NOVATION COMPANIES, INC. - Quarter Report: 2008 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, 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 April 30, 2008 was 9,391,341.

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NOVASTAR FINANCIAL, INC.

FORM 10-Q

For the Quarterly Period Ended March 31, 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 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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Supplemental Disclosure of Cash Flow Information

(unaudited; dollars in thousands)

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NOVASTAR FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

As of and for the quarterly period ended March 31, 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. 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 March 31, 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 March 31, 2008 and for the three months ended March 31, 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 as it continues into 2008.

Current Liquidity and Near-Term Obligations—The Company used $4.9 million in cash to fully repay outstanding indebtedness to Wachovia on May 9, 2008 and used $2.1 million of cash on May 8, 2008 to satisfy certain terms of the American Interbanc Mortgage (“AIM”) Settlement Agreement. See Note 7 for further discussion of the AIM Settlement Agreement. As of May 15, 2008, the Company had approximately $3 million in unrestricted cash and cash equivalents. On May 30, 2008, the Company has quarterly interest payments due on its trust preferred securities of approximately $1.7 million, which previously became due but were deferred. See below for further discussion of the Company’s near-term obligations on its trust preferred securities. Additionally, the Company expects to have near-term payments for pending litigation settlements, lease terminations and other normal operating expenses. Lease and other contract termination payments will vary, depending on negotiations and available cash. The Company’s current projections indicate sufficient available cash and cash flows from its mortgage assets to meet these short-term payment needs. However, the Company’s mortgage asset cash flows are currently volatile and uncertain in nature, and the amounts the Company receives could vary materially from its projections. Therefore, no assurances can be given that the Company will be able to meet its cash flow needs, in which case it would be required to seek protection of applicable bankruptcy laws.

Trust Preferred Obligations—To preserve short-term liquidity flexibility, on March 30, 2008, NovaStar Mortgage, Inc. (“NMI”), a wholly-owned subsidiary of NFI, did not make a quarterly interest payment of $1.3 million due on its unsecured junior subordinated notes issued to NovaStar Capital Trust I and NovaStar Capital Trust II. In addition, on April 30, 2008, NMI did not make a quarterly interest payment of $0.4 million. As a result, Trust I and Trust II were unable to make corresponding payments owed to the holders of the trust preferred securities issued by the trusts. NFI has guaranteed NMI’s obligations under these notes, including NMI’s obligations to make periodic interest payments thereon. Under the terms of the indentures governing the notes, NMI had a grace period of 30 days from March 30, 2008 and April 30, 2008 (the respective interest payment due dates) before the nonpayment gave the parties to, or beneficiaries of, the indentures a right to accelerate the obligations under the notes based on these payment failures.

NMI, NFI, and the trustees and security holders of NovaStar Capital Trust I and NovaStar Capital Trust II entered into Forbearance Agreements, dated April 29, 2008, under which the security holders and the trustees agreed to forbear in the exercise of their rights and remedies under the respective indenture, the respective notes and the other applicable documents and instruments with respect to these payment failures until May 30, 2008. Other than with respect to the payment failures, the parties to each indenture preserved all of their rights and remedies under the applicable indenture, the applicable notes and the other applicable documents and instruments related thereto. As a condition to the aforementioned forbearance, until May 30, 2008, NMI agreed: (1) not to incur any additional indebtedness (other than ordinary trade accounts payable); (2) not to convey, transfer, or lease any of its properties and assets (other than in the ordinary course of business); (3) not to consolidate with or merge into any other person; and (4) to fully repay all outstanding borrowings and remaining fees due to Wachovia.

While the Company has repaid the outstanding borrowings and fees to Wachovia and intends to negotiate with the applicable parties to restructure the terms of the indentures and to make the payments required thereunder on or before May 30, 2008, there can be no assurance that it will be able to do so. In the event that the Company is unable to restructure the terms of the indentures or fails to pay the interest owed on the notes as required by the Forbearance Agreements, the parties to the Forbearance Agreements may seek an acceleration of the obligations under the indentures. Such an event would have a material adverse effect on the Company and its financial condition and liquidity and would be likely to cause the Company to seek the protection of applicable bankruptcy laws.

Future Strategy, Liquidity and Going Concern Considerations – The Company will continue to focus on minimizing losses and preserving liquidity with its remaining operations which consists only of mortgage portfolio management. The Company’s residual and subordinated mortgage securities are currently its only 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, software contracts, and other obligations relating to its discontinued

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operations, as well as periodic interest payments with respect to junior subordinated debentures relating to the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II. 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 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.

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

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

The market has also seen a significant drop in LIBOR rates since the end of 2007 as the Federal Reserve made several cuts in short-term interest rates, which decreases the variable interest rates tied to one-month LIBOR within the Company’s securitizations which collateralize the Company’s mortgage securities and mortgage loans – held-in-portfolio. As a result, lower LIBOR rates could have positive effects on the cash flows the Company receives from its mortgage securities. However, these cash flows are also dependent on the credit and prepayment performance of the underlying collateral, which could offset any positive impact of decreased LIBOR rates.

Given the uncertainty regarding these market conditions, the Company expects to continue to operate with a historically low level of leverage and to continue to take actions in an effort to preserve liquidity and available cash.

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

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. If a purchaser enforces its remedies against the Company, it may not be able to recover losses from the originating broker or correspondent. Repurchased loans cannot currently be financed by the Company. As a result, significant repurchase activity would further harm the Company’s liquidity, cash flow, and financial condition.

Credit Deterioration - The residential mortgage market has encountered difficulties which have 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, in recent months residential property values in most states have declined, in some areas severely, after extended periods during which those values appreciated. A sustained decline or a lack of increase in those values is likely to result in additional increases in delinquencies and losses on residential mortgage loans generally, especially with respect to any residential mortgage loans where the aggregate loan amounts (including any subordinate loans) are close to or greater

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than the related property values. Another factor that may have contributed to, and may in the future result in, higher delinquency rates is the increase in monthly payments on adjustable rate mortgage loans. Any increase in prevailing market interest rates may result in increased payments for borrowers who have adjustable rate mortgage loans. Moreover, with respect to option ARM mortgage loans with a negative amortization feature which reach their negative amortization cap, borrowers may experience a substantial increase in their monthly payment even without an increase in prevailing market interest rates. Compounding this issue, the current lack of appreciation in residential property values and the adoption of tighter underwriting standards throughout the sub-prime mortgage loan industry may adversely affect the ability of borrowers to refinance these loans and avoid default, particularly borrowers facing a reset of the monthly payment to a higher amount. To the extent that delinquencies or losses continue to increase for these or other reasons, the value of 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 March 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“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.

Note 3. Mortgage Loans – Held in Portfolio

Mortgage loans – held-in-portfolio, all of which are secured by residential properties, consisted of the following as of March 31, 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 (“SFAS 140”), “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – a replacement of FASB Statement 125”. 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 are securitized the securitization trusts may acquire derivatives relating to beneficial interests retained by the Company and, the Company, has discretion to call (other than a clean-up call) loans back from the trust. The NHES 2007-1 securitization does not meet the qualifying special purpose entity criteria necessary for sale treatment under SFAS 140 and related interpretations because of the excessive benefit the Company receives from the derivative instruments delivered into the trust to counteract interest rate risk. Accordingly, the loans in these securitizations remain on the balance sheet as “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.

At March 31, 2008 all of the loans classified as held-in-portfolio were pledged as collateral for the related securitization bond financing.

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Activity in the allowance for credit losses on mortgage loans – held-in-portfolio is as follows for the three months ended March 31, 2008 and 2007, respectively (dollars in thousands):

Note 4. Mortgage Securities – Available-for-Sale

As of March 31, 2008, and December 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, but does not include the NMFT Series 2007-2 residual security, which was 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 residual security qualifies 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 March 31, 2008 and December 31, 2007 (dollars in thousands):

During the three months ended March 31, 2008 and 2007, 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 $19.4 million and $3.4 million during the three months ended March 31, 2008 and 2007, respectively.

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, 2008 to mature in one to five years.

Note 5. Mortgage Securities – Trading

As of March 31, 2008 and December 31, 2007, mortgage securities – trading consisted of the NMFT Series 2007-2 residual security 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 for a description of the valuation methods as of December 31, 2007 and March 31, 2008.

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

The Company recognized net trading losses of $(51.6) million and $(50.1) million for the three months ended March 31, 2008 and 2007, respectively. These net trading losses are included in the fair value adjustments line on the company’s condensed consolidated statements of operations.

As of March 31, 2008 and 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 May 15, 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.

Junior Subordinated Debentures

To preserve short-term liquidity flexibility, on March 30, 2008, NovaStar Mortgage, Inc. (“NMI”), a wholly-owned subsidiary of NFI, did not make a quarterly interest payment of $1.3 million due on its unsecured junior subordinated notes issued to NovaStar Capital Trust I and NovaStar Capital Trust II. In addition, on April 30, 2008 NMI did not make a quarterly interest payment of $0.4 million. As a result, NovaStar Capital Trust I and NovaStar Capital Trust II were unable to make corresponding payments owed to the holders of the trust preferred securities issued by the trusts. NFI has guaranteed NMI’s obligations under the notes, including NMI’s obligations to make periodic interest payments thereon. Under the terms of the indentures governing the notes, NMI had a grace period of 30 days from March 30, 2008 and April 30, 2008 (the respective interest payment due dates) before the nonpayment gave the parties to, or beneficiaries of, the indentures a right to accelerate the obligations under the notes based on these payment failures.

NMI, NFI, and the trustees and security holders of NovaStar Capital Trust I and NovaStar Capital Trust II entered into Forbearance Agreements, dated April 29, 2008, under which the security holders and the trustees agreed to forbear in the exercise of their rights and remedies under the respective indenture, the respective notes and the other applicable documents and instruments with respect to these payment failures until May 30, 2008. Other than with respect to the payment failures, the parties to each indenture preserved all of their rights and remedies under the applicable indenture, the applicable notes and the other applicable documents and instruments related thereto. As a condition to the aforementioned forbearance, until May 30, 2008, NMI agreed: (1) not to incur any additional indebtedness (other than ordinary trade accounts payable); (2) not to convey, transfer, or lease any of its properties and assets (other than in the ordinary course of business); (3) not to consolidate with or merge into any other person; and (4) to fully repay all outstanding borrowings and remaining fees due to Wachovia.

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While the Company has repaid the outstanding borrowings and fees to Wachovia and intends to negotiate with the applicable parties to restructure the terms of the indentures and to make the payments required thereunder on or before May 30, 2008 as required by the Forbearance Agreements, there can be no assurance that it will be able to do so. In the event that the Company is unable to restructure the terms of the indentures or fails to pay the interest owed on the notes as required by the Forbearance Agreements, the parties to the Forbearance Agreements may seek an acceleration of the obligations under the indentures. Such an event would have a material adverse effect on the Company and its financial condition and liquidity and would be likely to cause the Company 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, the Company paid Plaintiff $2,000,000 plus the balance in an account established by order of the Bankruptcy Court, and NHMI is obligated to otherwise satisfy obligations to its identified creditors up to $48,000. The parties also agreed to extend the Appeal briefing period pending finalization of the settlement of the other actions, judgments and claims, as described below.

The Settlement Terms provide that, 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 $47.1 million as of March 31, 2008 with a corresponding charge to earnings. The $47.1 million includes interest which is accruing on the obligation. Because NHMI is a wholly owned indirect subsidiary of the Company, the $47.1 million liability is included in the consolidated financial statements of the Company. The liability is included in the “Liabilities of discontinued operations” line of the consolidated balance sheets. The Company paid the Plaintiff $2.1 million on May 8, 2008 in accordance with the Settlement Terms.

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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 executive officers as defendants and generally allege, among other things, that the defendants made materially false and misleading statements regarding the Company’s business and financial results. The plaintiffs purport to have brought the actions on behalf of all persons who purchased or otherwise acquired the Company’s common stock during the period May 4, 2006 through February 20, 2007. Following consolidation of the actions, a consolidated amended complaint was filed on October 19, 2007. On December 29, 2007, the defendants moved to dismiss all of plaintiffs’ claims, and that motion is pending. The Company believes that these claims are without merit and will vigorously defend against them.

In May 2007, a lawsuit 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, or dwellings used for adult foster care or on rowhouses in Baltimore, Maryland in violation of the federal Fair Housing Act. The lawsuit seeks injunctive relief and damages, including punitive damages, in connection with the lawsuit. On May 30, 2007, the Company responded to the lawsuit by filing a motion to dismiss certain of plaintiff’s claims. 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 seek statutory and punitive damages, restitution, injunctive relief and attorney’s fees on behalf of California borrowers who allegedly failed to receive adequate disclosure of such premiums. The defendants filed a motion to dismiss the action. On December 19, 2007, the Court granted defendants’ motion to dismiss the complaint, including the claims against NovaStar Financial, Inc., but the Court allowed the plaintiffs to file an amended complaint. On January 9, 2008, the plaintiffs filed an amended complaint that does not make any claim against NovaStar Financial, Inc., but does assert the above claims against its subsidiaries, NovaStar Mortgage, Inc. and NHMI. The Company believes that these claims are without merit and will vigorously defend against them.

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

In addition to those matters listed above, the Company is currently a party to various other legal proceedings and claims, including, but not limited to, breach of contract claims, 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.

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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 three months ended March 31, 2008 and 2007 (dollars in thousands):

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.

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The following table presents for each of the fair value hierarchy levels, the Company’s assets and liabilities related to continuing operations which are measured at fair value on a recurring basis as of March 31, 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 three months ended March 31, 2008 (dollars in thousands):

The Company had no mortgage securities – trading which were measured at fair value using significant unobservable inputs as of
March 31, 2007.

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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 three months ended March 31, 2008 and 2007 (dollars in thousands):

The following table provides quantitative disclosures about the fair value measurements for the Company’s assets related to continuing operations which are measured at fair value on a nonrecurring basis as of March 31, 2008 (dollars in thousands):

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At the time a mortgage loan held-in-portfolio becomes real estate owned, the Company records the property at the lower of its carrying amount or fair value. Upon foreclosure and 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-in-portfolio, any valuation adjustments at the time the loan becomes real estate owned is charged to the allowance for credit losses.

The following table provides a summary of the impact to earnings for the three months ended March 31, 2008 and 2007 from the Company’s assets and liabilities related to continuing operations which are measured at fair value on a recurring and nonrecurring basis as of March 31, 2008 (dollars in thousands) :

Valuation Methods

Mortgage securities – trading. Trading securities are recorded at fair value with gains and losses, realized and unrealized, included in earnings. The Company uses the specific identification method in computing realized gains or losses. Fair value for the subordinated securities classified as trading is estimated using quoted market prices. The Company determined these quoted market prices would qualify as Level 2 due to the inactive and illiquid nature of the market for these securities.

In addition, upon the closing of its NMFT Series 2007-2 securitization, the Company classified the residual security it retained as trading. Management estimates the fair value of its residual securities by discounting the expected future cash flows of the collateral and bonds. Due to the unobservable inputs used by the Company in determining the expected future cash flows, the Company determined its valuation methodology for residual securities would qualify as Level 3. See “Mortgage securities – available-for-sale” for further discussion of the Company’s valuation policies relating to residual securities.

Mortgage securities – available-for-sale. Mortgage securities – available-for-sale represent beneficial interests the Company retains in securitization and resecuritization transactions which include residual securities. The Company had no subordinated securities included within the mortgage securities – available-for-sale classification as of March 31, 2008. Mortgage securities classified as available-for-sale are reported at their estimated fair value with unrealized gains and losses reported in accumulated other comprehensive income. To the extent that the cost basis of mortgage securities exceeds the fair value and the unrealized loss is considered to be other-than-temporary, an impairment charge is recognized and the amount recorded in accumulated other comprehensive income or loss is reclassified to earnings as a realized loss. The specific identification method is used in computing realized gains or losses. The Company uses two methodologies for determining the initial value of its residual securities 1) the whole loan price methodology and 2) the discount rate methodology. The Company believes the best estimate of the initial value of the residual securities it retains in its securitizations accounted for as sales is derived from the market value of the pooled loans. As such, the Company generally will try to use the whole loan price methodology when significant open market sales pricing data is available. Under this method, the initial value of the loans transferred in a securitization accounted for as a sale is estimated based on the expected open market sales price of a similar pool. In open market transactions, the purchaser has the right to reject loans at its discretion. In a loan securitization, loans generally cannot be rejected. As a result, the Company adjusts the market price for the loans to compensate for the estimated value of rejected loans. The market price of the securities retained is derived by deducting the net proceeds received in the securitization (i.e. the economic value of the loans transferred) from the estimated adjusted market price for the entire pool of the loans.

An implied yield (discount rate) is derived by taking the projected cash flows generated using assumptions for prepayments, expected credit losses and interest rates and then solving for the discount rate required to present value the cash flows back to the initial value derived above. The Company then ascertains whether the resulting discount rate is commensurate with current market conditions. Additionally, the initial discount rate serves as the initial accretable yield used to recognize income on the securities.

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

At each reporting period subsequent to the initial valuation of the residual securities, the fair value of the residual securities is estimated based on the present value of future expected cash flows to be received. Management’s best estimate of key assumptions, including credit losses, prepayment speeds, the market discount rates and forward yield curves commensurate with the risks involved, are used in estimating future cash flows.

Derivative instruments. The fair value of derivative instruments is estimated by discounting the projected future cash flows using appropriate market rates.

Asset-backed bonds secured by mortgage securities. The Company elected the fair value option for the asset-backed bonds issued from NovaStar ABS CDO I, which closed in the first quarter of 2007. The election was made for these liabilities to help reduce income statement volatility which otherwise would arise if the accounting method for this debt was not matched with the fair value accounting for the mortgage securities - trading. Fair value is estimated using quoted market prices. The Company determined these quoted market prices would qualify as Level 2 due to the inactive and illiquid nature of the market.

Real estate owned. Real estate owned is carried at the lower of cost or fair value less estimated selling costs. The Company estimates fair value at the asset’s liquidation value less selling costs using management’s assumptions which are based on historical loss severities for similar assets.

Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159)

Under SFAS 159, the Company may elect to report most financial instruments and certain other items at fair value on an instrument-by-instrument basis with changes in fair value reported in earnings. After the initial adoption, the election is made at the acquisition of an eligible financial asset, financial liability, or firm commitment or when certain specified reconsideration events occur. The fair value election may not be revoked once an election is made.

On January 1, 2007, the Company adopted the provisions of SFAS 159. The Company elected the fair value option for the asset-backed bonds issued from NovaStar ABS CDO I, which closed in the first quarter of 2007. The Company elected the fair value option for these liabilities to help reduce earnings volatility which otherwise would arise if the accounting method for this debt was not matched with the fair value accounting for the related mortgage securities - trading. The asset-backed bonds which are being carried at fair value are included in the “Asset-backed bonds secured by mortgage securities” line item on the condensed consolidated balance sheets. The Company recognized a fair value adjustment of $38.9 million and $40.6 million during the three months ended March 31, 2008 and 2007, respectively, which is included in the “Fair value adjustments” line item on the condensed consolidated statements of operations. The Company calculates interest expense for these asset-backed bonds based on the prevailing coupon rates of the specific classes of debt and records interest expense in the period incurred. Interest expense amounts are included in the “Interest expense” line item of the condensed consolidated statements of operations.

The Company has not elected fair value accounting for any other balance sheet items as allowed by SFAS 159.

The following table shows the difference between the unpaid principal balance and the fair value of the asset-backed bonds secured by mortgage securities for which the Company has elected fair value accounting as of March 31, 2008 (dollars in thousands):

Substantially all of the $38.9 million change in fair value of the asset-backed bonds is considered to be related to specific credit risk as all of the bonds are floating rate. The change in credit risk was caused by spreads widening in the asset-backed securities market during the first quarter of 2008.

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Note 10. Interest Income

The following table presents the components of interest income for the three months ended March 31, 2008 and 2007 (dollars in thousands):

Note 11. Interest Expense

The following table presents the components of interest expense for the three months ended March 31, 2008 and 2007 (dollars in thousands):

Note 12. Discontinued Operations

During 2007, the Company undertook workforce reductions pursuant to plans of termination (“Exit Plans”) to align its organization and costs with its decision to discontinue its mortgage lending and mortgage servicing activities. The Company considers an operating unit to be discontinued upon its termination date, which is the point in time when the operations substantially cease. The provisions of SFAS 144 require the results of operations associated with those operating units terminated to be classified as discontinued operations and segregated from the Company’s continuing results of operations for all periods presented. In accordance with Statement SFAS 144, the Company has reclassified the operating results of its mortgage lending segment and loan servicing operations segment as discontinued operations in the condensed consolidated statements of operations for the three months ended March 31, 2007.

The major classes of assets and liabilities reported as discontinued operations as of Mach 31, 2008 and December 31, 2007 are as follows (dollars in thousands):

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The operating results of all discontinued operations for the three months ended March 31, 2008 and 2007 are summarized as follows (dollars in thousands):