UNITED STATES
 
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 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, 2000.
 
OR
 
¨
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
(State or other jurisdiction
of incorporation or organization)
74-2830661
(I.R.S. Employer
Identification Number )
 
1901 W. 47 th Place, Suite 105, Westwood, KS 66205
(Address of principal executive offices)
(Zip Code)
 
(913) 362-1090
(Registrant’s telephone number, including area code)
 
(Former name, former address and former fiscal year, if changed since last report)
 
 
          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   ¨
 
          The number of shares of the registrant’s common stock outstanding as of November 10, 2000 was 6,163,741.
 
 
NOVASTAR FINANCIAL, INC.
 
FORM 10-Q
QUARTER ENDED SEPTEMBER 30, 2000
INDEX
 
            Page
PART I      FINANCIAL INFORMATION     
 
Item 1.      Consolidated Financial Statements:     
          Balance Sheets      1
          Statements of Operations      2
          Statements of Cash Flows      3
          Notes      4
 
Item 2.      Management’s Discussion and Analysis of Financial Condition and Results of Operations      6
 
Item 3.      Quantitative and Qualitative Disclosures about Market Risk      44
 
PART II      OTHER INFORMATION     
 
Item 1.      Legal Proceedings      49
         
Item 2.      Changes in Securities      49
         
Item 3.      Defaults Upon Senior Securities      49
         
Item 4.      Submission of Matters to a Vote of Security Holders      49
         
Item 5.      Other Information      49
         
Item 6.      Exhibits and Reports on Form 8-K      50
         
       Signatures      54

NOVASTAR FINANCIAL, INC.
CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except share amounts)  

       September 30, 2000
     December 31, 1999
     (unaudited)        
Assets          
  Cash and cash equivalents      $    2,767        $    2,395  
  Mortgage loans      424,547        620,406  
  Mortgage-backed securities—available-for-sale      41,784        6,775  
  Accrued interest receivable      9,782        12,452  
  Advances to and investment in NFI Holding Corporation      20,617        29,208  
  Assets acquired through foreclosure      15,315        16,891  
  Other assets      1,905        2,383  
   
   
 
          Total assets      $516,717        $690,510  
   
 
Liabilities and Stockholders’ Equity          
  Liabilities:
    Borrowings      $413,156        $586,868  
    Dividends payable      525        525  
    Accounts payable and other liabilities      2,173        1,803  
   
   
 
          Total liabilities      415,854        589,196  
 
  Stockholders’ equity:
    Capital stock, $0.01 par value, 50,000,000 shares authorized:          
      Class B, convertible preferred stock, 4,285,714
        shares issued and outstanding 		     43        43  
      Common stock, 8,143,407 and 8,130,069 shares issued;
        6,206,441 and 7,460,523 shares outstanding, respectively 		     81        81  
    Additional paid-in capital      151,197        151,173  
    Accumulated deficit      (39,742 )      (41,502 )
    Accumulated other comprehensive income      3,283        242  
    Cost of treasury stock, 1,936,966 and 673,400 shares, respectively      (7,153 )      (1,877 )
    Notes receivable from founders      (6,846 )      (6,846 )
   
   
 
          Total stockholders’ equity      100,863        101,314  
   
   
 
      Total liabilities and stockholders’ equity      $516,717        $690,510  
   
   
 

   See notes to consolidated financial statements.

 
 
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited; in thousands)
 
 
         For the Nine Months
Ended September 30,
       For the Three Months
Ended September 30,
 
    2000
    1999
    2000
  1999
 
Interest income on mortgage loans   $     34,981     $     52,236     $     10,391     $     15,595  
Interest expense on mortgage loans        26,881          36,059          8,240          11,206  
    
    
    
    
  
Net interest income        8,100          16,177          2,151          4,389  
Prepayment penalty income        1,431          2,385          448          769  
Provision for credit losses        (4,004 )         (11,499 )        (1,212 )        (5,634 )
Premiums for mortgage loan insurance        (1,009 )        (1,339 )        (302 )        (427 )
Loan servicing fees paid to NovaStar Mortgage, Inc.        (1,982 )        (3,056 )        (599 )        (936 )
    
    
    
    
  
Net portfolio income (loss)        2,536          2,668          486          (1,839 )
                                 
Net interest income on mortgage-backed securities        1,329          100          602          100  
                                 
Other income (loss)        (453 )        706          (591 )        322  
                                 
Equity in net income of NFI Holding Corporation        646          1,518          787          576  
                                 
General and administrative expenses:                                            
     Net fees for other services provided by (to) NovaStar Mortgage, Inc.     (1,460 )     287       (1,458 )     (169 )
     Compensation and benefits.        1,042          1,358          325          421  
     Professional and outside services        467          546          210          181  
     Office administration        607          611          206          203  
     Other        66          156
 
       23          60  
    
    
  
 
    
  
     Total general and administrative expenses        722          2,958
 
       (694 )        696  
    
    
  
 
    
  
               
               
Net income (loss)   $    3,336     $    2,034
 
  $   1,978     $   (1,537 )
   
   
 
   
 
Dividends on preferred shares   $    (1,575 )   $    (1,081
)
  $     (525 )   $     (525 )
    
    
  
 
    
  
Net income (loss) available to common shareholders   $    1,761     $     953
 
  $    1,453     $    (2,062 )
    
    
    
    
  
                                 
Basic earnings (loss) per share   $      0.25     $      0.12     $      0.21     $     (0.25 )
    
    
    
    
  
Diluted earnings (loss) per share   $   0.25     $ 0.11     $  0.18     $  (0.25 )
    
    
    
    
  
                                 
Weighted average basic shares outstanding        7,087          8,130          6,900          8,130  
Weighted average diluted shares outstanding        7,094          8,326          11,192          8,130  
                                 
Dividends declared per common share   $ —     $  —     $  —     $ —  
    
    
    
    
  
 
See notes to consolidated financial statements.
 
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited; in thousands)
 
       For the Ninth Months
Ended September 30,
       2000      1999
Net cash provided by operating activities      $  13,945        $  23,504  
 
Cash flow from investing activities:          
     Mortgage loan repayments      176,799        201,034  
     Sales of assets acquired through foreclosure      15,295        17,542  
     Mortgage loans sold to others      —        4,900  
     Proceeds from paydowns on mortgage-backed securities      2,161        —  
     Net change in advances to NFI Holding Corporation      7,309        (15,360 )
     Purchase of mortgage-backed securities from NFI Holding Corporation      (33,767 )      —  
     
     
  
     Net cash provided by investing activities      167,797        208,116  
 
Cash flow from financing activities:          
     Payments on collateralized mortgage obligations      (185,502 )      (236,872 )
     Change in short-term borrowings      10,960        (18,029 )
     Net proceeds from issuance of capital stock and exercise of equity instruments      23        29,029  
     Dividends paid on preferred stock      (1,575 )      (556 )
     Dividends paid on common stock      —        (2,845 )
     Treasury stock purchases      (5,276 )      —  
     
     
  
     Net cash used in financing activities      (181,370 )      (229,273 )
     
     
  
     Net increase in cash and cash equivalents      372        2,347  
     Cash and cash equivalents, beginning of period      2,395        —  
     
     
  
     Cash and cash equivalents, end of period      $    2,767        $    2,347  
     
     
  
 
Supplemental disclosure of cash flow information:          
     Cash paid for interest      $  27,048        $  36,567  
     
     
  
     Assets acquired through foreclosure      $  12,136        $  22,570  
     
     
  
     Dividends payable      $       525        $       525  
     
     
  
     Issuance of warrants      $         —        $       350  
     
     
  
 
See notes to consolidated financial statements.
 
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2000 (Unaudited)
 
 
Note 1.    Financial Statement Presentation
 
          The consolidated financial statements as of and for the periods ended September 30, 2000 and 1999 are unaudited. In the opinion of management, all adjustments have been made which were of a normal and recurring nature, necessary for a fair presentation of the balance sheets and results of operations. The 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 NovaStar Financial and the notes thereto, included in NovaStar Financial’s annual report to shareholders and annual report on Form 10-K for the fiscal year ended December 31, 1999.
 
          NovaStar Financial owns 100 percent of the common stock of three special purpose entities — NovaStar Assets Corporation, NovaStar Certificates Financing Corporation and NovaStar Mortgage Funding Corporation. NovaStar Financial formed these entities in connection with the issuance of collateralized mortgage obligations. The consolidated financial statements of NovaStar Financial include the accounts of these entities. Significant intercompany accounts and transactions have been eliminated in consolidation.
 
          NovaStar Financial owns 100 percent of the non-voting preferred stock of NFI Holding Corporation (Holding) for which it receives 99 percent of any dividends paid by NFI Holding. The founders of NovaStar Financial own the voting common stock of NFI Holding and receive 1% of any dividends paid by NFI Holding. NovaStar Mortgage, Inc., NovaStar Capital, Inc. and NovaStar Home Mortgage, Inc. are wholly owned subsidiaries of NFI Holding. NovaStar Mortgage Funding Corporation II, NovaStar Mortgage Funding Corporation III and NovaStar REMIC Financing Corporation are subsidiaries of NovaStar Mortgage. NovaStar Financial accounts for its investment in Holding using the equity method.
 
                 New Accounting Pronouncements .    During 1998, the Financial Accounting Standards Board (FASB) issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities . SFAS No. 133 standardizes the accounting for derivative instruments, including certain instruments embedded in other contracts, by requiring that an entity recognize those items as assets or liabilities in the balance sheet and measure them at fair value. If certain conditions are met, an entity may elect to designate a derivative instrument either as a cash flow hedge, a fair value hedge or a hedge of foreign currency exposure. Generally, SFAS No. 133 provides for matching the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of hedge asset or liability that is attributable to the hedge risk or the earnings effect of the hedge forecasted transaction. SFAS No. 137, Accounting for Derivative Instruments and Hedging Activities—Deferral of the Effective Date of FASB Statement No. 133 an amendment of FASB Statement No. 133 was issued in June 1999 and postponed the effective date of SFAS No. 133 to fiscal years beginning after June 15, 2000. Management has reviewed all financial instruments of NovaStar Financial and has determined that NovaStar Financial’s interest rate cap agreements are derivative instruments under SFAS No. 133. These derivatives are used to hedge the interest rate risk on variable rate debt and will be accounted for as cash flow hedges under SFAS No. 133. Management does not expect the adoption of SFAS No. 133 to have a material impact on the financial statements of the NovaStar Financial, Inc.
 
           In September 2000, the Financial Accounting Standards Board (FASB) issued SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities—a replacement of FASB Statement No. 125. SFAS 125 was issued in June 1996 to revise the standards for accounting for securitization and other transfers of financial assets and requires certain disclosures regarding those transfers. SFAS 140 replaces SFAS 125 in its entirety. However, it carries over most of the provisions of SFAS 125. SFAS 140 also formalizes guidance provided by the FASB in various committee publications and technical bulletins. This Statement is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001. This Statement is effective for recognition and reclassification of collateral and for disclosures relating to securitization transactions and collateral for fiscal years ending after December 15, 2000. Disclosures about securitization and collateral accepted need not be reported for periods ending on or before December 15, 2000, for which financial statements are presented for comparative purposes. Management does not expect the adoption of SFAS No. 140 to have a material impact on the financial statements of NovaStar Financial.
 
          In addition, Note 1 of the consolidated financial statements contained in the annual report on Form 10-K for the fiscal year ended December 31, 1999 describes certain recently issued accounting pronouncements. Management believes the implementation of these pronouncements and others that have gone into effect since the date of these reports will not have a material impact on the consolidated financial statements.
 
Note 2.    NovaStar Mortgage Funding Trust Series 2000-1 and 2000-2
 
          On March 31, 2000 and September 28, 2000, NovaStar Mortgage executed securitization transactions that were constructed to allow for accounting as sales of loans. Details of these transactions are as follows:
 
       Value of
Asset-Backed
Bonds Issued
     Economic Residual Value
as of September 30, 2000
     Value of
Collateral Sold
     Gain
Recognized
NMFT 2000-1      $226 million      $13,750,000      $229,846,000      $2,936,000
NMFT 2000-2 (A)      $334 million      $20,534,000      $188,734,000      $3,584,000

 
(A)       
A second closing for NMFT 2000-2 is scheduled for December 26, 2000 in which $151.3 million of loans will be added.
 
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 consolidated financial statements of NovaStar Financial 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, 1999.
 
Safe Harbor Statement
 
          “Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995: Statements in this discussion regarding NovaStar Financial, Inc. and its business, which are not historical facts, are “forward-looking statements” that involve risks and uncertainties. Certain matters discussed in this quarterly report may constitute forward-looking statements within the meaning of the federal securities laws that inherently include certain risks and uncertainties. Actual results and the time of certain events could differ materially from those projected in or contemplated by the forward-looking statements due to a number of factors, including general economic conditions, fluctuations in interest rates, fluctuations in prepayment speeds, fluctuations in losses due to defaults on mortgage loans, the availability of non-conforming residential mortgage loans, the availability and access to financing and liquidity resources, and other risk factors outlined in the annual report on Form 10-K for the fiscal year ended December 31, 1999. Other factors not presently identified may also cause actual results to differ. Management continuously updates and revises these estimates and assumptions based on actual conditions experienced. It is not practicable to publish all revisions and, as a result, no one should assume that results projected in or contemplated by the forward-looking statements will continue to be accurate in the future. Risks and uncertainties, which could cause results to differ from those discussed in the forward-looking statements herein, are listed in the “ Risk Management” section of the annual report on Form 10-K for the fiscal year ended December 31, 1999.
 
Basis of Presentation
 
          NovaStar Financial owns 100% of the common stock of NovaStar Assets Corporation, NovaStar Certificates Financing Corporation and NovaStar Mortgage Funding Corporation. These entities were established as special purpose entities used in issuance of collateralized mortgage obligations. The consolidated financial statements of NovaStar Financial include the financial condition and results of operations of these entities.
 
          NovaStar Financial also owns 100% of the non-voting preferred stock of NFI Holding Corporation for which it receives 99% of any dividends paid by NFI Holding. Scott Hartman and Lance Anderson, the founders of NovaStar Financial, own the voting common stock of NFI Holding and receive 1% of any dividends paid by NFI Holding. NovaStar Mortgage, Inc., NovaStar Capital and NovaStar Home Mortgage, Inc. are wholly owned subsidiaries of NFI Holding. NovaStar Mortgage Funding Corporation II, NovaStar Mortgage Funding Corporation III and NovaStar REMIC Financing Corporation are subsidiaries of NovaStar Mortgage. The business of NovaStar Mortgage is discussed in “Description of Business—Business of NovaStar Mortgage.” NovaStar Capital was formed to focus on acquiring non-conforming residential mortgage loans from banks, thrifts and credit unions. In February 2000, NovaStar Capital discontinued operations. NovaStar Home Mortgage was created in May 1999 to operate a network of mortgage brokers. Currently, NovaStar Home Mortgage operates 48 branches in 24 states.
 
           A significant component of the financial results of NovaStar Financial are derived from the operations of NovaStar Mortgage, Inc. Key officers of NovaStar Financial also serve as officers of NFI Holding, NovaStar Mortgage, NovaStar Capital, Inc and NovaStar Home Mortgage, Inc. The founders are the only members of the Board of Directors of NFI Holding, NovaStar Mortgage, NovaStar Capital and NovaStar Home Mortgage, Inc. NovaStar Mortgage owns 100% of NovaStar Mortgage Funding Corporation II, NovaStar Mortgage Funding Corporation III and NovaStar REMIC Financing Corporation. These special purpose entities were created for the issuance of interests in real estate mortgage investment conduits commonly known as REMICs. NovaStar Financial accounts for its investment in NFI Holding using the equity method, meaning the operations of NFI Holding are not consolidated with NovaStar Financial.
 
Recent Developments
 
           Federal Tax Legislation . REITs will be allowed to own directly all of the stock of taxable subsidiaries beginning in the tax year 2001. The value of all taxable subsidiaries of a REIT will be limited to 20% of the total value of the REIT’s assets. Accordingly, NovaStar Financial expects to acquire all of the common stock of NFI Holding Corporation from Scott Hartman and Lance Anderson in January 2001. As a result, NFI Holding will become a wholly-owned consolidated subsidiary of NovaStar Financial.
 
          Also, effective beginning with the 2001 tax year, the minimum dividend distributions of a REIT will have to equal 90% of taxable income, down from 95% of taxable income under current law. This provision will also first be effective beginning with the 2001 tax year. These and other federal tax legislation changes and proposals are discussed further in NovaStar Financial’s Annual Report on Form 10K under “Federal Income Tax Consequences”.
 
Description of Business
 
Business of NovaStar Financial:
 
·
Founded in 1996 as a specialty finance lender to invest in mortgage assets;
 
·
Assets have primarily come from the wholesale origination of nonconforming, single-family, residential mortgage loans of its affiliate, NovaStar Mortgage;
 
·
Operates as a long-term portfolio investor;
 
·
Loans are financed on a short-term basis through various warehouse facilities. Long-term financing is provided through securitization where asset-backed bonds are issued in financing-structured transactions;
 
·
Earnings are generated from spread income on the mortgage loan and securities portfolio and indirectly by gains associated with the sale of loans to outside parties or through securitization transactions of NovaStar Mortgage.
 
Business of NovaStar Mortgage:
 
·
Primary customer is the retail mortgage broker who deals with the borrower. NovaStar Mortgage’s account executives work with more than 4,500 brokers to solicit loans.
 
·
Borrowers generally are individuals or families who do not qualify for agency/conventional lending programs because of a lack of available documentation or previous credit difficulties. Often, these borrowers have built up high-rate consumer debt and are attempting to use equity in their home to consolidate debt and lower their total monthly payments.
 
·
Loans are financed on a short-term basis through warehouse facilities. Long-term financing is provided through securitization where asset-backed bonds are issued in transactions that are structured as a sale.
 
·
Loans are held for sale—either to affiliates, third parties for cash or subsidiaries as collateral for securitization.
 
Financial Condition of NovaStar Financial, Inc. as of September 30, 2000 and December 31, 1999
 
          NovaStar Financial’s balance sheets consist primarily of securitized mortgage loans originated by and purchased from NovaStar Mortgage, which serve as collateral for its collateralized mortgage obligations. The carrying value of mortgage loans as of September 30, 2000 was $425 million versus $620 million as of December 31, 1999. The carrying value of collateralized mortgage obligations as of September 30, 2000 was $402 million compared with $587 million as of December 31, 1999. The decline in both balance sheet items is primarily a result of principal paydowns that occurred during the first nine months of 2000. Even though NovaStar Financial is no longer purchasing the loans originated from NovaStar Mortgage, NovaStar Financial has been able to grow its mortgage asset portfolio by purchasing the residual assets of all NovaStar Mortgage’s securitization transactions. The carrying value of the residual assets of NovaStar Financial was $42 million as of September 30, 2000 compared with $7 million as of December 31, 1999. Mortgage loans collateralizing residual assets totaled $526 million as of September 30, 2000 compared with $143 million as of December 31, 2000 bringing the total carrying value of mortgage assets managed by NovaStar Financial to nearly $1 billion as of September 30, 2000 compared with $770 million as of December 31, 1999.
 
           Mortgage Loans .     Table 1 is a presentation of loans as of September 30, 2000 and December 31, 1999 and their credit grades. Table 2 is a summary of all mortgage loans owned by NovaStar Financial as of September 30, 2000 and December 31, 1999 by state. These tables also provide details regarding the collateral outstanding on NovaStar Mortgage’s REMIC transactions, which NovaStar Financial owns the residual interests. The REMIC transactions are discussed further in the “Mortgage Loans—Available for Sale” and “Mortgage Loans Sales” sections of this document.
 
Table 1
Mortgage Loans by Credit Grade
(dollars in thousands)
 
          September 30, 2000
  December 31, 1999
Credit
Grade
  Allowed
Mortgage
Lates (A)
  Maximum
Loan-to-
value
  Current
Principal
  Weighted
Average
Coupon
  Weighted
Average
Loan-to-
value
  Current
Principal
  Weighted
Average
Coupon
  Weighted
Average
Loan-to-
value
Retained loans collateralizing
asset-backed bonds: 		                                                
AA        0 x 30        95   $  62,099        10.11 %        82.8 %   $  85,476        9.50 %        83.2 %
A        1 x 30        90        170,903        10.61          79.3          244,187        10.06          80.1  
A-        2 x 30        90        100,568        11.18          81.8          149,248        10.45          81.8  
B        3 x 30, 1 x 60        85        59,056        11.68          78.0          89,477        10.86          78.4  
         5 x 30, 2 x 60                                                 
C        1 x 90        75        26,353        12.11          72.8          42,766        11.35          72.5  
D        6 x 30, 3 x 60,        65        5,004        12.95          63.4          7,668        12.16          62.1  
              
           
         
         2 x 90                                                 
Total on balance sheet          $     423,983        10.94 %        79.6 %   $     618,822        10.31 %        80.0 %
              
 
    
    
 
    
  
 
                      September 30, 2000
     December 31, 1999
Credit
Grade
       Allowed
Mortgage
Lates (A)
       Maximum
Loan-to-
value
     Current
Principal
     Weighted
Average
Coupon
     Weighted
Average
Loan-to-
value
     Current
Principal
     Weighted
Average
Coupon
     Weighted
Average
Loan-to-
value
Sold loans collateralizing asset-
backed bonds: 		                               
AAA        0 x 30        97 (B)      $115,453      9.69 %      80.8 %      $    3,474      9.18 %      80.7 %
AA        0 x 30        95        136,895      10.17        83.6        27,236      9.47        84.8  
A        1 x 30        90        106,876      10.39        81.2        43,119      9.86        83.1  
A-        2 x 30        90        75,505      10.49        81.4        35,311      10.09        83.1  
B        3 x 30, 1x 60        85      39,052      10.97        79.3        19,612      10.59        79.7  
         5 x 30, 2 x 60                                              
C        1 x 90        75        16,180      11.50        70.4        11,405      11.09        71.9  
D        6 x 30, 3 x 60,        65        2,071      12.29        70.0        3,171      12.16        62.1  
         2 x 90                                     
Other        Varies        97        36,525      11.42        92.6        —      —        —  
                  
              
           
Total off balance sheet             $528,557      10.35 %      82.0 %      $143,328      10.08 %      81.5 %
                  
  
     
     
  
     
  
(A)
Represents the number of times a prospective borrower is allowed to be late more than 30, 60 or 90 days. For instance, a 3x30, 1x60 category would afford the prospective borrower to be more than 30 days late on three separate occasions and 60 days late no more than one time.
(B)
97% on fixed-rate purchases; all other maximum of 95%.
 
Table 2
Mortgage Loans by State
Percent of Portfolio
(based on current principal balance)
 
       Retained loans collateralizing asset-
backed bonds—on balance sheet
     Sold loans collateralizing asset-backed
bonds—off balance sheet
     September 30, 2000
     December 31, 1999
     September 30, 2000
     December 31, 1999
Collateral Location
                   
Florida      15 %      14 %      16 %      21 %
California      14        16        10        7  
Washington      6        7        4        4  
Texas      5        5        3        6  
Nevada      4        4        6        4  
Oregon      4        5        2        1  
Tennessee      4        3        6        5  
Michigan      3        3        8        5  
Ohio      3        3        6        4  
All other states      42        40        39        43  
     
     
     
     
  
Total      100 %      100 %      100 %      100 %
     
     
     
     
  
 
          Table 3 provides a summary of NovaStar Financial’s mortgage loans by type and carrying value as of September 30, 2000 and December 31, 1999.
 
Table 3
Carrying Value of Loans by Product/Type
September 30, 2000 and December 31, 1999
(in thousands)
 
Product/Type
     September 30, 2000
     December 31, 1999
 
     Retained loans collateralizing asset-backed bonds—
         on balance sheet: 		         
               Two and three-year fixed.      $201,440        $343,193  
               Six-month LIBOR and one-year CMT      27,164        43,178  
               30/15-year fixed and other      195,379        232,451  
     
     
  
               Outstanding principal      423,983        618,822  
               Premium      8,696        12,689  
               Allowance for credit losses      (8,132 )      (11,105 )
     
     
  
               Carrying Value      $424,547        $620,406  
     
     
  
               Carrying value as a percent of principal      100.13 %      100.26 %
     
     
  
 
     Sold loans collateralizing asset-backed bonds—
         off balance sheet: 		         
               Two and three-year fixed.      $357,210        $  78,238  
               Six-month LIBOR and one-year CMT      2,864        5,052  
               30/15-year fixed and other      168,483        60,038  
     
     
  
               Outstanding principal      $528,557        $143,328  
     
     
  
               Mortgage securities retained.      $  41,784        $    6,775  
     
     
  
 
          Substantially all mortgage loans are acquired at a premium. Premiums are amortized as a reduction of interest income over the lives of the assets. See Tables 4, 5, and 6 for the impact of principal payments on amortization. To mitigate the effect of prepayments on interest income from mortgage loans, NovaStar Financial generally strives to acquire mortgage loans that have prepayment penalties. During the nine months ended September 30, 2000, prepayment penalties collected from borrowers totaled $1.4 million in comparison with $2.4 million for the same period of 1999. Table 4 is an analysis of mortgage loans and prepayment penalties.
 
Table 4
Mortgage Loan Prepayment Penalties
September 30, 2000 and December 31, 1999
(dollars in thousands)
 
       Current
Principal
     Premium
     Percent with
Prepayment
Penalty
     Weighted Average
       Coupon
     Loan-to-
value
  Remaining
Prepayment Penalty
Period (in years) -
Loans with Penalty
As of September 30, 2000                             
Retained loans collateralizing asset-backed bonds:                              
          NHES 1997-1      $  58,054      $2,679      23 %      11.61 %      74.9 %  
0.33
          NHES 1997-2      63,337      1,269      22        11.34        79.1      
0.31
          NHES 1998-1      127,936      2,126      48        10.96        80.6    
0.57
          NHES 1998-2      174,393      2,609      58        10.54        81.0      
0.98
          All other loans      263      13      —        12.86        76.0      
—
     
  
                  
          Total on balance sheet      $423,983      $8,696      45 %      10.94 %      79.6 %    
0.67
     
  
  
     
     
   
Sold loans collateralizing asset-backed bonds (A):                               
          NMFT 1999-1      $119,327      $     —      66 %      10.43 %      81.7 %    
1.36
          NMFT 2000-1 (B)      221,963      —      93        10.15        81.1      
2.63
          NMFT 2000-2 (C)      187,267      —      90        10.54        83.3       
2.62
     
  
                  
          Total off balance sheet      $528,557      $     —      86 %      10.35 %      82.0 %    
2.34
     
  
  
     
     
   
 
       Current
Principal
     Premium
     Percent with
Prepayment
Penalty
     Weighted Average
       Coupon
     Loan-to-
value
  Remaining
Prepayment Penalty
Period (in years) -
Loans with Penalty
As of December 31, 1999                              
Retained loans collateralizing asset-backed bonds:                              
          NHES 1997-1      $  85,015      $  3,942      32 %       11.04  %      75.5  %     
0.51
          NHES 1997-2      101,031      1,917      35        10.90        79.3       
0.55
          NHES 1998-1      195,170      3,205      63        10.08        81.1       
0.93
          NHES 1998-2      237,223      3,606      74        9.97        81.1       
1.51
          All other loans      383      19      6        11.96        77.6       
0.10
     
  
                    
                    Total on balance sheet      $618,822      $12,689      58 %      10.31 %      80.0 %     
1.03
     
  
  
     
     
   
Sold loans collateralizing asset-backed bonds (A):                              
          Off balance sheet NMFT 1999-1      $143,328      $       —      84 %      10.08 %      81.5 %     
2.03
     
  
  
     
     
   
(A)
NovaStar Financial owns economic residual interests. The mortgage loans are not retained on the balance sheet of NovaStar Financial.
(B)
The economic residual interests in NMFT 2000-1 were purchased by NovaStar Financial April 1, 2000.
(C)
The economic residual interests in NMFT 2000-2 were purchased by NovaStar Financial September 29, 2000.
 
           In periods of decreasing interest rates, borrowers are more likely to refinance their mortgages to obtain a better interest rate. Even in rising rate environments, borrowers tend to repay their mortgage principal balances earlier than is required by the terms of their mortgages. Non-conforming borrowers, as they update their credit rating, are more likely to refinance their mortgage loan to obtain a lower interest rate.
 
          Prepayment rates in the table below represent the annualized principal prepayment rate in the most recent one, three and twelve month periods and over the life of the pool of loans.
 
Table 5
Prepayment Speeds
(dollars in thousands)
 
       Issue Date
     Current
Principal
Balance
     Weighted
Average Age
of Loans at
Inception
(in months)
     Constant Prepayment Rate
(Annual Percent)
       One-
month
     Three-
month
     Twelve-
month
     Life
September 30, 2000                                   
Retained loans
collateralizing asset-
backed bonds: 		                                  
          NHES 1997-1      October 1, 1997      $  58,054      7      44      41      41      40
          NHES 1997-2      December 11, 1997      63,337      3      33      38      47      35
          NHES 1998-1      April 30, 1998      127,936      3      38      45      41      29
          NHES 1998-2      August 18, 1998      174,393      3      39      43      30      23
               
Sold loans collateralizing
asset—backed bonds: 		                                  
          NMFT 1999-1      January 29, 1999      $119,327      5      36      31      23      18
          NMFT 2000-1      March 31, 2000      221,963      2      8      9      —      7
          NMFT 2000-2      September 28, 2000      187,267      1      —      —      —      —
 
       Issue Date
     Current
Principal
Balance
     Weighted
Average Age
of Loans at
Inception
(in months)
     Constant Prepayment Rate
(Annual Percent)
       One-
month
     Three-
month
     Twelve-
month
     Life
December 31, 1999                                   
Retained loans
collateralizing asset-
backed bonds: 		                                  
          NHES 1997-1      October 1, 1997      $  85,015      7      44      42      50      40
          NHES 1997-2      December 11, 1997      101,031      3      64      58      42      32
          NHES 1998-1      April 30, 1998      195,170      3      47      36      29      23
          NHES 1998-2      August 18, 1998      237,223      3      26      21      21      18
               
Sold loans collateralizing
asset—backed bonds: 		                                  
          NMFT 1999-1      January 29, 1999      $143,328      5      14      20      14      14
 
Table 6 details the amount of premium as a percent of principal at quarter end for 2000 and 1999.
 
Table 6  
Premium as a Percent of Principal
 
 
      Mortgage
Loans
  September 30, 2000   2.05 %
  June 30, 2000   2.03  
  March 31, 2000   2.05  
  December 31, 1999   2.05  
  September 30, 1999   2.09  
  June 30, 1999   2.15  
  March 31, 1999   2.22  
 
           Mortgage-Backed Securities – Available-For-Sale .     NovaStar Financial owns the economic residual certificates in NovaStar Mortgage Funding Trust Series 1999-1, 2000-1 and 2000-2. As the owner of the residual certificates, NovaStar Financial receives the net cash flow of the NovaStar Mortgage Funding Trust Series asset-backed bonds, which represent the right to receive, over the life of the securitizations, the excess of the weighted average coupon on the mortgage loan collateral over the sum of the interest rate on the bonds, a normal servicing fee, a trustee fee, insurance premiums and the credit losses relating to the securitized loans. As of September 30, 2000 and December 31, 1999, the carrying value of the residual interests was $41.8 million and $6.8 million. These values represent the present value of the residual cashflows that NovaStar Financial expects to receive over the life of the securitizations, taking into consideration estimated prepayment speeds and credit losses, and is discounted at a rate which management believes is an appropriate risk-adjusted market rate of return for the residual asset. The residual cashflows are realized over the life of the securitizations as cash distributions are received from the trusts. NovaStar Financial believes its residual assets are fairly valued as of September 30, 2000, but can provide no assurance that future prepayment and loss experience or changes in the required market discount rate will not require write-downs of the residual asset. Write-downs would reduce the income of future periods and could cause NovaStar Financial to report net losses.
 
          Key statistics, assumptions and characteristics of the NovaStar Mortgage Funding Trust Series mortgage loan collateral and bonds as of September 30, 2000 and December 31, 1999 are included in the table below and in Tables 4, 5 and 8 of this document.
 
          NovaStar Mortgage originated and securitized the loans serving as collateral in NMFT 1999-1, 2000-1 and 2000-2. Upon securitization, NovaStar Mortgage recognized gains on the transfer of the loans. Details of these transactions are provided in “Mortgage Loan Sales.”
 
Table 7
Residual Assets’ Key Statistics, Assumptions and Characteristics
September 30, 2000 and December 31, 1999
(dollars in thousands)
 
       September 30, 2000
    December 31, 1999
 
    1999-1     2000-1     2000-2     1999-1  
  Estimated Fair Value   $ 7,500     $ 13,750     $ 20,534     $ 6,775  
    
    
    
    
 
  Constant Prepayment Rate (weighted average life)     37       29       28       31  
    
    
    
    
 
  Static loss, net of mortgage insurance     2.5 %     1.0 %     1.0 %     2.5 %
 
 
 
 
  Discount Rate     17 %     15 %     15 %     17 %
 
 
 
 
As a percent of mortgage loan principal:        
  Delinquent loans (30 days and greater)     9.05 %     2.59 %     0.21 %     7.03 %
 
 
 
 
  Loans in foreclosure     4.16       0.13       —       3.22  
 
 
 
 
  Real Estate Owned     1.92       —       —       1.26  
 
 
 
 
  Cumulative losses   $ 969     $        —     $        —     $  —  
 
 
 
 
 
           Assets Acquired through Foreclosure . As of September 30, 2000, NovaStar Financial had 174 loans in real estate owned with a carrying value of $15.3 million (principal of $16.7 million) compared to 192 loans with a carrying value of $16.9 million (principal of $24.4 million) as of December 31, 1999.
 
           Short-term and Long-term Financing Arrangements . Mortgage loan originations are funded with various financing facilities prior to securitization. Loans originated are funded initially using committed warehouse lines with First Union National Bank or Residential Funding Corporation (RFC) under which NovaStar Financial and NovaStar Mortgage are co-borrowers. NovaStar Financial and NovaStar Mortgage can borrow up to $75 million from First Union and $50 million from RFC under these warehouse agreements. NovaStar Financial and NovaStar Mortgage also use repurchase agreements as a means of warehousing loans prior to securitization. First Union provides a $175 million committed facility for this purpose. These First Union and RFC facilities are committed through July 27, 2001 and December 27, 2000, respectively.
 
          First Union also provides a $25 million committed facility secured by residual interests in asset-backed bonds that is committed through December 2001. Amounts outstanding as of September 30, 2000 under this financing arrangement were $11.0 million.
 
          Amounts outstanding under short-term financing arrangements as of September 30, 2000 are detailed in Table 25 of this document.
 
          On a long-term basis, NovaStar Financial has financed its mortgage loans using collateralized mortgage obligations commonly called CMOs. Investors in CMOs are repaid based on the performance of the mortgage loans collateralizing the CMOs. These non-recourse financing arrangements match the loans with the financing arrangement for long periods of time, as compared to repurchase agreements that mature frequently with interest rates that reset frequently and have liquidity risk in the form of margin calls. Under the terms of its CMOs, NovaStar Financial is entitled to repurchase the mortgage loan collateral and repay the remaining CMO when their aggregate principal balance falls below 35% for issue 97-01 and 25% for issues 97-02, 98-01 and 98-02. Non-conforming mortgage loans are not readily
 
obtainable financial assets. As a result, NovaStar Financial retains effective control over the transferred assets as defined in paragraph 9c. of Statement of Financial Accounting Standards (SFAS) No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities and further clarified by paragraph 30 of SFAS No. 125. Accordingly, NovaStar Financial records its CMO transactions as secured borrowings, rather than sales of the transferred loans. The securitization transactions executed by NovaStar Mortgage have been structured as sales for financial reporting and tax purposes. NovaStar Financial as the residual owner does not have an option to call these bonds in the future. However, NovaStar Mortgage, as servicer of the collateral of these transactions, holds a small clean up call.
 
          Under its CMOs, NovaStar Financial retains the mortgage loans and incurs the obligation to pay the CMO bondholders. NovaStar Financial earns the net spread between the interest income on the loans and the interest expense on the bonds. The spread earned also is reduced by credit losses on the portfolio. Prepayments on the mortgage loans serve to reduce the term over which interest spread is earned. The longer the mortgage collateral is outstanding, the longer the period of cash flow. To the extent the borrowers prepay, it shortens the life of the CMO and the period over which cash flow is received. The cash flow will change when interest rates on the bonds fluctuate at amounts or times that are different from the mortgage loan collateral, thereby subjecting NovaStar Financial to interest rate risk. The carrying value of CMOs as of September 30, 2000 was $402 million compared with $587 million as of December 31, 1999. The decline in carrying value is primarily a result of principal paydowns.
 
          The following table provides details regarding NovaStar Financial’s CMOs as of September 30, 2000 and December 31, 1999. This table also provides details regarding the bonds and collateral outstanding underlying NovaStar Financial’s economic residual interests.
 
Table 8
Collateralized Mortgage Obligations
September 30, 2000 and December 31, 1999
(dollars in thousands)
 
       Collateralized
Mortgage Obligation
     Mortgage Loans
       Remaining
Principal
    
Current
Interest
Rate
    
Remaining
Principal
(A)
    
Weighted
Average
Coupon
     Estimated
Weighted
Average
Months to Call
As of September 30, 2000:                         
Retained loans collateralizing asset-backed bonds:                         
     NHES 1997-1      $  54,325        7.13 %      $59,297      11.61 %     
—
     NHES 1997-2      59,453        6.88        65,061      11.34       
 4
     NHES 1998-1      116,152        6.90        130,671      10.96       
13
     NHES 1998-2      173,663        6.84        183,913      10.54       
25
     Unamortized debt issuance costs, net      (1,397 )                    
     
                             
  
          Total on balance sheet      $402,196  
    
 
       Collateralized
Mortgage
Obligation
     Mortgage Loans
       Remaining
Principal
    
Current
Interest
Rate
    
Remaining
Principal
(A)
    
Weighted
Average
Coupon
     Estimated
Weighted
Average
Months
to Call
Sold loans collateralizing asset-backed bonds:                          
                           
     NMFT 1999-1      $116,659        7.14 %      $119,327      10.43 %      50
     NMFT 2000-1 (B)      218,166        7.02        221,963      10.15        63
     NMFT 2000-2 (C)      334,220        6.95        187,267      10.54        66
     
                                
          Total off balance sheet      $669,045                      
     
  
  As of December 31, 1999:                         
Retained loans collateralizing asset-backed bonds:                         
     NHES 1997-1      $  75,580        6.94        $  87,534      11.04        —
     NHES 1997-2      95,053        6.72        104,851      10.90        12
     NHES 1998-1      186,493        6.55        200,625      10.08        22
     NHES 1998-2      231,969        6.71        244,109      9.97        29
     Unamortized debt issuance costs, net      (2,227 )                    
     
                                
          Total on balance sheet      $586,868                      
     
                                
Sold loans collateralizing asset-backed bonds:                         
     Off balance sheet NMFT 1999-1      $140,710        6.67 %      $143,328      10.08 %      55
     
                    
(A) Includes assets acquired through foreclosure.
(B) NovaStar Financial purchased the residual interests in NMFT 2000-1 on April 1, 2000.
(C) NovaStar Financial purchased the residual interests in NMFT 2000-2 on September 29, 2000.
 
           Stockholders’ Equity . The decrease in NovaStar Financial’s stockholders’ equity as of September 30, 2000 compared with December 31, 1999 is a result of the following:
 
·
$3.3 million increase due to net income recognized for the nine months ended September 30, 2000.
 
·
$5.3 million decrease as a result of common stock repurchases . NovaStar Financial’s Board of Directors amended its stock repurchase program to increase the amount of common stock authorized to be acquired up to an aggregate purchase price of $9 million. Stock repurchases may be made in the open market, in block purchase transactions, through put options or through privately negotiated transactions. The timing of repurchases and the number of shares ultimately repurchased will depend upon market conditions and corporate requirements. As of September 30, 2000, NovaStar Financial had repurchased 1,936,966 shares of its common stock. The number of shares repurchased by NovaStar Financial has increased to 1,979,666 through November 10, 2000 for an aggregate purchase price of $7.3 million.
 
·
$3.0 million increase in the unrealized gain on the economic residual interests in NovaStar Mortgage’s asset backed bond transactions that for tax and accounting purposes were treated by NovaStar Mortgage as sales. The residual interests in those transactions have been classified as available-for-sale securities and the unrealized gain is recognized as a component of accumulated other comprehensive income.
 
·
$1.6 million decrease due to dividends on Class B 7% cumulative convertible preferred stock in 2000.
 
           Notes Receivable from Founders . The founders of NovaStar Financial purchased 216,666 units in the 1996 private placement in exchange for forgivable promissory notes. A unit consisted of one share of convertible preferred stock and one common stock warrant. Principal on these notes is divided into three equal parts, called “tranches”, and is forgiven if certain incentive performance targets are achieved. The incentive tests relate to the return generated to investors in the private placement, including the appreciation in stock price, the value of the warrants, and dividends paid. One tranche will be forgiven for each fiscal year NovaStar Financial generates a return of 15% to investors in the private placement. All three tranches will be forgiven if a return of 100% is generated within five years.
 
          During the period from the closing of the private placement through December 31, 1997, NovaStar Financial’s stock price averaged $17.08 per share, dividends of $0.28 were declared and the value of each warrant was $2.08. The combination of these produced a return to investors in the private placement exceeding 15%. As a result, the first tranche of these notes was forgiven resulting in a non-cash charge of $1,083,000 during the fourth quarter of 1997. NovaStar Financial has not recognized any further forgiveness of the notes since 1997, as incentive performance targets have not been met.
 
          In March 1998, the founders exercised options to acquire 289,332 shares of common stock by executing notes payable to NovaStar Financial. The notes bear interest at one month LIBOR plus 1%, are collateralized by the common stock issued, and are non-recourse in nature which means that NovaStar Financial’s recourse is limited to the collateral. These notes and accrued interest are classified as part of the contra-equity account, notes receivable from founders. Unpaid principal on the notes was $4,340,000 as of September 30, 2000 and December 31, 1999. Accrued interest on these notes was $339,000 as of September 30, 2000 and December 31, 1999.
 
Results of Operations of NovaStar Financial, Inc.—Nine Months Ended September 30, 2000 Compared to the Nine Months Ended September 30, 1999
 
Net Income
 
          During the nine months ended September 30, 2000, NovaStar Financial recorded net income of $3.3 million, $0.25 per diluted common share, compared with net income of $2.0 million, $0.11 per diluted common share, for the nine months ended September 30, 1999.
 
           NovaStar Financial’s primary sources of revenue are interest earned on its securitized mortgage loan portfolio and prepayment penalty income. In addition, results indirectly reflect gains from the sale of whole loans to third parties and securitization transactions executed by NovaStar Mortgage.
 
Net Interest Income
 
          Table 9 presents a summary of the average interest-earning assets, average interest-bearing liabilities and the related yields and rates thereon for the nine months ended September 30, 2000 and 1999.
 
Table 9
Interest Analysis
(dollars in thousands)
 
     Mortgage Loans
  Mortgage-Backed Securities
  Total
    Average
Balance
  Interest
Income/
Expense
   Annual
Yield/
Rate
   Average
Balance
  Interest
Income/
Expense
  Annual
Yield/
Rate
  Average
Balance
  Interest
Income/
Expense
  Annual
Yield/
Rate
Nine months ended September 30, 2000                     
Interest-earning mortgage assets   $475,419    $34,981   9.81 %   $13,648   $1,611    15.74 %   $489,067   $36,592   9.98 %
    
 
      
 
      
 
    
Interest-bearing liabilities                  
        Collateralized mortgage obligations   $499,805    $26,721   7.13 %   —   —   —     $499,805   $26,721   7.13 %
        Other borrowings   —   —   —     5,228   282   7.19 %   5,228   282   7.19  
    
        
        
      
        Cost of derivative financial                               
        Instruments hedging liabilities     160       —   —       160  
         
              
           
       
                Total borrowings   $499,805   $26,881   7.17 %   $  5,228   $  282    7.19 %   $505,033    $27,163   7.17 %
    
 
 
    
 
 
    
 
 
  
        Net interest income     $  8,100       $1,329       $  9,429  
         
              
              
       
        Net interest spread       2.64 %       8.55 %       2.81 %
              
              
              
  
        Net yield       2.27 %       12.98 %       2.57 %
              
              
              
  
 
    Mortgage Loans
  Mortgage-Backed Securities
  Total
    Average
Balance
  Interest
Income/
Expense
   Annual
Yield/
Rate
  Average
Balance
   Interest
Income/
Expense
  Annual
Yield/
Rate
  Average
Balance
  Interest
Income/
Expense
  Annual
Yield/
Rate
Nine months ended September 30, 1999                                
Interest-earning mortgage assets    $765,073    $52,236    9.10 %   $808   $100   16.50 %   $765,845   $52,336   9.11 %
    
 
      
 
 
    
 
    
Interest-bearing liabilities                               
        Collateralized mortgage obligations   $785,547   $33,782    5.73 %   $  —   $  —   — %   $785,547   $33,782   5.73 %
        Other borrowings   5,623   541    12.83     —   —   —     5,623   541   12.83  
    
        
        
      
        Cost of derivative financial                               
        Instruments hedging liabilities     1,736        —       1,736  
         
              
              
       
                Total borrowings   $791,170   $36,059    6.08 %   $  —   —   — %   $791,170   $36,059   6.08 %
    
 
 
    
 
 
    
 
 
  
        Net interest income     $16,177        $100       $16,277  
         
              
              
       
        Net interest spread        3.02 %       16.50 %       3.03 %
              
              
              
  
        Net yield        2.82 %       16.50 %       2.83 %
              
              
              
  
 
           Interest Income. During 2000, mortgage loans earned $35.0 million, or a yield of 9.8%, compared with $52.2 million, or a yield of 9.1% for the same period of 1999. Mortgage-backed securities income for 2000 consists of earnings on economic residual interests that NovaStar Financial purchased from NovaStar Mortgage starting in September 1999. In total, assets earned $36.6 million, or a yield of 10.0% for the nine months ended September 30, 2000. During the same period of 1999, assets earned $52.3 million or a 9.1% yield. As noted in Table 9, interest income is a function of volume and rates. Increasing the volume of assets will cause future increases in interest income, while declining balances will reduce interest income. Market interest rates will also affect future interest income.
 
           Interest Expense. The cost of borrowed funds for mortgage loans was $26.9 million for the nine months ended September 30, 2000, or 7.2% of average borrowings compared with $36.1 million, or 6.1% for the same period of 1999. Mortgage-backed securities’ cost of borrowed funds for the nine months
 
ended September 30, 2000 includes repurchase agreements secured by economic residual interests executed during the second and third quarters of 2000. Average interest-bearing liabilities for the nine months ended September 30, 2000 also consisted of financing costs on collateralized mortgage obligations compared with the same period of 1999, which also included a short-term financing arrangement with GMAC/RFC secured by residual interests in NovaStar Financial’s CMOs. In 1998, NovaStar Financial borrowed $15 million from GMAC/RFC, which included a $3 million financing fee. In February 1999, NovaStar Financial used the First Union residual facility to pay this debt in full. In March 1999, proceeds from the convertible preferred stock offering repaid all the outstanding debt on the residual facility.
 
          NovaStar Financial’s collateralized mortgage obligations are indexed to LIBOR. During the nine months ended September 30, 2000, one-month LIBOR averaged 6.33% compared with 5.07% for same period of 1999. Because the Federal Reserve Board increased the targeted federal funds interest rate in the latter part of 1999, effective borrowing costs have been higher in 2000. As with interest income, the cost of funds in the future will largely depend on market conditions, most notably levels of short-term interest rates. Rates on other borrowings generally fluctuate with short-term market interest rates, such as LIBOR or the federal funds rate.
 
           Net Interest Income and Spread.     Net interest income on mortgage loans for the nine months ended September 30, 2000 was $9.4 million, or 2.6% of average interest-earning mortgage loans, compared with $16.3 million, or 2.8% for the same period of 1999. Net interest spread on mortgage loans was 2.8% and 3.0%, respectively, for the nine months ended September 30, 2000 and 1999. Net interest income on mortgage-backed securities (economic residual interests) during the nine months ended September 30, 2000 was $1.3 million, or 13.0% of average interest-earning mortgage securities with a net interest spread of 8.6%. The volume of assets and liabilities and how well the spread between earnings on assets and the cost of funds is managed will dictate future net interest income.
 
           Impact of Interest Rate Agreements.     NovaStar Financial has entered into interest rate agreements designed to mitigate exposure to interest rate risk. Interest rate cap agreements require NovaStar Financial to pay a monthly fixed premium while allowing it to receive a rate that adjusts with LIBOR, when rates rise above a certain agreed-upon rate. These agreements are used to alter, in effect, the interest rates on funding costs to more closely match the yield on interest-earning assets.
 
          As part of the NMFT 2000-1 asset-backed bond transaction discussed under “Mortgage Securities— Available-For-Sale” and “Mortgage Loan Sales” sections of this document, NovaStar Financial sold a cap with a carrying value of $480,000 to NovaStar Mortgage recognizing a deferred gain of $880,000. The cap was hedging liabilities incurred to fund the mortgage loans sold to NMFT 2000-1 and the deferred gain will be amortized over the remaining cap term. This cap had a carrying value of $545,000 as of September 30, 2000. During the nine months ended September 30, 2000 and 1999, net interest expense incurred on hedging agreements was $160,000 and $1.7 million, respectively, which is included as a component of interest expense. The significant decline in this expense in 2000 compared with the same period of 1999 is a result of the majority of the caps’ quarterly LIBOR resets in 2000 were greater than their strike rates.
 
Prepayment Penalty Income
 
          NovaStar Financial strives to purchase loans that have some form of prepayment penalty fee to mitigate exposure to prepayment risk. During the nine months ended September 30, 2000 and 1999, 91% of the mortgage loans originated by NovaStar Mortgage had prepayment penalties. As of September 30, 2000, 45% of NovaStar Financial’s mortgage loan portfolio had prepayment penalties compared with 58% as of December 31, 1999. Prepayment penalties totaled $1.4 million during the nine months ended September 30, 2000 compared with $2.4 million for the same period of 1999. The decrease is due to NovaStar Financial no longer purchasing loans from NovaStar Mortgage, seasoning of the portfolio and prepayment penalty windows expiring in 2000 compared with 1999.
 
Premiums for Mortgage Loan Insurance
 
          NovaStar Financial and NovaStar Mortgage have executed agreements whereby lender-paid mortgage insurance coverage is purchased on selected mortgage loans. The use of mortgage insurance is one method of managing the credit risk in the mortgage asset portfolio.
 
          As of September 30, 2000 and December 31, 1999, approximately 66% and 39% of the loans owned by NovaStar Financial are covered under this agreement, including loans serving as collateral for the REMIC deals. The loans collateralizing REMIC deals are not recorded as loans of NovaStar Financial, but the performance of NovaStar’s investment in the residual interests of the REMIC deals is dependent on the credit losses of the underlying collateral.
 
          Premiums for mortgage insurance on loans maintained on the balance sheet of NovaStar Financial are recorded as a portfolio cost and included in the income statement under the caption “Premiums for Mortgage Loan Insurance.” During the nine months ended September 30, 2000, total premiums paid by NovaStar Financial totaled $1.0 million compared with $1.3 million for the same period of 1999. Premiums for mortgage insurance on loans serving as collateral for the residual interests owned by NovaStar Financial is paid from the loan collateral proceeds, and therefore are not included in the amount of total premiums paid as shown above.
 
Provisions for Credit Losses
 
          NovaStar Financial owns loans where the borrower possesses credit risk higher than that of conforming borrowers. Delinquent loans and losses are expected to occur. Most of the loans owned by NovaStar Financial were underwritten and funded by NovaStar Mortgage. All loans owned by NovaStar Financial are serviced by NovaStar Mortgage. NovaStar Mortgage uses several techniques to mitigate credit losses, including pre-funding audits by quality control personnel and in-depth appraisal reviews. Another loss mitigation technique allows a borrower to sell their property for less than the outstanding loan balance prior to foreclosure in transactions known as short sales, when it is believed that the resulting loss is less than what would be realized through foreclosure. While short sales serve to reduce the overall severity of losses incurred, they also accelerate the timing of losses. Loans are charged off in full when the cost of pursuing foreclosure and liquidation exceed recorded balances. Management also believes aggressive servicing is an important element to managing credit risk.
 
           As discussed further under the caption “Premiums for Mortgage Loan Insurance”, lender paid mortgage insurance is also used as a means of managing credit risk exposure. Generally, the exposure to credit loss on insured loans is considered minimal.
 
          Provisions for credit losses are made in amounts considered necessary to maintain the allowance at a level sufficient to cover probable losses inherent in the loan portfolio. Charge-offs are recognized at the time of foreclosure by recording the value of real estate owned property at its estimated realizable value. Subsequent gains or losses on dispositions, if any, are recorded in operations. The net gains or (losses) recognized on real estate owned properties are discussed further under “Other Income”. One of the principal methods used to estimate expected losses is a delinquency migration analysis. This analysis takes into consideration historical information regarding foreclosure and loss severity experience and applies that information to the portfolio at the reporting date.
 
          During the nine months ended September 30, 2000, NovaStar Financial made provisions for losses of $4.0 million and incurred net charge-offs of $7.0 million, compared to $11.5 million and $9.7 million during the same period of 1999. Charge-offs during the nine months of 2000 include $586,000 resulting from short sale transactions and loans charged off in full compared with $879,000 during the same period of 1999.
 
          In the opinion of management, the allowance for credit losses as of September 30, 2000 is adequate to cover losses inherent in the portfolio at that date. If losses do not develop in accordance with current expectations, future provisions will be increased or decreased as necessary. Management also believes that internal processes involving quality control, appraisal review and servicing that have been made as a result of experience to-date will result in lower losses being incurred on loans currently being originated.
 
          Table 10 is a rollforward of the activity in the allowance for credit losses during 2000 and 1999.
 
Table 10
Rollforward of Allowance for Credit Losses
(in thousands)
 
    2000
    1999
 
    September 30
    June 30
    March 31
    December 31
    September 30
    June 30
    March 31
 
Beginning balance      $  8,993     $  9,763     $11,105     $  5,370     $  3,573     $  3,492     $  3,573  
Provision for credit losses   1,212     1,213     1,579     10,579     5,634     3,566     2,299  
Amounts charged off, net
of recoveries 		   (2,073 )    (1,983 )    (2,921 )    (4,844 )    (3,837 )    (3,485 )    (2,380 )
    
   
   
   
   
   
   
 
Ending Balance   $  8,132     $  8,993     $  9,763     $11,105     $  5,370     $  3,573     $  3,492  
    
   
   
   
   
   
   
 
 
          The following tables provide details regarding the delinquencies, defaults, and loss statistics of NovaStar Financial’s mortgage loan portfolio.
 
Table 11
Loan Delinquencies (90 days and greater) (A)
2000 and 1999
(in thousands)
 
       2000
   1999
       September 30
   June 30
   March 31
   December 31
   September 30
   June 30
   March 31
Mortgage loans Collateralizing
NovaStar Home Equity Series
(CMO): 		                      
1997-1 Issued October 1, 1997      $3,410    $4,039    $3,434    $4,726    $6,093    $6,087    $6,454
1997-2 Issued December 11, 1997      5,222    6,336    6,311    6,047    5,934    5,671    8,388
1998-1 Issued April 30, 1998      8,131    6,455    5,987    8,467    11,411    9,687    11,818
1998-2 Issued August 18, 1998      10,621    11,159    11,433    12,754    10,247    10,808    10,832
(A)
Includes loans in foreclosure or bankruptcy.
 
Table 12
Loan Delinquencies (90 days and greater) as a Percent of Total Loan Principal(A)
2000 and 1999
 
       2000
   1999
       September 30
   June 30
   March 31
   December 31
   September 30
   June 30
   March 31
Mortgage loans Collateralizing
NovaStar Home Equity Series
(CMO): 		                      
1997-1 Issued October 1, 1997      6.01 %    6.21 %    4.59 %    5.63 %    6.32 %    5.13 %    4.37 %
1997-2 Issued December 11, 1997      8.23      8.88      7.66      6.24      4.92      4.03      5.38  
1998-1 Issued April 30, 1998      6.44      4.40      3.58      4.42      5.32      4.13      4.64  
1998-2 Issued August 18, 1998 6.03 5.48 5.10 5.38 4.06 3.94 3.72
(A)
Includes loans in foreclosure or bankruptcy.
 
Table 13
Delinquencies, Defaults and Losses
September 30, 2000 and December 31, 1999
(dollars in thousands)
 
NovaStar Home Equity Series
September 30, 2000 1997-1
1997-2
1998-1
1998-2
All Loans
Allowance for Credit Losses:
          Balance, January 1, 2000      $2,335        $  2,861        $4,214        $  1,685        $11,105  
          Provision for credit losses      532        815        1,419        1,235        4,004  
          Amounts charged off, net of Recoveries      (1,154 )      (1,796 )       (2,246 )      (1,778 )      (6,977 )
     
     
     
     
     
  
          Balance, September 30, 2000      $1,713        $  1,880        $3,387        $  1,142        $  8,132  
     
     
     
     
     
  
Defaults as a percent of loan balance                                 
          Delinquent loans (A)    11.46 %      9.09 %      8.81 %      12.49 %      10.78 %
      
     
     
     
     
  
          Loans in foreclosure      3.99        6.71        4.80        4.53        4.86  
     
     
     
     
     
  
          Real estate owned      4.34        3.70        3.88        3.82        3.90  
     
     
     
     
     
  
Cumulative losses      $4,102        $  4,272        $4,015        $  2,345       
     
     
     
     
        
NovaStar Home Equity Series
December 31, 1999 1997-1
1997-2
1998-1
1998-2
All Loans
Allowance for Credit Losses:
          Balance, January 1, 1999      $  816        $  1,049        $1,163        $  346        $  3,573  
          Provision for credit losses      4,317        5,436        8,194        4,065        22,078  
          Amounts charged off, net of Recoveries      (2,798 )       (3,624 )       (5,143 )       (2,726 )       (14,546 ) 
     
     
     
     
     
  
Balance, December 31, 1999      $2,335        $  2,861        $4,214        $1,685        $11,105  
     
     
     
     
     
  
Defaults as a percent of loan balance
          Delinquent loans (A)      8.03 %      9.89 %      6.38 %      7.50 %      7.63 %
     
     
     
     
     
  
          Loans in foreclosure      4.73        4.32        3.75        4.02        4.09  
     
     
     
     
     
  
          Real estate owned      3.85        4.88        3.61        2.62        3.51  
     
     
     
     
     
  
Cumulative losses      $2,377        $  1,756        $  538        $  745       
     
     
     
     
        
(A)
Includes loans delinquent 30 days or greater
 
Loan Servicing Fees Paid to NovaStar Mortgage, Inc.
 
          Loan servicing fees paid to NovaStar Mortgage, Inc. include the 50 basis point fee charged by NovaStar Mortgage for servicing the loans owned by NovaStar Financial serving as collateral on CMOs. The fee charged is based on the loan principal balance of the mortgage loans serviced. Loan servicing fees for the first nine months of 2000 were $2.0 million compared with $3.1 million for the same period of 1999. The reduction is due to principal paydowns between the two periods.
 
Other Income
 
          Other income (loss) during the nine months ended September 30, 2000 primarily consists of net losses recognized on the sale of real estate owned properties of $722,000 compared with net gains on the sale of real estate owned properties of $74,000 during the same period of 1999. The net losses recognized in 2000 resulted from the liquidation of aged properties with slightly higher severities than
 
Novastar Financial’s historical average severity. Other income for the nine months ended September 30, 2000 also consists of interest earned on securitization funds held in trust of $169,000 and interest earned on money market funds of $101,000. Other income for the same period of 1999 also included interest earned on notes receivable from founders of $368,000 and interest earned on securitization funds held in trust of $173,000.
 
General and Administrative Expenses
 
          General and administrative expenses for the nine months ended September 30, 2000 and 1999 are provided in Table 14. Table 15 displays the relationship of portfolio expenses to stockholders’ equity during 2000 and 1999 by quarter.
 
Table 14
General and Administrative Expenses
(dollars in thousands)
 
       Nine Months Ended September 30,
       2000
     1999
              Percent of
Stockholders’
Equity
(Annualized)
            Percent of
Stockholders’
Equity
(Annualized)
Compensation and benefits      $1,042        1.38 %      $1,358      1.61 %
Professional and outside services      467        0.62        546      0.65  
Office administration      607        0.80        611      0.72  
Other      66        0.09        156      0.18  
     
     
     
  
  
Total general and administrative expenses before Intercompany fees      2,182        2.89 %      2,671      3.16 %
         
     
Net fees for other services provided by (to) NovaStar Mortgage, Inc.      (1,460 )           287     
     
              
        
Total general and administrative expenses.      $  722             $2,958     
     
              
        
 
Table 15
Portfolio Related Expenses as a
Percent of Stockholders’ Equity
2000 and 1999
 
       Percent of
Stockholders’
Equity
2000:     
Third quarter      3.05 %
Second quarter      2.80  
First quarter      2.80  
1999:     
Fourth quarter      3.63  
Third quarter      3.06  
Second quarter      2.07  
First quarter      3.94  
 
          Compensation and benefits includes employee base salaries, benefit costs and incentive compensation awards. The decrease in compensation and benefits for the nine months ended September 30, 2000 compared with the same period of 1999 is due to staff reductions and employee cost allocations to NovaStar Mortgage.
 
          Professional and outside services include fees for legal and accounting services. In the normal course of business, fees are incurred for professional services related to general corporate matters and specific transactions. The 2000 decline is a result of legal fees incurred on the structuring of various financing arrangements and general company growth experienced during the first nine months of 1999. Office administration includes items such as rent, depreciation, telephone, office supplies, postage, delivery, maintenance and repairs.
 
          The following is a summary of the fees, in thousands, paid to (received from) NovaStar Mortgage for the nine months ended September 30, 2000 and 1999.
 
       Nine Months Ended
September 30,
 
       2000
         1999
 
Amounts paid to NovaStar Mortgage:     
               
          Loan servicing fees $      1,982     $     3,056  
 
   
 
          Administrative fees      126          1,263  
Amounts received from NovaStar Mortgage:
          Guaranty, commitment, loan sale and securitization fees      (1,246 )        —  
          Interest income      (340 )        (976 )
 
   
 
  $     (1,460 )    $        287  
 
   
 
 
          The decline in these fees for the nine months ended September 30, 2000 compared with 1999 is due to the cancellation of the administrative fees intercompany agreement on April 1, 1999, since NovaStar Financial is no longer purchasing loans from NovaStar Mortgage. This agreement was replaced with an intercompany loan and guarantee agreement with NovaStar Mortgage. Under the terms of this agreement,

NovaStar Mortgage pays interest on amounts it borrows from NovaStar Financial. Interest on the borrowings accrues at the federal funds rate plus 1.75%. Under this agreement, NovaStar Mortgage is required to pay guaranty fees in the amount 0.25% of the loans sold by NovaStar Mortgage for which NovaStar Financial has guaranteed the performance of NovaStar Mortgage. In addition, beginning July 1, 2000, NovaStar Mortgage entered into the following intercompany agreements:

· Servicing support fee : NovaStar Mortgage pays NovaStar Financial a fee equal to five basis points of the weighted average mortgage loan servicing principal.
 
· Financing commitment fee : NovaStar Mortgage pays NovaStar Financial a fee equal to 25 basis points on a $150 million annual commitment
 
· Residual purchase commitment fee : NovaStar Mortgage pays NovaStar Financial a fee at each securitization close equal to 20 basis points of the collateral principal value.
 
· Securitization consulting fee : NovaStar Mortgage pays NovaStar Financial a fee at each securitization close equal to 12.5 basis points of the collateral principal value.
 
· Guaranty spread fee : NovaStar Mortgage pays NovaStar Financial a fee equal to one basis point of the weighted average mortgage loan warehouse and repurchase borrowings.
 
          NovaStar Financial provides liquidity resources for all operations and enhances the creditworthiness of NovaStar Mortgage. In addition, Novastar Financial provides substantial expertise to NovaStar Mortgage in its execution of loan sales and securitizations. The fees charged to NovaStar Mortgage are designed to recognize this liquidity, credit and financial support.
 
Equity in Earnings of NFI Holding Corporation
 
          For the nine months ended September 30, 2000, NFI Holding recorded net income of $652,000 compared with net income of $1.5 million for the same period of 1999. NovaStar Financial records its portion of the earnings as equity in net earnings of NFI Holding in its income statement. NFI Holding’s net earnings include the net earnings of NovaStar Mortgage, a subsidiary of NFI Holding as discussed under “Basis of Presentation”. NFI Holding’s financial position and results of operation for the nine months ended September 30, 2000 and 1999 are discussed further under the heading “NFI Holding Corporation”.
 
Results of Operations of NovaStar Financial, Inc.—Three Months Ended September 30, 2000 Compared to the Three Months Ended September 30, 1999
 
Net Income
 
          During the three months ended September 30, 2000, NovaStar Financial recorded net income of $2.0 million, $0.18 per diluted common share, compared with a net loss of $1.5 million, $0.25 per diluted common share, for the three months ended September 30, 1999.
 
Net Interest Income
 
          Table 16 presents a summary of the average interest-earning assets, average interest-bearing liabilities and the related yields and rates thereon for the three months ended September 30, 2000 and 1999.
 
Table 16
Interest Analysis
(dollars in thousands)
 
      Cost of derivative financial instruments hedging liabilities
       Mortgage Loans
     Mortgage-Backed Securities
     Average
Balance
     Total
     Annual
Yield/
Rate
Three months ended September 30, 2000
     Average
Balance
     Interest
Income/
Expense
     Annual
Yield/
Rate
     Average
Balance
     Interest
Income/
Expense
     Annual
Yield/
Rate
     Interest
Income/
Expense
Interest-earning mortgage assets      $417,846      $10,391        9.95 %      $18,701      $733      15.68 %      $436,548      $11,124        10.19 %
     
  
     
     
  
  
     
  
     
  
Interest-bearing liabilities                                              
      Collateralized mortgage obligations      $443,082      $  8,400        7.58 %      —      —      —        $443,082      $  8,400        7.58 %
      Other borrowings      —      —        —        6,787      131      7.72 %      6,787      131        7.72 %
     
                    
                 
                 
      Cost of derivative financial instruments hedging liabilities           (160 )                —                (160 )     
           
                    
                 
           
          Total borrowings      $443,082      $  8,240        7.44 %      $  6,787      $131      7.72 %      $449,869      $  8,371        7.44 %
     
  
     
     
  
           
  
     
  
      Net interest income           $  2,151                  $602                $  2,753       
           
                    
                 
           
      Net interest spread                2.51 %                7.96 %                2.75 %
                    
                 
                    
  
      Net yield                2.06 %                12.88 %                2.52 %
                    
                 
                    
  
 
       Mortgage Loans
     Mortgage-Backed Securities
     Average
Balance
     Total
     Annual
Yield/
Rate
Three months ended September 30, 2000
     Average
Balance
     Interest
Income/
Expense
     Annual
Yield/
Rate
     Average
Balance
     Interest
Income/
Expense
     Annual
Yield/
Rate
     Interest
Income/
Expense
Interest-earning mortgage assets      $690,323      $15,595        9.04 %      $  2,424      $100      16.50 %      $692,747      $15,695        9.06 %
     
  
     
     
  
  
     
  
     
  
Interest-bearing liabilities                                              
      Collateralized mortgage obligations      $706,685      $10,626        6.01 %      —      —      —        $706,685      $10,626        6.01 %
      Other borrowings      —      —        —        —      —      —        —      —        —  
     
                    
                 
                 
      Cost of derivative financial instruments hedging liabilities           580                  —                580       
           
                    
                 
           
          Total borrowings      $706,685      $11,206        6.34 %      $      —      —      — %      $706,685      $11,206        6.34 %
     
  
     
     
  
           
  
     
  
      Net interest income           $  4,389                  $100                $  4,489       
           
                    
                 
           
      Net interest spread                2.70 %                16.50 %                2.72 %
                    
                 
                    
  
      Net yield                2.54 %                16.50 %                2.59 %
                    
                 
                    
  
 
          Average interest-earning assets were $436.5 million during the three months ended September 30, 2000, which included in $18.7 million of residual assets classified as mortgage-backed securities, compared with average interest-earning assets of $692.7 million for the same period of 1999, comprised primarily of mortgage loans. Mortgage securities earned $733,000 for the three months ended September 30, 2000, or a yield of 15.7% compared with $100,000, or a yield of 16.5% for the same period of 1999. During the three months ended September 30, 2000, mortgage loans earned $10.4 million, or a yield of 10.0%, compared with $15.6 million, or a yield of 9.0% for the same period of 1999. In total, assets earned $11.1 million—a 10.2% yield for three months ended September 30, 2000 compared to $15.7 million, or a 9.1% yield for the same period ended September 30, 1999.
 
          During the three months ended September 30, 2000, borrowed funds for NovaStar Financial averaged $443.1 million on which interest was incurred of $8.2 million, or 7.4%. In comparison, for the three months ended September 30, 1999, borrowed funds for NovaStar Financial averaged $706.7 million on which interest was incurred of $11.2 million, or 6.3%.
 
          Net interest income during the three months ended September 30, 2000 was $2.8 million or 2.5% of average interest-earning assets, compared with $4.4 million, or 2.6% of average interest-earning assets during the same period of 1999. Net interest spread was 2.8% during the three months ended September 30, 2000 compared with 2.7% during the three months ended September 30, 1999.
 
           During the three months ended September 30, 2000 and 1999, net interest expense was incurred on hedging agreements of $(160,000) and $580,000, respectively, which is included as a component of interest expense. The decline in this expense for the third quarter of 2000 compared with the same period of 1999 is due to the fact that quarterly LIBOR reset rates were higher than the interest rate agreement strike rates on a majority of NovaStar Financial’s interest rate agreements during the third quarter of 2000. NovaStar Financial receives credits against the quarterly premium payments to counterparties whenever LIBOR reset rates are higher than the strike rates.
 
Provisions for Credit Losses and Premium for Mortgage Loan Insurance
 
          During the three months ended September 30, 2000, NovaStar Financial provided $1.2 million to the allowance for credit losses, compared with $5.6 million during the same period of 1999. Charge-offs during the three months ended September 30, 2000 were $2.1 million compared with $3.8 million during the same period of 1999. See “Mortgage Insurance” and Provisions for Credit Losses“ under ”Results of Operations of NovaStar Financial, Inc.—Nine Months Ended September 30, 2000 Compared to the Nine Months Ended September 30, 2000.“
 
          Premiums for mortgage loan insurance include the premiums paid to Radian Guaranty, Inc. and PMI, Inc. on certain loans held in NovaStar Financial’s portfolio.
 
Loan Servicing Fees Paid to NovaStar Mortgage, Inc.
 
          Loan servicing fees paid to NovaStar Mortgage, Inc. include the 50 basis point fee that NovaStar Mortgage charges NovaStar Financial for the loans collateralizing the CMOs. This fee is based on the collected principal balance of the mortgage loans serviced. The decrease in loan servicing fees paid to NovaStar Mortgage during the three months ended September 30, 2000 compared with the same period of 1999 is due to principal paydowns in NovaStar Financial’s CMO collateral during the two periods.
 
Other Income
 
          Other income during the three months ended September 30, 2000 primarily consists of prepayment penalties of $448,000, net loss recognized on the sale of real estate owned properties of $684,000, interest earned on securitization funds held in trust of $59,000 and interest earned on money market funds of $34,000. Other income for the same period of 1999 primarily consisted of prepayment penalties of $769,000, net gains on the sale of real estate owned properties of $91,000, interest earned on notes receivable from founders of $126,000 and interest earned on securitization funds held in trust of $62,000.
 
General and Administrative Expenses
 
          General and administrative expenses for the three months ended September 30, 2000 and 1999 are provided in Table 17.
 
Table 17
General and Administrative Expenses
(dollars in thousands)
 
       Three Months Ended September 30,
       2000
     1999
              Percent of
Stockholders’
Equity
(Annualized)
            Percent of
Stockholders’
Equity
(Annualized)
Compensation and benefits   $ 325        1.30 % $    421      1.49 %
Professional and outside services      210        0.84        181      0.64  
Office administration      206        0.82        203      0.72  
Other      23        0.09        60      0.21  
  
     
  
  
  
Total general and administrative expenses before Intercompany fees      764        3.05 %      865      3.06 %
                       
 
Net fees for other services provided by (to) NovaStar Mortgage, Inc.       (1,458 )            (169 )
  
           
        
     Total general and administrative expenses. $ (694 )      $     696     
  
           
        
 
          Compensation and benefits totaled $325,000 for the nine months ended September 30, 2000 compared with $421,000 for the same period of 1999. The decline is due to staff reductions and intercompany employee expense allocations to NovaStar Mortgage.
 
          Professional and outside services for the three months ended September 30, 2000 was $210,000 compared with $181,000 for the three months ended September 30, 1999. This line-item includes the cost of various accounting and legal services and varies based on the nature and timing of operational needs.
 
          The following is a summary of the fees, in thousands, paid to NovaStar Mortgage for the three months ended September 30, 2000 and 1999:
 
         Three Months
Ended
September 30,
    2000
       1999
Amounts paid to NovaStar Mortgage:              
     Loan servicing fees   $ 599     $   936  
    
    
  
     Administrative fees, net of guaranty fees.        (111 )        115  
Amounts received from NovaStar Mortgage:          
     Guaranty, commitment, loan sale and securitization fees        (1,239 )        —  
     Interest income        (108 )        (284 )
    
    
  
    $   (1,458)     $   (169 )
    
    
  
 
          The decline in loan servicing fees paid to NovaStar Mortgage for the three months ended September 30, 2000 compared with the three months ended September 30, 1999 is due to a decline in NovaStar Financial’s mortgage loan portfolio serviced by NovaStar Mortgage.
 
           The guaranty, commitment, loan sale and securitization fees are a result of the intercompany agreements NovaStar Mortgage and NovaStar Financial entered July 1, 2000. These agreements are discussed further under the “Results of Operations of NovaStar Financial, Inc.—Nine Months Ended September 30, 2000 Compared to the Nine Months Ended September 30, 1999”.
 
          The decrease in the interest income paid to NovaStar Mortgage during these same periods is a result of the decline in average intercompany borrowings in 2000.
 
Equity in Earnings (Loss) of NFI Holding Corporation
 
          For the three months ended September 30, 2000, NFI Holding recorded net income of $795,000 compared with net income of $583,000 for the same period of 1999. NFI Holding’s financial position and results of operation for the three month period ended September 30, 2000 and 1999 are discussed further under the heading “NFI Holding Corporation”.
 
Estimated Taxable Income (Loss)
 
          Income reported for financial reporting purposes as calculated in accordance with generally accepted accounting principles (GAAP) differs from income computed for income tax purposes. This distinction is important as dividends paid are based on taxable income. Table 18 is a summary of the differences between net income or loss reported for GAAP and estimated taxable income for nine months ended September 30, 2000 and 1999.
 
Table 18
Estimated Taxable Income (Loss)
Nine Months Ended September 30, 2000 and 1999
(in thousands)
 
    September 30,
 
    2000
    1999
 
Net income   $ 3,336     $ 2,034  
Use of net operating loss carryforward        (176 )        (2,628 )
Results of NFI Holding and subsidiaries        (646 )        (1,518 )
Provision for credit losses        4,004          11,499  
Loans charged-off        (6,977 )        (9,702 )
Other, net        459          1,175  
    
    
  
Estimated taxable income (loss)   $ —     $ 860  
    
    
  
 
          NovaStar Financial has a net operating loss carryforward of approximately $2.3 million available to offset taxable income in 2000, and thereby reduce the amount of required distributions under REIT guidelines. In addition, dividends paid on convertible preferred stock serve to reduce the amount of required distributions to common shareholders.
 
NFI Holding Corporation
 
          Since NovaStar Financial discontinued purchasing loans from NovaStar Mortgage and holding them in portfolio in the latter part of 1998, NovaStar Mortgage has had a larger impact on NovaStar Financial’s operational results. Instead of selling loans to NovaStar Financial, NovaStar Mortgage has sold loans to outside third parties. Through its indirect equity ownership of NFI Holding, NovaStar Financial has shared in the profits of NovaStar Mortgage’s loan sales.
 
          The following table presents NFI Holding’s consolidated financial statements as of September 30, 2000 and 1999, which consists primarily of the assets, liabilities, and operational results of NovaStar Mortgage.
 
NFI Holding Corporation
Condensed Consolidated Balance Sheets
(unaudited, dollars in thousands)
         September 30,
2000 		    December 31,
1999
Assets              
          Cash and cash equivalents   $ 3,272   $ 1,466
          Mortgage loans        68,750        107,916
          Other assets        12,647        10,061
    
 
                               Total assets   $   84,669   $ 119,443
    
 
Liabilities and Stockholders’ Equity              
          Liabilities:
                    Borrowings   $   44,805   $      78,448
                    Due to NovaStar Financial, Inc.        12,918        22,161
                    Accounts payable and other liabilities        19,247        11,787
    
 
                               Total liabilities        76,970        112,396
                    Stockholders’ equity        7,699        7,047
    
 
                               Total liabilities and stockholders’ equity   $ 84,669   $ 119,443
    
 
 
NFI Holding Corporation
Condensed Consolidated Statements of Operations
(unaudited, dollars in thousands)
       Nine Months Ended
September 30,
     Three Months Ended
September 30,
       2000
     1999
     2000
     1999
Interest income      $11,828      $  7,948        $ 4,723        $3,122  
Interest expense.      7,034      3,764        3,007        1,544  
     
  
     
     
  
     Net interest income      4,794      4,184        1,716        1,578  
Provision for credit losses      80      (284 )      97        (168 )
     
  
     
     
  
Net interest income after provision for credit losses      4,714      4,468        1,619        1,746  
Other income:                    
     Fees from third parties      5,057      706        2,826        152  
     Fees received from, net of paid to, NovaStar Financial, Inc.      522      3,343        (859 )      767  
                       
     Net gain on sales of mortgage assets      9,909      9,189        5,075        3,101  
     
  
     
     
  
          Total other income      15,488      13,238        7,042        4,020  
General and administrative expenses      19,550      16,172        7,866        5,183  
     
  
     
     
  
Net income before taxes      652      1,534        795        583  
Income tax expense      —      —        —        —  
     
  
     
     
  
Net income      $     652      $  1,534        $    795        $   583  
     
  
     
     
  
 
Financial Condition of NFI Holding Corporation as of September 30, 2000 and December 31, 1999
 
           Mortgage Loan Originations.     NFI Holding originated 4,498 non-conforming residential mortgage loans during the nine months ended September 30, 2000 with an aggregate principal amount of $511 million. Virtually all of NFI Holding’s mortgage assets as of September 30, 2000 and December 31, 1999 consist of non-conforming mortgage loans that will be sold directly to independent buyers of whole loans or through securitization transactions that are treated for tax and accounting purposes as sales.
 
          Table 19 is a summary of NFI Holding’s wholesale loan originations for 2000 and 1999. Table 20 presents a summary of mortgage loan transfers of NFI Holding during 2000 and 1999. Table 21 is a summary of wholesale loan origination costs of production.
 
Table 19
2000 and 1999 Quarterly Wholesale Loan Originations
(dollars in thousands, except for average loan balance)
 
       Number
of Loans
     Principal
     Average
Loan
Balance
          Weighted Average
     Percent with
Prepayment
Penalty
  Price Paid
to
Broker
     Loan to
Value
     Credit
Rating (A)
     Coupon
2000:                                        
          Third quarter      1,793      $207,662      $115,818      101.1      84 %      5.20      10.72 %      90 %
          Second quarter      1,473      171,375      116,344      101.0      82        5.32      10.50        91  
          First quarter      1,232      132,072      107,201      101.1      80        5.45      10.16        93  
     
  
                                      
2000 total      4,498      $511,109      $113,630      101.1      82 %      5.30      10.50 %      91 %
     
  
  
  
  
     
  
     
  
1999:                                        
          Fourth quarter      1,265      $130,288      $102,994      101.0      82 %      5.30      10.04 %      91 %
          Third quarter      1,204      125,140      103,937      100.8      82        5.28      9.87        91  
          Second quarter      1,161      114,631      98,735      101.1      82        5.14      9.82        89  
          First quarter      865      82,495      95,370      100.5      80        4.95      9.85        89  
     
  
                                      
1999 total      4,495      $452,554      $100,679      100.9      82 %      5.19      9.90 %      90 %
     
  
  
  
  
     
  
     
  
 
(A)
AAA=7, AA=6, A=5, A-=4, B=3, C=2, D=1
 
Table 20
Quarterly Mortgage Loan Transfers
(dollars in thousands)
 
       Mortgage Loan Sales to Third
Parties
     Mortgage Loans
Transferred in
Securitizations
       Principal
Amount
     Net Gain
Recognized
     Weighted
Average
Price To
Par
     Principal
Amount
     Net Gain
Recognized
2000:                         
          Third quarter      $  50,334      $  1,552      104.0        $188,734      $3,584
          Second quarter      27,799      661      104.0        101,675      1,392
          First quarter      48,548      1,204      104.0        128,171      1,544
     
  
        
  
          2000 total      $126,681      $  3,417      104.0        $418,580      $6,520
     
  
  
     
  
1999:                         
          Fourth quarter      $109,443      $  2,583      104.1 %      $        —      $    —
          Third quarter      110,512      3,075      104.2        —      —
          Second quarter      98,048      2,911      104.4        25,800      355
          First quarter      72,824      1,593      103.6        138,847      1,250
     
  
          
  
          1999 total      $390,827      $10,162      104.1        $164,647      $1,605
     
  
  
     
  
 
Table 21
Wholesale Loan Costs of Production
 
     Gross Loan
Production
     Premium paid to
broker, net of fees
collected
     Total
Acquisition
Cost
Costs as a percent of principal:
 
2000:
          Third quarter      2.6 %      0.5 %      3.1 %
     
     
     
  
          Second quarter      3.0 %      0.5 %      3.5 %
     
     
     
  
          First quarter      3.3 %      0.5 %      3.8 %
     
     
     
  
 
1999:
          Fourth quarter      3.1 %      0.5 %      3.6 %
     
     
     
  
          Third quarter      3.8 %      0.4 %      4.2 %
     
     
     
  
          Second quarter      4.2 %      0.5 %      4.7 %
     
     
     
  
          First quarter.      6.2 %      0.2 %      6.4 %
     
     
     
  
 
          As noted in the table above, NovaStar Mortgage’s quarter-to-quarter 1999 wholesale loan production costs steadily declined as a result of increased efficiencies in the mortgage lending operation. During the third quarter of 1999, NovaStar Mortgage introduced Internet Underwriter®, “IU”, a web-based origination system that has allowed NovaStar Mortgage to increase production volumes without adding infrastructure. First quarter 2000 production costs were slightly higher than fourth quarter 1999 due in part to more expense allocations from NovaStar Financial. In addition, NovaStar Mortgage hired more account executives during the first three months of 2000. Account executive costs typically are higher in the first few months of employment and are expected to decline, as a percent of principal, as the sales force becomes more productive with added experience and exposure to NovaStar Mortgage’s whole loan origination products and markets.
 
          Table 22 is a summary of loans originated by state for 2000 and 1999 by quarter. As of September 30, 2000, NovaStar Mortgage had 78 account executives 46 covering states.
 
Table 22
Mortgage Loan Originations by State
2000 and 1999
 
     Percent of Total Originations during Quarter
(based on original principal balance)
 
    2000
          1999
 
Collateral Location
   Third
    Second
    First
    Fourth
    Third
    Second
    First
 
Florida    12 %   13 %   14 %   12 %   15 %   12 %   15 %
California    11     10     10     10     10     8     6  
Ohio    7     8     7     8     12     10     8  
Michigan    10     11     11     12     10     10     12  
Nevada    6     7     7     5     4     4     3  
Arizona    5     5     5     8     5     7     4  
Colorado    5     5     4     2     1     1     2  
Tennessee    5     6     7     6     4     6     9  
Washington    5     5     5     4     4     5     3  
All other states    34     30     30     33     35     37     38  
 
          NFI Holding’s loan originations are funded through warehouse and repurchase facilities at First Union and GMAC/RFC. Table 25 of the “Liquidity Resources and Capital” section of this document detail borrowings outstanding under these financing arrangements as of September 30, 2000.
 
           Mortgage Loan Sales .     NovaStar Mortgage executed two securitizations during the first nine months of 2000, combining $570 million in loans, which were sold to a Special Purpose Entity (SPE), of which $151 million will settle in December 2000. A gain of $6.5 million was recognized on these transactions. Bonds issued by the SPE were $560 million and proceeds received were used to pay down warehouse and mortgage loan repurchase facilities of NovaStar Mortgage. The loans were sold without recourse. NovaStar Mortgage retained residual certificates issued by the SPE, which NovaStar Financial subsequently purchased. NovaStar Mortgage also retained loan servicing rights for the loans sold. The values of the retained interests and the mortgage servicing rights have been recorded as an asset and the loans sold have been removed from the balance sheet of NovaStar Mortgage.
 
          NovaStar Mortgage allocated its basis in the mortgage loans between the portion of the mortgage loans sold and the retained assets based on the relative fair values of those portions at the time of sale. The values of these assets are determined by discounting estimated future cash flows using the cash out method. The following table details the significant assumptions used to determine the value of the resulting retained assets in NMFT 2000-1 and 2000-2.
 
  Constant
prepayment rate
(weighted average
life) 		Static loss, net of
mortgage insurance
(basis points) 		Discount
Rate
    2000-1 27 1% 15%
    2000-2 28 1% 15%
 
          Details regarding loan collateral as of September 30, 2000 and December 31, 1999 are included in Tables 4, 5 and 8 of this document.
 
           NFI Holding also sold $126.7 million of its whole loan portfolio to unrelated third parties for cash at a net gain of $3.4 million at an average price to par of 104.0 during 2000. Table 20 of “Financial Condition of NFI Holding Corporation as of September 30, 2000 and December 31, 1999” provides a quarterly analysis of NFI Holding’s mortgage loan sales to third parties.
 
           Mortgage Loan Servicing.     Loan servicing is a critical part of NovaStar Mortgage’ s business. The majority of the loans serviced by NovaStar Mortgage are owned by NovaStar Financial. In the opinion of management, maintaining contact with borrowers is vital in managing credit risk and in borrower retention. Non-conforming borrowers are prone to late payments and are more likely to default on their obligations than conventional borrowers. NovaStar Mortgage strives to identify issues and trends with borrowers early and take quick action to address such matters.
 
          Table 23 provides summaries of delinquencies and default statistics of NovaStar Mortgage’s mortgage loan portfolio in 2000 and 1999 by quarter. The information presented in both tables includes mortgage loans owned by NovaStar Financial and its affiliates. Other information regarding the credit quality of NovaStar Financial’s mortgage loans is provided in Table 1.
 
    Table 23
Delinquencies and Defaults
(dollars in thousands)
 
       2000
     1999
     September 30
  June 30
  March 31
  December 31
   September 30
  June 30
  March 31
Loan servicing
portfolio 		     $1,016,952   $970,016   $872,693   $894,572   $969,343   $1,032,065   $1,072,393
   
 
 
 
 
 
 
Total defaults:               
     Delinquent loans (A)         4.90%      4.82%       5.58%      6.28%      4.75%       5.21%       4.12%
   
 
 
 
 
 
 
     Loans in
          foreclosure 		     3.34    3.25    3.55   3.62   3.79   3.36   3.39