconforming mortgage loans to third parties during the year ended December 31, 2003, recognizing net gains of $3.4 million from these sales with a weighted average price to par of the loans sold of 104.10.

 

DuringTable 15 provides the third quartercomponents of 2001, we resecuritized AAA-rated interest-only and prepayment penalty securities issued in 2000.our gains on sales of mortgage assets within the mortgage lending segment. This transaction, CAPS 2001-1, was structured as a sale for financial reporting and income tax purposes. Senior bonds intable also helps to reconcile the amountgains on sales of $29.3 million were soldmortgage assets of the mortgage lending segment to the public. We retained a subordinated interest, the CAPS 2001-1 C1 bond, and recognized a gainour consolidated gains on sales of $14.9 million. For tax purposes, this gain was capital in nature and offsets existing capital losses we incurred in 1998. In October 2002, the senior bond was fully repaid and the AAA-rated interest-only and prepayment penalty securities were transferred back to us by the trust.mortgage assets.

 

Table 15 — Mortgage Lending Gains (Losses) on Sales of Mortgage Assets

(dollars in thousands)

   For the Year Ended December 31,

 
   2005

  2004

  2003

 

Gains on sales of mortgage loans transferred in securitizations

  $40,267  $112,873  $132,294 

Gains on sales of mortgage loans to third parties – nonconforming

   9,918   —     3,404 

Gains on sales of mortgage loans to third parties – conforming

   145   1,435   5,904 

Losses on sales of real estate owned

   (1,027)  (1,097)  (732)
   


 


 


Mortgage lending gains on sales of mortgage assets

   49,303   113,211   140,870 

Plus: Mortgage portfolio management and branch operations gains (losses) on sales of mortgage assets

   3,638   360   (1,911)

Plus: Intersegment eliminations related to loans securitized (A)

   15,232   31,379   5,046 
   


 


 


Consolidated gains on sales of mortgage assets

  $68,173  $144,950  $144,005 
   


 


 



(A)See Note 16 to the consolidated financial statements for discussion of eliminations between segments.

Gains (Losses) on Derivative Instruments.We have entered into derivative instrument contracts that do not meet the requirements for hedge accounting treatment, but contribute to our overall risk management strategy by serving to reduce interest rate risk related to short-term borrowing rates. ChangesAdditionally, we transfer certain of these derivative instruments into our securitization trusts to provide interest rate protection to the third-party bondholders. Prior to the date when we transfer these derivatives, changes in the fair value of these derivative instruments and net settlements with counterparties are credited or charged to current earnings. As

The derivative instruments we use to mitigate interest rate risk will generally increase in value as short-term interest rates have decreased since December 31, 2001, we recognized lossesdecrease and decrease in value as rates increase. Fair value, at the date of $30.8 million and $36.8 million in 2003 and 2002, respectively, reflectivesecuritization, of the corresponding decreasederivative instruments transferred into securitizations is included as part of the cost basis of the mortgage loans securitized. Derivative instruments transferred into a securitization trust are administered by the trustee in fair value ofaccordance with the trust documents. Any cash flows from these non-hedge derivative instruments. Our lossderivatives which are projected to flow to our residual securities we retain are included in the valuation. The gains (losses) on derivative instruments during 2001 was $4.0 million.

Table 8 providesin our mortgage lending segment can be summarized for the components of our gains on sales of mortgage assetsyears ended December 31, 2005, 2004 and losses on derivative instruments.2003 as follows:

 

Table 816Mortgage Lending Gains on Sales of Mortgage Assets and Losses(Losses) on Derivative Instruments

(in thousands)


   For the Year Ended December 31,

 
   2003

  2002

  2001

 

Gains on sales of mortgage loans transferred in securitizations

  $136,302  $47,894  $21,730 

Gains on sales of mortgage loans to third parties – nonconforming

   3,404   2,299   954 

Gains on sales of mortgage loans to third parties – conforming

   6,942   3,903   171 

Gain on sale of mortgage securities

   —     —     14,946 

Losses on sales of real estate owned

   (2,643)  (791)  (454)
   


 


 


Gains on sales of mortgage assets

   144,005   53,305   37,347 

Losses on derivatives

   (30,837)  (36,841)  (3,953)
   


 


 


Net gains on sales of mortgage assets and derivative instruments

  $113,168  $16,464  $33,394 
   


 


 


Table 9 — Mortgage Loan Sales and Securitizations

(dollars in thousands)


   Outright Mortgage Loan Sales (A)

For the Year Ended December 31,


  Principal
Amount


  

Percent of

Total Sales


  

Net Gain (Loss)

Recognized


  

Weighted

Average Price

To Par


2003

  $151,210  2.8% $3,404  104.1
   

  

 

  

2002

  $142,159  8.4% $2,299  102.9
   

  

 

  

2001

  $73,324  5.7% $954  102.1
   

  

 

  

 

   
 
   

Mortgage Loans

Transferred in Securitizations


 
               Weighted Average Assumptions
Underlying Initial Value of Mortgage
Securities


 

For the Year Ended December 31,


  

Principal

Amount


  

Percent of

Total Sales


  

Net Gain

Recognized


  Initial Value of
Mortgage
Securities


  Constant
Prepayment
Rate


  Discount
Rate


  Expected Total
Credit Losses,
Net of
Mortgage
Insurance


 

2003

  $5,319,435  97.2% $136,302  $299,752  26  22% 3.61%
   

  

 

  

  
  

 

2002

  $1,560,001  91.6% $47,894  $92,903  29  21% 1.50%
   

  

 

  

  
  

 

2001

  $1,215,100  94.3% $21,730  $62,862  28  23% 1.20%
   

  

 

  

  
  

 

   Year Ended December 31,

 
   2005

  2004

  2003

 

Mark-to-market adjustments on derivatives transferred in securitizations

  $18,138  $3,850  $(17,009)

Other mark-to-market adjustments on derivatives during the period (A)

   (1,257)  7,215   (3,621)

Net settlements

   2,752   (19,433)  (9,313)

Mark-to-market adjustments on commitments to originate mortgage loans

   (1,726)  (426)  —   
   


 


 


Gains (losses) on derivative instruments

  $17,907  $(8,794) $(29,943)
   


 


 



(A)Does not include conforming loan sales.Consists of market value adjustments for derivatives that will be transferred in securitizations in subsequent periods as well as market value adjustments for derivatives used to hedge our balance sheet. A majority of the derivatives held at each period end will be transferred into securitizations in the subsequent period.

 

Fee Income.Our mortgage lending segment experienced a decrease in fee income to $9.2 million for the year ended December 31, 2005 from $10.4 million and $26.5 million for the years ended December 31, 2004 and 2003, respectively. Fee income for this segment primarily consists of fees on retail-originated loans brokered to third parties and credit report fees. Fee income related to loans which we originate are deferred until the related loans are securitized or sold. The credit report fee we charge is generally equal to our cost of obtaining the credit report. For loans which we did not successfully originate, the cost of obtaining these credit reports is included in general and administrative expenses. For loans which we did successfully originate, the cost is deferred until the related loans are sold or securitized. The decrease in fee income from 2003 to 2004 and from 2004 to 2005 is primarily related to the decrease in retail-originated loans brokered to third parties. In 2004, our retail business began an initiative to originate only loans which economically made sense for us to retain and securitize or sell instead of broker to third parties.

Premiums for Mortgage Loan Insurance

Insurance.The use of mortgage insurance is one method of managing the credit risk in the mortgage asset portfolio. Premiums for mortgage insurance on loans maintained on our balance sheet are paid by us and are recorded as a portfolio cost and included in the income statement under the caption “Premiums for Mortgage Loan Insurance”. These premiums totaled $3.1$5.3 million, $2.3$3.7 million and $2.7$2.2 million in 2005, 2004 and 2003, 2002 and 2001, respectively. We receivedrespectively for our mortgage insurance proceeds on claims filed of $1.9 million, $2.1 million and $3.7 million in 2003, 2002 and 2001, respectively.lending segment.

 

ManySome of the mortgage loans that serve as collateral for our mortgage securitiessecurities—available-for-sale carry mortgage insurance. When loans are securitized in transactions treated as sales, the obligation to pay mortgage insurance premiums is legally assumed by the trust. Therefore, we have no obligation to pay for mortgage insurance premiums on these loans.

 

We intend to continue to use mortgage insurance coverage as a credit management tool as we continue to originate, purchase and securitize mortgage loans. The percentage ofMortgage insurance claims on loans with mortgage insurance has decreased in 2003 and generally should be lower than 50%where a defect occurred in the future.loan origination process will not be paid by the mortgage insurer. The assumptions we use to value our mortgage securities—available-for-sale consider this risk. For the 2003-1, 2003-2, 2003-3NMFT Series 2005-1, 2005-2, 2005-3 and 2003-42005-4 securitizations, the mortgage loans that were transferred into the truststrust had mortgage insurance coverage at the time of transfer of 64%44%, 48%68%, 46%70% and 27%,60% of total principal, respectively. As of December 31, 2005, 53% of the total principal of our securitized loans had mortgage insurance coverage compared to 45% as of December 31, 2004. The amount of mortgage insurance in our 2005 securitizations increased from 2004 due to favorable market pricing in meeting our long-term portfolio management objectives.

We have the risk that mortgage insurance providers will revise their guidelines to an extent where we will no longer be able to acquire coverage on all of our new production. Similarly, the providers may also increase insurance premiums to a point where the cost of coverage outweighs its benefit. We monitor the mortgage insurance market and currently anticipate being able to obtain affordable coverage on a substantial portion of our future production to the extent we deem it is warranted.

 

Other Expense.Other expense represents intersegment fees paid to the mortgage portfolio management segment and, as such, these fees are eliminated in consolidation and therefore have no impact on consolidated earnings.

General and Administrative Expenses

The main categoriesExpenses.Our mortgage lending segment’s general and administrative expenses increased from $127.1 million and $118.9 million for the years ended December 31, 2004 and 2003, respectively, to $128.6 million for the same period of 2005. Because of our major initiative to reduce our cost to produce nonconforming loans, we were able to keep our general and administrative expenses are compensation and benefits, loan expense, travel and public relations, office administration and professional and outside services. Compensation and benefits includes employee base salaries, benefit costs and incentive compensation awards. For discussion on stock-based compensation expense includedrelatively flat from 2004 to 2005 while increasing our nonconforming originations by approximately 10%. We were able to decrease our cost to produce wholesale loans by 14 basis points in compensation and benefits, see discussion of the adoption of SFAS No. 123 under “Significance of Estimates and Critical Accounting Policies” and “Results of Operations.” Loan expense primarily includes expenses relating2005 compared to the underwriting of mortgage loans that do not fund successfully. Travel and

public relations primarily includes travel related expenses and promotional and marketing expenses. Office administration includes items such2004 as rent, depreciation, telephone, office supplies, postage, delivery, maintenance and repairs. Professional and outside services include fees for legal, accounting and other consulting services. In the normal course of business, fees are incurred for professional services related to general corporate matters and specific transactions.shown in Table 17 below.

 

The increase in general and administrative expenses from $46.5 million2003 to 2004 was primarily due to the 60% increase in 2001 to $84.6 millionnonconforming originations in 2002 and to $174.4 million in 2003 is attributable to our new retail lines of business, growth in our wholesale business, our expanding servicing operations and growth in our branch operations. As a result of this growth, we employed 1,476 people as of December 31, 2003,2004 compared with 944 and 379 as of December 31, 2002 and 2001, respectively. Note 12 to the consolidated financial statements presents a condensed income statement for our three segments, detailing our expenses by segment.2003.

 

The wholesale loan costs of production table below includes all costs paid and fees collected during the wholesale loan origination cycle, including loans that do not fund. This distinction is important as we can only capitalize as deferred broker premium and costs, those costs (net of fees) directly associated with a “funded” loan. Costs associated with loans that do not fund are recognized immediately as a component of general and administrative expenses. For loans held-for-sale, deferred net costs are recognized when the related loans are sold outright or transferred in securitizations. For loans held-in-portfolio, deferred net costs are recognized over the life of the loan as a reduction to interest income. The cost of our production is also critical to our financial results as it is a significant factor in the gains we recognize. Increased efficiencies in the nonconforming lending operation correlate to lower general and administrative costs and higher interest income and gaingains on sales of mortgage assets.

 

Table 1017 Wholesale Loan Costs of Production, as a Percent of Principal


   Gross
Loan
Production


  Premium Paid
to Broker, Net
of Fees
Collected


  

Total

Acquisition
Cost


2003

  1.69  0.71  2.40

2002

  1.93  0.78  2.71

2001

  1.98  0.63  2.61

   Overhead
Costs


  

Premium Paid to

Broker, Net of Fees
Collected


  

Total

Acquisition
Cost


2005

  1.75  0.64  2.39

2004

  1.79  0.74  2.53

2003

  1.69  0.71  2.40

The following table is a reconciliation of our wholesale overhead costs included in our cost of wholesale loan production to general and administrative expenses of the mortgage lending and loan servicing segment as shown in Note 16 to the consolidated financial statements, presented in accordance with GAAP. The reconciliation does not address premiums paid to brokers because they are deferred at origination under GAAP and recognized when the related loans are sold or securitized. We believe this presentation of wholesale overhead costs provides useful information to investors regarding our financial performance because it more accurately reflects the direct costs of loan production and allows us to monitor the performance of our core operations, which is more difficult to do when looking at GAAP financial statements, and provides useful information regarding our financial performance. Management uses this measure for the same purpose. However, this presentation is not intended to be used as a substitute for financial results prepared in accordance with GAAP.

 

Table 18 — Reconciliation of Overhead Costs, Non-GAAP Financial Measure

(dollars in thousands)

   For the Year Ended December 31,

 
   2005

  2004

  2003

 

Mortgage lending general and administrative expenses (A)

  $128,619  $127,063  $118,935 

Direct origination costs classified as a reduction in gain-on-sale

   41,548   44,641   26,351 

Other lending expenses (B)

   (32,999)  (42,930)  (65,402)
   


 


 


Wholesale overhead costs

  $137,168  $128,774  $79,884 
   


 


 


Wholesale production, principal (C)

  $7,823,677  $7,185,773  $4,735,061 

Wholesale overhead, as a percentage

   1.75%  1.79%  1.69%

(A)Mortgage lending general and administrative expenses are presented in Note 16 to the consolidated financial statements.
(B)Consists of expenses related to our retail and correspondent originations as well as other non-wholesale overhead costs.
(C)Includes loans originated through NovaStar Home Mortgage, Inc. and purchased by our wholesale division in NovaStar Mortgage, Inc. Only the costs borne by our wholesale division are included in the total cost of wholesale production.

Loan Servicing Results of Operations.

 

Loan servicing is a critical part of our business. In the opinion of management, maintaining contact with borrowers is vital in managing credit risk and in borrower retention. Nonconforming borrowers are prone to late payments and are more likely to default on their obligations than conventional borrowers. We strive to identify issues and trends with borrowers early and take quick action to address such matters.

Our loan servicing segment reported net income (loss) of $3.4 million, $1,000 and $(1.6) million for the years ended December 31, 2005, 2004 and 2003, respectively. The following table illustrates how our net annualized costs of servicing income (loss) per unit decreased from $286 and $267increased to $57 at December 31, 20012005 from $2 and 2002, respectively, to $263$(71) at December 31, 2003.2004 and 2003, respectively.

 

Table 1119 — Summary of Servicing Operations

(dollars in thousands, except per loan cost)

   2005

  2004

  2003

 
   Amount

  Per
Unit (B)


  Amount

  Per
Unit (B)


  Amount

  Per
Unit (B)


 

Unpaid principal at period end

  $14,030,697   (A) $12,151,196      $7,206,113     
   


     


     


    

Number of loans at period end

   98,287   (A)  87,543       54,196     
   


     


     


    

Average unpaid principal during the period

  $13,547,325   (A) $9,881,848      $5,384,383     
   


     


     


    

Average number of loans during the period

   96,726   (A)  72,415       41,170     
   


     


     


    

Servicing income, before amortization of mortgage servicing rights

  $68,370  $707  $41,793  $577  $20,833  $506 

Costs of servicing

   (34,515)  (357)  (24,698)  (341)  (14,793)  (359)
   


 


 


 


 


 


Net servicing income, before amortization of mortgage servicing rights

   33,855   350   17,095   236   6,040   147 

Amortization of mortgage servicing rights

   (28,364)  (293)  (16,934)  (234)  (8,995)  (218)
   


 


 


 


 


 


Servicing income (loss) before income tax

  $5,491  $57  $161  $2  $(2,955) $(71)
   


 


 


 


 


 



   2003

  2002

  2001

   Amount

  Per
Unit


  Amount

  Per
Unit


  Amount

  Per
Unit


Unpaid principal

  $7,206,113      $3,657,640      $1,994,448    
   


     

      

    

Number of loans

   54,196       28,849       17,425    
   


     

      

    

Servicing income, before amortization of mortgage servicing rights

  $20,486  $378  $12,796  $444  $8,213  $471

Costs of servicing

   14,261   263   7,703   267   4,976   286
   


 


 

  

  

  

Net servicing income, before amortization of mortgage servicing rights

   6,225   115   5,093   177   3,237   185

Amortization of mortgage servicing rights

   8,995   166   4,609   160   2,131   122
   


 


 

  

  

  

Net servicing income (loss)

  $(2,770) $(51) $484  $17  $1,106  $63
   


 


 

  

  

  

(A)Includes loans we have sold and are still servicing on an interim basis.
(B)Per unit amounts are calculated using the average number of loans during the period presented.

 

BranchesServicing Income, Before Amortization of Mortgage Servicing Rights.Servicing fees are paid to us by either the investor or the borrower on mortgage loans serviced. Fees paid by investors on loans serviced are determined as a percentage of the principal collected for the loans serviced or on a negotiated price per loan serviced and are recognized in the period in which payments on the loans are received. Fees paid by borrowers on loans serviced are considered ancillary fees related to loan servicing and include late fees, processing fees and, for loans held-in-portfolio, prepayment penalties. Revenue is recognized on fees received from borrowers when an event occurs that generates the fee and they are considered to be collectible.

 

We operate ourreceive annual servicing fees approximating 0.50% of the outstanding balance and rights to future cash flows arising after the investors in the securitization trusts have received the return for which they contracted. Servicing fees received from the securitization trusts were $59.8 million, $41.5 million and $21.1 million for the years ended December 31, 2005, 2004 and 2003, respectively. During the year ended December 31, 2005, we purchased $220,000 in principal amount of delinquent or foreclosed loans on securitizations in which we did not maintain control over the mortgage brokerage unit underloans transferred. We incurred losses of $220,000 from the name NovaStar Home Mortgage, Inc. (NHMI). Branch operations (offices) are divided into two groups: 1) branches operating under NHMI,purchase of these delinquent or foreclosed loans during the year ended December 31, 2005. No such purchases were made in the years ended December 31, 2004 and 2) branches operating as

separate companies with an administrative relationship with NHMI, identified as NHMI LLC (Limited Liability Company) branches.2003.

 

The NHMI branchesAlso included in servicing income before amortization of mortgage servicing rights for the loan servicing segment is interest income earned on servicing funds we hold as custodian. These funds consist of principal and interest collected from borrowers on behalf of the securitization trusts, as well as, funds collected from borrowers to ensure timely payment of hazard and primary mortgage insurance and property taxes related to the properties securing the loans. These funds are considered departmental functionsnot owned by us and are held in trust. We held, as custodian, $585.1 million and $471.5 million at December 31, 2005 and 2004, respectively. Other income, net for the loan servicing segment increased to $18.3 million for the year ended December 31, 2005 from $4.2 million and $0.3 million for the years ended December 31, 2004 and 2003, respectively,. This increase from 2004 to 2005 as well as from 2003 to 2004 is a result of NHMI under which the branch manager (department head) is an employee of NHMI and receives compensation basedhigher average cash balances in bank accounts where we earn income on the profitability of the branch (department) as bonus compensation. NHMI branchesaverage collected balances. In addition, we are included in the NovaStar Financial consolidated financial statements.

LLC branches are established through LLC agreements entered into between solicited brokers and NHMI. The LLC agreements provide for initial capitalization and membership interests of 99.9%earning higher rates on these balances due to the broker (branch manager)increase in short-term interest rates. This income source will continue to fluctuate as our servicing portfolio changes and 0.1% to NHMI. NHMI provides accounting, payroll, human resources, loan investor management and license management in conjunction with separate contractual agreements. We account for our minorityas short-term interest in the LLC agreements using the equity method of accounting.

As of December 31, 2003 there were a total of 432 active branches, 9 of these were NHMI branches and 423 were NHMI LLC branches. As of December 31, 2002 there were a total of 216 active branches, 9 of these were NHMI branches and 207 were NHMI LLC branches.

The NHMI and LLC branch offices offer conforming and nonconforming loans to potential borrowers. Loans are brokered for approved investors, including NovaStar Mortgage, Inc. (NMI). Of the $5.3 billion and $2.8 billion nonconforming loans we originated, 23% and 20% were brokered to NMI from the branches in 2003 and 2002, respectively.rates change.

 

Income TaxesCosts of Servicing.Our loan servicing segment’s general and administrative expenses increased to $34.5 for the year ended December 31, 2005 from $24.7 for the year ended December 31, 2004 . Our loan servicing segment’s general and administrative expenses increased to $24.7 for the year ended December 31, 2004 from $14.8 for the year ended December 31, 2003. The increase from 2004 to 2005 and from 2003 to 2004 is the direct result of the growth in our servicing portfolio.

 

NovaStar Financial, Inc. intendsAmortization of Mortgage Servicing Rights. Amortization of mortgage servicing rights increased to continue$28.4 million for the year ended December 31, 2005 from $16.9 million and $9.0 million for the years ended December 31, 2004 and 2003, respectively. Mortgage servicing rights are amortized in proportion to operate and qualifyover the estimated period of net servicing income. Generally, as the size of our servicing portfolio increases the amortization expense will increase. Additionally, prepayment speeds continued to increase in 2005 on the underlying mortgage loans of our securitizations due to borrowers taking advantage of the equity they have built up in their

homes as a Real Estate Investment Trust (REIT) underresult of substantial increases in housing prices in recent years. During periods of increasing loan prepayments, the requirementsamortization on our mortgage servicing rights will increase. See Table 5 for a summary of our expected prepayment rate assumptions by securitization trust.

Branch Operations Results of Operation and Discontinued Operations

Our branch operations segment reported net income (loss) from continuing operations of $(4.1) million, $(11.7) million and $3.5 million for the years ended December 31, 2005, 2004 and 2003, respectively. As the demand for conforming loans declined significantly during 2004 and into 2005, many branches have not been able to produce sufficient fees to meet operating expense demands. As a result of these conditions, a significant number of branch managers voluntarily terminated employment with us. We also terminated branches when loan production results were substandard. In these terminations, the branch and all operations are eliminated. The operating results for these discontinued operations have been segregated from our on-going operating results. Our loss from discontinued operations net of income taxes for the years ended December 31, 2005 and 2004 was $4.5 million and $11.3 million, respectively. On November 4, 2005, we adopted a formal plan to terminate substantially all of the Internal Revenue Code. Therefore, it will generally notremaining NHMI branches. We had 16 branches remaining at December 31, 2005 and we expect all of these branches to be subjectterminated by June 30, 2006. Note 15 to federal income taxes atour consolidated financial statements provides detail regarding the corporate level on taxable income distributedimpact of the discontinued operations.

Income Taxes

Since our inception, NFI has elected to stockholders. Requirements for qualificationbe treated as a REIT include various restrictions on common stock ownership andfor federal income tax purposes. As a REIT, NFI is not required to pay any corporate level income taxes as long as we distribute 100 percent of our taxable income in the natureform of dividend distributions to our shareholders. To maintain our REIT status, NFI must meet certain requirements prescribed by the assets and sources of income.Code. We intend to operate NFI in a manner that allows us to meet these requirements.

 

Below is a summary of the taxable net income available to common shareholders for the years ended December 31, 2003, 20022005, 2004 and 2001.2003.

 

Table 1220 — Taxable Net Income

(dollars in thousands)

   For the Year Ended December 31,

 
   2005
Estimated


  2004
Actual


  2003
Actual


 

Consolidated net income

  $139,124  $115,389  $111,996 

Equity in net loss (income) of NFI Holding Corp

   24,678   (2,517)  (27,737)

Consolidation eliminations between the REIT and TRS

   2,073   2,800   7,686 
   


 


 


REIT net income

   165,875   115,672   91,945 

Adjustments to net income to compute taxable income

   119,528   141,148   45,906 
   


 


 


Taxable income before preferred dividends

   285,403   256,820   137,851 

Preferred dividends

   (6,653)  (6,265)  —   
   


 


 


Taxable net income available to common shareholders

  $278,750  $250,555  $137,851 
   


 


 


Taxable net income per common share (A)

  $8.66  $9.04  $5.64 
   


 


 



   For the Year Ended December 31,

 
   2003

  2002

  2001

 

Consolidated net income

  $111,996  $48,761  $32,308 

Equity in net income of NFI Holding Corp.

   (20,051)  9,013   (1,723)
   


 


 


REIT net income

   91,945   57,774   30,585 

Adjustments to net income to compute taxable income

   44,550   (9,301)  (20,179)
   


 


 


Taxable income before preferred dividends

   136,495   48,473   10,406 

Preferred dividends

   —     —     (5,164)
   


 


 


Estimated taxable income available to common shareholders

  $136,495  $48,473  $5,242 
   


 


 


Estimated taxable income per common shareholder

  $5.58  $2.32  $0.46 
   


 


 


(A)The common shares outstanding as of the end of each period presented are used in calculating the taxable income per common share.

 

In orderThe primary difference between consolidated net income and taxable income is due to qualifydifferences in the recognition of income on our portfolio of interest-only mortgage securities – available-for-sale. Generally, the accrual of interest on interest-only securities is accelerated for income tax purposes. This is the result of the current original issue discount rules as promulgated under Code Sections 1271 through 1275. During the second quarter of 2005, we made changes to our securitization structure. We anticipate that deals using this securitization structure should have the effect of narrowing the spread between net income available to common shareholders per our consolidated statements of income and taxable net income available to common shareholders in future periods. Table 20 incorporates the estimated changes to taxable income through December 31, 2005. On September 30, 2004, the IRS released Announcement 2004-75. This Announcement describes rules that may be included in proposed regulations regarding the timing of income and/or deductions attributable to interest-only securities. No proposed regulations that would impact income for 2005 have been issued.

To maintain our qualification as a REIT, we must distributeNFI is required to declare dividend distributions of at least 90 percent of our taxable income beforeby the duefiling date of our federal tax return, including extensions. Additionally,Any taxable income that has not been declared to be distributed by this date is subject to corporate income taxes. At this time, NFI intends to declare dividends equal to 100 percent of our taxable income for 2005 by the required distribution date. Accordingly, we have not accrued any corporate income tax for NFI for the year ended December 31, 2005.

As a REIT, NFI may be subject to avoid payinga federal income tax, there are two other distribution requirements. First, in order to avoid a 4 percentexcise tax. An excise tax the REIT must generally distribute at leastis incurred if NFI distributes less than 85 percent of its taxable income (plus undistributed priorby the end of the calendar year. As part of the amount distributed by the end of the calendar year, amounts) no later thanNFI may include dividends that were declared in October, November or December and paid on or before January 31 of the current year (or no later than 30 days after year end if certain requirements are met). Alternatively, in order to avoid paying an income tax atfollowing year. To the REIT level, we must distribute allextent that 85 percent of our taxable income before the timely filing of our tax return. This second distribution requirement may be met by designating certain dividends paid in the following year as applying to the current year (“spillover dividends”). This spillover dividend rule allows a REIT to pay dividends at regular intervals and amounts and avoid volatility in its dividend policy.

The dividend policy adopted by our Board applies the spillover dividend rules for purposes of managing the REIT distribution requirement and in computing REIT taxable income. This policy better aligns dividends with economic income and allows us to better manage volatility inexceeds our dividend payments.

We declared dividendsdistributions in any given year, an excise tax of $2.15 per common share in 2002. Since it4 percent is due and payable on the shortfall. For the years ended December 31, 2005 and 2004, we have accrued excise tax of $7.3 million and $2.1 million, respectively. Excise taxes are reflected as a component of general and administrative expenses on our consolidated statements of income. As of December 31, 2005 and December 31, 2004, accrued excise tax payable was $6.5 million and $1.8 million, respectively. The excise tax payable is reflected as a component of accounts payable and other liabilities on our intent to distribute approximately 100% of our taxable income in 2002, we declared a special dividend related to 2002 taxable income of $0.165 per common share on January 29, 2003.consolidated balance sheets.

 

NFI Holding Corporation, a wholly-owned subsidiary of NovaStar Financial, Inc., has not elected REIT-statusNFI, and its subsidiaries (collectively known as “the TRS”) are treated as “taxable REIT subsidiaries.” The TRS is subject to corporate income taxes and files a consolidated federal income tax return with its subsidiaries. NFI Holding Corporationreturn. The TRS reported a net

(loss) income (loss)from continuing operations before income taxes of $50.6 million and ($11.0)$(31.1) million for the yearsyear ended December 31, 20032005 compared with $23.4 million and 2002,$50.6 million for the same periods of 2004 and 2003, respectively. As shown in our statementconsolidated statements of income, this resulted in an income tax (benefit) expense (benefit) of $22.9$(10.9) million, $9.5 million and $(2.0)$22.9 million for the years ended December 31, 2005, 2004 and 2003, respectively. Additionally, the TRS reported a net loss from discontinued operations before income taxes of $7.1 million and 2002, respectively. We did not report income tax expense (benefit)$18.1 million for the yearyears ended December 31, 2001 due2005 and 2004. This resulted in an income tax benefit of $2.6 million and $6.7 million for the years ended December 31, 2005 and 2004, respectively.

During the past five years, we believe that a minority of our shareholders have been non-United States holders. Accordingly, we anticipate that NFI will qualify as a “domestically-controlled REIT” for United States federal income tax purposes. Investors who are non-United States holders should contact their tax advisor regarding the United States federal income tax consequences of dispositions of shares of a “domestically-controlled REIT.”

Contractual Obligations

We have entered into certain long-term debt and lease agreements, which obligate us to make future payments to satisfy the related contractual obligations. Notes 8, 9, and 11 of the consolidated financial statements discuss these obligations in further detail.

Since December 31, 2004, we have issued junior subordinated debentures as discussed in Note 8. The following table summarizes our contractual obligations with regard to our long-term debt and lease agreements as of December 31, 2005.

Table 21 — Contractual Obligations

(dollars in thousands)

   Payments Due by Period

Contractual Obligations


  Total

  Less than 1
Year


  1-3
Years


  4-5
Years


  After 5
Years


Short-term borrowings (A)

  $1,421,790  $1,421,790  $—    $—    $—  

Long-term debt (B)

   159,230   124,381   30,115   4,734   —  

Junior subordinated debentures (C)

   167,393   4,013   8,027   8,027   147,326

Operating leases (D)

   46,221   9,612   18,214   15,157   3,238

Purchase obligations (E)

   33,446   33,446   —     —     —  

Premiums due to counterparties related to interest rate cap agreements

   3,363   1,503   1,671   189   —  
   

  

  

  

  

Total

  $1,831,443  $1,594,745  $58,027  $28,107  $150,564
   

  

  

  

  


(A)This amount includes accrued interest on the obligation as of December 31, 2005.
(B)Repayment of the asset-backed bonds is dependent upon payment of the underlying mortgage loans, which collateralize the debt. The repayment of these mortgage loans is affected by prepayments. This amount includes expected interest payments on the obligation. Interest obligations on our variable-rate long-term debt are based on the prevailing interest rate at December 31, 2005 for each respective obligation.
(C)The junior subordinated debentures are assumed to mature in 2035 in computing the future payments. This amount includes expected interest payments on the obligation. Interest obligations on our junior subordinated debentures are based on the prevailing interest rate at December 31, 2005 for each respective obligation.
(D)Does not include rental income of $2.8 million to be received under a sublease contract.
(E)The commitment to purchase mortgage loans does not necessarily represent future cash requirements as some portion of the commitment may be declined for credit or other reasons.

We entered into various lease agreements in which the lessor agreed to repay us for certain existing lease obligations. We received approximately $61,000 and $2.3 million related to these agreements in 2005 and 2004, respectively. We recorded deferred lease incentives related to these payments, which will be amortized into rent expense over the life of the respective lease. Deferred lease incentives as of December 31, 2005 and 2004 were $3.5 million and $3.0 million.

We also entered into various sublease agreements for office space formerly occupied by us. We received approximately $53,000, $1.2 million and $537,000 in 2005, 2004 and 2003, respectively under these agreements.

As of December 31, 2005 we had expected cash requirements for the payment of interest of $3.7 million. The future amount of these interest payments will depend on the outstanding amount of our borrowings as well as the underlying rates for our variable rate borrowings. As of December 31, 2005 we had expected cash requirements for taxes of $5.1 million. The amount of taxes to be paid in the future will depend on taxable income in future periods as well as the amount and timing of dividend payments and other factors as discussed in Note 1 to the immaterial nature of the pretax income reported at NFI Holding Corporation.consolidated financial statements.

 

Liquidity and Capital Resources

 

Liquidity means the need for, access to and uses of cash. Our 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 our business operations. We strive to maintain adequate liquidity at all times to cover normal cyclical swings in funding availability and mortgage demand and to allow us to meet abnormal and unexpected funding requirements.

We believe that current cash balances, currently available financing facilities, capital raising capabilities and cash flows generated from our mortgage portfolio should adequately provide for projected funding needs and asset growth. However, if we are unable to raise capital in the future, we may not be able to grow as planned. Refer to Item 1A. “Risk Factors” for additional information regarding risks that could adversely affect our liquidity.

The following table provides a summary of our operating, activitiesinvesting and financing cash flows as taken from our consolidated statements of cash flows for the business, especiallyyears ended December 31, 2005, 2004 and 2003.

Table 22 — Summary of Operating, Investing and Financing Cash Flows

(dollars in thousands)

   For the Year Ended December 31,

  Increase/(Decrease)

 
   2005

  2004

  2003

  2005 vs. 2004

  2004 vs. 2003

 

Consolidated Statements of Cash Flows:

                     

Cash (used in) provided by operating activities

  $(727,181) $(565,706) $42,048  $(161,475) $(607,754)

Cash flows provided by investing activities

   467,017   376,215   222,137   90,802   154,078 

Cash flows provided by (used in) financing activities

   256,295   339,874   (225,747)  (83,579)  565,621 

The following discussion provides detail and analysis of our cash uses and sources which significantly drive the mortgage origination operation. Mortgage asset sales, principal, interest and fees collected on mortgage assets support cash needs. Drawing upon various borrowing arrangements typically satisfies major cash requirements. Asamounts shown in Table 5, we have $130.1 million22 as well as the year over year changes in immediately available funds, including $118.2 million in cash.those amounts.

 

Primary Uses of Cash

Our primary uses of cash include the following:

Investments in new mortgage securities through the securitization of our mortgage loans (capital is required for the funding of the overcollateralization, securitization expenses and costs to originate the mortgage loans),

Origination and purchase of mortgage loans,

Repayments of long-term borrowings,

Operating expense payments, and

Common and preferred stock dividend payments.

Table 23 and the paragraphs that follow provide more detail regarding the liquidity needs to operate our business.

Table 23 — Primary Uses of Cash

(dollars in thousands)

   For the Year December 31,

   2005

  2004

  2003

Primary Uses of Cash:

            

Investments in new mortgage securities (A)

  $375,110  $366,719  $239,576

Origination and purchases of mortgage loans

   9,366,720   8,560,314   6,071,042

Repayments of long-term borrowings

   371,683   254,867   120,083

Common and preferred stock dividend payments

   202,413   138,611   99,256
   

  

  

Total primary uses of cash

  $10,315,926  $9,320,511  $6,529,957
   

  

  


(A)Represents the sum of the overcollateralization we funded in our securitizations during the year and our estimated cost to produce the loans securitized. See Table 24 for a computation of this estimate.

Investments in New Mortgage Securities. We retain significant interests in the nonconforming loans we originate and purchase through our mortgage securities investment portfolio. We require capital in our securitizations to fund the primary bonds we retain, overcollateralization, securitization expenses and our operating costs to originate the mortgage loans. We generally know the exact amounts invested related to all of these components except for our costs to originate in which we must estimate. The following table illustrates how we compute the estimated capital invested in our securitizations for the years ended December 31, 2005, 2004 and 2003.

Table 24 — Summary of Estimated Capital Invested in New Mortgage Securities

(dollars in thousands)

   For the Year Ended December 31,

 
   2005

  % of
Principal
Transferred


  2004

  % of
Principal
Transferred


  2003

  % of
Principal
Transferred


 

Estimated Capital Invested in New Mortgage Securities:

                      

Principal balance of mortgage loans transferred

  $7,621,030  100.00% $8,329,804  100.00% $5,319,435  100.00%

Less: Net proceeds received

   7,428,063  97.47   8,173,829  98.13   5,207,525  97.90 
       

 

  

 

  

Capital invested in subordinated securities, overcollateralization and securitization expenses

   192,967  2.53   155,975  1.87   111,910  2.10 

Plus: Estimated costs to originate (A)

   182,143  2.39   210,744  2.53   127,666  2.40 
   

  

 

  

 

  

Estimated total capital invested in new mortgage securities

  $375,110  4.92% $366,719  4.40% $239,576  4.50%
   

  

 

  

 

  


(A)Estimated costs to originate is based on costs to originate as reported in Table 17.

Our investments in new mortgage securities should generally increase or decrease in conjunction with our mortgage loan production. In 2005, because we began retaining certain subordinated primary bonds, the amount of capital needed for our securitizations increased. We will continue to retain certain subordinated primary bonds when we feel they provide attractive risk-adjusted returns.

Originations and Purchases of Mortgage Loans.Mortgage lending requires significant cash to fund loan originations.originations and purchases. The capital invested in our mortgage loans is outstanding until we sell or securitize the loans. Initial capital invested in our mortgage loans includes premiums paid to the broker plus any haircut required upon financing, which is generally determined by the value and type of the mortgage loan being financed. A haircut is the difference between the principal balance of a mortgage loan and the amount we can borrower from a lender when using that loan to secure the debt. As values of mortgage loans have decreased in 2004 and 2005, we have invested more capital in our mortgage loans due to higher haircuts. The lender haircuts have generally been between zero and two percent of the principal balance of our mortgage loans. Margin compression within the mortgage banking industry has also resulted in a decline in the premiums we paid to brokers for our mortgage loans to 1.1% in 2005 from 1.3% in 2004. We paid 1.2% in premiums to brokers in 2003.

Repayments of Long-Term Borrowings. Long-term borrowing repayments will fluctuate with the timing of new issuances of long-term debt and their respective maturities. See “Proceeds From Issuances of Long-Term Debt.”

Common and Preferred Stock Dividend Payments. To maintain our qualification as a REIT, we must distribute at least 90% of our REIT taxable income to our common shareholders in the form of dividend payments. Historically, we have generally declared dividends equal to 100% of our REIT taxable income and we currently expect to declare dividends equal to 100% of our 2005 REIT taxable income. The amount and timing of future dividends are determined by our Board of Directors based on REIT tax requirements as well as our financial condition and business trends at the time of declaration.

See discussion of preferred stock issuances under “Proceeds From Issuances of Common and Preferred Stock.”

We declared common stock dividends per share of $5.60, $6.75 and $5.04 for the years ended December 31, 2005, 2004 and 2003, respectively. Preferred stock dividends declared per share were $2.23 and $2.11 for the years ended December 31, 2005 and 2004, respectively.

Primary Sources of Cash

Our primary sources of cash are as follows:

Warehouse lending arrangements (short-term borrowings),

Cash received from our mortgage securities portfolio,

Net proceeds from the sale and securitization of mortgage assets,

Net proceeds from issuances of long-term debt, and

Net proceeds from issuances of preferred and common equity.

Table 25 and the paragraphs that follow provide more detail regarding the liquidity sources available to us to meet our operational cash needs.

Table 25 — Primary Sources of Cash

(dollars in thousands)

   For the Year Ended December 31,

 
   2005

  2004

  2003

 

Primary Sources of Cash:

             

Change in short-term borrowings, net

  $513,041  $32,992  $(153,000)

Cash received from our mortgage securities portfolio (A)

   471,314   378,802   200,024 

Net proceeds from securitizations of mortgage loans

   7,428,063   8,173,829   5,207,525 

Net proceeds from sales of mortgage loans to third parties

   1,176,518   64,476   966,537 

Net proceeds from issuances of long-term debt

   177,349   506,745   52,271 

Net proceeds from issuances of preferred and common stock

   142,114   193,615   94,321 
   

  

  


Total primary sources of cash

  $9,908,399  $9,350,459  $6,367,678 
   

  

  



(A)Includes proceeds from paydowns on available-for-sale securities as reported in the investing activities section of our consolidated statements of cash flows plus the cash received on our mortgage securities available-for-sale with zero basis as reported in Note 18 to the consolidated financial statements.

Warehouse Lending Arrangements (Change in Short-Term Borrowings, net). Mortgage lending requires significant cash to fund loan originations and purchases. Our warehouse lending arrangements, includingwhich include repurchase agreements, support theour mortgage lending operation. Our warehouse mortgage lenders allow us to borrow between 98%95% and 100% of the outstanding principal.principal of the loans that secure the debt. Funding for the difference, – generally 2% of the principal—or “haircut”, must come from other cash inflows. We use operating cash inflowon hand. Of the $3.5 billion in the form of cash flow from mortgage securities principal and interest on mortgage loans and fee incomerepurchase facilities, we have approximately $2.1 billion available to support loan originations. In addition, proceeds from equity offerings have been used to support operations. Our immediately available funds would support funding more than $6.5 billionour mortgage lending and mortgage portfolio operations at December 31, 2005, as shown in loans, assuming no other demands on cashTable 7. The changes in short-term borrowings will generally correlate with the changes in our mortgage loans—held-for-sale as shown in Tables 23 and assuming a 2% “haircut”.24.

 

Loans financed with warehouse and repurchase credit facilities are subject to changing market valuation and margin calls. The market value of our loans is dependent on a variety of economic conditions, including interest rates, (and borrower demand)demand, and end investor desire and capacity. Market values of our loans have been consistentdeclined over the past three years.year, but have remained in excess of par. However, there is no certainty that the prices will remain constant.in excess of par. To the extent the value of the loans declines significantly,below the required market value margin set forth in the lending agreements, we would be required to repay portions of the amounts we have borrowed. The value of our “recourse” loans (classified as held-for-sale)held-for-sale, excluding the loans under removal of accounts provision, as of December 31, 20032005 would need to decline by nearly 19%approximately 21% before we would use all immediately available funds to satisfy the margin calls, assuming no other constraints on our immediately available funds.

 

All of our warehouse repurchase credit facilities include numerous representations, warranties and covenants, including requirements to maintain a certain minimum net worth, minimum equity ratios and other customary debt covenants. If we were unable to make the necessary representations and warranties at the time we need financing, we would not be able to obtain needed funds. In addition, if we breach any covenant contained in any warehouse repurchase credit facility, the lenders under all existing warehouse repurchase credit facilities could demand immediate repayment of all outstanding amounts because all of our warehouse repurchase credit facilities contain cross-default provisions. While management believes we are in compliance with all applicable material covenants, any future breach or non-compliance could have a material adverse effect on our financial condition.

Cash Received From Our Mortgage Securities Portfolio. Our principal driver of cash flows from investing activities are the proceeds we receive on our mortgage securities—available-for-sale. The cash flows we receive on our mortgage securities—available-for-sale are highly dependent on the interest rate spread between the underlying collateral and the bonds issued by the securitization trusts and default and prepayment experience of the underlying collateral. The following factors have been the significant drivers in the overall fluctuations in these cash flows:

The coupons on the underlying collateral of our mortgage securities have increased modestly while the interest rates paid on the bonds issued by the securitization trusts have dramatically risen over the last couple of years.

The lower spreads have been offset by lower credit losses due to the substantial rise in housing prices of the underlying collateral in recent years.

We have no recoursehigher average balances of our mortgage securities retained over the last three years.

Net Proceeds From Securitizations of Mortgage Loans. We depend on the capital markets to finance the mortgage loans we originate and purchase. The primary bonds we issue in our loan securitizations are sold to large, institutional investors and U.S. government-sponsored enterprises. The capital markets also provide us with capital to operate our business. The trend has been favorable in the capital markets for the types of securitization transactions we execute. Investor appetite for the bonds created by securitizations has been strong. Additionally, commercial and investment banks have provided significant liquidity to finance our mortgage lending operations through warehouse repurchase facilities. While management cannot predict the future liquidity environment, we are unaware of any material trend that would disrupt continued liquidity support in the capital markets for our business.

Net Proceeds From Sales of Mortgage Loans to Third Parties. We also depend on third party investors to provide liquidity for our mortgage loans. We generally will sell loans financed withto third party investors which do not possess the economic characteristics which meet our long-term portfolio management objectives. The increase in proceeds from sales of mortgage loans to third parties is a result of the environment of tighter margins in the mortgage banking industry. These tighter margins prompted us to not add an increasing number of loans to our securitized portfolio due to unattractive returns.

Net Proceeds from Issuances of Long-Term Debt. The resecuritization of our mortgage securities—available-for-sale as well as private debt offerings provide long-term sources of liquidity.

In 2005, 2004 and 2003, we issued asset-backed bonds (NIMs) secured by our mortgage securities – available-for-sale as a means for long-term financing for these assets, which raised $128.9 million, $506.7 million and $52.3 million, respectively, in net proceeds. Even though we do have repurchase agreements in place which give us the ability to borrow against our mortgage securities in the short-term, our ability to leverage our mortgage securities through a NIMs transaction provides significant liquidity and long-term financing for the securities. While management cannot predict the future liquidity environment, we are unaware of any material trend that would disrupt continued liquidity support in the NIMs market for our business. We will generally continue to leverage our mortgage securities in the future, yet, we are also focusing on more efficient ways to execute this leverage which could lead to new strategies.

Additionally, we received net proceeds of $48.4 million from the issuance of unsecured floating rate junior subordinated debentures during the year ended December 31, 2005. We will continue to take advantage of this market when we feel we can issue debt at more attractive costs than issuing capital.

Factors management considers important in determining whether to finance our operations via warehouse and repurchase facilities, resecuritization or other asset-backed bond issuances or equity or debt offerings are as such,follows:

The financing costs involved.

Does the financing arrangement have a dilutive effect to our common shareholders?

The market price of our common stock.

Subordination rights of lenders and shareholders.

Collateral and other covenant requirements.

Net Proceeds From Issuances of Common and Preferred Stock.If our board of directors determines that additional financing is required, we may raise the funds through additional equity offerings, debt financings, retention of cash flow (subject to provisions in the Code concerning distribution requirements and taxability of undistributed REIT taxable income) or a combination of these methods. In the event that our board of directors determines to raise additional equity capital, it has the authority, without stockholder approval, subject to applicable law and NYSE regulations, to issue additional common stock or preferred stock in any manner and on terms and for consideration it deems appropriate up to the amount of authorized stock set forth in our charter. Since inception, we have raised $420 million in net proceeds through private and public equity offerings.

Within the past two years, the mortgage REIT industry has seen a significant increase in the desire for raising public capital. Additionally, there is minimal liquidity risk.have been several new entrants to the mortgage REIT business and other mortgage lenders that have converted to (or that are considering conversion to) REIT status. This increased reliance on the capital markets and increase in number of mortgage REITs may decrease the pricing and increase the underwriting costs of raising equity in the mortgage REIT industry.

In 2005, we completed a public offering of 1,725,000 shares of common stock raising $57.8 million in net proceeds. Additionally, we sold 2,609,320 shares of common stock under our DRIP raising $83.6 million in net proceeds and 148,797 shares of common stock under the stock-based compensation plan raising $0.7 million.

In 2004, we completed a public offering of 1,725,000 shares of common stock raising $70.1 million in net proceeds. Additionally, we sold 1,104,488 shares of common stock under our DRIP raising $49.4 million in net proceeds and 433,181 shares of common stock under the stock-based compensation plan raising $2.0 million. We also sold 2,990,000 shares of redeemable preferred stock raising $72.1 million in net proceeds.

In 2003, we completed public offerings of 2,610,500 shares of common stock raising $76.9 million in net proceeds. Additionally, we sold 578,120 shares of common stock under our DRIP raising $15.8 million in net proceeds and 298,875 shares of common stock under the stock-based compensation plan raising $1.6 million.

Other Liquidity Factors

 

The derivative financial instruments we use also subject us to “margin call” risk. Under our interest rate swaps, we pay a fixed rate to the counterparties while they pay us a floating rate. While floating rates are low on a net basis, we are paying the counterparty. In order to mitigate credit exposure to us, the counterparty requiredrequires us to post margin deposits with them. As of December 31, 2003,2005, we have approximately $20.9$4.4 million on deposit. Further decliningA decline in interest rates would subject us to additional exposure for cash margin calls. However, the asset side of the balance sheet should increase in value in a further declining interest rate scenario. Incoming cash on our mortgage loans and securities is a principal source of cash. The volume of cash depends on, among other things, interest rates. Whilewhen short-term interest rates (the basis for our funding costs) are low and the coupon rates on our loans are high, our net interest margin (and therefore incoming cash flow) is high.high which should offset any requirement to post additional collateral. Severe and immediate changes in interest rates will impact the volume of our incoming cash flow. To the extent rates increase dramatically, our funding costs will increase quickly. While many of our loans are adjustable, they typically will not reset as quickly as our funding costs. This circumstance would temporarily reduce incoming cash flow. As noted above, derivative financial instruments are used to mitigate the effect of interest rate volatility. In this rising rate situation, our interest rate swaps and caps would provide additional cash flows to mitigate the lower cash flow on loans and securities.

 

LoansIn the ordinary course of business, we originate cansell loans with recourse where a defect occurred in the loan origination process and guarantee to cover investor losses should origination defects occur. Historically, repurchases of loans where a defect has occurred have been insignificant, as such, there is minimal liquidity risk. For additional detail, refer to “Off Balance Sheet Arrangements”.

Table 21 details our major contractual obligations due over the next 12 months and beyond. Management believes cash and cash equivalents on hand combined with other available liquidity sources: 1) proceeds from mortgage loan sales and securitizations, 2) cash received on our mortgage securities available-for-sale, 3) draw downs on mortgage loan and securities repurchase agreements, 4) proceeds from private and public debt and equity offerings and 5) proceeds from resecuritizations will be soldadequate to meet our liquidity needs for the next twelve months. In addition, we do not believe our long-term growth plans will be constrained due to a third party, which also generates cash to fund on-going operations. When market prices exceed our cost to originate, we believelack of available liquidity resources. However, we can operateprovide no assurance, that, if needed, the liquidity resources we utilize will be on terms we consider favorable. Factors that can affect our liquidity are discussed in the “Risk Factors” section of this manner, provided that the level of loan originations is at or near the capacity of its production infrastructure.document.

 

CashAdditional cash activity during the years ended December 31, 2003, 20022005, 2004 and 20012003 is presented in the consolidated statement of cash flows.

As noted above, proceeds from equity offerings have supported our operations. Since inception, we have raised $220 million in net proceeds through private and public equity offerings. Equity offerings provide another avenue as a future liquidity source.

 

Off Balance Sheet Arrangements

 

As discussed previously, we pool the loans we originate and purchase and typically securitize them to obtain long-term financing for the assets. The loans are transferred to a trust where they serve as collateral for asset-backed bonds, which the trust issues to the public. Our ability to use the securitization capital market is critical to the operations of our business. Table 4 summarizes our off balance sheet securitizations.

External factors that are reasonably likely to affect our ability to continue to use this arrangement would be those factors that could disrupt the securitization capital market. A disruption in the market could prevent us from being able to sell the securities at a favorable price, or at all. Factors that could disrupt the securitization market include an international liquidity crisis such as occurred in the fall of 1998, sudden changes in interest rates, a terrorist attack, outbreak of war or other significant event risk, and market specific events such as a default of a comparable type of securitization. If we were unable to access the securitization market, we may still be able to finance our mortgage operations by selling our loans to investors in the whole loan market. We were able to do this following the liquidity crisis in 1998.

Specific items that may affect our ability to use the securitizations to finance our loans relate primarily to the performance of the loans that have been securitized. Extremely poor loan performance may lead to poor bond performance and investor unwillingness to buy bonds supported by our collateral. Our financial performance and condition has little impact on our ability to securitize, as evidenced by our ability to securitize in 1998, 1999 and 2000 when our financial trend was weak. There, however, are no assurances that we will be able to securitize loans in the future when we have poor loan performance. Table 14 summarizes our off balance sheet securitizations for the there years ended December 31, 2005.

 

We have commitments to borrowers to fund residential mortgage loans as well as commitments to purchase and sell mortgage loans to third parties. As nonconforming mortgage loans are not readily convertible to cash and cannot readily be settled net, commitments to originate and purchase such loans do not meet the definition of a derivative under accounting principles generally accepted in the United States of America. Accordingly, they are not recorded in the consolidated financial statements. As of December 31, 2003, we had outstanding commitments to originate and purchase loans of $228 million and $60 million, respectively. We had no commitments to sell loans to third parties at December 31, 2003. As of December 31, 2002,2005, we had outstanding commitments to originate, purchase and sell loans of $108$545.4 million, $16$33.4 million and $98$93.6 million, respectively. As of December 31, 2004, we had outstanding commitments to originate loans of $370.6 million. We had no commitments to purchase or sell loans at December 31, 2004. The commitments to originate and purchase loans do not necessarily represent future cash requirements, as some portion of the commitments are likely to expire without being drawn upon or may be subsequently declined for credit or other reasons. See the “Mortgage Lending Results of Operation” section for further information on our originations and purchases of mortgage loans.

 

On November 20, 2003,In the ordinary course of business, we executedsold whole pools of loans with recourse for borrower defaults. When whole pools are sold as opposed to securitized, the third party has recourse against us for certain borrower defaults. Because the loans are no longer on our balance sheet, the recourse component is considered a securitization transaction accountedguarantee. During 2005, we sold $1.1 billion of loans with recourse for asborrower defaults compared to none in 2004. We maintained a sale of loans. We delivered $1.0 billion in loans collateralizing NMFT Series 2003-4 (see Note 3 of the consolidated financial statements). On January 14, 2004, we delivered an additional $479.8$2.3 million in loans collateralizing NMFT Series 2003-4.

Contractual Obligations

We have entered into certain long-term debt and lease agreements, which obligate usreserve related to make future payments to satisfy the related contractual obligations. Notes 6 and 15 of the consolidated financial statements discuss these obligations in further detail.

The following table summarizes our contractual obligations with regard to our long-term debt and lease agreementsguarantees as of December 31, 2003.2005 compared with a reserve of $45,000 as of December 31, 2004. During 2005 we paid $2.3 million in cash to repurchase loans sold to third parties. In 2004, we paid $0.5 million in cash to repurchase loans sold to third parties in prior periods. See Table 12 for further information on the volume of loan sales.

 

Table 13 — Contractual Obligations

(In the ordinary course of business, we sell loans to securitization trusts and make a guarantee to cover losses suffered by the trust resulting from defects in thousands)


   Payments Due by Period

   Total

  Less than 1
Year


  1-3 Years

  4-5 Years

  After 5
Years


Contractual Obligations

                    

Short-term borrowings

  $872,536  $872,536   —     —     —  

Long-term debt (A)

  $132,980  $82,346  $28,909  $12,745  $8,980

Mortgage loan purchase commitments

  $60,000  $60,000   —     —     —  

Operating leases

  $31,543  $6,425  $10,855  $10,698  $3,565

Premiums due to counterparties related to interest rate cap agreements

  $3,459  $1,568  $1,891   —     —  

(A)Repayment of the asset-backed bonds is dependent upon payment of the underlying mortgage loans, which collateralize the debt. The repayment of these mortgage loans is affected by prepayments.

The Companythe loan origination process. Defects may occur in the loan documentation and underwriting process, either through processing errors made by us or through intentional or unintentional misrepresentations made by the borrower or agents during those processes. If a defect is identified, we are required to repurchase the loan. As of December 31, 2005 and December 31, 2004, we had loans sold with recourse with an outstanding principal balance of $12.7 billion and $11.4 billion, respectively. Historically, repurchases of loans where a defect has entered into various lease agreements in which the lessor agreed to repay the Company for certain existing lease obligations. The Company received approximately $2.3 million and $62,000occurred have been insignificant, therefore, we have not recorded any reserves related to these agreementsguarantees. See Note 2 and Note 3 to our consolidating financial statements for further information on our loan securitizations.

Our branches broker loans to third parties in 2003 and 2002, respectively, and expectsthe ordinary course of business where the third party has recourse against us for certain borrower defaults. Because the loans are no longer on our balance sheet, the recourse component is considered a guarantee. During 2005, our branches brokered $1.4 billion of loans with recourse for borrower defaults compared to receive approximately $1.0 million$4.8 billion in future payments through 2004 from the lessor unless the properties we previously occupied are subleased.2004. We entered into various sublease agreements for office space formerly occupied by us. We received approximately $537,000 in 2003maintained a $476,000 reserve related to these agreements and expect to receive approximately $61,000 in future payments throughguarantees as of December 31, 2005 compared with a reserve of $116,000 as of December 31, 2004.

Inflation

 

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

 

Impact of Recently Issued Accounting Pronouncements

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued a revision of Statement of Financial Accounting Standards (“SFAS”) No. 123,Accounting for Stock-Based Compensation(“SFAS No. 123(R)”). This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. Entities no longer have the option to use the intrinsic value method of APB 25 that was provided in SFAS No. 123 as originally issued, which generally resulted in the recognition of no compensation cost. Under SFAS No. 123(R), the cost of employee services received in exchange for an equity award must be based on the grant-date fair value of the award. The cost of the awards under SFAS No. 123(R) will be recognized over the period an employee provides service, typically the vesting period. No compensation cost is recognized for equity instruments in which the requisite service is not provided. This Statement is effective at the beginning of the next fiscal year that begins after June 15, 2005. As discussed in Note 1 of theto our consolidated financial statements, describewe implemented the fair value provisions of SFAS No. 123 during 2003. As such, the adoption of SFAS No. 123(R) is not anticipated to have a significant impact on our consolidated financial statements.

In March 2005, SEC Staff Accounting Bulletin (“SAB”) No. 107,Application of FASB No. 123 (revised 2004), Accounting for Stock-Based Compensationwas released. This release summarizes the SEC staff position regarding the interaction between SFAS No. 123(R) and certain recentlySEC rules and regulations and provides the SEC’s views regarding the valuation of share-based payment arrangements for public companies. The adoption of this release is not anticipated to have a significant impact on our consolidated financial statements.

In May 2005, the FASB issued Statement No. 154,Accounting Changes and Error Corrections, a Replacement of APB Opinion No. 20 and FASB Statement No. 3. This Statement changes the requirements for the accounting pronouncements. Management believes the implementationand reporting of these pronouncementsa change in accounting principle, reporting entity, accounting estimate and otherscorrection of an error. SFAS No. 154 applies to (a) financial statements of business enterprises and not-for-profit organizations and (b) historical summaries of information based on primary financial statements that have gone into effect sinceinclude an accounting period in which an accounting change or error correction is reflected and is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date the Statement was issued. The adoption of these reports willthis Statement is not anticipated to have a significant impact on our consolidated financial statements.

In November 2005, FASB Staff Position (“FSP”) SFAS 140-2,Clarification of the Application of Paragraphs 40(b) and 40(c) of FASB Statement No. 140,was issued. This FSP addresses whether a QSPE would fail to meet the conditions of a QSPE under the current requirements of Statement 140 if either (a) unexpected events outside the control of the transferor or (b) a transferor’s temporary holdings of beneficial interests previously issued by a QSPE and sold to outside parties, cause the notional amount of passive derivatives held by an QSPE to exceed the amount of beneficial interests held by outside parties. This FSP clarifies that the requirements of paragraphs 40(b) and 40(c) must be met only at the date a QSPE issues beneficial interests or when a passive derivative financial instrument needs to be replaced upon the occurrence of a specified event outside the control of the transferor. This FSP is effective as of November 9, 2005. The guidance regarding unexpected events should be applied prospectively. The adoption of this FSP did not have a materialsignificant impact on our consolidated financial statements.

During November 2005, the FASB issued FSP SFAS 115-1 and SFAS 124-1,The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which outlines a three-step model that should be applied each reporting period to identify investment impairments. In periods after an impairment loss on a debt security is recognized, the investor should account for the security as if it had been purchased on the impairment measurement date. The discount (or reduced premium), based on the new cost basis, should be amortized over the remaining life of the security. This FSP carries forward the disclosure requirements of Emerging Issues Task Force (“EITF”) Issue 03-1,The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, but nullifies certain other requirements of this EITF. This FSP also clarifies that investments within the scope of EITF Issue 99-20,Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets, must be included in the required tabular disclosures. The guidance in this FSP should be applied to reporting periods beginning after December 15, 2005. Earlier application is permitted. The adoption of this FSP is not anticipated to have a significant impact on our consolidated financial statements.

During December 2005, the FASB issued FSP Statement of Position (“SOP”) 94-6-1,Terms of Loan Products That May Give Rise to a Concentration of Credit Risk, which addresses the circumstances under which the terms of loan products give rise to such risk and the disclosures or other accounting considerations that apply for entities that originate, hold, guarantee, service, or invest in loan products with terms that may give rise to a concentration of credit risk. The guidance under this FSP is effective for interim and annual periods ending after December 19, 2005 and for loan products that are determined to represent a concentration of credit risk, disclosure requirements of SFAS 107,Disclosures about Fair Value of Financial Instruments, should be provided for all periods presented. The adoption of this FSP did not have a significant impact on our consolidated financial statements.

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments”, an amendment of FASB Statements No. 133 and SFAS No. 140 (“SFAS 155”). This statement permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. It also clarifies which interest-only strips and principal-only strips are not subject to FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). The statement also establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or hybrid financial instruments that contain an embedded derivative requiring bifurcation. The statement also clarifies that concentration of credit risks in the form of subordination are not embedded derivatives, and it also amends SFAS 140 to eliminate the prohibition on a QSPE from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Early adoption of this statement is allowed. We are still evaluating the impact the adoption of this statement will have on our consolidated financial statements.

Item 7A.Quantitative and Qualitative Disclosures Aboutabout Market Risk

 

See discussion under “Interest Rate/Market Risk” in “Item 1. Business”.

Item 8.Financial Statements and Supplementary Data

 

NOVASTAR FINANCIAL, INC.

CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except share amounts)


 

  December 31,

   December 31,

 
  2003

 2002

   2005

 2004

 

Assets

      

Cash and cash equivalents

  $118,180  $79,742   $264,694  $268,563 

Mortgage loans – held-for-sale

   697,992   983,633    1,291,556   747,594 

Mortgage loans – held-in-portfolio

   94,717   149,876    28,840   59,527 

Mortgage securities – available-for-sale

   382,287   178,879    505,645   489,175 

Mortgage securities – trading

   43,738   143,153 

Mortgage servicing rights

   57,122   42,010 

Servicing related advances

   19,281   11,875    26,873   20,190 

Mortgage servicing rights

   19,685   7,906 

Accrued interest receivable

   3,739   7,673 

Assets acquired through foreclosure

   3,192   5,935 

Derivative instruments, net

   12,765   18,841 

Property and equipment, net

   13,132   15,476 

Deferred income tax asset, net

   30,780   11,190 

Warehouse notes receivable

   25,390   5,921 

Other assets

   60,884   26,978    35,199   39,671 
  


 


  


 


Total assets

  $1,399,957  $1,452,497   $2,335,734  $1,861,311 
  


 


  


 


Liabilities and Stockholders’ Equity

   

Liabilities and Shareholders’ Equity

   

Liabilities:

      

Short-term borrowings secured by mortgage loans

  $639,852  $927,472   $1,238,122  $720,791 

Short-term borrowings secured by mortgage securities

   232,684   98,064    180,447   184,737 

Asset-backed bonds secured by mortgage loans

   89,384   143,459    26,949   53,453 

Asset-backed bonds secured by mortgage securities

   43,596   56,233    125,630   336,441 

Junior subordinated debentures

   48,664   —   

Dividends payable

   45,070   73,431 

Due to securitization trusts

   44,382   20,930 

Accounts payable and other liabilities

   63,658   27,244    62,250   45,184 

Dividends payable

   30,559   16,768 
  


 


  


 


Total liabilities

   1,099,733   1,269,240    1,771,514   1,434,967 

Commitments and contingencies

   

Stockholders’ equity:

   

Commitments and contingencies (Note 9)

   

Shareholders’ equity:

   

Capital stock, $0.01 par value, 50,000,000 shares authorized:

      

Common stock, 24,447,315 and 20,959,820 shares issued

and outstanding, respectively

   245   210 

Redeemable preferred stock, $25 liquidating preference per share; 2,990,000 shares, issued and outstanding

   30   30 

Common stock, 32,193,101 and 27,709,984 shares, issued and outstanding, respectively

   322   277 

Additional paid-in capital

   231,294   133,253    581,580   433,107 

Accumulated deficit

   (15,522)  (12,026)   (128,554)  (85,354)

Accumulated other comprehensive income

   85,183   62,935    111,538   79,120 

Other

   (976)  (1,115)   (696)  (836)
  


 


  


 


Total stockholders’ equity

   300,224   183,257 

Total shareholders’ equity

   564,220   426,344 
  


 


  


 


Total liabilities and stockholders’ equity

  $1,399,957  $1,452,497 

Total liabilities and shareholders’ equity

  $2,335,734  $1,861,311 
  


 


  


 


 

See notes to consolidated financial statements.

NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF INCOME

(Dollarsdollars in thousands, except per share amounts)


 

  For the Year Ended December 31,

   For the Year Ended December 31,

 
  2003

 2002

 2001

   2005

 2004

 2003

 

Interest income:

      

Mortgage securities

  $98,804  $56,481  $11,706   $188,856  $133,633  $98,804 

Mortgage loans held-for-sale

   60,878   33,736   19,507    106,605   83,718   60,878 

Mortgage loans held-in-portfolio

   10,738   16,926   26,691    4,311   6,673   10,738 
  


 


 


  


 


 


Total interest income

   170,420   107,143   57,904    299,772   224,024   170,420 

Interest expense:

      

Short-term borrowings secured by mortgage loans

   20,060   10,406   8,546    58,580   30,005   20,060 

Short-term borrowings secured by mortgage securities

   3,450   2,107   1,911    1,770   4,836   3,450 

Asset-backed bonds secured by mortgage loans

   2,269   4,195   14,874    1,630   1,422   2,269 

Asset-backed bonds secured by mortgage securities

   5,226   727   —      15,628   13,255   5,226 

Net settlements of derivative instruments used in cash flow hedges

   9,359   10,293   2,035    180   3,072   9,359 

Junior subordinated debentures

   3,055   —     —   
  


 


 


  


 


 


Total interest expense

   40,364   27,728   27,366    80,843   52,590   40,364 
  


 


 


  


 


 


Net interest income before credit recoveries (losses)

   130,056   79,415   30,538 

Credit recoveries (losses)

   389   432   (3,608)

Net interest income before credit (losses) recoveries

   218,929   171,434   130,056 

Provision for credit (losses) recoveries

   (1,038)  (726)  389 
  


 


 


  


 


 


Net interest income

   130,445   79,847   26,930    217,891   170,708   130,445 

Gains on sales of mortgage assets

   144,005   53,305   37,347    68,173   144,950   144,005 

Losses on derivative instruments

   (30,837)  (36,841)  (3,953)

Gains (losses) on derivative instruments

   18,155   (8,905)  (30,837)

Impairment on mortgage securities – available-for-sale

   (17,619)  (15,902)  —   

Fee income

   68,341   35,983   20,994    46,286   50,752   68,873 

Premiums for mortgage loan insurance

   (3,102)  (2,326)  (2,655)   (5,672)  (4,218)  (3,102)

Other income, net

   412   1,356   1,856    20,880   6,609   412 

General and administrative expenses:

      

Compensation and benefits

   89,954   49,060   26,934    116,699   105,715   89,954 

Loan expense

   26,174   8,002   1,865 

Travel and public relations

   23,339   11,400   7,008 

Office administration

   22,945   10,092   6,394    32,079   31,641   22,945 

Professional and outside services

   7,482   3,402   1,989    19,628   19,573   7,482 

Loan Expense

   13,897   15,488   19,433 

Marketing

   10,907   16,603   23,109 

Other

   4,514   2,638   2,315    22,187   18,710   12,017 
  


 


 


  


 


 


Total general and administrative expenses

   174,408   84,594   46,505    215,397   207,730   174,940 
  


 


 


  


 


 


Income before income tax expense (benefit) and cumulative effect of a change in accounting principle

   134,856   46,730   34,014 

Income tax expense (benefit)

   22,860   (2,031)  —   

Income from continuing operations before income tax (benefit) expense

   132,697   136,264   134,856 

Income tax (benefit) expense

   (10,900)  9,526   22,860 
  


 


 


  


 


 


Income before cumulative effect of a change in accounting principle

   111,996   48,761   34,014 

Cumulative effect of a change in accounting principle

   —     —     (1,706)

Income from continuing operations

   143,597   126,738   111,996 

Loss from discontinued operations, net of income tax

   (4,473)  (11,349)  —   
  


 


 


  


 


 


Net income

   111,996   48,761   32,308    139,124   115,389   111,996 

Dividends on preferred shares

   —     —     (5,025)   (6,653)  (6,265)  —   
  


 


 


  


 


 


Net income available to common shareholders

  $111,996  $48,761  $27,283   $132,471  $109,124  $111,996 
  


 


 


  


 


 


Basic earnings per share – before cumulative effect of a change in accounting principle

  $5.04  $2.35  $1.69 

Basic loss per share due to cumulative effect of a change in accounting principle

   —     —     (0.08)

Basic earnings per share:

   

Income from continuing operations available to common shareholders

  $4.61  $4.76  $5.04 

Loss from discontinued operations, net of income tax

   (0.15)  (0.45)  —   
  


 


 


  


 


 


Basic earnings per share

  $5.04  $2.35  $1.61 

Net income available to common shareholders

  $4.46  $4.31  $5.04 
  


 


 


  


 


 


Diluted earnings per share – before cumulative effect of a change in accounting principle

  $4.91  $2.25  $1.59 

Diluted loss per share due to cumulative effect of a change in accounting principle

   —     —     (0.08)

Diluted earnings per share:

   

Income from continuing operations available to common shareholders

  $4.57  $4.68  $4.91 

Loss from discontinued operations, net of income tax

   (0.15)  (0.44)  —   
  


 


 


  


 


 


Diluted earnings per share

  $4.91  $2.25  $1.51 

Net income available to common shareholders

  $4.42  $4.24  $4.91 
  


 


 


  


 


 


Weighted average basic shares outstanding

   22,220   20,758   20,050    29,669   25,290   22,220 
  


 


 


  


 


 


Weighted average diluted shares outstanding

   22,821   21,660   21,382    29,993   25,763   22,821 
  


 


 


  


 


 


Dividends declared per common share

  $5.04  $2.15  $0.48   $5.60  $6.75  $5.04 
  


 


 


  


 


 


 

See notes to consolidated financial statements.

NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’SHAREHOLDERS’ EQUITY

(Dollarsdollars in thousands, except share amounts)


 

  Convertible
Preferred
Stock


 Common
Stock


 Additional
Paid-in
Capital


 Accumulated
Deficit


 Accumulated
Other
Comprehensive
Income


 Other

 Total
Stockholders’
Equity


   

Preferred

Stock


  

Common

Stock


  

Additional

Paid-in

Capital


  

Accumulated

Deficit


 

Accumulated

Other

Comprehensive

Income


 Other

 

Total

Shareholders’

Equity


 

Balance, January 1, 2001

  $43  $122  $141,936  $(37,976) $10,168  $(6,374) $107,919 

Common stock repurchased, 230,294 shares

   —     (2)  (652)  —     —     —     (654)

Return of common stock underlying founders’ notes receivable, 578,664 shares

   —     (6)  (4,334)  —     —     4,340   —   

Forgiveness of founders’ notes receivable

   —     —     —     —     —     139   139 

Payment of founders’ notes receivable

   —     —     —     —     —     641   641 

Exercise of stock options, 228,278 shares

   —     2   852   —     —     —     854 

Dividends on common stock ($0.48 per share)

   —     —     —     (5,194)  —     —     (5,194)

Dividends on preferred stock ($1.08 per share)

   —     —     —     (5,025)  —     —     (5,025)
  


 


 


 


 


 


 


Comprehensive income:

   

Net income

    32,308   —     32,308 

Other comprehensive income

    —     (991)  (991)
   


Total comprehensive income

    31,317 
   


Balance, December 31, 2001

   43   116   137,802   (15,887)  9,177   (1,254)  129,997 
  


 


 


 


 


 


 


Conversion of preferred stock to common, 8,571,428 shares

   (43)  86   (43)  —     —     —     —   

Acquisition of warrants, 812,731

   —     —     (9,499)  —     —     —     (9,499)

Conversion of 350,000 warrants for 421,406 shares of common stock

   —     4   (4)  —     —     —     —   

Forgiveness of founders’ notes receivable

   —     —     —     —     —     139   139 

Exercise of stock options, 358,476 shares

   —     4   1,782   —     —     —     1,786 

Compensation recognized under stock option plan

   —     —     3,215   —     —     —     3,215 

Dividends on common stock ($2.15 per share)

   —     —     —     (44,900)  —     —     (44,900)

Increase in common stock held in rabbi trusts

   —     —     —     —     —     (911)  (911)

Increase in deferred compensation obligation

   —     —     —     —     —     911   911 
  


 


 


 


 


 


 


Comprehensive income:

   

Net income

    48,761   —     48,761 

Other comprehensive income

    —     53,758   53,758 
   


Total comprehensive income

    102,519 
   


Balance, December 31, 2002

   —     210   133,253   (12,026)  62,935   (1,115)  183,257 
  


 


 


 


 


 


 


Balance, January 1, 2003

  $—    $210  $133,253  $(12,026) $62,935  $(1,115) $183,257 

Forgiveness of founders’ notes receivable

   —     —     —     —     —     139   139    —     —     —     —     —     139   139 

Issuance of common stock, 3,188,620 shares

   —     32   93,889   —     —     —     93,921    —     32   93,889   —     —     —     93,921 

Exercise of stock options, 298,875 shares

   —     3   1,644   —     —     —     1,647    —     3   1,644   —     —     —     1,647 

Compensation recognized under stock option plan

   —     —     1,310   —     —     —     1,310    —     —     1,310   —     —     —     1,310 

Dividend equivalent rights (DERs) on vested options

   —     —     1,198   (1,198)  —     —     —   

Dividend equivalent rights (DERs) on vested stock options

   —     —     1,198   (1,198)  —     —     —   

Dividends on common stock ($5.04 per share)

   —     —     —     (114,294)  —     —     (114,294)   —     —     —     (114,294)  —     —     (114,294)

Increase in common stock held in rabbi trusts

   —     —     —     —     —     (3,145)  (3,145)   —     —     —     —     —     (3,145)  (3,145)

Increase in deferred compensation obligation

   —     —     —     —     —     3,145   3,145    —     —     —     —     —     3,145   3,145 
  


 


 


 


 


 


 


  

  

  

  


 


 


 


Comprehensive income:

               

Net income

    111,996   —     111,996             111,996   —     111,996 

Other comprehensive income

    —     22,248   22,248             —     22,248   22,248 
   


            


Total comprehensive income

    134,244              134,244 
   


            


Balance, December 31, 2003

  $—    $245  $231,294  $(15,522) $85,183  $(976) $300,224   $—    $245  $231,294  $(15,522) $85,183  $(976) $300,224 
  


 


 


 


 


 


 


  

  

  

  


 


 


 


Forgiveness of founders’ notes receivable

   —     —     —     —     —     140   140 

Issuance of common stock, 2,829,488 shares

   —     28   121,306   —     —     —     121,334 

Issuance of preferred stock, 2,990,000 shares

   30   —     72,089   —     —     —     72,119 

Issuance of stock under stock compensation plans, 433,181 shares

   —     4   3,811   —     —     —     3,815 

Compensation recognized under stock compensation plans

   —     —     1,810   —     —     —     1,810 

Dividend equivalent rights (DERs) on vested stock options

   —     —     1,900   (1,900)  —     —     —   

Dividends on common stock ($6.75 per share)

   —     —     —     (177,056)  —     —     (177,056)

Dividends on preferred stock ($2.11 per share)

   —     —     —     (6,265)  —     —     (6,265)

Tax benefit derived from stock compensation plans

   —     —     897   —     —     —     897 

Increase in common stock held in rabbi trusts

   —     —     —     —     —     (2,290)  (2,290)

Increase in deferred compensation obligation

   —     —     —     —     —     2,290   2,290 
  

  

  

  


 


 


 


Comprehensive income:

            

Net income

            115,389   —     115,389 

Other comprehensive loss

            —     (6,063)  (6,063)
            


Total comprehensive income

             109,326 
            


Balance, December 31, 2004

  $30  $277  $433,107  $(85,354) $79,120  $(836) $426,344 
  

  

  

  


 


 


 


Continued

   

Preferred

Stock


  

Common

Stock


  

Additional

Paid-in

Capital


  

Accumulated

Deficit


  

Accumulated

Other

Comprehensive

Income


  Other

  

Total

Shareholders’

Equity


 

Balance, December 31, 2004

  $30  $277  $433,107  $(85,354) $79,120  $(836) $426,344 
   

  

  


 


 

  


 


Forgiveness of founders’ notes receivable

   —     —     —     —     —     140   140 

Issuance of common stock, 4,334,320 shares

   —     43   145,313   —     —     —     145,356 

Issuance of stock under stock compensation plans, 148,797 shares

   —     2   921   —     —     —     923 

Compensation recognized under stock compensation plans

   —     —     2,226   —     —     —     2,226 

Dividend equivalent rights (DERs) on vested stock options

   —     —     304   (4,369)  —     —     (4,065)

Dividends on common stock ($5.60 per share)

   —     —     —     (171,302)  —     —     (171,302)

Dividends on preferred stock ($2.23 per share)

   —     —     —     (6,653)  —     —     (6,653)

Tax benefit derived from stock compensation plans

   —     —     (291)  —     —     —     (291)

Decrease in common stock held in rabbi trusts

   —     —     —     —     —     33   33 

Decrease in deferred compensation obligation

   —     —     —     —     —     (33)  (33)
   

  

  


 


 

  


 


Comprehensive income:

                             

Net income

               139,124   —         139,124 

Other comprehensive income

               —     32,418       32,418 
                           


Total comprehensive income

                           171,542 
                           


Balance, December 31, 2005

  $30  $322  $581,580  $(128,554) $111,538  $(696) $564,220 
   

  

  


 


 

  


 


                            Concluded 

 

See notes to consolidated financial statements.

NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Indollars in thousands)


 

  For the Year Ended December 31,

   For the Year Ended December 31,

 
  2003

 2002

 2001

   2005

 2004

 2003

 

Cash flows from operating activities:

      

Net income

  $111,996  $48,761  $32,308 

Income from continuing operations

  $143,597  $126,738  $111,996 

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

      

Cumulative effect of change in accounting principle

   —     —     1,706 

Amortization of premiums on mortgage assets

   1,120   1,930   3,208 

Amortization of mortgage servicing rights

   8,995   4,609   2,131    28,364   16,934   8,995 

Accretion of available-for-sale securities

   (98,804)  (56,481)  (11,706)

Impairment on mortgage securities – available-for-sale

   17,619   15,902   —   

(Gains) losses on derivative instruments

   (18,155)  8,905   30,837 

Depreciation expense

   7,433   6,090   3,872 

Losses on disposals of property and equipment

   226   —     —   

Amortization of deferred debt issuance costs

   1,100   172   1,022    5,683   5,036   1,100 

Compensation recognized under stock compensation plans

   2,226   1,810   1,310 

Provision for credit losses (recoveries)

   1,038   726   (389)

Amortization of premiums on mortgage loans

   376   699   1,120 

Forgiveness of founders’ promissory notes

   139   139   139    140   140   139 

Credit (recoveries) losses

   (389)  (432)  3,608 

Provision for deferred income taxes

   (5,848)  (4,652)  —      (19,659)  (1,322)  (5,848)

Accretion of available-for-sale and trading securities

   (172,019)  (100,666)  (78,097)

Gains on sales of mortgage assets

   (68,173)  (144,950)  (144,005)

Gains on trading securities

   (549)  —     —   

Originations and purchases of mortgage loans held-for-sale

   (9,366,720)  (8,560,314)  (6,071,042)

Proceeds from repayments of mortgage loans held-for-sale

   9,908   27,979   18,474 

Repurchase of mortgage loans from securitization trusts

   (6,784)  —     —   

Proceeds from sale of mortgage loans held-for-sale to third parties

   1,176,518   64,476   966,537 

Proceeds from sale of mortgage loans held-for-sale in securitizations

   5,207,233   1,532,483   1,191,977    7,428,063   8,173,829   5,207,525 

Proceeds from sale of mortgage loans held-for-sale to third parties

   966,537   391,506   110,879 

Originations of mortgage loans held-for-sale

   (6,066,002)  (2,811,315)  (1,403,289)

Repayments of mortgage loans held-for-sale

   18,474   10,943   1,731 

Gains on sales of mortgage assets

   (144,005)  (53,305)  (37,347)

Losses on derivative instruments

   30,837   36,841   3,953 

Compensation recognized under stock option plan

   1,310   3,215   —   

Depreciation expense

   3,872   1,203   940 

Purchase of mortgage securities - trading

   —     (143,153)  —   

Proceeds from sale of mortgage securities - trading

   143,153   —     —   

Changes in:

      

Servicing related advances

   (6,752)  (707)  (6,247)

Derivative instruments, net

   2,509   13,553   (9,577)

Other assets

   (61,618)  (56,085)  (26,532)   (44,958)  (40,895)  (25,074)

Other liabilities

   33,394   (3,114)  1,325 

Accounts payable and other liabilities

   15,448   (26,778)  30,422 
  


 


 


  


 


 


Net cash provided by (used in) operating activities

   8,341   (953,582)  (123,947)

Net cash (used in) provided by operating activities from continuing operations

   (721,468)  (555,968)  42,048 

Net cash used in operating activities from discontinued operations

   (5,713)  (9,738)  —   
  


 


 


Net cash (used in) provided by operating activities

   (727,181)  (565,706)  42,048 

Cash flows from investing activities:

      

Mortgage loan repayments—held-in-portfolio

   49,101   65,505   125,198 

Proceeds from paydowns on available-for-sale securities

   200,024   100,071   40,190    453,750   346,558   179,317 

Proceeds from sales of available-for-sale securities

   —     —     28,626 

Proceeds from repayments of mortgage loans held-in-portfolio

   16,673   31,781   49,101 

Proceeds from sales of assets acquired through foreclosure

   6,719   14,876   20,466    1,909   4,905   6,719 

Net assets acquired in acquisition of common stock of NFI Holding Corporation

   —     —     872 

Payment on founders’ promissory notes

   —     —     641 

Purchases of property and equipment

   (5,315)  (7,029)  (13,000)
  


 


 


  


 


 


Net cash provided by investing activities

   255,844   180,452   215,993    467,017   376,215   222,137 

Cash flows from financing activities:

      

Proceeds from issuance of asset-backed bonds, net of debt issuance costs

   128,921   506,745   52,271 

Payments on asset-backed bonds

   (120,083)  (86,434)  (139,411)   (363,861)  (254,867)  (120,083)

Proceeds from asset-backed bonds

   52,271   66,906   —   

Change in short-term borrowings

   (153,000)  882,186   81,450 

Payments on asset-backed bonds due to exercise of redemption provisions

   (7,822)  —     —   

Proceeds from issuance of capital stock and exercise of equity instruments, net of offering costs

   94,321   1,786   854    142,114   193,615   94,321 

Repurchase of warrants

   —     (9,499)  —   

Net change in short-term borrowings

   513,041   32,992   (153,000)

Proceeds from the issuance of junior subordinated debentures

   48,428   —     —   

DERs paid on vested stock options

   (2,113)  —     —   

Dividends paid on preferred stock

   —     (2,014)  (3,150)   (6,653)  (6,265)  —   

Dividends paid on common stock

   (99,256)  (30,876)  (2,836)   (195,760)  (132,346)  (99,256)

Common stock repurchases

   —     —     (654)
  


 


 


  


 


 


Net cash provided by (used in) financing activities

   (225,747)  822,055   (63,747)   256,295   339,874   (225,747)
  


 


 


  


 


 


Net increase in cash and cash equivalents

   38,438   48,925   28,299 

Net (decrease) increase in cash and cash equivalents

   (3,869)  150,383   38,438 

Cash and cash equivalents, beginning of year

   79,742   30,817   2,518    268,563   118,180   79,742 
  


 


 


  


 


 


Cash and cash equivalents, end of year

  $118,180  $79,742  $30,817   $264,694  $268,563  $118,180 
  


 


 


  


 


 


 

See notes to consolidated financial statements.

See notes to consolidated financial statements.Concluded

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


 

Note 1. Summary of Significant Accounting and Reporting Policies

 

Description of Operations NovaStar Financial, Inc. and subsidiaries (the “Company”) operates as a specialty finance company that originates, purchases, invests in and services residential nonconforming loans. The Company offers a wide range of mortgage loan products to borrowers, commonly referred to as “nonconforming borrowers,” who generally do not satisfy the credit, collateral, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers, including U.S. government-sponsored entities such as Fannie Mae or Freddie Mac. The Company retains significant interests in the nonconforming loans originated and purchased through their mortgage securities investment portfolio. Historically, the Company has serviced all of the loans in which they retain interests through their servicing platform.

Financial Statement PresentationThe Company’s consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and prevailing practices within the financial services industry. The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of income and expense during the period. The Company uses estimates and employs the judgments of management in determining the amount of its allowance for credit losses, amortizing premiums or accreting discounts on its mortgage assets, amortizing mortgage servicing rights and establishing the fair value of its mortgage securities, derivative instruments, mortgage servicing rights and estimating appropriate accrual rates on mortgage securities.securities – available-for-sale. While the consolidated financial statements and footnotes reflect the best estimates and judgments of management at the time, actual results could differ significantly from those estimates. For example, it is possible that credit losses or prepayments could rise to levels that would adversely affect profitability if those levels were sustained for more than brief periods.

 

The consolidated financial statements of the Company include the accounts of all wholly-owned subsidiaries. Intercompany accounts and transactions have been eliminated during consolidation.

 

Unconsolidated AffiliatesThe Company is party to limited liability company agreements (“LLCs”), formed to facilitate the operation of retail mortgage broker businesses as branch affiliates. The LLC agreements provide for initial capitalization and membership interests of 99.9% to a branch manager and 0.1% to the Company. The LLCs broker loans to mortgage investors, including a subsidiary of the Company. The Company provides accounting, payroll, human resources, loan investor management and license management in conjunction with separate contractual agreements. The Company accounts for its interest in the LLC agreements using the equity method of accounting.

Cash and Cash Equivalents The Company considers investments with original maturities of three months or less at the date of purchase to be cash equivalents. The Company maintains cash balances at several major financial institutions in the United States. Accounts at each institution are secured by the Federal Deposit Insurance Corporation up to $100,000. At December 31, 2005 and 2004, 96% and 89% of the Company’s cash and cash equivalents were with one institution. Uninsured balances with this institution aggregated $253.0 million and $238.8 million at December 31, 2005 and 2004, respectively.

 

Mortgage LoansMortgage loans include loans originated by the Company and acquired in bulk pools from other originators and securities dealers.originators. Mortgage loans are recorded net of deferred loan origination fees and associated direct costs and are stated at amortized cost. Mortgage loan origination fees and associated direct mortgage loan origination costs on mortgage loans held-in-portfolio are deferred and recognized over the estimated life of the loan as an adjustment to yield using the level yield method. Mortgage loan origination fees and direct mortgage loan origination costs on mortgage loans held-for-sale are deferred until the related loans are sold. Mortgage loans held-for-sale are carried at the lower of cost or market determined on an aggregate basis.

 

Interest is recognized as revenue when earned according to the terms of the mortgage loans and when, in the opinion of management, it is collectible. For all mortgage loans held-for-sale and only mortgage loans held-in-portfolio which do not carry mortgage insurance, the accrual of interest on loans is discontinued when, in management’s opinion, the interest is not collectible in the normal course of business, but in no case beyond when a loan becomes ninety days delinquent. For mortgage loans, held-in-portfolio, which do carry mortgage insurance, the accrual of interest is only discontinued when in management’s opinion, the interest is not collectible in the ordinary course of business.collectible. Interest collected on non-accrual loans is recognized as income upon receipt.

 

The mortgage loan portfolio is collectively evaluated for impairment as the loans are smaller-balance and are homogeneous in nature. TheFor mortgage loans held-in-portfolio, the Company maintains an allowance for credit losses inherent in the portfolio at the balance sheet date. The allowance is based upon the assessment by management of various factors affecting its mortgage loan portfolio, including current economic conditions, the makeup of the portfolio based on credit grade, loan-to-value, delinquency status, historical credit losses, whether the Company purchased mortgage insurance and other factors deemed to warrant consideration. The Company uses contractual terms in determining past due or delinquency status of loans.

 

The servicing agreements the Company executes for loans it has securitized include a removal of accounts provision which gives it the right, not the obligation, to repurchase mortgage loans from the trust. The removal of accounts provision can be exercised for loans that are 90 days to 119 days delinquent. The Company records the mortgage loans subject to the removal of accounts provision in mortgage loans held-for-sale at fair value.

Mortgage Securities – Available-for-SaleMortgage securities – available-for-sale represent beneficial interests the Company retains in securitization and resecuritization transactions which include residual interests (the “residual securities”) and subordinated primary securities (the “subordinated securities”). The residual securities include interest-only mortgage securities, prepayment penalty bonds over-collateralizationand overcollateralization bonds. The subordinated securities represent investment-grade rated bonds which are senior to the residual interests but subordinated to the bonds sold to third party investors. Mortgage securities classified as available-for-sale are reported at their estimated fair value with unrealized gains and losses reported in accumulated other subordinated securities. comprehensive income. To the extent that the cost basis of mortgage securities exceeds the fair value and the unrealized loss is considered to be other than temporary, an impairment charge is recognized and the amount recorded in accumulated other comprehensive income or loss is reclassified to earnings as a realized loss. The specific identification method was used in computing realized gains or losses.

Interest-only mortgage securities represent the contractual right to receive excess interest cash flows from a pool of securitized mortgage loans. Interest payments received by the independent trust are first applied to the principal and interest bonds (held by outside investors), servicing fees and administrative fees. The excess, if any, is remitted to the Company related to its ownership of the interest-only mortgage security. Prepayment penalty bonds give the holder the contractual right to receive prepayment penalties collected by the independent trust on the underlying mortgage loans. Overcollateralization bonds represent the contractual right to excess principal payments resulting from over collateralization of the obligations of the trust. Subordinated

The subordinated securities retained by the Company in resecuritizations represent the contractual right to receive the remaining cash flowsits securitization transactions have a stated principal amount and interest rate and have been retained at a market discount from the trust afterstated principal amount. The performance of the obligationssecurities is dependent upon the performance of the underlying pool of securitized mortgage loans. The interest rates these securities earn are variable and are subject to an available funds cap as well as a maximum rate cap. The securities receive principal payments in accordance with a payment priority which is designed to maintain specified levels of subordination to the outside bond

holders have been satisfied. When those obligations have been satisfied,senior bonds within the trust returns the transferred securities torespective securitization trust. Because the subordinated interest holders.

Mortgage securities are classified as availablerated lower than AA, they are considered low credit quality and the Company accounts for sale and, accordingly, are reported at their estimated fair value with unrealized gains and losses reported in accumulated other comprehensive income.the securities based on the effective yield method.

 

As previously described, mortgage securities available-for-sale represent the retained beneficial interests in certain components of the cash flows of the underlying mortgage loans or mortgage securities transferred to securitization trusts. As payments are received on both the residual and subordinated securities, the payments are applied to the cost basis of the related mortgage related security.securities. Each period, the accretable yield for each mortgage security is evaluated and, to the extent there has been a change in the estimated cash flows, it is adjusted and applied prospectively. The estimated cash flows change as management’s assumptions for credit losses, borrower prepayments and interest rates are updated. The assumptions are established using sophisticatedproprietary models the Company has developed. The accretable yield is recorded as interest income with a corresponding increase to the cost basis of the mortgage security.

 

Management believes the best estimate of the initial value of the residual securities it retains in a whole loan securitization is derived from the market value of the pooled loans. The initial value of the loans is estimated based on the expected open market sales price of a similar pool. In open market transactions, the purchaser has the right to reject loans at its discretion. In a loan securitization, loans cannot generally be rejected. As a result, management adjusts the market price for loans to compensate for the estimated value of rejected loans. The market price of the securities retained is derived by deducting the net proceeds received in the securitization (i.e. the economic value of the loans transferred) from the estimated adjusted market price for the entire pool of the loans.

At each reporting period subsequent to the initial valuation of the retained residual securities, the fair value of mortgage securities is estimated based on the present value of future expected cash flows to be received. Management’s best estimate of key assumptions, including credit losses, prepayment speeds, the market discount rates and forward yield curves commensurate with the risks involved, are used in estimating future cash flows. To the extent that the cost basis of mortgage securities exceeds the

The Company estimates initial and subsequent fair value andfor the unrealized loss is considered to be other than temporary, an impairment charge is recognized and the amount recorded in accumulated other comprehensive income or loss is reclassified to earnings as a realized loss.subordinated securities based on quoted market prices.

 

Servicing related advancesMortgage Securities - TradingMortgage securities – trading consist of mortgage securities purchased by the Company as well as retained by the Company in its securitization transactions with the principal intent to sell in the near term. Trading securities are recorded at fair value with gains and losses, realized and unrealized, included in earnings. The Company advancesuses the specific identification method in computing realized gains or losses.

As described underMortgage Securities – Available-for-Sale, the Company retains subordinated securities in its securitization transactions which have a stated principal amount and interest rate and have been retained at a market discount from the stated principal amount. The Company has designated certain subordinated securities as trading due to the Company’s intent to sell in the near term. The performance of the securities is dependent upon the performance of the underlying pool of securitized mortgage loans. The interest rates these securities earn are variable and are subject to an available funds cap as well as a maximum rate cap. The securities receive principal payments in accordance with a payment priority which is designed to

maintain specified levels of subordination to the senior bonds within the respective securitization trust. Because the subordinated securities are rated lower than AA, they are considered low credit quality and the Company accounts for the securities based on behalf of borrowers for taxes, insurance and other customer service functions. These advances are routinely assessed for collectibility and any uncollectible advances are appropriately charged to earnings.the effective yield method. Fair value is estimated using quoted market prices.

 

Mortgage Servicing Rights Originated mortgageMortgage servicing rights are recorded at allocated cost based upon the relative fair values of the transferred loans and the servicing rights. Mortgage servicing rights are amortized in proportion to and over the projected net servicing revenue over the expected life of the related mortgage loans.revenues. Periodically, the Company evaluates the carrying value of originated mortgage servicing rights based on their estimated fair value. If the estimated fair value, using a discounted cash flow methodology, is less than the carrying amount of the mortgage servicing rights, the mortgage servicing rights are written down to the amount of the estimated fair value. For purposes of evaluating and measuring impairment of mortgage servicing rights the Company stratifies the mortgage servicing rights based on their predominant risk characteristics. The significant risk characteristic considered by the Company is period of origination. The mortgage loans underlying the mortgage servicing rights are pools of homogenous, nonconforming residential loans.

 

Assets Acquired Through ForeclosureServicing Related Advances Real estate owned, which consistsThe Company advances funds on behalf of residential real estate acquired in satisfactionborrowers for taxes, insurance and other customer service functions. These advances are routinely assessed for collectability and any uncollectible advances are appropriately charged to earnings.

Derivative Instruments, netThe Company uses derivative instruments with the objective of loans, is carriedhedging interest rate risk. Interest rates on the Company’s liabilities typically adjust more frequently than interest rates on the Company’s assets. Derivative instruments are recorded at the lower of cost or estimatedtheir fair value less estimated selling costs. Adjustments to the loan carryingwith hedge ineffectiveness recognized in earnings. For derivative instruments that qualify for hedge accounting, any changes in fair value required at time of foreclosure are charged against the allowance for credit losses. Costsderivative instruments related to the developmenthedge effectiveness are reported in accumulated other comprehensive income. Changes in fair value of real estate are capitalized and thosederivative instruments related to holdinghedge ineffectiveness and non-hedge activity are recorded as adjustments to earnings through the propertygains (losses) on derivative instruments line item of the Company’s consolidated income statement. For those derivative instruments that do not qualify for hedge accounting, changes in the fair value of the instruments are expensed. Losses orrecorded as adjustments to earnings through the gains from(losses) on derivative instruments line item of the ultimate dispositionCompany’s consolidated income statement. The fair value of real estate ownedthe Company’s derivative instruments, along with any margin accounts associated with the contracts, are charged or credited to operating income.included in derivative instruments, net on the Company’s balance sheet.

 

Property and Equipment, netLeasehold improvements, furniture and fixtures and office and computer equipment are stated at cost less accumulated depreciation. Net property and equipment is included in other assets. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets. The estimated useful lives of the assets are as follows:

 

Leasehold improvements

  5 years
(A)

Furniture and fixtures

  5 years

Office and computer equipment

  3 years

(A)Lesser of 5 years or remaining lease term.

 

Maintenance and repairs are charged to expense. Major renewals and improvements are capitalized. Gains and losses on dispositions are credited or charged to earnings as incurred.

Warehouse Notes Receivable Warehouse notes receivable represent outstanding warehouse lines of credit the Company provides to approved borrowers. The lines of credit are used by the borrowers to originate mortgage loans. The notes receivable are collateralized by the mortgage loans originated by the Company’s borrowers and are recorded at amortized cost. The Company recognizes interest income in accordance with the terms of agreement with the borrower. The accrual of interest is discontinued when, in management’s opinion, the interest is not collectible in the normal course of business.

Due to Securitization TrustsDue to trusts represents the fair value of the mortgage loans the Company has the right to repurchase from the securitization trusts. The servicing agreements the Company executes for loans it has securitized include a removal of accounts provision which gives it the right, not the obligation, to repurchase mortgage loans from the trust. The removal of accounts provision can be exercised for loans that are 90 days to 119 days delinquent. Upon exercise of the call options, the related obligation to the trusts is removed from the Company’s balance sheet.

 

Premiums for Mortgage Loan InsuranceThe Company uses lender paid mortgage insurance to mitigate the risk of loss on loans that are originated. For those loans held-in-portfolio, the premiums for mortgage insurance are expensed by the Company as the costcosts of the premiums are incurred. For those loans sold in securitization transactions accounted for as a sale, the independent trust assumes the obligation to pay the premiums and obtains the right to receive insurance proceeds.

 

Transfers of Assets A transfer of mortgage loans or mortgage securities in which the Company surrenders control over the financial assets is accounted for as a sale. When the Company retains control over transferred mortgage loans or mortgage securities, the transaction is accounted for as a secured borrowing. When the Company sells mortgage loans or mortgage

securities in securitization and resecuritization transactions, it may

retain one or more bond classes and servicing rights in the securitization. Gains and losses on the assets transferred are recognized based on the carrying amount of the financial assets involved in the transfer, allocated between the assets transferred and the retained interests based on their relative fair value at the date of transfer.

 

Management believes the best estimate of the initial value of the residual securities it retains in a whole loan securitization is derived from the market value of the pooled loans. The initial value of the loans is estimated based on the expected open market sales price of a similar pool. The Company regularly accepts bids on its whole loans in order to test the market price. In open market transactions, the purchaser has the right to reject loans at its discretion. In a loan securitization, loans cannot generally be rejected. As a result, management adjusts the market price for loans to compensate for the estimated value of rejected loans. The market price of the securities retained is derived by deducting the percent of net proceeds received in the securitization (i.e. the economic value of the loans transferred) from the estimated adjusted market price for the entire pool of the loans.

 

An implied yield (discount rate) is calculated based onderived by taking the initial value derived above and using projected cash flows generated using assumptions for prepayments, expected credit losses and interest rates. We ensurerates and then solving for the discount rate required to present value the cash flows back to the initial value derived above. The Company then ascertains the resulting implied yielddiscount rate is commensurate with current market conditions. Additionally, this yieldthe initial discount rate serves as the initial accretable yield used to recognize income on the securities.

 

The Company estimates fair value forFor purposes of valuing the Company’s residual securities, it retainsis important to know that in recent securitization transactions they not only have transferred loans to the trust, but they have also transferred interest rate agreements to the trust with the objective of reducing interest rate risk within the trust. During the period before loans are transferred in a resecuritizationsecuritization transaction based on the present valueCompany enters into interest rate swap or cap agreements. Certain of future expected cash flows estimated using management’s best estimatethese interest rate agreements are then transferred into the trust at the time of securitization. Therefore, the trust assumes the obligation to make payments and obtains the right to receive payments under these agreements.

In valuing the Company’s residual securities, it is also important to understand what portion of the key assumptions, includingunderlying mortgage loan collateral is covered by mortgage insurance. At the time of a securitization transaction, the trust legally assumes the responsibility to pay the mortgage insurance premiums associated with the loans transferred and the rights to receive claims for credit losses. Therefore, the Company has no obligation to pay these insurance premiums. The cost of the insurance is paid by the trust from proceeds the trust receives from the underlying collateral. This information is significant for valuation as the mortgage insurance significantly reduces the credit losses prepayment speeds, forward yield curves, and discount rates commensurate withborn by the risks involved.owner of the loan. Mortgage insurance claims on loans where a defect occurred in the loan origination process will not be paid by the mortgage insurer. The assumptions the Company uses to value its residual securities consider this risk.

 

The following is a description of the methods used by the Company to transfer assets, including the related accounting treatment under each method:

 

Whole Loan Sales Whole loan sales represent loans sold to third parties with servicing released. Gains and losses on whole loan sales are recognized in the period the sale occurs and the Company has determined that the criteria for sales treatment has been achieved as it has surrendered control over the assets transferred. The Company generally has an obligation to repurchase whole loans sold in circumstances in which the borrower fails to make the first payment. Additionally, the Company is also required to repay all or a portion of the premium it receives on the sale of whole loans in the event that the loan prepays in its entirety in the first year. The Company records the fair value of recourse obligations upon the sale of the mortgage loans. See Note 15.9.

 

Loans and Securities Sold Under Agreements to Repurchase (Repurchase Agreements)Repurchase agreements represent legal sales of loans or mortgage securities and an agreement to repurchase the loans or mortgage securities at a later date. Repurchase agreements are accounted for as secured borrowings because the Company has not surrendered control of the transferred assets as it is both entitled and obligated to repurchase the transferred assets prior to their maturity.

 

Securitization TransactionsThe Company regularly securitizes mortgage loans by transferring mortgage loans to independent trusts which issue securities to investors. The securities are collateralized by the mortgage loans transferred into the independent trusts. The Company generally retains interests in some of the securities issued by the trust. Certain of the securitization agreements require the Company to repurchase loans that are found to have legal deficiencies subsequent to the date of transfer. The Company is also required to buy back any loan for which the borrower converts from an adjustable rate to a fixed rate. The fair values of these recourse obligations are recorded upon the transfers of the mortgage loans and on an ongoing basis. The Company also has the right, but not the obligation, to acquire loans when they are 90 to 119 days delinquent and at the time a property is liquidated. As discussed above, the accounting treatment for transfers of assets upon securitization depends on whether or not the Company has retained control over the transferred assets. The Company records an asset and a liability on the balance sheet for the aggregate fair value of delinquent loans that it has a right to call as of the balance sheet date.date when the securitization is accounted for as a sale.

 Resecuritization Transactions The Company also engages in resecuritization transactions. A resecuritization is the transfer or sale of mortgage securities that the Company has retained in previous securitization transactions to an independent trust. Similar to a securitization, the trust issues securities that are collateralized by the mortgage securities transferred to the trust. Resecuritization transactions are accounted for as either a sale or a secured borrowing based on whether or not the Company has retained or surrendered control over the transferred assets. In the resecuritization transaction, the Company may retain an interest in a security that represents the right to receive the cash flows on the underlying mortgage security collateral after the senior bonds, issued to third parties, have been repaid in full.

Fee Income The Company receives fee income from several sources. The following describes significant fee income sources and the related accounting treatment:

 

Broker FeesBroker fees are paid by other lenders for placing loans with third partythird-party investors (lenders) and are based on negotiated rates with each lender to whom the Company brokers loans. Revenue is recognized upon loan origination and delivery.

 

Loan Origination Fees Loan origination fees represent fees paid to the Company by borrowers and are associated with the origination of mortgage loans. Loan origination fees are determined based on the type and amount of loans originated. Loan origination fees and direct origination costs on mortgage loans held-in-portfolio are deferred and recognized over the life of the loan using the level yield method. Loan origination fees and direct origination costs on mortgage loans held-for-sale are deferred and considered as part of the carrying value of the loan when sold.

 

Service Fee Income Service fees are paid to the Company by either the investor on mortgage loans serviced or the borrower. Fees paid by investors on loans serviced are determined as a percentage of the principal collected for the loans serviced and are recognized in the period in which payments on the loans are received. Fees paid by borrowers on loans serviced are considered ancillary fees related to loan servicing and include late fees, processing fees and, for loans held-in-portfolio, prepayment penalties. Revenue is recognized on fees received from borrowers when an event occurs that generates the fee and they are considered to be collectible.

 

AffiliatedNovaStar Home Mortgage, Inc. (“NHMI”) Branch Management Fees These During 2003, these fees arewere charged to affiliated mortgage brokersLLCs formed to support NHMI branches to manage theirbranch administrative operations, which includeincluded providing accounting, payroll, human resources, loan investor management and license management. The amount of the fees iswas agreed upon when entering a contractual agreement with affiliated mortgage brokersthe LLC agreements and is recognized as services arewere rendered. Due to the elimination of the LLCs and their subsequent inclusion in the consolidated financial statements, branch management fees were eliminated in consolidation in 2004 and 2005.

 

Stock-Based Compensation Prior to 2003, the Company accounted for its stock-based compensation plan using the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25,Accounting for Stock Issued to Employees and related interpretations. The Company accounted for stock options based on the specific terms of the options granted. Options with variable terms, including those options for which the strike price has been adjusted and options issued by the Company with attached dividend equivalent rights, resulted in adjustments to compensation expense to the extent the market price of the common stock changed. No expense was recognized for options with fixed terms.

During the fourth quarter of 2003, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123,Accounting for Stock-Based Compensation. The Company selected the modified prospective method of adoption described in SFAS No. 148,Accounting for Stock-Based Compensation-Transition and Disclosure. Under this method, the change is retroactive to January 1, 2003 and compensation cost recognized in 2003 is the same as that which would have been recognized had the fair value method of SFAS No. 123 been applied from its original effective date. In accordance with the modified prospective method of adoption, results for prior years have not been restated. SFAS No. 123 states that the adoption of the fair value based method is a change to a preferable method of accounting. Management believes that use of the fair value based method to record stock-based compensation expense is consistent with the accounting for all other forms of compensation.

The following table illustrates the effect on net income and earnings per share as if the fair value method had been applied to all outstanding and unvested awards in each period (in thousands, except per share amounts):

   For the Year Ended December 31,

 
   2003

  2002

  2001

 

Net income, as reported

  $111,996  $48,761  $32,308 

Add: Stock-based employee compensation expense included in reported net income, net of related tax effects

   1,310   2,473   704 

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects

   (1,310)  (600)  (318)
   


 


 


Pro forma net income

  $111,996  $50,634  $32,694 
   


 


 


Earnings per share:

             

Basic – as reported

  $5.04  $2.35  $1.61 
   


 


 


Basic – pro forma

  $5.04  $2.44  $1.63 
   


 


 


Diluted – as reported

  $4.91  $2.25  $1.51 
   


 


 


Diluted – pro forma

  $4.91  $2.34  $1.53 
   


 


 


The following table summarizes the weighted average fair value of the granted options, determined using the Black-Scholes option pricing model and the assumptions used in their determination.

   2003

  2002

  2001

 

Weighted average:

             

Fair value, at date of grant

  $22.48  $10.29  $5.88 

Expected life in years

   7   7   7 

Annual risk-free interest rate

   3.3%  4.1%  5.0%

Volatility

   2.0   2.1   2.3 

Dividend yield

   0.0%  2.2%  1.8%

 

Income TaxesThe Company is taxed as a Real Estate Investment Trust (REIT)(“REIT”) under Section 856(c)857 of the Code.Internal Revenue Code of 1986, as amended (the “Code”). As a REIT, the Company generally is not subject to federal income tax. To maintain its qualification as a REIT, the Company must distribute at least 90% of its REIT taxable income to its stockholdersshareholders and meet certain other tests relating to assets and income. If the Company fails to qualify as a REIT in any taxable year, the Company will be subject to federal income tax on its taxable income at regular corporate rates. The Company may also be subject to certain state and local taxes. Under certain circumstances, even though the Company qualifies as a REIT, federal income and excise taxes may be due on its undistributed taxable income. Because the Company has paid or willintends to pay dividends in amounts approximatingthe amount of its taxable income by the statutorily required due date, no provision for income taxes has been provided in the accompanying financial statements related to the REIT. However, NFI Holding Corporation, a wholly-owned subsidiary, hasand its subsidiaries have not elected REIT-status and, filestherefore, are subject to corporate income taxes. Accordingly, a consolidated federalprovision for income tax return with itstaxes has been provided for the Company’s non-REIT subsidiaries.

 

The Company has elected to treat NFI Holding Corporation and its subsidiaries as taxable REIT subsidiaries (each a(collectively the “TRS”). In general, athe TRS of the Company may hold assets that the Company cannot hold directly and generally may engage in any real estate or non-real estate related business. AThe subsidiaries comprising the TRS isare subject to corporate federal income tax and will beare taxed as a regular C corporation.corporations. However, special rules do apply to certain activities between a REIT and a TRS. For example, athe TRS willmay be subject to earnings stripping limitations on the deductibility of interest paid to its REIT. In addition, a REIT will be subject to a 100% excise tax on certain excess amounts to ensure that (i) tenants who payamounts paid to a TRS for services are based on amounts that would be charged in an arm’s-length amount by the TRS, (ii) fees paid to a REIT by itsthe TRS are reflected at fair market value and (iii) interest paid by athe TRS to its REIT is commercially reasonable. Securities of a

The TRS will constitute non-real estate assets for purposes of determining whether at least 75% of a REIT’s assets consist of real estate. Under current law, no more than 20% of a REIT’s total assets can consist of securities of one or more taxable REIT subsidiaries. As of December 31, 2003, the amount of the Company’s assets attributable to its taxable REIT subsidiaries was less than 20%.

With respect to the Company’s taxable REIT subsidiaries, the Company records deferred tax assets and liabilities for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective income tax bases. The Company believes the deferred tax assethas recorded is recoverable and, therefore, noa valuation allowance as discussed in Note 12.

Discontinued Operations As the demand for conforming loans has declined significantly since 2004, many branches have not been recorded.able to produce sufficient fees to meet operating expense demands. As a result of these conditions, a significant number of branch managers have voluntarily terminated employment with the Company. The deferred tax assetCompany has also terminated branches when loan production results were substandard. On November 4, 2005, the Company adopted a formal plan to terminate substantially all of the remaining NHMI branches. The Company considers a branch to be discontinued upon its termination date, which is includedthe point in other assetstime when the operations cease. The provisions of SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets, require the results of operations associated with those branches terminated subsequent to January 1, 2004 to be classified as discontinued operations and segregated from the Company’s continuing results of operations for all periods presented. The Company has presented the operating results of those branches terminated through December 31, 2005, as discontinued operations in the Consolidated Statements of Income for the years ended December 31, 2005 and 2004. The Consolidated Statement of Income for the year ended December 31, 2003 has not been reclassified, as the effect of branch terminations on the consolidated balance sheet.operating results in those years is immaterial.

 

Earnings Per Share (EPS)Basic earnings per share excludes dilution and is computed by dividing net income available to common stockholdersshareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. Diluted EPS is calculated assuming all options, restricted stock, performance based awards and warrants on the Company’s common stock have been exercised, and the convertible preferred stock is converted, unless the exercise would be antidilutive.

 

Derivative Instruments and Hedging Activities Derivative instruments are recorded at their fair value with hedge ineffectiveness recognized in earnings. The Company adopted SFAS No. 133,Accounting for Derivative Instruments and Hedging Activities (as amended), on January 1, 2001 and recorded a charge to earnings of $1.7 million and an increase in accumulated other comprehensive income of $34,000. The transition adjustments resulted from adjusting the carrying value of certain interest rate cap agreements to their fair value.

The Company uses derivative instruments with the objective of hedging interest rate risk. Interest rates on liabilities of the Company adjust frequently, while interest rates on the Company’s assets adjust annually, or not at all. The fair value of the Company’s derivative instruments along with any margin accounts associated with the contracts are included in other assets. Any changes in fair value of derivative instruments related to hedge effectiveness are reported in accumulated other comprehensive income. Changes in fair value of derivative instruments related to hedge ineffectiveness and non-hedge activity are recorded as adjustments to earnings. For

those derivative instruments that do not qualify for hedge accounting, changes in the fair value of the instruments are recorded as adjustments to earnings.

Commitments to Originate Purchase and Sell Mortgage Loans As nonconforming mortgage loans are not readily convertible to cash and cannot readily be settled net, commitments to originate and purchase such loans do not meet the definition of a derivative under accounting principles generally accepted in the United States of America. Accordingly, they are not recorded in the consolidated financial statements. Commitments to originate and sell conforming mortgage loans meet the definition of a derivative and are recorded at fair value and are classified as other liabilities in the Company’s consolidated financial statements.balance sheets. The Company uses the Black-Scholes option pricing model to determine the value of its commitments. Significant assumptions used in the valuation determination include volatility, strike price, current market price, expiration and one-month LIBOR.

 

New Accounting PronouncementsIn December 2002,2004, the Financial Accounting Standards Board (FASB)(“FASB”) issued SFASa revision of Statement of Financial Accounting Standards (“SFAS”) No. 148,123,Accounting for Stock-Based Compensation-Transition and DisclosureCompensation, which amends (“SFAS No. 123. SFAS No. 148 provides alternative methods of transition123(R)”). This Statement establishes standards for a voluntary change tothe accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value basedof the entity’s equity instruments or that may be settled by the issuance of those equity instruments. Entities no longer have the option to use the intrinsic value method of accountingAccounting Principal Board Opinion 25,Account for stock-based compensation. Under the fair value based method, compensation cost for stock options is measured when options are issued. In addition, SFAS No. 148 amends the disclosure requirements ofStock Issued to Employees (“APB 25”) that was provided in SFAS No. 123 to require more prominent and more frequent disclosuresas originally issued, which generally resulted in financial statementsthe recognition of no compensation cost. Under SFAS No. 123(R), the cost of employee services received in exchange for an equity award must be based on the grant-date fair value of the effectsaward. The cost of stock-based compensation. The transition guidance and annual disclosure provisions ofthe awards under SFAS No. 148 were123(R) will be recognized over the period an employee provides service, typically the vesting period. No compensation cost is recognized for equity instruments in which the requisite service is not provided. This Statement is effective forat the beginning of the next fiscal years endingyear that begins after DecemberJune 15, 2002, with earlier application permitted in certain circumstances. The interim disclosure provisions were effective for financial reports containing financial statements for interim periods beginning after December 15, 2002.2005. As discussed previously in Note 1, the Company appliedimplemented the transitionfair value provisions of SFAS No. 148 in the implementation of SFAS No. 123 during 2003.

In May 2003, As such, the FASB issued SFAS No. 149,Amendments of Statement 133 on Derivative Instruments and Hedging Activities. This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133. This statement was effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. SFAS No. 133 Implementation Issues that are effective for fiscal quarters beginning prior to June 15, 2003 will continue to be effective based on their respective effective dates, and the paragraphs relating to forward purchases or sales of “when issued” or other securities that do not yet exist would be applicable to both existing transactions as well as new transactions entered into after June 30, 2003. The Company’s adoption of SFAS No. 149 did123(R) is not anticipated to have a significant impact on itsthe Company’s consolidated financial statements.

In March 2005, SEC Staff Accounting Bulletin (“SAB”) No. 107,Application of FASB No. 123 (revised 2004), Accounting for Stock-Based Compensationwas released. This release summarizes the SEC staff position regarding the interaction between SFAS No. 123(R) and certain SEC rules and regulations and provides the SEC’s views regarding the valuation of share-based payment arrangements for public companies. The adoption of this release is not anticipated to have a significant impact on the Company’s consolidated financial statements.

 

In May 2003,2005, the FASB issued SFASStatement No. 150,154,Accounting for Certain Financial Instruments with CharacteristicsChanges and Error Corrections, a Replacement of Both LiabilitiesAPB Opinion No. 20 and Equity.FASB Statement No. 3 This statement establishes standards for how an issuer classifies and measures certain financial instruments that are within its scope as a liability (or an asset in some circumstances). This Statement was effectivechanges the requirements for financial instruments entered into or modified after May 31, 2003,the accounting and otherwise was effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatorily redeemable financial instruments of nonpublic entities. It is to be implemented by reporting the cumulative effect of a change in accounting principle, reporting entity, accounting estimate and correction of an error. SFAS No. 154 applies to (a) financial statements of business enterprises and not-for-profit organizations and (b) historical summaries of information based on primary financial statements that include an accounting principleperiod in which an accounting change or error correction is reflected and is effective for financial instruments created beforeaccounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the issuance date the Statement was issued. The adoption of this Statement is not anticipated to have a significant impact on the Company’s second quarter consolidated financial statements.

In November 2005, FASB Staff Position (“FSP”) SFAS 140-2,Clarification of the Application of Paragraphs 40(b) and 40(c) of FASB Statement No. 140,was issued. This FSP addresses whether a QSPE would fail to meet the conditions of a QSPE under the current requirements of Statement 140 if either (a) unexpected events outside the control of the transferor or (b) a transferor’s temporary holdings of beneficial interests previously issued by a QSPE and sold to outside parties, cause the notional amount of passive derivatives held by an QSPE to exceed the amount of beneficial interests held by outside parties. This FSP clarifies that the requirements of paragraphs 40(b) and 40(c) must be met only at the date a QSPE issues beneficial interests or when a passive derivative financial instrument needs to be replaced upon the occurrence of a specified event outside the control of the transferor. This FSP is effective as of November 9, 2005. The Company’sguidance regarding unexpected events should be applied prospectively. The adoption of SFAS No. 150this FSP did not have a significant impact on itsthe Company’s consolidated financial statements.

 

InDuring November 2002,2005, the FASB issued Financial Interpretation (FIN) No. 45,Guarantors AccountingFSP SFAS 115-1 and Disclosure Requirements for Guarantees, Including Indirect GuaranteesSFAS 124-1,The Meaning of Indebtedness of OthersOther-Than-Temporary Impairment and Its Application to Certain Investments, which expandsoutlines a three-step model that should be applied each reporting period to identify investment impairments. In periods after an impairment loss on a debt security is recognized, the investor should account for the security as if it had been purchased on the accounting guidance of Statements No. 5, 57 and 107 and incorporates without changeimpairment measurement date. The discount (or reduced premium), based on the provisions of FIN No. 34, which is being superseded. FIN No. 45 requires a guarantor to recognize, atnew cost basis, should be amortized over the inceptionremaining life of the guarantee,security. This FSP carries forward the disclosure requirements of Emerging Issues Task Force (“EITF”) Issue 03-1,The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, but nullifies certain other requirements of this EITF. This FSP also clarifies that investments within the scope of EITF Issue 99-20,Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets, must be included in the required tabular disclosures. The guidance in this FSP should be applied to reporting periods beginning after December 15, 2005. Earlier application is permitted. The adoption of this FSP is not anticipated to have a liability for the fair value of the obligation undertaken in issuing the guarantee. It also provides additional guidancesignificant impact on the disclosureCompany’s consolidated financial statements.

During December 2005, the FASB issued FSP Statement of guarantees.Position (“SOP”) 94-6-1,Terms of Loan Products That May Give Rise to a Concentration of Credit Risk, which addresses the circumstances under which the terms of loan products give rise to such risk and the disclosures or other accounting considerations that apply for entities that originate, hold, guarantee, service, or invest in loan products with terms that may give rise to a concentration of credit risk. The recognition and measurement provisions wereguidance under this FSP is effective for guarantees made or modified after December 31, 2002. The disclosure provisions were effective for fiscalinterim and annual periods ending after December 15, 2002.19, 2005 and for loan products that are determined to represent a concentration of credit risk, disclosure requirements of SFAS 107,Disclosures about Fair Value of Financial Instruments, should be provided for all periods presented. The Company’s adoption of FIN No. 45this FSP did not have a significant impact on itsthe Company’s consolidated financial statements. Significant guarantees that have been entered into by the Company are discussed in Note 15.

 

In January 2003,February 2006, the FASB issued FINSFAS No. 46,Consolidation155, “Accounting for Certain Hybrid Financial Instruments”, an amendment of Variable Interest Entities,FASB Statements No. 133 and SFAS No. 140 (“SFAS 155”). This statement permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. It also clarifies which was replaced by FINinterest-only strips and principal-only strips are not subject to FASB Statement No. 46 (Revised December 2003),Consolidation of Variable Interest Entities(FIN No. 46(R)133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). FIN No. 46 requires consolidation by business enterprises of variable interest entities that meet certain requirements. FIN No. 46(R) changes the effective date of FIN No. 46 for certain entities. Public companies shall apply either FIN No. 46 or FIN No. 46(R)The statement also establishes a requirement to theirevaluate interests in special purpose entities (SPEs) assecuritized financial assets to identify interests that are freestanding derivatives or hybrid financial instruments that contain an embedded derivative requiring bifurcation. The statement also clarifies that concentration of credit risks in the form of subordination are not embedded derivatives, and it also amends SFAS 140 to eliminate the prohibition on a QSPE from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first interim or annual period endingfiscal year that begins after DecemberSeptember 15, 2003. The decision to apply FIN No. 46 or FIN No. 46(R) may be made on an SPE by SPE basis. The Company’s2006. Early adoption of FIN No. 46 and FIN No. 46(R) did notthis statement is allowed. The Company is still evaluating the impact the adoption of this statement will have a significant impact on its consolidated financial statements.

 

Reclassifications Reclassifications to prior year amounts have been made to conform to current year presentation. In accordance with SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets, the Company has reclassified the operating results of those branches terminated through December 31, 2005, as discontinued operations in the Consolidated Statement of Income for the year ended 2004.

Note 2. Mortgage Loans

 

Mortgage loans, all of which are secured by residential properties, consisted of the following as of December 31, (in(dollars in thousands):

 

  2005

 2004

 

Mortgage loans – held-for-sale:

   

Outstanding principal

  $1,235,159  $719,904 

Net premium

   12,015   6,760 
  


 


   1,247,174   726,664 

Loans under removal of accounts provision

   44,382   20,930 
  


 


Mortgage loans – held-for-sale

  $1,291,556  $747,594 
  2003

 2002

   


 


Mortgage loans – held-in-portfolio:

      

Outstanding principal

  $94,162  $149,918   $29,084  $58,859 

Net unamortized premium

   1,874   2,994    455   1,175 
  


 


  


 


Amortized cost

   96,036   152,912    29,539   60,034 

Allowance for credit losses

   (1,319)  (3,036)   (699)  (507)
  


 


  


 


Mortgage loans – held-in-portfolio

  $94,717  $149,876   $28,840  $59,527 
  


 


  


 


Mortgage loans – held-for-sale:

   

Outstanding principal

  $687,880  $972,360 

Net premium

   10,112   11,273 
  


 


Mortgage loans – held-for-sale

  $697,992  $983,633 
  


 


 

Activity in the allowance for credit losses is as follows for the three years ended December 31, (in(dollars in thousands):

 

  2003

 2002

 2001

   2005

 2004

 2003

 

Balance, January 1

  $3,036  $5,557  $7,690   $507  $1,319  $3,036 

Credit (recoveries) losses

   (389)  (432)  3,608 

Provision for credit losses (recoveries)

   1,038   726   (389)

Amounts charged off, net of recoveries

   (1,328)  (2,089)  (5,741)   (846)  (1,538)  (1,328)
  


 


 


  


 


 


Balance, December 31

  $1,319  $3,036  $5,557   $699  $507  $1,319 
  


 


 


  


 


 


 

AllThe servicing agreements the Company executes for loans securitized include a “clean up” call option which gives them the right, not the obligation, to repurchase mortgage loans from the trust when the aggregate principal balance of the mortgage loans has declined to ten percent or less of the original aggregated mortgage loan principal balance. On September 25, 2005, the Company exercised the “clean up” call option on NMFT Series 1999-1 and repurchased loans with a remaining principal balance of $14.0 million from the trust for $6.8 million in cash. The trust distributed the $6.8 million to retire the bonds held by third parties. Along with the cash paid to the trust, the cost basis of the NMFT Series 1999-1 mortgage security, $7.4 million, became part of the cost basis of the repurchased mortgage loans. At December 31, 2005, the Company had the right, not the obligation to repurchase $71.1 million of mortgage loans from the NMFT Series 2000-1, NMFT Series 2000-2 and NMFT Series 2001-1 securitization trust.

During 1997 and 1998, the Company completed the securitization of loans in transactions that were structured as financing arrangements for accounting purposes. 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 the asset-backed bonds the Company is entitled to repurchase the mortgage loan collateral and repay the remaining bond obligations when the aggregate collateral principal balance falls below 35% of their original balance for the loans in Series 97-01 and 25% for the loans in Series 97-02, Series 98-01 and Series 98-02. During the fourth quarter of 2005, the Company exercised this option for issues 1997-1 and 1997-2 and retired the related asset-backed bonds, which had a remaining balance of $7.8 million. The mortgage loans were transferred from the held-in-portfolio classification to held-for-sale and have been or will be sold to third party investors or used as collateral in the Company’s securitization transactions.

The majority of mortgage loans serve as collateral for borrowing arrangements discussed in Note 6.8. The weighted-average interest rate on mortgage loans as of December 31, 20032005 and 20022004 was 7.94%8.15% and 8.29%7.88%, respectively.

 

Collateral for 22% and 17%20% of the mortgage loans outstanding as of December 31, 20032005 was located in California and Florida, respectively. The Company has no other significant concentration of credit risk.risk on mortgage loans.

The recorded investment in loans in non-accrual status and in loans past due 90 days or more, but still accruing interest was $3.7 million and $7.2 million as of December 31, 2005, respectively.

Details of loan securitization transactions on the date of the securitization are as follows (in(dollars in thousands):

 

      Allocated Value of
Retained Interests


      
   Net Bond
Proceeds


  Mortgage
Servicing
Rights


  Subordinated
Bond Classes


  Principal
Balance of
Loans Sold


  Gain
Recognized


Year ended December 31, 2003:

                    

NMFT Series 2003-4

  $1,476,818  $3,986  $47,499  $1,019,922(A) $22,035

NMFT Series 2003-3

   1,472,920   5,829   84,268   1,499,374   34,544

NMFT Series 2003-2

   1,476,358   5,843   78,686   1,499,998   50,109

NMFT Series 2003-1

   1,253,820   5,116   82,222   1,300,141   29,614
   

  

  

  


 

   $5,679,916  $20,774  $292,675  $5,319,435  $136,302
   

  

  

  


 

Year ended December 31, 2002:

                    

NMFT Series 2002-3

  $734,584  $2,939  $39,099  $750,003  $29,353

NMFT Series 2002-2

   300,304   1,173   22,021   310,000   10,459

NMFT Series 2002-1

   485,824   1,958   29,665   499,998   8,082
   

  

  

  


 

   $1,520,712  $6,070  $90,785  $1,560,001  $47,894
   

  

  

  


 

Year ended December 31, 2001:

                    

NMFT Series 2001-2

  $785,509  $3,817  $36,942  $800,033  $12,745

NMFT Series 2001-1

   407,372   1,837   22,628   415,067   8,985
   

  

  

  


 

   $1,192,881  $5,654  $59,570  $1,215,100  $21,730
   

  

  

  


 

   

Net Bond

Proceeds


  

Allocated Value of Retained

Interests


  

Principal Balance

of Loans Sold


  

Fair Value of

Derivative

Instruments

Transferred


  

Gain

Recognized


    

Mortgage

Servicing

Rights


  

Subordinated

Bond Classes


     

Year ended December 31, 2005:

                    

NMFT Series 2005-1

  $2,066,840  $11,448  $88,433  $2,100,000  $13,669  $18,136

NMFT Series 2005-2

   1,783,102   9,751   62,741   1,799,992   2,364   29,202

NMFT Series 2005-3

   2,425,088   14,966   104,206(D)  2,499,983   9,194   3,947

NMFT Series 2005-4 (A)

   1,153,033   7,311   77,040(C)  1,221,055   5,232  $7,480
   

  

  


 

  


 

   $7,428,063  $43,476  $332,420  $7,621,030  $30,459  $58,765
   

  

  


 

  


 

Year ended December 31, 2004:

                        

NMFT Series 2003-4 (B)

  $472,391  $1,880  $22,494  $479,810  $—    $9,015

NMFT Series 2004-1

   1,722,282   7,987   92,059   1,750,000   (13,848)  64,112

NMFT Series 2004-2

   1,370,021   6,244   67,468   1,399,999   15,665   8,961

NMFT Series 2004-3

   2,149,260   9,520   104,901   2,199,995   (6,705)  40,443

NMFT Series 2004-4

   2,459,875   13,628   94,911   2,500,000   5,617   21,721
   

  

  


 

  


 

   $8,173,829  $39,259  $381,833  $8,329,804  $729  $144,252
   

  

  


 

  


 

Year ended December 31, 2003:

                        

NMFT Series 2003-1

  $1,253,820  $5,116  $82,222  $1,300,141  $(11,723) $29,614

NMFT Series 2003-2

   1,476,358   5,843   78,686   1,499,998   (14,000)  50,109

NMFT Series 2003-3

   1,472,920   5,829   84,268   1,499,374   6,988   34,544

NMFT Series 2003-4

   1,004,427   3,986   47,499   1,019,922   (192)  22,035
   

  

  


 

  


 

   $5,207,525  $20,774  $292,675  $5,319,435  $(18,927) $136,302
   

  

  


 

  


 


(A)On January 20, 2006 NovaStar Mortgage delivered the remaining $378.9 million in loans collateralizing NMFT Series 2005-4. All of the bonds were issued to the third-party investors at the date of initial close, but the Company did not receive the escrowed proceeds related to the final close until January 20, 2006.
(B)On January 14, 2004 NovaStar Mortgage delivered the remaining $479.8 million in loans collateralizing NMFT Series 2003-42003-4. All of the bonds were deliveredissued to the third-party investors at the date of initial close, but the Company did not receive the escrowed proceeds related to the final close until January 14, 2004.
(C)NMFT Series 2005-4 subordinated bond classes includes $42.9 million related to the Class M-9, Class M-10, Class M-11 and Class M-12 certificates, which were retained by the Company. The Class M-9, Class M-10, Class M-11 and Class M-12 certificates have a gaincombined initial certificate balance (par value) of $9.0$54.4 million. The Class M-9 is rated A/Baa3/BBB+ by Standard & Poor’s (“S&P”), Moody’s and Fitch, respectively. The Class M-10 is rated BBB+/Ba1/BBB by S&P, Moody’s and Fitch, respectively. The Class M-11 is rated BBB/BBB- by S&P and Fitch, respectively. The Class M-12 is rated BBB- by S&P.
(D)NMFT Series 2005-3 subordinated bond classes includes $44.3 million was recognized.related to the Class M-11 and Class M-12 certificates, which were retained by the Company. The Class M-11 and Class M-12 certificates have a combined initial certificate balance (par value) of $55 million. The M-11 is rated BBB/BBB- by S&P and Fitch, respectively. The M-12 is rated BBB- by S&P,

 

In the securitizations, the Company retains residual securities (representing interest-only securities, prepayment penalty bonds and otherovercollateralization bonds) and certain investment-grade rated subordinated securities representing subordinated interests in the underlying cash flows and servicing responsibilities. The Company receives annual servicing fees approximating 0.50%value of the outstanding balanceCompany’s retained securities is subject to credit, prepayment, and rightsinterest rate risks on the transferred financial assets.

During 2005 and 2004, U.S. government-sponsored enterprises purchased 51% and 55%, respectively, of the bonds sold to future cash flows arising after the third-party investors in the Company’s securitization trusts have received the return for which they contracted.transactions. The investors and securitization trusts have no recourse to the Company’s assets for failure of borrowers to pay when due. The value ofdue except when defects occur in the Company’s interests is subject to credit, prepayment,loan documentation and interest rate risks on the transferred financial assets.

Servicing fees received from the securitization trusts were $21.1 million, $10.0 million and $4.9 million for the years ended December 31, 2003, 2002 and 2001, respectively. No purchases of delinquent or foreclosed loans wereunderwriting process, either through processing errors made on securitizations in whichby the Company did not maintain control overor through intentional or unintentional misrepresentations made by the mortgage loans transferredborrower or agents during the three years ended December 31, 2003.those processes. Refer to Note 9 for further discussion.

Fair value of the subordinated bond classesresidual securities at the date of securitization is measured by estimating the open market sales price of a similar loan pool. An implied yield (discount rate) is calculated based on the value derived and using projected cash flows generated using key economic assumptions. Key economic assumptions used to project cash flows at the time of loan securitization during the three years ended December 31, 20032005 were as follows:

 

   

Mortgage Loan Collateral for

NovaStar Mortgage Funding Trust Series


 
   2003-4

  2003-3

  2003-2

  2003-1

  2002-3

  2002-2

  2002-1

  2001-2

  2001-1

 

Constant prepayment rate(B)

  30% 22% 25% 28% 30% 27% 32% 28% 28%

Average life (in years)

  3.06  3.98  3.54  3.35  3.09  3.13  2.60  2.61  2.54 

Expected total credit losses, net of mortgage insurance(A)(B)

  5.1% 3.6% 2.7% 3.3% 1.0% 1.6% 1.7% 1.2% 1.2%

Discount rate(B)

  20% 20% 28% 20% 20% 25% 20% 25% 20%

Mortgage Loan Collateral

for NovaStar Mortgage

Funding Trust Series


  

Constant

Prepayment

Rate


  

Average Life

(in Years)


  

Expected Total Credit

Losses, Net of

Mortgage Insurance

(A)


  

Discount

Rate


 

2005-4

  43% 2.13  2.3% 15%

2005-3

  41  2.06  2.0  15 

2005-2

  39  2.02  2.1  13 

2005-1

  37  2.40  3.6  15 

2004-4

  35  2.29  4.0  26 

2004-3

  34  2.44  4.5  19 

2004-2

  31  2.70  5.1  26 

2004-1

  33  2.71  5.9  20 

2003-4

  30  3.06  5.1  20 

2003-3

  22  3.98  3.6  20 

2003-2

  25  3.54  2.7  28 

2003-1

  28  3.35  3.3  20 

(A)Represents the expected credit losses for the life of the securitization up to the expected date in which the related asset-backed bonds can be called.
(B)The current discount rate and assumptions and those at trust securitization, which were previously disclosed, have been adjusted to reflect management’s revised estimates for volatility and risk associated with the underlying mortgage loan collateral. These revisions do not impact previously recorded amounts.

Fair value of the subordinated securities at the date of securitization is based on quoted market prices.

Note 3. Mortgage Securities – Available-for-Sale

 

Available-for-sale mortgageMortgage securities – available-for-sale consisted of the Company’s investment in the interest-only, prepayment penaltyresidual securities and other subordinated securities that the trusttrusts issued. The primary bonds were sold to parties independentManagement estimates the fair value of the Company. Management estimates their fair valueresidual securities by discounting the expected future cash flowflows of the collateral and bonds. Fair value of the subordinated securities is based on quoted market prices. The average yield on mortgage securities – available-for-sale is the interest income for the year as a percentage of the average fair market value on mortgageof the securities. The cost basis, unrealized gains and losses, and estimated fair value and average yield of mortgage securities – available-for-sale as of December 31, 20032005 and 20022004 were as follows (dollars in thousands):

 

   Cost Basis

  Gross Unrealized

  Estimated
Fair Value


  Average
Yield


 
     Gains

  Losses

    

As of December 31, 2003

  $294,562  $87,826  $101  $382,287  34.3%

As of December 31, 2002

   102,665   77,755   1,541   178,879  42.7 
   Cost Basis

  

Unrealized

Gains


  

Unrealized

Losses Less

Than Twelve

Months


  

Estimated

Fair Value


  

Average

Yield


 

As of December 31, 2005

  $394,107  $113,785  $(2,247) $505,645  35.6%

As of December 31, 2004

   409,946   79,229   —     489,175  31.4 

During 2005 and 2004, management concluded that the decline in value on various securities in the Company’s mortgage securities portfolio were other-than-temporary. As a result, the Company recognized an impairment on mortgage securities – available-for-sale of $17.6 million in 2005 and $15.9 million in 2004. The impairments were a result of a significant increase in short-term interest rates during the year as well as higher than anticipated prepayments. While the Company uses forward yield curves in valuing mortgage securities, the increase in two-year and three-year swap rates was greater than the forward yield curve had anticipated, thus causing a greater than expected decline in value. Prepayments were higher than expected due to substantial increases in housing prices in the past few years.

As of December 31, 2005, the Company had two subordinated available-for-sale securities with fair values aggregating $42.8 million that were not deemed to be other-than-temporarily impaired. The temporary impairment was caused by market spreads increasing for these securities. Because there was not an unfavorable change in the estimated future discounted cash flows related to these securities from the prior reporting period and the Company has the ability and intent to hold these securities until a recovery of fair value, the Company does not consider these securities to be other-than-temporarily impaired as of December 31, 2005.

The following table is a rollforward of mortgage securities – available-for-sale from January 1, 2004 to December 31, 2005 (dollars in thousands):

   Cost Basis

  

Net

Unrealized

Gain


  

Estimated Fair

Value of

Mortgage

Securities


 

As of January 1, 2004

  $294,562  $87,725  $382,287 

Increases (decreases) to mortgage securities:

             

New securities retained in securitizations

   381,833   6,637   388,470 

Accretion of income (A)

   100,666   —     100,666 

Proceeds from paydowns of securities (A) (B)

   (351,213)  —     (351,213)

Impairment on mortgage securities - available-for-sale

   (15,902)  15,902   —   

Mark-to-market value adjustment

   —     (31,035)  (31,035)
   


 


 


Net increase (decrease) to mortgage securities

   115,384   (8,496)  106,888 
   


 


 


As of December 31, 2004

  $409,946  $79,229  $489,175 
   


 


 


Increases (decreases) to mortgage securities:

             

New securities retained in securitizations

   289,519   2,073   291,592 

Accretion of income (A)

   171,734   —     171,734 

Proceeds from paydowns of securities (A)(B)

   (452,050)  —     (452,050)

Impairment on mortgage securities - available-for-sale

   (17,619)  17,619   —   

Transfer of basis to mortgage loans held-for-sale due to repurchase of mortgage loans from securitization trust (C)

   (7,423)  —     (7,423)

Mark-to-market value adjustment

   —     12,617   12,617 
   


 


 


Net increase (decrease) to mortgage securities

   (15,839)  32,309   16,470 
   


 


 


As of December 31, 2005

  $394,107  $111,538  $505,645 
   


 


 



(A)Cash received on mortgage securities with no cost basis was $17.6 million for the year ended December 31, 2005 and $32.2 million for the year ended December 31, 2004.
(B)For mortgage securities with a remaining cost basis, the Company reduces the cost basis by the amount of cash that is contractually due from the securitization trusts. In contrast, for mortgage securities in which the cost basis has previously reached zero, the Company records in interest income the amount of cash that is contractually due from the securitization trusts. In both cases, there are instances where the Company may not receive a portion of this cash until after the balance sheet reporting date. Therefore, these amounts are recorded as receivables from the securitization trusts and included in other assets. As of December 31, 2005 and December 31, 2004, the Company had receivables from securitization trusts of $3.4 million and $4.1 million, respectively, related to mortgage securities with a remaining cost basis. Also, the Company had receivables from securitization trusts of $0.3 million and $0.7 million related to mortgage securities with a zero cost basis as of December 31, 2005 and 2004, respectively.
(C)The NMFT Series 1999-1 was called on September 25, 2005.

 

Maturities of mortgage securities owned by the Company depend on repayment characteristics and experience of the underlying financial instruments. The Company expects the securities it owns as of December 31, 20032005 to mature in one to five years.

 

All mortgage securities owned by the Company are pledged for borrowings as discussed in Note 6.

On July 2, 2003,During 2005 and 2004, the Company securitized the interest-only, prepayment penalty and subordinatedovercollateralization securities of NMFT 2003-2various securitizations and issued NovaStar NIMS Certificate Series 2003-N1 in the amount of $54,000,000. The resecuritization wasNet Interest Margin Certificates (NIMs). These resecuritizations were accounted for as a secured borrowing.borrowings. In accordance with SFAS No. 140,Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, control over the transferred assets was not surrendered and thus the transaction wastransactions were recorded as financingfinancings for the mortgage securities. The detail of these transactions is shown in Note 8.

On November 5, 2002, the Company securitized the interest-only and prepayment penalty securities of NMFT 2001-1 and NMFT 2001-2 and issued NovaStar CAPS Certificate Series 2002-C1 in the amount of $68,000,000. The resecuritization was accounted for as a secured borrowing. In accordance with SFAS No. 140, control over the transferred assets was not surrendered and thus the transaction was recorded as financing for the mortgage securities.

On September 26, 2001, the Company securitized interest-only and prepayment penalty securities and issued NovaStar CAPS Certificates Series 2001-C1 in the amount of $29,250,000. A gain of $14.9 million was recognized on this transaction. A subordinated security, valued by the Company at $8.2 million, was retained entitling the Company to receive cash flows of the collateral once the primary bonds are paid. On October 25, 2002, the primary bonds were paid off and the interest-only and prepayment penalty securities were transferred back to the Company by the trust.

As of December 31, 2003,2005, key economic assumptions and the sensitivity of the current fair value of retained interests owned by the CompanyCompany’s residual securities to immediate adverse changes in those assumptions are as follows, on average for the portfolio (dollars in thousands):

 

Carrying amount/fair value of retained interests

  $382,287

Average life (in years)

   3.0

Prepayment speed assumption (CPR)

   29

Carrying amount/fair value of residual interests (A)

  $462,834

Weighted average life (in years)

   1.4

Weighted average prepayment speed assumption (CPR) (percent)

   49

Fair value after a 10% increase

  $371,496  $461,467

Fair value after a 25% increase

  $358,031  $463,143

Expected annual credit losses (percent of current collateral balance)

   3.2

Weighted average expected annual credit losses (percent of current collateral balance)

   2.1

Fair value after a 10% increase

  $374,446  $440,991

Fair value after a 25% increase

  $364,128  $411,016

Residual cash flows discount rate (%)

   22

Weighted average residual cash flows discount rate (percent)

   18

Fair value after a 500 basis point increase

  $360,240  $438,251

Fair value after a 1000 basis point increase

  $341,303  $411,459

Market interest rates

      

Fair value after a 100 basis point increase

  $351,292  $430,372

Fair value after a 200 basis point increase

  $313,298  $404,931

(A)The subordinated securities are not included in this table as their fair value is based on quoted market prices.

 

These sensitivities are hypothetical and should be used with caution. As the analysis indicates, changes in fair value based on a 10% variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table the effect of a variation in a

particular assumption on the fair value of the retained interest is calculated without changing any other assumption; in reality, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments and increased credit losses), which might magnify or counteract the sensitivities.

 

The actual static pool credit loss as of December 31, 20032005 was 0.19%0.28% and the cumulative projected static pool credit loss for the remaining life of the securities is 2.55%1.35%. Static pool losses are calculated by summing the actual and projected future credit losses and dividing them by the original balance of each pool of assets.

 

The table below presents quantitative information about delinquencies, net credit losses, and components of securitized financial assets and other assets managed together with them (in(dollars in thousands):

 

  December 31,

      December 31,

    
  Total Principal Amount of
Loans (A)


  Principal Amount of
Loans 30 Days or More
Past Due


  Net Credit Losses
During the Year
Ended December 31,


   

Total Principal Amount

of Loans (A)


  

Principal Amount of Loans

30 Days or More Past Due


  

Net Credit Losses During the

Year Ended December 31,


 
  2003

  2002

  2003

  2002

  2003

 2002

   2005

  2004

  2005

  2004

  2005

 2004

 

Loans securitized(B)

  $6,428,364  $2,586,493  $201,774  $125,700  $7,700  $4,558   $12,722,279  $11,350,311  $573,235  $324,333  $38,639  $21,535 

Loans held-for-sale

   688,506   973,224   3,125   37,466   498   484    1,235,423   720,035   5,333   3,383   1,027   1,097 

Loans held-in-portfolio

   96,729   155,683   15,313   28,743   4,402(B)  7,857(B)   30,028   59,836   5,564   10,174   1,072(C)  2,490(C)
  

  

  

  

 ��


 


  

  

  

  

  


 


Total loans managed or securitized(D)

  $7,213,599  $3,715,400  $220,212  $191,909  $12,600  $12,899   $13,987,730  $12,130,182  $584,132  $337,890  $40,738  $25,122 
  

  

  

  

  


 


  

  

  

  

  


 



(A)Includes assets acquired through foreclosure.

(B)Loans under removal of accounts provision have not been repurchased from the securitization trusts, therefore, they are included in loans securitized.
(C)Excludes mortgage insurance proceeds on policies paid by the Company and includes interest accrued in excess of 120on loans 90 days or more past due for which the Company had discontinued interest accrual.
(D)Does not include loans being interim serviced after sale.

Note 4. Mortgage Securities - Trading

As of December 31, 2005, mortgage securities – trading consisted of the NMFT Series 2005-4 M-9, M-10, M-11 and M-12 bond class securities retained by the Company from this securitization transaction as discussed in Note 2. The aggregate fair market value of these securities as of December 31, 2005 was $43.7 million. Management estimates their fair value based on quoted market prices. The $549,000 net trading gains recognized to earnings by the Company for the year ended December 31, 2005 relate to the NMFT Series 2005-4 class M-9 through M-12 securities still held by the Company as of December 31, 2005.

As of December 31, 2004, mortgage securities - trading consisted of an adjustable-rate mortgage-backed security with a fair market value of $143.2 million. During the first quarter of 2005, the Company sold this security. No gain or loss was recognized on this security during the years ended December 31, 2005 and 2004.

The Company owned no trading securities during the year ended December 31, 2003, therefore, no trading gains or losses were recognized by the Company during 2003.

As of December 31, 2005 and 2004, the Company had pledged all of its trading securities as collateral for financing purposes.

Note 5. Mortgage Servicing Rights

 

The Company records mortgage servicing rights arising from the transfer of loans to the securitization trusts. The following schedule summarizes the carrying value of mortgage servicing rights and the activity during 2005, 2004 and 2003 2002 and 2001 (in(dollars in thousands):

 

  2003

 2002

 2001

   2005

 2004

 2003

 

Balance, January 1

  $7,906  $6,445  $—     $42,010  $19,685  $7,906 

Amount acquired in purchase of common stock of NFI Holding Corporation

   —     —     2,922 

Amount capitalized in connection with transfer of loans to securitization trusts

   20,774   6,070   5,654    43,476   39,259   20,774 

Amortization

   (8,995)  (4,609)  (2,131)   (28,364)  (16,934)  (8,995)
  


 


 


  


 


 


Balance, December 31

  $19,685  $7,906  $6,445   $57,122  $42,010  $19,685 
  


 


 


  


 


 


 

The estimated fair value of the servicing assetsrights aggregated $33.4$71.9 million and $12.6$58.6 million at December 31, 20032005 and December 31, 2002,2004, respectively. The fair value is estimated by discounting estimated future cash flows from the servicing assets using discount rates that approximate current market rates. The fair value as of December 31, 20032005 was determined utilizing a 12% discount rate, credit losses net of mortgage insurance (as a percent of current principal balance) of 2.1% and an annual prepayment rate of 49%. The fair value as of December 31, 2004 was determined utilizing a 15% discount rate, credit losses net of mortgage insurance (as a percent of current principal balance) of 2.8%3.3% and an annual prepayment rate of 26%39%. The fair valueThere was no allowance for the impairment of mortgage servicing rights as of December 31, 2002 was determined utilizing a 15% discount rate, credit losses net of mortgage insurance (as a percent of current principal balance) of 1.8%2005, 2004 and an annual prepayment rate of 40%.2003.

 

Mortgage servicing rights are amortized in proportion to and over the estimated period of net servicing income. The estimated amortization expense for 2004, 2005, 2006, 2007, 2008, 2009, 2010 and 2007thereafter is $10.9$28.0 million, $6.7$15.1 million, $1.6$5.9 million, $2.9 million, $1.7 million and $0.5$3.5 million, respectively.

The Company receives annual servicing fees approximating 0.50% of the outstanding balance and rights to future cash flows arising after the investors in the securitization trusts have received the return for which they contracted. Servicing fees received from the securitization trusts were $59.8 million, $41.5 million and $21.1 million for the years ended December 31, 2005, 2004 and 2003, respectively. During the year ended December 31, 2005, the Company purchased $220,000 in principal balance of delinquent or foreclosed loans on securitizations in which the Company did not maintain control over the mortgage loans transferred. The Company incurred losses of $220,000 from the purchase of these delinquent or foreclosed loans during the year ended December 31, 2005. No such purchases were made in the years ended December 31, 2004 and 2003.

 

The Company holds, as custodian, principal and interest collected from borrowers on behalf of the securitization trusts, as well as funds collected from borrowers to ensure timely payment of hazard and primary mortgage insurance and property taxes related to the properties securing the loans. These funds are not owned by the Company and are held in trust. The Company held, $20.9as custodian, $585.1 million and $9.1$471.5 million in escrow forat December 31, 2005 and 2004, respectively.

Note 6. Warehouse Notes Receivable

The Company had $25.4 million and $5.9 million due from borrowers at December 31, 20032005 and 2002,2004, respectively.

These notes receivable represent warehouse lines of credit provided to a network of approved mortgage borrowers. The weighted average interest rate on these notes receivable is indexed to one-month LIBOR and was 7.89% and 5.92% at December 31, 2005 and 2004, respectively.

Note 5.7. Property and Equipment, Net

 

Property and equipment consisted of the following at December 31, (in(dollars in thousands):

 

  2003

  2002

  2005

  2004

Office and computer equipment

  $13,617  $7,691  $15,473  $18,957

Furniture and fixtures

   7,209   2,770   9,523   8,406

Leasehold improvements

   3,048   838   4,807   3,423
  

  

  

  

   23,874   11,299   29,803   30,786

Less accumulated depreciation

   9,337   5,889   16,671   15,310
  

  

  

  

Property and equipment, net

  $14,537  $5,410  $13,132  $15,476
  

  

  

  

 

Depreciation expense for the years ended December 31, 2005, 2004 and 2003 2002was $7.4 million, $6.1 million and 2001 was $3.9 million, $1.2 millionrespectively. The Company recorded losses from disposals of property and $0.9 million, respectively.equipment of $226,000 during the year ended December 31, 2005.

 

Note 6.8. Borrowings

 

Short-term BorrowingsThe following tables summarize the Company’s repurchase agreements and warehouse agreements as of December 31, 20032005 and 20022004 (dollars in thousands):

 

   Maximum
Borrowing
Capacity


  Rate

  

Days to

Reset


  Balance

  

Average
Daily

Balance
During the

Year


  Weighted
Average
Interest
Rate
During
the Year


  Maximum
Amount
Outstanding
During the
Year


December 31, 2003

                         

Short-term borrowings (indexed to one-month LIBOR):

                         

Repurchase agreement expiring March 31, 2004

  $600,000  2.91% 22  $100,161           

Repurchase agreement expiring June 5, 2004

   600,000  1.87  16   431,515           

Repurchase agreement expiring April 30, 2004

   300,000  1.64  26   28,179           

Repurchase agreement expiring September 8, 2004

   500,000  —    —     —             

Repurchase agreement expiring May 22, 2004

   300,000  2.25  15   214,899           

Repurchase agreement expiring October 23, 2004

   575,000  2.17  15   97,782           
   

        

           

Total short-term borrowings

  $2,875,000        $872,536  $915,689  2.57% $1,574,156
   

        

  

  

 

December 31, 2002

                         

Short-term borrowings (indexed to one-month LIBOR):

                         

Repurchase agreement expiring March 31, 2003

  $50,000  1.88% 29  $40,650           

Repurchase agreement expiring September 18, 2003

   50,000  1.88  24   46,500           

Repurchase agreement expiring October 28, 2003

   50,000  1.88  27   10,914           

Repurchase agreement expiring March 31, 2003

   200,000  2.38  13   84,320           

Repurchase agreement expiring September 18, 2003

   150,000  2.38  1   107,705           

Repurchase agreement expiring October 28, 2003

   300,000  2.42  10   264,658           

Repurchase agreement expiring December 6, 2003

   200,000  2.51  Daily   117,312           

Warehouse agreement expiring March 3, 2003 (indexed to Federal funds rate)

   125,000  2.74  Daily   123,317           

Warehouse agreement expiring September 29, 2003

   250,000  2.98  Daily   230,160           
   

        

           

Total short-term borrowings

  $1,375,000        $1,025,536  $410,951  3.04% $1,025,536
   

        

  

  

 

   

Maximum

Borrowing

Capacity


  Rate

  

Days to

Reset


  Balance

  

Average

Daily

Balance

During the

Year


  

Weighted

Average

Interest

Rate During

the Year


  

Maximum

Amount

Outstanding

During the

Year


December 31, 2005

                         

Short-term borrowings (indexed to one-month LIBOR):

                         

Repurchase agreement expiring November 15, 2006

  $1,000,000  4.98% 1  $388,056           

Repurchase agreement expiring April 14, 2006

   800,000  5.30  13   262,867           

Repurchase agreement expiring February 6, 2006

   800,000  5.12  25   422,452           

Repurchase agreement expiring September 29, 2006

   750,000  5.25  9   327,339           

Repurchase agreement expiring August 4, 2006

   100,000  —    25   —             

Repurchase agreement, expiring December 1, 2006

   50,000  5.38  12   17,855           
   

        

           

Total short-term borrowings

  $3,500,000        $1,418,569  $1,294,452  4.20% $2,839,953
   

        

  

  

 

December 31, 2004

                         

Short-term borrowings (indexed to one-month LIBOR):

                         

Repurchase agreement expiring November 15, 2005

  $1,000,000  3.39% 1  $488,089           

Repurchase agreement expiring March 30, 2005

   800,000  3.25  11   128,107           

Repurchase agreement expiring October 7, 2005

   800,000  3.30  25   104,693           

Repurchase agreement expiring June 30, 2005

   750,000  2.88  1   36,113           

Repurchase agreement expiring April 30, 2005

   300,000  2.93  25   8,643           

Repurchase agreement expiring August 26, 2005

   100,000  3.90  12   3,971           

Repurchase agreement, expiring January 24, 2005

   135,912  2.47  24   135,912           
   

        

           

Total short-term borrowings

  $3,885,912        $905,528  $1,226,313  2.96% $2,587,112
   

        

  

  

 

The Company’s mortgage loans and certain mortgage securities are pledged as collateral on borrowings. All short-term financing arrangements require the Company to maintain minimum tangible net worth, meet a minimum equity ratio test and comply with other customary debt covenants. Management believes theThe Company is in compliance with all debt covenants.

Repurchase agreements generally contain margin calls under which a portion of the borrowings must be repaid if the fair value of the mortgage securities – available-for-sale, mortgage securities - trading or mortgage loans collateralizing the repurchase agreements falls underbelow a predefinedcontractual ratio to the borrowings outstanding.

 

Accrued interest on the Company’s repurchase agreements was $3.2 million as of December 31, 2005 as compared to $1.6 million as of December 31, 2004.

In connection with the lending agreement with UBS Warburg Real Estate Securities, Inc. (UBS), NovaStar Mortgage SPV I (NovaStar Trust), a Delaware statutory trust, has been established by NovaStar Mortgage, Inc. (NMI) as a wholly owned special-purpose warehouse finance subsidiary whose assets and liabilities are included in the Company’s consolidated financial statements.

NovaStar Trust has agreed to issue and sell to UBS mortgage notes (the “Notes”). Under the legal agreements which document the issuance and sale of the Notes:

all assets which are from time to time owned by NovaStar Trust are legally owned by NovaStar Trust and not by NMI.

NovaStar Trust is a legal entity separate and distinct from NMI and all other affiliates of NMI.

the assets of NovaStar Trust are legally assets only of NovaStar Trust, and are not legally available to NMI and all other affiliates of NMI or their respective creditors, for pledge to other creditors or to satisfy the claims of other creditors.

none of NMI or any other affiliate of NMI is legally liable on the debts of NovaStar Trust, except for an amount limited to 10% of the maximum dollar amount of the Notes permitted to be issued.

the only assets of NMI which result from the issuance and sale of the Notes are:

1)any cash portion of the purchase price paid from time to time by NovaStar Trust in consideration of Mortgage Loans sold to NovaStar Trust by NMI; and

2)the value of NMI’s net equity investment in NovaStar Trust.

As of December 31, 2005, NovaStar Trust had the following assets:

1)whole loans: $389.0 million

2)cash and cash equivalents: $1.8 million.

As of December 31, 2005, NovaStar Trust had the following liabilities and equity:

1)short-term debt due to UBS: $388.0 million, and

2)$2.8 million in members’ equity investment.

Asset-backed Bonds (ABB)(“ABB”) The Company issued ABB secured by its mortgage loans as a means for long-term financing. For financial reporting and tax purposes, the mortgage loans held-in-portfolio as collateral are recorded as assets of the Company and the ABB are recorded as debt. Interest and principal on each ABB is payable only from principal and interest on the underlying mortgage loans collateralizing the ABB. Interest rates reset monthly and are indexed to one-month LIBOR. The estimated weighted-average months to maturity is based on estimates and assumptions made by management. The actual maturity may differ from expectations. However, the Company retains the option to repay the ABB, and reacquire the mortgage loans, when the remaining unpaid principal balance of the underlying mortgage loans falls below 35% of their original amounts for issue 1997-1 and 25% on 1997-2, 1998-1 and 1998-2. During the fourth quarter of 2005, the Company exercised this option for issues 1997-1 and 1997-2 and retired the related asset-backed bonds which had a remaining balance of $7.8 million. The mortgage loans were transferred from the held-in-portfolio classification to held-for-sale and have been or will be sold to third party investors or used as collateral in the Company’s securitization transactions.

 

On July 2, 2003, theThe Company issued ABB in the amount of $54 millionnet interest margin certificates (“NIMs”) secured by the interest-only, prepayment penalty and subordinatedits mortgage securities of NMFT 2003-2available-for-sale as a means for long-term financing. TheFor financial reporting and tax purposes, the mortgage securities available-for-sale collateral are recorded as assets of the Company and the ABBNIMs are recorded as debt. The performance of the mortgage loan collateral underlying these securities, as presented in Note 2 directly affects the performance of the 2003-N1 bond. The interest rate isthese bonds. Interest rates are fixed at 7.385%the time of issuance and do not adjust over the life of the bonds. The estimated weighted average months to maturity isare based on estimates and assumptions made by management. The actual maturity may differ from expectations.

 

On November 5, 2002,The following table summarizes the Company issued ABBNIMs transactions for the years ended December 31, 2005 and 2004 (dollars in the amount of $68 million secured by the AAA-IO and prepayment penalty mortgage securities of NMFT 2001-1 and NMFT 2001-2 as a means for long-term financing. The mortgage securities are recorded as assets of the Company and the ABB are recorded as debt. The performance of the mortgage loan collateral underlying these securities, as presented in Note 2 directly affects the performance of the 2002-C1 bond. The interest rate is fixed at 7.15% and the estimated weighted average months to maturity is based on estimates and assumptions made by management. The actual maturity may differ from expectations.thousands):

   Date Issued

  Bonds Issued

  

Interest

Rate


  

Collateral

(NMFT Series) (A)


Year ended December 31, 2005:

             

Issue 2005-N1

  June 22, 2005  $130,875  4.78% 2005-1 and 2005-2

Year ended December 31, 2004:

             

Issue 2004-N1

  February 19, 2004  $156,600  4.46% 2003-3 and 2003-4

Issue 2004-N2

  July 23, 2004   157,500  4.46  2004-1 and 2004-2

Issue 2004-N3

  December 21, 2004   201,000  3.97  2004-3 and 2004-4

(A)The NIMs transactions are secured by the interest-only, prepayment penalty and overcollateralization securities of the respective residual mortgage securities – available-for-sale.

FollowingThe following is a summary of outstanding ABB and related loans (dollars in thousands):

 

   Asset-backed Bonds

  Mortgage Loans

 
   Remaining
Principal


  Interest Rate

  

Remaining

Principal

(A)


  

Weighted

Average
Coupon


  Estimated
Weighted
Average Months
to Call


 

As of December 31, 2003:

                  

NovaStar Home Equity Series:

                  

Collateralizing Mortgage Loans:

                  

Issue 1997-1

  $10,249  1.63% $11,721  10.17% —   

Issue 1997-2

   13,177  1.63   14,629  10.51  —   

Issue 1998-1

   24,337  1.54   27,118  9.94  —   

Issue 1998-2

   41,621  1.55   43,261  9.87  —   
   


             
   $89,384              
   


             

Collateralizing Mortgage Securities:

                  

Issue 2002-C1

  $7,070  7.15%(B)   (B)  (B)  (B)

Issue 2003-N1

   38,100  7.39(C)   (C)  (C)  (C)

Unamortized debt issuance costs, net

   (1,574)             
   


             
   $43,596              
   


             

As of December 31, 2002:

                  

NovaStar Home Equity Series:

                  

Collateralizing Mortgage Loans:

                  

Issue 1997-1

  $17,147  1.88% $19,076  10.27% —   

Issue 1997-2

   20,714  1.88   22,812  10.51  —   

Issue 1998-1

   39,692  1.82   44,363  10.02  —   

Issue 1998-2

   65,906  1.63   69,432  9.85  —   
   


             
   $143,459              
   


             

Collateralizing Mortgage Securities:

                  

Issue 2002-C1

  $57,219  7.15%(B)   (B)  (B)  (B)

Unamortized debt issuance costs, net

   (986)             
   


             
   $56,233              
   


             

   Asset-backed Bonds

  Mortgage Loans

 
   

Remaining

Principal


  

Interest

Rate


  

Estimated

Weighted

Average

Months

to Call


  

Remaining

Principal

(A)


  

Weighted

Average

Coupon


 

As of December 31, 2005:

                  

NovaStar Home Equity Series:

                  

Collateralizing Mortgage Loans:

                  

Issue 1998-1

  $9,391  4.78% 33  $10,933  9.91%

Issue 1998-2

   17,558  4.79  48   19,095  9.82 
   


       


   
   $26,949        $30,028    
   


       


   

Collateralizing Mortgage Securities – Available-for-Sale:

                  

Issue 2004-N2

  $3,557  4.46% 1    (B)  (B)

Issue 2004-N3

   49,475  3.97  9    (C)  (C)

Issue 2005-N1

   73,998  4.78  22    (D)  (D)

Unamortized debt issuance costs, net

   (1,400)             
   


             
   $125,630              
   


             

As of December 31, 2004:

                  

NovaStar Home Equity Series:

                  

Collateralizing Mortgage Loans:

                  

Issue 1997-1

  $5,508  2.69% 21  $6,939  10.36%

Issue 1997-2

   8,333  2.69  36   9,414  10.29 

Issue 1998-1

   13,827  2.58  50   16,152  9.95 

Issue 1998-2

   25,785  2.59  60   27,331  9.76 
   


       


   
   $53,453        $59,836    
   


       


   

Collateralizing Mortgage Securities – Available-for-Sale:

                  

Issue 2003-N1

  $5,825  7.39% 4    (E)  (E)

Issue 2004-N1

   48,830  4.46  9    (F)  (F)

Issue 2004-N2

   93,586  4.46  6    (B)  (B)

Issue 2004-N3

   193,093  3.97  36    (C)  (C)

Unamortized debt

    issuance costs, net

   (4,893)             
   


             
   $336,441              
   


             

(A)Includes assets acquired through foreclosure.

(B)Collateral for the 2002-C1 asset backed bond is the AAA-IO and prepayment penalty mortgage securities of NMFT 2001-1 and NMFT 2001-2.

(C)Collateral for the 2003-N1 asset backed bond2004-N2 ABB is the interest-only, prepayment penalty and subordinatedovercollateralization mortgage securities of NMFT 2003-2.2004-1 and NMFT 2004-2.
(C)Collateral for the 2004-N3 ABB is the interest-only, prepayment penalty and overcollateralization mortgage securities of NMFT 2004-3 and NMFT 2004-4.
(D)Collateral for the 2005-N1 ABB is the interest-only, prepayment penalty and overcollateralization mortgage securities of NMFT 2005-1 and NMFT 2005-2.
(E)Collateral for the 2003-N1 ABB is the interest-only, prepayment penalty and overcollateralization mortgage securities of NMFT 2003-2.
(F)Collateral for the 2004-N1 ABB is the interest-only, prepayment penalty and overcollateralization mortgage securities of NMFT 2003-3 and NMFT 2003-4.

The following table summarizes the expected repayment requirements relating to the securitization bond financing at December 31, 2003.2005. Amounts listed as bond payments are based on anticipated receipts of principal and interest on underlying mortgage loan collateral using historicalexpected prepayment speeds (in(dollars in thousands):

 

  Asset-backed
Bonds


  

Asset-backed

Bonds


2004

  $82,346

2005

   18,584

2006

   10,325  $120,609

2007

   6,558   22,616

2008

   6,187   6,268

2009

   1,549

2010

   2,937

Thereafter

   8,980   —  

Note 7. Stockholders’ EquityJunior Subordinated Debentures In March 2005, the Company established NovaStar Capital Trust I (“NCTI”), a statutory trust organized under Delaware law for the sole purpose of issuing trust preferred securities. The Company owns all of the common securities of NCTI. On March 15, 2005, NCTI issued $50 million in unsecured floating rate trust preferred securities to other investors. The trust preferred securities require quarterly interest payments. The interest rate is floating at the three-month LIBOR rate plus 3.5% and resets quarterly. The trust preferred securities are redeemable, at NCTI’s option, in whole or in part, anytime without penalty on or after March 15, 2010, but are mandatorily redeemable when they mature on March 15, 2035. If they are redeemed on or after March 15, 2010, but prior to maturity, the redemption price will be 100% of the principal amount plus accrued and unpaid interest.

 

The Boardproceeds from the issuance of Directors declaredthe trust preferred securities and from the sale of 100% of the voting common stock of NCTI to the Company were loaned to the Company in exchange for $51.6 million of junior subordinated debentures of the Company, which are the sole assets of NCTI. The terms of the junior subordinated debentures match the terms of the trust preferred securities. The debentures are subordinate and junior in right of payment to all present and future senior indebtedness and certain other financial obligations of the Company. The Company also entered into a two-for-one splitguarantee, which together with its obligations under the junior subordinated debentures, provides full and unconditional guarantees of the trust preferred securities. Following payment by the Company of offering costs, the Company’s net proceeds from the offering aggregated $48.4 million.

The assets and liabilities of NCTI are not consolidated into the consolidated financial statements of the Company. Accordingly, the Company’s equity interest in NCTI is accounted for using the equity method. Interest on the junior subordinated debt is included in the Company’s consolidated statements of income as interest expense—subordinated debt and the junior subordinated debentures are presented as a separate category on the consolidated balance sheets.

Note 9. Commitments and Contingencies

CommitmentsThe Company has commitments to borrowers to fund residential mortgage loans as well as commitments to purchase and sell mortgage loans to third parties. As of December 31, 2005, the Company had outstanding commitments to originate, purchase and sell loans of $545.4 million, $33.4 million and $93.6 million, respectively. As of December 31, 2004, the Company had outstanding commitments to originate loans of $370.6 million. The Company had no commitments to purchase or sell loans at December 31, 2004. The commitments to originate and purchase loans do not necessarily represent future cash requirements, as some portion of the commitments are likely to expire without being drawn upon or may be subsequently declined for credit or other reasons.

The Company leases office space under various operating lease agreements. Rent expense for 2005, 2004 and 2003, aggregated $11.0 million, $15.9 million and $7.5 million, respectively. At December 31, 2005, future minimum lease commitments under those leases are as follows (dollars in thousands):

   

Lease

Obligations


2006

  $9,612

2007

   9,310

2008

   8,904

2009

   8,603

2010

   6,554

Thereafter

   3,238

The Company has entered into various lease agreements in which the lessor agreed to repay the Company for certain existing lease obligations. The Company received approximately $61,000 and $2.3 million related to these agreements in 2004 and 2003, respectively. The Company received no funds related to these lease agreements during 2005 due to the agreements expiring in 2004. The Company has recorded deferred lease incentives related to these payments which will be amortized into rent expense over the life of the respective lease on a straight-line basis. Deferred lease incentives as of December 31, 2005 and 2004 were $3.5 million and $3.0 million.

The Company has also entered into various sublease agreements for office space formerly occupied by the Company. The Company received approximately $53,000, $1.2 million and $537,000 in 2005, 2004 and 2003, respectively under these agreements. At December 31, 2005, future minimum rental receipts under those subleases are as follows (dollars in thousands):

   

Lease

Receipts


2006

  $637

2007

   656

2008

   673

2009

   694

2010

   118

Thereafter

   —  

On December 15, 2005, the Company executed a securitization transaction accounted for as a sale of loans and $1.2 billion in loans collateralizing NMFT Series 2005-4 were delivered (see Note 2). On December 31, 2005, the Company was committed to deliver an additional $378.9 million in loans collateralizing NMFT Series 2005-4. These loans were delivered on January 20, 2006.

In the ordinary course of business, the Company sold whole pools of loans with recourse for borrower defaults. When whole pools are sold as opposed to securitized, the third party has recourse against the Company for certain borrower defaults. Because the loans are no longer on the Company’s balance sheet, the recourse component is considered a guarantee. During 2005, the Company sold $1.1 billion of loans with recourse for borrower defaults compared to none in 2004. The Company maintained a $2.3 million reserve related to these guarantees as of December 31, 2005 compared with a reserve of $45,000 as of December 31, 2004. During 2005 the Company paid $2.3 million in cash to repurchase loans sold to third parties. In 2004, the Company paid $0.5 million in cash to repurchase loans sold to third parties in prior periods.

In the ordinary course of business, the Company sells loans to securitization trusts and make a guarantee to cover losses suffered by the trust resulting from defects in the loan origination process. Defects may occur in the loan documentation and underwriting process, either through processing errors made by the Company or through intentional or unintentional misrepresentations made by the borrower or agents during those processes. If a defect is identified, the Company is required to repurchase the loan. As of December 31, 2005 and December 31, 2004, the Company had loans sold with recourse with an outstanding principal balance of $12.7 billion and $11.4 billion, respectively. Historically, repurchases of loans where a defect has occurred have been insignificant, therefore, the Company has recorded no reserves related to these guarantees.

Our branches broker loans to third parties in the ordinary course of business where the third party has recourse against the Company for certain borrower defaults. Because the loans are no longer on the Company’s balance sheet, the recourse component is considered a guarantee. During 2005, the Company’s branches brokered $1.4 billion of loans with recourse for borrower defaults compared to $4.8 billion in 2004. The Company maintained a $476,000 reserve related to these guarantees as of December 31, 2005 compared with a reserve of $116,000 as of December 31, 2004.

ContingenciesSince April 2004, a number of substantially similar class action lawsuits have been filed and consolidated into a single action in the Untied States District Court for the Western District of Missouri. The consolidated complaint names as defendants the Company and three of its executive officers and generally alleges that the defendants made public statements that were misleading for failing to disclose certain regulatory and licensing matters. The plaintiffs purport to have brought this consolidated action on behalf of all persons who purchased the Company’s common stock providing shareholders(and sellers of recordput options on the Company’s stock) during the period October 29, 2003 through April 8, 2004. On January 14, 2005, the Company filed a motion to dismiss this action, and on May 12, 2005, the court denied such motion. The Company believes that these claims are without merit and continues to vigorously defend against them.

In the wake of the securities class action, the Company has also been named as a nominal defendant in several derivative actions brought against certain of November 17, 2003,the Company’s officers and directors in Missouri and Maryland. The complaints in these actions generally claim that the defendants are liable to the Company for failing to monitor corporate affairs so as to ensure compliance with oneapplicable state licensing and regulatory requirements.

In July 2004, an employee of NovaStar Home Mortgage, Inc. (“NHMI”), a wholly-owned subsidiary of the Company, filed a class and collective action lawsuit against NHMI and NMI in California Superior Court for the County of Los Angeles. Subsequently, NHMI and NMI removed the matter to the United States District Court for the Central District of California and NMI was removed from the lawsuit. The putative class is comprised of all past and present employees of NHMI who were employed since May 1, 2000 in the capacity generally described as Loan Officer. The plaintiffs alleged that NHMI failed to pay them overtime and minimum wage as required by the Fair Labor Standards Act (“FLSA”) and California state laws for the period commencing May 1, 2000 to present. In 2005, the plaintiffs and NHMI agreed upon a nationwide settlement in the amount of $3.3 million on behalf of a class of all NHMI Loan Officers. The settlement, which is subject to final court approval, covers all claims for minimum wage, overtime, meal and rest periods, record-keeping, and penalties under California and federal law during the class period. Since not all class members will elect to be part of the settlement, the Company estimated the probable obligation related to the settlement to be in a range of $1.3 million to $1.7 million. In accordance with SFAS No. 5, Accounting for Contingencies, the Company recorded a charge to earnings of $1.3 million in 2004. In 2005, the Company recorded an additional share charge to earnings of $200,000 as the estimated probable obligation increased to a range of $1.5 million to $1.9 million.

In April 2005, three putative class actions filed against NHMI and certain of its affiliates were consolidated for pre-trial proceedings in the United States District Court for the Southern District of Georgia entitledIn Re NovaStar Home Mortgage, Inc. Mortgage Lending Practices Litigation.These cases allege that NHMI improperly shared settlement service fees with limited liability companies in which NHMI had an interest (the “LLCs”) alleging violations of the fee splitting and anti-referral provisions of the federal Real Estate Settlement Procedures Act (“RESPA”), and alleging certain violations of state law and civil conspiracy. Plaintiffs seek treble damages with respect to the RESPA claims, disgorgement of fees with respect to the state law claims as well as other damages, injunctive relief and attorney fees. In addition, two other related class actions have been filed in state courts.Miller v. NovaStar Financial, Inc. et al., was filed in October 2004 in the Circuit Court of Madison County, Illinois andJones et al. v. NovaStar Home Mortgage, Inc. et al., was filed in December 2004 in the Circuit Court for Baltimore City, Maryland. In theMiller case,plaintiffs allege a violation of the Illinois Consumer Fraud and Deceptive Practices Act and civil conspiracy alleging certain LLCs provided settlement services without the borrower’s knowledge. In theJones case, the plaintiffs allege the LLCs violated the Maryland Lender Act by acting as lenders and/or brokers in Maryland without proper licenses and allege this arrangement amounted to a civil conspiracy. The plaintiffs in both theMiller andJones cases seek a disgorgement of fees, other damages, injunctive relief and attorney fees on behalf of the class of plaintiffs. The Company believes that these claims are without merit and intends to vigorously defend against them.

In December 2005, a putative class action was filed against NHMI in the United States District Court for the Middle District of Louisiana entitledPearson v. NovaStar Home Mortgage, Inc.Plaintiff contends that NHMI violated the federal Fair Credit Reporting Act (“FCRA”) in connection with its use of pre-approved offers of credit and its failure to make certain disclosures required by federal law. Plaintiff seeks (on his own behalf, as well as for others similarly situated) statutory damages, other nominal damages, punitive damages and attorney’s fees and costs. The Company believes that these claims are without merit and intends to vigorously defend against them.

In December 2005, a putative class action was filed against NovaStar Mortgage in the United States District Court for the Western District of Washington entitledPierce et al. v. NovaStar Mortgage, Inc.Plaintiffs contend that NovaStar Mortgage failed to disclose prior to closing that a broker payment would be made on their loans, which was an unfair and deceptive practice in violation of the Washington Consumer Protection Act. The plaintiffs seek a return of fees paid on the affected loans, excess interest charged, and damage to plaintiffs’ credit and finances, treble damages as provided in the Washington Consumer Protection Act and attorney fees. The Company believes that these claims are without merit and intends to vigorously defend against them.

In addition to those matters listed above, the Company is currently a party to various other legal proceedings and claims, including, but not limited to, breach of contract claims, class action or individual claims for violations of the RESPA, FLSA, federal and state laws prohibiting employment discrimination and federal and state licensing and consumer protection laws.

While management, including internal counsel, currently believes that the ultimate outcome of all these proceedings and claims will not have a material adverse effect on the Company’s financial condition or results of operations, litigation is subject to inherent uncertainties. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on the Company’s financial condition and results of operations.

In April 2004, the Company received notice of an informal inquiry from the Commission requesting that the Company provide various documents relating to our business. The Company has cooperated fully with the Commission’s inquiry and provided it with the requested information.

The Company maintains a number of equity-based compensation plans for its employees, including a 401(k) plan, and a Direct Stock Purchase and Dividend Reinvestment Plan (“DRIP”) for its employees and the public. Up to approximately 23,000 shares

of common stock under the Company’s 401(k) plan and up to approximately 287,000 shares of common stock under the DRIP (collectively, the “Subject Shares”), may have been sold in a manner that may not have complied with the registration requirements of applicable securities laws during the twelve month period ending January 20, 2006, the date the rescission offers were initiated. In connection with sales under the Company’s 401(k) plan, the Subject Shares were purchased in the open market and as a result the Company did not receive any proceeds from such transactions, which may not be deemed to be sales for each share owned.these purposes. In connection with sales of up to approximately 287,000 Subject Shares that were not registered under the Company’s DRIP in May 2005, the Company received approximately $10.8 million in net proceeds. As a result, the Company initiated offers to rescind the purchase of the Subject Shares. While the Company does not expect all eligible purchasers to exercise their rescission rights pursuant to the rescission offers, the Company has agreed to repurchase the Subject Shares still held by eligible purchasers generally for an amount equal to the original purchase price for the shares plus interest, less dividends, and to compensate eligible purchasers generally for any losses incurred in the sale of the Subject Shares, plus interest, less dividends. The additional shares resulting from the split were issued on December 1, 2003 increasing the number of eligible purchasers and the amount that the Company will pay for the shares that are rescinded will be determined by reference to the closing price of the Company’s common shares outstandingstock on March 30, 2006, the expiration date of the rescission offers. Furthermore, the Company could be subject to 24.1 million. Prior year share amountsmonetary fines or other regulatory sanctions as provided under applicable securities laws.

The damage caused by the Gulf State hurricanes, particularly Katrina, Rita and earnings per share disclosuresWilma, has affected the Company’s mortgage loans held-for-sale and the mortgage loan portfolio it services which underlies its mortgage securities – available-for-sale by impairing the ability of certain borrowers to repay their loans. At present, the Company is unable to predict the ultimate impact of the Gulf State hurricanes on its future financial results and condition as the impact will depend on a number of factors, including the extent of damage to the collateral, the extent to which damaged collateral is not covered by insurance, the extent to which unemployment and other economic conditions caused by the hurricane adversely affect the ability of borrowers to repay their loans, and the cost to the Company of collection and foreclosure moratoriums, loan forbearances and other accommodations granted to borrowers. Many of the loans are to borrowers where repayment prospects have not yet been determined to be diminished, or are in areas where properties may have suffered little, if any, damage or may not yet have been restatedinspected. The Company currently has a mortgage protection insurance policy, which protects it from uninsured losses as a result of these hurricanes up to reflecta maximum of $5 million in aggregate losses with a deductible of $100,000 per hurricane. At this time, the stock split.Company believes the overall financial impact the Gulf State hurricanes will have on its future financial condition and results of operations will be immaterial.

Note 10. Shareholders’ Equity

 

On May 21, 2003,June 2, 2005, the Company completed a public offering of 1,207,5001,725,000 shares of its common stock at $22.13$35 per share. The Company raised $25.2$57.9 million in net proceeds from this offering. The Company completed another public offering of 1,403,000 shares of its common stock at $38.50 per share on November 7, 2003, resulting in $51.7 million in net proceeds.

 

On May 2, 2003, the Company established a direct stock purchase and dividend reinvestment plan. The PlanCompany’s DRIP allows for the purchase of stock directly from the Company and/or the automatic reinvestment of all or a percentage of the dividends shareholders receive. The Planreceive and allows for a discount from market of up to 3%. Under the Plan, theThe Company sold 578,1202,609,320 shares of its common stock during 20032005 at a weighted average discount of 1.9%2.0%. Net proceeds of $17.0$83.6 million were raised under these sales of common stock. Under the DRIP, the Company sold 1,104,488 shares of its common stock during 2004 at a weighted average discount of 1.4%. Net proceeds of $49.4 million were raised under these sales of common stock.

 

TermsDuring 2005 and 2004, 148,797 and 433,181 shares of common stock were issued under the Class B,Company’s stock-based compensation plan, respectively. Proceeds of $0.7 million and $2.0 million were received under these issuances during 2005 and 2004, respectively.

In November 2004, the Company completed a public offering of 1,725,000 shares of its common stock at $42.50 per share. The Company raised $70.1 million in net proceeds from this offering.

In the first quarter of 2004, the Company sold 2,990,000 shares of Series C Cumulative Redeemable Perpetual Preferred Stock, raising $72.1 million in net proceeds. The shares have a liquidation value of $25.00 per share and pay an annual coupon of 8.90% and are not convertible into any other securities. The Company may, at its option, redeem the preferred stock, issued in 1999 allowed the Company to redeemaggregate or in part, at any time on or after January 22, 2009. As such, this stock is not considered mandatorily or contingently redeemable under the sharesprovisions of SFAS 150,Accounting for $7.00 per share beginning April 1, 2002. In February 2002, the Company notified the preferred shareholdersCertain Financial Instruments with Characteristics of its intent to redeem allboth Liabilities and Equity and is therefore classified as a component of the outstanding preferred shares at the earliest possible time. On February 21, 2002, the preferred shareholders exercised their options to convert to common shares.

As of December 31, 2001, the Company had 1,162,731 warrants outstanding for the purchase of Company common stock. On January 30, 2002, warrant holders surrendered 350,000 warrants with an exercise price of $6.94 in a “cashless” exchange for 421,406 shares of the Company’s common stock valued at $8.72 per share. On April 5, 2002, the Company acquired the remaining 812,731 warrants with an exercise price of $4.56 from warrant holders for $9.5 million.equity.

 

The Company’s Board of Directors has approved the purchase of up to $9 million of the Company’s common stock. No shares were purchased in 2002 or 2003. Duringduring the yearthree years ended December 31, 2001, 230,2942005. Under Maryland law, shares were purchased with an aggregate purchase price of $655,000. The purchased shares have beenunder this plan are to be returned to the Company’s authorized but unissued shares of common stock. All commonCommon stock purchases arepurchased under this plan is charged against additional paid-in capital.

In connection with various regulatory lending requirements, certain wholly-owned subsidiaries of the Company are required to maintain minimum levels of net worth. At December 31, 2005, the highest minimum net worth requirement applicable to any subsidiary was $250,000. The wholly-owned subsidiaries were in compliance with these requirements as of December 31, 2005.

The following is a rollforward of accumulated other comprehensive income for the three years ended December 31, 2003 (in2005 (dollars in thousands):

 

   Available-
for-sale
Securities


  Derivative
Instruments
Used in
Cash Flow
Hedges


  Total

 

Balance, January 1, 2001

  $10,168  $—    $10,168 

Change in unrealized gain (loss)

   21,768   (9,882)  11,886 

Implementation of SFAS No. 133

   —     34   34 

Net settlements reclassified to earnings

   —     2,087   2,087 

Realized gain reclassified to earnings

   (14,946)  —     (14,946)

Other amortization

   —     (52)  (52)
   


 


 


Other comprehensive income (loss)

   6,822   (7,813)  (991)
   


 


 


Balance, December 31, 2001

   16,990   (7,813)  9,177 
   


 


 


Change in unrealized gain (loss)

   55,649   (12,184)  43,465 

Net settlements reclassified to earnings

   —     10,396   10,396 

Other amortization

   —     (103)  (103)
   


 


 


Other comprehensive income (loss)

   55,649   (1,891)  53,758 
   


 


 


Balance, December 31, 2002

   72,639   (9,704)  62,935 
   


 


 


Change in unrealized gain (loss)

   15,086   (2,197)  12,889 

Net settlements reclassified to earnings

   —     9,462   9,462 

Other amortization

   —     (103)  (103)
   


 


 


Other comprehensive income

   15,086   7,162   22,248 
   


 


 


Balance, December 31, 2003

  $87,725  $(2,542) $85,183 
   


 


 


Prior to 2001, the Company and its founders entered into a series of transactions which resulted in non-recourse forgivable promissory notes (the Notes) payable to the Company aggregating $6.4 million and the founders owning 723,108 shares of common stock of the Company. On January 1, 2001, the Company and its founders entered into another series of transactions, which resulted in a significant reduction in the balance of the Notes. The founders returned 578,664 shares of the common stock and the Company cancelled the related non-recourse debt. The Company then repurchased the remaining 144,444 shares of common stock. The Company also purchased all of the voting common stock of NFI Holding Corporation from the founders. As a result of this purchase, NFI Holding Corporation became a wholly-owned subsidiary of the Company on January 1, 2001.

The founders used the proceeds received from the sale of NFI Holding Corporation and Company common stock to repay a portion of their obligations described above. The remaining obligations, aggregating $1,393,000, were rewritten into new non-recourse, non interest-bearing promissory notes. Those notes will be forgiven and charged to expense in equal installments over 10 years as long as the Company employs the founders on December 31st of each year. The notes will be forgiven in full in the event of a change in control. During the years ended December 31, 2003, 2002 and 2001, the Company recognized $139,000 in compensation expense related to these notes. The founders have each pledged 144,444 shares of common stock as collateral for these loans.

   

Available-

for-Sale

Mortgage

Securities


  

Derivative

Instruments

Used in Cash Flow

Hedges


  Total

 

Balance, January 1, 2003

  $72,639  $(9,704) $62,935 

Change in unrealized gain (loss), net of related tax effects

   15,086   (1,038)  14,048 

Net settlements reclassified to earnings

   —     8,303   8,303 

Other amortization

   —     (103)  (103)
   


 


 


Other comprehensive income (loss)

   15,086   7,162   22,248 
   


 


 


Balance, December 31, 2003

  $87,725  $(2,542) $85,183 
   


 


 


Change in unrealized gain (loss), net of related tax effects

   (24,398)  (38)  (24,436)

Impairment reclassified to earnings

   15,902   —     15,902 

Net settlements reclassified to earnings

   —     2,497   2,497 

Other amortization

   —     (26)  (26)
   


 


 


Other comprehensive (loss) income

   (8,496)  2,433   (6,063)
   


 


 


Balance, December 31, 2004

  $79,229  $(109) $79,120 
   


 


 


Change in unrealized gain, net of related tax effects

   14,690   —     14,690 

Impairment reclassified to earnings

   17,619   —     17,619 

Net settlements reclassified to earnings

   —     109   109 
   


 


 


Other comprehensive income (loss)

   32,309   109   32,418 
   


 


 


Balance, December 31, 2005

  $111,538  $—    $111,538 
   


 


 


 

Note 8.11. Derivative Instruments and Hedging Activities

 

The Company’s objective and strategy for using derivative instruments is to mitigate the risk of increased costs on its variable rate liabilities during a period of rising rates. The Company’s primary goals for managing interest rate risk are to maintain the net interest margin between its assets and liabilities and diminish the effect of changes in general interest rate levels on the market value of the Company.

 

The derivative instruments used by the Company to manage this risk are interest rate caps and interest rate swaps. Interest rate caps are contracts in which the Company pays either an upfront premium or monthly or quarterly premium to a counterparty. In return, the Company receives payments from the counterparty when interest rates rise above a certain rate specified in the contract. During 2003, 20022005, 2004 and 2001,2003, premiums paid related to interest rate cap agreements aggregated $7.4$2.4 million, $1.2$1.6 million and $3.7$7.4 million, respectively. When premiums are

financed by the Company, a liability is recorded for the premium obligation. Premiums due to counterparties as of December 31, 20032005 and 20022004 were $3.5$3.4 million and $171,000,$1.9 million, respectively, and bear a weighted average interest rate of 3.5% and 1.9% in 2005 and 7.1%,2004, respectively. The future contractual maturities of premiums due to counterparties as of December 31, 20032005 are $1.6$1.5 million, $1.4$1.0 million, $0.7 million, $0.1 million and $0.5$0.1 million due in 2004, 2005years 2006, 2007, 2008, 2009 and 2006,2010, respectively. The interest rate swap agreements to which the Company is party stipulate that the Company pay a fixed rate of interest to the counterparty and the counterparty pays the company a variable rate of interest based on the notional amount of the contract. The liabilities the Company hedges are asset-backed bonds and borrowings under its warehouse, mortgage loan and mortgage security repurchase agreements as discussed in Note 6.8.

 

All of theThe Company’s derivative instruments that meet the hedge accounting criteria of SFAS No. 133 are considered cash flow hedges. TheDuring the three years ended December 31, 2005, there was no hedge ineffectiveness. At December 31, 2005, the Company also hashad no derivative instruments that doconsidered cash flow hedges, as they all had not meetmet the requirements for hedge accounting. However, these derivative instruments alsodo contribute to the Company’s overall risk management strategy by serving to reduce interest rate risk on average short-term borrowings used to fundcollateralized by the Company’s loans held-for-sale.

The following tables present derivative instruments as of December 31, 20032005 and 20022004 (dollars in thousands):

 

  Notional
Amount


  Fair
Value


 

Maximum

Days to

Maturity


  

Notional

Amount


  

Fair

Value


 

Maximum

Days to

Maturity


As of December 31, 2003:

      

As of December 31, 2005:

      

Non-hedge derivative instruments

  $1,555,000  $8,395  1,820
  

  


 

As of December 31, 2004:

      

Cash flow hedge derivative instruments

  $250,000  $(3,224) 450  $35,000  $(179) 84

Non-hedge derivative instruments

   2,085,144   1,255  1,090   1,965,000   12,141  1,089
  

  


   

  


 

Total derivative instruments

  $2,335,144  $(1,969)   $2,000,000  $11,962  
  

  


   

  


 

As of December 31, 2002:

      

Cash flow hedge derivative instruments

  $435,000  $(11,267) 815

Non-hedge derivative instruments

   1,648,486   (6,977) 1,090
  

  


 

Total derivative instruments

  $2,083,486  $(18,244) 
  

  


 

 

DuringThe Company recognized $0.2 million, $3.1 million and $9.4 million during the three years ended December 31, 2003, the Company recognized $9.4 million, $10.3 million2005, 2004 and $2.0 million,2003, respectively, in net expense on derivative instruments qualifying as cash flow hedges, which is recorded as a component of interest expense.

 

The net amount included in other comprehensive income expected to be reclassified into earnings within the next twelve months is a charge to earnings of approximately $3.1 million.

The derivative financial instruments we usethe Company uses also subject usthem to “margin call” risk. The Company’s deposits with derivative counterparties were $20.9$4.4 million and $30.3$6.7 million as of December 31, 20032005 and 2002,2004, respectively.

 

The Company’s derivative instruments involve, to varying degrees, elements of credit and market risk in addition to the amount recognized in the consolidated financial statements.

 

Credit RiskThe Company’s exposure to credit risk on derivative instruments is limitedequal to the amount of deposits (margin) held by the counterparty, plus any net receivable due from the counterparty, plus the cost of replacing the contracts should the counterparty fail. The Company seeks to minimize credit risk through the use of credit approval and review processes, the selection of only the most creditworthy counterparties, continuing review and monitoring of all counterparties, exposure reduction techniques and thorough legal scrutiny of agreements. Before engaging in negotiated derivative transactions with any counterparty, the Company has in place fully executed written agreements. Agreements with counterparties also call for full two-way netting of payments. Under these agreements, on each payment exchange date all gains and losses of counterparties are netted into a single amount, limiting exposure to the counterparty to any net receivable amount due.

 

Market RiskThe potential for financial loss due to adverse changes in market interest rates is a function of the sensitivity of each position to changes in interest rates, the degree to which each position can affect future earnings under adverse market conditions, the source and nature of funding for the position, and the net effect due to offsetting positions. The derivative instruments utilized leave the Company in a market position that is designed to be a better position than if the derivative instrument had not been used in interest rate risk management.

 

Other Risk ConsiderationsThe Company is cognizant of the risks involved with derivative instruments and has policies and procedures in place to mitigate risk associated with the use of derivative instruments in ways appropriate to its business activities, considering its risk profile as a limited end-user.

Note 9.12. Income Taxes

 

The components of income tax expense (benefit) allocatedattributable to earnings arecontinuing operations for the years ended December 31, 2005, 2004 and 2003 were as follows (in(dollars in thousands):

 

   

For the

Year Ended December 31,


 
   2003

  2002

 

Current

  $28,708  $2,621 

Deferred

   (5,848)  (4,652)
   


 


Total income tax expense (benefit)

  $22,860  $(2,031)
   


 


   For the Year Ended December 31,

 
   2005

  2004

  2003

 

Current:

             

Federal

  $7,561  $9,976  $24,181 

State and local

   1,198   872   4,527 
   


 


 


Total current

   8,759   10,848   28,708 

Deferred: (A)

             

Federal

   (17,477)  (1,258)  (4,926)

State and local

   (2,182)  (64)  (922)
   


 


 


Total deferred

   (19,659)  (1,322)  (5,848)
   


 


 


Total income tax (benefit) expense

  $(10,900) $9,526  $22,860 
   


 


 



(A)Does not reflect the deferred tax effects of unrealized gains and losses on derivative financial instruments that are included in shareholders’ equity. As a result of these tax effects, shareholders’ equity decreased by $70,000 and $587,000 in 2005 and 2004, respectively.

 

The difference betweenA reconciliation of the expected federal income tax benefit computed atexpense (benefit) using the federal statutory tax rate of 35% and35 percent to the taxable REIT subsidiary’s actual income tax benefit recorded atexpense and resulting effective tax rate from continuing operations for the years ended December 31, 2005, 2004 and 2003 were as follows (dollars in thousands):

   For the Year Ended December 31,

   2005

  2004

  2003

Income tax at statutory rate (taxable REIT subsidiary)

  $(10,887) $8,187  $18,102

Taxable gain on security sale to REIT

   —     1,342   2,761

State income taxes, net of federal tax benefit

   (639)  525   1,549

Nondeductible expenses

   601   240   228

Reduction of estimated income tax accruals

   —     (904)  —  

Other

   25   136   220
   


 


 

Total income tax (benefit) expense

  $(10,900) $9,526  $22,860
   


 


 

Significant components of the taxable REIT subsidiary is as follows (in thousands):

   

For the

Year Ended December 31,


 
   2003

  2002

 

Income tax at statutory rate (taxable REIT subsidiary)

  $18,102  $(3,755)

State income taxes

   1,549   (442)

Nondeductible expenses

   228   117 

Taxable gain on security sale to REIT

   2,761   805 

Other

   220   1,244 
   

  


Total income tax expense (benefit)

  $22,860  $(2,031)
   

  


The tax effects of temporary differences that give rise to the significant portions of thesubsidiary’s deferred tax assets and liabilities areat December 31, 2005 and 2004 were as follows (in(dollars in thousands):

 

  December 31,

  December 31,

 
  2003

  2002

  2005

 2004

 

Deferred tax assets:

         

Federal net operating loss carryforwards

  $22,569  $—   

Excess inclusion income

   16,489   18,449 

Deferred compensation

   5,997   5,158 

Deferred lease incentive income

   2,353   1,026 

Deferred loan fees, net

   542   548 

Mark-to-market adjustment on held-for-sale loans

  $7,724  $—     2,123   5,423 

Unrealized loss on derivative instruments

   —     3,108

Excess inclusion income

   10,242   2,383

Net operating loss carryforwards

   —     1,368

Unrealized loss on derivatives used in cash flow hedges

   —     1,396

Deferred compensation plan contributions

   1,893   —  

Fixed assets

   —     138

State net operating loss carryforwards

   7,469   2,353 

Accrued expenses for branch closings

   201   743 

Accrued expenses, other

   2,181   666 

Other

   1,956   853   358   427 
  

  

  


 


Gross deferred tax asset

   60,282   34,793 

Valuation allowance

   (5,498)  (2,353)
  


 


Deferred tax asset

   21,815   9,246   54,784   32,440 
  


 


Deferred tax liabilities:

         

Unrealized gain on available for sale securities

   —     3,575

Mortgage servicing rights

   7,677   3,004   21,246   16,199 

Fixed assets

   2,319   —  

Mark-to-market adjustment on derivative instruments

   1,470   2,706 

Premises and equipment

   996   2,119 

Other

   1,364   201   292   226 
  

  

  


 


Deferred tax liability

   11,360   6,780   24,004   21,250 
  

  

  


 


Net deferred tax asset

  $10,455  $2,466  $30,780  $11,190 
  

  

  


 


As of December 31, 2005 the taxable REIT subsidiary has an estimated federal net operating loss carryforward of $64.5 million, which will be available to offset future taxable income. If not used, this net operating loss will expire in 2025.

The valuation allowance included in the taxable REIT subsidiary’s deferred tax assets at December 31, 2005 and 2004 represent various state net operating loss carryforwards for which it is more likely than not that realization will not occur. The state net operating losses will expire in varying amounts through 2025. The $3.1 million increase in the valuation allowance for deferred tax assets resulted from the net increase of state net operating losses generated by the taxable REIT subsidiary in 2005 where realization is not expected to occur.

 

Note 10.13. Employee Benefit Plans

 

The NovaStar Financial, Inc. 401(k) Plan (the Plan) is a defined contribution plan which allows eligible employees to save for retirement through pretax contributions. Under the Plan, employees of the Company may contribute up to the statutory limit. The Company may elect to match a certain percentage of participants’ contributions. The Company may also elect to make a discretionary contribution, which is allocated to participants based on each participant’s compensation. Contributions to the Plan by the Company for the years ended December 31, 2005, 2004 and 2003 2002were $1.2 million, $3.1 million and 2001 were $2.0 million, $806,000 and $472,000, respectively.

 

The Company’sCompany has a Deferred Compensation Plan (the Plan)DCP) that is a nonqualified deferred compensation plan that benefits certain designated key members of management and highly compensated employees and allows them to defer payment of a portion of their compensation to future years. Under the Plan,DCP, an employee may defer up to 50% of his or her base salary, bonus and/or commissions on a pretax basis. The Company may make both voluntarydiscretionary and/or matching contributions to the PlanDCP on behalf of PlanDCP participants. All PlanDCP assets are corporate assets rather than individual property and are therefore subject to creditors’ claims against the Company. The Company made contributions to the PlanDCP for the years ended December 31, 2005, 2004 and 2003 of $777,000, $371,000 and 2002 of $643,000, and $482,000, respectively.

 

Note 11.14. Stock Option PlanCompensation Plans

 

TheOn June 8, 2004, the Company’s 1996 Stock Option Plan (the Plan)“1996 Plan”) was replaced by the 2004 Incentive Stock Plan (“the 2004 Plan”). The 2004 Plan provides for the grant of qualified incentive stock options (ISOs)(“ISOs”), non-qualified stock options (NQSOs)(“NQSOs”), deferred stock, restricted stock, performance shares,share awards, dividend equivalent rights (“DERs”) and stock appreciation and limited stock appreciations awards and dividend equivalent rights (DERs)(“SARs”). Since inception of the Plan, theThe Company has granted only ISOs, NQSOs, restricted stock, performance share awards and DERs. ISOs may be granted to the officers and employees of the Company. NQSOs, DERs, SARs and stock awards may be granted to the directors, officers, employees, agents and consultants of the Company or any subsidiaries. Under the terms of the Plan, the number of shares available for issuancegrant is equal to 10%2.5 million shares of the Company’s outstanding common stock. Individuals who receive awards under theThe Plan will vestremain in those awards ratably over a four-year period. Unless previouslyeffect unless terminated by the Board of Directors the Plan will terminate on September 1, 2006.or no shares of stock remain available for awards to be granted.

 

Prior to 2003, the Company accounted for stock-based compensation plans under the recognition and measurement provisions of APB No. 25 and related interpretations. Effective January 1, 2003, the Company adopted the fair value recognition provisions of SFAS No. 123. The Company selected the modified prospective method of adoption described in SFAS No. 148. Compensation cost recognized in 2003 is the same as that which would have been recognized had the fair value method of SFAS No. 123 been applied from its original effective date. See Note 1.

In accordance with the provisions of SFAS No. 123 and SFAS No. 148, $2.2 million, $1.8 million and $1.3 million was recorded for total stock-based compensation expense in 2003. In accordance with APB No. 25, totalof stock-based compensation expense was $2.5 millionrecorded in 2005, 2004 and $0.7 million, respectively, for the years ended December 31, 2002 and 2001.2003, respectively.

 

All options have been granted at exercise prices greater than or equal to the estimated fair value of the underlying stock at the date of grant. Outstanding options generally vest equally over four years and expire ten years after the date of grant.

The following table summarizes stock option activity under the 1996 Plan for 2003, 20022005, 2004 and 2001,2003, respectively:

 

  2003

  2002

  2001

  2005

  2004

  2003

  Shares

 Weighted
Average
Price


  Shares

 Weighted
Average
Price


  Shares

 Weighted
Average
Price


Stock Options


  Shares

 

Weighted

Average

Price


  Shares

 

Weighted

Average

Price


  Shares

 

Weighted

Average

Price


Outstanding at the beginning of year

  1,032,670  $7.40  1,078,840  $4.69  1,083,820  $3.82  433,600  $10.16  746,800  $8.22  1,032,670  $7.40

Granted

  15,000   22.66  314,000   12.05  225,000   6.73  396,946   29.72  15,000   33.59  15,000   22.66

Exercised

  (275,390)  5.98  (355,250)  3.05  (226,500)  2.80  (108,750)  6.08  (305,700)  6.55  (275,390)  5.98

Forfeited

  (22,810)  19.28  (22,500)  10.50  (25,480)  7.79

Canceled

  (25,480)  7.79  (4,920)  8.25  (3,480)  9.00  (297,818)  25.95  —     —    —     —  
  

   

   

 
  

   

   

 

Outstanding at the end of year

  746,800  $8.22  1,032,670  $7.40  1,078,840  $4.69  401,168  $18.39  433,600  $10.16  746,800  $8.22
  

 

  

 

  

 

  

 

  

 

  

 

Exercisable at the end of year

  275,050  $7.67  294,420  $7.63  406,090  $6.19  242,100  $11.57  215,600  $7.48  275,050  $7.67
  

 

  

 

  

 

  

 

  

 

  

 

 

Certain options granted during 2003, 2002 and 2001 were granted with DERs. In December 2001,Pursuant to a resolution of the Company’s compensation committee of the Board of Directors approved that certain existingdated December 14, 2005, 227,455 and 70,363 options issued to employees and directors, respectively, were modified. The Company modified all future stock option grants haveoptions which were either unvested as of January 1, 2005 or were granted during 2005. For employee options, the rate in which DERs attached to them. Under the termsaccrue was modified from sixty percent of the dividend per share amount to one hundred percent and the form for which DERs will be paid was modified from stock to cash upon vesting. For director options, only the form for which DERs will be paid was modified from stock to cash upon vesting. These options are included in the granted and canceled amounts during 2005 in the table above. No modifications were made to the exercise prices, vesting periods or expiration dates. At the date of modification, the canceled options were revalued and the modified options were initially valued. The incremental difference between the value of the modified option and the canceled option will be amortized into compensation expense over the remaining vesting period. The Company recognized $0.2 million in incremental compensation expense due to the modification of these awards in 2005.

For options which vested prior to January 1, 2005, a recipient is entitled to receive additional shares of stock upon the exercise of options. For employees, the DERs accrue at a rate equal to the number of options outstanding times sixty percent of the dividends per share amount at each dividend payment date. For directors, the DERs accrue at a rate equal to the number of options outstanding times the dividends per share amount at each dividend payment date. The accrued DERs convert to shares based on the stock’s fair value on the dividend payment date. Certain of the options exercised in 2003, 20022005, 2004 and 20012003 had DERs attached to them when issued. As a result of these exercises, an additional 23,485, 3,22613,972, 47,969 and 1,77823,485 shares of common stock were issued in 2005, 2004 and 2003, 2002 and 2001, respectively.

For options granted after January 1, 2005, a recipient is entitled to receive DERs paid in cash upon vesting of the options. The DERs accrue at a rate equal to the number of options outstanding times the dividends per share amount at each dividend payment date. The DERs begin accruing immediately upon grant, but are not paid until the options vest.

The following table presents information on stock options outstanding as of December 31, 2003.2005.

 

   Outstanding

  Exercisable

Exercise Price


  Quantity

  

Weighted
Average
Remaining
Contractual Life

(Years)


  Weighted
Average
Exercise
Price


  Quantity

  Weighted
Average
Exercise
Price


$1.53 - $7.16

  349,250  7.40  $4.27  120,500  $4.55

$7.91 - $10.41

  114,500  4.43   8.92  103,250   9.03

$12.22 - $22.66

  283,050  8.96   12.81  51,300   12.28
   
         
    
   746,800  7.53  $8.22  275,050  $7.67
   
  
  

  
  

   Outstanding

  Exercisable

Exercise Price


  Quantity

  

Weighted Average

Remaining

Contractual Life

(Years)


  

Weighted

Average

Exercise Price


  Quantity

  

Weighted

Average

Exercise Price


$1.53 – $7.16

  93,500  5.66  $5.79  93,500  $5.79

$7.91 - $12.97

  184,350  6.44   11.74  122,350   11.61

$22.66 - $33.59

  30,000  7.91   28.12  11,250   26.30

$36.20 - $42.13

  93,318  9.20   41.00  15,000   36.20
   
         
    
   401,168  7.01  $18.39  242,100  $11.57
   
  
  

  
  

The following table summarizes the weighted average fair value of options granted, determined using the Black-Scholes option pricing model and the assumptions used in their determination.

   2005 (A)

  2004

  2003

 

Weighted average:

             

Fair value, at date of grant

  $14.25  $21.24  $22.48 

Expected life in years

   2   6   7 

Annual risk-free interest rate

   4.4%  4.7%  3.3%

Volatility

   0.3   0.7   2.0 

Dividend yield

   0.0%  0.0%  0.0%

(A)Includes the assumptions used in the revaluation of modified options. The weighted average expected life of newly granted options in 2005 (not including prior year granted options modified in 2005) was four.

The Company granted and issued shares of restricted stock during 2005 and 2004. The 2005 restricted stock awards vest at the end of 10 years while the 2004 restricted stock awards vest equally over four years.

During 2005, the Company granted restricted shares to employees and officers under Performance Contingent Deferred Stock Award Agreements. Under the agreements, the Company will issue shares of restricted stock if certain performance targets are achieved by the Company within a three-year period. The shares vest equally over two years upon issuance. No shares were issued under these agreements in 2005 and the total number of shares which can be issued in the future is 21,185 as of December 31, 2005.

In November 2004, the Company entered into a Performance Contingent Deferred Stock Award Agreement with an executive of the Company. Under the agreement, the Company will issue shares of restricted stock if certain performance targets based on wholesale nonconforming origination volume are achieved by the Company within a five-year period. The shares vest equally over four years upon issuance. No shares were issued related to this agreement in 2005 and the total number of shares that can be issued in the future is 100,000 as of December 31, 2005.

The following table summarizes restricted stock activity for 2005 and 2004, respectively:

Restricted Stock


  

2005

Shares


  

2004

Shares


 

Outstanding at the beginning of year

  140,300  —   

Granted

  46,050  141,200 

Vested

  (10,076) —   

Forfeited

  (6,305) (900)
   

 

Outstanding at the end of year

  169,969  140,300 
   

 

During 2005 and 2004, the Company issued 7,515 and 39,112 shares of restricted stock as payment for bonus compensation earned by certain executives of the Company in 2004 and 2003, respectively. The shares were issued at an average fair market value of $34.85 and $46.42 in 2005 and 2004, respectively. The shares are fully vested upon issuance but may not be sold by the holders for four years.

 

Note 12.15. Branch Operations

Prior to 2004, the Company was party to limited liability company (“LLC”) agreements governing LLCs formed to facilitate the operation of retail mortgage broker businesses as branches of NHMI. The LLC agreements provided for initial capitalization and membership interests of 99.99% to each branch manager and 0.01% to the Company. The Company accounted for its interest in the LLC agreements using the equity method of accounting. In December 2003, the Company determined it would terminate the LLCs effective January 1, 2004. During February 2004, the Company notified the branch managers of the limited liability companies that the Company was terminating these agreements effective January 1, 2004. Continuing branches that were formerly supported under these agreements became operating units of the Company and their financial results are included in the consolidated financial statements. The inclusion resulted in expected increases in general and administrative expenses, which were substantially offset by increases in related fee income. The Company did not purchase any assets or liabilities as a result of these branches becoming operating units.

On November 4, 2005, the Company adopted a formal plan to terminate substantially all of the remaining NHMI branches by June 30, 2006. As the demand for conforming loans has declined significantly since 2004, many branches have not been able to produce sufficient fees to meet operating expense demands. As a result of these conditions, a significant number of branch

managers have voluntarily terminated employment with the Company. The Company has also terminated branches when loan production results were substandard. The Company considers a branch to be discontinued upon its termination date, which is the point in time when the operations cease. The discontinued operations apply to the branch operations segment presented in Note 16. The Company has presented the operating results of those branches terminated through December 31, 2005, as discontinued operations in the Consolidated Statements of Income for the years ended December 31, 2005 and 2004. The consolidated statement of income for the year ended December 31, 2003 has not been reclassified, as the effect of branch terminations on the operating results in that year is immaterial. The operating results of all discontinued operations are summarized as follows (dollars in thousands):

   

For the Year Ended

December 31, 2005


  

For the Year Ended

December 31, 2004


 

Fee income

  $20,998  $114,166 

General and administrative expenses

   28,120   132,238 
   


 


Loss before income tax benefit

   (7,122)  (18,072)

Income tax benefit

   (2,649)  (6,723)
   


 


Loss from discontinued operations

  $(4,473) $(11,349)
   


 


As of December 31, 2005 the Company has $0.3 million in cash, $0.1 million receivables included in other assets and $0.4 million in payables included in accounts payable and other liabilities pertaining to discontinued operations, which are included in the consolidated balance sheets. As of December 31, 2004, the Company had $1.6 million in cash, $2.2 in receivables included in other assets and $3.8 in payables included in accounts payable and other liabilities pertaining to discontinued operations, which are included in the consolidated balance sheets. The discontinued operations only impacted the cash from operations section of the consolidated statement of cashflows for the periods ending December 31, 2005 and December 31, 2004.

As of December 31, 2003, there were 423 such branches. For the year ended December 31, 2003 the Company recorded fee income aggregating $12.8 million for providing administrative services for the branches. During 2003 the aggregate amount of loans brokered by these branches was approximately $5.7 billion. Of this amount, approximately $1.3 billion was acquired by the Company’s mortgage subsidiary. The aggregate premiums paid by the Company for loans brokered by these branches was approximately $15.1 million for the year ended December 31, 2003.

Note 16. Segment Reporting

 

The Company reviews, manages and operates its business in three segments. These business segments are:four segments: mortgage portfolio management, mortgage lending, and loan servicing and branches.branch operations. Mortgage portfolio management operating results are driven from the income generated on the assets we managethe Company manages less associated management costs. Mortgage lending and loan servicing operations include the marketing, underwriting and funding of loan production. ServicingLoan servicing operations represent the income and costs to service the Company’s on and off-balance sheet loans (See Note 2). Branchesloans. The loan servicing segment was previously reported as part of mortgage lending and loan servicing, but it has been separated to more closely align the segments with the way the Company reviews, manages and operates its business. The information for the years ended December 31, 2004 and 2003 have been restated for this change. Branch operations include the collective income generated by NovaStar Home Mortgagethe Company’s wholly-owned subsidiary (NHMI), brokers and the associated operating costs. TheAlso, the corporate-level income and costs to support the NovaStar Home Mortgage, Inc (NHMI)NHMI branches as well as the LLC branches isare represented in the branchesbranch operations segment.

The Company’s operations As discussed in Note 15, the LLC agreements were restructured into this decentralized organization structure beginningterminated effective January 1, 2001 as2004. As of January 1, 2004 the branches became more significant to the overall performancefinancial results of the Company. Certain reclassificationscontinuing branch operations, that were formerly supported by these agreements, were included in the consolidated financial statements. Branches that have terminated through December 31, 2005 have been made to prior year amounts to conform with current year segment presentation.segregated from the results of the ongoing operations of the Company for the years ended December 31, 2005 and 2004. Following is a summary of income and assets bythe operating results of the Company’s primary operating unitssegments for the yearyears ended December 31, 2005, 2004 and 2003, 2002as reclassified to reflect the operations of branches closed from January 1, 2004 through December 31, 2005 as discontinued operations for the years ended December 31, 2004 and 2001 (inDecember 31, 2005 (dollars in thousands):

For the Year Ended December 31, 2005

 

  For the Year Ended December 31, 2003

 
  Mortgage
Portfolio
Management


 Mortgage
Lending
and Loan
Servicing


 Branches

 Eliminations

 Total

   

Mortgage

Portfolio

Management


 

Mortgage

Lending


 

Loan

Servicing


 

Branch

Operations


 Eliminations

 Total

 

Interest income

  $109,542  $60,878  $—    $—    $170,420   $193,167  $106,118  $—    $536  $(49) $299,772 

Interest expense

   17,433   31,055   —     (8,124)  40,364    19,028   74,708   —     88   (12,981)  80,843 
  


 


 


 


 


  


 


 


 


 


 


Net interest income before credit recoveries

   92,109   29,823   —     8,124   130,056 

Credit recoveries

   389   —     —     —     389 

Net interest income before credit losses

   174,139   31,410   —     448   12,932   218,929 

Provision for credit losses

   (1,038)  —     —     —     —     (1,038)

Gains (losses) on sales of mortgage assets

   (1,911)  140,870   —     5,046   144,005    (27)  49,303   —     3,665   15,232   68,173 

Premiums for mortgage loan insurance

   (341)  (5,331)  —     —     —     (5,672)

Fee income

   65   37,505   40,290   (9,519)  68,341    —     9,188   21,755   27,041   (11,698)  46,286 

Losses on derivative instruments

   (894)  (29,943)  —     —     (30,837)

Gains on derivative instruments

   248   17,907   —     —     —     18,155 

Impairment on mortgage securities – available-for-sale

   (17,619)  —     —     —     —     (17,619)

Other income (expense)

   15,934   (14,563)  53   (4,114)  (2,690)   22,911   (7,788)  18,251   173   (12,667)  20,880 

General and administrative expenses

   (6,667)  (133,196)  (34,545)  —     (174,408)   (14,450)  (128,619)  (34,515)  (37,813)  —     (215,397)
  


 


 


 


 


  


 


 


 


 


 


Income before income tax

   99,025   30,496   5,798   (463)  134,856 

Income tax expense

   —     20,580   2,280   —     22,860 

Income (loss) from continuing operations before income tax (benefit

   163,823   (33,930)  5,491   (6,486)  3,799   132,697 

Income tax expense (benefit)

   —     (12,599)  2,062   (2,388)  2,025   (10,900)
  


 


 


 


 


  


 


 


 


 


 


Net income

  $99,025  $9,916  $3,518  $(463) $111,996 

Income (loss) from continuing operations

   163,823   (21,331)  3,429   (4,098)  1,774   143,597 

Loss from discontinued operations, net of income tax

   —     —     —     (1,054)  (3,419)  (4,473)
  


 


 


 


 


  


 


 


 


 


 


December 31, 2003:

   

Net income (loss)

  $163,823  $(21,331) $3,429  $(5,152) $(1,645) $139,124 
  


 


 


 


 


 


December 31, 2005:

   

Total assets

  $563,930  $834,980  $17,276  $(16,229) $1,399,957   $968,740  $1,489,211  $27,553  $19,072  $(168,842) $2,335,734 
  


 


 


 


 


  


 


 


 


 


 


For the Year Ended December 31, 2004

For the Year Ended December 31, 2004

 

 
  

Mortgage

Portfolio

Management


 

Mortgage

Lending


 

Loan

Servicing


 

Branch

Operations


 Eliminations

 Total

 

Interest income

  $140,306  $83,757  $—    $—    $(39) $224,024 

Interest expense

   21,071   39,727   —     108   (8,316)  52,590 
  


 


 


 


 


 


Net interest income before credit losses

   119,235   44,030   —     (108)  8,277   171,434 

Provision for credit losses

   (726)  —     —     —     —     (726)

Gains (losses) on sales of mortgage assets

   360   113,211   —     —     31,379   144,950 

Premiums for mortgage loan insurance

   (528)  (3,690)  —     —     —     (4,218)

Fee income

   —     10,431   20,692   39,534   (19,905)  50,752 

Gains on derivative instruments

   (111)  (8,794)  —     —     —     (8,905)

Impairment on mortgage securities – available-for-sale

   (15,902)  —     —     —     —     (15,902)

Other income (expense)

   16,651   (6,445)  4,167   35   (7,799)  6,609 

General and administrative expenses

   (7,473)  (127,063)  (24,698)  (58,676)  10,180   (207,730)
  


 


 


 


 


 


Income (loss) from continuing operations before income tax (benefit

   111,506   21,680   161   (19,215)  22,132   136,264 

Income tax expense (benefit)

   —     7,651   160   (7,494)  9,209   9,526 
  


 


 


 


 


 


Income (loss) from continuing operations

   111,506   14,029   1   (11,721)  12,923   126,738 

Income (loss) from discontinued operations, net of income tax

   —     —     —     5,202   (16,551)  (11,349)
  


 


 


 


 


 


Net income (loss)

  $111,506  $14,029  $1  $(6,519) $(3,628) $115,389 
  


 


 


 


 


 


December 31, 2004:

   

Total assets

  $1,078,064  $894,338  $21,022  $35,283  $(167,396) $1,861,311 
  


 


 


 


 


 


   For the Year Ended December 31, 2002

 
   Mortgage
Portfolio
Management


  

Mortgage

Lending and
Loan
Servicing


  Branches

  Eliminations

  Total

 

Interest income

  $73,407  $33,736  $—    $—    $107,143 

Interest expense

   15,650   20,715   —     (8,637)  27,728 
   


 


 


 


 


Net interest income before credit recoveries

   57,757   13,021   —     8,637   79,415 

Credit recoveries

   432   —     —     —     432 

Gains (losses) on sales of mortgage assets

   (791)  52,282   —     1,814   53,305 

Fee income

   432   18,084   21,495   (4,028)  35,983 

Losses on derivative instruments

   (2,282)  (34,559)  —     —     (36,841)

Other income (expense)

   12,466   (6,532)  62   (6,966)  (970)

General and administrative expenses

   (6,991)  (59,306)  (18,840)  543   (84,594)
   


 


 


 


 


Income (loss) before income tax

   61,023   (17,010)  2,717   —     46,730 

Income tax expense (benefit)

   —     (3,372)  1,341   —     (2,031)
   


 


 


 


 


Net income (loss)

  $61,023  $(13,638) $1,376  $—    $48,761 
   


 


 


 


 


December 31, 2002:

                     

Total assets

  $387,600  $1,053,477  $11,814  $(394) $1,452,497 
   


 


 


 


 


   For the Year Ended December 31, 2001

 
   Mortgage
Portfolio
Management


  

Mortgage

Lending and
Loan
Servicing


  Branches

  Eliminations

  Total

 

Interest income

  $38,394  $19,425  $85  $—    $57,904 

Interest expense

   18,996   12,301   —     (3,931)  27,366 
   


 


 


 


 


Net interest income before credit losses

   19,398   7,124   85   3,931   30,538 

Credit losses

   (3,608)  —     —     —     (3,608)

Gains on sales of mortgage assets

   14,745   22,431   171   —     37,347 

Fee income

   790   2,088   19,689   (1,573)  20,994 

Losses on derivative instruments

   —     (3,953)  —     —     (3,953)

Other income (expense)

   4,789   (2,436)  (1)  (3,151)  (799)

General and administrative expenses

   (4,386)  (26,573)  (16,339)  793   (46,505)
   


 


 


 


 


Income (loss) before cumulative effect of a change in accounting principle

   31,728   (1,319)  3,605   —     34,014 

Cumulative effect of a change in accounting principle

   1,384   322   —     —     1,706 
   


 


 


 


 


Net income (loss)

  $30,344  $(1,641) $3,605  $—    $32,308 
   


 


 


 


 


December 31, 2001:

                     

Total assets

  $344,676  $152,593  $15,111  $—    $512,380 
   


 


 


 


 


For the Year Ended December 31, 2003

   

Mortgage

Portfolio

Management


  

Mortgage

Lending


  

Loan

Servicing


  

Branch

Operations


  Eliminations

  Total

 

Interest income

  $109,542  $60,878  $—    $—    $—    $170,420 

Interest expense

   17,433   31,055   —     —     (8,124)  40,364 
   


 


 


 


 


 


Net interest income before credit recoveries

   92,109   29,823   —     —     8,124   130,056 

Credit recoveries

   389   —     —     —     —     389 

Gains (losses) on sales of mortgage assets

   (1,911)  140,870   —     —     5,046   144,005 

Premiums for mortgage loan insurance

   (908)  (2,194)  —     —     —     (3,102)

Fee income

   (620)  26,541   11,496   40,290   (8,834)  68,873 

Gains on derivative instruments

   (894)  (29,943)  —     —     —     (30,837)

Other income (expense)

   17,185   (12,369)  342   53   (4,799)  412 

General and administrative expenses

   (6,667)  (118,935)  (14,793)  (34,545)  —     (174,940)
   


 


 


 


 


 


Income (loss) from continuing operations before income tax (benefit

   98,683   33,793   (2,955)  5,798   (463)  134,856 

Income tax expense (benefit)

   —     21,916   (1,336)  2,280   —     22,860 
   


 


 


 


 


 


Net income (loss)

  $98,683  $11,877  $(1,619) $3,518  $(463) $111,996 
   


 


 


 


 


 


December 31, 2003:

                         

Total assets

  $563,930  $814,478  $20,502  $17,276  $(16,229) $1,399,957 
   


 


 


 


 


 


Intersegment revenues and expenses that were eliminated in consolidation were as follows (in(dollars in thousands):

 

   2003

  2002

  2001

 

Amounts paid (received) to (from) mortgage portfolio from (to) mortgage lending and loan servicing:

             

Loan servicing fees

  $(685) $(1,074) $(1,573)

Administrative fees

   —     (449)  (704)

Intercompany interest income

   8,124   8,637   3,931 

Guaranty, commitment, loan sale and securitization fees

   9,244   6,001   3,871 

Amounts paid (received) to (from) branches from (to) mortgage lending and loan servicing:

             

Lender premium

   5,509   1,814   —   

Subsidized fees

   3,325   1,139   —   

Administrative fees

   —     (94)  (88)
   2005

  2004

  2003

 

Amounts paid to (received from) mortgage portfolio management from (to) mortgage lending:

             

Interest income on intercompany debt

  $12,819  $8,200  $8,124 

Guaranty, commitment, loan sale and securitization fees

   9,494   10,833   9,244 

Interest income on warehouse borrowings

   100   47   —   

Gain on sale of mortgage securities – available-for-sale retained in securitizations

   (2,073)  (2,800)  —   

Amounts paid to (received from) mortgage portfolio management from (to) loan servicing:

             

Loan servicing fees

  $(251) $(423) $(685)

Amounts paid to (received from) branch operations from (to) mortgage lending:

             

Lender premium (A)

  $16,878  $27,269  $5,509 

Subsidized fees

   —     24   3,325 

Interest income on warehouse line

   (49)  (39)  —   

Fee income on warehouse line

   (13)  (30)  —   

Gain on sales of loans

   641   —     —   

(A)Approximately $5.4 million and $19.1 million of this elimination is related to discontinued operations for the years ended December 31, 2005 and 2004, respectively.

 

In 2004, based on SFAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases”, the Company deferred certain nonrefundable fees and direct costs associated with the origination of loans in the branch operations segment which were subsequently brokered to the mortgage lending segment. The mortgage lending segment ultimately funded the loans and then sold the loans either through securitizations or outright sales to third parties. The net deferred cost (income) became part of the cost basis of the loans and served to either increase (net deferred income) or decrease (net deferred cost) the gain or loss recognized by the mortgage lending and servicing segment. In 2004, these transactions were accounted for in the eliminations column. In 2005, the branch operations segment began originating and selling these loans to the mortgage lending segment instead of brokering the loans as in prior years. Therefore, the Company began recording the net deferred cost (income) to the branch operations segment instead of through the eliminations column. The following table summarizes these amounts for the year ended December 31, 2005 (dollars in thousands):

   2005

  2004

 

Gains on sales of mortgage assets

  $(140) $8,472 

Fee income

   —     (11,277)

General & administrative expenses

   —     10,182 

Loss from discontinued operations

   —     (7,236)

Note 13.17. Fair Value of Financial Instruments

 

The following disclosure of the estimated fair value of financial instruments presents amounts that have been determined using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that could be realized in a current market exchange. The use of different market assumptions or estimation methodologies could have a material impact on the estimated fair value amounts.

 

The estimated fair values of the Company’s financial instruments are as follows as of December 31, (in(dollars in thousands):

 

  2003

 2002

   2005

  2004

  Carrying
Value


 Fair Value

 Carrying
Value


 Fair Value

   Carrying Value

  Fair Value

  Carrying Value

  Fair Value

Financial assets:

               

Cash and cash equivalents

  $118,180  $118,180  $79,742  $79,742   $264,694  $264,694  $268,563  $268,563

Mortgage loans:

               

Held-for-sale

   697,992   716,006   983,633   995,320    1,291,556   1,298,244   747,594   758,932

Held-in-portfolio

   94,717   96,455   149,876   151,954    28,840   29,452   59,527   61,214

Mortgage securities - available-for-sale

   382,287   382,287   178,879   178,879    505,645   505,645   489,175   489,175

Mortgage securities - trading

   43,738   43,738   143,153   143,153

Mortgage servicing rights

   19,685   33,788   7,906   12,617    57,122   71,897   42,010   58,616

Deposits with counterparties

   20,900   20,900   30,310   30,310 

Deposits with derivative instrument counterparties

   4,370   4,370   6,700   6,700

Accrued interest receivable

   4,866   4,866   2,841   2,841

Financial liabilities:

               

Borrowings:

               

Short-term

   872,536   872,536   1,025,536   1,025,536    1,418,569   1,418,569   905,528   905,528

Asset-backed bonds

   132,980   132,980   199,692   199,352 

Asset-backed bonds secured by mortgage loans

   26,949   26,949   53,453   53,453

Asset-backed bonds secured by mortgage securities

   125,630   123,965   336,441   336,726

Accrued interest payable

   3,676   3,676   1,977   1,977

Derivative instruments:

               

Interest rate cap agreements

   6,679   6,679   1,200   1,200    5,105   5,105   5,819   5,819

Interest rate swap agreements

   (8,648)  (8,648)  (19,444)  (19,444)   3,290   3,290   6,143   6,143

 

Cash and cash equivalents – The fair value of cash and cash equivalents approximates its carrying value.

 

Mortgage loans – The fair value for all loans is estimated by discounting the projected future cash flows using market discount rates at which similar loans made to borrowers with similar credit ratings and maturities would be discounted in the market.

 

Mortgage securities – available for saleavailable-for-sale - -– Mortgage securities – available-for-sale is made up of residual securities and subordinated securities. The fair value of mortgageresidual securities is estimated by discounting future projected cash flows using a discount rate commensurate with the risks involved. The fair value of the subordinated securities is estimated using quoted market prices.

Mortgage securities- trading – The fair value of mortgage securities - trading is estimated using quoted market prices.

Mortgage servicing rights – The fair value of mortgage servicing rights is calculated based on a discounted cash flow methodology incorporating numerous assumptions, including servicing income, servicing costs, market discount rates and prepayment speeds.

 

Deposits with derivative instrument counterparties – The fair value of deposits with counterparties approximates its carrying value.

Borrowings – The fair value of allshort-term borrowings and asset-backed bonds secured by mortgage loans approximates carrying value as the borrowings bear interest at rates that approximate current market rates for similar borrowings. The fair value of asset-backed bonds secured by mortgage securities is determined by the present value of future payments based on interest rate conditions at December 31, 2005 and 2004.

Derivative instruments – The fair value of derivative instruments is estimated by discounting the projected future cash flows using appropriate rates. The fair value of deposits with counterparties approximates its carrying value.commitments to originate mortgage loans is estimated using the Black-Scholes option pricing model.

 

Accrued interest receivable and payableThe fair value of accrued interest receivable and payable approximates their carrying value.

 

Note 14.18. Supplemental Disclosure of Cash Flow Information

(in thousands)  2003

  2002

  2001

Cash paid for interest

  $41,058  $37,546  $28,918
   

  

  

Cash paid for income taxes

  $18,831  $3,581  $684
   

  

  

Non-cash items:

            

Dividends payable

  $30,559  $16,768  $4,758
   

  

  

Securities retained in securitizations

  $292,675  $90,785  $59,570
   

  

  

Retention of mortgage servicing rights

  $20,774  $6,070  $5,654
   

  

  

Surrender of warrants

  $—    $3,673  $—  
   

  

  

Assets acquired through foreclosure

  $6,619  $8,417  $20,159
   

  

  

Dividend reinvestment plan program

  $1,247  $—    $—  
   

  

  

Non-cash activities related to the acquisition of common stock of NFI Holding Corporation on January 1, 2001 were as follows (in(dollars in thousands):

 

   2001

 

Operating activities:

     

Increase in mortgage loans held-for-sale

  $(81,733)
   


Increase in other assets

  $(11,132)
   


Decrease in other liabilities

  $(9,422)
   


Investing activities:

     

Increase in real estate owned

  $(892)
   


Financing activities:

     

Increase in borrowings

  $36,900 
   


Non-cash financing activities related to founders’ notes receivable:

     

Decrease in founders’ notes receivable

  $4,340 
   


Decrease in additional paid-in capital

  $(4,340)
   


   2005

  2004

  2003

 

Cash paid for interest

  $79,880  $51,431  $41,058 
   


 


 


Cash paid (received) for income taxes

   (4,712)  27,944   18,831 
   


 


 


Cash received on mortgage securities – available-for-sale with no cost basis

   17,564   32,244   20,707 
   


 


 


Cash received for dividend reinvestment plan

   3,903   1,839   1,247 
   


 


 


Non-cash investing and financing activities:

             

Cost basis of securities retained in securitizations

   332,420   381,833   292,675 
   


 


 


Retention of mortgage servicing rights

   43,476   39,259   20,774 
   


 


 


Change in loans under removal of accounts provision

   23,452   6,455   3,020 
   


 


 


Change in due to securitization trusts

   (23,452)  (6,455)  (3,020)
   


 


 


Repurchase of mortgage loans from securitization trusts

   7,423   —     —   
   


 


 


Assets acquired through foreclosure

   2,891   3,558   6,619 
   


 


 


Dividends payable

   45,070   73,431   30,559 
   


 


 


Restricted stock issued in satisfaction of prior year accrued bonus

   262   1,816   —   
   


 


 


Note 15. Commitments, Guarantees and Contingencies

The Company makes commitments to borrowers to fund residential mortgage loans as well as commitments to purchase and sell mortgage loans to third parties. At December 31, 2003, the Company had outstanding commitments to originate, purchase and sell loans of $228 million, $60 million and $0, respectively. The Company had outstanding commitments to originate, purchase and sell loans of $108 million, $16 million and $98 million, respectively as of December 31, 2002.

The Company leases office space under various operating lease agreements. Rent expense for 2003, 2002 and 2001, aggregated $7.5 million, $2.4 million and $1.5 million respectively. Future minimum lease commitments under those leases are as follows (in thousands):

   

Lease

Obligations


2004

  $6,425

2005

   5,523

2006

   5,332

2007

   5,349

2008

   5,349

Thereafter

   3,565

The Company has entered into various lease agreements in which the lessor agreed to repay the Company for certain existing lease obligations. The Company received approximately $2.3 million and $62,000 related to these agreements in 2003 and 2002, respectively, and expects to receive approximately $1.0 million in future payments through 2004 from the lessor unless the properties previously occupied are subleased.

The Company has also entered into various sublease agreements for office space formerly occupied by the Company. The Company received approximately $537,000, $704,000 and $846,000 in 2003, 2002 and 2001, respectively, related to these agreements and expects to receive approximately $61,000 in future payments through 2004.

In the ordinary course of business, the Company sells loans with recourse for borrower defaults. For loans that have been sold with recourse and are no longer on the Company’s balance sheet, the recourse component is considered a guarantee. The Company sold loans with recourse for borrower defaults totaling $151.2 million and $142.2 million in 2003 and 2002, respectively. The Company’s reserve related to these guarantees totaled $41,000 and $29,000 as of December 31, 2003 and 2002, respectively.

In the ordinary course of business, the Company sells loans with recourse where a defect occurred in the loan origination process. The Company typically guarantees to cover investor losses should origination defects occur. The defects are categorized as documentation and underwriting errors, judgments, early payment defaults and fraud. If a defect is identified, the Company is required to repurchase the loan. As of December 31, 2003, the Company had loans sold with recourse with an outstanding principal balance of $6.4 billion.

In connection with various regulatory lending requirements, certain wholly-owned subsidiaries of the Company are required to maintain minimum levels of net worth. The wholly-owned subsidiaries were in compliance with these requirements as of December 31, 2003.

In the normal course of its business, the Company is subject to various legal proceedings and claims, the resolution of which, in the opinion of management, will not have a material adverse effect on the Company’s financial condition or results of operations.

Note 16. Affiliated Branches

As discussed in Note 1, the Company is party to LLC agreements for the purpose of establishing affiliated branches. As of December 31, 2003 and 2002, there were 423 and 207 such affiliated branches. For the years ended December 31, 2003, 2002 and 2001, the Company recorded fee income aggregating $12.8 million, $5.2 million and $1.9 million respectively, for providing administrative services for affiliated branches. During 2003, 2002 and 2001, the aggregate amount of loans brokered by affiliated branches were approximately $5.7 billion, $2.2 billion and $710.3 million, respectively. Of those amounts, approximately $1.3 billion, $399.6 million and $110.5 million, respectively, were acquired by the Company’s mortgage subsidiary. The aggregate premiums paid by the Company for loans brokered by the affiliated branches were approximately $15.1 million, $5.1 million and $1.2 million for the years ended December 31, 2003, 2002 and 2001, respectively. In conjunction with the use of the Company’s mortgage broker license, the Company is contingently liable for limited representations and warrantees of the affiliated branches as well as certain operating liabilities in the event that the LLCs are unable to meet their obligations upon dissolution. The Company requires that the branch managers maintain a reserve with

the Company to cover such obligations. Historically, the amounts that the Company has been required to pay as a result of these arrangements have been insignificant. The Company records an estimate of obligations regarding affiliated branch arrangements in the consolidated financial statements.

Note 17.19. Earnings Per Share

 

The computations of basic and diluted earnings per share for the years ended December 31, 2003, 20022005, 2004 and 20012003 are as follows (in(dollars in thousands, except per share amounts):

 

  For the Year Ended December 31,

  For the Year Ended December 31,

  2003

  2002

  2001

  2005

 2004

 2003

Numerator

  $111,996  $48,761  $32,308

Numerator:

   

Income from continuing operations

  $143,597  $126,738  $111,996

Dividends on preferred shares

   (6,653)  (6,265)  —  
  


 


 

Income from continuing operations available to common shareholders

   136,944   120,473   111,996

Loss from discontinued operations, net of income tax

   (4,473)  (11,349)  —  
  


 


 

Net income available to common shareholders

  $132,471  $109,124  $111,996
  

  

  

  


 


 

Denominator:

            

Weighted average common shares outstanding – basic

            29,669   25,290   22,220

Common shares outstanding

   22,220   20,758   11,478

Convertible preferred stock

   —     —     8,572
  

  

  

  


 


 

Weighted average common shares outstanding – dilutive:

   

Weighted average common shares outstanding – basic

   22,220   20,758   20,050   29,669   25,290   22,220
  

  

  

Weighted average common shares outstanding – dilutive

         

Stock options

   601   524   378   316   435   601

Warrants

   —     378   954

Restricted stock

   8   38   —  
  

  

  

  


 


 

Weighted average common shares outstanding – dilutive

   22,821   21,660   21,382   29,993   25,763   22,821
  

  

  

  


 


 

Basic earnings per share

  $5.04  $2.35  $1.61

Basic earnings per share:

   

Income from continuing operations

  $4.84  $5.01  $5.04

Dividends on preferred shares

   (0.23)  (0.25)  —  
  

  

  

  


 


 

Diluted earnings per share

  $4.91  $2.25  $1.51

Income from continuing operations available to common shareholders

   4.61   4.76   5.04

Loss from discontinued operations, net of income tax

   (0.15)  (0.45)  —  
  

  

  

  


 


 

Net income available to common shareholders

  $4.46  $4.31  $5.04
  


 


 

Diluted earnings per share:

   

Income from continuing operations

  $4.79  $4.92  $4.91

Dividends on preferred shares

   (0.22)  (0.24)  —  
  


 


 

Income from continuing operations available to common shareholders

   4.57   4.68   4.91

Loss from discontinued operations, net of income tax

   (0.15)  (0.44)  —  
  


 


 

Net income available to common shareholders

  $4.42  $4.24  $4.91
  


 


 

 

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 number of shares assumed to be repurchased, as calculated, was greater than the number of shares to be obtained upon exercise, therefore, the effect would be antidilutive:

 

   For the Year Ended
December 31,


   2003

  2002

  2001

Number of stock options and warrants (in thousands)

   15   300   420

Weighted average exercise price

  $22.66  $12.50  $8.17

Note 18. Subsequent Events

On January 16, 2004, the Company sold 2.6 million shares of Series C Cumulative Redeemable Perpetual Preferred Stock, raising $62.9 million in net proceeds. The shares have a liquidation value of $25.00 per share and will pay an annual coupon of 8.90%. The Company has granted its underwriters an option, exercisable for 30 days, to purchase up to an additional 390,000 shares to cover over-allotments, if any. On February 6, 2004, the underwriters exercised their options for 390,000 shares in over-allotments resulting in net proceeds of $9.4 million.

During February 2004, the Company notified the branch managers of the limited liability companies described in Notes 1 and 16 to the consolidated financial statements, that the Company was terminating these agreements effective January 1, 2004. Branches that formerly operated under these agreements either become independent of the Company, or will become operating units of the Company. As operating units of the Company, their financial results will be included in the consolidated financial statements.

   For the Year Ended December 31,

   2005

  2004

  2003

Number of stock options and warrants (in thousands)

   93   15   15

Weighted average exercise price

  $40.58  $33.59  $22.66

Note 19.20. Condensed Quarterly Financial Information (unaudited)

 

FollowingDuring 2004, the Company changed policies governing its broker branches, as discussed in Note 15. As a result, a significant number of branch managers have voluntarily terminated employment with the Company. On November 4, 2005, the Company adopted a formal plan to terminate substantially all of the remaining NHMI branches. The Company considers a branch to be discontinued upon its termination date, which is the point in time when the operations cease. The provisions of SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets, require the results of operations associated with those branches terminated subsequent to January 1, 2004 to be classified as discontinued operations and segregated from the Company’s continuing results of operations for all periods presented. The Company has presented the operating results of those branches terminated through December 31, 2005, as discontinued operations in the Consolidated Statements of Income for the years ended December 31, 2005 and 2004. The Company’s condensed consolidated quarterly operating results for the Company (in thousands, except per share amounts):

   2003 Quarters

  2002 Quarters

 
   First

  Second

  Third

  Fourth

  First

  Second

  Third

  Fourth

 

Net interest income before credit recoveries (losses)

  $28,687  $31,547  $33,469  $36,353  $12,943  $18,873  $19,690  $27,909 

Credit recoveries (losses)

   92   171   875   (749)  (133)  379   383   (197)

Gains on sales of mortgage assets

   29,443   44,031   34,188   36,343   4,630   15,993   17,293   15,389 

Gains (losses) on derivative instruments

   (9,149)  (15,037)  (8,144)  1,493   1,438   (15,766)  (16,349)  (6,164)

Income before income tax benefit (expense)

   27,100   32,904   30,952   43,900   10,221   7,752   11,359   17,398 

Income tax benefit (expense)

   (4,141)  (4,183)  (5,844)  (8,692)  (1,300)  2,638   840   (147)

Net income

   22,959   28,721   25,108   35,208   8,921   10,390   12,199   17,251 

Basic earnings per share

  $1.09  $1.32  $1.12  $1.49  $0.43  $0.50  $0.59  $0.83 
   


 


 


 


 


 


 


 


Diluted earnings per share

  $1.07  $1.28  $1.09  $1.45  $0.40  $0.49  $0.57  $0.81 
   


 


 


 


 


 


 


 


Effective January 1, 2003, the Company adopted the fair value recognition provisions of SFAS No. 123,Accounting for Stock-Based Compensation. The Company selected the modified prospective method of adoption as described in SFAS No. 148,Accounting for Stock-Based Compensation-Transition and Disclosure. In adopting SFAS No. 123 retroactive to January 1, 2003, results for the quarters previously reported in the 2003 Quarterly Reports on Form 10-Q were restated to the amounts noted above for the modified prospective method of adoption. The pretax impact of adopting the provisions under the modified prospective method for the three months ended March 31, 2003, June 30, 2003 and September 30, 2003 was a decrease to compensation expense of $0.6 million, $5.6 million and $0.8 million, respectively. Results for prior years have not been restated. See Note 1.

The following amounts from the Company’s financial statements for the three months ended March 31, June 30 and September 30, 2003 have been2005 and 2004 as revised from amounts previously reported to account for stock compensation expense under the fair value method prescribed by SFAS No. 123,branches discontinued through December 31, 2005 are as follows (dollars in accordance with the modified prospective method of SFAS No. 148 (in thousands, except per share amounts):

 

   March 31, 2003

  June 30, 2003

  September 30, 2003

 
   As
Previously
Reported


  As
Adjusted


  As
Previously
Reported


  As
Adjusted


  As
Previously
Reported


  As
Adjusted


 

Additional paid-in capital (A)

  $134,448  $133,811  $166,512  $160,273  $180,746  $173,672 

Accumulated deficit

   (16,818)  (16,181)  (21,737)  (15,498)  (26,010)  (18,936)

Stockholders’ equity

   194,597   194,597   230,469   230,469   236,242   236,242 

Compensation and benefits expense

   19,442   18,805   30,419   24,817   26,287   25,452 

Income before income tax expense (benefit)

   26,463   27,100   27,302   32,904   30,117   30,952 

Net income

   22,322   22,959   23,119   28,721   24,273   25,108 

Basic earnings per share (A)

  $1.06  $1.09  $1.06  $1.32  $1.08  $1.12 
   


 


 


 


 


 


Diluted earnings per share (A)

  $1.04  $1.07  $1.03  $1.28  $1.05  $1.09 
   


 


 


 


 


 



(A)Additional paid-in capital, basic earnings per share and diluted earnings per share as reported have been adjusted to reflect the Company’s two-for-one stock split on December 1, 2003.
   2005 Quarters

  2004 Quarters

 
   First

  Second

  Third

  Fourth

  First

  Second

  Third

  Fourth

 

Net interest income before credit (losses) recoveries

  $45,448  $54,109  $63,039  $56,333  $39,638  $42,947  $45,439  $43,410 

Credit (losses) recoveries

   (619)  (100)  (331)  12   (146)  (515)  (182)  117 

Gains on sales of mortgage assets

   18,385   32,570   10,829   6,389   51,780   25,174   46,415   21,581 

Gains (losses) on derivative instruments

   14,601   (7,848)  6,522   4,880   (25,398)  27,115   (19,536)  8,914 

Income from continuing operations before income tax expense (benefit)

   38,310   37,692   35,207   21,488   36,155   47,498   28,482   24,129 

Income tax expense (benefit)

   1,283   (2,602)  (2,357)  (7,224)  2,226   8,809   (48)  (1,461)

Income from continuing operations

   37,027   40,294   37,564   28,712   33,929   38,689   28,530   25,590 

Loss from discontinued operations, net of income tax

   (1,824)  (775)  (1,271)  (603)  (3,004)  (3,063)  (4,142)  (1,140)

Net income

   35,203   39,519   36,293   28,109   30,925   35,626   24,388   24,450 

Dividends on preferred stock

   1,663   1,663   1,663   1,664   1,275   1,663   1,663   1,664 

Net income available to common shareholders

   33,540   37,856   34,630   26,445   29,650   33,963   22,725   22,786 

Basic earnings per share:

                                 

Income from continuing operations available to common shareholders

  $1.28  $1.34  $1.17  $0.87  $1.32  $1.48  $1.08  $0.90 

Loss from discontinued operations, net of income tax

   (0.07)  (0.03)  (0.04)  (0.02)  (0.12)  (0.12)  (0.17)  (0.04)
   


 


 


 


 


 


 


 


Net income available to common shareholders

  $1.21  $1.31  $1.13  $0.85  $1.20  $1.36  $0.91  $0.86 
   


 


 


 


 


 


 


 


Diluted earnings per share:

                                 

Income from continuing operations available to common shareholders

  $1.25  $1.32  $1.16  $0.86  $1.29  $1.46  $1.05  $0.89 

Loss from discontinued operations, net of income tax

   (0.06)  (0.03)  (0.04)  (0.02)  (0.12)  (0.12)  (0.16)  (0.04)
   


 


 


 


 


 


 


 


Net income available to common shareholders

  $1.19  $1.29  $1.12  $0.84  $1.17  $1.34  $0.89  $0.85 
   


 


 


 


 


 


 


 


REPORT OF INDEPENDENT AUDITORS’ REPORTREGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and StockholdersShareholders of

NovaStar Financial, Inc.

Kansas City, Missouri

 

We have audited the accompanying consolidated balance sheets of NovaStar Financial, Inc. and subsidiaries (the “Company”) as of December 31, 20032005 and 2002,2004, and the related consolidated statements of income, stockholders’shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2003.2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with auditingthe standards generally accepted inof the United States of America.Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 20032005 and 2002,2004, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 20032005 in conformity with accounting principles generally accepted in the United States of America.

 

As discussedWe have also audited, in Note 1 toaccordance with the consolidatedstandards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial statements,reporting as of December 31, 2005, based on the Company changed its methodcriteria established inInternal Control—Integrated Framework issued by the Committee of accounting for stock-based compensation to conform to StatementSponsoring Organizations of Financial Accounting Standards No. 123,Accounting for Stock-Based Compensation effective January 1, 2003.the Treadway Commission and our report dated March 14, 2006 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

 

/s/ Deloitte & Touche LLP

 

Kansas City, Missouri

March 3, 200414, 2006

Item 9.Changes in and Disagreements Withwith Accountants on Accounting and Financial Disclosure

 

None

 

Item 9A.Controls and Procedures

 

Disclosure Controls and Procedures.Procedures

The Company maintains a system of disclosure controls and procedures which are designed to ensure that information required to be disclosed by the Company in reports that it files or submits under the federal securities laws, including this report, is recorded, processed, summarized and reported on a timely basis. These disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed under the federal securities laws is accumulated and communicated to the Company’s management on a timely basis to allow decisions regarding required disclosure. The Company’s principal executive officer and principal financial officer evaluated the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(d)) as of the end of the period covered by this report and concluded that the Company’s controls and procedures were effective.

Internal Control over Financial Reporting

Management’s Report on Internal Control over Financial Reporting

Management of NovaStar Financial, Inc. and subsidiaries (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) of the Securities Exchange Act of 1934. This internal control system has been designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation and fair presentation of the company’s published financial statements.

All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

Management of the Company has assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005. To make this assessment, management used the criteria for effective internal control over financial reporting described inInternal Control—Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our assessment under the framework inInternal Control—Integrated Framework, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2005.

Our independent registered public accounting firm, Deloitte & Touche LLP, has issued an attestation report, included herein, on our assessment of the Company’s internal control over financial reporting.

 

Changes in Internal Control over Financial Reporting.Reporting

There has beenwere no changechanges in NovaStar Financial, Inc.’sour internal controlcontrols over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rule 13a-15 that occurred during the quarter ended December 31, 20032005 that hashave materially affected, or is reasonably likely to materially affect NovaStar Financial, Inc.’sour internal control over financial reporting.

Attestation Report of the Registered Public Accounting Firm

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of

NovaStar Financial, Inc.

Kansas City, Missouri

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that NovaStar Financial, Inc. and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2005, based on the criteria established inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the criteria established inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the criteria established inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2005 of the Company and our report dated March 14, 2006 expressed an unqualified opinion on those financial statements.

/s/ Deloitte & Touche LLP

Kansas City, Missouri

March 14, 2006

Item 9B. Other Information

None

PART III

 

PART III

Item 10.Directors and Executive Officers of the Registrant

 

Information with respect to Item 401 and Item 405 of Regulation S-K is incorporated by reference to the information included on NovaStar Financial’s Proxy Statement, dated March 18, 2004, for the Annual Meeting of Shareholders to be held at May 25, 20045, 2006 at 10:00 a.m.,11:30, Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 84018140 Ward Parkway, Kansas City, Missouri 64114.

The Board of Directors has determined that Edward W. Mehrer qualifies as an audit committee financial expert; as such term is defined in recently adopted rules of the Securities and Exchange Commission implementing requirements of the Sarbanes-Oxley Act of 2002.

 

Information with respect to our corporate governance guidelines, charters of audit, compensation, nominating and corporate governance committees, and code of conduct may be obtained onfrom the corporate governance section of our website (www.novastarmortgage.com) or by contacting us directly. References to our website do not incorporate by reference the information on such website into this Annual Report on Form 10-K and we disclaim any such incorporation by reference.

The code of conduct applies to our principal executive officer, principal financial officer, principal accounting officer, directors and other employees performing similar functions. A Form 8-K will be filed and a posting on our website will be made uponWe intend to satisfy the disclosure requirements regarding any amendment to, or waiver from, a provision of theour code of conduct that applies to anyour principal executive officer, principal financial officer, principal accounting officer, controller or director. persons performing similar functions by disclosing such matters on our website.

Our investor relations contact information follows.follows:

 

Investor Relations

8140 Ward Parkway, Suite 300

Kansas City, MO 64114

816.237.7000

Email: ir@novastar1.com

 

Because our common stock is listed on NYSE, our chief executive officer is required to make an annual certification to the NYSE stating that he is not aware of any violation by NovaStar Financial, Inc. of the NYSE Corporate Governance listing standards. Last year, our chief executive officer submitted such annual certification to the NYSE. In addition, NovaStar Financial, Inc. has filed, as exhibits to last year’s Annual Report on Form 10-K and is filing as exhibits to this Annual Report, the certifications of its chief executive officer and chief financial officer required under Section 302 of the Sarbanes-Oxley Act of 2002 to be filed with the Securities and Exchange Commission regarding the quality of NovaStar Financial, Inc. public disclosure.

Item 11.Executive Compensation

 

Information with respect to Item 402 of Regulation S-K is incorporated by reference to the information included on NovaStar Financial’s Proxy Statement, dated March 18, 2004, for the Annual Meeting of Shareholders to be held at May 25, 20045, 2006 at 10:0011:30 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 84018140 Ward Parkway, Kansas City, Missouri 64114.

Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

Information with respect to Item 403 of Regulation S-K is incorporated by reference to the information included on NovaStar Financial’s Proxy Statement, dated March 18, 2004, for the Annual Meeting of Shareholders to be held at May 25, 20045, 2006 at 10:0011:30 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 84018140 Ward Parkway, Kansas City, Missouri 64114.

 

The following table sets forth information as of December 31, 2003 with respect to compensation plans under which our common stock may be issued.

Equity Compensation Plan Information


Plan Category


  Number of
Shares to be
Issued Upon
Exercise of
Outstanding
Options,
Warrants and
Rights


  Weighted Average
Exercise Price of
Outstanding
Options,
Warrants and
Rights


  Number of Shares
Remaining
Available for
Future Issuance
Under Equity
Compensation
Plans (Excluding
Shares Reflected
in the First
Column)


Equity compensation plans approved by stockholders

  746,800 (A) $8.22  207,128

Equity compensation plans not approved by stockholders

  —     —    —  
   

 

  

Total

  746,800  $8.22  207,128
   

 

  

(A)Certain of the options have dividend equivalent rights (DERs) attached to them when issued. As of December 31, 2003, these options have 90,522 DERs attached.

Item 13.Certain Relationships and Related Transactions.

 

Information with respect to Item 404 of Regulation S-K is incorporated by reference to the information included on NovaStar Financial’s Proxy Statement, dated March 18, 2004, for the Annual Meeting of Shareholders to be held at May 25, 20045, 2006 at 10:0011:30 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 84018140 Ward Parkway, Kansas City, Missouri 64114.

 

Item 14.Principal Accountant Fees and Services.

 

Information with respect to Item 9(e) of Schedule 14A is incorporated by reference to the information included on NovaStar Financial’s Proxy Statement, dated March 18, 2004, for the Annual Meeting of Shareholders to be held at May 25, 20045, 2006 at 10:0011:30 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 84018140 Ward Parkway, Kansas City, Missouri 64114.

PART IV

 

Item 15.Exhibits and Financial StatementStatements Schedules and Reports on Form 8-K

 

(a)Financial Statements and Schedules

Financial Statements and Schedules

 

 (1)The financial statements as set forth under Item 8 of this report on Form 10-K are included herein.

 (2)The required financial statement schedules are omitted because the information is disclosed elsewhere herein.

 

(b)Reports on Form 8-K

Exhibit Listing

NovaStar Financial, Inc. filed the following Form 8-K’s during the fourth quarter of 2003.

(1)Press Release, dated October 29, 2003 “Novastar Announces Third Quarter Earnings Per Share of $2.11, a Two for One Stock Split and Dividend of $2.50.” Current report on Form 8-K was filed on October 30, 2003.

(2)Underwriting Agreement dated November 6, 2003, by and among NovaStar Financial, Inc., JMP Securities LLC and Flagstone Securities, LLC. Opinion of Tobin & Tobin, dated November 13, 2003, as to legal matters in connection with the Common Stock Offering. Opinion of Falk, Shaff & Ziebell, LLP, dated November 13, 2003, as to federal income tax matter in connection with the Common Stock Offering. Underwriting Agreement dated May 7, 2003, by and among NovaStar Financial, Inc., JMP Securities LLC and Flagstone Securities, LLC (the “May Underwriting Agreement”, with the Opinion of Tobin & Tobin, dated May 13, 2003, as to legal matters, and the Opinion of Falk, Shaff & Ziebell, LLP, dated May 13, 2003, as to federal income tax matters, as required pursuant to the May Underwriting Agreement. Current report on Form 8-K was filed on November 13, 2003.

(3)Press Release, dated December 17, 2003 “Novastar Announces Dividend and Adoption of New Dividend Policy and SFAS No. 123 for Stock Compensation.” Current report on Form 8-K was filed on December 19, 2003.

(c)Exhibit Listing

 

Exhibit No.

  

Description of Document


3.1*3.1(13)  

Articles of Amendment and Restatement of the Registrant

3.3*3.1.1(12)  Bylaws

Certificate of Amendment of the Registrant

3.3a*****3.1.2(8)  Amendment to

Articles Supplementary of the Registrant adopted January 15, 2004.

3.3.1(10)

Amended and Restated Bylaws of the Registrant, adopted February 2, 2000July 27, 2005

3.4****4.1(10)  Articles Supplementary of NovaStar Financial, Inc. dated as of March 24, 1999, as filed with the Maryland Department of Assessment and Taxation.

Specimen Common Stock Certificate

4.1*4.3(9)  

Specimen CommonPreferred Stock Certificate

4.3****10.6(1)  Specimen certificate for Preferred Stock
10.6*

Form of Master Repurchase Agreement for mortgage loan financing

10.7*

Mortgage Loan Warehousing Agreement dated as of November 24, 1997 between First Union

National Bank of North Carolina, NovaStar Mortgage, Inc. and the Registrant.

10.14*10.7.1(2)

Form of Master Repurchase Agreement of the Registrant

10.8(6)

Employment Agreement, dated September 30, 1996, between the Registrant and Scott F. Hartman

10.9(6)

Employment Agreement, dated September 30, 1996, between the Registrant and W. Lance Anderson

10.10(14)

Form of Indemnification Agreement for Officers and Directors of NovaStar Financial, Inc. and its Subsidiaries

10.11(13)

NovaStar Mortgage, Inc. Amended and Restated Deferred Compensation Plan

10.14(1)  

1996 Executive and Non-Employee Director Stock Option Plan, as last amended

December 6, 1996.1996

10.23***10.25(4)  Warrant Agreement dated as of February 12, 1999 between the Registrant and First Union National Bank.

NovaStar Financial Inc. 2004 Incentive Stock Plan

10.24****10.25.1(5)  Warrant

Stock Option Agreement dated asunder NovaStar Financial, Inc. 2004 Incentive Stock Plan

10.25.2(5)

Restricted Stock Agreement under NovaStar Financial, Inc. 2004 Incentive Stock Plan

10.25.3(5)

Performance Contingent Deferred Stock Award Agreement under NovaStar Financial, Inc. 2004 Incentive Stock Plan

10.26(5)

NovaStar Financial, Inc. Executive Officer Bonus Plan

10.27(7)Employment Agreement between NovaStar Mortgage, Inc. and David A. Pazgan, Executive Vice President of March 10, 1999, by andNovaStar Mortgage, Inc.

10.28(7)Description of Oral At-Will Agreement between NovaStar Financial, Inc. and Residential Funding Corporation,Jeffrey D. Ayers, Senior Vice President, General Counsel and related Guaranty Warrant, Tag Along Warrant and Registration Rights Agreement as filed with April 6, 1999 8-K of NovaStar Financial, Inc.Secretary
11.1******10.29(7)2004 Supplemental Compensation for Independent Directors
10.30(7)2005 Compensation Plan for Independent Directors
10.31(7)Employment Agreement between NovaStar Financial, Inc. and Gregory S. Metz, Senior Vice President and Chief Financial Officer
10.32(7)Employment Agreement between NovaStar Financial, Inc. and Michael L. Bamburg, Senior Vice President and Chief Investment Officer
10.33(7)Description of Oral At-Will Agreement between NovaStar Financial, Inc. and Rodney E. Schwatken, Vice President, Controller and Chief Accounting Officer
10.34(11)Purchase Agreement, dated March 15, 2005, among the Registrant, NovaStar Mortgage, Inc., NovaStar Capital Trust I, Merrill Lynch International and Taberna Preferred Funding I, LTD
10.35(11)Amended and Restated Trust Agreement, dated March 15, 2005, between the Registrant, JPMorgan Chase Bank, Chase Bank USA and certain administrative trustees
10.36(11)Junior Subordinated Indenture, dated March 15, 2005, between the Registrant and JPMorgan Chase Bank
10.37(11)Parent Guarantee Agreement, dated March 15, 2005, between the Registrant and JP Morgan Chase Bank
10.34(15)NovaStar Financial, Inc. Long Term Incentive Plan
11.1(3) Statement regarding computation of per share earnings
14.1(15)NovaStar Financial, Inc. Code of Conduct
21.1 Subsidiaries of the Registrant
23.1 Consents of Deloitte & Touche LLP
31.1 Chief Executive Officer Certification—Certification - Section 302 of the Sarbanes-Oxley Act of 2002
31.2 Principal Financial Officer Certification—Certification - Section 302 of the Sarbanes-Oxley Act of 2002
32.1 Chief Executive Officer Certification—Certification - Section 906 of the Sarbanes-Oxley Act of 2002
32.2 Principal Financial Officer Certification—Certification - Section 906 of the Sarbanes-Oxley Act of 2002


*(1)Incorporated by reference to the correspondingly numbered exhibit to the Registration Statement on Form S-11 (373-32327) filed by the Registrant with the SEC on July 29, 1997, as amended.
**Incorporated by reference to the correspondingly numbered exhibit to Form 8-K filed by the Registrant with the SEC on December 22, 1998.

***Incorporated by reference to the correspondingly numbered exhibit to Form 8-K filed by the Registrant with the SEC on February 23, 1999.
****Incorporated by reference to the correspondingly numbered exhibit to Form 8-K filed by the Registrant with the SEC on April 5, 1999.
*****(2)Incorporated by reference to the correspondingly numbered exhibit to the Annual Report on Form 10-K filed by the Registrant with the SEC on March 20, 2000.16, 2005.
******(3)See Note 1719 to the consolidated financial statements.
(4)Incorporated by reference to Exhibit 10.15 to the Registration Statement on Form S-8 (333-116998) filed by the Registrant with the SEC on June 30, 2004.
(5)Incorporated by reference to the correspondingly numbered exhibit to Form 8-K filed by the Registrant with the SEC on February 4, 2005.

(6)Incorporated by reference to the correspondingly numbered exhibit to Form S-11 filed by the Registrant with the SEC on July 29, 1997.
(7)Incorporated by reference to the correspondingly numbered exhibit to Form 8-K filed by the Registrant with the SEC on February 11, 2005.
(8)Incorporated by reference to Exhibit 3.4 to Form 8-A/A filed by the Registrant with the SEC on January 20, 2004.
(9)Incorporated by reference to the correspondingly numbered exhibit to Form 8-A/A filed by the Registrant with the SEC on January 20, 2004.
(10)Incorporated by reference to the correspondingly numbered exhibit to Form 10-Q filed by the Registrant with the SEC on August 5, 2005.
(11)Incorporated by reference to the correspondingly numbered exhibit to Form 10-Q filed by the Registrant with the SEC on May 5, 2005.
(12)Incorporated by reference to Exhibit 3.1 to Form 8-K filed by the Registrant with the SEC on May 26, 2005.
(13)Incorporated by reference to the correspondingly numbered exhibit to the Registration Statement on Form S-3 (333-126699) filed by the Registrant with the SEC on July 19, 2005.
(14)Incorporated by reference to Exhibit 10.10 to Form 8-K filed by the Registrant with the SEC on November 16, 2005.
(15)Incorporated by reference to the correspondingly numbered exhibit to Form 8-K filed by the Registrant with the SEC on February 14, 2006.

Signatures

 

Pursuant to the requirements of Section 13 or 15(d) 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.

(Registrant)

Date:March 5, 2004

By:/s/    SCOTT F. HARTMAN        
  NOVASTAR FINANCIAL, INC
  (Registrant)
DATE:March 15, 2006

/s/ SCOTT F. HARTMAN


  

Scott F. Hartman, Chairman of the Board

of Directors and Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and dates indicated.

Date:DATE:March 5, 200415, 2006

 By:

/s/ W. LANCE ANDERSON        

SCOTT F. HARTMAN


  

W. Lance Anderson, President,

Chief Operating Officer and Director

Date:March 5, 2004

By:/s/    RODNEY E. SCHWATKEN        Scott F. Hartman, Chairman of the Board
  of Directors and Chief Executive Officer
  (Principal Executive Officer)
DATE:March 15, 2006

/s/ W. LANCE ANDERSON


  

Rodney E. Schwatken, ViceW. Lance Anderson, President,

Secretary and Treasurer

(Chief Accounting Officer)

Date:March 5, 2004

By:/s/    EDWARD W. MEHRER        
  Chief Operating Officer and Director
DATE:March 15, 2006 

/s/ GREGORY S. METZ


  Edward W. Mehrer, Director

Date:March 5, 2004

By:/s/    GREGORY T. BARMORE        Gregory S. Metz, Chief Financial Officer
  (Principal Financial Officer)
DATE:March 15, 2006 

/s/ RODNEY E. SCHWATKEN


  Gregory T. Barmore, Director

Date:March 5, 2004

By:/s/    ART N. BURTSCHER        Rodney E. Schwatken, Vice President,
  Controller and Chief Accounting Officer
  (Principal Accounting Officer)
DATE:March 15, 2006

/s/ EDWARD W. MEHRER


  Edward W. Mehrer, Director
DATE:March 15, 2006

/s/ GREGORY T. BARMORE


  Gregory T. Barmore, Director
DATE:March 15, 2006

/s/ ART N. BURTSCHER


Art N. Burtscher, Director
DATE:March 15, 2006

/s/ DONALD M. BERMAN


Donald M. Berman, Director

 

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