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

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the Quarterly Period Ended March 31, 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):

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 April 30, 2007 was 37,898,736.

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NOVASTAR FINANCIAL, INC.

FORM 10-Q

For the Quarterly Period Ended March 31, 2007

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited; dollars in thousands, except share amounts)

See notes to condensed consolidated financial statements.

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NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(unaudited; dollars in thousands, except share amounts)

See notes to condensed consolidated financial statements.

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NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(unaudited; dollars in thousands, except share amounts)

See notes to condensed consolidated financial statements.

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NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited; dollars in thousands)

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Supplemental Disclosure of Cash Flow Information

(unaudited; dollars in thousands)

See notes to condensed consolidated financial statements.

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NOVASTAR FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2007 (Unaudited)

Note 1. Financial Statement Presentation

NovaStar Financial, Inc. and its subsidiaries (the “Company”) operate as a specialty finance company that originates, purchases, securitizes, sells, invests in and services residential nonconforming loans and mortgage backed securities. The Company offers a wide range of mortgage loan products to “nonconforming borrowers,” who generally do not satisfy the credit, collateral, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers, including U.S. government-sponsored entities such as Fannie Mae or Freddie Mac. The Company retains significant interests in the nonconforming loans originated and purchased through their mortgage securities investment portfolio. Historically, the Company has serviced all of the loans in which it retains interests through its servicing platform. The Company has elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended.

The Company’s condensed consolidated financial statements as of March 31, 2007 and for the three months ended March 31, 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.

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, the Company has reclassified the operating results of NovaStar Home Mortgage, Inc. and its branches (“NHMI”) through December 31, 2006, as discontinued operations in the condensed consolidated statements of income for the three months ended March 31, 2006.

The Company created two new line items on the condensed consolidated statements of income named “Fair Value Adjustments” and “Valuation adjustment on mortgage loans—held-for-sale” to separate activity which was previously reported in the “other income, net” line item in the prior year period. These line items were created due to the materiality of the amounts recorded in the first quarter of 2007.

The Company’s condensed 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 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.

Significant Liquidity Factors in the First Quarter of 2007

The Company had $63.4 million in cash and cash equivalents at March 31, 2007, which was a decrease of $87.2 million from December 31, 2006. The following factors contributed to the Company’s change in liquidity position:

During the first quarter of 2007, bond spreads on mortgage-backed securities widened as a result of investor concerns over credit quality in the subprime mortgage market. This widening 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 first quarter of 2007 the Company was subject to cash margin calls of approximately $72.4 million and $23.8 million on the Company’s mortgage securities and mortgage loans held-for-sale, respectively. The Company could continue to be subject to additional margin calls if the value of our mortgage assets decline.

As the values of mortgage loans decreased in the first quarter of 2007, not only was the Company subject to cash margin calls but the capital the Company was required to invest in new originations increased at the time of funding. The Company has invested approximately $61.4 million of capital in its mortgage loans held-for-sale on its balance sheet as of March 31, 2007 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.

The Company also had significant cash outlays to repurchase loans sold to third parties. When whole pools 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

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unpaid accrued interest and any other out-of-pocket advances in accordance with the loan sale agreement. Typically, repurchased loans will subsequently be financed on the Company’s warehouse repurchase agreements if eligible and then liquidated or sold. The Company paid $82.0 million in cash in the first quarter of 2007 to repurchase loans sold to third parties in the first quarter of 2007. Significant capital is tied up in these assets as the amount the Company can borrow against these assets is very low and some may not be eligible for financing.

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 quarter the Company also closed a loan securitization accounted for as a financing transaction. The Company retained approximately $46.5 million of bonds from this securitization due to the significant bond spread widening which occurred in the market and made retaining these bonds more attractive than selling them. The net cash outflow from this transaction was $2.2 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. But, due to the significant amount of subordinated bonds the Company retained, this transaction was a net cash outflow event.

As of March 31, 2007, the Company failed to satisfy the profitability covenant under one of its warehouse financing facilities. The Company’s GAAP net income, determined on a pre-tax basis, was not greater than $1 for the six months ended March 31, 2007 and it has been unable to obtain a modification or waiver of this requirement. Therefore, the $1 billion of borrowing capacity under this facility is not available to the Company so long as the Company remains out of compliance. Further, the Company only had $120,000 of borrowings outstanding under this facility as of March 31, 2007 and, thus, the breach did not trigger any cross-default provisions with its other warehouse facilities, and thus did not permit those lenders to accelerate all amounts then outstanding under those facilities. The borrowing on this line was paid in full on April 2, 2007. On May 1, 2007, the lender under this facility delivered a notice of default to the Company demanding payment of $2.9 million representing fees owed under the agreement and notifying the Company that it was applying $2.9 million in cash that it held as collateral towards this amount.

As a result of the significant decline in the Company’s liquidity position, in April 2007, the Company executed a Master Repurchase Agreement (2007 Residual Securities) (the “Securities Facility’) with Wachovia Investment Holdings, LLC and Wachovia Capital Markets, LLC ( “Wachovia Capital”), providing for the financing of certain of the Company’s existing residual securities and the Company also executed a Master Repurchase Agreement (2007 Servicing Rights) (the “Servicing Rights Facility”) with Wachovia Bank, NA and Wachovia Capital (collectively, with Wachovia Investment Holdings, LLC and their respective affiliates, “Wachovia”), providing for the financing of certain mortgage servicing rights.

The maximum amount that may be outstanding at any time under the Securities Facility and the Servicing Rights Facility is $40 million and $70 million, respectively, which amounts will be reduced if and to the extent necessary so that the aggregate amount outstanding from time to time under both the Securities Facility and Servicing Rights Facility does not exceed $100 million. The advance rate under each facility is up to 60% of the fair value of the assets securing the facility, as determined from time to time by Wachovia. The interest rate under the Securities Facility is LIBOR plus 3.5% and the interest rate under the Servicing Rights Facility is LIBOR plus 3.75%. Loan proceeds from the additional financing facility will be used for general corporate purposes. The facility has a term of 364 days, subject to automatic renewal for another 364 days unless Wachovia gives at least 120 days notice of its intention to terminate the facility on the maturity date. The Company is required to notify Wachovia of any margin calls under any repurchase facilities the Company has with any third parties in excess of $5 million in the aggregate, in which event Wachovia will have the option to increase the aggregate amount available under other financing facilities between the Company and Wachovia and cause the Company to place the assets subject to the margin call on such facilities. Upon a change of control, Wachovia has the right to terminate the facilities and require the payment of a termination fee.

Mortgage servicing rights eligible for financing under the Servicing Rights Facility include rights of NovaStar Mortgage, Inc. (“NMI”) under existing servicing agreements relating to certain of the Company’s securitizations and, subject to certain approvals of the related securitization trustees, other existing mortgage servicing rights of the Company. Servicing rights arising in connection with future securitizations may also be financed under the Servicing Rights Facility if mutually agreed by the parties. In each case, the related servicing agreement must be acceptable to Wachovia.

Under the Servicing Rights Facility, the Company will remain the servicer of the pledged servicing rights, provided Wachovia will have the right to replace the Company as the servicer if (1) the tangible net worth of the Company falls below a certain amount, (2) the Company’s servicing rating is downgraded below a certain level by Moody’s, S&P or Fitch or (3) an event of default under either facility occurs.

        On April 30, 2007, the Company entered into a commitment letter (the “Commitment Letter”) setting forth the terms of a commitment for a $1.9 billion comprehensive financing facility arranged by Wachovia Capital. The facility would expand and replace the whole-loan and securities repurchase agreements currently existing between Wachovia and the Company, other than the Servicing Rights Facility and the Residual Securities Facility. The intent of the comprehensive facility is to put in place a financing facility that will enable the Company to primarily use Wachovia for its borrowing

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needs. Based on this intent, our credit limit could decrease from $3.4 billion to $2.0 billion during the second quarter of 2007. The $2.0 billion could be increased in the event we need additional borrowing capacity but only upon Wachovia’s approval of such an increase. Upon the close of the comprehensive facility, we anticipate that we will transfer all borrowings with our other lenders to Wachovia. Upon the close of this facility, the Company anticipates that it will transfer all borrowings with its other lenders to Wachovia. As previously discussed, the Whole Loan Master Repurchase Agreement closed on May 9, 2007.

The proposed facility is expected to consist of the following separate agreements (collectively, the “Agreements”): (1) a Whole Loan Master Repurchase Agreement; (2) a Securities Master Repurchase Agreement (Investment Grade); (3) a Securities Master Repurchase Agreement (Non Investment Grade); (4) a Servicing Advance Master Repurchase Agreement; and (5) a Whole Loan Master Repurchase Agreement (New York). The aggregate purchase price under each individual Agreement will reduce availability under the other Agreements such that the maximum aggregate purchase price under all Agreements at any point in time will not exceed $1.9 billion. Financing capacity under the proposed facility will be in addition to the aggregate $100 million financing capacity under the Servicing Rights Facility and the Residual Securities Facility.

The Agreements will be cross-collateralized with each other and all other repurchase and similar financing facilities between the Company and Wachovia, including the Servicing Rights Facility and the Residual Securities Facility. The Company will be required to pay Wachovia a structuring fee in connection with the facility and certain additional fees and expenses, including but not limited to reimbursement of due diligence expenses and payment of certain fees in the event of voluntary prepayment or termination by the Company or the occurrence of an event of default. In addition, upon a change of control, Wachovia has the right to terminate the Agreements and require the payment of a termination fee.

On May 9, 2007, the Company closed the Whole Loan Master Repurchase Agreement.

On May 4, 2007, the Company entered into short-term extensions of the existing one-year warehouse repurchase agreements with Wachovia, extending the termination date of the agreements to May 11, 2007.

During the quarter, the Company initiated a formal process to explore a range of strategic alternatives, including without limitation a potential sale or other change of control transactions. The Company has retained Deutsche Bank Securities Inc. to act as a financial advisor in this process.

Note 2. New Accounting Pronouncements

In February 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 155, “Accounting for Certain Hybrid Financial Instruments”, an amendment of SFAS No. 133 and SFAS No. 140 (“SFAS 155”). This statement permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. It also clarifies which interest-only strips and principal-only strips are not subject to FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). The statement also establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or hybrid financial instruments that contain an embedded derivative requiring bifurcation. The statement also clarifies that concentration of credit risks in the form of subordination are not embedded derivatives, and it also amends SFAS No. 140 (“SFAS 140”), “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – a replacement of FASB Statement No. 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. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006.

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 No. 156, “Accounting for Servicing of Financial Assets”, an amendment of SFAS No. 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 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

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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 as of January 1, 2007 and elected to continue using the amortization method for measuring its servicing assets.

In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 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 as of 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 No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 establishes a framework for measuring fair value and requires expanded disclosures regarding fair value measurements. This accounting standard is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company adopted the provisions of SFAS 157 as of January 1, 2007. See Note 9 which describes 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 No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB No. 108”). SAB No. 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 No. 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 No. 108 are effective for financial statements issued for fiscal years beginning after December 31, 2006. The Company adopted SAB No. 108 as of January 1, 2007 and has deemed the impact immaterial on its condensed consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—including an amendment of FASB Statement No. 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. The Company adopted the provisions of SFAS 159 as of January 1, 2007. See Note 9 which describes the impact of the adoption of SFAS 159 on the Company’s condensed consolidated financial statements.

FASB has been deliberating on a technical interpretation of accounting principles generally accepted in the United States of America (“GAAP”) with respect to the accounting for transactions where assets are purchased and simultaneously financed through a repurchase agreement with the same party and whether these transactions create derivatives requiring a “net” presentation instead of the acquisition of assets and related financing obligation. The Company’s current accounting for these transactions is to record the transactions as an acquisition of assets and related financing obligation. The alternative accounting treatment would be to record any net cash representing the “haircut” amount as a deposit and the forward leg of the repurchase agreement (that is, the obligation to purchase the financial asset(s) at the end of the repo term) as a derivative. Because the FASB has not issued any guidance on this matter as of the filing date of this report, the Company has not changed its accounting treatment for this item. 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 March 31, 2007, the entire $1.0 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.

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Note 3. Mortgage Loans

Mortgage loans, all of which are secured by residential properties, consisted of the following as of March 31, 2007 and December 31, 2006 (dollars in thousands):

Activity in the allowance for the lower of cost or fair value on mortgage loans—held-for-sale is as follows for the three months ended March 31, 2007 and 2006, respectively (dollars in thousands):

Activity in the allowance for credit losses on mortgage loans—held-in-portfolio is as follows for the three months ended March 31, 2007 and 2006, respectively (dollars in thousands):

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Note 4. Loan Securitizations and Loan Sales

The Company closed one mortgage loan securitization during the three months ended March 31, 2007. This securitization was structured legally as a sale, but for accounting purposes was treated as a financing under SFAS No. 140. This securitization did not meet the qualifying special purpose entity criteria under SFAS No. 140 at the time of the securitization, but may meet the criteria at a future date which then would be accounted for as a sale. Accordingly, the loans remain on the Company’s balance sheet as “mortgage loans—held-in-portfolio”, retained interests are not created, and securitization bond financing replaces the short-term debt with the loans. The Company records interest income on loans held-in-portfolio and interest expense on the bonds issued in the securitizations over the life of the securitizations. Deferred debt issuance costs and discounts related to the bonds are amortized on a level yield basis over the estimated life of the bonds.

Details of the Company’s loan securitization transaction structured as a financing which closed during the three months ended March 31, 2007 is as follows (dollars in thousands):

Loan Sales. The Company executes sales of loans to third parties with the related servicing on those loans released. Gains and losses on whole loan sales are recognized in the period the sale occurs. The Company generally has an obligation to repurchase whole loans sold in circumstances in which the borrower fails to make the first payment. Additionally, the Company is also required to repay all or a portion of the premium it receives on the sale of whole loans in the event that the loan is prepaid in its entirety in the first year. The Company records a reserve for losses on repurchased loans upon the sale of the mortgage loans which is included in the accounts payable and other liabilities line on the company’s condensed consolidated balance sheets.

Activity in the reserve for repurchases is as follows for the three months ended March 31, (dollars in thousands):

Note 5. Mortgage Securities—Available-for-Sale

As of March 31, 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. Residual securities consist of interest-only, prepayment penalty and overcollateralization bonds. Subordinated securities consist of rated bonds which are lower 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 March 31, 2007 and December 31, 2006 (dollars in thousands):

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During the three months ended March 31, 2007 and 2006, management concluded that the decline in value on certain securities in the Company’s mortgage securities—available-for-sale portfolio were other-than-temporary. As a result, the Company recognized an impairment on mortgage securities—available-for-sale of $3.4 million and $2.0 million during the three months ended March 31, 2007 and 2006, respectively.

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 March 31, 2007, the Company had no available-for-sale securities with unrealized losses and had no subordinated securities within its mortgage securities—available-for-sale.

Maturities of mortgage securities owned by the Company depend on repayment characteristics and experience of the underlying financial instruments. The Company expects the securities it owns as of March 31, 2007 to mature in one to five years.

Note 6. Mortgage Securities—Trading

As of March 31, 2007 and December 31, 2006, mortgage securities – trading consisted of subordinated securities retained by the Company from securitization transactions as well as subordinated securities purchased from other issuers in the open market. Management estimates their fair value based on quoted market prices. The Company adopted SFAS 157 on January 1, 2007 and as part of that the Company changed policies on valuing the trading securities portfolio. Refer to Note 9 for a description of the valuation methods as of December 31, 2006 and March 31, 2007. The following table summarizes the Company’s mortgage securities – trading as of March 31, 2007 and December 31, 2006 (dollars in thousands):

The Company recognized net trading (losses) gains of $(50.1) million and $2.4 million for the three months ended March 31, 2007 and 2006, respectively. These net trading (losses) gains are included in the fair value adjustments line on the company’s condensed consolidated statements of income.

As discussed in Note 5, 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.

In the first quarter of 2007 the Company purchased four subordinated bonds with a fair value at the date of purchase of $17.7 million to include in NovaStar ABS CDO I. At March 31, 2007 these trades had not settled.

In the first quarter of 2006, the Company sold the M-9 bond class security which it had retained from its NMFT Series 2005-4 securitization, to a third party and recognized a gain on the sale of approximately $351,000.

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

Note 7. 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 No. 140. This securitization did not meet the qualifying special purpose entity criteria under SFAS No. 140. Accordingly, the securities remain on the Company’s balance sheet, retained interests were not created, and securitization

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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 8. Mortgage Servicing Rights

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

The following table summarizes the carrying value of mortgage servicing rights and the activity during the three months ended March 31, 2007 and 2006 (dollars in thousands):

The following table summarizes the activity to the valuation allowance for impairment of MSRs for the three months ended March 31, 2007 (dollars in thousands):

The estimated fair value of the MSR’s aggregated $61.2 million and $65.4 million at March 31, 2007 and March 31, 2006, respectively. The fair value is estimated by discounting estimated future cash flows from the servicing assets using discount rates that approximate current market rates. The fair value as of March 31, 2007 was determined utilizing a 12% discount rate, credit losses net of mortgage insurance (as a percent of current principal balance) of 3.3% and an annual prepayment rate of 45%. The fair value as of March 31, 2006 was determined utilizing a 12% discount rate, credit losses net of mortgage insurance (as a percent of current principal balance) of 1.9% and an annual prepayment rate of 50%.

At March 31, 2007 the amortized cost basis on certain stratifications of the Company’s MSR’s exceeded their fair value. The impairment of $1.0 million was recognized in current period earnings. This amount is included in the fee income line item on the condensed consolidated statements of income. The Company did not recognize an impairment on MSR’s during the three months ended March 31, 2006.

The Company receives annual servicing fees approximating 0.50% of the outstanding balance and rights to future cash flows arising after the investors in the securitization trusts have received the return for which they contracted. Servicing fees received from the securitization trusts were $16.3 million and $15.7 million for the three months ended March 31, 2007 and 2006, respectively.

The Company holds, as custodian, principal and interest collected from borrowers on behalf of the securitization trusts, as well as funds collected from borrowers to ensure timely payment of hazard and primary mortgage insurance and property taxes related to the properties securing the loans. These funds are not owned by the Company and are held in trust. The Company held, as custodian, $494.5 million and $563.5 million at March 31, 2007 and 2006, respectively.

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Note 9. 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.

The Company recognized a cumulative-effect adjustment resulting from the adoption of SFAS 157 resulting from the Company’s change in policies to measure fair value of trading securities. Upon adoption of SFAS 157 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):

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The following table presents for each of the fair value hierarchy levels, the Company’s assets and liabilities which are measured at fair value on a recurring basis as of March 31, 2007 (dollars in thousands).

The following table provides a reconciliation of the beginning and ending balances for the Company’s mortgage securities—available-for-sale which are measured at fair value on a recurring basis using significant unobservable inputs (Level 3) from December 31, 2006 to March 31, 2007 (dollars in thousands):

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The following table provides quantitative disclosures about the fair value measurements for the Company’s assets which are measured at fair value on a nonrecurring basis as of March 31, 2007 (dollars in thousands).

Mortgage loans held-for-sale have a carrying value of $1.2 billion as of March 31, 2007 of which $227.2 million were written down to fair value with the remaining balance recorded at cost. The loans which are carried at fair value had a cost basis of $244.4 million resulting in a valuation adjustment of $17.2 million during the first quarter of 2007.

At the time a mortgage loan held-for-sale or held-in-portfolio becomes real estate owned, the Company records the property at the lower of its carrying amount or fair value. Upon foreclosure and through liquidation, the Company evaluates the property’s fair value as compared to its carrying amount and records a valuation adjustment when the carrying amount exceeds fair value. For mortgage loans held-for-sale, any valuation adjustments are recorded to earnings in the “(losses gains on sales of mortgage assets” line item of the Company’s condensed consolidated income statements. For mortgage loans held-in-portfolio, any valuation adjustments at the time the loan becomes real estate owned is charged to the allowance for credit losses. Any subsequent valuation adjustments are recorded to earnings in the “(losses) gains on sales of mortgage assets” line item of the Company’s condensed consolidated income statements. During the first quarter of 2007, the Company recorded $4.4 million of losses due to valuation adjustments in its condensed consolidated income statements.

MSRs have a carrying value of $52.5 million as of March 31, 2007 of which $20.1 million were written down to fair value with the remaining balance recorded at amortized cost. Periodically, the Company evaluates the carrying value of originated MSRs based on their estimated fair value. If the estimated fair value, using a discounted cash flow methodology, is less than the carrying amount of the mortgage servicing rights, the mortgage servicing rights are written down to the amount of the estimated fair value. For purposes of evaluating and measuring impairment of MSRs the Company stratifies the mortgage servicing rights based on their predominant risk characteristics. The most predominant risk characteristic considered is period of origination. The Company recorded an impairment of $1 million during the first quarter of 2007 related to the stratums which had a fair value lower than amortized cost.

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The following table provides a summary of the impact to earnings for the three months ended March 31, 2007 from the Company’s assets and liabilities which are measured at fair value on a recurring and nonrecurring basis as of March 31, 2007 (dollars in thousands).