NOVATION COMPANIES, INC. - Quarter Report: 2008 June (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 June 30, 2008

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 July 31, 2008 was 9,391,341.

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NOVASTAR FINANCIAL, INC.

FORM 10-Q

For the Quarterly Period Ended June 30, 2008

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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.

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NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

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

See notes to condensed consolidated financial statements.

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NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ DEFICIT

(unaudited; dollars in thousands)

See notes to condensed consolidated financial statements.

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NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited; dollars in thousands)

Continued

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Continued

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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

June 30, 2008 (Unaudited)

Note 1. Financial Statement Presentation

Description of Operations - NovaStar Financial, Inc. (“NFI”) and its subsidiaries (the “Company”) operate as a non-conforming residential mortgage portfolio manager and is exploring opportunities in the residential housing and other markets. Prior to changes in its business in 2007 and early 2008, 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 would not be able to pay a dividend on its common stock with respect to its 2006 taxable income, and as a result the Company’s status as a REIT terminated, retroactive to January 1, 2006. This retroactive revocation of the Company’s REIT status resulted in it becoming taxable as a C corporation for 2006 and subsequent years.

Financial Statement Presentation - The Company’s condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and prevailing practices within the financial services industry. The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of income and expense during the period. The Company uses estimates and employs the judgments of management in determining the amount of its allowance for credit losses, amortizing premiums or accreting discounts on its mortgage assets, establishing the fair value of its mortgage securities, reserve for losses on third party sales, derivative instruments, CDO debt and estimating appropriate accrual rates on mortgage securities – available-for-sale. While the condensed consolidated financial statements and footnotes reflect the best estimates and judgments of management at the time, actual results could differ significantly from those estimates.

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

As of June 30, 2008, the Company’s total liabilities exceeded its total assets under Generally Accepted Accounting Principles (“GAAP”), resulting in a shareholders’ deficit. The Company’s losses, negative cash flows from operations and its shareholders’ deficit raise substantial doubt about the Company’s ability to continue as a going concern, which is dependent upon, among other things, the maintenance of sufficient operating cash flows. There is no assurance that cash flows will be sufficient to meet the Company’s obligations.

The Company’s condensed consolidated financial statements as of June 30, 2008 and for the three and six months ended June 30, 2008 and 2007 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.

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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 condensed 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, 2007.

Liquidity, Business Plan, 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.

Current Liquidity - The Company used $4.9 million in cash to fully repay outstanding indebtedness to Wachovia on May 9, 2008. In addition, $2.1 million of cash was used on May 8, 2008 to satisfy terms of the American Interbanc Mortgage (“AIM”) Settlement Agreement as discussed in detail in Note 7 to these financial statements.

Short and Long Term Obligations - A discussion of the Company’s borrowings is included in Note 6 to these financial statements. NFI’s wholly owned subsidiary NovaStar Mortgage, Inc. (“NMI”) has approximately $77.1 million in principal amount of unsecured notes (collectively, the “Notes”) outstanding to NovaStar Capital Trust I and NovaStar Capital Trust II (collectively, the “Trusts”) which secure trust preferred securities issued by the Trusts. The foregoing is net of amounts owed in respect of trust preferred securities of NovaStar Capital Trust II having a par value of $6.9 million purchased by NMI on May 29, 2008 for $0.6 million. NFI has guaranteed NMI’s obligations under the Notes.

NMI failed to make quarterly interest payments that were due on March 30, April 30, June 30 and July 30, 2008 totaling, for all payment dates combined, approximately $2.8 million on the Notes. As a result, NMI is in default under the related indentures and NFI is in default under the related guarantees. An agreement by the trustees and trust preferred security holders of the Trusts to forbear in the exercise of remedies with respect to the initial payment defaults expired on May 30, 2008. Consequently, the trustee and holders of 25% of the outstanding trust preferred securities of each Trust have the right to accelerate all principal, accrued interest, and other obligations of NMI under the related Notes and to demand payment of all such amounts from NFI under the related guarantees. The total principal and accrued interest owed under the Notes, net of amounts owed in respect of the trust preferred securities held by NMI, was approximately $80.4 million as of August 18, 2008. In addition, the Company is obligated to reimburse the trustees for all reasonable expenses, disbursements and advances in connection with the exercise of rights under the indentures.

On June 4, 2008 and August 14, 2008, the Company received written notices of acceleration from the holders of the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II, respectively, which declared all obligations of NMI under the related Notes and indenture to be immediately due and payable, and stated the intention of the trust preferred security holders to pursue all available rights and remedies, including but not limited to enforcing their rights under the related guarantee. As of the date of filing, no suit has been filed to enforce the holders’ rights under the indentures or the related guarantees.

While NFI is attempting to restructure the terms of the indentures, there can be no assurance that it will be able to do so. Enforcement of remedies under the Notes and related indentures and guarantees would have a material adverse effect on NFI’s financial condition and liquidity and would likely cause NFI to seek the protection of applicable bankruptcy laws.

The Company also expects to have near-term payments for lease and other contract terminations and normal operating expenses. Lease and other contract termination payments will vary, depending on negotiations and available cash. The Company’s current projections indicate sufficient cash and cash flows will be available from its mortgage assets to meet short-term payment needs through 2008. However, the Company’s mortgage asset cash flows are currently volatile and uncertain in nature, and the amounts the Company receives could vary materially from its projections. In addition, these cash flows are expected to continue to decrease over the next several months. Therefore, no assurance can be given that the Company will be able to meet its cash flow needs, in which case it would be required to seek protection of applicable bankruptcy laws.

Certain states required the Company to post surety bonds in connection with its former mortgage lending operations. During 2007, the Company was required to post letters of credit to support its reimbursement obligations to the sureties, and was required to cash collateralize the letters of credit pursuant to its letter of credit agreements with Wachovia Bank. The Company is in the process of terminating these surety bonds and the associated letters of credit as a result of the discontinuation of its mortgage lending operations and has received back collateral associated with letters of credit terminated to date. Collateral totaling $7.2 million remained outstanding as of June 30, 2008, $1.0 million of which the Company has received back subsequent to June 30, 2008. Cancellation of the remaining surety bonds and related letters of credit is subject to certain conditions and may take several months or longer to complete. In addition, the Company is currently in default under the letter of credit agreements as a result of, among other matters, the Company being in default under debt agreements related to its trust preferred securities, discussed further below. Although the Company has received a return of collateral notwithstanding this default, Wachovia Bank is not obligated to return cash collateral to the Company so long as a default exists. Consequently, no assurances can be given as to the timing or amount of any additional return of the remaining cash collateral.

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Future Strategy, Liquidity and Going Concern Considerations – The Company will continue to focus on minimizing losses and preserving liquidity as it manages its existing portfolio of mortgage securities. The Company’s residual and subordinated mortgage securities are currently its only significant source of cash flows. Based on current projections, the cash flows from its mortgage securities will decrease in the next several months as the underlying mortgage loans are repaid, and could be significantly less than the current projections if losses on the underlying mortgage loans exceed, or prepayments are less than, the current assumptions. In addition, the Company has significant operating expenses associated with office leases and other obligations relating to its discontinued operations. As noted above, the Company also has significant obligations with respect to Notes relating to the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II.

If, as the cash flows from its mortgage securities decrease, the Company is unable to recommence or invest in profitable operations, restructure its unsecured debt, capital structure and contractual obligations or if the cash flows from its mortgage securities are less than currently anticipated, there can be no assurance that the Company will be able to realize its assets and discharge its liabilities in the normal course of business and continue as a going concern or avoid seeking the protection of applicable bankruptcy laws. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or to the amounts and classification of liabilities that may be necessary should the Company be unable to continue as a going concern.

The Company has initiated efforts to restructure its indebtedness and certain contractual obligations and is assessing potential changes to elements of its capital structure, with the goal of negotiating and implementing changes to facilitate the achievement of long-term value. There can be no assurances that any of these efforts will be successful.

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

To the extent available, the Company may use excess cash to make certain investments if it determines that such investments could provide attractive risk-adjusted returns to shareholders, including, potentially investing in new or existing operating companies. Because of certain state licensing requirements, it is unlikely the Company will be able to directly recommence mortgage lending activities so long as the Company continues to have a shareholders’ deficit. The Company’s ability to start or acquire new businesses is significantly constrained by its limited liquidity and its likely inability to obtain debt financing or to issue equity securities as a result of its current financial condition, including a shareholders’ deficit, as well as other uncertainties and risks. As discussed in Note 16 to the condensed consolidated financial statements, the Company acquired a majority interest in an appraisal management company subsequent to June 30, 2008. There can be no assurances that the Company will be able to establish or acquire additional new business operations.

Recent Market Developments - During 2008, global financial market conditions have continued to deteriorate. Financial services, and the mortgage industry in particular, have remained under continuous pressure due to numerous factors, which include industry-wide deterioration of the value of mortgage assets held by financial institutions, the deterioration of mortgage credit among mortgage lenders, the downgrades of mortgage securities by the rating agencies, and a reluctance on the part of banks and broker-dealers to finance mortgage securities within the credit markets. Because of these factors, mortgage security market valuations remain volatile, mortgage securities trading remains limited and mortgage securities financing markets remain challenging as the industry continues to report negative news. The global financial market conditions have led to the failure of numerous financial lenders during 2007 and 2008. The factors described above continue to contribute to the decline in the market values of the Company’s securities and loans.

The market has also seen a significant drop in LIBOR rates since the end of 2007 as the Federal Reserve made several cuts in short-term interest rates, which decreases the variable interest rates paid on the bonds issued by the securitization trusts. Because the Company largely holds residual and subordinated securities issued by these trusts, absent any other changes, lower LIBOR rates would have positive effects on the cash flows the Company receives from its mortgage securities. However, the severe deterioration in credit and prepayment performance of the underlying collateral will likely offset part or all of any positive impact of decreased LIBOR rates.

Given the current uncertainty regarding these market conditions, the Company is unable to offer any additional factual information on the situation and how it will impact it other than to disclose what the Company is currently seeing in the mortgage market. As a result, the Company expects to continue to operate with no leverage and to continue to take actions in an effort to preserve liquidity and available cash.

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Home prices - Generally, housing values are experiencing broad-based declines nationwide. Housing values are likely to continue to decrease during the near term which could affect the Company’s credit loss experience, and will continue to impact its earnings, cash flows, financial condition and ability to continue as a going concern.

Loan Repurchases - When the Company sold mortgage loans, whether as whole loans or pursuant to a securitization, it made customary representations and warranties to the purchaser about the mortgage loans and the manner in which they were originated. The Company’s whole loan sale agreements require it to repurchase or substitute mortgage loans in the event the Company breaches any of these representations or warranties. In addition, the Company may be required to repurchase mortgage loans as a result of borrower, broker, or employee fraud. Likewise, the Company is required to repurchase or substitute mortgage loans if it breaches a representation or warranty in connection with its securitizations. Enforcement of repurchase obligations against the Company would further harm the Company’s liquidity, cash flow, financial condition, and ability to continue as a going concern.

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

Note 2. New Accounting Pronouncements

In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 141 (R), “Business Combinations” (“SFAS 141(R)”). In summary, SFAS 141(R) requires the acquirer of a business combination to measure at fair value the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, with limited exceptions. In addition, this standard will require acquisition costs to be expensed as incurred. The standard is effective for fiscal years beginning after December 15, 2008, and is to be applied prospectively, with no earlier adoption permitted. The adoption of this standard may have an impact on the accounting for certain costs related to any future acquisitions.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (SFAS 160), which requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and non-controlling interest. SFAS 160 is effective for fiscal years beginning on or after December 15, 2008. The adoption of this standard is not expected to have a material effect on our consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS 161”). The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The Company does not expect the adoption of SFAS 161 will have a material impact on its condensed consolidated financial statements, however, the Company is still in the process of evaluating the impact of adopting SFAS 161.

In April 2008, the FASB issued FASB Staff Position (“FSP”) No. SFAS 142-3, “Determination of the Useful Life of Intangible Assets” (FSP SFAS 142-3). FSP SFAS 142-3 amends paragraph 11(d) of FASB Statement No. 142 “Goodwill and Other Intangible Assets” (SFAS 142) which amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS 142. FSP SFAS 142-3 is intended to improve the consistency between the useful life of a recognized intangible asset under SFAS 142 and the period of expected cash flows used to measure the fair value of the asset. FSP SFAS 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008 and must be applied prospectively to intangible assets acquired after the effective date. The Company is evaluating the impact that adoption of FSP SFAS 142-3 will have on our consolidated financial statements.

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In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (SFAS 162”). SFAS 162 identifies the sources of accounting principles and the framework for selecting principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles in the United States. This statement shall be effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board’s amendments to the PCAOB’s Interim Auditing Standards (AU) section 411, “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles.” The Company is in the process of evaluating the potential effect of adoption of SFAS 162.

Note 3. Mortgage Loans – Held in Portfolio

Mortgage loans, all of which are secured by residential properties, consisted of the following as of June 30, 2008 and December 31, 2007 (dollars in thousands):

Mortgage loans held-in-portfolio consist of loans that the Company has securitized in structures that are accounted for as financings. These securitizations are structured legally as sales, but for accounting purposes are treated as financings under SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – a replacement of FASB Statement 125” (“SFAS 140”). The NHES 2006-1 and NHES 2006-MTA1 securitizations do not meet the qualifying special purpose entity criteria necessary for sale treatment under SFAS 140 and related interpretations because after the loans were securitized the securitization trusts were able to acquire derivatives relating to beneficial interests retained by the Company, and the Company has discretion to call (other than a clean-up call) loans back from the trust. Accordingly, the loans in these securitizations remain on the balance sheet as “Mortgage loans held-in-portfolio”, retained interests were not created, and securitization bond financing is reflected on the balance sheet as a liability. 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.

Prior to June 30, 2008, the NHES 2007-1 securitization did not meet the qualifying special purpose entity criteria necessary for sale treatment under SFAS 140 and related interpretations because of the excessive benefit the Company received from the derivative instruments delivered into the trust to counteract interest rate risk. Prior to June 30, 2008, significant provisions for loan losses had been recorded against these securitized loans, resulting in an allowance for loan loss relating to this pool of loans totaling $309 million and an overall net deficit for the trust totaling $312 million. As of June 30, 2008 it was determined that the Company is no longer receiving excessive benefit from the derivative instruments relating to the NHES 2007-1 securitization. Therefore, the Company has relinquished all control over the receivables and now that the issuer is deemed to meet the requirements under SFAS No. 140 as a Qualifying Special Purpose Entity, the assets and liabilities should be deconsolidated pursuant to SFAS No. 140. As a result, the mortgage loans – held-in-portfolio, asset-backed bonds secured by mortgage loans, and all other assets and liabilities relating to this securitization were removed from the balance sheet, the retained interest and the other subordinated securities the Company retained in this transaction were recorded in the “Mortgage securities – trading” line, and a gain of $312 million was recorded through the “Gains (losses) on sales of mortgage assets” line of the condensed consolidated statement of operations. This transaction is referred to within the notes to the condensed consolidated financial statements as the “NHES 2007-1 Sale.”

At June 30, 2008 all of the loans classified as held-in-portfolio were pledged as collateral for the related securitization bond financing.

Activity in the allowance for credit losses on mortgage loans – held-in-portfolio is as follows for the six and three months ended June 30, 2008 and 2007, respectively (dollars in thousands):

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Note 4. Mortgage Securities – Available-for-Sale

As of June 30, 2008, and December 31, 2007, mortgage securities – available-for-sale consisted entirely of the Company’s investment in the residual securities issued by securitization trusts sponsored by the Company, but did not include the NMFT Series 2007-2 or NHES Series 2007-1 residual securities, which were designated as trading as a result of the Company’s adoption of SFAS 155, “Accounting for Certain Hybrid Financial Instruments”, an amendment of SFAS 133 and SFAS 140 (“SFAS 155”) on January 1, 2007 and the complexities and uncertainties surrounding the application of this Statement. As a result, the NMFT Series 2007-2 and NHES Series 2007-1 residual securities qualify for the scope exception concerning bifurcation provided by SFAS 155. Residual securities consist of interest-only, prepayment penalty and overcollateralization bonds. Management estimates the fair value of the residual securities by discounting the expected future cash flows of the collateral and bonds.

The following table presents certain information on the Company’s portfolio of mortgage securities – available-for-sale as of June 30, 2008 and December 31, 2007 (dollars in thousands):

During the six and three months ended June 30, 2008 and 2007, 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 impairments on mortgage securities – available-for-sale of $21.2 million and $1.8 million during the six and three months ended June 30, 2008, respectively, as compared to $26.0 million and $22.6 million during the same periods of 2007.

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 June 30, 2008 to mature in one to five years.

Note 5. Mortgage Securities – Trading

As of June 30, 2008, mortgage securities – trading consisted of the NHES 2007-1 and NMFT Series 2007-2 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. As of December 31, 2007, mortgage securities – trading consisted of NMFT Series 2007-2 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 9 to the condensed consolidated financial statements for a description of the valuation methods as of June 30, 2008 and December 31, 2007.

The following table summarizes the Company’s mortgage securities – trading as of June 30, 2008 and December 31, 2007 (dollars in thousands):

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The Company recognized net trading losses of $(74.9) million and $(23.3) million for the six and three months ended June 30, 2008, respectively as compared to net trading losses of $(89.7) million and $(39.7) million for the same periods of 2007. These net trading losses are included in the fair value adjustments line on the Company’s condensed consolidated statements of operations.

Due to the NHES 2007-1 Sale, subordinated securities having an original face amount of $51.0 million, an amortized cost basis of $42.6 million and a fair value of $1.0 million and a residual interest having an amortized cost basis and fair value of $1.5 million retained by the Company in this transaction were added to the balance sheet in the “Mortgage securities – trading” line and are included in the table above. See Note 3 to the condensed consolidated financial statements for further discussion.

As of December 31, 2007 the Company had pledged all of its trading securities as collateral for financing purposes. On May 9, 2008, the short-term borrowings collateralized by the Company’s trading securities were repaid and the collateral was released back to the Company.

Note 6. Borrowings

Short-term Borrowings

On May 9, 2008, the Company fully repaid all outstanding borrowings with Wachovia and all agreements were terminated effective the same day. As a result, the Company has no short-term borrowing capacity or agreements currently available to it.

Asset-backed Bonds (“ABB”)

On January 30, 2008, an event of default occurred under the CDO bond indenture agreement due to noncompliance with certain overcollateralization tests. As a result, the trustee, upon notice and at the direction of a majority of the secured noteholders, may declare all of the secured notes to be immediately due and payable including accrued and unpaid interest. No such notice has been given as of August 18, 2008. The Company does not expect any significant impact to its financial condition, cash flows or results of operation as a result of the event of default.

Due to the NHES 2007-1 Sale, asset-backed bonds totaling $1.5 billion were removed from the balance sheet. See Note 3 to the condensed consolidated financial statements for further discussion.

Junior Subordinated Debentures

Trust Preferred Obligations. NFI’s wholly owned subsidiary NovaStar Mortgage, Inc. (“NMI”) has approximately $77.1 million in principal amount of unsecured notes (collectively, the “Notes”) outstanding to NovaStar Capital Trust I and NovaStar Capital Trust II (collectively, the “Trusts”) which secure trust preferred securities issued by the Trusts. The foregoing is net of amounts owed in respect of trust preferred securities of NovaStar Capital Trust II having a par value of $6.9 million purchased by NMI on May 29, 2008 for $0.6 million. NFI has guaranteed NMI’s obligations under the Notes.

NMI failed to make quarterly interest payments on the Notes, that were due on March 30, April 30, June 30 and July 30, 2008 totaling, approximately $2.8 million for all payment dates combined. As a result, NMI is in default under the related indentures and NFI is in default under the related guarantees. An agreement by the trustees and trust preferred security holders of the Trusts to forbear in the exercise of remedies with respect to the initial payment defaults expired on May 30, 2008. Consequently, the trustee and holders of 25% of the outstanding trust preferred securities of each Trust have the right to accelerate all principal, accrued interest, and other obligations of NMI under the related Notes and to demand payment of all such amounts from NFI under the related guarantees. The total principal and accrued interest owed under the Notes, net of amounts owed in respect of the trust preferred securities held by NMI, was approximately $80.4 million as of August 18, 2008. In addition, the Company is obligated to reimburse the trustees for all reasonable expenses, disbursements and advances in connection with the exercise of rights under the indentures.

On May 29, 2008, NFI purchased trust preferred securities of NovaStar Capital Trust II having a par value of $6.9 million for $0.6 million. As a result, $6.9 million of principal and accrued interest of $0.2 million of the Notes was retired and the principal amount, accrued interest, and related unamortized debt issuance costs related to these Notes were removed from the balance sheet at June 30, 2008 resulting in a gain of $6.4 million, recorded to the “Gains on debt extinguishment” line item of the condensed consolidated statements of operations.

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On June 4, 2008 and August 14, 2008, the Company received written notices of acceleration from the holders of the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II, respectively, which declared all obligations of NMI under the related Notes and indenture to be immediately due and payable, and stated the intention of the trust preferred security holders to pursue all available rights and remedies, including but not limited to enforcing their rights under the related guarantee. As of the date of filing, no suit has been filed to enforce the holders’ rights under the indentures or the related guarantees.

While NFI is attempting to restructure the terms of the indentures, there can be no assurance that it will be able to do so. Enforcement of remedies under the Notes and related indentures and guarantees would have a material adverse effect on NFI’s financial condition and liquidity and would likely cause NFI to seek the protection of applicable bankruptcy laws.

Note 7. Commitments and Contingencies

Contingencies

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

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

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

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

Pursuant to the Settlement Terms, the Involuntary was dismissed on April 24, 2008. As provided in the Settlement Terms, on May 8, 2008, the Company paid Plaintiff $2.0 million plus the balance in an account established by order of the Bankruptcy Court, and NHMI satisfied obligations totaling $48,000 to certain identified creditors. The parties also agreed to extend the Appeal briefing period pending finalization of the settlement of the other actions, judgments and claims, as described below.

The Settlement Terms provide that, following satisfaction of certain other conditions, the parties will dismiss the California Action as to NHMI and the Kansas City Action and Delaware Judgment, effect notice of satisfaction of the Judgment, and effect a mutual release of all claims that were or could have been raised in any of the foregoing or that are related to the subject matter thereof. In the event that the conditions are not satisfied, as to which no assurance can be given, the Judgment will remain in effect and the related claims will not be released, which could result in NHMI and, if found liable for the Judgment, the Company seeking the protection of applicable bankruptcy laws.

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

In accordance with generally accepted accounting principles, NHMI has recorded a liability of $45.2 million as of June 30, 2008 with a corresponding charge to earnings. The $45.2 million includes interest which is accruing on the obligation. Because NHMI is a wholly owned indirect subsidiary of the Company, the $45.2 million liability is included in the consolidated financial statements of the Company. The liability is included in the “Liabilities of discontinued operations” line of the consolidated balance sheets.

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Other Litigation. Since April 2004, a number of substantially similar class action lawsuits have been filed and consolidated into a single action in the United States District Court for the Western District of Missouri. The consolidated complaint names the Company and three of the Company’s current and former executive officers as defendants and generally alleges that the defendants made public statements that were misleading for failing to disclose certain regulatory and licensing matters. The plaintiffs purport to have brought this consolidated action on behalf of all persons who purchased the Company’s common stock (and sellers of put options on the Company’s common stock) during the period October 29, 2003 through April 8, 2004. On January 14, 2005, the Company filed a motion to dismiss this action, and on May 12, 2005, the court denied such motion. On February 8, 2007, the court certified the case as a class action. The case is now in the discovery stage. The Company believes that these claims are without merit and continues to vigorously defend against them.

In February 2007, a number of substantially similar putative class actions were filed in the United States District Court for the Western District of Missouri. The complaints name the Company and three of the Company’s former and current executive officers as defendants and generally allege, among other things, that the defendants made materially false and misleading statements regarding the Company’s business and financial results. The plaintiffs purport to have brought the actions on behalf of all persons who purchased or otherwise acquired the Company’s common stock during the period May 4, 2006 through February 20, 2007. Following consolidation of the actions, a consolidated amended complaint was filed on October 19, 2007. On December 29, 2007, the defendants moved to dismiss all of plaintiffs’ claims. On June 4, 2008, the Court dismissed the plaintiffs’ complaints without leave to amend. The plaintiffs have filed an appeal of the Court’s ruling.

In May 2007, a lawsuit entitled National Community Reinvestment Coalition v. NovaStar Financial, Inc., et al., was filed against the Company in the United States District Court for the District of Columbia. Plaintiff, a non-profit organization, alleges that the Company maintains corporate policies of not making loans on Indian reservations, on dwellings used for adult foster care or on rowhouses in Baltimore, Maryland in violation of the federal Fair Housing Act. The lawsuit seeks injunctive relief and damages, including punitive damages, in connection with the lawsuit. On May 30, 2007, the Company responded to the lawsuit by filing a motion to dismiss certain of plaintiff’s claims. On March 31, 2008 that motion was denied by the Court. The Company believes that these claims are without merit and will vigorously defend against them.

In June 2007, two borrowers filed a putative class action entitled Kubiak v. NovaStar Mortgage, Inc., against the Company and two of its subsidiaries in the United States District Court for the Northern District of California, alleging that payments of premiums to brokers by one of the subsidiaries were not properly disclosed to borrowers in the manner allegedly required by federal or state law, thus constituting unfair competition and false advertising under California law and violation of the California Consumer Legal Remedies Act. Plaintiffs sought statutory and punitive damages, restitution, injunctive relief and attorney’s fees on behalf of California borrowers who allegedly failed to receive adequate disclosure of such premiums. The defendants filed a motion to dismiss the action. On December 19, 2007, the Court granted defendants’ motion to dismiss the complaint, including the claims against NovaStar Financial, Inc., but the Court allowed the plaintiffs to file an amended complaint. On January 9, 2008, the plaintiffs filed an amended complaint that did not make any claim against NovaStar Financial, Inc., but did assert the above claims against its subsidiaries, NovaStar Mortgage, Inc. and NovaStar Home Mortgage, Inc. (the “Subsidiary Defendants”). In June 2008, the named plaintiffs and Subsidiary Defendants agreed to settle the claims of the named plaintiffs and to dismiss the lawsuit for a nominal amount.

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

On January 31, 2008, two purported shareholders filed separate derivative actions in the Circuit Court of Jackson County, Missouri against various former and current officers and directors and named the Company as a nominal defendant. The essentially identical petitions allege that the individual defendants breached fiduciary duties owed to the Company in connection with alleged insider selling and misappropriation of information, abuse of control, gross mismanagement, waste of corporate assets, and unjust enrichment between May 2006 and December 2007. On June 24, 2008 a third, similar case was filed in United States District Court for the Western District of Missouri. The Company believes that these claims are without merit and will vigorously defend against them.

On May 6, 2008, the Company received a letter written on behalf of J.P. Morgan Mortgage Acceptance Corp. and certain affiliates (“Morgan”) demanding indemnification of claims asserted against Morgan in a case entitled Plumbers & Pipefitters Local #562 Supplemental Plan and Trust v. J.P. Morgan Acceptance Corp. et al, filed in the Supreme Court of the State of New York, County of Nassau. The case seeks class action certification for alleged violations by Morgan of sections 11 and 15 of the Securities Act of 1933, on behalf of all persons who purchased certain categories of mortgage backed securities issued by Morgan in 2006 and 2007. Morgan’s indemnity demand alleges that any liability it might

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have to plaintiffs would be based, in part, upon alleged misrepresentations made by the Company with respect to certain mortgages that make up a portion of the collateral for the securities at issue. The Company believes it has meritorious defenses to this demand and expects to defend vigorously any claims asserted.

On May 21, 2008, a purported class action case was filed in the Supreme Court of the State of New York, New York County, by the New Jersey Carpenters’ Health Fund, on behalf of itself and all others similarly situated. Defendants in the case include NovaStar Mortgage Funding Corporation, several securitization trusts sponsored by the Company, the individual directors of those trusts, and several unaffiliated investment banks and credit rating agencies. The case was removed to the United States District Court for the Southern District of New York, and plaintiff has filed a motion to remand the case to state court. Plaintiff alleges that the defendants violated sections 11, 12 and 15 of the Securities Act of 1933 by making allegedly false statements regarding mortgage loans that served as collateral for securities purchased by plaintiff and the purported class members. The Company has not yet filed its initial responsive pleading, and discovery is not yet underway. The Company believes it has meritorious defenses to the case and expects to defend the case vigorously.

On July 7, 2008, plaintiff Jennifer Jones filed a purported class action case in the United States District Court for the Western District of Missouri against the Company, certain former and current officers of the Company, and unnamed members of the Company’s “Retirement Committee”. Plaintiff, a former employee of the Company, seeks class action certification on behalf of all persons who were participants in or beneficiaries of the Company’s 401(k) plan from May 4, 2006 until November 15, 2007 and whose accounts included investments in the Company’s common stock. Plaintiff alleges that the Company’s common stock was an inappropriately risky investment option for retirement savings, and that defendants breached their fiduciary duties by allowing investment of some of the assets contained in the 401(k) plan to be made in the Company’s common stock. The Company has not yet filed its initial responsive pleading, and discovery is not yet underway. The Company believes it has meritorious defenses to the case and expects to defend the case vigorously.

In addition to those matters listed above, the Company is currently a party to various other legal proceedings and claims, including, but not limited to, breach of contract claims, tort claims, and claims for violations of federal and state consumer protection laws.

In addition, the Company has received requests or subpoenas for information from various regulators or law enforcement officials, including, without limitation, the United States Department of Justice, the Federal Bureau of Investigation, the New York Attorney General and the Department of Labor.

Note 8. Comprehensive Income

Comprehensive income includes revenues, expenses, gains and losses that are not included in net income. The following is a rollforward of accumulated other comprehensive income for the six and three months ended June 30, 2008 and 2007 (dollars in thousands):

Note 9. Fair Value Accounting

Effective January 1, 2007, the Company adopted SFAS No. 157, “Fair Value Measurements” (“SFAS 157”) and SFAS No. 159, “The Fair Value Option for Financial Assets” (“SFAS 159”). Both standards address aspects of the expanding application of fair value accounting.

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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 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 June 30, 2008 (dollars in thousands):

The following table provides a reconciliation of the beginning and ending balances for the Company’s mortgage securities – trading which are measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the six months ended June 30, 2008 and 2007 (dollars in thousands):

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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) for the six months ended June 30, 2008 and 2007 (dollars in thousands):