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, 20042007

 

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

For the Transition Period From            to            

Commission File Number 001-13533

 


 

NOVASTAR FINANCIAL, INC.

(Exact Name of Registrant as Specified in its Charter)

 


 

Maryland 74-2830661

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

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

Registrant’s Telephone Number, Including Area Code:(816) 237-7000

 


 

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

Title of Each ClassNone

Name of Each Exchange on

Which Registered

Common Stock, $0.01 par valueNew York Stock Exchange

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

NoneTitle of Each Class

Common Stock, $0.01 par value

Redeemable Preferred Stock

 


 

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

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.    Yes  x    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  ¨    Accelerated filer  x    Non-accelerated filer  ¨

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

The aggregate market value of voting and non-voting stock held by non-affiliates of the registrant as of June 30, 20042007 was approximately $948,751,931$239,636,773, 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 March 11, 200531, 2008 was 27,860,629.

9,390,840.

Documents Incorporated by Reference

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, 2004.2007.

 



NOVASTAR FINANCIAL, INC.

FORM 10-K

For the Fiscal Year Ended December 31, 20042007

 

TABLE OF CONTENTS

 

PART I

      

Item 1.

  Business  2

Item 1A.

Risk Factors7
Item 1B.Unresolved Staff Comments16
Item 2.

  Properties  1316

Item 3.

  Legal Proceedings  1416

Item 4.

  Submission of Matters to a Vote of Security Holders  1418

PART II

      

Item 5.

  Market For Registrant’s Common Equity, and Related Stockholder Matters and Issuer Purchases of Equity Securities  1519

Item 6.

  Selected Financial Data  1620

Item 7.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations  1822

Item 7A.

  Quantitative and Qualitative Disclosures About Market Risk  4655

Item 8.

  Financial Statements and Supplementary Data  4756

Item 9.

  Changes in and Disagreements withWith Accountants on Accounting and Financial Disclosure  85120

Item 9A.

  Controls and Procedures  85120

Item 9B.

  Other Information  87122

PART III

      

Item 10.

  Directors, and Executive Officers of the Registrantand Corporate Governance  87122

Item 11.

  Executive Compensation  87122

Item 12.

  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters  88123

Item 13.

  Certain Relationships and Related Transactions, and Director Independence  88123

Item 14.

  Principal AccountantAccounting Fees and Services  88123

PART IV

      

Item 15.

  Exhibits, and Financial StatementsStatement Schedules  89124

PART I

 

Item 1.BusinessSafe Harbor Statement

 

Statements in this report regarding NovaStar Financial, Inc. and its business, which are not historical facts, are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. Forward looking statements are those that predict or describe future events and that do not relate solely to historical matters and include statements regarding management’s beliefs, estimates, projections, and assumptions with respect to, among other things, our future operations, business plans and strategies, as well as industry and market conditions, all of which are subject to change at any time without notice. Words such as “believe,” “expect,” “anticipate,” “promise,” “plan,” and other expressions or words of similar meanings, as well as future or conditional verbs such as “will,” “would,” “should,” “could,” or “may” are generally intended to identify forward-looking statements. Actual results and operations for any future period may vary materially from those discussed herein. Some important factors that could cause actual results to differ materially from those anticipated include: our ability to manage our business during this difficult period for the subprime industry; our ability to continue as a going concern; decreases in cash flows from our mortgage securities; our ability to reduce expenses from our discontinued operations; increases in the credit losses on mortgage loans underlying our mortgage securities and our mortgage loans – held in portfolio; our ability to repay Wachovia in a manner and time period acceptable to Wachovia; our ability to remain in compliance with the agreements governing our indebtedness; impairments on our mortgage assets; increases in prepayment or default rates on our mortgage assets; increases in margin calls and loan repurchase requests; changes in assumptions regarding estimated loan losses and fair value amounts; our ability to maintain effective internal control over financial reporting and disclosure controls and procedures in the future; events impacting the subprime mortgage industry in general, including events impacting our competitors and liquidity available to the industry; residential property values; interest rate fluctuations on our assets that differ from our liabilities; the outcome of litigation or regulatory actions pending against us or other legal contingencies; our compliance with applicable local, state and federal laws and regulations; our ability to adapt to and implement technological changes; compliance with new accounting pronouncements; the impact of general economic conditions; and the risks that are from time to time included in our filings with the Securities and Exchange Commission (“SEC”), including this report on Form 10-K. Other factors not presently identified may also cause actual results to differ. This report on Form 10-K speaks only as of its date and we expressly disclaim any duty to update the information herein except as required by federal securities laws.

OverviewItem 1. Business

 

We are a Maryland corporation formed on September 13, 1996 which operates solely as a specialty finance company that originates, purchases, investsnon-conforming residential mortgage portfolio manager. Prior to significant changes in our business during 2007 and the first quarter of 2008, we originated, purchased, securitized, sold, invested in and servicesserviced residential nonconforming loans.mortgage loans and mortgage backed securities. We operateretained, through three separate but inter-related units—our mortgage lending and loan servicing, mortgagesecurities investment portfolio, management and 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 United States of America government-sponsored entities such as Fannie Mae or Freddie Mac. We retain significant interests in the nonconforming loans we originateoriginated and purchasepurchased, and through our mortgage securities investment portfolio. Through our servicing platform, we then serviceserviced all of the loans in which we retain interestsretained interests. During 2007 and early 2008, we discontinued our mortgage lending operations and sold our mortgage servicing rights which subsequently resulted in in orderthe abandonment of our servicing operations. See “Executive Overview of Performance” and “Known Material Trends, Significant Events and Uncertainties” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion of the severely disrupted mortgage industry and credit markets and the changes we made to betterour operations to manage the credit performance ofthrough those loans.changes.

 

We currently intend to manage only our mortgage portfolio management segment. In the event we are able to significantly increase our liquidity position (as to which no assurance can be given), we may use excess cash to make certain investments if we determine that such investments could provide attractive risk-adjusted returns to shareholders, including, potentially investing in new or existing operating companies. Because of certain state licensing requirements, it is unlikely we are able, ourselves, to directly recommence mortgage lending activities so long as we continue to have a shareholders’ deficit. Segment information for the three years ended December 31, 2007 is included in Note 16 to our consolidated financial statements.

Historically, we had elected to be taxed as a real estate investment trust or REIT,(“REIT”) under the Internal Revenue Code of 1986, as amended (Code)(the “Code”). Management believes the tax-advantaged structure ofDuring 2007, we announced that we would not be able to pay a REIT maximizes the after-tax returns from mortgage assets. We must meet numerous rules established by the Internal Revenue Service (IRS)dividend on our common stock with respect to retainour 2006 taxable income, and as a result, our status as a REIT. In summary, they require us to:

Restrict investmentsREIT terminated retroactive to certain real estate related assets,

Avoid certain investment trading and hedging activities, and

Distribute virtually all taxable income to stockholders.

As long as we maintainJanuary 1, 2006. This retroactive revocation of our REIT status distributions to stockholders will generally be deductible byresulted in us becoming taxable as a C corporation for income tax purposes. This deduction effectively eliminates REIT level income taxes. Management believes it has2006 and will continue to meet the requirements to maintain our REIT status.subsequent years.

 

Our consolidated financial statements have been prepared on a going concern basis of accounting which contemplates continuity of operations, realization of assets, liabilities and commitments in the normal course of business. There are substantial doubts that we will be able to continue as a going concern and, therefore, may be unable to realize our assets and discharge our liabilities in the normal course of business. The financial statements do not reflect any adjustments relating to the recoverability and classification of recorded asset amounts or to the amounts and classification of liabilities that may be necessary should we be unable to continue as a going concern.

Mortgage Portfolio Management

 

We invest in

The continued deterioration of the secondary market for subprime mortgage assets generated primarilyhas altered the focus of our portfolio management business from that of seeking investment opportunities to that of only managing our current portfolio of mortgage securities and mortgage loans. Our portfolio of mortgage securities includes interest-only, prepayment penalty, and overcollateralization securities retained from our origination and purchasesecuritizations of nonconforming, single-family residential mortgage loans.

loans which we have accounted for as sales, under applicable accounting rules (collectively, the “residual securities”). Our portfolio of mortgage securities also includes subordinated mortgage securities retained from our securitizations and subordinated home equity loan asset-backed securities (“ABS”) purchased from other ABS issuers (collectively, the “subordinated securities”).

 

We operate as a

The long-term mortgage securitiesloan portfolio investor.

Financing is providedon our balance sheet consists of mortgage loans classified as held-in-portfolio resulting from securitization transactions treated as financings completed in the second quarter of 2006 and the first quarter of 2007 (NHES Series 2006-1, NHES Series 2006-MTA1, and NHES Series 2007-1). We have financed our investment in these loans by issuing asset-backedasset backed bonds and entering into reverse repurchase agreements.
(“ABB”).

 

Earnings are generated

Our mortgage portfolio management operations generate earnings primarily from the return oninterest income generated from our mortgage securities and mortgage loan portfolio.

Our mortgage securities – available-for-sale include AAA- and non-rated interest-only, prepayment penalty, overcollateralization and other subordinated mortgage securities.

Earnings from our portfolio of mortgage loans and securities generate a substantial portion of our earnings. Gross interest income was $224.0 million, $170.4 million and $107.1 million in the three years ended December 31, 2004, 2003 and 2002, respectively. Net interest income before credit losses/recoveries from the portfolio was $171.4 million, $130.1 million and $79.4 million in the three years ended December 31, 2004, 2003 and 2002, respectively. See our discussion of interest income under the heading “Results of Operations” and “Net Interest Income”. See Note 15 to our consolidated financial statements for a summary of operating results and total assets for mortgage portfolio management.portfolios.

 

A significant risk toThe credit performance and prepayment rates of the nonconforming loans underlying our operations, relating to our portfolio management, issecurities, as well as the risk thatloans classified as held-in-portfolio, directly affects the profitability of this segment. In addition, short-term interest rates have a significant impact on our assets will not adjust at the same times or amounts that rates on our 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 – available-for-sale).this segment’s profitability.

 

In certain circumstances, because we enter into interest rate agreements that do not meet the hedging criteria set forth in accounting principles generally accepted in the United States of America,event we are requiredable to record the changesignificantly increase our liquidity position (as to which no assurance can be given), we may use excess cash to make certain investments if we determine that such investments could provide attractive risk-adjusted returns to shareholders, including, potentially investing in the value of derivatives as a component of earnings even though they may reduce our interest rate risk. In times where short-term rates risenew or drop significantly, the value of our agreements will increase or decrease, respectively. As a result, we recognized losses on these derivatives of $8.9 million, $30.8 million and $36.8 millionexisting operating companies.

Market in 2004, 2003 and 2002, respectively.

Mortgage Lending and Loan ServicingWhich NovaStar Competes

 

The mortgage lending operationindustry is significant to ourdominated by large, sophisticated financial resultsinstitutions. To compete effectively, we must have a very high level of operational, technological, and managerial expertise as it produces the loans that ultimately collateralize the mortgage securities – available-for-sale that we hold in our portfolio. During 2004, we originated and purchased $8.4 billion in nonconforming mortgage loans, the majority of which were retained in our servicing portfolio and servewell as collateral for our securities. The loans we originate and purchase are sold, either in securitization transactions or in outright sales to third parties. We recognized gains on sales of mortgage assets totaling $145.0 million, $144.0 million and $53.3 million during the three years ended December 31, 2004, 2003 and 2002, respectively. In securitization transactions accounted for as sales, we retain interest-only, prepayment penalty, overcollateralization and other subordinated securities, along with the right to service the loans. See Note 15 to our consolidated financial statements for a summary of operating results and total assets for mortgage lending and loan servicing.

Our wholly-owned subsidiary, NovaStar Mortgage, Inc., originates and purchases primarily nonconforming, single-family residential mortgage loans. 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. 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, correspondent institutions and direct to consumer operations. We have developed a nationwide network of wholesale loan brokers and mortgage lenders who submit mortgage loans to us. Except for NovaStar Home Mortgage brokers described below, these brokers and mortgage lenders are independent from any of the NovaStar entities. Our sales force, which includes account executives in 39 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. Our direct to consumer origination channel consists of call centers, which use telemarketing and internet loan lead sources to originate mortgage loans.

We underwrite, process, fund and service the nonconforming mortgage loans sourced through our broker network 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. 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 repurchase agreements. In addition, we have access to facilities secured by our mortgage securities – available-for-sale. 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 7 to the consolidated financial statements.

For long-term funding, we pool our mortgage loans and issue asset-backed bonds (ABB). Primary bonds – AAA through BBB rated – are issued to the public. We retain the interest-only, prepayment penalty, overcollateralization and other subordinated bonds. We also retain the right to service the loans. Prior to 1999, our ABB transactions were executed and designed to meet accounting rules that resulted in securitizations being treated as financing transactions. 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 securities and servicing rights we retain. Details regarding ABBs we issued can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in Note 7 to our consolidated financial statements.

Loan servicing remainscapital at a critical part of our business operation. In the opinion of management, 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 company 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 and rights to future cash flows arising after the investors in the securitization trusts have received the return for which they contracted. We recognized $41.5 million, $21.1 million and $10.0 million in loan servicing fee income from the securitization trusts during the three years ended December 31, 2004, 2003 and 2002, respectively. See also “Mortgage Loan Servicing” 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 LLC’s operating under LLC agreements where 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 LLC’s effective January 1, 2004. As of January 1, 2004, continuing branches that formerly operated under LLC agreements became operating units of NHMI and their financial results are included in the consolidated financial statements. See Note 14 to our consolidated financial statements for further discussion. 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 to our consolidated financial statements for a summary of operating results and total assets for our branches.

We routinely close branches and branch managers voluntarily terminate their employment with us, which generally results in the branch’s closure. As the demand for conforming loans declined significantly during 2004, many branches were not able to produce sufficient fees to meet operating expense demands.competitive cost. As a result of these conditions, a significant number of branch managers voluntarily terminated employment with us. We have also terminated many branches when loan production results were substandard. In these terminations, the branch and all operations are eliminated. Note 14 to our consolidated financial statements provides detail regarding the impact of the discontinued operations and modifications to our branch program.

The branch business provides an additional source for mortgage loan originations that, in most cases, we will eventually sell, either in securitizations or in outright sales to third parties. During 2004 and 2003, our branches brokered $3.7 billion and $6.4 billion, respectively, in nonconforming loans, of which we funded $1.7 billion and $1.2 billion, respectively.

Following is a diagram of the industry in which we operate and our loan production including nonconforming and conforming during 2004 (in thousands).


(A)A portion of the loans securitized or sold to unrelated parties as of December 31, 2004 were originated prior to 2004, but due to timing were not yet securitized or sold at the end of 2003. Loans originated and purchased in 2004 that we have not securitized or sold to unrelated parties as of December 31, 2004 are included in our mortgage loans held-for-sale
(B)The AAA-BBB rated securities related to NMFT Series 2004-1, 2004-2, 2004-3 and 2004-4 were purchased by bond investors during 2004.
(C)The excess cash flow and subordinated bonds retained by NovaStar includes the securitization transactions that occurred during 2004 for NMFT Series 2003-4, 2004-1, 2004-2, 2004-3 and 2004-4.

Market in Which NovaStar Operates and Competes

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 – available-for-sale 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.

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;

reduced access to capital, markets to securitize our assets.
general housing trends, rising delinquencies and defaults and other factors, many mortgage lenders have recently experienced severe financial difficulty, with some exiting the business or filing for bankruptcy protection. Primarily because of these factors, the industry continues its consolidation trend.

 

Risk Management

 

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

 

Interest Rate/Market

 

Liquidity/Funding

Liquidity

 

Credit

 

Prepayment

Regulatory

 

Interest Rate/Market Risk

Risk.Our investment policy sets the following general goals:

(1) Maintaingoals are to maintain the net interest margin between our assets and liabilities and

(2) Diminish to diminish the effect of changes in interest rate levels on ourthe market value of our assets, to the extent consistent with our liquidity needs.

 

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 useshistorically has used financing sources whereunder which the interest rate resets frequently. As of December 31, 2004,2007, all borrowings under allour financing arrangements adjust daily or monthly.monthly off LIBOR. 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 that 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.

 

Historically, we have transferred 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 entered into these interest rate agreements as we originated and purchased mortgage loans in our mortgage lending segment. At the time of a securitization structured as a sale, we transferred interest rate agreements into the securitization trusts and they were removed from our balance sheet. The trust assumed the obligation to make payments and obtained 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 used either to cover interest shortfalls on the third-party primary bonds or to provide credit enhancement with any remaining funds then flowing to our residual securities. For securitizations structured as financings the derivatives remain on our balance sheet. Generally, these interest rate agreements do not meet the hedging criteria set forth in Generally Accepted Accounting Principles (“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. Occasionally, we enter into interest rate agreements that do meet the hedging criteria set forth in GAAP. In these instances, we record their change in value, if effective, directly to other comprehensive income on our statement of shareholder’s equity.

Interest Rate Sensitivity AnalysisAnalysis..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 same mortgage assets and interest rate agreements assuming interest rates were 100 and 200 basis points, or 1 and 2 percent, higher andor 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 a majority of our short-term borrowings and asset-backed bonds (“ABB”) are adjustable rate; however, as noted above, rapid increases in short-term interest rates would negatively impact the interest-rate spread between our liabilities onand assets and, consequently, our balance sheet which finance our mortgage assets is insignificant.earnings.

 

Interest Rate Sensitivity - Market Value

 

(dollars in thousands)

 

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

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

 
  (200) (C)

 (100)

 100

 200

   (200)

 (100)

 100

 200

 

As of December 31, 2004:

   

As of December 31, 2007:

   

Change in market values of:

      

Assets

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

Assets – non trading (B)

  $42,484  $19,234  $(18,057) $(32,868)

Assets – trading (C)

   33,448   15,269   (14,210)  (26,053)
  


 


 


 


Cumulative change in market value

  $75,932  $34,503  $(32,267) $(58,921)
  


 


 


 


Percent change of market value portfolio equity (D)

   61.0%  24.6%  (17.5%)  (30.5%)
  


 


 


 


As of December 31, 2006:

   

Change in market values of:

   

Assets – non trading (B)

  $226,262  $105,038  $(78,698) $(150,481)

Assets – trading (C)

   9,999   7,080   (14,120)  (30,707)

Interest rate agreements

  (54,085)  (28,046)  27,832   55,113    (40,018)  (20,946)  23,998   49,264 
  

 


 


 


  


 


 


 


Cumulative change in market value

  16,353  $5,152  $(6,213) $(17,727)  $196,243  $91,172  $(68,820) $(131,924)
  

 


 


 


  


 


 


 


Percent change of market value portfolio equity (B)

  3.3%  1.0%  (1.3)%  (3.6)%

Percent change of market value portfolio equity (D)

   34.0%  15.8%  (11.9%)  (22.9%)
  

 


 


 


  


 


 


 


As of December 31, 2003:

   

Change in market values of:

   

Assets

  N/A  $34,499  $(65,216) $(144,343)

Interest rate agreements

  N/A   (31,250)  34,073   69,497 
  

 


 


 


Cumulative change in market value

  N/A  $3,249  $(31,143) $(74,846)
  

 


 


 


Percent change of market value portfolio equity (B)

  N/A   1.0%  (9.1)%  (21.9)%
  

 


 


 



(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)Includes mortgage loans held-for-sale, mortgage loans held-in-portfolio and mortgage securities—available-for-sale for 2007 and 2006, and also includes mortgage servicing rights for 2006 as well.
(C)Consists of mortgage securities – trading.
(D)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 one-month LIBOR at or below zero at31, 2007 and December 31, 2003.2006.

HedgingHedging..In order to address a mismatch ofWe use derivative instruments, including interest rate indicesswap and adjustment periodscap contracts, to mitigate the risk of our cost of funding increasing at a faster rate than the interest on our assets and liabilities, the hedging section of the investment policy is followed, as approved by the Board. Specifically, theassets. We adhere to an interest rate risk management program that is approved by our Board. This program is formulated with the intent to offsetmitigate 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 However, our hedging strategy is subject to, and swap contracts to mitigate the riskis currently limited by, considerations 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, 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.

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.liquidity risk.

 

Interest rate cap and swap agreements are legal contracts between us and a third-party firm or “counterparty”. TheUnder an interest rate cap agreement 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. 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,Under interest rate swap agreements allow us towe 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. Substantiallycontracts as of December 31, 2007, all of thewhich are held by securitization trusts. All of our pay-fixed swapsswap contracts and interest rate capscap contracts are indexed to one-month LIBOR. During 2007, we terminated all of our derivative instruments not in securitization trusts. The cash impact was minimal to settle the terminations.

 

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, 2004.2007.

 

Interest Rate Risk Management Contracts

(dollars in thousands)

 

   Maturity Range

 
   

Net Fair

Value


  

Total

Notional

Amount


  2005

  2006

  2007

 

Pay-fixed swaps:

                     

Contractual maturity

  $6,143  $1,350,000  $285,000  $840,000  $225,000 

Weighted average pay rate

       3.0%  2.4%  3.1%  3.5%

Weighted average receive rate

       2.4%  (A)  (A)  (A)

Interest rate caps:

                     

Contractual maturity

  $5,819  $650,000  $450,000  $200,000  $—   

Weighted average strike rate

       1.7%  1.6%  2.0%  —   

   Net Fair
Value


  Total
Notional
Amount


  Maturity Range

    2007

  2008

  2009

  2010

  2011 and
beyond


Pay-fixed swaps:

                            

Contractual maturity

  $(9,441) $1,165,000  $720,000  $405,000  $40,000  $—    $—  

Weighted average pay rate

       4.9%  5.0%  4.9%  5.0%  —     —  

Weighted average receive rate

       4.6%  (A)  (A)  (A)  (A)  —  

Interest rate caps:

                            

Contractual maturity

  $85  $220,000  $180,000  $40,000  $—    $—    $—  

Weighted average strike rate

       5.0%  5.0%  5.0%  —     —     —  

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

 

Liquidity/Funding Risk

Mortgage lending requiresLiquidity Risk.A significant risk to our operations is the risk that we will not have enough cash to fund loan originations and purchases. Our warehouse lending arrangements, including repurchase agreements, support the mortgage lending operation. Our warehouse mortgage lenders allow us to borrow between 98% and 100% of the outstanding principal. Funding for the difference – generally 2% of the principal - must come from cash on hand. If we are unable to obtain sufficient cash resources, we may not be ableliquidity available to operate our mortgage lending (banking) segment.

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. At that time, we faced significant liquidity constraints that harmed our business and meet our profitability.debt payment and other obligations. We can provide no assurance that those adverse circumstances will not recur.

We use repurchase agreements to finance the acquisition of mortgage assets in the short-term. In a repurchase agreement, we sell an assetcurrently face substantial liquidity risk 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 onuncertainty, near-term and otherwise, which threatens our balance sheet and record an obligation to repurchase the asset. For our repurchase agreements secured by mortgage loans, the amount we may borrow is generally 98% of the mortgage loan market value. For our repurchase agreements secured by mortgage securities, the amount we may borrow is generally 75% of the mortgage securities 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 default on our obligations under the applicable repurchase agreement. In that event, the lender retains the right to liquidate the collateral we provided to it to settle the amount due from us.

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 orcontinue as a change in the market’s demand for our loans could have a material adverse effect on our results of operations, financial conditiongoing concern and business prospects.

avoid bankruptcy. 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

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 all of our entire mortgage loan portfolio and serve as collateral for our mortgage securities – available-for-sale. Our nonconformingsecurities. 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.difficulties. 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

We have traditionally utilized our role as servicer of our securitized pools of mortgage loans to evaluate the credit historyattempt to identify and address potential and actual borrower delinquencies and defaults. As a result of the potential borrower,sale of our mortgage servicing rights effective November 1, 2007, we no longer control the capacitylender-borrower relationship, which may exacerbate the increase in delinquencies and willingness of the borrower to repay the loan,defaults under such mortgage loans and the adequacy of the collateral securing the loan.

Underwriting staff work under the credit policies established by our Chief Credit Officer. 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.

The 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 dependnegative impact 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.

Key to our successful underwriting process is the use of NovaStarIS®. NovaStarIS® is the second generationvalue and cash flows of our proprietary automated underwriting system. IS provides more consistency in underwritingresidual and subordinated securities and mortgage loans – held-in-portfolio resulting from such delinquencies and allows underwriting personnel to focus more of their time on loans that are not initially accepted by the IS system.

Our mortgage loan portfolio by credit grade, all of which are nonconforming can be accessed via our website at www.novastarmortgage.com.

A tool 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. Details regarding loans charged off are disclosed in Note 2 to our consolidated financial statements.

We have purchased mortgage insurance on many of the loans that are held in our portfolio – on the balance sheet and those that serve as collateral for our mortgage securities – available-for-sale. 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”.defaults.

 

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 increases when credit ratings improve. When home values rise, loan-to-value ratios drop, making it more likely that a borrower has a low loan-to-value ratio, 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.speeds.

 

The majority of our residual securities portfolio consists of securities which 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 mitigatemitigated 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 theA majority of our loans have a prepayment penalty is charged equalup to but no greater than 80% of six months interest on the principal balance that is to be paid in full.being repaid. As of December 31, 2004, 73%2007, 51% of our securitizedthe loans had a prepayment penalty. These loanswhich serve as collateral for our mortgage securities – available-for-sale.had a prepayment penalty. As of December 31, 2004, 65%2007, 62% of our mortgage loans - held-for-sale– held-in-portfolio had a prepayment penalty, which serve as collateral for our short-term borrowings. During 2004, 72% of the loans we originated and purchased had prepayment penalties.penalty.

 

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.

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 either in jurisdictions unacceptable to the rating agencies or otherwise within newly defined thresholds and could have a material adverse effect on our business.

Recently enacted and effective laws, regulations and standards relating to corporate governance and disclosure requirements applicable to public companies, including the Sarbanes-Oxley Act of 2002, new Securities and Exchange Commission regulations and New York Stock Exchange rules have increased the costs of corporate governance, reporting and disclosure practices. These costs may increase in the future due to our continuing implementation of compliance programs mandated by these requirements. In addition, these new laws, rules and regulations create new legal bases for administrative enforcement and civil and criminal proceedings against us in case of non-compliance, thereby increasing our risks of liability and potential sanctions.

Other Risk Factors

Although management considers the risk components set forth above to be its primary business risks, the following are other risks that should be considered by our investors. Further information regarding these risks is included in our registration statements filed with the Commission.

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.From time to time we use mortgage insurance to mitigate the risk of credit losses. The inclination to obtain mortgage insurance coverage is dependent on pricing trends. In the future there can be no assurance that mortgage insurance coverage on our new mortgage loan production will be available at rates that we believe are economically viable for us. In addition, mortgage insurers have the right to deny a claim if the loan is not properly serviced or has been improperly originated. We also face the risk that mortgage insurance providers will revise their guidelines to such an extent that we will no longer be able to acquire coverage on our new mortgage loan production or will set their premiums at levels that we believe are not economically viable. Any of those events could increase our credit losses and harm our results of operations.

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 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 – available-for-sale. The gain on sale method of 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 – available-for-sale, 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 – available-for-sale 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.

We face loss exposure due to fraudulent and negligent acts on the part of loan applicants, employees, mortgage brokers and other vendors.When we originate and 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 the misrepresentation. A loan subject to misrepresentation typically cannot be sold or is subject to repurchase by us if it is sold prior to our detection of the misrepresentation. Even though we may have rights against the person(s) who knew or made the misrepresentation, we may not be able to recover against such persons the amount of the monetary loss caused to us by the misrepresentation.

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.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 speeds and fluctuations in losses due to defaults on mortgage loans. These differences and fluctuations could rise to levels that may harm our profitability.

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.

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, savings and loans, other independent mortgage lenders and other mortgage REITs. The government-sponsored entities Fannie Mae and Freddie Mac may also expand 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. In addition, certain of the states where we originate mortgage loans restrict or prohibit prepayment penalties on mortgage loans. In the past, we have been able to rely on the federal Alternative Mortgage Transaction Parity Act (the “Parity Act”) to preempt these state restrictions and prohibitions. However, on September 25, 2002, the Office of Thrift Supervision (the “OTS”) released a rule that reduced the scope of the federal preemption. As a result, we are required to comply with state restrictions on prepayment penalties, which may put us at a competitive disadvantage relative to other financial institutions that will continue to benefit from the federal preemption rule.

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 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.

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.

Various legal proceedings could adversely affect our financial condition or results of operations. In the normal course of our business, we are subject to various legal proceedings and claims. The resolution of these legal matters could adversely affect our financial condition or results of operation.

U.S. Federal Income Tax Consequences

 

General. We believeHistorically, we have complied, and intendwere taxed as a REIT under Section 857 of the Code. As a REIT, we generally were not subject to comply in the future, with the requirements forfederal income tax. To maintain our qualification as a REIT, under the Code. To the extent that we qualify as ahad to distribute at least 90% of our REIT for federaltaxable income tax purposes,to our shareholders and meet certain other tests relating to assets, income and ownership. However, we generally will not be subjecthad elected 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, which are owned bytreat NFI Holding – aCorporation and its subsidiaries as taxable REIT subsidiary (TRS). Consequently, all ofsubsidiaries (collectively the taxable income of NFI Holding is subject to federal and state corporate income taxes.“TRS”). In general, athe TRS maycould hold assets that athe REIT cannotcould not hold directly and generally maycould 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, aThe subsidiaries comprising the TRS will bewere subject to earnings stripping limitations on the deductibility of interest paid to its REIT. In addition, a REIT will be subject to a 100% excisecorporate federal and state income tax on certain excess amounts to ensure that (i) tenants who pay a TRS for services are charged an arm’s-length amount by the TRS, (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.were taxed as regular C corporations.

 

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 ifDuring 2007, we failedwere unable to satisfy those rulesthe REIT distribution requirement for the tax year ended December 31, 2006 either in the form of cash 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 causepreferred stock. This action resulted in our loss of REIT status. Ifstatus retroactive to January 1, 2006. Our failure to satisfy the REIT distribution test resulted from demands on our liquidity and the substantial decline in our market capitalization during 2007.

As a result of our termination of REIT status, we failelected to qualify asfile a REIT for any taxable year, we would be subject toconsolidated 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 amountreturn with our eligible affiliated members. We reported taxable income in 2006 of after-tax earnings available for distribution to shareholders would decrease substantially. While we intend to operateapproximately $212 million, which resulted in a manner that will enabletax liability of approximately $74 million along with interest and penalties due of approximately $5.8 million. After applying the payments and credits, we reported an amount owed to the IRS of approximately $67 million. We applied for and received an extension of time to pay the income taxes due to our expectation of generating a net operating loss for 2007, which may be carried back to 2006. This approved extension should allow 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. We must satisfy two tests with respect to the sources of income: the 75% income test, and the 95% income test. The 75% income test requires that we derive at least 75% of gross income, excluding gross income from prohibited transactions, from certain passive real estate-related activities. In order to satisfy the 95% income test, at least 95% of gross income must be derived from the same sources as the 75% income test or from dividends or interest from any source. Management believes that we were in compliance with both of the income tests for the 2004 and 2003 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% assets test, no more than 25% of our total assets can be represented by securities, other than government securities, stock of a qualified REIT subsidiary, and securities that qualify as real estate assets under the 75% assets test (collectively “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 are in compliance withreduce all of the requirements of both asset tests for all quarters during 2004 and 2003.

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 2004 and 2003.

Distributions. We must distribute at least 90% of our taxable income (excluding excess inclusion income) from 2006, and eliminate the outstanding tax liability due to the IRS. However, we will be required to pay interest and any after-taxpenalties that apply on the balance due to the IRS in 2008.

Because we terminated our REIT status effective January 1, 2006 and were taxable as a C corporation for 2006 and beyond, we recorded deferred taxes based on the estimated cumulative temporary differences as of December 31, 2007.

In determining the amount of deferred tax assets to recognize in the financial statements, we evaluate the likelihood of realizing such benefits in future periods. Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standard No. 109 “Accounting for Income Taxes” (“SFAS 109”) requires the recognition of a valuation allowance if it is more likely than not that all or some portion of the deferred tax asset will not be realized. SFAS 109 indicates the more likely than not threshold is a level of likelihood that is more than 50 percent.

Based on the evidence available as of December 31, 2007, including the significant pre-tax losses incurred by us in both the current quarter and previous quarters, the ongoing disruption to the credit markets, the liquidity issues facing us and our decision to close all of our mortgage lending operations, we concluded that it is more likely than not that our entire net income from certain typesdeferred tax asset will not be realized. Based on these conclusions, we recorded a valuation allowance of foreclosure property less any non-cash income. No distributions are required in$368.3 million for deferred tax assets as of December 31, 2007 compared to $0.7 million as of December 31, 2006. In future periods, in which there is no income.we will continue to monitor all factors that impact positive and negative evidence relating to our deferred tax assets.

Taxable Income.As of December 31, 2007, we had a federal net operating loss of approximately $368.4 million. We useare expecting to carryback $196.1 million of the calendar year for both tax and financial reporting purposes. However, there may be differences between2007 projected federal net operating loss against our 2006 taxable income and have recorded a current receivable for such benefit. The receivable was netted against the 2006 federal liability. The remaining $172.3 federal net operating loss may be carried forward to offset future taxable income, computed in accordance with accounting principles generally acceptedsubject to provisions of the Code, including substantial limitations that would be imposed in the United Statesevent of America (GAAP). These differences primarily arise from timingan “ownership change” as defined by Section 382 of the Code. If not used, this net operating loss will begin to expire in 2025.

The IRS is currently examining the 2005 federal income tax return of NFI Holding Corporation, a wholly-owned subsidiary. We are not aware of any significant findings as a result of this exam, however, the exam is still ongoing. Management believes it has adequately provided for potential tax liabilities that may be assessed for years in which the statute of limitations remains open. However, the assessment of any material liability would adversely affect our financial condition, liquidity 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.ability to continue as a going concern.

 

Personnel

 

As of December 31, 2004,2007, we employed 3,502247 people. Of these, 1,738 were employedBecause of further reductions in our mortgage portfolio management and mortgage lending and loan servicing operations. Our branches employed 1,721workforce subsequent to December 31, 2007, we employ approximately 53 people as of December 31, 2004. The remainingMarch 27, 2008. None of our employees were employed in our branch administrative functions.are represented by a union or covered by a collective bargaining agreement.

 

Available Information

 

A copyCopies of the filings we have madeour 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 Securities and Exchange Commission (SEC) may be obtained onSEC 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 (www.novastarmortgage.com), throughdo 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 SEC (www.sec.gov)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

816.237.7000816.237.7424

Email: ir@novastar1.com

 

Item 1A.Risk Factors

Risk Factors

You should carefully consider the risks described below in evaluating our business and before investing in our publicly traded securities. Any of the risks we describe below or elsewhere in this report could negatively affect our results of operations, financial condition, liquidity, business prospects and ability to continue as a going concern. The risks described below are not the only ones facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial may also materially adversely affect our results of operations, financial condition, liquidity, business prospects and ability to continue as a going concern. 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.

Risks Related to Recent Changes in Our Business

The subprime loan market has largely ceased to operate, which has adversely affected our business and may adversely affect our ability to continue as a going concern.

Due to a number of market factors, including increased delinquencies and defaults on residential mortgage loans, investor concerns over asset quality, a weakening of the United States housing market and the failure of certain subprime mortgage companies and hedge funds that have invested in subprime loans, there has been extreme uncertainty and disruption in the subprime mortgage industry as a whole. As a result, our business has been materially and adversely affected in a number of ways. Due to the fact that the

secondary market for mortgage loans has effectively been unavailable to us since the middle of 2007, we have discontinued our mortgage lending business and have sold, at a loss, most of the loans that we originated during 2007 and had not previously securitized. Further, we have sold our mortgage servicing assets to generate cash to repay existing indebtedness and to reduce cash requirements. We have also terminated a substantial portion of our workforce. All of these events have had a material adverse effect on our business and have forced us to change business strategies. Our business now is focused solely on managing our portfolio of mortgage securities. If the subprime market fails to significantly improve, our results of operations, financial condition, liquidity, and business prospects will be further adversely affected and there can be no assurance that we will be able to continue as a going concern. Further, because of state licensing requirements, we are unlikely to be able, ourselves, to recommence mortgage lending activities so long as we continue to have a shareholders’ deficit. As a result of this and other factors, in the event that the subprime market recovers, there can be no assurance that we will be able to operate in the manner or at the levels that we have historically.

Payments on our mortgage securities are currently our only source of cash flows and will decrease in the next several months. Absent the reestablishment of profitable operations and reduction of our expenses from discontinued operations and other obligations, our cash flows will not be sufficient for us to continue as a going concern.

Our residual and subordinated mortgage securities are currently our only source of cash flows. Based on the current projections, the cash flows from our mortgage securities will decrease in the next several months as the underlying mortgage loans are repaid, and could be significantly less than the current projections if losses on the underlying mortgage loans exceed the current assumptions. In addition, we have significant operating expenses associated with office leases, software contracts, and other obligations relating to our discontinued operations, as well as payment obligations with respect to secured and unsecured debt, including periodic interest payments with respect to junior subordinated debentures relating to the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II. We intend to use available cash inflows in excess of our immediate operating needs, including debt service payments, to repay all of Wachovia’s short-term borrowings and any remaining fees due under the repurchase agreements at the earliest practical date. Any new advances under our financing facilities are at Wachovia’s sole discretion and we do not expect any such advances to be made. If, as the cash flows from mortgage securities decrease, we are unable to recommence or invest in mortgage loan origination or brokerage business on a profitable basis, and restructure our unsecured debt and contractual obligations or if the cash flows from our mortgage securities are less than currently anticipated, there can be no assurance that we will be able to continue as a going concern and avoid seeking the protection of applicable federal and state bankruptcy laws.

To the extent that the mortgage loans underlying our residual and subordinated securities continue to experience significant credit losses, our liquidity and ability to continue as a going concern will be adversely affected.

Our mortgage securities consist of certain residual securities retained from our past securitizations of mortgage loans, which typically consist of interest-only, prepayment penalty, and over collateralization bonds, and certain investment grade and non-investment grade rated subordinated mortgage securities retained from our past securitizations and purchased from other ABS issuers. These residual and subordinated securities are generally unrated or rated below investment grade and, as such, involve significant investment risk that exceeds the aggregate risk of the full pool of securitized loans. By holding the residual and subordinated securities, we generally retain the “first loss” risk associated with the underlying pool of mortgage loans. As a result, losses on the underlying mortgage loans directly affect our returns on, and cash flows from, these mortgage securities. In addition, if delinquencies and/or losses on the underlying mortgage loans exceed specified levels, the level of over-collateralization required for higher rated securities held by third parties may be increased, further decreasing cash flows presently payable to us.

Increased delinquencies and defaults on the mortgage loans underlying our residual and subordinated mortgage securities have resulted in a decrease in the cash flow we receive from these investments. To the extent we continue to experience significant realized losses and decreased cash flows from these assets, our results of operations, financial condition, liquidity, and ability to continue as a going concern will be adversely affected. In addition, because we have financed our mortgage securities under short-term warehouse repurchase agreements, continued decreases in the value of these retained securities may result in additional margin calls, which will further undermine our liquidity and ability to continue as a going concern.

There can be no assurance that we will have access to financing necessary to support our business and assets. Further, if we are unable to remain in compliance with agreements governing our indebtedness or to obtain waivers of any noncompliance, we will not be able to continue as a going concern.

We have incurred significant debt to finance our past operations, including the origination and purchase of mortgage loans and the purchase of mortgage securities. A significant amount of our indebtedness is represented by multiple secured financing facilities with Wachovia and the junior subordinated debentures related to the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II.

We currently intend to use available cash inflows in excess of our immediate operating needs, including debt service payments, to repay all of Wachovia’s outstanding borrowings and any remaining fees due under the repurchase agreements at the earliest practical date. During and after this period of repayment, any new advances under the Wachovia lending facilities are at Wachovia’s sole discretion and we do not expect any such advances to be made.

As of December 31, 2007 and thereafter, we are out of compliance with the net worth and liquidity covenants in our financing agreements with Wachovia. While Wachovia has waived this non compliance through April 30, 2008, there can be no assurance that we will be able to obtain further waivers of, or amendments to, our financing facilities if we were to breach any representation, warranty or covenant contained in such financing facilities or waiver or amendment. In addition, we project that we will be out of compliance with our current waiver prior to its expiration of April 30, 2008. Any default under our secured financing facilities and failure to obtain any necessary waivers or amendments in the future could result in the acceleration of the indebtedness under these facilities and the liquidation by the lender of the related collateral. Any acceleration of indebtedness would have a material adverse affect on our liquidity and ability to continue as a going concern and any liquidation of our collateral could be at a substantial loss.

Our wholly owned subsidiary NovaStar Mortgage, Inc. has outstanding junior subordinated debentures related to the outstanding trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II. We have guaranteed NovaStar Mortgage’s obligations under these debentures, including NovaStar Mortgage’s obligations to make periodic interest payments thereon. Our financing facilities with Wachovia prohibit us from making any such payments without Wachovia’s consent in the event that we have less than $30 million of available liquidity. In the event that any such payments are not made when due, whether as a result of the restrictions in our financing agreements with Wachovia or otherwise, or we or NovaStar Mortgage otherwise breach any of our obligations relating to the debentures or trust preferred securities and fail to remedy the default within the applicable cure period, if any, all of our obligations with respect thereto, including the repayment of principal, may be accelerated and declared to be immediately due and payable, in which case we would be forced to seek the protection of applicable federal and state bankruptcy laws.

In light of current market conditions, our current financial condition, and our lack of significant unencumbered assets, no assurance can be given regarding our ability to meet our debt service obligations or to secure additional financing. To the extent we are unable to meet our debt service obligations or do not have access to adequate financing, our business prospects and ability to continue as a going concern will be negatively affected. There is no assurance that we will continue to have access to financing at levels necessary for operations or other liquidity needs or that we will not be forced to file for bankruptcy.

Various legal proceedings could adversely affect our financial condition, our results of operations, liquidity and our ability to continue as a going concern.

In the course of our business, we are subject to various legal proceedings and claims. See Part I “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, liquidity, financial condition and ability to continue as a going concern.

The Securities and Exchange Commission (the “Commission”) has requested information from issuers in our industry, including us, regarding accounting for mortgage loans and other mortgage related assets. In addition, we have received requests or subpoenas for information relating to our operations from various federal and state regulators and law enforcement, including, without limitation, the Federal Trade Commission, the Department of Housing and Urban Development, the United States Department of Justice, the Federal Bureau of Investigation, the New York Attorney General and the Department of Labor. While we have provided, or are in the process of providing, the requested information to the applicable officials, we may be subject to further information requests from, or action by, these or other regulators or law enforcement officials. To the extent we are subject to any actions, our financial condition, liquidity, and ability to continue a going concern could be materially adversely affected.

There can be no assurance that our common stock or Series C Preferred Stock will continue to be traded in an active market.

Our common stock and our 8.90% Series C Preferred Stock were delisted by the New York Stock Exchange (“NYSE”) in January 2008, as a result of failure to meet applicable standards for continued listing on the NYSE. Our common stock and Series C Preferred Stock are currently quoted on the OTC Bulletin Board and on the Pink Sheets. However, there can be no assurance that an active trading market will be maintained. Trading of securities on the OTC and Pink Sheets is generally limited and is effected on a less regular basis than on exchanges, such as the NYSE, and accordingly investors who own or purchase our stock will find that the

liquidity or transferability of the stock may be limited. Additionally, a shareholder may find it more difficult to dispose of, or obtain accurate quotations as to the market value of, our stock. If an active public trading market cannot be sustained, the trading price of our common and preferred stock could be adversely affected and your ability to transfer your shares of our common and preferred stock may be limited.

We are not likely to pay dividends to our common or preferred stockholders in the near future.

We are not required to pay out our taxable income in the form of dividends, as we are no longer subject to a REIT distribution requirement. Instead, payment of dividends is at the discretion of our board of directors. To preserve liquidity and to remain in compliance with our financing facilities, our board of directors has suspended dividend payments on our Series C and Series D-1 Preferred Stock. Dividends on our Series C and D-1 Preferred Stock continue to accrue and the dividend rate on our Series D-1 Preferred Stock increased from 9.0% to 13.0%, compounded quarterly, effective January 16, 2008 with respect to all unpaid dividends and subsequently accruing dividends. No dividends can be paid on any of our common stock until all accrued and unpaid dividends on our Series C and Series D-1 Preferred Stock are paid in full. Accumulating dividends with respect to our preferred stock will negatively affect the ability of our common stockholders to receive any distribution or other value upon liquidation.

Risks Related to Mortgage Asset Financing, Sale, and Investment Activities

We may be required to repurchase mortgage loans or indemnify mortgage loan purchasers as a result of breaches of representations and warranties, borrower fraud, or certain borrower defaults, which could further harm our liquidity and ability to continue as a going concern.

When we sold mortgage loans, whether as whole loans or pursuant to a securitization, we made customary representations and warranties to the purchaser about the mortgage loans and the manner in which they were originated. Our whole loan sale agreements require us to repurchase or substitute mortgage loans in the event we breach any of these representations or warranties. In addition, we may be required to repurchase mortgage loans as a result of borrower fraud. Likewise, we are required to repurchase or substitute mortgage loans if we breach a representation or warranty in connection with our securitizations. If a purchaser enforces its remedies against us, we may not be able to recover losses from the originating broker or correspondent. Repurchased loans are typically sold at a significant discount to the unpaid principal balance and, prior to sale, cannot currently be financed by us. As a result, significant repurchase activity would further harm our liquidity, cash flow, and financial condition.

During 2007, we received an increased number of repurchase and indemnity demands from purchasers of whole loans as a result of, among other things, borrower fraud, which had a negative impact on our liquidity and results of operations. In the event that we experience further repurchase and indemnity demands, our liquidity, cash flow, and financial condition will be further harmed.

Differences in our actual experience compared to the assumptions that we use to determine the value of our residual mortgage securities and to estimate reserves could further adversely affect our financial position.

Our securitizations of mortgage loans that were structured as sales for financial reporting purposes resulted in gain recognition at closing as well as the recording of the residual mortgage securities we retained at fair value. The value of residual securities represents the present value of future cash flows expected to be received by us from the excess cash flows created in the securitization transaction. In general, future cash flows are estimated by taking the coupon rate of the loans underlying the transaction less the interest rate paid to the investors, less contractually specified servicing and trustee fees, and after giving effect to estimated prepayments and credit losses. We estimate future cash flows from these securities and value them utilizing assumptions based in part on projected discount rates, delinquency, mortgage loan prepayment speeds and credit losses. It is extremely difficult to validate the assumptions we use in valuing our residual interests. Even if the general accuracy of the valuation model is validated, valuations are highly dependent upon the reasonableness of our assumptions and the predictability of the relationships which drive the results of the model. Due to deteriorating market conditions, our actual experience has differed significantly from our assumptions, resulting in a reduction in the fair value of these securities and impairments on these securities. If our actual experience continues to differ materially from the assumptions that we used to determine the fair value of these securities, our financial condition, results of operations and ability to continue as a going concern will continue to be negatively affected.

Risks Related to Interest Rates and Our Hedging Strategies

Changes in interest rates may harm our results of operations and equity value.

Our results of operations are likely to be harmed during any period of unexpected or rapid changes in interest rates. Our primary interest rate exposures relate to our mortgage securities, mortgage loans, floating rate debt obligations, interest rate swaps, and interest rate caps. Interest rate changes could adversely affect our cash flow, results of operations, financial condition, liquidity, business prospects, and ability to continue as a going concern in the following ways:

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

the value of our residual and subordinated securities and the income we receive from them are based primarily on LIBOR, and an increase in LIBOR increases our funding costs which reduces the cash flow we receive from, and the value of, these securities;

existing borrowers with adjustable-rate mortgages or higher risk loan products may incur higher monthly payments as the interest rate increases, and consequently may experience higher delinquency and default rates, resulting in decreased cash flows from, and decreased value of, our mortgage securities; and

mortgage prepayment rates vary depending on such factors as mortgage interest rates and market conditions, and changes in prepayment rates may harm our earnings and the value of our mortgage securities.

In addition, interest rate changes may also further impact our net book value as our mortgage securities and related hedge derivatives are marked to market each quarter. Generally, as interest rates increase, the value of our mortgage securities decreases which decreases the book value of our equity.

Furthermore, shifts in the yield curve, which represents the market’s expectations of future interest rates, also affects the yield required for the purchase of our mortgage securities and therefore their value. To the extent that there is an unexpected change in the yield curve it could have an adverse effect on our mortgage securities portfolio and our financial position and operations.

Risks Related to Credit Losses

Further delinquencies and losses with respect to residential mortgage loans, particularly in the sub-prime sector, may cause us to recognize additional losses, which would further adversely affect our operating results, liquidity, financial condition, business prospects and ability to continue as a going concern.

The residential mortgage market has encountered difficulties which have adversely affected our performance. Delinquencies and losses with respect to residential mortgage loans generally have increased and may continue to increase, particularly in the sub-prime sector. In addition, in recent months residential property values in most states have declined, in some areas severely, after extended periods during which those values appreciated. A sustained decline or a lack of increase in those values is likely to result in additional increases in delinquencies and losses on residential mortgage loans generally, especially with respect to any residential mortgage loans where the aggregate loan amounts (including any subordinate loans) are close to or greater than the related property values. Another factor that may have contributed to, and may in the future result in, higher delinquency rates is the increase in monthly payments on adjustable rate mortgage loans. Any increase in prevailing market interest rates may result in increased payments for borrowers who have adjustable rate mortgage loans. Moreover, with respect to option ARM mortgage loans with a negative amortization feature which reach their negative amortization cap, borrowers may experience a substantial increase in their monthly payment even without an increase in prevailing market interest rates. Compounding this issue, the current lack of appreciation in residential property values and the adoption of tighter underwriting standards throughout the sub-prime mortgage loan industry may adversely affect the ability of borrowers to refinance these loans and avoid default, particularly borrowers facing a reset of the monthly payment to a higher amount. To the extent that delinquencies or losses continue to increase for these or other reasons, the value of our mortgage securities and the mortgage loans held in our portfolio will be further reduced, which will adversely affect our operating results, liquidity, cash flow, financial condition, business prospects and ability to continue as a going concern.

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

Nonconforming mortgage borrowers 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 higher risk of delinquency and foreclosure than mortgage loans made to borrowers with better credit and, therefore, will result in higher levels of realized losses than conventional loans.

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 and costs of sale. In the event of a borrower’s bankruptcy, that borrower’s mortgage loan will be deemed to be secured only to the extent of the value of the underlying collateral at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the mortgage loan may in some circumstances be subject to the avoidance powers of the bankruptcy trustee under applicable state law. Foreclosure of a mortgage loan can be an expensive and lengthy process that can have a substantial negative effect on our originally anticipated return on the foreclosed mortgage loan. Also, our cost of financing a delinquent or defaulted loan is higher than for a performing loan, and loans that are delinquent or in default may be unmarketable or saleable only at a discount.

We have experienced an increase in borrower delinquencies and defaults, which has adversely affected our liquidity, cash flows, results of operations and financial condition. Nearly all of our remaining loans held for sale are delinquent or are in default. In addition, we continue to be exposed to delinquencies and losses with respect to loans that we have securitized, either through residual securities that we retain in securitizations structured as sales, or through the loans that remain on our balance sheet in securitizations structured as financings.

To the extent that loan delinquencies and defaults continue at their current rates or become more severe, our results of operations, cash flows, liquidity, financial condition and ability to continue as a going concern may be further adversely affected.

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

In our origination and purchasing of mortgage loans, we relied 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 was fraudulently or negligently misrepresented to us, the value of the loan may be significantly lower than we expected. Whether a misrepresentation was 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, if sold prior to our detection of the misrepresentation, generally must be repurchased by us. We may not be able to recover losses incurred as a result of the misrepresentation.

As with the broader nonconforming mortgage loan industry, we have experienced an increase in exposure due to fraud, which has resulted in an increase in our repurchase and indemnity obligations and has adversely affected our cash flow, liquidity, results of operations and financial condition. In the event that we experience further repurchase and indemnity demands, our liquidity, cash flow, financial condition and ability to continue as a going concern will be adversely affected.

The value of, and cash flows from, our mortgage securities may further decline due to factors beyond our control.

There are many factors that affect the value of, and cash flows from, our mortgage securities, many of which are beyond our control. For example, the value of the homes collateralizing residential loans may decline due to a variety of reasons beyond our control, such as weak economic conditions or natural disasters, and a borrower’s ability to repay a loan may be adversely affected by factors beyond our control, such as subsequent over-leveraging of the borrower, reductions in personal incomes, and increases in unemployment. Interest-only loans, negative amortization loans, adjustable-rate loans, reduced documentation 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. To the extent that these factors continue to negatively affect the value of, and cash flows from, our mortgage assets our operating results, liquidity, cash flows, financial condition and ability to continue as a going concern will be adversely affected.

Mortgage insurers may not pay claims resulting in increased credit losses.

We use mortgage insurance to mitigate our risk of credit losses. We 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, financial condition, liquidity and cash flows, and ability to continue as a going concern.

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

A substantial portion of our mortgage assets consist of single-family mortgage loans or mortgage securities evidencing interests in single-family mortgage loans. Because substantially all of our loans were made to credit-impaired borrowers, the actual rates of delinquencies, foreclosures and losses on these loans tend to be higher during economic slowdowns. We have experienced a significant increase in delinquencies and defaults, which has harmed and continues to harm our financial condition, results of operations, liquidity, cash flows and ability to continue as going concern. In addition, material declines in real estate values have weakened our collateral loan-to-value ratios, have increased the risk of default by decreasing the ability of borrowers to refinance loans they are unable to sustain or to sell the mortgage property to repay the loan, and have increased the possibility of loss if a borrower defaults. In such cases, we are subject to the risk of loss on such mortgage assets arising from borrower defaults to the extent not covered by third-party credit enhancement.

Geographic concentration of mortgage loans increases our exposure to risks in those areas.

Over-concentration in any one geographic area of our loans held for sale or underlying our mortgage securities increases our exposure to the economic risks associated with that area. Declines in the residential real estate markets in which we are concentrated, including California and Florida, have reduced the values of the properties collateralizing our mortgages which in turn has increased the risk of delinquency, foreclosure, or losses from those loans. In addition, increases in the unemployment rate in markets in which we are concentrated increases the likelihood that borrowers in those areas may become delinquent on their loans. To the extent that borrowers in a geographic area in which we have made a significant number of loans become delinquent or otherwise default on such loans, the value of, and cash flows from, our mortgage securities will further decrease which will adversely affect our operating results, liquidity, cash flows, financial condition and ability to continue as a going concern.

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 negatively affect the value of, and cash flows from, our mortgage assets, which will adversely affect our operating results, liquidity, cash flows, financial condition and ability to continue as a going concern.

As a result of our sale of our mortgage servicing rights, we no longer possess the ability to identify and address potential or actual delinquencies and defaults on the mortgage loans underlying our residual and subordinated securities.

We have traditionally utilized our role as servicer of our securitized pools of mortgage loans to attempt to identify and address potential and actual borrower delinquencies and defaults. On November 1, 2007, we sold to a third party our servicing rights with respect to our securitized loans. As a result, we no longer control the lender-borrower relationship, which may exacerbate the increase in delinquencies and defaults under such mortgage loans and the negative impact on the value and cash flows of our residual and subordinated securities resulting from such delinquencies and defaults.

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

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 prohibition 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 would negatively affect our liquidity, financial condition, results of operations and ability to continue as a going concern.

Failure to qualify for an exemption from regulation as an investment company could harm our business.

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 SEC’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. Mortgage-backed securities

that do not represent all the certificates issued with respect to an underlying pool of mortgages may be treated as securities separate from the underlying mortgage loans and thus may not qualify as a qualifying real estate interest for the purposes of the 55% requirement. If we 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, results of operations, liquidity, and ability to continue as a going concern.

Failure to comply with federal, state or local regulation of, or licensing requirements with respect to, our business could harm our financial condition and ability to recommence mortgage banking operations.

Our prior mortgage lending, brokerage and loan servicing operations were subject to an extensive body of federal, state and local laws and licensing requirements. Although we utilized systems and procedures designed to facilitate compliance, these requirements were voluminous and, in some cases, complex and subject to interpretation, and our compliance with these requirements depended on the actions of a large number of employees. Borrowers experiencing foreclosure and terminated employees may make retaliatory allegations of non-compliance. Investigations, enforcement actions, litigation, fines, penalties and liability with respect to non-compliance with these requirements may consume attention of key personnel, may adversely affect our ability to recommence mortgage lending, brokerage or servicing operations, and may materially and adversely affect our financial condition, results of operations, liquidity and ability to continue as a going concern.

Risks Related to Our Capital Stock

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

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

actual or perceived changes in our ability to continue as a going concern;

actual or anticipated changes in the delinquency and default rates on mortgage loans, in general, and specifically on the loans we invest in through our mortgage securities;

actual or anticipated changes in residential real estate values;

actual or anticipated changes in market interest rates;

actual or anticipated changes in our earnings and cash flow;

general market and economic conditions, including the operations and stock performance of our competitors;

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

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

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.

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 shareholder approval, to:

authorize the issuance of additional shares of common stock or preferred stock without shareholder 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 may access the capital markets to raise additional funds 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 capital 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 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.

Other Risks Related to our Business

You should exercise caution in reviewing our consolidated financial statements.

Our consolidated financial statements have been prepared on a going concern basis of accounting which contemplates continuity of operations, realization of assets, liabilities and commitments in the normal course of business. The financial statements do not reflect any adjustments that might result if we were unable to continue as a going concern. In light of these facts, you should exercise caution in reviewing our financial statements.

Our ability to use our net operating loss carryforwards and net unrealized built-in losses could be severely limited if transfer restrictions are not adopted or are not effective in preventing an ownership change from occurring.

We currently have recorded a net deferred tax asset, before valuation allowance, of $368.3 million, almost all of which relates to certain loss carryforwards and net unrealized built-in-losses. While we believe that it is more likely than not that we will not be able to utilize such losses in the future, the net operating loss carryforwards and net unrealized built-in losses could provide significant future tax savings to us if we are able to use such losses. However, our ability to use these tax benefits may be impacted, restricted or eliminated due to a future ownership change within the meaning of Section 382 of the Code. Pursuant to Section 382 of the Code, a corporation is limited in its ability to use existing net operating loss carryforwards and net unrealized built in losses once that corporation experiences an “ownership change” (as that term is defined in the Code and IRS regulations). We have imposed certain transfer restrictions on our Series D-1 Preferred Stock, and have also agreed to submit an amendment to our Charter to our shareholders for approval, to limit the transferability of our common stock in order to attempt to preserve certain of our net operating loss carryforwards and net unrealized built-in losses. Our shareholders may fail to approve this amendment. Further, although transfer restrictions are valid under the Maryland General Corporation Law, we are not aware of any published court decisions enforcing similar transfer restrictions. Thus, a transfer could occur that would violate the transfer restrictions, and we may be unable to enforce such transfer restrictions. Even if a court were to enforce the transfer restrictions, the Internal Revenue Service might not agree that the transfer restrictions provided a sufficient remedy with respect to an ownership change resulting from a prohibited transfer. Further, our Board of Directors has waived, and may in the future waive, application of the transfer restrictions to certain shareholders or transfers if determined to otherwise be in the interests of the Company. In any of these cases, despite the implementation of the transfer restrictions, an ownership change could occur that would severely limit our ability to use the tax benefits associated with the net operating loss carryforwards and net unrealized built-in losses, which may result in higher taxable income for us (and a significantly higher tax cost as compared to the situation where these tax benefits are preserved).

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 negatively affect our business. Additionally, we have access to the personal financial information of borrowers which is highly sensitive and confidential, and subject to significant federal and state regulation. If a third party were to misappropriate this information or if we inadvertently disclosed 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 or inadvertent disclosure 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.

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

The transfer restrictions applicable or proposed to be applicable to our capital stock are complex and are designed to preserve the value of our net operating loss carryforwards and net unrealized built-in losses for the benefit of our stockholders. The transfer restrictions may make it more difficult to acquire a significant interest in us or to effect a business combination transaction that stockholders may perceive to be favorable. The transfer restrictions could also make it more difficult for a stockholder to replace current management because a stockholder’s ability to increase its voting power is limited.

Certain additional 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 shareholders. 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.

Item 1B.Unresolved Staff Comments

None

Item 2.Properties

 

Our executive, administrative and loan servicingportfolio management 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 $4.1$4.3 million.

 

We leaseare leasing office space in various other states which were used for our mortgage lending operations which were discontinued in Lake Forest, California; Independence, Ohio; Richfield, Ohio; Troy, Michigan; Columbia, Maryland2007 and Vienna, Virginia. Currently, these offices consist of approximately 255,000 square feet.early 2008. The leases on thethese premises expire from January 20052008 through May 2012,2013, and the current annual rent on those premises not terminated as of March 31, 2008 is approximately $4.1$3.0 million.

Item 3.Legal Proceedings

 

American Interbanc Mortgage Litigation. On March 17, 2008, NovaStar Financial, Inc. (“NFI”), NovaStar Mortgage, Inc. (“NMI”), NFI Holding Corp. (“NFI Holding”) and NovaStar Home Mortgage, Inc. (“NHMI” and, with NFI, NMI and NFI Holding, the “NovaStar Entities”) and American Interbanc Mortgage, LLC (“Plaintiff”) entered into a Confidential Settlement Term Sheet Agreement (the “Settlement Terms”) with respect to the actions, judgments and claims described below.

In March 2002, Plaintiff filed an action against NHMI in Superior Court of Orange County, California entitled American Interbanc Mortgage LLC v. NovaStar Home Mortgage, Inc. et. al. (the “California Action”). In the California Action, Plaintiff alleged that NHMI and two other mortgage companies (“Defendants”) engaged in false advertising and unfair competition under certain California statutes and interfered intentionally with Plaintiff’s prospective economic relations. On May 4, 2007, a jury returned a verdict by a 9-3 vote awarding Plaintiff $15.9 million. The court trebled the award, made adjustments for amounts paid by settling Defendants, and entered a $46.1 million judgment against Defendants on June 27, 2007. The award is joint and several against the Defendants, including NHMI. It is unknown if the other two Defendants, one of which has filed a bankruptcy petition, have the financial ability to pay any of the award.

NHMI’s motion for the trial court to overturn or reduce the verdict was denied on August 20, 2007, and NHMI appealed that decision (the “Appeal”). Pending the Appeal, Plaintiff commenced enforcement actions in the states of Missouri (the “Kansas City Action”) and Delaware, and obtained an enforcement judgment in Delaware (the “Delaware Judgment”). On January 23, 2008, Plaintiff filed an involuntary petition for bankruptcy against NHMI under 11 U.S.C. Sec. 303, in the United States Bankruptcy Court for the Western District of Missouri (the “Involuntary”). Plaintiff was joined by two individuals alleging claims totaling $150 in the Involuntary filing. NHMI filed an answer and contested the standing of Plaintiff and the individuals to be petitioning creditors in bankruptcy.

On March 17, 2008, the NovaStar Entities and Plaintiff entered into the Settlement Terms with respect to the California Action, the Judgment, the Kansas City Action, the Delaware Judgment, the Involuntary, and all related claims.

Under the Settlement Terms, the parties agreed to move to dismiss the Involuntary. Within ten (10) business days after notice of entry of the dismissal of the Involuntary, NFI will pay Plaintiff $2,000,000 plus the balance in an account established by order of the Bankruptcy Court in an amount no less than $50,000 (but not anticipated to be greater than $65,000 at the time of payment), with NHMI obligated to otherwise satisfy obligations to its identified creditors up to $48,000. The parties also agreed to extend the Appeal briefing period pending finalization of the settlement of the other actions, judgments and claims, as described below.

The Settlement Terms provide that, subject to payment of the amounts described above and satisfaction of certain other conditions, the parties will dismiss the California Action as to NHMI and the Kansas City Action and Delaware Judgment, effect notice of satisfaction of the Judgment, and effect a mutual release of all claims that were or could have been raised in any of the foregoing or that are related to the subject matter thereof, upon the earliest of the following: (i) July 1, 2010, (ii) a waiver by Wachovia of Wachovia’s right to file an involuntary bankruptcy proceeding against any of the NovaStar Entities prior to July 1, 2010, (iii) an extension of the maturity date of our indebtedness to Wachovia until at least July 1, 2010, or (iv) delivery to Plaintiff of written documentation evidencing the full satisfaction of our current indebtedness to Wachovia.

In addition to the initial payments to be made to the Plaintiff following dismissal of the Involuntary, we will pay Plaintiff $5.5 million if, prior to July 1, 2010, (i) NFI’s average common stock market capitalization is at least $94.4 million over a period of five (5) consecutive business days, or (ii) the holders of NFI’s common stock are paid $94.4 million in net asset value as a result of any sale of NFI or its assets. If NFI is sold prior to July 1, 2010 for less than $94.4 million and ceases to be a public company, then NFI will obligate the purchaser either to immediately pay $2 million to Plaintiff, or to pay Plaintiff $5.5 million in the event the value of NFI exceeds $94.4 million prior to July 1, 2010 as determined by an independent valuation company.

We make no assurances with regard to our ability to satisfy of any of the conditions described or referenced above. Without limiting the foregoing, we have obtained no commitment from Wachovia with regard to any action that may be required of Wachovia in order to effect, prior to July 1, 2010, the dismissals and releases described above. Further, nothing in the Settlement Terms constitutes an expression of our belief, projection, assumption, or intent regarding any future event, any industry or market conditions, or our financial condition, stock price, or business plans or strategies.

In accordance with generally accepted accounting principles, NHMI has recorded a liability of $47.1 million as of December 31, 2007 with a corresponding charge to earnings. The $47.1 million includes interest which is accruing on the obligation. Because NHMI is a wholly owned indirect subsidiary of NFI, the $47.1 million liability is included in our consolidated financial statements. The liability is included in the “Liabilities of discontinued operations” line of the consolidated balance sheets while the charge to earnings is included in the “(Loss) income from discontinued operations, net of income tax” line of the consolidated statements of operations.

Other Litigation. Since April 2004, a number of substantially similar class action lawsuits have been filed and consolidated into a single action in the United States District Court for the Western District of Missouri. The consolidated complaint names as defendants the Companyus and three of itsour executive officers as defendants 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’sour common stock (and sellers of put options on the Company’sour 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. On February 8, 2007, the court certified the case as a class action. The Company believescase is now in the discovery stage. We believe that these claims are without merit and intendswill continue to vigorously defend against them.

In April 2006, a single plaintiff filed a putative nationwide class action against NovaStar Mortgage in the United States District Court for the Western District of Tennessee. The complaint asserts claims under 42 U.S.C. Sections 1981 and 1982; the Fair Housing Act, 42 U.S.C. Sections 3601-3619; and the Equal Credit Opportunity Act, 15 U.S.C. Sections 1691-1691f. Plaintiff alleges that NovaStar Mortgage paid higher yield spread premiums to brokers for loans made to minorities as compared to loans made to white borrowers. The lawsuit seeks injunctive relief and damages, including punitive damages. We believe that these claims are without merit and will vigorously defend against them.

 

InSince February 2007, a number of substantially similar putative class actions have been filed in the wakeUnited States District Court for the Western District of the securities class action, the Company has also been named as a nominal defendant in several derivative actions brought against certain of the Company’s officers and directors in Missouri and Maryland.Missouri. The complaints in these actionsname us and three of our executive officers as defendants and generally claimallege, among other things, that the defendants made materially false and misleading statements regarding our business and financial results. The plaintiffs purport to have brought the actions on behalf of all persons who purchased or otherwise acquired our common stock during the period May 4, 2006 through February 20, 2007. Following consolidation of the actions, a consolidated amended complaint was filed on October 19, 2007. On December 29, 2007, the defendants moved to dismiss all of plaintiffs’ claims, and that motion is pending. We believe that these claims are liable to the Company for failing to monitor corporate affairs so as to ensure compliance with applicable state licensingwithout merit and regulatory requirements.will vigorously defend against them.

 

In July 2004, an employeeMay 2007, a lawsuit entitledNational Community Reinvestment Coalition v. NovaStar Financial, Inc., et al., was filed against us in the United States District Court for the District of NHMIColumbia. Plaintiff, a non-profit organization, alleges that we maintain corporate policies of not making loans on Indian reservations, or dwellings used for adult foster care or on rowhouses in Baltimore, Maryland

that violates the federal Fair Housing Act. The lawsuit seeks injunctive relief and damages, including punitive damages, in connection with the lawsuit. On May 30, 2007, we responded to the lawsuit by filing a motion to dismiss certain of plaintiff’s claims. That motion is pending resolution by the court. We believe that these claims are without merit and will vigorously defend against them.

In June 2007, two borrowers filed a putative class action entitledKubiak v. NovaStar Mortgage, Inc., against us and collective action lawsuittwo of our subsidiaries in the United States District Court for the Northern District of California, alleging that payments of premiums to brokers by one of the subsidiaries were not properly disclosed to borrowers in the manner allegedly required by federal or state law, thus constituting unfair competition and false advertising under California law and violation of the California Consumer Legal Remedies Act. Plaintiffs seek statutory and punitive damages, restitution, injunctive relief and attorney’s fees on behalf of California borrowers who allegedly failed to receive adequate disclosure of such premiums. The defendants filed a motion to dismiss the action. On December 19, 2007, the Court granted defendants’ motion to dismiss the complaint, including the claims against NHMI andNovaStar Financial, Inc., but the Court allowed the plaintiffs to file an amended complaint. On January 9, 2008, the plaintiffs filed an amended complaint that does not make any claim against NovaStar Financial, Inc., but does assert the above claims against its subsidiaries, NovaStar Mortgage, Inc. (“NMI”)and NovaStar Home Mortgage, Inc. We believe that these claims are without merit and will vigorously defend against them.

In November 2007, a borrower filed a putative class action, entitledDenman v. Novastar Mortgage, Inc., in the California superiorUnited States District Court for the CountyDistrict of Los Angeles. Subsequently, NHMIMassachusetts alleging that NovaStar Mortgage induced him to enter into a disadvantageous mortgage with an adjustable rate and NMIa balloon note. Plaintiff contends that NovaStar Mortgage’s actions violated the Massachusetts Consumer Protection Act and seeks actual and statutory damages, reformation of his mortgage contract and injunctive and declaratory relief. On March 6, 2008, NovaStar Mortgage filed a motion to dismiss the litigation. That motion is pending. We believe that these claims are without merit and will vigorously defend against them.

On January 10, 2008, the City of Cleveland, Ohio filed suit against us and approximately 20 other mortgage, commercial and investment bankers alleging a public nuisance had been created in the City of Cleveland by the operation of the subprime mortgage industry. The case was filed in state court and promptly removed the matter to the United States District courtCourt for the CentralNorthern District of California.Ohio. The plaintiff brought this class and collective action on behalfseeks damages for loss of herself and all past and present employees of NHMI and NMI who were employed since May 1, 2000property values in the capacity generally describedCity, and for increased costs of providing services and infrastructure, as Loan Officer. The plaintiff allegeda result of foreclosures of subprime mortgages. We believe that NHMIthese claims are without merit and NMI failed to pay her and the members of the class shewill vigorously defend against them.

On January 31, 2008, two purported to represent overtime premium and minimum wage as required by the Fair Labor Standards Act and California state laws for the period commencing May 1, 2000. In January 2005, the plaintiff and NHMI agreed upon a nationwide settlementshareholders filed separate derivative actions in the Circuit Court of Jackson County, Missouri against various former and current officers and directors and named us as a nominal amountdefendant. The essentially identical petitions allege that the individual defendants breached fiduciary duties owed to us in connection with alleged insider selling and misappropriation of $3.1 million on behalfinformation, abuse of a classcontrol, gross mismanagement, waste of all NHMI Loan Officers nationwide. The settlement, which is subject to court approval, covers all minimum wagecorporate assets, and overtimeunjust enrichment between May 2006 and December 2007. We believe that these claims going back to July 30, 2001,are without merit and includes the dismissal with prejudice of the claimswill vigorously defend against NMI. 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.them.

 

In addition to those matters listed above, the Company iswe are currently a party to various other legal proceedings and claims. 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, federal and state laws prohibiting discrimination in lending and federal and state licensing and consumer protection laws.

In addition, we have received requests or subpoenas for information from various Federal and State regulators or law enforcement officials, including, without limitation, the Federal Trade Commission, the Securities & Exchange Commission, the United State Department of Justice, the Federal Bureau of Investigation, the New York Attorney General and the Department of Labor.

While management including internal counsel, currently believes that the ultimate outcome of all these proceedings and claims individually and in the aggregate, will not have a material adverse effect on the Company’sour financial condition, or results of operations, litigation is subject to inherent uncertainties.uncertainties and our ability to withstand an unfavorable ruling has greatly diminished. If an unfavorable ruling were to occur in any one of them, there exists the possibility of a material adverse impact on theour financial condition, results of operations for the period in which the ruling occurs.

In April 2004, the Company also received notice of an informal inquiry from the Securities & Exchange Commission requesting that it provide various documents relatingand cash flows and our ability to its business. The Company has been cooperating fully with the Commission’s inquiry.avoid bankruptcy would be materially and adversely affected.

 

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 and Preferred Equity and Related Stockholder MattersMatters.. The Our common stock of NovaStar Financial, Inc (“NFI”) iswas traded on the NYSE under the symbol “NFI”. through December 31, 2007. Our Series C Cumulative Redeemable Perpetual Preferred Stockcommon stock has subsequently been delisted from the NYSE in 2008 and is tradedcurrently quoted on the NYSEOTC Bulletin Board and on the Pink Sheets under the symbol “NFI-PC”“NOVS”. 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. The Board of Directors declared a one-for-four reverse stock split of its common stock, providing shareholders of record as of July 27, 2007, with one share of common stock for each four shares owned. The reduction in shares resulting from the split was effective on July 27, 2007 decreasing the number of common shares outstanding to 9.5 million. Prior year share amounts and earnings per share disclosures have been restated to reflect the reverse stock split.

 

Common Stock Prices


  Cash Dividends

   High

  Low

  

Class of

Stock


  Declared

  

Paid or

Payable


  

Amount

Per Share


1/1/03 to 3/31/03

  $18.10  $13.90  Common
Common
  1/29/03
4/22/03
  2/11/03
5/15/03
  $
 
0.17
1.13

4/1/03 to 6/30/03

   30.50   17.15  Common  7/30/03  8/20/03   1.25

7/1/03 to 9/30/03

   37.75   24.25  Common  10/29/03  11/19/03   1.25

10/1/03 to 12/31/03

   45.80   28.63  Common  12/17/03  1/6/04   1.25

1/1/04 to 3/31/04

   70.32   42.50  Preferred
Common
  1/28/04
4/28/04
  3/31/04
5/26/04
   
 
0.43
1.35

4/1/04 to 6/30/04

   66.59   28.75  Preferred
Common
  4/28/04
7/28/04
  6/30/04
8/26/04
   
 
0.56
1.35

7/1/04 to 9/30/04

   48.69   37.29  Preferred
Common
  7/28/04
10/28/04
  9/30/04
11/22/04
   
 
0.56
1.40

10/1/04 to 12/31/04

   58.04   40.19  Preferred
Common
  10/28/04
12/22/04
  12/31/04
1/14/05
   
 
0.56
2.65
   High

  Low

  Dividends

      Date Declared

  Date Paid

  Amount Per
Share


2006

                  

First Quarter

  $135.20  $102.80  5/4/06  5/26/06  $5.60

Second Quarter

   150.52   116.32  8/3/06  8/28/06   5.60

Third Quarter

   142.40   113.00  9/11/06  11/30/06   5.60

Fourth Quarter

   131.24   105.28  9/11/06  12/29/06   5.60

2007

                  

First Quarter

  $105.80   13.72  N/A  N/A   N/A

Second Quarter

   40.00   19.56  N/A  N/A   N/A

Third Quarter

   34.68   5.10  N/A  N/A   N/A

Fourth Quarter

   9.32   1.16  N/A  N/A   N/A

 

As of March 11, 2005,12, 2008, we had approximately 27,000 stockholders held1,010 shareholders of record of our 27,860,629 shares of common stock, asincluding holders who are nominees for an undetermined number of beneficial owners 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 stockholders 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. AllDividend distributions will be made at the discretion of the Board of Directors and will depend on earnings, financial condition, maintenancecost of REIT statusequity, investment opportunities and other factors as the Board of Directors may deem relevant. In addition, accrued and unpaid dividends on our preferred stock must be paid prior to the declaration of any dividends on our common stock. We do not expect to declare any stock dividend distributions for the near future. See “Industry Overview and Known Material Trends and Uncertainties” for further discussion regarding future uncertainties.

 

Recent Sales of Unregistered Securities. None.

Purchase of Equity Securities by the Issuer.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, 2004 – October 31, 2004

  —    —    —    $1,020

November 1, 2004 – November 30, 2004

  —    —    —    $1,020

December 1, 2004 – December 31, 2004

  —    —    —    $1,020

(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 DataSafe Harbor Statement

 

The following selected consolidated financial data is derivedStatements in this report regarding NovaStar Financial, Inc. and its business, which are not historical facts, are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. Forward looking statements are those that predict or describe future events and that do not relate solely to historical matters and include statements regarding management’s beliefs, estimates, projections, and assumptions with respect to, among other things, our future operations, business plans and strategies, as well as industry and market conditions, all of which are subject to change at any time without notice. Words such as “believe,” “expect,” “anticipate,” “promise,” “plan,” and other expressions or words of similar meanings, as well as future or conditional verbs such as “will,” “would,” “should,” “could,” or “may” are generally intended to identify forward-looking statements. Actual results and operations for any future period may vary materially from those discussed herein. Some important factors that could cause actual results to differ materially from those anticipated include: our ability to manage our business during this difficult period for the subprime industry; our ability to continue as a going concern; decreases in cash flows from our audited consolidated financial statements formortgage securities; our ability to reduce expenses from our discontinued operations; increases in the periods presentedcredit losses on mortgage loans underlying our mortgage securities and should be readour mortgage loans – held in conjunctionportfolio; our ability to repay Wachovia in a manner and time period acceptable to Wachovia; our ability to remain in compliance with the more detailedagreements governing our indebtedness; impairments on our mortgage assets; increases in prepayment or default rates on our mortgage assets; increases in margin calls and loan repurchase requests; changes in assumptions regarding estimated loan losses and fair value amounts; our ability to maintain effective internal control over financial reporting and disclosure controls and procedures in the future; events impacting the subprime mortgage industry in general, including events impacting our competitors and liquidity available to the industry; residential property values; interest rate fluctuations on our assets that differ from our liabilities; the outcome of litigation or regulatory actions pending against us or other legal contingencies; our compliance with applicable local, state and federal laws and regulations; our ability to adapt to and implement technological changes; compliance with new accounting pronouncements; the impact of general economic conditions; and the risks that are from time to time included in our filings with the Securities and Exchange Commission (“SEC”), including this report on Form 10-K. Other factors not presently identified may also cause actual results to differ. This report on Form 10-K speaks only as of its date and we expressly disclaim any duty to update the information thereinherein except as required by federal securities laws.

Item 1. Business

We are a Maryland corporation formed on September 13, 1996 which operates solely as a non-conforming residential mortgage portfolio manager. Prior to significant changes in our business during 2007 and the first quarter of 2008, we originated, purchased, securitized, sold, invested in and serviced residential nonconforming mortgage loans and mortgage backed securities. We retained, through our mortgage securities investment portfolio, significant interests in the nonconforming loans we originated and purchased, and through our servicing platform, serviced all of the loans in which we retained interests. During 2007 and early 2008, we discontinued our mortgage lending operations and sold our mortgage servicing rights which subsequently resulted in the abandonment of our servicing operations. See “Executive Overview of Performance” and “Known Material Trends, Significant Events and Uncertainties” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion of the severely disrupted mortgage industry and credit markets and the changes we made to our operations to manage through those changes.

We currently intend to manage only our mortgage portfolio management segment. In the event we are able to significantly increase our liquidity position (as to which no assurance can be given), we may use excess cash to make certain investments if we determine that such investments could provide attractive risk-adjusted returns to shareholders, including, potentially investing in new or existing operating companies. Because of certain state licensing requirements, it is unlikely we are able, ourselves, to directly recommence mortgage lending activities so long as we continue to have a shareholders’ deficit. Segment information for the three years ended December 31, 2007 is included elsewhere in Note 16 to our consolidated financial statements.

Historically, we had elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Code”). During 2007, we announced that we would not be able to pay a dividend on our common stock with respect to our 2006 taxable income, and as a result, our status as a REIT terminated retroactive to January 1, 2006. This retroactive revocation of our REIT status resulted in us becoming taxable as a C corporation for 2006 and subsequent years.

Our consolidated financial statements have been prepared on a going concern basis of accounting which contemplates continuity of operations, realization of assets, liabilities and commitments in the normal course of business. There are substantial doubts that we will be able to continue as a going concern and, therefore, may be unable to realize our assets and discharge our liabilities in the normal course of business. The financial statements do not reflect any adjustments relating to the recoverability and classification of recorded asset amounts or to the amounts and classification of liabilities that may be necessary should we be unable to continue as a going concern.

Mortgage Portfolio Management

The continued deterioration of the secondary market for subprime mortgage assets has altered the focus of our portfolio management business from that of seeking investment opportunities to that of only managing our current portfolio of mortgage securities and mortgage loans. Our portfolio of mortgage securities includes interest-only, prepayment penalty, and overcollateralization securities retained from our securitizations of nonconforming, single-family residential mortgage loans which we have accounted for as sales, under applicable accounting rules (collectively, the “residual securities”). Our portfolio of mortgage securities also includes subordinated mortgage securities retained from our securitizations and subordinated home equity loan asset-backed securities (“ABS”) purchased from other ABS issuers (collectively, the “subordinated securities”).

The long-term mortgage loan portfolio on our balance sheet consists of mortgage loans classified as held-in-portfolio resulting from securitization transactions treated as financings completed in the second quarter of 2006 and the first quarter of 2007 (NHES Series 2006-1, NHES Series 2006-MTA1, and NHES Series 2007-1). We have financed our investment in these loans by issuing asset backed bonds (“ABB”).

Our mortgage portfolio management operations generate earnings primarily from the interest income generated from our mortgage securities and mortgage loan portfolios.

The credit performance and prepayment rates of the nonconforming loans underlying our securities, as well as the loans classified as held-in-portfolio, directly affects the profitability of this annual report. Operating resultssegment. In addition, short-term interest rates have a significant impact on this segment’s profitability.

In the event we are not necessarily indicative of future performance.able to significantly increase our liquidity position (as to which no assurance can be given), we may use excess cash to make certain investments if we determine that such investments could provide attractive risk-adjusted returns to shareholders, including, potentially investing in new or existing operating companies.

 

Selected Consolidated FinancialMarket in Which NovaStar Competes

The mortgage industry is dominated by large, sophisticated financial institutions. To compete effectively, we must have a very high level of operational, technological, and Other Datamanagerial expertise as well as access to capital at a competitive cost. As a result of reduced access to capital, general housing trends, rising delinquencies and defaults and other factors, many mortgage lenders have recently experienced severe financial difficulty, with some exiting the business or filing for bankruptcy protection. Primarily because of these factors, the industry continues its consolidation trend.

Risk Management

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

Interest Rate/Market

Liquidity

Credit

Prepayment

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 the market value of our assets, to the extent consistent with our liquidity needs.

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 historically has used financing sources under which the interest rate resets frequently. As of December 31, 2007, all borrowings under our financing arrangements adjust daily or monthly off LIBOR. 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 rates that are fixed for some period of time and then adjust frequently 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.

Historically, we have transferred 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 entered into these interest rate agreements as we originated and purchased mortgage loans in our mortgage lending segment. At the time of a securitization structured as a sale, we transferred interest rate agreements into the securitization trusts and they were removed from our balance sheet. The trust assumed the obligation to make payments and obtained 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 used either to cover interest shortfalls on the third-party primary bonds or to provide credit enhancement with any remaining funds then flowing to our residual securities. For securitizations structured as financings the derivatives remain on our balance sheet. Generally, these interest rate agreements do not meet the hedging criteria set forth in Generally Accepted Accounting Principles (“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. Occasionally, we enter into interest rate agreements that do meet the hedging criteria set forth in GAAP. In these instances, we record their change in value, if effective, directly to other comprehensive income on our statement of shareholder’s equity.

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 a majority of our short-term borrowings and asset-backed bonds (“ABB”) are adjustable rate; however, as noted above, rapid increases in short-term interest rates would negatively impact the interest-rate spread between our liabilities and assets and, consequently, our earnings.

Interest Rate Sensitivity - Market Value

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

 

   For the Year Ended December 31,

 
   2004

  2003

  2002

  2001

  2000 (A)

 

Consolidated Statement of Operations Data:

                     

Interest income

  $224,024  $170,420  $107,143  $57,904  $47,627 

Interest expense

   52,590   40,364   27,728   27,366   34,696 

Net interest income before credit recoveries (losses)

   171,434   130,056   79,415   30,538   12,931 

Credit (losses) recoveries

   (726)  389   432   (3,608)  (5,449)

Gains (losses) on sales of mortgage assets

   144,950   144,005   53,305   37,347   (826)

Losses on derivative instruments

   (8,905)  (30,837)  (36,841)  (3,953)  —   

Impairment on mortgage securities – available for sale

   (15,902)  —     —     —     —   

General and administrative expenses

   271,125   174,408   84,594   46,505   3,017 

Income from continuing operations

   119,497   111,996   48,761   32,308   5,626 

Loss from discontinued operations, net of income tax (C)

   (4,108)  —     —     —     —   

Net income available to common shareholders

   109,124   111,996   48,761   32,308   5,626 

Basic income per share:

                     

Income from continuing operations available to common shareholders

  $4.47  $5.04  $2.35  $1.61  $0.26 

Loss from discontinued operations, net of income tax (C)

   (0.16)  —     —     —     —   
   


 


 


 


 


Net income available to common shareholders

  $4.31  $5.04  $2.35  $1.61  $0.26 

Diluted income per share:

                     

Income from continuing operations available to common shareholders

  $4.40  $4.91  $2.25  $1.51  $0.25 

Loss from discontinued operations, net of income tax (C)

   (0.16)  —     —     —     —   
   


 


 


 


 


Net income available to common shareholders

  $4.24  $4.91  $2.25  $1.51  $0.25 
   As of December 31,

 
   2004

  2003

  2002

  2001

  2000 (A)

 

Consolidated Balance Sheet Data:

                     

Mortgage Assets:

                     

Mortgage loans

  $807,121  $792,709  $1,133,509  $365,560  $375,927 

Mortgage securities – available-for-sale

   489,175   382,287   178,879   71,584   46,650 

Mortgage securities - trading

   143,153   —     —     —     —   

Total assets

   1,861,311   1,399,957   1,452,497   512,380   494,482 

Borrowings

   1,295,422   1,005,516   1,225,228   362,398   382,437 

Stockholders’ equity

   426,344   300,224   183,257   129,997   107,919 

   For the Year Ended December 31,

 
   2004

  2003

  2002

  2001

  2000

 

Other Data:

                     

Loans originated and purchased, principal

  $8,486,028  $5,994,492  $2,781,539  $1,333,366  $719,341 

Loans securitized, principal

  $8,329,804  $5,319,435  $1,560,001  $1,215,100  $584,350 

Nonconforming loans sold, principal

  $—    $151,210  $142,159  $73,324  $172,839 

Loan servicing portfolio, principal

  $12,151,196  $7,206,113  $3,657,640  $1,994,448  $1,112,615 

Annualized return on assets

   7.01%  9.93%  6.05%  6.03%  0.97%

Annualized return on equity

   34.29%  58.90%  30.30%  27.04%  5.50%

Taxable income (loss) available to common shareholders (D)

  $250,501  $137,851  $49,511  $5,221  $(2)

Taxable income (loss) per common share (B) (D)

  $9.04  $5.64  $2.36  $0.45  $—   

Dividends declared per common share (B)

  $6.75  $5.04  $2.15  $0.48  $—   

Dividends declared per preferred share

  $2.11  $—    $—    $1.08  $0.49 
   Basis Point Increase (Decrease) in Interest Rates (A)

 
   (200)

  (100)

  100

  200

 

As of December 31, 2007:

                 

Change in market values of:

                 

Assets – non trading (B)

  $42,484  $19,234  $(18,057) $(32,868)

Assets – trading (C)

   33,448   15,269   (14,210)  (26,053)
   


 


 


 


Cumulative change in market value

  $75,932  $34,503  $(32,267) $(58,921)
   


 


 


 


Percent change of market value portfolio equity (D)

   61.0%  24.6%  (17.5%)  (30.5%)
   


 


 


 


As of December 31, 2006:

                 

Change in market values of:

                 

Assets – non trading (B)

  $226,262  $105,038  $(78,698) $(150,481)

Assets – trading (C)

   9,999   7,080   (14,120)  (30,707)

Interest rate agreements

   (40,018)  (20,946)  23,998   49,264 
   


 


 


 


Cumulative change in market value

  $196,243  $91,172  $(68,820) $(131,924)
   


 


 


 


Percent change of market value portfolio equity (D)

   34.0%  15.8%  (11.9%)  (22.9%)
   


 


 


 



(A)Does not includeChange in market value of assets or interest rate agreements in a parallel shift in the assets, liabilities, equityyield curve, up and results of operations for NFI Holding Corporation. The common stock of NFI Holding Corporation was acquired on January 1, 2001.down 1% and 2%.
(B)On January 29, 2003, a $0.165 special dividend related to 2002 taxable income was declared per common share.Includes mortgage loans held-for-sale, mortgage loans held-in-portfolio and mortgage securities—available-for-sale for 2007 and 2006, and also includes mortgage servicing rights for 2006 as well.
(C)Discussion and detail regarding the loss from discontinued operations is provided in Note 14 to the consolidated financial statements.Consists of mortgage securities – trading.
(D)Taxable income (loss) for years prior to 2004, are actual while 2004 taxable income is an estimate. ForTotal change in estimated market value as a reconciliationpercent 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 outstandingmarket value portfolio equity as of the end of each period presented is used in calculating the taxable income (loss) per common share.December 31, 2007 and December 31, 2006.

Hedging.We use derivative instruments, including interest rate swap and cap contracts, to mitigate the risk of our cost of funding increasing at a faster rate than the interest on assets. We adhere to an interest rate risk management program that is approved by our Board. This program is formulated with the intent to mitigate 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. However, our hedging strategy is subject to, and is currently limited by, considerations of cost and liquidity risk.

Interest rate cap and swap agreements are legal contracts between us and a third-party firm or “counterparty”. Under an interest rate cap agreement 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. Under interest rate swap agreements we 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 as of December 31, 2007, all of which are held by securitization trusts. All of our pay-fixed swap contracts and interest rate cap contracts are indexed to one-month LIBOR. During 2007, we terminated all of our derivative instruments not in securitization trusts. The cash impact was minimal to settle the terminations.

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, 2007.

Interest Rate Risk Management Contracts

(dollars in thousands)

   Net Fair
Value


  Total
Notional
Amount


  Maturity Range

    2007

  2008

  2009

  2010

  2011 and
beyond


Pay-fixed swaps:

                            

Contractual maturity

  $(9,441) $1,165,000  $720,000  $405,000  $40,000  $—    $—  

Weighted average pay rate

       4.9%  5.0%  4.9%  5.0%  —     —  

Weighted average receive rate

       4.6%  (A)  (A)  (A)  (A)  —  

Interest rate caps:

                            

Contractual maturity

  $85  $220,000  $180,000  $40,000  $—    $—    $—  

Weighted average strike rate

       5.0%  5.0%  5.0%  —     —     —  

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

Item 7.Liquidity Risk.Management’sA significant risk to our operations is the risk that we will not have enough cash and liquidity available to operate our business and meet our debt payment and other obligations. We currently face substantial liquidity risk and uncertainty, near-term and otherwise, which threatens our ability to continue as a going concern and avoid bankruptcy. See the “Liquidity and Capital Resources” section of “Management’s Discussion and Analysis of Financial Condition and Results of OperationsOperations” 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 all of our mortgage loan portfolio and serve as collateral for our mortgage securities. Nonconforming borrowers include individuals who do not qualify for agency/conventional lending programs because of a lack of conventional documentation or previous credit difficulties. 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.

We have traditionally utilized our role as servicer of our securitized pools of mortgage loans to attempt to identify and address potential and actual borrower delinquencies and defaults. As a result of the sale of our mortgage servicing rights effective November 1, 2007, we no longer control the lender-borrower relationship, which may exacerbate the increase in delinquencies and defaults under such mortgage loans and the negative impact on the value and cash flows of our residual and subordinated securities and mortgage loans – held-in-portfolio resulting from such delinquencies and defaults.

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 incentive to refinance increases when credit ratings improve. When home values rise, loan-to-value ratios drop, making it more likely that a borrower will do a “cash-out” refinance. Each of these factors increases the chance for higher prepayment speeds.

The majority of our residual securities portfolio consists of securities which 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 mitigated 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. A majority of our loans have a prepayment penalty up to but no greater than 80% of six months interest on the principal balance that is being repaid. As of December 31, 2007, 51% of the loans which serve as collateral for our mortgage securities had a prepayment penalty. As of December 31, 2007, 62% of our mortgage loans – held-in-portfolio had a prepayment penalty.

U.S. Federal Income Tax Consequences

Historically, we were taxed as a REIT under Section 857 of the Code. As a REIT, we generally were not subject to federal income tax. To maintain our qualification as a REIT, we had to distribute at least 90% of our REIT taxable income to our shareholders and meet certain other tests relating to assets, income and ownership. However, we had elected to treat NFI Holding Corporation and its subsidiaries as taxable REIT subsidiaries (collectively the “TRS”). In general, the TRS could hold assets that the REIT could not hold directly and generally could engage in any real estate or non-real estate related business. The subsidiaries comprising the TRS were subject to corporate federal and state income tax and were taxed as regular C corporations.

During 2007, we were unable to satisfy the REIT distribution requirement for the tax year ended December 31, 2006 either in the form of cash or preferred stock. This action resulted in our loss of REIT status retroactive to January 1, 2006. Our failure to satisfy the REIT distribution test resulted from demands on our liquidity and the substantial decline in our market capitalization during 2007.

As a result of our termination of REIT status, we elected to file a consolidated federal income tax return with our eligible affiliated members. We reported taxable income in 2006 of approximately $212 million, which resulted in a tax liability of approximately $74 million along with interest and penalties due of approximately $5.8 million. After applying the payments and credits, we reported an amount owed to the IRS of approximately $67 million. We applied for and received an extension of time to pay the income taxes due to our expectation of generating a net operating loss for 2007, which may be carried back to 2006. This approved extension should allow us to reduce all of our taxable income (excluding excess inclusion income) from 2006, and eliminate the outstanding tax liability due to the IRS. However, we will be required to pay interest and any penalties that apply on the balance due to the IRS in 2008.

Because we terminated our REIT status effective January 1, 2006 and were taxable as a C corporation for 2006 and beyond, we recorded deferred taxes based on the estimated cumulative temporary differences as of December 31, 2007.

In determining the amount of deferred tax assets to recognize in the financial statements, we evaluate the likelihood of realizing such benefits in future periods. Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standard No. 109 “Accounting for Income Taxes” (“SFAS 109”) requires the recognition of a valuation allowance if it is more likely than not that all or some portion of the deferred tax asset will not be realized. SFAS 109 indicates the more likely than not threshold is a level of likelihood that is more than 50 percent.

Based on the evidence available as of December 31, 2007, including the significant pre-tax losses incurred by us in both the current quarter and previous quarters, the ongoing disruption to the credit markets, the liquidity issues facing us and our decision to close all of our mortgage lending operations, we concluded that it is more likely than not that our entire net deferred tax asset will not be realized. Based on these conclusions, we recorded a valuation allowance of $368.3 million for deferred tax assets as of December 31, 2007 compared to $0.7 million as of December 31, 2006. In future periods, we will continue to monitor all factors that impact positive and negative evidence relating to our deferred tax assets.

As of December 31, 2007, we had a federal net operating loss of approximately $368.4 million. We are expecting to carryback $196.1 million of the 2007 projected federal net operating loss against our 2006 taxable income and have recorded a current receivable for such benefit. The receivable was netted against the 2006 federal liability. The remaining $172.3 federal net operating loss may be carried forward to offset future taxable income, subject to provisions of the Code, including substantial limitations that would be imposed in the event of an “ownership change” as defined by Section 382 of the Code. If not used, this net operating loss will begin to expire in 2025.

The IRS is currently examining the 2005 federal income tax return of NFI Holding Corporation, a wholly-owned subsidiary. We are not aware of any significant findings as a result of this exam, however, the exam is still ongoing. Management believes it has adequately provided for potential tax liabilities that may be assessed for years in which the statute of limitations remains open. However, the assessment of any material liability would adversely affect our financial condition, liquidity and ability to continue as a going concern.

Personnel

As of December 31, 2007, we employed 247 people. Because of further reductions in workforce subsequent to December 31, 2007, we employ approximately 53 people as of March 27, 2008. None of our employees are represented by a union or covered by a collective bargaining agreement.

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

816.237.7424

Email: ir@novastar1.com

Item 1A.Risk Factors

Risk Factors

You should carefully consider the risks described below in evaluating our business and before investing in our publicly traded securities. Any of the risks we describe below or elsewhere in this report could negatively affect our results of operations, financial condition, liquidity, business prospects and ability to continue as a going concern. The risks described below are not the only ones facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial may also materially adversely affect our results of operations, financial condition, liquidity, business prospects and ability to continue as a going concern. 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.

Risks Related to Recent Changes in Our Business

The subprime loan market has largely ceased to operate, which has adversely affected our business and may adversely affect our ability to continue as a going concern.

Due to a number of market factors, including increased delinquencies and defaults on residential mortgage loans, investor concerns over asset quality, a weakening of the United States housing market and the failure of certain subprime mortgage companies and hedge funds that have invested in subprime loans, there has been extreme uncertainty and disruption in the subprime mortgage industry as a whole. As a result, our business has been materially and adversely affected in a number of ways. Due to the fact that the

secondary market for mortgage loans has effectively been unavailable to us since the middle of 2007, we have discontinued our mortgage lending business and have sold, at a loss, most of the loans that we originated during 2007 and had not previously securitized. Further, we have sold our mortgage servicing assets to generate cash to repay existing indebtedness and to reduce cash requirements. We have also terminated a substantial portion of our workforce. All of these events have had a material adverse effect on our business and have forced us to change business strategies. Our business now is focused solely on managing our portfolio of mortgage securities. If the subprime market fails to significantly improve, our results of operations, financial condition, liquidity, and business prospects will be further adversely affected and there can be no assurance that we will be able to continue as a going concern. Further, because of state licensing requirements, we are unlikely to be able, ourselves, to recommence mortgage lending activities so long as we continue to have a shareholders’ deficit. As a result of this and other factors, in the event that the subprime market recovers, there can be no assurance that we will be able to operate in the manner or at the levels that we have historically.

Payments on our mortgage securities are currently our only source of cash flows and will decrease in the next several months. Absent the reestablishment of profitable operations and reduction of our expenses from discontinued operations and other obligations, our cash flows will not be sufficient for us to continue as a going concern.

Our residual and subordinated mortgage securities are currently our only source of cash flows. Based on the current projections, the cash flows from our mortgage securities will decrease in the next several months as the underlying mortgage loans are repaid, and could be significantly less than the current projections if losses on the underlying mortgage loans exceed the current assumptions. In addition, we have significant operating expenses associated with office leases, software contracts, and other obligations relating to our discontinued operations, as well as payment obligations with respect to secured and unsecured debt, including periodic interest payments with respect to junior subordinated debentures relating to the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II. We intend to use available cash inflows in excess of our immediate operating needs, including debt service payments, to repay all of Wachovia’s short-term borrowings and any remaining fees due under the repurchase agreements at the earliest practical date. Any new advances under our financing facilities are at Wachovia’s sole discretion and we do not expect any such advances to be made. If, as the cash flows from mortgage securities decrease, we are unable to recommence or invest in mortgage loan origination or brokerage business on a profitable basis, and restructure our unsecured debt and contractual obligations or if the cash flows from our mortgage securities are less than currently anticipated, there can be no assurance that we will be able to continue as a going concern and avoid seeking the protection of applicable federal and state bankruptcy laws.

To the extent that the mortgage loans underlying our residual and subordinated securities continue to experience significant credit losses, our liquidity and ability to continue as a going concern will be adversely affected.

Our mortgage securities consist of certain residual securities retained from our past securitizations of mortgage loans, which typically consist of interest-only, prepayment penalty, and over collateralization bonds, and certain investment grade and non-investment grade rated subordinated mortgage securities retained from our past securitizations and purchased from other ABS issuers. These residual and subordinated securities are generally unrated or rated below investment grade and, as such, involve significant investment risk that exceeds the aggregate risk of the full pool of securitized loans. By holding the residual and subordinated securities, we generally retain the “first loss” risk associated with the underlying pool of mortgage loans. As a result, losses on the underlying mortgage loans directly affect our returns on, and cash flows from, these mortgage securities. In addition, if delinquencies and/or losses on the underlying mortgage loans exceed specified levels, the level of over-collateralization required for higher rated securities held by third parties may be increased, further decreasing cash flows presently payable to us.

Increased delinquencies and defaults on the mortgage loans underlying our residual and subordinated mortgage securities have resulted in a decrease in the cash flow we receive from these investments. To the extent we continue to experience significant realized losses and decreased cash flows from these assets, our results of operations, financial condition, liquidity, and ability to continue as a going concern will be adversely affected. In addition, because we have financed our mortgage securities under short-term warehouse repurchase agreements, continued decreases in the value of these retained securities may result in additional margin calls, which will further undermine our liquidity and ability to continue as a going concern.

There can be no assurance that we will have access to financing necessary to support our business and assets. Further, if we are unable to remain in compliance with agreements governing our indebtedness or to obtain waivers of any noncompliance, we will not be able to continue as a going concern.

We have incurred significant debt to finance our past operations, including the origination and purchase of mortgage loans and the purchase of mortgage securities. A significant amount of our indebtedness is represented by multiple secured financing facilities with Wachovia and the junior subordinated debentures related to the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II.

We currently intend to use available cash inflows in excess of our immediate operating needs, including debt service payments, to repay all of Wachovia’s outstanding borrowings and any remaining fees due under the repurchase agreements at the earliest practical date. During and after this period of repayment, any new advances under the Wachovia lending facilities are at Wachovia’s sole discretion and we do not expect any such advances to be made.

As of December 31, 2007 and thereafter, we are out of compliance with the net worth and liquidity covenants in our financing agreements with Wachovia. While Wachovia has waived this non compliance through April 30, 2008, there can be no assurance that we will be able to obtain further waivers of, or amendments to, our financing facilities if we were to breach any representation, warranty or covenant contained in such financing facilities or waiver or amendment. In addition, we project that we will be out of compliance with our current waiver prior to its expiration of April 30, 2008. Any default under our secured financing facilities and failure to obtain any necessary waivers or amendments in the future could result in the acceleration of the indebtedness under these facilities and the liquidation by the lender of the related collateral. Any acceleration of indebtedness would have a material adverse affect on our liquidity and ability to continue as a going concern and any liquidation of our collateral could be at a substantial loss.

Our wholly owned subsidiary NovaStar Mortgage, Inc. has outstanding junior subordinated debentures related to the outstanding trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II. We have guaranteed NovaStar Mortgage’s obligations under these debentures, including NovaStar Mortgage’s obligations to make periodic interest payments thereon. Our financing facilities with Wachovia prohibit us from making any such payments without Wachovia’s consent in the event that we have less than $30 million of available liquidity. In the event that any such payments are not made when due, whether as a result of the restrictions in our financing agreements with Wachovia or otherwise, or we or NovaStar Mortgage otherwise breach any of our obligations relating to the debentures or trust preferred securities and fail to remedy the default within the applicable cure period, if any, all of our obligations with respect thereto, including the repayment of principal, may be accelerated and declared to be immediately due and payable, in which case we would be forced to seek the protection of applicable federal and state bankruptcy laws.

In light of current market conditions, our current financial condition, and our lack of significant unencumbered assets, no assurance can be given regarding our ability to meet our debt service obligations or to secure additional financing. To the extent we are unable to meet our debt service obligations or do not have access to adequate financing, our business prospects and ability to continue as a going concern will be negatively affected. There is no assurance that we will continue to have access to financing at levels necessary for operations or other liquidity needs or that we will not be forced to file for bankruptcy.

Various legal proceedings could adversely affect our financial condition, our results of operations, liquidity and our ability to continue as a going concern.

In the course of our business, we are subject to various legal proceedings and claims. See Part I “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, liquidity, financial condition and ability to continue as a going concern.

The Securities and Exchange Commission (the “Commission”) has requested information from issuers in our industry, including us, regarding accounting for mortgage loans and other mortgage related assets. In addition, we have received requests or subpoenas for information relating to our operations from various federal and state regulators and law enforcement, including, without limitation, the Federal Trade Commission, the Department of Housing and Urban Development, the United States Department of Justice, the Federal Bureau of Investigation, the New York Attorney General and the Department of Labor. While we have provided, or are in the process of providing, the requested information to the applicable officials, we may be subject to further information requests from, or action by, these or other regulators or law enforcement officials. To the extent we are subject to any actions, our financial condition, liquidity, and ability to continue a going concern could be materially adversely affected.

There can be no assurance that our common stock or Series C Preferred Stock will continue to be traded in an active market.

Our common stock and our 8.90% Series C Preferred Stock were delisted by the New York Stock Exchange (“NYSE”) in January 2008, as a result of failure to meet applicable standards for continued listing on the NYSE. Our common stock and Series C Preferred Stock are currently quoted on the OTC Bulletin Board and on the Pink Sheets. However, there can be no assurance that an active trading market will be maintained. Trading of securities on the OTC and Pink Sheets is generally limited and is effected on a less regular basis than on exchanges, such as the NYSE, and accordingly investors who own or purchase our stock will find that the

liquidity or transferability of the stock may be limited. Additionally, a shareholder may find it more difficult to dispose of, or obtain accurate quotations as to the market value of, our stock. If an active public trading market cannot be sustained, the trading price of our common and preferred stock could be adversely affected and your ability to transfer your shares of our common and preferred stock may be limited.

We are not likely to pay dividends to our common or preferred stockholders in the near future.

We are not required to pay out our taxable income in the form of dividends, as we are no longer subject to a REIT distribution requirement. Instead, payment of dividends is at the discretion of our board of directors. To preserve liquidity and to remain in compliance with our financing facilities, our board of directors has suspended dividend payments on our Series C and Series D-1 Preferred Stock. Dividends on our Series C and D-1 Preferred Stock continue to accrue and the dividend rate on our Series D-1 Preferred Stock increased from 9.0% to 13.0%, compounded quarterly, effective January 16, 2008 with respect to all unpaid dividends and subsequently accruing dividends. No dividends can be paid on any of our common stock until all accrued and unpaid dividends on our Series C and Series D-1 Preferred Stock are paid in full. Accumulating dividends with respect to our preferred stock will negatively affect the ability of our common stockholders to receive any distribution or other value upon liquidation.

Risks Related to Mortgage Asset Financing, Sale, and Investment Activities

We may be required to repurchase mortgage loans or indemnify mortgage loan purchasers as a result of breaches of representations and warranties, borrower fraud, or certain borrower defaults, which could further harm our liquidity and ability to continue as a going concern.

When we sold mortgage loans, whether as whole loans or pursuant to a securitization, we made customary representations and warranties to the purchaser about the mortgage loans and the manner in which they were originated. Our whole loan sale agreements require us to repurchase or substitute mortgage loans in the event we breach any of these representations or warranties. In addition, we may be required to repurchase mortgage loans as a result of borrower fraud. Likewise, we are required to repurchase or substitute mortgage loans if we breach a representation or warranty in connection with our securitizations. If a purchaser enforces its remedies against us, we may not be able to recover losses from the originating broker or correspondent. Repurchased loans are typically sold at a significant discount to the unpaid principal balance and, prior to sale, cannot currently be financed by us. As a result, significant repurchase activity would further harm our liquidity, cash flow, and financial condition.

During 2007, we received an increased number of repurchase and indemnity demands from purchasers of whole loans as a result of, among other things, borrower fraud, which had a negative impact on our liquidity and results of operations. In the event that we experience further repurchase and indemnity demands, our liquidity, cash flow, and financial condition will be further harmed.

Differences in our actual experience compared to the assumptions that we use to determine the value of our residual mortgage securities and to estimate reserves could further adversely affect our financial position.

Our securitizations of mortgage loans that were structured as sales for financial reporting purposes resulted in gain recognition at closing as well as the recording of the residual mortgage securities we retained at fair value. The value of residual securities represents the present value of future cash flows expected to be received by us from the excess cash flows created in the securitization transaction. In general, future cash flows are estimated by taking the coupon rate of the loans underlying the transaction less the interest rate paid to the investors, less contractually specified servicing and trustee fees, and after giving effect to estimated prepayments and credit losses. We estimate future cash flows from these securities and value them utilizing assumptions based in part on projected discount rates, delinquency, mortgage loan prepayment speeds and credit losses. It is extremely difficult to validate the assumptions we use in valuing our residual interests. Even if the general accuracy of the valuation model is validated, valuations are highly dependent upon the reasonableness of our assumptions and the predictability of the relationships which drive the results of the model. Due to deteriorating market conditions, our actual experience has differed significantly from our assumptions, resulting in a reduction in the fair value of these securities and impairments on these securities. If our actual experience continues to differ materially from the assumptions that we used to determine the fair value of these securities, our financial condition, results of operations and ability to continue as a going concern will continue to be negatively affected.

Risks Related to Interest Rates and Our Hedging Strategies

Changes in interest rates may harm our results of operations and equity value.

Our results of operations are likely to be harmed during any period of unexpected or rapid changes in interest rates. Our primary interest rate exposures relate to our mortgage securities, mortgage loans, floating rate debt obligations, interest rate swaps, and interest rate caps. Interest rate changes could adversely affect our cash flow, results of operations, financial condition, liquidity, business prospects, and ability to continue as a going concern in the following ways:

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

the value of our residual and subordinated securities and the income we receive from them are based primarily on LIBOR, and an increase in LIBOR increases our funding costs which reduces the cash flow we receive from, and the value of, these securities;

existing borrowers with adjustable-rate mortgages or higher risk loan products may incur higher monthly payments as the interest rate increases, and consequently may experience higher delinquency and default rates, resulting in decreased cash flows from, and decreased value of, our mortgage securities; and

mortgage prepayment rates vary depending on such factors as mortgage interest rates and market conditions, and changes in prepayment rates may harm our earnings and the value of our mortgage securities.

In addition, interest rate changes may also further impact our net book value as our mortgage securities and related hedge derivatives are marked to market each quarter. Generally, as interest rates increase, the value of our mortgage securities decreases which decreases the book value of our equity.

Furthermore, shifts in the yield curve, which represents the market’s expectations of future interest rates, also affects the yield required for the purchase of our mortgage securities and therefore their value. To the extent that there is an unexpected change in the yield curve it could have an adverse effect on our mortgage securities portfolio and our financial position and operations.

Risks Related to Credit Losses

Further delinquencies and losses with respect to residential mortgage loans, particularly in the sub-prime sector, may cause us to recognize additional losses, which would further adversely affect our operating results, liquidity, financial condition, business prospects and ability to continue as a going concern.

The residential mortgage market has encountered difficulties which have adversely affected our performance. Delinquencies and losses with respect to residential mortgage loans generally have increased and may continue to increase, particularly in the sub-prime sector. In addition, in recent months residential property values in most states have declined, in some areas severely, after extended periods during which those values appreciated. A sustained decline or a lack of increase in those values is likely to result in additional increases in delinquencies and losses on residential mortgage loans generally, especially with respect to any residential mortgage loans where the aggregate loan amounts (including any subordinate loans) are close to or greater than the related property values. Another factor that may have contributed to, and may in the future result in, higher delinquency rates is the increase in monthly payments on adjustable rate mortgage loans. Any increase in prevailing market interest rates may result in increased payments for borrowers who have adjustable rate mortgage loans. Moreover, with respect to option ARM mortgage loans with a negative amortization feature which reach their negative amortization cap, borrowers may experience a substantial increase in their monthly payment even without an increase in prevailing market interest rates. Compounding this issue, the current lack of appreciation in residential property values and the adoption of tighter underwriting standards throughout the sub-prime mortgage loan industry may adversely affect the ability of borrowers to refinance these loans and avoid default, particularly borrowers facing a reset of the monthly payment to a higher amount. To the extent that delinquencies or losses continue to increase for these or other reasons, the value of our mortgage securities and the mortgage loans held in our portfolio will be further reduced, which will adversely affect our operating results, liquidity, cash flow, financial condition, business prospects and ability to continue as a going concern.

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

Nonconforming mortgage borrowers 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 higher risk of delinquency and foreclosure than mortgage loans made to borrowers with better credit and, therefore, will result in higher levels of realized losses than conventional loans.

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 and costs of sale. In the event of a borrower’s bankruptcy, that borrower’s mortgage loan will be deemed to be secured only to the extent of the value of the underlying collateral at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the mortgage loan may in some circumstances be subject to the avoidance powers of the bankruptcy trustee under applicable state law. Foreclosure of a mortgage loan can be an expensive and lengthy process that can have a substantial negative effect on our originally anticipated return on the foreclosed mortgage loan. Also, our cost of financing a delinquent or defaulted loan is higher than for a performing loan, and loans that are delinquent or in default may be unmarketable or saleable only at a discount.

We have experienced an increase in borrower delinquencies and defaults, which has adversely affected our liquidity, cash flows, results of operations and financial condition. Nearly all of our remaining loans held for sale are delinquent or are in default. In addition, we continue to be exposed to delinquencies and losses with respect to loans that we have securitized, either through residual securities that we retain in securitizations structured as sales, or through the loans that remain on our balance sheet in securitizations structured as financings.

To the extent that loan delinquencies and defaults continue at their current rates or become more severe, our results of operations, cash flows, liquidity, financial condition and ability to continue as a going concern may be further adversely affected.

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

In our origination and purchasing of mortgage loans, we relied 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 was fraudulently or negligently misrepresented to us, the value of the loan may be significantly lower than we expected. Whether a misrepresentation was 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, if sold prior to our detection of the misrepresentation, generally must be repurchased by us. We may not be able to recover losses incurred as a result of the misrepresentation.

As with the broader nonconforming mortgage loan industry, we have experienced an increase in exposure due to fraud, which has resulted in an increase in our repurchase and indemnity obligations and has adversely affected our cash flow, liquidity, results of operations and financial condition. In the event that we experience further repurchase and indemnity demands, our liquidity, cash flow, financial condition and ability to continue as a going concern will be adversely affected.

The value of, and cash flows from, our mortgage securities may further decline due to factors beyond our control.

There are many factors that affect the value of, and cash flows from, our mortgage securities, many of which are beyond our control. For example, the value of the homes collateralizing residential loans may decline due to a variety of reasons beyond our control, such as weak economic conditions or natural disasters, and a borrower’s ability to repay a loan may be adversely affected by factors beyond our control, such as subsequent over-leveraging of the borrower, reductions in personal incomes, and increases in unemployment. Interest-only loans, negative amortization loans, adjustable-rate loans, reduced documentation 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. To the extent that these factors continue to negatively affect the value of, and cash flows from, our mortgage assets our operating results, liquidity, cash flows, financial condition and ability to continue as a going concern will be adversely affected.

Mortgage insurers may not pay claims resulting in increased credit losses.

We use mortgage insurance to mitigate our risk of credit losses. We 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, financial condition, liquidity and cash flows, and ability to continue as a going concern.

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

A substantial portion of our mortgage assets consist of single-family mortgage loans or mortgage securities evidencing interests in single-family mortgage loans. Because substantially all of our loans were made to credit-impaired borrowers, the actual rates of delinquencies, foreclosures and losses on these loans tend to be higher during economic slowdowns. We have experienced a significant increase in delinquencies and defaults, which has harmed and continues to harm our financial condition, results of operations, liquidity, cash flows and ability to continue as going concern. In addition, material declines in real estate values have weakened our collateral loan-to-value ratios, have increased the risk of default by decreasing the ability of borrowers to refinance loans they are unable to sustain or to sell the mortgage property to repay the loan, and have increased the possibility of loss if a borrower defaults. In such cases, we are subject to the risk of loss on such mortgage assets arising from borrower defaults to the extent not covered by third-party credit enhancement.

Geographic concentration of mortgage loans increases our exposure to risks in those areas.

Over-concentration in any one geographic area of our loans held for sale or underlying our mortgage securities increases our exposure to the economic risks associated with that area. Declines in the residential real estate markets in which we are concentrated, including California and Florida, have reduced the values of the properties collateralizing our mortgages which in turn has increased the risk of delinquency, foreclosure, or losses from those loans. In addition, increases in the unemployment rate in markets in which we are concentrated increases the likelihood that borrowers in those areas may become delinquent on their loans. To the extent that borrowers in a geographic area in which we have made a significant number of loans become delinquent or otherwise default on such loans, the value of, and cash flows from, our mortgage securities will further decrease which will adversely affect our operating results, liquidity, cash flows, financial condition and ability to continue as a going concern.

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 negatively affect the value of, and cash flows from, our mortgage assets, which will adversely affect our operating results, liquidity, cash flows, financial condition and ability to continue as a going concern.

As a result of our sale of our mortgage servicing rights, we no longer possess the ability to identify and address potential or actual delinquencies and defaults on the mortgage loans underlying our residual and subordinated securities.

We have traditionally utilized our role as servicer of our securitized pools of mortgage loans to attempt to identify and address potential and actual borrower delinquencies and defaults. On November 1, 2007, we sold to a third party our servicing rights with respect to our securitized loans. As a result, we no longer control the lender-borrower relationship, which may exacerbate the increase in delinquencies and defaults under such mortgage loans and the negative impact on the value and cash flows of our residual and subordinated securities resulting from such delinquencies and defaults.

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

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 prohibition 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 would negatively affect our liquidity, financial condition, results of operations and ability to continue as a going concern.

Failure to qualify for an exemption from regulation as an investment company could harm our business.

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 SEC’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. Mortgage-backed securities

that do not represent all the certificates issued with respect to an underlying pool of mortgages may be treated as securities separate from the underlying mortgage loans and thus may not qualify as a qualifying real estate interest for the purposes of the 55% requirement. If we 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, results of operations, liquidity, and ability to continue as a going concern.

Failure to comply with federal, state or local regulation of, or licensing requirements with respect to, our business could harm our financial condition and ability to recommence mortgage banking operations.

Our prior mortgage lending, brokerage and loan servicing operations were subject to an extensive body of federal, state and local laws and licensing requirements. Although we utilized systems and procedures designed to facilitate compliance, these requirements were voluminous and, in some cases, complex and subject to interpretation, and our compliance with these requirements depended on the actions of a large number of employees. Borrowers experiencing foreclosure and terminated employees may make retaliatory allegations of non-compliance. Investigations, enforcement actions, litigation, fines, penalties and liability with respect to non-compliance with these requirements may consume attention of key personnel, may adversely affect our ability to recommence mortgage lending, brokerage or servicing operations, and may materially and adversely affect our financial condition, results of operations, liquidity and ability to continue as a going concern.

Risks Related to Our Capital Stock

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

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

actual or perceived changes in our ability to continue as a going concern;

actual or anticipated changes in the delinquency and default rates on mortgage loans, in general, and specifically on the loans we invest in through our mortgage securities;

actual or anticipated changes in residential real estate values;

actual or anticipated changes in market interest rates;

actual or anticipated changes in our earnings and cash flow;

general market and economic conditions, including the operations and stock performance of our competitors;

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

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

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.

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 shareholder approval, to:

authorize the issuance of additional shares of common stock or preferred stock without shareholder 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 may access the capital markets to raise additional funds 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 capital 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 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.

Other Risks Related to our Business

You should exercise caution in reviewing our consolidated financial statements.

Our consolidated financial statements have been prepared on a going concern basis of accounting which contemplates continuity of operations, realization of assets, liabilities and commitments in the normal course of business. The financial statements do not reflect any adjustments that might result if we were unable to continue as a going concern. In light of these facts, you should exercise caution in reviewing our financial statements.

Our ability to use our net operating loss carryforwards and net unrealized built-in losses could be severely limited if transfer restrictions are not adopted or are not effective in preventing an ownership change from occurring.

We currently have recorded a net deferred tax asset, before valuation allowance, of $368.3 million, almost all of which relates to certain loss carryforwards and net unrealized built-in-losses. While we believe that it is more likely than not that we will not be able to utilize such losses in the future, the net operating loss carryforwards and net unrealized built-in losses could provide significant future tax savings to us if we are able to use such losses. However, our ability to use these tax benefits may be impacted, restricted or eliminated due to a future ownership change within the meaning of Section 382 of the Code. Pursuant to Section 382 of the Code, a corporation is limited in its ability to use existing net operating loss carryforwards and net unrealized built in losses once that corporation experiences an “ownership change” (as that term is defined in the Code and IRS regulations). We have imposed certain transfer restrictions on our Series D-1 Preferred Stock, and have also agreed to submit an amendment to our Charter to our shareholders for approval, to limit the transferability of our common stock in order to attempt to preserve certain of our net operating loss carryforwards and net unrealized built-in losses. Our shareholders may fail to approve this amendment. Further, although transfer restrictions are valid under the Maryland General Corporation Law, we are not aware of any published court decisions enforcing similar transfer restrictions. Thus, a transfer could occur that would violate the transfer restrictions, and we may be unable to enforce such transfer restrictions. Even if a court were to enforce the transfer restrictions, the Internal Revenue Service might not agree that the transfer restrictions provided a sufficient remedy with respect to an ownership change resulting from a prohibited transfer. Further, our Board of Directors has waived, and may in the future waive, application of the transfer restrictions to certain shareholders or transfers if determined to otherwise be in the interests of the Company. In any of these cases, despite the implementation of the transfer restrictions, an ownership change could occur that would severely limit our ability to use the tax benefits associated with the net operating loss carryforwards and net unrealized built-in losses, which may result in higher taxable income for us (and a significantly higher tax cost as compared to the situation where these tax benefits are preserved).

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 negatively affect our business. Additionally, we have access to the personal financial information of borrowers which is highly sensitive and confidential, and subject to significant federal and state regulation. If a third party were to misappropriate this information or if we inadvertently disclosed 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 or inadvertent disclosure 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.

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

The transfer restrictions applicable or proposed to be applicable to our capital stock are complex and are designed to preserve the value of our net operating loss carryforwards and net unrealized built-in losses for the benefit of our stockholders. The transfer restrictions may make it more difficult to acquire a significant interest in us or to effect a business combination transaction that stockholders may perceive to be favorable. The transfer restrictions could also make it more difficult for a stockholder to replace current management because a stockholder’s ability to increase its voting power is limited.

Certain additional 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 shareholders. 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.

Item 1B.Unresolved Staff Comments

None

Item 2.Properties

Our executive, administrative and portfolio management 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 $4.3 million.

We are leasing office space in various other states which were used for operations which were discontinued in 2007 and early 2008. The leases on these premises expire from January 2008 through May 2013, and the current annual rent on those premises not terminated as of March 31, 2008 is approximately $3.0 million.

Item 3.Legal Proceedings

American Interbanc Mortgage Litigation. On March 17, 2008, NovaStar Financial, Inc. (“NFI”), NovaStar Mortgage, Inc. (“NMI”), NFI Holding Corp. (“NFI Holding”) and NovaStar Home Mortgage, Inc. (“NHMI” and, with NFI, NMI and NFI Holding, the “NovaStar Entities”) and American Interbanc Mortgage, LLC (“Plaintiff”) entered into a Confidential Settlement Term Sheet Agreement (the “Settlement Terms”) with respect to the actions, judgments and claims described below.

In March 2002, Plaintiff filed an action against NHMI in Superior Court of Orange County, California entitled American Interbanc Mortgage LLC v. NovaStar Home Mortgage, Inc. et. al. (the “California Action”). In the California Action, Plaintiff alleged that NHMI and two other mortgage companies (“Defendants”) engaged in false advertising and unfair competition under certain California statutes and interfered intentionally with Plaintiff’s prospective economic relations. On May 4, 2007, a jury returned a verdict by a 9-3 vote awarding Plaintiff $15.9 million. The court trebled the award, made adjustments for amounts paid by settling Defendants, and entered a $46.1 million judgment against Defendants on June 27, 2007. The award is joint and several against the Defendants, including NHMI. It is unknown if the other two Defendants, one of which has filed a bankruptcy petition, have the financial ability to pay any of the award.

NHMI’s motion for the trial court to overturn or reduce the verdict was denied on August 20, 2007, and NHMI appealed that decision (the “Appeal”). Pending the Appeal, Plaintiff commenced enforcement actions in the states of Missouri (the “Kansas City Action”) and Delaware, and obtained an enforcement judgment in Delaware (the “Delaware Judgment”). On January 23, 2008, Plaintiff filed an involuntary petition for bankruptcy against NHMI under 11 U.S.C. Sec. 303, in the United States Bankruptcy Court for the Western District of Missouri (the “Involuntary”). Plaintiff was joined by two individuals alleging claims totaling $150 in the Involuntary filing. NHMI filed an answer and contested the standing of Plaintiff and the individuals to be petitioning creditors in bankruptcy.

On March 17, 2008, the NovaStar Entities and Plaintiff entered into the Settlement Terms with respect to the California Action, the Judgment, the Kansas City Action, the Delaware Judgment, the Involuntary, and all related claims.

Under the Settlement Terms, the parties agreed to move to dismiss the Involuntary. Within ten (10) business days after notice of entry of the dismissal of the Involuntary, NFI will pay Plaintiff $2,000,000 plus the balance in an account established by order of the Bankruptcy Court in an amount no less than $50,000 (but not anticipated to be greater than $65,000 at the time of payment), with NHMI obligated to otherwise satisfy obligations to its identified creditors up to $48,000. The parties also agreed to extend the Appeal briefing period pending finalization of the settlement of the other actions, judgments and claims, as described below.

The Settlement Terms provide that, subject to payment of the amounts described above and satisfaction of certain other conditions, the parties will dismiss the California Action as to NHMI and the Kansas City Action and Delaware Judgment, effect notice of satisfaction of the Judgment, and effect a mutual release of all claims that were or could have been raised in any of the foregoing or that are related to the subject matter thereof, upon the earliest of the following: (i) July 1, 2010, (ii) a waiver by Wachovia of Wachovia’s right to file an involuntary bankruptcy proceeding against any of the NovaStar Entities prior to July 1, 2010, (iii) an extension of the maturity date of our indebtedness to Wachovia until at least July 1, 2010, or (iv) delivery to Plaintiff of written documentation evidencing the full satisfaction of our current indebtedness to Wachovia.

In addition to the initial payments to be made to the Plaintiff following dismissal of the Involuntary, we will pay Plaintiff $5.5 million if, prior to July 1, 2010, (i) NFI’s average common stock market capitalization is at least $94.4 million over a period of five (5) consecutive business days, or (ii) the holders of NFI’s common stock are paid $94.4 million in net asset value as a result of any sale of NFI or its assets. If NFI is sold prior to July 1, 2010 for less than $94.4 million and ceases to be a public company, then NFI will obligate the purchaser either to immediately pay $2 million to Plaintiff, or to pay Plaintiff $5.5 million in the event the value of NFI exceeds $94.4 million prior to July 1, 2010 as determined by an independent valuation company.

We make no assurances with regard to our ability to satisfy of any of the conditions described or referenced above. Without limiting the foregoing, we have obtained no commitment from Wachovia with regard to any action that may be required of Wachovia in order to effect, prior to July 1, 2010, the dismissals and releases described above. Further, nothing in the Settlement Terms constitutes an expression of our belief, projection, assumption, or intent regarding any future event, any industry or market conditions, or our financial condition, stock price, or business plans or strategies.

In accordance with generally accepted accounting principles, NHMI has recorded a liability of $47.1 million as of December 31, 2007 with a corresponding charge to earnings. The $47.1 million includes interest which is accruing on the obligation. Because NHMI is a wholly owned indirect subsidiary of NFI, the $47.1 million liability is included in our consolidated financial statements. The liability is included in the “Liabilities of discontinued operations” line of the consolidated balance sheets while the charge to earnings is included in the “(Loss) income from discontinued operations, net of income tax” line of the consolidated statements of operations.

Other Litigation. Since April 2004, a number of substantially similar class action lawsuits have been filed and consolidated into a single action in the United States District Court for the Western District of Missouri. The consolidated complaint names us and three of our executive officers as defendants 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. On February 8, 2007, the court certified the case as a class action. The case is now in the discovery stage. We believe that these claims are without merit and will continue to vigorously defend against them.

In April 2006, a single plaintiff filed a putative nationwide class action against NovaStar Mortgage in the United States District Court for the Western District of Tennessee. The complaint asserts claims under 42 U.S.C. Sections 1981 and 1982; the Fair Housing Act, 42 U.S.C. Sections 3601-3619; and the Equal Credit Opportunity Act, 15 U.S.C. Sections 1691-1691f. Plaintiff alleges that NovaStar Mortgage paid higher yield spread premiums to brokers for loans made to minorities as compared to loans made to white borrowers. The lawsuit seeks injunctive relief and damages, including punitive damages. We believe that these claims are without merit and will vigorously defend against them.

Since February 2007, a number of substantially similar putative class actions have been filed in the United States District Court for the Western District of Missouri. The complaints name us and three of our executive officers as defendants and generally allege, among other things, that the defendants made materially false and misleading statements regarding our business and financial results. The plaintiffs purport to have brought the actions on behalf of all persons who purchased or otherwise acquired our common stock during the period May 4, 2006 through February 20, 2007. Following consolidation of the actions, a consolidated amended complaint was filed on October 19, 2007. On December 29, 2007, the defendants moved to dismiss all of plaintiffs’ claims, and that motion is pending. We believe that these claims are without merit and will vigorously defend against them.

In May 2007, a lawsuit entitledNational Community Reinvestment Coalition v. NovaStar Financial, Inc., et al., was filed against us in the United States District Court for the District of Columbia. Plaintiff, a non-profit organization, alleges that we maintain corporate policies of not making loans on Indian reservations, or dwellings used for adult foster care or on rowhouses in Baltimore, Maryland

that violates the federal Fair Housing Act. The lawsuit seeks injunctive relief and damages, including punitive damages, in connection with the lawsuit. On May 30, 2007, we responded to the lawsuit by filing a motion to dismiss certain of plaintiff’s claims. That motion is pending resolution by the court. We believe that these claims are without merit and will vigorously defend against them.

In June 2007, two borrowers filed a putative class action entitledKubiak v. NovaStar Mortgage, Inc., against us and two of our subsidiaries in the United States District Court for the Northern District of California, alleging that payments of premiums to brokers by one of the subsidiaries were not properly disclosed to borrowers in the manner allegedly required by federal or state law, thus constituting unfair competition and false advertising under California law and violation of the California Consumer Legal Remedies Act. Plaintiffs seek statutory and punitive damages, restitution, injunctive relief and attorney’s fees on behalf of California borrowers who allegedly failed to receive adequate disclosure of such premiums. The defendants filed a motion to dismiss the action. On December 19, 2007, the Court granted defendants’ motion to dismiss the complaint, including the claims against NovaStar Financial, Inc., but the Court allowed the plaintiffs to file an amended complaint. On January 9, 2008, the plaintiffs filed an amended complaint that does not make any claim against NovaStar Financial, Inc., but does assert the above claims against its subsidiaries, NovaStar Mortgage, Inc. and NovaStar Home Mortgage, Inc. We believe that these claims are without merit and will vigorously defend against them.

In November 2007, a borrower filed a putative class action, entitledDenman v. Novastar Mortgage, Inc., in the United States District Court for the District of Massachusetts alleging that NovaStar Mortgage induced him to enter into a disadvantageous mortgage with an adjustable rate and a balloon note. Plaintiff contends that NovaStar Mortgage’s actions violated the Massachusetts Consumer Protection Act and seeks actual and statutory damages, reformation of his mortgage contract and injunctive and declaratory relief. On March 6, 2008, NovaStar Mortgage filed a motion to dismiss the litigation. That motion is pending. We believe that these claims are without merit and will vigorously defend against them.

On January 10, 2008, the City of Cleveland, Ohio filed suit against us and approximately 20 other mortgage, commercial and investment bankers alleging a public nuisance had been created in the City of Cleveland by the operation of the subprime mortgage industry. The case was filed in state court and promptly removed to the United States District Court for the Northern District of Ohio. The plaintiff seeks damages for loss of property values in the City, and for increased costs of providing services and infrastructure, as a result of foreclosures of subprime mortgages. We believe that these claims are without merit and will vigorously defend against them.

On January 31, 2008, two purported shareholders filed separate derivative actions in the Circuit Court of Jackson County, Missouri against various former and current officers and directors and named us as a nominal defendant. The essentially identical petitions allege that the individual defendants breached fiduciary duties owed to us in connection with alleged insider selling and misappropriation of information, abuse of control, gross mismanagement, waste of corporate assets, and unjust enrichment between May 2006 and December 2007. We believe that these claims are without merit and will 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, federal and state laws prohibiting discrimination in lending and federal and state licensing and consumer protection laws.

In addition, we have received requests or subpoenas for information from various Federal and State regulators or law enforcement officials, including, without limitation, the Federal Trade Commission, the Securities & Exchange Commission, the United State Department of Justice, the Federal Bureau of Investigation, the New York Attorney General and the Department of Labor.

While management currently believes that the ultimate outcome of all these proceedings and claims will not have a material adverse effect on our financial condition, litigation is subject to inherent uncertainties and our ability to withstand an unfavorable ruling has greatly diminished. If an unfavorable ruling were to occur in any one of them, there exists the possibility of a material adverse impact on our financial condition, results of operations and cash flows and our ability to avoid bankruptcy would be materially and adversely affected.

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

None

PART II

Item 5.Market for Registrant’s Common Equity, 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 was traded on the NYSE under the symbol “NFI” through December 31, 2007. Our common stock has subsequently been delisted from the NYSE in 2008 and is currently quoted on the OTC Bulletin Board and on the Pink Sheets under the symbol “NOVS”. 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 Financial, Inc.common stock on the NYSE and the notes thereto included elsewherecash dividends paid or payable per share of common stock. The Board of Directors declared a one-for-four reverse stock split of its common stock, providing shareholders of record as of July 27, 2007, with one share of common stock for each four shares owned. The reduction in this report.shares resulting from the split was effective on July 27, 2007 decreasing the number of common shares outstanding to 9.5 million. Prior year share amounts and earnings per share disclosures have been restated to reflect the reverse stock split.

 

   High

  Low

  Dividends

      Date Declared

  Date Paid

  Amount Per
Share


2006

                  

First Quarter

  $135.20  $102.80  5/4/06  5/26/06  $5.60

Second Quarter

   150.52   116.32  8/3/06  8/28/06   5.60

Third Quarter

   142.40   113.00  9/11/06  11/30/06   5.60

Fourth Quarter

   131.24   105.28  9/11/06  12/29/06   5.60

2007

                  

First Quarter

  $105.80   13.72  N/A  N/A   N/A

Second Quarter

   40.00   19.56  N/A  N/A   N/A

Third Quarter

   34.68   5.10  N/A  N/A   N/A

Fourth Quarter

   9.32   1.16  N/A  N/A   N/A

As of March 12, 2008, we had approximately 1,010 shareholders of record of our common stock, including holders who are nominees for an undetermined number of beneficial owners based upon a review of the securities position listing provided by our transfer agent.

Dividend distributions will be made at the discretion of the Board of Directors and will depend on earnings, financial condition, cost of equity, investment opportunities and other factors as the Board of Directors may deem relevant. In addition, accrued and unpaid dividends on our preferred stock must be paid prior to the declaration of any dividends on our common stock. We do not expect to declare any stock dividend distributions for the near future. See “Industry Overview and Known Material Trends and Uncertainties” for further discussion regarding future uncertainties.

Purchase of Equity Securities by the Issuer

Safe Harbor Statement

 

“Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995: Statements in this discussionreport 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 report may constitute forward-looking statements within the meaning of Section 21E of the federal securities lawsSecurities Exchange Act of 1934, as amended. Forward looking statements are those that inherentlypredict or describe future events and that do not relate solely to historical matters and include certain risksstatements regarding management’s beliefs, estimates, projections, and uncertainties.assumptions with respect to, among other things, our future operations, business plans and strategies, as well as industry and market conditions, all of which are subject to change at any time without notice. Words such as “believe,” “expect,” “anticipate,” “promise,” “plan,” and other expressions or words of similar meanings, as well as future or conditional verbs such as “will,” “would,” “should,” “could,” or “may” are generally intended to identify forward-looking statements. Actual results and the time of certain eventsoperations for any future period may vary materially from those discussed herein. Some important factors that could cause actual results to differ materially from those projectedanticipated include: our ability to manage our business during this difficult period for the subprime industry; our ability to continue as a going concern; decreases in or contemplated bycash flows from our mortgage securities; our ability to reduce expenses from our discontinued operations; increases in the forward-looking statements due to a number of factors, including general economic conditions, fluctuations in interest rates, fluctuations in prepayment speeds, fluctuations incredit losses due to defaults on mortgage loans the availability of nonconforming residentialunderlying our mortgage securities and our mortgage loans – held in portfolio; our ability to repay Wachovia in a manner and time period acceptable to Wachovia; our ability to remain in compliance with the availabilityagreements governing our indebtedness; impairments on our mortgage assets; increases in prepayment or default rates on our mortgage assets; increases in margin calls and accessloan repurchase requests; changes in assumptions regarding estimated loan losses and fair value amounts; our ability to financingmaintain effective internal control over financial reporting and disclosure controls and procedures in the future; events impacting the subprime mortgage industry in general, including events impacting our competitors and liquidity resources,available to the industry; residential property values; interest rate fluctuations on our assets that differ from our liabilities; the outcome of litigation or regulatory actions pending against us or other legal contingencies; our compliance with applicable local, state and other risk factors previously outlinedfederal laws and regulations; our ability to adapt to and implement technological changes; compliance with new accounting pronouncements; the impact of general economic conditions; and the risks that are from time to time included in our filings with the Securities and Exchange Commission (“SEC”), including this annual report on Form 10-K for the fiscal year ended December 31, 2004.10-K. Other factors not presently identified may also cause actual results to differ. Management continuously updatesThis report on Form 10-K speaks only as of its date and revises these estimates and assumptions based on actual conditions experienced. It is not practicablewe expressly disclaim any duty to publish all revisions and,update the information herein except as a result, no one should assume that results projected in or contemplatedrequired by the forward-looking statements will continue to be accurate in the future.federal securities laws.

 

Overview of PerformanceItem 1. Business

 

During 2004,We are a Maryland corporation formed on September 13, 1996 which operates solely as a non-conforming residential mortgage portfolio manager. Prior to significant changes in our business during 2007 and the first quarter of 2008, we reported income from continuing operations available to common shareholders of $113.2 million, or $4.40 per diluted share, as compared to $112.0 million, or $4.91 per diluted shareoriginated, purchased, securitized, sold, invested in 2003.and serviced residential nonconforming mortgage loans and mortgage backed securities. We also reported a loss from discontinued operations, net of income tax, of $4.1 million, or $0.16 per diluted share in 2004. See further discussion of discontinued operations under the heading “Results of Operations.”

Our income from continuing operations available to common shareholders was driven largely by the income generated byretained, through our mortgage securities investment portfolio, which increased from $382.3 million as of December 31, 2003 to $489.2 million as of December 31, 2004. These securities are retained from securitizations ofsignificant interests in the mortgage loans we originate and purchase. We securitized $8.3 billion of mortgage loans in 2004 as compared to $5.3 billion in 2003. The increased volume of mortgage loans we securitized is directly attributable to the increase in our loan origination and purchase volume. During 2004 and 2003, we originated and purchased $8.4 billion and $5.3 billion, respectively, in nonconforming residential mortgage loans. We increased our loan production through adding sales personnel primarily in new and underserved markets. Although we securitized approximately $3.0 billion more of nonconforming, residential mortgage loans in 2004 as compared to 2003, our income from continuing operations available to common shareholders increased only slightly by $1.2 million as a result of the decline in profit margins in our mortgage lending (banking) segment and the impairments on our mortgage securities available-for-sale within our mortgage portfolio segment.

Our profit margins within the mortgage lending (banking) segment were down as a result of the significant increase in short-term rates while the coupons on the mortgage loans we originated and purchased, increased only slightly from 2003. One-month LIBORand through our servicing platform, serviced all of the loans in which we retained interests. During 2007 and early 2008, we discontinued our mortgage lending operations and sold our mortgage servicing rights which subsequently resulted in the abandonment of our servicing operations. See “Executive Overview of Performance” and “Known Material Trends, Significant Events and Uncertainties” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion of the severely disrupted mortgage industry and credit markets and the two-year swap rate increased from 1.12% and 2.15%, respectively, at December 31, 2003changes we made to 2.40% and 3.45%, respectively, at December 31, 2004 while the weighted average coupon on our nonconforming originations and purchases in 2004 was 7.6% as comparedoperations to 7.3% in 2003. These factors contributedmanage through those changes.

We currently intend to the whole loan price used in valuingmanage only our mortgage securitiesportfolio management segment. In the event we are able to significantly decreaseincrease our liquidity position (as to which no assurance can be given), we may use excess cash to make certain investments if we determine that such investments could provide attractive risk-adjusted returns to shareholders, including, potentially investing in 2004, whichnew or existing operating companies. Because of certain state licensing requirements, it is unlikely we are able, ourselves, to directly correlatedrecommence mortgage lending activities so long as we continue to have a shareholders’ deficit. Segment information for the decrease in gains on sales of mortgage loans as a percentage of the collateral securitized. For thethree years ended December 31, 20042007 is included in Note 16 to our consolidated financial statements.

Historically, we had elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Code”). During 2007, we announced that we would not be able to pay a dividend on our common stock with respect to our 2006 taxable income, and 2003, the weighted average net whole loan price usedas a result, our status as a REIT terminated retroactive to January 1, 2006. This retroactive revocation of our REIT status resulted in us becoming taxable as a C corporation for 2006 and subsequent years.

Our consolidated financial statements have been prepared on a going concern basis of accounting which contemplates continuity of operations, realization of assets, liabilities and commitments in the initial valuationnormal course of business. There are substantial doubts that we will be able to continue as a going concern and, therefore, may be unable to realize our assets and discharge our liabilities in the normal course of business. The financial statements do not reflect any adjustments relating to the recoverability and classification of recorded asset amounts or to the amounts and classification of liabilities that may be necessary should we be unable to continue as a going concern.

Mortgage Portfolio Management

The continued deterioration of the secondary market for subprime mortgage assets has altered the focus of our portfolio management business from that of seeking investment opportunities to that of only managing our current portfolio of mortgage securities and mortgage loans. Our portfolio of mortgage securities includes interest-only, prepayment penalty, and overcollateralization securities retained from our securitizations of nonconforming, single-family residential mortgage loans which we have accounted for as sales, under applicable accounting rules (collectively, the “residual securities”). Our portfolio of mortgage securities was 103.28also includes subordinated mortgage securities retained from our securitizations and 104.21, respectively,subordinated home equity loan asset-backed securities (“ABS”) purchased from other ABS issuers (collectively, the “subordinated securities”).

The long-term mortgage loan portfolio on our balance sheet consists of mortgage loans classified as held-in-portfolio resulting from securitization transactions treated as financings completed in the second quarter of 2006 and the weighted average gain on securitization as a percentagefirst quarter of the collateral securitized was 1.7%2007 (NHES Series 2006-1, NHES Series 2006-MTA1, and 2.6%, respectively.NHES Series 2007-1). We have financed our investment in these loans by issuing asset backed bonds (“ABB”).

 

We recognized impairments onOur mortgage portfolio management operations generate earnings primarily from the interest income generated from our mortgage securities available-for-saleand mortgage loan portfolios.

The credit performance and prepayment rates of $15.9 millionthe nonconforming loans underlying our securities, as well as the loans classified as held-in-portfolio, directly affects the profitability of this segment. In addition, short-term interest rates have a significant impact on this segment’s profitability.

In the event we are able to significantly increase our liquidity position (as to which no assurance can be given), we may use excess cash to make certain investments if we determine that such investments could provide attractive risk-adjusted returns to shareholders, including, potentially investing in 2004. new or existing operating companies.

Market in Which NovaStar Competes

The mortgage industry is dominated by large, sophisticated financial institutions. To compete effectively, we must have a very high level of operational, technological, and managerial expertise as well as access to capital at a competitive cost. As a result of reduced access to capital, general housing trends, rising delinquencies and defaults and other factors, many mortgage lenders have recently experienced severe financial difficulty, with some exiting the business or filing for bankruptcy protection. Primarily because of these factors, the industry continues its consolidation trend.

Risk Management

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

Interest Rate/Market

Liquidity

Credit

Prepayment

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 the market value of our assets, to the extent consistent with our liquidity needs.

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 historically has used financing sources under which the interest rate resets frequently. As of December 31, 2007, all borrowings under our financing arrangements adjust daily or monthly off LIBOR. 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 rates that are fixed for some period of time and then adjust frequently 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 weremay be incurred, as the asset rate resets would lag the borrowing rate resets.

Historically, we have transferred 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 significantsecuritized mortgage loans. We entered into these interest rate agreements as we originated and purchased mortgage loans in our mortgage lending segment. At the time of a securitization structured as a sale, we transferred interest rate agreements into the securitization trusts and they were removed from our balance sheet. The trust assumed the obligation to make payments and obtained 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 used either to cover interest shortfalls on the third-party primary bonds or to provide credit enhancement with any remaining funds then flowing to our residual securities. For securitizations structured as financings the derivatives remain on our balance sheet. Generally, these interest rate agreements do not meet the hedging criteria set forth in Generally Accepted Accounting Principles (“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. Occasionally, we enter into interest rate agreements that do meet the hedging criteria set forth in GAAP. In these instances, we record their change in value, if effective, directly to other comprehensive income on our statement of shareholder’s equity.

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 a majority of our short-term borrowings and asset-backed bonds (“ABB”) are adjustable rate; however, as noted above, rapid increases in short-term interest rates during 2004would negatively impact the interest-rate spread between our liabilities and assets and, consequently, our earnings.

Interest Rate Sensitivity - Market Value

(dollars in thousands)

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

 
   (200)

  (100)

  100

  200

 

As of December 31, 2007:

                 

Change in market values of:

                 

Assets – non trading (B)

  $42,484  $19,234  $(18,057) $(32,868)

Assets – trading (C)

   33,448   15,269   (14,210)  (26,053)
   


 


 


 


Cumulative change in market value

  $75,932  $34,503  $(32,267) $(58,921)
   


 


 


 


Percent change of market value portfolio equity (D)

   61.0%  24.6%  (17.5%)  (30.5%)
   


 


 


 


As of December 31, 2006:

                 

Change in market values of:

                 

Assets – non trading (B)

  $226,262  $105,038  $(78,698) $(150,481)

Assets – trading (C)

   9,999   7,080   (14,120)  (30,707)

Interest rate agreements

   (40,018)  (20,946)  23,998   49,264 
   


 


 


 


Cumulative change in market value

  $196,243  $91,172  $(68,820) $(131,924)
   


 


 


 


Percent change of market value portfolio equity (D)

   34.0%  15.8%  (11.9%)  (22.9%)
   


 


 


 



(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)Includes mortgage loans held-for-sale, mortgage loans held-in-portfolio and mortgage securities—available-for-sale for 2007 and 2006, and also includes mortgage servicing rights for 2006 as well.
(C)Consists of mortgage securities – trading.
(D)Total change in estimated market value as a percent of market value portfolio equity as of December 31, 2007 and December 31, 2006.

Hedging.We use derivative instruments, including interest rate swap and cap contracts, to mitigate the risk of our cost of funding increasing at a faster rate than the interest on assets. We adhere to an interest rate risk management program that is approved by our Board. This program is formulated with the intent to mitigate 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. However, our hedging strategy is subject to, and is currently limited by, considerations of cost and liquidity risk.

Interest rate cap and swap agreements are legal contracts between us and a third-party firm or “counterparty”. Under an interest rate cap agreement 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. Under interest rate swap agreements we 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 as wellof December 31, 2007, all of which are held by securitization trusts. All of our pay-fixed swap contracts and interest rate cap contracts are indexed to one-month LIBOR. During 2007, we terminated all of our derivative instruments not in securitization trusts. The cash impact was minimal to settle the terminations.

We have determined the following estimated net fair value amounts by using available market information and valuation methodologies we deem appropriate as higher than anticipated prepayments which resulted from substantial increasesof December 31, 2007.

Interest Rate Risk Management Contracts

(dollars in housing prices in recent years. The impairments were primarily relatedthousands)

   Net Fair
Value


  Total
Notional
Amount


  Maturity Range

    2007

  2008

  2009

  2010

  2011 and
beyond


Pay-fixed swaps:

                            

Contractual maturity

  $(9,441) $1,165,000  $720,000  $405,000  $40,000  $—    $—  

Weighted average pay rate

       4.9%  5.0%  4.9%  5.0%  —     —  

Weighted average receive rate

       4.6%  (A)  (A)  (A)  (A)  —  

Interest rate caps:

                            

Contractual maturity

  $85  $220,000  $180,000  $40,000  $—    $—    $—  

Weighted average strike rate

       5.0%  5.0%  5.0%  —     —     —  

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

Liquidity Risk.A significant risk to our 2004operations is the risk that we will not have enough cash and liquidity available to operate our business and meet our debt payment and other obligations. We currently face substantial liquidity risk and uncertainty, near-term and otherwise, which threatens our ability to continue as a going concern and avoid bankruptcy. 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. As discussed under the heading “Mortgage Securities Available-for-Sale” under “Critical Accounting Estimates,” to the extent that the cost basisNonconforming mortgage loans comprise substantially all of our mortgage securities exceedsloan portfolio and serve as collateral for our mortgage securities. Nonconforming borrowers include individuals who do not qualify for agency/conventional lending programs because of a lack of conventional documentation or previous credit difficulties. Often, they are individuals or families who have built up high-rate consumer debt and are attempting to use the fair valueequity in their home to consolidate debt and reduce the unrealized loss is considered other than temporary, an impairment charge is recognized in earnings. Conversely, whenamount of money it takes to service their monthly debt obligations.

We have traditionally utilized our role as servicer of our securitized pools of mortgage loans to attempt to identify and address potential and actual borrower delinquencies and defaults. As a result of the fair valuesale of our mortgage securities exceedsservicing rights effective November 1, 2007, we no longer control the cost basis thenlender-borrower relationship, which may exacerbate the unrealized gain is recordedincrease in accumulated other comprehensive income which is a component ofdelinquencies and defaults under such mortgage loans and the stockholders’ equity sectionnegative impact on the value and cash flows of our consolidated balance sheet.

Summary of Operationsresidual and Key Performance Measurementssubordinated securities and mortgage loans – held-in-portfolio resulting from such delinquencies and defaults.

 

Our net income is highly dependent upon our mortgage securities - available-for-sale portfolio, which is generated from the securitization of nonconforming loans we have originated and purchased. These mortgage securities represent the right to receive the net future cash flows from a pool of nonconforming loans. 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 nonconforming loans we originate and purchase,incentive he or she has to refinance the larger our securities portfolio and, therefore,mortgage when rates decline. In addition, the greater earnings potential. Asincentive to refinance increases when credit ratings improve. When home values rise, loan-to-value ratios drop, making it more likely that a result, earnings are related toborrower will do a “cash-out” refinance. Each of these factors increases the volume of nonconforming loans and related performance factorschance for those loans, including their average coupon, borrower default rate and borrowerhigher prepayment rate. Information regarding our lending volume is presented under the heading “Mortgage Loans.”speeds.

 

The primary functionmajority of our residual securities portfolio consists of securities which 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 lending operationsloans early, the effect is to generate nonconformingshorten the period over which interest is earned, and therefore, reduce the cash flow and yield on our securities.

We mitigated 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. A majority of our loans have a prepayment penalty up to but no greater than 80% of six months interest on the principal balance that is being repaid. As of December 31, 2007, 51% of the loans which will serve as collateral for our mortgage securities - available-for-sale. Whilehad a prepayment penalty. As of December 31, 2007, 62% of our mortgage loans – held-in-portfolio had a prepayment penalty.

U.S. Federal Income Tax Consequences

Historically, we were taxed as a REIT under Section 857 of the Code. As a REIT, we generally were not subject to federal income tax. To maintain our qualification as a REIT, we had to distribute at least 90% of our REIT taxable income to our shareholders and meet certain other tests relating to assets, income and ownership. However, we had elected to treat NFI Holding Corporation and its subsidiaries as taxable REIT subsidiaries (collectively the “TRS”). In general, the TRS could hold assets that the REIT could not hold directly and generally could engage in any real estate or non-real estate related business. The subsidiaries comprising the TRS were subject to corporate federal and state income tax and were taxed as regular C corporations.

During 2007, we were unable to satisfy the REIT distribution requirement for the tax year ended December 31, 2006 either in the form of cash or preferred stock. This action resulted in our loss of REIT status retroactive to January 1, 2006. Our failure to satisfy the REIT distribution test resulted from demands on our liquidity and the substantial decline in our market capitalization during 2007.

As a result of our termination of REIT status, we elected to file a consolidated federal income tax return with our eligible affiliated members. We reported taxable income in 2006 of approximately $212 million, which resulted in a tax liability of approximately $74 million along with interest and penalties due of approximately $5.8 million. After applying the payments and credits, we reported an amount owed to the IRS of approximately $67 million. We applied for and received an extension of time to pay the income taxes due to our expectation of generating a net operating loss for 2007, which may be carried back to 2006. This approved extension should allow us to reduce all of our taxable income (excluding excess inclusion income) from 2006, and eliminate the outstanding tax liability due to the IRS. However, we will be required to pay interest and any penalties that apply on the balance due to the IRS in 2008.

Because we terminated our REIT status effective January 1, 2006 and were taxable as a C corporation for 2006 and beyond, we recorded deferred taxes based on the estimated cumulative temporary differences as of December 31, 2007.

In determining the amount of deferred tax assets to recognize in the financial statements, we evaluate the likelihood of realizing such benefits in future periods. Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standard No. 109 “Accounting for Income Taxes” (“SFAS 109”) requires the recognition of a valuation allowance if it is more likely than not that all or some portion of the deferred tax asset will not be realized. SFAS 109 indicates the more likely than not threshold is a level of likelihood that is more than 50 percent.

Based on the evidence available as of December 31, 2007, including the significant pre-tax losses incurred by us in both the current quarter and previous quarters, the ongoing disruption to the credit markets, the liquidity issues facing us and our decision to close all of our mortgage lending operations, we concluded that it is more likely than not that our entire net deferred tax asset will not be realized. Based on these conclusions, we recorded a valuation allowance of $368.3 million for deferred tax assets as of December 31, 2007 compared to $0.7 million as of December 31, 2006. In future periods, we will continue to monitor all factors that impact positive and negative evidence relating to our deferred tax assets.

As of December 31, 2007, we had a federal net operating loss of approximately $368.4 million. We are expecting to carryback $196.1 million of the 2007 projected federal net operating loss against our 2006 taxable income and have recorded a current receivable for such benefit. The receivable was netted against the 2006 federal liability. The remaining $172.3 federal net operating loss may be carried forward to offset future taxable income, subject to provisions of the Code, including substantial limitations that would be imposed in the event of an “ownership change” as defined by Section 382 of the Code. If not used, this net operating loss will begin to expire in 2025.

The IRS is currently examining the 2005 federal income tax return of NFI Holding Corporation, a wholly-owned subsidiary. We are not aware of any significant findings as a result of this exam, however, the exam is still ongoing. Management believes it has adequately provided for potential tax liabilities that may be assessed for years in which the statute of limitations remains open. However, the assessment of any material liability would adversely affect our financial condition, liquidity and ability to continue as a going concern.

Personnel

As of December 31, 2007, we employed 247 people. Because of further reductions in workforce subsequent to December 31, 2007, we employ approximately 53 people as of March 27, 2008. None of our employees are represented by a union or covered by a collective bargaining agreement.

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

816.237.7424

Email: ir@novastar1.com

Item 1A.Risk Factors

Risk Factors

You should carefully consider the risks described below in evaluating our business and before investing in our publicly traded securities. Any of the risks we describe below or elsewhere in this report could negatively affect our results of operations, financial condition, liquidity, business prospects and ability to continue as a going concern. The risks described below are not the only ones facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial may also materially adversely affect our results of operations, financial condition, liquidity, business prospects and ability to continue as a going concern. 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.

Risks Related to Recent Changes in Our Business

The subprime loan market has largely ceased to operate, which has adversely affected our business and may adversely affect our ability to continue as a going concern.

Due to a number of market factors, including increased delinquencies and defaults on residential mortgage loans, investor concerns over asset quality, a weakening of the United States housing market and the failure of certain subprime mortgage companies and hedge funds that have invested in subprime loans, there has been extreme uncertainty and disruption in the subprime mortgage industry as a whole. As a result, our business has been materially and adversely affected in a number of ways. Due to the fact that the

secondary market for mortgage loans has effectively been unavailable to us since the middle of 2007, we have discontinued our mortgage lending business and have sold, at a loss, most of the loans that we originated during 2007 and had not previously securitized. Further, we have sold our mortgage servicing assets to generate sizable revenuescash to repay existing indebtedness and to reduce cash requirements. We have also terminated a substantial portion of our workforce. All of these events have had a material adverse effect on our business and have forced us to change business strategies. Our business now is focused solely on managing our portfolio of mortgage securities. If the subprime market fails to significantly improve, our results of operations, financial condition, liquidity, and business prospects will be further adversely affected and there can be no assurance that we will be able to continue as a going concern. Further, because of state licensing requirements, we are unlikely to be able, ourselves, to recommence mortgage lending activities so long as we continue to have a shareholders’ deficit. As a result of this and other factors, in the event that the subprime market recovers, there can be no assurance that we will be able to operate in the manner or at the levels that we have historically.

Payments on our mortgage securities are currently our only source of cash flows and will decrease in the next several months. Absent the reestablishment of profitable operations and reduction of our expenses from discontinued operations and other obligations, our cash flows will not be sufficient for us to continue as a going concern.

Our residual and subordinated mortgage securities are currently our only source of cash flows. Based on the current projections, the cash flows from our mortgage securities will decrease in the next several months as the underlying mortgage loans are repaid, and could be significantly less than the current projections if losses on the underlying mortgage loans exceed the current assumptions. In addition, we have significant operating expenses associated with office leases, software contracts, and other obligations relating to our discontinued operations, as well as payment obligations with respect to secured and unsecured debt, including periodic interest payments with respect to junior subordinated debentures relating to the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II. We intend to use available cash inflows in excess of our immediate operating needs, including debt service payments, to repay all of Wachovia’s short-term borrowings and any remaining fees due under the repurchase agreements at the earliest practical date. Any new advances under our financing facilities are at Wachovia’s sole discretion and we do not expect any such advances to be made. If, as the cash flows from mortgage securities decrease, we are unable to recommence or invest in mortgage loan origination or brokerage business on a profitable basis, and restructure our unsecured debt and contractual obligations or if the cash flows from our mortgage securities are less than currently anticipated, there can be no assurance that we will be able to continue as a going concern and avoid seeking the protection of applicable federal and state bankruptcy laws.

To the extent that the mortgage loans underlying our residual and subordinated securities continue to experience significant credit losses, our liquidity and ability to continue as a going concern will be adversely affected.

Our mortgage securities consist of certain residual securities retained from our past securitizations of mortgage loans, which typically consist of interest-only, prepayment penalty, and over collateralization bonds, and certain investment grade and non-investment grade rated subordinated mortgage securities retained from our past securitizations and purchased from other ABS issuers. These residual and subordinated securities are generally unrated or rated below investment grade and, as such, involve significant investment risk that exceeds the aggregate risk of the full pool of securitized loans. By holding the residual and subordinated securities, we generally retain the “first loss” risk associated with the underlying pool of mortgage loans. As a result, losses on the underlying mortgage loans directly affect our returns on, and cash flows from, these mortgage securities. In addition, if delinquencies and/or losses on the underlying mortgage loans exceed specified levels, the level of over-collateralization required for higher rated securities held by third parties may be increased, further decreasing cash flows presently payable to us.

Increased delinquencies and defaults on the mortgage loans underlying our residual and subordinated mortgage securities have resulted in a decrease in the cash flow we receive from these investments. To the extent we continue to experience significant realized losses and decreased cash flows from these assets, our results of operations, financial condition, liquidity, and ability to continue as a going concern will be adversely affected. In addition, because we have financed our mortgage securities under short-term warehouse repurchase agreements, continued decreases in the value of these retained securities may result in additional margin calls, which will further undermine our liquidity and ability to continue as a going concern.

There can be no assurance that we will have access to financing necessary to support our business and assets. Further, if we are unable to remain in compliance with agreements governing our indebtedness or to obtain waivers of any noncompliance, we will not be able to continue as a going concern.

We have incurred significant debt to finance our past operations, including the origination and purchase of mortgage loans and the purchase of mortgage securities. A significant amount of our indebtedness is represented by multiple secured financing facilities with Wachovia and the junior subordinated debentures related to the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II.

We currently intend to use available cash inflows in excess of our immediate operating needs, including debt service payments, to repay all of Wachovia’s outstanding borrowings and any remaining fees due under the repurchase agreements at the earliest practical date. During and after this period of repayment, any new advances under the Wachovia lending facilities are at Wachovia’s sole discretion and we do not expect any such advances to be made.

As of December 31, 2007 and thereafter, we are out of compliance with the net worth and liquidity covenants in our financing agreements with Wachovia. While Wachovia has waived this non compliance through April 30, 2008, there can be no assurance that we will be able to obtain further waivers of, or amendments to, our financing facilities if we were to breach any representation, warranty or covenant contained in such financing facilities or waiver or amendment. In addition, we project that we will be out of compliance with our current waiver prior to its expiration of April 30, 2008. Any default under our secured financing facilities and failure to obtain any necessary waivers or amendments in the future could result in the acceleration of the indebtedness under these facilities and the liquidation by the lender of the related collateral. Any acceleration of indebtedness would have a material adverse affect on our liquidity and ability to continue as a going concern and any liquidation of our collateral could be at a substantial loss.

Our wholly owned subsidiary NovaStar Mortgage, Inc. has outstanding junior subordinated debentures related to the outstanding trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II. We have guaranteed NovaStar Mortgage’s obligations under these debentures, including NovaStar Mortgage’s obligations to make periodic interest payments thereon. Our financing facilities with Wachovia prohibit us from making any such payments without Wachovia’s consent in the event that we have less than $30 million of available liquidity. In the event that any such payments are not made when due, whether as a result of the restrictions in our financing agreements with Wachovia or otherwise, or we or NovaStar Mortgage otherwise breach any of our obligations relating to the debentures or trust preferred securities and fail to remedy the default within the applicable cure period, if any, all of our obligations with respect thereto, including the repayment of principal, may be accelerated and declared to be immediately due and payable, in which case we would be forced to seek the protection of applicable federal and state bankruptcy laws.

In light of current market conditions, our current financial condition, and our lack of significant unencumbered assets, no assurance can be given regarding our ability to meet our debt service obligations or to secure additional financing. To the extent we are unable to meet our debt service obligations or do not have access to adequate financing, our business prospects and ability to continue as a going concern will be negatively affected. There is no assurance that we will continue to have access to financing at levels necessary for operations or other liquidity needs or that we will not be forced to file for bankruptcy.

Various legal proceedings could adversely affect our financial condition, our results of operations, liquidity and our ability to continue as a going concern.

In the course of our business, we are subject to various legal proceedings and claims. See Part I “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, liquidity, financial condition and ability to continue as a going concern.

The Securities and Exchange Commission (the “Commission”) has requested information from issuers in our industry, including us, regarding accounting for mortgage loans and other mortgage related assets. In addition, we have received requests or subpoenas for information relating to our operations from various federal and state regulators and law enforcement, including, without limitation, the Federal Trade Commission, the Department of Housing and Urban Development, the United States Department of Justice, the Federal Bureau of Investigation, the New York Attorney General and the Department of Labor. While we have provided, or are in the process of providing, the requested information to the applicable officials, we may be subject to further information requests from, or action by, these or other regulators or law enforcement officials. To the extent we are subject to any actions, our financial condition, liquidity, and ability to continue a going concern could be materially adversely affected.

There can be no assurance that our common stock or Series C Preferred Stock will continue to be traded in an active market.

Our common stock and our 8.90% Series C Preferred Stock were delisted by the New York Stock Exchange (“NYSE”) in January 2008, as a result of failure to meet applicable standards for continued listing on the NYSE. Our common stock and Series C Preferred Stock are currently quoted on the OTC Bulletin Board and on the Pink Sheets. However, there can be no assurance that an active trading market will be maintained. Trading of securities on the OTC and Pink Sheets is generally limited and is effected on a less regular basis than on exchanges, such as the NYSE, and accordingly investors who own or purchase our stock will find that the

liquidity or transferability of the stock may be limited. Additionally, a shareholder may find it more difficult to dispose of, or obtain accurate quotations as to the market value of, our stock. If an active public trading market cannot be sustained, the trading price of our common and preferred stock could be adversely affected and your ability to transfer your shares of our common and preferred stock may be limited.

We are not likely to pay dividends to our common or preferred stockholders in the near future.

We are not required to pay out our taxable income in the form of gainsdividends, as we are no longer subject to a REIT distribution requirement. Instead, payment of dividends is at the discretion of our board of directors. To preserve liquidity and to remain in compliance with our financing facilities, our board of directors has suspended dividend payments on salesour Series C and Series D-1 Preferred Stock. Dividends on our Series C and D-1 Preferred Stock continue to accrue and the dividend rate on our Series D-1 Preferred Stock increased from 9.0% to 13.0%, compounded quarterly, effective January 16, 2008 with respect to all unpaid dividends and subsequently accruing dividends. No dividends can be paid on any of our common stock until all accrued and unpaid dividends on our Series C and Series D-1 Preferred Stock are paid in full. Accumulating dividends with respect to our preferred stock will negatively affect the ability of our common stockholders to receive any distribution or other value upon liquidation.

Risks Related to Mortgage Asset Financing, Sale, and Investment Activities

We may be required to repurchase mortgage loans or indemnify mortgage loan purchasers as a result of breaches of representations and warranties, borrower fraud, or certain borrower defaults, which could further harm our liquidity and ability to continue as a going concern.

When we sold mortgage loans, whether as whole loans or pursuant to a securitization, we made customary representations and warranties to the purchaser about the mortgage loans and the manner in which they were originated. Our whole loan sale agreements require us to repurchase or substitute mortgage loans in the event we breach any of these representations or warranties. In addition, we may be required to repurchase mortgage loans as a result of borrower fraud. Likewise, we are required to repurchase or substitute mortgage loans if we breach a representation or warranty in connection with our securitizations. If a purchaser enforces its remedies against us, we may not be able to recover losses from the originating broker or correspondent. Repurchased loans are typically sold at a significant discount to the unpaid principal balance and, prior to sale, cannot currently be financed by us. As a result, significant repurchase activity would further harm our liquidity, cash flow, and financial condition.

During 2007, we received an increased number of repurchase and indemnity demands from purchasers of whole loans as a result of, among other things, borrower fraud, which had a negative impact on our liquidity and results of operations. In the event that we experience further repurchase and indemnity demands, our liquidity, cash flow, and financial condition will be further harmed.

Differences in our actual experience compared to the assumptions that we use to determine the value of our residual mortgage securities and to estimate reserves could further adversely affect our financial position.

Our securitizations of mortgage loans that were structured as sales for financial reporting purposes resulted in gain recognition at closing as well as the recording of the residual mortgage securities we retained at fair value. The value of residual securities represents the present value of future cash flows expected to be received by us from the excess cash flows created in the securitization transaction. In general, future cash flows are estimated by taking the coupon rate of the loans underlying the transaction less the interest rate paid to the investors, less contractually specified servicing and feetrustee fees, and after giving effect to estimated prepayments and credit losses. We estimate future cash flows from these securities and value them utilizing assumptions based in part on projected discount rates, delinquency, mortgage loan prepayment speeds and credit losses. It is extremely difficult to validate the assumptions we use in valuing our residual interests. Even if the general accuracy of the valuation model is validated, valuations are highly dependent upon the reasonableness of our assumptions and the predictability of the relationships which drive the results of the model. Due to deteriorating market conditions, our actual experience has differed significantly from our assumptions, resulting in a reduction in the fair value of these securities and impairments on these securities. If our actual experience continues to differ materially from the assumptions that we used to determine the fair value of these securities, our financial condition, results of operations and ability to continue as a going concern will continue to be negatively affected.

Risks Related to Interest Rates and Our Hedging Strategies

Changes in interest rates may harm our results of operations and equity value.

Our results of operations are likely to be harmed during any period of unexpected or rapid changes in interest rates. Our primary interest rate exposures relate to our mortgage securities, mortgage loans, floating rate debt obligations, interest rate swaps, and interest rate caps. Interest rate changes could adversely affect our cash flow, results of operations, financial condition, liquidity, business prospects, and ability to continue as a going concern in the following ways:

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

the value of our residual and subordinated securities and the income we receive from them are based primarily on LIBOR, and an increase in LIBOR increases our funding costs which reduces the cash flow we receive from, and the value of, these securities;

existing borrowers with adjustable-rate mortgages or higher risk loan products may incur higher monthly payments as the interest rate increases, and consequently may experience higher delinquency and default rates, resulting in decreased cash flows from, and decreased value of, our mortgage securities; and

mortgage prepayment rates vary depending on such factors as mortgage interest rates and market conditions, and changes in prepayment rates may harm our earnings and the value of our mortgage securities.

In addition, interest rate changes may also further impact our net book value as our mortgage securities and related hedge derivatives are marked to market each quarter. Generally, as interest rates increase, the value of our mortgage securities decreases which decreases the book value of our equity.

Furthermore, shifts in the yield curve, which represents the market’s expectations of future interest rates, also affects the yield required for the purchase of our mortgage securities and therefore their value. To the extent that there is an unexpected change in the yield curve it could have an adverse effect on our mortgage securities portfolio and our financial position and operations.

Risks Related to Credit Losses

Further delinquencies and losses with respect to residential mortgage loans, particularly in the sub-prime sector, may cause us to recognize additional losses, which would further adversely affect our operating results, liquidity, financial condition, business prospects and ability to continue as a going concern.

The residential mortgage market has encountered difficulties which have adversely affected our performance. Delinquencies and losses with respect to residential mortgage loans generally have increased and may continue to increase, particularly in the sub-prime sector. In addition, in recent months residential property values in most states have declined, in some areas severely, after extended periods during which those values appreciated. A sustained decline or a lack of increase in those values is likely to result in additional increases in delinquencies and losses on residential mortgage loans generally, especially with respect to any residential mortgage loans where the aggregate loan amounts (including any subordinate loans) are close to or greater than the related property values. Another factor that may have contributed to, and may in the future result in, higher delinquency rates is the increase in monthly payments on adjustable rate mortgage loans. Any increase in prevailing market interest rates may result in increased payments for borrowers who have adjustable rate mortgage loans. Moreover, with respect to option ARM mortgage loans with a negative amortization feature which reach their negative amortization cap, borrowers may experience a substantial increase in their monthly payment even without an increase in prevailing market interest rates. Compounding this issue, the current lack of appreciation in residential property values and the adoption of tighter underwriting standards throughout the sub-prime mortgage loan industry may adversely affect the ability of borrowers to refinance these loans and avoid default, particularly borrowers facing a reset of the monthly payment to a higher amount. To the extent that delinquencies or losses continue to increase for these or other reasons, the value of our mortgage securities and the mortgage loans held in our portfolio will be further reduced, which will adversely affect our operating results, liquidity, cash flow, financial condition, business prospects and ability to continue as a going concern.

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

Nonconforming mortgage borrowers 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 higher risk of delinquency and foreclosure than mortgage loans made to borrowers with better credit and, therefore, will result in higher levels of realized losses than conventional loans.

Delinquency interrupts the flow of projected interest income from borrowersa mortgage loan, and third party investors,default can ultimately lead to a loss if the revenue serves largelynet realizable value of the real property securing the mortgage loan is insufficient to offsetcover the related costs.principal and interest due on the loan and costs of sale. In the event of a borrower’s bankruptcy, that borrower’s mortgage loan will be deemed to be secured only to the extent of the value of the underlying collateral at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the mortgage loan may in some circumstances be subject to the avoidance powers of the bankruptcy trustee under applicable state law. Foreclosure of a mortgage loan can be an expensive and lengthy process that can have a substantial negative effect on our originally anticipated return on the foreclosed mortgage loan. Also, our cost of financing a delinquent or defaulted loan is higher than for a performing loan, and loans that are delinquent or in default may be unmarketable or saleable only at a discount.

 

We also servicehave experienced an increase in borrower delinquencies and defaults, which has adversely affected our liquidity, cash flows, results of operations and financial condition. Nearly all of our remaining loans held for sale are delinquent or are in default. In addition, we continue to be exposed to delinquencies and losses with respect to loans that we have securitized, either through residual securities that we retain in securitizations structured as sales, or through the loans that remain on our balance sheet in securitizations structured as financings.

To the extent that loan delinquencies and defaults continue at their current rates or become more severe, our results of operations, cash flows, liquidity, financial condition and ability to continue as a going concern may be further adversely affected.

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

In our origination and purchasing of mortgage loans, we relied 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 was fraudulently or negligently misrepresented to us, the value of the loan may be significantly lower than we expected. Whether a misrepresentation was 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, if sold prior to our detection of the misrepresentation, generally must be repurchased by us. We may not be able to recover losses incurred as a result of the misrepresentation.

As with the broader nonconforming mortgage loan industry, we have experienced an increase in exposure due to fraud, which has resulted in an increase in our repurchase and indemnity obligations and has adversely affected our cash flow, liquidity, results of operations and financial condition. In the event that we experience further repurchase and indemnity demands, our liquidity, cash flow, financial condition and ability to continue as a going concern will be adversely affected.

The value of, and cash flows from, our mortgage securities may further decline due to factors beyond our control.

There are many factors that affect the value of, and cash flows from, our mortgage securities, many of which are beyond our control. For example, the value of the homes collateralizing residential loans may decline due to a variety of reasons beyond our control, such as weak economic conditions or natural disasters, and a borrower’s ability to repay a loan may be adversely affected by factors beyond our control, such as subsequent over-leveraging of the borrower, reductions in personal incomes, and increases in unemployment. Interest-only loans, negative amortization loans, adjustable-rate loans, reduced documentation 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. To the extent that these factors continue to negatively affect the value of, and cash flows from, our mortgage assets our operating results, liquidity, cash flows, financial condition and ability to continue as a going concern will be adversely affected.

Mortgage insurers may not pay claims resulting in increased credit losses.

We use mortgage insurance to mitigate our risk of credit losses. We 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, financial condition, liquidity and cash flows, and ability to continue as a going concern.

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

A substantial portion of our mortgage assets consist of single-family mortgage loans or mortgage securities evidencing interests in single-family mortgage loans. Because substantially all of our loans were made to credit-impaired borrowers, the actual rates of delinquencies, foreclosures and losses on these loans tend to be higher during economic slowdowns. We have experienced a significant increase in delinquencies and defaults, which has harmed and continues to harm our financial condition, results of operations, liquidity, cash flows and ability to continue as going concern. In addition, material declines in real estate values have weakened our collateral loan-to-value ratios, have increased the risk of default by decreasing the ability of borrowers to refinance loans they are unable to sustain or to sell the mortgage property to repay the loan, and have increased the possibility of loss if a borrower defaults. In such cases, we are subject to the risk of loss on such mortgage assets arising from borrower defaults to the extent not covered by third-party credit enhancement.

Geographic concentration of mortgage loans increases our exposure to risks in those areas.

Over-concentration in any one geographic area of our loans held for sale or underlying our mortgage securities increases our exposure to the economic risks associated with that area. Declines in the residential real estate markets in which we are concentrated, including California and Florida, have reduced the values of the properties collateralizing our mortgages which in turn has increased the risk of delinquency, foreclosure, or losses from those loans. In addition, increases in the unemployment rate in markets in which we are concentrated increases the likelihood that borrowers in those areas may become delinquent on their loans. To the extent that borrowers in a geographic area in which we have made a significant number of loans become delinquent or otherwise default on such loans, the value of, and cash flows from, our mortgage securities will further decrease which will adversely affect our operating results, liquidity, cash flows, financial condition and ability to continue as a going concern.

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 negatively affect the value of, and cash flows from, our mortgage assets, which will adversely affect our operating results, liquidity, cash flows, financial condition and ability to continue as a going concern.

As a result of our sale of our mortgage servicing rights, we no longer possess the ability to identify and address potential or actual delinquencies and defaults on the mortgage loans underlying our residual and subordinated securities.

We have traditionally utilized our role as servicer of our securitized pools of mortgage loans to attempt to identify and address potential and actual borrower delinquencies and defaults. On November 1, 2007, we originatesold to a third party our servicing rights with respect to our securitized loans. As a result, we no longer control the lender-borrower relationship, which may exacerbate the increase in delinquencies and purchasedefaults under such mortgage loans and the negative impact on the value and cash flows of our residual and subordinated securities resulting from such delinquencies and defaults.

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

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 prohibition 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 would negatively affect our liquidity, financial condition, results of operations and ability to continue as a going concern.

Failure to qualify for an exemption from regulation as an investment company could harm our business.

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 SEC’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. Mortgage-backed securities

that do not represent all the certificates issued with respect to an underlying pool of mortgages may be treated as securities separate from the underlying mortgage loans and thus may not qualify as a qualifying real estate interest for the purposes of the 55% requirement. If we 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, results of operations, liquidity, and ability to continue as a going concern.

Failure to comply with federal, state or local regulation of, or licensing requirements with respect to, our business could harm our financial condition and ability to recommence mortgage banking operations.

Our prior mortgage lending, brokerage and loan servicing operations were subject to an extensive body of federal, state and local laws and licensing requirements. Although we utilized systems and procedures designed to facilitate compliance, these requirements were voluminous and, in some cases, complex and subject to interpretation, and our compliance with these requirements depended on the actions of a large number of employees. Borrowers experiencing foreclosure and terminated employees may make retaliatory allegations of non-compliance. Investigations, enforcement actions, litigation, fines, penalties and liability with respect to non-compliance with these requirements may consume attention of key personnel, may adversely affect our ability to recommence mortgage lending, brokerage or servicing operations, and may materially and adversely affect our financial condition, results of operations, liquidity and ability to continue as a going concern.

Risks Related to Our Capital Stock

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

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

actual or perceived changes in our ability to continue as a going concern;

actual or anticipated changes in the delinquency and default rates on mortgage loans, in general, and specifically on the loans we invest in through our mortgage securities;

actual or anticipated changes in residential real estate values;

actual or anticipated changes in market interest rates;

actual or anticipated changes in our earnings and cash flow;

general market and economic conditions, including the operations and stock performance of our competitors;

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

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

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.

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 shareholder approval, to:

authorize the issuance of additional shares of common stock or preferred stock without shareholder 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 may access the capital markets to raise additional funds 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 capital 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 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.

Other Risks Related to our Business

You should exercise caution in reviewing our consolidated financial statements.

Our consolidated financial statements have been prepared on a going concern basis of accounting which contemplates continuity of operations, realization of assets, liabilities and commitments in the normal course of business. The financial statements do not reflect any adjustments that might result if we were unable to continue as a going concern. In light of these facts, you should exercise caution in reviewing our financial statements.

Our ability to use our net operating loss carryforwards and net unrealized built-in losses could be severely limited if transfer restrictions are not adopted or are not effective in preventing an ownership change from occurring.

We currently have recorded a net deferred tax asset, before valuation allowance, of $368.3 million, almost all of which relates to certain loss carryforwards and net unrealized built-in-losses. While we believe that it is more likely than not that we will not be able to utilize such losses in the future, the net operating loss carryforwards and net unrealized built-in losses could provide significant future tax savings to us if we are able to use such losses. However, our ability to use these tax benefits may be impacted, restricted or eliminated due to a future ownership change within the meaning of Section 382 of the Code. Pursuant to Section 382 of the Code, a corporation is limited in its ability to use existing net operating loss carryforwards and net unrealized built in losses once that corporation experiences an “ownership change” (as that term is defined in the Code and IRS regulations). We have imposed certain transfer restrictions on our Series D-1 Preferred Stock, and have also agreed to submit an amendment to our Charter to our shareholders for approval, to limit the transferability of our common stock in order to attempt to preserve certain of our net operating loss carryforwards and net unrealized built-in losses. Our shareholders may fail to approve this amendment. Further, although transfer restrictions are valid under the Maryland General Corporation Law, we are not aware of any published court decisions enforcing similar transfer restrictions. Thus, a transfer could occur that would violate the transfer restrictions, and we may be unable to enforce such transfer restrictions. Even if a court were to enforce the transfer restrictions, the Internal Revenue Service might not agree that the transfer restrictions provided a sufficient remedy with respect to an ownership change resulting from a prohibited transfer. Further, our Board of Directors has waived, and may in the future waive, application of the transfer restrictions to certain shareholders or transfers if determined to otherwise be in the interests of the Company. In any of these cases, despite the implementation of the transfer restrictions, an ownership change could occur that would severely limit our ability to use the tax benefits associated with the net operating loss carryforwards and net unrealized built-in losses, which may result in higher taxable income for us (and a significantly higher tax cost as compared to the situation where these tax benefits are preserved).

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 negatively affect our business. Additionally, we have access to the personal financial information of borrowers which is highly sensitive and confidential, and subject to significant federal and state regulation. If a third party were to misappropriate this information or if we inadvertently disclosed 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 or inadvertent disclosure 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.

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

The transfer restrictions applicable or proposed to be applicable to our capital stock are complex and are designed to preserve the value of our net operating loss carryforwards and net unrealized built-in losses for the benefit of our stockholders. The transfer restrictions may make it more difficult to acquire a significant interest in us or to effect a business combination transaction that stockholders may perceive to be favorable. The transfer restrictions could also make it more difficult for a stockholder to replace current management because a stockholder’s ability to increase its voting power is limited.

Certain additional 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 shareholders. 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.

Item 1B.Unresolved Staff Comments

None

Item 2.Properties

Our executive, administrative and portfolio management 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 $4.3 million.

We are leasing office space in various other states which were used for operations which were discontinued in 2007 and early 2008. The leases on these premises expire from January 2008 through May 2013, and the current annual rent on those premises not terminated as of March 31, 2008 is approximately $3.0 million.

Item 3.Legal Proceedings

American Interbanc Mortgage Litigation. On March 17, 2008, NovaStar Financial, Inc. (“NFI”), NovaStar Mortgage, Inc. (“NMI”), NFI Holding Corp. (“NFI Holding”) and NovaStar Home Mortgage, Inc. (“NHMI” and, with NFI, NMI and NFI Holding, the “NovaStar Entities”) and American Interbanc Mortgage, LLC (“Plaintiff”) entered into a Confidential Settlement Term Sheet Agreement (the “Settlement Terms”) with respect to the actions, judgments and claims described below.

In March 2002, Plaintiff filed an action against NHMI in Superior Court of Orange County, California entitled American Interbanc Mortgage LLC v. NovaStar Home Mortgage, Inc. et. al. (the “California Action”). In the California Action, Plaintiff alleged that NHMI and two other mortgage companies (“Defendants”) engaged in false advertising and unfair competition under certain California statutes and interfered intentionally with Plaintiff’s prospective economic relations. On May 4, 2007, a jury returned a verdict by a 9-3 vote awarding Plaintiff $15.9 million. The court trebled the award, made adjustments for amounts paid by settling Defendants, and entered a $46.1 million judgment against Defendants on June 27, 2007. The award is joint and several against the Defendants, including NHMI. It is unknown if the other two Defendants, one of which has filed a bankruptcy petition, have the financial ability to pay any of the award.

NHMI’s motion for the trial court to overturn or reduce the verdict was denied on August 20, 2007, and NHMI appealed that decision (the “Appeal”). Pending the Appeal, Plaintiff commenced enforcement actions in the states of Missouri (the “Kansas City Action”) and Delaware, and obtained an enforcement judgment in Delaware (the “Delaware Judgment”). On January 23, 2008, Plaintiff filed an involuntary petition for bankruptcy against NHMI under 11 U.S.C. Sec. 303, in the United States Bankruptcy Court for the Western District of Missouri (the “Involuntary”). Plaintiff was joined by two individuals alleging claims totaling $150 in the Involuntary filing. NHMI filed an answer and contested the standing of Plaintiff and the individuals to be petitioning creditors in bankruptcy.

On March 17, 2008, the NovaStar Entities and Plaintiff entered into the Settlement Terms with respect to the California Action, the Judgment, the Kansas City Action, the Delaware Judgment, the Involuntary, and all related claims.

Under the Settlement Terms, the parties agreed to move to dismiss the Involuntary. Within ten (10) business days after notice of entry of the dismissal of the Involuntary, NFI will pay Plaintiff $2,000,000 plus the balance in an account established by order of the Bankruptcy Court in an amount no less than $50,000 (but not anticipated to be greater than $65,000 at the time of payment), with NHMI obligated to otherwise satisfy obligations to its identified creditors up to $48,000. The parties also agreed to extend the Appeal briefing period pending finalization of the settlement of the other actions, judgments and claims, as described below.

The Settlement Terms provide that, subject to payment of the amounts described above and satisfaction of certain other conditions, the parties will dismiss the California Action as to NHMI and the Kansas City Action and Delaware Judgment, effect notice of satisfaction of the Judgment, and effect a mutual release of all claims that were or could have been raised in any of the foregoing or that are related to the subject matter thereof, upon the earliest of the following: (i) July 1, 2010, (ii) a waiver by Wachovia of Wachovia’s right to file an involuntary bankruptcy proceeding against any of the NovaStar Entities prior to July 1, 2010, (iii) an extension of the maturity date of our indebtedness to Wachovia until at least July 1, 2010, or (iv) delivery to Plaintiff of written documentation evidencing the full satisfaction of our current indebtedness to Wachovia.

In addition to the initial payments to be made to the Plaintiff following dismissal of the Involuntary, we will pay Plaintiff $5.5 million if, prior to July 1, 2010, (i) NFI’s average common stock market capitalization is at least $94.4 million over a period of five (5) consecutive business days, or (ii) the holders of NFI’s common stock are paid $94.4 million in net asset value as a result of any sale of NFI or its assets. If NFI is sold prior to July 1, 2010 for less than $94.4 million and ceases to be a public company, then NFI will obligate the purchaser either to immediately pay $2 million to Plaintiff, or to pay Plaintiff $5.5 million in the event the value of NFI exceeds $94.4 million prior to July 1, 2010 as determined by an independent valuation company.

We make no assurances with regard to our ability to satisfy of any of the conditions described or referenced above. Without limiting the foregoing, we have obtained no commitment from Wachovia with regard to any action that may be required of Wachovia in order to effect, prior to July 1, 2010, the dismissals and releases described above. Further, nothing in the Settlement Terms constitutes an expression of our belief, projection, assumption, or intent regarding any future event, any industry or market conditions, or our financial condition, stock price, or business plans or strategies.

In accordance with generally accepted accounting principles, NHMI has recorded a liability of $47.1 million as of December 31, 2007 with a corresponding charge to earnings. The $47.1 million includes interest which is accruing on the obligation. Because NHMI is a wholly owned indirect subsidiary of NFI, the $47.1 million liability is included in our consolidated financial statements. The liability is included in the “Liabilities of discontinued operations” line of the consolidated balance sheets while the charge to earnings is included in the “(Loss) income from discontinued operations, net of income tax” line of the consolidated statements of operations.

Other Litigation. Since April 2004, a number of substantially similar class action lawsuits have been filed and consolidated into a single action in the United States District Court for the Western District of Missouri. The consolidated complaint names us and three of our executive officers as defendants 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. On February 8, 2007, the court certified the case as a class action. The case is now in the discovery stage. We believe that these claims are without merit and will continue to vigorously defend against them.

In April 2006, a single plaintiff filed a putative nationwide class action against NovaStar Mortgage in the United States District Court for the Western District of Tennessee. The complaint asserts claims under 42 U.S.C. Sections 1981 and 1982; the Fair Housing Act, 42 U.S.C. Sections 3601-3619; and the Equal Credit Opportunity Act, 15 U.S.C. Sections 1691-1691f. Plaintiff alleges that NovaStar Mortgage paid higher yield spread premiums to brokers for loans made to minorities as compared to loans made to white borrowers. The lawsuit seeks injunctive relief and damages, including punitive damages. We believe that these claims are without merit and will vigorously defend against them.

Since February 2007, a number of substantially similar putative class actions have been filed in the United States District Court for the Western District of Missouri. The complaints name us and three of our executive officers as defendants and generally allege, among other things, that the defendants made materially false and misleading statements regarding our business and financial results. The plaintiffs purport to have brought the actions on behalf of all persons who purchased or otherwise acquired our common stock during the period May 4, 2006 through February 20, 2007. Following consolidation of the actions, a consolidated amended complaint was filed on October 19, 2007. On December 29, 2007, the defendants moved to dismiss all of plaintiffs’ claims, and that servemotion is pending. We believe that these claims are without merit and will vigorously defend against them.

In May 2007, a lawsuit entitledNational Community Reinvestment Coalition v. NovaStar Financial, Inc., et al., was filed against us in the United States District Court for the District of Columbia. Plaintiff, a non-profit organization, alleges that we maintain corporate policies of not making loans on Indian reservations, or dwellings used for adult foster care or on rowhouses in Baltimore, Maryland

that violates the federal Fair Housing Act. The lawsuit seeks injunctive relief and damages, including punitive damages, in connection with the lawsuit. On May 30, 2007, we responded to the lawsuit by filing a motion to dismiss certain of plaintiff’s claims. That motion is pending resolution by the court. We believe that these claims are without merit and will vigorously defend against them.

In June 2007, two borrowers filed a putative class action entitledKubiak v. NovaStar Mortgage, Inc., against us and two of our subsidiaries in the United States District Court for the Northern District of California, alleging that payments of premiums to brokers by one of the subsidiaries were not properly disclosed to borrowers in the manner allegedly required by federal or state law, thus constituting unfair competition and false advertising under California law and violation of the California Consumer Legal Remedies Act. Plaintiffs seek statutory and punitive damages, restitution, injunctive relief and attorney’s fees on behalf of California borrowers who allegedly failed to receive adequate disclosure of such premiums. The defendants filed a motion to dismiss the action. On December 19, 2007, the Court granted defendants’ motion to dismiss the complaint, including the claims against NovaStar Financial, Inc., but the Court allowed the plaintiffs to file an amended complaint. On January 9, 2008, the plaintiffs filed an amended complaint that does not make any claim against NovaStar Financial, Inc., but does assert the above claims against its subsidiaries, NovaStar Mortgage, Inc. and NovaStar Home Mortgage, Inc. We believe that these claims are without merit and will vigorously defend against them.

In November 2007, a borrower filed a putative class action, entitledDenman v. Novastar Mortgage, Inc., in the United States District Court for the District of Massachusetts alleging that NovaStar Mortgage induced him to enter into a disadvantageous mortgage with an adjustable rate and a balloon note. Plaintiff contends that NovaStar Mortgage’s actions violated the Massachusetts Consumer Protection Act and seeks actual and statutory damages, reformation of his mortgage contract and injunctive and declaratory relief. On March 6, 2008, NovaStar Mortgage filed a motion to dismiss the litigation. That motion is pending. We believe that these claims are without merit and will vigorously defend against them.

On January 10, 2008, the City of Cleveland, Ohio filed suit against us and approximately 20 other mortgage, commercial and investment bankers alleging a public nuisance had been created in the City of Cleveland by the operation of the subprime mortgage industry. The case was filed in state court and promptly removed to the United States District Court for the Northern District of Ohio. The plaintiff seeks damages for loss of property values in the City, and for increased costs of providing services and infrastructure, as collaterala result of foreclosures of subprime mortgages. We believe that these claims are without merit and will vigorously defend against them.

On January 31, 2008, two purported shareholders filed separate derivative actions in the Circuit Court of Jackson County, Missouri against various former and current officers and directors and named us as a nominal defendant. The essentially identical petitions allege that the individual defendants breached fiduciary duties owed to us in connection with alleged insider selling and misappropriation of information, abuse of control, gross mismanagement, waste of corporate assets, and unjust enrichment between May 2006 and December 2007. We believe that these claims are without merit and will 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, federal and state laws prohibiting discrimination in lending and federal and state licensing and consumer protection laws.

In addition, we have received requests or subpoenas for information from various Federal and State regulators or law enforcement officials, including, without limitation, the Federal Trade Commission, the Securities & Exchange Commission, the United State Department of Justice, the Federal Bureau of Investigation, the New York Attorney General and the Department of Labor.

While management currently believes that the ultimate outcome of all these proceedings and claims will not have a material adverse effect on our financial condition, litigation is subject to inherent uncertainties and our ability to withstand an unfavorable ruling has greatly diminished. If an unfavorable ruling were to occur in any one of them, there exists the possibility of a material adverse impact on our financial condition, results of operations and cash flows and our ability to avoid bankruptcy would be materially and adversely affected.

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

None

PART II

Item 5.Market for Registrant’s Common Equity, 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 was traded on the NYSE under the symbol “NFI” through December 31, 2007. Our common stock has subsequently been delisted from the NYSE in 2008 and is currently quoted on the OTC Bulletin Board and on the Pink Sheets under the symbol “NOVS”. 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. The Board of Directors declared a one-for-four reverse stock split of its common stock, providing shareholders of record as of July 27, 2007, with one share of common stock for each four shares owned. The reduction in shares resulting from the split was effective on July 27, 2007 decreasing the number of common shares outstanding to 9.5 million. Prior year share amounts and earnings per share disclosures have been restated to reflect the reverse stock split.

   High

  Low

  Dividends

      Date Declared

  Date Paid

  Amount Per
Share


2006

                  

First Quarter

  $135.20  $102.80  5/4/06  5/26/06  $5.60

Second Quarter

   150.52   116.32  8/3/06  8/28/06   5.60

Third Quarter

   142.40   113.00  9/11/06  11/30/06   5.60

Fourth Quarter

   131.24   105.28  9/11/06  12/29/06   5.60

2007

                  

First Quarter

  $105.80   13.72  N/A  N/A   N/A

Second Quarter

   40.00   19.56  N/A  N/A   N/A

Third Quarter

   34.68   5.10  N/A  N/A   N/A

Fourth Quarter

   9.32   1.16  N/A  N/A   N/A

As of March 12, 2008, we had approximately 1,010 shareholders of record of our common stock, including holders who are nominees for an undetermined number of beneficial owners based upon a review of the securities position listing provided by our transfer agent.

Dividend distributions will be made at the discretion of the Board of Directors and will depend on earnings, financial condition, cost of equity, investment opportunities and other factors as the Board of Directors may deem relevant. In addition, accrued and unpaid dividends on our preferred stock must be paid prior to the declaration of any dividends on our common stock. We do not expect to declare any stock dividend distributions for the near future. See “Industry Overview and Known Material Trends and Uncertainties” for further discussion regarding future uncertainties.

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, 2007 – October 31, 2007

  —    —    —    $1,020

November 1, 2007 – November 30, 2007

  —    —    —     1,020

December 1, 2007 – December 31, 2007

  —    —    —     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,

 
   2007

  2006(A)

  2005(A)

  2004(A)

  2003(A)

 

Consolidated Statement of Operations Data:

                     

Interest income

  $366,246  $304,122  $199,482  $142,513  $110,063 

Interest expense

   228,369   131,334   22,263   21,071   20,304 

Net interest income before provision for credit losses

   137,877   172,788   177,219   121,432   89,758 

Credit losses

   (265,288)  (30,131)  (1,038)  (726)  (389)

(Losses) gains on sales of mortgage assets

   (136)  362   (27)  359   (1,911)

(Losses) gains on derivative instruments

   (10,997)  109   247   (111)  (894)

Fair value adjustments

   (85,803)  (3,192)  549   —     —   

Impairment on mortgage securities – available for sale

   (98,692)  (30,690)  (17,619)  (15,902)  —   

General and administrative expenses

   59,420   69,907   62,231   60,897   39,533 

(Loss) income from continuing operations

   (467,497)  55,393   121,029   43,638   58,001 

(Loss) income from discontinued operations, net of income tax

   (256,780)  17,545   18,095   68,569 �� 53,994 

Net (loss) income available to common shareholders

   (733,082)  66,285   132,471   109,124   111,996 

Basic income per share:

                     

(Loss) income from continuing operations available to common shareholders

  $(51.04) $5.70  $15.42  $9.85  $10.44 

(Loss) income from discontinued operations, net of income tax

   (27.51)  2.05   2.44   7.41   9.72 
   


 


 


 


 


Net (loss) income available to common shareholders

  $(78.55) $7.75  $17.86  $17.26  $20.16 

Diluted income per share:

                     

(Loss) income from continuing operations available to common shareholders

  $(51.04) $5.66  $15.25  $9.67  $10.17 

(Loss) income from discontinued operations, net of income tax

   (27.51)  2.03   2.42   7.27   9.46 
   


 


 


 


 


Net (loss) income available to common shareholders

  $(78.55) $7.69  $17.67  $16.94  $19.63 

   As of December 31,

   2007

  2006(A)

  2005(A)

  2004(A)

  2003(A)

Consolidated Balance Sheet Data:

                    

Mortgage Assets:

                    

Mortgage loans – held-in-portfolio

  $2,870,013  $2,116,535  $28,840  $59,527  $94,717

Mortgage securities – available-for-sale

   33,371   349,312   505,645   489,175   382,287

Mortgage securities – trading

   109,203   329,361   43,738   143,153   —  

Total assets

   3,230,766   5,028,263   2,335,734   1,861,311   1,399,957

Long-term borrowings

   3,223,692   2,160,050   201,243   389,894   132,980

Shareholders’ (deficit) equity

   (211,488)  514,570   564,220   426,344   300,224

   For the Year Ended December 31,

 
   2007

  2006

  2005

  2004

  2003

 

Other Data:

                     

Annualized return on assets

   (B)  1.98%  6.63%  7.08%  7.85%

Annualized return on equity

   (B)  13.52%  28.09%  31.76%  46.33%

Dividends declared per common share

  $—    $22.40  $22.40  $27.00  $20.16 

Dividends declared per preferred share

  $1.67  $2.23  $2.23  $2.11  $—   


(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)Not computed due to net loss available to common shareholders for the year ended December 31, 2007 and a shareholders’ deficit as of December 31, 2007.

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 Maryland corporation formed on September 13, 1996 which operates solely as a non-conforming residential mortgage portfolio manager. Prior to significant changes in our business during 2007 and the first quarter of 2008, we originated, purchased, securitized, sold, invested in and serviced residential nonconforming mortgage loans and mortgage backed securities. We retained, through our mortgage securities - available-for-sale. Theinvestment portfolio, significant interests in the nonconforming loans we originated and purchased, and through our servicing function is critical toplatform, serviced all of the management of credit risk (risk of borrower defaultloans in which we retained interests. During 2007 and the related economic loss) withinearly 2008, we discontinued our mortgage portfolio. Again, while this operation generates significant fee revenue, its revenue serves largelylending operations and sold our mortgage servicing rights which subsequently resulted in the abandonment of our servicing operations.

Historically, we had elected to offsetbe taxed as a REIT under the costCode. During 2007, we announced that we would not be able to pay a dividend on our common stock with respect to our 2006 taxable income, and as a result, our status as a REIT terminated retroactive to January 1, 2006. This retroactive revocation of this function.our REIT status results in us becoming taxable as a C corporation for 2006 and subsequent years.

 

The key performance measures for executive management are:

 

net income available to common shareholders, and

 

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 expectednet interest yield and

return on our mortgage asset investments and the related management of interest rate risk.securities.

 

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.

 

Our consolidated financial statements have been prepared on a going concern basis of accounting which contemplates continuity of operations, realization of assets, liabilities and commitments in the normal course of business. There are substantial doubts that we will be able to continue as a going concern and, therefore, may be unable to realize our assets and discharge our liabilities in the normal course of business. The financial statements do not reflect any adjustments relating to the recoverability and classification of recorded asset amounts or to the amounts and classification of liabilities that may be necessary should we be unable to continue as a going concern.

Known Material TrendsExecutive Overview of Performance

 

OverDuring 2007, significant disruptions occurred in the last ten years,U.S. mortgage market and the nonconforming lending market has grown from less than $50 billion to approximately $530 billion in 2004 as estimated by the National Mortgage News. A significant portionglobal capital markets, both of these loans are made to borrowers who are using equity in their primary residence to consolidate low-balance, installment or consumer debt. 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 has a 1-2% 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 should continue to experience long term growth.

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 United States of America government-sponsored enterprises. The equity marketplace provides 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 has been strong. Additionally, commercial and investment banks have provided significant liquidityhistorically relied upon to finance our mortgage production and operations. The combination of a weakening housing market and concern over certain industry-wide product offerings negatively impacted the expectations of future performance and the value investors assign to mortgage loans and securities. Because of this, investor demand for non-agency mortgage-backed securities abruptly declined and participants in the debt markets substantially curtailed financing of mortgage loan inventories.

Mortgage lenders responded by adjusting loan programs and underwriting standards, which had the effect of reducing the availability of mortgage credit to borrowers. These developments further weakened the housing market and affected mortgage loan and security performance.

Additionally, due to these sharp declines in mortgage asset values, we experienced severe liquidity constraints due to margin calls on our mortgage assets which were being financed with short-term borrowings.

In an effort to manage through these difficult conditions and preserve liquidity and shareholder value, we undertook several strategies including:

Execution of a $1.9 billion global financing facility with Wachovia, and subsequent reduction of short-term borrowings;

Issuance of convertible preferred stock;

The exit of our mortgage lending and loan servicing operations;

Sale of our mortgage servicing rights;

Termination of REIT status; and

Termination of full recourse derivative instruments

The severely disrupted mortgage and capital markets, along with the strategies we undertook to manage through such disruptions, were significant drivers in our financial results for the year ended December 31, 2007. The following discussion outlines the major factors which drove our 2007 financial performance.

Credit performance/Bond spread widening – With repayment risks no longer offset by rapidly rising home values, delinquencies in the industry began to rise in 2006 and accelerated during the year ended December 31, 2007. These credit issues caused whole loans to lose significant value, affecting the value of and income generated by our portfolio of mortgage loans and securities.

Generally, the market value of our mortgage assets (i.e. mortgage loans and mortgage securities) fluctuates inversely with bond spreads in the market. As bond spreads widen (i.e. investors demand more return), the value of our mortgage assets will decline, alternatively, as they tighten, the market value will increase. Bond spreads dramatically widened during 2007 as investor concerns over deterioration of subprime asset quality continued. Because of these adverse market factors, we experienced significant mark-to-market losses on our mortgage securities – trading and mortgage loans – held-for-sale as well as impairments on our mortgage securities – available-for-sale. We recognized losses on our mortgage securities—trading due to fair value adjustments of $342.9 million for the year ended December 31, 2007. We recorded $101.1 million of losses from valuation adjustments on our mortgage loans – held-for-sale for the year ended December 31, 2007. We recorded an impairment on our mortgage securities – available-for-sale as a result of credit deterioration of $98.7 million during the year ended December 31, 2007.

Another significant effect of the credit deterioration in our loan portfolio was our recording of provision for credit losses of $265.3 million for the year ended December 31, 2007.

Exit Plans - As a result of the significant deterioration in the subprime secondary markets, during 2007, we undertook certain workforce reductions pursuant to plans of termination (“Exit Plans”) to align our organization and costs with our decision to discontinue our mortgage lending and loan servicing operations. We incurred pre-tax charges of approximately $26.9 million related to these Exit Plans.

Sale of mortgage servicing rights - On November 1, 2007, we closed the sale of all of our mortgage servicing rights and servicing advances relating to our securitizations. The transaction provided $154.9 million of cash to us after deduction of expenses. We used the proceeds from the sale to repay our short-term borrowings. We recorded a gain on the sale of $19.8 million which is included in the “(Loss) income from discontinued operations, through warehouse repurchase facilities. While management cannot predictnet of income tax” line item of our consolidated statements of operations.

Termination of REIT status - We were not able to pay a dividend on our common stock with respect to our 2006 taxable income, and as a result our status as a REIT terminated, retroactive to January 1, 2006. This retroactive revocation of our REIT status resulted in us becoming taxable as a C corporation for 2006 and subsequent years. Tax treatment of a C corporation is materially different from tax treatment as a REIT and thus the futuretax characterization of our transactions and calculations of our taxable income are different than how they have previously been reported to investors and the IRS. Because we became taxable as a C corporation retroactive to January 1, 2006, we reported taxable income in 2006 of approximately $212 million, which resulted in a tax liability of approximately $74 million. After applying payments and credits, we reported an amount owed to the IRS of approximately $67 million. We applied for and received an extension of time to pay our income taxes due to our expectation of generating a net operating loss for 2007, which may be carried back to 2006. This approved extension should allow us to eliminate all of our taxable income (excluding excess inclusion income) from 2006, and eliminate the outstanding tax liability due to the IRS. We will, however, be required to pay interest and any penalties that apply on the balance due to the IRS in 2008. If the IRS were to reverse its decision and require us to pay the 2006 tax liability, it would have a material adverse effect on our financial condition, liquidity and ability to continue as a going concern.

Deferred tax asset valuation allowance - We recorded a valuation allowance for our net deferred tax asset as of December 31, 2007 of $368.3 million. See “Deferred Tax Asset, Net” under Critical Accounting Estimates” for further discussion of the accounting policies surrounding our deferred tax assets.

Adoption of SFAS 159 – As a result of the adoption of SFAS 159, we elected fair value treatment for the asset-backed bonds we issued in our CDO transaction executed in the first quarter of 2007. The adoption resulted in gains due to fair value adjustments of $257.1 million for the year ended December 31, 2007, which have substantially offset the mark-to-market losses on the trading securities which were a part of our CDO transaction. These mark-to-market gains are netted with the mark-to-market losses on our trading securities in the “Fair value adjustments” line item of our consolidated statements of operations.

Liquidity– As a result of the 2007 subprime environment, we are unawareused up significant cash reserves during the year ended December 31, 2007. Our cash balances declined by approximately $125.2 million during the year ended December 31, 2007 primarily due to margin calls under short-term borrowings, mortgage loan repurchases and normal business operations. In addition, all short-term borrowing

capacity in excess of any material reason that would disrupt continuedoutstanding borrowings was terminated or became unavailable to us, and we were required to repay a substantial portion of our outstanding borrowings. As a result, we face substantial liquidity support in the capital markets forrisk and uncertainty, near-term and otherwise, which threatens our business.ability to continue as a going concern and avoid bankruptcy. See the “Liquidity and Capital Resources” sectionfor further discussion of our liquidity position and steps we have taken to preserve liquidity levels.

See discussion under heading “Industry Overview and Known Material Trends” below for more information about current conditions in our industry and the steps we are taking or considering to manage and operate our business in this challenging environment.

The following selected key performance metrics are derived from our consolidated financial statements for the periods presented and should be read in conjunction with the more detailed information therein and with the disclosure included elsewhere in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussionOperations.”

Table 1 — Summary of liquidity risksFinancial Highlights and resourcesKey Performance Metrics

(dollars in thousands; except per share amounts)

   For the Year Ended December 31,

 
   2007

  2006

  2005

 

Net (loss) income available to common shareholders

  $(733,082) $66,285  $132,471 

Net (loss) income available to common shareholders, per diluted share

  $(78.55) $7.69  $17.67 

Net yield on mortgage securities (A)

   12.52%  29.82%  42.11%

(A)This metric is defined in Table 5.

For the Year Ended December 31, 2007 as Compared to the Year Ended December 31, 2006.

We had a net loss available to us.common shareholders of $733.1 million during the year ended December 31, 2007 as compared to net income available to common shareholders of $66.3 million for the same period in 2006.

 

WithinWe incurred a significant loss from continuing operations of $467.5 million during the past two years,year ended December 31, 2007 as compared to income from continuing operations of $55.4 million for the same period in 2006. The following factors contributed to the current year loss and the decrease in income from continuing operations from the year ended December 31, 2006:

An increase in our provision for credit losses for our mortgage loans held-in-portfolio of $235.2 million which was primarily due to the continued credit deterioration in our mortgage loans held-in-portfolio.

A net loss due to fair value adjustments of $85.8 million related to our trading securities and the asset-backed bonds issued in our CDO transaction. The trading securities had a negative fair value adjustment of approximately $342.9 million while the CDO asset-backed bonds had a positive fair value adjustment of $257.1 million. These adjustments were a result of significant spread widening in the subprime mortgage market for these types of asset-backed securities.

Higher delinquencies and thus higher expected credit losses as a result of the weakening housing market contributed to an increase in impairments in our mortgage securities available-for-sale portfolio of $68.0 million from 2006. Another major contributor to the impairments in 2007 was the lengthening of the term of the securitizations due to slower prepayments and our change in expected call date assumptions used in valuing our residual securities. Previously, we estimated cash flows on our residual securities through the clean-up call date. We have extended our estimate of time that the residual securities will be outstanding further into the future due to our inability to exercise the clean-up call right we retain from the related securitizations. Because of our liquidity concerns and the fact that it takes a significant amount of capital to exercise the clean-up call, which includes repurchasing loans from the securitization trusts, we extended the estimated call dates into the future based on management’s best estimate.

A decrease of $34.9 million in net interest income before provision for credit losses which resulted primarily from higher average outstanding borrowings and higher delinquencies on our mortgage loans held-in-portfolio. The higher average borrowings were due to our liquidity needs. The higher delinquencies caused our interest income to fall as many loans have gone to nonaccrual status.

Our income tax expense increased to $66.5 million from a tax benefit recorded of $21.6 million due to our recording of a valuation allowance against our deferred tax assets.

We incurred a significant loss from discontinued operations of $256.8 million during the year ended December 31, 2007 as compared to income from discontinued operations of $17.5 million for the same period in 2006. The following factors contributed to the current year loss and the decrease in income from discontinued operations from the year ended December 31, 2006:

An increase in the charge to earnings from the lower of cost or market valuation adjustment on our mortgage loans held-for-sale of $101.1 million. The increase in this adjustment was primarily the result of the significant decline in whole loan values in 2007 caused by investor concerns over deteriorating credit quality in the subprime whole loan secondary market which led to our sale to Wachovia of approximately $669 million of loans at 91.5% of par. We had mortgage loans – held-for-sale remaining at December 31, 2007 with a principal balance of $17.5 million which had been marked down to their estimated fair value of $5.3 million.

We incurred (losses) gains on sales of mortgage assets of $(2.6) million and $42.9 million for the year ended December 31, 2007 and 2006, respectively. The loss in 2007 was primarily due to $6.3 million of losses on sales of real estate owned offset by a gain on our NMFT Series 2007-2 securitization of approximately $5.0 million. As default rates have increased so have the assets we have acquired through foreclosure (real estate owned). We held real estate owned related to discontinued operations of $2.6 million at December 31, 2007.

For the Year Ended December 31, 2006 as Compared to the Year Ended December 31, 2005.

Net income available to common shareholders declined by approximately $66.2 million during 2006 as compared to 2005.

We earned income from continuing operations of $55.4 million during the year ended December 31, 2006 as compared to income from continuing operations of $121.0 million for the same period in 2005. The following factors contributed to the decline in income from continuing operations for the year ended December 31, 2006:

We increased our provision for credit losses by approximately $29.1 million during 2006 from 2005 due to $2.5 billion of securitizations structured as financing transactions we executed in 2006. Our provision for credit losses significantly offset the positive impact to interest income yielded by these transactions.

Higher expected credit losses contributed to impairments to our mortgage securities available-for-sale portfolio increasing by $13.1 million from 2005 to 2006.

Our income from discontinued operations decreased by $0.6 million from December 31, 2005 to 2006. A decline in our gains on sales of loans to third parties due to the increase in our reserve for losses related to loan repurchases was offset by an increase in net interest income resulting from a higher average balance of mortgage loans – held-for-sale. Because of the increase in loan repurchase requests which resulted from increased delinquencies in our 2006 production, we increased our reserve for future expected losses resulting from these repurchases by $25.4 million from 2005 to 2006. The higher average balance of loans was driven by the timing of our securitizations during 2006.

Industry Overview, Significant Events and Material Trends

Described below are some of the marketplace conditions, significant events and known material trends and uncertainties that may impact our future results of operations as we move into 2008.

Future Strategy, Liquidity and Going Concern Considerations - Our plan for the future will focus on minimizing losses and preserving liquidity with our remaining operations which consists only of mortgage portfolio management. Additionally, we will focus on paying down our outstanding borrowings with Wachovia and reducing operating costs. Our residual and subordinated mortgage securities are currently our only source of cash flows. Based on the current projections, the cash flows from our mortgage securities will decrease in the next several months as the underlying mortgage loans are repaid, and could be significantly less than the current projections if losses on the underlying mortgage loans exceed the current assumptions. In addition, we have significant operating expenses associated with office leases, software contracts, and other obligations relating to our discontinued operations, as well as payment obligations with respect to secured and unsecured debt, including periodic interest payments with respect to junior subordinated debentures relating to the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II. We intend to use available cash inflows in excess of our immediate operating needs, including debt service payments, to repay all of Wachovia’s short-term borrowings and any remaining fees due under the repurchase agreements at the earliest practical date. If, as the cash flows from our mortgage securities decrease, we are unable to recommence or invest in mortgage loan origination or brokerage businesses on a profitable basis, restructure our unsecured debt and contractual obligations or if the cash flows from our mortgage securities are less than currently anticipated, there can be no assurance that we will be able to continue as a going concern and avoid seeking the protection of applicable federal and state bankruptcy laws.

Due to the fact that we have a negative net worth, we do not currently have ongoing significant business operations that are profitable and our common stock and Series C preferred stock have been delisted from the New York Stock Exchange, it is unlikely that we will be able to obtain additional equity or debt financing on favorable terms, or at all, for the foreseeable future. To the extent we require additional liquidity and cannot obtain it, we will be forced to file for bankruptcy.

In the event we are able to significantly increase our liquidity position (as to which no assurance can be given), we may use excess cash to make certain investments if we determine that such investments could provide attractive risk-adjusted returns to shareholders, including, potentially investing in new or existing operating companies. Because of certain state licensing requirements, it is unlikely we are able, ourselves, to directly recommence mortgage lending activities so long as we continue to have a shareholders’ deficit.

Recent Market Developments - During 2008, the mortgage REIT industry has remained under continuous pressure due to numerous factors, which include industry-wide disclosures regarding the continued deterioration of the value of mortgage assets held by banks and broker-dealers, the deterioration of mortgage credit among mortgage lenders, the downgrades of mortgage securities by the rating agencies, and a reluctance on the part of banks and broker-dealers to finance mortgage securities within the credit markets. Because of these factors, mortgage security market valuations remain volatile, mortgage securities trading remains limited and mortgage securities financing markets remain challenging as the industry continues to report negative news. All of these factors continue to contribute to the decline in the market values of our securities to levels at or below those experienced in 2007.

We have also seen a significant increasedrop in LIBOR rates since the end of 2007 as the Federal Reserve made several cuts in short-term interest rates, which decreases the variable interest rates tied to one-month LIBOR within our securitizations which collateralize our mortgage securities and mortgage loans – held-in-portfolio. These trends, if they continue, could lead to positive effects on the cash flows we receive from our mortgage securities. However, these cash flows are also dependent on the credit and prepayment performance of the underlying collateral which could offset part or all of any positive impact of decreased LIBOR rates.

Given the current uncertainty regarding these market conditions, we are unable to offer any additional factual information on the situation and how it will impact us other than to disclose what we are currently seeing in the desiremortgage market. As a result, we expect to continue to operate with a historically low level of leverage and to continue to take actions to support liquidity and available cash.

Home prices - Recently, we have seen broad-based declines in housing values. Housing values could continue to decrease during the near term which could affect our credit loss experience, which will continue to impact our earnings, cash flows and financial condition and ability to continue as a going concern.

American Interbanc Mortgage Litigation. On March 17, 2008, the NovaStar Entities and American Interbanc Mortgage, LLC (“Plaintiff”) entered into a Confidential Settlement Term Sheet Agreement (the “Settlement Terms”) with respect to the actions, judgments and claims described below.

In March 2002, Plaintiff filed an action against NHMI in Superior Court of Orange County, California entitled American Interbanc Mortgage LLC v. NovaStar Home Mortgage, Inc. et. al. (the “California Action”). In the California Action, Plaintiff alleged that NHMI and two other mortgage companies (“Defendants”) engaged in false advertising and unfair competition under certain California statutes and interfered intentionally with Plaintiff’s prospective economic relations. On May 4, 2007, a jury returned a verdict by a 9-3 vote awarding Plaintiff $15.9 million. The court trebled the award, made adjustments for raising public capital. Additionally, thereamounts paid by settling Defendants, and entered a $46.1 million judgment against Defendants on June 27, 2007. The award is joint and several against the Defendants, including NHMI. It is unknown if the other two Defendants, one of which has filed a bankruptcy petition, have the financial ability to pay any of the award.

NHMI’s motion for the trial court to overturn or reduce the verdict was denied on August 20, 2007, and NHMI appealed that decision (the “Appeal”). Pending the Appeal, Plaintiff commenced enforcement actions in the states of Missouri (the “Kansas City Action”) and Delaware, and obtained an enforcement judgment in Delaware (the “Delaware Judgment”). On January 23, 2008, Plaintiff filed an involuntary petition for bankruptcy against NHMI under 11 U.S.C. Sec. 303, in the United States Bankruptcy Court for the Western District of Missouri (the “Involuntary”). Plaintiff was joined by two individuals alleging claims totaling $150 in the Involuntary filing. NHMI filed an answer and contested the standing of Plaintiff and the individuals to be petitioning creditors in bankruptcy.

On March 17, 2008, the NovaStar Entities and Plaintiff entered into the Settlement Terms with respect to the California Action, the Judgment, the Kansas City Action, the Delaware Judgment, the Involuntary, and all related claims.

Under the Settlement Terms, the parties agreed to move to dismiss the Involuntary. Within ten (10) business days after notice of entry of the dismissal of the Involuntary, NFI will pay Plaintiff $2,000,000 plus the balance in an account established by order of the Bankruptcy Court in an amount no less than $50,000 (but not anticipated to be greater than $65,000 at the time of payment), with NHMI obligated to otherwise satisfy obligations to its identified creditors up to $48,000. The parties also agreed to extend the Appeal briefing period pending finalization of the settlement of the other actions, judgments and claims, as described below.

The Settlement Terms provide that, subject to payment of the amounts described above and satisfaction of certain other conditions, the parties will dismiss the California Action as to NHMI and the Kansas City Action and Delaware Judgment, effect notice of satisfaction of the Judgment, and effect a mutual release of all claims that were or could have been several new entrantsraised in any of the foregoing or that are related to the mortgage REIT business and other mortgage lender conversions (or proposed conversions)subject matter thereof, upon the earliest of the following: (i) July 1, 2010, (ii) a waiver by Wachovia of Wachovia’s right to REIT status. This increased activity may impactfile an involuntary bankruptcy proceeding against any of the pricing and underwriting guidelines withinNovaStar Entities prior to July 1, 2010, (iii) an extension of the nonconforming marketplace.maturity date of our indebtedness to Wachovia until at least July 1, 2010, or (iv) delivery to Plaintiff of written documentation evidencing the full satisfaction of our current indebtedness to Wachovia.

 

StateIn addition to the initial payments to be made to the Plaintiff following dismissal of the Involuntary, we will pay Plaintiff $5.5 million if, prior to July 1, 2010, (i) NFI’s average common stock market capitalization is at least $94.4 million over a period of five (5) consecutive business days, or (ii) the holders of NFI’s common stock are paid $94.4 million in net asset value as a result of any sale of NFI or its assets. If NFI is sold prior to July 1, 2010 for less than $94.4 million and local governing bodies are focusedceases to be a public company, then NFI will obligate the purchaser either to immediately pay $2 million to Plaintiff, or to pay Plaintiff $5.5 million in the event the value of NFI exceeds $94.4 million prior to July 1, 2010 as determined by an independent valuation company.

We make no assurances with regard to our ability to satisfy of any of the conditions described or referenced above. Without limiting the foregoing, we have obtained no commitment from Wachovia with regard to any action that may be required of Wachovia in order to effect, prior to July 1, 2010, the dismissals and releases described above. Further, nothing in the Settlement Terms constitutes an expression of our belief, projection, assumption, or intent regarding any future event, any industry or market conditions, or our financial condition, stock price, or business plans or strategies.

In accordance with generally accepted accounting principles, NHMI has recorded a liability of $47.1 million as of December 31, 2007 with a corresponding charge to earnings. The $47.1 million includes interest which is accruing on the nonconforming lending businessobligation. Because NHMI is a wholly owned indirect subsidiary of NFI, the $47.1 million liability is included in our consolidated financial statements. The liability is included in the “Liabilities of discontinued operations” line of the consolidated balance sheets while the charge to earnings is included in the “(Loss) income from discontinued operations, net of income tax” line of the consolidated statements of operations.

Dividend payments - As a result of the termination of our REIT status and our current financial condition, we do not intend to pay any excessive fees borrowers incur in obtaining a mortgage loan – generally termed “predatory lending” within the mortgage industry. 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 impactdividends on our business.common stock for the foreseeable future. Also, our board of directors has suspended dividend payments on our Series C and Series D-1 Preferred Stock. As a result, dividends on the Series C and D-1 preferred stock will continue to accrue and the dividend rate on the Series D-1 preferred stock increased from 9.0% to 13.0%, compounded quarterly, effective January 16, 2008 with respect to all unpaid dividends and subsequently accruing dividends. All accrued and unpaid dividends on our preferred stock must be paid prior to payment of any dividends on our common stock. We have capped fee structures consistent with those adopted by federal mortgage agencies and have implemented rigid processesdo not expect to ensurepay dividends on any of our stock for the foreseeable future.

Trading of our stock - On January 11, 2008, we announced that NYSE Regulation determined that our lending practicescommon stock (ticker symbol: NFI) and our 8.90% Series C Cumulative Redeemable Preferred Stock (ticker symbol: NFI PR C) no longer met applicable listing standards for continued listing on the New York Stock Exchange. Our common and preferred shares are not predatory in nature.eligible for quotation on the OTC Bulletin Board and the Pink Sheets, an electronic quotation service for securities traded over-the-counter, under the symbols (“NOVS”) and (“NOVSP”), respectively.

Critical Accounting Estimates

 

We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of AmericaGAAP 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 two of our threeone reportable segments;segment, which is our mortgage portfolio management and mortgage lending and loan servicing segments.segment. 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 GainsGains.. In a loan securitization, we combinecombined the mortgage loans we originateoriginated and purchasepurchased in pools to serve as collateral for asset-backed bonds that are issued to the public.bonds. In a mortgage security securitization (also known as a “Resecuritization”“resecuritization”), we combinecombined mortgage securities - available-for-sale 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 - available-for-sale arewere 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 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – a replacement of FASB Statement No. 125Liabilities” (“SFAS 140”). The owners of the asset-backed bonds have no recourse to us in the event the collateral does not perform as planned except where defects have occurred in the loan documentation and underwriting process.

 

In order for us toTo determine proper accounting treatment for each securitization or resecuritization, we evaluateevaluated 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 arewere 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 totransfereeto return specific assets?

 

Is there an agreement that both obligates and entitles the transferortransferee to repurchase or redeemreturn 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 arewere executed in a manner such that we have surrendered control over the collateral, the transfer iswas accounted for as a sale. In accordance with SFAS No. 140, a gain or loss on the sale iswas 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 accounted for as a sale, we do retainretained (but have subsequently sold) the right to service the underlying mortgage loans and we also retainretained certain mortgage securities - available-for-sale issued by the trust (see Mortgage Securities – Available-for-Sale below).trust. As previously discussed, the gain recognized upon a securitization structured as a sale depends on, among other things, the estimated fair value of the components of the securitization – the loans or mortgage securities - available-for-saleand derivative instruments transferred, the securities retained and the mortgage servicing rights. The estimated fair value of the securitization components is considered a “critical accounting estimate” as 1) these gains or losses can 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 believeuse two methodologies for determining the best estimateinitial value of our residual securities: 1) the whole loan price methodology and 2) the discount rate methodology. We generally will try to use the whole loan price methodology when significant open market sales pricing data is available. Under this method, the initial value of the securities we retainloans transferred in a whole loan securitization is derived from the market value of the pooled loans. The initial value of the loansaccounted for as a sale 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 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 then 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.

When significant open market pricing information is not readily available to us, we use the discount rate methodology. Under this method, we first analyze market discount rates for similar assets. After establishing the market discount rate, the projected cash flows are discounted back to ascertain the initial value of the residual securities. We then ascertain whether the resulting initial value is commensurate with current market conditions.

 

For purposes of valuing our mortgageresidual securities, - available-for-sale, it is important to know that in recent securitization transactions we not only have transferred loans to the trust, but we have also transferredtransfer interest rate agreements to the securitization 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. Therefore, the trust assumes the obligation to make payments and obtains the right to receive payments under these agreements.

 

In valuing our mortgageresidual securities, - available-for-sale 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 mortgageresidual securities - available-for-sale 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 103.28 and 104.21 during 2004 and 2003, respectively. The weighted average implied discount rate for the years ended December 31, 2004 and 2003 was 22%. If the whole loan market price used in the initial valuation of our mortgage securities - available-for-sale in 2004 had been increased or decreased by 50 basis points, the initial value of our mortgage securities - available-for-sale and the gain we recognized would have increased or decreased by $41.6 million.

Information regarding the assumptions we used is discussed under “Mortgage Securities – Available-for-Sale” in the following discussion.

 

When we do have the ability to exert control over the transferred collateral in a securitization, the assets remain on our financial recordsstatements and a liability is recorded for the related asset-backed bonds. The servicing agreements that we executeexecuted for loans we have securitized includesinclude a removal of accounts provision which gives usthe servicer the right, but not the obligation, to repurchase mortgage loans from the trust. The removal of accounts provision can be exercised fortrust loans that are 90 days to 119 days delinquent. We recordWhile we retained these servicing rights, we recorded 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. The clean upHowever, in November 2007 we sold all of our mortgage servicing rights, including the removal of accounts rights, to a third party, which resulted in the removal of the mortgage loans subject to the removal of accounts provision from our balance sheet. In addition, we retained 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. However, we subsequently sold these clean up call rights, in part, to the buyer of our mortgage servicing rights, and we do not expect to exercise any of the call rights that we retained.

 

Mortgage Securities – Available-for-Sale.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 as well as bonds issued by others which we have purchased. The beneficial interestsresidual securities include interest-only mortgage securities, prepayment penalty bonds and over-collateralization bonds. The subordinated securities represent bonds which are senior to the residual securities but are subordinated to the bonds sold to third party investors. All of the subordinated securities retained by us have been classified as trading.

The residual securities we retain in securitization transactions structured as sales 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 subordinated securities we retain in our securitization transactions have a stated principal amount and interest rate. 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 we account for the securities based on guidance set forth from Emerging Issuance Task Force 99-20 “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets” (“EITF 99-20”) using 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 of 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 mortgage securities - available-for-sale.residual 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 - available-for-sale.securities. We believe the value of our mortgageresidual securities - available-for-sale is fair,appropriate, 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. ImpairmentsFor mortgage securities classified as available-for-sale, impairments would reduce income in future periods when deemed other-than-temporary.

 

As 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 our mortgage securities – available-for-sale and trading is based on the effective yield method. Under the effective yield method, 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 forabout 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 - available-for-sale 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, theexpected call dates, 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. See Note 4 to the consolidated financial statements for key economic assumptions and sensitivity of the current fair value of our residual securities.

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, 2004,When we recorded an impairment loss of $15.9 million on NMFT Series 1999-1, 2004-1, 2004-2 and 2004-3. The impairments wereretain new residual securities during a result of a significant increase inperiod when short-term interest rates during the year as well as higherrate increases are greater than anticipated prepayments. While we do use forward yield curves in valuing our securities, the increase in two-year and three-year swap rates was greater thanby the forward yield curve, had anticipated, thus causing a greater than expectedwe 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. Prepayments were higher than expected due to substantial increases in housing prices in the past few years. Increases in housing prices give borrowers the opportunity to use the increase in the equity in their homes to refinance their existing mortgage into lower-rate mortgages. See Table 4 for a quarterly summary of the cost basis, unrealized gain (loss) and fair value of our mortgage securities - - available-for-sale.

Our average security yield has decreased to 31.4% for the year ended December 31, 2004 from 34.3% for the same period of 2003. This decrease is a result of the significant rise in short-term interest rates in 2004. Mortgage securities – available-for-sale income has increased from $98.8 million for the year ended December 31, 2003 to $133.6 million for the same period of 2004 due to the increase in the average balance of our securities portfolio. If the rates used to accrue income on our mortgage securities - available-for-sale during 2004 had increased or decreased by 10%, net income during the year ended 2004 would have increased by $34.1 million and decreased by $36.8 million, respectively.

As of December 31, 2004 and 2003, the weighted average discount rate used in valuing our mortgage securities - available-for-sale was 22%. The weighted average constant prepayment rate used in valuing our mortgage securities - available-for-sale as of December 31, 2004 was 39 versus 33 as of December 31, 2003. If the discount rate used in valuing our mortgage securities - available-for-sale as of December 31, 2004 had been increased by 500 basis points, the value of our mortgage securities - available-for-sale would have decreased $24.8 million. If we had decreased the discount rate used in valuing our mortgage securities - available-for-sale by 500 basis points, the value of our mortgage securities - available-for-sale would have increased $28.6 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 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 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.

Allowance for Credit Losses. 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 thereforeamount of the related adjustment to income,allowance 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 ratios, 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 indicatorsin estimating the amount of the allowance for credit losses are highly uncertain and involve a great deal of judgment.

An internally developed migration analysis is the primary tool used in analyzing our allowance for credit losses. This tool takes into consideration historical information regarding foreclosure and loss severity experience and applies that information to the portfolio at the reporting date. We also take into consideration our use of mortgage insurance as a method of managing credit risk. We pay mortgage insurance premiums on a portion of the loans maintained on our balance sheet and have included the cost of mortgage insurance in our statement of operations.

Our estimate of expected losses could increase if our actual loss experience is different than originally estimated. In addition, our estimate of expected losses could increase if economic factors change the value we could reasonably expect to obtain from the sale of the property. If actual losses increase or if values reasonably expected to be obtained from property sales decrease, the provision for losses would increase. Any increase in the provision for losses would adversely affect our results of operations.

Real Estate Owned Real estate owned, which consists of residential real estate acquired in satisfaction of loans, is carried at the lower of cost or estimated fair value less estimated selling costs. We estimate fair value at the asset’s liquidation value less selling costs using management’s assumptions which are based on historical loss severities for similar assets. Adjustments to the loan carrying value required at time of foreclosure are charged against the allowance for credit losses. Costs related to the development of real estate are capitalized and those related to holding the property are expensed. Losses or gains from the ultimate disposition of real estate owned are charged or credited to earnings.

Mortgage Servicing Rights (“MSR’s”). We sold all of our mortgage servicing rights on November 1, 2007 and, therefore, did not have any MSR’s recorded as of December 31, 2007. We did have significant MSR balances as of December 31, 2006, as well as significant MSR activity during 2007.

Beginning in 2007, due to the adoption of SFAS 156, “Accounting for Servicing of Financial Assets” (“SFAS 156”), MSR’s were initially recorded at fair value. Prior to 2007, MSR’s were initially recorded at allocated cost based upon the relative fair values of the transferred loans, derivative instruments and the servicing rights. Additionally, we elected to continue to amortize our MSR’s in proportion to and over the projected net servicing revenues as opposed to the fair value method as allowed under SFAS 156. Periodically, we evaluated the carrying value of originated MSR’s based on their estimated fair value. If the estimated fair value was less than the carrying amount of the mortgage servicing rights, the mortgage servicing rights were written down to the amount of the estimated fair value. For purposes of evaluating and measuring impairment of MSR’s, we stratified the mortgage servicing rights based on their predominant risk characteristics. The most predominant risk characteristic considered was period of origination. The mortgage loans underlying the MSR’s were pools of homogeneous, nonconforming residential loans.

We used a discounted cash flow methodology to arrive at a fair value. The fair value of MSR’s is highly sensitive to changes in assumptions. Changes in prepayment speed assumptions have the greatest impact on the fair value of MSR’s. Generally, as interest rates decline, prepayments accelerate due to increased refinance activity, which results in a decrease in the fair value of MSR’s. Conversely, as interest rates rise, prepayments typically slow down, which generally results in an increase in the fair value of MSR’s. 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’s 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.

Reserve for Loan Repurchases. We maintain a reserve for the representation and warranty liabilities related to loans sold to third parties, and for the contractual obligation to rebate a portion of any premium paid by a purchaser when a borrower prepays a sold loan within an agreed period. The reserve, which is recorded as a liability on the consolidated balance sheet, is established when loans are sold, and is calculated as the estimated fair value of losses reasonably estimated to occur over the life of the contractual obligation. Management estimates inherent losses based upon historical loss trends and frequency and severity of losses for similar loan product sales. The adequacy of this reserve is evaluated and adjusted as required. The provision for losses recognized at the sale date is included in the consolidated statements of operations as a reduction of gains on sales of mortgage assets.

 

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)., subject to cost and liquidity constraints. 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 our market value. We primarily enter intoGenerally 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.nature. 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 “Accounting for Derivative Instruments and Hedging Activities (as amended),Activities” (“SFAS 133”) standardizes the accounting for derivative instruments, including certain instruments embedded in other contracts, by requiring that an entity recognize those items as assets or liabilities in the balance sheet and measure them at fair value. If certain conditions are met, an entity may elect to designate a derivative instrument either as a cash flow hedge, a fair value hedge or a hedge of foreign currency exposure. SFAS No. 133 requires derivative instruments to be recorded at their fair value with hedge ineffectiveness recognized in earnings.

Due to the negative fair value of our derivative instruments at December 31, 2007, they are included in accounts payable and other liabilities in our consolidated balance sheet. Our derivative instruments had a positive fair value as of December 31, 2006 and are included in other assets on our consolidated balance sheet as of that date.

Derivative instruments that meet the hedge accounting criteria of SFAS No. 133 are considered cash flow hedges. We also have derivative instruments that do not meet 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-termlong-term borrowings used to fundcollateralized by our loans held-for-sale.held-in-portfolio.

 

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)CDO Asset-backed Bonds (“CDO ABB”). MSR are recorded at allocated cost based upon We elected the relative fair valuesvalue option for the asset-backed bonds issued from NovaStar ABS CDO I in 2007. We elected the fair value option for these liabilities to help reduce earnings volatility which otherwise would arise if the accounting method for this debt was not matched with the fair value accounting for the related mortgage securities—trading. Fair value is estimated using quoted market prices of the transferred loansunderlying assets.

The asset-backed bonds which are being carried at fair value are included in the “Asset-backed bonds secured by mortgage securities” line item on the consolidated balance sheets. We recognize fair value adjustments for the change in fair value of the bonds which are included in the “Fair value adjustments” line item on the consolidated statements of operations. We calculate interest expense for these asset-backed bonds based on the prevailing coupon rates of the specific classes of debt and record interest expense in the period incurred. Interest expense amounts are included in the “Interest expense” line item of the consolidated statements of operations.

Deferred Tax Asset, net. We recorded deferred tax assets and liabilities for the future tax consequences attributable to differences between the GAAP carrying amounts and their respective income tax bases. A deferred tax liability was recognized for all future taxable temporary differences, while a deferred tax asset was recognized for all future deductible temporary differences, operating loss carryforwards and tax credit carryforwards. In accordance with SFAS 109, we recorded deferred tax assets and liabilities using the enacted tax rate that is expected to apply to taxable income in the periods in which the deferred tax asset or liability is expected to be realized.

We previously elected to be treated as a REIT for federal income tax purposes and, as a result, were not required to pay any corporate level income taxes as long as we remained a REIT and distributed 100 percent of our taxable income in the form of dividend distributions to our shareholders. During 2007, we were unable to satisfy the REIT distribution requirement for the tax year ended December 31, 2006, either in the form of cash or preferred stock. This action resulted in our loss of REIT status retroactive to January 1, 2006. Our failure to satisfy the REIT distribution test resulted from demands on our liquidity and a substantial decline in our market capitalization during 2007.

Although we had planned to revoke REIT status effective January 1, 2008, the termination of REIT status two years prior to our plan adversely impacted our financial statements. The impact of the termination of our REIT status has been reflected in our 2007 financial statements.

As a result of our termination of REIT status, we elected to file a consolidated federal income tax return with our eligible affiliated members. We reported taxable income in 2006 of approximately $212 million, which resulted in a tax liability of approximately $74 million along with interest and penalties due of approximately $5.8 million. After applying our payments and credits, we reported an amount owed to the IRS of approximately $67 million. We applied for and received an extension of time to pay our income taxes due to our expectation of generating a net operating loss for 2007, which may be carried back to 2006. This approved extension should allow us to eliminate all of our taxable income (excluding excess inclusion income) from 2006, and eliminate the outstanding tax liability due to the IRS. However, we will be required to pay interest and any penalties that apply on the balance due to the IRS in 2008.

Because we terminated our REIT status effective January 1, 2006, and were taxable as a C corporation for 2006 and beyond, we recorded deferred taxes as of December 31, 2007 based on the estimated cumulative temporary differences as of the current date.

In determining the amount of deferred tax assets to recognize in the financial statements, we evaluate the likelihood of realizing such benefits in future periods. SFAS 109 requires the recognition of a valuation allowance if it is more likely than not that all or some portion of the deferred tax asset will not be realized. SFAS 109 indicates the more likely than not threshold is a level of likelihood that is more than 50 percent.

Under SFAS 109, companies are required to identify and consider all available evidence, both positive and negative, in determining whether it is more likely than not that all or some portion of its deferred tax assets will not be realized.

Positive evidence includes, but is not limited to the following: cumulative earnings in recent years, earnings expected in future years, excess appreciated asset value over the tax basis, and positive industry trends. Negative evidence includes, but is not limited to the following: cumulative losses in recent years, losses expected in future years, a history of operating losses or tax credits carryforwards expiring, and adverse industry trends.

The weight given to the potential effect of negative and positive evidence should be commensurate with the extent to which it can be objectively verified. Accordingly, the more negative evidence that exists requires more positive evidence to counter, thus making it more difficult to support a conclusion that a valuation allowance is not needed for all or some of the deferred tax assets. A cumulative loss in recent years is significant negative evidence that is difficult to overcome when determining the need for a valuation allowance. Similarly, cumulative earnings in recent years represents significant positive objective evidence. If the weight of the positive evidence is sufficient to support a conclusion that it is more likely than not that a deferred tax asset will be realized, a valuation allowance should not be recorded.

We examine and weigh all available evidence (both positive and negative and both historical and forecasted) in the process of determining whether it is more likely than not that a deferred tax asset will be realized. We consider the relevancy of historical and forecasted evidence when there has been a significant change in circumstances. Additionally, we evaluate the realization of our recorded deferred tax assets on an interim and annual basis. We do not record a valuation allowance if the weight of the positive evidence exceeds the negative evidence and is sufficient to support a conclusion that it is more likely than not that our deferred tax asset will be realized.

If the weighted positive evidence is not sufficient to support a conclusion that it is more likely than not that all or some of our deferred tax assets will be realized, we consider all alternative sources of taxable income identified in SFAS 109 in determining the amount of valuation allowance to be recorded. Alternative sources of taxable income identified in SFAS 109 include the following: 1) taxable income in prior carryback year, 2) future reversals of existing taxable temporary differences, 3) future taxable income exclusive of reversing temporary differences and carryforwards, and 4) tax planning strategies.

Based on the evidence available as of December 31, 2007, including the significant pre-tax losses incurred by us in both the current quarter and previous quarters, the ongoing disruption to the credit markets, the liquidity issues facing us and our decision to close all of our mortgage lending operations, we concluded that it is more likely than not that our entire net deferred tax asset will not be realized. Based on these conclusions, we recorded a valuation allowance of $368.3 million for deferred tax assets as of December 31, 2007 compared to $0.7 million as of December 31, 2006. In future periods, we will continue to monitor all factors that impact positive and negative evidence relating to our deferred tax assets.

As of December 31, 2007, we had a federal net operating loss of approximately $368.4 million. We are expecting to carryback $196.1 million of the 2007 projected federal net operating loss against our 2006 taxable income and have recorded a current receivable for such benefit. The receivable was netted against the 2006 federal liability. The remaining $172.3 federal net operating loss may be carried forward to offset future taxable income, subject to applicable provisions of the Code, including substantial limitations in the event of an “ownership change” as defined in Section 382 of the Code. If not used, this net operating loss will begin to expire in 2025.

Impact of Recently Issued Accounting Pronouncements

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments”, an amendment of SFAS 133 and SFAS 140. 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 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.

In January 2007, the FASB provided a scope exception under SFAS 155 for securitized interests that only contain an embedded derivative that is tied to the prepayment risk of the underlying prepayable financial assets, and for which the investor does not control the right to accelerate the settlement. If a securitized interest contains any other embedded derivative (for example, an inverse floater), then it would be subject to the bifurcation tests in SFAS 133, as would securities purchased at a significant premium. In previous years, our policy was to designate our residual securities as available-for-sale but as a result of our adoption of SFAS 155 on January 1, 2007 and the complexities and uncertainties surrounding the application of this Statement, we designated the NMFT Series 2007-2 residual security as trading. As a result, the NMFT Series 2007-2 residual security qualifies for the scope exception concerning bifurcation provided by SFAS 155.

In March 2006, the FASB issued SFAS 156. This statement requires that an entity separately recognize a servicing rights. MSRasset or a servicing liability when it undertakes an obligation to service a financial asset under a servicing contract in certain situations. Such servicing assets or servicing liabilities are amortizedrequired to be initially measured at fair value, if practicable. SFAS 156 also allows an entity to choose one of two methods when subsequently measuring its servicing assets and servicing liabilities: (1) the amortization methodor (2) the fair value measurement method. The amortization method existed under SFAS 140 and remains unchanged in (1) allowing entities to amortize their servicing assets or servicing liabilities in proportion to and over the projectedperiod of estimated net servicing revenues. Periodically, we evaluateincome or net servicing loss and (2) requiring the carrying valueassessment of originated MSRthose servicing assets or servicing liabilities for impairment or increased obligation 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 most predominant risk characteristic considered is period of origination. The mortgage loans underlying the MSR are pools of homogeneous, nonconforming residential loans.

at each reporting date. The fair value of MSR is highly sensitivemeasurement method allows entities to measure their servicing assets or servicing liabilities at fair value at each reporting date and report changes in assumptions. Changes in prepayment speed assumptions have the most significant impact on the fair value of MSR. Generally, as interest rates decline, prepayments accelerate due to increased refinance activity, which results in a decreaseearnings in the fair valueperiod the change occurs. SFAS 156 introduces the notion of MSR. As interest rates rise, prepayments slow down, which generally results in an increase in the fair valueclassesand allows companies to make a separate subsequent measurement election for each class of MSR. All assumptions are reviewedits servicing rights. In addition, SFAS 156 requires certain comprehensive roll-forward disclosures that must be presented for reasonableness on a quarterly basis and adjustedeach class. The Statement is effective as necessary to reflect current and anticipated market conditions. Thus, any measurement of the fair valuebeginning of MSR is limited by the existing conditionsan entity’s first fiscal year that begins after September 15, 2006. We adopted SFAS 156 on January 1, 2007 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. Priorelected to 2003, we accounted for our stock-based compensation plancontinue 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 prospectiveamortization 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.measuring our servicing assets.

 

In accordance withJune 2006, the FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or to be taken on a tax return. This interpretation also provides additional guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation is effective for fiscal years beginning after December 15, 2006. We adopted the provisions of FIN 48 on January 1, 2007. The cumulative effect of applying the provisions of FIN 48 is reported as an adjustment to the opening balance of accumulated deficit on January 1, 2007 and resulted in an increase to our accumulated deficit of $1.1 million.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”, (“SFAS 157”). SFAS 157 establishes a framework for measuring fair value and requires expanded disclosures regarding fair value measurements. This accounting standard is effective for financial statements issued for fiscal years beginning after November 15, 2007, however early adoption is permitted. We adopted the provisions of SFAS No. 123157 on January 1, 2007. See Note 11 and Note 15 which describe the impact of the adoption of SFAS 157 on our consolidated financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides guidance regarding the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of materiality assessments. The method established by SAB 108 requires each of our financial statements and the related financial statement disclosures to be considered when quantifying and assessing the materiality of the misstatement. The provisions of SAB 108 are effective for financial statements issued for fiscal years beginning after December 31, 2006. We adopted SAB 108 on January 1, 2007 and have deemed the impact immaterial on our consolidated financial statements.

In February 2007, the FASB issued SFAS No. 148, $1.8 million159, “The Fair Value Option for Financial Assets and $1.3 million was recordedFinancial Liabilities – Including an amendment of FASB Statement No. 115.” (“SFAS 159”) which permits entities to choose to measure many financial instruments and certain other items at fair value. Unrealized gains and losses on items for total stock-based compensation expensewhich the fair value option has been elected will be recognized in 2004earnings at each subsequent reporting date. This accounting standard is effective for financial statements issued for fiscal years beginning after November 15, 2007, however early adoption is permitted. We adopted the provisions of SFAS 159 on January 1, 2007. See Note 11 which describes the impact of the adoption of SFAS 159 on our consolidated financial statements.

On February 20, 2008, the FASB issued Staff Position (FSP) 140-3, “Accounting for Transfers of Financial Assets and 2003, respectively. Repurchase Financing Transactions”, (“FSP 140-3”). The FSP focuses on the circumstances that would permit a transferor and a transferee to separately evaluate the accounting for a transfer of a financial asset and a repurchase financing under SFAS 140.The FSP states that a transfer of a financial asset and a repurchase agreement involving the transferred financial asset should be considered part of the same arrangement when the counterparties to the two transactions are the same unless certain criteria are met. The criteria in the FSP are intended to identify whether (1) there is a valid and distinct business or economic purpose for entering separately into the two transactions and (2) the repurchase financing does not result in the initial transferor regaining control over the previously transferred financial assets. Its purpose is to limit diversity of practice in accounting for these situations, resulting in more consistent financial reporting. Consequently, it is the FASB’s desire to have the FSP effective as soon as practicable. This FSP would be effective for financial statements issued for fiscal years beginning after November 15, 2008 and interim periods within those fiscal years. Early application is not permitted.

During the first quarter of 2006, we purchased approximately $1.0 billion of mortgage loans from counterparties which were subsequently financed through repurchase agreements with that same counterparty. As of December 31, 2007, the entire $1.0 billion of mortgage loans purchased during 2006 remained on our consolidated balance sheet but they were no longer financed with repurchase agreements as they had been securitized in transactions structured as financings and the short-term repurchase agreements were replaced with asset-backed bond financing. We believe there would be no material change to our financial statements upon the adoption of FSP 140-3.

In accordanceMarch 2008, the FASB issued FASB Statement No. 161, “Disclosures about Derivative Instruments and Hedging Activities.” The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with APB No. 25, total stock-based compensation expense was $2.5 millionearly application encouraged. We do not expect the adoption of SFAS 161 to have a material impact on our consolidated financial statements, however, we are still in the process of evaluating the impact of adopting SFAS 161.

Results of Operations – Consolidated Earnings Comparisons

Continuing Operations

Year Ended December 31, 2007 as Compared to the Year Ended December 31, 2006

See the “Executive Overview of Performance” for discussion of the results of operations for the year ended December 31, 2002.2007 as compared to the year ended December 31, 2006.

 

Financial Condition as ofYear Ended December 31, 2004 and 20032006 as Compared to the Year Ended December 31, 2005

 

See the “Executive Overview of Performance” for discussion of the results of operations for the year ended December 31, 2006 as compared to the year ended December 31, 2005.

Mortgage Loans.Net Interest (Expense) Income. We classifyearn interest income primarily on our mortgage assets which include mortgage securities available-for-sale, mortgage securities trading and mortgage loans into two categories: “held-for-sale” and “held-in-portfolio”. Loansheld-in-portfolio. In addition we have originated and purchased, but have not yet sold or securitized, are classified as “held-for-sale”. We expect to sell these loans outright in third-party transactions or in securitization transactions that will be,earn interest income on available cash we hold for tax and accounting purposes, recorded as sales. We usegeneral operating needs. Interest expense consists primarily of interest paid on borrowings secured by mortgage assets, which includes warehouse 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, 2004 and December 31, 2003 is dependent on loans we have originated and purchased during the period as well as loans we have sold outright or through securitization transactions.asset backed bonds.

 

The volume and cost of our loan production is critical to our financial results. The loans we produce serve as collateral for our mortgage securities - available-for-sale 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 productionprovides the components of net interest income for 2004the years ended December 31, 2007, 2006 and 2003. We discuss our cost of production under “General and Administrative Expenses” under “Results of Operations”. Also, detail regarding mortgage loans sold or securitized and the gains recognized during 2004 can be found in the “Gains on Sales of Mortgage Assets and Gains (Losses) on Derivative Instruments” section of this document.2005.

 

Table 1 — 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

  

2004

  55,974  $8,424,361  $150,505  101.3% 82% 622  7.6% 72%
   
  

  

  

 

 
  

 

2003

  36,911  $5,250,978  $142,261  101.2% 81% 638  7.3% 77%
   
  

  

  

 

 
  

 

A portion of the mortgage loans on our balance sheet serve as collateral for asset-backed bonds we have issued and are classified as “held-in-portfolio.” The carrying value of “held-in-portfolio” mortgage loans as of December 31, 2004 was $59.5 million compared to $94.7 million as of December 31, 2003.

Premiums 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. To mitigate the effect of prepayments on interest income from mortgage loans, we generally strive to originate and purchase mortgage loans with prepayment penalties.

In periods of decreasing interest rates, borrowers are more likely to refinance their mortgages to obtain a better interest rate. Even 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.

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.” Gains on the sales of mortgage loans, including impact of securitizations treated as sales, is also discussed under “Results of Operations.” Additional information relating to 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.

Table 2 — Carrying Value of Mortgage LoansNet Interest Income

(dollars in thousands)

 

   

December 31,

2004


  

December 31,

2003


 

Held-in-portfolio:

         

Current principal

  $58,859  $94,162 
   


 


Premium

  $1,175  $1,874 
   


 


Coupon

   10.0%  10.0%
   


 


Percent with prepayment penalty

   %  %
   


 


Held-for-sale:

         

Current principal

  $719,904  $673,405 
   


 


Premium

  $6,760  $10,112 
   


 


Coupon

   7.7%  7.7%
   


 


Percent with prepayment penalty

   65%  74%
   


 


   For the Year Ended December 31,

 
   2007

  2006

  2005

 

Interest income:

             

Mortgage securities

  $102,500  $164,858  $188,856 

Mortgage loans held-in-portfolio

   258,663   134,604   4,311 

Other interest income

   5,083   4,660   6,315 
   


 


 


Total interest income

   366,246   304,122   199,482 
   


 


 


Interest expense:

             

Short-term borrowings secured by mortgage loans

   —     18,120   —   

Short-term borrowings secured by mortgage securities

   23,649   14,237   1,771 

Asset-backed bonds secured by mortgage loans

   178,937   88,116   1,809 

Asset-backed bonds secured by mortgage securities

   17,635   3,860   15,628 

Junior subordinated debentures

   8,148   7,001   3,055 
   


 


 


Total interest expense

   228,369   131,334   22,263 
   


 


 


Net interest income before provision for credit losses

   137,877   172,788   177,219 

Provision for credit losses

   (265,288)  (30,131)  (1,038)
   


 


 


Net interest (expense) income

  $(127,411) $142,657  $176,181 
   


 


 


Mortgage Securities– Available-for-Sale.Since 1998, we have pooled

Our net interest (expense) income decreased by $270.1 million and $33.5 million for 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, prepayment penalty and subordinated principal securities. Additionally, we service the loans sold in these securitizations (see “Mortgage Servicing Rights” under the header “Financial Condition as ofyears ended December 31, 20042007 and 2003”). As of2006, respectively. Interest income on mortgage loans held-in-portfolio increased for the years ended December 31, 20042007 and 2003,2006 as a result of higher average mortgage loan balances due to the fair value ofon-balance sheet securitizations accounted for as financings we executed in 2007 and 2006. This increase was offset by lower interest income from our mortgage securities was $489.2 million and $382.3 million, respectively. During 2004 and 2003, we executed securitizations totaling $8.3 billion and $5.3 billion, respectively, in mortgage loans and retained mortgage securities with a cost basis of $381.8 million and $292.7 million, respectively. See Note 3due to the consolidated financial statements for a summaryaddition of the activity in our mortgagelower-yielding securities portfolio.

The value of our mortgage securities 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 mortgage securities, management must make assumptions regarding the future performance and cash flowdeterioration of the mortgage loans collateralizingunderlying the mortgage securities. These estimates are based on management’s judgments about the natureThe increase in interest income from mortgage loans – held-in-portfolio was further offset by an increase in interest expense as a result of the loans. The cash flows we receive on our mortgage securities will be the net of the gross coupon and the bond cost less administrative costs (servicing and trustee fees) and thehigher average outstanding debt balances as well as an increased cost of mortgage insurance. Additionally, the trust is a party to interest rate agreements. Our cash flow will include (exclude) payments from (to) the interest rate agreement counterparty. Table 3 provides a summary of the critical assumptions used in estimating the cash flows of the collateral and the resulting estimated fair value of the mortgage securities.

In 2002 and 2003, interest expense on asset-backed bonds was unexpectedly low. As a result, the spread between the coupon interest and the bond cost was unusually high and our cost basis in many of our older mortgage securities was significantly reduced. For example, our cost basis in NMFT Series 2000-2, 2001-1 and 2001-2 has been reduced to zero (see Table 3). When our cost basisfinancing. Another major driver in the retained 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, includingdecline in net interest income (expense) for both 2007 and effects2006 was the fact that we experienced a significant increase in our provision for credit losses, which was a result of hedging are discussed under “Results of Operations”the on-balance sheet securitizations we executed in 2007 and “Interest Rate/Market Risk.” 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,2006, as well as overall credit deterioration in the mortgage loan performance characteristics such as credit quality and prepayment experience.

portfolio.

Table 3 — Valuation of IndividualAllowance for Credit Losses on Mortgage SecuritiesLoansAvailable-for-Sale and AssumptionsHeld-in-Portfolio

(dollars in thousands)

 

   Cost

  

Net

Unrealized

Gain
(Loss)


  

Estimated

Fair Value

of

Mortgage

Securities


  Current Assumptions

  Assumptions at Trust Securitization

 
         

Discount

Rate


  

Constant

Prepayment

Rate


  

Expected

Credit

Losses

(A)


  

Discount

Rate


  

Constant

Prepayment

Rate


  

Expected

Credit

Losses

(A)


 

December, 2004:

                               

NMFT 1999-1

                               

Subordinated securities

  $7,001  $—    $7,001  17% 33% 4.8% 17% 30% 2.5%

NMFT 2000-1

                               

Interest-only

   —     352   352                   

Prepayment penalty

   —     28   28                   

Subordinated securities

   681   158   839                   
   

  

  

                   
    681   538   1,219  15  46  1.2  15  27  1.0 

NMFT 2000-2

                               

Interest-only

   —     2,019   2,019                   

Prepayment penalty

   —     105   105                   

Subordinated securities

   —     166   166                   
   

  

  

                   
    —     2,290   2,290  15  34  1.0  15  28  1.0 

NMFT 2001-1

                               

Interest-only

   —     2,262   2,262                   

Prepayment penalty

   —     161   161                   

Subordinated securities

   —     688   688                   
   

  

  

                   
    —     3,111   3,111  20  37  1.1  20  28  1.2 

NMFT 2001-2

                               

Interest-only

   —     6,182   6,182                   

Prepayment penalty

   —     458   458                   

Subordinated securities

   —     1,961   1,961                   
   

  

  

                   
    —     8,601   8,601  25  33  0.8  25  28  1.2 

NMFT 2002-1

                               

Interest-only

   3,553   242   3,795                   

Prepayment penalty

   111   457   568                   

Subordinated securities

   1,314   5,413   6,727                   
   

  

  

                   
    4,978   6,112   11,090  20  42  0.9  20  32  1.7 

NMFT 2002-2

                               

Interest-only

   2,713   —     2,713                   

Prepayment penalty

   151   251   402                   

Subordinated securities

   2,184   1,391   3,575                   
   

  

  

                   
    5,048   1,642   6,690  25  40  1.4  25  27  1.6 

   Cost

  

Net

Unrealized

Gain (Loss)


  

Estimated

Fair Value

of

Mortgage

Securities


  Current Assumptions

  Assumptions at Trust Securitization

         

Discount

Rate


  

Constant

Prepayment

Rate


  

Expected

Credit

Losses

(A)


  

Discount

Rate


  

Constant

Prepayment

Rate


  

Expected

Credit

Losses

(A)


NMFT 2002-3

                           

Interest-only

  8,148  —    8,148                  

Prepayment penalty

  509  686  1,195                  

Subordinated securities

  2,387  3,131  5,518                  
   
  
  
                  
   11,044  3,817  14,861  20  41  0.7  20  30  1.0

NMFT 2003-1

                           

Interest-only

  17,963  363  18,326                  

Prepayment penalty

  2,316  956  3,272                  

Subordinated securities

  11,783  3,912  15,695                  
   
  
  
                  
   32,062  5,231  37,293  20  39  1.8  20  28  3.3

NMFT 2003-2

                           

Interest-only

  15,404  2,422  17,826                  

Prepayment penalty

  4,089  2,133  6,222                  

Subordinated securities

  2,487  3,368  5,855                  
   
  
  
                  
   21,980  7,923  29,903  28  38  1.5  28  25  2.7

NMFT 2003-3

                           

Interest-only

  20,825  3,449  24,274                  

Prepayment penalty

  5,108  3,427  8,535                  

Subordinated securities

  6,842  2,363  9,205                  
   
  
  
                  
   32,775  9,239  42,014  20  37  1.6  20  22  3.6

NMFT 2003-4

                           

Interest-only

  21,466  5,480  26,946                  

Prepayment penalty

  4,994  5,408  10,402                  

Subordinated securities

  —    6,839  6,839                  
   
  
  
                  
   26,460  17,727  44,187  20  44  1.7  20  30  5.1

NMFT 2004-1

                           

Interest-only

  35,731  —    35,731                  

Prepayment penalty

  6,816  5,968  12,784                  

Subordinated securities

  —    1,335  1,335                  
   
  
  
                  
   42,547  7,303  49,850  20  43  3.5  20  33  5.9

NMFT 2004-2

                           

Interest-only

  31,062  —    31,062                  

Prepayment penalty

  5,313  4,814  10,127                  

Subordinated securities

  3,481  881  4,362                  
   
  
  
                  
   39,856  5,695  45,551  26  41  3.8  26  31  5.1

   Cost

  

Net

Unrealized

Gain (Loss)


  

Estimated

Fair Value

of

Mortgage

Securities


  Current Assumptions

  Assumptions at Trust Securitization

         

Discount

Rate


  

Constant

Prepayment

Rate


  

Expected

Credit

Losses

(A)


  

Discount

Rate


  

Constant

Prepayment

Rate


  

Expected

Credit

Losses

(A)


NMFT 2004-3 (B)

   89,442   —     89,442  19  39  3.9  19  34  4.5

NMFT 2004-4 (B)

   96,072   —     96,072  25  36  3.7  25  35  4.0
   

  

  

                  

Total

  $409,946  $79,229  $489,175                  
   

  

  

                  


(A)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 interest-only, prepayment penalty and subordinated securities are packaged in one bond for the Series NMFT 2004-3 and 2004-4.

   Cost

  

Net

Unrealized

Gain (Loss)


  

Estimated

Fair

Value of

Mortgage

Securities


  Current Assumptions

  Assumptions at Trust Securitization

 
        

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  45  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  44  1.8  25  27  1.6 

   Cost

  

Net

Unrealized

Gain (Loss)


  

Estimated

Fair Value

of

Mortgage

Securities


  Current Assumptions

  Assumptions at Trust Securitization

         

Discount

Rate


  

Constant

Prepayment
Rate


  

Expected

Credit

Losses

(A)


  

Discount

Rate


  

Constant

Prepayment

Rate


  

Expected

Credit

Losses

(A)


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  39  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  28  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  30  2.6  28  25  2.7

NMFT 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  26  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  33  5.3  20  30  5.1
   

  

  

                  

Total

  $294,562  $87,725  $382,287                  
   

  

  

                  


(A)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.

The following table summarizes the cost basis, unrealized gain (loss) and fair value of our mortgage securities—available-for-sale with the mortgage securities—available-for-sale grouped by year of issue. For example, under the “Year of Issue for Mortgage Securities Retained” column, the year 2003 is a combination of NMFT Series 2003-1, NMFT Series 2003-2, NMFT Series 2003-3 and NMFT Series 2003-4.

Table 4 — Summary of Mortgage Securities – Available-for-Sale Retained by Year of Issue

(in thousands)

   2004

Year of
Issue
for

Mortgage
Securities
Retained


  As of December 31

  As of September 30

  As of June 30

  As of March 31

  Cost

  Unrealized
Gain
(Loss)


  Fair Value

  Cost

  

Unrealized
Gain

(Loss)


  Fair Value

  Cost

  Unrealized
Gain
(Loss)


  Fair Value

  Cost

  Unrealized
Gain
(Loss)


  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
   

  

  

  

  

  

  

  

  

  

  

  

   2003

Year
of
Issue
for

Mortgage
Securities
Retained


  As of December 31

  As of September 30

  As of June 30

  As of March 31

  Cost

  Unrealized
Gain
(Loss)


  Fair Value

  Cost

  Unrealized
Gain
(Loss)


  Fair Value

  Cost

  Unrealized
Gain
(Loss)


  Fair Value

  Cost

  Unrealized
Gain
(Loss)


  Fair Value

1999

  $6,119  $(101) $6,018  $6,014  $(423) $5,591  $5,938  $(363) $5,575  $5,864  $(655) $5,209

2000

   1,053   8,235   9,288   1,040   10,154   11,194   1,289   11,929   13,218   2,327   12,352   14,679

2001

   185   29,509   29,694   1,419   35,459   36,878   5,426   41,359   46,785   10,310   43,527   53,837

2002

   43,969   22,019   65,988   50,848   25,869   76,717   58,883   27,345   86,228   66,928   26,775   93,703

2003

   243,236   28,063   271,299   189,710   17,542   207,252   132,959   16,167   149,126   67,134   7,515   74,649
   

  


 

  

  


 

  

  


 

  

  


 

Total

  $294,562  $87,725  $382,287  $249,031  $88,601  $337,632  $204,495  $96,437  $300,932  $152,563  $89,514  $242,077
   

  


 

  

  


 

  

  


 

  

  


 

Mortgage Securities – Trading. Mortgage securities – trading consist of mortgage securities purchased by us that we intend to sellActivity in the near term. These securities are recorded at fair value with gains andallowance for credit losses realized and unrealized, included in earnings. 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. For the year ended December 31, 2004, we recorded no gains or losses related to the security. As of December 31, 2004, we had pledged the security as collateral for financing purposes.

Mortgage Servicing Rights. As discussed under Mortgage Securities – Available for Sale, we retain the right to serviceon 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, 2004, we have $42.0 million in capitalized mortgage servicing rights compared with $19.7 million– held-in-portfolio is as of December 31, 2003. The increase in our mortgage servicing rights is attributable to the increase in the size of our securitizations during 2004 as compared to 2003. The value of the mortgage servicing rights we retained in our securitizations during 2004 and 2003 was $39.3 million and $20.8 million, respectively. Amortization of mortgage servicing rights was $16.9 million, $9.0 million and $4.6 million for the years ended December 31, 2004, 2003 and 2002, respectively.

Servicing Related Advances.Advances on behalf of borrowers for taxes, insurance and other customer service functions are made by NovaStar Mortgage and aggregated $20.2 million as of December 31, 2004 compared with $19.3 million as of December 31, 2003.

Derivative Instruments, net.Derivative instruments, net decreased from $19.5 million at December 31, 2003 to $18.8 million at December 31, 2004. Derivative instruments include the collateral (margin deposits) required under the terms of our derivative instrument contracts, net of the derivative instrument market values. Due to the nature of derivative instruments we use, the margin deposits required will generally increase as interest rates decline and decrease as interest rates rise. On the other hand, the market value of our derivative instruments will decline as interest rates decline and increase as interest rates rise.

Other Assets. Included in other assets are receivables from securitizations, warehouse loans receivable, tax assets and other miscellaneous assets. Our receivables from securitizations were $4.8 million and $6.2 million at December 31, 2004 and December 31, 2003, respectively. These receivables represent cash due to us on our mortgage securities - available-for-sale. As of December 31, 2004 we had warehouse loans receivable of $5.9 million. In 2004, we began lending to independent mortgage loan brokers in an effort to strengthen our relationships with these brokers and, in turn, increase our nonconforming loan production. As of December 31, 2004, we had a deferred tax asset of $11.2 million compared to $10.5 million as of December 31, 2003. As of December 31, 2004, we had a current tax receivable of $17.2 million. We had a current tax liability as of December 31, 2003 as discussed under the heading “Accounts Payable and Other Liabilities”. The change from a current tax liability to a current tax receivable was primarily the result of an overpayment of estimated 2004 income taxes.

Short-term 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 arrangements fluctuate based on lending volume, cash flows from operating, investing and other financing activities and equity transactions. As shown in Table 5, we have $268.6 million in immediately available funds as of December 31, 2004. We have borrowed approximately $765.6 million of the $3.7 billion in committed mortgage securities repurchase facilities, leaving approximately $2.9 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 5 — Short-term Financing Resources

(in thousands)

   

Credit

Limit


  

Lending

Value of

Collateral


  Borrowings

  Availability

Unrestricted cash

              $268,563

Mortgage securities and mortgage loans repurchase facilities

  $3,650,000  $765,645  $765,645   —  

Other

   235,912   139,883   139,883   —  
   

  

  

  

Total.

  $3,885,912  $905,528  $905,528  $268,563
   

  

  

  

Asset-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 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 NHES 97-01 and 25% for the loans in NHES 97-02, 98-01 and 98-02. We have not exercised our right to repurchase any loans and repay bond obligations.

During 2004, we issued three asset-backed bonds, NIMs, totaling $515.1 million compared to one issue in 2003 for $54 million. These NIMs are secured by the interest-only, prepayment penalty and subordinated mortgage securities of our mortgage securities – available-for-sale as a means for long-term financing. The resecuritizations were structured as secured borrowings for financial reporting and income tax purposes. In accordance with SFAS No. 140, control over the transferred assets was not surrendered and thus the transaction was considered a financing for the mortgage securities - available-for-sale. Therefore, the mortgage securities are recorded as assets and the asset-backed bonds are recorded as debt. Note 7 to the consolidated financial statements provides additional detail regarding these transactions.

Due to trusts.Due to trusts represents the fair value of the loans we have the right to repurchase from the securitization trusts. The servicing agreements we execute for loans we have securitized include 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. As of December 31, 2004 and December 31, 2003, our liability related to this provision was $20.9 million and $14.5 million, respectively.

Accounts Payable and Other Liabilities. Included in accounts payable and other liabilities is accrued payroll and other liabilities. Our accrued payroll increased from $18.1 million at December 31, 2003 to $24.9 million at December 31, 2004. The increase in accrued payroll is due to our change from paying employees twice a month to every two weeks. Our current income tax liability was $7.9 million as of December 31, 2003.

Stockholders’ Equity.The increase in our stockholders’ equity as of December 31, 2004 compared to December 31, 2003 is a result of the following increases and decreases.

Stockholders’ equity increased by:

$115.4 million due to net income recognized for the year ended December 31, 2004

$72.1 million due to issuance of preferred stock

$121.3 million due to issuance of common stock

$15.9 million due to impairment on mortgage securities – available for sale reclassified to earnings

$2.5 million due to net settlements on cash flow hedges reclassified to earnings

$1.8 million due to compensation recognized under stock option plan

$3.8 million due to issuance of stock under stock compensation plans

$0.9 million due to tax benefit derived from stock compensation plans, and

$0.1 due to forgiveness of founders’ notes receivable.

Stockholders’ equity decreased by:

$177.0 million due to dividends accrued or paid on common stock

$24.4 million due to decrease in unrealized gains on mortgage securities classified as available-for-sale, and

$6.3 million due to dividends accrued or paid on preferred stock.

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.

Results of Operations

Continuing Operations.During the year ended December 31, 2004, we earned income from continuing operations available to common shareholders of $113.2 million, or $4.40 per diluted share, compared with income from continuing operations available to common shareholders of $112.0 million, or $4.91 per diluted share and of $48.8 million, or $2.25 per diluted share, for the same periods of 2003 and 2002, respectively.

Our primary sources of revenue are interest earned on our mortgage loan and securities portfolios, fee income and gains on sales and securitizations of mortgage loans. As discussed under “Overview of Performance,” income from continuing operations available to common shareholders increased during 2004 as compared to 2003 due primarily to higher volumes of average mortgage securities - available-for-sale held and mortgage loan originations and purchases securitized. The effects of the higher mortgage security volume are displayed in Table 6. Details regarding higher mortgage loan origination and purchase volumes and gains on securitization of these assets are shown in Tables 1, 8 and 9.

Discontinued Operations.As the demand for conforming loans declined significantly during 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 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 tax for the year ended December 31, 2004 was $4.1 million. Note 14 to our consolidated financial statements provides detail regarding the impact of the discontinued operations.

Net Interest Income.Our mortgage securities available-for-sale 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 and resets monthly while the coupon on the mortgage loan collateral adjusts more slowly depending on the contractual terms of the loan. In 2002, we began transferring interest rate agreements at the time of securitization into the securitization trusts to help reduce this interest rate risk and to decrease the volatility of future cash flows related to the securitized mortgage loans. As a result, future interest income on our mortgage securities is expected to be less volatile. The spreads on our newer mortgage securities - available-for-sale have returned to expected or normal levels as a result of this interest rate risk management strategy and also as a result of the coupon on the mortgage loans adjusting downward. The significant increase in one-month LIBOR in 2004 has also contributed to the decline in our overall securities yield from 2003.

While the spreads on our securities have decreased, the overall interest income continues to be high due to the sizeable increase in our mortgage securities - available-for-sale retained. Based on these factors, as shown in Table 6, we experienced a decrease in the average net yield on our securities from 31.3% for the year ended December 31, 2003 to 27.2% for the same period of 2004. Mortgage security net yield for the year ended December 31, 2002 was 40.6%.

The overall dollar volume of interest income has increased primarily because the size of our mortgage securities - available-for-sale portfolio has increased significantly during the past year. As shown in Tables 6 and 7, the average value of our mortgage securities - available-for-sale increased from $288.4 million and $132.3 million during the years ended December 31, 2003 and 2002, respectively, to $425.4 million during the year ended December 31, 2004. The average balance of mortgage loans collateralizing our securities increased from $4.3 billion in 2003 to $8.4 billion in 2004. We expect to increase the amount of mortgage securities - available-for-sale we own as we securitize the mortgage loans we originate and purchase.

As previously discussed, the trust that issues our interest-only securities owns interest rate agreements. 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. Table 6 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 securitiesfollows for the three years ended December 31, 2004.2007 (dollars in thousands):

   2007

  2006

  2005

 

Balance, beginning of period

  $22,452  $699  $507 

Provision for credit losses

   265,288   30,131   1,038 

Charge-offs, net of recoveries

   (57,602)  (8,378)  (846)
   


 


 


Balance, end of period

  $230,138  $22,452  $699 
   


 


 


Based on generally accepted accounting principles, for our mortgage loans held-in-portfolio, we must maintain an allowance for credit losses at a level that estimates the probable losses inherent in the loan portfolio. Because these loans have been legally sold into a securitization trust which has provided long-term nonrecourse financing, there are instances when the charge to earnings through our provision for credit losses can exceed the real economic investment we have in the trust (the “equity”). The equity investment at the time of securitization is defined as the difference in the cost basis of the assets legally sold to the trust and the net proceeds received from third-party bond investors. The following table presents the assets and liabilities of our securitization trusts accounted for as financing transactions as of December 31, 2007 and provides a reasonable indication of what the equity position of each trust was as of the end of the period presented.

 

Table 6 - Mortgage Securities Interest Analysis4 — Condensed Balance Sheet of Securitizations Accounted for as Financing Transactions

(dollars in thousands)

 

   December 31,

 
   2004

  2003

  2002

 

Average fair market value of mortgage securities – available-for-sale

  $425,400  $288,361  $132,250 

Average borrowings

   337,282   222,653   89,612 

Interest income

   133,633   98,804   56,481 

Interest expense

   18,091   8,676   2,834 
   


 


 


Net interest income

  $115,542  $90,128  $53,647 
   


 


 


Yields:

             

Interest income

   31.4%  34.3%  42.7%

Interest expense

   5.4   3.9   3.2 
   


 


 


Net interest spread

   26.0%  30.4%  39.5%
   


 


 


Net Yield

   27.2%  31.3%  40.6%
   


 


 


   NHES
2006-MTA1


  NHES
2006-1


  NHES
2007-1


  Totals

 

Assets:

                 

Mortgage loans – held-in-portfolio

                 

Outstanding principal

  $753,787  $694,101  $1,619,849  $3,067,737 

Net unamortized deferred origination costs

   27,177   5,237   —     32,414 

Allowance for credit losses

   (27,312)  (40,031)  (162,795)  (230,138)
   


 


 


 


Mortgage loans – held-in-portfolio

   753,652   659,307   1,457,054   2,870,013 

Accrued interest receivable

   14,091   14,238   33,375   61,704 

Real estate owned

   4,851   32,126   39,637   76,614 
   


 


 


 


Total assets

  $772,594  $705,671  $1,530,066  $3,008,331 
   


 


 


 


Liabilities:

                 

Asset-backed bonds secured by mortgage loans

  $748,182  $714,476  $1,603,088  $3,065,746 

Other liabilities

   5,751   19,927   45,087   70,765 
   


 


 


 


Total liabilities

   753,933   734,403   1,648,175   3,136,511 

Net assets (deficiency)

   18,661   (28,732)  (118,109)  (128,180)
   


 


 


 


Total liabilities and net assets (deficiency)

  $772,594  $705,671  $1,530,066  $3,008,331 
   


 


 


 


Net interest income on mortgage loans represents income on loans held-for-sale during their warehouse period as well as loans held-in-portfolio, which are maintained

As shown in table 5 below, our average net security yield on our balance sheet asmortgage securities decreased to 12.52% for 2007 from 29.82% for 2006 and 42.11% for 2005. The decrease in our average security yields in both 2007 and 2006 from the 2005 yield was primarily a result of margin compression caused by credit deterioration of the four securitization transactions we executed in 1997 and 1998. Net interest income onunderlying mortgage loans.

The following table presents the average balances for our mortgage securities, mortgage loans before other expense increased from $39.9 millionheld-in-portfolio and $25.8 millionour repurchase agreement and securitization financings for those assets with the corresponding yields for the years ended December 31, 20032007, 2006 and 2002, respectively to $55.9 million for the same period of 2004.2005. The net interest income from mortgage loans is primarily driven by loan volume and the amount of time held-for-sale loans areexpense used in the warehouse.calculations includes the effects of premium amortization, discount accretion, debt issuance cost amortization and commitment fees on warehouse lines of credit.

 

Future net interest income will be dependent upon the size and volume of our mortgage securities - available-for-sale and loan portfolios and economic conditions.

Our portfolio income comes from mortgage loans either directly (mortgage loans held-in-portfolio) or indirectly (mortgage securities). Table 7 attempts to look through the balance sheet presentation of our portfolio income and present income as a percentage of average assets under management. The net interest income for mortgage securities, mortgage loans held-for-sale and mortgage loans held-in-portfolio reflects the income after interest expense, hedging, prepayment penalty income and credit expense (mortgage insurance and credit (losses) recoveries). This metric allows us 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. Over time, we believe a sustainable return on these assets should be in the range of 1% to 1.25%.

Our portfolio net interest yield on assets was 1.53% for the year ended December 31, 2004 as compared to 2.25% and 2.49%, respectively, for the same period of 2003 and 2002. As previously discussed, the decrease in our net interest yield on assets primarily resulted from the decrease in the spreads on our mortgage securities. Table 7 shows the net yield in both assets under management and the return on assets during the three years ended December 31, 2004.

Table 75 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, 2004

                 

Interest income

  $133,633  $83,718  $6,673  $224,024 

Interest expense:

                 

Short-term borrowings (A)

   4,836   30,005   —     34,841 

Asset-backed bonds

   13,255   —     1,422   14,677 

Cash flow hedging net settlements

   —     1,514   1,558   3,072 
   


 


 


 


Total interest expense

   18,091   31,519   2,980   52,590 
   


 


 


 


Mortgage portfolio net interest income before other expense

   115,542   52,199   3,693   171,434 

Other expense (B)

   368   (23,123)  (1,254)  (24,009)
   


 


 


 


Mortgage portfolio net interest income

  $115,910  $29,076  $2,439  $147,425 
   


 


 


 


Average balance of the underlying loans

  $8,431,708  $1,113,736  $71,784  $9,617,228 

Net interest yield on assets

   1.37%  2.61%  3.40%  1.53%
   


 


 


 


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%
   


 


 


 


   For the Year Ended December 31,

 
   2007

  2006

  2005

 

Mortgage securities interest analysis

             

Average balances:

             

Mortgage securities (A)

  $489,092  $492,155  $407,119 

Short-term borrowings secured by mortgage securities

   224,236   223,715   42,376 

Asset-backed bonds secured by mortgage securities

   302,158   54,836   227,733 

Yield analysis:

             

Interest income (A)

   20.95%  33.50%  46.39%

Interest expense short-term borrowings

   10.55%  6.36%  4.18%

Interest expense asset backed bonds

   5.84%  7.04%  6.86%
   


 


 


Total financing expense

   7.84%  6.50%  6.44%
   


 


 


Net interest spread

   13.11%  27.00%  39.95%
   


 


 


Net yield (B)

   12.52%  29.82%  42.11%
   


 


 


Mortgage loans held-in-portfolio interest analysis

             

Average balances:

             

Mortgage loans held-in-portfolio

  $3,195,292  $1,790,302  $47,857 

Asset-backed bonds secured by mortgage loans held-in-portfolio

   3,198,242   1,511,650   42,916 

Short-term borrowings secured by mortgage loans held-in-portfolio

   —     327,609   —   

Yield analysis:

             

Interest income

   8.10%  7.52%  9.01%

Interest expense asset backed bonds

   5.59%  5.83%  4.22%

Interest expense short-term borrowings

   —  %  5.53%  —  %
   


 


 


Total financing expense

   5.59%  5.78%  4.22%
   


 


 


Net interest spread

   2.51%  1.74%  4.79%
   


 


 


Net yield (B)

   2.50%  1.58%  5.23%
   


 


 



(A)Primarily includesConsists of the average cost basis of our mortgage loan andsecurities-available-for-sale portfolio as well as the average fair value of our mortgage securities repurchase agreements.trading portfolio. The yield information does not give effect to the changes in fair value of our mortgage securities-available-for-sale portfolio which are reflected as a component of shareholders’ equity.
(B)Other expense includes prepayment penaltyNet yield is calculated as the net interest income divided by the average daily balance of the asset. The net settlements on non-cash flow hedges and credit expense (mortgage insurance and credit (losses) recoveries).yield will, generally, not equal the net interest spread due to the difference in denominators of the two calculations.

 

Impact of Interest Rate Agreements.We have executed interest rate 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. We incurred expenses of $22.1 million, $18.7 million and $21.5 million related to the net settlements of our interest rate agreements for the three years ended December 31, 2004, 2003 and 2002, respectively. Fluctuations in these expenses are solely dependent upon the movement in LIBOR as well as our average notional amount outstanding.

Credit (Losses) Recoveries.We originate, purchase and own loans in which the borrower possesses credit risk higher than that of conforming borrowers. Delinquent loans and losses are expected to occur. We maintain an allowance for credit losses for our mortgage loans – held-in-portfolio. 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.

During the year ended December 31, 2004 we recognized net credit losses of $0.7 million compared with net credit recoveries of $0.4 million and $0.4 million for the years ended December 31, 2003 and 2002, respectively. We incurred net charge-offs of $1.5 million, $1.3 million and $2.1 million for the years ended December 31, 2004, 2003 and 2002, respectively. A rollforward of the allowance for credit losses for the three years ended December 31, 2004 is presented in Note 2 to the consolidated financial statements.

Fee Income.Fee income in 2004 primarily consists of broker fees and service fee income. During 2003 and 2002, NHMI branch management fees were also a component of fee income. Due to the elimination of the LLC’s and their subsequent inclusion in the consolidated financial statements, branch management fees are eliminated in consolidation in 2004.

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.

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.

NHMI branch management fees, a source of fee income in 2003 and 2002, were charged to LLC’s formed to support NHMI branches to manage branch administrative operations, which included providing accounting, payroll, human resources, loan investor management and license management services. The amount of the fees was agreed upon when entering the LLC agreements and recognized as services were rendered. NHMI branch management fees were $13.0 million and $5.2 million for the years ended December 31, 2003 and 2002, respectively.

Overall, fee income increased from $68.3 million and $36.0 million for the years ended December 31, 2003 and 2002, respectively, to $102.8 million for the same period of 2004 due primarily to the termination of the LLC’s and the inclusion of those branches in our consolidated financial statements. This had a significant impact on fee income due to the volume of broker fee income that these branches generate. For comparative purposes, if the LLC’s had been operating units during 2003 and 2002 fee income would have been $91.8 million and $41.5 million for the years ended December 31, 2003 and 2002, respectively.

Additionally, fee income increased due to the increase in our servicing portfolio from $7.2 billion and $3.7 billion as of December 31, 2003 and 2002, respectively, to $12.2 billion as of December 31, 2004.

Gains on Sales of Mortgage Assets and Losses on Derivative InstrumentsInstruments.. 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-only, prepayment penalty and non-investment grade 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, 2004. Whole loan sales have also been executed whereby we sell loans to third parties. In the outright sales of mortgage loans, we retain no assets or servicing rights. Table 9 provides a summary of mortgage loans sold outright and transferred in securitizations.

 

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, the derivative instruments on our balance sheet which are not included in discontinued operations represent derivative instruments which have been transferred into our securitization trusts structured as financings. The derivative instruments we use to mitigate interest rate risk will generally increase in value as short-term interest rates increase and decrease in value as rates decrease. Derivative instruments transferred into a securitization trust are administered by the trustee in accordance with the trust documents.

We also entered into three credit default swaps (“CDS”) during 2007 as part of our CDO transaction previously discussed. The CDS had a notional amount of $16.5 million and a fair value of $6.1 million at the date of purchase and are pledged as collateral against the CDO ABB. At December 31, 2007 the fair value was $2.5 million and we had recorded losses related to fair value adjustments of these derivative instruments are credited or charged to current earnings. We recognized losses of $8.9$3.6 million duringfor the year ended December 31, 2004, compared with $30.8 million2007.

As a result of declining interest rates and $36.8declining values of the CDS, the losses on derivative instruments from continuing operations were $11.0 million for the same periodyear ended December 31, 2007, as compared to a gain of 2003 and 2002, respectively.

Table 8 provides$109,000 for the components of our gains on sales of mortgage assets and losses on derivative instruments.year ended December 31, 2006.

 

Table 8 — Gains on Sales of Mortgage Assets and Losses on Derivative Instruments

(in thousands)Fair Value Adjustments.

 

   For the Year Ended December 31,

 
   2004

  2003

  2002

 

Gains on sales of mortgage loans transferred in securitizations

  $144,252  $136,302  $47,894 

Gains on sales of mortgage loans to third parties – nonconforming

   —     3,404   2,299 

Gains on sales of mortgage loans to third parties – conforming

   1,435   6,942   3,903 

Losses on sales of real estate owned

   (737)  (2,643)  (791)
   


 


 


Gains on sales of mortgage assets

   144,950   144,005   53,305 

Losses on derivatives

   (8,905)  (30,837)  (36,841)
   


 


 


Net gains on sales of mortgage assets and derivative instruments

  $136,045  $113,168  $16,464 
   


 


 


We recorded net (losses) gains due to fair value adjustments of $(85.8) million, $(3.2) million and $0.5 million related to our trading securities and the asset-backed bonds issued in our CDO transaction executed during the years ended December 31, 2007, 2006 and 2005, respectively. The trading securities had a fair value adjustment of approximately $(342.9) million, $(3.2) million and $0.5 million for the years ended December 31, 2007, 2006 and 2005, respectively, while the CDO asset-backed bonds had a positive fair value adjustment of $257.1 million in 2007. These adjustments were a result of significant spread widening in the subprime mortgage market for these types of asset-backed securities as well as poor credit performance of the underlying mortgage loans.

Table 9 — Mortgage Loan Sales and Securitizations

(dollars in thousands)Impairment on Mortgage Securities – Available-for-Sale.

 

   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


2004

   There were no outright mortgage loan sales in 2004.

2003

  $151,210  2.8% $3,404  104.1
   

  

 

  

2002

  $142,159  8.4% $2,299  102.9
   

  

 

  

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, 2007, 2006 and 2005, we recorded an impairment loss of $98.7 million, $30.7 million and $17.6 million, respectively. The increase in impairments in 2007 and 2006 were primarily driven by an increase in projected losses due to the deteriorating credit quality of the loans underlying the securities and the fact that we changed the expected call date assumption used in valuing our residual securities. Previously, we estimated cash flows on our residual securities through the clean-up call date. We have extended our estimate of time that the residual securities will be outstanding further into the future due to our inability to exercise the clean-up call right we retain from the related securitizations. Because of our liquidity concerns and the fact that it takes a significant amount of capital to exercise the clean-up call, which includes repurchasing loans from the securitization trusts, we extended the estimated call dates into the future based on management’s best estimate. As the call date extends into the future, the fair value of the overcollateralization bond, included in our residual securities, declines significantly due to higher expected credit losses.

   

Mortgage Loans

Transferred in Securitizations


 
   

Principal

Amount


  

Percent of

Total Sales


  

Net Gain

Recognized


  

Initial Cost Basis

of Mortgage

Securities


  Weighted Average Assumptions Underlying
Initial Value of Mortgage Securities –
Available-for-Sale


 

For the Year Ended

December 31,


         

Constant

Prepayment

Rate


  

Discount

Rate


  

Expected Total

Credit Losses, Net

of Mortgage

Insurance


 

2004

  $8,329,804  100.0% $144,252  $381,833  33% 22% 4.77%
   

  

 

  

  

 

 

2003

  $5,319,435  97.2% $136,302  $292,675  26% 22% 3.55%
   

  

 

  

  

 

 

2002

  $1,560,001  91.6% $47,894  $90,785  29% 21% 1.50%
   

  

 

  

  

 

 


(A)Does not include conforming loan sales.

 

Premiums for Mortgage Loan InsuranceInsurance..

The use of mortgage insurance is one method of managing the credit risk in the mortgage asset portfolio. Premiums for mortgage insurance on our mortgage loans – held-in-portfolio maintained on our balance sheet are paid by usthe trust and are recorded as a portfolio cost and are included in the income statement of operations under the caption “Premiums for Mortgage Loan Insurance”. These premiums totaled $4.2$16.5 million, $3.1$6.3 million and $2.3$0.3 million in 2004, 20032007, 2006 and 2002,2005, respectively. We receivedThe increase in premiums on mortgage loan insurance proceeds on claims filedfor 2007 as compared to 2006 and 2005 is due to the increase in loans-held-in-portfolio as a result of $2.2 million, $1.9 millionstructuring three loan securitizations as financings during 2007 and $2.1 million in 2004, 2003 and 2002, respectively.2006.

 

Some of the mortgage loans that serve as collateral for our mortgage securities - 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. 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 mortgage securities - available-for-sale consider this risk. The percentage of loans with mortgage insurance has decreased in 2004 and 2003 and generally should be lower than 50% in the future. For the 2004-1, 2004-2, 2004-3 and 2004-4 securitizations, the mortgage loans that were transferred into the trusts had mortgage insurance coverage at the time of transfer of 26%, 38%, 35% and 51%, respectively. As of December 31, 2004, 45% of our securitized loans had mortgage insurance coverage.

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 to the extent we deem it is warranted.

Other Income, net.Other income, net increased from $0.4 million and $1.4 million for the years ended December 31, 2003 and 2002, respectively, to $6.6 million for the same period of 2004. Included in other income, net is primarily interest income on our cash accounts and deposits with derivative instrument counterparties (swap margin). The increase from prior years to 2004 is primarily attributable to the increase in our cash on hand and the increase in the interest rates we are earning on this cash.

General and Administrative Expenses.

The main categories of our general and administrative expenses areare: compensation and benefits, loan expense, marketing, office administration, and professional and outside services.services and other expense. Compensation and benefits includes employee base salaries, benefit costs and incentive compensation awards. For discussion on stock-based compensation expense included in compensation and benefits, see discussion of the adoption of SFAS No. 123 under “Critical Accounting Estimates” and “Results of Operations.” Loan expense primarily includes expenses relating to the underwriting of mortgage loans that do not fund successfully and servicing costs. Marketing primarily includes costs of purchased loan leads, advertising and business promotion. Office administration includes items such as rent, depreciation, telephone, office supplies, postage, delivery, maintenance and repairs. Professional and outside services include fees for legal, accounting and other consulting services. Other expense primarily includes miscellaneous banking fees, travel and entertainment expenses and marketing expenses. General and administrative expenses decreased by $10.5 million from 2006 to 2007. Factors contributing to the decrease for the comparative period were:

Decrease in compensation expense as a result of the significant employee terminations during 2007 as a result of cost reduction initiatives.

$5.0 million excise tax reversal included in the “Other” category which resulted from the termination of our REIT status as of January 1, 2006.

General and administrative expenses for the year ended December 31, 2006 increased by $7.7 million from the same period of 2005 primarily due to the excise tax accrual of $4.6 million which was subsequently reversed out in 2007.

Income and Excise Taxes & REIT Status

 

The increase in general and administrative expenses from $174.4 million and $84.6 million in 2003 and 2002, respectively, to $271.1 million in 2004 is primarily attributable to the termination of the LLC’s and the inclusion of those branches in our consolidated financial statements. Our new retail lines of business, growth in our wholesale business and our expanding servicing operations also contributed to the increase in general and administrative expenses. Nonrecurring costs related to the implementation of requirements under the Sarbanes-Oxley Act also contributed to the increase in general and administrative expenses in 2004. We employed 1,738 people as of December 31, 2004 compared with 1,409 and 913 as of December 31, 2003 and 2002, respectively, in our mortgage portfolio management and mortgage lending and loan servicing operations.

Note 15 to the consolidated financial statements presents an income statement for our three segments, detailing our expenses by segment. For comparative purposes, Table 10 presents the general and administrative expenses assuming the LLC’s had been included in our consolidated financial statements during 2003 and 2002.

Table 10 — General and Administrative Expenses

(dollars in thousands)

   For the Year Ended December 31,

   2004

  

2003

Pro Forma


  

2002

Pro Forma


       

Compensation and benefits

  $138,516  $107,708  $54,509

Office administration

   38,625   28,278   12,196

Marketing

   37,812   43,911   16,477

Professional and outside services

   19,887   7,462   3,254

Loan expense

   18,753   19,707   6,262

Other

   17,532   11,260   4,092
   

  

  

Total general and administrative expenses

  $271,125  $218,326  $96,790
   

  

  

Employees Other

   3,502   2,661   1,457

The 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 gains on sales of mortgage assets.

Table 11 — Wholesale Loan Costs of Production, as a Percent of Principal

   

Overhead

Costs


  

Premium Paid to

Broker, Net of Fees

Collected


  

Total

Acquisition

Cost


2004

  1.79  0.74  2.53

2003

  1.69  0.71  2.40

2002

  1.93  0.78  2.71

The following table is a reconciliation of our overhead costs to the general and administrative expenses of the mortgage lending and loan servicing segment as shown in Note 15 to the consolidated financial statements, presented in accordance with GAAP. The reconciliation does not address premiums paid to brokers since they are deferred at origination under GAAP and recognized when the related loans are sold or securitized. The presentation of overhead costs allows us to monitor the performance of our core operations, which is more difficult when looking at GAAP financial statements. This provides useful information regarding our financial performance. However, this presentation is not intended to be used as a substitute for financial results prepared in accordance with GAAP.

Table 12 – Reconciliation of Overhead Costs

(dollars in thousands, except overhead as a percentage)

   2004

  2003

  2002

 

Mortgage lending and loan servicing general and administrative expenses (A)

  $149,908  $133,196  $59,306 

Direct origination costs classified as a reduction in gain-on-sale

   44,641   26,351   13,334 

Costs of servicing

   (22,845)  (14,261)  (7,703)

Other lending expenses (B)

   (42,930)  (65,402)  (17,995)
   


 


 


Overhead costs

  $128,774  $79,884  $46,942 
   


 


 


Wholesale production, principal

  $7,185,773  $4,735,061  $2,427,048 

Overhead, as a percentage

   1.79%  1.69%  1.93%

(A)Mortgage lending and loan servicing general and administrative expenses are presented in Note 15 to the consolidated financial statements.
(B)In 2003 and 2002, other lending expenses primarily includes costs related to our retail, correspondent and conforming operations. In 2004, we did not have conforming operations.

Income Taxes.Since our inception, NFI haspreviously elected to be treated as a REIT for federal income tax purposes. Aspurposes and, as a REIT, NFI isresult, were not required to pay any corporate level income taxes as long as we distributeremained a REIT and distributed 100 percent of our taxable income in the form of dividend distributions to our shareholders. To maintainDuring 2007, we were unable to satisfy the REIT distribution requirement for the tax year ended December 31, 2006, either in the form of cash or preferred stock. This action resulted in our loss of REIT status retroactive to January 1, 2006. Our failure to satisfy the REIT distribution test resulted from demands on our liquidity and the substantial decline in our market capitalization during 2007.

Although we had planned to revoke REIT status effective January 1, 2008, the termination of REIT status two years prior to our plan adversely impacted our financial statements. The impact of the termination of our REIT status NFI must meet certain requirements prescribed by the Code.has been reflected in our 2007 financial statements.

As a result of our termination of REIT status, we elected to file a consolidated federal income tax return with our eligible affiliated members. We intend to operate NFIreported taxable income in 2006 of approximately $212 million, which resulted in a manner that allowstax liability of approximately $74 million along with interest and penalties due of approximately $5.8 million. After applying our payments and credits, we reported an amount owed to the IRS of approximately $67 million. We applied for and received an extension of time to pay our income taxes due to our expectation of generating a net operating loss for 2007, which may be carried back to 2006. This approved extension should allow us to meet these requirements.

Below is a summary of the taxable net income available to common shareholders for the years ended December 31, 2004, 2003 and 2002.

Table 13 — Taxable Net Income

(dollars in thousands)

   For the Year Ended December 31,

 
   

2004

Estimated


  

2003

Actual


  

2002

Actual


 

Consolidated net income

  $115,389  $111,996  $48,761 

Equity in net income of NFI Holding Corp.

   (2,517)  (27,737)  9,013 

Consolidation eliminations between the REIT and TRS

   2,800   7,686   —   
   


 


 


REIT net income

   115,672   91,945   57,774 

Adjustments to net income to compute taxable income

   141,094   45,906   (8,263)
   


 


 


Taxable income before preferred dividends

   256,766   137,851   49,511 

Preferred dividends

   (6,265)  —     —   
   


 


 


Taxable income available to common shareholders

  $250,501  $137,851  $49,511 
   


 


 


Taxable income per common share (A)

  $9.04  $5.64  $2.36 
   


 


 



(A)The common shares outstanding as of the end of each period presented is used in calculating the taxable income per common share.

The primary difference between consolidated net income and taxable income is due to differences 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 by Internal Revenue Code Sections 1271 through 1275. 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 2004 have been issued. Based on the Announcement, we believe that if the IRS does propose and adopt new regulations on this issue, the change will have the effect of narrowing the spread between book income and taxable income on interest-only mortgage securities, and thus, will have a similar impact to NFI in years following the effective date of the rules.

To maintain its qualification as a REIT, NFI is required to declare dividend distributions of at least 90 percentreduce all of our taxable income by(excluding excess inclusion income) from 2006, and eliminate the filing dateoutstanding tax liability due to the IRS. However, we will be required to pay interest and any penalties that apply on the balance due to the IRS in 2008. As of December 31, 2007, we had recorded additional interest of $1.5 million related to the balance due which is included in the accounts payable and other liabilities line item of our federalconsolidated balance sheet.

Because we terminated our REIT status effective January 1, 2006, and were taxable as a C corporation for 2006 and beyond, we recorded deferred taxes as of December 31, 2007 based on the estimated cumulative temporary differences as of the current date.

In accordance with SFAS 109, we examine and weigh all available evidence (both positive and negative and both historical and forecasted) in the process of determining whether it is more likely than not that a deferred tax return, including extensions. Any taxable income thatasset will be realized. We consider the relevancy of historical and forecasted evidence when there 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 percenta significant change in circumstances. Additionally, we evaluate the realization of our taxable income for 2004 byrecorded deferred tax assets on an interim and annual basis.

Based on the required distribution date. Accordingly, we have not accrued any corporate income tax for NFI for the year endedevidence available as of December 31, 2004.2007, including the significant pre-tax losses incurred by us in both the current quarter and previous quarters, the ongoing disruption to the credit markets, the liquidity issues facing us and our decision to close all of our mortgage lending operations, we concluded that it is more likely than not that our entire net deferred tax asset will not be realized. Based on these conclusions, we recorded a valuation allowance of $368.3 million for deferred tax assets as of December 31, 2007 compared to $0.7 million as of December 31, 2006. In future periods, we will continue to monitor all factors that impact positive and negative evidence relating to our deferred tax assets.

 

As of December 31, 2007, we had a federal net operating loss of approximately $368.4 million. We are expecting to carryback $196.1 million of the 2007 projected federal net operating loss against our 2006 taxable income and have recorded a current receivable for such benefit. The receivable was netted against the 2006 federal liability previously described. The remaining $172.3 million federal net operating loss may be carried forward to offset future taxable income, subject to provisions of the Code, including substantial limitations that would be imposed in the event of an “ownership change” as defined in Section 382 of the Code. If not used, this net operating loss will begin to expire in 2025.

When we were a REIT, NFI may bewe were subject to a federal excise tax. An excise tax iswas incurred if NFI distributeswe distributed less than 85 percent of itsour taxable income by the end of the calendar year. As part of the amount distributed by the end of the calendar year, NFI may includewe included dividends that were declared in October, November or December and paid on or before January 31 of the following year. To the extent that 85 percent of oura REIT’s taxable income exceeds our dividend distributions in any given year, an excise tax of 4 percent is due and payable on the shortfall. For the year ended December 31, 2004,2007 and 2006, we have provided foraccrued excise tax (benefit) expense of $2.1 million.approximately $(5.0) million and $4.6 million, respectively. Excise taxes are reflected as atax (benefit) expense is recorded in the other component of general and administrative expenses on our Consolidated Statementsconsolidated statements of Income.operations. As of December 31, 20042007 and 2003,2006, accrued excise tax payable was $1.8$0.8 million and $0.2$4.7 million, respectively. In lieu of requesting a refund of our excise tax payment of $5.9 million, we applied this payment to our 2006 federal income tax liability. The excise tax payable is reflected as a component of accounts payable and other liabilities on our Consolidated Balance Sheets.consolidated balance sheets.

The IRS is currently examining the 2005 federal income tax return of NFI Holding Corporation, a wholly-owned subsidiarysubsidiary. We are not aware of NFI,any significant findings as a result of this exam, however, the exam is still ongoing. Management believes it has adequately provided for potential tax liabilities that may be assessed for years in which the statute of limitations remains open. However, the assessment of any material liability would adversely affect our financial condition, liquidity and its subsidiaries (collectively knownability to continue as “the TRS”)a going concern.

Discontinued Operations

Year Ended December 31, 2007 as Compared to the Year Ended December 31, 2006

See the “Executive Overview of Performance” for discussion of the results of operations for the year ended December 31, 2007 as compared to the year ended December 31, 2006.

Year Ended December 31, 2006 as Compared to the Year Ended December 31, 2005

See the “Executive Overview of Performance” for discussion of the results of operations for the year ended December 31, 2006 as compared to the year ended December 31, 2005.

Net Interest Income (Expense).

The interest income we earn on our mortgage loans held-for-sale and the interest income we earn on the funds we held as custodian as a servicer of mortgage loans are treatedincluded in discontinued operations, as “taxable REIT subsidiaries.” The TRS is subjectthe interest expense on our borrowings used to corporatefinance the loans, servicing rights and servicing related advances.

Our net interest income taxes and files a consolidated federal income tax return. The TRS reported net income (loss) from continuingdiscontinued operations before income taxes of $12.0decreased to $23.2 million for the year ended December 31, 2004 compared with $50.6 million and $(11.0)2007, from $86.8 million for the same period in 2006. Interest income on mortgage loans held-for-sale decreased from 2006 primarily as a result of 2003 and 2002. As shown inlower than average mortgage loan balances resulting from lower originations as well as higher financing costs due to commitment fees charged by Wachovia for our statementcurrent financing facilities. Net interest income increased for the year ended December 31, 2006 by $23.4 million as compared to the same period of income, this resulted in an income tax expense (benefit)2005 due to a higher average balance of $5.4mortgage loans during 2006.

(Losses) Gains on Sales of Mortgage Assets.

We recorded losses on sales of mortgage assets for the year ended December 31, 2007 of $2.6 million, $22.9as compared to gains on sales of mortgage assets of $42.9 million and $(2.0)$68.2 million for the same periods of 2006 and 2005. The losses on sales of mortgage assets in 2007 is primarily a result of $6.3 million of losses on sales of real estate owned, offset in part by a gain on our NMFT Series 2007-2 securitization of approximately $5.0 million. Our real estate owned increased due to the poor credit performance of the 2006 loan vintage and due to loans we repurchased from our loan sales in 2006 and 2007 and from our securitizations in 2006. The decrease in gains on sales from 2005 to 2006 was a result of margin compression in the industry and the result of higher expected loan repurchase reserves related to third party sales.

(Losses) Gains 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. The derivative instruments we use to mitigate interest rate risk generally increase in value as short-term interest rates increase and decrease in value as rates decrease. The derivative instruments included in discontinued operations include those which have never been assigned into a securitization trust. The (losses) gains on derivative instruments from discontinued operations were $(4.9) million, $11.9 million and $17.9 million for the years ended December 31, 2004, 20032007, 2006 and 20022005, respectively. Additionally,The losses in 2007 and the TRS reporteddecline in gains in 2006 from 2005 were driven by interest rates decreasing during those periods. As of December 31, 2007, we had terminated all of our derivative instruments included in discontinued operations. The cash impact from termination was minimal.

Valuation Adjustments for Mortgage Loans Held-for-Sale.

We recorded a net losscharge to earnings from discontinued operations beforethe lower of cost or market valuation adjustment on our mortgage loans held-for-sale of $101.1 million during the year ended December 31, 2007 as compared to $1.2 million for the same period of 2006. The increase in this adjustment was primarily the result of the significant decline in whole loan values in 2007 caused by investor concerns over deteriorating credit quality in the subprime whole loan secondary market. We also significantly marked down our nonperforming assets to reflect current market prices for such assets.

Fee Income.

Our fee income taxes of $6.7declined to $22.9 million for the year ended December 31, 2004 resulting2007 from $35.1 million and $64.9 million for same periods of 2006 and 2005. Fee income primarily consisted of broker fee income and service fee income. Broker fees were paid to us

for placing loans with third-party investors (lenders) and were based on negotiated rates with each lender to whom we broker loans. Revenue was recognized upon loan origination and delivery. Service fees were paid to us by either the investor or the borrower on mortgage loans serviced. Fees paid by investors on loans serviced were determined as a percentage of the principal collected for the loans serviced and were recognized in the period in which payments on the loans were received. These fees were approximately 0.50% of the outstanding balance of the loans being serviced. Fees paid by borrowers on loans serviced were considered ancillary fees related to loan servicing and include late fees and processing fees. Revenue was recognized on fees received from borrowers when an income tax benefit of $2.6 million.event occurs that generates the fee and they were considered to be collectible.

 

DuringThe amortization of mortgage servicing rights was also included in fee income. Mortgage servicing rights were amortized in proportion to and over the past five years, we believe that a minorityestimated period of net servicing income. Generally, as the size of our shareholdersservicing portfolio increases the amortization expense will increase. In addition the amortization of mortgage servicing rights was impacted by our assumptions regarding prepayment speeds for the loans serviced for investors. During periods of increasing loan prepayments, the amortization on our mortgage servicing rights generally would increase.

Origination fees were received from borrowers at the time of loan closing and are deferred until the related loans were sold or securitized in transactions structured as sales. For securitizations structured as financings this fee income was deferred and amortized into interest income over the life of the loans using a level yield method.

The decreases in fee income from 2006 to 2007 and from 2005 to 2006 were a result of the gradual shutdown of our NHMI branch operations in 2005 and 2006 and the shutdown of our mortgage lending and loan servicing operations in 2007.

General and Administrative Expenses.

The main categories of our general and administrative expenses are: compensation and benefits, office administration, professional and outside services, loan expense, marketing expense and other expense. General and administrative expenses for discontinued operations increased by $38.9 million for the year ended December 31, 2007 from the same period of 2006. The increase for the year ended December 31, 2007 as compared to 2006 is due to the $47.2 million accrual for the NHMI litigation judgment discussed in “Item 3. Legal Proceedings”. Without this accrual, general and administrative expenses would have been non-United States holders. Accordingly, we anticipate that NFI will qualifyslightly decreased for the year ended December 31, 2007 as a “domestically-controlled REIT” for United States federal income tax purposes. Investors who are non-United States holders should contact their tax advisor regardingcompared to the United States federal income tax consequencessame periods of dispositions2006 due to the exit of shares of a “domestically-controlled REIT.”

Pro Forma 2003our lending and 2002 Statements of Income.Prior to 2004, we were party to limited liability company (“LLC”) agreements governing LLC’s formed to facilitate the operation of retail mortgage broker businesses as branches of NHMI.servicing businesses. The LLC agreements were terminated effective January 1, 2004. Continuing branches that formerly operated under these agreements became our operating units and their financial results are included in the consolidated financial statements. The inclusion resulted in expected increasesdecrease in general and administrative expenses which were substantially offset by increases in related fee income. We did not purchase any assets or liabilities asfrom 2005 to 2006 was a result of these branches becoming operating units.the shutdown of our NHMI branch operations.

Financial Condition as of December 31, 2007 and December 31, 2006

Cash and Cash Equivalents.

See “Liquidity and Capital Resources” for discussion of our cash and cash equivalents.

Mortgage Loans - Held-in-Portfolio.

 

The following table comparessummarizes the activity of our mortgage loans classified as held-in-portfolio for the year ended December 31, 20032007.

Table 6 — Rollforward of Mortgage Loans - Held-in-Portfolio

(dollars in thousands)

Beginning principal balance

  $2,101,768 

Borrower repayments

   (801,286)

Capitalization of interest

   41,973 

Transfers of mortgage loans from held-for-sale

   1,888,776 

Transfers to real estate owned

   (163,494)
   


Ending principal balance

   3,067,737 

Net unamortized deferred origination costs

   32,414 
   


Amortized cost

   3,100,151 

Allowance for credit losses

   (230,138)
   


Mortgage loans held-in-portfolio

  $2,870,013 
   


Our portfolio of mortgage loans held-in-portfolio increased to $2.9 billion at December 31, 2007 from $2.1 billion at December 31, 2006. During the first quarter of 2007 we transferred mortgage loans with a principal balance of $1.9 billion from the held-for-sale classification to the held-in-portfolio classification which was used as the underlying collateral for our NHEL 2007-1 securitization, which was structured as a financing and 2002completed in 2007.

The following table provides delinquency information for our loans classified as reported Pro Forma as if the LLC’s had been our operating units. The Pro Forma only includes LLC’s that are still in existenceheld-in-portfolio as of December 31, 2004.2007 and December 31, 2006.

 

Table 14Table7 — Mortgage LoansPro Forma 2003 and 2002Held-in-Portfolio Delinquencies

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

 

   

For the Year Ended

December 31, 2003


  

For the Year Ended

December 31, 2002


 
   Actual

  Pro Forma

  Actual

  Pro Forma

 

Net interest income

  $130,445  $130,445  $79,847  $79,847 

Gains on sales of mortgage assets

   144,005   165,879   53,305   59,506 

Fee income

   68,341   91,784   35,983   41,542 

Other expense, net

   (33,527)  (33,527)  (37,811)  (37,811)

General and administrative expenses

   (174,408)  (218,326)  (84,594)  (96,790)
   


 


 


 


Income before income tax expense (benefit)

   134,856   136,255   46,730   46,294 

Income tax expense (benefit)

   22,860   23,207   (2,031)  (1,913)
   


 


 


 


Income from continuing operations

   111,996   113,048   48,761   48,207 

Loss from discontinued operations, net of income tax

   —     (2,505)  —     (605)
   


 


 


 


Net income

  $111,996  $110,543  $48,761  $47,602 
   


 


 


 


Basic earnings per share:

                 

Income from continuing operations

  $5.04  $5.09  $2.35  $2.32 

Loss from discontinued operations, net of income tax

   —     (0.11)  —     (0.03)
   


 


 


 


Net income available to common shareholders

  $5.04  $4.98  $2.35  $2.29 
   


 


 


 


Diluted earnings per share:

                 

Income from continuing operations

  $4.91  $4.96  $2.25  $2.23 

Loss from discontinued operations, net of income tax

   —     (0.11)  —     (0.03)
   


 


 


 


Net income available to common shareholders

  $4.91  $4.85  $2.25  $2.20 
   


 


 


 


   As of December 31,

 
   2007

  2006

 
   Current
Principal


  Percent of
Total


  Current
Principal


  Percent of
Total


 

Current

  $2,484,386  81% $2,013,541  96%

30-59 days delinquent

   158,366  5   29,316  1 

60-89 days delinquent

   98,039  3   15,593  1 

90 + days delinquent

   150,811  5   5,080  —   

In process of foreclosure

   176,135  6   38,238  2 
   

  

 

  

Total principal

  $3,067,737  100% $2,101,768  100%
   

  

 

  

Mortgage Loan Servicing.Loan servicingWe have $753.8 million in principal balance of MTA loans on our consolidated balance sheet as of December 31, 2007 as compared to $1.2 billion as of December 31, 2006. This product is also commonly referred to as an “option ARM”, “negative amortization ARM”, “pay-option” or “MTA” loan within the mortgage industry. We refer to this product as MTA, which stands for monthly treasury average. The monthly treasury average is the interest rate index for a critical partmajority of the loans of this product type which we have originated or purchased.

The interest rates for MTA loans are generally fixed for one, two or three months following their origination and then adjust monthly. These loans allow the borrower to defer making the full interest payment for at least the first year of the loan. After this “option” period, minimum monthly payments increase by no more than 7.50% per year unless the unpaid balance increases to a specified limit, which is no more than 125% of the original loan amount, at which time a new monthly payment amount adequate to repay the loan over its remaining contractual life is established. To ensure that contractual loan payments are adequate to repay a loan, the fully amortizing loan payment amount is re-established every five years.

Due to the MTA loans’ amortization characteristics, the loss that we would realize in the event of default may be higher than that realized on a “traditional” loan that results in the payment of principal. Our MTA loans contain features that help mitigate the risk of borrower default and the increased risk of loss in the event of default. Specifically, our business.underwriting standards for MTA loans required, at the date of funding, that the borrower meet secondary market debt-service ratio tests designed to ensure that they can make the fully amortizing loan payment assuming the loan’s interest rate is fully indexed. (A fully indexed loan rate equals the sum of the current index rate plus the margin applicable to the loan.) In addition, the opinionloan’s terms limit the amount of management, maintaining contactpotential increase of loss in the event of default by restricting the amount of interest that may be added to the loan’s balance as described in the preceding paragraph.

Our MTA loan portfolio has a relatively high initial loan quality, with borrowers is vital in managinga weighted average original FICO score (a measure of credit rating) of 706 and weighted average original loan-to-value (“LTV”) of 76.0% at December 31, 2007. However, the lower initial payment requirements of MTA loans may increase the credit risk inherent in our portfolio of loans held-in-portfolio. This is because when the required monthly payments for pay-option loans eventually increase (in a period not to exceed 60 months), borrowers may be less able to pay the increased amounts and, in borrower retention. Nonconforming borrowers are prone to late payments and aretherefore, more likely to default on their obligationsthe loan, than conventional borrowers. We strivea borrower with an amortizing loan. Our exposure to identify issues and trends with borrowers early and take quick actionthis higher credit risk is increased by any negative amortization that has been added to address such matters. Our annualized coststhe principal balance.

The following is a summary of servicing per unit decreased from $263 and $267 atour MTA loan portfolio for year ended December 31, 20032007 and 2002, respectively, to $261 at December 31, 2004.2006 as well as information on the negative amortization on these loans during the time periods presented:

 

Table 158 — Summary of Servicing OperationsMTA Loan Activity

(dollars in thousands, except per loan cost)thousands)

 

   2004

  2003

  2002

 
   Amount

  

Per

Unit


  Amount

  

Per

Unit


  Amount

  

Per

Unit


 

Unpaid principal

  $12,151,196      $7,206,113      $3,657,640     
   


     


     


    

Number of loans

   87,543       54,196       28,849     
   


     


     


    

Servicing income, before amortization of mortgage servicing rights

  $35,773  $409  $20,486  $378  $12,796  $444 

Costs of servicing

   (22,845)  (261)  (14,261)  (263)  (7,703)  (267)
   


 


 


 


 


 


Net servicing income, before amortization of mortgage servicing rights

   12,928   148   6,225   115   5,093   177 

Amortization of mortgage servicing rights

   (16,934)  (193)  (8,995)  (166)  (4,609)  (160)
   


 


 


 


 


 


Net servicing income (loss)

  $(4,006) $(45) $(2,770) $(51) $484  $17 
   


 


 


 


 


 


   2007

  2006

 

MTA loan portfolio at period end

  $753,787  $1,219,447 
   


 


Accumulated negative amortization during the period

  $41,973  $29,541 
   


 


Number of loans with negative amortization during the period

   1,965   3,295 
   


 


Original Weighted Average LTV at period end

   76.0%  80.4%
   


 


Original Weighted Average FICO score at period end

   706   708 
   


 


LiquidityMortgage Securities Available-for-Sale and Capital ResourcesTrading.

 

Liquidity meansThe following tables summarize our mortgage securities – available for sale and trading portfolios and the needcurrent assumptions and assumptions at the time of securitization as of December 31, 2007 and December 31, 2006.

Table 9 — Valuation and Assumptions for accessIndividual Mortgage Securities – Available-for-Sale and Trading

(dollars in thousands):

As of December 31, 2007

Securitization Trust


  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)


 

NMFT Series – Available-for-Sale:

                               

2002-3

  $1,932  $—    $1,932  25% 24% 0.6% 20% 30% 1.0%

2003-1

   3,260   —     3,260  25  20  1.7  20  28  3.3 

2003-2

   2,817   —     2,817  25  18  1.2  28  25  2.7 

2003-3

   1,233   —     1,233  25  16  1.2  20  22  3.6 

2003-4

   1,279   —     1,279  25  20  1.6  20  30  5.1 

2004-1

   180   —     180  25  24  2.4  20  33  5.9 

2004-2

   180   —     180  25  23  2.4  26  31  5.1 

2004-3

   986   —     986  25  24  3.0  19  34  4.5 

2004-4

   48   —     48  25  26  2.6  26  35  4.0 

2005-1

   512   —     512  25  27  3.6  15  37  3.6 

2005-2

   642   —     642  25  24  3.3  13  39  2.1 

2005-3

   1,335   —     1,335  25  24  3.6  15  41  2.0 

2005-3 (C)

   158   69   227  25  N/A  N/A  N/A  N/A  N/A 

2005-4

   1,344   —     1,344  25  27  4.5  15  43  2.3 

2005-4 (C)

   212   —     212  25  N/A  N/A  N/A  N/A  N/A 

2006-2

   2,301   —     2,301  25  32  6.8  15  44  2.4 

2006-3

   2,994   —     2,994  25  31  8.4  15  43  3.0 

2006-4

   2,960   —     2,960  25  32  8.2  15  43  2.9 

2006-5

   4,217   —     4,217  25  31  11.0  15  43  3.9 

2006-6

   4,712   —     4,712  25  30  10.0  15  41  3.7 
   

  


 

                   

Total

  $33,302  $69  $33,371                   
   

  


 

                   

NMFT Series – Trading Securities:

                               

2007-2

  $41,275  $(13,959) $27,316  25% 20% 12.5% 20% 34% 5.7%
   

  


 

                   

(A)The interest-only, prepayment penalty and overcollateralization securities are presented on a combined basis.
(B)For securities that have not reached their call date - 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, net of mortgage insurance recoveries.
(C)Represents derivative cash flow bonds (“CT Bonds”).

As of December 31, 2006

Securitization Trust


  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)


 

NMFT Series:

                               

2002-3

  $3,384  $56  $3,440  20% 35% 0.4% 20% 30% 1.0%

2003-1

   9,398   418   9,816  20  32  1.3  20  28  3.3 

2003-2

   5,458   2,450   7,908  20  31  0.8  28  25  2.7 

2003-3

   5,255   254   5,509  20  29  0.8  20  22  3.6 

2003-4

   3,509   1,513   5,022  20  38  1.0  20  30  5.1 

2004-1

   13,511   3,170   16,681  20  47  1.3  20  33  5.9 

2004-1 (D)

   132   —     132  20  N/A  N/A  N/A  N/A  N/A 

2004-2

   14,321   4,492   18,813  20  47  1.3  26  31  5.1 

2004-2 (D)

   1,322   60   1,382  20  N/A  N/A  N/A  N/A  N/A 

2004-3

   24,939   8,982   33,921  19  48  1.5  19  34  4.5 

2004-4

   16,237   8,684   24,921  20  56  1.3  26  35  4.0 

2005-1

   20,525   4,558   25,083  15  60  1.7  15  37  3.6 

2005-2

   13,831   67   13,898  13  54  1.5  13  39  2.1 

2005-3

   13,047   1,169   14,216  15  51  1.5  15  41  2.0 

2005-3 (C)

   47,814   (1,131)  46,683  N/A  N/A  N/A  N/A  N/A  N/A 

2005-3 (D)

   6,423   1,473   7,896  15  N/A  N/A  N/A  N/A  N/A 

2005-4

   11,087   1,194   12,281  15  49  2.0  15  43  2.3 

2005-4 (D)

   5,278   1,143   6,421  15  N/A  N/A  N/A  N/A  N/A 

2006-2

   13,835   —     13,835  15  46  3.2  15  44  2.4 

2006-3

   13,746   —     13,746  15  45  4.3  15  43  3.0 

2006-4

   19,019   —     19,019  15  45  3.5  15  43  2.9 

2006-5

   22,181   —     22,181  15  44  4.8  15  43  3.9 

2006-6

   26,508   —     26,508  15  42  3.9  15  41  3.7 
   

  


 

                   

Total

  $310,760  $38,552  $349,312                   
   

  


 

                   

(A)The interest-only, prepayment penalty and overcollateralization securities are presented on a combined basis.
(B)For securities that have not reached their call date - 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, net of mortgage insurance recoveries.
(C)Consists of the Class M-11 and M-12 certificates of NMFT Series 2005-3. The M-11 is rated BBB/BBB- by Standard & Poor’s and Fitch, respectively. The M-12 is rated BBB- by Standard and Poor’s. The fair value for these securities is based upon market prices.
(D)Represents derivative cash flow bonds (“CT Bonds”).

As of December 31, 2007 and December 31, 2006 the fair value of our mortgage securities – available-for-sale was $33.4 million and $349.3 million, respectively. The decline is mostly due to compressed margins, an increase in expected credit losses and usesnormal paydowns. The value of cash. Our primary needs forour mortgage securities – available-for-sale, as well as the cash include the acquisition of mortgage loans, principal repaymentflows we receive from them, are highly dependent upon interest rate spreads, as well as credit losses and interest on borrowings, operating expenses and dividend payments. Substantial cash is required to support the operating activitiesprepayment experience of the business, especiallyborrowers of the underlying mortgage origination operation. Mortgage asset sales, principal, interestsecurity collateral.

The following tables provide a summary of our portfolio of trading securities at December 31, 2007 and fees collected on mortgage assets support cash needs. Drawing upon various borrowing arrangements typically satisfies major cash requirements. As shown in Table 5, we have $268.6 million in immediately available funds.December 31, 2006:

 

Table 10 — Mortgage lending requires significant cash to fund loan originationsSecurities - Trading

(dollars in thousands)

As of December 31, 2007

S&P Rating


  Original Face

  Amortized Cost
Basis

  Fair Value

  Number of
Securities

  Weighted Average
Yield


 

A+

  $2,199  $2,204  $264  1  6.20%

A

   21,263   20,770   6,471  5  7.59 

A-

   17,932   16,495   2,405  4  11.13 

BBB+

   52,802   50,959   9,537  15  9.20 

BBB

   129,795   122,480   25,063  31  10.97 

BBB-

   165,890   154,674   36,264  35  13.15 

BB+

   31,733   27,461   3,220  12  16.15 

BB

   13,500   11,052   1,238  5  19.39 

Unrated

   N/A   41,275   24,741  1  21.00 
   

  

  

  
    

Total

  $435,114  $447,370  $109,203  109  13.85%
   

  

  

  
  

As of December 31, 2006

S&P Rating


  Original Face

  Amortized Cost
Basis

  Fair Value

  Number of
Securities

  Weighted Average
Yield


 

A+

  $2,199  $2,202  $2,195  1  6.40%

A

   15,692   15,444   15,466  3  6.96 

A-

   13,432   12,338   12,227  4  10.52 

BBB+

   53,657   51,442   51,367  14  8.56 

BBB

   99,795   93,035   92,750  24  9.71 

BBB-

   135,890   121,971   120,003  28  11.94 

BB+

   31,733   25,584   25,181  8  16.25 

BB

   13,500   10,029   10,172  3  19.50 
   

  

  

  
    

Total

  $365,898  $332,045  $329,361  85  11.03%
   

  

  

  
  

As of December 31, 2007, mortgage securities – trading consisted of residual securities, subordinated securities which were retained from our securitization transactions and purchases. Our warehouse lending arrangements, which include repurchase agreements, supportsubordinated securities purchased from other issuers. We had not classified any residual securities as mortgage securities –trading at December 31, 2006. The aggregate fair market value of these securities as of December 31, 2007 and December 31, 2006 was $109.2 million and $329.4 million, respectively. Management estimates the mortgage lending operation. Our warehouse mortgage lenders allow us to borrow between 98% and 100%fair value of the outstanding principal. Funding forresidual securities by discounting the difference – generally 2%expected future cash flows of the principal - must come from cashcollateral and bonds and estimates the fair value of the subordinated securities based on hand.

Loans financed with warehouse repurchase credit facilities are subject to changingquoted market valuation and margin calls.prices. The market value of our loans is dependent on a variety of economic conditions, including interest rates (and borrower demand) and end investor desire and capacity. Market values have been consistent over the past three years. However, there is no certainty thatsubordinated securities within mortgage securities – trading fluctuates inversely with bond spreads in the prices will remain constant. To the extentmarket. Generally, as bond spreads widen (i.e. investors demand more return), the value of our mortgage securities – trading will decline; alternatively, as they tighten, the loans declines significantly, we would be required to repay portions of the amounts we have borrowed. Themarket value of our loans held-for-sale, excluding the loans under removalmortgage securities – trading will increase. We recognized net trading (losses) gains of accounts provision, as of December 31, 2004 would need to decline by approximately 37% before we would use all immediately available funds, assuming no other constraints on our immediately available funds.

In the ordinary course of business, we sell loans with recourse where a defect occurred in the loan origination process$(342.9) million, $(3.2) million and guarantee to cover investor losses should origination defects occur. 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, 2004 and 2003, we had loans sold with recourse with an outstanding principal balance of $11.4 billion and $6.4 billion, respectively. Repurchases of loans where a defect has occurred have been insignificant, as such, there is minimal liquidity risk.

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 requires us to post margin deposits with them. As of December 31, 2004, we have approximately $6.7$0.5 million on deposit. A 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. While 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. 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 flows on loans and securities.

Loans we originate and purchase can be sold to a third-party, which also generates cash to fund on-going operations. When market prices exceed our cost to originate, we believe we can operate in this manner, provided that the level of loan originations is at or near the capacity of the loan production infrastructure.

Cash activity during the years ended December 31, 2004, 20032007, 2006 and 2002 is presented2005, respectively. The significant trading losses in 2007 were the result of significant spread widening in the credit markets. If bond spreads continue to widen or credit performance continues to deteriorate, we are likely to experience additional mark-to-market losses on our mortgage securities – trading if this trend does not reverse.

Real Estate Owned.

Real estate owned relating to continuing operations at December 31, 2007 was $76.6 million. We had no real estate owned at December 31, 2006 from continuing operations. This increase is directly related to foreclosures arising out of our NHEL 2006-1 and 2007-1 securitizations. The stated amount of real estate owned on our consolidated statementbalance sheet is net of expected future losses on the sale of the property.

Short-term Borrowings

We finance certain of our mortgage securities by using repurchase agreements. However, we have actively reduced the amount of these borrowings in 2007 and in the first quarter of 2008. We have no further borrowing capacity currently available to us. See “Liquidity and Capital Resources” for further discussion of our financing availability and liquidity.

Stockholders’ (Deficit) Equity.

The decrease in our shareholders’ (deficit) equity as of December 31, 2007 compared to December 31, 2006 is a result of the following increases and decreases.

Shareholders’ (deficit) equity increased by:

$73.1 million due to impairment on mortgage securities – available for sale reclassified to earnings;

$43.6 million due to the issuance of preferred stock;

$5.4 million due to cumulative effect adjustment from adoption of SFAS 157;

$3.2 million due to the issuance of common stock;

$0.7 million due to compensation recognized under the stock compensation plan;

$0.2 million due to issuance of stock under incentive stock plans;

$1.3 million due to changes in other miscellaneous activity.

Shareholders’ (deficit) equity decreased by:

$724.3 million due to a net loss recognized for the year ended December 31, 2007;

$112.1 million due to the decrease in unrealized gains on mortgage securities classified as available-for-sale;

$7.2 million due to the reversal of tax benefit derived from capitalization of affiliates;

$8.8 million due to dividends accrued or paid on preferred stock;

$0.1 million due to adjustments on derivative instruments used in cash flows.flow hedges reclassified to earnings; and

$1.1 million due to cumulative effect adjustment from the adoption of FIN 48.

 

As noted above, proceedsof December 31, 2007, our total liabilities exceeded our total assets under GAAP, resulting in a shareholders’ deficit. Our losses, negative cash flows from equity offerings have supportedoperations and our operations. Since inception, we have raised $362 million in net proceeds through private and public equity offerings. Equity offerings provide another future liquidity source.

Off Balance Sheet Arrangements

As discussed previously, we pool the loans we originate and purchase and 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 3 summarizes our off balance sheet securitizations.

External factors that are reasonably likely to affectshareholders’ deficit raise substantial doubt about 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, a terrorist attack, outbreak of war or other significant event risk, and market specific events such as a defaultgoing concern, which is dependent upon, among other things, the maintenance of a comparable type of securitization. If we were unablesufficient operating cash flows. There is no assurance that cash flows will be sufficient to access the securitization market, we may still be able to financemeet 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.obligations.

 

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.

We have 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, 2004, we had outstanding commitments to originate loans of $361.2 million. We had no commitments to purchase or sell loans at December 31, 2004. 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. 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.

Contractual Obligations

 

We have entered into certain long-term debt, hedging and lease agreements, which obligate us to make future payments to satisfy the related contractual obligations. Notes 7 and 8 of the consolidated financial statements discuss these obligations in further detail.

 

The following table summarizes our contractual obligations with regard to our long-term debtfor both continuing and lease agreementsdiscontinued operations, as of December 31, 2004.2007, other than short-term borrowing arrangements.

 

Table 1611 — Contractual Obligations

(dollars in thousands)

 

  Payments Due by Period

  Payments Due by Period

Contractual Obligations


  Total

  

Less than 1

Year


  1-3 Years

  4-5 Years

  

After 5

Years


  Total

  Less than
1 Year


  1-3
Years

  3-5
Years

  After 5
Years

Short-term borrowings

  $905,528  $905,528   —     —     —  

Long-term debt (A)

  $407,242  $292,325  $100,887  $10,579  $3,451

Long—term debt (A)

  $4,216,819  $700,420  $1,159,419  $736,331  $1,620,649

Junior subordinated debentures (B)

   278,456   6,970   13,940   13,940   243,606

Operating leases(C)

  $48,965  $8,540  $16,471  $16,052  $7,902   23,880   8,710   12,640   2,301   229

Premiums due to counterparties related to interest rate cap agreements

  $1,874  $1,372  $502   —     —     451   387   64   —     —  
  

  

  

  

  

Total

  $4,519,606  $716,487  $1,186,063  $752,572  $1,864,484
  

  

  

  

  


(A)Repayment of theOur asset-backed bonds are non-recourse as repayment is dependent upon payment of the underlying mortgage loans, which collateralize the debt. The timing of the repayment of these mortgage loans is affected by prepayments. These amounts include expected interest payments on the obligations. Interest obligations on our variable-rate long-term debt are based on the prevailing interest rate at December 31, 20042007 for each respective obligation.
(B)The junior subordinated debentures are assumed to mature in 2035 and 2036 in computing the future payments. These amounts include expected interest payments on the obligations. Interest obligations on our junior subordinated debentures are based on the prevailing interest rate at December 31, 2007 for each respective obligation.
(C)Does not include rental income of $2.9 million to be received under sublease contracts.

Liquidity and Capital Resources

Historically, substantial cash was required to support our business operations. During 2007 and early 2008, we completed several actions to reduce our cash needs and liquidity risk, yet, we continue to have significant cash requirements and risks as a result of our continuing and discontinued operations.

Our residual and subordinated mortgage securities are currently our only source of significant positive cash flows. Based on the current projections, the cash flows from our mortgage securities will decrease in the next several months as the underlying mortgage

loans are repaid, and could be significantly less than the current projections if losses on the underlying mortgage loans exceed the current assumptions. We have significant operating expenses associated with office leases, software contracts, and other obligations relating to our discontinued operations, as well as payment obligations with respect to secured and unsecured debt, including periodic interest payments with respect to junior subordinated debentures relating to the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II. We intend to use available cash inflows in excess of our immediate operating needs, including debt service payments, to repay all of Wachovia’s short-term borrowings and any remaining fees due under the repurchase agreements at the earliest practical date. If, as the cash flows from mortgage securities decrease, we are unable to recommence or invest in mortgage loan origination or brokerage businesses on a profitable basis, and restructure our unsecured debt and contractual obligations or if the cash flows from our mortgage securities are less than currently anticipated, there can be no assurance that we will be able to continue as a going concern and avoid seeking the protection of applicable federal and state bankruptcy laws.

As of March 27, 2008, we had approximately $14 million in available cash on hand. In addition to our operating expenses, which currently range from approximately $1.5 million to $2.0 million per month, and repayments of outstanding obligations to Wachovia discussed below, we have quarterly interest payments due on our trust preferred securities and intend to make payments in settlement of certain litigation and to terminate certain leases, software contracts and other matters relating to our discontinued operations. The next payments due on the trust preferred securities are due on March 31 and April 30, 2008 and total an estimated $1.8 million. However, we intend to defer these interest payments during the applicable thirty-day grace period to assist in managing our liquidity. Additionally, we expect to have near-term payments for pending litigation settlements and lease terminations which are estimated to be approximately $3.0 million. Lease and other contract termination payments will vary, depending on negotiations and available cash. Our current projections indicate sufficient available cash and cash flows from our mortgage assets to meet these payment needs. However, our mortgage asset cash flows are currently volatile and uncertain in nature, and the amounts we receive could vary materially from our projections. Therefore, no assurances can be given that we will be able to meet our cash flow needs, in which case we would be required to seek protection of applicable bankruptcy laws.

Overview of Significant Factors Affecting Liquidity During Year Ended December 31, 2007

 

We entered into various leasehad $25.4 million in unrestricted cash and cash equivalents at December 31, 2007, which was a decrease of $125.2 million from December 31, 2006. Subsequent to December 31, 2007, our unrestricted cash has been impacted by the events described in Management’s Discussion and Analysis of Financial Condition and Results of Operations and the notes to our financial statements. As disclosed elsewhere, our intent is to use available cash inflows in excess of immediate operating needs, including debt service payments, to repay our secured debt with Wachovia. We do not have, and do not expect to have, any availability for borrowings under our current financing facilities with Wachovia.

Wachovia Short-Term Borrowings Repayment. As of December 31, 2007 and thereafter, we were out of compliance with the net worth covenant and the liquidity covenant in our repurchase agreements with Wachovia, but have obtained multiple waivers to be in whichcompliance. The current waiver expires on April 30, 2008 and we expect to be out of compliance prior to its expiration. No assurance can be given with respect to future waivers. If waivers are not obtained, we would be in default and Wachovia could exercise its remedies including, but not limited to, accelerating the lessor agreedoutstanding indebtedness and liquidating the underlying collateral. In the event this were to occur, there can be no assurance that we will be able to continue as a going concern and avoid seeking the protection of applicable federal and state bankruptcy laws.

As of March 27, 2008, we had $19 million of short-term borrowings outstanding with Wachovia. All payments received on the collateral securing these obligations are being remitted directly to Wachovia. Based on the expected cash flows from our mortgage securities from the March 25, 2008 bondholder remittances and the expected release of a portion of our cash held as collateral against letters of credit, we expect our short-term borrowings outstanding to be reduced to approximately $11 million in the near-term. Our repurchase agreements with Wachovia expire on May 8 and May 29, 2008, and any remaining amounts then outstanding will be due and payable at that time.

We have no financing facilities in place to provide liquidity in excess of outstanding borrowings. As a result, any adverse liquidity events could cause us to exhaust our cash balances and may result in our filing bankruptcy.

Sale of Mortgage Servicing Rights. On November 1, 2007, we sold all of our mortgage servicing rights and servicing advances relating to our securitizations. The transaction provided $154.9 million of cash to us after deduction of expenses. We used the proceeds from the sale to repay short-term borrowings.

Margin Calls.During the year ended December 31, 2007, poor credit performance of subprime loans and wider bond spreads on mortgage-backed securities caused a significant decline in the fair value of our mortgage securities as well as our mortgage loans held-for-sale. Consequently, during the year ended December 31, 2007, we were subject to cash margin calls of approximately $222.2 million, on our mortgage securities and mortgage loans held-for-sale.

Loan Repurchases. We also had significant cash outlays in 2007 to repurchase loans sold to third parties during 2006. When whole pools of mortgage loans are sold as opposed to securitized, the third party has recourse against us for certain borrower defaults. We are currently unable to finance any of these assets under our existing lease obligations.financing facilities. We paid $104.3 million in cash during the year ended December 31, 2007 to repurchase loans sold to third parties.

CDO Debt Issuance. We closed a CDO structured as a financing transaction in the first quarter of 2007. The collateral for this securitization consisted of subordinated securities which we retained from our loan securitizations as well as subordinated securities purchased from other issuers. We received net proceeds from the issuance of the asset-backed bonds and from the proceeds of our financing of the BBB bond aggregating $64.3 million.

Loan Securitizations. During the first and second quarter of 2007, we closed two loan securitizations. The net cash inflow from these transactions was $24.4 million. Generally, our securitizations were net positive cash flow events due to the financing we received on the residual security we retained.

Distressed Loan and Real Estate Owned Sales. To help reduce margin call risk and as a result of the value of our mortgage loans held-for-sale continuing to dramatically decline in the third quarter, we entered into a mortgage loan sale agreement with Wachovia to sell substantially all of our mortgage loans held-for-sale which were not, and had never been, delinquent, for a price of 91.5% of par. As of December 31, 2007 we had sold to Wachovia approximately $61,000, $2.3$668.8 million of our mortgage loans held-for-sale. In light of the 91.5% sale price, a lower of cost or market valuation adjustment of approximately $47.0 million was recorded for the year ended December 31, 2007, and is included in the “(Loss) income from discontinued operations, net of income tax” line item on our consolidated statements of operations.

We also completed two other distressed loan and real estate owned sales resulting in net proceeds of approximately $38.1 million which were used to repay short-term borrowings. We will continue to actively pursue the sale to other third party investors all of our mortgage loans held-for-sale and real estate owned. Substantially all of our remaining mortgage loans held-for-sale are delinquent or are in default. Yet, a portion of these loans do have mortgage insurance. Any proceeds from additional sales or liquidations of these assets would be used to repay Wachovia’s short-term borrowings. After Wachovia is repaid, any proceeds would be used by us for future needs.

Preferred Stock Issuance. On July 16, 2007, we issued $48.8 million of convertible preferred stock to certain private investors to enhance our liquidity position.

See discussion below under “Industry Overview, Significant Events and Material Trends” for other events affecting our liquidity.

Execution of Short-Term Borrowing Facilities during 2007.The following facilities were executed with Wachovia during 2007 to help us manage through our liquidity crisis:

$100 Million Repurchase Facility.As a result of the significant decline in our liquidity position, in April 2007, we executed a Residual Securities Facility with Wachovia providing for the financing of certain of our existing residual securities and we also executed a Servicing Rights Facility with Wachovia, providing for the financing of certain mortgage servicing rights. The facility provided vital cash availability to us during 2007 and early 2008 but was repaid and terminated as of January 2008.

$1.9 Billion Comprehensive Financing Facility. In May 2007, we executed a $1.9 billion comprehensive financing facility with Wachovia. The facility expanded and replaced the whole-loan and securities repurchase agreements previously existing between Wachovia and us. All payments on the collateral securing these facilities is being, and until full repayment will be, remitted directly to Wachovia. After we repay the borrowings under these facilities, we do not expect to have any future availability or advances under these facilities.

The $1.9 billion facility principally consists of the following separate agreements (collectively, the “Agreements”): (1) a Whole Loan Master Repurchase Agreement, expiring May 8, 2008; (2) a Securities Master Repurchase Agreement (Investment Grade), expiring May 29, 2008; and (3) a Securities Master Repurchase Agreement (Non Investment Grade), expiring May 29, 2008. Advances under the Agreements bear interest at rates ranging from LIBOR plus 0.65% to LIBOR plus 2.5%, depending on the assets securing the advance.

The Agreements are cross-collateralized with each other and all other secured transactions between us and Wachovia. We were required to pay Wachovia a structuring fee in connection with the Agreements and certain additional fees and expenses, including but not limited to reimbursement of due diligence expenses and payment of certain fees in the event of voluntary prepayment or termination by us or the occurrence of an event of default. In addition, upon a change of control, Wachovia has the right to terminate the Agreements and require the payment of a termination fee.

The Agreements require that the market value of the collateral posted under each facility exceed, by a specified amount, the funds borrowed under such facility. The market value of the collateral is determined by Wachovia from time to time in its sole discretion. If, in Wachovia’s opinion, the market value of the collateral that is then financed under the applicable facility decreases for any reason, we are required to repay the margin or difference in market value, or provide additional collateral.

The Agreements require that the adjusted consolidated tangible net worth of NFI exceed $150 million and $62,000that NFI maintain, on a consolidated basis, at least $30 million of liquidity. We do not currently meet these requirements and do not expect to meet these requirements in the foreseeable future. Wachovia has waived our compliance with these requirements on multiple occasions, with the

current waiver effective until April 30, 2008. During the waiver period, we must maintain liquidity of at least $9.5 million. We expect to be out of compliance prior to the expiration of the current waiver and no assurance can be given with respect to any future waiver.

In addition, the Agreements prohibit NFI from paying any cash dividends on our capital stock without the consent of Wachovia, and dividends can be paid on our 8.90% Series C Cumulative Redeemable Preferred Stock and on the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II only if, after such payments, we continue to have at least $30 million of liquidity or liquidity levels as amended by waiver.The Agreements contain other customary affirmative and negative covenants applicable to us and our subsidiaries that are parties to the facilities (“NovaStar Parties”), including but not limited to covenants prohibiting fundamental changes in the nature of the business of the NovaStar Parties, prohibiting sales by any NovaStar Party of a material portion of our business or assets outside of the ordinary course of business, and prohibiting transactions between a NovaStar Party and any of our other affiliates that are not on arms-length terms.

The Agreements provide for customary events of default, including but not limited to the failure by the NovaStar Parties to make any payment due or to satisfy any margin call or to comply with any other material covenant (including financial covenants) under any of the facilities, representations or warranties made by the NovaStar Parties under the facilities proving to be materially incorrect, certain cross defaults involving other contracts to which any NovaStar Party is a party, an act of insolvency occurring with respect to NFI or certain of our subsidiaries, the failure by any NovaStar Party to satisfy certain final non-appealable monetary judgments, regulatory enforcement actions that materially curtail the conduct of business by us or certain of our subsidiaries, and the occurrence of a material adverse change in the business, performance, assets, operations or condition of NFI and its consolidated subsidiaries taken as a whole.

If an event of default exists under any of the Agreements, Wachovia has the right, in addition to other rights and remedies, to accelerate the repurchase and other obligations of the NovaStar Parties under all of the facilities, to cause all income generated by the related collateral to be applied to the accelerated obligations, to direct the servicer of the mortgage asset collateral to remit payments directly to Wachovia, to sell or retain the collateral to satisfy obligations owed to it, and to recover any deficiency from us and our affiliates. In addition, an event of default under any of the Wachovia facilities would permit Wachovia and its affiliates to set off any outstanding obligations of us or our affiliates against any collateral pledged by us or our affiliates to Wachovia or any of its affiliates under any of the Wachovia facilities or under any other agreement. Further, the NovaStar Parties would be liable to Wachovia for all reasonable legal fees or other expenses incurred in connection with the event of default, the cost of entering into replacement transactions and entering into or terminating hedge transactions in connection or as a result of the event of default, and any other losses, damages, costs or expenses arising or resulting from the occurrence of the event of default.

Collateralization of letters of credit supporting surety bonds.Certain states required that we post surety bonds in connection with our former mortgage lending operations. During 2007, the sureties required that we provide letters of credit to support our reimbursement obligations to the sureties. In order to arrange these letters of credit, we were required to collateralize the letters of credit with cash, which totaled $9.0 million as of December 31, 2007. We are in the process of terminating these surety bonds as a result of the discontinuation of our mortgage lending operations, and we expect to receive a return of the cash collateral following such termination. However, the timing of the return of these funds is dependent upon the acceptance by various states of our surrender of state licenses, which in some cases may be subject to final state audits or examinations. As a result, the full return of the related cash collateral may take up to a year or longer.

Summary of Operating, Investing and Financing Activities

We historically have financed our operations via warehouse and repurchase facilities, resecuritization or other asset-backed bond issuances, and equity and debt offerings based upon a consideration of numerous factors, including:

The financing costs involved

The dilutive effect to our common shareholders

The market price of our common stock

Subordination rights of lenders and shareholders

Collateral and other covenant requirements.

The following table provides a summary of our operating, investing and financing cash flows as taken from our consolidated statements of cash flows for years ended December 31, 2007, 2006 and 2005.

Table 12 — Summary of Operating, Investing and Financing Cash Flows

(dollars in thousands)

   For the Year Ended December 31,

 
   2007

  2006

  2005

 

Consolidated Statements of Cash Flows:

             

Cash used in operating activities

  $(445,788) $(3,326,491) $(870,334)

Cash flows provided by investing activities

   1,073,063   624,888   610,170 

Cash flows (used in) provided by financing activities

   (752,433)  2,587,431   256,295 

Operating Activities. Net cash used in operating activities decreased to $445.8 million for the year ended December 31, 2007 from $3.3 billion for the year ended December 31, 2006. This decrease is due primarily to our reduced loan origination and purchase activity which is included in our cash flows from discontinued operations. Net cash used in operating activities increased to $3.4 billion for the year ended December 31, 2006 from $870.3 million for the year ended December 31, 2005. This increase is due primarily to the issuance of $2.5 billion in asset-backed bonds secured by our mortgage loans held-in-portfolio in 2006. Because the loans securing these transactions were not sold in securitizations, the transactions are presented as financing activities rather than operating activities on our consolidated statements of cash flows for the year ended December 31, 2006.

Investing Activities. Net cash provided by investing activities increased to $1.1 billion for the year ended December 31, 2007 from $624.9 million for the same period of 2006. This increase is due primarily to higher repayments of our mortgage loans held-in-portfolio during the year ended December 31, 2007 compared to the same period of 2006 which was driven by the on-balance sheet securitizations structured as financings we executed in 2006 and 2007. Net cash provided by investing activities increased to $624.9 million for the year ended December 31, 2006 from $610.2 million for the year ended December 31, 2005.

Financing Activities. Our financing activities caused a decrease in cash of $752.4 million for year ended December 31, 2007 as compared to an increase in cash of $2.6 billion for the year ended December 31, 2006. This decrease is due primarily to a net decrease in short-term borrowings of $2.1 billion during 2007 compared to a net increase in short-term borrowings of $0.7 billion for the same period of 2006. This change was the result of lower originations in 2007 as well as our initiative to repay all of our short-term borrowings. Net cash provided by financing activities increased to $2.6 billion for the year ended December 31, 2006 from $256.3 million for the year ended December 31, 2005. This increase is due primarily to the issuance of $2.5 billion in asset-backed bonds secured by our mortgage loans held-in-portfolio during 2006 as discussed above.

Primary Uses of Cash

Investments in New Mortgage Securities.During 2007 we altered our operations substantially when we discontinued our origination businesses. Prior to that, we retained significant interests in the nonconforming loans we originated and purchased through our mortgage securities investment portfolio. Our securitization activities required capital to fund the primary bonds we retained, overcollateralization, securitization expenses and our operating costs to originate the mortgage loans. Due to the depressed market conditions and our liquidity constraints, we do not intend to invest in new mortgage securities for the foreseeable future.

For the year ended December 31, 2007, we retained residual securities with a cost basis of $56.4 million and no subordinated securities from our securitization transactions. In addition, we purchased subordinated securities during 2007 with a cost basis of $22.0 million from other issuers. For the year ended December 31, 2006 and 2005 we retained residual securities with a cost basis of $155.0 million and $289.5 million, respectively, and subordinated securities with a cost basis of $90.0 million and $42.9 million, respectively, from our securitization transactions and in 2006 we purchased subordinated securities with a cost basis of $205.1 million from other issuers.

Originations and Purchases of Mortgage Loans.Mortgage lending requires significant cash to fund loan originations and purchases. The capital invested in our mortgage loans is outstanding until we sell or securitize the loans. Again, due to the significant deterioration in the subprime market, we have discontinued our lending and purchasing activities. For the year ended December 31, 2007, 2006 and 2005 we used $2.7 billion, $11.3 billion and $9.4 billion in cash for the origination and purchase of mortgage loans held-for-sale, respectively. As the values of mortgage loans decreased in 2007, we were subject to cash margin calls on mortgage loans financed under short-term repurchase agreements. We have invested approximately $17.5 million of capital invested in our mortgage loans held-for-sale on our balance sheet as of December 31, 2007 which consists of the difference between the current principal on the loans and the amount borrowed against these loans. We do not expect to recover a substantial portion of this capital investment due to the non-performing nature of our remaining loans.

Repayments of Long-Term Borrowings.Our payments on asset-backed bonds increased to $797.1 million for the year ended December 31, 2007 from $565.2 million and $363.9 million for the same periods of 2006 and 2005, respectively. These increases are due to an increase in our mortgage loans – held-in-portfolio as a result of on-balance sheet securitizations completed in 2006 and 2007. Due to the fact that we do not intend to engage in any additional on-balance sheet securitizations in the foreseeable future, we expect our payments on asset-backed bonds to decrease as our current asset-backed bonds mature.

In addition, as of December 31, 2007, our wholly owned subsidiary NovaStar Mortgage, Inc. had $83.6 million in outstanding principal of junior subordinated debentures relating to the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II. We have guaranteed the obligations of our wholly owned subsidiary NovaStar Mortgage, Inc. under the junior subordinated

debentures. We make periodic interest payments based on a variable interest rate of three-month LIBOR plus 3.5% which resets quarterly. See Table 11 for an estimate of our contractual obligations related to these agreementsjunior subordinated debentures.

Repayments of Short-term Borrowings.See “Short-Term Borrowings” above for discussion of our repayment plan with respect to our outstanding borrowings with Wachovia and the facilities under which those borrowings are outstanding.

Common and Preferred Stock Dividend Payments. We announced that we will not be able to pay a dividend on our common stock with respect to our 2006 taxable income, and as a result our status as a REIT terminated, retroactive to January 1, 2006. This retroactive revocation of our REIT status results in 2004, 2003us becoming taxable as a C corporation for 2006 and 2002,subsequent years.

We did not declare any common stock dividends for the year ended December 31, 2007. We declared common stock dividends per share of $22.40 for the years ended December 31, 2006 and 2005. Preferred stock dividends declared per share were $1.67, $2.23 and $2.23 for the years ended December 31, 2007, 2006 and 2005, respectively. These agreements expired in 2004.Our Board of Directors has suspended dividend payments on our Series C and Series D-1 Preferred Stock. As a result, dividends on our Series C and Series D-1 preferred stock continue to accrue and the dividend rate on the Series D-1 Preferred Stock increased from 9.0% to 13.0%, compounded quarterly, effective January 16, 2008, with respect to all unpaid dividends and subsequently accruing dividends. Accrued and unpaid dividends on our preferred stock must be paid prior to the payment of any dividend on our common stock. We entered into various sublease agreementsdo not expect to pay any dividends for office space formerly occupied by us.the foreseeable future.

Loan Sale and Securitization Repurchases. We received approximately $1.2have sold whole pools of loans with recourse for certain borrower defaults. Because the loans are no longer on our balance sheet, the recourse component is considered a guarantee. During the year ended December 31, 2007, we sold $912.9 million $537,000of loans with recourse for borrower defaults compared to $2.2 billion and $704,000 in 2004, 2003$1.1 billion for the same period of 2006 and 2002, respectively2005, respectively. We maintained a $2.2 million recourse reserve related to these guarantees as of December 31, 2007 compared with a reserve of $24.8 million as of December 31, 2006. We paid $104.3 million in cash to repurchase loans sold to third parties during the year ended December 31, 2007 compared to $21.3 million and $2.3 million during the same periods of 2006 and 2005, respectively. The recourse reserve is our estimate of the loss we expect to incur in repurchasing the loan and then either liquidating or reselling the loan. The cash we must have on hand to repurchase these loans is much higher as we generally must reimburse the investor for the remaining unpaid principal balance, any premium recapture, any unpaid accrued interest and any other out-of-pocket advances in accordance with the loan sale agreement. The recourse reserve as of December 31, 2007 declined by $22.6 million from December 31, 2006 due to the fact that we had repurchased the majority of loans reserved for at December 31, 2006 and the early payment default recourse period for all loan sales in 2007 had passed as of December 31, 2007.

We also have sold loans to securitization trusts and guaranteed losses suffered by the trust resulting from defects in the loan origination process. Defects may have occurred 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, 2007 and December 31, 2006, we had loans sold with recourse to securitization trusts with an outstanding principal balance of $10.1 billion and $12.6 billion, respectively. Historically, repurchases of loans from securitization trusts where a defect has occurred have been insignificant. Because we have received no significant requests to repurchase loans from our securitization trusts as of December 31, 2007, we have not recorded any reserves related to these guarantees.

Expenses Related to Discontinued Operations. We have significant ongoing expenses associated with our discontinued operations, including obligations under multiple office leases, software agreements, and other contractual obligations, that no longer contribute to our revenue producing operations. See “Other Liquidity Factors” for further discussion.

Primary Sources of Cash

Change in Short-Term Borrowings, net (Warehouse Lending Arrangements). As of December 31, 2007, our current short-term borrowing facilities are solely supporting the financing of our mortgage securities. We do not have borrowing capacity available to us in excess of outstanding borrowings, and we do not expect any availability under these facilities in the future.

We experienced a decrease in short-term borrowings of $2.1 billion during 2007 compared to a net increase in short-term borrowings of $0.7 billion for the same period of 2006 and a net increase in short-term borrowings of $0.5 million for the same period of 2005. This change was the result of lower originations in 2007 as well as our initiative to repay all of our short-term borrowings. Changes in short-term borrowings from 2005 to 2006 are the result of loan originations and the timing of the securitization and sale of those loans.

Loans and securities financed with warehouse repurchase agreements 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, borrower demand, borrower creditworthiness, and end investor desire and capacity. The market value of our securities is also dependent on a variety of economic

conditions, including interest rates, default rates on the underlying loans and market demand for the types of securities we retain from our securitizations and purchase from other issuers. To the extent the value of the loans or securities declines 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.

During the year ended December 31, 2007, bond spreads widened on mortgage-backed securities to uncommon levels as a result of investor concerns over deteriorating credit quality in the subprime mortgage market. This widening caused a significant decline in the value of our mortgage securities as well as our mortgage loans held-for-sale. Consequently, we were subject to cash margin calls of approximately $222.2 million on our mortgage securities and mortgage loans held-for-sale.

See “Short-Term Borrowings” under “Liquidity and Capital Resources” for further discussion of our repayment plan with Wachovia as well as discussion of all of our repurchase agreements.

Cash Received From Our Mortgage Securities Portfolio.A major driver of cash flows from investing activities are the proceeds we receive from our mortgage securities—available-for-sale portfolio. We are required to use the cash inflows from these securities to paydown Wachovia’s remaining debt until fully repaid. For the year ended December 31, 2007 we received $235.2 million in proceeds from repayments on mortgage securities as compared to $336.7 million and $453.8 million for the same period of 2006 and 2005. 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.

Higher credit losses have decreased cash available to distribute with respect to our residual securities.

We have lower average balances of our mortgage securities—available-for-sale portfolio as our paydowns have increased faster than our addition of new bonds from our securitization transactions.

Proceeds from Repayments of Mortgage Loans. For the year ended December 31, 2007 we received $801.3 million in proceeds from the repayments of our portfolio of mortgage loans held-in-portfolio compared to $551.8 million and $16.7 million for the same periods of 2006 and 2005. The significant increase in repayments is due to a larger portfolio of mortgage loans held-in-portfolio in 2007 as compared to 2006 and 2005.

Net Proceeds from Securitizations of Mortgage Loans. We depended on the capital markets to finance the mortgage loans we originated and purchased. The primary bonds we issued in our loan securitizations structured as sales were sold to large, institutional investors and U.S. government-sponsored enterprises. The net proceeds from sales of mortgage loans held-for-sale in securitizations decreased to $1.3 billion for the year ended December 31, 2007 from $5.9 billion and $7.4 billion for the same periods of 2006 and 2005. We currently do not expect to enter into any new securitizations as we have discontinued our loan origination operations.

Net Proceeds from Sales of Mortgage Loans to Third Parties.Sales of mortgage loans to third party investors have also historically been a source of liquidity, with proceeds from sale being used to repay funds used to finance the origination or purchase of these loans and any excess being retained by us in respect of the capital we had invested in the loans. Due to the depressed mortgage banking environment in the year ended December 31, 2007, we significantly decreased the volume of loans that we originated and purchased, and that we sold to third parties.

During 2007, we sold to Wachovia mortgage loans held-for-sale with a principal balance of $668.8 million, at a price equal to approximately 91.5% of par. In light of the 91.5% sale price, a lower of cost or market valuation adjustment of approximately $47.0 million was recorded for the year ended December 31, 2007, and is included in the “(Loss) income from discontinued operations, net of income tax” line item on our consolidated statements of operations.

Net Proceeds from Issuances of Long-Term Debt.The resecuritization of our mortgage securities—available-for-sale, on balance sheet securitizations, collateralized debt obligations as well as private debt offerings have provided long-term sources of liquidity. We do not expect to enter into any securitizations, resecuritizations, or CDOs or private debt offerings in the foreseeable future. Other issuances of long-term debt are highly dependent upon industry and market conditions and our financial condition, which are currently significantly unfavorable. As a result, no assurances can be given that we would have access to these sources of liquidity.

We received net proceeds of $1.8 billion through the issuance of NHES Series 2007-1, a securitization structured as a financing during the year ended December 31, 2007. These asset-backed bonds are collateralized by mortgage loans – held-in-portfolio on our consolidated balance sheet. The $1.8 billion is prior to the netting of the repayment of short-term borrowings secured by the underlying mortgage loans and prior to any new short-term borrowings secured by retained mortgage securities. The net cash outflow for this securitization was approximately $2.2 million.

In 2005 we began retaining various subordinated investment-grade securities from our securitization transactions that were previously held in the form of overcollateralization bonds. We also purchase subordinated securities from other ABS issuers. We executed our first CDO in February 2007 with these securities and received net proceeds of $326.8 million through the issuance of asset-backed bonds. The $326.8 million is prior to the netting of the repayment of short-term borrowings secured by the underlying mortgage securities and prior to any new short-term borrowings secured by the retained mortgage securities. The net cash inflow for the CDO was approximately $64.3 million.

Net Proceeds from Issuances Equity or Debt or the Retention of Cash Flow. Since inception, we have raised $612.9 million in net proceeds through private and public equity offerings. As discussed previously under “Overview of Significant Factors Affecting Liquidity in the Year Ended December 31, 2007” within “Liquidity and Capital Resources”, we raised $43.6 million in 2007 due to the issuance of preferred stock. While we have historically raised funds by issuing debt and equity securities, such issuances are highly dependent upon industry and market conditions and our financial condition, which are currently significantly unfavorable. As a result, it is unlikely that we would have access to these sources of liquidity.

Due to the fact that we have a negative net worth, we do not currently have ongoing significant business operations that are profitable and our common stock and Series C preferred stock have been delisted from the New York Stock Exchange, it is unlikely that we will be able to obtain additional equity or debt financing on favorable terms, or at all, for the foreseeable future. To the extent we require additional liquidity and cannot obtain it, we will be forced to file for bankruptcy.

Other Liquidity Factors

Table 11 details our major contractual obligations due over the next 12 months and beyond. As previously discussed, for the near future, we will focus on minimizing losses and preserving liquidity with our remaining operations which consist solely of mortgage portfolio management. Our residual and subordinated mortgage securities are currently our only source of significant positive cash flows. Based on the current projections, the cash flows from our mortgage securities will decrease in the next several months as the underlying mortgage loans are repaid, and could be significantly less than the current projections if losses on the underlying mortgage loans exceed the current assumptions. In addition, we have significant operating expenses associated with office leases, software contracts, and other obligations relating to our discontinued operations, as well as payment obligations with respect to secured and unsecured debt, including periodic interest payments with respect to junior subordinated debentures relating to the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II. We intend to use available cash inflows in excess of our immediate operating needs, including debt service payments, to repay all of Wachovia’s short-term borrowings and any remaining fees due under the repurchase agreements expiredat the earliest practical date. We do not expect any new advances under these or any other financing facilities. If, as the cash flows from mortgage securities decrease, we are unable to recommence our mortgage loan origination or brokerage businesses on a profitable basis, and restructure our unsecured debt and contractual obligations or if the cash flows from our mortgage securities and are less than currently anticipated, there can be no assurance that we will be able to continue as a going concern and avoid seeking the protection of applicable federal and state bankruptcy laws. Factors that can affect our liquidity are discussed in 2004.the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors” sections of this document.

Off-Balance Sheet Arrangements

As discussed previously, historically, we have pooled the loans we originated and purchased and typically securitized them to obtain long-term financing for the assets. The loans were transferred to a trust where they serve as collateral for asset-backed bonds, which the trust issued to the public. We often retained our residual and subordinated securities issued by the trust. We also securitized residual and subordinated securities that we retained from our securitizations and that we purchased from third parties. As discussed elsewhere, our inability to access the securitization market has had a material adverse effect on our results of operations, financial condition, liquidity and ability to continue as a going concern. “Management’s Discussion and Analysis of Financial Condition” discusses the steps we are undertaking, in part, as a result of our inability to access the securitization market.

Information about the revenues, expenses, liabilities and cash flows we have in connection with our securitization transactions, as well as information about the securities issued and interests retained in our securitizations, are detailed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

In an attempt to preserve liquidity as a result of the disruption in the secondary market for loans, we have undertaken the steps set forth under “Liquidity and Capital Resources – Overview of Significant Factors Affecting Liquidity during the Year Ended December 31, 2007.” There, however, can be no assurance that these steps will be sufficient to support our liquidity.

As of December 31, 2007, we had no outstanding commitments to sell, originate or purchase loans. As of December 31, 2006, we had outstanding commitments to originate and purchase loans of $774.0 million and $11.8 million, respectively. We had no outstanding commitments to sell loans at December 31, 2006.

In the ordinary course of business, we have sold whole pools of loans to investors with recourse for certain borrower defaults. We also have sold loans to securitization trusts and guaranteed to cover losses suffered by the trust resulting from defects in the loan origination process. See “Liquidity and Capital Resources – Primary Uses of Cash – Loan Sale and Securitization Repurchases” for further discussion of these guarantees and recourse obligations.

 

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,GAAP. As a result, 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 FASB issued a revision of FASB Statement No. 123,Accounting for Stock-Based Compensation. 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. This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions and does not change the accounting guidance for share-based payment transactions with parties other than employees provided in SFAS No. 123 and Emerging Issues Task Force of the Financial Accounting Standards Board (EITF) Issue No. 96-18,Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. Entities no longer have the option to use the intrinsic value method of APB 25 that was provided in SFAS 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 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. For employee awards that are treated as liabilities, initial cost of the awards will be measured at fair value. The fair value of the liability awards will be remeasured subsequently at each reporting date through the settlement date with changes in fair value during the period an employee provides service recognized as compensation cost over that period. This Statement is effective as of the first interim or annual reporting period that begins after June 15, 2005. As discussed in Note 1 of the consolidated financial statements, we implemented the fair value provisions of SFAS No. 123 during 2003. As such, the adoption of this statement is not anticipated to have a significant impact on the consolidated financial statements.

In March 2004, SEC Staff Accounting Bulletin (SAB) No. 105,Application of Accounting Principles to Loan Commitments was released. This release summarizes the SEC staff position regarding the application of accounting principles generally accepted in the United States of America to loan commitments accounted for as derivative instruments. We account for interest rate lock commitments issued on mortgage loans that will be held for sale as derivative instruments. Consistent with SAB No. 105, we considered the fair value of these commitments to be zero at the commitment date, with subsequent changes in fair value determined solely on changes in market interest rates. As of December 31, 2004, we had interest rate lock commitments on mortgage loans with principal balances of $361.2 million, the fair value of which was $(75,000).

At the March 17-18, 2004 EITF meeting, the EITF reached a consensus on Issue No. 03-1,The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. Issue 03-1 provides guidance for determining when an investment is other-than-temporarily impaired and disclosure requirements regarding impairments that have not been recognized as other-than-temporary. In September 2004, the FASB delayed the effective date of paragraphs 10-20 of this issue. These paragraphs give guidance on how to evaluate and recognize an impairment loss that is other than temporary. The delay does not suspend the requirements to recognize other than temporary impairments as required by existing authoritative literature. The disclosure requirements were effective for reporting periods beginning after June 15, 2004. Issue 03-1 is not expected to have a material impact on the consolidated financial statements.

In December 2003, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 03-3,Accounting for Certain Loans or Debt Securities Acquired in a Transfer.This SOP addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. It includes such loans acquired in purchase business combinations and applies to all nongovernmental entities, including not-for-profit organizations. This SOP does not apply to loans originated by the entity, loans acquired in a business combination accounted for at historical cost, mortgage-backed securities in securitization transactions, acquired loans classified as held-for-sale, trading securities and derivatives. This SOP limits the yield that may be accreted to the excess of the investor’s estimate of undiscounted expected principal, interest, and other cash flows (cash flows expected at acquisition to be collected) over the investor’s initial investment in the loan. This SOP requires that the excess of contractual cash flows over cash flows expected to be collected (nonaccretable difference) not be recognized as an adjustment of yield, loss accrual, or valuation allowance. This SOP prohibits investors from displaying the accretable yield and nonaccretable difference in the balance sheet. Subsequent increases in cash flows expected to be collected generally should be recognized prospectively through adjustment of the loan’s yield over its remaining life. Decreases in cash flows expected to be collected should be recognized as impairment. This SOP prohibits “carrying over” or creation of valuation allowances in the initial accounting of all loans acquired in a transfer that are within the scope of this SOP. The prohibition of the valuation allowance carryover applies to the purchase of an individual loan, a pool of loans, a group of loans, and loans acquired in a purchase business combination. This SOP is effective for loans acquired in fiscal years beginning after December 15, 2004. Early adoption is encouraged. For loans acquired in fiscal years beginning on or before December 15, 2004, this SOP should be applied prospectively for fiscal years beginning after December 15, 2004. SOP 03-3 is not expected to have a significant impact on the consolidated financial statements.

Item 7A.Quantitative and Qualitative Disclosures about 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,

 
   2004

  2003

 

Assets

         

Cash and cash equivalents

  $268,563  $118,180 

Mortgage loans – held-for-sale

   747,594   697,992 

Mortgage loans – held-in-portfolio

   59,527   94,717 

Mortgage securities – available-for-sale

   489,175   382,287 

Mortgage securities – trading

   143,153   —   

Mortgage servicing rights

   42,010   19,685 

Servicing related advances

   20,190   19,281 

Derivative instruments, net

   18,841   19,492 

Property and equipment, net

   15,476   14,537 

Other assets

   56,782   33,786 
   


 


Total assets

  $1,861,311  $1,399,957 
   


 


Liabilities and Stockholders’ Equity

         

Liabilities:

         

Short-term borrowings secured by mortgage loans

  $720,791  $639,852 

Short-term borrowings secured by mortgage securities

   184,737   232,684 

Asset-backed bonds secured by mortgage loans

   53,453   89,384 

Asset-backed bonds secured by mortgage securities

   336,441   43,596 

Dividends payable

   73,431   30,559 

Due to trusts

   20,930   14,475 

Accounts payable and other liabilities

   45,184   49,183 
   


 


Total liabilities

   1,434,967   1,099,733 

Commitments and contingencies (Note 8)

         

Stockholders’ equity:

         

Capital stock, $0.01 par value, 50,000,000 shares authorized:

         

Redeemable preferred stock, $25 liquidating preference per share; 2,990,000 shares authorized, issued and outstanding

   30   —   

Common stock, 27,709,984 and 24,447,315 shares authorized, issued and outstanding, respectively

   277   245 

Additional paid-in capital

   433,107   231,294 

Accumulated deficit

   (85,354)  (15,522)

Accumulated other comprehensive income

   79,120   85,183 

Other

   (836)  (976)
   


 


Total stockholders’ equity

   426,344   300,224 
   


 


Total liabilities and stockholders’ equity

  $1,861,311  $1,399,957 
   


 


   December 31,

 
   2007

  2006

 

Assets

         

Unrestricted cash and cash equivalents

  $25,364  $150,522 

Restricted cash

   8,998   —   

Mortgage loans – held-in-portfolio, net of allowance of $230,138 and $22,452, respectively

   2,870,013   2,116,535 

Mortgage securities – trading

   109,203   329,361 

Mortgage securities – available-for-sale

   33,371   349,312 

Real estate owned

   76,614   —   

Accrued interest receivable

   61,704   29,109 

Deferred income tax asset, net

   —     47,188 

Other assets

   37,244   74,167 

Assets of discontinued operations

   8,255   1,932,069 
   


 


Total assets

  $3,230,766  $5,028,263 
   


 


Liabilities and Shareholders’ (Deficit) Equity

         

Liabilities:

         

Asset-backed bonds secured by mortgage loans

  $3,065,746  $2,067,490 

Asset-backed bonds secured by mortgage securities

   74,385   9,519 

Short-term borrowings secured by mortgage securities

   45,488   503,680 

Junior subordinated debentures

   83,561   83,041 

Due to servicer

   56,450   —   

Accounts payable and other liabilities

   57,208   46,142 

Liabilities of discontinued operations

   59,416   1,803,821 
   


 


Total liabilities

   3,442,254   4,513,693 

Commitments and contingencies (Note 8)

         

Shareholders’ (deficit) equity:

         

Capital stock, $0.01 par value, 50,000,000 shares authorized:

         

Redeemable preferred stock, $25 liquidating preference per share; 2,990,000 shares, issued and outstanding

   30   30 

Convertible participating preferred stock, $25 liquidating preference per share; 2,100,000 shares, issued and outstanding

   21   —   

Common stock, 9,439,273 and 9,315,313 shares, issued and outstanding, respectively

   94   93 

Additional paid-in capital

   786,342   742,028 

Accumulated deficit

   (996,649)  (263,572)

Accumulated other comprehensive (loss) income

   (1,117)  36,548 

Other

   (209)  (557)
   


 


Total shareholders’ (deficit) equity

   (211,488)  514,570 
   


 


Total liabilities and shareholders’ (deficit) equity

  $3,230,766  $5,028,263 
   


 


 

See notes to consolidated financial statements.

NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF INCOMEOPERATIONS

(dollars in thousands, except per share amounts)

 

   For the Year Ended December 31,

 
   2004

  2003

  2002

 

Interest income:

             

Mortgage securities

  $133,633  $98,804  $56,481 

Mortgage loans held-for-sale

   83,718   60,878   33,736 

Mortgage loans held-in-portfolio

   6,673   10,738   16,926 
   


 


 


Total interest income

   224,024   170,420   107,143 

Interest expense:

             

Short-term borrowings secured by mortgage loans

   30,005   20,060   10,406 

Short-term borrowings secured by mortgage securities

   4,836   3,450   2,107 

Asset-backed bonds secured by mortgage loans

   1,422   2,269   4,195 

Asset-backed bonds secured by mortgage securities

   13,255   5,226   727 

Net settlements of derivative instruments used in cash flow hedges

   3,072   9,359   10,293 
   


 


 


Total interest expense

   52,590   40,364   27,728 
   


 


 


Net interest income before credit (losses) recoveries

   171,434   130,056   79,415 

Credit (losses) recoveries

   (726)  389   432 
   


 


 


Net interest income

   170,708   130,445   79,847 

Gains on sales of mortgage assets

   144,950   144,005   53,305 

Fee income

   102,756   68,341   35,983 

Premiums for mortgage loan insurance

   (4,218)  (3,102)  (2,326)

Losses on derivative instruments

   (8,905)  (30,837)  (36,841)

Impairment on mortgage securities – available-for-sale

   (15,902)  —     —   

Other income, net

   6,609   412   1,356 

General and administrative expenses:

             

Compensation and benefits

   138,516   89,954   49,060 

Office administration

   38,625   22,945   10,092 

Marketing

   37,812   23,109   9,986 

Professional and outside services

   19,887   7,482   3,263 

Loan expense

   18,753   19,433   6,667 

Other

   17,532   11,485   5,526 
   


 


 


Total general and administrative expenses

   271,125   174,408   84,594 
   


 


 


Income from continuing operations before income tax expense (benefit)

   124,873   134,856   46,730 

Income tax expense (benefit)

   5,376   22,860   (2,031)
   


 


 


Income from continuing operations

   119,497   111,996   48,761 

Loss from discontinued operations, net of income tax

   (4,108)  —     —   
   


 


 


Net income

   115,389   111,996   48,761 

Dividends on preferred shares

   (6,265)  —     —   
   


 


 


Net income available to common shareholders

  $109,124  $111,996  $48,761 
   


 


 


Basic earnings per share:

             

Income from continuing operations available to common shareholders

  $4.47  $5.04  $2.35 

Loss from discontinued operations, net of income tax

   (0.16)  —     —   
   


 


 


Net income available to common shareholders

  $4.31  $5.04  $2.35 
   


 


 


Diluted earnings per share:

             

Income from continuing operations available to common shareholders

  $4.40  $4.91  $2.25 

Loss from discontinued operations, net of income tax

   (0.16)  —     —   
   


 


 


Net income available to common shareholders

  $4.24  $4.91  $2.25 
   


 


 


Weighted average basic shares outstanding

   25,290   22,220   20,758 
   


 


 


Weighted average diluted shares outstanding

   25,763   22,821   21,660 
   


 


 


Dividends declared per common share

  $6.75  $5.04  $2.15 
   


 


 


   For the Year Ended December 31,

 
   2007

  2006

  2005

 

Interest income

  $366,246  $304,122  $199,482 

Interest expense

   228,369   131,334   22,263 
   


 


 


Net interest income before provision for credit losses

   137,877   172,788   177,219 

Provision for credit losses

   (265,288)  (30,131)  (1,038)
   


 


 


Net interest (expense) income after provision for credit losses

   (127,411)  142,657   176,181 

Other operating expense:

             

(Losses) gains on sales of mortgage assets

   (136)  362   (27)

(Losses) gains on derivative instruments

   (10,997)  109   247 

Fair value adjustments

   (85,803)  (3,192)  549 

Impairments on mortgage securities – available-for-sale

   (98,692)  (30,690)  (17,619)

Premiums for mortgage loan insurance

   (16,462)  (6,270)  (340)

Other (expense) income, net

   (2,064)  682   —   
   


 


 


Total other operating expense

   (214,154)  (38,999)  (17,190)

General and administrative expenses:

             

Compensation and benefits

   27,688   34,824   34,709 

Office administration

   12,565   11,479   12,138 

Professional and outside services

   21,811   15,905   14,220 

Other

   (2,644)  7,699   1,164 
   


 


 


Total general and administrative expenses

   59,420   69,907   62,231 

(Loss) income from continuing operations before income tax expense (benefit)

   (400,985)  33,751   96,760 

Income tax expense (benefit)

   66,512   (21,642)  (24,269)
   


 


 


(Loss) income from continuing operations

   (467,497)  55,393   121,029 

(Loss) income from discontinued operations, net of income tax

   (256,780)  17,545   18,095 
   


 


 


Net (loss) income

   (724,277)  72,938   139,124 

Dividends on preferred shares

   (8,805)  (6,653)  (6,653)
   


 


 


Net (loss) income available to common shareholders

  $(733,082) $66,285  $132,471 
   


 


 


Basic earnings per share:

             

(Loss) income from continuing operations available to common shareholders

  $(51.04) $5.70  $15.42 

(Loss) income from discontinued operations, net of income tax

   (27.51)  2.05   2.44 
   


 


 


Net (loss) income available to common shareholders

  $(78.55) $7.75  $17.86 
   


 


 


Diluted earnings per share:

             

(Loss) income from continuing operations available to common shareholders

  $(51.04) $5.66  $15.25 

(Loss) income from discontinued operations, net of income tax

   (27.51)  2.03   2.42 
   


 


 


Net (loss) income available to common shareholders

  $(78.55) $7.69  $17.67 
   


 


 


Weighted average basic shares outstanding

   9,332,405   8,552,911   7,417,267 
   


 


 


Weighted average diluted shares outstanding

   9,332,405   8,617,904   7,498,232 
   


 


 


Dividends declared per common share

  $—    $22.40  $22.40 
   


 


 


 

See notes to consolidated financial statements.

NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’SHAREHOLDERS’ (DEFICIT) EQUITY

(dollars in thousands, except share amounts)

 

   

Preferred

Stock


  

Common

Stock


  

Additional

Paid-in

Capital


  

Accumulated

Deficit


  

Accumulated

Other

Comprehensive

Income


  Other

  

Total

Stockholders’

Equity


 

Balance, January 1, 2002

  $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 
   


 

  


 


 

  


 


Forgiveness of founders’ notes receivable

   —     —     —     —     —     139   139 

Issuance of common stock, 3,188,620 shares

   —     32   93,889   —     —     —     93,921 

Exercise of stock options, 298,875 shares

   —     3   1,644   —     —     —     1,647 

Compensation recognized under stock option plan

   —     —     1,310   —     —     —     1,310 

Dividend equivalent rights (DERs) on vested options

   —     —     1,198   (1,198)  —     —     —   

Dividends on common stock ($5.04 per share)

   —     —     —     (114,294)  —     —     (114,294)

Increase in common stock held in rabbi trusts

   —     —     —     —     —     (3,145)  (3,145)

Increase in deferred compensation obligation

   —     —     —     —     —     3,145   3,145 
   


 

  


 


 

  


 


Comprehensive income:

                             

Net income

               111,996   —         111,996 

Other comprehensive income

               —     22,248       22,248 
                           


Total comprehensive income

                           134,244 
                           


Balance, December 31, 2003

   —     245   231,294   (15,522)  85,183   (976)  300,224 
   


 

  


 


 

  


 


   Redeemable
Preferred
Stock

  Convertible
Participating
Preferred
Stock


  Common
Stock


  Additional
Paid-in
Capital


  Accumulated
Deficit


  Accumulated
Other
Comprehensive
(Loss) Income


  Other

  Total
Shareholders’
(Deficit) Equity


 

Balance, January 1, 2005

  $30  $—    $70  $433,314  $(85,354) $79,120  $(836) $426,344 

Forgiveness of founders’ notes receivable

   —     —     —     —     —     —     140   140 

Issuance of common stock, 1,083,580 shares

   —     —     11   145,345   —     —     —     145,356 

Issuance of stock under stock compensation plans, 37,199 shares

   —     —     —     923   —     —     —     923 

Compensation recognized under stock compensation plans

   —     —     —     2,226   —     —     —     2,226 

Dividend equivalent rights (DERs) on vested options

   —     —     —     304   (4,369)  —     —     (4,065)

Dividends on common stock ($22.40 per share)

   —     —     —     —     (171,302)  —     —     (171,302)

Dividends on preferred stock ($2.23 per share)

   —     —     —     —     (6,653)  —     —     (6,653)

Other

   —     —     —     (291)  —     —     —     (291)
   

  

  

  


 


 

  


 


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  $—    $81  $581,821  $(128,554) $111,538  $(696) $564,220 
   

  

  

  


 


 

  


 


 

Continued

   

Preferred

Stock


  

Common

Stock


  

Additional

Paid-in

Capital


  Accumulated
Deficit


  Accumulated
Other
Comprehensive
Income


  Other

  

Total

Stockholders’

Equity


 

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 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 
   

  

  

  


 


 


 


                            Concluded 
   Redeemable
Preferred
Stock


  Convertible
Participating
Preferred
Stock


  Common
Stock


  Additional
Paid-in
Capital


  Accumulated
Deficit


  Accumulated
Other
Comprehensive
(Loss) Income


  Other

  Total
Shareholders’
(Deficit) Equity


 

Balance, January 1, 2006

  $30  $—    $81  $581,821  $(128,554) $111,538  $(696) $564,220 

Forgiveness of founders’ notes receivable

   —     —     —     —     —     —     139   139 

Issuance of common stock, 1,234,550 shares

   —     —     12   148,779   —     —     —     148,791 

Issuance of stock under stock compensation plans, 32,611 shares

   —     —     —     907   —     —     —     907 

Compensation recognized under stock compensation plans

   —     —     —     2,548   —     —     —     2,548 

Dividend equivalent rights (DERs) on vested options

   —     —     —     825   (3,084)  —     —     (2,259)

Dividends on common stock ($22.40 per share)

   —     —     —     —     (198,219)  —     —     (198,219)

Dividends on preferred stock ($2.23 per share)

   —     —     —     —     (6,653)  —     —     (6,653)

Common stock repurchased, 123 shares

   —     —     —     (17)  —     —     —     (17)

Tax benefit derived from capitalization of affiliate

   —     —     —     7,173   —     —     —     7,173 

Other

   —     —     —     (8)  —     —     —     (8)
   

  

  

  


 


 


 


 


Comprehensive income:

                                 

Net income

                   72,938           72,938 

Other comprehensive loss

                       (74,990)      (74,990)
                               


Total comprehensive loss

                               (2,052)
   

  

  

  


 


 


 


 


Balance, December 31, 2006

  $30  $—    $93  $742,028  $(263,572) $36,548  $(557) $514,570 
   

  

  

  


 


 


 


 


 

See notes to consolidated financial statements.Continued

   Redeemable
Preferred
Stock


  Convertible
Participating
Preferred
Stock


  Common
Stock


  Additional
Paid-in
Capital


  Accumulated
Deficit


  Accumulated
Other
Comprehensive
(Loss) Income


  Other

  Total
Shareholders’
(Deficit) Equity


 

Balance, January 1, 2007

  $30  $—    $93  $742,028  $(263,572) $36,548  $(557) $514,570 

Cumulative effect adjustment from adoption of SFAS 157

   —     —     —     —     5,430   —     —     5,430 

Cumulative effect adjustment from adoption of SFAS 159

   —     —     —     —     (1,131)  1,131   —     —   

Cumulative effect adjustment from adoption of FIN 48

   —     —     —     —     (1,072)  —     —     (1,072)

Forgiveness of founders’ notes receivable

   —     —     —     —     —     —     348   348 

Issuance of preferred stock, 2,100,000 shares

   —     21   —     43,591   —     —     —     43,612 

Preferred stock beneficial conversion feature

   —     —     —     3,825   (3,825)  —     —     —   

Issuance of common stock, 35,094 shares

   —     —     —     3,190   —     —     —     3,190 

Issuance of stock under stock compensation plans, 88,867 shares

   —     —     1   209   —     —     —     210 

Compensation recognized under stock compensation plans

   —     —     —     707   —     —     —     707 

Dividends on preferred stock ($1.67 per share declared)

   —     —     —     —     (8,805)  —     —     (8,805)

Reversal of tax benefit derived from capitalization of affiliates

   —     —     —     (7,195)  —     —     —     (7,195)

Other

   —     —     —     (13)  603   —     —     590 
   

  

  

  


 


 


 


 


Comprehensive loss:

                                 

Net loss

                   (724,277)          (724,277)

Other comprehensive loss

                       (38,796)      (38,796)
                               


Total comprehensive loss

                               (763,073)
   

  

  

  


 


 


 


 


Balance, December 31, 2007

  $30  $21  $94  $786,342  $(996,649) $(1,117) $(209) $(211,488)
   

  

  

  


 


 


 


 


See notes to consolidated financial statements.Concluded

NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands)

 

   For the Year Ended December 31,

 
   2004

  2003

  2002

 

Cash flows from operating activities:

             

Income from continuing operations

  $119,497  $111,996  $48,761 

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

             

Amortization of mortgage servicing rights

   16,934   8,995   4,609 

Impairment on mortgage securities – available-for-sale

   15,902   —     —   

Losses on derivative instruments

   8,905   30,837   36,841 

Depreciation expense

   6,090   3,872   1,203 

Amortization of deferred debt issuance costs

   5,036   1,100   172 

Compensation recognized under stock compensation plans

   1,810   1,310   3,215 

Tax benefit derived from stock compensation plans

   897   —     —   

Credit losses (recoveries)

   726   (389)  (432)

Amortization of premiums on mortgage loans

   699   1,120   1,930 

Forgiveness of founders’ promissory notes

   140   139   139 

Provision for deferred income taxes

   (1,322)  (5,848)  (4,652)

Accretion of available-for-sale securities

   (100,666)  (78,097)  (56,481)

Originations and purchases of mortgage loans held-for-sale

   (8,560,314)  (6,071,042)  (2,811,315)

Repayments of mortgage loans held-for-sale

   27,979   18,474   10,943 

Proceeds from sale of mortgage loans held-for-sale to third parties

   64,476   966,537   394,240 

Proceeds from sale of mortgage loans held-for-sale in securitizations

   8,173,829   5,207,525   1,520,712 

Gains on sales of mortgage assets

   (144,950)  (144,005)  (53,305)

Purchase of mortgage securities - trading

   (143,153)  —     —   

Changes in:

             

Servicing related advances

   (707)  (6,247)  (3,173)

Derivative instruments, net

   13,553   (9,577)  (41,866)

Other assets

   (43,753)  (25,074)  3,093 

Accounts payable and other liabilities

   (24,204)  30,422   (2,936)
   


 


 


Net cash provided by (used in) operating activities from continuing operations

   (562,596)  42,048   (948,302)

Net cash used in operating activities from discontinued operations

   (3,110)  —     —   
   


 


 


Net cash provided by (used in) operating activities

   (565,706)  42,048   (948,302)

Cash flows from investing activities:

             

Proceeds from paydowns on available-for-sale securities

   346,558   179,317   100,071 

Mortgage loan repayments—held-in-portfolio

   31,781   49,101   65,505 

Proceeds from sales of assets acquired through foreclosure

   4,905   6,719   14,876 

Purchases of property and equipment

   (7,029)  (13,000)  (5,280)
   


 


 


Net cash provided by investing activities

   376,215   222,137   175,172 

Cash flows from financing activities:

             

Proceeds from issuance of asset-backed bonds, net of debt issuance costs

   506,745   52,271   66,906 

Payments on asset-backed bonds

   (254,867)  (120,083)  (86,434)

Proceeds from issuance of capital stock and exercise of equity instruments, net of offering costs

   193,615   94,321   1,786 

Change in short-term borrowings

   32,992   (153,000)  882,186 

Repurchase of warrants

   —     —     (9,499)

Dividends paid on preferred stock

   (6,265)  —     (2,014)

Dividends paid on common stock

   (132,346)  (99,256)  (30,876)
   


 


 


Net cash provided by (used in) financing activities

   339,874   (225,747)  822,055 
   


 


 


Net increase in cash and cash equivalents

   150,383   38,438   48,925 

Cash and cash equivalents, beginning of year

   118,180   79,742   30,817 
   


 


 


Cash and cash equivalents, end of year

  $268,563  $118,180  $79,742 
   


 


 


   For the Year Ended December 31,

 
   2007

  2006

  2005

 

Cash flows from operating activities:

             

Net (loss) income

  $(724,277) $72,938  $139,124 

Loss (income) from discontinued operations

   256,780   (17,545)  (18,095)
   


 


 


(Loss) income from continuing operations

   (467,497)  55,393   121,029 

Adjustments to reconcile net (loss) income to net cash used in operating activities:

             

Accretion of available-for-sale and trading securities

   (99,773)  (158,984)  (172,019)

Interest capitalized on loans held-in-portfolio

   (41,973)  (29,541)  —   

Amortization of premiums on mortgage loans

   4,805   10,409   376 

Amortization of deferred debt issuance costs

   1,696   3,408   5,683 

Provision for credit losses

   265,288   30,131   1,038 

Losses (gains) on sales of mortgage assets

   136   (362)  27 

Fair value adjustments

   85,803   3,192   (549)

Impairments on mortgage securities – available-for-sale

   98,692   30,690   17,619 

Losses (gains) on derivative instruments

   10,997   (109)  (247)

Compensation recognized under stock compensation plans

   707   2,548   2,226 

Forgiveness of founders’ promissory notes

   348   139   140 

Depreciation expense

   2,865   3,195   3,594 

Provision for deferred income taxes

   41,620   (21,510)  (30,379)

Changes in:

             

Accrued interest receivable

   (31,855)  (70,912)  (35,296)

Derivative instruments, net

   3,496   893   —   

Other assets

   37,147   (24,461)  (9,750)

Due to servicer

   56,450   —     —   

Accounts payable and other liabilities

   34,515   48,662   15,467 
   


 


 


Net cash provided by (used in) operating activities from continuing operations

   3,467   (117,219)  (81,041)

Net cash used in operating activities from discontinued operations

   (449,255)  (3,209,272)  (789,293)
   


 


 


Net cash used in operating activities

   (445,788)  (3,326,491)  (870,334)

Cash flows from investing activities:

             

Proceeds from paydowns on mortgage securities - available-for-sale

   188,443   327,218   453,750 

Proceeds from paydowns of mortgage securities - trading

   46,731   9,436   —   

Purchases of mortgage securities - trading

   (21,957)  (205,078)  —   

Proceeds from sale of mortgage securities - trading

   7,420   11,223   143,153 

Purchase of mortgage securities – available-for-sale

   —     (1,922)  —   

Proceeds from repayments of mortgage loans held-in-portfolio

   824,060   551,796   16,673 

Proceeds from sales of assets acquired through foreclosure

   6,288   2,267   1,909 

Cash used to collateralize letter of credit

   (8,998)  —     —   

Purchases of property and equipment

   (3,132)  (10,021)  (5,315)
   


 


 


Net cash provided by investing activities

   1,038,855   684,919   610,170 

Net cash provided by (used in) investing activities from discontinued operations

   34,208   (60,031)  —   
   


 


 


Net cash provided by investing activities

   1,073,063   624,888   610,170 

 

See notes to consolidated financial statements.Continued

   For the Year Ended December 31,

 
   2007

  2006

  2005

 

Cash flows from financing activities:

             

Proceeds from issuance of asset-backed bonds, net of debt issuance costs

   2,111,415   2,505,457   128,921 

Payments on asset-backed bonds

   (797,101)  (565,188)  (363,861)

Payments on asset-backed bonds due to exercise of redemption provisions

   —     (18,788)  (7,822)

Proceeds from issuance of capital stock and exercise of equity instruments, net of offering costs

   47,012   143,478   142,114 

Net change in short-term borrowings

   (458,192)  323,233   (4,290)

Proceeds from the issuance of junior subordinated debentures

   —     33,917   48,428 

Repurchase of common stock

   —     (17)  —   

Dividends paid on vested stock options

   (405)  (2,725)  (2,113)

Dividends paid on preferred stock

   (6,653)  (4,990)  (6,653)

Dividends paid on common stock

   —     (237,352)  (195,760)
   


 


 


Net cash provided by (used in) financing activities from continuing operations

   896,076   2,177,025   (261,036)

Net cash (used in) provided by financing activities from discontinued operations

   (1,648,509)  410,406   517,331 
   


 


 


Net cash (used in) provided by financing activities

   (752,433)  2,587,431   256,295 
   


 


 


Net decrease in cash and cash equivalents

   (125,158)  (114,172)  (3,869)

Cash and cash equivalents, beginning of year

   150,522   264,694   268,563 
   


 


 


Cash and cash equivalents, end of year

  $25,364  $150,522  $264,694 
   


 


 


 

See notes to consolidated financial statements.Concluded

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

Note 1. SummaryBasis of Significant AccountingPresentation, Liquidity and Reporting PoliciesGoing Concern Considerations and Management’s Plan

 

Description of Operations NovaStar Financial, Inc. (“NFI”) and its subsidiaries (the “Company”) operatesoperate as a specialty finance company that originates, purchases, investsnon-conforming residential mortgage portfolio manager. Prior to changes in its business in 2007 and early 2008, the Company originated, purchased, securitized, sold, invested in and servicesserviced residential nonconforming loans.mortgage loans and mortgage backed securities. The Company offers a wide range ofretained, through its 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 United States of America government-sponsored entities such as Fannie Mae or Freddie Mac. The Company retainssecurities investment portfolio, significant interests in the nonconforming loans it originated and purchased, and through their mortgage securities investment portfolio. The Company servicesits servicing platform, serviced all of the loans they retain interests in through their servicing platform,which it retained interests. Historically, the Company had elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (“the Code”). During the third quarter of 2007, the Company announced that it would not be able to pay a dividend on its common stock with respect to its 2006 taxable income, and as a result the Company’s status as a REIT terminated, retroactive to January 1, 2006. This retroactive revocation of the Company’s REIT status resulted in order to better manage the credit performance of those loans.it becoming taxable as a C corporation for 2006 and subsequent years.

 

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, reserve for losses on third party sales, derivative instruments, CDO debt and mortgage servicing rights and estimating appropriate accrual rates on mortgage 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.

The Company’s consolidated financial statements have been prepared on a going concern basis of accounting which contemplates continuity of operations, realization of assets, liabilities and commitments in the normal course of business. There are substantial doubts that the Company will be able to continue as a going concern and, therefore, may be unable to realize its assets and discharge its liabilities in the normal course of business. The financial statements do not reflect any adjustments relating to the recoverability and classification of recorded asset amounts or to the amounts and classification of liabilities that may be necessary should the Company be unable to continue as a going concern.

As of December 31, 2007, the Company’s total liabilities exceeded its total assets under GAAP, resulting in a shareholders’ deficit. The Company’s losses, negative cash flows from operations and its shareholders’ deficit raise substantial doubt about the Company’s ability to continue as a going concern, which is dependent upon, among other things, the maintenance of sufficient operating cash flows. There is no assurance that cash flows will be sufficient to meet the Company’s obligations.

Current Liquidity and Near-Term Obligations. As of March 27, 2008, the Company had approximately $14 million in available cash on hand. In addition to the Company’s operating expenses and repayments of outstanding obligations to Wachovia discussed below, the Company has quarterly interest payments due on its trust preferred securities and intends to make payments in settlement of certain litigation and to terminate certain leases, software contracts and other matters relating to its discontinued operations. The next payments due on the Company’s trust preferred securities are due on March 31 and April 30, 2008 and total an estimated $1.8 million. However, the company intends to defer these interest payments during the applicable thirty-day grace period to assist in managing liquidity. Additionally, the Company expects to have near-term payments for pending litigation settlements and lease terminations. Lease and other contract termination payments will vary, depending on negotiations and available cash. The Company’s current projections indicate sufficient available cash and cash flows from its mortgage assets to meet these payment needs. However, the Company’s mortgage asset cash flows are currently volatile and uncertain in nature, and the amounts the Company receives could vary materially from its projections. Therefore, no assurances can be given that the Company will be able to meet its cash flow needs, in which case it would be required to seek protection of applicable bankruptcy laws.

Overview of Significant Factors Affecting Liquidity During the Year Ended December 31, 2007

The Company had $25.4 million in unrestricted cash and cash equivalents at December 31, 2007, which was a decrease of $125.2 million from December 31, 2006. Subsequent to December 31, 2007, the Company’s unrestricted cash has been impacted by the events described in the notes to the Company’s financial statements. The Company’s intent is to use available cash inflows in excess of immediate operating needs, including debt service payments, to repay its secured debt with Wachovia. The Company does not expect to have any availability for future borrowings under its current financing facilities with Wachovia or any other facilities.

Wachovia Short-Term Borrowings Repayment. As of December 31, 2007 and thereafter, the Company was out of compliance with the net worth covenant and the liquidity covenant in its repurchase agreements with Wachovia but has obtained multiple waivers to be in compliance. The current waiver expires on April 30, 2008 and the Company expects to be out of compliance prior to its expiration. No assurance can be given with respect to future waivers. If waivers are not obtained, the Company would be in default and Wachovia could exercise its remedies including, but not limited to, accelerating the outstanding indebtedness and liquidating the underlying collateral. In the event this were to occur, there can be no assurance that the Company will be able to continue as a going concern and avoid seeking the protection of applicable federal and state bankruptcy laws.

As of March 28, 2008, the Company had $19 million of short-term borrowings outstanding with Wachovia. All payments received on the collateral securing these obligations are being remitted directly to Wachovia. Based on the expected cash flows from the Company’s mortgage securities from the March 25, 2008 bondholder remittances and the expected release of a portion of its cash held as collateral against letters of credit, the Company expects its short-term borrowings outstanding to be reduced to $11 million in the near-term. The Company’s repurchase agreements with Wachovia expire on May 8 and May 29, 2008, and any remaining amounts then outstanding will be due and payable at that time.

The Company has no financing facilities in place to provide liquidity in excess of its outstanding borrowings. As a result, any adverse liquidity events could cause the Company to exhaust its cash balances and may result in its filing bankruptcy.

Sale of Mortgage Servicing Rights. On November 1, 2007, the Company sold all of its mortgage servicing rights and servicing advances relating to its securitizations. The transaction provided $154.9 million of cash to the Company after deduction of expenses. The Company used the proceeds from the sale to repay its short-term borrowings. See Note 15 for further discussion of this transaction.

Margin Calls. During the year ended December 31, 2007, poor credit performance of subprime loans and wider bond spreads on mortgage-backed securities caused a significant decline in the fair value of the Company’s mortgage securities as well as its mortgage loans held-for-sale. Consequently, during the year ended December 31, 2007, the Company was subject to cash margin calls of approximately $138.0 million and $57.7 million, respectively, on its mortgage securities and mortgage loans held-for-sale.

Loan Repurchases. The Company also had significant cash outlays in 2007 to repurchase loans sold to third parties during 2006. When whole pools of mortgage loans are sold as opposed to securitized, the third party has recourse against us for certain borrower defaults. The cash the Company must have on hand to repurchase these loans is much higher than the principal amount of the loan as the Company generally must reimburse the investor for the remaining unpaid principal balance, any premium recapture, any unpaid accrued interest and any other out-of-pocket advances in accordance with the loan sale agreement. Typically, repurchased loans have subsequently been financed on the Company’s warehouse repurchase agreements if eligible and then liquidated or sold. The Company is unable to obtain any financing for these assets as of, and for any period subsequent to, December 31, 2007. The Company paid $104.3 million in cash during the year ended December 31, 2007 to repurchase loans sold to third parties.

CDO Debt Issuance. The Company closed a collateralized debt obligation (“CDO”) transaction structured as a financing transaction in the first quarter of 2007. The collateral for this securitization consisted of subordinated securities which it retained from its loan securitizations as well as subordinated securities purchased from other issuers. The Company received net proceeds from the issuance of the asset-backed bonds and from the proceeds of its financing of the BBB bond aggregating $64.3 million.

See Note 6 for further discussion of the Company’s CDO transaction.

Loan Securitizations. During the first and second quarter of 2007, the Company closed two loan securitizations. The net cash inflow from these transactions was $24.4 million. Generally, the Company’s securitizations were net positive cash flow events due to the financing it received on the residual security it retained.

Distressed Loan and Real Estate Owned Sales. To help reduce margin call risk and as a result of the value of the Company’s mortgage loans held-for-sale continuing to dramatically decline in the third quarter, the Company sold to Wachovia mortgage loans held-for-sale with a principal balance of $668.8 million for a price of 91.5%. In light of the 91.5% sale price, a lower of cost or market valuation adjustment of approximately $47.0 million was recorded for the year ended December 31, 2007, and is included in the “(Loss) income from discontinued operations, net of income tax” line item on the Company’s consolidated statements of operations.

The Company also completed two other distressed loan and real estate owned sales resulting in net proceeds of approximately $38.1 million which were used to repay short-term borrowings. The Company will continue to actively pursue the sale to other third party investors all of its mortgage loans held-for-sale and real estate owned. Substantially all of the Company’s remaining mortgage loans held-for-sale are delinquent or are in default. Yet, a portion of these loans do have mortgage insurance. Any proceeds from additional sales or liquidations of these assets would be used to repay Wachovia’s short-term borrowings. After Wachovia is repaid, any proceeds would be used by the Company for future cash needs.

Preferred Stock Issuance. On July 16, 2007, the Company issued $48.8 million of convertible preferred stock to certain private investors to enhance its liquidity position. See Note 9 for further discussion of this transaction.

Execution of Short-Term Borrowing Facilities during 2007. The following facilities were executed with Wachovia during 2007 to help the Company manage through its liquidity crisis:

$100 Million Repurchase Facility.As a result of the significant decline in the Company’s liquidity position, in April 2007, it executed a Residual Securities Facility with Wachovia providing for the financing of certain of its existing residual securities, and a Servicing Rights Facility with Wachovia, providing for the financing of certain mortgage servicing rights. The facility provided cash availability to the Company during 2007 and early 2008 but was repaid and terminated as of January 2008.

$1.9 Billion Comprehensive Financing Facility. In May 2007, the Company executed a $1.9 billion comprehensive financing facility with Wachovia. The facility expanded and replaced the whole-loan and securities repurchase agreements previously existing between Wachovia and the Company. All payments on the collateral securing these facilities is being, and until full repayment will be, remitted to Wachovia. After the Company repays the borrowings under these facilities, it does not expect to have any future availability or advances under these or any other facilities.

See Note 7 for further discussion of the Company’s short-term borrowings.

Collateralization of letters of credit supporting surety bonds.Certain states required that the Company post surety bonds in connection with its former mortgage lending operations. During 2007, the sureties required that the Company provide letters of credit to support its reimbursement obligations to the sureties. In order to arrange these letters of credit, the Company was required to collateralize the letters of credit with cash, which totaled $9.0 million as of December 31, 2007. The Company is in the process of terminating these surety bonds as a result of the discontinuation of its mortgage lending operations, and it expects to receive a return of the cash collateral following such termination. However, the timing of the return of these funds is dependent upon the acceptance by various states of the Company’s surrender of state licenses, which in some cases may be subject to final state audits or examinations. As a result, the full return of the related cash collateral may take up to a year or longer.

Industry Overview, Significant Events and Material Trends

Described below are some of the marketplace conditions, significant events and known material trends and uncertainties that may impact the Company’s future results of operations as it moves into 2008.

Future Strategy, Liquidity and Going Concern Considerations – The Company’s plan for the future will focus on minimizing losses and preserving liquidity with its remaining operations which consists only of mortgage portfolio management. Additionally, the Company will focus on paying down its outstanding borrowings with Wachovia and reducing operating costs. The Company’s residual and subordinated mortgage securities are currently its only source of significant positive cash flows. Based on current projections, the cash flows from its mortgage securities will decrease in the next several months as the underlying mortgage loans are repaid, and could be significantly less than the current projections if losses on the underlying mortgage loans exceed the current assumptions. In addition, the Company has significant operating expenses associated with office leases, software contracts, and other obligations relating to its discontinued operations, as well as payment obligations with respect to secured and unsecured debt, including periodic interest payments with respect to junior subordinated debentures relating to the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II. The Company intends to use available cash inflows in excess of its immediate operating needs, including debt service payments, to repay all of Wachovia’s short-term borrowings and any remaining fees due under the repurchase agreements at the earliest practical date. If, as the cash flows from its mortgage securities decrease, the Company is unable to recommence or invest in mortgage loan origination or brokerage businesses on a profitable basis, restructure its unsecured debt and contractual obligations or if the cash flows from its mortgage securities are less than currently anticipated, there can be no assurance that the Company will be able to realize its assets and discharge its liabilities in the normal course of business and continue as a going concern or avoid seeking the protection of applicable federal and state bankruptcy laws. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or to the amounts and classification of liabilities that may be necessary should the Company be unable to continue as a going concern.

Due to the fact that the Company has a negative net worth, it does not currently have ongoing significant business operations that are profitable and its common stock and Series C preferred stock have been delisted from the New York Stock Exchange, it is unlikely that the Company will be able to obtain additional equity or debt financing on favorable terms, or at all, for the foreseeable future. To the extent the Company requires additional liquidity and cannot obtain it, the Company will be forced to file for bankruptcy.

In the event the Company is able to significantly increase its liquidity position (as to which no assurance can be given), the Company may use excess cash to make certain investments if it determines that such investments could provide attractive risk-adjusted returns to shareholders, including, potentially investing in new or existing operating companies. Because of certain state licensing requirements, it is unlikely the Company will be able, ourselves, to directly recommence mortgage lending activities so long as the Company continues to have a shareholders’ deficit.

Recent Market Developments - During 2008, the mortgage industry has remained under continuous pressure due to numerous factors, which include industry-wide disclosures regarding the continued deterioration of the value of mortgage assets held by banks and broker-dealers, the deterioration of mortgage credit among mortgage lenders, the downgrades of mortgage securities by the rating agencies, and a reluctance on the part of banks and broker-dealers to finance mortgage securities within the credit markets. Because of these factors, mortgage security market valuations remain volatile, mortgage securities trading remains limited and mortgage securities financing markets remain challenging as the industry continues to report negative news. All of these factors continue to contribute to the decline in the market values of our securities to levels at or below those experienced in 2007.

The market has also seen a significant drop in LIBOR rates since the end of 2007 as the Federal Reserve made several cuts in short-term interest rates, which decreases the variable interest rates tied to one-month LIBOR within the Company’s securitizations which collateralize the Company’s mortgage securities and mortgage loans – held-in-portfolio. The Company believes that these trends in interest rates, if they continue, could lead to positive effects on the cash flows the Company receives from its mortgage securities. However, these cash flows are also dependent on the credit and prepayment performance of the underlying collateral, which could offset any positive impact of decreased LIBOR rates.

Given the uncertainty regarding these market conditions, the Company expects to continue to operate with a historically low level of leverage and to continue to take actions that would support higher levels of liquidity and available cash.

Home prices - Recently, the Company has seen broad-based declines in housing values. Housing values could continue to decrease during the near term which could affect the Company’s credit loss experience, which will continue to impact its earnings, cash flows, financial condition and ability to continue as a going concern.

American Interbanc Mortgage Litigation - On March 17, 2008, the Company and American Interbanc Mortgage, LLC (“Plaintiff”) entered into a Confidential Settlement Term Sheet Agreement (the “Settlement Terms”) with respect to the actions, judgments and claims described below.

In March 2002, Plaintiff filed an action against NHMI in Superior Court of Orange County, California entitled American Interbanc Mortgage LLC v. NovaStar Home Mortgage, Inc. et. al. (the “California Action”). In the California Action, Plaintiff alleged that NHMI and two other mortgage companies (“Defendants”) engaged in false advertising and unfair competition under certain California statutes and interfered intentionally with Plaintiff’s prospective economic relations. On May 4, 2007, a jury returned a verdict by a 9-3 vote awarding Plaintiff $15.9 million. The court trebled the award, made adjustments for amounts paid by settling Defendants, and entered a $46.1 million judgment against Defendants on June 27, 2007. The award is joint and several against the Defendants, including NHMI. It is unknown if the other two Defendants, one of which has filed a bankruptcy petition, have the financial ability to pay any of the award.

NHMI’s motion for the trial court to overturn or reduce the verdict was denied on August 20, 2007, and NHMI appealed that decision (the “Appeal”). Pending the Appeal, Plaintiff commenced enforcement actions in the states of Missouri (the “Kansas City Action”) and Delaware, and obtained an enforcement judgment in Delaware (the “Delaware Judgment”). On January 23, 2008, Plaintiff filed an involuntary petition for bankruptcy against NHMI under 11 U.S.C. Sec. 303, in the United States Bankruptcy Court for the Western District of Missouri (the “Involuntary”). Plaintiff was joined by two individuals alleging claims totaling $150 in the Involuntary filing. NHMI filed an answer and contested the standing of Plaintiff and the individuals to be petitioning creditors in bankruptcy.

On March 17, 2008, the Company and Plaintiff entered into the Settlement Terms with respect to the California Action, the Judgment, the Kansas City Action, the Delaware Judgment, the Involuntary, and all related claims.

Under the Settlement Terms, the parties agreed to move to dismiss the Involuntary. Within ten (10) business days after notice of entry of the dismissal of the Involuntary, the Company will pay Plaintiff $2,000,000 plus the balance in an account established by order of the Bankruptcy Court in an amount no less than $50,000, with NHMI obligated to otherwise satisfy obligations to its identified creditors up to $48,000. The parties also agreed to extend the Appeal briefing period pending finalization of the settlement of the other actions, judgments and claims, as described below.

The Settlement Terms provide that, subject to payment of the amounts described above and satisfaction of certain other conditions, the parties will dismiss the California Action as to NHMI and the Kansas City Action and Delaware Judgment, effect notice of satisfaction of the Judgment, and effect a mutual release of all claims that were or could have been raised in any of the foregoing or that are related to the subject matter thereof, upon the earliest of the following: (i) July 1, 2010, (ii) a waiver by Wachovia of Wachovia’s right to file an involuntary bankruptcy proceeding against any of the NovaStar Entities prior to July 1, 2010, (iii) an extension of the maturity date of the Company’s indebtedness to Wachovia until at least July 1, 2010, or (iv) delivery to Plaintiff of written documentation evidencing the full satisfaction of the Company’s current indebtedness to Wachovia.

In addition to the initial payments to be made to the Plaintiff following dismissal of the Involuntary, the Company will pay Plaintiff $5.5 million if, prior to July 1, 2010, (i) NFI’s average common stock market capitalization is at least $94.4 million over a period of five (5) consecutive business days, or (ii) the holders of NFI’s common stock are paid $94.4 million in net asset value as a result of any sale of NFI or its assets. If NFI is sold prior to July 1, 2010 for less than $94.4 million and ceases to be a public company, then NFI will obligate the purchaser either to immediately pay $2 million to Plaintiff, or to pay Plaintiff $5.5 million in the event the value of the company exceeds $94.4 million prior to July 1, 2010 as determined by an independent valuation company.

In accordance with generally accepted accounting principles, NHMI has recorded a liability of $47.1 million as of December 31, 2007 with a corresponding charge to earnings. The $47.1 million includes interest which is accruing on the obligation. Because NHMI is a wholly owned indirect subsidiary of the Company, the $47.1 million liability is included in the consolidated financial statements of the Company. The liability is included in the “Liabilities of discontinued operations” line of the consolidated balance sheets while the charge to earnings is included in the “(Loss) income from discontinued operations, net of income tax” line of the consolidated statements of operations.

Dividend payments - As a result of the termination of the Company’s REIT status and its current financial condition, the Company does not intend to pay any dividends on its common stock for the foreseeable future. Also, the Company’s board of directors suspended dividend payments on its Series C and Series D-1 Preferred Stock. As a result, dividends on the Series C and D-1 preferred stock continue to accrue and the dividend rate on the Series D-1 preferred stock increased from 9.0% to 13.0%, compounded quarterly, effective January 16, 2008 with respect to all unpaid dividends and subsequently accruing dividends. All accrued and unpaid dividends on the Company’s preferred stock must be paid prior to payment of any dividends on the Company’s common stock. The Company does not expect to pay any dividends for the foreseeable future.

Trading of the Company’s stock - On January 11, 2008, the Company announced that NYSE Regulation determined that its common stock (ticker symbol: NFI) and our 8.90% Series C Cumulative Redeemable Preferred Stock (ticker symbol: NFI PR C) no longer met applicable listing standards for continued listing on the New York Stock Exchange. The Company’s common and preferred shares are eligible for quotation on the OTC Bulletin Board and the Pink Sheets, an electronic quotation service for securities traded over-the-counter, under the symbols (“NOVS”) and (“NOVSP”), respectively.

Note 2. Summary of Significant Accounting and Reporting Policies

 

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, 2007 and 2006, 71% and 93% of the Company’s cash and cash equivalents were with one institution. The uninsured balances aggregated $27.4 million and $139.2 million, respectively.

Restricted Cash Restricted cash includes funds the Company is required to post as cash collateral for letters of credit it obtained in connection with the purchase of surety bond coverage required for state licensing purposes. The cash may not be released to the Company without the consent of the insurance company which is at its discretion. The cash could be subject to the indemnification of losses incurred by the insurance company.

 

Mortgage LoansMortgage loans include loans originated by the Company and acquired from other 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. The Company uses actual and estimated cash flows, which consider the actual and future estimated prepayments of the loans, to derive an effective level yield. 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 whichthat 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 ninety90 days delinquent. For mortgage loans held-in-portfolio, whichthat do carry mortgage insurance, the accrual of interest is only discontinued when in management’s opinion, the interest is not collectible. Interest collected on non-accrual loans is recognized as income upon receipt.

 

The mortgage loan portfolio is collectively evaluated for impairment as the individual loans are smaller-balance and are homogeneous in nature. For 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 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.

An internally developed migration analysis is the primary tool used in analyzing the adequacy of the allowance for credit losses. This tool takes into consideration historical information regarding foreclosure and loss severity experience and applies that information to the portfolio at the reporting date. Management also takes into consideration the use of mortgage insurance as a method of managing credit risk. The Company uses contractual termspays mortgage insurance premiums on loans maintained on the consolidated balance sheet and includes the cost of mortgage insurance in determining past duethe consolidated statements of income.

Management’s estimate of expected losses could increase if the actual loss experience is different than originally estimated. In addition, the estimate of expected losses could increase if economic factors change the value that can be reasonably expected to obtain from the sale of the property. If actual losses increase, or delinquency status of loans.if amounts reasonably expected to be obtained from property sales decrease, the provision for losses would increase.

 

The servicing agreements the Company executesexecuted for loans it has securitized include a removal of accounts provision which givesgave it the right, not the obligation, to repurchase mortgage loans from the trust. The removal of accounts provision cancould be exercised for loans that arewere 90 days to 119 days delinquent. The Company recordsrecorded the mortgage loans subject to the removal of accounts provision in mortgage loans held-for-sale at fair value. In conjunction with the mortgage servicing rights sale in 2007, the removal of accounts provision was transferred to the buyer which resulted in the removal of the mortgage loans subject to the removal of accounts provision from the Company’s balance sheet. See Note 15 for further discussion of the removal of accounts provision and sale of mortgage servicing rights.

 

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 securities (the “subordinated securities”). The residual securities include interest-only mortgage securities, prepayment penalty bonds and overcollateralization bonds. The subordinated securities represent investment-grade and non-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 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.

over-collateralization bonds and other subordinated securities. 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.

 

SubordinatedThe Company has designated two subordinated securities retained in resecuritizations represent the contractual right to receive the remaining cash flows from the trust after the obligations to the outside bond holders have been satisfied. Whenas mortgage securities – available-for-sale as of December 31, 2006 and subsequently transferred those obligations have been satisfied, the trust returns the transferred securities to the trading classification on January 1, 2007 in accordance with the adoption of Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—including an amendment of FASB Statement 115” (“SFAS 159”). The subordinated securities retained by the Company in its securitization transactions have a stated principal amount and interest holders.

Mortgagerate. The performance of the securities classifiedis 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 availablewell 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. The Company accounts for sale are reported at their estimated fair value with unrealized gains and losses reported in accumulated other comprehensive income. The specific identification method was used in computing realized gains or losses.the securities based on EITF 99-20 which prescribes 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 proprietary 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.

The initial value of the loans is estimated based on the expected open market sales price of a similar pool (“the whole loan price methodology”). 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 toThe Company uses the whole loan price methodology when it feels enough relevant information is available through its internal bidding processes for purchasing similar pools of loans in the market. When such information is not available, the Company estimates the initial valuation of the retained securities, the fair value of mortgageresidual securities is estimatedretained in a whole loan securitization based on the present value of future expected cash flows to be received.received (“the discount rate methodology”). 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

For purposes of valuing the extent thatretained residual securities at each reporting period subsequent to the cost basis of mortgage securities exceedsinitial valuation, the Company uses the discount rate methodology.

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 obtained from brokers.

 

Mortgage Securities - TradingMortgage securities – trading consist of mortgage securities purchased by the Company withas well as retained by the principal intent to sellCompany in the near term. Theseits securitization transactions. Trading securities are recorded at fair value with gains and losses, realized and unrealized, included in earnings. The Company uses the specific identification method in computing realized gains or losses.

Mortgage securities – trading consisted of one residual security at December 31, 2007 with the remaining balance comprised of subordinated securities. The fair value is estimated using quoted market prices.Company had no residual securities classified as trading at December 31, 2006. SeeMortgage Securities – Available-for-Sale for further details of the Company’s residual and subordinated securities.

 

Mortgage Servicing Rights MortgagePrior to 2007, mortgage servicing rights arewere recorded at allocated cost based upon the relative fair values of the transferred loans and the servicing rights. In accordance with the adoption of SFAS 156, “Accounting for Servicing of Financial Assets”, an amendment of SFAS 140 (“SFAS 156”), the Company initially recorded mortgage servicing rights upon a securitization at fair value during 2007. Mortgage servicing rights arewere amortized in proportion to and over the projected net servicing revenues. Periodically, the Company evaluatesevaluated the carrying value of mortgage servicing rights based on their estimated fair value. If the estimated fair value, using a discounted cash flow methodology, iswas less than the carrying amount of the mortgage servicing rights, the mortgage servicing rights arewere written down to the amount of the estimated fair value. For purposes of evaluating and measuring impairment of mortgage servicing rights, the Company stratifiesstratified the mortgage servicing rights based on their predominant risk characteristics. The significant risk characteristic considered by the Company iswas period of origination. The mortgage loans underlying the mortgage servicing rights arewere pools of homogenous, nonconforming residential loans.

 

The Company sold its entire mortgage servicing rights portfolio on November 1, 2007. See Note 15 for further discussion.

Servicing Related AdvancesTheIn its capacity as loan servicer, the Company advancesadvanced funds 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 Company sold the servicing related advance balances attributable to the securitization trusts comprising its mortgage servicing rights portfolio in conjunction with the sale of its mortgage servicing rights portfolio on November 1, 2007.

Real Estate OwnedReal estate owned, which consists of residential real estate acquired in satisfaction of loans, is carried at the lower of cost or estimated fair value less estimated selling costs. Adjustments to the loan carrying value required at time of foreclosure are charged against the allowance for credit losses. Costs related to the development of real estate are capitalized and those related to holding the property are expensed. Losses or gains from the ultimate disposition of real estate owned are charged or credited to earnings.

 

Derivative Instruments, netThe Company uses derivative instruments with the objective of hedging 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 their fair value with hedge ineffectiveness recognized in earnings.on the consolidated balance sheet. For derivative instruments that qualify for hedge accounting, any changes in fair value of derivative instruments related to hedge effectiveness are reported in accumulated other comprehensive income. Gains and losses reported as a component of accumulated other comprehensive (loss) income are reclassified into earnings as the forecasted transactions occur. Changes in fair value of derivative instruments related to hedge ineffectiveness and non-hedge activity are recorded as adjustments to earnings.earnings through the gains (losses) on derivative instruments line item of the Company’s consolidated statements of operations. 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.earnings through the gains (losses) on derivative instruments line item of the

Company’s consolidated statements of operations. The fair value of the Company’s derivative instruments, along with any margin accounts associated with the contracts, are included in derivative instruments, net.

other liabilities on the Company’s balance sheet as of December 31, 2007 and other assets as of December 31, 2006.

Property and Equipment, netLeasehold improvements, furniture and fixtures and office and computer equipment are stated at cost less accumulated depreciation. 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

  33-5 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. Depreciation expense related to continuing operations for the years ended December 31, 2007, 2006 and 2005 was $2.9 million, $3.2 million and $3.6 million, respectively. Depreciation expense related to discontinued operations for the years ended December 31, 2007, 2006 and 2005 was $6.0 million, $4.1 million and $3.8 million, respectively.

Warehouse Notes Receivable Warehouse notes receivable represent outstanding warehouse lines of credit the Company provided to approved borrowers. The lines of credit were used by the borrowers to originate mortgage loans. The notes receivable were collateralized by the mortgage loans originated by the Company’s borrowers and were recorded at amortized cost. The Company recognized interest income in accordance with the terms of agreement with the borrower. The accrual of interest was discontinued when, in management’s opinion, the interest was not collectible in the normal course of business. The Company discontinued its warehouse operations during 2007 and had no notes receivable as of December 31, 2007. Warehouse notes receivable are included in assets of discontinued operations on the Company’s consolidated balance sheet as of December 31, 2006.

 

Due to Securitization TrustsDue to securitization trusts represents the fair value of the mortgage loans the Company hashad the right to repurchase from the securitization trusts. The servicing agreements the Company executesexecuted for loans it hashad securitized include a removal of accounts provision which givesgave it the right, not the obligation, to repurchase mortgage loans from the trust. The removal of accounts provision cancould be exercised for loans that are 90 days to 119 days delinquent. Upon exercise of the call options, the related obligation to the trusts iswas removed from the Company’s balance sheet. In conjunction with the mortgage servicing rights sale in 2007, the removal of accounts provision was transferred to the buyer which resulted in the removal of the related obligation from the Company’s balance sheet. See Note 15 for further discussion of the removal of accounts provision and the sale of mortgage servicing rights.

 

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 and loans held-for-sale, 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 – available-for-sale 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, – available-for-sale, the transaction is accounted for as a secured borrowing. When the Company sells mortgage loans or mortgage securities – available-for-sale 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 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 saleswhole loan price of a similar pool.methodology. 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.

 

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 uses the whole loan price methodology when it feels enough relevant information is available through its internal bidding processes for purchasing similar pools of loans in the market. When such information is not available, the Company estimates fairthe initial value for theof residual securities it retainsretained in a resecuritization transactionwhole loan securitization based on the present value of future expected cash flows estimated using management’sdiscount rate methodology. Management’s best estimate of the key assumptions, including credit losses, prepayment speeds, market discount rates and forward yield curves and discount rates commensurate with the risks involved.involved, are used in estimating future cash flows.

For purposes of valuing the retained residual securities at each reporting period subsequent to the initial valuation, the Company uses the discount rate methodology.

For purposes of valuing the Company’s securities, the Company also transfers 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 the Company enters into interest rate swap or cap agreements. Certain of these 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.

A significant factor in valuing the residual securities is the portion of the underlying mortgage loan collateral that 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 severity of credit losses incurred by the trust. 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 during the years ended December 31, 2007, 2006 and 2005, 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 up to the first payment. Additionally,three payments due to 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 8.buyer.

 

 

Loans and Securities Sold Under Agreements to Repurchase (Repurchase Agreements)Repurchase agreements represent legal sales of loans or mortgage securities – available-for-sale and ana related 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. Repurchase agreements are classified as short-term borrowings in the Company’s consolidated balance sheet.

securities – available-for-sale 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 transferringA securitization transaction is the transfer or sale of mortgage loans to independent trusts which issue securities to investors. 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 securities are collateralized by the mortgage loans transferred into the independent trusts. The Company 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 hasretained 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,liquidated, but transferred this right to the accounting treatment for transferspurchaser of assets upon securitization depends on whether or notthe Company’s mortgage servicing rights in 2007. Prior to that transfer, the Company has retained control over the transferred assets. The Company recordsrecorded an asset and a liability on the balance sheet for the aggregate fair value of delinquent loans that it hashad 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 – available-for-sale 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 – available-for-sale 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.

Reserve for Losses – Loans Sold to Third PartiesThe Company maintains a reserve for the representation and warranty liabilities related to loans sold to third parties, and for the contractual obligation to rebate a portion of any premium paid by a purchaser when a borrower prepays a sold loan within an agreed period. The reserve, which is recorded as a liability on the consolidated balance sheet, is established when loans are sold, and is calculated as the estimated fair value of losses reasonably estimated to occur over the life of

the loan. Management estimates inherent losses based upon historical loss trends and frequency and severity of losses for similar loan product sales. The adequacy of this reserve is evaluated and adjusted as required. The provision for losses recognized at the sale date is included in the consolidated statements of operations as a reduction of gains (losses) on sales of mortgage assets.

Due to Servicer Principal and interest payments (the “monthly repayment obligations”) on asset-backed bonds secured by mortgage loans recorded on the Company’s balance sheet are remitted to bondholders on a monthly basis by the securitization trust (the “remittance period”). Funds used for the monthly repayment obligations are based on the monthly scheduled principal and interest payments of the underlying mortgage loan collateral, as well as actual principal and interest collections from borrower prepayments. When a borrower defaults on a scheduled principal and interest payment, the servicer must advance the scheduled principal and interest to the securitization trust to satisfy the monthly repayment obligations. The servicer must continue to advance all delinquent scheduled principal and interest payments each remittance period until the loan is liquidated. Upon liquidation, the servicer may recover their advance through the liquidation proceeds. During the period the servicer has advanced funds to a securitization trust which the Company accounts for as a financing, the Company records a liability representing the funds due back to the servicer.

 

Fee Income TheDuring the years ended December 31, 2007, 2006 and 2005, the Company receivesreceived 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-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 and processing fees and, for loans held-in-portfolio, prepayment penalties.fees. Revenue is recognized on fees received from borrowers when an event occurs that generates the fee and they are considered to be collectible.

NovaStar Home Mortgage, Inc. (“NHMI”) Branch Management Fees During 2003 and 2002, these fees were charged to LLC’s formed to support NHMI branches to manage branch administrative operations, which included providing accounting, payroll, human resources, loan investor management and license management. The amount of the fees was agreed upon when entering the LLC agreements and recognized as services were rendered. Due to the elimination of the LLC’s and their subsequent inclusion in the consolidated financial statements, branch management fees were eliminated in consolidation in 2004.

 

Due to the discontinuance of the mortgage lending and loan servicing operations in 2007, the Company has no significant continuing source of fee income.

Stock-Based Compensation Prior to 2003,At December 31, 2007, the Company had one stock-based employee compensation plan, which is described more fully in Note 20. From January 1, 2004 through December 31, 2005, the Company accounted for its stock-based compensationthe plan usingunder the recognition and measurement principlesprovisions of Accounting Principles Board (APB) OpinionFASB Statement No. 25,Accounting123 (“SFAS 123”), “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,Stock-Based Compensation.” Effective January 1, 2006, the Company adopted the fair value recognition provisions of FASB Statement No. 123(R) (“SFAS 123(R)”), “Share-Based Payment”, using the modified-prospective-transition method. Because the Company was applying the provisions of Financial Accounting Standards (SFAS) No.SFAS 123Accounting 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 prior to January 1, 2003 and2006, the adoption of SFAS 123(R) had no material impact on the consolidated financial statements.

Prior to adoption of SFAS 123(R), the Company presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the Statement of Cash Flows. SFAS 123(R) requires the cash flows resulting from the tax benefits of tax deductions in excess of the compensation cost recognized in 2003 isfor those options (excess tax benefits) to be classified as financing cash flows. Additionally, the same as that which would have beenwrite-off of deferred tax assets relating to the excess of recognized hadcompensation cost over the fair value method of SFAS No. 123 been appliedtax deduction resulting from its original effective date. In accordance with the modified prospective method of adoption, results for prior years have not been restated.

The following table illustrates the effect on net income and earnings per share as if the fair value method had been appliedaward will continue to all outstanding and unvested awards in each period (in thousands, except per share amounts):be reflected within operating cash flows.

   For the Year Ended December 31,

 
   2004

  2003

  2002

 

Net income, as reported

  $115,389  $111,996  $48,761 

Add: Stock-based employee compensation expense included in reported net income, net of related tax effects

   1,810   1,310   2,473 

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects

   (1,810)  (1,310)  (600)
   


 


 


Pro forma net income

  $115,389  $111,996  $50,634 
   


 


 


Earnings per share:

             

Basic – as reported

  $4.31  $5.04  $2.35 
   


 


 


Basic – pro forma

  $4.31  $5.04  $2.44 
   


 


 


Diluted – as reported

  $4.24  $4.91  $2.25 
   


 


 


Diluted – pro forma

  $4.24  $4.91  $2.34 
   


 


 


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.

   2004

  2003

  2002

 

Weighted average:

             

Fair value, at date of grant

  $21.24  $22.48  $10.29 

Expected life in years

   6   7   7 

Annual risk-free interest rate

   4.7%  3.3%  4.1%

Volatility

   0.7   2.0   2.1 

Dividend yield

   0.0%  0.0%  2.2%

 

Income TaxesTheHistorically, the Company iswas taxed as a Real Estate Investment Trust (REIT)REIT under Section 857 of the Internal Revenue Code of 1986, as amended.Code. As a REIT, the Company generally iswas not subject to federal income tax. To maintain its qualification as a REIT, the Company musthad to distribute at least 90% of its REIT taxable income to its stockholdersshareholders and meet certain other tests relating to assets, income and income. Ifownership. However, 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 intends to pay dividends in the 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, and its subsidiaries have not elected REIT-status and, therefore, are subject to corporate income taxes. Accordingly, a provision for income taxes has been provided for the Company’s non-REIT subsidiaries.

The Company hashad elected to treat NFI Holding Corporation and its subsidiaries as taxable REIT subsidiaries (collectively the “TRS”). In general, the TRS maycould hold assets that the Company cannotcould not hold directly and generally maycould engage in any real estate or non-real estate related business. The subsidiaries comprising the TRS arewere subject to corporate federal and state income tax and arewere taxed as regular C corporations. However, special rules do apply

During 2007, the Company was unable to certain activities between asatisfy the REIT and a TRS. For example,distribution requirement for the TRS will be subjecttax year ended December 31, 2006, either in the form of cash or preferred stock. This action resulted in the Company’s loss of REIT status retroactive to earnings stripping limitationsJanuary 1, 2006. The failure to satisfy the REIT distribution test resulted from demands on the deductibilityCompany’s liquidity and the substantial decline in the Company’s market capitalization during 2007.

As a result of the Company’s termination of REIT status, the Company elected to file a consolidated federal income tax return with its eligible affiliated members. The Company reported taxable income in 2006 of approximately $212 million, which resulted in a tax liability of approximately $74 million along with interest paidand penalties due of approximately $5.8 million. After applying payments and credits, the Company reported an amount owed to its REIT. In addition, a REIT will be subjectthe IRS of approximately $67 million. The Company applied for and received an extension of time to a 100% excise tax on certain excess amounts to ensure that (i) tenants who pay the TRSincome taxes due to the Company’s expectation of generating a net operating loss for services are charged an arm’s-length amount by2007, which may be carried back to 2006. This approved extension should allow the TRS, (ii) fees paidCompany to a REIT byreduce all of its taxable income (excluding excess inclusion income) from 2006, and eliminate the TRS are reflected at fair market valueoutstanding tax liability due to the IRS. The Company will, however, be required to pay interest and (iii) interest paid byany penalties that apply on the TRSbalance due to the IRS in 2008.

Since the Company terminated its REIT status effective January 1, 2006 and was taxable as a C corporation for 2006 and 2007, the Company recorded deferred taxes based on the estimated cumulative temporary differences as of December 31, 2007.

In determining the amount of deferred tax assets to recognize in the financial statements, the Company evaluates the likelihood of realizing such benefits in future periods. FASB Statement 109 “Accounting for Income Taxes” (“SFAS 109”) requires the recognition of a valuation allowance if it is commercially reasonable.more likely than not that all or some portion of the deferred tax asset will not be realized. SFAS 109 indicates the more likely than not threshold is a level of likelihood that is more than 50 percent.

Under SFAS 109, companies are required to identify and consider all available evidence, both positive and negative, in determining whether it is more likely than not that all or some portion of its deferred tax assets will not be realized. Positive evidence includes, but is not limited to the following: cumulative earnings in recent years, earnings expected in future years, excess appreciated asset value over the tax basis, and positive industry trends. Negative evidence includes, but is not limited to the following: cumulative losses in recent years, losses expected in future years, a history of operating losses or tax credits carryforwards expiring, and adverse industry trends.

 

The TRS recordsweight given to the potential effect of negative and positive evidence should be commensurate with the extent to which it can be objectively verified. Accordingly, the more negative evidence that exists requires more positive evidence to counter, thus making it more difficult to support a conclusion that a valuation allowance is not needed for all or some of the deferred tax assets. A cumulative loss in recent years is significant negative evidence that is difficult to overcome when determining the need for a valuation allowance. Similarly, cumulative earnings in recent years represents significant positive objective evidence. If the weight of the positive evidence is sufficient to support a conclusion that it is more likely than not that a deferred tax asset will be realized, a valuation allowance should not be recorded.

The Company examines and weighs all available evidence (both positive and negative and both historical and forecasted) in the process of determining whether it is more likely than not that a deferred tax asset will be realized. The Company considers the relevancy of historical and forecasted evidence when there has been a significant change in circumstances. Additionally, the Company evaluates the realization of its recorded deferred tax assets on an interim 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.annual basis. The Company has recordeddoes not record a valuation allowance as discussed in Note 11. Theif the weight of the positive evidence exceeds the negative evidence and is sufficient to support a conclusion that it is more likely than not that its deferred tax asset will be realized.

If the weighted positive evidence is includednot sufficient to support a conclusion that it is more likely than not that all or some of the Company’s deferred tax assets will be realized, the Company considers all alternative sources of taxable income identified in other assetsFAS 109 in determining the amount of valuation allowance to be recorded. Alternative sources of taxable income identified in FAS 109 include the following: 1) taxable income in prior carryback year, 2) future reversals of existing taxable temporary differences, 3) future taxable income exclusive of reversing temporary differences and carryforwards, and 4) tax planning strategies.

Effective January 1, 2007, the Company adopted FASB Interpretation 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement 109”. FIN 48 requires a company to evaluate whether a tax position taken by the company will “more likely than not” be sustained upon examination by the appropriate taxing authority. It also provides guidance on how a company should measure the amount of benefit that the company is to recognize in its financial statements. As a result of the implementation of FIN 48, the Company recorded a $1.1 million net liability as an increase to the opening balance of accumulated deficit. It is the Company’s policy to recognize interest and penalties related to income tax matters in income tax expense (benefit).

Discontinued Operations As a result of the significant deterioration in the subprime secondary markets, during 2007, the Audit Committee of the Board of Directors of the Company committed to workforce reductions pursuant to plans of termination (the “Exit Plans”) as described in FASB Statement of Financial Accounting Standards (“SFAS”) 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). The Company undertook these Exit Plans to align its organization and costs with its decision to discontinue its mortgage lending and mortgage servicing activities. The Company considers an operating unit to be discontinued upon its termination date, which is the point in time when the operations substantially cease. In accordance with SFAS 144, the Company has reclassified the operating results of its entire mortgage lending segment and loan servicing operations segment as discontinued operations in the consolidated balance sheet.statements of operations for the year ended December 31, 2007, 2006 and 2005.

On November 4, 2005, the Company adopted a formal plan to terminate substantially all of the branches operated by NovaStar Home Mortgage, Inc. (“NHMI”). By June 30, 2006, the Company had terminated all of the remaining NHMI branches and related operations. The Company considers a branch to be discontinued upon its termination date, which is the point in time when the operations substantially cease. In accordance with SFAS 144, the Company has presented the operating results of NHMI as discontinued operations in the consolidated statements of operations for the years ended December 31, 2007, 2006 and 2005.

Earnings Per Share (EPS)Basic earnings per shareEPS 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 shareEPS 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, unless the exercise would be antidilutive.

 

Commitments to Originate Mortgage Loans Commitments to originate mortgage loansloans—held-for-sale meet the definition of a derivative and are recorded at fair value and are classified as accounts payable and other liabilities in the Company’s consolidated 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 2004,February 2006, the FASB issued SFAS 155, “Accounting for Certain Hybrid Financial Instruments”, an amendment of SFAS 133 and SFAS 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 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). The statement also establishes a revisionrequirement 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 (“SFAS 140”), “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – a replacement of FASB Statement No. 123,Accounting125” to eliminate the prohibition on a Qualifying Special Purpose Entity (“QSPE”) from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument.

In January 2007, the FASB provided a scope exception under SFAS 155 for Stock-Based Compensation. Thissecuritized interests that only contain an embedded derivative that is tied to the prepayment risk of the underlying prepayable financial assets, and for which the investor does not control the right to accelerate the settlement. If a securitized interest contains any other embedded derivative (for example, an inverse floater), then it would be subject to the bifurcation tests in SFAS 133, as would securities purchased at a significant premium. In previous years, the Company’s policy was to designate its residual securities as available-for-sale but as a result of the Company’s adoption of SFAS 155 on January 1, 2007 and the complexities and uncertainties surrounding the application of this Statement, establishes standardsthe Company has designated the NMFT Series 2007-2 residual security as trading. As a result, the NMFT Series 2007-2 residual security qualifies for the accounting for transactions in whichscope exception concerning bifurcation provided by SFAS 155.

In March 2006, the FASB issued SFAS 156. This statement requires that an entity exchanges its equity instruments for goodsseparately recognize a servicing asset or services. Ita servicing liability when it undertakes an obligation to service a financial asset under a servicing contract in certain situations. Such servicing assets or servicing liabilities are required to be initially measured at fair value, if practicable. SFAS 156 also addresses transactions in whichallows an entity incurs liabilities in exchange for goods to choose one of two methods when subsequently measuring its servicing assets and servicing liabilities: (1) the amortization methodor services that are based on (2) the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions and does not change the accounting guidance for share-based payment transactions with parties other than employees provided in SFAS No. 123 and Emerging Issues Task Force of the Financial Accounting Standards Board (EITF) Issue No. 96-18,Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Servicesmeasurement method. Entities no longer have the option to use the intrinsic valueThe amortization method of APB 25 that was provided in SFAS 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 awardsexisted under SFAS 123(R) will be recognized140 and remains unchanged in (1) allowing entities to amortize their servicing assets or servicing liabilities in proportion to and over the period an employee provides service, typicallyof estimated net servicing income or net servicing loss and (2) requiring the vesting period. No compensation cost is recognizedassessment of those servicing assets or servicing liabilities for equity instruments in which the requisite service is not provided. For employee awards that are treated as liabilities, initial cost of the awards will be measuredimpairment or increased obligation based on fair value at fair value.each reporting date. The fair value of the liability awards will be remeasured subsequentlymeasurement method allows entities to measure their servicing assets or servicing liabilities at fair value at each reporting date through the settlement date withand report changes in fair value duringin earnings in the period an employee provides service recognized as compensation cost overthe change occurs. SFAS 156 introduces the notion ofclassesand allows companies to make a separate subsequent measurement election for each class of its servicing rights. In addition, SFAS 156 requires certain comprehensive roll-forward disclosures that period. Thismust be presented for each class. The Statement is effective as of the beginning of an entity’s first interim or annual reporting periodfiscal year that begins after JuneSeptember 15, 2005. As discussed previously in Note 1, the Company implemented the fair value provisions of SFAS No. 123 during 2003. As such, the adoption of this Statement is not anticipated to have a significant impact on the consolidated financial statements.

In March 2004, SEC Staff Accounting Bulletin (SAB) No. 105,Application of Accounting Principles to Loan Commitments was released. This release summarizes the SEC staff position regarding the application of accounting principles generally accepted in the United States of America to loan commitments accounted for as derivative instruments.2006. The Company accountsadopted SFAS 156 on January 1, 2007 and elected to continue using the amortization method for interest rate lock commitmentsmeasuring its servicing assets. The Company sold its mortgage servicing rights on November 1, 2007.

In June 2006, the FASB issued on mortgage loans that will be heldFIN 48. FIN 48 prescribes a recognition threshold and measurement attribute for sale as derivative instruments. Consistent with SAB No. 105, the Company considers the fair valuefinancial statement recognition and measurement of these commitmentsa tax position taken or to be zero at the commitment date, with subsequent changes in fair value determined solelytaken on changes in market interest rates. As of December 31, 2004, the Company had interest rate lock commitments on mortgage loans with principal balances of $361.2 million, the fair value of which was $(75,000).

At the March 17-18, 2004 EITF meeting, the EITF reached a consensus on Issue No. 03-1,The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. Issue 03-1tax return. This interpretation also provides guidance for determining when an investment is other-than-temporarily impaired and disclosure requirements regarding impairments that have not been recognized as other-than-temporary. An impairment exists when the carrying amount of an asset exceeds its fair value and is determined to be other-than-temporary. In September 2004, the FASB delayed the effective date of paragraphs 10-20 of this issue. These paragraphs giveadditional guidance on how to evaluate and recognize an impairment loss that is other than temporary. The delay does not suspend the requirements to recognize other than temporary impairments as required by existing authoritative literature. The disclosure requirements were effective for reporting periods beginning after June 15, 2004. Issue 03-1 is not expected to have a significant impact on the consolidated financial statements.

In December 2003, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 03-3,Accounting for Certain Loans or Debt Securities Acquired in a Transfer.This SOP addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. It includes such loans acquired in purchase business combinations and applies to all nongovernmental entities, including not-for-profit organizations. This SOP does not apply to loans originated by the entity, loans acquired in a business combination accounted for at historical cost, mortgage-backed securities in securitization transactions, acquired loans classified as held-for-sale, trading securities and derivatives. This SOP limits the yield that may be accreted to the excess of the investor’s estimate of undiscounted expected

principal,derecognition, classification, interest and other cash flows (cash flows expected at acquisition to be collected) over the investor’s initial investmentpenalties, accounting in the loan.interim periods, disclosure, and transition. This SOP requires that the excess of contractual cash flows over cash flows expected to be collected (nonaccretable difference) not be recognized as an adjustment of yield, loss accrual, or valuation allowance. This SOP prohibits investors from displaying the accretable yield and nonaccretable difference in the balance sheet. Subsequent increases in cash flows expected to be collected generally should be recognized prospectively through adjustment of the loan’s yield over its remaining life. Decreases in cash flows expected to be collected should be recognized as impairment. This SOP prohibits “carrying over” or creation of valuation allowances in the initial accounting of all loans acquired in a transfer that are within the scope of this SOP. The prohibition of the valuation allowance carryover applies to the purchase of an individual loan, a pool of loans, a group of loans, and loans acquired in a purchase business combination. This SOPinterpretation is effective for loans acquired in fiscal years beginning after December 15, 2004. Early adoption is encouraged. For loans acquired in fiscal years beginning on or before December 15, 2004, this SOP should be applied prospectively for fiscal years beginning after December 15, 2004. SOP 03-32006. The Company adopted the provisions of FIN 48 on January 1, 2007. The cumulative effect of applying the provisions of FIN 48 is reported as an adjustment to the opening balance of accumulated deficit on January 1, 2007 and resulted in an increase to the Company’s accumulated deficit of $1.1 million.

In September 2006, the FASB issued SFAS 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 establishes a framework for measuring fair value and requires expanded disclosures regarding fair value measurements. This accounting standard is effective for financial statements issued for fiscal years beginning after November 15, 2007, however early adoption is permitted. The Company adopted the provisions of SFAS 157 on January 1, 2007. See Note 11 and Note 15 which describe the impact of the adoption of SFAS 157 on the Company’s consolidated financial statements.

In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides guidance regarding the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of materiality assessments. The method established by SAB 108 requires each of the Company’s financial statements and the related financial statement disclosures to be considered when quantifying and assessing the materiality of the misstatement. The provisions of SAB 108 are effective for financial statements issued for fiscal years beginning after December 31, 2006. The Company adopted SAB 108 on January 1, 2007 and has deemed the impact immaterial on its consolidated financial statements.

In February 2007, the FASB issued SFAS 159. SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. Unrealized gains and losses on items for which the fair value option has been elected will be recognized in earnings at each subsequent reporting date. This accounting standard is effective for financial statements issued for fiscal years beginning after November 15, 2007, however early adoption is permitted. The Company adopted the provisions of SFAS 159 on January 1, 2007. See Note 11 which describes the impact of the adoption of SFAS 159 on the Company’s consolidated financial statements.

On February 20, 2008, the FASB issued Staff Position (FSP) FAS 140-3, “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions.” The FSP focuses on the circumstances that would permit a transferor and a transferee to separately evaluate the accounting for a transfer of a financial asset and a repurchase financing under FASB Statement 140, “Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.”The FSP states that a transfer of a financial asset and a repurchase agreement involving the transferred financial asset should be considered part of the same arrangement when the counterparties to the two transactions are the same unless certain criteria are met. The criteria in the FSP are intended to identify whether (1) there is a valid and distinct business or economic purpose for entering separately into the two transactions and (2) the repurchase financing does not result in the initial transferor regaining control over the previously transferred financial assets. Its purpose is to limit diversity of practice in accounting for these situations, resulting in more consistent financial reporting. Consequently, it is the FASB’s desire to have the FSP effective as soon as practicable. This FSP would be effective for financial statements issued for fiscal years beginning after November 15, 2008 and interim periods within those fiscal years. Early application is not expectedpermitted.

During the first quarter of 2006, the Company purchased approximately $1.0 billion of mortgage loans from counterparties which were subsequently financed through repurchase agreements with that same counterparty. As of December 31, 2007, the entire $1.0 billion of mortgage loans purchased during 2006 remained on the Company’s consolidated balance sheet but they were no longer financed with repurchase agreements as they had been securitized in transactions structured as financings and the short-term repurchase agreements were replaced with asset-backed bond financing. The Company believes there would be no material change to its financial statements based on FSP 140-3.

In March 2008, the FASB issued FASB Statement No. 161, “Disclosures about Derivative Instruments and Hedging Activities.” The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The Company does not expect the adoption of SFAS 161 to have a significantmaterial impact on theits consolidated financial statements.statements, however, the Company is still in the process of evaluating the impact of adopting SFAS 161.

 

Reclassifications Reclassifications to prior year amounts have been made to conform to current year presentation.presentation, as follows:

As discussed underDiscontinued operations, the Company discontinued its mortgage lending and loan servicing operations. The provisions of SFAS 144 require the results of operations associated with those operating units terminated to be classified as discontinued operations and segregated from the Company’s continuing results of operations for all periods presented. In accordance with Statement SFAS 144, the Company has reclassified the operating results of its mortgage lending and loan servicing operations as discontinued operations in the consolidated statements of operations for the years ended December 31, 2007, 2006 and 2005.

The Company has reclassified the operating results of NovaStar Home Mortgage, Inc. and its branches (“NHMI”) through December 31, 2007, as discontinued operations in the Company’s consolidated statements of operations for the years ended December 31, 2007, 2006 and 2005, in accordance with Statement SFAS 144.

The Company created two new line items on the consolidated statements of operations named “Fair value adjustments” and “Valuation adjustment on mortgage loans - held-for-sale” to separate activity which was previously reported in the “Other income, net” line item in prior periods. These line items were created due to the materiality of the amounts recorded in 2007. The “Valuation adjustment on mortgage loans – held-for-sale” is included in the “(Loss) income from discontinued operations, net of income tax” line item on the Company’s consolidated statements of operations.

As a result of the adoption of SFAS 159, the Company reclassified the cash flow activities for its mortgage securities – trading, which were previously reported in the “Cash flows from operating activities” section of its consolidated statements of cash flows, to the “Cash flows from investing activities” section for the years ended December 31, 2006 and 2005.

The Board of Directors declared a one-for-four reverse stock split of its common stock, providing shareholders of record as of July 27, 2007, with one share of common stock for each four shares owned. The reduction in shares resulting from the split was effective on July 27, 2007 decreasing the number of common shares outstanding to 9.5 million. Prior year share amounts and earnings per share disclosures have been restated to reflect the reverse stock split.

 

Note 2.3. Mortgage Loans – Held-in-Portfolio

 

Mortgage loans – held-in-portfolio, all of which are secured by residential properties, consisted of the following as of December 31, (in2007 and 2006 (dollars in thousands):

 

  2004

 2003

   December 31,

 

Mortgage loans – held-for-sale:

   

Outstanding principal

  $719,904  $673,405 

Net premium

   6,760   10,112 
  


 


   726,664   683,517 

Loans under removal of accounts provision

   20,930   14,475 
  


 


Mortgage loans – held-for-sale

  $747,594  $697,992 
  


 


  2007

 2006

 

Mortgage loans – held-in-portfolio:

      

Outstanding principal

  $58,859  $94,162   $3,067,737  $2,101,768 

Net unamortized premium

   1,175   1,874 

Net unamortized deferred origination costs

   32,414   37,219 
  


 


  


 


Amortized cost

   60,034   96,036    3,100,151   2,138,987 

Allowance for credit losses

   (507)  (1,319)   (230,138)  (22,452)
  


 


  


 


Mortgage loans – held-in-portfolio

  $59,527  $94,717   $2,870,013  $2,116,535 
  


 


  


 


Weighted average coupon

   8.59%  8.35%
  


 


 

ActivityDuring 2007 and 2006 the Company transferred $1.9 billion and $2.7 billion, respectively, of mortgage loans from its held-for-sale classification to held-in-portfolio. These loans were either subsequently securitized in transactions structured as financings or paid off.

Mortgage loans held-in-portfolio include loans that the Company has securitized in structures that are accounted for as financings. During 2007, the Company executed one securitization transaction, NovaStar Home Equity Series (“NHES”) 2007-1, which was accounted for as a financing under SFAS 140. During 2006, the Company executed two securitization transactions accounted for as financings, NHES 2006-1 and NHES 2006-MTA1. See below for details of the Company’s securitization transactions structured as financings during 2007 and 2006.

These securitizations are structured legally as sales, but for accounting purposes are treated as financings under SFAS No. 140. The NHES 2006-1 and NHES 2006-MTA1 securitizations do not meet the qualifying special purpose entity criteria under SFAS No. 140 and related interpretations because after the loans are securitized the securitization trusts may acquire derivatives relating to beneficial interests retained by the Company and, the Company, has discretion to call (other than a clean-up call) loans back from the trust. The NHES 2007-1 securitization does not meet the qualifying special purpose entity criteria under SFAS No. 140 and related interpretations because of the excessive benefit the Company receives from the derivative instruments delivered into the trust to counteract interest rate risk. Accordingly, the loans remain on the balance sheet as “loans held-in-portfolio”, retained interests are not created, and securitization bond financing replaces the short-term debt with the loans. The Company records interest income on loans held-in-portfolio and interest expense on the bonds issued in the allowancesecuritizations over the life of the securitizations. Deferred debt issuance costs and discounts related to the bonds are amortized on a level yield basis over the estimated life of the bonds.

Details of the Company’s loan securitization transactions structured for credit losses isaccounting purposes as follows forfinancings which closed during the three years ended December 31, (in2007 and 2006 are as follows (dollars in thousands):

 

   2004

  2003

  2002

 

Balance, January 1

  $1,319  $3,036  $5,557 

Credit losses (recoveries)

   726   (389)  (432)

Amounts charged off, net of recoveries

   (1,538)  (1,328)  (2,089)
   


 


 


Balance, December 31

  $507  $1,319  $3,036 
   


 


 


Securitization Name


  Date Issued

  Principal
Balance of
Loans
Pledged


  Bonds
Issued (A)


  Net Bond
Proceeds


  Interest Rate Spread
Over One Month

LIBOR (A)(B)

2007:

                  

NHES 2007-1

  February 28, 2007  $1,888,756  $1,794,386  $1,784,662  0.10%-1.75%

2006:

                  

NHES 2006-1

  April 28, 2006  $1,350,000  $1,320,974  $1,317,346  0.06%-1.95%

NHES 2006-MTA1

  June 8, 2006  $1,199,913  $1,189,785  $1,188,111  0.19%-0.65%

(A)The amounts shown do not include subordinated bonds retained by the Company.
(B)The interest rate for the A-2A2 bond is fixed at 5.86%

 

The servicing agreements the Company executesCollateral for loans it has securitized include a “clean up” call option which gives it the right, not the obligation, to repurchase mortgage loans from the trust. The clean up call option can be exercised when the aggregate principal balance26% and 20% of the mortgage loans has declined to ten percent or less of the original aggregated mortgage loan principal balance. At December 31, 2004, the Company had the right, not the obligation to repurchase $32.8 million of mortgage loans from the NMFT Series 2000-2 securitization trust.

The majority of mortgage loans serve as collateral for borrowing arrangements discussed in Note 7. The weighted-average interest rate on mortgage loans as of December 31, 2004 and 2003 was 7.88% and 7.94%, respectively.

Collateral for 18% and 17% of the mortgage loansheld-in-portfolio outstanding as of December 31, 20042007 was located in California and Florida, respectively. As of December 31, 2007 interest only loan products made up 7% of the loans classified as held-in-portfolio. In addition, as of December 31, 2007, moving treasury average (“MTA”) loan products made up 25% of the loans classified as held-in-portfolio. These MTA loans had $41.9 million and $29.5 million in negative amortization during 2007 and 2006, respectively. The Company has no other significant concentration of credit risk on mortgage loans.

 

The recorded investment inAt December 31, 2007 and 2006 all of the loans inclassified as held-in-portfolio were pledged as collateral for financing purposes.

Mortgage loans – held-in-portfolio that the Company has placed on non-accrual status totaled $402.7 million and $48.8 million at December 31, 2007 and 2006, respectively. At December 31, 2007 the Company had $169.8 million in mortgage loans – held-in-portfolio past due 90 days or more, butwhich were still accruing interest was $2.7as compared to $57.4 million and $9.8 million as ofat December 31, 2004, respectively.

2006. These loans carried mortgage insurance and the accrual will be discontinued when in management’s opinion the interest is not collectible.

Details of loan securitization transactionsActivity in the allowance for credit losses on the date of the securitization aremortgage loans – held-in-portfolio is as follows (in thousands):

   

Net Bond
Proceeds


  Allocated Value of Retained
Interests


  

Principal Balance
of Loans Sold


  

Gain
Recognized


    Mortgage
Servicing
Rights


  Subordinated
Bond Classes


    

Year ended December 31, 2004:

                    

NMFT Series 2004-4

  $2,459,875  $13,628  $94,911  $2,500,000  $21,721

NMFT Series 2004-3

   2,149,260   9,520   104,901   2,199,995   40,443

NMFT Series 2004-2

   1,370,021   6,244   67,468   1,399,999   8,961

NMFT Series 2004-1

   1,722,282   7,987   92,059   1,750,000   64,112

NMFT Series 2003-4 (A)

   472,391   1,880   22,494   479,810   9,015
   

  

  

  

  

   $8,173,829  $39,259  $381,833  $8,329,804  $144,252
   

  

  

  

  

Year ended December 31, 2003:

                    

NMFT Series 2003-4

  $1,004,427  $3,986  $47,499  $1,019,922  $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
   

  

  

  

  

   $5,207,525  $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
   

  

  

  

  


(A)On January 14, 2004 NovaStar Mortgage delivered the remaining $479.8 million in loans collateralizing NMFT Series 2003-4. All of the bonds were issued to the third-party investor at the date of initial close, but the Company did not receive the escrowed proceeds related to the final close until January 14, 2004.

In the securitizations, the Company retains interest-only, prepayment penalty and other subordinated interests in the underlying cash flows and servicing responsibilities. The value of the Company’s retained interests is subject to credit, prepayment, and interest rate risks on the transferred financial assets.

During 2004 and 2003, United States of America government-sponsored enterprises purchased 55% and 70%, respectively, of the bonds sold to the third-party investors in the Company’s securitization transactions. The investors and securitization trusts have no recourse to the Company’s assets for failure of borrowers to pay when due except when defects 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. Refer to Note 8 for further discussion.

Fair value of the subordinated bond classes 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, 2004 were as follows:2007 (dollars in thousands):

 

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


 

2004-4

  35% 2.29  4.0% 25%

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 

2002-3

  30  3.09  1.0  20 

2002-2

  27  3.13  1.6  25 

2002-1

  32  2.60  1.7  20 

(A)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.
   2007

  2006

  2005

 

Balance, beginning of period

  $22,452  $699  $507 

Provision for credit losses

   265,288   30,131   1,038 

Charge-offs, net of recoveries

   (57,602)  (8,378)  (846)
   


 


 


Balance, end of period

  $230,138  $22,452  $699 
   


 


 


 

Note 3.4. Mortgage Securities – Available-for-Sale

 

Available-for-saleAs of December 31, 2007, mortgage securities consisted– available-for-sale consist entirely of the Company’s investment in the residual securities issued by securitization trusts sponsored by the Company. As of December 31, 2006 mortgage securities – available-for-sale contained residual securities as well as subordinated securities issued by securitization trusts sponsored by the Company. In previous years, the Company’s policy was to designate its residual securities as available-for-sale but as a result of the Company’s adoption of SFAS 155 on January 1, 2007 and the complexities and uncertainties surrounding the application of this Statement, the Company has designated the NMFT Series 2007-2 residual security as trading. As a result, the NMFT Series 2007-2 residual security qualifies for the scope exception concerning bifurcation provided by SFAS 155. Residual securities consist of interest-only, prepayment penalty and overcollateralization bonds. Subordinated securities consist of rated bonds which are lower than other subordinated securities thatrated bonds on the trust issued. The primary bonds were sold to parties independentcapital structure. Management 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 yieldfollowing table presents certain information on the Company’s portfolio of mortgage securities is the interest income for the year as a percentage of the average fair market value on mortgage securities. The cost basis, unrealized gains and losses, estimated fair value and average yield of mortgage securities– available-for-sale as of December 31, 20042007 and 2003 were as followsDecember 31, 2006 (dollars in thousands):

 

   Cost Basis

  Gross Unrealized

  Estimated Fair
Value


  Average
Yield


 
    Gains

  Losses

    

As of December 31, 2004

  $409,946  $79,229  $—    $489,175  31.4%

As of December 31, 2003

   294,562   87,826   101   382,287  34.3 
   Cost Basis

  Unrealized
Gain


  Unrealized
Losses Less

Than Twelve
Months

  Estimated
Fair Value


  Average
Yield (A)


 

As of December 31, 2007

  $33,302  $69  $—    $33,371  26.94%

As of December 31, 2006

  $310,760  $39,683  $(1,131) $349,312  41.84%

(A)The average yield is calculated from the cost basis of the mortgage securities and does not give effect to changes in fair value that are reflected as a component of shareholders’ equity.

 

The $101,000 gross unrealized loss as ofDuring the twelve months ended December 31, 2003 was on NMFT Series 1999-1. During 2004,2007 and 2006 management concluded that the decline in value on this security and othercertain securities in the Company’s mortgage securities – available-for-sale portfolio were other-than-temporary. As a result, the Company recognized an impairment on mortgage securities - available-for-sale of $15.9$98.7 million, $30.7 million and $17.6 million during the twelve months ended December 31, 2007, 2006 and 2005 respectively.

During the twelve months ended December 31, 2006, the Company exercised the “clean up” call option on NMFT Series 2000-1, NMFT Series 2000-2, NMFT Series 2001-1, NMFT Series 2001-2, NMFT Series 2002-1 and NMFT Series 2002-2. The mortgage loans were repurchased from the trusts and cash was paid to retire the bonds held by third parties. Along with the cash paid to the trusts, any remaining cost basis of the related mortgage securities and mortgage servicing rights, $6.6 million, became part of the cost basis of the repurchased mortgage loans.

As of December 31, 2006, the Company had two subordinated available-for-sale securities with unrealized losses and fair values aggregating $46.7 million that were not deemed to be other-than-temporarily impaired. In accordance with the Company’s adoption of SFAS 159, these securities were transferred from “available-for-sale” to the “trading” classification on January 1, 2007 and the related unrealized losses of $1.1 million representing the cumulative effect adjustment were reclassified from accumulated other comprehensive income to accumulated deficit. As of December 31, 2007, the Company had no available-for-sale securities with unrealized losses and had no subordinated securities within its mortgage securities – available-for-sale.

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, 2007 to mature in one to five years.

As of December 31, 2007, key economic assumptions and the sensitivity of the current fair value of the Company’s residual securities available-for-sale and trading to immediate adverse changes in those assumptions are as follows, on average for the portfolio (dollars in thousands):

Carrying amount/fair value of residual interests (A)

  $58,112

Weighted average life (in years)

   1.1

Weighted average prepayment speed assumption (CPR) (percent)

   27

Fair value after a 10% increase in prepayment speed

  $59,110

Fair value after a 25% increase in prepayment speed

  $60,088

Weighted average expected annual credit losses (percent of current collateral balance)

   9.4

Fair value after a 10% increase in annual credit losses

  $53,570

Fair value after a 25% increase in annual credit losses

  $49,063

Weighted average residual cash flows discount rate (percent)

   25

Fair value after a 500 basis point increase in discount rate

  $53,731

Fair value after a 1000 basis point increase in discount rate

  $50,418

Market interest rates:

    

Fair value after a 100 basis point increase in market rates

  $46,272

Fair value after a 200 basis point increase in market rates

  $41,187

(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% or 25% change 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, 2007 was 1.12% and the cumulative projected static pool credit loss for the life of the securities is 4.33%. 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 (dollars in thousands):

   For the Year Ended December 31,

  Net Credit Losses During the
Year Ended December 31, (B)

   Total Principal Amount
of Loans (A)

  Principal Amount of Loans
60 Days or More Past Due

  
   2007

  2006

  2007

  2006

  2007

  2006

Loans securitized

  $10,087,692  $12,586,366  $1,806,141  $809,874  $231,814  $73,784

Loans held-in-portfolio

   3,215,695   2,108,129   572,943   78,384   15,458   1,605
   

  

  

  

  

  

Total loans securitized or held-in-portfolio

  $13,303,387  $14,694,495  $2,379,084  $888,258  $247,272  $75,389
   

  

  

  

  

  


(A)Includes assets acquired through foreclosure.
(B)Represents the realized losses as reported by the securitization trusts for each period presented.

Note 5. Mortgage Securities – Trading

As of December 31, 2007, mortgage securities – trading consisted of residual securities and subordinated securities retained by the Company from securitization transactions as well as subordinated securities purchased from other issuers in the open market. Mortgage securities – trading consisted entirely of subordinated securities as of December 31, 2006. Management estimates the fair value of the residual securities by discounting the expected future cash flows of the collateral and bonds. The fair value of the subordinated securities is estimated based on quoted market prices. Refer to Note 11 for a description of the valuation methods as of December 31, 2007 and December 31, 2006. The following table summarizes the Company’s mortgage securities – trading as of December 31, 2007 and December 31, 2006 (dollars in thousands):

   Original Face

  Amortized Cost
Basis

  Fair Value

  Average
Yield (A)


 

As of December 31, 2007

                

Subordinated securities pledged to CDO

  $332,489  $314,046  $60,870    

Other subordinated securities

   102,625   92,049   23,592    

Residual securities

   N/A   41,275   24,741    
   

  

  

    

Total

  $435,114  $447,370  $109,203  13.85%
   

  

  

  

As of December 31, 2006

  $365,898  $332,045  $329,361  11.03%
   

  

  

  


(A)Calculated from the ending fair value of the securities.

The Company recognized net trading (losses) gains of $(342.9) million, $(3.2) million and $0.5 million for the years ended December 31, 2007, 2006 and 2005, respectively, which are included in the fair value adjustments line of the Company’s consolidated statements of operations.

As discussed in Note 4, on January 1, 2007 the Company transferred two securities with an aggregate fair value of $46.7 million from “available-for-sale” to the “trading” classification in accordance with the adoption of SFAS 159. The unrealized losses related to these securities of $1.1 million were reclassified from other comprehensive income to accumulated deficit on the consolidated balance sheet as a cumulative effect adjustment.

During the year ended December 31, 2007, the Company purchased four subordinated bonds with a fair value at the date of purchase of $22.0 million to include in NovaStar ABS CDO I.

The Company sold three subordinated bonds to a third party during the year ended December 31, 2007 with a fair value of $7.2 million. The Company realized losses on the sales of these securities of $3.1 million during the year ended December 31, 2007, which is included in the fair value adjustments line on the Company’s consolidated statements of operations.

On February 23, 2006, the Company sold the M-9 bond class security which it had retained from its NMFT Series 2005-4 securitization, to a third party and recognized a gain on the sale of approximately $351,000.

As of December 31, 2007 and 2006 the Company had pledged all of its trading securities as collateral for financing purposes.

Note 6. Collateralized Debt Obligation Issuance

In the first quarter of 2007 the Company closed a CDO. The collateral for this securitization consisted of subordinated securities which the Company retained from its loan securitizations as well as subordinated securities purchased from other issuers. This securitization was structured legally as a sale, but for accounting purposes was accounted for as a financing under SFAS 140. This securitization did not meet the qualifying special purpose entity criteria under SFAS 140. Accordingly, the securities remain on the Company’s balance sheet, retained interests were not created, and securitization bond financing replaced the short-term debt used to finance the securities. The Company records interest income on the securities and interest expense on the bonds issued in the securitization over the life of the related securities and bonds.

Details of the CDO transaction are as follows (dollars in thousands):

Securitization Name


  Date Issued

  Par Amount of
Securities
Pledged (A)


  Bonds Issued
(B)


  Net Bond Proceeds
(B)


  Interest Rate Spread
Over Three Month
LIBOR (B)


NovaStar ABS CDO I

  February 8, 2007  $374,862  $331,500  $326,753  0.32%-2.25%

(A)The amount shown includes subordinated bonds retained by the Company.
(B)The amounts shown do not include the Class D and subordinated bonds retained by the Company.

Note 7. Borrowings

Short-term Borrowings

Wachovia Short-Term Borrowings Repayment. As of December 31, 2007 and thereafter, the Company was out of compliance with the net worth covenant and the liquidity covenant in its repurchase agreements with Wachovia but has obtained multiple waivers to be in compliance. The current waiver expires on April 30, 2008 and the Company expects to be out of compliance prior to its expiration. No assurance can be given with respect to future waivers. If waivers are not obtained, the Company would be in default and Wachovia could exercise its remedies including, but not limited to, accelerating the outstanding indebtedness and liquidating the underlying collateral. In the event this were to occur, there can be no assurance that the Company will be able to continue as a going concern and avoid seeking the protection of applicable federal and state bankruptcy laws.

As of March 28, 2008, the Company had $19 million of short-term borrowings outstanding with Wachovia. All payments received on the collateral securing these obligations are being remitted directly to Wachovia. Based on the expected cash flows from the Company’s mortgage securities from the March 25, 2008 bondholder remittances and the expected release of a portion of its cash held as collateral against letters of credit, the Company expects its short-term borrowings outstanding to be reduced to $11 million in 2004.the near-term. The impairments wereCompany’s repurchase agreements with Wachovia expire on May 8, 2008 and May 29, 2008 and any remaining amounts then outstanding will be due and payable at that time.

The Company has no financing facilities in place to provide liquidity in excess of its outstanding borrowings. As a result, any adverse liquidity events could cause the Company to exhaust its cash balances and may result in its filing bankruptcy.

$1.9 Billion Comprehensive Financing Facility. In May 2007, the Company executed a $1.9 billion comprehensive financing facility arranged by Wachovia. The facility expanded and replaced the whole-loan and securities repurchase agreements previously existing between Wachovia and the Company, other than the Servicing Rights Facility and the Residual Securities Facility. All payments on the collateral securing these facilities is being, and until full repayment will be, remitted directly to Wachovia. After the Company repays the borrowings under these facilities, they do not expect to have any future availability or advances under these or any other facilities.

The $1.9 billion facility consists of the following separate agreements (collectively, the “Agreements”): (1) a Whole Loan Master Repurchase Agreement, expiring May 8, 2008; (2) a Securities Master Repurchase Agreement (Investment Grade), expiring May 29, 2008; and (3) a Securities Master Repurchase Agreement (Non Investment Grade), expiring May 29, 2008. Advances under the Agreements bear interest at rates ranging from LIBOR plus 0.65% to LIBOR plus 2.5%, depending on the asset securing the advance.

The Agreements are cross-collateralized with each other and all other secured transactions between the Company and Wachovia. The Company was required to pay Wachovia a structuring fee in connection with the Agreements and certain additional fees and expenses, including but not limited to reimbursement of due diligence expenses and payment of certain fees in the event of voluntary prepayment or termination by the Company or the occurrence of an event of default. In addition, upon a change of control, Wachovia has the right to terminate the Agreements and require the payment of a termination fee.

The Agreements require that the market value of the collateral posted under each facility exceed, by a specified amount, the funds borrowed under such facility. The market value of the collateral is determined by Wachovia from time to time in its sole discretion. If, in Wachovia’s opinion, the market value of the collateral that is then financed under the applicable facility decreases for any reason, the Company is required to repay the margin or difference in market value, or provide additional collateral.

In addition, the Agreements prohibit the Company from paying any cash dividends on its capital stock without the consent of Wachovia, and dividends can be paid on the Company’s 8.90% Series C Cumulative Redeemable Preferred Stock and on the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II only if, after such payments, the Company continues to have at least $30 million of liquidity or liquidity levels as amended by waiver. The Agreements contain other customary affirmative and negative covenants applicable to the Company and its subsidiaries that are parties to the facilities (“NovaStar Parties”), including but not limited to covenants prohibiting fundamental changes in the nature of the business of the NovaStar Parties, prohibiting sales by any NovaStar Party of a material portion of its business or assets outside of the ordinary course of business, and prohibiting transactions between a NovaStar Party and any of its other affiliates that are not on arms-length terms.

The Agreements provide for customary events of default, including but not limited to the failure by the NovaStar Parties to make any payment due or to satisfy any margin call or to comply with any other material covenant (including financial covenants) under any of the facilities, representations or warranties made by the NovaStar Parties under the facilities proving to be materially incorrect, certain cross defaults involving other contracts to which any NovaStar Party is a party, an act of insolvency occurring with respect to NFI or certain of its subsidiaries, the failure by any NovaStar Party to satisfy certain final non-appealable monetary judgments, regulatory enforcement actions that materially curtail the conduct of business by the Company or certain of its subsidiaries, and the occurrence of a material adverse change in the business, performance, assets, operations or condition of the Company taken as a whole.

If an event of default exists under any of the Agreements, Wachovia has the right, in addition to other rights and remedies, to accelerate the repurchase and other obligations of the NovaStar Parties under all of the facilities, to cause all income generated by the related collateral to be applied to the accelerated obligations, to direct the servicer of the mortgage asset collateral to remit payments directly to Wachovia, to sell or retain the collateral to satisfy obligations owed to it, and to recover any deficiency from the Company and its affiliates. In addition, an event of default under any of the Wachovia facilities would permit Wachovia and its affiliates to set off any outstanding obligations of the Company or its affiliates against any collateral pledged by the Company or its affiliates to Wachovia or any of its affiliates under any of the Wachovia facilities or under any other agreement. Further, the NovaStar Parties would be liable to Wachovia for all reasonable legal fees or other expenses incurred in connection with the event of default, the cost of entering into replacement transactions and entering into or terminating hedge transactions in connection or as a result of a significant increase in short-term interest rates during the year as well as higher than anticipated prepayments. Whileevent of default, and any other losses, damages, costs or expenses arising or resulting from the occurrence of the event of default.

The Agreements require that the adjusted consolidated tangible net worth of the Company uses forward yield curvesexceed $150 million and that the Company maintain, on a consolidated basis, at least $30 million of liquidity. The Company does not currently meet these requirements and does not expect to meet these requirements in valuing mortgage securities, the increase in two-yearforeseeable future. Wachovia has waived the Company’s compliance with these requirements on multiple occasions, with the current waiver effective until April 30, 2008. During the waiver period, the Company must maintain liquidity of at least $9.5 million. The Company expects to be out of compliance prior to the expiration of the current waiver and three-year swap rates was greater thanno assurances can be given with respect to any future waiver.

$40 Million Residual Securities Facility.As a result of the forward yield curve had anticipated, thus causing a greater than expectedsignificant decline in value. Prepayments were higher than expected due to substantial increasesthe Company’s liquidity position, in housing prices inApril 2007, the past few years.Company executed the Residual Securities Facility with Wachovia providing for the financing of certain of the Company’s existing residual securities. In January 2008, the Company repaid all borrowings under the Residual Securities Facility and it was subsequently terminated.

The following table summarizes the Company’s repurchase agreements used in connection with continuing operations as of the dates indicated (dollars in thousands):

   Maximum
Borrowing
Capacity


  Rate

  Days
to
Reset


  Balance

December 31, 2007

              

Short-term borrowings (indexed to one-month LIBOR):

              

Repurchase agreement expiring May 29, 2008 (A) (C)

  $400,000  7.01% 25  $22,811

Repurchase agreement expiring May 29, 2008 (A) (C)

   400,000  5.32  25   21,033

Repurchase agreement, expiring April 16, 2008 (C) (D)

   40,000  7.36  25   1,644
             

Total short-term borrowings

            $45,488
             

December 31, 2006

              

Short-term borrowings (indexed to one-month LIBOR):

              

Repurchase agreement expiring April 14, 2007 (B)

  $800,000  7.85  11  $28,998

Repurchase agreement expiring November 9, 2007 (B)

   750,000  7.85  12   11,200

Repurchase agreement expiring May 31, 2007 (C)

   500,000  6.00  1   322,906

Repurchase agreement expiring June 28, 2009 (C)(D)

   150,000  7.10  1   60,000

Repurchase agreement expiring April 12, 2009 (C)(D)

   150,000  7.10  25   40,127

Repurchase agreement expiring July 31, 2009 (C)(D)

   150,000  7.13  1   40,449
             

Total short-term borrowings

            $503,680
             


(A)Agreements do not provide for additional capacity beyond the maximum capacity of $1.9 billion the Company has in place under the whole loan master repurchase agreement with Wachovia and essentially act as sub-limits underneath the overall capacity. Because of the Company’s inability to meet certain financial covenants, no further advances are, or are expected to be, available to the Company.
(B)Eligible collateral for this agreement is both mortgage loans and mortgage securities.
(C)Eligible collateral for this agreement is mortgage securities.
(D)Agreement was terminated prior to original expiration date.

The following table presents certain information on the Company’s repurchase agreements related to continuing operations for the periods indicated (dollars in thousands):

   For the Year Ended December 31,

 
   2007

  2006

 

Maximum month-end outstanding balance during the period

  $495,181  $503,680 

Average balance outstanding during the period

   220,740   223,715 

Weighted average rate for period

   6.53%  6.25%

Weighted average interest rate at period end

   6.24%  6.90%

Certain of the Company’s mortgage securities are pledged as collateral on these borrowings.

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 below a contractual ratio to the borrowings outstanding.

Accrued interest on the Company’s repurchase agreements used in connection with continuing operations was $38,000 as of December 31, 2007 as compared to $2.2 million as of December 31, 2006.

Asset-backed Bonds (“ABB”). The Company issued ABB secured by its mortgage loans and ABB secured by its mortgage securities – trading in certain transactions treated as financings as a means for long-term non-recourse financing. For financial reporting purposes, the mortgage loans held-in-portfolio and mortgage securities–trading, 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 or mortgage securities collateralizing the ABB. Interest rates reset monthly and are indexed to one-month LIBOR. The estimated weighted-average months to maturity are based on estimates and assumptions made by management. The actual maturity may differ from expectations.

The Company elected the fair value option for the asset-backed bonds issued from NovaStar ABS CDO I, which closed in the first quarter of 2007. The election was made for these liabilities to help reduce income statement volatility which otherwise would arise if the accounting method for this debt was not matched with the fair value accounting for the mortgage securities—trading. Fair value is estimated using quoted market prices. The Company recognized a fair value adjustment of $257.1 million for the year ended December 31, 2007, which is included in the “Fair value adjustments” line item on the consolidated statements of operations.

On January 30, 2008, an event of default occurred under the CDO bond indenture agreement due to the noncompliance of certain overcollateralization tests. As a result, the trustee, upon notice and at the direction of a majority of the secured noteholders, may declare all of the secured notes to be immediately due and payable including accrued and unpaid interest. No such notice has been given as of March 31, 2008. The Company does not expect any significant impact to its financial condition, cash flows or results of operation as a result of the event of default.

For ABB secured by mortgage loans, 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 10% of their original amounts. During the fourth quarter of 2006, the Company exercised the call option for its Series 1998-1 and 1998-2 and retired the related ABB which had a remaining balance of $18.8 million. The mortgage loans were transferred from the held-in-portfolio classification to held-for-sale. The Company transferred its remaining call rights, in part, to the purchaser of its mortgage servicing rights in 2007, and the Company does not expect to exercise any of the call rights it retained.

The following table summarizes the ABB transactions for the year ended December 31, 2007 and 2006 (dollars in thousands):

   Date Issued

  Bonds Issued
(A)(B)


  Interest Rate Spread
Over LIBOR (A)


  Par Amount of
Collateral
Pledged


2007:

              

NovaStar ABS CDO I

  February 8, 2007  $331,500  0.32%-2.25% $374,862

NHES Series 2007-1

  February 28, 2007   1,794,386  0.10%-1.75%  1,888,756

2006:

              

NHES Series 2006-1

  April 28, 2006  $1,320,974  0.06%-1.95% $1,350,000

NHES Series 2006-MTA 1

  June 8, 2006   1,189,785  0.19%-0.65%  1,199,913

(A)The amounts shown do not include subordinated bonds retained by the Company.
(B)The bonds issued for the NHES 2006-MTA1 securitization include $19.2 million in Class X Notes. The Class X Notes are AAA-rated and are entitled to interest-only cash flows.

The following is a summary of outstanding ABB and related loans (dollars in thousands):

   Asset-backed Bonds

  Mortgage Loans

 
   Remaining
Principal


  Weighted
Average
Interest
Rate


  Estimated
Weighted
Average
Months
to Call or
Maturity


  Remaining
Principal


  Weighted
Average
Coupon


 

As of December 31, 2007:

                  

ABB Secured by Mortgage Loans:

                  

NHES Series 2006-1

  $716,768  5.17% 24  $694,101  8.49%

NHES Series 2006-MTA1

   750,048  5.14  19   753,787  8.23 

NHES Series 2007-1

   1,611,592  5.17  30   1,619,849  8.79 

Unamortized debt issuance costs, net

   (12,662)             
   


             
   $3,065,746              
   


             

ABB Secured by Mortgage Securities:

                  

NovaStar ABS CDO I

  $331,500(A) 5.56% 32   (B) (B)
   


             

As of December 31, 2006:

                  

ABB Secured by Mortgage Loans:

                  

NHES Series 2006-1

  $1,039,797  5.61% 40  $1,059,353  8.58%

NHES Series 2006-MTA1

   1,031,782  5.60  49   1,042,415  8.12 

Unamortized debt issuance costs, net

   (4,089)             
   


             
   $2,067,490              
   


             

ABB Secured by Mortgage Securities:

                  

Issue 2005-N1

  $9,558  4.78% 5   (C) (C)

Unamortized debt issuance costs, net

   (39)             
   


             
   $9,519              
   


             

(A)The NovaStar ABS CDO I ABB are carried at a fair value of $74.4 million on the Company’s consolidated balance sheet.
(B)Collateral for the NovaStar ABS CDO I are subordinated mortgage securities.
(C)Collateral for the 2005-N1 ABB is the interest-only, prepayment penalty and overcollateralization mortgage securities of NMFT 2005-1 and NMFT 2005-2.

The following table summarizes the expected repayment requirements relating to the securitization bond financing at December 31, 2007 (dollars in thousands). Amounts listed as bond payments are based on anticipated receipts of principal on underlying mortgage loan and security collateral using expected prepayment speeds. Principal repayments on these ABB are payable only from the mortgage loans and securities collateralizing the ABB. In the event that principal receipts from the underlying collateral are adversely impacted by credit losses, there could be insufficient principal receipts available to repay the ABB principal.

   Asset-backed
Bonds


2008

  $538,035

2009

   508,159

2010

   404,164

2011

   311,647

2012

   252,769

Thereafter

   1,395,134
   

   $3,409,908
   

Junior Subordinated Debentures. In 2005 and 2006, the Company established NovaStar Capital Trust I (“NCTI”) and NovaStar Capital Trust II (“NCTII”), respectively. They are statutory trusts organized under Delaware law for the sole purpose of issuing trust preferred securities. NovaStar Mortgage, Inc. (“NMI”) owns all of the common securities of NCTI and NCTII. NCTI and NCTII issued $50 million and $35 million, respectively, in unsecured floating rate trust preferred securities to other investors. The trust

preferred securities require quarterly interest payments. The interest rates are floating at the three-month LIBOR rate plus 3.5% and reset quarterly. The trust preferred securities are redeemable, at NCTI and NCTII’s option, in whole or in part, anytime without penalty on or after March 15, 2010 and June 30, 2011, respectively, but are mandatorily redeemable when they mature on March 15, 2035 and June 30, 2036, respectively. If they are redeemed prior to maturity, the redemption price will be 100% of the principal amount plus accrued and unpaid interest.

The proceeds from the issuance of the trust preferred securities and the common securities of NCTI and NCTII were loaned to NMI in exchange for $51.6 million and $36.1 million, respectively, of junior subordinated debentures of NMI, which are the sole assets of NCTI and NCTII, respectively. 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 entered into a guarantee for the purpose of guaranteeing the payment of any amounts to be paid by NMI under the terms of the debentures. The Company may not declare or pay any dividends or distributions on, or redeem, purchase, acquire or make a liquidation payment with respect to any of its capital stock if there has occurred and is continuing an event of default under the guarantee. Following payment by the Company of offering costs, the Company’s net proceeds from the NCTI and NCTII offerings aggregated $48.4 million and $33.9 million, respectively.

The assets and liabilities of NCTI and NCTII are not consolidated into the consolidated financial statements of the Company. Accordingly, the Company’s equity interests in NCTI and NCTII are 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 8. Commitments and Contingencies

Commitments.The Company leases office space under various operating lease agreements. Rent expense for 2007, 2006 and 2005, under leases related to continuing operations, aggregated $3.9 million, $3.8 million and $4.0 million, respectively. At December 31, 2007, future minimum lease commitments under those leases are as follows (dollars in thousands):

   Lease
Obligations


2008

  $4,265

2009

   4,265

2010

   4,265

2011

   355

2012

   —  

Thereafter

   —  

The Company has entered into various lease agreements pursuant to which the lessor agreed to repay the Company for certain existing lease obligations. 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 related to continuing operations as of December 31, 2007 and 2006 were $0.9 million and $1.2 million, respectively.

The Company has also entered into a sublease agreement during 2007 for office space formerly occupied by the Company. The Company received approximately $44,000 in 2007 under this agreement.

Contingencies

American Interbanc Mortgage Litigation. On March 17, 2008, the Company and American Interbanc Mortgage, LLC (“Plaintiff”) entered into a Confidential Settlement Term Sheet Agreement (the “Settlement Terms”) with respect to the actions, judgments and claims described below.

In March 2002, Plaintiff filed an action against NHMI in Superior Court of Orange County, California entitled American Interbanc Mortgage LLC v. NovaStar Home Mortgage, Inc. et. al. (the “California Action”). In the California Action, Plaintiff alleged that NHMI and two other mortgage companies (“Defendants”) engaged in false advertising and unfair competition under certain California statutes and interfered intentionally with Plaintiff’s prospective economic relations. On May 4, 2007, a jury returned a verdict by a 9-3 vote awarding Plaintiff $15.9 million. The court trebled the award, made adjustments for amounts paid by settling Defendants, and entered a $46.1 million judgment against Defendants on June 27, 2007. The award is joint and several against the Defendants, including NHMI. It is unknown if the other two Defendants, one of which has filed a bankruptcy petition, have the financial ability to pay any of the award.

NHMI’s motion for the trial court to overturn or reduce the verdict was denied on August 20, 2007, and NHMI appealed that decision (the “Appeal”). Pending the Appeal, Plaintiff commenced enforcement actions in the states of Missouri (the “Kansas City Action”) and Delaware, and obtained an enforcement judgment in Delaware (the “Delaware Judgment”). On January 23, 2008, Plaintiff filed an involuntary petition for bankruptcy against NHMI under 11 U.S.C. Sec. 303, in the United States Bankruptcy Court for the Western District of Missouri (the “Involuntary”). Plaintiff was joined by two individuals alleging claims totaling $150 in the Involuntary filing. NHMI filed an answer and contested the standing of Plaintiff and the individuals to be petitioning creditors in bankruptcy.

On March 17, 2008, the Company and Plaintiff entered into the Settlement Terms with respect to the California Action, the Judgment, the Kansas City Action, the Delaware Judgment, the Involuntary, and all related claims.

Under the Settlement Terms, the parties agreed to move to dismiss the Involuntary. Within ten (10) business days after notice of entry of the dismissal of the Involuntary, the Company will pay Plaintiff $2,000,000 plus the balance in an account established by order of the Bankruptcy Court in an amount no less than $50,000, with NHMI obligated to otherwise satisfy obligations to its identified creditors up to $48,000. The parties also agreed to extend the Appeal briefing period pending finalization of the settlement of the other actions, judgments and claims, as described below.

The Settlement Terms provide that, subject to payment of the amounts described above and satisfaction of certain other conditions, the parties will dismiss the California Action as to NHMI and the Kansas City Action and Delaware Judgment, effect notice of satisfaction of the Judgment, and effect a mutual release of all claims that were or could have been raised in any of the foregoing or that are related to the subject matter thereof, upon the earliest of the following: (i) July 1, 2010, (ii) a waiver by Wachovia of Wachovia’s right to file an involuntary bankruptcy proceeding against any of the NovaStar Entities prior to July 1, 2010, (iii) an extension of the maturity date of the Company’s indebtedness to Wachovia until at least July 1, 2010, or (iv) delivery to Plaintiff of written documentation evidencing the full satisfaction of the Company’s current indebtedness to Wachovia.

In addition to the initial payments to be made to the Plaintiff following dismissal of the Involuntary, the Company will pay Plaintiff $5.5 million if, prior to July 1, 2010, (i) NFI’s average common stock market capitalization is at least $94.4 million over a period of five (5) consecutive business days, or (ii) the holders of NFI’s common stock are paid $94.4 million in net asset value as a result of any sale of NFI or its assets. If NFI is sold prior to July 1, 2010 for less than $94.4 million and ceases to be a public company, then NFI will obligate the purchaser either to immediately pay $2 million to Plaintiff, or to pay Plaintiff $5.5 million in the event the value of the company exceeds $94.4 million prior to July 1, 2010 as determined by an independent valuation company.

In accordance with generally accepted accounting principles, NHMI has recorded a liability of $47.1 million as of December 31, 2007 with a corresponding charge to earnings. The $47.1 million includes interest which is accruing on the obligation. Because NHMI is a wholly owned indirect subsidiary of the Company, the $47.1 million liability is included in the consolidated financial statements of the Company. The liability is included in the “Liabilities of discontinued operations” line of the consolidated balance sheets while the charge to earnings is included in the “(Loss) income from discontinued operations, net of income tax” line of the consolidated statements of operations.

Other Litigation. Since April 2004, a number of substantially similar class action lawsuits have been filed and consolidated into a single action in the United States District Court for the Western District of Missouri. The consolidated complaint names the Company and three of the Company’s executive officers as defendants 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 (and sellers of put options on the Company’s common 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. On February 8, 2007, the court certified the case as a class action. The case is now in the discovery stage. 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 was named as a nominal defendant in several derivative actions brought against certain of the Company’s officers and directors in Missouri and Maryland. The complaints in these actions generally claimed that the defendants were liable to the Company for failing to monitor corporate affairs so as to ensure compliance with applicable state licensing and regulatory requirements. The parties reached a settlement of the derivative actions under which the Company agreed to adopt certain corporate governance measures and the Company’s insurance carrier paid attorney’s fees to plaintiffs’ counsel. The settlement agreement was subject to court approval, which was granted on September 19, 2007 and has become final.

In April 2006, a single plaintiff filed a putative nationwide class action against NovaStar Mortgage in the United States District Court for the Western District of Tennessee. The complaint asserts claims under 42 U.S.C. Sections 1981and 1982; the Fair Housing Act, 42 U.S.C. Sections 3601-3619; and the Equal Credit Opportunity Act, 15 U.S.C.

Sections1691-1691f. Plaintiff alleges that NovaStar Mortgage paid higher yield spread premiums to brokers for loans made to minorities as compared to loans made to white borrowers. The lawsuit seeks injunctive relief and damages, including punitive damages. The Company believes that these claims are without merit and will vigorously defend against them.

Since February 2007, a number of substantially similar putative class actions have been filed in the United States District Court for the Western District of Missouri. The complaints name the Company and three of the Company’s executive officers as defendants and generally allege, among other things, that the defendants made materially false and misleading statements regarding the Company’s business and financial results. The plaintiffs purport to have brought the actions on behalf of all persons who purchased or otherwise acquired the Company’s common stock during the period May 4, 2006 through February 20, 2007. Following consolidation of the actions, a consolidated amended complaint was filed on October 19, 2007. On December 29, 2007, the defendants moved to dismiss all of plaintiffs’ claims, and that motion is pending. The Company believes that these claims are without merit and will vigorously defend against them.

In May 2007, a lawsuit entitledNational Community Reinvestment Coalition v. NovaStar Financial, Inc., et al., was filed against the Company in the United States District Court for the District of Columbia. Plaintiff, a non-profit organization, alleges that the Company maintains corporate policies of not making loans on Indian reservations, or dwellings used for adult foster care or on rowhouses in Baltimore, Maryland in violation of the federal Fair Housing Act. The lawsuit seeks injunctive relief and damages, including punitive damages, in connection with the lawsuit. On May 30, 2007, the Company responded to the lawsuit by filing a motion to dismiss certain of plaintiff’s claims. That motion is pending resolution by the court. The Company believes that these claims are without merit and will vigorously defend against them.

In June 2007, two borrowers filed a putative class action entitledKubiak v. NovaStar Mortgage, Inc., against the Company and two of its subsidiaries in the United States District Court for the Northern District of California, alleging that payments of premiums to brokers by one of the subsidiaries were not properly disclosed to borrowers in the manner allegedly required by federal or state law, thus constituting unfair competition and false advertising under California law and violation of the California Consumer Legal Remedies Act. Plaintiffs seek statutory and punitive damages, restitution, injunctive relief and attorney���s fees on behalf of California borrowers who allegedly failed to receive adequate disclosure of such premiums. The defendants filed a motion to dismiss the action. On December 19, 2007, the Court granted defendants’ motion to dismiss the complaint, including the claims against NovaStar Financial, Inc., but the Court allowed the plaintiffs to file an amended complaint. On January 9, 2008, the plaintiffs filed an amended complaint that does not make any claim against NovaStar Financial, Inc., but does assert the above claims against its subsidiaries, NovaStar Mortgage, Inc. and NovaStar Home Mortgage, Inc. The Company believes that these claims are without merit and will vigorously defend against them.

In November 2007, a borrower filed a putative class action, entitledDenman v. Novastar Mortgage, Inc., in the United States District Court for the District of Massachusetts alleging that NovaStar Mortgage induced him to enter into a disadvantageous mortgage with an adjustable rate and a balloon note. Plaintiff contends that NovaStar Mortgage’s actions violated the Massachusetts Consumer Protection Act and seeks actual and statutory damages, reformation of his mortgage contract and injunctive and declaratory relief. On March 6, 2008, NovaStar Mortgage filed a motion to dismiss the litigation. That motion is pending. The Company believes that these claims are without merit and will vigorously defend against them.

On January 10, 2008, the City of Cleveland, Ohio filed suit against the Company and approximately 20 other mortgage, commercial and investment bankers alleging a public nuisance had been created in the City of Cleveland by the operation of the subprime mortgage industry. The case was filed in state court and promptly removed to the United States District Court for the Northern District of Ohio. The plaintiff seeks damages for loss of property values in the City, and for increased costs of providing services and infrastructure, as a result of foreclosures of subprime mortgages. The Company believes that these claims are without merit and will vigorously defend against them.

On January 31, 2008, two purported shareholders filed separate derivative actions in the Circuit Court of Jackson County, Missouri against various former and current officers and directors and named the Company as a nominal defendant. The essentially identical petitions allege that the individual defendants breached fiduciary duties owed to the Company in connection with alleged insider selling and misappropriation of information, abuse of control, gross mismanagement, waste of corporate assets, and unjust enrichment between May 2006 and December 2007. The Company believes that these claims are without merit and will 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, federal and state laws prohibiting discrimination in lending and federal and state licensing and consumer protection laws.

In addition, the Company has received requests or subpoenas for information from various Federal and State regulators or law enforcement officials, including, without limitation, the Federal Trade Commission, the Securities & Exchange Commission, Department of Housing and Urban Development, the United States Department of Justice, the Federal Bureau of Investigation, the New York Attorney General and the Department of Labor.

While management 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, litigation is subject to inherent uncertainties and the Company’s ability to withstand an unfavorable ruling has greatly diminished. If an unfavorable ruling were to occur in any one of them, the Company’s financial condition, results of operations, cash flows and ability to avoid bankruptcy would be materially and adversely affected.

Note 9. Shareholders’ Equity

The Board of Directors declared a one-for-four reverse stock split of the Company’s common stock, providing shareholders of record as of July 27, 2007, with one share of common stock in exchange for each four shares owned. The reduction in shares resulting from the split was effective on July 27, 2007 decreasing the number of common shares outstanding to 9.5 million. Current and prior year share amounts and earnings per share disclosures have been restated to reflect the reverse stock split.

On July 16, 2007, the Company entered into a Securities Purchase Agreement (the “Securities Purchase Agreement”) pursuant to which certain investors purchased for $48.8 million in cash 2,100,000 shares of the Company’s 9.00% Series D1 Mandatory Convertible Preferred Stock, having a par value $0.01 per share and initial liquidation preference of $25.00 per share (“Series D1 Preferred Stock”), in a private placement not registered under the Securities Act of 1933. The Company used the proceeds from the sale of the Series D1 Preferred Stock under the Securities Purchase Agreement for general working capital.

Dividends on the Series D1 Preferred Stock are payable in cash and accrue at a rate of 9.00% per annum, or 13.00% per annum if any such dividends are not declared and paid when due. In addition, holders of the Series D1 Preferred Stock are entitled to participate in any common stock dividends on an as converted basis. The Company’s board of directors has suspended the payment of dividends on the Company’s Series C Preferred Stock and the Series D1 Preferred Stock. As a result, dividends continue to accrue on the Series C and Series D1 Preferred Stock, and the dividend rate on the Series D1 Preferred Stock increased from 9.0% to 13.0%, compounded quarterly, effective January 16, 2008 with respect to all unpaid dividends and subsequently accruing dividends. All accrued and unpaid dividends on the Company’s preferred stock must be paid prior to any payments of dividends or other distributions on the Company’s common stock. The Company does not expect to pay any dividends for the foreseeable future.

The Series D1 Preferred Stock is convertible into the Company’s 9.00% Series D2 Mandatory Convertible Preferred Stock having a par value of $0.01 per share and an initial liquidation preference of $25.00 per share (“Series D2 Preferred Stock”) upon the later of (a) July 16, 2009, or (b) the date on which the stockholders of the Company approve certain anti-dilution protection for the Series D1 Preferred Stock and Series D2 Preferred Stock that, upon such shareholder approval, would apply in the event the Company issues additional common stock for a price below the price at which the Series D1 Preferred Stock (or the Series D2 Preferred Stock into which the Series D1 Preferred Stock has been converted, if any) may be converted into common stock. The rights, powers and privileges of the Series D2 Preferred Stock are substantially similar to those of the Series D1 Preferred Stock, except that accrued and unpaid dividends on the Series D2 Preferred Stock can be added to the common stock conversion and liquidation value of the Series D2 Preferred Stock in lieu of cash payment, and the dividend rate on the Series D2 Preferred Stock is fixed in all circumstances at 9.00%.

The Series D1 Preferred Stock (or the Series D2 Preferred Stock into which the Series D1 Preferred stock has been converted, if any) is convertible into the Company’s common stock at any time at the option of the holders. The Series D1 Preferred Stock (or the Series D2 Preferred Stock into which the Series D1 Preferred stock has been converted, if any) is currently convertible into 1,875,000 shares (post-split) of common stock based upon an initial conversion price of $28.00 per share (post-split), subject to adjustment as provided above or certain other extraordinary events. On or prior to July 16, 2010, the Company may elect to convert all of the Series D1 Preferred Stock (or the Series D2 Preferred Stock into which the Series D1 Preferred stock has been converted, if any) into common stock, if at such time the Company’s common stock is publicly traded and the common stock price is greater than 200% of the then existing conversion price for 40 of 50 consecutive trading days preceding delivery of the forced conversion notice. On July 16, 2016, the Series D1 Preferred Stock (or the Series D2 Preferred Stock into which the Series D1 Preferred stock has been converted, if any) will automatically convert into shares of common stock.

Because the conversion price of $28.00 was less than the closing price of the Company’s common stock on July 16, 2007 of $30.04, the conversion feature, as discussed above, was considered to be in-the-money. As a result, the Company recorded a beneficial conversion feature of $3.8 million at the date of issuance which represents the product of the closing price ($30.04) less the conversion price ($28.00) multiplied by the conversion shares (1,875,000). The beneficial conversion was recorded to additional paid-in capital and accumulated deficit which resulted in no change to total shareholders’ (deficit) equity.

The Company’s Direct Stock Purchase and Dividend Reinvestment Plan (“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 and allows for a discount from market of up to 3%. During 2007 the Company sold 35,094 shares of its common stock under the DRIP at a weighted average discount of 0%, resulting in net proceeds of $3.2 million. During 2006 the Company sold 2,938,200 shares of its common stock under the DRIP at a weighted average discount of 1.6%, resulting in net proceeds of $85.4 million. The Company suspended the DRIP in 2007.

The Company also sold 500,000 shares of its common stock during 2006 in a registered controlled equity offering. The Company raised $57.5 million in proceeds from these sales, which were net of $0.5 million in expenses related to the offering.

During the years ended December 31, 2007, 2006 and 2005, 88,867, 32,611 and 37,199 shares of common stock were issued under the Company’s stock-based compensation plan, respectively. Proceeds of $0.2 million, $0.6 million and $0.7 million were received under these issuances during 2007 and 2006, respectively.

On January 20, 2006, the Company initiated offers to rescind certain shares of its common stock issued pursuant to its 401(k) plan and DRIP that may have been sold in a manner that may not have complied with the registration requirements of applicable securities laws. The Company repurchased 123 shares of its common stock from eligible investors who accepted the rescission offers as of March 31, 2006, the date the rescission offers expired.

In June 2005, the Company completed a firm-commitment underwritten public offering of 431,250 shares of its common stock at $35.00 per share. The Company raised $57.9 million in net proceeds from this offering.

The Company’s Board of Directors has approved the purchase of up to $9 million of the Company’s common stock. No shares were repurchased during 2007 and 2006. Under Maryland law, shares purchased under this plan are to be returned to the Company’s authorized but unissued shares of common stock. Common stock purchased under this plan is charged against additional paid-in capital.

Note 10. Comprehensive Income

Comprehensive income includes revenues, expenses, gains and losses that are not included in net (loss) income. The following is a rollforward of accumulated other comprehensive (loss) income for the three years ended December 31, 2007 (dollars in thousands):

   For the Year Ended December 31,

   2007

  2006

  2005

Net (loss) Income

  $(724,277) $72,938  $139,124

Other comprehensive (loss) income:

            

Change in unrealized gain on mortgage securities – available-for-sale (net of deferred tax of $1.2 million for 2006)

   (138,306)  (99,703)  14,690

Change in unrealized gain on mortgage securities – available-for-sale due to repurchase of mortgage loans from securitization trusts

   —     (5,153)  —  

Impairment on mortgage securities – available-for-sale reclassified to earnings (net of deferred tax of $681,000 for 2006)

   98,692   30,009   17,619

Reclassification adjustment into income for derivatives used in cash flow hedges (net of deferred tax of $70,000 for 2005)

   (301)  (315)  109

Change in unrealized gain on derivative instruments used in cash flow hedges

   (736)  172   —  

Valuation allowance for deferred taxes

   1,855        
   


 


 

Other comprehensive (loss) income

   (38,796)  (74,990)  32,418
   


 


 

Total comprehensive (loss) income

  $(763,073) $(2,052) $171,542
   


 


 

Note 11. Fair Value Accounting

Effective January 1, 2007, the Company adopted SFAS 157 and SFAS 159. Both standards address aspects of the expanding application of fair value accounting.

Fair Value Measurements (SFAS 157)

SFAS 157 defines fair value, establishes a consistent framework for measuring fair value and expands disclosure requirements about fair value measurements. SFAS 157, among other things, requires the Company to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

These valuation techniques are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. These two types of inputs create the following fair value hierarchy:

Level 1 – Quoted prices for identical instruments in active markets

Level 2 – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.

Level 3 – Instruments whose significant value drivers are unobservable.

The Company determines fair value based upon quoted prices when available or through the use of alternative approaches, such as discounting the expected cash flows using market interest rates commensurate with the credit quality and duration of the investment. The methods the Company uses to determine fair value on an instrument specific basis are detailed in the section titled “Valuation Methods”, below.

The Company recognized a cumulative-effect adjustment resulting from the Company’s change in policies to measure fair value of trading securities upon adoption of SFAS 157. Specifically, the Company began using quoted market prices which constitute the Company’s highest and best execution for its trading securities as compared to the midpoint of mid-market pricing which was used at December 31, 2006.

Detailed below are the December 31, 2006 carrying values prior to adoption, the transition adjustments recorded to opening accumulated deficit and the fair values (that is, the carrying values at January 1, 2007 after adoption) for the trading securities the Company held at January 1, 2007 (dollars in thousands):

Description


  December 31, 2006
(Carrying value
prior to adoption)


  Cumulative-effect
Adjustment to
January 1, 2007
Accumulated Deficit


  January 1, 2007
(Carrying value after

adoption)

Mortgage securities – trading

  $329,361  $5,430  $334,791

The following table presents for each of the fair value hierarchy levels, the Company’s assets and liabilities related to continuing operations which are measured at fair value on a recurring basis as of December 31, 2007 (dollars in thousands):

   Fair Value Measurements at Reporting Date Using

Description


  Fair Value at
12/31/2007


  Quoted Prices in
Active Markets
for Identical
Assets (Level 1)


  Significant
Other
Observable
Inputs (Level 2)


  Significant
Unobservable
Inputs (Level 3)


Assets

                

Mortgage securities -trading

  $109,203  $—    $84,462  $24,741

Mortgage securities – available-for-sale

   33,371   —     —     33,371

Derivative instruments, net

   (6,896)  —     (6,896)  —  
   


 

  


 

Total Assets

  $135,678  $—    $77,566  $58,112
   


 

  


 

Liabilities

                

Asset-backed bonds secured by mortgage securities

  $74,385  $—    $74,385  $—  
   


 

  


 

The following table provides a reconciliation of the beginning and ending balances for the Company’s mortgage securities – trading which are measured at fair value on a recurring basis using significant unobservable inputs (Level 3) from December 31, 2006 to December 31, 2007 (dollars in thousands):

   Cost
Basis

  Unrealized
Loss


  Estimated Fair
Value of
Mortgage
Securities


 

As of December 31, 2006

  $—    $—    $—   

Increases (decreases) to mortgage securities-trading:

             

New securities retained in securitizations

   56,387   226   56,613 

Accretion of income

   3,102   —     3,102 

Proceeds from paydowns of securities

   (18,214)  —     (18,214)

Mark-to-market value adjustment

   —     (16,760)  (16,760)
   


 


 


Net increase (decrease) to mortgage securities

   41,275   (16,534)  24,741 
   


 


 


As of December 31, 2007

  $41,275  $(16,534) $24,741 
   


 


 


The following table provides a reconciliation of the beginning and ending balances for the Company’s mortgage securities – available-for-sale which are measured at fair value on a recurring basis using significant unobservable inputs (Level 3) from January 1, 2003December 31, 2006 to December 31, 2004 (in2007 (dollars in thousands):

 

   Cost Basis

  Net
Unrealized
Gain


  Estimated Fair
Value of
Mortgage
Securities


 

As of January 1, 2003

  $102,665  $76,214  $178,879 
   


 


 


Increases (decreases) to mortgage securities:

             

New securities retained in securitizations

   292,675   7,077   299,752 

Accretion of income (A)

   78,097   —     78,097 

Proceeds from paydowns of securities (A) (B)

   (178,875)  —     (178,875)

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 
   


 


 


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

   —     (15,133)  (15,133)
   


 


 


Net increase (decrease) to mortgage securities

   115,384   (8,496)  106,888 
   


 


 


As of December 31, 2004

  $409,946  $79,229  $489,175 
   


 


 


   Cost
Basis

  Unrealized
Gain


  Estimated Fair
Value of
Mortgage
Securities


 

As of December 31, 2006

  $310,760  $38,552  $349,312 

Increases (decreases) to mortgage securities:

             

Transfer to mortgage securities – trading upon adoption of SFAS 159

   (47,814)  1,131   (46,683)

Accretion of income (A)

   48,778   —     48,778 

Proceeds from paydowns of securities (A) (B)

   (179,730)  —     (179,730)

Impairment on mortgage securities – available-for-sale

   (98,692)  98,692   —   

Mark-to-market value adjustment

   —     (138,306)  (138,306)
   


 


 


Net decrease to mortgage securities

   (277,458)  (38,483)  (315,941)
   


 


 


As of December 31, 2007

  $33,302  $69  $33,371 
   


 


 



(A)Cash received on mortgage securities with no cost basis was $32.2$3.5 million for the year ended December 31, 2004 and $20.7 million for the year ended December 31, 2003.2007.
(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, andwhich are included in the other assets.assets line on the Company’s consolidated balance sheets. As of December 31, 20042007 and December 31, 2003,2006 the Company had receivables from securitization trusts of $4.0$12.5 million and $0.1$21.2 million, respectively, related to mortgage securities available-for-sale with a remaining cost basis. Also the Company had receivables from securitization trusts of $0.7 million related to mortgage securities with a zero cost basis as of December 31, 2004.2006. At December 31, 2007 there were no receivables from securitization trusts related to mortgage securities with a zero cost basis.

 

Maturities of mortgage securities owned byThe following table provides quantitative disclosures about the Company dependfair value measurements for the Company’s assets related to continuing operations which are measured at fair value on repayment characteristics and experience of the underlying financial instruments. The Company expects the securities it ownsa nonrecurring basis as of December 31, 2004 to mature in one to five years.

All mortgage securities owned by the Company are pledged for borrowings as discussed in Note 7.

During 2004 and 2003, the Company securitized the interest-only, prepayment penalty and subordinated securities of various securitizations and issued NovaStar Net Interest Margin Certificates (NIMs). These resecuritizations were accounted for as secured 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 transactions were recorded as financings for the mortgage securities. The detail of these transactions is shown in Note 7.

As of December 31, 2004, key economic assumptions and the sensitivity of the current fair value of retained interests owned by the Company to immediate adverse changes in those assumptions are as follows, on average for the portfolio2007 (dollars in thousands):

 

Carrying amount/fair value of retained interests

  $489,175

Weighted average life (in years)

   1.8

Weighted average prepayment speed assumption (CPR)

   39

Fair value after a 10% increase

  $479,571

Fair value after a 25% increase

  $478,020

Weighted average expected annual credit losses (percent of current collateral balance)

   3.3

Fair value after a 10% increase

  $467,837

Fair value after a 25% increase

  $440,032

Weighted average residual cash flows discount rate (percent)

   22

Fair value after a 500 basis point increase

  $464,423

Fair value after a 1000 basis point increase

  $442,335

Market interest rates

    

Fair value after a 100 basis point increase

  $456,057

Fair value after a 200 basis point increase

  $422,580
      Fair Value Measurements at Reporting Date Using

Description


  Fair Value at
12/31/2007


  Quoted Prices in
Active Markets
for Identical
Assets (Level 1)


  Significant
Other
Observable
Inputs (Level 2)


  Significant
Unobservable
Inputs (Level 3)


Real estate owned

  $76,614  $—    $—    $76,614

 

These sensitivities are hypotheticalAt the time a mortgage loan held-in-portfolio becomes real estate owned, the Company records the property at the lower of its carrying amount or fair value. Upon foreclosure and should be used with caution. Asthrough liquidation, the analysis indicates, changes inCompany evaluates the property’s fair value as compared to its carrying amount and records a valuation adjustment when the carrying amount exceeds fair value. For mortgage loans held-in-portfolio, any valuation adjustments at the time the loan becomes real estate owned is charged to the allowance for credit losses. Any subsequent valuation adjustments are recorded to earnings in the “(Losses) gains on sales of mortgage assets” line item of the Company’s consolidated statements of operations. During the year ended December 31, 2007, the Company recorded losses of approximately $136,000 due to valuation adjustments on real estate owned in its consolidated statements of operations.

The following table provides a summary of the impact to earnings for the year ended December 31, 2007 from the Company’s assets and liabilities which are measured at fair value on a recurring and nonrecurring basis as of December 31, 2007 (dollars in thousands):

Asset or Liability Measured at Fair Value


  

Fair Value
Measurement
Frequency


  Fair Value
Adjustments
Included In
Current Period
Earnings


  

Statement of Operations Line Item Impacted


Mortgage securities – trading

  Recurring  $(342,918) 

Fair value adjustments

Mortgage securities – available-for-sale

  Recurring   (98,692) 

Impairment on mortgage securities – available-for-sale

Derivative instruments, net

  Recurring   (14,027) 

(Losses) gains on derivative instruments

Asset-backed bonds secured by mortgage securities

  Recurring   257,115  

Fair value adjustments

Real estate owned

  Nonrecurring   (136) 

(Losses) gains on sales of mortgage assets

      


  

Total fair value gains (losses)

     $(198,658)  
      


  

Valuation Methods

Mortgage securities – trading.Trading securities are recorded at fair value with gains and losses, realized and unrealized, included in earnings. The Company uses the specific identification method in computing realized gains or losses. Fair value for the subordinated securities classified as trading is estimated using quoted market prices. The Company determined these quoted market prices would qualify as Level 2 due to the inactive and illiquid nature of the market for these securities. The Company recorded a cumulative-effect adjustment to its accumulated deficit of $5.4 million which represented a gain on its mortgage securities—trading as part of the adoption of FAS 157 on January 1, 2007. This cumulative-effect adjustment resulted from the Company’s change in policies to use quoted market prices which constitute the Company’s highest and best execution as compared to the midpoint of mid-market pricing at December 31, 2006.

In addition, upon the closing of its NMFT Series 2007-2 securitization, the Company classified the residual security it retained as trading. Management estimates the fair value of its residual securities by discounting the expected future cash flows of the collateral and bonds. Due to the unobservable inputs used by the Company in determining the expected future cash flows, the Company determined its valuation methodology for residual securities would qualify as Level 3. See “Mortgage securities – available-for-sale” for further discussion of the Company’s valuation policies relating to residual securities.

Mortgage securities – available-for-sale.Mortgage securities – available-for-sale represent beneficial interests the Company retains in securitization and resecuritization transactions which include residual securities. The Company had no subordinated securities included within the mortgage securities – available-for-sale classification as of December 31, 2007. Mortgage securities classified as available-for-sale are reported at their estimated fair value with unrealized gains and losses reported in accumulated other 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 is used in computing realized gains or losses. The Company uses two methodologies for determining the initial value of its residual securities 1) the whole loan price methodology and 2) the discount rate methodology. The Company believes the best estimate of the initial value of the residual securities it retains in its securitizations accounted for as sales is derived from the market value of the pooled loans. As such, the Company generally will try to use the whole loan price methodology when significant open market sales pricing data is available. Under this method, the initial value of the loans transferred in a securitization accounted for as a sale is estimated based on the expected open market sales price of a 10% variation in assumptionssimilar pool. In open market transactions, the purchaser has the right to reject loans at its discretion. In a loan securitization, loans generally cannot be extrapolated becauserejected. As a result, the relationshipCompany adjusts the market price for the loans to compensate for the estimated value of rejected loans. The market price of the changesecurities retained is derived by deducting the net proceeds received in assumptionthe 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 derived by taking the projected cash flows generated using assumptions for prepayments, expected credit losses and interest rates and then solving for the discount rate required to present value the cash flows back to the change in fairinitial value mayderived above. The Company then ascertains whether the resulting discount rate is commensurate with current market conditions. Additionally, the initial discount rate serves as the initial accretable yield used to recognize income on the securities.

When significant open market pricing information is not be linear. Also, inreadily available to the Company, the Company uses the discount rate methodology. Under this tablemethod, the effectCompany first analyzes market discount rates for similar assets. After establishing the market discount rate, the projected cash flows are discounted back to ascertain the initial value of a variation in a particular assumption onthe residual securities. The Company then ascertains whether the resulting initial value is commensurate with current market conditions.

At each reporting period subsequent to the initial valuation of the residual securities, the fair value of the retained interestresidual securities is calculated without changing any other assumption;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 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.estimating future cash flows.

 

Derivative instruments.The actual static pool credit loss asfair value of December 31, 2004 was 0.21% andderivative instruments is estimated by discounting the cumulative projected static pool credit loss for the remaining life of the securities is 2.49%. 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 thousands):

   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,


 
   2004

  2003

  2004

  2003

  2004

  2003

 

Loans securitized (C)

  $11,350,311  $6,428,364  $324,333  $201,774  $21,535  $7,700 

Loans held-for-sale

   720,035   674,031   3,383   3,125   1,097   498 

Loans held-in-portfolio

   59,836   96,729   10,174   15,313   2,490(B)  4,402(B)
��  

  

  

  

  


 


Total loans managed or securitized

  $12,130,182  $7,199,124  $337,890  $220,212  $25,122  $12,600 
   

  

  

  

  


 



(A)Includes assets acquired through foreclosure.
(B)Excludes mortgage insurance proceeds on policies paid by the Company and includes interest accrued on loans 90 days or more past due for which the Company had discontinued interest accrual.
(C)Loans under removal of accounts provision have not been repurchased from the securitization trusts, therefore, they are included in loans securitized.

Note 4. Mortgage Securities - Tradingcash flows using appropriate market rates.

 

AsAsset-backed bonds secured by mortgage securities.The Company elected the fair value option for the asset-backed bonds issued from NovaStar ABS CDO I, which closed in the first quarter of December 31, 2004,2007. The election was made for these liabilities to help reduce income statement volatility which otherwise would arise if the accounting method for this debt was not matched with the fair value accounting for the mortgage securities - trading consisted– trading. Fair value is estimated using quoted market prices. The Company determined these quoted market prices would qualify as Level 2 due to the inactive and illiquid nature of the market.

Real estate owned.Real estate owned is carried at the lower of cost or fair value less estimated selling costs. The Company estimates fair value at the asset’s liquidation value less selling costs using management’s assumptions which are based on historical loss severities for similar assets.

Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159)

Under SFAS 159, the Company may elect to report most financial instruments and certain other items at fair value on an instrument-by-instrument basis with changes in fair value reported in earnings. After the initial adoption, the election is made at the acquisition of an adjustable-rate mortgage-backed securityeligible financial asset, financial liability, or firm commitment or when certain specified reconsideration events occur. The fair value election may not be revoked once an election is made.

Additionally, the transition provisions of SFAS 159 permit a one-time election for existing positions at the adoption date with a cumulative-effect adjustment included in opening retained earnings and future changes in fair market value reported in earnings.

On January 1, 2007, the Company adopted the provisions of $143.2 million. ForSFAS 159. The Company elected the fair value option for the asset-backed bonds issued from NovaStar ABS CDO I, which closed in the first quarter of 2007. The Company elected the fair value option for these liabilities to help reduce earnings volatility which otherwise would arise if the accounting method for this debt was not matched with the fair value accounting for the related mortgage securities – trading. The asset-backed bonds which are being carried at fair value are included in the “Asset-backed bonds secured by mortgage securities” line item on the consolidated balance sheets. The Company recognized a fair value adjustment of $257.1 million for the year ended December 31, 2004,2007, which is included in the “Fair value adjustments” line item on the consolidated statements of operations. The Company calculates interest expense for these asset-backed bonds based on the prevailing coupon rates of the specific classes of debt and records interest expense in the period incurred. Interest expense amounts are included in the “Interest expense” line item of the consolidated statements of operations.

In accordance with the Company’s adoption of SFAS 159, the Company recorded no gains or losses relatedredesignated two mortgage securities with a fair value of $46.7 million from the “available-for-sale” to the security. As“trading” classification on January 1, 2007 and the related unrealized losses of December 31, 2004,$1.1 million were reclassified from accumulated other comprehensive income to accumulated deficit on the Company had pledged the securityconsolidated balance sheet as collateral for financing purposes.

Note 5. Mortgage Servicing Rightsa cumulative effect adjustment.

 

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 2004, 2003 and 2002 (in thousands):

   2004

  2003

  2002

 

Balance, January 1

  $19,685  $7,906  $6,445 

Amount capitalized in connection with transfer of loans to securitization trusts

   39,259   20,774   6,070 

Amortization

   (16,934)  (8,995)  (4,609)
   


 


 


Balance, December 31

  $42,010  $19,685  $7,906 
   


 


 


The estimated fair value of the servicing rights aggregated $58.6 million and $33.8 million at December 31, 2004 and December 31, 2003, respectively. The fair value is estimated by discounting estimated futurealso reclassified its cash flows from the servicing assets using discount rates that approximate current market rates. The fair value as of December 31, 2004 was determined utilizing a 15% discount rate, credit losses netpurchases and sales of mortgage insurance (assecurities – trading from the operating activities section to the investing activities section of the consolidated statements of cash flows as a percentresult of current principal balance)the adoption of 3.3% and an annual prepayment rate of 39%. The fair value as of December 31, 2003 was determined utilizing a 15% discount rate, credit losses net of mortgage insurance (as a percent of current principal balance) of 2.8% and an annual prepayment rate of 26%. There was no allowance for the impairment of mortgage servicing rights as of December 31, 2004, 2003 and 2002.

Mortgage servicing rights are amortized in proportion to and over the estimated period of net servicing income. The estimated amortization expense for 2005, 2006, 2007, 2008, 2009 and thereafter is $16.4 million, $8.7 million, $4.7 million, $3.1 million, $2.2 million and $6.9 million, respectively.SFAS 159.

 

The Company receives annual servicing fees approximating 0.50%has not elected fair value accounting for any other balance sheet items as allowed by SFAS 159.

The following table shows the impact of electing 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 $41.5 million, $21.1 million and $10.0 millionfair value option for the yearsyear ended December 31, 2004, 2003 and 2002, respectively.

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, as custodian, $471.5 million and $188.8 million at December 31, 2004 and 2003, respectively.

Note 6. Property and Equipment, Net

Property and equipment consisted of the following at December 31, (in thousands):

   2004

  2003

Office and computer equipment

  $18,957  $13,617

Furniture and fixtures

   8,406   7,209

Leasehold improvements

   3,423   3,048
   

  

    30,786   23,874

Less accumulated depreciation

   15,310   9,337
   

  

Property and equipment, net

  $15,476  $14,537
   

  

Depreciation expense for the years ended December 31, 2004, 2003 and 2002 was $6.1 million, $3.9 million and $1.2 million, respectively.

Note 7. Borrowings

Short-term Borrowings The following tables summarize the Company’s repurchase agreements as of December 31, 2004 and 2003 (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, 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
   

        

 

 

 

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
   

        

 

 

 

The Company’s mortgage loans and 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 the 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 or mortgage loans collateralizing the repurchase agreements falls below a contractual ratio to the borrowings outstanding.

Asset-backed Bonds (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.

The Company issued NIMs secured by its mortgage securities available-for-sale as a means for long-term financing. For financial reporting and tax purposes, the mortgage securities available-for-sale collateral 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 these bonds. The estimated weighted average months to maturity are based on estimates and assumptions made by management. The actual maturity may differ from expectations. The following table summarized the NIMs transactions for the years ending December 31, 2004 and 20032007 (dollars in thousands):

 

  

Date Issued


 Bonds
Issued


 Interest
Rate


  

Collateral

(NMFT Series) (A)


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

Year ended December 31, 2003:

          

Issue 2003-N1

 July 2, 2003  54,000 7.39  2003-2

(A)The NIMs transactions are secured by the interest-only, prepayment penalty and subordinated securities of the respective mortgage securities – available-for-sale.

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, 2004:

                  

NovaStar Home Equity Series:

                  

Collateralizing Mortgage Loans:

                  

Issue 1997-1

  $5,508  2.69% $6,939  10.36% —   

Issue 1997-2

   8,333  2.69   9,414  10.29  —   

Issue 1998-1

   13,827  2.58   16,152  9.95  —   

Issue 1998-2

   25,785  2.59   27,331  9.76  —   
   


    


      
   $53,453     $59,836       
   


    


      

Collateralizing Mortgage Securities – Available-for-Sale:

                  

Issue 2003-N1

  $5,825  7.39%(C)  (C) (C) (C)

Issue 2004-N1

   48,830  4.46(D)  (D) (D) (D)

Issue 2004-N2

   93,586  4.46(E)  (E) (E) (E)

Issue 2004-N3

   193,093  3.97(F)  (F) (F) (F)

Unamortized debt issuance costs, net

   (4,893)             
   


             
   $336,441              
   


             

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     $96,729       
   


    


      

Collateralizing Mortgage Securities - Available-for-Sale:

                  

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              
   


             

(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 bond is the interest-only, prepayment penalty and subordinated mortgage securities of NMFT 2003-2.
(D)Collateral for the 2004-N1 asset backed bond is the interest-only, prepayment penalty and subordinated mortgage securities of NMFT 2003-3 and NMFT 2003-4.
(E)Collateral for the 2004-N2 asset backed bond is the interest-only, prepayment penalty and subordinated mortgage securities of NMFT 2004-1 and NMFT 2004-2.
(F)Collateral for the 2004-N3 asset backed bond is the interest-only, prepayment penalty and subordinated mortgage securities of NMFT 2004-3 and NMFT 2004-4.

The following table summarizes the expected repayment requirements relating to the securitization bond financing at December 31, 2004. Amounts listed as bond payments are based on anticipated receipts of principal and interest on underlying mortgage loan collateral using expected prepayment speeds (in thousands):

   Asset-backed
Bonds


2005

  $283,058

2006

   82,503

2007

   15,665

2008

   5,649

2009

   4,505

Thereafter

   3,407

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, 2004, NovaStar Trust had the following assets:

1)whole loans: $488.9 million

2)real estate owned properties: $0, and

3)cash and cash equivalents: $1.3 million.

As of December 31, 2004, NovaStar Trust had the following liabilities and equity:

1)short-term debt due to UBS: $488.1 million, and

2)$2.1 million in members’ equity investment.

Note 8. Commitments and Contingencies

Commitments The Company has commitments to borrowers to fund residential mortgage loans as well as commitments to purchase and sell mortgage loans to third parties. At December 31, 2004, the Company had outstanding commitments to originate loans of $361.2 million. The Company had no commitments to purchase and sell loans at December 31, 2004. At December 31, 2003, the Company had outstanding commitments to originate, purchase and sell loans of $228 million, $60 million and $0, respectively. 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.

Description


  Unpaid Principal Balance
as of December 31, 2007

  Gain
Recognized


  Balance at Fair Value

Asset-backed bonds secured by mortgage securities

  $331,500  $257,115  $74,385

 

The Company leases office space under various operating lease agreements. Rent expense for 2004, 2003 and 2002, aggregated $15.9$257.1 million $7.5gain was recorded directly to the “Fair value adjustments” line item within the consolidated statements of operations as this CDO closed in the first quarter of 2007. Therefore, there was no cumulative-effect adjustment to accumulated deficit related to this transaction. Substantially all of the $257.1 million and $2.4 million, respectively. Atchange in fair value of the asset-backed bonds is considered to be related to specific credit risk as all of the bonds are floating rate. The change in credit risk was caused by spreads widening in the asset-backed securities market during the year ended December 31, 2004, future minimum lease commitments under those leases are as follows (in thousands):

   

Lease

Obligations


2005

  $8,540

2006

   8,344

2007

   8,127

2008

   8,030

2009

   8,022

Thereafter

   7,902

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, $2.3 million and $62,000 related to these agreements in 2004, 2003 and 2002, respectively. These agreements expired in 2004.2007.

 

The Company has also entered into various sublease agreements for office space formerly occupied by the Company. The Company received approximately $1.2 million, $537,000 and $704,000 in 2004, 2003 and 2002, respectively under these agreements. These agreements expired in 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 no loans with recourse for borrower defaults in 2004, compared to $151.2 million in 2003. The Company’s reserve related to these guarantees totaled $45,000 and $41,000 as of December 31, 2004 and 2003, respectively.

In the ordinary course of business, the Company sells loans with recourse where a defect occurred in the loan origination process and guarantees to cover investor losses should origination defects occur. 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, 2004 and 2003, the Company had loans sold with recourse with an outstanding principal balance of $11.4 billion and $6.4 billion, respectively. Repurchases of loans where a defect has occurred have been insignificant.

Contingencies Since April 2004, a number of substantially similar class action lawsuits have been filed and consolidated into a single action in United 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 (and sellers of put options on the Company’s stock) during the period October 29, 2003 through April 8, 2004. The Company believes that these claims are without merit and intends 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 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 applicable state licensing and regulatory requirements.

In July 2004, an employee of NHMI filed a class and collective action lawsuit against NHMI and NMI in the 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. The plaintiff brought this class and collective action on behalf of herself and all past and present employees of NHMI and NMI who were employed since May 1, 2000 in the capacity generally described as Loan Officer. The plaintiff alleged that NHMI and NMI failed to pay her and the members of the class she purported to represent overtime premium and minimum wage as required by the Fair Labor Standards Act and California state laws for the period commencing May 1, 2000. In January 2005, the plaintiff and NHMI agreed upon a nationwide settlement in the nominal amount of $3.1 million on behalf of a class of all NHMI Loan Officers nationwide. The settlement, which is subject to court approval, covers all minimum wage and overtime claims going back to July 30, 2001, and includes the dismissal with prejudice of the claims against NMI. 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,159, debt issuance costs are current period expenses and are not amortized over the life of the debt on a level-yield basis. The $4.7 million in expenses the Company recorded a charge to earningsincurred as part of $1.3 million in 2004.

In addition to those matters listed above, the Company is currently party to various other legal proceedings and claims. While management, including internal counsel, currently believes that the ultimate outcomeissuance of these proceedings and claims, individually andNovaStar ABS CDO I were included in the aggregate, will not have a material adverse effect“Professional and outside services” line item 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 resultsconsolidated statements of operations for the period in which the ruling occurs.

In April 2004, the Company also received notice of an informal inquiry from the Securities & Exchange Commission requesting that it provide various documents relating to its business. The Company has been cooperating fully with the Commission’s inquiry.year ended December 31, 2007.

 

Note 9. Stockholders’ Equity

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, in the aggregate 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 provisions of SFAS 150,Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity and is therefore classified as a component of equity.

On May 21, 2003, the Company completed a public offering of 1,207,500 shares of its common stock at $22.13 per share. The Company raised $25.2 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 Plan 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 Plan allows for a discount from market of up to 3%. The Company sold 1,104,488 shares of its common stock during 2004 at a weighted average discount of 1.4%. Net proceeds of $51.2 million were raised under these sales of common stock. Under the Plan, the Company sold 578,120 shares of its common stock during 2003 at a weighted average discount of 1.9%. Net proceeds of $17.0 million were raised under these sales of common stock.

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. Share amounts and earnings per share disclosures for 2002 have been restated to reflect the stock split.

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 during the three years ended December 31, 2004. Under Maryland law, shares purchased under this plan are to be returned to the Company’s authorized but unissued shares of common stock. Common stock purchased 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, 2004, the highest minimum net worth requirement applicable to each subsidiary was $250,000. The wholly-owned subsidiaries were in compliance with these requirements as of December 31, 2004.

The following is a rollforward of accumulated other comprehensive income for the three years ended December 31, 2004 (in thousands):

   

Available-

for-Sale
Mortgage
Securities


  

Derivative
Instruments

Used in Cash Flow
Hedges


  Total

 

Balance, January 1, 2002

  $16,990  $(7,813) $9,177 

Change in unrealized gain (loss), net of related tax effects

   55,649   (11,492)  44,157 

Net settlements reclassified to earnings

   —     9,704   9,704 

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), 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

   15,086   7,162   22,248 
   


 


 


Balance, December 31, 2003

   87,725   (2,542)  85,183 
   


 


 


Change in unrealized (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 income (loss)

   (8,496)  2,433   (6,063)
   


 


 


Balance, December 31, 2004

  $79,229  $(109) $79,120 
   


 


 


Note 10.12. 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.rates, subject to cost and liquidity risk constraints. 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 2004, 20032007 and 2002,2006, premiums paid relatedpursuant to interest rate cap agreements related to continuing operations aggregated $1.6 million, $7.4$0.8 million and $3.9$0.4 million, respectively. There were no premiums paid in 2005. When premiums are financed by the Company, a liability is recorded for the premium obligation. Premiums due to counterparties as of December 31, 20042007 and 20032006 were $1.9$0.5 million and $3.5$0.7 million, respectively, and bearhad a weighted average interest rate of 1.9%3.9% and 3.6% in 20042007 and 2003.2006, respectively. The future contractual maturities of premiums due to counterparties as of December 31, 20042007 are $1.4$0.4 million and $0.5$0.1 million due in 2005years 2008 and 2006,2009, 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 mortgage loan and mortgage security repurchase agreements as discussed in Note 7.

 

AllDuring 2007, the Company entered into several inter-related transactions involving credit default swaps (“CDS”) and other investments. A CDS is an agreement to provide credit event protection based on a specific security in exchange for receiving an upfront premium and a fixed-rate fee over the life of the contract. The additional investments purchased bear yields that mirror LIBOR. The result of the transaction is to create an instrument that mirrors the results of the referenced securities underlying the CDS. The CDS had a notional amount of $16.5 million and a fair value of $6.1 million at the date of purchase and are pledged as collateral against the CDO ABB. At December 31, 2007 the fair value was $2.5 million and the Company had recorded losses related to fair value adjustments of $3.6 million for the year ended December 31, 2007. These losses are included in the “(Losses) gains on derivative instruments” line item of the Company’s consolidated statements of operations.

These CDS are accounted for as non-cash flow hedging derivative instruments, reported at fair value with the changes in fair value recognized through the Company’s statements of operations. The value of these contracts decrease for a variety of reasons, including when the probability of the occurrence of a specific credit event increases, when the market’s perceptions of default risk in general change, or when there are changes in the supply and demand of these instruments.

The Company’s derivative instruments that meet the hedge accounting criteria of SFAS No. 133 are considered cash flow hedges. During the three years ended December 31, 2004, there was no hedge ineffectiveness. The Company also has derivative instruments that do not meet 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 fundasset-backed bonds collateralized by the Company’s loans held-for-sale. held-in-portfolio.

The following tables present derivative instruments as of December 31, 20042007 and 20032006 (dollars in thousands):

  Notional
Amount


  Fair
Value


 

Maximum

Days to

Maturity


  Notional
Amount


  Fair
Value


 Maximum
Days to
Maturity


As of December 31, 2004:

      

As of December 31, 2007:

      

Non-hedge derivative instruments

  $1,101,500  (6,406) 756

Cash flow hedge derivative instruments

  $35,000  $(179) 84   300,000  (490) 391

Non-hedge derivative instruments

   1,965,000   12,141  1,089
  

  


 

Total derivative instruments

  $2,000,000  $11,962  
  

  


 

As of December 31, 2003:

      

As of December 31, 2006:

      

Cash flow hedge derivative instruments

  $250,000  $(3,224) 450  $810,000  4,050  756

Non-hedge derivative instruments

   2,085,144   1,255  1,090
  

  


 

Total derivative instruments

  $2,335,144  $(1,969) 
  

  


 

 

The Company recognized $3.1net (income) expense of $(0.3) million, $9.4$(0.3) million and $10.3$0.2 million during the three years ended December 31, 2004, 20032007, 2006 and 2002,2005, respectively, in net expense on derivative instruments qualifying as cash flow hedges, which is recorded as a component of interest expense.

 

During the three years ended December 31, 2007, hedge ineffectiveness was insignificant. The net amount included in other comprehensive income expected to be reclassified into earnings within the next twelve months is a charge to earningsexpense of approximately $179,000 ($109,000, net of income tax benefit).

The derivative financial instruments we use also subject us to “margin call” risk. The Company’s deposits with derivative counterparties were $6.7 million and $20.9 million as of December 31, 2004 and 2003, respectively.$490,000.

 

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 11.13. Interest Income Taxes

 

The following table presents the components of interest income tax expense (benefit) attributablerelated to continuing operations for the years ended December 31, 2004, 20032007, 2006 and 2002 were as follows (in2005 (dollars in thousands):

 

   For the Year Ended December 31,

 
   2004

  2003

  2002

 

Current:

             

Federal

  $6,078  $24,181  $2,303 

State and local

   620   4,527   318 
   


 


 


Total current

   6,698   28,708   2,621 

Deferred: (A)

             

Federal

   (1,258)  (4,926)  (4,088)

State and local

   (64)  (922)  (564)
   


 


 


Total deferred

   (1,322)  (5,848)  (4,652)
   


 


 


Total income tax expense (benefit)

  $5,376  $22,860  $(2,031)
   


 


 


   For the Year Ended December 31,

   2007

  2006

  2005

Interest income:

            

Mortgage securities

  $102,500  $164,858  $188,856

Mortgage loans held-in-portfolio

   258,663   134,604   4,311

Other interest income (A)

   5,083   4,660   6,315
   

  

  

Total interest income

  $366,246  $304,122  $199,482
   

  

  


(A)Does not reflect the deferred tax effects of unrealized gains and lossesOther interest income represents interest earned on derivative financial instruments that are included in stockholders’ equity. As a result of these tax effects, stockholders’ equity decreased by $587,000 and $779,000 in 2004 and 2003, respectively.corporate operating cash balances.

Note 14. Interest Expense

 

A reconciliationThe following table presents the components of the expected federal income taxinterest expense using the federal statutory tax rate of 35 percentrelated to the taxable REIT subsidiary’s actual income tax expense and resulting effective tax rate from continuing operations for the years ended December 31, 2004, 20032007, 2006 and 2002 were as follows (in2005 (dollars in thousands):

 

   For the Year Ended December 31,

 
   2004

  2003

  2002

 

Income tax at statutory rate (taxable REIT subsidiary)

  $4,200  $18,102  $(3,755)

Taxable gain on security sale to REIT

   1,342   2,761   805 

State income taxes, net of federal tax benefit

   362   1,549   (442)

Nondeductible expenses

   240   228   117 

Reduction of estimated income tax accruals

   (904)  —     —   

Other

   136   220   1,244 
   


 

  


Total income tax expense (benefit)

  $5,376  $22,860  $(2,031)
   


 

  


Significant components of the taxable REIT subsidiary’s deferred tax assets and liabilities at December 31, 2004 and 2003 were as follows (in thousands):

   December 31,

 
   2004

  2003

 

Deferred tax assets:

         

Excess inclusion income

  $18,449  $10,242 

Deferred compensation

   5,158   2,319 

Deferred lease incentive income

   1,026   —   

Deferred loan fees, net

   548   —   

Mark-to-market adjustment on held-for-sale loans

   4,871   7,724 

State net operating loss carryforwards

   2,353   1,470 

Accrued expenses for branch closings

   743   87 

Accrued expenses, other

   666   630 

Allowance for losses on loans and other real estate

   552   142 

Other

   427   671 
   


 


Gross deferred tax asset

   34,793   23,285 

Valuation allowance

   (2,353)  (1,470)
   


 


Deferred tax asset

   32,440   21,815 
   


 


Deferred tax liabilities:

         

Mortgage servicing rights

   16,199   7,677 

Mark-to-market adjustment on derivative instruments

   2,706   —   

Premises and equipment

   2,119   2,319 

Other

   226   1,364 
   


 


Deferred tax liability

   21,250   11,360 
   


 


Net deferred tax asset

  $11,190  $10,455 
   


 


The valuation allowance included in the taxable REIT subsidiary’s deferred tax assets at December 31, 2004 and 2003 represent 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 2024. The $0.9 million increase in the valuation allowance for deferred tax assets resulted from state net operating losses being generated by the taxable REIT subsidiary in 2004 where realization is not expected to occur.

   For the Year Ended December 31,

   2007

  2006

  2005

Interest expense:

            

Short-term borrowings secured by mortgage loans

  $—    $18,120  $—  

Short-term borrowings secured by mortgage securities

   23,649   14,237   1,771

Asset-backed bonds secured by mortgage loans

   178,937   88,116   1,809

Asset-backed bonds secured by mortgage securities

   17,635   3,860   15,628

Junior subordinated debentures

   8,148   7,001   3,055
   

  

  

Total interest expense

  $228,369  $131,334  $22,263
   

  

  

 

Note 12. Employee Benefit Plans15. Discontinued Operations

 

The NovaStar Financial, Inc. 401(k) Plan (the Plan) is a defined contribution plan which allows eligible employeesAs discussed in Note 2, the Company undertook Exit Plans to save for retirement through pretax contributions. Under the Plan, employeesalign its organization and costs with its decision to discontinue its mortgage lending and mortgage servicing activities. Implementation 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 PlanExit Plans approved by the Company for the years ended December 31, 2004, 2003Audit Committee in 2007 both began and 2002 were $3.1 million, $2.0 million and $806,000, respectively.

The Company’s Deferred Compensation Plan (the DCP) 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 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 voluntary and/or matching contributions to the DCP on behalf of DCP participants. All DCP assets are corporate assets rather than individual property and are therefore subject to creditors’ claims against the Company. The Company made contributions to the DCP for the years ended December 31, 2004, 2003 and 2002 of $371,000, $643,000 and $482,000, respectively.

Note 13. Stock Compensation Plans

On June 8, 2004, the Company’s 1996 Stock Option Plan terminated except for outstanding awards that remain to become vested, exercised or free of restrictions and was replaced by the 2004 Incentive Stock Plan (the Plan). The Plan provides for the grant of qualified incentive stock options (ISOs), non-qualified stock options (NQSOs), deferred stock, restricted stock, performance share awards, dividend equivalent rights (DERs) and stock appreciation and limited stock appreciations awards (SARs). The Company has granted 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 grant is equal to 2.5 million shares of common stock. The Plan will remain in effect unless terminated by the Board of Directors 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, $1.8 million and $1.3 million of stock-based compensation expense was recorded in 2004 and 2003. In accordance with APB No. 25, total stock-based compensation expense was $2.5 million forconcluded during the year ended December 31, 2002.2007.

 

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 vest equally over four years and expire ten years after the date of grant. The following table summarizes stock option activity for 2004, 2003 and 2002, respectively:

   2004

  2003

  2002

Stock Options


  Shares

  Weighted
Average
Price


  Shares

  Weighted
Average
Price


  Shares

  Weighted
Average
Price


Outstanding at the beginning of year

  746,800  $8.22  1,032,670  $7.40  1,078,840  $4.69

Granted

  15,000   33.59  15,000   22.66  314,000   12.05

Exercised

  (305,700)  6.55  (275,390)  5.98  (355,250)  3.05

Forfeited

  (22,500)  10.50  (25,480)  7.79  (4,920)  8.25
   

     

     

   

Outstanding at the end of year

  433,600  $10.16  746,800  $8.22  1,032,670  $7.40
   

 

  

 

  

 

Exercisable at the end of year

  215,600  $7.48  275,050  $7.67  294,420  $7.63
   

 

  

 

  

 

Options granted since 2002 were granted with DERs. Under the terms of the DERs, 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 2004, 2003 and 2002 had DERs attached to them when issued. As a result of these exercises, an additional 47,969, 23,485 and 3,226 shares of common stock were issued in 2004, 2003 and 2002, respectively.

During 2004,On November 1, 2007, the Company granted and issued 41,200 sharessold all of restricted stock at an average fair market value of $46.42.its mortgage servicing rights. The restricted stock awards vest over four years. Of these shares, 800 shares were forfeited in 2004.

Additionally, during the first quarter of 2004, the Company issued 39,112 shares of restricted stock as payment for bonus compensation earned by certain executives of the Company in 2003. The shares were issued at an average fair market value of $46.42. The shares are fully vested upon issuance.

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 grant 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 total number of shares that can be issued under this agreement is 100,000.

The following table presents information on stock options outstandingloan servicing operations had ceased as of December 31, 2004.

   Outstanding

  Exercisable

Exercise Price


  Quantity

  

Weighted Average
Remaining
Contractual Life

(Years)


  Weighted
Average
Exercise Price


  Quantity

  Weighted
Average
Exercise Price


$1.53 – $7.16

  169,250  6.46  $4.65  118,500  $3.78

$7.91 - $12.22

  220,600  7.56   11.78  87,100   11.46

$12.97 - $33.59

  43,750  8.43   23.36  10,000   16.60
   
         
    
   433,600  7.22  $10.16  215,600  $7.48
   
  
  

  
  

Note 14. Branch Operations2007.

 

Prior to 2004, the Company was party to limited liability company (“LLC”) agreements governing LLC’s 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 99.9% to each branch manager and 0.1% 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 LLC’s 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 formerly operated 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.

As the demand for conforming loans has declined significantly during 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 branchan operating unit to be discontinued upon its termination date, which is the point in time when the operations substantially cease. The provisions of SFAS 144 require the results of operations associated with those operating units terminated to be classified as discontinued operations apply to the branch operations segment presented in Note 15. The operating results for these discontinued operations have beenand segregated from the on-goingCompany’s continuing results of operations for all periods presented. In accordance with Statement SFAS 144, the Company has reclassified the operating results of its entire mortgage lending segment and servicing operations segment as discontinued operations in the Company. consolidated statements of operations for the year ended December 31, 2007, 2006 and 2005.

As of June 30, 2006, the Company had terminated all of the remaining NHMI branches and related operations. The Company has reclassified the operating results of NHMI through December 31, 2007, as discontinued operations in the consolidated statements of operations for the years ended December 31, 2007, 2006 and 2005 in accordance with Statement SFAS 144.

The major classes of assets and liabilities reported as discontinued operations as of December 31, 2007 and December 31, 2006 are as follows (dollars in thousands):

   December 31,
2007


  December 31,
2006


Assets

        

Mortgage loans – held-for-sale

  $5,253  $1,741,819

Accrued interest receivable

   —     8,584

Mortgage servicing rights

   —     62,830

Servicing related advances

   —     40,923

Warehouse notes receivable

   —     39,462

Real estate owned

   2,574   21,533

Derivative instruments, net

   —     12,766

Other assets

   428   4,152
   

  

Total assets

  $8,255  $1,932,069
   

  

Liabilities

        

Short-term borrowings secured by mortgage loans

  $19  $1,648,528

Due to trusts

   —     107,043

Accounts payable and other liabilities

   59,397   48,250
   

  

Total liabilities

  $59,416  $1,803,821
   

  

The operating results of all discontinued operations for the years ended December 31, 2007, 2006 and 2005 are summarized as follows (in(dollars in thousands):

 

   

For the Year Ended

December 31, 2004


 

Fee income

  $60,309 

General and administrative expenses

   66,989 
   


Loss before income tax benefit

   (6,680)

Income tax benefit

   (2,572)
   


Loss from discontinued operations

  $(4,108)
   


   For the Year Ended December 31,

 
   2007

  2006

  2005

 

Interest income

  $102,648  $190,998  $122,035 

Interest expense

   (79,483)  (104,190)  (58,580)
   


 


 


Net interest income

   23,165   86,808   63,455 

Other operating (expense) income:

             

(Losses) gains on sales of mortgage assets

   (2,579)  42,876   68,200 

(Losses) gains on derivative instruments

   (4,913)  11,889   17,908 

Valuation adjustment on mortgage loans – held-for-sale

   (101,125)  (1,163)  (1,284)

Fee income

   22,900   35,089   64,850 

Premiums for mortgage loan insurance

   (2,668)  (6,149)  (5,332)

Other (expense) income

   (6,777)  4,473   (130)
   


 


 


Total other operating (expense) income

   (95,162)  87,015   144,212 
   


 


 


General and administrative expenses

   (184,783)  (145,885)  (178,853)
   


 


 


(Loss) income before income tax expense

   (256,780)  27,938   28,814 

Income tax expense

   —     10,393   10,719 
   


 


 


(Loss) income from discontinued operations

  $(256,780) $17,545  $18,095 
   


 


 


Mortgage Loans – Held-for-Sale

Mortgage loans – held-for-sale, all of which are secured by residential properties, consisted of the following as of December 31, 2007 and December 31, 2006 (dollars in thousands):

   December 31,
2007


  December 31,
2006


 

Mortgage loans – held-for-sale:

         

Outstanding principal

  $17,545  $1,631,891 

Loans under removal of accounts provision

   —     107,043 

Net deferred origination (fees) costs

   —     7,891 

Allowance for the lower of cost or fair value

   (12,292)  (5,006)
   


 


Mortgage loans – held-for-sale

  $5,253  $1,741,819 
   


 


Weighted average coupon

   10.23%  8.69%
   


 


Activity in the allowance for the lower of cost or fair value on mortgage loans – held-for-sale is as follows for years ended December 31, 2007, 2006 and 2005, respectively (dollars in thousands):

   2007

  2006

  2005

Balance, beginning of period

  $5,006  $3,530  $1,357

Valuation adjustment on mortgage loans – held-for-sale

   101,125   1,163   1,284

Transfer from the reserve for loan repurchases

   23,206   5,284   —  

Transfer to cost basis of mortgage loans – held-in-portfolio

   (14,843)  —     —  

Reduction due to loans securitized or sold to third parties

   (82,384)  —     —  

Transfers to real estate owned

   (19,818)  (3,509)  —  

Charge-offs, net of recoveries

   —     (1,462)  889
   


 


 

Balance, end of period

  $12,292  $5,006  $3,530
   


 


 

Loan Securitizations and Loan Sales

Loan Securitizations. The Company executed loan securitization transactions that are accounted for as sales of loans. Derivative instruments were transferred into the trusts as part of each of these sales transactions to reduce interest rate risk to the third-party bondholders.

Details of the securitizations structured as sales during the years ended December 31, 2007, 2006 and 2005 are as follows (dollars in thousands):

   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


      

2007:

                        

NMFT Series 2007-2

  $1,331,299  $9,766  $56,387  $1,400,000  $4,161  $4,981
   

  

  

  

  

  

2006:

                        

NMFT Series 2005-4 (A)

  $378,944  $2,258  $9,416  $378,944  $259  $1,203

NMFT Series 2006-2

   999,790   6,041   40,858   1,021,102   6,015   11,942

NMFT Series 2006-3

   1,072,258   6,516   47,408   1,100,000   5,073   10,209

NMFT Series 2006-4

   993,841   7,040   51,956   1,025,359   1,818   14,401

NMFT Series 2006-5

   1,264,695   8,969   46,762   1,300,000   1,732   5,675

NMFT Series 2006-6

   1,213,447   8,650   48,578   1,250,000   2,811   6,785
   

  

  

  

  

  

   $5,922,975  $39,474  $244,978  $6,075,405  $17,708  $50,215
   

  

  

  

  

  

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   2,499,983   9,194   3,947

NMFT Series 2005-4 (A)

   1,153,033   7,311   77,040   1,221,055   5,232   7,480
   

  

  

  

  

  

   $7,428,063  $43,476  $332,420  $7,621,030  $30,459  $58,765
   

  

  

  

  

  


(A)On January 20, 2006 NovaStar Mortgage delivered to the trust 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.

In these securitizations, the Company retained residual securities (representing interest-only securities, prepayment penalty bonds and overcollateralization bonds) and certain subordinated securities representing subordinated interests in the underlying cash flows and servicing responsibilities. The value of the Company’s retained securities is subject to credit, prepayment, and interest rate risks on the transferred financial assets.

During 2007 and 2006, U.S. government-sponsored enterprises purchased 50% and 49%, respectively, of the bonds sold to the third-party investors in the Company’s securitization transactions. The investors and securitization trusts have no recourse to the Company’s assets for failure of borrowers to pay when due except when defects 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. Refer to Note 8 for further discussion.

 

As described in Note 1, fair value of the residual securities at the date of securitization is either measured by the whole loan price methodology or the discount rate methodology. For the whole loan price methodology, an implied yield (discount rate) is calculated based on the value derived and using projected cash flows generated using key economic assumptions. Comparatively, under the discount rate methodology, the Company assumes a discount rate that it feels is commensurate with current market conditions.

Key economic assumptions used to project cash flows at the time of loan securitization during the three years ended December 31, 2004,2007 were as follows:

NovaStar Mortgage Funding
Trust Series


 Constant
Prepayment
Rate


  Average Life
(in Years)


 Expected Total Credit
Losses, Net of
Mortgage Insurance
(A)


  Discount
Rate


 
2007-2 34% 2.31 5.7% 20%
2006-6 41  2.19 3.7  15 
2006-5 43  2.11 3.9  15 
2006-4 43  2.07 2.9  15 
2006-3 43  2.15 3.0  15 
2006-2 44  2.02 2.4  15 
2005-4 43  2.12 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 

(A)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.

Fair value of the subordinated securities at the date of securitization is based on quoted market prices.

Loan Sales. The Company executes all of its sales of loans to third parties with servicing released. Gains and losses on whole loan sales are recognized in the period the sale occurs.

The Company sold approximately $969.1 million of mortgage loans during 2007 as compared to $2.2 billion and $1.2 billion during 2006 and 2005, respectively. The Company sold $668.8 million of mortgage loans held-for-sale at a price of 91.5% of par to Wachovia during 2007 in an effort to reduce margin call risk. In light of the 91.5% sale price, a lower of cost or market valuation adjustment of approximately $47.0 million was recorded for the year ended December 31, 2007, and is included in the “(Loss) income from discontinued operations, net of income tax” line item on the Company’s consolidated statements of operations.

The Company generally has an obligation to repurchase whole loans sold in circumstances in which the borrower fails to make any of the first several (generally not more than the first three) payments. Additionally, the Company has $1.0 millionis also required to repay all or a portion of the premium it receives on the sale of whole loans in cash, $0.2 millionthe event that the loan is prepaid in receivablesits entirety in the first year. The Company records a reserve for losses on repurchased loans upon the sale of the mortgage loans which is included in other assets and $1.2 million in payables included in accounts payable and otherthe liabilities pertaining toof discontinued operations which are included inon the Company’s consolidated balance sheets.

 

As of December 31, 2003, there were 423 such branches. ForActivity in the reserve for repurchases was as follows for the years ended December 31, 20032007, 2006 and 2002,2005 (dollars in thousands):

   2007

  2006

  2005

 

Balance, beginning of period

  $24,773  $2,345  $—   

Provision for repurchased loans

   3,254   28,568   3,265 

Transfer to the allowance for the lower of cost or fair value on mortgage loans – held-for-sale

   (23,206)  (5,284)  —   

Charge-offs, net

   (2,668)  (856)  (920)
   


 


 


Balance, end of period

  $2,153  $24,773  $2,345 
   


 


 


Mortgage Servicing Rights

The Company recorded mortgage servicing rights arising from the transfer of loans to securitization trusts.

The Company sold all of its mortgage servicing rights and servicing advances relating to its securitizations. The transaction closed on November 1, 2007 and the Company recorded fee income aggregating $12.8received total proceeds of $154.9 million after deduction of expenses. The mortgage servicing rights and servicing related advances sold for $95.0 million and $5.2$62.9 million, respectively,respectively. The Company removed $47.3 million of mortgage servicing rights from its consolidated balance sheet and recorded a gain of $19.8 million which is included in the (Loss) income from discontinued operations, net of income tax line item of the consolidated statements of operations. The $95.0 million of proceeds also included $22.8 million for providing administrative servicesmortgage servicing rights related to the Company’s securitizations structured as financings where no mortgage servicing rights have been recorded by the Company.

The following schedule summarizes the carrying value of mortgage servicing rights and the activity during 2007, 2006 and 2005 (dollars in thousands):

   2007

  2006

  2005

 

Balance, January 1

  $62,830  $57,122  $42,010 

Amount capitalized in connection with transfer of loans to securitization trusts

   9,766   39,474   43,476 

Amortization

   (25,252)  (33,639)  (28,364)

Sale of mortgage servicing rights

   (47,344)  —     —   

Transfer of cost basis to mortgage loans held-for-sale due to securitization calls

   —     (127)  —   
   


 


 


Balance, December 31

  $—    $62,830  $57,122 
   


 


 


The estimated fair value of the servicing rights aggregated $74.2 million at December 31, 2006. 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, 2006 was determined utilizing a 12% discount rate, credit losses net of mortgage insurance (as a percent of current principal balance) of 3.2% and an annual prepayment rate of 47%. There was no allowance for the branches. During 2003 and 2002, the aggregate amountimpairment of loans brokered by these branches was approximately $5.7 billion and $2.2 billion, respectively. Of those amounts, approximately $1.3 billion and $399.6 million, respectively, were acquired by the Company’s mortgage subsidiary. The aggregate premiums paid byservicing rights as of December 31, 2006.

When the Company was the servicer, it received 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 loans brokered by these brancheswhich they contracted. Servicing fees received from the securitization trusts were approximately $15.1$43.5 million, $59.2 million and $5.1$59.8 million for the years ended December 31, 20032007, 2006 and 2002,2005, respectively.

During the years ended December 31, 2006 and 2005 the Company paid $32,000 and $220,000, respectively, to cover losses on delinquent or foreclosed loans from securitizations in which the Company did not maintain control over the mortgage loans transferred.

The Company held, 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 were not owned by the Company and were held in trust. The Company held, as custodian, $545.2 million as of December 31, 2006. The Company held no funds as custodian as of December 31, 2007.

Note 15. Segment ReportingWarehouse Notes Receivable

 

The Company reviews, manageshad $39.5 million due from borrowers at December 31, 2006. These notes receivable represented warehouse lines of credit provided to a network of approved mortgage borrowers. The weighted average interest rate on these notes receivable was indexed to one-month LIBOR and operates its businesswas 9.12% at December 31, 2006. The allowance for losses the Company recorded on these notes receivable was insignificant as of December 31, 2006. The Company discontinued it warehouse operations during 2007 and had no remaining notes receivable as of December 31, 2007.

Short-term Borrowings

$1.9 Billion Comprehensive Financing Facility. In May 2007, the Company executed a $1.9 billion comprehensive financing facility arranged by Wachovia. See Note 7 for further discussion of the terms of this facility. The Company is repaying the borrowings under this facility, and does not expect to have any future availability or advances under this facility.

The following table summarizes the Company’s repurchase agreements used in three segments. These business segments are:connection with discontinued operations as of the dates indicated (dollars in thousands):

   Maximum
Borrowing
Capacity


  Rate

  Days to
Reset


  Balance

December 31, 2007

              

Short-term borrowings (indexed to one-month LIBOR):

              

Repurchase agreement expiring May 8, 2008 (A)

  $1,900,000  4.57% 1  $19
             

December 31, 2006

              

Short-term borrowings (indexed to one-month LIBOR):

              

Repurchase agreement expiring November 15, 2007 (B)

  $1,000,000  5.77% 1  $393,746

Repurchase agreement expiring April 14, 2007 (A)

   800,000  5.77  11   407,304

Repurchase agreement expiring January 6, 2007 (A)

   800,000  5.77  25   371,860

Repurchase agreement expiring November 9, 2007 (A)

   750,000  5.77  12   418,533

Loan and receivables agreement expiring January 6, 2007 (C) (D)

   80,000  6.02  3   16,755

Repurchase agreement, expiring January 10, 2007 (B) (D)

   100,000  6.32  12   40,330
             

Total short-term borrowings

            $1,648,528
             


(A)Eligible collateral for this agreement is both mortgage loans and mortgage securities. The maximum borrowing capacity under this facility is reduced by the amount of borrowings outstanding from time to time with this lender under related facilities. Because of the Company’s inability to meet certain financial covenants, no further advances are, or are expected to be, available to the Company.
(B)Eligible collateral for this agreement is mortgage loans.
(C)Eligible collateral for this agreement is servicing related advances.
(D)Agreements do not provide for additional capacity beyond the maximum capacity the Company has in place under the primary master repurchase agreement with this lender and essentially act as sub-limits underneath the overall capacity.

The following table presents certain information on the Company’s repurchase agreements related to discontinued operations for the periods indicated (dollars in thousands):

   For the Year Ended December 31,

 
   2007

  2006

 

Maximum month-end outstanding balance during the period

  $2,339,431  $3,422,660 

Average balance outstanding during the period

   865,495   2,016,966 

Weighted average rate for period

   6.80%  5.92%

Weighted average interest rate at period end

   4.57%  5.79%

The Company’s mortgage portfolio management,loans and certain servicing related advances were pledged as collateral on these borrowings. As of December 31, 2007, there were no servicing related advances.

Repurchase agreements generally contain margin calls under which a portion of the borrowings must be repaid if the fair value of the assets collateralizing the repurchase agreements falls below a contractual ratio to the borrowings outstanding.

Accrued interest on the Company’s repurchase agreements used in connection discontinued operations was $4.5 million as of December 31, 2006.

Commitments and Contingencies

The Company had no outstanding commitments to originate, purchase or sell loans at December 31, 2007. At December 31, 2006, the Company had outstanding commitments to originate and purchase loans of $774.0 million and $11.8 million, respectively. The Company had no outstanding commitments to sell loans at December 31, 2006.

In the ordinary course of the Company’s mortgage lending and loan servicing and branch operations. Mortgage portfolio management operating resultsbusiness, the Company sold whole pools of loans with recourse for borrower defaults. When whole pools are driven fromsold as opposed to securitized, the income generatedthird party has recourse against the Company for certain borrower defaults. Because the loans are no longer on the assetsCompany’s balance sheet, the recourse component is considered a

guarantee. During 2007 the Company manages less associated management costs. Mortgage lendingsold $912.9 million of loans with recourse for borrower defaults as compared to $2.2 billion in 2006. The Company maintained a $2.2 million reserve related to these guarantees as of December 31, 2007 compared with a reserve of $24.8 million as of December 31, 2006. During 2007, 2006 and loan servicing operations include2005, the marketing, underwritingCompany paid $104.3 million, $21.3 million and funding$2.3 million, respectively, in cash to repurchase loans sold to third parties.

In the ordinary course of loan production. Servicing operations represent the income and costs to service the Company’s onmortgage lending business, the Company sold loans to securitization trusts and off -balance sheet loans. Branch operations includeguarantees losses suffered by the collective income generated by NovaStar Home Mortgage, Inc. (NHMI) brokers and the associated operating costs. Also, the corporate-level income and costs to support the NHMI branches are representedtrusts resulting from defects in the branchloan 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, 2007 and 2006 the Company had loans sold with recourse with an outstanding principal balance of $10.1 billion and $12.6 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.

Commitments.The Company leases office space under various operating lease agreements. Rent expense for 2007, 2006 and 2005, under leases related to discontinued operations, segment. As discussedaggregated $9.3 million, $4.9 million and $7.0 million, respectively. At December 31, 2007, future minimum lease commitments under those leases are as follows (dollars in Note 14,thousands):

   Lease
Obligations


2008

  $4,444

2009

   2,421

2010

   1,689

2011

   1,141

2012

   805

Thereafter

   229

The Company has entered into various lease agreements pursuant to which the LLClessor agreed to repay the Company for certain existing lease obligations. 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 related to discontinued operations as of December 31, 2007 and 2006 were $54,000 and $1.8 million, respectively.

The Company has also entered into various sublease agreements were terminated effectivefor office space formerly occupied by the Company. The Company received approximately $1.1 million, $861,000 and $53,000 in 2007, 2006 and 2005, respectively under these agreements. At December 31, 2007, future minimum rental receipts under these subleases are as follows (dollars in thousands):

   Lease
Receipts


2008

  $588

2009

   602

2010

   586

2011

   608

2012

   377

Thereafter

   86

Fair Value Accounting

Effective January 1, 2004. Continuing branch operations that formerly operated under these agreements became operating units2007, the Company adopted SFAS 157 and SFAS 159. Both standards address aspects of the expanding application of fair value accounting.

Fair Value Measurements (SFAS 157)

SFAS 157 defines fair value, establishes a consistent framework for measuring fair value and expands disclosure requirements about fair value measurements. SFAS 157, among other things, requires the Company to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

The following table provides quantitative disclosures about the fair value measurements for the Company’s assets related to discontinued operations which are measured at fair value on a nonrecurring basis as of December 31, 2007 (dollars in thousands):

   Fair Value Measurements at Reporting Date Using

Description


  Fair Value at
12/31/2007


  Quoted Prices in
Active Markets
for Identical
Assets
(Level 1)


  Significant
Other
Observable
Inputs (Level 2)


  Significant
Unobservable
Inputs (Level 3)


Mortgage loans-held-for-sale

  $5,253  $—    $—    $5,253

Real estate owned

   2,574   —     —     2,574
   

  

  

  

Total

  $7,827  $—    $—    $7,827
   

  

  

  

The Company’s mortgage loans held-for-sale have a fair value lower than their financial results are included in the consolidated financial statements. Branches that have terminated in 2004cost basis of $12.3 million. Therefore, all mortgage loans held-for-sale have been segregated from the resultswritten down to fair value. The Company recorded a valuation adjustment of the ongoing operations of the Company$101.1 million on mortgage loans – held-for-sale for the year ended December 31, 2004. Following is2007. At the time a mortgage loan held-for-sale becomes real estate owned, the Company records the property at the lower of its carrying amount or fair value. Upon foreclosure and through liquidation, the Company evaluates the property’s fair value as compared to its carrying amount and records a valuation adjustment when the carrying amount exceeds fair value. For mortgage loans held-for-sale, valuation adjustments for discontinued operations are recorded in the “(Loss) income from discontinued operations, net of income tax” line item of the Company’s consolidated statements of operations.

The following table provides a summary of the operating results of the Company’s primary operating unitsimpact to earnings for the year ended December 31, 2004, 20032007 from the Company’s assets and 2002 (inliabilities which are measured at fair value on a recurring and nonrecurring basis as of December 31, 2007 (dollars in thousands):

 

Asset or Liability Measured
at Fair Value


  Fair Value
Measurement
Frequency


  Fair Value
Adjustments
Included In
Current Period
Earnings


  

Statement of Operations Line Item
Impacted


Mortgage loans – held-for-sale

  Nonrecurring  $(101,125) Valuation adjustment on mortgage loans – held-for-sale

Real estate owned

  Nonrecurring   (6,250) (Losses) gains on sales of mortgage assets
      


  

Total fair value losses

     $(107,375)  
      


  

ForValuation Methods

Mortgage loans - held-for-sale and real estate owned.Both mortgage loans - held-for-sale and real estate owned are carried at the Year Endedlower of cost or fair value. As of December 31, 20042007, the Company estimated the fair value of its mortgage loans – held-for-sale and real estate owned based on two categories. All loans and real estate owned that had mortgage insurance were marked down to a value which reflects current market pricing for such assets. The Company received market bids for the pool of assets with mortgage insurance and believes the market bids to be indicative of the net realizable value of the loans. All loans and real estate owned which did not have mortgage insurance were valued at zero due to their nonperforming characteristics.

Derivative Instruments and Hedging Activities

 

   Mortgage
Portfolio
Management


  

Mortgage

Lending and
Loan
Servicing


  Branch
Operations


  Eliminations

  Total

 

Interest income

  $140,304  $83,759  $—    $(39) $224,024 

Interest expense

   21,071   39,727   108   (8,316)  52,590 
   


 


 


 


 


Net interest income before credit losses

   119,233   44,032   (108)  8,277   171,434 

Credit losses

   (726)  —     —     —     (726)

Gains on sales of mortgage assets

   360   113,211   —     31,379   144,950 

Fee income

   —     29,269   129,149   (55,662)  102,756 

Losses on derivative instruments

   (111)  (8,794)  —     —     (8,905)

Impairment on mortgage securities – available-for-sale

   (15,902)  —     —     —     (15,902)

Other income (expense)

   20,291   (10,135)  35   (7,800)  2,391 

General and administrative expenses

   (7,473)  (149,908)  (135,842)  22,098   (271,125)
   


 


 


 


 


Income (loss) before income tax

   115,672   17,675   (6,766)  (1,708)  124,873 

Income tax expense (benefit)

   —     7,540   (2,638)  474   5,376 
   


 


 


 


 


Income (loss) from continuing operations

   115,672   10,135   (4,128)  (2,182)  119,497 

Income (loss) from discontinued operations, net of income tax

   —     —     (2,562)  (1,546)  (4,108)
   


 


 


 


 


Net income (loss)

  $115,672  $10,135  $(6,690) $(3,728) $115,389 
   


 


 


 


 


December 31, 2004:

                     

Total assets

  $1,078,064  $915,360  $35,283  $(167,396) $1,861,311 
   


 


 


 


 


For the Year EndedThe Company had terminated all of its derivative instruments related to discontinued operations as of December 31, 2003

   Mortgage
Portfolio
Management


  

Mortgage

Lending and
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 

Fee income

   65   37,505   40,290   (9,519)  68,341 

Losses on derivative instruments

   (894)  (29,943)  —     —     (30,837)

Other income (expense)

   15,934   (14,563)  53   (4,114)  (2,690)

General and administrative expenses

   (6,667)  (133,196)  (34,545)  —     (174,408)
   


 


 


 


 


Income (loss) before income tax

   99,025   30,496   5,798   (463)  134,856 

Income tax expense

   —     20,580   2,280   —     22,860 
   


 


 


 


 


Net income (loss)

  $99,025  $9,916  $3,518  $(463) $111,996 
   


 


 


 


 


December 31, 2003:

                     

Total assets

  $563,930  $834,980  $17,276  $(16,229) $1,399,957 
   


 


 


 


 


For the Year Ended December 31, 2002

 

 

   Mortgage
Portfolio
Management


  

Mortgage

Lending and
Loan
Servicing


  Branch
Operations


  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 
   


 


 


 


 


Intersegment revenues and expenses that were eliminated2007. The following table presents the Company’s derivative instruments included in consolidation werediscontinued operations as follows (inof December 31, 2006 (dollars in thousands):

 

   2004

  2003

  2002

 

Amounts paid to (received from) mortgage portfolio from (to) mortgage lending and loan servicing:

             

Loan servicing fees

  $(423) $(685) $(1,074)

Administrative fees

   —     —     (449)

Intercompany interest income

   8,200   8,124   8,637 

Guaranty, commitment, loan sale and securitization fees

   10,833   9,244   6,001 

Interest income on warehouse borrowings

   47   —     —   

Gain on sale of mortgage securities – available-for-sale retained in securitizations

   (2,800)  —     —   

Amounts paid to (received from) branch operations from (to) mortgage lending and loan servicing:

             

Lender premium

   27,269   5,509   1,814 

Subsidized fees

   24   3,325   1,139 

Interest income on warehouse line

   (39)  —     —   

Fee income on warehouse line

   (30)  —     —   

Administrative fees

   —     —     (94)
   Notional
Amount


  Fair
Value


  Maximum
Days to
Maturity


As of December 31, 2006:

           

Non-hedge derivative instruments

  $1,375,000  $7,111  1,606

 

Additionally, as previously discussed, the LLC agreements were terminated effective January 1, 2004 and all continuing branches that formerly operated under these agreements became operating units of the Company. As a result, during consolidation, the Company applied the provisions of SFAS No. 91 “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases” to its branch operations segment. Based on SFAS No. 91, the Company defers certain nonrefundable fees and direct costs associated with the origination of loans in the branch operations segment which are subsequently brokered to the mortgage lending and servicing segment. The mortgage lending and servicing segment ultimately funds the loans and then sells the loans either through securitizations or outright sales to third parties. The net deferred cost (income) becomes part of the cost basis of the loans and serves to either increase (net deferred income) or decrease (net deferred cost) the gain or loss recognized by the mortgage lending and servicing segment. These transactions are accounted for in the eliminations columnAll of the Company’s segment reporting.derivative instruments included in discontinued operations do not meet the requirements for hedge accounting. However, these derivative instruments contributed to the Company’s overall risk management strategy by serving to reduce interest rate risk on average short-term borrowings collateralized by the Company’s loans held-for-sale. The following table summarizesCompany used both interest rate cap and swap agreements related to its discontinued operations.

During 2007, 2006 and 2005, premiums paid related to interest rate cap agreements aggregated $1.9 million, $2.8 million and $2.4 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, 2006 were $3.2 million, and had a weighted average interest rate of 4.2% in 2006. The Company had no premiums due to counterparties as of December 31, 2007 related to its discontinued operations.

Exit or Disposal Activities

During 2007, management of the Company committed the Company to workforce reductions pursuant to Exit Plans. The Company undertook these Exit Plans to align its organization with changing conditions in the mortgage market and as a result of the sale of its mortgage servicing rights portfolio. The Exit Plans resulted in the elimination of approximately 1,316 positions in 2007. The Exit Plans were approved and concluded in 2007.

During the year ended December 31, 2007, the Company recorded pre-tax charges of $11.3 million related to one-time employment termination benefits for the Exit Plans. These amounts are included in the “(Loss) income from discontinued operations, net of income tax” line item of the Company’s consolidated statements of operations. The Company had no liability as of December 31, 2007 remaining to be paid under the Exit Plans.

The Company also recorded charges related to the abandonment of property, plant and equipment and termination costs related to leases for the Exit Plans. The charges related to property, plant and equipment for the year ended December 31, 2004 (in thousands):2007 aggregated approximately $12.2 million, while the charges related to leases aggregated approximately $3.4 million during the year ended December 31, 2007.

 

   2004

 

Gains on sales of mortgage assets

  $8,472 

Fee income

   (36,913)

General & administrative expenses

   28,582 

Note 16. 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 related to discontinued operations are as follows as of December 31, (in2007 and 2006 (dollars in thousands):

 

   2004

  2003

 
   Carrying Value

  Fair Value

  Carrying Value

  Fair Value

 

Financial assets:

                 

Cash and cash equivalents

  $268,563  $268,563  $118,180  $118,180 

Mortgage loans:

                 

Held-for-sale

   747,594   758,932   697,992   715,414 

Held-in-portfolio

   59,527   61,214   94,717   96,455 

Mortgage securities - available-for-sale

   489,175   489,175   382,287   382,287 

Mortgage securities - trading

   143,153   143,153   —     —   

Mortgage servicing rights

   42,010   58,616   19,685   33,788 

Deposits with derivative instrument counterparties

   6,700   6,700   20,900   20,900 

Financial liabilities:

                 

Borrowings:

                 

Short-term

   905,528   905,528   872,536   872,536 

Asset-backed bonds secured by mortgage loans

   53,453   53,453   89,384   89,384 

Asset-backed bonds secured by mortgage securities

   336,441   336,726   43,596   44,253 

Derivative instruments:

                 

Interest rate cap agreements

   5,819   5,819   6,679   6,679 

Interest rate swap agreements

   6,143   6,143   (8,648)  (8,648)
   2007

  2006

   Carrying
Value


  Fair Value

  Carrying
Value


  Fair Value

Financial assets:

               

Mortgage loans – held-for-sale

  $5,253  5,253  $1,741,819  $1,757,965

Mortgage servicing rights

   —    —     62,830   74,177

Warehouse notes receivable

   —    —     39,462   39,462

Deposits with derivative instrument counterparties

   —    —     5,655   5,655

Accrued interest receivable

   —    —     8,584   8,584

Financial liabilities:

               

Short-term borrowings

   19  19   1,648,528   1,648,528

Accrued interest payable

   —    —     4,507   4,507

Derivative instruments:

               

Interest rate cap agreements

   —    —     3,549   3,549

Interest rate swap agreements

   —    —     3,562   3,562

Mortgage loans – held-for-sale - The fair value of mortgage loans - held-for-sale is based on two categories. All loans that had mortgage insurance were marked down to a value which reflects current market pricing for such assets. The Company received market bids for the pool of loans with mortgage insurance and believes the market bids to be indicative of the net realizable value of the loans. All loans which did not have mortgage insurance were valued at zero due to their nonperforming characteristics.

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.

Warehouse notes receivable– The fair value of warehouse notes receivable approximates their carrying value.

Deposits with derivative instrument counterparties – The fair value of deposits with counterparties approximates their carrying value.

Borrowings – The fair value of short-term borrowings approximates their carrying value as the borrowings bear interest at rates that approximate current market rates for similar borrowings.

Derivative instruments – The fair value of derivative instruments is estimated by discounting the projected future cash flows using appropriate rates. The fair value of commitments to originate mortgage loans is estimated using the Black-Scholes option pricing model.

Accrued interest receivable and payable – The fair value of accrued interest receivable and payable approximates their carrying value.

Note 16. Segment Reporting

As of December 31, 2007, the Company reviews, manages and operates its business in one segment: mortgage portfolio management. Mortgage portfolio management operating results come from the income generated on the mortgage assets the Company manages less associated costs. As discussed under Note 15, the Company discontinued its mortgage lending and loan servicing segments during 2007 and had discontinued its branch operations in 2006. The mortgage lending, loan servicing and branch operations are now included as part of the mortgage portfolio management segment and are presented as discontinued operations. The prior period results have been reclassified to reflect this change. Generally, the operating results for the mortgage portfolio management segment are presented in a manner similar to the Company’s consolidated statements of operations.

Following is a summary of the operating results of the Company’s mortgage portfolio management segment as reclassified to reflect the change in segment structure and the results of the discontinued operations for the years ended December 31, 2007, 2006 and 2005 (dollars in thousands):

   2007

  2006

  2005

 

Interest income

  $366,246  $304,122  $199,482 

Interest expense

   228,369   131,334   22,263 
   


 


 


Net interest income (loss) before provision for credit losses

   137,877   172,788   177,219 

Provision for credit losses

   (265,288)  (30,131)  (1,038)

(Losses) gains on sales of mortgage assets

   (136)  362   (27)

(Losses) gains on derivative instruments

   (10,997)  109   247 

Fair value adjustments

   (85,803)  (3,192)  549 

Impairment on mortgage securities – available- for-sale

   (98,692)  (30,690)  (17,619)

Premiums for mortgage loan insurance

   (16,462)  (6,270)  (340)

Other (expense) income, net

   (2,064)  682   —   

General and administrative expenses

   (59,420)  (69,907)  (62,231)
   


 


 


(Loss) income from continuing operations before income tax expense (benefit)

   (400,985)  33,751   96,760 

Income tax expense (benefit)

   66,512   (21,642)  (24,269)
   


 


 


(Loss) income from continuing operations

   (467,497)  55,393   121,029 

(Loss) income from discontinued operations, net of income tax

   (256,780)  17,545   18,095 
   


 


 


Net (loss) income

  $(724,277) $72,938  $139,124 
   


 


 


As of December 31:

             

Total assets

  $3,230,766  $5,028,263  $2,335,734 
   


 


 


Note 17. Earnings Per Share

The computations of basic and diluted earnings per share for the years ended December 31, 2007, 2006 and 2005 are as follows (dollars in thousands, except per share amounts):

   For the Year Ended December 31,

 
   2007

  2006

  2005

 

Numerator:

             

(Loss) income from continuing operations

  $(467,497) $55,393  $121,029 

Dividends on preferred shares

   (8,805)  (6,653)  (6,653)
   


 


 


(Loss) income from continuing operations available to common shareholders

   (476,302)  48,740   114,376 

(Loss) income from discontinued operations, net of income tax

   (256,780)  17,545   18,095 
   


 


 


Net (loss) income available to common shareholders

  $(733,082) $66,285  $132,471 
   


 


 


Denominator:

             

Weighted average common shares outstanding – basic

   9,332,405   8,552,911   7,417,267 
   


 


 


Weighted average common shares outstanding – dilutive:

             

Weighted average common shares outstanding – basic

   9,332,405   8,552,911   7,417,267 

Stock options

   —     59,312   79,095 

Restricted stock

   —     5,681   1,870 
   


 


 


Weighted average common shares outstanding – dilutive

   9,332,405   8,617,904   7,498,232 
   


 


 


Basic earnings per share:

             

(Loss) income from continuing operations

  $(50.10) $6.48  $16.32 

Dividends on preferred shares

   (0.94)  (0.78)  (0.90)
   


 


 


(Loss) income from continuing operations available to common shareholders

   (51.04)  5.70   15.42 

(Loss) income from discontinued operations, net of income tax

   (27.51)  2.05   2.44 
   


 


 


Net (loss) income available to common shareholders

  $(78.55) $7.75 ��$17.86 
   


 


 


Diluted earnings per share:

             

(Loss) income from continuing operations

  $(50.10) $6.43  $16.14 

Dividends on preferred shares

   (0.94)  (0.77)  (0.89)
   


 


 


(Loss) income from continuing operations available to common shareholders

   (51.04)  5.66   15.25 

(Loss) income from discontinued operations, net of income tax

   (27.51)  2.03   2.42 
   


 


 


Net (loss) income available to common shareholders

  $(78.55) $7.69  $17.67 
   


 


 


The following stock options 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 effect would be antidilutive (in thousands, except exercise prices):

   For the Year Ended December 31,

   2007

  2006

  2005

Number of stock options and warrants (in thousands)

   340   62   23

Weighted average exercise price

  $35.88  $140.80  $162.32

Note 18. Income Taxes

The components of income tax expense (benefit) attributable to continuing operations for the years ended December 31, 2007, 2006 and 2005 were as follows (dollars in thousands):

   For the Year Ended December 31,

 
   2007

  2006

  2005

 

Current:

             

Federal

  $21,422  $105  $5,153 

State and local

   3,470   (237)  957 
   

  


 


Total current

   24,892   (132)  6,110 

Deferred:

             

Federal

   36,706   (19,121)  (27,221)

State and local

   4,914   (2,389)  (3,158)
   

  


 


Total deferred (A)

   41,620   (21,510)  (30,379)
   

  


 


Total income tax expense (benefit)

  $66,512  $(21,642) $(24,269)
   

  


 



(A)Does not reflect the deferred tax effects of unrealized gains and losses on mortgage securities-available-for-sale and derivative financial instruments that are included in shareholders’ equity. As a result of these tax effects, shareholders’ equity increased by $1.9 million in 2007 and decreased by $1.9 million and $70,000 in 2006 and 2005, respectively. Additionally, it does not reflect the deferred tax effects of a contribution of securities and the write-off of net operating losses related to equity based compensation recorded to additional paid-in-capital of $7.4 million for the year ended December 31, 2007.

The deferred tax expense attributable to continuing operations of $41.6 million for the year ended December 31, 2007 represents an increase to the beginning-of-the-year valuation allowance because of a change in circumstances that caused a change in judgment about the realizability of the deferred tax asset in future years.

A reconciliation of the expected federal income tax expense (benefit) using the federal statutory tax rate of 35 percent to the Company’s actual income tax expense (benefit) and resulting effective tax rate from continuing operations for the years ended December 31, 2007, 2006 and 2005 were as follows (dollars in thousands):

   For the Year Ended December 31,

 
   2007

  2006

  2005

 

Income tax at statutory rate

  $(140,345) $11,813  $33,866 

Benefit of REIT election

   —     (31,492)  (57,331)

State income taxes, net of federal tax benefit

   (29,618)  (1,708)  (1,430)

Tax effect of REIT termination effective January 1, 2006

   (51,476)  —     —   

Valuation allowance

   276,967   —     —   

Interest and penalties

   8,132   —     —   

Other

   2,852   (255)  626 
   


 


 


Total income tax expense (benefit)

  $66,512  $(21,642) $(24,269)
   


 


 


Significant components of the Company’s deferred tax assets and liabilities at December 31, 2007 and 2006 were as follows (dollars in thousands):

   December 31,

 
   2007

  2006

 

Deferred tax assets:

         

Basis difference – investments

  $229,371  $10,639 

Federal net operating loss carryforwards

   60,335   19,055 

Accrued litigation

   17,887   1,646 

Allowance for loan losses

   25,375   —   

Mark-to-market adjustment on mortgage loans

   —     7,866 

State net operating loss carryforwards

   14,964   2,474 

Deferred compensation

   7,070   8,158 

Excess inclusion income

   4,932   10,884 

Loan sale recourse obligations

   811   9,272 

Other

   8,650   4,984 
   


 


Gross deferred tax asset

   369,395   74,978 

Valuation allowance

   (368,312)  (685)
   


 


Deferred tax asset

   1,083   74,293 
   


 


Deferred tax liabilities:

         

Mortgage servicing rights

   —     23,675 

Other

   1,083   3,430 
   


 


Deferred tax liability

   1,083   27,105 
   


 


Net deferred tax asset

  $—    $47,188 
   


 


The Company had previously elected to be treated as a REIT for federal income tax purposes and, as such, was not required to pay corporate level income taxes as long as the Company remained a REIT and distributed 100 percent of its taxable income in the form of dividend distributions to its shareholders.

During 2007, the Company was unable to satisfy the REIT distribution requirement for the tax year ended December 31, 2006, either in the form of cash or preferred stock. This action resulted in the Company’s loss of REIT status retroactive to January 1, 2006. The failure to satisfy the REIT distribution test resulted from demands on the Company’s liquidity and the substantial decline in the Company’s market capitalization during 2007.

Although the Company had planned to revoke REIT status effective January 1, 2008, the termination of REIT status two years prior to the Company’s plan adversely impacted its financial statements. The impact of the termination of the Company’s REIT status has been reflected in the Company’s 2007 financial statements.

As a result of the Company’s termination of REIT status, the Company elected to file a consolidated federal income tax return with its eligible affiliated members for its 2006 tax year. The Company reported taxable income in 2006 of approximately $212 million, which resulted in a tax liability of approximately $74 million along with interest and penalties due of approximately $5.8 million. After applying payments and credits, the Company reported an amount owed to the IRS of approximately $67 million. The Company applied for and received an extension of time to pay the income taxes due to the Company’s expectation of generating a net operating loss for 2007, which may be carried back to 2006. This approved extension should allow the Company to reduce all of its taxable income (excluding excess inclusion income) from 2006, and eliminate the outstanding tax liability due to the IRS. However, the Company will be required to pay interest and any penalties that apply on the balance due to the IRS in 2008. As of December 31, 2007, the Company had recorded additional interest of $1.5 million related to the balance due which is included in the accounts payable and other liabilities line item of the Company’s consolidated balance sheet.

It is the Company’s intent to offset the 2006 tax liability discussed above with the receivable recorded for the projected 2007 federal net operating loss to be carried back against the 2006 taxable income. As of December 31, 2007, the Company reported a current federal and state income tax payable of $7.9 million and $2.6 million, respectively. As of December 31, 2006, the Company reported a current federal and state income tax receivable of $1.3 million and $0.9 million, respectively.

Because the Company terminated its REIT status effective January 1, 2006, was taxable as a C corporation for 2006 and beyond, the Company recorded deferred taxes as of December 31, 2007 based on the estimated cumulative temporary differences as of the current date.

The Company examines and weighs all available evidence (both positive and negative and both historical and forecasted) in the process of determining whether it is more likely than not that a deferred tax asset will be realized. The Company considers the relevancy of historical and forecasted evidence when there has been a significant change in circumstances. Additionally, the Company evaluates the realization of its recorded deferred tax assets on an interim and annual basis.

Based on the evidence available as of December 31, 2007, including the significant pre-tax losses incurred by the Company in 2007, the ongoing disruption to the credit markets, the liquidity issues facing the Company and the decision by the Company to close all of its mortgage lending and loan servicing operations, the Company believes that it is more likely than not that the Company will not realize its deferred tax assets.

In determining the amount of valuation allowance to record as of December 31, 2007, the Company concluded that it is more likely than not that the entire net deferred tax asset will not be realized. Based on these conclusions, the Company recorded a valuation allowance of $368.3 million for deferred tax assets as of December 31, 2007 compared to $0.7 million as of December 31, 2006. The Company’s valuation allowance increased $367.6 million during the year ended December 31, 2007.

As of December 31, 2007, the Company had a federal net operating loss of approximately $368.4 million. The Company is expecting to carryback $196.1 million of the 2007 projected federal net operating loss against its 2006 taxable income and has recorded a current receivable for such benefit. The receivable was netted against the 2006 federal liability previously described in this footnote. The remaining $172.3 million federal net operating loss may be carried forward to offset future taxable income, subject to applicable provisions of the Code, including substantial limitations in the event of an “ownership change” as defined in Section 382 of the Code. If not used, this net operating loss will begin to expire in 2025.

FIN 48

Effective January 1, 2007, the Company adopted FIN 48. FIN 48 requires a company to evaluate whether a tax position taken by the company will “more likely than not” be sustained upon examination by the appropriate taxing authority. It also provides guidance on how a company should measure the amount of benefit that the company is to recognize in its financial statements. As a result of the implementation of FIN 48, the Company recorded a $1.1 million net liability as an increase to the opening balance of accumulated deficit. As of January 1, 2007, the total gross amount of unrecognized tax benefits was $1.0 million and the total amount of unrecognized tax benefits that would impact the effective tax rate, if recognized, was $0.6 million.

As of December 31, 2007, the total gross amount of unrecognized tax benefits was $6.3 million which also represents the total amount of unrecognized tax benefits that would impact the effective tax rate. The Company believes that it is reasonably possible the IRS will issue a closing agreement or determination letter in 2008 with respect to an uncertain tax position taken by the Company in 2007. The unrecognized tax benefit related to such uncertain tax position was approximately $5.4 million at December 31, 2007.

It is the Company’s policy to recognize interest and penalties related to income tax matters in income tax expense. Interest and penalties recorded in income tax expense, classified as a component of income tax expense, was $8.2 million for the year ended December 31, 2007. Accrued interest and penalties was $0.6 million and $3.0 million as of January 1, 2007 and December 31, 2007, respectively.

The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax of multiple state and local jurisdictions. Tax years 2003 to 2007 remain open to examination for U.S. federal income tax and major state tax jurisdictions.

The activity in the accrued liability for unrecognized tax benefits for the year ended December 31, 2007 was as follows (dollars in thousands):

   2007

Beginning balance

  $962

Gross increases – tax positions in prior period

   —  

Gross increases – tax positions in current period

   5,367
   

Ending balance

  $6,329
   

The IRS is currently examining the 2005 federal income tax return of NFI Holding Corporation, a wholly-owned subsidiary of the Company. The Company is not aware of any significant findings as a result of this exam, however, the exam is still ongoing. Management believes it has adequately provided for potential tax liabilities that may be assessed for years in which the statute of limitations remains open. However, the assessment of any material liability would adversely affect the Company’s financial condition, liquidity and ability to continue as a going concern.

Note 19. 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, 2006 and 2005 were $0.8 million and $1.2 million, respectively. No company contributions were made to the Plan for the year ended December 31, 2007. As a result of the Exit Plans described in Note 15, the Plan was subject to a partial termination during 2007.

The Company had a Deferred Compensation Plan (the “DCP”) that was a nonqualified deferred compensation plan that benefited certain designated key members of management and highly compensated employees and allowed them to defer payment of a portion of their compensation to future years. Under the DCP, an employee could defer up to 50% of his or her base salary, bonus and/or commissions on a pretax basis. The Company could make both discretionary and/or matching contributions to the DCP on behalf of DCP participants. The Company made contributions to the DCP for the year ended December 31, 2005 of $777,000. The Company made no contributions to the DCP for the years ended December 31, 2007 and 2006. The DCP was terminated effective December 31, 2007 and all assets, which included $7.5 million in cash and Company stock, were distributed in January 2008 as a result of prior distribution elections and such termination.

Note 20. Stock Compensation Plans

On June 8, 2004, the Company’s 1996 Stock Option Plan (the “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”), non-qualified stock options (“NQSOs”), deferred stock, restricted stock, restricted stock units, performance share awards, dividend equivalent rights (“DERs”) and stock appreciation awards (“SARs”). The Company has granted ISOs, NQSOs, restricted stock, performance share awards and DERs. ISOs may be granted to 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. The Company registered 625,000 shares of common stock under the 2004 Plan, of which approximately 305,000 shares were available for future issuances as of December 31, 2007. The 2004 Plan will remain in effect unless terminated by the Board of Directors or no shares of stock remain available for awards to be granted. The Company’s policy is to issue new shares upon option exercise.

Effective January 1, 2006, the Company adopted provisions of SFAS No. 123(R). The Company selected the modified prospective method of adoption. The Company recorded stock-based compensation expense of $0.7 million, $2.5 million and $2.2 million for the years ended December 31, 2007, 2006 and 2005, respectively. The total income tax benefit recognized in the income statement for stock-based compensation arrangements was $627,000 and $411,000 for 2006 and 2005, respectively. There was no income tax benefit recognized in the income statement for stock-based compensation arrangements in 2007. As of December 31, 2007, there was $0.7 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted. The cost is expected to be amortized over a weighted average period of 2.37 years.

The Company adopted an Equity Award Policy on February 12, 2007 governing the grant of equity awards. In general, equity awards may be granted only at a meeting of the Compensation Committee or the entire Board during the “Trading Window,” as defined in the Company’s Insider Trading and Disclosure Policy for Designated Insiders. The Trading Window for a particular quarter is open beginning on the second business day following an earnings release with respect to the prior quarter until the 15th day of the third month of the quarter. The exercise price (if applicable) of all equity awards will be equal to the price at which the Company’s common stock was last sold on the date of grant.

Grants of long-term equity awards for 2007 were made on March 14, 2007, in accordance with the Company’s Equity Award Policy. On that date 206,096 stock options were granted to employees with an exercise price of $16.72, which was the closing market price on the NYSE of the Company’s common stock on that date. The options granted are subject to a four year vesting period.

During the second quarter of 2007 the Company granted 6,000 stock options to employees with an exercise price of $25.68, which was the closing market price on the NYSE of the Company’s common stock on May 3, 2007, the date of grant. The options granted are subject to a four year vesting period.

On May 7, 2007 the Company granted 5,000 stock options to directors with an exercise price of $27.36, which was the closing market price on the NYSE of the Company’s common stock on the date of grant. The options granted vested immediately.

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 the weighted average fair value of options granted for the years ended December 31, 2007, 2006 and 2005, respectively, determined using the Black-Scholes option pricing model and the assumptions used in their determination. Due to the unusual market conditions and significant volatility in the Company’s stock price during 2007, the expected volatility for options granted in 2007 was based on historical volatility of the Company’s stock. The historical volatility was estimated based on a period of time during the Company’s past which management believed would be representative of the expected volatility for the life of the options granted. For 2006 and 2005, expected volatilities were based on implied volatilities from traded options on the Company’s common stock. The expected life is a significant assumption as it determines the period for which the risk free interest rate, volatility and dividend yield must be applied. The expected life is the period over which employees and directors are expected to hold their options and is based on the Company’s historical experience with similar grants. The Company’s options have DERs and accordingly, the assumed dividend yield was zero for these options.

   2007

  2006

  2005 (A)

 

Weighted average:

             

Fair value, at date of grant

  $10.06  $12.48  $14.25 

Expected life in years

   5   5   2 

Annual risk-free interest rate

   4.46%  4.7%  4.4%

Volatility

   65.0%  37.5%  33.3%

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 years.

The following table summarizes activity, pricing and other information for the Company’s stock options activity for the year ended December 31, 2007:

Stock Options


  Number of
Shares


  Weighted Average
Exercise Price


  Weighted Average
Remaining
Contractual Term
(Years)


  Aggregate
Intrinsic Value
(in thousands)


 

Outstanding at the beginning of the year

  124,432  $94.60        

Granted

  217,101   15.08        

Exercised

  (6,875)  30.48        

Forfeited or expired

  (67,316)  37.41        
   

           

Outstanding at the end of the year

  267,342  $47.81  7.94  $(12,009)
   

 

  
  


Exercisable at the end of the year

  81,499  $77.45  5.52  $(6,076)
   

 

  
  


Stock options expected to vest at the end of the year

  41,468  $68.23  8.56  $(2,710)
   

 

  
  


The total intrinsic value of options exercised during the years ended December 31, 2007, 2006 and 2005 was $51,925, $1.1 million and $3.2 million, respectively. The total fair value of options vested during the years ended December 31, 2007, 2006 and 2005 was $0.8 million, $2.0 million and $1.3 million, respectively.

Pursuant to a resolution of the Company’s compensation committee of the Board of Directors dated December 14, 2005, 227,455 and 70,363 options issued to employees and directors, respectively, were modified. The Company modified all options that were either unvested as of January 1, 2005 or were granted during 2005. For employee options, the rate at which DERs accrue was modified from sixty percent of the dividend per share amount to one hundred percent and the form in which DERs will be paid was modified from stock to cash upon vesting. For director options, only the form in which DERs will be paid was modified from stock to cash upon vesting. These options were granted and canceled during the fourth quarter of 2005. 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.

For options that vested prior to January 1, 2005, a recipient is entitled to receive additional shares of stock upon the exercise of options as a result of DERs associated with the option. 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 2007, 2006 and 2005 had DERs payable in additional shares of stock attached to them when issued. As a result of these exercises, an additional 8,766, 15,793 and 13,972 shares of common stock were issued in 2007, 2006 and 2005, 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 Company granted and issued shares of restricted stock during 2007, 2006 and 2005. The 2007 and 2006 restricted stock awards vest at the end of 5 years and the 2005 restricted stock awards vest at the end of 10 years.

During 2005, the Company granted restricted shares to employees and officers under Performance Contingent Deferred Stock Award Agreements. Under the agreements, the Company would have issued shares of restricted stock if certain performance targets were achieved by the Company within a three-year period. As of December 31, 2007 which is the end of the three-year period, the targets were not achieved and the shares were subsequently forfeited.

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. The agreement was terminated in 2007.

The following table presents information on restricted stock outstanding as of December 31, 2007.

   Number of
Shares

  Weighted Average Grant
Date Fair Value


Outstanding at the beginning of year

  55,219  $111.52

Granted

  115,463   16.72

Vested

  (2,237)  185.68

Forfeited

  (61,234)  28.55
   

   

Outstanding at the end of period

  107,211  $36.50
   

 

The weighted average grant date fair value of restricted stock granted during the years ended December 31, 2007, 2006 and 2005 was $16.72, $124.76 and $163.84, respectively.

Note 21. 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 related to continuing operations are as follows as of December 31, 2007 and 2006 (dollars in thousands):

   2007

  2006

   Carrying
Value


  Fair Value

  Carrying
Value


  Fair Value

Financial assets:

                

Cash and cash equivalents

  $25,364  $25,364  $150,522  $150,522

Restricted cash

   8,998   8,998   —     —  

Mortgage loans - held-in-portfolio

   2,870,013   2,459,105   2,116,535   2,141,028

Mortgage securities - available-for-sale

   33,371   33,371   349,312   349,312

Mortgage securities - trading

   109,203   109,203   329,361   329,361

Accrued interest receivable

   61,704   61,704   29,109   29,109

Financial liabilities:

                

Borrowings:

                

Short-term

   45,488   45,488   503,680   503,680

Asset-backed bonds secured by mortgage loans

   3,065,746   2,410,894   2,067,490   2,067,490

Asset-backed bonds secured by mortgage securities

   74,385   74,385   9,519   9,467

Junior subordinated debentures

   83,561   83,561   83,041   83,041

Accrued interest payable

   6,903   6,903   4,820   4,820

Derivative instruments:

                

Interest rate cap agreements

   (85)  (85)  1,085   1,085

Interest rate swap agreements

   9,441   9,441   2,965   2,965

Credit-default swap agreements

   (2,460)  (2,460)  —     —  

 

Cash and cash equivalents – The fair value of cash and cash equivalents approximates its carrying value.

Restricted Cash – The fair value of restricted cash 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-sale – Mortgage securities – available-for-sale is made up of residual securities and subordinated securities. The fair value of mortgageresidual securities – available-for-sale is estimated by discounting future projected cash flows using a discount rate commensurate with the risks involved.

Mortgage securities- trading – The fair value of mortgagethe subordinated securities - trading is estimated using quoted market prices.

 

Mortgage servicing rightssecurities – trading – Mortgage securities trading is made up of residual securities and subordinated securities. The fair value of mortgage servicing rightsresidual securities is calculated based onestimated by discounting future projected cash flows using a discounted cash flow methodology incorporating numerous assumptions, including servicing income, servicing costs, market discount rates and prepayment speeds.

Depositsrate commensurate with derivative instrument counterpartiesthe risks involved. The fair value of deposits with counterparties approximates its carrying value.the subordinated securities is estimated using quoted market prices.

 

Borrowings – The fair value of short-term borrowings and asset-backed bonds secured by mortgage loansjunior subordinated debentures approximates their 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 conditionsloans was estimated using observable market prices for similar borrowings at December 31, 2004 and 2003.2007. At December 31, 2006, the fair value of asset-backed bonds secured by mortgage loans approximated its carrying value as the interest rate on the borrowings approximated current market rates for similar borrowings as of that date. The fair value of asset-backed bonds secured by mortgage securities is approximated using quoted market prices.

 

Derivative instruments – The fair value of derivative instruments is estimated by discounting the projected future cash flows using appropriate rates. The fair value of commitments to originate mortgage loans is estimated using the Black-Scholes option pricing model.

Accrued interest receivable and payable – The fair value of accrued interest receivable and payable approximates their carrying value.

Note 17.22. Supplemental Disclosure of Cash Flow Information

(dollars in thousands)

(in thousands)


  2004

  2003

  2002

 

Cash paid for interest

  $51,431  $41,058  $37,546 
   


 


 


Cash paid for income taxes

  $27,944  $18,831  $3,581 
   


 


 


Cash received on mortgage securities – available-for-sale with no cost basis

  $32,244  $20,707  $—   
   


 


 


Non-cash operating, investing and financing activities:

             

Cost basis of securities retained in securitizations

  $381,833  $292,675  $90,785 
   


 


 


Retention of mortgage servicing rights

  $39,259  $20,774  $6,070 
   


 


 


Change in loans under removal of accounts provision

  $6,455  $3,020  $11,455 
   


 


 


Change in due to trusts

  $(6,455) $(3,020) $(11,455)
   


 


 


Assets acquired through foreclosure

  $3,558  $6,619  $8,417 
   


 


 


Dividends payable

  $73,431  $30,559  $16,768 
   


 


 


Dividend reinvestment plan program

  $1,839  $1,247  $—   
   


 


 


Restricted stock issued in satisfaction of prior year accrued bonus

  $1,816  $—    $—   
   


 


 


Surrender of warrants

  $—    $—    $3,673 
   


 


 


   2007

  2006

  2005

 

Cash paid for interest

  $310,293  $242,014  $79,880 

Cash paid (received) for income taxes

   6,012   2,836   (4,712)

Cash received on mortgage securities – available-for-sale with no cost basis

   3,475   5,407   17,564 

Cash received for dividend reinvestment plan

   —     5,937   3,903 

Non-cash investing and financing activities:

             

Cost basis of securities retained in securitizations

   56,387   244,978   332,420 

Transfer of mortgage securities – trading from mortgage securities – available-for-sale (A)

   46,683   —     —   

Transfer of loans to held-in-portfolio from held-for-sale

   1,880,340   2,663,731   —   

Assets acquired through foreclosure

   120,148   25,601   2,891 

Dividends payable

   3,816   1,663   45,070 

Tax benefit derived from capitalization of affiliate

   7,195   7,173   —   

Restricted stock issued in satisfaction of prior year accrued bonus

   —     283   262 

(A)Transfer was made upon adoption of SFAS 159.

See notes to consolidated financial statements.

Note 18. Earnings Per Share

The computations of basic and diluted earnings per share for the years ended December 31, 2004, 2003 and 2002 are as follows (in thousands, except per share amounts):

��

   For the Year Ended December 31,

   2004

  2003

  2002

Numerator:

            

Income from continuing operations

  $119,497  $111,996  $48,761

Dividends on preferred shares

   (6,265)  —     —  
   


 

  

Income from continuing operations available to common shareholders

   113,232   111,996   48,761

Loss from discontinued operations, net of income tax

   (4,108)  —     —  
   


 

  

Net income available to common shareholders

  $109,124  $111,996  $48,761
   


 

  

Denominator:

            

Weighted average common shares outstanding – basic:

            

Common shares outstanding

   25,290   22,220   19,537

Convertible preferred stock

   —     —     1,221
   


 

  

Weighted average common shares outstanding – basic

   25,290   22,220   20,758
   


 

  

Weighted average common shares outstanding – dilutive:

            

Weighted average common shares outstanding – basic

   25,290   22,220   20,758

Stock options

   435   601   524

Restricted stock

   38   —     —  

Warrants

   —     —     378
   


 

  

Weighted average common shares outstanding – dilutive

   25,763   22,821   21,660
   


 

  

Basic earnings per share:

            

Income from continuing operations

  $4.72  $5.04  $2.35

Dividends on preferred shares

   (0.25)  —     —  
   


 

  

Income from continuing operations available to common shareholders

   4.47   5.04   2.35

Loss from discontinued operations, net of income tax

   (0.16)  —     —  
   


 

  

Net income available to common shareholders

  $4.31  $5.04  $2.35
   


 

  

Diluted earnings per share:

            

Income from continuing operations

  $4.64  $4.91  $2.25

Dividends on preferred shares

   (0.24)  —     —  
   


 

  

Income from continuing operations available to common shareholders

   4.40   4.91   2.25

Loss from discontinued operations, net of income tax

   (0.16)  —     —  
   


 

  

Net income available to common shareholders

  $4.24  $4.91  $2.25
   


 

  

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,

   2004

  2003

  2002

Number of stock options and warrants (in thousands)

   15   15   300

Weighted average exercise price

  $33.59  $22.66  $12.50

Note 19. Subsequent Events

On February 22, 2005, the Company executed a securitization, NovaStar Mortgage Funding Trust Series 2005-1, which offered 15 rated classes of certificates with a face value of $2,073,750,000. The Company retained the Class C certificate, which was not covered by the prospectus. Class C has a notional amount of $2.1 billion, entitles the Company to excess and prepayment penalty fee cash flow from the underlying loan collateral and serves as overcollateralization. Other than prepayment penalty fee cash flow, Class C is subordinated to the other classes, all of which were offered pursuant to the prospectus. On February 22, 2005, $1.3 billion in loans collateralizing NMFT Series 2005-1 were delivered to the trust. The remaining $0.8 billion in loans is expected to be delivered to the trust by March 31, 2005.

On March 15, 2005, the Company issued $51.6 million of unsecured floating rate junior subordinated notes (“Trust Preferred Securities”). The floating interest rate is three-month LIBOR plus 3.5% and resets quarterly. The notes will mature in 30 years and are redeemable, in whole or in part, anytime without penalty after five years.

Note 20.23. Condensed Quarterly Financial Information (unaudited)

 

Following isThe Company undertook Exit Plans during 2007 to align its organization and costs with its decision to discontinue its mortgage lending and mortgage servicing operations. The provisions of SFAS 144 require the results of operations associated with those operating units terminated to be classified as discontinued operations and segregated from the Company’s continuing results of operations for all periods presented. In accordance with SFAS 144, the Company has reclassified the operating results of its entire mortgage lending segment and loan servicing segment as discontinued operations in the consolidated statements of operations for the year ended December 31, 2007, 2006 and 2005.

As of June 30, 2006, the Company had terminated all of the remaining NHMI branches and related operations. The Company has reclassified the operating results of NHMI through December 31, 2007, as discontinued operations in the consolidated statements of operations for the years ended December 31, 2007, 2006 and 2005 in accordance with SFAS 144.

The Company’s condensed consolidated quarterly operating results for the Company (in thousands, except per share amounts):

   2004 Quarters

  2003 Quarters

 
   First

  Second

  Third

  Fourth

  First

  Second

  Third

  Fourth

 

Net interest income before credit (losses) recoveries

  $39,638  $42,947  $45,439  $43,410  $28,687  $31,547  $33,469  $36,353 

Credit (losses) recoveries

   (146)  (515)  (182)  117   92   171   875   (749)

Gains on sales of mortgage assets

   51,780   25,174   46,415   21,581   29,443   44,031   34,188   36,343 

Gains (losses) on derivative instruments

   (25,398)  27,115   (19,536)  8,914   (9,149)  (15,037)  (8,144)  1,493 

Income from continuing operations before income tax expense (benefit)

   33,073   44,505   24,364   22,931   27,100   32,904   30,952   43,900 

Income tax expense (benefit)

   1,101   7,720   (1,547)  (1,898)  4,141   4,183   5,844   8,692 

Income from continuing operations

   31,972   36,785   25,911   24,829   22,959   28,721   25,108   35,208 

Loss from discontinued operations, net of income tax

   (1,047)  (1,159)  (1,523)  (379)  —     —     —     —   

Net income

   30,925   35,626   24,388   24,450   22,959   28,721   25,108   35,208 

Dividends on preferred stock

   1,275   1,663   1,663   1,664   —     —     —     —   

Net income available to common shareholders

   29,650   33,963   22,725   22,786   22,959   28,721   25,108   35,208 

Basic earnings per share:

                                 

Income from continuing operations available to common shareholders

  $1.24  $1.41  $0.97  $0.87  $1.09  $1.32  $1.12  $1.49 

Loss from discontinued operations, net of income tax

   (0.04)  (0.05)  (0.06)  (0.01)  —     —     —     —   
   


 


 


 


 


 


 


 


Net income available to common shareholders

  $1.20  $1.36  $0.91  $0.86  $1.09  $1.32  $1.12  $1.49 
   


 


 


 


 


 


 


 


Diluted earnings per share:

                                 

Income from continuing operations available to common shareholders

  $1.21  $1.39  $0.95  $0.86  $1.07  $1.28  $1.09  $1.45 

Loss from discontinued operations, net of income tax

   (0.04)  (0.05)  (0.06)  (0.01)  —     —     —     —   
   


 


 


 


 


 


 


 


Net income available to common shareholders

  $1.17  $1.34  $0.89  $0.85  $1.07  $1.28  $1.09  $1.45 
   


 


 


 


 


 


 


 


During 2004, the Company changed policies governing its broker branches. As a result, a significant number of branch managers have voluntarily terminated employment with the Company and the Company has terminated branches when loan production results were substandard. The operating results for these discontinued operations have been segregated from the on-going operating results of the Company. The following amounts from the Company’s financial statements for the three months ended March 31, June 30, and September 30, 2004 have beenand December 31, 2007 and 2006 as revised from amounts previously reported to account for theall operations discontinued operations (inthrough December 31, 2007 are as follows (dollars in thousands, except per share amounts):

 

   March 31, 2004

  June 30, 2004

  September 30, 2004

 
   As Previously
Reported


  As Adjusted

  As
Previously
Reported


  As Adjusted

  As
Previously
Reported


  As Adjusted

 

Fee Income

  $45,519  $25,452  $43,231  $23,056  $34,265  $24,692 

General and administrative expenses

   80,383   58,735   89,506   67,706   79,733   69,862 

Income from continuing operations before income tax expense (benefit)

   31,371   33,073   42,620   44,505   24,066   24,364 

Income tax expense (benefit)

   446   1,101   6,994   7,720   (1,385)  (1,547)
   

  


 

  


 


 


Income from continuing operations

   30,925   31,972   35,626   36,785   25,451   25,911 

Loss from discontinued operations, net of income tax

   —     (1,047)  —     (1,159)  (1,063)  (1,523)
   

  


 

  


 


 


Net income

  $30,925  $30,925  $35,626  $35,626  $24,388  $24,388 
   

  


 

  


 


 


Basic earnings per share:

                         

Income from continuing operations available to common shareholders

  $1.20  $1.24  $1.36  $1.41  $0.95  $0.97 

Loss from discontinued operations, net of income tax

   —     (0.04)  —     (0.05)  (0.04)  (0.06)
   

  


 

  


 


 


Net income available to common shareholders

  $1.20  $1.20  $1.36  $1.36  $0.91  $0.91 
   

  


 

  


 


 


Diluted earnings per share:

                         

Income from continuing operations available to common shareholders

  $1.17  $1.21  $1.34  $1.39  $0.93  $0.95 

Loss from discontinued operations, net of income tax

   —     (0.04)  —     (0.05)  (0.04)  (0.06)
   

  


 

  


 


 


Net income available to common shareholders

  $1.17  $1.17  $1.34  $1.34  $0.89  $0.89 
   

  


 

  


 


 


   2007 Quarters

  2006 Quarters

 
   First

  Second

  Third

  Fourth

  First

  Second

  Third

  Fourth

 

Net interest income before credit losses

  $33,884  38,194  25,368  40,431  $40,808  50,134  44,604  37,242 

Credit losses

   (19,913) (73,254) (99,159) (72,962)  (3,545) (6,045) (10,286) (10,255)

(Losses) gains on sales of mortgage assets

   —    (212) 12  64   328  34  168  (168)

Gains (losses) on derivative instruments

   378  6,128  (9,394) (8,109)  —    109  —    —   

(Loss) income from continuing operations before income tax (benefit) expense

   (23,777) (90,963) (175,433) (110,812)  18,046  14,398  10,972  (9,665)

Income tax (benefit) expense

   (115,376) (71,206) 245,783  7,311   (5,557) (4,365) (5,376) (6,344)

Income (loss) from continuing operations

   91,599  (19,757) (421,216) (118,123)  23,603  18,763  16,348  (3,321)

(Loss) income from discontinued operations, net of income tax

   (45,586) (33,120) (174,155) (3,919)  425  15,973  12,230  (11,083)

Net income (loss)

   46,013  (52,877) (595,371) (122,042)  24,028  34,736  28,578  (14,404)

Dividends on preferred stock

   (1,663) (1,663) (2,634) (2,845)  (1,663) (1,663) (3,327) —   

Net income (loss) available to common shareholders

   44,350  (54,540) (598,005) (124,887)  22,365  33,073  25,251  (14,404)

Basic earnings per share:

                           

Income (loss) from continuing operations available to common shareholders

  $9.65  (2.29) (45.40) (12.96) $2.71  2.07  1.51  (0.36)

(Loss) income from discontinued operations, net

   (4.89) (3.55) (18.65) (0.42)  0.05  1.93  1.42  (1.20)
   


 

 

 

 


 

 

 

Net income (loss) available to common shareholders

  $4.76  (5.84) (64.05) (13.38) $2.76  4.00  2.93  (1.56)
   


 

 

 

 


 

 

 

Diluted earnings per share:

                           

Income (loss) from continuing operations available to common shareholders

  $9.60  (2.29) (45.40) (12.96) $2.69  2.05  1.50  (0.36)

(Loss) income from discontinued operations, net

   (4.86) (3.55) (18.65) (0.42)  0.05  1.92  1.41  (1.20)
   


 

 

 

 


 

 

 

Net income (loss) available to common shareholders

  $4.74  (5.84) (64.05) (13.38) $2.74  3.97  2.91  (1.56)
   


 

 

 

 


 

 

 

REPORT OF INDEPENDENT REGISTERED 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, 20042007 and 2003,2006, and the related consolidated statements of income, stockholders’operations, shareholders’ (deficit) equity, and cash flows for each of the three years in the period ended December 31, 2004.2007. 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 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 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, 20042007 and 2003,2006, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 20042007 in conformity with accounting principles generally accepted in the United States of America.

 

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company’s significant losses incurred in 2007, the deficit in shareholders’ equity, the disruption in the credit markets and related liquidity issues, the sale of its loan servicing operations and the decision to cease all of its mortgage lending operations raise substantial doubt about its ability to continue as a going concern. Management’s plans concerning these matters are also discussed in Note 1 to the financial statements. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

As discussed in Note 2 to the Consolidated Financial Statements, in 2007 the Company changed its methodadopted the provisions of accountingFASB Statement No. 157, “Fair Value Measurements”, FASB Statement No. 159, “Fair Value Option for stock-based compensation to conform toFinancial Assets and Liabilities – Including an Amendment of FASB Statement of Financial Accounting Standards No. 123,Accounting115”, and FASB Interpretation No. 48, “Accounting for Stock-Based Compensation effective January 1, 2003.Uncertainty in Income Taxes”.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004,2007, based on the criteria established inInternal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 15, 200528, 2008 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 15, 200528, 2008

Item 9.Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

None

 

Item 9A.Controls and Procedures

 

Disclosure Controls and 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’sCompany’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’sCompany’s internal control over financial reporting as of December 31, 2004.2007. 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 we believeunder the framework inInternal Control—Integrated Framework, management concluded that as of December 31, 2004, the Company’s internal control over financial reporting met those criteria.was effective as of December 31, 2007.

 

Our independent registered public accounting firm, Deloitte & Touche LLP, havehas issued an attestation report, included herein, on our assessmentthe effectiveness of the Company’s internal control over financial reporting.reporting as of December 31, 2007.

March 15, 2005

/s/ SCOTT F. HARTMAN

Scott F. Hartman

Chairman of the Board of Directors and

Chief Executive Officer

/s/ GREGORY S. METZ

Gregory S. Metz

Chief Financial Officer

 

Changes in Internal Control over Financial Reporting

 

There were no changes in our internal controls over financial reporting during the quarter ended December 31, 20042007 that have materially affected, or isare reasonably likely to materially affect our 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 StockholdersShareholders 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, thatinternal control over financial reporting of NovaStar Financial, Inc. and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2004,2007, 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.reporting, included in the accompanying Management’s Report on 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,assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control, based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.opinion.

 

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, 2004, 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, 2004,2007, 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, 20042007 of the Company and our report dated March 15, 200528, 2008 expressed an unqualified opinion on those financial statements.

statements, and contains explanatory paragraphs regarding the Company’s ability to continue as a going concern and changes in accounting methods.

 

/s/ Deloitte & Touche LLP

 

Kansas City, Missouri

March 15, 200528, 2008

Item 9B.Other Information

 

None

 

PART III

 

Item 10.Directors, and Executive Officers of the Registrantand Corporate Governance

 

Information with respect to Item 401Items 401,405 and Item 405407(d)(4) and (d)(5) of Regulation S-K is incorporated by reference to the information included on NovaStar Financial’sin our Proxy Statement, dated April 18, 2005, for the 2007 Annual Meeting of Shareholders to be held at May 20, 2005 at 10:00 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 8401 Ward Parkway, Kansas City, Missouri 64114.Shareholders.

 

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.disclosures.

 

Item 11.Executive Compensation

 

Information with respect to ItemItems 402 and 407(e)(4) and (e)(5) of Regulation S-K is incorporated by reference to the information included on NovaStar Financial’sin our Proxy Statement dated April 18, 2005, for the 2008 Annual Meeting of Shareholders to be held at May 20, 2005 at 10:00 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 8401 Ward Parkway, Kansas City, Missouri 64114.Shareholders.

Item 12.Security Ownership of Certain Beneficial Owners and Management and Related Stockholder MattersMatters.

 

Information with respect to ItemItems 403 and 407(a) of Regulation S-K is incorporated by reference to the information included on NovaStar Financial’sin our Proxy Statement dated April 18, 2005, for the 2008 Annual Meeting of Shareholders to be held at May 20, 2005 at 10:00 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 8401 Ward Parkway, Kansas City, Missouri 64114.Shareholders.

 

The following table sets forth information as of December 31, 20042007 with respect to compensation plans under which our common stock may be issued.

 

Equity Compensation Plan Information

 

 

Plan Category


  Number of
Securities to be
Issued Upon
Exercise of
Outstanding
Options, Warrants
and Rights


 Weighted Average
Exercise Price of
Outstanding Options,
Warrants and Rights


  Number of Securities
Remaining Available
for Future Issuance
Under Equity
Compensation Plans
(Excluding Shares
Reflected in the First
Column)


  Number of Securities to
be Issued Upon
Exercise of
Outstanding Options,
Warrants and Rights


 Weighted Average
Exercise Price of
Outstanding Options,
Warrants and Rights


  Number of Securities
Remaining Available
for Future Issuance
Under Equity
Compensation Plans
(Excluding Shares
Reflected in the First
Column)


 

Equity compensation plans approved by stockholders

  433,600(A) $10.16  2,500,000  267,342(A) $47.81  304,764(B)

Equity compensation plans not approved by stockholders

  —     —    —    —     —    —   
  

   
  

 

  

Total

  433,600  $10.16  2,500,000  267,342  $47.81  304,764(B)
  

 

  
  

 

  


(A)Certain of the options have dividend equivalent rights (DERs) attached to them when issued. As of December 31, 2004,2007, these options have 85,12422,149 DERs attached.
(B)Represents shares that may be issued pursuant to the Company’s 2004 Incentive Stock Plan, which provides for the grant of qualified incentive stock options, non-qualified stock options, deferred stock, restricted stock, restricted stock units, performance share awards, dividend equivalent rights and stock appreciation awards.

 

Item 13.Certain Relationships and Related Transactions.Transactions, and Director Independence.

 

Information with respect to Item 404 of Regulation S-K is incorporated by reference to the information included on NovaStar Financial’sin our Proxy Statement dated April 18, 2005, for the 2008 Annual Meeting of Shareholders to be held at May 20, 2005 at 10:00 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 8401 Ward Parkway, Kansas City, Missouri 64114.Shareholders.

 

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’sin our Proxy Statement dated April 18, 2005, for the 2008 Annual Meeting of Shareholders to be held at May 20, 2005 at 10:00 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 8401 Ward Parkway, Kansas City, Missouri 64114.Shareholders.

PART IV

 

Item 15.Exhibits and Financial Statements 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.

(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.

 

Exhibit Listing

 

Exhibit No.


  

Description of Document


2.11Servicing Rights Transfer Agreement, dated as of October 12, 2007, between Saxon Mortgage Services, Inc. and NovaStar Mortgage, Inc.
3.1(1)2  Articles of Amendment and Restatement of the RegistrantNovaStar Financial, Inc. (including all amendments and applicable Articles Supplementary)
3.33.1.1(1)3  BylawsCertificate of Amendment of the Registrant
3.3a3.2(2)4Amendment to Bylaws of the Registrant, adopted February 2, 2000
3.3.1  Amended and Restated Bylaws of the Registrant, adopted February 7,July 27, 2005
3.4(8)Articles Supplementary of the Registrant adopted January 15, 2004
4.1(1)5  Specimen Common Stock Certificate
4.34.2(9)6  Specimen certificate for Preferred Stock Certificate
10.610.1(1)Form of Master Repurchase Agreement for mortgage loan financing
10.7.1Form of Master Repurchase Agreement of the Registrant
10.8(6)7  Employment Agreement, dated September 30, 1996, between the Registrant and Scott F. Hartman
10.910.1.1(6)8Amendment dated December 20, 2006 to the Employment Agreement dated September 30, 1996 between NovaStar Financial Inc., and Scott F. Hartman.
10.29  Employment Agreement, dated September 30, 1996, between the Registrant and W. Lance Anderson
10.1410.2.1(1)10  

Amendment dated December 20, 2006 to the Employment Agreement dated September 30, 1996 Executivebetween NovaStar Financial Inc., and Non-Employee Director Stock Option Plan, as last amended

December 6, 1996

W. Lance Anderson.
10.2510.3(4)NovaStar Financial Inc. 2004 Incentive Stock Plan
10.25.1(5)Stock Option Agreement under 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)11  Employment Agreement between NovaStar Mortgage, Inc. and David A. Pazgan, Executive Vice President of NovaStar Mortgage, Inc.

10.3.112Amendment dated December 20, 2006 to the Employment Agreement dated July 15, 2004 between NovaStar Mortgage Inc., and Dave Pazgan.
10.2810.4(7)13  DescriptionSeparation and Consulting Agreement, dated as of Oral At-WillOctober 16, 2007 among NovaStar Mortgage and David A. Pazgan.
10.514Employment Agreement between NovaStar Financial, Inc. and Jeffrey D. Ayers, Senior Vice President, General Counsel and Secretary
10.2910.6(7)2004 Supplemental Compensation for Independent Directors
10.30(7)2005 Compensation Plan for Independent Directors
10.31(7)15  Employment Agreement between NovaStar Financial, Inc. and Gregory S. Metz, Senior Vice President and Chief Financial Officer
10.3210.6.1(7)16Amendment dated December 20, 2006 to the Employment Agreement dated July 15, 2004 between NovaStar Financial Inc., and Gregory Metz.
10.717Separation and Consulting Agreement, dated as of January 3, 2008, by and between NovaStar Financial, Inc. and Gregory Metz.
10.818  Employment Agreement between NovaStar Financial, Inc. and Michael L. Bamburg, Senior ViceExecutive President and Chief Investment Officer
10.9Employment Agreement between NovaStar Financial, Inc. and Todd M. Phillips, dated December 17, 2007


1Incorporated by reference to Exhibit 2.1 to Form 10-Q filed by the Registrant on November 14, 2007.
2Incorporated by reference to Exhibit 3.1 to Form 10-Q filed by the Registrant on August 9, 2007.
3Incorporated by reference to Exhibit 3.1 to Form 8-K filed by the Registrant with the SEC on May 26, 2005.
4Incorporated by reference to Exhibit 3.3.1 to Form 10-Q filed by the Registrant with the SEC on August 5, 2005.
5Incorporated by reference to Exhibit 4.1 to Form 10-Q filed by the Registrant with the SEC on August 5, 2005.
6Incorporated by reference to Exhibit 4.3 to Form 8-A/A filed by the Registrant with the SEC on January 20, 2004.
7Incorporated by reference to Exhibit 10.8 to Form S-11 filed by the Registrant with the SEC on July 29, 1997.
8Incorporated by reference to Exhibit 10 to Form 8-K filed by the Registrant with the SEC on December 21, 2006.
9Incorporated by reference to Exhibit 10.9 to Form S-11 filed by the Registrant with the SEC on July 29, 1997.
10Incorporated by reference to Exhibit 10 to Form 8-K filed by the Registrant with the SEC on December 21, 2006.
11Incorporated by reference to Exhibit 10.27 to Form 8-K filed by the Registrant with the SEC on February 11, 2005.
12Incorporated by reference to an Exhibit 10 to Form 8-K filed by the Registrant with the SEC on December 21, 2006.
13Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on October 18, 2007
14Incorporated by reference to Exhibit 10.28 to Form 10-K filed by the Registrant with the SEC on March 1, 2007.
15Incorporated by reference to Exhibit 10.31 to Form 8-K filed by the Registrant with the SEC on February 11, 2005.
16Incorporated by reference to Exhibit 10 to Form 8-K filed by the Registrant with the SEC on December 21, 2006.
17Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on January 8, 2008.
18Incorporated by reference to Exhibit 10.32 to Form 8-K filed by the Registrant with the SEC on March 28, 2007.

10.10Retention Agreement, dated as of December 17, 2007, by and between NovaStar Financial, Inc. and Todd M. Phillips
10.3310.11(7)19  DescriptionEmployment Agreement, dated as of Oral At-Will AgreementJanuary 7, 2008, by and between NovaStar Financial, Inc. and Rodney E. Schwatken, Vice President, ControllerSchwatken.
10.1220Form of Indemnification Agreement for Officers and Chief Accounting OfficerDirectors of NovaStar Financial, Inc. and its Subsidiaries
10.1321NovaStar Mortgage, Inc. Deferred Compensation Plan Amended and Restated Effective as of December 31, 2007
10.13.122Amended and Restated Trust Agreement for the NovaStar Mortgage, Inc. Deferred Compensation Plan
10.13.223Amendment One to the Amended and Restated Trust Agreement for the NovaStar Mortgage, Inc. Deferred Compensation Plan
10.14241996 Executive and Non-Employee Director Stock Option Plan, as last amended December 6, 1996
10.1525NovaStar Financial Inc. 2004 Incentive Stock Plan
10.15.126Amendment One to the NovaStar Financial, Inc. 2004 Incentive Stock Option Plan
10.15.227Stock Option Agreement under NovaStar Financial, Inc. 2004 Incentive Stock Plan
10.15.328Restricted Stock Agreement under NovaStar Financial, Inc. 2004 Incentive Stock Plan
10.15.429Performance Contingent Deferred Stock Award Agreement under NovaStar Financial, Inc. 2004 Incentive Stock Plan
10.1630NovaStar Financial, Inc. Executive Bonus Plan
10.17312005 Compensation Plan for Independent Directors
10.1832NovaStar Financial, Inc. Long Term Incentive Plan
10.1933Purchase Agreement, dated March 15, 2005, among NovaStar Financial, Inc., NovaStar Mortgage, Inc., NovaStar Capital Trust I, Merrill Lynch International and Taberna Preferred Funding I, LTD
10.2034Amended and Restated Trust Agreement, dated March 15, 2005, between NovaStar Financial, Inc., JPMorgan Chase Bank, Chase Bank USA and certain administrative trustees
10.2135Junior Subordinated Indenture, dated March 15, 2005, between NovaStar Financial, Inc., and JPMorgan Chase Bank
10.2236Parent Guarantee Agreement, dated March 15, 2005, between NovaStar Financial, Inc., and JP Morgan Chase Bank
10.2337Purchase Agreement, dated April 18, 2006, among NovaStar Financial, Inc., NovaStar Mortgage, Inc., NovaStar Capital Trust II and Kodiak Warehouse LLC
10.2438Amended and Restated Trust Agreement, dated April 18, 2006, between NovaStar Mortgage, Inc., JPMorgan Chase Bank, NA Chase Bank USA, NA and certain administrative trustees as well as the form of security representing the Junior Subordinated Notes and the form of Trust Preferred Securities Certificate
10.2539Junior Subordinated Indenture, dated April 18, 2006 between NovaStar Mortgage, Inc., NovaStar Financial, Inc. and JPMorgan Chase Bank, NA
10.2640Parent Guarantee Agreement, dated April 18, 2006, between NovaStar Financial, Inc. and JP Morgan Chase Bank, NA


19Incorporated by reference to Exhibit 10.1 to Form 8-K/A filed by the Registrant with the SEC on January 10, 2008.

20

Incorporated by reference to Exhibit 10.10 to Form 8-K filed by the Registrant with the SEC on November 16, 2005.

21Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on December 21, 2007.
22Incorporated by reference to Exhibit 4.6 to Form S-8 filed by the Registrant with the SEC on November 29, 2006.
23Incorporated by reference to Exhibit 10.45.1 to Form 10-Q filed by the Registrant with the SEC on May 10, 2007.
24Incorporated by reference to Exhibit 10.14 to Form S-11 filed by the Registrant with the SEC on July 29, 1997.
25Incorporated by reference to Exhibit 10.15 to Form S-8 filed by the Registrant with the SEC on June 30, 2004.
26Incorporated by reference to Exhibit 10.46 to Form 10-Q filed by the Registrant with the SEC on May 10, 2007.
27Incorporated by reference to Exhibit 10.25.1 to Form 8-K filed by the Registrant with the SEC on February 4, 2005.
28Incorporated by reference to Exhibit 10.25.2 to Form 8-K filed by the Registrant with the SEC on February 4, 2005.
29Incorporated by reference to Exhibit 10.25.3 to Form 8-K filed by the Registrant with the SEC on February 4, 2005.
30Incorporated by reference to Exhibit 10.26 to Form 8-K filed by the Registrant with the SEC on March 15, 2007.
31Incorporated by reference to Exhibit 10.30 to Form 8-K filed by the Registrant with the SEC on February 11, 2005.
32Incorporated by reference to Exhibit 10.34 to Form 8-K filed by the Registrant with the SEC on February 14, 2006.
33Incorporated by reference to Exhibit 10.34 to Form 10-Q filed by the Registrant with the SEC on May 5, 2005.
34Incorporated by reference to Exhibit 4.4 to Form 10-Q filed by the Registrant with the SEC on May 5, 2005.
35Incorporated by reference to Exhibit 4.5 to Form 10-Q filed by the Registrant with the SEC on May 5, 2005.
36Incorporated by reference to Exhibit 4.6 to Form 10-Q filed by the Registrant with the SEC on May 5, 2005.
37Incorporated by reference to Exhibit 10.38 to Form 8-K filed by the Registrant with the SEC on April 24, 2006.
38Incorporated by reference to Exhibit 10.39 to Form 8-K filed by the Registrant with the SEC on April 24, 2006.
39Incorporated by reference to Exhibit 10.40 to Form 8-K filed by the Registrant with the SEC on April 24, 2006.
40Incorporated by reference to Exhibit 10.41 exhibit to Form 8-K filed by the Registrant with the SEC on April 24, 2006.

10.2741Master Repurchase Agreement (2007 Residual Securities), dated as of April 18, 2007, among Wachovia Investment Holdings, LLC, Wachovia Capital Markets, LLC, NovaStar Mortgage, Inc., NovaStar Certificates Financing LLC and NovaStar Certificates Financial Corporation
10.27.142Amendment Number One to Master Repurchase Agreement (Residual Securities), dated as of May 10, 2007, among Wachovia Investment Holdings, LLC, Wachovia Capital Markets, LLC, NovaStar Mortgage, Inc., NovaStar Certificates Financing, LLC, NovaStar Certificates Financing Corporation, NovaStar Financial, Inc., NFI Holding Corporation and HomeView Lending, Inc.
10.27.243Amendment Number Two, dated as of September 7, 2007, to the Master Repurchase Agreement (2007 Residual Securities), dated as of April 18, 2007, among Wachovia Investment Holdings, LLC, Wachovia Capital Markets LLC, NovaStar Mortgage, Inc., NovaStar Certificates Financing LLC, NovaStar Certificates Financing Corp., NovaStar Financial, Inc. and NFI Holding Corporation
10.27.344Letter Agreement (Release of Security Interest relating to Master Repurchase Agreement (2007 Residual Securities)), dated as of January 4, 2008, by and among NovaStar Mortgage, Inc., NovaStar Certificates Financing LLC, NovaStar Certificates Financing Corporation, NFI Holding Corporation, NovaStar Financial, Inc., HomeView Lending, Inc., Wachovia Investment Holdings, LLC, and Wachovia Capital Markets, LLC.
10.2845Guaranty, dated as of April 18, 2007, made by NovaStar Financial, Inc., NFI Holding Corporation, NovaStar Mortgage Inc. and Homeview Lending, Inc. in favor of Wachovia Investment Holdings, LLC
10.2946Collateral Security, Setoff and Netting Agreement, dated as of April 18, 2007, among Wachovia Bank, NA, Wachovia Investment Holdings, LLC, Wachovia Capital Markets, LLC, NovaStar Financial, Inc., NovaStar Mortgage, Inc. and certain of their respective affiliates
10.3047Master Repurchase Agreement (2007 Servicing Rights), dated as of April 25, 2007, among Wachovia Bank, N.A., Wachovia Capital Markets, LLC, and NovaStar Mortgage, Inc
10.30.148Amendment Number One to Master Repurchase Agreement (2007 Servicing Rights), dated as of May 10, 2007, among Wachovia Bank, N.A., Wachovia Capital Markets, LLC, NovaStar Mortgage, Inc., NovaStar Financial, Inc., NovaStar Holding Corporation and HomeView Lending, Inc.
10.30.249Amendment Number Two, dated as of September 7, 2007 to Master Repurchase Agreement (2007 Servicing Rights), dated as of April 25, 2007, among Wachovia Bank, N.A., Wachovia Capital Markets, LLC, NovaStar Mortgage, Inc., NovaStar Financial, Inc., NovaStar Holding Corporation and HomeView Lending, Inc.
10.30.350Amendment Number Three, dated as of October 22, 2007, to the Master Repurchase Agreement (2007 Servicing Rights), dated as of April 25, 2007, among Wachovia Bank, N.A., as Buyer, Wachovia Capital Markets, LLC, as Agent, NovaStar Mortgage, Inc., as Seller and a Guarantor, and NovaStar Financial, Inc., NFI Holding Corporation, and HomeView Lending, Inc., as Guarantors.
10.3151Guaranty and Pledge Agreement, dated as of April 25, 2007, made by NovaStar Financial, Inc., NFI Holding Corporation, NovaStar Mortgage Inc. and HomeView Lending, Inc. in favor of Wachovia Bank, N.A.
10.3252Amended and Restated Master Repurchase Agreement, dated January 5, 2007, among DB Structured Products, Inc., Aspen Funding Corp., and Newport Funding Corp., as Buyers, and NovaStar Financial, Inc., NovaStar Mortgage, Inc., NovaStar Certificates Financing Corporation, NovaStar Certificates Financing LLC, Acceleron Lending, Inc., and HomeView Lending, Inc., as Sellers
10.3353Master Repurchase Agreement, dated August 2, 2006, among Aspen Funding Corp., Newport Funding Corp., and Deutsche Bank Securities, Inc., as Buyers, and NovaStar Certificates Financing Corporation, NovaStar Certificates Financing LLC, and NovaStar Mortgage, Inc., as Sellers
10.3454Guaranty dated August 2, 2006, by NovaStar Financial, Inc., as Guarantor, in favor of Buyers


41Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on April 25, 2007.
42Incorporated by reference to Exhibit 10.4 to Form 8-K filed by the Registrant with the SEC on May 15, 2007
43Incorporated by reference to Exhibit 10.5 to Form 8-K filed by the Registrant with the SEC on September 12, 2007.
44Incorporated by reference to Exhibit 10.2 to Form 8-K filed by the Registrant with the SEC on January 10, 2008.
45Incorporated by reference to Exhibit 10.2 to Form 8-K filed by the Registrant with the SEC on April 25, 2007.
46Incorporated by reference to Exhibit 10.3 to Form 8-K filed by the Registrant with the SEC on April 25, 2007.
47Incorporated by reference to Exhibit 10.2 to Form 8-K filed by the Registrant with the SEC on May 1, 2007.
48Incorporated by reference to Exhibit 10.3 to Form 8-K filed by the Registrant with the SEC on May 15, 2007
49Incorporated by reference to Exhibit 10.4 to Form 8-K filed by the Registrant with the SEC on September 12, 2007.
50Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on October 25, 2007.
51Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on May 1, 2007.
52Incorporated by reference to Exhibit 10.58 to Form 10-Q filed by the Registrant with the SEC on May 10, 2007.
53Incorporated by reference to Exhibit 10.59 to Form 10-Q filed by the Registrant with the SEC on May 10, 2007.
54Incorporated by reference to Exhibit 10.60 to Form 10-Q filed by the Registrant with the SEC on May 10, 2007.

10.3555Amended and Restated Master Netting Agreement dated January 5, 2007, among DB Structured Products, Inc., Aspen Funding Corp., and Newport Funding Corp., and NovaStar Financial, Inc., NovaStar Mortgage, Inc., NovaStar Certificates Financing Corporation, NovaStar Certificates Financing LLC, Acceleron Lending, Inc., and HomeView Lending, Inc.
10.3656Master Repurchase Agreement dated May 19, 2006 between Greenwich Capital Financial Products, Inc., as Buyer, and NovaStar Mortgage, Inc., NovaStar Financial, Inc., NovaStar Home Mortgage, Inc., NovaStar Certificates Financing Corporation, NovaStar Certificates Financing LLC, HomeView Lending, Inc., and Acceleron Lending, Inc., as Sellers
10.36.157Amendment Number One to Master Purchase Agreement, dated September 20, 2006, among NovaStar Mortgage, Inc., NovaStar Financial, Inc., NovaStar Home Mortgage, Inc., NovaStar Certificates Financing Corporation, NovaStar Certificates Financing LLC, HomeView Lending, Inc., and Acceleron Lending, Inc., as Sellers, and Greenwich Capital Financial Products, Inc., as Buyer
10.36.258Amendment Number Two to Master Purchase Agreement, dated October 27, 2006, among NovaStar Mortgage, Inc., NovaStar Financial, Inc., NovaStar Home Mortgage, Inc., NovaStar Certificates Financing Corporation, NovaStar Certificates Financing LLC, HomeView Lending, Inc., and Acceleron Lending, Inc., as Sellers, and Greenwich Capital Financial Products, Inc., as Buyer
10.36.359Amendment Number Three to Master Purchase Agreement, dated November 9, 2006, among NovaStar Mortgage, Inc., NovaStar Financial, Inc., NovaStar Home Mortgage, Inc., NovaStar Certificates Financing Corporation, NovaStar Certificates Financing LLC, HomeView Lending, Inc., and Acceleron Lending, Inc., as Sellers, and Greenwich Capital Financial Products, Inc., as Buyer
10.3760Master Repurchase Agreement dated June 30, 2006 between Greenwich Capital Financial Products, Inc., as Buyer, and NovaStar Mortgage, Inc., NovaStar Certificates Financing LLC, and NovaStar Certificates Financing Corporation, as Sellers
10.3861Guaranty dated June 30, 2006, by NovaStar Financial, Inc., as Guarantor, in favor of Buyer
10.3962Sales Agreement between NovaStar Financial, Inc. and Cantor Fitzgerald & Co., dated September 8, 2006
10.4063Master Repurchase Agreement (2007 Whole Loan), dated as of May 9, 2007, among Wachovia Bank, N.A., NFI Repurchase Corporation, NMI Repurchase Corporation, HomeView Lending, Inc., NMI Property Financing, Inc., NovaStar Financial, Inc., NFI Holding Corporation and NovaStar Mortgage, Inc.
10.40.164Amendment Number One, dated as of September 7, 2007, to the Master Repurchase Agreement (2007 Whole Loan), dated as of May 9, 2007, among Wachovia Bank, N.A., NFI Repurchase Corporation, NMI Repurchase Corporation, HomeView Lending, Inc., NMI Property Financing, Inc., NovaStar Financial, Inc., NFI Holding Corporation and NovaStar Mortgage, Inc.
10.4165Guaranty, dated as of May 9, 2007, among NovaStar Financial, Inc., NFI Holding Corporation, NovaStar Mortgage, Inc., HomeView Lending, Inc. and Wachovia Bank, NA
10.4266Master Repurchase Agreement (2007 Non-Investment Grade Securities), dated as of May 31, 2007, among Wachovia Investment Holdings, LLC, Wachovia Capital Markets, LLC, NovaStar Mortgage, Inc., NovaStar Certificates Financing, LLC, NovaStar Certificates Financing Corporation, NFI Holding Corporation and NovaStar Financial, Inc.
10.42.167Amendment Number One, dated as of September 7, 2007, to the Master Repurchase Agreement (Non-Investment Grade Securities), dated as of May 31, 2007, among Wachovia Investment Holdings, LLC, Wachovia Capital Markets LLC, NovaStar Mortgage, Inc., NovaStar Certificates Financing LLC, and NovaStar Certificates Financing Corp.
10.4368Guaranty, dated as of May 31, 2007, among NovaStar Financial, Inc., NFI Holding Corporation and Wachovia Investment Holdings, LLC


55Incorporated by reference to Exhibit 10.61 to Form 10-Q filed by the Registrant with the SEC on May 10, 2007.
56Incorporated by reference to Exhibit 10.62 to Form 10-Q filed by the Registrant with the SEC on May 10, 2007.
57Incorporated by reference to Exhibit 10.62.1 to Form 10-Q filed by the Registrant with the SEC on May 10, 2007.
58Incorporated by reference to Exhibit 10.62.2 to Form 10-Q filed by the Registrant with the SEC on May 10, 2007.
59Incorporated by reference to Exhibit 10.62.3 to Form 10-Q filed by the Registrant with the SEC on May 10, 2007.
60Incorporated by reference to Exhibit 10.63 to Form 10-Q filed by the Registrant with the SEC on May 10, 2007.
61Incorporated by reference to Exhibit 10.64 to Form 10-Q filed by the Registrant with the SEC on May 10, 2007.
62Incorporated by reference to Exhibit 1.1 to Form 8-K filed by the Registrant with the SEC on September 8, 2006.
63Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on May 15, 2007
64Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on September 12, 2007
65Incorporated by reference to Exhibit 10.2 to Form 8-K filed by the Registrant with the SEC on May 15, 2007
66Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on June 6, 2007
67Incorporated by reference to Exhibit 10.3 to Form 8-K filed by the Registrant with the SEC on September 12, 2007
68Incorporated by reference to Exhibit 10.2 to Form 8-K filed by the Registrant with the SEC on June 6, 2007

10.4469Master Repurchase Agreement (2007 Investment Grade Securities), dated as of May 31, 2007, among Wachovia Bank, N.A., Wachovia Capital Markets, LLC, NovaStar Mortgage, Inc., NovaStar Certificates Financing, LLC, NovaStar Certificates Financing Corporation, NFI Holding Corporation and NovaStar Financial, Inc.
10.44.170Amendment Number One, dated as of September 7, 2007, to the Master Repurchase Agreement (Investment Grade Securities), dated as of May 31, 2007, among Wachovia Bank, N.A., Wachovia Capital Markets LLC, NovaStar Mortgage, Inc., NovaStar Certificates Financing LLC, NovaStar Certificates Financing Corp., and NovaStar Financial, Inc. and NFI Holding Corporation.
10.4571Guaranty, dated as of May 31, 2007, among NovaStar Financial, Inc., NFI Holding Corporation and Wachovia Bank, N.A.
10.4672Waiver Agreement dated August 17, 2007 by and among NovaStar Mortgage, Inc., NovaStar Certificates Financing LLC, NovaStar Certificates Financing Corporation, NFI Repurchase Corporation, NMI Repurchase Corporation, NMI Property Financing, Inc., HomeView Lending, Inc., NovaStar Financial, Inc., NFI Holding Corporation, Wachovia Bank, N.A., Wachovia Capital Markets, LLC and Wachovia Investment Holdings, LLC.
10.46.173Waiver Agreement, dated as of November 7, 2007, by and among NovaStar Mortgage, Inc., NovaStar Certificates Financing LLC, NovaStar Certificates Financing Corporation, NFI Repurchase Corporation, NMI Repurchase Corporation, NMI Property Financing, Inc., HomeView Lending, Inc., NovaStar Financial, Inc., NFI Holding Corporation, Wachovia Bank, N.A. and Wachovia Investment Holdings, LLC.
10.46.274Waiver Agreement, dated as of November 30, 2007, by and among NovaStar Mortgage, Inc., NovaStar Certificates Financing LLC, NovaStar Certificates Financing Corporation, NFI Repurchase Corporation, NMI Repurchase Corporation, NMI Property Financing, Inc., HomeView Lending, Inc., NovaStar Financial, Inc., NFI Holding Corporation, Wachovia Bank, N.A. and Wachovia Investment Holdings, LLC.
10.46.375Waiver Agreement, dated as of December 7, 2007, by and among NovaStar Mortgage, Inc., NovaStar Certificates Financing LLC, NovaStar Certificates Financing Corporation, NFI Repurchase Corporation, NMI Repurchase Corporation, NMI Property Financing, Inc., HomeView Lending, Inc., NovaStar Financial, Inc., NFI Holding Corporation, Wachovia Bank, N.A. and Wachovia Investment Holdings, LLC.
10.46.476Waiver Agreement, dated as of January 4, 2008, by and among NovaStar Mortgage, Inc., NovaStar Certificates Financing LLC, NovaStar Certificates Financing Corporation, NFI Repurchase Corporation, NMI Repurchase Corporation, NMI Property Financing, Inc., HomeView Lending, Inc., NovaStar Financial, Inc., NFI Holding Corporation, Wachovia Bank, N.A. and Wachovia Investment Holdings, LLC.
10.46.577Waiver Agreement, dated February 4, 2008, by and among NovaStar Mortgage, Inc., NovaStar Certificates Financing LLC, NovaStar Certificates Financing Corporation, NFI Repurchase Corporation, NMI Repurchase Corporation, NMI Property Financing, Inc., HomeView Lending, Inc., NovaStar Financial, Inc., NFI Holding Corporation, Wachovia Bank, N.A. and Wachovia Investment Holdings, LLC.
10.46.678Waiver Agreement, dated February 11, 2008, by and among NovaStar Mortgage, Inc., NovaStar Certificates Financing LLC, NovaStar Certificates Financing Corporation, NFI Repurchase Corporation, NMI Repurchase Corporation, NMI Property Financing, Inc., HomeView Lending, Inc., NovaStar Financial, Inc., NFI Holding Corporation, Wachovia Bank, N.A. and Wachovia Investment Holdings, LLC.
10.46.779Waiver Agreement, dated March 11, 2008, by and among NovaStar Mortgage, Inc., NovaStar Certificates Financing LLC, NovaStar Certificates Financing Corporation, NFI Repurchase Corporation, NMI Repurchase Corporation, NMI Property Financing, Inc., HomeView Lending, Inc., NovaStar Financial, Inc., NFI Holding Corporation, Wachovia Bank, N.A. and Wachovia Investment Holdings, LLC.
10.4780Securities Purchase Agreement, dated July 16, 2007, by and among NovaStar Financial, Inc., Massachusetts Mutual Life Insurance Company, Jefferies Capital Partners IV L.P., Jefferies Employee Partners IV LLC and JCP Partners IV LLC
10.4881Standby Purchase Agreement, dated July 16, 2007, by and among NovaStar Financial, Inc., Massachusetts Mutual Life Insurance Company, Jefferies Capital Partners IV L.P., Jefferies Employee Partners IV LLC and JCP Partners IV LLC


69Incorporated by reference to Exhibit 10.3 to Form 8-K filed by the Registrant with the SEC on June 6, 2007
70Incorporated by reference to Exhibit 10.2 to Form 8-K filed by the Registrant with the SEC on September 12, 2007
71Incorporated by reference to Exhibit 10.4 to Form 8-K filed by the Registrant with the SEC on June 6, 2007
72Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on August 23, 2007
73Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on November 14, 2007.
74Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on December 5, 2007.
75Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on December 10, 2007.
76Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on January 10, 2008.
77Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on February 8, 2008.
78Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on February 15, 2008.
79Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on March 14, 2008.
80Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on July 20, 2007
81Incorporated by reference to Exhibit 10.2 to Form 8-K filed by the Registrant with the SEC on July 20, 2007

10.4982Registration Rights and Shareholders Agreement, dated July 16, 2007, by and among NovaStar Financial, Inc., Massachusetts Mutual Life Insurance Company, Jefferies Capital Partners IV L.P., Jefferies Employee Partners IV LLC and JCP Partners IV LLC
10.5083Letter Agreement, dated July 16, 2007, by and among NovaStar Financial, Inc., Massachusetts Mutual Life Insurance Company, Jefferies Capital Partners IV L.P., Jefferies Employee Partners IV LLC and JCP Partners IV LLC, and Scott Hartman
10.5184Letter Agreement, dated July 16, 2007, by and among NovaStar Financial, Inc., Massachusetts Mutual Life Insurance Company, Jefferies Capital Partners IV L.P., Jefferies Employee Partners IV LLC and JCP Partners IV LLC, and Lance Anderson
10.5285Letter Agreement, dated July 16, 2007, by and among NovaStar Financial, Inc., Massachusetts Mutual Life Insurance Company, Jefferies Capital Partners IV L.P., Jefferies Employee Partners IV LLC and JCP Partners IV LLC, and Mike Bamburg
11.1(3)86  Statement regarding computationRegarding Computation of per share earningsPer Share Earnings
14.187NovaStar Financial, Inc. Code of Conduct
21.1  Subsidiaries of the Registrant
23.1  Consents of Deloitte & Touche LLP
31.1  Chief Executive Officer Certification - Section 302 of the Sarbanes-Oxley Act of 2002
31.2  Principal Financial Officer Certification - Section 302 of the Sarbanes-Oxley Act of 2002
32.1  Chief Executive Officer Certification - Section 906 of the Sarbanes-Oxley Act of 2002
32.2  Principal Financial Officer Certification - Section 906 of the Sarbanes-Oxley Act of 2002


(1)82Incorporated by reference to the correspondingly numbered exhibitExhibit 10.3 to the Registration Statement on Form S-11 (373-32327)8-K filed by the Registrant with the SEC on July 29, 1997, as amended.20, 2007
(2)83Incorporated by reference to the correspondingly numbered exhibitExhibit 10.4 to the Annual Report on Form 10-K8-K filed by the Registrant with the SEC on MarchJuly 20, 2000.2007
(3)See Note 19 to the consolidated financial statements.
(4)84Incorporated by reference to Exhibit 10.1510.5 to the Registration Statement on Form S-8 (333-116998)8-K filed by the Registrant with the SEC on June 30, 2004.July 20, 2007
(5)85Incorporated by reference to Exhibit 10.6 to Form 8-K filed by the Registrant with the SEC on July 20, 2007
86See Note 17 to the condensed consolidated financial statements
87Incorporated 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 the correspondingly numbered exhibit 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, 2004.14, 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 16, 2005By:

/s/ SCOTT F. HARTMAN


  Scott F. Hartman, Chairman of the BoardNOVASTAR FINANCIAL, INC
  of Directors and Chief Executive Officer(Registrant)
Date:DATE:March 16, 2005April 1, 2008By: 

/s/ W. LANCE ANDERSON


  

W. Lance Anderson, 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:April 1, 2008

/s/ W. LANCE ANDERSON


  

W. Lance Anderson, President,

Chairman of the Board

of Directors and Chief Executive Officer

(Principal Executive Officer)

Chief Operating Officer and Director
Date:DATE:March 16, 2005April 1, 2008By:

/s/ GREGORY S. METZ


Gregory S. Metz, Chief Financial Officer
Date:March 16, 2005By: 

/s/ RODNEY E. SCHWATKEN


  

Rodney E. Schwatken, Chief Financial Officer

(Principal Financial Officer)

DATE:April 1, 2008

/s/ TODD M. PHILLIPS


  Rodney E. Schwatken,

Todd M. Phillips, Vice President,

Controller and Chief Accounting Officer

(Principal Accounting Officer)

Date:DATE:March 16, 2005April 1, 2008By: 

/s/ EDWARD W. MEHRER


  Edward W. Mehrer, Director
Date:DATE:March 16, 2005April 1, 2008By: 

/s/ GREGORY T. BARMORE


  Gregory T. Barmore, Director
Date:DATE:March 16, 2005April 1, 2008By: 

/s/ ART N. BURTSCHER


  Art N. Burtscher, Director
DATE:April 1, 2008

/s/ DONALD M. BERMAN


  Donald M. Berman, Director

 

91130