NOVATION COMPANIES, INC. - Quarter Report: 2009 September (Form 10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
____________________

FORM 10-Q

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

For the Quarterly Period Ended September 30, 2009

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

For the Transition Period From ___________ to ____________

____________________

Commission File Number 001-13533

NOVASTAR FINANCIAL, INC.
(Exact Name of Registrant as Specified in its Charter)

Maryland	74-2830661
(State or Other Jurisdiction of Incorporation or	(I.R.S. Employer Identification No.)
Organization)

2114 Central Street, Suite 600, Kansas City, MO	64108
(Address of Principal Executive Office)	(Zip Code)

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 o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer
o

Accelerated filer
o

Non-accelerated filer
o

Smaller reporting company
x

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

The number of shares of the Registrant’s Common Stock outstanding on November 12, 2009 was 9,368,053.

NOVASTAR FINANCIAL, INC.
FORM 10-Q
For the Quarterly Period Ended September 30, 2009

TABLE OF CONTENTS

Part I	Financial Information

Item 1.	Financial Statements (Unaudited)	1
	Condensed Consolidated Balance Sheets	1
	Condensed Consolidated Statements of Operations	2
	Condensed Consolidated Statement of Shareholders’ Deficit	3
	Condensed Consolidated Statements of Cash Flows	4
	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	27

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	41

Item 4.	Controls and Procedures	41

Part II	Other Information

Item 1.	Legal Proceedings	42

Item 1A.	Risk Factors	43

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	43

Item 3.	Defaults Upon Senior Securities	43

Item 4.	Submission of Matters to a Vote of Security Holders	44

Item 5.	Other Information	44

Item 6.	Exhibits	44

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

NOVASTAR FINANCIAL, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited; dollars in thousands, except share amounts)

	September 30,			December 31,
	2009			2008
Assets
Unrestricted cash and cash equivalents	$	14,818		$	24,790
Restricted cash		4,294			6,046
Mortgage loans – held-in-portfolio, net of allowance of $746,702 and
$776,001, respectively		1,387,555			1,772,838
Mortgage securities − trading		1,425			7,085
Mortgage securities − available-for-sale		6,669			12,788
Real estate owned		83,573			70,480
Accrued interest receivable		74,842			77,292
Other assets		8,693			5,704
Assets of discontinued operations		-			1,441
Total assets	$	1,581,869		$	1,978,464

Liabilities and Shareholders’ Deficit
Liabilities:
Asset-backed bonds secured by mortgage loans	$	2,361,588		$	2,599,351
Asset-backed bonds secured by mortgage securities		1,063			5,376
Junior subordinated debentures		77,692			77,323
Due to servicer		141,093			117,635
Dividends payable		30,450			19,088
Accounts payable and other liabilities		18,294			33,928
Liabilities of discontinued operations		-			2,536
Total liabilities		2,630,180			2,855,237

Commitments and contingencies (Note 7)

Shareholders’ deficit :
Capital stock, $0.01 par value, 50,000,000 shares authorized:
Redeemable preferred stock, $25 liquidating preference per share;
2,990,000 shares, issued and outstanding		30			30
Convertible participating preferred stock, $25 liquidating preference per
share; 2,100,000 shares, issued and outstanding		21			21
Common stock, 9,368,053, issued and outstanding		94			94
Additional paid-in capital		786,811			786,279
Accumulated deficit		(1,840,393	)		(1,671,984	)
Accumulated other comprehensive income		4,662			8,926
Other		(87	)		(139	)
Total NovaStar shareholders’ deficit		(1,048,862	)		(876,773	)
Noncontrolling interests		551			-
Total shareholders’ deficit		(1,048,311	)		(876,773	)
Total liabilities and shareholders’ deficit	$	1,581,869		$	1,978,464

See notes to condensed consolidated financial statements.

NOVASTAR FINANCIAL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited; dollars in thousands, except share and per share amounts)

	For the Nine Months						For the Three Months
	Ended September 30,						Ended September 30,
	2009			2008			2009			2008
Interest income	$	114,269		$	183,277		$	39,136		$	52,269
Interest expense		18,803			91,157			7,071			25,874
Net interest income before provision for credit losses		95,466			92,120			32,065			26,395
Provision for credit losses		211,050			667,638			42,062			206,202
Net interest loss after provision for credit losses		(115,584	)		(575,518	)		(9,997	)		(179,807	)

Other operating (expense) income:
(Losses) gains on derivative instruments		(4,817	)		(9,480	)		(191	)		1,133
Gains on debt extinguishment		-			6,418			-			-
Fair value adjustments		(6,597	)		(20,269	)		(397	)		2,400
Impairment on mortgage securities – available-for-sale		(1,155	)		(22,897	)		(703	)		(1,668	)
Appraisal fee income		22,018			1,522			9,945			1,522
Appraisal fee expense		(15,306	)		(1,195	)		(6,748	)		(1,195	)
Premiums for mortgage loan insurance		(4,908	)		(12,126	)		944			(3,809	)
Servicing fee expense		(8,343	)		(10,365	)		(2,482	)		(3,272	)
Other income (expense), net		433			(37	)		205			(117	)
Total other operating (expense) income		(18,675	)		(68,429	)		573			(5,006	)

General and administrative expenses:
Compensation and benefits		4,015			4,583			1,422			1,104
Office administration		4,023			6,734			1,178			2,181
Professional and outside services		5,635			5,686			1,877			1,799
Other appraisal management expenses		9,456			509			3,615			509
Other		589			390			383			20
Total general and administrative expenses		23,718			17,902			8,475			5,613

Loss from continuing operations before income tax		(157,977	)		(661,849	)		(17,899	)		(190,426	)
Income tax expense (benefit)		245			(16,753	)		116			(17,837	)
Loss from continuing operations		(158,222	)		(645,096	)		(18,015	)		(172,589	)
Income from discontinued operations, net of income tax		-			22,471			-			29,818
Net loss		(158,222	)		(622,625	)		(18,015	)		(142,771	)
Less: Net loss attributable to noncontrolling interests		(1,174	)		-			(395	)		-
Net loss available to common shareholders	$	(157,048	)	$	(622,625	)	$	(17,620	)	$	(142,771	)
Basic earnings per share:
Loss from continuing operations available to common
shareholders	$	(17.98	)	$	(70.33	)	$	(2.29	)	$	(19.00	)
Income from discontinued operations, net of income tax		-			2.41			-			3.19
Net loss available to common shareholders	$	(17.98	)	$	(67.92	)	$	(2.29	)	$	(15.81	)
Diluted earnings per share:
Loss from continuing operations available to common
shareholders	$	(17.98	)	$	(70.33	)	$	(2.29	)	$	(19.00	)
Income from discontinued operations, net of income tax		-			2.41			-			3.19
Net loss available to common shareholders	$	(17.98	)	$	(67.92	)	$	(2.29	)	$	(15.81	)
Weighted average basic shares outstanding		9,368,053			9,337,517			9,638,053			9,337,695
Weighted average diluted shares outstanding		9,368,053			9,337,517			9,638,053			9,337,695

See notes to condensed consolidated financial statements.

NOVASTAR FINANCIAL, INC.
CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ DEFICIT
(unaudited; dollars in thousands)

	Redeemable Preferred Stock		Convertible Participating Preferred Stock		Common Stock		Additional Paid-in Capital		Accumulated Deficit			Accumulated Other Comprehensive Income			Noncontrolling Interest			Other			Total Shareholders’ Deficit
Balance, January 1, 2009	$	30	$	21	$	94	$	786,279	$	(1,671,984	)	$	8,926		$	-		$	(139	)	$	(876,773	)
Forgiveness of
founder’s notes
receivable		-		-		-		-		-			-			-			52			52
Compensation
recognized under
stock compensation
plans		-		-		-		532		-			-			-			-			532
Accumulating
dividends on
preferred stock		-		-		-		-		(11,361	)		-			-			-			(11,361	)
Contribution from
noncontrolling
interests		-		-		-		-		-			-			525			-			525
Acquisition of
noncontrolling
interests		-		-		-		-		-			-			1,200			-			1,200
Comprehensive loss:
Net loss		-		-		-		-		(157,048	)		-			(1,174	)		-			(158,222	)
Other
comprehensive loss		-		-		-		-		-			(4,264	)		-			-			(4,264	)
Total
comprehensive
loss		-		-		-		-		-			-			-			-			(162,486	)
Balance, September 30, 2009	$	30	$	21	$	94	$	786,811	$	(1,840,393	)	$	4,662		$	551		$	(87	)	$	(1,048,311	)

See notes to condensed consolidated financial statements.

NOVASTAR FINANCIAL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited; dollars in thousands)

	For the Nine Months Ended
	September 30,
	2009			2008
Cash flows from operating activities:
Net loss	$	(158,222	)	$	(622,625	)
Income from discontinued operations		-			22,471
Loss from continuing operations		(158,222	)		(645,096	)
Adjustments to reconcile loss from continuing operations to net cash used in
operating activities:
Accretion of available-for-sale and trading securities		(21,414	)		(35,301	)
Interest capitalized on loans held-in-portfolio		(1,550	)		(17,957	)
Amortization of premiums on mortgage loans		2,774			12,671
Amortization of deferred debt issuance costs		1,026			3,325
Provision for credit losses		211,050			667,638
Impairments on mortgage securities – available-for-sale		1,155			22,897
Fair value adjustments		6,597			20,269
Losses on derivative instruments		4,817			9,480
Compensation recognized under stock compensation plans		532			(39	)
Forgiveness of founder’s promissory notes		52			52
Depreciation expense		677			844
Gains on debt extinguishment		-			(6,418	)
Changes in:
Accrued interest receivable		2,450			(10,519	)
Other assets		(401	)		5,820
Due to servicer		23,458			39,483
Accounts payable and other liabilities		(21,588	)		(24,692	)
Net cash provided by operating activities from continuing operations		51,413			42,457
Net cash used in operating activities from discontinued operations		-			(28,837	)
Net cash provided by operating activities		51,413			13,620

Cash flows from investing activities:
Proceeds from paydowns on mortgage securities – available-for-sale		12,030			23,475
Proceeds from paydowns of mortgage securities – trading		4,397			48,605
Proceeds from repayments of mortgage loans – held-in-portfolio		74,426			254,793
Proceeds from sales of assets acquired through foreclosure		86,425			94,719
Cash used to collateralize customer warranties		(273	)		-
Purchases of property and equipment		(1,026	)		-
Restricted cash proceeds		2,025			3,210
Proceeds from disposal of property and equipment		2			-
Acquisition of business, net of cash acquired		2			(709	)
Net cash provided by investing activities from continuing operations		178,008			424,093
Net cash provided by investing activities from discontinued operations		-			2,092
Net cash provided by investing activities		178,008			426,185

Continued

	For the Nine Months Ended
	September 30,
Cash flows from financing activities:	2009			2008
Payments on asset-backed bonds		(239,543	)		(400,358	)
Net change in short-term borrowings		-			(45,488	)
Repurchases of trust preferred debt		-			(550	)
Contributions from noncontrolling interests		150			-
Net cash used in financing activities from continuing operations		(239,393	)		(446,396	)
Net cash used in financing activities from discontinued operations		-			(19	)
Net cash used in financing activities		(239,393	)		(446,415	)
Net decrease in cash and cash equivalents		(9,972	)		(6,610	)
Cash and cash equivalents, beginning of period		24,790			25,364
Cash and cash equivalents, end of period	$	14,818		$	18,754

Supplemental Disclosure of Cash Flow Information
(unaudited; dollars in thousands)

	For the Nine Months Ended
	September 30,
	2009		2008
Cash paid for interest	$	27,846	$	89,058
Cash paid for income taxes		347		3,456
Cash received on mortgage securities – available-for-sale with no cost basis		1,861		1,982
Non-cash investing and financing activities:
Assets acquired through foreclosure		99,193		71,653
Preferred stock dividends accrued, not yet paid		11,361		11,536

See notes to condensed consolidated financial statements.

Concluded

NOVASTAR FINANCIAL, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
As of and for the period ended September 30, 2009 (Unaudited)

Note 1. Financial Statement Presentation

Description of Operations - NovaStar Financial, Inc. and its subsidiaries (“NFI” or the “Company”) hold certain nonconforming residential mortgage securities. Prior to changes in its business in 2007, the Company originated, purchased, securitized, sold, invested in and serviced residential nonconforming mortgage loans and mortgage backed securities. The Company retained, through its mortgage securities investment portfolio, significant interests in the nonconforming loans it originated and purchased, and through its servicing platform, serviced all of the loans in which it retained interests.

Effective August 1, 2008, the Company acquired a 75% interest in StreetLinks National Appraisal Services, LLC (StreetLinks), a residential mortgage appraisal company, for an initial cash purchase price of $750,000 plus future payments contingent upon StreetLinks reaching certain earnings targets. Results of operations from August 1, 2008 forward are included in the consolidated statement of operations. Simultaneously with the acquisition, the Company transferred ownership of 5% of StreetLinks to the Chief Executive Officer of StreetLinks. Subsequent to September 30, 2009, the Company contributed capital to StreetLinks and increased its ownership to 88%.

On April 26, 2009, the Company acquired a 70% interest in Advent Financial Services, LLC (“Advent”), a start up operation which will provide access to tailored banking accounts, small dollar banking products and related services to meet the needs of low and moderate income level individuals, for an initial cash contribution into Advent of $2 million. Management is continuing to evaluate opportunities to invest excess cash as it is available.

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 (“GAAP”) 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, 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. In accordance with Subsequent Event guidance, the Company evaluated all events or transactions that occurred after September 30, 2009 through November 12, 2009, the date the Company issued these financial statements. During this period the Company did not have any material recognizable or nonrecognizable subsequent events.

The condensed consolidated financial statements of the Company include the accounts of all wholly-owned and majority-owned subsidiaries. Investments in entities for which the Company has significant influence are accounted for under the equity method. 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 as of September 30, 2009 and for the nine and three months ended September 30, 2009 and 2008 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.

The Company’s condensed consolidated financial statements should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements of the Company and the notes thereto, included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2008.

Going Concern Considerations - As of September 30, 2009, the Company’s total liabilities exceeded its total assets under GAAP, resulting in a shareholders’ deficit. The Company’s losses, negative cash flows, shareholders’ deficit, and lack of significant operations raise substantial doubt about the Company’s ability to continue as a going concern and, therefore, may not realize its assets and discharge its liabilities in the normal course of business. There is no assurance that cash flows will be sufficient to meet the Company’s obligations. 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. The Company’s condensed consolidated 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.

Current Liquidity and Near-Term Obligations - As of November 12, 2009, the Company had approximately $18.6 million in available cash on hand (including restricted cash of $4.3 million). In addition to the Company’s operating expenses, the Company has quarterly interest payments due on its trust preferred securities and intends to make payments in legal/lease obligations related to its discontinued lending and servicing operations. The Company’s current projections indicate sufficient available cash and cash flows from its mortgage securities to meet these payment needs. However, the cash flow from the Company’s mortgage securities is 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 may seek protection under applicable bankruptcy laws.

Cash flows from mortgage loans – held-in-portfolio are used to repay the asset-backed bonds secured by mortgage loans and are not available to pay the Company’s other debts, the asset-backed bonds are obligations of the securitization trusts and will be repaid using collections of the securitized assets. The trusts have no recourse to the Company’s other, unsecuritized assets.

Business Plan - The Company continues to develop its operating entities, StreetLinks and Advent, and to increase their production and revenue. The Company will continue to focus on minimizing losses, preserving liquidity, and exploring new operating company opportunities.

Note 2. New Accounting Pronouncements

Accounting Pronouncements Adopted in 2009

Accounting standards codification - In June 2009, the Financial Accounting Standards Board (“FASB”) issued an accounting pronouncement establishing the FASB Accounting Standards Codification as the source of authoritative accounting principles recognized by the FASB to be applied by nongovernmental entities. This pronouncement was effective for financial statements issued for interim and annual periods ending after September 15, 2009, for most entities. On the effective date, all non-SEC accounting and reporting standards will be superceded. The Company adopted this new accounting pronouncement for the quarterly period ended September 30, 2009, as required, and adoption did not have a material impact on the Company’s financial statements taken as a whole.

Accounting Pronouncements Not Yet Adopted

Consolidation of variable interest entities - In June 2009, the FASB issued variable interest entity guidance, which amends the consolidation guidance applicable to variable interest entities (“VIEs”). The amendments to the consolidation guidance affect all entities currently within the scope of the previous guidance, as well as qualifying special-purpose entities (“QSPEs”) that are currently excluded from the previous guidance. This guidance is effective as of the beginning of the first fiscal year that begins after November 15, 2009. The Company is continuing to evaluate the impact that this guidance will have on its financial condition and results of operation upon adoption.

Accounting for transfers of financial assets - In June 2009, the FASB issued guidance relating to the transfers of financial assets. This guidance amends the derecognition accounting and disclosure requirements of previous guidance. It also eliminates the exemption from consolidation for QSPEs and also requires a transferor to evaluate all existing QSPEs to determine whether it must be consolidated. This guidance is effective for financial asset transfers occurring after the beginning of an entity’s first fiscal year that begins after November 15, 2009. The Company is continuing to evaluate the impact that this guidance will have on its financial condition and results of operation upon adoption.

Note 3. Mortgage Loans – Held-in-Portfolio

Mortgage loans – held-in-portfolio, all of which are secured by residential properties, consisted of the following as of September 30, 2009 and December 31, 2008 (dollars in thousands):

	September 30,			December 31,
	2009			2008
Mortgage loans – held-in-portfolio:
Outstanding principal	$	2,117,984		$	2,529,791
Net unamortized deferred origination costs		16,273			19,048
Amortized cost		2,134,257			2,548,839
Allowance for credit losses		(746,702	)		(776,001	)
Mortgage loans – held-in-portfolio	$	1,387,555		$	1,772,838
Weighted average coupon		7.11	%		8.00	%

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 the “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” guidance. See below for details of the Company’s securitization transactions structured as financings.

At inception the NHES 2006-1 and NHES 2006-MTA1 securitizations did not meet the qualifying special purpose entity criteria necessary for derecognition because after the loans were securitized the securitization trusts were able to acquire derivatives relating to beneficial interests retained by the Company; additionally, the Company had the unilateral ability to repurchase a limited number of loans back from the trusts. The NHES 2007-1 securitization does not meet the qualifying special purpose entity criteria necessary for derecognition because of the excessive benefit the Company received at inception 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 “Mortgage loans – held-in-portfolio”. Given this treatment, retained interests are 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.

Mortgage loans – held-in-portfolio are serviced by a third party entity. During the nine months ended September 30, 2009, the servicer modified loans totaling $210.0 million in principal with weighted-average interest rates of 8.41% and 4.75% before and after modification, respectively. During the three months ended September 30, 2009, the servicer modified loans totaling $24.9 million in principal with weighted-average interest rates of 8.40% and 4.16% before and after modification, respectively. Generally, the modifications are offered to borrowers experiencing financial difficulties and serve to reduce monthly payments and defer unpaid interest. The Company’s estimates for the allowance for loan losses and related provision include the projected impact of the modified loans.

At September 30, 2009 all of the loans classified as held-in-portfolio were pledged as collateral for financing purposes.

Activity in the allowance for credit losses on mortgage loans – held-in-portfolio is as follows for the nine and three months ended September 30, 2009 and 2008, respectively (dollars in thousands):

	For the Nine Months Ended						For the Three Months Ended
	September 30,						September 30,
	2009			2008			2009			2008
Balance, beginning of period	$	776,001		$	230,138		$	810,274		$	616,690
Provision for credit losses		211,050			667,638			42,062			206,202
Charge-offs, net of recoveries		(240,349	)		(105,870	)		(105,634	)		(30,986	)
Balance, end of period	$	746,702		$	791,906		$	746,702		$	791,906

The FASB Staff Position, Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities (“VIE Guidance”), which was adopted by the Company on December 31, 2008, provides the disclosure requirements for transactions with VIEs or special purpose entities and transfers of financial assets in securitizations or asset-backed financing arrangements. Under the VIE Guidance, the Company is required to disclose information for consolidated VIEs, for VIEs in which the Company is the sponsor as defined below or is a significant variable interest holder (“Sponsor/Significant VIH”) and for VIEs that are established for securitizations and asset-backed financing arrangements. The VIE Guidance has expanded the population of VIEs for which disclosure is required.

The Company has defined “sponsor” to include all transactions where the Company has transferred assets to a VIE and/or structured the VIE, regardless of whether or not the asset transfer has met the sale conditions in the previous FASB guidance. The Company discloses all instances where continued involvement with the assets exposes it to potential economic gain/(loss), regardless of whether or not that continued involvement is considered to be a variable interest in the VIE.

The Company’s only continued involvement, relating to these transactions, is retaining interests in the VIEs.

For the purposes of this disclosure, transactions with VIEs are categorized as follows:

Securitization transactions. For the purposes of this disclosure, securitization transactions include transactions where the Company transferred mortgage loans and accounted for the transfer as a sale. This category includes both QSPEs and non-QSPEs and is reflected in the securitization section of this Note. QSPEs are commonly used by the Company in securitization transactions as described below. In accordance with VIE Guidance, the Company does not consolidate QSPEs.

Mortgage Loan VIEs. The Company consolidates securitization transactions that are structured legally as sales, but for accounting purposes are treated as financings as defined by the previous FASB guidance. The NHES 2006-1 and NHES 2006-MTA1 securitizations at inception did not meet the criteria necessary for derecognition under the previous FASB guidance and related interpretations because after the loans were securitized the securitization trusts was able to acquire derivatives relating to beneficial interests retained by the Company; additionally, the Company, had the unilateral ability to repurchase a limited number of loans back from the trust. These provisions were removed effective September 30, 2008. Since the removal of these provisions did not substantively change the transactions’ economics, the original accounting conclusion remains the same. The NHES 2007-1 securitization does not meet the qualifying special purpose entity criteria necessary for derecognition under the previous FASB guidance and related interpretations because of the excessive benefit the Company received at inception from the derivative instruments delivered into the trust to counteract interest rate risk. These transactions could continue to fail QSPE status and require consolidation and related disclosures. The Company has no control over the mortgage loans held by these VIEs due to their legal structure. Therefore, these mortgage loans have been pledged to the bondholders in the VIEs, and these assets are included in the assets pledged balance reported within this footnote. The beneficial interest holders in these VIEs have no recourse to the general credit of the Company; rather their investments are paid exclusively from the assets in the VIE. Securitization VIEs that hold loan assets are typically financed through the issuance of several classes of debt (i.e., tranches) with ratings that range from AAA to unrated residuals.

Collateralized Debt Obligations (“CDO”). In the first quarter of 2007, the Company closed a CDO. The collateral for this securitization consisted of subordinated securities which the Company retained from its loan securitizations as well as subordinated securities purchased from other issuers. This securitization was structured legally as a sale, but for accounting purposes was accounted for as a financing under the accounting guidance. This securitization did not meet the qualifying special purpose entity criteria under the accounting guidance. Accordingly, the securities remain on the Company’s balance sheet, retained interests were not created, and securitization bond financing replaced the short-term debt used to finance the securities. The Company is not the primary beneficiary in this transaction.

Transactions with these VIEs are reflected in the Sponsor/Significant VIH table in instances where the Company has not transferred the assets to the VIE or in the tables where the Company has transferred assets and has accounted for the transfer as a sale.

Variable Interest Entities

The VIE Guidance requires an entity to consolidate a VIE if that entity holds a variable interest that will absorb a majority of the VIE’s expected losses, receive a majority of the VIE’s expected residual returns, or both. The entity required to consolidate a VIE is known as the primary beneficiary. VIEs are reassessed for consolidation when reconsideration events occur. Reconsideration events include, changes to the VIEs’ governing documents that reallocate the expected losses/returns of the VIE between the primary beneficiary and other variable interest holders or sales and purchases of variable interests in the VIE.

There were no material reconsideration events during the period.

The table below provides the disclosure information required by the VIE guidance for VIEs that are consolidated by the Company (dollars in thousands):

			Assets After Intercompany
			Eliminations				Liabilities After
							Intercompany		Recourse to the
Consolidated VIEs	Total Assets		Unrestricted		Restricted (A)		Eliminations		Company (B)
September 30, 2009
Mortgage Loan VIEs(C)	$	1,554,109	$	-	$	1,545,793	$	2,539,598	$	-
CDO(D)		1,517		-		1,513		1,513		-
December 31, 2008
Mortgage Loan VIEs(C)	$	1,930,063	$	-	$	1,920,610	$	2,730,280	$	-
CDO(D)		7,435		-		7,035		8,557		-

(A)		Assets are considered restricted when they cannot be freely pledged or sold by the Company.

(B)		This column reflects the extent, if any, to which investors have recourse to the Company beyond the assets held by the VIE and assumes a total loss of the assets held by the VIE.

(C)		For Mortgage Loan VIEs, assets are primarily recorded in Mortgage loans – held-in-portfolio. Liabilities are primarily recorded in Asset-backed bonds secured by mortgage loans.

(D)		For the CDO, assets are primarily recorded in Mortgage securities – trading and liabilities are recorded in Asset-backed bonds secured by mortgage securities.

Securitizations

Prior to changes in its business in 2007, the Company securitized residential nonconforming mortgage loans. The Company’s involvement with VIEs that are used to securitize financial assets consists of owning securities issued by VIEs.

The following table relates to securitizations where the Company is the retained interest holder of assets issued by the entity (dollars in thousands):

	Size/Principal		Assets on		Liabilities		Maximum		Year to		Year to
	Outstanding		Balance		on Balance		Exposure to		Date Loss		Date Cash
	(A)		Sheet		Sheet		Loss(B)		on Sale		Flows
September 30, 2009
Residential mortgage
loans(C)	$	7,039,707	$	7,096	$	-	$	7,096	$	-	$	13,401
December 31, 2008
Residential mortgage
loans(C)	$	8,121,668	$	15,919	$	-	$	15,919	$	-	$	58,891

(A)		Size/Principal Outstanding reflects the estimated principal of the underlying assets held by the VIE/SPEs.

(B)		The maximum exposure to loss includes the following: the assets held by the Company – including the value of derivatives that are in an asset position and retained interests in the VIEs/SPEs. The maximum exposure to loss assumes a total loss on the referenced assets held by the VIE.

(C)		For residential mortgage loans QSPEs, assets on balance sheet are primarily securities issued by the entity and are recorded in Mortgage securities-available-for-sale and Mortgage securities-trading.

In certain instances, the Company retains interests in the subordinated tranche and residual tranche of securities issued by VIEs that are created to securitize assets. The gain or loss on the sale of the assets is determined with reference to the previous carrying amount of the financial assets transferred, which is allocated between the assets sold and the retained interests, if any, based on their relative fair values at the date of transfer.

Retained interests are recorded in the Condensed Consolidated Balance Sheets at fair value. The Company estimates fair value based on the present value of expected future cash flows using management’s best estimates of credit losses, prepayment rates, forward yield curves, and discount rates, commensurate with the risks involved. Retained interests are either held as mortgage securities – trading, with changes in fair value recorded in the Condensed Consolidated Statements of Operations, or as mortgage securities – available-for-sale, with changes in fair value included in accumulated other comprehensive income.

Retained interests are reviewed periodically for impairment. Retained interests in securitized assets held as available-for-sale and trading were approximately $7.1 million and $13.5 million at September 30, 2009 and December 31, 2008, respectively. The retained interests consisted of $6.9 million of residual interests and $0.2 million of retained subordinated interests as of September 30, 2009.

The following table presents information on retained interests excluding the offsetting benefit of financial instruments used to hedge risks, held by the Company as of September 30, 2009 arising from the Company’s residential mortgage-related securitization transactions. The pre-tax sensitivities of the current fair value of the retained interests to immediate 10% and 25% adverse changes in assumptions and parameters are also shown (dollars in thousands):

Carrying amount/fair value of residual interests	$	6,923
Weighted average life (in years)		3.67
Weighted average prepayment speed assumption (CPR) (percent)		17.5
Fair value after a 10% increase in prepayment speed	$	6,414
Fair value after a 25% increase in prepayment speed	$	5,722
Weighted average expected annual credit losses (percent of current collateral balance)		25.8
Fair value after a 10% increase in annual credit losses	$	6,094
Fair value after a 25% increase in annual credit losses	$	5,644
Weighted average residual cash flows discount rate (percent)		25.0
Fair value after a 500 basis point increase in discount rate	$	6,676
Fair value after a 1000 basis point increase in discount rate	$	6,447
Market interest rates:
Fair value after a 100 basis point increase in market rates	$	4,073
Fair value after a 200 basis point increase in market rates	$	2,583

The preceding sensitivity analysis is hypothetical and should be used with caution. In particular, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated independent of changes in any other assumption; in practice, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities. Further, changes in fair value based on a 10% or 25% variation in an assumption or parameter generally cannot be extrapolated because the relationship of the change in the assumption to the change in fair value may not be linear. Also, the sensitivity analysis does not include the offsetting benefit of financial instruments that the Company utilizes to hedge risks, including credit, interest rate, and prepayment risk, that are inherent in the retained interests. These hedging strategies are structured to take into consideration the hypothetical stress scenarios above, such that they would be effective in principally offsetting the Company’s exposure to loss in the event that these scenarios occur.

Note 4. Mortgage Securities – Available-for-Sale

As of September 30, 2009, and December 31, 2008, 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 residual security, which was designated as trading as a result of the Company’s adoption of Accounting for Certain Hybrid Financial Instruments an amendment of previous FASB guidance on January 1, 2007. As a result, the NMFT Series 2007-2, residual security qualifies for the scope exception concerning bifurcation provided by the new guidance. 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 September 30, 2009 and December 31, 2008 (dollars in thousands):

					Unrealized Losses
			Unrealized		Less Than Twelve		Estimated Fair		Average
	Cost Basis		Gain		Months		Value		Yield (A)
As of September 30, 2009	$	2,007	$	4,662	$	-	$	6,669	243.0	%
As of December 31, 2008	$	3,771	$	9,017	$	-	$	12,788	38.2	%

(A)

The average yield is calculated from the cost basis of the mortgage securities and does not give effect to changes in fair value that are reflected as a component of shareholders’ equity.

During the nine and three months ended September 30, 2009 and 2008, 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 impairments on mortgage securities – available-for-sale of $1.2 million and $0.7 million during the nine and three months ended September 30, 2009, respectively, as compared to $22.9 million and $1.7 million during the same periods of 2008.

Maturities of mortgage securities owned by the Company depend on repayment characteristics and experience of the underlying financial instruments.

Note 5. Mortgage Securities – Trading

As of September 30, 2009 and December 31, 2008, 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 broker prices. Refer to Note 9 for a description of the valuation methods as of September 30, 2009 and December 31, 2008.

The following table summarizes the Company’s mortgage securities – trading as of September 30, 2009 and December 31, 2008 (dollars in thousands):

			Amortized Cost				Average
	Original Face		Basis		Fair Value		Yield (A)
As of September 30, 2009
Subordinated securities pledged to CDO	$	332,489	$	145,086	$	1,055
Other subordinated securities		102,625		28,358		116
Residual securities		-		408		254
Total	$	435,114	$	173,852	$	1,425	6.45	%

As of December 31, 2008	$	435,114	$	433,968	$	7,085	9.55	%

(A)

Calculated from the ending fair value of the securities.

The Company recognized net trading losses of $11.3 million and $1.6 million for the nine and three months ended September 30, 2009, respectively as compared to net trading losses of $78.6 million and $3.7 million for the same periods of 2008. These net trading losses are included in the fair value adjustments line on the Company’s condensed consolidated statements of operations.

There were no trading securities pledged as collateral as of September 30, 2009 and December 31, 2008.

Note 6. Borrowings

Junior Subordinated Debentures

NFI’s wholly owned subsidiary NovaStar Mortgage, Inc. (“NMI”) has approximately $77.7 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. NFI has guaranteed NMI's obligations under the Notes. NMI failed to make quarterly interest payments that were due on all payment dates in 2008 and through April 24, 2009 on these Notes.

On April 24, 2009 (the “Exchange Date”), the parties executed the necessary documents to complete an exchange of the Notes for new preferred obligations. On the Exchange Date, the Company paid interest due through December 31, 2008, in the aggregate amount of $5.3 million. In addition, the Company paid $0.3 million in legal and administrative costs on behalf of the Trusts which was recorded in the “Professional and outside services” line item on the Statement of Operations.

The new preferred obligations require quarterly distributions of interest to the holders at a rate equal to 1.0% per annum beginning January 1, 2009 through December 31, 2009, subject to reset to a variable rate equal to the three-month LIBOR plus 3.5% upon the occurrence of an “Interest Coverage Trigger.” For purposes of the new preferred obligations, an Interest Coverage Trigger occurs when the ratio of EBITDA for any quarter ending on or after December 31, 2008 and on or prior to December 31, 2009 to the product as of the last day of such quarter, of the stated liquidation value of all outstanding 2009 Preferred Securities (i) multiplied by 7.5%, (ii) multiplied by 1.5 and (iii) divided by 4, equals or exceeds 1.00 to 1.00. Beginning January 1, 2010 until the earlier of February 18, 2019 or the occurrence of an Interest Coverage Trigger, the unpaid principal amount of the new preferred obligations will bear interest at a rate of 1.0% per annum and, thereafter, at a variable rate, reset quarterly, equal to the three-month LIBOR plus 3.5% per annum.

Note 7. Commitments and Contingencies

Litigation.

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. In October 2009 the Company reached a settlement to this claim which did not significantly impact the Company’s financial statements.

At this time, the Company does not believe that an adverse ruling against the Company is probable for the following claims and as such no amounts have been accrued in the consolidated financial statements.

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 District Court dismissed the plaintiffs’ complaints without leave to amend. The plaintiffs filed an appeal of the District Court’s ruling. On September 1, 2009 the United States Court of Appeals for the Eight Circuit affirmed the judgment of the District Court.

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. On October 8, 2008, the City of Cleveland filed an amended complaint in federal court which did not include claims against the Company but made similar claims against NovaStar Mortgage, Inc., a wholly owned subsidiary of NFI. On November 24, 2008 the Company filed a motion to dismiss. On May 15, 2009 the Court granted Company’s motion to dismiss. The City of Cleveland has filed an appeal. 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 seek monetary damages alleging that the individual defendants breached fiduciary duties owed to the Company, alleging 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. On July 13, 2009 the Company filed a motion to dismiss the plaintiff’s claims. 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 for 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 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 and its individual directors, several securitization trusts sponsored by the Company, 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. On June 16, 2009, the plaintiff filed an amended complaint. Plaintiff seeks monetary damages, alleging 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. On August 31, 2009 the Company filed a motion to dismiss the plaintiff’s claims. 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 seeks monetary damages alleging 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. On November 12, 2008, the Company filed a motion to dismiss which was denied by the Court on February 11, 2009. On April 6, 2009 the Court granted the plaintiff’s motion for class certification. The Company sought permission from the 8^th Circuit Court of Appeals to appeal the order granting class certification. On May 11, 2009 the Court of Appeals granted the Company permission to appeal the class certification order. 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. Furthermore, the Company has received indemnification and loan repurchase demands with respect to alleged violations of representations and warranties made in loan sale and securitization agreements. These indemnification and repurchase demands have been addressed without significant loss to the Company, but such claims can be significant when multiple loans are involved.

Note 8. Comprehensive Income

The following is a rollforward of accumulated other comprehensive income for the nine and three months ended September 30, 2009 and 2008 (dollars in thousands):

	For the Nine Months						For the Three Months
	Ended September 30,						Ended September 30,
	2009			2008			2009			2008
Net loss	$	(158,222	)	$	(622,625	)	$	(18,015	)	$	(142,771	)
Other comprehensive (loss) income:
Change in unrealized loss on mortgage securities –
available-for-sale		(5,511	)		(21,443	)		(3,446	)		(879	)
Change in unrealized gain (loss) on derivative instruments
used in cash flow hedges		8			(1,059	)		-			88
Impairment on mortgage securities - available-for-sale
reclassified to earnings		1,155			22,897			702			1,669
Net settlements of derivative instruments used in cash flow
hedges reclassified to earnings		84			1,988			-			633
Other comprehensive (loss) income		(4,264	)		2,383			(2,744	)		1,511
Total comprehensive loss		(162,486	)		(620,242	)		(20,759	)		(141,260	)
Comprehensive loss attributable to noncontrolling
interests		1,174			-			395			-
Total comprehensive loss attributable to NovaStar
Financial, Inc.	$	(161,312	)	$	(620,242	)	$	(20,364	)	$	(141,260	)

Note 9. Fair Value Accounting

Fair Value Measurements

The FASB pronouncement, Fair Value Measurements, defines fair value, establishes a consistent framework for measuring fair value and expands disclosure requirements about fair value measurements. Fair Value Measurements, 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:

Level 1—Quoted prices for identical instruments in active markets.
Level 2—Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.
Level 3—Instruments whose significant value drivers are unobservable.

The Company determines fair value based upon quoted broker 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 tables present 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 September 30, 2009 and December 31, 2008 (dollars in thousands).

			Fair Value Measurements at Reporting Date Using
			Quoted Prices		Significant
			in Active		Other
	Fair Value at		Markets for		Observable		Significant
	September 30,		Identical Assets		Inputs		Unobservable
Description	2009		(Level 1)		(Level 2)		Inputs (Level 3)
Assets:
Mortgage securities -trading	$	1,425	$	-	$	-	$	1,425
Mortgage securities – available-for-sale		6,669		-		-		6,669
Total assets	$	8,094	$	-	$	-	$	8,094

Liabilities:
Asset-backed bonds secured by mortgage
securities	$	1,063	$	-	$	-	$	1,063
Derivative instruments, net		2,394		-		2,394		-
Total liabilities	$	3,457	$	-	$	2,394	$	1,063

			Fair Value Measurements at Reporting Date Using
			Quoted Prices		Significant
			in Active		Other		Significant
	Fair Value at		Markets for		Observable		Unobservable
	December 31,		Identical Assets		Inputs		Inputs
Description	2008		(Level 1)		(Level 2)		(Level 3)
Assets:
Mortgage securities -trading	$	7,085	$	-	$	-	$	7,085
Mortgage securities – available-for-sale		12,788		-		-		12,788
Total assets	$	19,873	$	-	$	-	$	19,873

Liabilities:
Asset-backed bonds secured by mortgage
securities	$	5,376	$	-	$	-	$	5,376
Derivative instruments, net		9,102		-		9,102		-
Total liabilities	$	14,478	$	-	$	9,102	$	5,376

The following tables provide 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 nine and three months ended September 30, 2009 and 2008 (dollars in thousands):

							Estimated Fair
							Value of
							Mortgage
	Cost Basis			Unrealized Gain			Securities
As of December 31, 2008	$	433,968		$	(426,883	)	$	7,085
Increases (decreases) to mortgage securities -
trading
Accretion of income		9,992			-			9,992
Proceeds from paydowns of securities		(4,397	)		-			(4,397	)
Other than temporary impairments		(265,711	)		265,711			-
Mark-to-market value adjustment		-			(11,255	)		(11,255	)
Net (decrease) increase to mortgage securities -
trading		(260,116	)		254,456			(5,660	)
As of September 30, 2009	$	173,852		$	(172,427	)	$	1,425


							Estimated Fair
							Value of
							Mortgage
	Cost Basis			Unrealized Loss			Securities
As of December 31, 2007	$	41,275		$	(16,534	)	$	24,741
Increases (decreases) to mortgage securities -
trading
Securities transferred from Level 2 to Level 3		414,080			(395,359	)		18,721
Accretion of income		11,259			-			11,259
Proceeds from paydowns of securities		(34,859	)		-			(34,859	)
Mark-to-market value adjustment		-			(4,881	)		(4,881	)
Net (decrease) increase to mortgage securities -
trading		390,480			(400,240	)		(9,760	)
As of September 30, 2008	$	431,755		$	(416,774	)	$	14,981

							Estimated Fair
							Value of
							Mortgage
	Cost Basis			Unrealized Gain			Securities
As of June 30, 2009	$	402,192		$	(399,747	)	$	2,445
Increases (decreases) to mortgage securities -
trading
Accretion of income		1,292			-			1,292
Proceeds from paydowns of securities		(762	)		-			(762	)
Other than temporary impairments		(228,870	)		228,870			-
Mark-to-market value adjustment		-			(1,550	)		(1,550	)
Net (decrease) increase to mortgage securities -
trading		(228,340	)		227,320			(1,020	)
As of September 30, 2009	$	173,852		$	(172,427	)	$	1,425



							Estimated Fair
							Value of
							Mortgage
	Cost Basis			Unrealized Loss			Securities
As of June 30, 2008	$	24,228		$	(17,675	)	$	6,553
Increases (decreases) to mortgage securities -
trading
Securities transferred from Level 2 to Level 3		414,080			(395,359	)		18,721
Accretion of income		6,619			-			6,619
Proceeds from paydowns of securities		(13,172	)		-			(13,172	)
Mark-to-market value adjustment		-			(3,740	)		(3,740	)
Net (decrease) increase to mortgage securities -
trading		407,527			(399,099	)		8,428
As of September 30, 2008	$	431,755		$	(416,774	)	$	14,981

The following tables provide 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 nine and three months ended September 30, 2009 and 2008 (dollars in thousands):

							Estimated Fair
							Value of
							Mortgage
	Cost Basis			Unrealized Gain			Securities
As of December 31, 2008	$	3,771		$	9,017		$	12,788
Increases (decreases) to mortgage securities –
available-for-sale
Accretion of income (A)		11,421			-			11,421
Proceeds from paydowns of securities (A) (B)		(12,030	)		-			(12,030	)
Impairment on mortgage securities – available-
for-sale		(1,155	)					(1,155	)
Mark-to-market value adjustment		-			(4,355	)		(4,355	)
Net (decrease) increase to mortgage securities –
available-for-sale		(1,764	)		(4,355	)		(6,119	)
As of September 30, 2009	$	2,007		$	4,662		$	6,669

(A)		Cash received on mortgage securities with no cost basis was $1.9 million for the nine months ended September 30, 2009.

(B)		For mortgage securities with a remaining cost basis, the Company reduces the cost basis by the amount of cash that is contractually due from the securitization trusts. In contrast, for mortgage securities in which the cost basis has previously reached zero, the Company records in interest income the amount of cash that is contractually due from the securitization trusts. In both cases, there are instances where the Company may not receive a portion of this cash until after the balance sheet reporting date. Therefore, these amounts are recorded as receivables from the securitization trusts. As of September 30, 2009, the Company had no receivables from securitization trusts related to mortgage securities available-for-sale with a remaining cost basis.

						Estimated Fair
						Value of
				Unrealized Gain		Mortgage
	Cost Basis			(Loss)		Securities
As of December 31, 2007	$	33,302		$	69	$	33,371
Increases (decreases) to mortgage securities –
available-for-sale
Accretion of income (A)		5,976			-		5,976
Proceeds from paydowns of securities (A) (B)		(10,992	)		-		(10,992	)
Impairment on mortgage securities – available-
for-sale		(22,897	)		-		(22,897	)
Mark-to-market value adjustment		-			1,454		1,454
Net (decrease) increase to mortgage securities –
available-for-sale		(27,913	)		1,454		(26,459	)
As of September 30, 2008	$	5,389		$	1,523	$	6,912

(A)		Cash received on mortgage securities with no cost basis was $2.0 million for the nine months ended September 30, 2008.

(B)		For mortgage securities with a remaining cost basis, the Company reduces the cost basis by the amount of cash that is contractually due from the securitization trusts. In contrast, for mortgage securities in which the cost basis has previously reached zero, the Company records in interest income the amount of cash that is contractually due from the securitization trusts. In both cases, there are instances where the Company may not receive a portion of this cash until after the balance sheet reporting date. Therefore, these amounts are recorded as receivables from the securitization trusts. As of September 30, 2008, the Company had no receivable due from securitization trusts. As of December 31, 2007 the Company had receivables from securitization trusts of $12.5 million related to mortgage securities available-for-sale with a remaining cost basis.

							Estimated Fair
							Value of
							Mortgage
	Cost Basis			Unrealized Gain			Securities
As of June 30, 2009	$	2,314		$	7,405		$	9,719
Increases (decreases) to mortgage securities –
available-for-sale
Accretion of income (A)		3,445			-			3,445
Proceeds from paydowns of securities (A)		(3,049	)		-			(3,049	)
Impairment on mortgage securities – available-
for-sale		(703	)					(703	)
Mark-to-market value adjustment		-			(2,743	)		(2,743	)
Net (decrease) increase to mortgage securities –
available-for-sale		(307	)		(2,743	)		(3,050	)
As of September 30, 2009	$	2,007		$	4,662		$	6,669

(A)		Cash received on mortgage securities with no cost basis was $0.7 million for the three months ended September 30, 2009.

						Estimated Fair
						Value of
				Unrealized Gain		Mortgage
	Cost Basis			(Loss)		Securities
As of June 30, 2008	$	8,434		$	733	$	9,167
Increases (decreases) to mortgage securities –
available-for-sale
Accretion of income (A)		2,617			-		2,617
Proceeds from paydowns of securities (A)		(3,994	)		-		(3,994	)
Impairment on mortgage securities – available-
for-sale		(1,668	)		-		(1,668	)
Mark-to-market value adjustment		-			790		790
Net (decrease) increase to mortgage securities –
available-for-sale		(3,045	)		790		(2,255	)
As of September 30, 2008	$	5,389		$	1,523	$	6,912

(A)

Cash received on mortgage securities with no cost basis was $0.5 million for the three months ended September 30, 2008.

The following table provides quantitative disclosures about the fair value measurements for the Company’s assets which are measured at fair value on a nonrecurring basis as of September 30, 2009 and December 31, 2008 (dollars in thousands):

			Fair Value Measurements at Reporting Date Using
			Quoted Prices in		Significant
			Active Markets for		Other		Significant
	Real Estate		Identical Assets		Observable		Unobservable
Fair Value at	Owned		(Level 1)		Inputs (Level 2)		Inputs (Level 3)
September 30, 2009	$	83,573	$	-	$	-	$	83,573
December 31, 2008		70,480		-		-		70,480

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. 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 nine and three months ended September 30, 2009 and 2008 from the Company’s assets and liabilities related to continuing operations which are measured at fair value on a recurring and nonrecurring basis (dollars in thousands):

		Fair Value						Fair Value
		Adjustments For						Adjustments For
		the Nine Months						the Three Months
		Ended September						Ended September
		30						30
	Fair Value
Asset or Liability	Measurement													Statement of Operations Line
Measured at Fair Value	Frequency	2009			2008			2009			2008			Item Impacted
Mortgage securities -
trading	Recurring	$	(11,255	)	$	(78,607	)	$	(1,550	)	$	(3,741	)	Fair value adjustments
Mortgage securities –														Impairment on mortgage
available-for-sale	Recurring		(1,155	)		(22,897	)		(703	)		(1,668	)	securities – available-for-sale
Real estate owned	Nonrecurring		(9,164	)		(7,831	)		-			(6,013	)	Provision for credit losses
Derivative instruments,														(Losses) gains on derivative
net	Recurring		5,124			2,343			2,345			4,793		instruments
Asset-backed bonds
secured by mortgage
securities	Recurring		4,658			58,338			1,153			6,141		Fair value adjustments
Total fair value losses		$	(11,792	)	$	(48,654	)	$	1,245		$	(488	)

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. Prior to September 30, 2008, the Company estimated fair value for its subordinated securities solely from quoted market prices. Commencing September 30, 2008, the Company estimated fair value for its subordinated securities based on quoted broker prices compared to estimates based on discounting the expected future cash flows of the collateral and bonds. The Company determined this change in valuation method caused a change from Level 2 to Level 3 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 also qualify as Level 3.

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 September 30, 2009 or December 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.

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. See discussion under “Fair Value Option for Financial Assets and Financial Liabilities.

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

The Company elected the fair value option for the asset-backed bonds issued from the CDO, which the Company 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 fair value adjustments of $4.7 million and $1.2 million for the nine and three months ended September 30, 2009, respectively, and $58.3 million and $6.1 million for the same periods in 2008, respectively, which is included in the “Fair value adjustments” line item on the condensed consolidated statements of operations. A significant majority of the change in the asset-backed bonds balance is due to the fair value adjustments since adoption of the guidance.

The Company has not elected fair value accounting for any other balance sheet items as allowed by the guidance from Fair Value Option for Financial Assets and Financial Liabilities.

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 September 30, 2009 and December 31, 2008 (dollars in thousands):

	Asset-Backed
	Bonds Secured by
	Mortgage		Year to Date Gain
Unpaid Principal Balance as of	Securities		Recognized			Fair Value
September 30, 2009	$	323,869	$	4,658		$	1,063
December 31, 2008		324,243		58,337	(A)		5,376

(A)

For the nine months ended September 30, 2008.

Substantially all of the $4.7 million change in fair value of the asset-backed bonds during the nine months ended September 30, 2009 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 nine months ended September 30, 2009.

Note 10. Derivative Instruments and Hedging Activities

The Company’s objective and strategy for using derivative instruments is to mitigate the risk of increased costs on its variable rate liabilities during a period of rising rates, subject to cost and liquidity risk constraints. The Company’s primary goals for managing interest rate risk are to maintain the net interest margin between its assets and liabilities and diminish the effect of changes in general interest rate levels on the market value of the Company.

The derivative instruments used by the Company to manage this risk are interest rate caps and interest rate swaps. Interest rate caps are contracts in which the Company pays either an upfront premium or monthly or quarterly premium to a counterparty. In return, the Company receives payments from the counterparty when interest rates rise above a certain rate specified in the contract. During the nine and three months ended September 30, 2009, premiums paid pursuant to interest rate cap agreements related to continuing operations aggregated approximately $54,000 and $16,000, respectively, as compared to $0.3 and $0.1 million for the same periods in 2008. When premiums are financed by the Company, a liability is recorded for the premium obligation. Premiums due to counterparties as of September 30, 2009 and December 31, 2008 were approximately $11,000 and $0.1 million, respectively, and had a weighted average interest rate of 4.5% and 3.9%, respectively. The future contractual maturities of premiums due to counterparties as of September 30, 2009 are all due during 2009. There are no future contractual maturities premiums due in 2010 or thereafter. The interest rate swap agreements to which the Company is party stipulate that the Company pay a fixed rate of interest to the counterparty and the counterparty pays the company a variable rate of interest based on the notional amount of the contract. The liabilities that the Company hedges are asset-backed bonds as discussed in Note 3.

The Company also has derivative instruments that do not meet the requirements for hedge accounting. However, these derivative instruments do contribute to the Company’s overall risk management strategy by serving to reduce interest rate risk on asset-backed bonds collateralized by the Company’s loans held-in-portfolio.

The following tables present derivative instruments as of September 30, 2009 and December 31, 2008 (dollars in thousands):

						Maximum
						Days to
	Notional Amount		Fair Value			Maturity
As of September 30, 2009:
Non-hedge derivative instruments	$	230,000	$	(2,394	)	117

As of December 31, 2008:
Non-hedge derivative instruments	$	461,500	$	(9,034	)	390
Cash flow hedge derivative instruments		40,000		(68	)	25

The Company recognized net expense of $2.0 and $0.6 million during the nine and three months ended September 30, 2008 on derivative instruments qualifying as cash flow hedges, which is recorded as a component of interest expense. There was no expense recorded relating to derivative instruments qualifying as cash flow hedges during the nine and three months ended September 30, 2009

During the three months ended September 30, 2009 and 2008, respectively, hedge ineffectiveness was insignificant.

The Company’s derivative instruments involve, to varying degrees, elements of credit and market risk in addition to the amount recognized in the consolidated financial statements.

Credit Risk The Company’s exposure to credit risk on derivative instruments is equal to the amount of deposits (margin) held by the counterparty, plus any net receivable due from the counterparty, plus the cost of replacing the contracts should the counterparty fail. The Company seeks to minimize credit risk through the use of credit approval and review processes, the selection of only the most creditworthy counterparties, continuing review and monitoring of all counterparties, exposure reduction techniques and thorough legal scrutiny of agreements. Before engaging in negotiated derivative transactions with any counterparty, the Company has in place fully executed written agreements. Agreements with counterparties also call for full two-way netting of payments. Under these agreements, on each payment exchange date all gains and losses of counterparties are netted into a single amount, limiting exposure to the counterparty to any net receivable amount due.

Market Risk The potential for financial loss due to adverse changes in market interest rates is a function of the sensitivity of each position to changes in interest rates, the degree to which each position can affect future earnings under adverse market conditions, the source and nature of funding for the position, and the net effect due to offsetting positions. The derivative instruments utilized leave the Company in a market position that is designed to be a better position than if the derivative instrument had not been used in interest rate risk management.

Other Risk Considerations The Company is cognizant of the risks involved with derivative instruments and has policies and procedures in place to mitigate risk associated with the use of derivative instruments in ways appropriate to its business activities, considering its risk profile as a limited end-user.

Note 11. Income Taxes

Based on the evidence available as of September 30, 2009 and December 31, 2008, including the significant pre-tax losses incurred by the Company in 2008 and the second quarter of 2009, the liquidity issues facing the Company and the decision by the Company to close all of its mortgage lending and loan servicing operations, the Company believes that it is more likely than not that the Company will not realize its deferred tax assets. Based on these conclusions, the Company recorded a valuation allowance against its entire net deferred tax assets as of September 30, 2009 and December 31, 2008.

The Company recognizes tax benefits in accordance with the FASB interpretation, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement, Accounting for Income Taxes. This interpretation establishes a “more-likely-than-not” recognition threshold that must be met before a tax benefit can be recognized in the financial statements. As of September 30, 2009 and December 31, 2008, the total gross amount of unrecognized tax benefits was $1.1 million and $0.5 million, respectively. The increase of $0.6 million is attributed to filing positions taken on recently filed returns.

Note 12. Segment Reporting

As of September 30, 2009, the Company reviews, manages and operates its business in one segment: portfolio management. Portfolio management operating results come from the income generated on the mortgage assets and operating business the Company manages less associated costs. The portfolio management segment’s operating results for the nine and three months ended September 30, 2009 and 2008 are the same as the Company’s condensed consolidated statements of operations.

Note 13. Earnings Per Share

The computations of basic and diluted earnings per share for the nine and three months ended September 30, 2009 and 2008 (dollars in thousands, except per share amounts):

	For the Nine Months Ended						For the Three Months
	September 30,						Ended September 30,
	2009			2008			2009			2008
Numerator:
Loss from continuing operations	$	(158,222	)	$	(645,096	)	$	(18,015	)	$	(172,589	)
Less loss attributable to noncontrolling interests		(1,174	)		-			(395	)		-
Dividends on preferred shares		(11,361	)		(11,536	)		(3,880	)		(4,879	)
Loss from continuing operations available to
common shareholders		(168,409	)		(656,632	)		(21,500	)		(177,468	)
Income from discontinued operations, net of income tax		-			22,471			-			29,818
Net loss available to common shareholders	$	(168,409	)	$	(634,161	)	$	(21,500	)	$	(147,650	)

Denominator:
Weighted average common shares outstanding –
basic and diluted		9,368,053			9,337,517			9,368,053			9,337,695

Basic earnings per share:
Loss from continuing operations	$	(16.89	)	$	(69.09	)	$	(1.92	)	$	(18.48	)
Less loss attributable to noncontrolling interests		(0.12	)		-			(0.04	)		-
Dividends on preferred shares		(1.21	)		(1.24	)		(0.41	)		(0.52	)
Loss from continuing operations available to
common shareholders		(17.98	)		(70.33	)		(2.29	)		(19.00	)
Income from discontinued operations, net of income tax		-			2.41			-			3.19
Net loss available to common shareholders	$	(17.98	)	$	(67.92	)	$	(2.29	)	$	(15.81	)

Diluted earnings per share:
Loss from continuing operations	$	(16.89	)	$	(69.09	)	$	(1.92	)	$	(18.48	)
Less loss attributable to noncontrolling interests		(0.12	)		-			(0.04	)		-
Dividends on preferred shares		(1.21	)		(1.24	)		(0.41	)		(0.52	)
Loss from continuing operations available to
common shareholders		(17.98	)		(70.33	)		(2.29	)		(19.00	)
Income from discontinued operations, net of income
tax		-			2.41			-			3.19
Net loss available to common shareholders	$	(17.98	)	$	(67.92	)	$	(2.29	)	$	(15.81	)

The following stock options to purchase shares of common stock were outstanding during each period presented, but were not included in the computation of diluted earnings per share because the number of shares assumed to be repurchased, as calculated was greater than the number of shares to be obtained upon exercise, therefore, the effect would be antidilutive (in thousands, except exercise prices):

	For the Nine Months Ended				For the Three Months
	September 30,				Ended September 30,
	2009		2008		2009		2008
Number of stock options		114		185		114		185
Weighted average exercise price	$	52.98	$	53.26	$	52.98	$	53.26

Note 14. Fair Value of Financial Instruments

The following disclosure of the estimated fair value of financial instruments presents amounts that have been determined using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that could be realized in a current market exchange. The use of different market assumptions or estimation methodologies could have a material impact on the estimated fair value amounts.

The estimated fair values of the Company’s financial instruments related to continuing operations are as follows as of September 30, 2009 and December 31, 2008 (dollars in thousands):

	As of September 30, 2009				As of December 31, 2008

	Carrying Value		Fair Value		Carrying Value		Fair Value
Financial assets:
Cash and cash equivalents	$	14,818	$	14,818	$	24,790	$	24,790
Restricted cash		4,294		4,111		6,046		5,595
Mortgage loans - held-in-portfolio		1,387,555		1,248,800		1,772,838		1,772,838
Mortgage securities - trading		1,425		1,425		7,085		7,085
Mortgage securities - available-for-sale		6,669		6,669		12,788		12,788
Accrued interest receivable		74,842		74,842		77,292		77,292
Financial liabilities:
Borrowings:
Asset-backed bonds secured by mortgage
loans		2,361,588		1,406,208		2,599,351		1,772,838
Asset-backed bonds secured by mortgage
securities		1,063		1,063		5,376		5,376
Junior subordinated debentures		77,692		6,215		77,323		6,248
Accrued interest payable		1,007		1,007		10,242		10,242
Derivative instruments:
Interest rate swap agreements		2,394		2,394		9,302		9,302

Cash and cash equivalents – The fair value of cash and cash equivalents approximates its carrying value.

Restricted Cash – The fair value of restricted cash was estimated by discounting estimated future release of the cash from restriction.

Mortgage loans – held-in-portfolio – The fair value of mortgage loans – held-in-portfolio was estimated using the carrying value less a market discount as of September 30, 2009. The internal rate of return is less than what an outside investor would require due to the embedded credit risk, therefore a market discount is required to get to the fair value. The fair value of mortgage loans – held-in-portfolio approximated its carrying value at December 31, 2008.

Mortgage securities- trading – Mortgage securities – trading is made up of residual securities and subordinated securities. The fair value of residual securities is estimated by discounting future projected cash flows using a discount rate commensurate with the risks involved. The fair value of the subordinated securities is estimated using quoted broker prices and compared to internal discounted cash flows.

Mortgage securities – available-for-sale – Mortgage securities – available-for-sale is made up of residual securities. The fair value of residual securities is estimated by discounting future projected cash flows using a discount rate commensurate with the risks involved.

Accrued interest receivable – The fair value of accrued interest receivable approximates its carrying value.

Asset-backed bonds secured by mortgage loans – The fair value of asset-backed bonds secured by mortgage loans and the related accrued interest payable was estimated using the fair value of mortgage loans – held-in-portfolio at September 30, 2009 as the trusts have no recourse to the Company’s other, unsecuritized assets.

Asset-backed bonds secured by mortgage securities –The fair value of asset-backed bonds secured by mortgage securities and the related accrued interest payable is approximated using quoted market prices.

Junior subordinated debentures – The fair value of junior subordinated debentures is estimated using the price from the repurchase transaction that the Company completed during 2008 as it is greater than an estimate of discounting future projected cash flows using a discount rate commensurate with the risks involved.

Accrued interest payable – The fair value of accrued interest payable approximates its carrying value.

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

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

The following discussion should be read in conjunction with the preceding unaudited condensed consolidated financial statements of NovaStar Financial, Inc. and its subsidiaries (the “Company” ,”NovaStar Financial”, “NFI” , “we” or “us”) and the notes thereto as well as NovaStar Financial’s annual report to shareholders and Annual Report on Form 10-K for the fiscal year ended December 31, 2008.

Executive Overview

Corporate Overview, Background and Strategy - We are a Maryland corporation formed on September 13, 1996. Prior to significant changes in our business during 2007 and the first quarter of 2008, we originated, purchased, securitized, sold, invested in and serviced residential nonconforming mortgage loans and mortgage securities. We retained, through our mortgage securities investment portfolio, significant interests in the nonconforming loans we originated and purchased, and through our servicing platform, serviced all of the loans in which we retained interests. During 2007 and early 2008, we discontinued our mortgage lending operations and sold our mortgage servicing rights which subsequently resulted in the closing of our servicing operations.

Because of severe declines in housing prices and national and international economic crises, we have suffered significant losses during 2008 and 2009 because of declining values of our investments in mortgage loans and securities. Liquidity constraints forced us to reduce operations and administrative staff and take other measures to conserve cash.

Management’s focus is building its newly acquired operating businesses, reducing corporate operating cash needs, clearing follow-on matters arising from our legacy lending and servicing operations and evaluating investment opportunities.

Management made significant steps in the rebuilding process by investing in StreetLinks National Appraisal Services, LLC (“StreetLinks”) during the third quarter of 2008 and Advent Financial Services, LLC (“Advent”) during the second quarter of 2009. StreetLinks is a national residential appraisal management company. StreetLinks collects a fee for appraisal services from lenders and borrowers and passes most of the fee through to an independent residential appraiser. StreetLinks retains a portion of the fee to cover its costs of managing the process of fulfilling the appraisal order. Management believes that StreetLinks is situated to take advantage of growth opportunities in the residential appraisal management business. We have added significant new customers for StreetLinks during 2009, which have produced significant increases in revenue for StreetLinks during 2009. Advent is in its start-up phase and will provide access to tailored banking accounts, small dollar banking products and related services to meet the needs of low and moderate income level individuals. Advent is currently developing systems and a network of business partners for the distribution of its services.

Going Concern Considerations - As of September 30, 2009, the Company’s total liabilities exceeded its total assets under GAAP, resulting in a shareholders’ deficit. The Company’s losses, negative cash flows, shareholders’ deficit, and lack of significant operations raise substantial doubt about the Company’s ability to continue as a going concern and, therefore, may not realize its assets and discharge its liabilities in the normal course of business. There is no assurance that cash flows will be sufficient to meet the Company’s obligations. The Company’s consolidated financial statements have been prepared on a going concern basis of accounting which contemplates continuity of operations, realization of assets, liabilities and commitments in the normal course of business. The Company’s condensed consolidated 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.

Impact of Recently Issued Accounting Pronouncements

Accounting Pronouncements Adopted in 2009

Accounting Pronouncements Not Yet Adopted

Strategy - Management is focused on building the operations of StreetLinks and Advent. If and when opportunities arise, we intend to use available cash resources to invest in or start businesses that can generate income and cash. Additionally, management will attempt to renegotiate and/or restructure the components of our equity in order to realign the capital structure with our current business model.

The key performance measures for executive management are:

maintaining and/or generating adequate liquidity to sustain us and allow us to take advantage of investment opportunity, and
generating income for our shareholders.

The following selected key performance metrics are derived from our condensed consolidated financial statements for the periods presented and should be read in conjunction with the more detailed information therein and with the disclosure included elsewhere in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Management’s discussion and analysis of financial condition and results of operations, along with other portions of this report, are designed to provide information regarding our performance and these key performance measures.

Table 1 —Key Performance Metrics
(dollars in thousands; except per share amounts)

	September 30,			December 31,
	2009			2008
Cash and cash equivalents, including restricted cash	$	19,112		$	30,836

	For the Nine Months Ended
	September 30,
	2009			2008
Net loss available to common shareholders, per diluted share	$	(17.98	)	$	(67.92	)

Liquidity – During the nine months ended September 30, 2009, we received $16.4 million in cash on our securities portfolio. We received $20.8 million in cash relating to appraisal fee income. We used cash to repay interest on borrowings, pay for current operating and administrative costs, invest in StreetLinks and Advent and pay for costs related to our legacy mortgage lending and servicing operations. As of September 30, 2009, we had $19.1 million in cash, cash equivalents and restricted cash, a decrease of $11.7 million from December 31, 2008. As of November 12, 2009, we have $18.6 million in cash and cash equivalents (including restricted cash of $4.3 million). See “Liquidity and Capital Resources” for further discussion of our liquidity position and steps we have taken to preserve liquidity levels.

As part of our near-term future strategy, we are focused on building our operating businesses, minimizing losses, preserving liquidity and, if and when cash is available, investing in opportunities that can contribute positively to our liquidity position. Our mortgage securities are a primary source of new cash flows. Based on the current projections, the cash flows from our mortgage securities will continue to decrease in the next several months as the underlying mortgage loans are repaid and could be significantly less than the current projections if future market conditions are not as projected. While StreetLinks is generating significant revenues, it is using all cash generated in building its infrastructure to sustain growth and is not profitable. We have significant outstanding obligations under our subordinated debt agreements. Our liquidity consists solely of cash and cash equivalents.

Significant Recent Events – As discussed in Note 6 to our condensed consolidated financial statement, we renegotiated the terms of our junior subordinated debentures in April 2009. As discussed above, during the quarter ended June 30, 2009, we acquired a 70% ownership in Advent for an initial cash contribution into Advent of $2 million.

Impact of Consolidation of Securitized Mortgage Assets on Our Financial Statements – The discussions of our financial condition and results of operation below provide analysis for the changes in our balance sheet and income statement as presented using Generally Accepted Accounting Principles in the United States of America ("GAAP"). Mortgage loans – held-in-portfolio and certain of our mortgage securities – trading are owned by trusts established when those assets were securitized. The trusts issued asset-backed bonds to finance the assets. In accordance with GAAP, we have consolidated these trusts. Due to significant events that have occurred subsequent to the securitization of these assets, we no longer have a significant economic benefit from these assets. We have provided additional disclosure in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the heading “Assets and Liabilities of Consolidated Securitization Trusts” to demonstrate the impact of the trusts on our consolidated financial statements.

Financial Condition as of September 30, 2009 as Compared to December 31, 2008

The following provides explanations for material changes in the components of our balance sheet when comparing amounts from September 30, 2009 and December 31, 2008.

Cash and Cash Equivalents. See “Liquidity and Capital Resources” for discussion of our cash and cash equivalents.

Mortgage Loans - Held-in-Portfolio. Mortgage loans – held-in-portfolio consist of subprime mortgage loans which have been securitized and are owned by three separate trusts – NHES 2006-1, NHES 2006MTA-1 and NHES 2007-1. We consolidate these trusts for GAAP reporting.

The mortgage loans – held-in-portfolio balance has declined as their value has decreased significantly. The value is dependent largely in part on their credit quality and the borrowers’ repayment performance. The credit quality of the portfolio continues to worsen and borrowers’ repayment performance continues to be poor. Specifically, during recent months, the loss severity rate on foreclosed and liquidated loans has increased. Therefore, we continue to increase the allowance for losses as a percentage of loan principal. The allowance has decreased from $776.0 as of December 31, 2008 to $746.7 million as of September 30, 2009 due to the loan principal balances declining by a greater amount which was mainly due to borrower repayments and foreclosures. Additionally, the balance of mortgage loans – held-in-portfolio has decreased due to regular borrower repayments. During the nine months ended September 30, 2009 the trusts received repayments of the mortgage loans totaling $74.4 million. These balances will continue to decline either through normal borrower repayments or through continued devaluation as delinquencies, foreclosures and losses occur.

Mortgage loans – held-in-portfolio are serviced by a third party entity. During the nine months ended September 30, 2009, the servicer modified loans totaling $210.0 million in principal with weighted-average interest rates of 8.41% and 4.75% before and after modification, respectively. Generally, the modifications are offered to borrowers experiencing financial difficulties and serve to reduce monthly payments and/or defer unpaid interest. The Company’s estimates for the allowance for loan losses and related provision include the projected impact of the modified loans.

As discussed under the heading “Assets and Liabilities of Consolidated Securitization Trusts”, these assets have no economic benefit to us and we have no control over these assets. We have also provided the assets and liabilities of the trusts on a separate and combined basis.

Mortgage Securities – Trading and Available-for-Sale. During the nine months ended September 30, 2009, the value of the securities continued to decline as the estimated future cash flow from the securities is decreasing. The decrease is attributable largely to the continued poor credit quality and repayment performance of the mortgage loans underlying these securities. In general, the default rate on the underlying loans has increased dramatically over the past two years. Defaults are the result of national economic conditions that have led to job losses, severe declines in housing prices and the inability for credit-challenged individuals to refinance mortgage loans. In many cases, the securities we own have ceased to generate cash flow and, for the securities generating cash, we expect cash flow to continue to decline. We have consistently written the value of our securities down over the past two years and will likely continue to write them down as their economic value declines.

The following tables provide details of our mortgage securities.

Table 2 — Values of Individual Mortgage Securities – Available-for-Sale
(dollars in thousands)
	September 30, 2009								December 31, 2008
					Constant		Expected						Constant		Expected
Securitization	Estimated		Discount		Pre-payment		Credit		Estimated		Discount		Pre-payment		Credit
Trust (A)	Fair Value		Rate		Rate		Losses		Fair Value		Rate		Rate		Losses
NMFT Series :
2002-3	$	1,253	25	%	17	%	0.8	%	$	2,041	25	%	16	%	0.8	%
2003-1		3,910	25		14		2.1			5,108	25		13		2.0
2003-2		552	25		12		1.9			2,272	25		12		1.9
2003-3		908	25		11		2.6			2,402	25		12		2.7
2003-4		-	25		13		2.7			1	25		13		2.7
2004-1		-	25		15		3.5			16	25		15		3.4
2004-2		-	25		14		3.7			27	25		14		3.5
2004-3		-	25		15		4.7			73	25		15		4.4
2004-4		-	25		16		4.7			11	25		16		4.3
2005-1		-	25		17		6.9			-	25		17		6.2
2005-2		-	25		15		7.9			-	25		16		7.0
2005-3		-	25		16		10.7			-	25		17		9.3
2005-4		-	25		18		13.7			3	25		18		11.5
2006-2		-	25		20		20.5			73	25		19		17.0
2006-3		-	25		20		23.5			125	25		20		19.8
2006-4		-	25		20		23.6			136	25		20		20.0
2006-5		3	25		20		27.9			214	25		20		24.0
2006-6		43	25		19		28.7			286	25		19		24.4
Total	$	6,669							$	12,788

(A)	We established the trust upon securitization of the underlying loans, which generally were originated by us.

Table 3 — Mortgage Securities - Trading
(dollars in thousands)
As of September 30, 2009
			Amortized Cost				Number of	Weighted
S&P Rating	Original Face		Basis		Fair Value		Securities	Average Yield
Subordinated Securities:
Non-investment Grade (B)	$	435,114		173,444		1,171	89	2.43	%
Residual Securities:
Unrated		59,500		408		254	1	25.00
Total	$	494,614	$	173,852	$	1,425	90	6.45	%

As of December 31, 2008
Subordinated Securities:
Investment Grade (A)	$	12,505	$	11,891	$	833	3	6.25	%
Non-investment Grade (B)		422,609		406,125		5,547	87	8.08
Total Subordinated Securities		435,114		418,016		6,380	90	7.84
Residual Securities:
Unrated		59,500		15,952		705	1	25.00
Total	$	494,614	$	433,968	$	7,085	91	9.55	%

(A)	Investment grade includes all securities with S&P ratings above BB+.

(B)	Non-investment grade includes all securities with S&P ratings below BBB-.

We re-securitized, by way of a CDO, some of the mortgage securities – trading we owned in the first quarter of 2007. We retained a residual interest in the CDO. However, due to the poor performance of the securities within the CDO, our residual interest in the CDO is not providing any cash flow to us and has no value. As discussed under the heading “Assets and Liabilities of Consolidated Securitization Trusts”, the assets in the CDO have no economic benefit to us and we have no control over these assets. We have also provided the assets and liabilities of the trusts on a separate and combined basis.

Real Estate Owned. Real estate owned includes the value of properties for foreclosed loans owned by securitization trusts, as discussed under “Mortgage Loans – Held-in-Portfolio”. We consolidate the assets and liabilities as part of the securitization trust. A servicer that is independent from us and the trusts services the mortgage loans and processes defaults for liquidation. Proceeds from liquidation of this real estate will flow through the trust and will generally be paid to third party bondholders. The amount of real estate owned is dependent upon the number of the overall mortgage loans outstanding, the rate of defaults, the timing of liquidations and the estimated value of the real estate. The amount of real estate owned has fluctuated during 2008 and 2009, and will continue to fluctuate in the short term. Over the long term, the amount of real estate owned will decrease as the mortgage loans owned by the consolidated trusts decline.

Under the heading “Assets and Liabilities of Consolidated Securitization Trusts”, we have provided the assets and liabilities of the trusts on a separate and combined basis.

Accrued Interest Receivable. Accrued interest receivable includes the interest due from individual borrowers to the trusts who own the mortgage loans – held-in-portfolio. For all mortgage loans that do not carry mortgage insurance, the accrual of interest on loans is discontinued when, in management’s opinion, the interest is not collectible in the normal course of business, but in no case beyond when a loan becomes 90 days delinquent. For mortgage loans that do carry mortgage insurance, the accrual of interest is only discontinued when in management’s opinion, the interest is not collectible. Management generally deems all of the accrued interest on loans with mortgage interest to be collectible. The quantity of delinquent loans has significantly increased, as a percent of total loans outstanding, from December 31, 2008 to September 30, 2009. Therefore, the amount of accrued interest has also increased. Over the long term, the amount of accrued interest receivable will decrease as the mortgage loans owned by the consolidated trusts decline.

Under the heading “Assets and Liabilities of Consolidated Securitization Trusts”, we have provided the assets and liabilities of the trusts on a separate and combined basis.

Asset-backed Bonds Secured by Mortgage Assets. The balances of the asset-backed bonds have decreased as the bonds have repaid. We record the value of the bonds secured by loans at the value of the proceeds, less repayments. We record the CDO (secured by mortgage securities) at its market value. These balances will decrease going forward as the underlying assets repay or may be charged off as the assets are deemed to be insufficient to fully repay the bond obligations.

Under the heading “Assets and Liabilities of Consolidated Securitization Trusts”, we have provided the assets and liabilities of the trusts on a separate and combined basis.

Due to Servicer. The mortgage loans – held-in-portfolio on our balance sheet have been securitized and we consolidate the securitized trust. In accordance with the agreements for the securitized mortgage loans, the servicer of the loans is required to make regularly scheduled payments to the bondholders, regardless of whether the borrower has made payments as required. The servicer is required to make advances from its own funds. Upon liquidation of defaulted loans, the servicer is repaid the advanced funds. Until such time as the loans liquidate, the trust has an obligation to the servicer, which we have classified as “Due to Servicer” on the balance sheet. The amount of the obligation is dependent on the rate and timing of delinquencies of the individual borrowers. The trusts continue to experience a significant increase in the amount of delinquencies, which increases the amount of advances the servicer has made to the bondholders and therefore increases the liability to the servicer.

Stockholders’ Deficit. As of September 30, 2009 our total liabilities exceeded our total assets under GAAP by $1.0 billion.

The liabilities of the securitization trusts exceed the assets of those trusts as of September 30, 2009 and December 31, 2008 by $1.0 billion and $932.1 million, respectively. These amounts do not include any adjustments for intercompany eliminations, see Table 9 for further detail. The severe devaluation of the mortgage assets, as discussed in the respective categories above, has resulted in the significant deficit of these trusts. The assets and liabilities of these trusts are consolidated under GAAP. Due to the significant impact to our financial statements of these trusts, we have also provided the assets and liabilities of the trusts on a separate and combined basis under the heading “Assets and Liabilities of Consolidated Securitization Trusts.”

The significant increase in our shareholders’ deficit during the nine months ended September 30, 2009 results from our large net loss, driven primarily by valuation allowances taken on our mortgage loans.

Results of Operations – Comparisons Consolidated Earnings

Net Interest (Expense) Income. As discussed above, in general, our mortgage assets have been significantly impaired due to national and international economic crises, housing price deterioration and mortgage loan credit defaults. The trends and reasons for the changes in the components of interest income and expense are generally the same when comparing the nine months and three months ended September 30, 2009 with the same periods in 2008. Interest income has declined as these assets have become impaired and due to repayments and liquidations. Interest expense has declined as the related principals balances have declined, as interest rates have declined and as we repaid all short-term borrowings during 2008. Interest expense is adjustable, generally based on a spread to LIBOR.

Provision for Credit Losses. The provision for credit losses relates to mortgage loans which have been securitized. As discussed above, in general, the credit quality of the securitized mortgage loans significantly deteriorated beginning generally before 2008 due to national and international economic crises, housing price deterioration and mortgage loan credit defaults. The performance of the loans continues to deteriorate. A significant portion of the securitized loans have become uncollectible or will only be partially collected. Provisions for these losses have increased in connection with the declining credit quality of the loans.

The total dollar amount of the provision for credit losses is smaller when comparing the nine and three months ended September 30, 2009 to the same periods in 2008. As the amount of securitized loans decreases and as they age, the credit exposure is smaller, resulting in decreasing provisions.

Table 4 — Net Interest Expense
(dollars in thousands)
	For the Nine Months						For the Three Months
	Ended September 30,						Ended September 30,
	2009			2008			2009			2008
Interest income:
Mortgage securities	$	19,553		$	33,319		$	4,115		$	6,561
Mortgage loans held-in-portfolio		93,933			148,829			34,792			45,517
Other interest income		783			1,129			229			191
Total interest income		114,269			183,277			39,136			52,269

Interest expense:
Short-term borrowings secured by mortgage securities		-			434			-			-
Asset-backed bonds secured by mortgage loans		16,537			75,445			5,247			20,516
Asset-backed bonds secured by mortgage securities		1,490			10,699			843			4,093
Junior subordinated debentures		776			4,579			981			1,265
Total interest expense		18,803			91,157			7,071			25,874
Net interest income before provision for credit losses		95,466			92,120			32,065			26,395
Provision for credit losses		211,050			667,638			42,062			206,202
Net interest loss	$	(115,584	)	$	(575,518	)	$	(9,997	)	$	(179,807	)

(Losses) Gains on Derivative Instruments. The derivative instruments for which the value is on our balance sheet are owned by securitization trusts. Derivative instruments transferred into a securitization trust are administered by the trustee in accordance with the trust documents. These derivative instruments are used to mitigate interest rate risk within the related securitization trust.

Losses or gains on the derivative instruments are dependent on short-term interest rates (generally declining rates produce greater losses or lower gains) and the amount of the notional balance outstanding during the reporting period. For the three month period ended September 30, 2008, interest rates were generally flat and the gain on derivative instruments was due to the reversal of previous losses as instruments matured. For the three month period ended September 30, 2009, interest rates were declining and instruments were maturing, resulting in a small net loss. Significant declines in interest rates during the first three months of 2008 and 2009 generated significant losses on derivatives for each of the nine month period ended September 30, 2009 and 2008.

Gains on Debt Extinguishment. We recorded gains on debt extinguish for the nine months ended September 30, 2008 of $6.4 million. There were no gains recorded for the same period of 2009. On May 29, 2008, we 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 September 30, 2008 resulting in a gain of $6.4 million.

Fair Value Adjustments. Adjustment for changes in value on our trading securities and the asset-backed bonds issued in our CDO are recorded as Fair Value Adjustments. The significant value declines during the nine and three month period ended September 30, 2008 are a result of significant spread widening in the subprime mortgage market for these types of asset-backed securities, along with the poor credit performance of the underlying mortgage loans. By the end of 2008, the total value of the trading securities and the asset-backed bonds had declined significantly, resulting in a lower overall adjustment in the nine months ended September 30, 2009 when compared to the same period in 2008. During the three months ended September 30, 2009, very low short-term interest rates are driving higher expected cash flows from these securities and, therefore, higher overall values.

Impairment on Mortgage Securities – Available-for-Sale. To the extent that the cost basis of mortgage securities – available-for-sale 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 large impairments during the nine and three months ended September 30, 2008 were primarily driven by an increase in actual and projected losses due to the deteriorating credit quality of the loans underlying the securities. By September 30, 2008, the total value of the available-for-sale securities had declined significantly, resulting in a lower overall impairment in the nine and three months ended September 30, 2009 when compared to the same periods in 2008.

Appraisal Fee Income and Expense. Fees are collected from customers (borrowers or lenders), a portion of which is paid to independent mortgage loan appraisers. Fee income and expense is recognized when the appraisal is completed and delivered to the customer. During the nine months ended September 30, 2009, the unit volume appraisal services increased significantly, resulting in high revenue and expense when comparing to the first nine months of 2008. We acquired a majority interest in StreetLinks on August 1, 2008, and therefore recognized minimal revenue and incurred minimal expense for appraisal management services during the nine and three month periods ended September 30, 2008. Following is a summary of the unit count of completed orders:

Table 5 — Appraisals Completed 2009
First quarter	4,809
Second quarter	27,440
Third quarter	26,960

Nine months ended September 30, 2009	59,209

General and Administrative Expenses. During late 2007 and into early 2008, we eliminated a significant portion of our administrative overhead. We terminated officers and staff in our executive, information systems, legal, human resource and finance/accounting departments. We also terminated numerous contracts for professional services. One of management’s key focuses during 2008 was to reduce or eliminate all unnecessary general and administrative expenses. As a result, excluding the impact on operating expenses for StreetLinks of $9.5 million and $3.6 million for the nine and three months ended September 30, 2009, respectively and $0.5 million for the nine and three months ended September 30, 2008, operating expenses have declined when comparing general and administrative expenses for the nine and three month periods ended September 30, 2009 and 2008.

Contractual Obligations

We have entered into certain long-term debt, hedging and lease agreements, which obligate us to make future payments to satisfy the related contractual obligations.

The following table summarizes our contractual obligations for both continuing and discontinued operations, as of September 30, 2009, other than short-term borrowing arrangements.

Table 6 — Contractual Obligations
(dollars in thousands)
	Payments Due by Period
				Less than 1
Contractual Obligations	Total			Year			1-3 Years			3-5 Years			After 5 Years
Estimated long-term debt payments (A)	$	2,705,144		$	603,282		$	700,359		$	512,439		$	889,064
Junior subordinated debentures (B)		98,389			781			1,563			1,563			94,482
Operating leases (C)		5,094			1,889			2,342			662			201
Total, consolidated obligations		2,808,627			605,952			704,264			514,664			983,747
Non-recourse obligations		(2,705,144	)		(603,282	)		(700,359	)		(512,439	)		(889,064	)

Recourse obligations	$	103,483		$	2,670		$	3,905		$	2,225		$	94,683

(A)	The asset-backed bonds will be repaid only to the extent there is sufficient cash receipts on the underlying mortgage loans, which collateralize the debt. The trusts that own these assets and asset-backed obligations have no recourse to us for any shortfall. The timing of the repayment of these mortgage loans is affected by prepayments. These amounts include expected interest payments on the obligations. Interest obligations on our variable-rate long-term debt are based on the prevailing interest rate as of September 30, 2009 for each respective obligation. The trustee considers the remaining collateral to be insufficient to cover the bonds outstanding and therefore has reduced the obligations accordingly by $144.5 million.

(B)	The junior subordinated debentures are assumed to mature in 2035 and 2036 in computing the future payments. These amounts include expected interest payments on the obligations. Interest obligations on our junior subordinated debentures are based on the prevailing interest rate of 1.0% per annum as of September 30, 2009 for each respective obligation. See Note 6 to the condensed consolidated financial statements for additional details.

(C)	The operating lease obligations do not include rental income of $1.3 million to be received under sublease contracts.

Liquidity and Capital Resources

We have taken numerous actions to reduce our cash needs and liquidity risk. Our residual and subordinated mortgage securities are a primary source of significant cash flows. Based on the current projections, the cash flows from our mortgage securities will decrease in the next several months as the underlying mortgage loans are repaid, and could be significantly less than the current projections if losses on the underlying mortgage loans exceed the current assumptions or if short-term interest rates increase significantly. We have operating expenses associated with our administration, as well as payment obligations with respect to unsecured debt, including periodic interest payments with respect to junior subordinated debentures. As discussed in “Item 1. Legal Proceedings” we are the subject of various legal proceedings, the outcome of which is uncertain. We may also face demands in the future that are unknown to us today related to our legacy lending and servicing operations. If the cash flows from our mortgage securities are less than currently anticipated and our operating businesses do not generate positive cash flow, there can be no assurance that we will be able to continue as a going concern.

As of November 12, 2009, we had approximately $18.6 million in cash on hand (including restricted cash of $4.3 million). In addition to our corporate administrative expenses, which currently range from approximately $650,000 to $1.25 million per month we have quarterly interest payments due on our trust preferred securities. The Company made a payment on the trust preferred securities on October 30, 2009 of $0.1 million. The next payment on the trust preferred securities is due on December 30, 2009 and totals $0.1 million. Our current projections indicate sufficient available cash and cash flows from our mortgage assets to meet these payment needs. However, our mortgage asset cash flows are currently volatile and uncertain in nature, and the amounts we receive could vary materially from our projections. Therefore, no assurances can be given that we will be able to meet our cash flow needs.

Overview of Cash Flow for the nine months ended September 30, 2009

During 2007 and early 2008, we discontinued our mortgage lending operations and sold our mortgage servicing rights which subsequently resulted in the closing of our servicing operations. Prior to exiting the lending business, we sold the majority of the loans we originated to securitization trusts. Three of these securitization trusts are consolidated for financial reporting under GAAP, which means all of the assets and the liabilities of the trust are included in our consolidated financial statements. Our results of operations and cash flows include the activity of these trusts. The cash proceeds from the repayment of the loan collateral are owned by the trust and serve to only repay the obligations of the trust. We do not collect the cash and we are not responsible for the obligations of the trust. Principal and interest on the bonds (securities) of the trust can only be paid if there is sufficient cash flow the underlying collateral. We own some of the securities issued by the trust, which is a component of our cash flow. As a result of the national economic crises, the loans within these trusts have very high rates of default. Therefore, the cash flow on the securities we own has declined significantly within the past two years.

We have provided a summary of the cash flow for the securitization trusts under the heading “Assets and Liabilities of Consolidated Securitization Trusts.”

Following are the primary and simplified sources of cash receipts and disbursements, excluding the impact of the securitization trusts.

Table 7 — Primary Sources Cash Receipts and Disbursements
(dollars in thousands)
	For the Nine
	Months Ended
	September 30,
	2009
Primary sources:
Payments received on mortgage securities	$	13,908
Receipts for appraisal management services		20,770

Primary uses:
Payment of corporate general, administrative and capital expenditures		22,950
Payments for appraisals and related administrative costs		20,801

Statement of Cash Flows - Operating, Investing and Financing Activities

The following table provides a summary of our operating, investing and financing cash flows as taken from our consolidated statements of cash flows for the nine months ended September 30, 2009 and 2008.

Table 8 — Summary of Operating, Investing and Financing Cash Flows
(dollars in thousands)
	For the Nine Months
	Ended September 30,
	2009			2008
Consolidated Statements of Cash Flows:
Cash provided by operating activities	$	51,413		$	13,620
Cash flows provided by investing activities		178,008			426,185
Cash flows used in financing activities		(239,393	)		(446,415	)

Operating Activities. The increase in cash provided by operating activities was substantially related to the increase in the balance of the amounts due to servicer. Operating activities, other than the cash flow of the securitized loan trusts, generated a net use of cash during the nine months ended September 30, 2009. See a discussion of the impact of the consolidated loan trusts under the heading “Assets and Liabilities of Consolidated Securitization Trusts.”

Investing Activities. Substantially all of the cash flow from investing activities relates to either payments on securitized loans or sales upon foreclosure of securitized loans. Our mortgage loan portfolio declined significantly and borrower defaults increased, resulting in lower repayments of our mortgage loans held-in-portfolio and lower cash proceeds from the sale of assets acquired through foreclosure. We also experienced a decrease in payments received on our mortgage securities – available-for-sale during 2009 as compared to 2008 as a result of poor credit performance of the underlying loans.

Financing Activities. All short term borrowings were paid off in 2008 and therefore we have no repayments of short-term borrowings during 2009. The payments on asset-backed bonds relates to bonds issued by securitization loan trusts, which have decreased as the assets in the trusts used to pay those bonds have declined.

Future Sources and Uses of Cash

Primary Sources of Cash

Cash Received From Our Mortgage Securities Portfolio. A major driver of cash flows is the proceeds we receive from our mortgage securities. For the nine months ended September 30, 2009 we received $16.4 million in proceeds from repayments on mortgage securities. The cash flows we receive on our mortgage securities—available-for-sale are highly dependent on the interest rate spread between the underlying collateral and the bonds issued by the securitization trusts and default and prepayment experience of the underlying collateral. The following factors have been the significant drivers in the overall fluctuations in these cash flows:

Higher credit losses have decreased cash available to distribute with respect to our securities,
As short-term interest rates decline, the net spread to us increases and if short-term interest rates increase, the spread we receive will decline,
We have lower average balances of our mortgage securities—available-for-sale portfolio as the securities have paid down and we have not acquired new bonds.

Proceeds from Repayments of Mortgage Loans. As we discussed above, significant cash is collected by the securitization trusts from the payment of principal and interest on securitized loans and securities. The cash is held by the trust and is used to repay obligations (primarily to bondholders) of the trust. The cash is not available to us and we are not responsible for the obligations of the trust.

Primary Uses of Cash

Payments of General and Administrative Expenses. We continue to have significant general and administrative expenses associated with managing and operating our business. These expenses include staff and management compensation and related benefit payments, professional expenses for audit, tax and related services, legal services, rent and general office operational costs.

Investment in Assets or Operating Businesses. To the extent we have cash available to invest in assets or operating businesses, management intends to do so. During the second quarter of 2009, we invested $2 million to acquire Advent.

Repayments of Long-Term Borrowings. As of September 30, 2009, we had $78.1 million in outstanding principal of junior subordinated debentures relating to the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II We have unamortized debt issue costs of $500,000 and therefore a carrying value for the debt of $77.6 million. During the second quarter of 2009, we restructured our obligations under the junior subordinated debentures, which we expect to reduce cash requirements for interest in the near term. As part of the restructuring, we repaid all interest accrued through December 31, 2008, totaling $5.3 million. Details of the restructuring are included in Note 6 to the financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2008. See Table 6 for an estimate of our contractual obligations related to these junior subordinated debentures.

Assets and Liabilities of Consolidated Securitization Trusts

During 2006 and 2007, we executed loan securitization transactions that did not meet the criteria necessary for derecognition of the securitized assets and liabilities pursuant to Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities and related authoritative accounting literature. As a result, the assets and liabilities relating to this securitization are included in our consolidated financial statements.

At the time these loans were securitized, we owned significant beneficial interests in the securitized loan pools, including various subordinated bond classes and the residual interests in these pools. For the 2006 securitized loan pools, we owned the right to unilaterally place certain derivative instruments into the securitization trust and to repurchase a limited number of loans from the trust for any reason and at any time. For the 2007 securitized loan pool, we determined that it excessively benefited from the derivatives transferred to the trust at inception.

During 2007, we also securitized certain mortgage securities through a Collateralized Debt Obligation structure.

During and prior to 2008, the following events occurred that have significantly changed the economics of these securitized loan pools including:

1.	We sold a portion of the beneficial interests we owned,
2.	The credit losses on the securitized loans increased to the point where the remaining beneficial interests we own are not significant,
3.	We sold the right to service all securitized loans,
4.	We executed amendments to the securitization agreements for the 2006 loan pools whereby we relinquished all rights to place certain derivative instruments into the securitization trust and to repurchase a limited number of loans from the trust for any reason and at any time, and
5.	For the 2007 securitized loan pool, a significant portion of the derivatives placed into the trust have expired and the remaining derivatives will expire by the first quarter of 2010.

While the securities, loans and bond liabilities, along with miscellaneous related assets and liabilities, remain on our balance sheet as presented in accordance with accounting principles generally accepted in the United States of America, we have no ability to control the assets, no obligations related to the trust payables, and no significant economic benefit from our ownership interests issued by the trust. Likewise, the income and expenses associated with these assets and liabilities represent earnings and costs of the securitization trust, but have no bearing on our performance due to the current economic condition of the trusts.

Below is financial information for each of the securitization trusts we consolidate and for the total of all consolidated trust balance sheets. The discussion of the individual line items within this financial information is included in the discussion of our consolidated financial statements in the applicable forgoing sections of this report. The following disclosure is considered non-GAAP financial information.

Table 9 — Non-GAAP Disclosure: Assets and Liabilities of Securitization Trusts (A)
(dollars in thousands)
	September 30, 2009															December 31, 2008
							NHES															NHES
				NHES			2006			NHES									NHES			2006			NHES
	CDO			2006-1			MTA1			2007-1			Total			CDO			2006-1			MTA1			2007-1			Total
Assets
Mortgage loans – held
in portfolio, net of
allowance	$	-		$	310,077		$	433,792		$	652,003		$	1,395,872		$	-		$	411,146		$	523,183		$	847,962		$	1,782,291
Trading securities		1,059			-			-			-			1,059			5,199			-			-			-			5,199
Real estate owned		-			30,620			15,289			37,486			83,395			-			23,289			9,233			37,958			70,480
Accrued interest
receivable		-			20,765			7,629			46,448			74,842			-			22,566			10,134			44,592			77,292
Other assets		458			-			-			-			458			2,043			-			-			-			2,043
Total assets	$	1,517		$	361,462		$	456,710		$	735,937		$	1,555,626		$	7,242		$	457,001		$	542,550		$	930,512		$	1,937,305

Liabilities and net deficiency in assets
Liabilities:
Asset-backed
bonds secured
by mortgage
loans (B)	$	-		$	476,963		$	619,749		$	1,205,642		$	2,302,354		$	-		$	566,577		$	700,335		$	1,398,115		$	2,665,027
Asset-backed
bonds secured
by mortgage
securities		1,059			-			-			-			1,059			5,384			-			-			-			5,384
Other liabilities		22,231			48,941			28,528			112,001			211,701			24,748			47,418			22,401			104,439			199,006
Total liabilities		23,290			525,904			648,277			1,317,643			2,515,114			30,132			613,995			722,736			1,502,554			2,869,417
Total net deficiency
in assets		(21,773	)		(164,442	)		(191,567	)		(581,706	)		(959,488	)		(22,890	)		(156,994	)		(180,186	)		(572,042	)		(932,112	)

Total liabilities and
net deficiency in
assets	$	1,517		$	361,462		$	456,710		$	735,937		$	1,555,626		$	7,242		$	457,001		$	542,550		$	930,512		$	1,937,305

(A)	Stand-alone balances do not include impact of intercompany eliminations.

(B)	In accordance with its obligations under the related securitization agreements, the trustee for the respective securitization trusts has charged off asset-backed bonds totaling $144.5 million as of September 30, 2009.

Table 10 – Non-GAAP Disclosure: Operating Results of Securitization Trusts (A)
(dollars in thousands)
	For the Nine Months Ended September 30,
	2009															2008
							NHES															NHES
				NHES			2006			NHES									NHES			2006			NHES
	CDO			2006-1			MTA1			2007-1			Total			CDO			2006-1			MTA1			2007-1			Total
Interest Income	$	8,619		$	21,292		$	13,801		$	57,702		$	101,414		$	19,557		$	36,457		$	20,946		$	87,321		$	164,281
Interest expense		2,168			3,408			5,611			10,292			21,479			10,271			17,784			19,743			43,402			91,200
Provision for credit
losses		-			55,331			42,545			113,174			211,050			-			119,892			151,423			396,323			667,638
Servicing fee
expense		-			1,814			1,860			4,669			8,343			-			2,402			2,070			5,893			10,365
Mortgage insurance		-			783			166			3,842			4,791			-			3,246			220			8,639			12,105
Other income
(expense) (B)		(5,204	)		32,616			25,080			64,651			117,143			(11,073	)		5,754			-			(6,793	)		(12,112	)
General and
administrative
expenses		130			20			24			40			214			654			38			35			48			775
Net income (loss)
before tax
expense		1,117			(7,448	)		(11,325	)		(9,664	)		(27,320	)		(2,441	)		(101,151	)		(152,545	)		(373,777	)		(629,914	)

Tax expense		-			-			56			-			56			-			-			1,822			-			1,822

Net income (loss)	$	1,117		$	(7,448	)	$	(11,381	)	$	(9,664	)	$	(27,376	)	$	(2,441	)	$	(101,151	)	$	(154,367	)	$	(373,777	)	$	(631,736	)

(A)		Stand-alone balances do not include impact of intercompany eliminations.

(B)		In accordance with its obligations under the related securitization agreements, the trustee for the respective securitization trusts has charged off asset-backed bonds totaling $126.9 million and $6.6 million for the nine months ended September 30, 2009 and 2008, respectively. In the opinion of the trustee, the securitized assets will not be sufficient to pay for these bonds. The gain recorded on this debt forgiveness is included in other income (expense). The debt forgiveness and related gain is not recorded under GAAP as the debt is not legally extinguished, even though in the opinion of the trustee the debt will not likely be paid.

	For the Three Months Ended September 30,
	2009														2008
						NHES															NHES
			NHES			2006			NHES									NHES			2006			NHES
	CDO		2006-1			MTA1			2007-1			Total			CDO			2006-1			MTA1			2007-1			Total
Interest Income	$	1,174	$	6,779		$	4,336		$	22,899		$	35,188		$	3,618		$	10,004		$	5,253		$	28,922		$	47,797
Interest expense		6,329		895			1,566			3,016			11,806			3,068			3,879			5,353			12,259			24,559
Provision for credit
losses		-		15,490			4,688			21,884			42,062			-			78			6,937			199,188			206,203
Servicing fee
expense		-		523			579			1,380			2,482			-			734			676			1,861			3,271
Mortgage insurance		-		(617	)		46			(471	)		(1,042	)		-			990			72			2,739			3,801
Other income
(expense) (B)		5,184		16,733			16,724			33,466			72,107			(1,327	)		(424	)		-			(26,911	)		(28,662	)
General and
administrative
expenses		28		6			6			13			53			128			13			11			15			167
Net income (loss)
before tax
expense		1		7,215			14,175			30,543			51,934			(905	)		3,886			(7,796	)		(214,051	)		(218,866	)

Tax expense
(benefit)		-		-			(14	)		-			(14	)		-			-			1,821			-			1,821

Net income (loss)	$	1	$	7,215		$	14,189		$	30,543		$	51,948		$	(905	)	$	3,886		$	(9,617	)	$	(214,051	)	$	(220,687	)

(A)		Stand-alone balances do not include impact of intercompany eliminations.

(B)		In accordance with its obligations under the related securitization agreements, the trustee for the respective securitization trusts has charged off asset-backed bonds owned by us totaling $66.3 million and $0.4 million for the three months ended September 30, 2009 and 2008, respectively. In the opinion of the trustee, the securitized assets will not be sufficient to pay for these bonds. The gain recorded on this debt forgiveness is included in other income (expense). The debt forgiveness and related gain is not recorded under GAAP as the debt is not legally extinguished, even though in the opinion of the trustee the debt will not likely be paid.

Table 11 – Non-GAAP Disclosure: Cash Flows of Securitization Trusts (A)
(dollars in thousands)
	For the Nine Months Ended September 30,
	2009															2008
							NHES															NHES
				NHES			2006			NHES									NHES			2006			NHES
Net cash flow from:	CDO			2006-1			MTA1			2007-1			Total			CDO			2006-1			MTA1			2007-1			Total
Operating activities	$	(1,769	)	$	36,674		$	34,008		$	41,891		$	110,804		$	(8,018	)	$	31,251		$	(5,283	)	$	33,152		$	51,102
Investing activities		2,891			37,162			39,673			83,257			162,983			12,952			125,787			61,846			161,880			362,465
Financing activities		(1,122	)		(73,836	)		(73,681	)		(125,148	)		(273,787	)		(4,934	)		(157,038	)		(56,563	)		(195,032	)		(413,567	)

Net cash flow		-			-			-			-			-			-			-			-			-			-
Cash, beginning of
year		-			-			-			-			-			-			-			-			-			-

Cash, end of year	$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-		$	-

(A)

Stand-alone balances do not include impact of intercompany eliminations.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

As a smaller reporting company, we are not required to provide the information required by this Item.

Item 4. Controls and Procedures

Disclosure Controls and Procedures

The Company maintains a system of disclosure controls and procedures which are designed to ensure that information required to be disclosed by the Company in reports that it files or submits under the federal securities laws, including this report, is recorded, processed, summarized and reported on a timely basis. These disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed under the federal securities laws is accumulated and communicated to the Company’s management on a timely basis to allow decisions regarding required disclosure. The Company’s principal executive officer and principal financial officer evaluated the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(d)) as of the end of the period covered by this report and concluded that the Company’s controls and procedures were effective.

Internal Control over Financial Reporting

Management’s Report on Internal Control over Financial Reporting

Management of NovaStar Financial, Inc. and subsidiaries (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) of the Securities Exchange Act of 1934. This internal control system has been designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation and fair presentation of the Company’s published financial statements.

All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

Management of the Company has assessed the effectiveness of the Company’s internal control over financial reporting as of September 30, 2009. To make this assessment, management used the criteria for effective internal control over financial reporting described in Internal Control—Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our assessment under the framework in Internal Control—Integrated Framework, management concluded that the Company’s internal control over financial reporting was not effective as of September 30, 2009 because of the existence of a material weakness in internal controls over financial reporting related to the lack of segregation of duties within our accounting department.

A material weakness is a deficiency, or combination of deficiencies, in internal controls over financial reporting, such that there is a reasonable possibility a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.

The Company identified a control deficiency that was deemed a material weakness in internal controls over financial reporting at September 30, 2008. The deficiency relates to the inadequate segregation of duties amongst the Company's employees with respect to accounting, financial reporting and disclosure. The material weakness was a result of the reduction in our accounting staff which occurred during the third quarter ended September 30, 2008. The material weakness identified above did not result in the restatement of prior period financial statements or any other related financial disclosure, nor did it disclose any errors or misstatements.

Management has taken steps to remedy the material weakness by hiring additional accounting department staff, and reallocating duties, including responsibilities for financial reporting, among the Company’s employees. However, based on the overall lack of accounting department resources, this material weakness was not remediated as of September 30, 2009.

Changes in Internal Control over Financial Reporting

There were no changes in our internal controls over financial reporting during the three months ended September 30, 2009 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Litigation.

Item 1A. Risk Factors

Risk Factors

There have been no material changes to the risk factors previously disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2008.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
(dollars in thousands)
Issuer Purchases of Equity Securities
			Total Number of
			Shares	Approximate Dollar
			Purchased as	Value of Shares
			Part of Publicly	That May Yet Be
	Total Number	Average	Announced	Purchased Under
	of Shares	Price Paid	Plans or	the Plans or
	Purchased	per Share	Programs	Programs (A)
July 1, 2009 – July 30, 2009	-	-	-	$	1,020
August 1, 2009 – August 31, 2009	-	-	-	$	1,020
September 1, 2009 – September 30, 2009	-	-	-	$	1,020

(A)

A current report on Form 8-K was filed on October 2, 2000 announcing that the Board of Directors authorized the Company to repurchase its common shares, bringing the total authorization to $9 million.

Item 3. Defaults Upon Senior Securities

NFI’s wholly owned subsidiary NovaStar Mortgage, Inc. (“NMI”) has approximately $77.6 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. NFI has guaranteed NMI's obligations under the Notes. NMI failed to make quarterly interest payments that were due on all payment dates in 2008 and through April 24, 2009 on these Notes.

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

None.

Item 5. Other Information

At its meeting on November 10, 2009, the Company’s Board of Directors (the “Board”) appointed Gregory T. Barmore as Lead Independent Director for a maximum tenure of three years. Mr. Barmore will receive no additional compensation for serving as Lead Independent Director.

The Lead Independent Director assists the Chairman of the Board with board-related matters and acts, as necessary, as a liaison between the independent directors and the Chairman of the Board. To that end, the Lead Director will, among other things: (i) approve an appropriate schedule of meetings of the Company’s Board of Directors; (ii) review agendas for the Board and Committee meetings; (iii) assess the quality, quantity and timeliness of the flow of information from the Company’s management to the independent directors; (iv) whenever appropriate, direct the retention of consultants who report directly to the Board; (v) assist the Board and the Company’s officers in assuring compliance with and implementation of the Company’s Corporate Governance Guidelines and be principally responsible for recommending revisions to the Corporate Governance Guidelines; (vi) coordinate an agenda for the Board’s independent directors; (vii) evaluate, along with the members of the Compensation Committee and the full Board, the Chief Executive Officer’s performance and meet with the Chief Executive Officer to discuss the Board’s evaluation; and (vii) review the membership and performance of the various Board committees and committee chairs.

Item 6. Exhibits

Exhibit Listing

Exhibit No.		Description of Document
11.1	⁽¹⁾	Statement Regarding Computation of Per Share Earnings

31.1		Chief Executive Officer Certification - Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Principal Financial Officer Certification - Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Chief Executive Officer Certification - Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Principal Financial Officer Certification - Section 906 of the Sarbanes-Oxley Act of 2002

____________________

(1)

See Note 13 to the condensed consolidated financial statements.

SIGNATURES

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

NOVASTAR FINANCIAL, INC.

DATE: November 12, 2009		/s/ W. Lance Anderson
		W. Lance Anderson, Chairman of the
		Board of Directors and Chief
		Executive Officer
		(Principal Executive Officer)

DATE: November 12, 2009		/s/ Rodney E. Schwatken
		Rodney E. Schwatken, Chief
		Financial Officer
		(Principal Financial Officer)