NOVATION COMPANIES, INC. - Quarter Report: 2007 September (Form 10-Q)

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the Quarterly Period Ended September 30, 2007

For the Transition Period From              to             

Commission File Number 001-13533

NOVASTAR FINANCIAL, INC.

(Exact Name of Registrant as Specified in its Charter)

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

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

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

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

The number of shares of the Registrant’s Common Stock outstanding on October 31, 2007 was 9,440,442.

Table of Contents

NOVASTAR FINANCIAL, INC.

FORM 10-Q

For the Quarterly Period Ended September 30, 2007

TABLE OF CONTENTS

Table of Contents

PART I. FINANCIAL INFORMATION

NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited; dollars in thousands, except share amounts)

See notes to condensed consolidated financial statements.

1

Table of Contents

NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

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

See notes to condensed consolidated financial statements.

2

Table of Contents

NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ (DEFICIT) EQUITY

(unaudited; dollars in thousands, except share amounts)

See notes to condensed consolidated financial statements.

3

Table of Contents

NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited; in thousands)

(Continued)

4

Table of Contents

(Continued)

5

Table of Contents

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

(unaudited; in thousands)

See notes to condensed consolidated financial statements.

6

Table of Contents

NOVASTAR FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2007 (Unaudited)

Note 1. Financial Statement Presentation

NovaStar Financial, Inc. and its subsidiaries (the “Company”) operate as a non-conforming residential mortgage portfolio manager and retail broker of mortgage loans. Prior to changes in its business in the third quarter of 2007, the Company originated, purchased, securitized, sold, invested in and serviced residential nonconforming mortgage loans and mortgage backed securities. The Company retained, through its mortgage securities investment portfolio, significant interests in the nonconforming loans it originated and purchased, and through its servicing platform, serviced all of the loans in which it retained interests. Historically, the Company had elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (“the Code”). During the third quarter of 2007, the Company announced that it will not be able to pay a dividend on its common stock with respect to its 2006 taxable income, and as a result the Company’s status as a REIT terminated, retroactive to January 1, 2006. This retroactive revocation of the Company’s REIT status results in it becoming taxable as a C corporation for 2006 and subsequent years.

The Company’s condensed consolidated financial statements as of September 30, 2007 and for the nine and three months ended September 30, 2007 and 2006 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 condensed consolidated financial statements. Reclassifications to prior year amounts have been made to conform to current year presentation, as follows:

The Company undertook these Third Quarter Exit Plans to align its organization and costs with its decision to discontinue its wholesale and correspondent loan origination activities and significantly reduce its retail operations. Implementation of the Third Quarter Exit Plans began during the third quarter of 2007 and subject to completion of the necessary legal notices and requirements is expected to conclude during the fourth quarter of 2007. The Company maintained four of its retail branches and has refocused the retail channel business model from originator to broker. The Company considers an operating unit to be discontinued upon its termination date, which is the point in time when the operations cease. The provisions of SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), require the results of operations associated with those operating units terminated to be classified as discontinued operations and segregated from the Company’s continuing results of operations for all periods presented. In accordance with Statement SFAS 144, the Company has reclassified the operating results of its entire wholesale and correspondent operations and certain of its retail operations as discontinued operations in the condensed consolidated statements of operations for the nine and three months ended September 30, 2007 and 2006.

7

Table of Contents

The Company’s condensed consolidated financial statements should be read in conjunction with the consolidated financial statements of the Company and the notes thereto, included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2006.

The condensed consolidated financial statements of the Company include the accounts of all wholly-owned subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation. Interim results are not necessarily indicative of results for a full year.

The accompanying consolidated financial statements have been prepared on a going concern basis of accounting which contemplates continuity of operations, realization of assets, liabilities, and commitments in the normal course of business. The accompanying financial statements do not reflect any adjustments that might result if the Company is unable to continue as a going concern.

The Company’s losses, negative cash flows from operations and its shareholders’ deficit raise substantial doubt about the Company’s ability to continue as a going concern and the appropriateness of using the going concern basis, which is dependent upon, among other things, the maintenance of sufficient operating cash flows. There is no assurance that cash flows will be sufficient to meet the Company’s obligations. See the discussion below concerning the Company’s plans.

Significant Liquidity Factors During the Nine Months Ended September 30, 2007

The Company had $51.5 million in unrestricted cash and cash equivalents at September 30, 2007, which was a decrease of $99.0 million from December 31, 2006. The $51.5 million includes $18.5 million of funds which were repaid to Wachovia Bank, N.A., Wachovia Investment Holdings, LLC and Wachovia Capital Markets, LLC (collectively “Wachovia”) during the first two business days of October. The Company no longer discloses that it has any borrowing availability under its financing facilities because any future availability is at the sole discretion of Wachovia and there can be no assurance that Wachovia will provide additional advances to the Company. See “Wachovia Short-Term Borrowings Repayment” for further discussion.

Sale of Mortgage Servicing Rights. On October 12, 2007, the Company, and Saxon Mortgage Services, Inc. (“Saxon”) entered into a Servicing Rights Transfer Agreement (the “MSR Transfer Agreement”) for the sale to Saxon of all of the Company’s mortgage servicing rights and servicing advances relating to its securitizations. The transaction closed on November 1, 2007 and provided $147.0 million of cash to the Company after deduction of certain expenses. An additional $7.9 million is expected to be released upon the delivery of all closing documents. The Company retained $21.5 million of the proceeds from the sale and used the remaining proceeds to payoff its outstanding debt with Deutsche Bank and significantly paydown its short-term borrowings with Wachovia. The Deutsche Bank Servicing Advance Facility and the Wachovia Servicing Rights Facility terminated as a result of the satisfaction of all obligations thereunder upon the closing of the sale of the Company’s mortgage servicing rights. The $7.9 million holdback is expected to be paid to Wachovia upon its release to reduce outstanding borrowings.

The Company has traditionally utilized its role as servicer of its securitized pools of mortgage loans to attempt to identify and address potential and actual borrower delinquencies and defaults. As a result of the sale, the Company no longer controls the lender-borrower relationship, which may exacerbate the increase in delinquencies and defaults under such mortgage loans and the negative impact on the value and cash flows of its residual and subordinated securities resulting from such delinquencies and defaults.

Wachovia Short-Term Borrowings Repayment. As of September 30, 2007, the Company was out of compliance with the net worth covenant in its repurchase agreements with Wachovia but has obtained a waiver to be in compliance. The waiver expires on November 30, 2007. The Company expects to be out of compliance with the net worth covenant subsequent to November 30, 2007 and there can be no assurance that the Company will be able to obtain additional waivers or amendments. If the Company cannot obtain additional waivers or amendments, there can be no assurance Wachovia would not issue an event of default and cause the outstanding borrowings to become due and payable immediately which also could cause the Company to file bankruptcy.

The Company has made it a priority to repay its outstanding borrowings with Wachovia and has been selling its mortgage assets to generate cash to repay these borrowings. The Company’s plan is to continue to use available cash inflows in excess of its immediate operating needs, including debt service payments, to repay all of Wachovia’s outstanding borrowings and any remaining fees due under the repurchase agreements at the earliest practical date. As of November 13, 2007, the Company had $83.9 million of short-term borrowings outstanding with Wachovia and still owed approximately $11.8 million in commitment fees. The cash flows which the Company will use to repay Wachovia will most likely be generated from the following sources:

8

Table of Contents

While the Company believes that it can successfully repay Wachovia in a manner that is to Wachovia’s satisfaction, there can be no assurance the Company will be able to generate the cash flows needed to meet Wachovia’s repayment expectations. During and after this period of repayment, any new advances or availability provided to the Company will be at Wachovia’s sole discretion and there can be no assurance of any future advances or availability under the Wachovia facilities. As a result, any unforeseen adverse liquidity events could cause the Company to exhaust its cash balances and may result in the Company filing bankruptcy. Additionally, if the Company were unable to repay Wachovia to their satisfaction, there can be no assurance Wachovia would not issue an event of default and cause the outstanding borrowings to become due and payable immediately which also could cause the Company to file bankruptcy.

Other Significant Cash and Availability Events. As a result of the 2007 subprime environment, the Company used up significant cash reserves during the nine months ended September 30, 2007. The Company’s cash balances declined by approximately $99.0 million during the nine months ended September 30, 2007 primarily due to the following events:

During the nine months ended September 30, 2007, poor credit performance of subprime loans and wider bond spreads on mortgage-backed securities caused a significant decline in the fair value of the Company’s mortgage securities as well as its mortgage loans held-for-sale. Consequently, during the nine and three months ended September 30, 2007, the Company was subject to cash margin calls of approximately $138.0 million and $57.7 million, respectively, on the Company’s mortgage securities and mortgage loans held-for-sale. The Company could continue to be subject to additional margin calls if the value of its mortgage assets declines further. In October 2007, the Company was subject to an additional $26.5 million margin call on its mortgage loans and securities by Wachovia. The Company satisfied the margin call by using its availability under the Mortgage Servicing Rights and Residual Securities facilities. There is no assurance that if the Company is subject to additional margin calls that it will be able to satisfy them. If the Company is unable to satisfy them it may be forced to file bankruptcy.

The Company had invested approximately $68.8 million and $40.4 million of cash in its mortgage loans held-for-sale on its balance sheet as of September 30, 2007 and December 31, 2006, respectively, which consists of the difference between the current principal on the loans and the lending value assigned to the loans by the Company’s lenders. Also contributing to this investment of cash is the fact that the Company is financing a larger balance of delinquent mortgage loans which have a lower lending value and consequently require a larger cash investment by the Company because the amount the Company can borrow against these assets is very low.

The Company also had significant cash outlays in 2007 to repurchase loans sold to third parties during 2006. When whole pools of mortgage loans are sold as opposed to securitized, the third party has recourse against the Company for certain borrower defaults. The cash the Company must have on hand to repurchase these loans is much higher than the principal amount of the loan as the Company generally must reimburse the investor for the remaining unpaid principal balance, any premium recapture, any unpaid accrued interest and any other out-of-pocket advances in accordance with the loan sale agreement. Typically, repurchased loans have subsequently been financed on the Company’s warehouse repurchase agreements if eligible and then liquidated or sold. The Company paid $104.3 million in cash during the nine months ended September 30, 2007 to repurchase loans sold to third parties. Significant capital is tied up in these assets as the lending values assigned to these assets is usually much lower than newly originated loans and some may not be eligible for financing. There can be no assurance that the Company will have cash or financing available for further loan repurchases.

The Company closed a collateralized debt obligation (“CDO”) structured as a financing transaction in the first quarter of 2007. The collateral for this securitization consisted of subordinated securities which the Company retained from its loan securitizations as well as subordinated securities purchased from other issuers. The Company received net proceeds from the issuance of the asset-backed bonds and from the proceeds of its financing of the BBB bond aggregating $64.3 million.

During the first and second quarter of 2007, the Company closed two loan securitizations. The net cash inflow from these transactions was $24.4 million. Generally, the Company’s securitizations are a net positive cash flow event due to the financing it receives on the residual security it retains. The Company did not close any loan securitizations during the third quarter of 2007.

Other Strategic Liquidity Initiatives. As a result of the decrease in liquidity, the Company completed several strategic initiatives to attempt to ensure adequate liquidity levels for its business operations which included:

To help reduce margin call risk and as a result of the value of the Compay’s mortgage loans held-for-sale continuing to dramatically decline in the third quarter, the Company entered into a Mortgage Loan Purchase Agreement (the “MLPA”) with Wachovia to sell substantially all of its mortgage loans held-for-sale which are not and, have never been, delinquent for a price of 92% of par with a 50 basis point holdback for potential early payment defaults. As of September 30, 2007 and November 13, 2007, the Company had

9

Table of Contents

sold approximately $300.5 million and $664.8 million, respectively, of its mortgage loans held-for-sale. Because the amount borrowed against these assets was greater than the amount the Company received upon the sale of these assets, the $300.5 million sale in September 2007 resulted in a decrease of cash of approximately $5.0 million. The negative cash impact for sales which settled in the fourth quarter was minimal as the loans were being financed at approximately 92.70% of par. The Company does not expect any further transactions under the MLPA. See Note 16 for discussion of the accounting treatment of loans sold to Wachovia which are subject to this agreement.

In addition to sales under the Wachovia MLPA, the Company is actively pursuing the sale to other third party investors of all of its mortgage loans held-for-sale that did not meet the eligibility criteria for sale under the Wachovia MLPA. Most of the Company’s remaining mortgage loans held-for-sale are non-performing. Yet, a portion of these loans do have mortgage insurance. Sale proceeds must be used to repay the amount of any financing outstanding with respect to these loans. To the extent that proceeds are insufficient to repay such financing, these additional loan sales will have a negative impact on the Company’s cash position. On November 2, 2007, the Company closed the sale of a pool of nonperforming assets with a principal balance of $62.0 million for $26.2 million in cash of which $25.1 went to Wachovia to pay down borrowings against those assets.

In the second quarter, the Company closed a $100 million financing facility to provide financing for certain residual securities and mortgage servicing rights. In addition, the Company closed a $1.9 billion comprehensive financing facility with Wachovia in May 2007 for the financing of substantially all of its mortgage assets. Upon the closing of the comprehensive facility, the Company transferred all borrowings with its other lenders to Wachovia during the second quarter of 2007 except for borrowings under the Company’s servicing advance facility with Deutsche Bank, which was fully repaid upon the sale of the Company’s mortgage servicing rights on November 1, 2007. The Company is currently not in compliance with the net worth covenant under the Wachovia facilities but has obtained a waiver of this non-compliance. Going forward, the Company will continue to use all available cash inflows in excess of its immediate operating needs to repay all of Wachovia’s short-term borrowings and any remaining fees due under the repurchase agreements at the earliest practical date. See “Wachovia Short-Term Borrowings Repayment” for further discussion.

On July 16, 2007, the Company entered into a Securities Purchase Agreement for the issuance of $48.8 million of convertible preferred stock to certain private investors to enhance its liquidity position. See Note 11 for further discussion of this transaction.

See discussion below under “Industry Overview, Significant Events and Material Trends” for other events affecting the Company’s liquidity.

Industry Overview, Significant Events and Material Trends

Described below are some of the marketplace conditions, significant events and known material trends and uncertainties that may impact the Company’s future results of operations as the Company moves into the fourth quarter of 2007.

Conditions in the secondary markets, which dramatically worsened during the third quarter, continue to be depressed as investor concerns over subprime asset quality and a weakening of the United States housing market remain high. As a result, the capital markets remain very volatile and illiquid and, have effectively been unavailable to the Company. The Company believes the existing conditions in the secondary markets are unprecedented since the Company’s inception and, as such, inherently involve significant risks and uncertainty. These conditions could continue to adversely impact investor’s willingness to purchase bonds backed by subprime loans and whole pools of mortgage loans, the profit margins of mortgage originations, and the amounts lenders are willing to finance on mortgage loans pending their sale or securitization. Until bond spreads and credit performance return to more rational levels, it will be impossible for the Company to execute securitizations and loan sales at favorable prices. As a result, in the third quarter the Company has been forced to further alter its business strategies and operations in response to the market conditions. The Company implemented the Third Quarter Exit Plans and discontinued its wholesale and correspondent loan origination activities and significantly reduced its retail operations. Implementation of the Third Quarter Exit Plans began during the third quarter of 2007 and subject to completion of the necessary legal notices and requirements will conclude during the fourth quarter of 2007. The Company maintained four of its retail branches and has refocused the retail channel business model from originator to broker and is brokering loans for other lenders. The Company does not intend to re-enter mortgage banking until the economics become more favorable.

On September 4, 2007 the Company announced that it did not intend to proceed with its previously announced offering of rights to purchase $101,175,000 in shares of its 9.00% Series D-2 Mandatory Convertible Preferred Stock. The Series D-2 Preferred Stock was to be convertible into shares of the Company’s common stock at an initial common stock conversion price of $28.00 per share. NovaStar had agreed to conduct the rights offering in connection with its sale of $48.8 million of its 9.00% Series D-1 Preferred Stock to affiliates of MassMutual Capital Partners LLC (“MassMutual”) and funds managed by Jefferies Capital Partners IV LLC (“Jefferies”). In connection with that purchase, MassMutual and Jefferies entered into a standby purchase agreement with the

10

Table of Contents

Company, in which MassMutual and Jefferies committed, subject to certain conditions, to purchase any shares of Series D-2 Preferred Stock not subscribed for in the rights offering. The Company canceled plans for the rights offering because there were certain conditions that management believed the Company would not be able to satisfy in the current environment in connection with a requirement to file a registration statement relating to the rights offering with the Securities and Exchange Commission no later than August 30, 2007, including reissuing its 2006 financial statements. The following events occurred during the third quarter of 2007 and were significant contributors to the Company’s inability to meet the registration statement filing requirements: 1) Moody’s Investor Services downgrading the Company’s servicer quality rating, 2) concerns about the Company’s ability to remain in compliance with covenants contained in its financing arrangements, 3) the denial of the motions for a judgment notwithstanding the verdict and a new trial in the California case mentioned below, 4) the continued deterioration in the subprime industry and the secondary markets, and 5) the Company’s decision to suspend it’s wholesale originations and curtail its retail originations to preserve liquidity.

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

On October 17, 2007, the Company announced that NYSE Regulation, Inc. (“NYSE Regulation”) issued a press release, announcing the NYSE Regulation’s determination that the Company’s common stock (ticker symbol: NFI) and its 8.90% Series C Cumulative Redeemable Preferred Stock (ticker symbol: NFI PR C) no longer met applicable listing standards for continued listing on the New York Stock Exchange. In its press release, NYSE Regulation stated that the Company’s September 17, 2007 announcement that it would not declare a dividend related to its 2006 taxable income causing termination of the Company’s REIT status retroactive to January 1, 2006 required NYSE Regulation to promptly initiate suspension and delisting procedures unless the resultant non-REIT entity qualifies for original listing as a corporation. NYSE Regulation asserted that the Company did not meet the required original listing standards. The Company has requested a review of this determination and is currently exploring alternative arrangements for the listing or quoting of its common stock and 8.90% Series C Cumulative Redeemable Preferred Stock. The Company believes there is a high likelihood that its securities will be delisted from the NYSE following this review. Although the Company is exploring alternative arrangements for the listing or quoting of its common and preferred stock, trading is likely to take place on the OTC Bulletin Board.

In March 2002, an action was filed against NHMI in Superior Court of Orange County, California entitled American Interbanc Mortgage, LLC v. NovaStar Home Mortgage, Inc. et. al. In the action, the plaintiff alleged that NHMI and two other mortgage companies (“Defendants”) engaged in false advertising under a California statute permitting lawsuits by a competitor. Plaintiff amended its complaint subsequently to allege also that Defendants engaged in unfair competition under a different California statute and interfered intentionally with Plaintiff’s prospective economic relations. On May 4, 2007, a jury returned a verdict by a 9-3 vote awarding plaintiff $15.9 million. The court trebled the award, made adjustments for amounts paid by settling Defendants, and entered a $46.1 million judgment against Defendants on June 27, 2007. The award is joint and several against the three defendants including NHMI. It is unknown if the other two defendants have the financial ability to pay any of the award. One of the other defendants has filed a bankruptcy petition. NHMI’s motion for the trial court to overturn or reduce the verdict was denied on August 20, 2007. NHMI is currently appealing the decision. There can be no assurances that the appeal will be successful. NHMI has a negative net worth and no ability to pay the judgment and as a result management believes that it is unlikely the judgment will ever be paid by NHMI. The Company does not believe that the plaintiff has a valid legal basis to hold NFI or its subsidiaries other than NHMI responsible for the judgment. But should the plaintiff be successful at any such attempt, NFI may be forced to consider bankruptcy. In accordance with generally accepted accounting principles, NHMI has recorded a liability of $47.2 million as of September 30, 2007 with a corresponding charge to earnings. The $47.2 million includes interest which is accruing on the obligation. Because NHMI is a wholly owned indirect subsidiary of NFI, the $47.2 million liability is included in the consolidated financial statements of NFI. The liability is included in “Liabilities of discontinued operations” line of the condensed consolidated balance sheets while the charge to earnings is included in the “(Loss) income from discontinued operations, net of income tax” line of the consolidated statements of operations.

11

Table of Contents

As a result of the termination of its REIT status and current financial condition, the Company does not intend to pay any dividends on its common stock for the foreseeable future. Also, recently the Company’s board of directors determined to suspend the next scheduled dividend payment on its Series C and Series D-1 Preferred Stock. As a result, dividends on the Series C and D-1 preferred stock will continue to accrue and the dividend rate on the Company’s Series D-1 preferred stock will increase from 9.0% to 13.0%, compounded quarterly, effective January 16, 2008 with respect to all unpaid dividends and subsequently accruing dividends. If and when paid, all payments with respect to the Company’s preferred stock will negatively affect its liquidity.

The Company’s plan for the future will focus on minimizing losses and preserving liquidity with its remaining operations which consist of the mortgage portfolio management and retail broker businesses. Additionally, the Company will focus on paying down its outstanding borrowings with Wachovia and reducing operating costs. The Company’s residual and subordinated mortgage securities are currently its only source of significant positive cash flows. Based on its current projections, the cash flows from the Company’s mortgage securities will decrease in the next several months as the underlying mortgage loans are repaid, and could be significantly less than the current projections if losses on the underlying mortgage loans exceed the current assumptions. The Company’s recently commenced retail mortgage loan brokerage operations do not currently generate positive cash flows. In addition, the Company has significant operating expenses associated with office leases, software contracts, and other obligations relating to the Company’s discontinued operations, as well as payment obligations with respect to secured and unsecured debt including periodic interest payments with respect to junior subordinated debentures relating to the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II. The Company’s repayment plan is to use available cash inflows in excess of its immediate operating needs, including debt servicing payments, to repay its secured debt with Wachovia. If, as the cash flows from mortgage securities decrease, the Company is unable to expand its mortgage brokerage business or recommence its mortgage loan origination business on a profitable basis, and restructure its unsecured debt and contractual obligations or if the cash flows from the Company’s mortgage securities are less than currently anticipated, there can be no assurance that the Company will be able to continue as a going concern and avoid seeking the protection of applicable federal and state bankruptcy laws.

Additionally, as the Company reorganizes its operations in a manner which aligns its costs to support its profitability and cash flow objectives, the Company may enter into additional workforce reductions which could include the departure of executive officers as well as other key management personnel.

Note 2. New Accounting Pronouncements

In February 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS 155, “Accounting for Certain Hybrid Financial Instruments”, an amendment of SFAS 133 and SFAS 140 (“SFAS 155”). This statement permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. It also clarifies which interest-only strips and principal-only strips are not subject to FASB Statement 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). The statement also establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or hybrid financial instruments that contain an embedded derivative requiring bifurcation. The statement also clarifies that concentration of credit risks in the form of subordination are not embedded derivatives, and it also amends SFAS 140 (“SFAS 140”), “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – a replacement of FASB Statement 125” to eliminate the prohibition on a Qualifying Special Purpose Entity (“QSPE”) from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument.

In January 2007, the FASB provided a scope exception under SFAS 155 for securitized interests that only contain an embedded derivative that is tied to the prepayment risk of the underlying prepayable financial assets, and for which the investor does not control the right to accelerate the settlement. If a securitized interest contains any other embedded derivative (for example, an inverse floater), then it would be subject to the bifurcation tests in SFAS 133, as would securities purchased at a significant premium. The adoption of this standard on January 1, 2007 did not have a significant impact on the Company’s financial position, results of operations or cash flows. However, to the extent that certain of the Company’s future investments in securitized financial assets do not meet the scope exception adopted by the FASB, the Company’s future results of operations may exhibit volatility if such investments are required to be bifurcated or marked to market value in their entirety through the income statement, depending on the election made by the Company.

In March 2006, the FASB issued SFAS 156, “Accounting for Servicing of Financial Assets”, an amendment of SFAS 140 (“SFAS 156”). This statement requires that an entity separately recognize a servicing asset or a servicing liability when it undertakes an obligation to service a financial asset under a servicing contract in certain situations. Such servicing assets or servicing liabilities are required to be initially measured at fair value, if practicable. SFAS 156 also allows an entity to choose one of two methods when subsequently measuring its servicing assets and servicing liabilities: (1) the amortization method or (2) the fair value measurement

12

Table of Contents

method. The amortization method existed under SFAS 140 and remains unchanged in (1) allowing entities to amortize their servicing assets or servicing liabilities in proportion to and over the period of estimated net servicing income or net servicing loss and (2) requiring the assessment of those servicing assets or servicing liabilities for impairment or increased obligation based on fair value at each reporting date. The fair value measurement method allows entities to measure their servicing assets or servicing liabilities at fair value at each reporting date and report changes in fair value in earnings in the period the change occurs. SFAS 156 introduces the notion of classes and allows companies to make a separate subsequent measurement election for each class of its servicing rights. In addition, SFAS 156 requires certain comprehensive roll-forward disclosures that must be presented for each class. The Statement is effective as of the beginning of an entity’s first fiscal year that begins after September 15, 2006. The Company adopted SFAS 156 on January 1, 2007 and elected to continue using the amortization method for measuring its servicing assets.

In June 2006, the FASB issued FASB Interpretation 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement 109”. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or to be taken on a tax return. This interpretation also provides additional guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation is effective for fiscal years beginning after December 15, 2006. The Company adopted the provisions of FIN 48 on January 1, 2007. The cumulative effect of applying the provisions of FIN 48 is reported as an adjustment to the opening balance of accumulated deficit on January 1, 2007 and resulted in an increase to the Company’s accumulated deficit of $1.1 million.

In September 2006, the FASB issued SFAS 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 establishes a framework for measuring fair value and requires expanded disclosures regarding fair value measurements. This accounting standard is effective for financial statements issued for fiscal years beginning after November 15, 2007, however early adoption is permitted. The Company adopted the provisions of SFAS 157 on January 1, 2007. See Note 8 and Note 16 which describe the impact of the adoption of SFAS 157 on the Company’s condensed consolidated financial statements.

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

In February 2007, the FASB issued SFAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities—including an amendment of FASB Statement 115” (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. Unrealized gains and losses on items for which the fair value option has been elected will be recognized in earnings at each subsequent reporting date. This accounting standard is effective for financial statements issued for fiscal years beginning after November 15, 2007, however early adoption is permitted. The Company adopted the provisions of SFAS 159 on January 1, 2007. See Note 8 which describes the impact of the adoption of SFAS 159 on the Company’s condensed consolidated financial statements.

On July 24, 2007, the FASB released proposed Staff Position (FSP) FAS 140-d, “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions.” The FSP focuses on the circumstances that would permit a transferor and a transferee to separately evaluate the accounting for a transfer of a financial asset and a repurchase financing under FASB Statement 140, “Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” The proposed FSP states that a transfer of a financial asset and a repurchase agreement involving the transferred financial asset should be considered part of the same arrangement when the counterparties to the two transactions are the same unless certain criteria are met. The criteria in the proposed FSP are intended to identify whether (1) there is a valid and distinct business or economic purpose for entering separately into the two transactions and (2) the repurchase financing does not result in the initial transferor regaining control over the previously transferred financial assets. Its purpose is to limit diversity of practice in accounting for these situations, resulting in more consistent financial reporting. Consequently, it is the FASB’s desire to have the proposed FSP effective as soon as practicable. This FSP would be effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. Early application is not permitted.

During the first quarter of 2006, the Company purchased approximately $1.0 billion of mortgage loans from counterparties which were subsequently financed through repurchase agreements with that same counterparty. As of September 30, 2007, the entire $1.0

13

Table of Contents

billion of mortgage loans purchased during 2006 remained on the Company’s condensed consolidated balance sheet but they were no longer financed with repurchase agreements as they had been securitized in transactions structured as financings and the short-term repurchase agreements were replaced with asset-backed bond financing. Additionally, the Company is still evaluating FSP 140-d but believes there would be no material change to its financial statements based on this current proposal issued by the FASB.

Note 3. Mortgage Loans – Held-in-Portfolio

Mortgage loans – held-in-portfolio, all of which are secured by residential properties, consisted of the following as of September 30, 2007 and December 31, 2006 (dollars in thousands):

Activity in the allowance for credit losses on mortgage loans – held-in-portfolio is as follows for the nine and three months ended September 30, 2007 and 2006, respectively (dollars in thousands):

Note 4. Mortgage Securities – Available-for-Sale

As of September 30, 2007, mortgage securities – available-for-sale consist entirely of the Company’s investment in the residual securities issued by securitization trusts sponsored by the Company. As of December 31, 2006 mortgage securities – available-for-sale contained residual securities as well as subordinated securities issued by securitization trusts sponsored by the Company. In previous years, the Company’s policy was to designate its residual securities as available-for-sale but as a result of the Company’s adoption of SFAS 155 on January 1, 2007 and the complexities and uncertainties surrounding the application of this Statement, the Company has designated the NMFT Series 2007-2 residual security as trading. As a result, the NMFT Series 2007-2 residual security qualifies for the scope exception concerning bifurcation provided by SFAS 155. Residual securities consist of interest-only, prepayment penalty and overcollateralization bonds. Subordinated securities consist of rated bonds which are lower than other rated bonds on the capital structure. Management estimates the fair value of the residual securities by discounting the expected future cash flows of the collateral and bonds. Fair value of the subordinated securities is based on quoted market prices. The following table presents certain information on the Company’s portfolio of mortgage securities – available-for-sale as of September 30, 2007 and December 31, 2006 (dollars in thousands):

14

Table of Contents

During the nine months ended September 30, 2007 and 2006, management concluded that the decline in value on certain securities in the Company’s mortgage securities portfolio were other-than-temporary. As a result, the Company recognized an impairment on mortgage securities – available-for-sale of $72.2 million and $46.2 million during the nine and three months ended September 30, 2007, respectively, as compared to $13.2 million and $6.8 million during the same periods of 2006.

As of December 31, 2006, the Company had two subordinated available-for-sale securities with unrealized losses and fair values aggregating $46.7 million that were not deemed to be other-than-temporarily impaired. In accordance with the Company’s adoption of SFAS 159, these securities were transferred from “available-for-sale” to the “trading” classification on January 1, 2007 and the related unrealized losses of $1.1 million representing the cumulative effect adjustment were reclassified from accumulated other comprehensive income to accumulated deficit. As of September 30, 2007, the Company had no available-for-sale securities with unrealized losses and had no subordinated securities within its mortgage securities – available-for-sale.

Maturities of mortgage securities owned by the Company depend on repayment characteristics and experience of the underlying financial instruments. The Company expects the securities it owns as of September 30, 2007 to mature in one to five years.

As of September 30, 2007 and December 31, 2006 the Company had pledged all of its mortgage securities – available-for-sale as collateral for financing purposes.

Note 5. Mortgage Securities – Trading

As of September 30, 2007 and December 31, 2006, mortgage securities – trading consisted of residual securities and subordinated securities retained by the Company from securitization transactions as well as subordinated securities purchased from other issuers in the open market. Management estimates the fair value of the residual securities by discounting the expected future cash flows of the collateral and bonds. The fair value of the subordinated securities is estimated based on quoted market prices. Refer to Note 8 for a description of the valuation methods as of September 30, 2007 and December 31, 2006. The following table summarizes the Company’s mortgage securities – trading as of September 30, 2007 and December 31, 2006 (dollars in thousands):

The Company recognized net trading losses of $237.9 million and $148.2 million for the nine and three months ended September 30, 2007, respectively as compared to net trading gains (losses) of $2.9 million and $(1.4) million for the same periods of 2006. These net trading (losses) gains are included in the “Fair value adjustments” line on the Company’s condensed consolidated statements of operations.

As discussed in Note 4, on January 1, 2007 the Company transferred two securities with an aggregate fair value of $46.7 million from “available-for-sale” to the “trading” classification in accordance with the adoption of SFAS 159. The unrealized losses related to these securities of $1.1 million were reclassified from other comprehensive income to accumulated deficit on the condensed consolidated balance sheet as a cumulative effect adjustment.

During the nine months ended September 30, 2007, the Company purchased four subordinated bonds with a fair value at the date of purchase of $22.0 million to include in NovaStar ABS CDO I.

The Company sold three subordinated bonds to a third party during the nine months ended September 30, 2007 with a fair value of $7.2 million. The Company realized losses on the sales of these securities of $3.1 million during the nine months ended September 30, 2007, which is included in the fair value adjustments line on the Company’s condensed consolidated statements of operations. The Company did not sell any subordinated bonds during the three months ended September 30, 2007.

15

Table of Contents

As of September 30, 2007 and December 31, 2006, the Company had pledged all of its trading securities as collateral for financing purposes.

Note 6. Collateralized Debt Obligation Issuance

In the first quarter of 2007 the Company closed a CDO. The collateral for this securitization consisted of subordinated securities which the Company retained from its loan securitizations as well as subordinated securities purchased from other issuers. This securitization was structured legally as a sale, but for accounting purposes was accounted for as a financing under SFAS 140. This securitization did not meet the qualifying special purpose entity criteria under SFAS 140. Accordingly, the securities remain on the Company’s balance sheet, retained interests were not created, and securitization bond financing replaced the short-term debt used to finance the securities. The Company records interest income on the securities and interest expense on the bonds issued in the securitization over the life of the related securities and bonds.

Details of the CDO transaction are as follows (dollars in thousands):

Note 7. Mortgage Servicing Rights

The Company records mortgage servicing rights (“MSR’s”) arising from the transfer of loans to the securitization trusts structured as sales.

As discussed in Note 1, the Company entered into a Servicing Rights Transfer Agreement for the sale to Saxon of all of the Company’s mortgage servicing rights and servicing advances relating to its securitizations. The transaction closed on November 1, 2007. The mortgage servicing rights sold for $95.0 million which includes $22.8 million for mortgage servicing rights related to the securitizations structured as financings where no mortgage servicing rights have been recorded by the Company.

The following table summarizes the carrying value of mortgage servicing rights and the activity during the nine and three months ended September 30, 2007 and 2006 (dollars in thousands):

16

Table of Contents

The following table summarizes the activity to the valuation allowance for impairment of MSR’s for the nine and three months ended September 30, 2007 (dollars in thousands):

The estimated fair value of the MSR’s aggregated $74.1 million and $74.2 million at September 30, 2007 and December 31, 2006, respectively. The fair value at September 30, 2007 was based on the sales price of the MSR Transfer Agreement which closed on November 1, 2007. The fair value at December 31, 2006 was estimated by discounting estimated future cash flows from the servicing assets using discount rates that approximate current market rates. The fair value as of December 31, 2006 was determined utilizing a 12% discount rate, credit losses net of mortgage insurance (as a percent of current principal balance) of 3.2% and an annual prepayment rate of 47%.

At September 30, 2007 and December 31, 2007, the Company had no MSR stratifications which were impaired. The Company recorded a reversal of temporary impairments of $0.2 million for the three months ended September 30, 2007. For the nine months ended September 30, 2007, the Company had fully reversed the provision for impairment it had recorded during the period and did not maintain any valuation allowance as of September 30, 2007.

The Company receives annual servicing fees approximating 0.50% of the outstanding balance. Servicing fees received from the securitization trusts were $42.4 million and $12.8 million for the nine and three months ended September 30, 2007, respectively, as compared to $44.5 million and $14.7 million for the same periods of 2006. These amounts are included in the “Fee income” line item on the condensed consolidated statements of operations.

The Company holds, as custodian, principal and interest collected from borrowers on behalf of the securitization trusts, as well as funds collected from borrowers to ensure timely payment of hazard and primary mortgage insurance and property taxes related to the properties securing the loans. These funds are not owned by the Company and are held in trust. The Company held, as custodian, $184.8 million and $545.2 million at September 30, 2007 and December 31, 2006, respectively.

Note 8. Fair Value Accounting

Effective January 1, 2007, the Company adopted SFAS 157 and SFAS 159. Both standards address aspects of the expanding application of fair value accounting.

Fair Value Measurements (SFAS 157)

SFAS 157 defines fair value, establishes a consistent framework for measuring fair value and expands disclosure requirements about fair value measurements. SFAS 157, among other things, requires the Company to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

These valuation techniques are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. These two types of inputs create the following fair value hierarchy:

The Company determines fair value based upon quoted prices when available or through the use of alternative approaches, such as discounting the expected cash flows using market interest rates commensurate with the credit quality and duration of the investment. The methods the Company uses to determine fair value on an instrument specific basis are detailed in the section titled “Valuation Methods”, below.

17

Table of Contents

The Company recognized a cumulative-effect adjustment resulting from the Company’s change in policies to measure fair value of trading securities upon adoption of SFAS 157. Specifically, the Company began using quoted market prices which constitute the Company’s highest and best execution for its trading securities as compared to the midpoint of mid-market pricing which was used at December 31, 2006.

Detailed below are the December 31, 2006 carrying values prior to adoption, the transition adjustments booked to opening accumulated deficit and the fair values (that is, the carrying values at January 1, 2007 after adoption) for the trading securities the Company held at January 1, 2007 (dollars in thousands):