NOVATION COMPANIES, INC. - Quarter Report: 2003 September (Form 10-Q)

Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2003.

¨	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 offices)

(Zip Code)

(816) 237-7000

(Registrant’s telephone number, including area code)

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

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

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

The number of shares of the registrant’s common stock outstanding as of October 31, 2003 was 11,422,328.

NOVASTAR FINANCIAL, INC.

FORM 10-Q

QUARTER ENDED September 30, 2003

INDEX

		Page
PART I	FINANCIAL INFORMATION

Item 1.	Consolidated Financial Statements:
	Balance Sheets	1
	Statements of Income	2
	Statements of Cash Flows	3
	Notes to Consolidated Financial Statements	5

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	10
	Table 1, Carrying Value of Mortgage Loans	16
	Table 2, Rollforward of Mortgage Securities	17
	Table 3, Valuation of Individual Mortgage Securities and Assumptions	18
	Table 4, Short-term Financing Resources	20
	Table 5, Summary of Short-term borrowings and Asset-backed bonds	21
	Table 6, Non-conforming Loan Originations	22
	Table 7, Mortgage Securities Interest Analysis	23
	Table 8, Loans Under Management Net Interest Income Analysis	24
	Table 9, Quarterly Activity – Allowance for Credit Losses	26
	Table 10, Gains on Sales of Mortgage Assets and Losses on Derivative Instruments	27
	Table 11, Quarterly Mortgage Loan Sales	28
	Table 12, Wholesale Loan Costs of Production	30
	Table 13, Summary of Servicing Operations	30
	Table 14, Taxable Net Income	31
	Table 15, Contractual Obligations	33

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	34
	Table 16, Interest Rate Sensitivity – Income	35
	Table 17, Interest Rate Sensitivity – Market Value	35

Item 4.	Controls and Procedures	37

PART II	OTHER INFORMATION

Item 1.	Legal Proceedings	38

Item 2.	Changes in Securities and Use of Proceeds	38

Item 3.	Defaults Upon Senior Securities	38

Item 4.	Submission of Matters to a Vote of Security Holders	38

Item 5.	Other Information	38

Item 6.	Exhibits and Reports on Form 8-K	39

	Signatures	40

NOVASTAR FINANCIAL, INC.

CONSOLIDATED BALANCE SHEETS

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

	September 30, 2003			December 31, 2002
Assets
Cash and cash equivalents	$	70,148		$	79,742
Mortgage loans – held-for-sale		824,273			983,633
Mortgage loans – held-in-portfolio		106,810			149,876
Mortgage securities – available-for-sale		337,632			178,879
Corporate advances to borrowers		17,065			11,875
Mortgage servicing rights		15,955			7,906
Assets acquired through foreclosure		5,760			5,935
Accrued interest receivable		5,018			7,673
Other assets		58,447			26,978

Total assets	$	1,441,108		$	1,452,497

Liabilities and Stockholders’ Equity
Liabilities:
Short-term borrowings	$	960,984		$	1,025,536
Asset-backed bonds		163,606			199,692
Accounts payable and other liabilities		51,756			27,244
Dividends payable		28,520			16,768

Total liabilities		1,204,866			1,269,240
Commitments and contingencies
Stockholders’ equity:
Capital stock, $0.01 par value, 50,000,000 shares authorized:
Common stock, 11,408,154 and 10,479,910 shares issued and outstanding, respectively		114			105
Additional paid-in capital		180,860			133,358
Accumulated deficit		(26,010	)		(12,026	)
Accumulated other comprehensive income		82,288			62,935
Other		(1,010	)		(1,115	)

Total stockholders’ equity		236,242			183,257

Total liabilities and stockholders’ equity	$	1,441,108		$	1,452,497

See accompanying notes to consolidated financial statements.

NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF INCOME

(unaudited; in thousands, except per share amounts)

	For the Nine Months Ended September 30,						For the Three Months Ended September 30,
	2003			2002			2003			2002
Interest income:
Mortgage securities	$	68,286		$	35,658		$	26,611		$	13,872
Mortgage loans		55,816			34,861			17,179			12,688

Total interest income		124,102			70,519			43,790			26,560

Interest expense		30,399			19,377			10,321			7,052

Net interest income before recovery of credit losses		93,703			51,142			33,469			19,508
Recovery of credit losses		1,138			629			875			383

Net interest income		94,841			51,771			34,344			19,891
Gains on sales of mortgage assets		107,662			37,916			34,188			17,293
Fee income		52,721			24,884			18,526			10,077
Premiums for mortgage loan insurance		(2,656	)		(1,705	)		(653	)		(595	)
Losses on derivative instruments		(32,330	)		(30,313	)		(8,144	)		(16,167	)
Other income, net		1,067			1,388			124			560

General and administrative expenses:
Compensation and benefits.		76,148			31,497			26,287			10,001
Loan expense		19,856			4,612			7,109			2,614
Travel and public relations		18,105			7,807			6,405			2,945
Office administration		16,261			6,649			6,136			2,563
Professional and outside services		4,825			2,224			1,847			804
Other		2,228			1,820			484			773

Total general and administrative expenses		137,423			54,609			48,268			19,700

Income before income tax expense (benefit)		83,882			29,332			30,117			11,359
Income tax expense (benefit)		14,168			(2,178	)		5,844			(840	)

Net income available to common shareholders	$	69,714		$	31,510		$	24,273		$	12,199

Basic earnings per share	$	6.42		$	3.04		$	2.17		$	1.17

Diluted earnings per share	$	6.23		$	2.90		$	2.11		$	1.14

Weighted average basic shares outstanding		10,867			10,365			11,193			10,417

Weighted average diluted shares outstanding		11,182			10,878			11,524			10,680

Dividends declared per common share	$	7.58		$	2.70		$	2.50		$	1.00

See accompanying notes to consolidated financial statements.

NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited; in thousands)

	For the Nine Months Ended September 30,
	2003			2002
Cash flows from operating activities:
Net income	$	69,714		$	31,510
Adjustments to reconcile net income to net cash used in operating activities:
Amortization of premiums on mortgage assets		868			1,491
Amortization of mortgage servicing rights		6,206			3,316
Accretion of available-for-sale securities		(68,286	)		(35,658	)
Amortization of deferred debt costs		688			64
Forgiveness of founders’ promissory notes		104			104
Recovery of credit losses		(1,138	)		(629	)
Proceeds from sales of mortgage loans held for sale		4,451,428			1,482,860
Originations of mortgage loans held for sale		(4,428,615	)		(1,726,927	)
Repayments of mortgage loans held for sale		17,440			4,753
Gains on sales of mortgage assets		(107,662	)		(37,916	)
Losses on derivative instruments		32,330			30,313
Compensation recognized under stock option plan		8,084			1,197
Changes in:
Other assets		(50,200	)		(48,636	)
Other liabilities		20,577			(2,572	)

Net cash used in operating activities		(48,462	)		(296,730	)
Cash flows from investing activities:
Mortgage loan repayments—held-in-portfolio		37,649			50,518
Proceeds from paydowns on available-for-sale securities		129,777			68,455
Sales of assets acquired through foreclosure		5,286			12,956

Net cash provided by investing activities		172,712			131,929
Cash flows from financing activities:
Payments on asset-backed bonds		(89,087	)		(59,164	)
Proceeds from issuance of asset-backed bonds		52,313			—
Change in short-term borrowings		(64,552	)		267,401
Proceeds from issuance of capital stock and exercise of equity instruments, net of offering costs		39,428			1,519
Repurchase of warrants		—			(9,499	)
Dividends paid on preferred stock		—			(2,014	)
Dividends paid on common stock		(71,946	)		(20,457	)

Net cash provided by (used in) financing activities		(133,844	)		177,786

Net increase (decrease) in cash and cash equivalents		(9,594	)		12,985
Cash and cash equivalents, beginning of period		79,742			30,817

Cash and cash equivalents, end of period	$	70,148		$	43,802

Continued

Supplemental disclosure of cash flow information:
Cash paid for interest	$	30,467		$	29,208

Surrender of warrants	$	—		$	13,172

Dividends payable	$	28,520		$	10,419

Cash paid for taxes	$	5,222		$	3,455

Non-cash operating and investing activities:
Retention of mortgage servicing rights	$	(14,255	)	$	(4,710	)

Assets acquired through foreclosure	$	(6,794	)	$	(6,959	)

Fair value of securities retained in securitizations	$	(216,811	)	$	(74,488	)

Concluded

See accompanying notes to consolidated financial statements.

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2003 (Unaudited)

Note 1. Financial Statement Presentation

The consolidated financial statements as of September 30, 2003 and for the periods ended September 30, 2003 and 2002 are unaudited. In the opinion of management, all necessary adjustments have been made, which were of a normal and recurring nature, for a fair presentation of the consolidated financial statements. Certain reclassifications to prior year amounts have been made to conform to current year presentation.

The consolidated financial statements should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements of NovaStar Financial and the notes thereto, included in NovaStar Financial’s annual report to shareholders and annual report on Form 10-K for the fiscal year ended December 31, 2002.

The consolidated financial statements of NovaStar Financial include the accounts of all wholly owned subsidiaries. Significant intercompany accounts and transactions have been eliminated in consolidation. Interim results are not necessarily indicative of results for a full year.

Note 2. Stock Based Compensation

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation.

	For the Nine Months Ended September 30,						For the Three Months Ended September 30,
	2003			2002			2003			2002
Net income, as reported	$	69,714		$	31,510		$	24,273		$	12,199
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects		8,084			1,197			1,184			(1,497	)
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(1,144	)		(529	)		(395	)		(184	)

Pro forma net income	$	76,654		$	32,178		$	25,062		$	10,518

Earnings per share:
Basic – as reported	$	6.42		$	3.04		$	2.17		$	1.17

Basic – pro forma	$	7.05		$	3.10		$	2.24		$	1.01

Diluted – as reported	$	6.23		$	2.90		$	2.11		$	1.14

Diluted – pro forma	$	6.92		$	2.98		$	2.19		$	0.99

Note 3. NovaStar Mortgage Funding Trust Series 2003-1, 2003-2 and 2003-3

On February 27, 2003, June 12, 2003 and September 16, 2003, NovaStar Mortgage executed securitization transactions accounted for as sales of loans. In addition, derivative instruments with a fair value of $(11.7) million, $(14.0) million and $7.0 million were transferred into the 2003-1, 2003-2 and 2003-3 trusts, respectively. These instruments serve to reduce interest rate risk to the bondholders. Details of these transactions are as follows (dollars in thousands):

	Value of Asset- Backed Bonds Issued		Economic Residual Value as of September 30, 2003		Principal Balance of Collateral Sold		Net Gain Recognized
NMFT Series 2003-1	$	1,257,750	$	75,679	$	1,300,141	$	29,614
NMFT Series 2003-2	$	1,481,250	$	79,349	$	1,499,998	$	50,324
NMFT Series 2003-3 (A)	$	1,477,500	$	52,224	$	850,516	$	19,260

(A)	By December 12, 2003, the remaining $649.5 million in loans collateralizing NMFT Series 2003-3 will be delivered.

Note 4. Issuance of Common Stock

On May 21, 2003, the Company completed a public offering of 603,750 shares of its common stock at $44.25 per share. The Company raised $25.2 million in net proceeds from this offering.

The Company sold 235,990 shares of its common stock during the nine months ended September 30, 2003 under the Direct Purchase and Dividend Reinvestment Plan. Net proceeds of $13.1 million were raised under these sales of common stock.

Note 5. Comprehensive Income

Comprehensive income includes net income and revenues, expenses, gains and losses that are not included in net income. Following is a summary of comprehensive income for the nine and three months ended September 30, 2003 and 2002 (in thousands).

	For the Nine Months Ended September 30,						For the Three Months Ended September 30,
	2003			2002			2003			2002
Net income.	$	69,714		$	31,510		$	24,273		$	12,199
Other comprehensive income
Change in unrealized gain on available-for-sale securities, net of income taxes		14,093			43,779			(6,261	)		12,332
Change in unrealized loss on derivative instruments used in cash flow hedges		(1,825	)		(11,379	)		(233	)		(5,638	)
Net settlements of derivative instruments used in cash flow hedges reclassified to earnings		7,162			7,526			2,292			2,720
Other amortization		(77	)		(77	)		(26	)		(26	)

Comprehensive income	$	89,067		$	71,359		$	20,045		$	21,587

Note 6. Segment Reporting

The Company reviews, manages and operates its business in three segments. These business segments are: mortgage portfolio management, mortgage lending and loan servicing and branches. Mortgage portfolio management operating results are driven from the income generated on the assets we manage less associated management costs. Mortgage lending and loan servicing operations include the marketing, underwriting and funding of loan production. Servicing operations represent the income and costs to service our on and off -balance sheet loans. Branches include the collective income generated by NovaStar Home Mortgage brokers and the associated operating costs. Also, the corporate-level income and costs to support the NHMI branches as well as the LLC branches are represented in our branches segment. Following is a summary of the operating results of the Company’s primary operating units for the nine and three months ended September 30, 2003 and 2002 (in thousands).

Nine Months Ended September 30, 2003

	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing			Branches			Eliminations			Total
Interest income	$	76,930		$	47,172		$	—		$	—		$	124,102
Interest expense		12,751			23,762			—			(6,114	)		30,399

Net interest income before recovery of credit losses		64,179			23,410			—			6,114			93,703
Recovery of credit losses		1,138			—			—			—			1,138
Gains (losses) on sales of mortgage assets		(4,574	)		107,904			—			4,332			107,662
Fee income		289			27,140			30,160			(4,868	)		52,721
Gains (losses) on derivative instruments		(962	)		(31,368	)		—			—			(32,330	)
Other income (expense)		12,926			(8,443	)		42			(6,114	)		(1,589	)
General and administrative expenses		(12,840	)		(99,283	)		(25,836	)		536			(137,423	)

Income before income tax		60,156			19,360			4,366			—			83,882
Income tax expense		—			12,509			1,659			—			14,168

Net income	$	60,156		$	6,851		$	2,707		$	—		$	69,714

Nine Months Ended September 30, 2002

	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing			Branches			Eliminations			Total
Interest income	$	48,230		$	22,289		$	—		$	—		$	70,519
Interest expense		11,307			13,427			—			(5,357	)		19,377

Net interest income before recovery of credit losses		36,923			8,862			—			5,357			51,142
Recovery of credit losses		629			—			—			—			629
Gains (losses) on sales of mortgage assets		(686	)		37,551			—			1,051			37,916
Fee income		312			11,064			15,865			(2,357	)		24,884
Losses on derivative instruments		—			(30,313	)		—			—			(30,313	)
Other income (expense)		8,538			(3,537	)		39			(5,357	)		(317	)
General and administrative expenses		(4,570	)		(38,301	)		(13,044	)		1,306			(54,609	)

Income (loss) before income tax		41,146			(14,674	)		2,860			—			29,332
Income tax expense (benefit)		—			(3,152	)		974			—			(2,178	)

Net income (loss)	$	41,146		$	(11,522	)	$	1,886		$	—		$	31,510

Three Months Ended September 30, 2003

	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing			Branches			Eliminations			Total
Interest income	$	29,239		$	14,551		$	—		$	—		$	43,790
Interest expense		4,574			4,034			—			1,713			10,321

Net interest income before recovery of credit losses		24,665			10,517			—			(1,713	)		33,469
Recovery of credit losses		875			—			—			—			875
Gains (losses) on sales of mortgage assets		(3,581	)		36,576			—			1,193			34,188
Fee income		34			8,889			10,960			(1,357	)		18,526
Losses on derivative instruments		156			(8,300	)		—			—			(8,144	)
Other income (expense)		178			(2,431	)		11			1,713			(529	)
General and administrative expenses		(2,621	)		(36,620	)		(9,191	)		164			(48,268	)

Income before income tax		19,706			8,631			1,780			—			30,117
Income tax expense		—			5,180			664			—			5,844

Net income	$	19,706		$	3,451		$	1,116		$	—		$	24,273

Three Months Ended September 30, 2002

	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing			Branches			Eliminations			Total
Interest income	$	17,363		$	9,197		$	—		$	—		$	26,560
Interest expense		3,800			5,623			—			(2,371	)		7,052

Net interest income before recovery of credit losses		13,563			3,574			—			2,371			19,508
Recovery of credit losses		383			—			—			—			383
Gains (losses) on sales of mortgage assets		(229	)		17,038			—			484			17,293
Fee income		89			4,669			6,069			(750	)		10,077
Losses on derivative instruments		—			(16,167	)		—			—			(16,167	)
Other income (expense)		3,540			(1,221	)		17			(2,371	)		(35	)
General and administrative expenses		567			(15,819	)		(4,714	)		266			(19,700	)

Income (loss) before income tax		17,913			(7,926	)		1,372			—			11,359
Income tax expense (benefit)		—			(1,181	)		341			—			(840	)

Net income (loss)	$	17,913		$	(6,745	)	$	1,031		$	—		$	12,199

Intersegment revenues and expenses that were eliminated in consolidation were as follows for the nine and three months ended September 30, 2003 and 2002 (in thousands):

	For the Nine Months Ended September 30,				For the Three Months Ended September 30,
	2003		2002		2003			2002
Amounts paid to mortgage lending and loan servicing from mortgage portfolio:
Loan servicing fees	$	536	$	869	$	164		$	239
Administrative fees		—		437		—			27

Amounts paid (received) to (from) mortgage portfolio from (to) mortgage lending and loan servicing:
Intercompany interest income (expense)		6,114		5,357		(1,713	)		2,371
Guaranty, commitment, loan sale, and securitization fees		7,430		4,007		2,077			1,439

Amounts paid to branches from mortgage lending and loan servicing:
Lender premium		4,332		1,051		1,193			484
Subsidized fees		2,204		665		992			283

Note 7. Guarantees

In the ordinary course of business, the Company sells loans with recourse for borrower defaults. For loans that have been sold with recourse that are no longer on the Company’s balance sheet, the recourse component is considered a guarantee. The Company sold loans with recourse for borrower defaults totaling $151.2 million and $141.2 million for the nine months ended September 30, 2003 and 2002, respectively. The Company’s recorded obligation related to these guarantees totaled $37,000 and $29,000 as of September 30, 2003 and December 31, 2002, respectively.

In the ordinary course of business, the Company sells loans with and without recourse for borrower defaults that may have to be subsequently repurchased due to defects in the loan origination process. The Company typically guarantees to cover investor losses should origination defects occur. The defects are categorized as documentation and underwriting errors, judgments, early payment defaults and fraud. If a defect is identified, the Company is required to repurchase the loan. As of September 30, 2003, the Company had loans sold without recourse, except for loans with defects in the origination process, with an outstanding principal balance of $5.3 billion.

In the normal course of its business, the Company is subject to various legal proceedings and claims, the resolution of which, in the opinion of management, will not have a material adverse effect on the Company’s financial condition or results of operations.

Note 8. Earnings Per Share

The computations of basic and diluted EPS computations for the nine and three months ended September 30, 2003 and 2002 are as follows (in thousands except per share amounts):

	For the Nine Months Ended September 30,				For the Three Months Ended September 30,
	2003		2002		2003		2002
Numerator	$	69,714	$	31,510	$	24,273	$	12,199

Denominator:
Weighted average common shares outstanding – basic		10,867		10,365		11,193		10,417

Weighted average common shares outstanding – dilutive
Stock options		315		261		331		263
Warrants		—		252		—		—

Weighted average common shares outstanding – dilutive		11,182		10,878		11,524		10,680

Basic earnings per share	$	6.42	$	3.04	$	2.17	$	1.17

Diluted earnings per share	$	6.23	$	2.90	$	2.11	$	1.14

Note 9. NovaStar NIMS 2003-N1

On July 2, 2003, the Company issued asset-backed bonds in the amount of $54 million secured by the interest only, prepayment penalty and subordinated mortgage securities of NMFT 2003-2 as a means for long-term financing. The mortgage securities are recorded as assets of the Company and the asset-backed bonds are recorded as debt. The performance of the mortgage loan collateral underlying these securities, as presented in Note 3, directly affects the performance of the 2003-N1 bond. The interest rate is fixed at 7.385% and the estimated weighted average months to maturity is based on estimates and assumptions made by management. The actual maturity may differ from expectations.

Note 10. Subsequent Event

On October 29, 2003, NovaStar Financial, Inc 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 Company anticipates that the additional shares resulting from the split will be issued on or about December 1, 2003.

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

The following discussion should be read in conjunction with the preceding consolidated financial statements of NovaStar Financial and the notes thereto as well as NovaStar Financial’s annual report to shareholders and annual report on Form 10-K for the fiscal year ended December 31, 2002.

Safe Harbor Statement

“Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995: Statements in this discussion regarding NovaStar Financial, Inc. and its business, which are not historical facts, are “forward-looking statements” that involve risks and uncertainties. Certain matters discussed in this quarterly report may constitute forward-looking statements within the meaning of the federal securities laws that inherently include certain risks and uncertainties. Actual results and the time of certain events could differ materially from those projected in or contemplated by the forward-looking statements due to a number of factors, including general economic conditions, fluctuations in interest rates, fluctuations in prepayment speeds, fluctuations in losses due to defaults on mortgage loans, the availability of non-conforming residential mortgage loans, the availability and access to financing and liquidity resources, and other risk factors outlined in the annual report on Form 10-K for the fiscal year ended December 31, 2002. Other factors not presently identified may also cause actual results to differ. Management continuously updates and revises these estimates and assumptions based on actual conditions experienced. It is not practicable to publish all revisions and, as a result, no one should assume that results projected in or contemplated by the forward-looking statements will continue to be accurate in the future. Risks and uncertainties, which could cause results to differ from those discussed in the forward-looking statements herein, are listed in the “Risk Management” section of the annual report on Form 10-K for the fiscal year ended December 31, 2002.

Description of Businesses

Mortgage Lending and Loan Servicing

•

We originate primarily non-conforming, single family residential mortgage loans.

•

We reach the borrower through the retail mortgage broker and directly through outbound retail telemarketing.

•

Non-conforming borrowers generally include individuals or families who do not qualify for agency/conventional lending programs because of a lack of available documentation or previous credit difficulties.

•

We acquire mortgage loans on a flow and pool basis from correspondents.

•

We finance our loans through short-term warehouse facilities.

•

Loans we originate are held for sale in either securitization transactions or in outright sales for cash.

•

We service the non-conforming loans we originate and securitize.

The mortgage lending operation is significant to our financial results as it produces the loans that ultimately collateralize the mortgage securities that we hold in our portfolio. During the nine months ended September 30, 2003, we originated $4.4 billion in mortgage loans, the majority of which were retained in our servicing portfolio and serve as collateral for our securities. The loans we originate are sold, either in securitization transactions or in outright sales to third parties. We recognized gains on sales of mortgage loans totaling $107.7 million and $34.2 million for the nine and three months ended September 30, 2003, respectively, compared to $37.9 million and $17.3 million during the same period of 2002. In securitization transactions accounted for as sales, we retain interest-only, prepayment penalty and subordinated securities, along with the right to service the loans.

Mortgage servicing yields fee income for us in the form of normal customer service and processing fees. We recognized $13.9 million and $5.8 million in loan servicing fee income from the securitization trusts during the nine and three months ended September 30, 2003, respectively. For the same period in 2002, we recognized loan servicing fee income from the securitization trusts of $7.0 million and $2.7 million, respectively.

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.

Mortgage Portfolio Management

•

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

•

We operate as a long-term portfolio investor.

•

Financing is provided by issuing asset-backed bonds and entering into reverse repurchase agreements.

•

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

Earnings from our portfolio of mortgage loans and securities generate a substantial portion of our earnings. Gross interest income was $124.1 million and $43.8 million for the nine and three months ended September 30, 2003, respectively compared to $70.5 million and $26.6 million during the same period of 2002. Net interest income from the portfolio was $93.7 million and $33.5 million for the nine and three months ended September 30, 2003. During the nine and three months ended September 30, 2002, our net interest income from the portfolio was $51.1 million and $19.5 million, respectively. See our discussion of interest income under the heading “Results of Operations” and “Net Interest Income”.

A significant risk to our operations, relating to our portfolio management, is the risk that interest rates 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).

In certain circumstances, because we enter into interest rate agreements which do not meet the hedging criteria set forth in accounting principles generally accepted in the United States of America, we are required to record the change 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 drop significantly, the value of our agreements will decrease. As a result, we recognized losses on these derivatives of $32.3 million and $8.1 million for the nine and three months ended September 30, 2003, respectively, compared to $30.3 million and $16.2 million during the same period of 2002.

Branches

•

Branches include retail mortgage brokers that broker loans for more than 200 investors, including NovaStar Mortgage, Inc.

•

Branches operate under established policies.

•

The net operating income for the branch is returned as compensation to the branch “owner/manager.”

•

NovaStar Home Mortgage, Inc. receives fees for loans brokered by the branches.

The retail brokers provide an additional source for mortgage loan originations which, in most cases, we will eventually sell, either in securitizations or in outright sales to third parties. During the nine months ended September 30, 2003, our branches brokered $4.7 billion in loans, of which we funded $1.2 billion.

Mortgage Loan Production Summary

Following is a diagram of the mortgage loan industry in which we operate and our loan production during the nine months ended September 30, 2003 (in thousands).

LOGO

(A)

A portion of the loans securitized or sold to unrelated parties as of September 30, 2003 originated prior to 2003, but due to timing were not yet securitized or sold at the end of 2002. Loans originated in 2003 that we have not securitized or sold to unrelated parties as of September 30, 2003 are included in our mortgage loans held-for-sale.

Significance of Estimates and Critical Accounting Policies

We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America and, therefore, are required to make estimates regarding the values of our assets and liabilities and in recording income and expenses. These estimates are based, in part, on our judgment and assumptions regarding various economic conditions that we believe are reasonable based on facts and circumstances existing at the time of reporting. The results of these 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 included in our 2002 Annual Report on Form 10-K. Our critical accounting estimates impact only two of our three reportable segments; our mortgage portfolio management and mortgage lending and loan servicing segments. Management has discussed the development and selection of these critical accounting estimates with the audit committee of our board of directors and the audit committee has reviewed our disclosure.

Mortgage Loans and Allowance for Credit Losses. Mortgage loans held-in-portfolio are recorded at their cost, adjusted for the amortization of deferred costs and for credit losses inherent in the portfolio. Mortgage loan origination fees and associated direct mortgage loan origination costs on mortgage loans held-in-portfolio are deferred and recognized over the life of the loan as an adjustment to yield using the

level yield method. An allowance for credit losses is maintained for mortgage loans held-in-portfolio. Mortgage loans held-for-sale are recorded at the lower of cost or market. Mortgage loan origination fees and direct mortgage loan origination costs on mortgage loans held-for-sale are deferred until the related loans are sold.

The allowance for credit losses on mortgage loans held-in-portfolio, and therefore the related charge to income, is based on the assessment by management of various factors affecting our mortgage loan portfolio, including current economic conditions, the makeup of the portfolio based on credit grade, loan-to-value, delinquency status, mortgage insurance we purchase and other relevant factors. The allowance is maintained through ongoing provisions charged to operating income. The accounting estimate of the allowance for credit losses is considered a “critical accounting estimate” as significant changes in the mortgage loan portfolio, our ability to obtain mortgage insurance and/or economic conditions may affect the allowance for credit losses and net income. The assumptions used by management regarding these 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 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 loans maintained on our balance sheet and have included the cost of mortgage insurance in our income statement.

The allowance for credit losses was $1.4 million as of September 30, 2003 compared to $3.0 million at December 31, 2002. The allowance for credit losses as a percent of mortgage loans held-in-portfolio was 1.3% as of September 30, 2003 and 2.0% as of December 31, 2002. No loans have been added to our portfolio since our last asset-backed bond transaction treated as a financing transaction in 1998. If we were to assume the estimate of credit losses as a percent of outstanding principal increased or decreased by 10%, the allowance for credit losses and related provision as of and for the nine months ended September 30, 2003, respectively, would increase or decrease by $140,000. We have purchased mortgage insurance covering 81.0% of the mortgage loans held-in-portfolio principal balance as of September 30, 2003 compared to 81.1% as of December 31, 2002. The make-up of our mortgage loan portfolio is discussed under the heading “Mortgage Loans”. The allowance for credit losses is also discussed below under “Mortgage Loans”. We discuss purchased mortgage insurance under the heading “Premiums for Mortgage Loan Insurance”.

Transfers of Assets (Loan and Mortgage Security Securitizations) and Related Gains. In a loan securitization, we combine the mortgage loans we originate in pools to serve as collateral for asset-backed bonds that are issued to the public. In a mortgage security securitization (also known as a “Resecuritization”), we combine mortgage securities retained in previous loan securitization transactions to serve as collateral for asset-backed bonds that are issued to the public. The loans or mortgage securities are transferred to a trust designed to serve only for the purpose of holding the collateral. The trust is considered a qualifying special purpose entity as defined by SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – a replacement of FASB Statement No. 125. The owners of the asset-backed bonds have no recourse to us in the event the collateral does not perform as planned.

In order for us to determine proper accounting treatment for each securitization or resecuritizaion, we evaluate whether or not we have retained or surrendered control over the transferred assets by reference to the conditions set forth in SFAS No. 140. All terms of these transactions are evaluated against the conditions set forth in these statements. Some of the conditions that must be considered include:

•

Have the transferred assets been isolated from the transferor?

•

Does the transferee have the right to pledge or exchange the transferred assets?

•

Is there a “call” agreement that requires the transferor to return specific assets?

•

Is there an agreement that both obligates and entitles the transferor to repurchase or redeem the transferred assets prior to maturity?

Generally, we intend to structure our securitizations so that control over the collateral is transferred and the transfer is accounted for as a sale. For resecuritizations, we intend to structure these transactions to be accounted for as secured borrowings.

When these transfers are executed in a manner such that we have surrendered control over the collateral, the transfer is accounted for as a sale. In accordance with SFAS No. 140, a gain or loss on the sale is recognized based on the carrying amount of the financial assets involved in the transfer, allocated between the assets transferred and the retained interests based on their relative fair value at the date of

transfer. In a loan securitization, we do retain the right to service the underlying mortgage loans and we also retain certain mortgage securities issued by the trust (see Mortgage Securities below). In a resecuritization, we retain an interest in a subordinated security that represents the right to receive the cash flows on the underlying mortgage security collateral after the senior bonds have been satisfied. As previously discussed, the gain recognized upon securitization (or resecuritization) depends on, among other things, the estimated fair value of the components of the securitization (or resecuritization) – the loans or mortgage securities transferred, the securities retained and the mortgage servicing rights. The estimated fair value of the securitization (or resecuritization) components is considered a “critical accounting estimate” as 1) these gains or losses represent a significant portion of our operating results and 2) the valuation assumptions used regarding economic conditions and the make-up of the collateral, including interest rates, principal payments, prepayments and loan defaults are highly uncertain and require a large degree of judgment. The valuation of mortgage securities is based on the present value of future expected cash flows to be received (see Mortgage Securities discussion below). The rate used to discount the cash flow projections is critical in the evaluation of our mortgage securities. Management uses internal, historical collateral performance data and published forward yield curves when modeling future expected cash flows.

For purposes of valuing our mortgage securities, it is important to know that in recent securitization transactions we not only have transferred loans to the trust, but we have also transferred interest rate agreements to the trust with the objective of reducing interest rate risk within the trust. During the period before loans are transferred in a securitization transaction, as discussed under “Net Interest Income”, “Interest Rate/Market Risk” and “Hedging”, we enter into interest rate swap or cap agreements to reduce interest rate risk. We use interest rate cap and swap contracts to mitigate the risk of the cost of variable rate liabilities increasing at a faster rate than the earnings on assets during a period of rising rates. Certain interest rate agreements are then transferred into the trust at the time of securitization. The trust assumes the interest rate agreements and, therefore, the trust assumes the obligation to make payments and obtains the right to receive payments under these agreements.

Another important factor in valuing our mortgage securities is that a significant portion of the underlying mortgage loan collateral is covered by mortgage insurance. 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; therefore, we have no obligation to pay these insurance premiums. We discuss mortgage insurance premiums under the heading “Premiums for Mortgage Loan Insurance”.

The weighted average discount rates used in the initial valuation of mortgage securities for the nine months ended September 30, 2003 and 2002 were 33% and 30%, respectively. If the discount rate used in the initial valuation of our mortgage securities in 2003 had been increased by 500 basis points, the initial value of our mortgage securities would have decreased by $12.3 million and the gain recognized on the transfer of mortgage loans in securitizations would have decreased by $12.2 million. If we would have decreased the discount rate used in the initial valuation of our mortgage securities by 500 basis points, the value of our mortgage securities would have increased by $14.1 million and the gain recognized on the transfer of mortgage loans in securitizations would have increased by $13.6 million.

Information regarding the assumptions we used is discussed under “Mortgage Securities” in the following discussion.

When we do have the ability to exert control over the transferred collateral, the assets remain on our financial records and a liability is recorded for the related asset-backed bonds.

Mortgage Securities. Our mortgage securities represent beneficial interests we retain in securitization and resecuritization transactions. The beneficial interests we retain in securitization transactions primarily consist of the right to receive the future cash flows from a pool of securitized mortgage loans which include:

•

The interest spread between the coupon on the underlying loans and the cost of financing.

•

Prepayment penalties received from borrowers who payoff their loans early in their life.

•

Overcollateralization, which is designed to protect the primary bondholder from credit loss on the underlying loans.

The beneficial interests we retain in resecuritization transactions represent the right to receive the remaining cash flows from the underlying mortgage security collateral after the obligations to outside bondholders have been satisfied.

The cash flows we receive are highly dependent upon the interest rate environment. The cost of financing for the securitized loans is indexed to short-term interest rates, while the loan coupons are less interest sensitive. As a result, as rates rise and fall, our cash flows will fall and rise, which in turn will

decrease or increase the value of our mortgage securities. Likewise, increasing or decreasing cash flows will increase or decrease the yield on our securities. We adjust our yield (rate of income recognition) prospectively based on the expectation for cash flows on the securities.

We believe the accounting estimates related to the valuation of our mortgage securities and establishing the rate of income recognition on mortgage securities are “critical accounting estimates” because they can materially affect net income 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. Management uses internal, historical collateral performance data and published forward yield curves when modeling future expected cash flows and establishing the rate of income recognized on mortgage securities. We believe the value of our mortgage securities is fair, but can provide no assurance that future prepayment and loss experience or changes in their required market discount rate will not require write-downs of the residual assets. Write-downs would reduce income of future periods.

Our average security yield decreased to 34.4% for the nine months ended September 30, 2003 from 39.4% for the same period of 2002 (see Table 7). Mortgage securities income has increased from $35.7 million for the nine months ended September 30, 2002 to $68.3 million for the same period of 2003 due to the increase in the average balance of our securities portfolio. If the rates used to accrue income on our mortgage securities during 2003 had been increased or decreased by 10%, net income during the first nine months of 2003 would have increased by $15.0 million and decreased by $11.8 million, respectively.

As of September 30, 2003, the weighted average discount rate used in valuing our mortgage securities was 29% compared to 25% at December 31, 2002. The weighted-average constant prepayment rate used in valuing our mortgage securities as of September 30, 2003 was 28 versus 40 as of December 31, 2002. If the discount rate used in valuing our mortgage securities as of September 30, 2003 had been increased by 500 basis points, the value of our mortgage securities would have decreased by $19.6 million. If we had decreased the discount rate used in valuing our mortgage securities by 500 basis points, the value of our mortgage securities would have increased by $22.3 million.

Financial Condition as of September 30, 2003 and December 31, 2002

Mortgage Loans. Our balance sheet consists primarily of mortgage loans we have originated. We classify our mortgage loans into two categories: “held-for-sale” and “held-in-portfolio.” A portion of our loans 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 September 30, 2003 was $106.8 million compared to $149.9 million as of December 31, 2002.

Loans we have originated, 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, for tax and accounting purposes, recorded as sales. We use warehouse lines of credit and mortgage repurchase agreements to finance our held-for-sale loans. As such, the fluctuations in mortgage loans – held-for-sale and short-term borrowings between September 30, 2003 and December 31, 2002 is dependent on loans we have originated during the period as well as loans we have sold outright or through securitization transactions. Details regarding loan originations during 2003 as well as mortgage loans sold can be found in the “Mortgage Loan Production” and “Gains on Sales of Mortgage Assets and Losses on Derivative Instruments” sections of this document, respectively.

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 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. Non-conforming borrowers, as they update their credit rating, 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.novastaris.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 1 — Carrying Value of Mortgage Loans

(in thousands)

	September 30, 2003			December 31, 2002
Held-in-portfolio:
Outstanding principal	$	106,104		$	149,918
Deferred broker premium and costs		2,126			2,994
Allowance for credit losses		(1,420	)		(3,036	)

Carrying value	$	106,810		$	149,876

Carrying value as a percent of principal		100.67	%		99.97	%

Original principal	$	1,115,760		$	1,115,760

Coupon		10.0	%		10.0	%

Percent with prepayment penalty		0	%		18	%

Held-for-sale:
Outstanding principal	$	817,191		$	972,360
Deferred broker premium and costs		7,082			11,273

Carrying value	$	824,273		$	983,633

Carrying value as a percent of principal		100.87	%		101.16	%

Coupon		7.2	%		8.0	%

Percent with prepayment penalty		77	%		81	%

Mortgage Securities – Available-for-Sale. Since 1998, we have pooled the majority of the loans we have originated 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 of September 30, 2003 and December 31, 2002”). As of September 30, 2003 and December 31, 2002, the fair value of our mortgage securities was $337.6 million and $178.9 million, respectively. During the first nine months of 2003, we executed securitizations totaling $3.7 billion in mortgage loans and retained mortgage securities with a value of $216.8 million. See Table 2 for a summary of the activity in our mortgage securities portfolio.

The value of our 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 flows of the mortgage loans collateralizing the securities. These estimates are based on management’s judgments about the nature of the loans. The cash flows we receive on our mortgage securities will be the net of the gross coupon and the bond cost less administrative costs (servicing and trustee fees) and the 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.

During the past two years, interest expense on asset-backed bonds has been unexpectedly low. As a result, the spread between the coupon interest and the bond cost has been unusually high. As a result, our cost basis in many of our mortgage securities has been significantly reduced. For example, our cost basis in NMFT Series 2001-1 has been reduced to zero (see Table 3). When our cost basis 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, including net interest income and effects of hedging are discussed under “Results of Operations” and “Interest Rate/Market Risk.” Additional information relating to our loans collateralizing our mortgage securities can be accessed via our website at www.novastaris.com. Such information includes a summary of our loans collateralizing our mortgage securities by FICO score and geographic concentration, as well as, loan performance characteristics such as credit quality and prepayment experience.

Table 2 — Rollforward of Mortgage Securities

(dollars in thousands)

	Cost			Unrealized gain (loss)		Estimated fair value of mortgage securities
As of December 31, 2002	$	102,665		$	76,214	$	178,879
Increases (decreases) to mortgage securities
New securities retained in securitizations (A)		211,708			5,103		216,811
Accretion of income		68,286			—		68,286
Proceeds from paydowns of securities		(133,628	)		—		(133,628	)
Mark-to-market value adjustment		—			7,284		7,284

Net increase to mortgage securities		146,366			12,387		158,753

As of September 30, 2003	$	249,031		$	88,601	$	337,632

(A)	See Note 3 of the consolidated financial statements for further discussion.

Table 3 — Valuation of Individual Mortgage Securities and Assumptions

(dollars in thousands)

	Cost		Unrealized Gain (Loss)			Estimated Fair Value of Mortgage Securities		Current Assumptions						Assumptions at Trust Securitization
	Cost		Unrealized Gain (Loss)					Discount Rate		Constant Prepayment Rate		Expected Credit Losses (A)		Discount Rate		Constant Prepayment Rate		Expected Credit Losses (A)
September 30, 2003:
NMFT 1999-1
Subordinated securities	$	6,014	$	(423	)	$	5,591	25	%	44	%	4.7	%	17	%	30	%	2.5	%

NMFT 2000-1
Interest only		—		2,518			2,518
Prepayment penalty		—		297			297
Subordinated securities		296		926			1,222

		296		3,741			4,037	25		46		1.1		15		27		1.0

NMFT 2000-2
Interest only		—		4,054			4,054
Prepayment penalty		—		411			411
Subordinated securities		744		1,948			2,692

		744		6,413			7,157	25		52		1.0		15		28		1.0

NMFT 2001-1
Interest only		—		8,073			8,073
Prepayment penalty		—		793			793
Subordinated securities		—		1,890			1,890

		—		10,756			10,756	25		50		1.1		20		28		1.2

NMFT 2001-2
Interest only		1,120		19,501			20,621
Prepayment penalty		117		2,042			2,159
Subordinated securities		182		3,160			3,342

		1,419		24,703			26,122	25		48		1.0		25		28		1.2

NMFT 2002-1
Interest only		8,548		7,468			16,016
Prepayment penalty		1,204		1,052			2,256
Subordinated securities		2,369		2,069			4,438

		12,121		10,589			22,710	25		36		1.3		30		28		1.7

NMFT 2002-2
Interest only		7,857		2,711			10,568
Prepayment penalty		1,322		456			1,778
Subordinated securities		2,181		752			2,933

		11,360		3,919			15,279	25		36		1.8		30		24		1.6

NMFT 2002-3
Interest only		22,000		9,132			31,132
Prepayment penalty		2,623		1,089			3,712
Subordinated securities		2,744		1,140			3,884

		27,367		11,361			38,728	25		28		1.0		30		22		1.0

NMFT 2003-1
Interest only		54,208		7,508			61,716
Prepayment penalty		5,665		785			6,450
Subordinated securities		6,599		914			7,513

		66,472		9,207			75,679	25		24		2.7		30		21		2.4

NMFT 2003-2
Interest only		67,135		6,521			73,656
Prepayment penalty		5,039		489			5,528
Subordinated securities		150		15			165

		72,324		7,025			79,349	37		21		2.9		37		21		2.8

NMFT 2003-3
Interest only		46,067		1,185			47,252
Prepayment penalty		3,066		79			3,145
Subordinated securities		1,781		46			1,827

		50,914		1,310			52,224	30		19		2.9		30		19		2.9

Total	$	249,031	$	88,601		$	337,632

(A)	Represents expected credit losses for the entire life of the securitization.

	Cost		Unrealized Gain (Loss)			Estimated Fair Value of Mortgage Securities		Current Assumptions						Assumptions at Trust Securitization
	Cost		Unrealized Gain (Loss)					Discount Rate		Constant Prepayment Rate		Expected Credit Losses (A)		Discount Rate		Constant Prepayment Rate		Expected Credit Losses (A)
December 31, 2002:
NMFT 1999-1
Subordinated securities	$	5,791	$	(1,541	)	$	4,250	25	%	38	%	4.2	%	17	%	30	%	2.5	%

NMFT 2000-1
Interest only		984		3,089			4,073
Prepayment penalty		273		370			643
Subordinated securities		299		1,041			1,340

		1,556		4,500			6,056	25		53		1.0		15		27		1.0

NMFT 2000-2
Interest only		1,355		5,331			6,686
Prepayment penalty		379		620			999
Subordinated securities		792		1,629			2,421

		2,526		7,580			10,106	25		57		1.1		15		28		1.0

NMFT 2001-1
Interest only		1,766		10,263			12,029
Prepayment penalty		311		1,806			2,117
Subordinated securities		324		1,886			2,210

		2,401		13,955			16,356	25		59		1.4		20		28		1.2

NMFT 2001-2
Interest only		10,295		20,806			31,101
Prepayment penalty		2,007		4,055			6,062
Subordinated securities		1,315		2,658			3,973

		13,617		27,519			41,136	25		53		1.2		25		28		1.2

NMFT 2002-1
Interest only		14,925		6,306			21,231
Prepayment penalty		2,491		1,053			3,544
Subordinated securities		3,343		1,413			4,756

		20,759		8,772			29,531	25		38		1.3		30		28		1.7

NMFT 2002-2
Interest only		13,941		3,650			17,591
Prepayment penalty		1,764		462			2,226
Subordinated securities		2,443		639			3,082

		18,148		4,751			22,899	25		29		1.6		30		24		1.6

NMFT 2002-3
Interest only		31,729		8,947			40,676
Prepayment penalty		3,057		862			3,919
Subordinated securities		3,081		869			3,950

		37,867		10,678			48,545	25		24		1.0		30		22		1.0

Total	$	102,665	$	76,214		$	178,879

(A)	Represents expected credit losses for the entire life of the securitization.

Corporate Advances to Borrowers. Advances on behalf of borrowers for taxes, insurance and other customer service functions are made by NovaStar Mortgage, Inc. and aggregated $17.1 million as of September 30, 2003 compared with $11.9 million as of December 31, 2002. These balances will generally increase as our assets and loan servicing balances increase.

Mortgage Servicing Rights. As discussed under Mortgage Securities – Available for Sale, we retain the right to service mortgage loans we originate 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 September 30, 2003, we have $16.0 million in capitalized mortgage servicing rights compared with $7.9 million as of December 31, 2002. The value of the mortgage servicing rights we retained in our securitizations during the first nine months of 2003 was $14.3 million. Amortization of mortgage servicing rights was $6.2 million and $3.3 million for the nine months ended September 30, 2003 and 2002, respectively.

Assets Acquired through Foreclosure. As of September 30, 2003, we had 67 properties in real estate owned with a carrying value of $5.8 million compared to 69 properties with a carrying value of $5.9 million as of December 31, 2002. Losses or gains from the ultimate disposition of real estate owned are charged or credited to operating income and are detailed under the heading “Gains on Sales of Mortgage Assets and Losses on Derivative Instruments”.

Other Assets. Included in other assets is collateral required under the terms of our derivative instrument contracts, derivative instrument market values, fixed assets, receivables from securitizations and other miscellaneous assets. Deposits with our derivative counterparties were $26.6 million as of September 30, 2003 compared with $30.3 million as of December 31, 2002. The market value of the interest rate swaps offset the deposits by $15.3 million and $19.0 million as of September 30, 2003 and December 31, 2002, respectively. These balances will generally decrease as interest rates rise and increase when interest rates fall. Also included in other assets at September 30, 2003 and December 31, 2002 are fixed assets, net of accumulated depreciation of $14.8 million and $5.4 million, respectively. Fixed assets have increased primarily due to purchases of furniture and fixtures, computer equipment and office equipment related to the growth in the number of our employees. Our receivables from securitizations were $15.9 million and $0.6 million at September 30, 2003 and December 31, 2002, respectively. These receivables represent cash due to us when we deliver the remaining $649.5 million in loans collateralizing NMFT 2003-3 in December 2003 as well as cash due to us on our mortgage securities.

Short-term Financing Arrangements. Mortgage loan originations 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 flow from operating, investing and other financing activities and equity transactions. Amounts outstanding and available for borrowing as of September 30, 2003 are listed in Table 4.

Table 4 — Short-term Financing Resources

(in thousands)

	Credit Limit		Lending Value of Collateral		Borrowings		Availability
Unrestricted cash							$	70,148
Lines of credit and mortgage and securities repurchase facilities	$	3,075,000	$	970,897	$	960,984	$	9,913

Total.	$	3,075,000	$	970,897	$	960,984	$	80,061

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 lines of credit and repurchase agreements that mature frequently with interest rates that reset frequently and have liquidity risk in the form of margin calls. Under the terms of our asset-backed bonds we are entitled to repurchase the mortgage loan collateral and repay the remaining bond obligations when the aggregate collateral principal balance falls below 35% of their original balance for the loans in 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.

On November 5, 2002 we resecuritized interest-only and prepayment penalty securities and issued NovaStar CAPS Certificate Series 2002-C1 in the amount of $68 million. On July 2, 2003, we resecuritized interest-only, prepayment penalty and subordinated mortgage securities of NMFT 2003-2 and issued NovaStar NIMS Certificate Series 2003-N1 in the amount of $54 million. 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 financing for the mortgage securities.

The following table summarizes our short-term borrowings and asset-backed bonds related to our mortgage securities, mortgage loans held-for-sale and mortgage loans held-in-portfolio as of September 30, 2003 and December 31, 2002. The interest expense related to these borrowings is summarized in Table 8.

Table 5 — Summary of Short-term Borrowings and Asset-backed Bonds

(in thousands)

	Mortgage Securities		Mortgage Loans Held-for- Sale		Mortgage Loans Held-in- Portfolio		Total
As of September 30, 2003
Short-term borrowings (A)	$	205,904	$	755,080		—	$	960,984
Asset-backed bonds	$	62,089		—	$	101,517	$	163,606

As of December 31, 2002
Short-term borrowings (A)	$	98,064	$	927,472		—	$	1,025,536
Asset-backed bonds	$	56,233		—	$	143,459	$	199,692

(A)	Primarily includes mortgage loan and securities repurchase agreements.

Accounts Payable and Other Liabilities. Included in accounts payable and other liabilities is the provision for removal of loans from securitization trusts, accrued payroll, income taxes payable and other liabilities. A provision within the trust for each of our securitization transactions gives us the right, not the obligation, to repurchase loans from the trust that are between 90 and 119 days delinquent. In accordance with SFAS 140, we are required to record the loans that meet this definition and a corresponding liability to the trust on our balance sheet at fair value. As of September 30, 2003 and December 31, 2002, our liability related to this provision was $17.1 million and $11.5 million, respectively. This liability should generally increase as we continue to securitize the loans we originate. Our accrued payroll increased from $9.2 million at December 31, 2002 to $17.2 million at September 30, 2003 due primarily to our growth in number of employees. Our income tax liability was $5.8 million and $0.9 million as of September 30, 2003 and December 31, 2002, respectively. This increase is attributable to the increase in income before taxes of NFI Holding Corporation.

Stockholders’ Equity. The increase in our stockholders’ equity as of September 30, 2003 compared to December 31, 2002 is a result of the following:

•

$69.7 million increase due to net income recognized for the nine months ended September 30, 2003.

•

$14.1 million increase due to increase in unrealized gains on mortgage securities classified as available-for-sale.

•

$7.2 million increase due to net settlements on cash flow hedges reclassified to earnings.

•

$1.9 million decrease due to increase in unrealized losses on derivative instruments used in cash flow hedges.

•

$38.3 million increase due to issuance of common stock.

•

$8.1 million increase due to compensation recognized under stock option plan.

•

$1.1 million increase due to exercise of stock options.

•

$83.7 million decrease due to dividends accrued or paid on common stock.

•

$0.1 million increase due to forgiveness of founders’ notes receivable.

Mortgage Loan Production

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 and have generated 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.

Our non-conforming loans are originated through a network of mortgage brokers throughout the United States. Approximately 5,400 brokers are active customers and approximately 13,800 are approved. Loans are underwritten and funded in centralized facilities. We have a sales force of 248 account executives that operate in 42 states, allowing us to mitigate the risk of geographical concentrations of credit risk.

The following tables summarize our loan production. The gains we have recognized are discussed under “Results of Operations”. Additionally, we discuss our cost of production under “General and Administrative Expenses” under “Results of Operations”.

Table 6 — Non-conforming Loan Originations

(dollars in thousands, except for average loan balance)

	Number	Principal		Average Loan Balance		Price Paid to Broker		Weighted Average					Percent with Prepayment Penalty
	Number	Principal		Average Loan Balance		Price Paid to Broker		Loan to Value		Credit Rating (A)	Coupon		Percent with Prepayment Penalty
2003:
Third quarter	10,415	$	1,491,476	$	143,205	101.1	%	77	%	5.41	7.1	%	75	%
Second quarter	8,925		1,259,546		141,126	101.3		78		5.82	7.2		78
First quarter	6,426		912,599		142,017	101.3		78		5.73	7.5		80

Total	25,766	$	3,663,621	$	142,188	101.2	%	78	%	5.63	7.2	%	77	%


2002:
Fourth quarter	6,597	$	950,018	$	144,008	101.3	%	78	%	5.68	7.6	%	78	%
Third quarter	4,271		570,138		133,490	101.2		80		5.50	8.4		81
Second quarter	3,983		500,617		125,688	101.0		80		5.56	9.1		81
First quarter	3,602		471,994		131,037	101.0		80		5.45	9.0		84

Total	18,453	$	2,492,767	$	135,087	101.1	%	79	%	5.57	8.3	%	80	%

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

Results of Operations for the Nine and Three Months Ended September 30, 2003 Compared with the Nine and Three Months Ended September 30, 2002

During the nine and three months ended September 30, 2003, we earned net income of $69.7 million, $6.23 per diluted share, and $24.3 million, $2.11 per diluted share, compared with net income of $31.5 million, $2.90 per diluted share, and $12.2 million, $1.14 per diluted share, for the same period of 2002.

Our primary sources of revenue are interest earned on our mortgage loan and securities portfolios, fees from borrowers and gains on the sales and securitizations of mortgage loans. Earnings increased during 2003 as compared to 2002 due primarily to higher volume of average mortgage securities held. Additionally, larger lending volumes generate higher gains on sales and securitizations of loans as well as fees from borrowers for loan-related services.

Net Interest Income

Our securities primarily represent our ownership in the net cash flows of underlying mortgage loan collateral in excess of bond expenses and cost of funding. The cost of funding is indexed to one-month LIBOR. As one-month LIBOR decreased dramatically over the past two years, the net cash flows we have received has increased correspondingly. On the other hand, the coupon on the mortgage loan collateral has adjusted more slowly. Therefore, the yields (rate of accrual) on our older securities significantly increased during 2001 and 2002. For our newer securities, since the average coupon on the underlying mortgage loan collateral has adjusted downward, our overall yields are much lower as compared to the yields on the older securities. As a result of these factors, as shown in Table 7, we experienced a decrease in the average yield on our securities from 39.4% for the nine months ended September 30, 2002 to 34.4% for the same period of

2003 and a decrease on our average yield on our securities from 35.0% for the three months ended September 30, 2002 to 33.3% for the three months ended September 30, 2003.

The overall dollar volume of interest income has increased because the size of our mortgage securities portfolio has increased significantly during the past nine months. As shown in Tables 7 and 8, the average value of our mortgage securities increased from $120.6 million during the nine months ended September 30, 2002 to $264.9 million during the nine months ended September 30, 2003. The average balance of mortgage loans collateralizing our securities increased from $1.9 billion to $3.7 billion during those periods. We expect to increase the amount of mortgage securities we own as we securitize the mortgage loans we originate.

As previously discussed, the trust that issues our interest-only securities owns interest rate agreements. These agreements reduce interest rate risk within the trust and, as a result, the cash flows we receive on our interest-only securities are less volatile as interest rates change.

Net interest income on loans in portfolio represents income on loans held-for-sale during their warehouse period as well as loans held-in-portfolio, which are maintained on our balance sheet as a result of the four securitization transactions we executed in 1997 and 1998. Net interest income before recovery of credit losses from loans in portfolio increased from $17.0 million and $6.3 million for the nine and three months ended September 30, 2002 to $31.4 million and $9.4 million for the same periods of 2003, respectively. The net interest income from loans in portfolio is primarily driven by loan volume and the amount of time held-for-sale loans are in the warehouse.

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

Table 7 is a summary of the interest income and expense related to our mortgage securities and the related yields as a percentage of the fair market value of these securities for the nine and three months ended September 30, 2003 and 2002.

Table 7 — Mortgage Securities Interest Analysis

(dollars in thousands)

	For the Nine Months Ended September 30,						For the Three Months Ended September 30,
	2003			2002			2003			2002
Average fair market value of mortgage securities	$	264,880		$	120,593		$	319,282		$	158,739
Average borrowings	$	204,934		$	77,126		$	248,838		$	94,229

Interest income	$	68,286		$	35,658		$	26,611		$	13,872
Interest expense		5,942			1,553			2,575			647

Net interest income	$	62,344		$	34,105		$	24,036		$	13,225

Yields:
Interest income		34.4	%		39.4	%		33.3	%		35.0	%
Interest expense		3.9			2.7			4.1			2.8

Net interest spread		30.5	%		36.7	%		29.2	%		32.2	%

Net Yield		31.4	%		37.7	%		30.1	%		33.3	%

All of NovaStar’s portfolio income comes from mortgage loans either directly (mortgage loans held-in-portfolio) or indirectly (mortgage securities). Table 8 attempts to look through the balance sheet presentation of the Company’s portfolio income and present income as a percentage of average assets under management. This metric allows the Company 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.

The net interest income for mortgage securities, mortgage loans held-for-sale and mortgage loans held-in-portfolio reflect the income after interest expense, hedging, servicing, prepayment penalty income and credit expense (mortgage insurance and provision to loss reserve). Table 8 shows the net yield in both assets under management and the return on assets during the nine and three months ended September 30, 2003 and 2002.

Table 8 — Loans Under Management Net Interest Income Analysis

(dollars in thousands)

	Mortgage Securities			Mortgage Loans Held-for- Sale			Mortgage Loans Held-in- Portfolio			Total
For the Nine Months Ended:
September 30, 2003
Interest Income	$	68,286		$	47,172		$	8,644		$	124,102
Interest Expense:
Short-term borrowings (A)		2,163			15,524			—			17,687
Asset-backed bonds		3,779			—			1,848			5,627
Cash flow hedging net settlements		—			2,124			4,961			7,085

Total Interest Expense		5,942			17,648			6,809			30,399

Net interest income before other income (expense)		62,344			29,524			1,835			93,703
Other income (expense) (B)		—			(7,391	)		170			(7,221	)

Net interest income	$	62,344		$	22,133		$	2,005		$	86,482

Average balance of the underlying loans	$	3,717,057		$	825,177		$	123,245		$	4,665,479
Net interest yield on assets		2.24	%		3.58	%		2.17	%		2.47	%


September 30, 2002
Interest Income	$	35,658		$	21,892		$	12,969		$	70,519
Interest Expense:
Short-term borrowings (A)		1,553			6,999			—			8,552
Asset-backed bonds		—			—			3,376			3,376
Cash flow hedging net settlements		—			1,071			6,378			7,449

Total Interest Expense		1,553			8,070			9,754			19,377

Net interest income before other income (expense)		34,105			13,822			3,215			51,142
Other income (expense) (B)		—			(10,019	)		(703	)		(10,722	)

Net interest income	$	34,105		$	3,803		$	2,512		$	40,420

Average balance of the underlying loans	$	1,949,195		$	324,781		$	180,910		$	2,454,886
Net interest yield on assets		2.33	%		1.56	%		1.85	%		2.20	%

(A)	Primarily includes mortgage loan and securities repurchase agreements.

(B)	Other income (expense) includes servicing expense, prepayment penalty income, net settlements on non-cash flow hedges and credit expense (mortgage insurance and provision to loss reserve).

	Mortgage Securities			Mortgage Loans Held-for- Sale			Mortgage Loans Held-in- Portfolio			Total
For the Three Months Ended:
September 30, 2003
Interest Income	$	26,611		$	14,551		$	2,628		$	43,790
Interest Expense:
Short-term borrowings (A)		794			5,002			—			5,796
Asset-backed bonds		1,781			—			478			2,259
Cash flow hedging net settlements		—			746			1,520			2,266

Total Interest Expense		2,575			5,748			1,998			10,321

Net interest income before other income (expense)		24,036			8,803			630			33,469
Other income (expense) (B)		—			(2,497	)		535			(1,962	)

Net interest income	$	24,036		$	6,306		$	1,165		$	31,507

Average balance of the underlying loans	$	4,751,484		$	770,687		$	109,118		$	5,631,289
Net interest yield on assets		2.02	%		3.27	%		4.27	%		2.24	%


September 30, 2002
Interest Income	$	13,872		$	8,827		$	3,861		$	26,560
Interest Expense:
Short-term borrowings (A)		647			2,703			—			3,350
Asset-backed bonds		—			—			1,008			1,008
Cash flow hedging net settlements		—			549			2,145			2,694

Total Interest Expense		647			3,252			3,153			7,052

Net interest income before other income (expense)		13,225			5,575			708			19,508
Other income (expense) (B)		—			(3,184	)		(21	)		(3,205	)

Net interest income	$	13,225		$	2,391		$	687		$	16,303

Average balance of the underlying loans	$	2,213,170		$	378,016		$	164,352		$	2,755,538
Net interest yield on assets		2.39	%		2.53	%		1.67	%		2.37	%

(A)	Primarily includes mortgage loan and securities repurchase agreements.

(B)	Other income (expense) includes servicing expense, prepayment penalty income, net settlements on non-cash flow hedges and credit expense (mortgage insurance and provision to loss reserve).

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 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 related to these agreements for the nine and three months ended September 30, 2003 of $7.1 million and $2.3 million, respectively, as compared to the nine and three months ended September 30, 2002 of $7.4 million and $2.7 million, respectively. Fluctuations in these expenses are solely dependent upon the movement in LIBOR as well as our average notional amount outstanding.

Recovery of Credit Losses

We originate and own loans in which the borrower possesses credit risk higher than that of conforming borrowers. Delinquent loans and losses are expected to occur. Provisions for credit losses are made in amounts considered necessary to maintain an allowance at a level sufficient to cover probable losses inherent in the loan portfolio. Charge-offs are recognized at the time of foreclosure by recording the value of real estate owned property at its estimated realizable value. One of the principal methods used to estimate expected losses is a delinquency migration analysis. This analysis takes into consideration historical information regarding foreclosure and loss severity experience and applies that information to the portfolio at the reporting date.

We use several techniques to mitigate credit losses including pre-funding audits by quality control personnel and in-depth appraisal reviews. Another loss mitigation technique allows a borrower to sell their

property for less than the outstanding loan balance prior to foreclosure in transactions known as short sales, when it is believed that the resulting loss is less than what would be realized through foreclosure. Loans are charged off in full when the cost of pursuing foreclosure and liquidation exceed recorded balances. While short sales have served to reduce the overall severity of losses incurred, they also accelerate the timing of losses. As discussed further under the caption “Premiums for Mortgage Loan Insurance”, lender paid mortgage insurance is also used as a means of managing credit risk exposure. Generally, the exposure to credit loss on insured loans is considered minimal. Management also believes aggressive servicing is an important element to managing credit risk.

During the nine months ended September 30, 2003 and 2002 we had recovery of credit losses of $1.1 million and $629,000 respectively and incurred net charge-offs of $478,000 and $1.6 million, respectively. A rollforward of the allowance for credit losses is presented in Table 9.

Table 9 — Quarterly Activity - Allowance for Credit Losses

(in thousands)

	2003									2002
	September 30			June 30			March 31			December 31			September 30			June 30			March 31
Beginning balance	$	2,444		$	2,827		$	3,036		$	3,312		$	4,014		$	5,343		$	5,557
Provision for credit losses (recoveries)		(875	)		(171	)		(92	)		197			(383	)		(379	)		133
Amounts charged off, net of recoveries		(149	)		(212	)		(117	)		(473	)		(319	)		(950	)		(347	)

Ending balance	$	1,420		$	2,444		$	2,827		$	3,036		$	3,312		$	4,014		$	5,343

Fee Income

Fee income primarily consists of fees from five sources: broker fees, loan origination fees, service fee income, branch management fees and prepayment penalty income.

Broker fees are paid by borrowers and other lenders for placing loans with third party investors (lenders) and are based on negotiated rates with each lender to whom we broker loans. Revenue is recognized upon loan origination.

Loan origination fees represent fees paid to us by borrowers and are associated with the origination of mortgage loans. Loan origination fees are determined based on the type and amount of loans originated. Loan origination fees and direct origination costs on mortgage loans held-in-portfolio are deferred and recognized over the life of the loan using the level yield method. Loan origination fees and direct origination costs on mortgage loans held-for-sale are deferred and considered as part of the carrying value of the loan when sold.

Service fees are paid to us by either the investor on mortgage loans serviced or the borrower. Fees paid by investors on loans serviced are determined as a percentage of the principal collected for the loans serviced and are recognized in the period in which payments on the loans are received. Fees paid by borrowers on loans serviced are considered ancillary fees related to loan servicing and include late fees, processing fees and, for loans held in portfolio, prepayment penalties. Revenue is recognized on fees received from borrowers when an event occurs that generates the fee and they are considered to be collectible.

Affiliated branch management fees are charged to affiliated mortgage brokers to manage their administrative operations, which include providing accounting, payroll, human resources, loan investor management and license management. The amount of the fees is agreed upon when entering a contractual agreement with affiliated mortgage brokers and are recognized as services are rendered.

Prepayment penalty income are the fees we require the borrower to pay if they pay off their loan early in the loan’s life, generally within two years of origination. This income serves to mitigate and offset prepayment risk and the amortization expense of premiums we paid to loan brokers. The penalty is generally six months of interest on 80% of the unpaid principal at prepayment. Prepayment penalty income was $289,000 and $34,000 during the nine and three months ended September 30, 2003, respectively, compared to $312,000 and $89,000 for the same period of 2002.

Fee income increased from $24.9 million and $10.1 million for the nine and three months ended September 30, 2002, respectively, to $52.7 million and $18.5 million for the same period of 2003 due to the following reasons:

•

Loans originated increased from $1.7 billion and $0.6 billion for the nine and three months ended September 30, 2002, respectively, to $4.4 billion and $1.8 billion for the same period of 2003.

•

Our servicing portfolio increased from $2.9 billion to $6.2 billion for the nine months ended September 30, 2002 and 2003, respectively.

•

The number of NHMI LLC branches increased from 176 in the third quarter 2002 to 411 in the third quarter 2003.

Gains on Sales of Mortgage Assets and Losses on Derivative Instruments

We execute securitization transactions in which we transfer mortgage loan collateral to an independent trust. The trust holds the mortgage loans as collateral for the securities it issues to finance the sale of the mortgage loans. In those transactions, certain securities are issued to entities unrelated to us, and we retain the interest-only 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 nine months ended September 30, 2003 and 2002. 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 11 provides a summary of mortgage loans sold outright and transferred in securitizations.

For mortgage loans transferred in securitizations and accounted for as sales, we allocate our basis in the mortgage loans between the portion of the mortgage loans sold and the retained assets, securities and servicing rights, based on the relative fair values of those portions at the time of sale. The values of these servicing assets are determined by discounting estimated future cash flows using the cash flow method. The weighted average assumptions used for the valuation of our retained assets at the time of securitization were a constant prepayment rate of 23, projected losses of 2.0% and a discount rate of 29%.

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. Changes in the fair value of these derivative instruments are credited or charged to current earnings. As interest rates decreased from December 31, 2002 to September 30, 2003, we recognized a loss of $32.3 million, reflective of the corresponding decrease in fair value of these non-hedge derivative instruments.

Table 10 provides the components of our gains on sales of mortgage assets and losses on derivative instruments.

Table 10 — Gains on Sales of Mortgage Assets and Losses on Derivative Instruments

(dollars in thousands)

	For the Nine Months Ended September 30,						For the Three Months Ended September 30,
	2003			2002			2003			2002
Gains on sales of mortgage loans transferred in securitizations	$	99,198		$	35,433		$	32,853		$	16,893
Gains on sales of mortgage loans to third parties – nonconforming		3,404			2,235			428			(151	)
Gains on sales of mortgage loans to third parties – conforming		6,743			934			1,591			781
Losses on sales of real estate owned		(1,683	)		(686	)		(684	)		(230	)

Gains on sales of mortgage assets		107,662			37,916			34,188			17,293
Losses on derivatives		(32,330	)		(30,313	)		(8,144	)		(16,167	)

Net gains on sales of mortgage assets and derivative instruments	$	75,332		$	7,603		$	26,044		$	1,126

Table 11 — Quarterly Mortgage Loan Sales (A)

(dollars in thousands)

	Outright Mortgage Loan Sales
	Principal Amount		Percent of Total Sales		Net Gain (Loss) Recognized			Weighted Average Price To Par
2003:
Third quarter	$	27,085	2.1	%	$	428		102.7
Second quarter		12,057	0.9			101		105.3
First quarter		112,068	9.4			2,875		104.3

Total	$	151,210	4.0	%	$	3,404		104.1

2002:
Fourth quarter	$	986	0.3	%	$	64		102.5
Third quarter		13,727	3.3			(151	)	100.2
Second quarter		80,421	16.2			1,332		103.0
First quarter		47,025	10.6			1,054		103.5

Total	$	142,159	8.4	%	$	2,299		102.9

	Mortgage Loans Transferred in Securitizations
									Assumptions Underlying Initial Value of Mortgage Securities
	Principal Amount		Percent of Total Sales		Net Gain Recognized		Initial Value of Mortgage Securities		Constant Prepayment Rate	Discount Rate		Expected Total Credit Losses, Net of Mortgage Insurance
2003:
Third quarter	$	1,251,016	97.9	%	$	32,853	$	73,798	20	33	%	2.83	%
Second quarter		1,314,733	99.1			41,389		73,273	21	36		2.68
First quarter		1,084,906	90.6			24,956		69,740	21	30		2.40

Total	$	3,650,655	96.0	%	$	99,198	$	216,811	21	33	%	2.65	%

2002:
Fourth quarter	$	346,043	99.7	%	$	12,461	$	18,415	22	30	%	1.00	%
Third quarter		403,960	96.7			16,893		21,498	22	30		1.00
Second quarter		414,874	83.8			14,959		29,048	25	30		1.61
First quarter		395,124	89.4			3,581		23,942	28	30		1.65

Total	$	1,560,001	91.6	%	$	47,894	$	92,903	24	30	%	1.33	%

(A)	Does not include conforming loan sales.

Premiums for Mortgage Loan Insurance

The use of mortgage insurance is one method of managing the credit risk in the mortgage asset portfolio. Premiums for mortgage insurance on loans maintained on our balance sheet are paid by us and are recorded as a portfolio cost and included in the income statement under the caption “Premiums for Mortgage Loan Insurance”. These premiums totaled $2.7 million and $653,000 for the nine and three months ended September 30, 2003, respectively, compared with $1.7 million and $595,000 for the same period of 2002. We received mortgage insurance proceeds on claims filed of $1.4 million and $1.8 million during the first nine months of 2003 and 2002, respectively.

Many of the mortgage loans that serve as collateral for our mortgage securities 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 and securitize mortgage loans. The percentage of loans with mortgage insurance has decreased in 2003 and generally should be near 50% in the future. For the 2003-1, 2003-2 and 2003-3 securitizations, the mortgage loans that were transferred into the trusts had mortgage insurance coverage at the time of transfer of 63%, 52% and 45%, respectively. We have the risk that mortgage insurance providers will revise their guidelines to an extent where we will no longer be able to acquire coverage on all of our new production. Similarly, the providers may also increase insurance premiums to a point where the cost of coverage outweighs its benefit. We monitor the mortgage insurance market and currently anticipate being able to obtain affordable coverage on a substantial portion of our future production to the extent we deem it is warranted.

General and Administrative Expenses

Compensation and benefits includes employee base salaries, benefit costs and incentive compensation awards. Professional and outside services include fees for legal and accounting services. In the normal course of business, fees are incurred for professional services related to general corporate matters and specific transactions. Office administration includes items such as rent, depreciation, telephone, office supplies, postage, delivery, maintenance and repairs.

The increase in general and administrative expenses from $54.6 million and $19.7 million during the nine and three months ended September 30, 2002, respectively, to $137.4 million and $48.3 million for the same period in 2003 is attributable to our new conforming and retail lines of businesses, growth in our wholesale business and our expanding servicing operations. As a result of this growth, we employed 1,410 people as of September 30, 2003, compared with 732 as of September 30, 2002. Note 6 to the consolidated financial statements presents a condensed income statement for our three segments, detailing our expenses by segment.

The loan costs of production table below includes all costs paid and fees collected during the 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. Increased efficiencies in the non-conforming lending operation correlate to lower general and administrative costs and higher interest income and gain on sales of mortgage assets.

Table 12 — Wholesale Loan Costs of Production, as a Percent of Principal

	Gross Loan Production	Premium Paid to Broker, Net of Fees Collected	Total Acquisition Cost
2003:
Third quarter.	1.59	0.61	2.20
Second quarter.	1.71	0.72	2.43
First quarter.	1.85	0.75	2.60

2002:
Fourth quarter.	1.74	0.92	2.66
Third quarter.	2.03	0.86	2.89
Second quarter.	2.13	0.58	2.71
First quarter.	2.01	0.61	2.62

Mortgage Loan Servicing

Loan servicing is a critical part of our business. In the opinion of management, maintaining contact with borrowers is vital in managing credit risk and in borrower retention. Non-conforming borrowers are prone to late payments and are more likely to default on their obligations than conventional borrowers. We strive to identify issues and trends with borrowers early and take quick action to address such matters. Our nine and three month annualized costs of servicing per unit decreased from $320 and $369 for the respective periods ended September 30, 2002 to $282 and $308 for the same periods of 2003.

Table 13 — Summary of Servicing Operations

(dollars in thousands except per loan cost)

	2003
	September 30					June 30					March 31
	Amount			%		Amount			%		Amount			%
Unpaid principal	$	6,161,345				$	5,145,005				$	4,212,986

Number of loans		46,692					39,452					32,835

Servicing income, net of amortization of mortgage servicing rights	$	2,711		0.18		$	2,675		0.21		$	2,536		0.24
Costs of servicing		3,591		0.23			3,108		0.24			3,178		0.30

Net servicing income	$	(880	)	(0.05	)	$	(433	)	(0.03	)	$	(642	)	(0.06	)

Annualized costs of servicing per unit	$	308				$	315				$	387

	2002
	December 31			September 30			June 30				March 31
	Amount		%	Amount		%	Amount			%	Amount		%
Unpaid principal	$	3,657,640		$	2,911,263		$	2,558,407			$	2,307,620

Number of loans		28,849			23,757			21,379				19,593

Servicing income, net of amortization of mortgage servicing rights	$	2,478	0.27	$	2,261	0.31	$	1,773		0.28	$	1,675	0.29
Costs of servicing		2,181	0.24		2,194	0.30		1,791		0.28		1,538	0.27

Net servicing income	$	297	0.03	$	67	0.01	$	(18	)	0.00	$	137	0.02

Annualized costs of servicing per unit	$	302		$	369		$	335			$	314

Branches

We operate our mortgage brokerage unit under the name NovaStar Home Mortgage, Inc. (NHMI). Branch operations (offices) are divided into two groups: 1) branches operating under NHMI, and 2) branches operating as separate companies with an administrative relationship with NHMI, identified as NHMI LLC (Limited Liability Company) branches.

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. NHMI branches are included in the NovaStar Financial consolidated financial statements.

LLC branches are established through LLC agreements entered into between solicited brokers and NHMI. The LLC agreements provide for initial capitalization and membership interests of 99.9% to the broker (branch manager) and 0.1% to NHMI. NHMI provides accounting, payroll, human resources, loan investor management and license management in conjunction with separate contractual agreements. We account for our minority interest in the LLC agreements using the equity method of accounting.

As of September 30, 2003 there were a total of 420 active branches, 9 of these were NHMI branches and 411 were NHMI LLC branches. As of September 30, 2002 there were a total of 184 active branches, 8 of these were NHMI branches and 176 were NHMI LLC branches.

The NHMI and LLC branch offices offer conforming and non-conforming loans to potential borrowers. Loans are brokered for approved investors, including NovaStar Mortgage, Inc. (NMI). Of the $4.4 billion and $1.7 billion loans NMI originated, 28% and 19% were brokered from the branches during the nine months ended September 30, 2003 and 2002, respectively.

Income Taxes

NovaStar Financial, Inc. intends to operate and qualify as a Real Estate Investment Trust (REIT) under the requirements of the Internal Revenue Code. Therefore, it will generally not be subject to federal income taxes at the corporate level on taxable income distributed to stockholders. Requirements for qualification as a REIT include various restrictions on common stock ownership and the nature of the assets and sources of income.

Below is a summary of the taxable net income available to common shareholders for the nine and three months ended September 30, 2003 and 2002.

Table 14 — Estimated Taxable Net Income

(dollars in thousands)

	For the Nine Months Ended September 30,						For the Three Months Ended September 30,
	2003			2002			2003			2002
Consolidated net income	$	69,714		$	31,510		$	24,273		$	12,199
Equity in net (income) loss of NFI Holding Corp.		(16,639	)		9,610			(6,575	)		5,687

REIT GAAP income		53,075			41,120			17,698			17,886
Adjustments to GAAP income		39,374			(16,304	)		14,486			(2,279	)

Estimated taxable net income		92,449			24,816			32,184			15,607

Estimated taxable net income per common shareholder	$	8.10		$	2.38		$	2.81		$	1.50

Dividends declared per common shareholder	$	7.58	(A)	$	2.70		$	2.50		$	1.00

(A)	On January 29, 2003, a $0.33 special dividend related to 2002 taxable income was declared per common share.

Adjustments to GAAP income are the permanent and temporary differences between income and expense recognition for GAAP purposes and income and expense recognition for tax purposes. A primary component of these adjustments is the temporary difference in the rate of income recognition on our mortgage securities. Examples of other components include permanent and temporary differences caused by derivative market value adjustments and stock compensation expense.

NFI Holding Corporation, a wholly owned subsidiary of NovaStar Financial, Inc., has not elected REIT-status and files a consolidated federal income tax return with its subsidiaries. NFI Holding Corporation reported net income (loss) before income taxes of $30.8 million and $(11.8) million for the nine months ended September 30, 2003 and 2002, respectively. As shown in our statement of income, this resulted in income tax expense (benefit) of $14.2 million and $(2.2) million for the nine months ended September 30, 2003 and 2002, respectively.

Liquidity and Capital Resources

Liquidity means the need for, access to and uses of cash. Our primary needs for cash include the acquisition of mortgage loans, principal repayment and interest on borrowings, operating expenses and dividend payments. Substantial cash is required to support the operating activities of the business,

especially the mortgage origination operation. Mortgage asset sales, principal, interest and fees collected on mortgage assets support cash needs. Drawing upon various borrowing arrangements typically satisfies major cash requirements. As shown in Table 4, we have $80.1 million in immediately available funds, including $70.1 million in cash.

Mortgage lending requires significant cash to fund loan originations. 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 other cash inflows. We use operating cash inflow in the form of cash flow from mortgage securities, principal and interest on mortgage loans and fee income to support loan originations. In addition, proceeds from equity offerings have been used to support operations. Our immediately available funds would support funding more than $4.0 billion in loans, assuming no other demands on cash and assuming a 2% “haircut”.

Loans financed with warehouse and repurchase credit facilities are subject to changing market valuation and margin calls. The market value of our loans is dependent on a variety of economic conditions, including interest rates (and borrower demand) and end investor desire and capacity. Market values have been consistent over the past three years. However, there is no certainty that the prices will remain constant. To the extent the value of the loans declines significantly, we would be required to repay portions of the amounts we have borrowed. The value of our “recourse” loans (classified as held-for-sale) as of September 30, 2003 would need to decline by more than 9% before we would use all immediately available funds, assuming no other constraints on our immediately available funds.

We have no recourse for loans financed with asset-backed bonds and, 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 required us to post margin deposits with them. As of September 30, 2003, we have approximately $26.6 million on deposit. Further declining 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 on loans and securities.

Loans we originate 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 its production infrastructure.

Cash activity during the nine months ended September 30, 2003 and 2002 is presented in the consolidated statement of cash flows.

As noted above, proceeds from equity offerings have supported our operations. Since inception, we have raised $168 million in net proceeds through private and public equity offerings. Equity offerings provide another avenue as a future liquidity source.

Off Balance Sheet Arrangements

As discussed previously, we pool the loans we originate and 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 affect our ability to continue to use this arrangement would be those factors that could disrupt the securitization capital market. A disruption in the market could prevent us from being able to sell the securities at a favorable price, or at all. Factors that could disrupt the securitization market include an international liquidity crisis such as occurred in the fall of 1998, a terrorist

attack, outbreak of war or other significant event risk, and market specific events such as a default of a comparable type of securitization. If we were unable to access the securitization market, we may still be able to finance our mortgage operations by selling our loans to investors in the whole loan market. We were able to do this following the liquidity crisis in 1998.

Specific items that may affect our ability to use the securitizations to finance our loans relate primarily to the performance of the loans that have been securitized. Extremely poor loan performance may lead to poor bond performance and investor unwillingness to buy bonds supported by our collateral. Our financial performance and condition has little impact on our ability to securitize, as evidenced by our ability to securitize in 1998, 1999 and 2000 when our financial trend was weak.

We have commitments to borrowers to fund residential mortgage loans as well as commitments to purchase and sell mortgage loans to third parties. As commitments to originate, purchase and sell non-conforming loans are not readily convertible to cash and cannot readily be settled net, these commitments do not meet the definition of a derivative under accounting principles generally accepted in the United States of America. Accordingly, they are not recorded in the consolidated financial statements. As of September 30, 2003, we had outstanding commitments to originate loans of $270 million. We had no commitments to sell or purchase loans at September 30, 2003.

On September 16, 2003, we executed a securitization transaction accounted for as a sale of loans. We delivered $850.5 million in loans collateralizing NMFT Series 2003-3 (see Note 3). As of September 30, 2003, we had committed to deliver an additional $649.5 million in loans collateralizing NMFT Series 2003-3, which are scheduled to be delivered by December 12, 2003.

Contractual Obligations

We have entered into certain long-term debt and lease agreements, which obligate us to make future payments to satisfy the related contractual obligations. The following table summarizes our contractual obligations with regard to our long-term debt and lease agreements as of September 30, 2003.

Table 15 — Contractual Obligations

(dollars in thousands)

	Payments Due by Period
Contractual Obligations	Total		Less than 1 Year		1-3 Years		4-5 Years		After 5 Years
Short-term borrowings	$	960,984	$	960,984		—		—		—
Long-term debt (A)	$	163,606	$	112,230	$	31,898	$	11,877	$	7,601
Operating leases	$	29,706	$	6,543	$	9,759	$	8,889	$	4,515

(A)	Repayment of the asset-backed bonds is dependent upon payment of the underlying mortgage loans, which collateralize the debt. The repayment of these mortgage loans is affected by prepayments.

Inflation

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

Impact of Recently Issued Accounting Pronouncements

In May 2003, the FASB issued SFAS No. 149, “Amendments of Statement 133 on Derivative Instruments and Hedging Activities.” This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS 133. This statement is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. SFAS 133 Implementation Issues that are effective for fiscal quarters beginning prior to June 15, 2003 will continue to be effective based on their respective effective dates, and the paragraphs relating to forward purchases or sales of “when issued” or other securities that do not yet exist would be applicable to both existing transactions as well as new transactions entered into after June 30, 2003. The Company does not expect the adoption of SFAS No. 149 to have a significant impact on its consolidated financial statements.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” This statement establishes standards for how an issuer classifies and measures certain financial instruments that are within its scope as a liability (or an asset in some circumstances). This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatorily redeemable financial instruments of nonpublic entities. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of Company’s second quarter consolidated financial statements. The Company’s adoption of SFAS No. 150 did not have a significant impact on its consolidated financial statements.

Note 1 of the consolidated financial statements contained in the annual report on Form 10-K for the fiscal year ended December 31, 2002 describes certain recently issued accounting pronouncements. Management believes the implementation of these pronouncements and others that have gone into effect since the date of these reports will not have a material impact on the consolidated financial statements.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate/Market Risk

Our investment policy sets the following general goals:

(1)

Maintain the net interest margin between assets and liabilities, and

(2)

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

Loan Price Volatility. Under our current mode of operation, we depend heavily on the market for wholesale non-conforming mortgage loans. To conserve capital, we may sell loans we originate. To the extent loans are sold, financial results will depend, in part, on the ability to find purchasers for the loans at prices that cover origination expenses. Exposure to loan price volatility is reduced as mortgage loans are acquired and retained rather than sold.

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

Management primarily uses financing sources where the interest rate resets frequently. As of September 30, 2003, borrowings under all financing arrangements adjust daily or monthly. On the other hand, very few of the mortgage assets we own, adjust on a monthly or daily basis. Most of the mortgage loans contain features where their rates are fixed for some period of time and then adjust frequently thereafter. For example, one of our loan products is the “2/28” loan. This loan is fixed for its first two years and then adjusts every six months thereafter.

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

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

The following are summaries of the analysis.

Table 16 - Interest Rate Sensitivity-Income

(dollars in thousands)

	Basis Point Increase (Decrease) in Interest Rate (A)
	(200)(C)	(100)			Base			100			200
As of September 30, 2003:
Interest margin	N/A	$	292,842		$	253,248		$	210,574		$	166,087
Expense from interest rate agreements	N/A		(68,522	)		(41,342	)		(13,025	)		16,117

Net interest income	N/A	$	224,320		$	211,906		$	197,549		$	182,204

Percent change in net interest income from base	N/A		5.9	%		—			(6.8	)%		(14.0	)%

Percent change of capital (B)	N/A		5.0	%		—			(5.8	)%		(11.9	)%


As of December 31, 2002:
Interest margin	N/A	$	168,379		$	150,150		$	130,828		$	109,984
Expense from interest rate agreements	N/A		(42,284	)		(32,949	)		(20,573	)		(6,060	)

Net interest income	N/A	$	126,095		$	117,201		$	110,255		$	103,924

Percent change in net interest income from base	N/A		7.6	%		—			(5.9	)%		(11.3	)%

Percent change of capital (B)	N/A		4.9	%		—			(3.8	)%		(7.2	)%

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

(B)	Total change in estimated spread income as a percent of total stockholders’ equity as of September 30, 2003 and December 31, 2002.

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

Table 17 - Interest Rate Sensitivity—Market Value

(dollars in thousands)

	Basis Point Increase (Decrease) in Interest Rate(A)
	(200)(C)	(100)			100			200
As of September 30, 2003:
Change in market values of:
Assets	N/A	$	81,369		$	(116,346	)	$	(261,543	)
Liabilities	N/A		(4,245	)		5,204			10,665
Interest rate agreements	N/A		(86,230	)		94,966			202,999

Cumulative change in market value	N/A	$	(9,106	)	$	(16,176	)	$	(47,879	)

Percent change of market value portfolio equity (B)	N/A		(3.2	)%		(5.7	)%		(17.0	)%

As of December 31, 2002:
Change in market values of:
Assets	N/A	$	16,449		$	(49,343	)	$	(119,232	)
Liabilities	N/A		(2,311	)		2,451			4,969
Interest rate agreements	N/A		(36,249	)		37,930			76,873

Cumulative change in market value	N/A	$	(22,111	)	$	(8,962	)	$	(37,390	)

Percent change of market value portfolio equity (B)	N/A		(10.9	)%		(4.4	)%		(18.4	)%

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

(B)	Total change in estimated market value as a percent of market value portfolio equity as of September 30, 2003 and December 31, 2002.

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

Interest Rate Sensitivity Analysis. The values under the heading “Base” are management’s estimates of spread income for assets, liabilities and interest rate agreements on September 30, 2003 and December 31, 2002. The values under the headings “100”, “200”, “(100)” and “(200)” are management’s estimates of the income and change in market value of those same assets, liabilities and interest rate agreements assuming that interest rates were 100 and 200 basis points, or 1 and 2 percent higher and lower. The cumulative change in income or market value represents the change in income or market value of assets, net of the change in income or market value of liabilities and interest rate agreements.

The interest sensitivity analysis is prepared monthly. If the analysis demonstrates that a 100 basis point shift, up or down, in interest rates would result in a 25% or more cumulative decrease in income from base, or a 10% cumulative decrease in market value from base, policy requires management to adjust the portfolio

by adding or removing interest rate cap or swap agreements. The Board of Directors reviews and approves our interest rate sensitivity and hedged position quarterly. Although management also evaluates the portfolio using interest rate increases and decreases less than and greater than one percent, management focuses on the one percent increase.

Assumptions Used in Interest Rate Sensitivity Analysis. Management uses a variety of estimates and assumptions in determining the income and market value of assets, liabilities and interest rate agreements. The estimates and assumptions have a significant impact on the results of the interest rate sensitivity analysis, the results of which are shown as of September 30, 2003.

Management’s analysis for assessing interest rate sensitivity on its mortgage loans relies significantly on estimates for prepayment speeds. A prepayment model has been internally developed based upon four main factors:

•

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

•

Borrower credit grades

•

Loan-to-value ratios

•

Prepayment penalties, if any

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

These factors are weighted based on management’s experience and an evaluation of the important trends observed in the non-conforming mortgage origination industry. Actual results may differ from the estimates and assumptions used in the model and the projected results as shown in the sensitivity analyses.

Projected prepayment rates in each interest rate scenario start at a prepayment speed less than 5% in month one and increase to a long-term prepayment speed in nine to 18 months, to account for the seasoning of the loans. The long-term prepayment speed ranges from 20% to 40% and depends on the characteristics of the loan which include type of product (ARM or fixed rate), note rate, credit grade, loan to value, gross margin, weighted average maturity and lifetime and periodic caps and floors. This prepayment curve is also multiplied by a factor of 60% on average for periods when a prepayment penalty is in effect on the loan. Prepayment assumptions are also multiplied by a factor of greater than 100% during periods around rate resets and prepayment penalty expirations. These assumptions change with levels of interest rates.

As discussed above, actual prepayment rates on loans that have been held in portfolio for shorter periods are slower than long-term prepayment rates used in the interest rate sensitivity analysis. Also, as pools of loans held in portfolio season, the actual prepayment rates are more consistent with the long-term prepayment rates used in the interest sensitivity analysis.

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

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

Interest rate cap agreements are legal contracts between us and a third party firm or “counter-party”. The counter-party agrees to make payments to us in the future should the one- or three-month LIBOR interest rate rise above the strike rate specified in the contract. We make either quarterly premium payments or have chosen to pay the premiums at the beginning to the counterparties under contract. Each contract has a fixed notional face amount on which the interest is computed, and a set term to maturity. When the

referenced LIBOR interest rate rises above the contractual strike rate, we earn cap income. Payments on an annualized basis equal the contractual notional face amount times the difference between actual LIBOR and the strike rate. Interest rate swaps have similar characteristics. However, interest rate swap agreements allow us to pay a fixed rate of interest while receiving a rate that adjusts with one-month LIBOR.

Item 4. Controls and Procedures

Disclosure Controls and Procedures. The undersigned principal executive officer and principal financial officer of NovaStar Financial, Inc. conclude that NovaStar Financial, Inc.’s disclosure controls and procedures are effective as of September 30, 2003 based on their evaluation of these controls and procedures required by paragraph (b) of Exchange Act Rule 13a-15.

Changes in Internal Control over Financial Reporting. There has been no change in NovaStar Financial, Inc.’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rule 13a-15 that occurred during the quarter ended September 30, 2003 that has materially affected, or is reasonably likely to materially affect, NovaStar Financial, Inc.’s internal control over financial reporting.

(a) PART II. OTHER INFORMATION

Item 1. Legal Proceedings

As of September 30, 2003, there were no material legal proceedings pending to which we were a party or of which any of our property was subject.

Item 2. Changes in Securities and Use of Proceeds

Not applicable

Item 3. Defaults upon Senior Securities

Not applicable

Item 4. Submission of Matters of Vote of Security Holders

Not applicable

Item 5. Other Information

None

Item 6. Exhibits and Reports on Form 8-K

(a)	Exhibit Listing

Exhibit No.		Description of Document

3.1*		Articles of Amendment and Restatement of the Registrant

3.2*		Articles Supplementary of the Registrant

3.3*		Bylaws of the Registrant

3.3a***		Amendment to Bylaws of the Registrant, adopted February 2, 2000

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

*	Incorporated by reference to the correspondingly numbered exhibit to the Registration Statement on Form S-11 (373-32327) filed by the Registrant with the SEC on July 29 1997, as amended.

**	Incorporated by reference to the correspondingly numbered exhibit to Form 8-K filed by the Registrant with the SEC on April 5, 1999.

***	Incorporated by reference to the correspondingly numbered exhibit to Annual Report on Form 10-K filed by the Registrant with the SEC on March 20, 2000.

(b)	NovaStar Financial filed the following Form 8-K’s during the three months ended September 30, 2003.

Press Release, dated July 30, 2003 “Novastar Announces Record Earnings Per Share of $2.06 And Dividend of $2.50 For Second Quarter of 2003”. Current report on Form 8-K was filed on August 1, 2003.

NOVASTAR FINANCIAL, INC.

SIGNATURES

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

NOVASTAR FINANCIAL, INC.

DATE: November 3, 2003		/s/ Scott F. Hartman
		Scott F. Hartman
		Chairman of the Board, Secretary and
		Chief Executive Officer

DATE: November 3, 2003		/s/ Rodney E. Schwatken
		Rodney E. Schwatken
		Vice President, Treasurer and Controller
		(Principal Financial Officer)