10-K405 1 d10k405.htm FORM 10-K405 FORM 10-K405

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION    

WASHINGTON, D.C. 20549

FORM 10-K

           
  x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the Fiscal Year Ended December 31, 2000
   
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the Transition Period From ________________ to ________________
 
 
Commission File Number 001-13533
 
NOVASTAR FINANCIAL, INC.
(Exact name of registrant as specified in its charter)
 
                  Maryland    74-2830661
         (State or other jurisdiction of (I.R.S. Employer
      incorporation or organization) Identification No.)
 
1901 W. 47th Place, Suite 105, Westwood, KS 66205
   (Address of principal executive office) (Zip Code)
 
Registrant’s telephone number, including area code: (913) 362-1090
 
 
Securities registered pursuant to Section 12(b) of the Act:
     
Name of Each Exchange on
   Title of Each Class Which Registered
Common Stock, $0.01 par value New York Stock Exchange
 
Securities registered pursuant to Section 12(g) of the Act:
     
None

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. X

The aggregate market value of voting stock held by non-affiliates of the registrant as of March 13, 2001 was approximately $35,476,034 as reported by the New York Stock Exchange Composite Transactions on such date.

The number of shares of the Registrant’s Common Stock outstanding on March 13, 2001 was 5,721,941.

Documents incorporated by reference

Items 10, 11, 12, and 13 of Part III are incorporated by reference to the NovaStar Financial, Inc. definitive proxy statement to shareholders, which will be filed with the Commission no later than 120 days after December 31, 2000.

NOVASTAR FINANCIAL, INC.

FORM 10-K
For the Fiscal Year Ended December 31, 2000

TABLE OF CONTENTS
PART I
Item 1. Business
Item 2. Properties
Item 3. Legal Proceedings
Item 4. Submission of Matters to a Vote of Security Holders
     
PART II
Item 5. Market For Registrant’s Common Equity and Related Stockholder Matters
Item 6. Selected Consolidated Financial Data
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 8. Financial Statements and Supplementary Data
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
   
PART III
Item 10. Directors and Executive Officers of the Registrant
Item 11. Executive Compensation
Item 12. Security Ownership of Certain Beneficial Owners and Management
Item 13. Certain Relationships and Related Transactions
   
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K

PART I

Item 1.  Business

Overview

     NovaStar Financial, Inc. is a Maryland corporation formed on September 13, 1996 as an investor in mortgage assets, with a focus on non-conforming mortgage loans. NovaStar Financial’s mortgage assets have primarily come from the wholesale origination of single-family non-conforming loans of Novastar Mortgage, Inc., a subsidiary of NovaStar Financial’s affiliate, NFI Holding Corporation.

     Management believes the tax-advantaged structure of a real estate investment trust (REIT) maximizes the after-tax returns from mortgage assets. NovaStar Financial must meet numerous rules established by the Internal Revenue Service to retain its status as a REIT. In summary, they require NovaStar to:


  		• Restrict its investing to certain real estate related assets,
  		•   Avoid certain investment trading and hedging activities, and

  		• Distribute virtually all taxable income to stockholders.

         As long as NovaStar maintains its REIT status, distributions to stockholders will generally be deductible for income tax purposes. This deduction effectively eliminates corporate level income taxes. Management believes it has and will continue to meet the requirements to maintain its REIT status.

    2000 In Review

         During 2000, NovaStar Mortgage originated $719.3 million in nonconforming loans. NovaStar Mortgage continues to become more efficient in underwriting and funding wholesale mortgage loans through the use of its Internet Underwriter®, or “IU”, a web-based automated underwriting system used by selected customers for non-conforming residential mortgage loans. NovaStar Mortgage’s cost to originate a loan decreased from 4.2% in 1999 to 3.4% in 2000.

         During 2000, loans were sold through securitization transactions completed by NovaStar Mortgage. Included in NFI Holding’s net gain on sales of mortgage assets for the year ended December 31, 2000, are $9.7 million in gains recognized in two transactions securitizing a total of $794.2 million in loans. In addition, NovaStar Mortgage sold loans aggregating $172.8 million in unrelated third party transactions for cash, recognizing net gains of $5.1 million with an average price to par of 104.2.

         NovaStar Mortgage retains the servicing rights to loans securitized. During 2000 the loan-servicing portfolio increased from $762.1 million to $1,029.9 million.

         During 2000, NovaStar developed a net branch product using the name NovaStar Home Mortgage. Loan brokers/officers can open a branch facility under the NovaStar Home Mortgage name. NovaStar provides a license, loan investors and administrative services to the branch. Administrative services include accounting, payroll and human resource support. Branch management must adhere to lending policies established by NovaStar Home Mortgage. Net branch income – broker fee income less branch expenses and the administrative fees paid to NovaStar Home Mortgage – are profits earned by the branch manager.

          While the branch is free to broker loans for any approved investor, many of the loans produced by NovaStar net branches are funded by NovaStar Mortgage. This arrangement provides a tight relationship between the broker, operating as a NovaStar branch, and NovaStar Mortgage as the lender. In addition, fees generated are projected to be an additional form of revenue for NovaStar.

         At the beginning of 2000, NovaStar had four branches open. As of December 31, 2000 there were 60 branches in operation located in 27 states.

         During 2000, under its stock repurchase plan, NovaStar Financial repurchased 2,050,166 shares through December 31, 2000 and an additional 376,954 shares through March 13, 2001.

         NovaStar Financial and NovaStar Mortgage have committed financing facilities with First Union National Bank and GMAC/RFC. As of December 31, 2000, combined lending arrangements under these agreements totaled $325 million. Cash and availability under these committed facilities were $38.5 million.

         During the year ended December 31, 2000, NovaStar Financial recorded net income of $5.6 million, $0.50 per diluted share. NovaStar Financial’s operating results are discussed further under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this annual report.

    The Organization Structure of NovaStar Financial and Principal Affiliates

         Scott Hartman and Lance Anderson own 100% of the voting common stock of NFI Holding Corporation. NFI Holding was initially capitalized through the purchase of $20,000 in common stock by Scott Hartman and Lance Anderson and the purchase of non-voting preferred stock by NovaStar Financial in the amount of $1,980,000. Additional capital was contributed to NFI Holding in 1999 (NovaStar Financial, $6,930,000; Scott Hartman and Lance Anderson, $70,000) and 1998 (NovaStar Financial, $990,000; Scott Hartman and Lance Anderson $10,000). Mr. Hartman and Mr. Anderson receive 1% of the economic benefits derived from dividends and distributions of NFI Holding as a result of their common stock ownership. NovaStar Financial receives 99% of the economic benefits of NFI Holding as a result of its preferred stock ownership. Accordingly, NovaStar Financial indirectly receives 99% of the economic benefits of NovaStar Mortgage by virtue of its ownership interest in NFI Holding. In addition, Mr. Hartman and Mr. Anderson serve as the sole directors of both NFI Holding and NovaStar Mortgage.

         Beginning January 1, 2001, REITs are allowed to own directly all of the stock of taxable subsidiaries. Prior to this date, REITs were generally limited to holding non-voting preferred stock in taxable affiliates. The value of all taxable subsidiaries of a REIT is limited to 20% of the total value of the REIT’s assets. Accordingly, NFI acquired all of the common stock of NFI Holding from Scott Hartman and Lance Anderson on January 1, 2001. This federal tax legislation change is discussed further under “Federal Income Tax Consequences” of this annual report.

         NovaStar Mortgage has entered into several contracts to provide various services for NovaStar Financial. These relationships are discussed further in Note 12 to the consolidated financial statements located within this report.

      [GRAPHIC APPEARS HERE]

    Mortgage Lending

         NovaStar Financial invests in non-conforming residential mortgage loans. A primary source of NovaStar Financial’s assets has been the loans originated by NovaStar Mortgage, which shares common management with NovaStar Financial. NovaStar Mortgage lends to individuals who generally do not qualify for agency/conventional lending programs because of a lack of available documentation or previous credit difficulties, but generally have substantial equity in their homes. Often, these are individuals or families who have built high-rate consumer debt and are attempting to use the equity in their home to consolidate debt and lower their total monthly payments.

         The sales force of NovaStar Mortgage, which includes 85 account executives, develops and maintains relationships with a network of independent retail brokers. In 1997 and in much of 1998, NovaStar Financial financed and acquired the mortgage loans originated by NovaStar Mortgage. During 1999 and 2000, NovaStar Mortgage operated as a seller of whole loans to independent third parties. Two primary avenues were used for selling mortgage loans: 1) Directly to independent, third parties for cash and 2) through securitization transactions that are treated for tax and accounting purposes as loan sales. Through these channels, NovaStar Mortgage sold $742.7 million loans netting gains of $14.8 million. NovaStar Mortgage’s loan sales have generated profits and capital for NovaStar Financial in 2000 as profits earned by NovaStar Mortgage are shared through NovaStar Financial’s indirect equity ownership.

         On a short-term basis, NovaStar Mortgage has warehouse facilities available to finance mortgage loans with First Union National Bank and GMAC/RFC in which NovaStar Financial and NovaStar Mortgage are co-borrowers. NovaStar Mortgage also finances loans through a repurchase facility at First Union. In addition, NovaStar Financial and NovaStar Mortgage have access to facilities secured by residual interests in asset-back bonds. Details regarding available financing arrangements and amounts outstanding under those arrangements are included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 4 to the consolidated financial statements.

         For long-term financing, NovaStar Financial securitizes its loans by issuing asset-backed bonds (ABB). ABBs are debt arrangements whereby the investor in the ABB is paid based on the performance of the mortgage loans collateralizing the debt. As borrowers repay principal and pay interest on their mortgages, the funds are segregated to repay the investors in the ABB. Although these ABBs are non-recourse debt, NovaStar Financial retains the credit, prepayment and interest rate risks associated with the loans.

         Prior to 1999, ABB transactions executed by NovaStar Financial were designed to meet accounting rules that resulted in securitizations being treated as financing transactions. The mortgage loans and related debt continue to be presented on NovaStar Financial’s balance sheet, and no gain is recorded. Securitization transactions may also be structured as sales for accounting and tax purposes. NovaStar Mortgage completed several transaction of this type during 1999 and 2000. Details regarding ABBs issued by NovaStar Financial and the securitization transactions issued by NovaStar Mortgage can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Notes 3 and 4 to NovaStar Financial’s consolidated financial statements.

    Underwriting

         NovaStar Mortgage employs account executives that develop relationships with retail brokers and strives to provide a competitive menu of mortgage loan products. NovaStar Mortgage underwrites, processes, funds and services the mortgage loans sourced through its broker network.

         In the latter part of 1998, constraints on liquidity and concerns about non-conforming lending risk decreased investor appetite for such mortgage loans. In response, NovaStar Mortgage modified its underwriting guidelines to reflect the changing environment. NovaStar Mortgage focused on originating loans that were marketable in the current business environment. In addition, NovaStar Mortgage has emphasized reducing broker premiums, thereby reducing all-in loan costs.

         Further details regarding the loans originated by NovaStar Mortgage and other NFI Holding affiliates are discussed under the “NFI Holding” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.

    Loan Servicing

         Loan servicing remains a critical part of NovaStar Mortgage’s business operation. In the opinion of management, maintaining contact with NovaStar Mortgage’s borrowers is critical in managing credit risk and in borrower retention. Non-conforming borrowers are more prone to late payments and are more likely to default on their obligations than conventional borrowers. By servicing its own loans, NovaStar Mortgage strives to identify problems with borrowers early and take quick action to address problems. Common sense underwriting and thorough quality control reviews also control exposure to credit risk. NovaStar utilizes lender-paid mortgage insurance coverage to further manage the credit risk on mortgage loans. Borrowers may be motivated to refinance their mortgage loans either by improving their personal credit or due to a decrease in interest rates. By keeping in close touch with borrowers, NovaStar Financial can provide them with information about company products to entice them to refinance with NovaStar Financial.

     

    Market in Which NovaStar Operates and Competition

         NovaStar Financial and NovaStar Mortgage face intense competition in the business of originating, purchasing, selling and securitizing non-conforming mortgage loans. The number of market participants is believed to be well in excess of 100 companies and no single participant holds a dominant share of the non-conforming market. In addition to other residential mortgage REITs, NovaStar Financial is in competition for non-conforming borrowers with consumer finance companies, conventional mortgage bankers, commercial banks, credit unions and thrift institutions. NovaStar Financial also competes for holding mortgage loans with life insurance companies, institutional investors and other well-capitalized publicly owned mortgage lenders. Many of these competitors are substantially larger and have considerably greater financial, technical and marketing resources than NovaStar Financial.

         Based on market capitalization, as researched by management, NovaStar Financial ranked number 7 of 16 publicly traded nonconforming lenders. In addition, management’s research of the asset size of these companies indicates NovaStar Financial ranks number 11 of 16.

         Competition among industry participants can take many forms, including convenience in obtaining a loan, amount and term of the loan, customer service, marketing/distribution channels, loan origination fees and interest rates. To the extent any competitor significantly expands their activities in the non-conforming and subprime market, NovaStar Financial could be materially adversely affected.

         NovaStar Financial believes that one of its key competitive strengths is its employees and the level of service they are able to provide its borrowers. By servicing its loan portfolio directly, NovaStar Financial is able to stay in close contact with its borrowers and identify potential problems early. NovaStar Mortgage’s servicing staff is comprised of seasoned mortgage professionals with significant experience in the sub-prime marketplace. Standard and Poor’s assigned NovaStar’s servicing department an “Above Average” overall rating and designated NovaStar as a Special Servicer.

         In addition, regulated mortgage lenders, such as savings and loans and banks, are subject to regulatory review and must pay for the costs incurred by the regulator in their examinations. Novastar Financial incurs no such regulation fees or costs and is, therefore, competitively advantaged.

         NovaStar Financial effectively competes due to its:

    • experienced management team;
    • tax advantaged status as a REIT;
    •
    		vertical integration through its relationship with NovaStar Mortgage, which originates and services mortgage loans;
    • freedom from certain regulatory-related administrative and oversight costs;
    • access to capital markets to securitize its assets

    Risk Management

         Management recognizes the following primary risks associated with the business and industry in which it operates.

    • Credit
    • Prepayment
    •
    		Liquidity
    • Interest Rate/Market

    Credit Risk

         Credit risk is the risk that NovaStar Financial will not fully collect the principal it has invested in mortgage loans or securities. Non-conforming mortgage loans comprise 99% of NovaStar Financial’s mortgage assets portfolio as of December 31, 2000, compared with 100% as of December 31, 1999. NovaStar Financial’s non-conforming borrowers include individuals who do not qualify for agency/conventional lending programs because of a lack of available documentation or previous credit difficulties, but have substantial equity in their homes. Often, they are individuals or families who have built up high-rate consumer debt and are attempting to use the equity in their home to consolidate debt and reduce the amount of money it takes to service their monthly debt obligations.

         NovaStar Mortgage’s underwriting guidelines are intended to evaluate the credit history of the potential borrower, the capacity and willingness of the borrower to repay the loan, and the adequacy of the collateral securing the loan.

         NovaStar Mortgage employs an experienced underwriting staff who works under the supervision of the Chief Credit Officer. Underwriters are given approval authority only after their work has been reviewed for a period of at least two weeks. Thereafter, the Chief Credit Officer re-evaluates the authority levels of all underwriting personnel on an ongoing basis. All loans in excess of $350,000 currently require the approval of an underwriting supervisor. Loans in excess of $500,000 must be approved by the Chief Credit Officer or President of NovaStar Mortgage.

         The underwriting guidelines take into consideration the number of times the potential borrower has recently been late on a mortgage payment and whether that payment was 30, 60 or 90 days past due. Delinquency on consumer/revolving debt is also considered. Discharged bankruptcy filings are allowed under all credit ratings, however, to obtain an “A” or “B” grade, the borrower must have at least a one-year seasoning on a discharged Chapter 13 filing and two years for a Chapter 7 filing. The credit grade that is assigned to the borrower is a reflection of their historical credit and the loan-to-value determined by the amount of documentation the borrower can produce to support income. Maximum loan-to-value ratios for each credit grade depend on the level of income documentation provided by the potential borrower. In some instances, when the borrower exhibits strong compensating factors, exceptions to the underwriting guidelines may be approved.

         A key addition to NovaStar Mortgage’s underwriting process in 2000 was the growing use of IU, its automated underwriting system. IU provides more consistency in underwriting loans that meet NovaStar Mortgage’s guidelines and allows underwriting personnel to focus more of their time on loans that are not initially accepted by the IU system.

         Table 1 of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” sets forth NovaStar Financial’s mortgage loan portfolio by credit grade as of December 31, 2000 and 1999, all of which are non-conforming.

         Close attention is paid to geographic diversification in managing NovaStar Financial’s credit risk. Management believes one of the best tools for managing credit risk is to diversify the markets in which NovaStar Mortgage originates and NovaStar Financial purchases mortgage loans. Presented in Tables 3 of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of this annual report is a breakdown of NovaStar Financial’s geographic diversification as of December 31, 1999 and 1998. Detail regarding loan delinquencies and loans charged off during 1999 are disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the heading “Provisions for Credit Losses”.

    Prepayment Risk

         Significant portions of mortgage assets are acquired at a premium. When mortgage loans are originated, a premium of half a percent to one percent is generally paid to the retail brokers. Premiums are amortized over the life of the asset as an adjustment of the coupon received. When borrowers repay the principal on their mortgage loans early, the effect is to shorten the period over which premiums are amortized. The shorter this period, the lower the overall yield on the mortgage asset.

         Management attempts to mitigate prepayment risk by acquiring loans that are originated with a penalty if the borrower repays the loan in the early months of the loan’s life. For the majority of its loans, a prepayment penalty is charged equal to 80% of six months interest on the principal balance that is to be paid in full. Table 4 of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” is a summary of the loans originated by NovaStar Mortgage demonstrating the nature of prepayment penalties. As of December 31, 2000, 58% of all loans owned by NovaStar Financial had a prepayment penalty compared with 70% at December 31, 1999. The decline in NovaStar Financial’s percent of loans with prepayment penalty is due to seasoning of the portfolio and prepayment penalty windows expiring. The remaining weighted-average years to which the prepayment period applies was 1.0 at December 31, 2000 compared with 1.5 at December 31, 1999. In addition, the percent of loans NovaStar Mortgage originated with prepayment penalties increased from 74% during 1999 to 90% in 2000. Table 5 of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” detail prepayment speeds as of December 31, 2000 and 1999.

    Liquidity Risk

         See the “Liquidity and Capital Resources” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a discussion of liquidity risks and resources available to NovaStar Financial.

    Interest Rate/Market Risk

    The investment policy for NovaStar Financial sets the following general goals:

    (1) Maintain the net interest margin between assets and liabilities, and

    (2) Diminish the effect of changes in interest rate levels on the market value of NovaStar Financial.

             Loan Price Volatility. NovaStar Mortgage may sell some loans it originates to third parties. To the extent NovaStar Mortgage engages in this type of exit strategy, the financial results of NovaStar Financial will depend on the ability to find purchasers for the loans at prices that cover origination expenses. Exposure to loan price volatility is reduced to the degree that NovaStar Financial retains mortgage loans in portfolio.

             Interest Rate Risk. Interest rate risk is the risk that the market value of assets will increase or decrease at different rates than that of the liabilities. Expressed another way, this is the risk that NovaStar Financial's net asset value will experience an adverse change when interest rates change. When interest rates on the assets do not adjust at the same rates as the liabilities or when the assets are fixed rates and the liabilities are adjusting, future earnings potential is affected. Management primarily uses financing sources where the interest rate resets frequently. As of December 31, 2000 borrowings under all financing arrangements adjust daily, monthly, or quarterly. On the other hand, very few of the mortgage assets owned by NovaStar Financial, as of December 31, 2000, adjust on a monthly or daily basis. Most of the mortgage loans contain features where their rates are fixed for some period of time and then adjust frequently thereafter. For example, one of our loan products is the “2/28” loan. This loan is fixed for its first two years and then adjusts every six months thereafter.

             While short-term borrowing rates are low and long-term asset rates are high, this portfolio structure produces good results. However, if short-term interest rates rise rapidly, earning potential is significantly affected, as the asset rate resets would lag the borrowing rate resets. The converse can be true when sharp declines in short-term interest rates cause interest costs to fall faster than asset rate resets, thereby increasing earnings.

             In its assessment of the interest sensitivity and as an indication of exposure to interest rate risk, management relies on models of financial information in a variety of interest rate scenarios. Using these models, the fair value and interest rate sensitivity of each financial instrument, or groups of similar instruments is estimated, and then aggregated to form a comprehensive picture of the risk characteristics of the balance sheet. The risks are analyzed on both an income and market value basis.

    The following are summaries of the analysis as of December 31, 2000 and 1999.

    Interest Rate Sensitivity-Income
    December 31, 2000 and 1999
    (dollars in thousands)

    Basis Point Increase (Decrease)
    in Interest Rate(A)
    As of December 31, 2000 (100)
    		   Base
    		   100
    Income (expense) from:    
    Assets
    $
    91,334
    $
    93,189
    $
    95,138
    Liabilities (B)
    (60,327
    )
    (68,686
    )
    (77,207
    		 )
    Interest rate agreements
    (1,587
    )
    (1,424
    )
    ( 119
    		 )
    Net spread income
    $
    29,420
    $
    23,079
    $
    17,812
    Cumulative change in income from base (C)
    $
    6,341
    —
    $
    (5,267
    		 )
    Percent change from base spread income (D)
    27.5
    %
    —
    (22.8
    		 )%
    Percent change of capital(E)
    5.8
    %
    —
    (4.8
    		 )%
                           
    As of December 31, 1999
    Income from:
    Assets
    $
    61,610
    $
    64,419
    $
    66,954
    Liabilities (B)
    (42,173
    )
    (47,803
    )
    (53,442
    		 )
    Interest rate agreements
    (1,379
    )
    (1,379
    )
    1,122
    Net spread income
    $
    18,058
    $
    15,237
    $
    14,634
    Cumulative change in income from base (C)
    $
    2,821
    —
    $
    (603
    		 )
    Percent change from base spread income (D)
    18.5
    %
    —
    (4.0
    		 )%
    Percent change of capital(E)
    2.8
    %
    —
    (0.6
    		 )%
    ____________
    (A) Income of asset, liability or interest rate agreement in a parallel shift in the yield curve, up and down 1%
    (B) Includes debt issue costs, loan premium amortization, mortgage insurance premiums and provisions for credit losses.
    (C) Total change in estimated spread income, in dollars, from “base.” “Base” is the estimated spread income as of December 31, 2000 and 1999.
    (D) Total change in estimated spread income, as a percent, from base.
    (E) Total change in estimated spread income as a percent of total stockholders' equity as of December 31, 2000 and 1999.

    Interest Rate Sensitivity—Market Value December 31, 2000 and 1999 (dollars in thousands)

      Basis Point Increase  
    (Decrease)
    in Interest Rate(A)
    As of December 31, 2000 (100)
    		   100
    Change in market values of:  
          Assets $
    2,448
    		   $
    (9,763
    		 )
          Liabilities  
    (1,624
    		 )
    1,865
          Interest rate agreements
    (524
    		 )
    2,220
    		 
    Cumulative change in market value $
    300
    		   $
    (5,678
    		 )
    		   
    Percent change of market value portfolio equity (B)
    0.3
    		 %  
    (5.7
    		 )%
    		   
    		 
    		 
       As of December 31, 1999
    		 
    Change in market values of:
    		 
          Assets $
    1,913
    		   $
    (7,652
    		 )
          Liabilities  
    (2,068
    		 )
    2,376
          Interest rate agreements  
    (2,809
    		 )
    4,723
    		 
    Cumulative change in market value $ $
    (2,964
    		 )
    (553
    		 )
    		   
    Percent change of market value portfolio equity (B)
    (3.0
    		)%
    (0.6
    		 )%
    		   
    ____          
    (A) Change in market value of assets, liabilities or interest rate agreements in a parallel shift in the yield curve, up and down 1%.
    (B) Total change in estimated market value as a percent of market value portfolio equity as of December 31, 2000 and 1999.

               Interest Rate Sensitivity Analysis. The values under the heading “Base” are management's estimates of spread income for assets, liabilities and interest rate agreements on December 31, 2000 and 1999. The values under the headings “100” and “(100)” are management's estimates of the income and change in market value of those same assets, liabilities and interest rate agreements assuming that interest rates were 100 basis points, or 1 percent higher and lower. The cumulative change in income or market value represents the change in income or market value of assets, net of the change in income or market value of liabilities and interest rate agreements.

               The interest sensitivity analysis is prepared monthly. If the analysis demonstrates that a 100 basis point shift, up or down, in interest rates would result in 25 percent or more cumulative decrease in income from base, or a 10% cumulative decrease in market value from base, policy requires management to adjust the portfolio by adding or removing interest rate cap or swap agreements. The Board of Directors reviews and approves NovaStar Financial's interest rate sensitivity and hedged position quarterly. Management also evaluates the portfolio using interest rate increases and decreases less than and greater than one percent.

               Assumptions Used in Interest Rate Sensitivity Analysis. Management uses a variety of estimates and assumptions in determining the income and market value of assets, liabilities and interest rate agreements. The estimates and assumptions have a significant impact on the results of the interest rate sensitivity analysis, the results of which are shown as of December 31, 2000 and 1999.

              Management's analysis for assessing interest rate sensitivity on its mortgage loans relies significantly on estimates for prepayment speeds. The prepayment model used by management has been internally developed and is a function based on the borrowers’ payment change percentage. The factors affecting the size of the borrowers’ payment are as follows:

  		•  Refinancing incentives (the interest rate of the mortgage compared with the current mortgage rates available to the borrower)
  		• Program Type
  		• Borrower credit grades
  		• Loan Term
  		• Loan-to-value ratios
  		• Loan size
  		• Prepayment penalties (length and type)
  		• Estimated closing costs

              Generally speaking, when market interest rates decline, borrowers are more likely to refinance their mortgages. The higher the interest rate a borrower currently has on his or her mortgage the more incentive he or she has to refinance the mortgage when rates decline. In addition, the higher the credit grade, the more incentive there is to refinance when credit ratings improve. When a borrower has a low loan-to-value ratio, he or she is more likely to do a “cash-out” refinance. When a borrower has a higher balance loan, as refinancing rates fall, the percent of potential payment decrease is greater than on a comparably smaller balance loan, thereby making higher balance loans prepay faster. Each of these factors increases the chance for higher prepayment speeds during the term of the loan. On the other hand, prepayment penalties serve to mitigate the risk that loans will prepay because the penalty is a deterrent to refinancing.

              These factors are weighted based on management's experience and an evaluation of the important trends observed in the non-conforming mortgage origination industry and NovaStar Financial and NovaStar Mortgage’s mortgage loan portfolio. Actual results may differ from the estimates and assumptions used in the model and the projected results as shown in the sensitivity analyses. Management evaluates and updates the model periodically as the market changes and new data is collected.

              NovaStar Financial's projected prepayment rates are based on a prepayment vector and in each interest rate scenario start at a prepayment speed less than 5% in month one and increase to a long-term prepayment speed in nine to 18 months, to account for the seasoning of the loans. The long-term prepayment speed ranges from 20% to 40% and depends on the characteristics of the loan which include type of product (ARM or fixed rate), note rate, credit grade, LTV, gross margin, weighted average maturity and lifetime and periodic caps and floors. This prepayment vector is also multiplied by a factor of 55% to 70% depending on the length and type of penalty periods when a prepayment penalty is in effect on the loan. Prepayment assumptions are also multiplied by a factor of greater than 100% during periods around rate resets and prepayment penalty expirations. These assumptions change with levels of interest rates. The actual historical speeds experienced on NovaStar Financial's loans shown in Table 5 are weighted average speeds of all loans in each deal.

              As shown in Table 5, actual prepayment rates on loans that have been held in portfolio for shorter periods are slower than long term prepayment rates used in the interest rate sensitivity analysis. This table also indicates that as pools of loans held in portfolio season, the actual prepayment rates are more consistent with the long term prepayment rates used in the interest sensitivity analysis.

              Hedging with Off-Balance-Sheet Financial Instruments. In order to address a mismatch of assets and liabilities, the hedging section of the investment policy is followed, as approved by the Board. Specifically, the interest rate risk management program is formulated with the intent to offset the potential adverse effects resulting from rate adjustment limitations on its mortgage assets and the differences between interest rate adjustment indices and interest rate adjustment periods of its adjustable-rate mortgage loans and related borrowings.

              NovaStar Financial uses interest rate cap and swap contracts to mitigate the risk of the cost of its variable rate liabilities increasing at a faster rate than the earnings on its assets during a period of rising rates. In this way, management intends generally to hedge as much of the interest rate risk as determined to be in the best interest of NovaStar Financial, given the cost of hedging transactions and the need to maintain REIT status.

              NovaStar Financial seeks to build a balance sheet and undertake an interest rate risk management program that is likely, in management’s view, to enable NovaStar Financial to maintain an equity liquidation value sufficient to maintain operations given a variety of potentially adverse circumstances. Accordingly, the hedging program addresses both income preservation, as discussed in the first part of this section, and capital preservation concerns.

              Interest rate cap agreements are legal contracts between NovaStar Financial and a third party firm or “counter-party”. The counter-party agrees to make payments to NovaStar Financial in the future should the one- or three-month LIBOR interest rate rise above the strike rate specified in the contract. NovaStar Financial either makes quarterly premium payments or has chosen to pay the premiums upfront to the counterparties under contract. Each contract has a fixed notional face amount on which the interest is computed, and a set term to maturity. When the referenced LIBOR interest rate rises above the contractual strike rate, NovaStar Financial earns cap income. Payments on an annualized basis equal the contractual notional face amount times the difference between actual LIBOR and the strike rate.

              Interest rate swap agreements are also legal contracts between NovaStar Financial and a third party firm or “counter-party”. In this type of an agreement, NovaStar Financial agrees to pay a fixed rate to the counter-party and receive a floating rate from the counter-party, usually based on one or three-month LIBOR. These contracts also have a fixed notional amount on which the interest is computed and a set term to maturity.

    Other Risk Factors

            Although NovaStar Financial’s management considers the above risk components to be its primary business risks, the following are other risks that should be considered by NovaStar Financial’s investors. Further information regarding these risks is included in NovaStar Financial’s registration statements filed with the Commission on Form S-11.

  		• NovaStar’s dependence upon borrowings can result in significant liquidity constraints. NovaStar Financial’s profitability is dependent upon its ability to borrow money on favorable terms. In October 1998, the capital markets faced a liquidity crisis with respect to the availability of short-tem borrowings from major lenders and long-term borrowings through securitization. NovaStar faced significant liquidity constraints.
       
  		• NovaStar Financial has a limited operating history and significant net losses. NovaStar Financial has not yet developed an extensive earnings history or experienced a wide variety of interest rate or market conditions. Historical operating performance may be of limited relevance in predicting future performance. NovaStar Financial incurred significant net losses in 1999 and 1998.
       
  		• Should NovaStar Financial fail to maintain REIT status, NovaStar Financial would be subject to tax as a regular corporation. If NovaStar Financial fails to maintain qualification as a REIT, NovaStar Financial would be subject to federal income tax as a regular corporation. NovaStar Financial intends to conduct its business at all times in a manner consistent with the REIT provisions of the Code.
       
  		• Changes in interest rates may adversely affect results of operation. NovaStar Financial’s results of operations are likely to be adversely affected during any period of unexpected or rapid changes in interest rates. For example, a substantial or sustained increase in interest rates could adversely affect its ability to acquire mortgage loans in expected volumes necessary to support fixed overhead expense levels.
       
  		• Interest rate fluctuations may adversely affect the value of mortgage loans held for sale or securitization. Declines and increases in interest rates will cause the value of a loan to rise and fall respectively if the yield spread, or basis, between the loan and the duration-matched treasury remains the same. The basis does fluctuate over time, however, and NovaStar may experience mark-to-market gains and losses on its unsecuritized portfolio even though interest rates may have remained stable. This may effect the value of future securitizations to the company if the decrease in market value on loans was caused by basis widening in the securitization market, which would make long-term, non-recourse financing more expensive. Basis changes may not have an effect on future securitizations if, for example, there was simply an over supply in the whole loan market and securitization spreads had remained constant.

     

    		• Financing with repurchase agreements may lead to margin calls if the market value of mortgage assets decline. NovaStar uses repurchase agreements to finance the acquisition of mortgage assets in the short-term. In a repurchase agreement, NovaStar sells an asset and agrees to repurchase the same asset at some period in the future. Generally, the repurchase agreements entered into by NovaStar stipulate that it must repurchase the asset in 30 days. For financial accounting purposes, these arrangements are treated as secured financings. NovaStar retains the assets on its balance sheet and records an obligation to repurchase the asset. The amount NovaStar can borrow under these arrangements is generally 96% to 98% of the asset market value. When asset market values decrease, NovaStar is required to repay the margin, or difference in market value. To the extent the market values of assets financed with repurchase agreements decline rapidly, NovaStar will be required to meet cash margin calls. If cash is unavailable, NovaStar may be forced to default under the terms of the repurchase agreement. In that event, the lender retains the right to liquidate the collateral to settle the amount due from NovaStar.
       

    • Intense competition in the non-conforming mortgage industry may result in reduced net income or in revised underwriting standards which would adversely affect operations. NovaStar faces intense competition, primarily from commercial banks, savings and loans, other independent mortgage lenders, and certain other mortgage REITs. Any increase in the competition among lenders to originate or purchase non-conforming mortgage loans may result in either reduced interest income on mortgage loans compared to present levels or revised underwriting standards permitting higher loan-to-value ratios on properties securing non-conforming mortgage loans.
       
    		• Current loan performance data may not be indicative of future results. Management uses estimates and assumptions based on actual experience with the mortgage loans. Actual results and the time of certain events could differ materially from those projected, due to factors including general economic conditions, fluctuations in interest rates, fluctuations in prepayment speeds, and fluctuations in losses due to defaults on mortgage loans. These fluctuations could rise to levels that would adversely affect profitability.
       
    		• Failure to renew or obtain adequate funding under warehouse facilities and repurchase agreements may materially adversely impact NovaStar Mortgage’s lending operations. NovaStar Financial and NovaStar Mortgage are currently dependent upon two lenders to provide the primary credit facilities for its funding of mortgage loan originations and acquisitions. Any failure to renew or obtain adequate funding under these financing arrangements could have a material adverse effect on its lending operations.
       
    		• Failure to hedge effectively against interest rate changes may adversely affect results of operations. Asset/liability management hedging strategies involve risk and may not be effective in reducing its exposure to interest rate changes. Moreover, compliance with the REIT provisions of the Code may prevent NovaStar Financial from effectively implementing the strategies that management determines, absent such compliance, would best insulate NovaStar from the risks associated with changing interest rates.
       
    		• NovaStar Financial faces loss exposure due to the underlying real estate. A substantial portion of its mortgage assets consists of single family mortgage loans or mortgage securities evidencing interests in single family mortgage loans. NovaStar Financial will be subject to the risk of loss on mortgage assets arising from borrower defaults to the extent not covered by third-party credit enhancement.
    		• Market factors may limit NovaStar Financial’s ability to acquire mortgage assets at yields which are favorable relative to borrowing costs. Despite management's experience in the acquisition of mortgage assets and its relationships with various mortgage suppliers, there can be no assurance that NovaStar Financial will be able to acquire sufficient mortgage assets from mortgage suppliers at spreads above its cost of funds.
         
    		• Restrictions on ownership of capital stock may inhibit market activity and the resulting opportunity for holders of NovaStar Financial’s capital stock and warrants to receive a premium for their securities. In order for NovaStar Financial to meet the requirements for qualification as a REIT, its charter generally prohibits any person from acquiring or holding, directly or indirectly, shares of common stock in excess of 9.8% of the outstanding shares. This restriction may inhibit market activity and the resulting opportunity for the holders of its common stock to receive a premium for their stock that might otherwise exist in the absence of these restrictions.
         
    		• Mortgage insurers may not pay claims resulting in increased credit losses. NovaStar has place increased reliance on mortgage insurance to mitigate the risk of credit losses. However there can be no assurance that the mortgage insurers will continue to have the financial ability to pay all claims presented. In addition, insurers have the right to deny a claim if the loan is not properly serviced or has been defectively originated.
         
    		• Access to additional capital may ultimately curtail NovaStar Financial’s growth. Cash is required to fund loans originated by NovaStar Mortgage as financing arrangements allow NovaStar Mortgage to borrow a percentage, typically 98%, of the mortgage note amount. If NovaStar is unable to obtain sufficient cash resources, NovaStar Financial may not sustain asset growth. Liquidity and capital resources are discussed further under the “Liquidity and Capital Resources” section presented elsewhere in this report.
         
    Federal Income Tax Consequences
         
                   General. NovaStar Financial believes it has complied, and intends to comply in the future, with the requirements for qualification as a REIT under the Internal Revenue Code ("the Code"). To the extent that NovaStar qualifies as a REIT for federal income tax purposes, it generally will not be subject to federal income tax on the amount of its income or gain that is distributed to shareholders. However, origination operations are conducted through NovaStar Mortgage, which is a taxable REIT subsidiary. Consequently, all of the taxable income of NovaStar Mortgage is subject to federal and state corporate income taxes.
         
         
                   The REIT rules generally require that a REIT invest primarily in real estate-related assets, its activities be passive rather than active and it distribute annually to its shareholders substantially all of its taxable income. NovaStar Financial could be subject to a number of taxes if it failed to satisfy those rules or if it acquired certain types of income-producing real property through foreclosure. Although no complete assurance can be given, NovaStar Financial does not expect that it will be subject to material amounts of such taxes.

     

              Failure to satisfy certain Code requirements could cause loss of REIT status. If NovaStar failed to qualify as a REIT for any taxable year, it would be subject to federal income tax (including any applicable minimum tax) at regular corporate rates and would not receive deductions for dividends paid to shareholders. As a result, the amount of after-tax earnings available for distribution to shareholders would decrease substantially. While NovaStar intends to operate in a manner that will enable it to qualify as a REIT in future taxable years, there can be no certainty that such intention will be realized. Loss of REIT status by NovaStar Financial would reduce the amount of any distributions by taxes due from NovaStar Financial, but the character of such distributions for tax purposes should be unaffected.

              NovaStar Financial’s Qualification as a REIT. Qualification as a REIT requires that NovaStar Financial satisfy a variety of tests relating to its income, assets, distributions and ownership. The significant tests are summarized below. NovaStar Financial will make available more detailed information regarding its compliance with the REIT rules upon request.

              Sources of Income. NovaStar Financial must satisfy two tests with respect to the sources of its income: the 75% income test, and the 95% income test. The 75% income test requires that NovaStar derive at least 75% of its gross income, excluding gross income from prohibited transactions, from certain real estate-related sources. Management believes that NovaStar Financial’s income qualified for both of the income tests during 2000.

              In order to satisfy the 95% income test, at least an additional 20% of NovaStar Financial’s gross income for the taxable year must consist either of income that qualifies under the 75% income test or dividends and interest.

              Nature and Diversification of Assets. As of the last day of each calendar quarter, NovaStar Financial must meet three asset tests. Under the 75% of assets test, at least 75% of the value of NovaStar Financial’s total assets must represent cash or cash items (including receivables), government securities or real estate assets. Under the 10% asset test, NovaStar Financial may not own more than 10% of the outstanding securities of any single non-governmental issuer, if these securities do not qualify under the 75% asset test. There is an exception for electing corporations of which NovaStar Financial owns at least 35% of the outstanding securities. NovaStar Financial and NovaStar Mortgage intend to make such election. Under the 5% asset test, ownership of any stocks or securities that do not qualify under the 75% asset test must be limited, in respect of any single non-governmental issuer, to an amount not greater than 5% of the value of NovaStar Financial’s total assets. The definition of security for this purpose includes financial contracts and instruments that NovaStar Financial acquires in the normal course of business.

              If NovaStar Financial inadvertently fails to satisfy one or more of the asset tests at the end of a calendar quarter, such failure would not cause it to lose its REIT status. NovaStar Financial still could avoid disqualification by eliminating any discrepancy within 30 days after the close of the calendar quarter in which the discrepancy arose. Management believes that NovaStar Financial complied with the asset tests for all quarters during 2000.

              Ownership of Common Stock . The capital stock of NovaStar Financial must be held by a minimum of 100 persons for at least 335 days of each year. In addition, at all times during the second half of each taxable year, no more than 50% in value of the capital stock of NovaStar Financial may be owned directly or indirectly by 5 or fewer individuals. NovaStar Financial uses the calendar year as its taxable year for income tax purposes. The Code requires NovaStar Financial to send its annual information questionnaires to specified shareholders in order to assure compliance with the ownership tests. Management believes that NovaStar Financial complied with these stock ownership tests during 2000.

              Distributions. Through 2000 NovaStar Financial generally had to distribute to its shareholders an amount equal to at least 95% of the sum of its taxable income and any after-tax net income from certain types of foreclosure property minus any excess non-cash income. The Code provides that distributions relating to a particular year may be made early in the following year, under certain circumstances. NovaStar Financial expects to make distributions equal to 100% of its taxable income to avoid corporate level taxation. No distributions are required in periods in which there is no income. For year 2001 and thereafter NovaStar Financial must distribute at least 90% of its taxable income and any after-tax net income from certain types of foreclosure property less any non-cash income.

              Taxable Income. NovaStar Financial uses the calendar year for both tax and financial reporting purposes. However, there may be differences between taxable income and income computed in accordance with generally accepted accounting principles (GAAP). These differences primarily arise from timing and character differences in the recognition of revenue and expense and gains and losses for tax and GAAP purposes. Additionally, NovaStar Financial’s taxable income does not include the taxable income of its taxable affiliate, although the affiliate’s operating results are included in NovaStar Financial's GAAP results.

              Recent and Proposed Tax Legislation. Recently adopted legislation, H.R. 1180, contains several provisions affecting REITs. After the effective date of the bill, December 31, 2000 (i.e., beginning with the 2001 tax year), REITs will be able to own directly all of the stock of taxable subsidiaries. For year 2000 and earlier, REITs were generally limited to holding non-voting preferred stock in taxable affiliates. The value of all taxable subsidiaries of a REIT will be limited to 20% of the total value of the REIT’s assets. Existing taxable subsidiaries like NovaStar Mortgage will have to be converted to qualified taxable REIT subsidiaries after December 31, 2000, unless the existing taxable subsidiary has been in place since July 12, 1999 and there has been no material change in the taxable subsidiary’s assets or business since that time. In addition, a REIT will be subject to a 100% penalty tax equal to any rents or charges that the REIT imposed on the taxable subsidiary in excess of the arm’s length price for comparable services. NovaStar Financial acquired all of the common stock of NFI Holding from Scott Hartman and Lance Anderson on January 1, 2001.

              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. Under this provision, NovaStar Financial will be able to retain a greater percentage of its after-tax earnings if desired.

              Both of the foregoing provisions offer somewhat more flexibility for the management and operation of a REIT, and should not present risks for NovaStar Financial and its shareholders.

    Personnel

              As of December 31, 2000, NovaStar Financial employed 10 people, NovaStar Mortgage employed 258 people, and NovaStar Home Mortgage employed 264 people.

    Item 2.   Properties

              The executive and administrative offices of NovaStar Financial and NovaStar Mortgage are located in Westwood, Kansas, and consist of approximately 6,000 square feet. The lease agreements on the premises expire December 2002. The current annual rent for these offices is approximately $116,000.

              NovaStar Mortgage leases space for its mortgage lending operations in Orange County, California. Currently, these offices consist of approximately 16,000 square feet. The lease on the premise expires January 2004, and the current annual rent is approximately $480,000.

              NovaStar Mortgage also leases space for its mortgage servicing operation in Westwood, Kansas. The square footage on these premises is approximately 24,000, with annual rent of approximately $304,000, and a lease scheduled to expire in January 2005.

              NovaStar Home Mortgage leases space for its net branch operation in Westwood, Kansas. The square footage for this space is approximately 5,000 square feet. The lease of this space expires December 2004, and the current annual rent is approximately $111,000.

    Item 3.   Legal Proceedings

              NovaStar Financial occasionally becomes involved in litigation arising in the normal course of business. Management believes that any liability with respect to such legal actions, individually or in the aggregate, will not have a material adverse effect on its financial position or results of operations.

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

              None

    PART II

    Item 5.   Market for Registrant’s Common Equity and Related Stockholder Matters

              The common stock of NovaStar Financial is traded on the NYSE under the symbol “NFI”. The following table sets forth, for the periods indicated, the high and low sales prices per share of common stock on the NYSE and the cash dividends paid or payable per share of capital stock.

    Common Stock Prices
    		     Cash Dividends (A)
        Date Date Paid Amount
    High Low     Class Declared or Payable Per Share
    1/1/99 to 3/31/99
    $7.2500
    $5.6250
    		     Preferred Stock (B)
    4/21/99
    5/10/99
    $0.12
    4/1/99 to 6/30/99
    7.0625
    5.6250
    		     Preferred Stock
    7/21/99
    8/10/99
    0.12
    7/1/99 to 9/30/99
    6.5000
    3.1250
    		     Preferred Stock
    10/20/99
    11/10/99
    0.12
    10/1/99 to 12/31/99
    3.7500
    2.6250
    		     Preferred Stock
    12/21/99
    1/10/00
    0.12
    1/1/00 to 3/31/00
    4.3750
    3.1250
    		     Preferred Stock
    4/26/00
    5/10/00
    0.12
    4/1/00 to 6/30/00
    4.1875
    2.8750
    		     Preferred Stock
    7/26/00
    8/10/00
    0.12
    7/1/00 to 9/30/00
    4.0625
    2.8750
    		     Preferred Stock
    10/25/00
    11/10/00
    0.12
    10/1/00 to 12/31/00
    4.3125
    3.5625
    		     Preferred Stock
    12/20/00
    1/10/01
    0.12
    __________________
    (A)   NovaStar Financial did not declare dividends on its common stock during 1999 and 2000.
    (B)   NovaStar Financial issued the class B 7% convertible preferred stock in March 1999.

              As of March 13, 2001, over 2,000 stockholders held NovaStar Financial’s 5,721,941 shares of common stock as provided by third party broker search and transfer agent reports.

              NovaStar Financial intends to make distributions to its stockholders of all or substantially all of its taxable income in each year, subject to certain adjustments, so as to qualify for the tax benefits accorded to a REIT under the Code. All distributions will be made by NovaStar Financial at the discretion of the Board of Directors and will depend on the earnings of NovaStar Financial, financial condition of NovaStar Financial, maintenance of REIT status and such other factors as the Board of Directors may deem relevant from time to time.

    Recent Sales of Securities

              NovaStar Financial has no reportable unregistered and registered securities.

    Item 6.   Selected Consolidated Financial and Other Data

              The following selected consolidated financial data are derived from the audited consolidated financial statements of NovaStar Financial for the periods presented and should be read in conjunction with the more detailed information therein and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this annual report. Operating results are not necessarily indicative of future performance.

    Selected Consolidated Financial and Other Data
    (dollars in thousands, except per share amounts)

    For the
    Period
    Ended
    December
    For the Year Ended December 31,
    31,
    2000
    1999
    1998
    1997
    1996
    Consolidated Statement of Operations Data
       Interest income
    $
    46,895
    		   
    $
    66,713
    		  
    $
    100,747
    		   
    $
    36,961
    $
    155
       Interest expense
    33,964
    46,758
    80,794
    28,185
       Net interest income
    12,931
    19,955
    19,953
    8,776
    155
       Provision for credit losses
    5,449
    22,078
    7,430
    2,453
       Equity in net income (loss) – NFI Holding
    1,123
    88
    (2,984
    		 )
    28
       Gain (loss) on sales of mortgage assets
    (826
    		 )
    351
    (14,962
    		 )
    51
       General and administrative expenses
    3,017
    3,590
    4,379
    3,451
    457
       Net income (loss)
    5,626
    (7,092
    		 )
    (21,821
    		 )
    (1,135
    		 )
    (302
    		 )
       Basic income (loss) per share
    $
    0.51
    $
    (1.08
    		 )    
    $
    (2.71
    		 )
    $
    (0.26
    		 )
    $
    (0.08
    		 )
       Diluted income (loss) per share
    $
    0.50
    $
    (1.08
    		 )
    $
    (2.71
    		 )
    $
    (0.26
    		 )
    $
    (0.08
    		 )

     

    As of December 31,
    Consolidated Balance Sheet Data
    2000
    1999
    1998
    1997
    1996
       Mortgage Assets:
          Mortgage loans
    $
    375,927
    		    $
    620,406
    		   
    $
    945,798
    		    $
    574,984
    		    $
          Mortgage securities
    46,650
    6,775
    517,246
    13,239
       Total assets
    494,482
    689,427
    997,754
    1,126,252
    59,811
       Borrowings
    382,437
    586,868
    891,944
    1,002,560
       Stockholders’ equity
    107,919
    100,161
    82,808
    116,489
    46,380

     
    		As of or for the Year Ended December 31,
    As of or for
    the Period
    Ended
    December
    31,
    		  
    2000
      
    1999
      
    1998
      
    1997
      
    1996
    Other Data
    Loans originated by NovaStar Mortgage, Inc.:
       Principal at purchase
    $
     719,341
    		 
    $
     452,554
    		 
    $
     878,871
    		 
    $
     409,974
    		 
    $
       Average principal balance per loan
    $
    115
    $
    101
    $
    94
    $
    130
       Weighted average interest rate:
          Adjustable rate mortgage loans
    10.6
    %
    9.9
    %
    10.0
    %
    10.1
    %
          Fixed rate mortgage loans
    10.5
    %
    10.0
    %
    9.9
    %
       Loans with prepayment penalties  
    90
    %
    90
    %
    74
    %
    73
    %
       Weighted average prepayment period (in years)
    3.0
    3.2
    2.4
    2.4
    Annualized return on assets
    0.97
    %
    (0.83
    )%
    (1.66
    )%
    (0.01
    )%
    (0.50
    )%
    Annualized return on equity
    5.50
    %
    (6.71
    )%
    (20.71
    )%
    (0.06
    )%
    (0.65
    )%
    Taxable income (loss)
    $
    (2,628
    )
    $
    1,434
    $
    (173
    )
    Taxable income (loss) per share
    $
    (0.32
    )
    $
    0.18
    $
    (0.05
    )
    Dividends declared per common share
    $
    1.00
    $
    0.28
    $
    Dividends declared per preferred share
    $
    0.49
    $
    0.37
    $
    0.18
    $
    Number of account executives
    85
    47
    63
    36

    Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

    Management’s Discussion and Analysis of Financial Condition and Results of Operations

         The following discussion should be read in conjunction with the consolidated financial statements of NovaStar Financial and the notes thereto included elsewhere in this report.

    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 annual 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, 2000. 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, 2000.

    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 the issuance of asset-backed bonds. The consolidated financial statements of NovaStar Financial include the financial condition and results of operations of these entities.

         On December 31, 2000, NovaStar Financial also owned 100% of the non-voting preferred stock of NFI Holding Corporation. Scott Hartman and Lance Anderson, the founders of NovaStar Financial, owned the voting common stock of 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 businesses of NovaStar Mortgage and NovaStar Home Mortgage are discussed in “Description of Business –Business of NovaStar Mortgage” and “Business of NovaStar Home 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.

         A significant component of the financial results of NovaStar Financial is the operations of NovaStar Mortgage, Inc. and NovaStar Home 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. Effective January 1, 2001, Real Estate Investment Trusts (REITs) are 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 must be limited to 20% of the total value of the REIT’s assets. Accordingly, NovaStar Financial acquired all of the common stock of NFI Holding Corporation from Scott Hartman and Lance Anderson on January 1, 2001. As a result, NFI Holding became a wholly-owned consolidated subsidiary of NovaStar Financial. This transaction and pro forma balance sheet of NovaStar Financial are presented in more detail in Notes 8 and 14 to the consolidated financial statements.

         Also, effective beginning with the 2001 tax year, the minimum dividend distributions of a REIT must equal at least 90% of taxable income, down from 95% of taxable income under current law. 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 and the purchase of AAA-rated interest-only and subordinated securities from the securitization transactions of NovaStar Mortgage, its affiliate;

    • Operates as a long-term portfolio investor;

    • Long-term financing is provided through securitization where asset-backed bonds are issued in financing-structured and sale 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 5,097 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 and repurchase facilities. Loans are sold in securitization transactions where asset-backed bonds are issued or sold to affiliates or third parties for cash.

    Business of NovaStar Home Mortgage:

    • Retail mortgage brokers and their staffs operate under the NovaStar Home Mortgage name and are employees of NovaStar Home Mortgage.

    • Branches operate under a strict set of policies established by NovaStar Home Mortgage.

    • Branch can broker loans to any investor approved by NovaStar Home Mortgage, including NovaStar Mortgage, Inc.

    • Net operating income for the branch is returned as compensation to the branch “owner/manager.”

    • Fees, based on all loan volume, are paid to NovaStar Home Mortgage for license and investor management and accounting and payroll services.

    • As of December 31, 2000, there were 60 active branches in 27 states operating under the NovaStar Home Mortgage name.

    Financial Condition of NovaStar Financial, Inc. as of December 31, 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 asset-backed bonds. The carrying value of mortgage loans as of December 31, 2000 was $376 million versus $620 million as of December 31, 1999. The carrying value of asset-backed bonds as of December 31, 2000 was $357 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 2000. Even though NovaStar Financial is no longer purchasing the loans originated from NovaStar Mortgage, NovaStar Financial has increased its mortgage asset portfolio by purchasing the AAA-rated interest-only and subordinated securities of NovaStar Mortgage’s securitization transactions. The carrying value of these securities was $47 million as of December 31, 2000 compared with $7 million as of December 31, 1999. Mortgage loans collateralizing the AAA-rated interest-only and subordinated securities totaled $654 million as of December 31, 2000 compared with $143 million as of December 31, 2000 bringing the total principal balance of mortgage assets managed by NovaStar Financial to $1 billion as of December 31, 2000 compared to $762 million as of December 31, 1999.

         Mortgage Loans. Table 1 is a presentation of loans as of December 31, 2000 and December 31, 1999 and their credit grades. Table 2 is a summary of all mortgage loans owned by NovaStar Financial as of December 31, 2000 and December 31, 1999 by state. These tables also provide details regarding the collateral outstanding on NovaStar Mortgage’s REMIC transactions, in which NovaStar Financial owns AAA-rated interest-only and subordinated securities. 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)

                      December 31,  
                   
    		 
                    2000   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    
    $
    		 56,463   10.17 %   82.6 %   $ 85,476   9.50 %   83.2 %
    A  
    1 x 30
    		     90    
    		152,621   10.66     79.4       244,187   10.06     80.1  
    A-  
    2 x 30
    		     90    
    		88,617   11.30     81.7       149,248   10.45     81.8  
    B  
    3 x 30, 1x 60
    		     85    
    		51,001   11.80     78.1       89,477   10.86     78.4  
       
    5 x 30, 2 x 60
    		          
    		                               
    C  
    1 x 90
    		     75    
    		22,902   12.30     72.8       42,766   11.35     72.5  
    D  
    6 x 30, 3 x 60,
    		     65    
    		4,268   13.13     63.8       7,668   12.16     62.1  
       
    2 x 90
    		          
    		             
    		           
                   
    		                               
    Total on balance sheet      
    $
    		 375,872   11.02 %   79.7 %  
    $
    		 618,822   10.31 %   80.0 %
           
    		 
    		   
    		   
    		 
    		   
    		 
    Sold loans collateralizing
    asset- backed bonds:    		      
    		                               
           
    		                               
    AAA  
    0 x 30
    		     97 (B)  
    $
    		 143,673   9.71 %   80.9 %   $ 3,474   9.18 %   80.7 %
    AA  
    0 x 30
    		     95    
    		175,068   10.25     83.5       27,236   9.47     84.8  
    A  
    1 x 30
    		     90    
    		130,237   10.54     81.2       43,119   9.86     83.1  
    A-  
    2 x 30
    		     90    
    		86,660   10.65     81.3       35,311   10.09     83.1  
    B  
    3 x 30, 1x 60
    		     85    
    		44,487   11.16     79.3       19,612   10.59     79.7  
       
    5 x 30, 2 x 60
    		          
    		                               
    C  
    1 x 90
    		     75    
    		18,398   11.69     70.1       11,405   11.09     71.9  
    D  
    6 x 30, 3 x 60,
    		     65    
    		1,568   12.69     61.6       3,171   12.16     62.1  
       
    2 x 90
    		          
    		                               
    Other  
    Varies
    		     97    
    		53,958   11.44     92.7       —   —     —  
       
    		         
    		             
    		           
    Total off balance sheet      
    $
    		 654,049   10.45 %   82.2 %  
    $
    		 143,328   10.08 %   81.5 %
           
    		 
    		   
    		   
    		 
    		   
    		 
    Total managed mortgage loans      
    $
    		 1,029,921   10.66 %   81.3 %  
    $
    		 762,150   10.27 %   80.3 %
           
    		 
    		   
    		   
    		 
    		   
    		 

    _______
    (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    		  
    		 
    December 31,
    		  
    December 31,
    		 
    2000
    1999
    		  
    2000
    1999
     
    		 
    		   
    		 
    		 
      
    		Collateral Location
    		                  
    Florida 16 % 14 %   15 % 21 %
    California 15   16     10   7  
    Washington 6   7     5   4  
    Texas 5   5     3   6  
    Nevada 4   4     6   4  
    Oregon 4   5     2   1  
    Tennessee 4   3     6   5  
    Michigan 3   3     9   5  
    Ohio 3   3     6   4  
    All other states 40   40     38   43  
     
    		 
    		   
    		 
    		 
    Total 100 % 100 %   100 % 100 %
     
    		 
    		   
    		 
    		 

         Table 3 provides a summary of NovaStar Financial's mortgage loans by type and carrying value as of December 31, 2000 and 1999.

    Table 3
    Carrying Value of Loans by Product/Type
    December 31, 2000 and 1999
    (in thousands)

    December 31,
     
    		 
    Product/Type
    2000
    1999
    		 
    		 
       Retained loans collateralizing asset-backed bonds—            
          on balance sheet:            
             Two and three-year fixed $ 166,627   $
    343,193
    		  
             Six-month LIBOR and one-year CMT   23,428    
    43,178
    		  
             30/15-year fixed and other   185,817    
    232,451
    		  
     
    		 
    		 
             Outstanding principal   375,872   618,822  
             Premium   7,745    
    12,689
    		  
             Allowance for credit losses   (7,690 )  
    (11,105
    		 )
     
    		 
    		 
             Carrying Value $ 375,927   $
    620,406
    		  
     
    		 
    		 
             Carrying value as a percent of principal   100.01 %  
    100.26
    		 %
     
    		 
    		 
             
    		 
       Sold loans collateralizing asset-backed bonds—        
    		 
          off balance sheet:        
    		 
             Two and three-year fixed $ 465,976   $
    78,238
    		  
             Six-month LIBOR and one-year CMT   2,492    
    5,052
    		  
             30/15-year fixed and other   185,581    
    60,038
    		  
     
    		 
    		 
             Outstanding principal $ 654,049   $
    143,328
    		  
     
    		 
    		 
             Mortgage securities retained $ 46,650   $
    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 year ended December 31, 2000, prepayment penalties collected from borrowers totaled $1.8 million in comparison with $3.1 million during 1999. Table 4 is an analysis of mortgage loans and prepayment penalties.

    Table 4
    Mortgage Loan Prepayment Penalties
    December 31, 2000 and 1999
    (dollars in thousands)

                 
    Weighted Average
                 



    Current
    Principal

    		  



    Premium
    		  

    Percent with
    Prepayment
    Penalty
    		  



    Coupon
    		  


    Loan-to-
    value
    		  
    Remaining
    Prepayment Penalty
    Period (in years) -
    Loans with Penalty
     
    		 
    		 
    		 
    		 
    		 
    As of December 31, 2000
    		 
    		 
    Retained loans collateralizing
    		 
    		 
    asset-backed bonds:        
    		               
       NHES 1997-1
    $
    52,282
    		  
    $
    2,494
    		  
    25
    %
    11.80
    %
    74.5
    %
    0.30
       NHES 1997-2
    53,727
    		  
    1,040
    		  
    16
    11.55
    79.6
    0.28
       NHES 1998-1
    114,367
    		  
    1,877
    		  
    33
    11.03
    80.6
    0.46
       NHES 1998-2  
    155,376
    		    
    2,328
    		  
    60
    		  
    10.57
    		  
    80.9
    		  
    0.85
          All other loans  
    120
    		    
    6
    		  
    33
    		  
    10.85
    		  
    71.5
    		  
    0.81
     
    		 
    		               
             Total on balance sheet
    $
    375,872
    		  
    $
    7,745
    		  
    40
    %
    11.02
    %
    79.7
    %
    0.57
             
    		             
    Sold loans collateralizing        
    		             
    asset-backed bonds (A):        
    		             
       NMFT 1999-1  
    103,968
    		    
    —
    		  
    64
    		  
    10.66
    		  
    81.6
    		  
    1.23
       NMFT 2000-1 (B)  
    216,216
    		    
    —
    		  
    94
    		  
    10.18
    		  
    81.1
    		  
    2.43
       NMFT 2000-2 (C)  
    333,865
    		    
    —
    		  
    90
    		  
    10.57
    		  
    83.2
    		  
    2.49
     
    		 
    		               
                               
          Total off balance sheet  
    654,049
    		    
    —
    		  
    87
    		  
    10.45
    		  
    82.2
    		  
    2.27
     
    		 
    		 
    		 
    		 
    		 
                               
            Total managed mortgage loans $
    1,029,921
    		   $
    7,745
    		  
    70
    		 %
    10.66
    		 %
    81.3
    		 %
    1.65
     
    		 
    		 
    		 
    		 
    		 
             
    		               
    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
     
    		 
    		 
    		 
    		 
    		 
       
    		   
    		 
    		 
    		 
    		 
            Total managed mortgage loans $
    762,150
    		   $
    12,689
    		  
    63
    		 %
    10.27
    		 %
    80.3
    		 %
    1.22
     
    		 
    		 
    		 
    		 
    		 

     

    (A) NovaStar Financial owns asset-backed bonds. The mortgage loans are not retained on the balance sheet of NovaStar Financial.

    (B) The AAA-rated interest-only and subordinated securities of NMFT 2000-1 were purchased by NovaStar Financial April 1, 2000.

    (C) The AAA-rated interest-only and subordinated securities of 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)

       
    		 
        
     Current
    Principal
    Balance
    		 

    Weighted
    Average Age
    of Loans at
    Inception
    (in months)

    Constant Prepayment Rate
    (Annual Percent)
    Issue Date
    One-
    month
    Three-
    month
    Twelve-
    month
    Life
    December 31, 2000  
    		   
      
    		  
    		 
    		 
    		 
    		 
    Retained loans collateralizing
    asset-backed bonds:    		  
    		   
    		 
    		 
    		 
    		 
    		 
       NHES 1997-1  
    October 1, 1997
    		   $
    52,282
    		  
    7
    		  
    20
    		  
    29
    		  
    38
    		  
    39
       NHES 1997-2  
    December 11, 1997
    		    
    53,727
    		  
    3
    		  
    54
    		  
    52
    		  
    45
    		  
    36
       NHES 1998-1  
    April 30, 1998
    		    
    114,367
    		  
    3
    		  
    46
    		  
    38
    		  
    41
    		  
    30
       NHES 1998-2  
    August 18, 1998
    		    
    155,376
    		  
    3
    		  
    21
    		  
    32
    		  
    32
    		  
    24
       
    		   
    		 
    		 
    		 
    		 
    		 
    Sold loans collateralizing  
    		   
    		 
    		 
    		 
    		 
    		 
    asset-backed bonds:  
    		   
    		 
    		 
    		 
    		 
    		 
       NMFT 1999-1  
    January 29, 1999
    		   $
    103,968
    		  
    5
    		  
    37
    		  
    38
    		  
    28
    		  
    21
       NMFT 2000-1  
    March 31, 2000
    		    
    216,216
    		  
    2
    		  
    11
    		  
    10
    		  
    —
    		  
      8
       NMFT 2000-2  
    September 28, 2000
    		    
    333,865
    		  
    1
    		  
    5
    		  
      5
    		  
    —
    		  
      5
    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
    		  
     
    		 
    December 31, 2000 2.06 %
    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 subordinated securities of the NovaStar Mortgage Funding Trust Series 1999-1, 2000-1 and 2000-2. As the owner of these securities, 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 interest earned on the mortgage loan collateral over the sum of the interest paid on the bonds, a servicing fee, a trustee fee, mortgage insurance premiums and the credit losses relating to the securitized loans. As of December 31, 2000 and 1999, the carrying value of the interest-only and subordinated securities was $46.7 million and $6.8 million. These values represent the present value of the securities’ 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 subordinated asset. The cashflows are realized over the life of the securitizations as cash distributions received from the trusts. NovaStar Financial believes its AAA-rated interest-only and subordinated securities are fairly valued as of December 31, 2000, but can provide no assurance that future prepayment and loss experience or changes in the required discount rate will not require write-downs of the 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 December 31, 2000 and 1999 are included in the Tables 1 through 5 of this document and Note 4 to the consolidated financial statements.

         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.”

         Assets Acquired through Foreclosure. As of December 31, 2000, NovaStar Financial had 154 properties in real estate owned with a carrying value of $13.1 million (principal of $14.5 million) compared to 192 properties 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. NovaStar Mortgage funds loans with various financing facilities prior to securitization. Loans 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, 2001, respectively.

         First Union also provides a $25 million facility secured by subordinated interests in asset-backed bonds that is committed through December 17, 2001. Amounts outstanding as of December 31, 2000 under this financing arrangement were $25.0 million.

         Amounts outstanding under short-term financing arrangements as of December 31, 2000 are detailed in Table 27 of this document and Note 4 to the consolidated financial statements.

         On a long-term basis, NovaStar Financial has financed its mortgage loans using asset-backed bonds (ABB). Investors in ABB are repaid based on the performance of the mortgage loans collateralizing the ABB. 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 ABB, NovaStar Financial is entitled to repurchase the mortgage loan collateral and repay the remaining ABB 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 ABB 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 owner of AAA-rated interest-only and subordinated securities 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 “clean up” call.

         Under its ABB, NovaStar Financial retains the mortgage loans and incurs the obligation to pay the ABB 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 ABB 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 ABB as of December 31, 2000 was $357 million compared with $587 million as of December 31, 1999. The decline in carrying value is primarily a result of principal paydowns.

         Further details regarding NovaStar Financial’s short-term and long-term borrowing arrangements are located in Note 4 to the consolidated financial statements.

         Stockholders' Equity. The increase in NovaStar Financial’s stockholders’ equity as of December 31, 2000 compared to December 31, 1999 is a result of the following:

    • $5.6 million increase due to net income recognized in 2000.

    • $5.7 million decrease as a result of common stock purchases. NovaStar Financial's Board of Directors amended its stock purchase program to increase the amount of common stock authorized to be acquired up to an aggregate purchase price of $9 million. Stock purchases may be made in the open market, in block purchase transactions, through put options or through privately negotiated transactions. The timing of purchases and the number of shares ultimately purchased will depend upon market conditions and corporate requirements. As of December 31, 2000, NovaStar Financial had purchased 2,050,166 shares of its common stock. The number of shares purchased by NovaStar Financial has increased to 2,427,120 through March 13, 2001 at an aggregate purchase price of $7.9 million.
    • $9.9 million increase in the unrealized gain on the interest-only and subordinated securities in NovaStar Mortgage’s asset backed bond transactions that for tax and accounting purposes were treated by NovaStar Mortgage as sales. The interest-only and subordinated assets 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.

    • $2.1 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 was divided into three equal parts, called “tranches”, and was forgiven if certain incentive performance targets were achieved. The incentive tests related to the return generated to investors in the private placement, including the appreciation in stock price, the value of the warrants, and dividends paid.

         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.

         In 1999, NovaStar Financial advanced $584,000 to the founders for the payment of their personal tax liability arising from the 1997 forgiveness referred to above and advanced $70,000 in order for the founders to inject capital into NFI Holding Corporation. The carrying value of these notes at December 31, 2000 was $6,374,000 and $6,284,000 as of December 31, 2000 and 1999, respectively.

         On January 1, 2001, these notes were restructured into new non-recourse, non-interest bearing promissory notes that are to be forgiven in equal installments over a 10 year period as long as the founders remain employed by NovaStar Financial as of December 31. All of the notes will be forgiven in the event of a change in control. Further details regarding the original and restructured notes are discussed in Note 8 to the consolidated financial statements.

    Results of Operations of NovaStar Financial, Inc.—Year Ended December 31, 2000 Compared to the Year Ended December 31, 1999

    Net Income

         During the year ended December 31, 2000, NovaStar Financial recorded net income of $5.6 million, $0.50 per diluted common share, compared with a net loss of $7.1 million, $1.08 per diluted common share, for the year ended December 31, 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 7 presents a summary of the average interest-earning assets, average interest-bearing liabilities and the related yields and rates thereon for the year ended December 31, 2000 and 1999.

    Table 7
    Interest Analysis
    (dollars in thousands)

    Mortgage Loans
    Mortgage-Backed Securities
    Total
    Year ended December 31, 2000
    		Average
    Balance
    		Interest
    Income/
    Expense
    		Annual
    Yield/
    Rate
    		Average
    Balance
    		Interest
    Income/
    Expense
    		  Annual
    Yield/
    Rate
    		Average
    Balance
    		Interest
    Income/
    Expense
    		Annual
    Yield/
    Rate
    Interest-earning mortgage
        assets    		   $ 446,874   $ 44,676 10.00 %  
    $
    		 17,839   $ 2,951  
    16.54
    		 %   $ 464,713   $ 47,627
    10.25
    		 %
       
    		   
    		       
    		     
    		 
    		   
    		   
    		 
    		 
    Interest-bearing liabilities  
    		 
       Asset-backed bonds   $
    471,991
    		   $ 33,960
    7.20
    		 %
    —
    		  
    —
    		  
    —
    		   $
    471,991
    		   $
    33,960
    7.20
    		 %
       Other borrowings
    —
    		 —
    —
    		  
    8,993
    		  
    732
    		  
    8.14
    		 %
    8,993
    732
    8.14
       
    		               
    		         
    		   
    		     
    		 
    		 
       Cost of derivative financial
    		 
       Instruments hedging
           liabilities    		 4
    		 
    —
    		  
    —
    4
    		 
    		 
          Total borrowings   $ 471,991   $ 33,964 7.20 %  
    $
    		 8,993   $
    732
    		  
    8.14
    		 %   $ 480,984   $ 34,696
    7.21
    		 %
       
    		   
    		 
    		   
    		     
    		 
    		   
    		   
    		 
    		 
       Net interest income   $
    10,712
    		  $
    2,219
    		     $
    12,931
               
    		                 
    		               
    		     
       Net interest spread 2.80 %
    		 
    8.40
    		 %
    3.04
    		 %
                     
    		                 
    		                 
    		 
       Net yield
    2.40
    		 %
    		 
    12.44
    		 %
    2.78
    		 %
    		 
                                                               
    Mortgage Loans
    Mortgage-Backed Securities
    Total
    Year ended December 31, 1999
    Average
    Balance
    Interest
    Income/
    Expense
    Annual
    Yield/
    Rate
    Average
    Balance
    Interest
    Income/
    Expense
    Annual
    Yield/
    Rate
    Average
    Balance
    Interest
    Income/
    Expense
    Annual
    Yield/
    Rate
    Interest-earning mortgage assets $ 709,371 $ 66,324 9.35 % $ 2,357 $ 389   16.50 % $ 711,728 $ 66,713 9.37 %
       
    		   
    		 
    		   
    		   
    		 
    		   
    		   
    		 
    		 
    Interest-bearing liabilities  
       Asset-backed bonds $ 785,547 $ 43,963 5.60 % — —   — $ 785,547 $ 43,963 5.60 %
       Other borrowings 4,206 541 12.86 — —   — 4,206 541 12.86
       
    		                             
    		   
    		             
       Cost of derivative financial  
       Instruments hedging
          liabilities    		 2,254   2,254
               
    		                                   
    		     
          Total borrowings $ 789,753 $ 46,758 5.92 % $ — $ —   — % $ 789,753 $ 46,758 5.92 %
       
    		   
    		 
    		   
    		   
    		 
    		   
    		   
    		 
    		 
       Net interest income $ 19,566 $ 389   $ 19,955
               
    		               
    		               
    		     
       Net interest spread 3.43 %   16.50 % 3.45 %
                     
    		                 
    		                 
    		 
       Net yield 2.76 %   16.50 % 2.80 %
                     
    		                 
    		                 
    		 

         Interest Income. During 2000, mortgage loans earned $44.7 million, or a yield of 10.0%, compared with $66.3 million, or a yield of 9.4% for the same period in 1999. Mortgage-backed securities income for 2000 consists of earnings AAA-rated interest-only and subordinated securities that NovaStar Financial purchased from NovaStar Mortgage starting in September 1999. In total, assets earned $47.6 million, or a yield of 10.3% for the year ended December 31, 2000. During the same period of 1999, assets earned $66.7 million or a 9.4% yield. As noted in Table 7, 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 $34.7 million for the year ended December 31, 2000, or 7.2% of average borrowings compared with $46.8 million, or 5.9% for the same period of 1999. Mortgage-backed securities’ cost of borrowed funds for the year ended December 31, 2000 includes repurchase agreements secured by interest-only and subordinated securities executed during the second, third and fourth quarters of 2000. Average interest-bearing liabilities for the year ended December 31, 2000 also consisted of financing costs on asset-backed bonds compared with the same period of 1999, which also included a short-term financing arrangement with GMAC/RFC secured by subordinated assets in NovaStar Financial’s ABB. 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 subordinated asset facility to pay this debt in full. In March 1999, proceeds from the convertible preferred stock offering repaid all the outstanding debt on the subordinated asset facility.

         NovaStar Financial’s asset-backed bonds are indexed to LIBOR. During the year ended December 31, 2000, one-month LIBOR averaged 6.41% compared with 5.25% 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 were 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 year ended December 31, 2000 was $10.7 million, or 2.8% of average interest-earning mortgage loans, compared with $20.0 million, or 2.8% for the same period of 1999. Net interest spread on mortgage loans was 3.0% and 3.5%, respectively, for the years ended December 31, 2000 and 1999. Net interest income on mortgage-backed securities during the year ended December 31, 2000 was $2.2 million, or 12.4% of average interest-earning mortgage securities with a net interest spread of 8.4%. 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 remaining deferred gain of $376,000 as of December 31, 2000.

         During the year ended December 31, 2000 and 1999, net interest expense incurred on hedging agreements was $4,000 and $2.3 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

         During the year ended December 31, 2000 and 1999, 90% of the mortgage loans originated by NovaStar Mortgage had prepayment penalties. As of December 31, 2000, 40% of NovaStar Financial’s mortgage loan portfolio had prepayment penalties compared with 58% as of December 31, 1999. Prepayment penalties totaled $1.8 million during the year ended December 31, 2000 compared with $3.1 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 December 31, 2000 and 1999, approximately 72% 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 AAA-rated interest-only and subordinated securities 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 year ended December 31, 2000, total premiums paid by NovaStar Financial totaled $1.3 million compared with $1.7 million for the same period of 1999. Premiums for mortgage insurance on loans serving as collateral for the subordinated 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 year ended December 31, 2000, NovaStar Financial made provisions for losses of $5.4 million and incurred net charge-offs of $8.9 million, compared to $22.1 million and $14.5 million during 1999. Charge-offs during 2000 include $803,000 resulting from short sale transactions and loans charged off in full compared with $1.9 million during the same period of 1999.

         In the opinion of management, the allowance for credit losses as of December 31, 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 8 presents the activity in the allowance for credit losses during 2000 and 1999

    Table 8
    Allowance for Credit Losses
    (in thousands)

    2000
    1999
    December 31
    		    September 30
    		    June 30
    		 March 31
    		    December 31
    		   September 30
    		    June 30
    		   March 31
    Beginning balance
    $
    		 8,132  
    $
    		 8,993  
    $
    		 9,763  
    $
    		 11,105  
    $
    		 5,370  
    $
    		 3,573  
    $
    		 3,492  
    $
    		 3,573
    Provision for credit losses
    1,445
    		 1,212   1,213   1,579   10,579   5,634   3,566   2,299
    Amounts charged off, net
    		           
      of recoveries (1,887 ) (2,073 )   (1,983 )   (2,921 )   (4,844 )   (3,837 )   (3,485 )   (2,380 )
    		 
    		 
    		 
    		 
    		 
    		 
    Ending Balance
    $
    		 7,690
    $
    		 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 9
    Loan Delinquencies (90 days and greater) (A)
    2000 and 1999
    (in thousands)

    2000
    1999
    December 31    September 30   
    June 30
    		    March 31    December 31    September 30    June 30    March 31
    		 
    		 
    		 
    		 
    		 
    		 
    		 
    Mortgage loans Collateralizing                 
    		 
    NovaStar Home Equity Series              
    		 
    (ABB):              
    		 
      1997-1 Issued October 1, 1997 $  3,480   $  3,410       $  4,039     $  3,434    $  4,726      $  6,093      $  6,087   
    		$  6,454    
                 
    		 
      1997-2 Issued December 11, 1997 3,319   5,222   6,336   6,311   6,047   5,934   5,671  
    		8,388  
      1998-1 Issued April 30, 1998 7,322   8,131   6,455   5,987   8,467   11,411   9,687  
    		11,818  
      1998-2 Issued August 18, 1998 11,443   10,621   11,159   11,433   12,754   10,247   10,808  
    		10,832  
    (A) Includes loans in foreclosure or bankruptcy.

    Table 10
    Loan Delinquencies (90 days and greater) as a Percent of Total Loan Principal(A)
    2000 and 1999

    2000
    1999
       December 31
    		   September 30
    		   June 30
    		   March 31
    		   December 31
    		   September 30
    		   June 30
    		   March 31
    Mortgage loans Collateralizing                                                
    NovaStar Home Equity Series                                                
    (ABB):                                                
       1997-1 Issued October 1, 1997   6.68 %   6.01 %   6.21 %   4.59 %   5.63 %   6.32 %   5.13 %   4.37 %
                                                     
       1997-2 Issued December 11, 1997   6.29     8.23     8.88     7.66     6.24     4.92     4.03     5.38  
       1998-1 Issued April 30, 1998   6.54     6.44     4.40     3.58     4.42     5.32     4.13     4.64  
       1998-2 Issued August 18, 1998   7.17     6.03     5.48     5.10     5.38     4.06     3.94     3.72  

    (A) Includes loans in foreclosure or bankruptcy.

    Table 11
    Delinquencies, Defaults and Losses
    December 31, 2000 and 1999
    (dollars in thousands)

     
    NovaStar Home Equity Series
    		         
    December 31, 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  
    		1,014     873       1,773    
    		1,786       5,446  
       Amounts charged off, net of  
    		                   
    		           
          Recoveries  
    		(1,221 ) (2,322 )   (2,972 )  
    		(2,346 ) (8,861 )
       
    		 
    		 
    		   
    		   
    		 
       Balance, December 31, 2000  
    $
    		 2,128   $ 1,412     $ 3,015    
    $
    		 1,125     $ 7,680  
       
    		 
    		   
    		   
    		   
    		 
       
    		                                 
    Defaults as a percent of loan balance  
    		                                 
       Delinquent loans (A)  
    		10.06 % 9.20 %   9.59 %     9.43 %   9.55 %
       
    		 
    		   
    		   
    		   
    		 
       Loans in foreclosure     5.05     5.06       4.62       4.88       4.86  
       
    		 
    		   
    		   
    		   
    		 
       Real estate owned     1.58     5.02       3.15       4.73       3.86  
       
    		 
    		   
    		   
    		   
    		 
                                     
    		   
    Cumulative losses  
    $
    		 4,470   $ 4,272   $ 4,672     $ 3,112    
    		   
       
    		   
    		   
    		   
    		   
    		   
       
    		                   
    		     
    		   
    December 31, 1999  
    		                   
    		     
    		   
    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 ABB. The fee charged is based on the loan principal balance of the mortgage loans serviced. Loan servicing fees for 2000 were $2.5 million compared with $3.9 million for the same period of 1999. The decrease is due to principal paydowns between the two periods.

    Net Fees for Other Services Provided by NFI Holding Corporation

         The net fees for other services provided by NFI Holding Corporation during 2000 and 1999 are further detailed in Note 12 to the consolidated financial statements. The significant increase in these fees for the year ended December 31, 2000 compared with 1999 is due to a composition change in the intercompany agreements between NovaStar Financial and NFI Holding as discussed in Note 12 to the consolidated financial statements.

    Other Income

         Other income during the year ended December 31, 2000 primarily consists of net losses recognized on the sale of real estate owned properties of $826,000 compared with net gains on the sale of real estate owned properties of $351,000 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 year ended December 31, 2000 also consists of interest earned on securitization funds held in trust of $234,000 and interest earned on money market funds of $148,000. Other income for the same period of 1999 also included interest earned on notes receivable from founders of $496,000 and interest earned on securitization funds held in trust of $235,000.

    General and Administrative Expenses

         General and administrative expenses for the year ended December 31, 2000 and 1999 are provided in Table 12. Table 13 displays the relationship of portfolio expenses to stockholders’ equity during 2000 and 1999 by quarter.

    Table 12
    General and Administrative Expenses
    (dollars in thousands)

     
    Year Ended December 31,
    2000
    1999
    Percent of Stockholders’
    Equity
    (Annualized)
    Percent of Stockholders’
    Equity
    (Annualized)
    Compensation and benefits   $ 1,485 1.82 % $ 1,804 1.80 %
    Office administration 751 0.92 804 0.80
    Professional and outside services 690 0.84 801 0.80
    Other 91 0.11 181 0.18
    Total general and administrative expenses
    $
    		 3,017 3.69 % $ 3,590 3.58 %

    Table 13
    Portfolio Related Expenses as a
    Percent of Stockholders’ Equity
    2000 and 1999

    Percent of
    Stockholders’
    Equity
    2000:
    Fourth quarter   3.06 %
    Third quarter   3.03 %
    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 year ended December 31, 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 1999. Office administration includes items such as rent, depreciation, telephone, office supplies, postage, delivery, maintenance and repairs.

    Equity in Earnings of NFI Holding Corporation

         For the year ended December 31, 2000, NFI Holding recorded net income of $1.1 million compared with net income of $89,000 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 financial position and results of operation for the year ended December 31, 2000 and 1999 are discussed further under the heading “NFI Holding Corporation.”

    Results of Operations of NovaStar Financial, Inc.—Year Ended December 31, 1999 Compared to the Year Ended December 31, 1998

    Net Income

         During the year ended December 31, 1999, NovaStar Financial recorded a net loss of $7.1 million, $1.08 per diluted share, compared with net loss of $21.8 million, $2.71 per diluted share, for the year ended December 31, 1998. NovaStar Financial’s net loss for 1999 is principally a result of increased provisions for credit losses that aggregated $22.1 million in 1999 versus $7.4 million in 1998. This increase is discussed further under “Mortgage Insurance” and “Provisions for Credit Losses”. In 1998, NovaStar Financial recognized losses aggregating $23.4 million when it sold all of its agency securities and terminated various interest rate agreements as a result of the liquidity crisis faced by the capital markets in the fourth quarter of 1998.

         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 14 presents a summary of the average interest-earning assets, average interest-bearing liabilities and the related yields and rates thereon for the year ended December 31, 1999 and 1998.

         Table 14
    Interest Analysis
    (dollars in thousands)

     
    Mortgage Loans
    		 
    Mortgage Securities
    Total
    		 
    Year ended December 31, 1999
    		 
    Average
    Balance
    Interest
    Income/
    Expense
    Annual
    Yield/
    Rate
    		 
    Average
    Balance
    Interest
    Income/
    Expense
    Annual
    Yield/
    Rate
    Average
    Balance
    Interest
    Income/
    Expense
    Annual
    Yield/
    Rate
    Interest-earning mortgage assets   $ 709,371   $ 66,324   9.35 %   $ 2,357   $ 389   16.50 %   $ 711,728   $ 66,713   9.37 %
     
    		 
    		 
    Interest-bearing liabilities      
       Asset-backed bonds   $ 785,547 $ 43,963 5.60 %   — — — $ 785,547   $ 43,963 5.60 %
       Other borrowings   4,206 541 12.86   — — — 4,206   541 12.86
     
    		 
    		 
       Cost of derivative financial      
       Instruments hedging liabilities   2,254     2,254
     
    		   
          Total borrowings   $ 789,753 $ 46,758 5.92 %   $ — $ — — % $ 789,753   $ 46,758 5.92 %
     
    		 
    		 
       Net interest income   $ 19,566   $ 389   $ 19,955
     
    		 
    		 
       Net interest spread   3.43 %   16.50 %   3.45 %
     
    		 
    		 
       Net yield   2.76 %   16.50 %   2.80 %
      
    		 
    		 
         
             
     
    Mortgage Loans
    		 
    Mortgage Securities
    Total
    Year ended December 31, 1998
    		 
    Average
    Balance
    Interest
    Income/
    Expense
    Annual
    Yield/
    Rate
    		 
    Average
    Balance
    Interest
    Income/
    Expense
    Annual
    Yield/
    Rate
    Average
    Balance
    Interest
    Income/
    Expense
    Annual
    Yield/
    Rate
                             
    Interest-earning mortgage assets   $ 822,180 $ 76,751 9.34 %   $ 375,222 $ 23,996 6.40 %   $ 1,197,402   $ 100,747 8.41 %
     
    		 
    		 
    		 
    Interest-bearing liabilities       
       Repurchase agreements   $ 118,380    $ 7,817    6.60 %    $ 392,859    $ 21,891    5.57 %    $ 511,239   $ 29,708    5.81 %
       Asset-backed bonds   703,328 43,287 6.15   — — — 703,328   43,287 6.15
       Other borrowings   18,936 4,908 25.92   — — — 18,936   4,908 25.92
     
    		 
    		 
       Cost of derivative financial      
       Instruments hedging liabilities   2,162   729   2,891
     
    		 
    		 
          Total borrowings   $ 840,644 $ 58,174 6.92 %   $ 392,859 22,620 5.76 %   $ 1,233,503   $ 80,794 6.55 %
     
    		 
    		 
    		 
       Net interest income   $ 18,577   $ 1,376  
    $19,953
     
    		 
    		 
       Net interest spread   2.42 %   0.64 %   1.86 %
     
    		 
    		 
       Net yield   2.26 %   0.37 %   1.67 %
     
    		 
    		 

         Interest Income. NovaStar Financial's average interest-earning assets consist primarily of mortgage loans for the year ended December 31, 1999. For 1998, interest-earning assets included mortgage loans (70%) and lower-yielding agency securities (30%). Mortgage securities income for 1999 consists of earnings on interest-only and subordinated securities that NovaStar Financial purchased from NovaStar Mortgage in September 1999. During 1999, mortgage loans earned $66.3 million, or a yield of 9.4%, compared with $76.8 million, or a yield of 9.3% for the same period of 1998. In total, assets earned $66.7 million, or a yield of 9.4% for the year ended December 31, 1999. During 1998, assets earned $100.7 million or an 8.4% yield. NovaStar Financial sold all of its agency securities in October 1998 to meet short-term liquidity needs faced in the fourth quarter of 1998. Agency securities earned $24.0 million for the year ended December 31, 1998, or a yield of 6.4%.

         Interest Expense. Average interest-bearing liabilities for the year ended December 31, 1999 consisted entirely of financing costs on mortgage loans, compared with 1998 when mortgage loans represented 70% and agency securities were 30%. During the fourth quarter of 1998, NovaStar Financial sold all of its agency securities.

         The cost of borrowed funds for mortgage loans was $46.8 million for 1999, or 5.9% of average borrowings compared with $58.2 million, or 6.9% for 1998. The cost of financing agency securities was $22.6 million during 1998, or 5.8% of average borrowings. The composition of interest expense is significantly different for the year ended December 31, 1999 compared with the same period of 1998 due to the following factors:

    • The majority of mortgage loans serve as collateral on asset-backed bonds as of December 31, 1999. During 1998, mortgage loans secured debt consisting of asset-backed bonds and warehouse facilities. The change in financing composition is due to the fact that NovaStar Financial discontinued purchasing mortgage loans from NovaStar Mortgage during the last half of 1998. Prior to that point in time, NovaStar Financial had purchased 100% of NovaStar Mortgage's loan production upon origination. During that time, NovaStar Financial reimbursed NovaStar Mortgage for warehousing costs incurred prior to sale. Repurchase and warehouse facility costs for 1998 are included under repurchase agreements and other borrowings in Table 14.

    • NovaStar sold all of its agency securities in October 1998 and paid off all related borrowings. No agency securities have been purchased since that time.

    • In connection with the capital markets liquidity crisis that occurred in the last quarter of 1998, NovaStar Financial executed a short-term liquidity line with GMAC/Residential Funding Corporation that was secured by mortgage interests in NovaStar's asset-backed bonds. This facility carried a substantially higher interest cost than other borrowing arrangements. This debt was paid off in February 1999 with funds from a similar facility provided by First Union National Bank. The First Union line was repaid in full with proceeds from convertible preferred stock issued in March 1999. The interest on these facilities during the year ended December 31, 1999 and 1998 is included as a component of other borrowings in Table 14.

         Advances under the warehouse line of credit bear interest based on the federal funds rate plus a spread. Advances under the master repurchase agreement bear interest at rates based on LIBOR, plus a spread. During the year ended December 31, 1999, one-month LIBOR averaged 5.25% compared with 5.57% for the year ended December 31, 1998. Because the Federal Reserve Board increased the targeted federal funds interest rate in 1999, effective borrowing costs have been higher for the second half of 1999. 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 1999 was $19.6 million, or 2.8% of average interest-earning mortgage loans, compared with $18.6 million, or 2.3% for 1998. Net interest spread on mortgage loans was 3.4% and 2.4%, respectively, for 1999 and 1998. Net interest income on mortgage securities during 1999 was $389,000, or 16.5% of average interest-earning mortgage securities compared with net interest income of $1.4 million, or 0.4% for 1998. Net interest spread on mortgage securities was 16.5% for 1999 compared with 0.6% for 1998. The significant increase in net margin and spread during 1999 compared with 1998 is due to the change in NovaStar Financial's asset and liability composition. During the latter part of 1998, NovaStar Financial sold all agency securities and paid off related financing. NovaStar Financial has not purchased any more of these lower-yielding mortgage assets. Net interest income and the spread are functions of asset yields relative to its costs of funds. 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.

         During the years ended December 31, 1999 and 1998, net interest expense incurred on hedging agreements was $2.3 million and $2.9 million, respectively, which is included as a component of interest expense. In 1998, NovaStar Financial recognized losses aggregating $8.0 million due to the termination of all swap agreements during the liquidity crisis faced by the capital markets in the latter part of 1998. These agreements were related to the financing for disposed mortgage loans and securities. NovaStar Financial’s interest rate agreements as of December 31, 1999 and 1998 are further detailed in Note 5 of the consolidated financial statements.

    Prepayment Penalty Income

         NovaStar Financial strives to purchase loans that have some form of prepayment penalty fee to mitigate exposure to prepayment risk. During 1999, 90% of the mortgage loans originated by NFI Holding affiliates had prepayment penalties compared with 74% during 1998. As of December 31, 1999, 58% of NovaStar Financial’s mortgage loan portfolio had prepayment penalties compared with 70% as of December 31, 1998. Prepayment penalties totaled $3.1 million during 1999 compared with $2.0 million for 1998. This increase is attributable to more prepayments in the securitized mortgage loan portfolio in 1999.

    Gain (Loss) on Sales of Assets and Loss on Termination of Interest Rate Agreements

         For the year ended December 31, 1999, NovaStar Financial recognized $319,000 in net gains on the sale of real estate properties and $32,000 in gains on the sale of mortgage loans. In 1998, NovaStar Financial recognized losses aggregating $15.2 million and $8.0 million on the sale of agency securities and termination of related swap agreements. Also, in 1998 net gains of $305,000 were recognized on the sale of $7.9 million of mortgage loans.

    Mortgage Insurance

         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 year ended December 31, 1999, total premiums paid by NovaStar totaled $1.7 million compared with $744,000 for the same period of 1998. The monthly premiums paid on loans serving as collateral for NMFT 99-01 reduce NovaStar Financial’s monthly cashflow receipt.

    Provisions for Credit Losses

         During 1999, NovaStar Financial made provisions for losses of $22.1 million and incurred net charge-offs of $14.5 million, compared to $7.4 million and $6.2 million during 1998. Charge-offs in 1999 include $1.9 million resulting from short sale transactions and loans charged off in full.

            The level and trend of charge-offs in 1999 led management to conclude that total losses on securitized mortgage loans will be higher, and will occur earlier, than originally projected. The provisions during 1999 and resulting allowance as of December 31, 1999 reflect the increased loss activity.

            Table 15 is the activity in the allowance for credit losses during 1999 and 1998.

    Table 15
    Allowance for Credit Losses
    (in thousands)

                1999                       1998              
     
      December 31     September 30   June 30   March 31   December 31   September 30   June 30   March 31  
     
    		   
    		 
    		 
    		 
    		 
    		 
    		 
    		 
    Beginning balance $ 5,370     $ 3,573   $ 3,492   $ 3,573   $ 2,757   $ 3,341   $ 2,871   $ 2,313  
    Provision for credit losses   10,579       5,634   3,566     2,299     4,030     1,179     1,145     1,076  
    Amounts charged off, net                                                  
       of recoveries   (4,844 )     (3,837 ) (3,485 ) (2,380 )   (3,214 )   (1,763 )   (675 )   (518 )
     
    		   
    		 
    		 
    		 
    		 
    		   
    		 
    		 
    Ending Balance $ 11,105     $ 5,370   $ 3,573   $ 3,492   $ 3,573   $ 2,757   $ 3,341   $ 2,871  
     
    		   
    		 
    		 
    		 
    		 
    		 
    		 
    		 

         The following tables provide details regarding the delinquencies, defaults, and loss statistics of NovaStar Financial’s mortgage loan portfolio.

    Table 16
    Loan Delinquencies (90 days and greater) (A)
    1999 and 1998

            1999               1998          
       
        December 31   September 30   June 30   March 31   December 31   September 30   June 30   March 31  
       
    		 
    		 
    		 
    		 
    		 
    		 
    		 
    		 
    Mortgage loans                                
       Collateralizing                                
       NovaStar Home                                
       EquitySeries (ABB):                                
    1997-1                                  
      Issued October 1, 1997
        5.63%
    		  
        6.32%
    		  
        5.13%
    		  
        4.37%
    		  
        5.45%
    		  
        5.97%
    		  
        5.86%
    		  
        4.39%
    		  
    1997-2  
    		 
    		 
    		 
    		 
    		 
    		 
    		 
    		 
      Issued December 11, 1997
    6.24
    		  
    4.92
    		  
    4.03
    		  
    5.38
    		  
    5.62
    		  
    4.97
    		  
    4.72
    		  
    2.23
    		  
    1998-1  
    		 
    		 
    		 
    		 
    		 
    		 
    		 
    		 
      Issued April 30, 1998
    4.42
    		  
    5.32
    		  
    4.13
    		  
    4.64
    		  
    4.44
    		  
    2.06
    		  
    —
    		  
    —
    		  
    1998-2  
    		 
    		 
    		 
    		 
    		 
    		 
    		 
    		 
      Issued August 18, 1998
    5.38
    		  
    4.06
    		  
    3.94
    		  
    3.72
    		  
    2.35
    		  
    0.40
    		  
    —
    		  
    —
    		  
           
    		                         

    (A) Includes loans in foreclosure or bankruptcy.

    Table 17
    Delinquencies, Defaults and Losses
    December 31, 1999 and 1998
    (dollars in thousands)

     

       
    NovaStarHomeEquitySeries
    		           
    December 31, 1999   1997-1
    		    1997-2
    		    1998-1
    		  1998-2
    		 
    Warehouse
    		    All Loans
    Allowance for Credit Losses:                          
    		     
    		 
         Balance, January 1, 1999  
    $
    816
    		   $ 1,049   $ 1,163   $ 346  
    $
    		 199    
    $
    		 3,573
         Provision for credit losses    
    4,317
    		     5,436     8,194     4,065  
    		66    
    		22,078
         Amounts charged off, net of  recoveries    
    (2,798
    		 )   (3,624 )   (5,143 )   (2,726 )
    (255
    		 )  
    		(14,546
    )
       
    		 
    		 
    		 
    		 
    		 
         Balance, December 31, 1999   $
    2,335
    		   $ 2,861   $ 4,214   $ 1,685  
    $
    		 10    
    $
    		 11,105
       
    		 
    		 
    		 
    		 
    		   
       
    		                   
    		         
    Defaults as a percent of loan balance  
    		                   
    		         
         Delinquent loans (A)  
    		8.03 %   9.89 %   6.38 %   7.50 %
    91.75
    		 %     7.63
    %
       
    		 
    		 
    		 
    		 
    		   
          Loans in foreclosure    
    4.73
    		     4.32     3.75     4.02  
    		6.76       4.09
       
    		 
    		 
    		 
    		 
    		   
         Real estate owned     3.85     4.88     3.61     2.62  
    		47.00       3.51
       
    		 
    		 
    		 
    		 
    		   

     
    NovaStarHomeEquitySeries
    December 31, 1999
    1997-1
    1997-2
    1998-1
    1998-2
    Warehouse
    All Loans
    Allowance for Credit Losses:      
    		 
    		 
         Balance, January 1, 1998   $
    1,063
    $
    967
    $
    —
    $
    —
    $
    283
    		 
    $
    2,313
         Provision for credit losses    
    1,895
    		 
    2,257
    1,878
    222
    1,178
    		 
    7,430
         
    		 
    		 
         Amounts charged off, net of recoveries    
    (2,142
    )
    		  
    (2,175
    )
    (715
    )
    124
    (1,262
    )
    		  
    (6,170
    )
       
    		 
    		 
         Balance, December 31, 1998   $
    816
    		 
    $
    1,049
    $
    1,163
    $
    346
    $
    199
    		 
    $
    3,573
       
    		 
    		 
           
    		 
    		 
    Defaults as a percent of loan balance    
    		 
    		 
         Delinquent loans (A)    
    6.45
    %
    		  
    5.95
    %
    4.89
    %
    4.06
    %
    98.68
    %
    		  
    5.17
    %
       
    		 
    		 
         Loans in foreclosure .  
    2.63
    		 
    2.96
    3.60
    2.06
    8.82
    		 
    2.80
       
    		 
    		 
         Real estate owned    
    3.54
    		 
    2.76
    1.01
    0.09
    86.11
    		 
    1.56
       
    		 
    		 

    ______________________________________
    (B)     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 ABB. The fee charged is based on the collected loan principal balance of the mortgage loans serviced.

    Net fees for other services provided by NFI Holding Corporation

         Net fees for other services provided by NFI Holding Corporation during 1999 and 1998 are further detailed in Note 12 of NovaStar Financial’s consolidated financial statements. The significant decline in these fees for the year ended December 31, 1999 compared with 1998 is due to the net effect of the following:

    • The decline in the administrative fees paid to NovaStar Mortgage is due to the cancellation of this agreement on March 31, 1999, since NovaStar Financial is no longer purchasing loans from NovaStar Mortgage.
    • The decrease in purchase commitment fees is due to the discontinuance of this intercompany agreement beginning January 1, 1999.
    • The increase in interest income received from NovaStar Mortgage is due to the intercompany agreement that went into effect April 1, 1999.

    General and Administrative Expenses

         General and administrative expenses for the years ended December 31, 1999 and 1998 are provided in Table 18. Table 19 displays the relationship of portfolio expenses to net interest income during 1999 and 1998 by quarter.

    Table 18
    General and Administrative Expenses
    (dollars in thousands)

       
    Years EndedDecember 31,
    		  
     
    		 
       
    1999
    		      
    1998
    		  
     
    		   
    		 
     
    Percent of Stockholders’
    		    
    Percent of Stockholders’
    		  
       
    Equity
    		      
    Equity
    		  
       
    (Annualized)
    		      
    (Annualized)
    		  
     
    		   
    		 
    Compensation and benefits $ 1,804   1.82 %   $ 1,785   2.16 %
    Office administration   804   0.92       903   1.09  
    Professional and outside services   801   0.84     1,117   1.35  
    Other   181   0.11       574   0.69  
     
    		 
    		   
    		 
    		 
    Total general and administrative expenses   3,590   3.69 %     4,379   5.29 %
           
    		         
    		 

    Table 19
    Portfolio Related Expenses as a
    Percent of Net Interest Income
    1999 and 1998

      Percent of
    Stockholders’Equity
    		 
      (Annualized)
    		 
      1999:  
      Fourth quarter 3.63  
      Third quarter 3.06  
      Second quarter 2.07  
      First quarter 3.94  
      1998:  
      Fourth quarter 6.23  
      Third quarter 4.06  
      Second quarter 4.05  
      First quarter 2.80  

         The decrease in portfolio related expenses in 1999 compared with 1998 is attributable in part to increased general and administrative costs incurred during the capital markets’ liquidity crisis of 1998. Also, in 1998, fees were paid for portfolio management related services prior to the hiring of additional personnel to this department in 1998.

    Equity in Earnings (Loss) of NFI Holding Corporation

         For the years ended December 31, 1999, NFI Holding recorded net income of $89,000 compared with a net loss of $3.0 million for the same period of 1998. NovaStar Financial records its portion of the earnings (loss) as equity in net earnings (loss) of NFI Holding in its income statement. NFI Holding's financial position and results of operation for the years ended December 31, 1999 and 1998 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 20 is a summary of the differences between net income or loss reported for GAAP and estimated taxable income for the years ended December 31, 2000 and 1999.

    Table 20
         Estimated Taxable Income (Loss)
    Year Ended December 31, 2000, 1999 and 1998
    (in thousands)

    December 31,
    2000 1999 1998
    Net income (loss) $ 5,626 $ (7,092 ) $ (21,821 )
    Results of NFI Holding and    
       subsidiaries
    (1,123
    		 ) (88 ) 2,984
    Provision for credit losses 5,449 22,078 7,430
    Loans charged-off (8,864 ) (14,546 ) (6,170 )
    Capital losses — — 14,962
    Other, net 461 (442 ) (13 )
    1,549 (90 ) (2,628 )
    Effect of dividends paid (1,538 ) — —
    Use of net operating loss carryforward (11 ) — —
                       
    Estimated taxable loss $ — $ (90 ) $ (2,628 )
                       
    Net operating loss – December 31 $ 2,707 $ 2,718 $ 2,628
                       
    Total dividends paid $ 2,100 $ 1,606 $ 8,124

         Dividends paid on preferred and common stock reduce taxable income of the Company. However, dividends paid in excess of taxable income do not increase the net operating loss carryforward. The net operating loss carryforward will offset future taxable income and, thereby, reduce the amount of required distributions to maintain REIT status under IRS guidelines.

    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. Effective January 1, 2001, NovaStar Financial purchased the outstanding voting stock of NFI Holding from the founders. As a result of this purchase, NFI Holding is now a consolidated subsidiary of NovaStar Financial. This transaction and pro forma consolidated financial statements are presented in Notes 8 and 14 to the consolidated financial statements.

         NFI Holding’s consolidated financial statements as of December 31, 2000 and 1999, which consists primarily of the assets, liabilities, and operational results of NovaStar Mortgage and NovaStar Home Mortgage are presented in Note 12 to the consolidated financial statements.

    Financial Condition of NFI Holding Corporation as of December 31, 2000 and December 31, 1999

         Mortgage Loan Originations. NFI Holding originated 6,266 non-conforming residential mortgage loans during the year ended December 31, 2000 with an aggregate principal amount of $719 million. Virtually all of NFI Holding’s mortgage assets as of December 31, 2000 and 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 21 is a summary of NFI Holding’s wholesale loan originations for 2000 and 1999. Table 22 presents a summary of mortgage loan transfers of NFI Holding during 2000 and 1999. Table 23 is a summary of wholesale loan origination costs of production.

    Table 21
    2000 and 1999 Quarterly Wholesale Loan Originations
    (dollars in thousands, except for average loan balance)

                            Weighted Average      
                           
    		     
        Number
    of
    Loans
    		    Principal
    		  Average
    Loan
    Balance
    		  Price Paid
    to
    Broker
    		  Loan to
    Value
    		  Credit
    Rating (A)
    		  Coupon
    		  Percent with
    Prepayment
    Penalty
    		 
    2000:                                      
       Fourth quarter   1,768   $ 208,232   $ 117,778   101.1   82 % 5.12   10.73 % 86 %
       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   6,266   $ 719,341   $ 114,801   101.1   82 % 5.28   10.51 % 90 %
       
    		 
    		 
    		 
    		 
    		 
    		 
    		 
    		 
                                           
    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 22
    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:                            
       Fourth quarter $ 46,158   $ 1,666   104.6   $ 151,277   $ 3,227  
       Third quarter   50,334     1,552   104.4     188,734   3,584  
       Second quarter   27,799     661   103.8     101,675   1,392  
       First quarter   48,548     1,204   104.0     128,171   1,544  
     
    		 
    		     
    		 
    		 
       2000 total $ 172,839   $ 5,083   104.2   $ 569,857   $ 9,747  
     
    		 
    		 
    		 
    		 
    		 
                                 
    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 23
    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:
       2000 2.9 % 0.5 % 3.4 %
       Fourth quarter 2.8 % 0.5 % 3.3 %
       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:
       1999 4.2 % 0.4 % 4.6 %
       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 quarter 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 24 is a summary of loans originated by state for 2000 and 1999 by quarter. As of December 31, 2000, NovaStar Mortgage had 85 account executives.

    Table 24
    Mortgage Loan Originations by State
    2000 and 1999

        Percent of Total Originations during Quarter
    (based on original principal balance)
    		 
        2000
    		  1999
    		 
    Collateral Location
    		  Fourth
    		  Third
    		  Second
    		  First
    		  Fourth
    		  Third
    		  Second
    		  First
    		 
    California   14 % 11 % 10 % 10 % 10 % 10 % 8 % 6 %
    Florida   11   12   13   14   12   15   12   15  
    Michigan   9   10   11   11   12   10   10   12  
    Ohio   6   7   8   7   8   12   10   8  
    Nevada   5   6   7   7   5   4   4   3  
    Arizona   4   5   5   5   8   5   7   4  
    Colorado   4   5   5   4   2   1   1   2  
    Tennessee   4   4   6   7   6   4   6   9  
    Washington   3   5   5   5   4   4   5   3  
    All other states   40   35   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 27 of the “Liquidity Resources and Capital” section of this document and Note 4 to the consolidated financial statements detail borrowings outstanding under these financing arrangements as of December 31, 2000.

         Mortgage Loan Sales. NovaStar Mortgage executed two securitizations during 2000, combining $570 million in loans, which were sold to a Special Purpose Entity (SPE). A gain of $9.7 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 interest-only and subordinated securities 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 assets and the loans sold have been removed from the balance sheets 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    		 Discount
    Rate
    2000-1   27   1%   15%  
    2000-2   28   1%   15%

         Details regarding loan collateral as of December 31, 2000 and 1999 are included in Tables 4, 5 and 8 of this document.

         NFI Holding also sold $172.8 million of its whole loan portfolio to unrelated third parties for cash at net gains of $5.1 million and an average price to par of 104.2 during 2000. Table 22 of “Financial Condition of NFI Holding Corporation as of December 31, 2000 and 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 or managed 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 25 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 25
    Delinquencies and Defaults
    (dollars in thousands)

        2000
    		  1999
    		 
       
    December 31
    		September 30
    		June 30
    		March 31
    		December 31
    		September 30
    		June 30
    		March 31
    		 
                                          
    Loan servicing                                                  
    portfolio   $ 1,112,615   $ 1,016,952   $ 970,016   $ 872,693   $ 894,572   $ 969,343   $ 1,032,065   $ 1,072,393  
       
    		 
    		 
    		 
    		 
    		 
    		   
    		 
    		 
    Total defaults:                                                  
       Delinquent                                                  
          loans (A)     4.89 %   4.90 %   4.82 %   5.58 %   6.28 %   4.75 %   5.21 %   4.12 %
       
    		 
    		 
    		 
    		 
    		 
    		 
    		 
    		 
       Loans in                                                  
          foreclosure     2.71     3.34     3.25     3.55     3.62     3.79     3.36     3.39  
       
    		 
    		 
    		 
    		 
    		 
    		 
    		 
    		 
       Real estate                                                  
          owned     1.57     1.97     2.07     2.65     2.71     2.24     2.20     1.66  
       
    		 
    		 
    		 
    		 
    		 
    		 
    		 
    		 

    (A) Includes loans delinquent 30 days or greater

         The following table presents a summary of the mortgage loan activity of NFI Holding for 2000 and 1999 as a percent of the respective quarter’s beginning principal of mortgage loans held in portfolio and loan origination principal.

    Table 26
    Mortgage Loan Activity—NFI Holding Corporation

      Sold
    to
    NovaStar
    Financial, Inc.
    		Sold to
    Third
    Parties
    		Sold
    in
    Securitizations
    		Held in
    Portfolio
    		Normal and
    Prepayments
    		Total
                 
    2000
    Fourth quarter
    —
    		  
    9
    		 %
    55
    		 %
    34
    		 %
    2
    		 %
    100
    		 %
    Third quarter
    —
    		  
    9
    		  
    60
    		  
    30
    		  
    1
    		  
    100
    		  
    Second quarter
    —
    		  
    12
    		  
    44
    		  
    43
    		  
    1
    		  
    100
    		  
    First quarter
    —
    		  
    20
    		  
    53
    		  
    26
    		  
    1
    		  
    100
    		  
     
    		 
    		 
    		 
    		 
    		 
    		 
    1999
    		 
    		 
    		 
    		 
    		 
    		 
    Fourth quarter
    —
    		  
    52
    		  
    —
    		  
    46
    		  
    2
    		  
    100
    		  
    Third quarter
    —
    		  
    54
    		  
    —
    		  
    44
    		  
    2
    		  
    100
    		  
    Second quarter
    —
    		  
    32
    		  
    13
    		  
    54
    		  
    1
    		  
    100
    		  
    First quarter
    —
    		  
    25
    		  
    45
    		  
    29
    		  
    1
    		  
    100
    		  

    Results of Operations of NFI Holding Corporation—Year Ended December 31, 2000 Compared to the Year Ended December 31, 1999

         For the year ended December 31, 2000, NFI Holding recorded net income of $1.1 million compared with net income of $89,000 during the same period of 1999. A summarized income statement of NFI Holding is presented in Note 12 to the consolidated financial statements.

         The following summarizes operating results of NFI Holding for the year ended December 31, 2000 compared with the same period of 1999:

    • Fees from third parties increased from $905,000 during 1999 to $9.9 million during 2000. The significant increase is due to broker fees received on loans originated through the mortgage brokers of NovaStar Home Mortgage. NovaStar Home Mortgage operates 60 mortgage broker offices in 27 states. The operations of NovaStar Home Mortgage began in November 1999.

    • Fees received from, net of paid to, Novastar Financial, Inc. declined from $4.0 million in 1999 to $21,000 in 2000, primarily due to changes in the intercompany fee agreements between the two periods. A summary of the intercompany fees by type and changes between the two periods is discussed Note 12 to the consolidated financial statements.

    • During 2000, NovaStar Mortgage recognized net gains of $14.8 million on the sale of whole loans. Of that amount, $9.7 million was recognized in two securitization transactions that closed during the period. The remainder of the gain was primarily due to various whole loan sales to third parties for cash. During the same period of 1999, NovaStar Mortgage recognized gains of $11.8 million on the transfer of whole loans, including $1.6 million on the NMFT 1999-1 asset-backed bond transaction.

    • General and administrative expenses increased from $21.3 million during 1999 to $29.7 million during the same period of 2000. The increase is primarily attributable to various expenses incurred by the broker branches of NovaStar Home Mortgage, including the net income generated from the branches is expensed to the branch in the form of compensation. NovaStar Home Mortgage began providing various accounting and compensation services to mortgage brokerage companies during the fourth quarter of 1999.

    • No income tax expense has been recorded during 2000 because of the existence of substantial net operating loss carryforwards, which are expected to offset all of the pre-tax income in 2000.

    Results of Operations of NFI Holding Corporation—Year Ended December 31, 1999 Compared to the Year Ended December 31, 1998

         For the year ended December 31, 1999 NFI Holding recorded net income of $89,000 compared with a net loss of $3.0 million during 1998. Note 12 of the consolidated financial statements presents a summarized income statement of NFI Holding.

         The following summarizes reasons impacting operating results of NFI Holding for 1999 compared with 1998:

    • Effective July 1998, NovaStar Mortgage began retaining its mortgage loan production to sell to third parties or securitize versus its previous practice of selling 100% of originations directly to NovaStar Financial. Accordingly, NovaStar Mortgage recognized $5.5 million of net interest income on loans in warehouse for the year ended December 31, 1999 compared with $4.3 million during 1998. The net interest income recognized in 1998 also includes interest earned on agency securities. NovaStar Mortgage sold all of its agency securities during the latter part of 1998.
    • Provisions for credit losses in 1999 were $860,000 versus $210,000 in 1998. The increase in the provisions is partly due to the effects of maintaining warehouse loans as well as increases made to the provisions for credit losses in 1999 as discussed under “Provisions for Credit Losses”.

    • The administrative fee agreement between NovaStar Financial and NovaStar Mortgage was cancelled on April 1, 1999. These fees are included in services provided to NovaStar Financial, Inc.

    • During 1999, NovaStar Mortgage recognized net gains of $11.8 million from the sale of whole loans. Of that amount, $1.6 million of the gains recognized were a result of the closing of NovaStar Mortgage's first securitization transaction. The remainder of the gain resulted from various whole loan sales to third parties for cash. During 1998, NovaStar Mortgage recognized gains of $3.0 million on sales of whole loans and $164,000 from selling mortgage securities.

    • NovaStar Mortgage's wholesale origination operation did not operate at full capacity during 1999. The cost of loan production as a percent of principal averaged 4.6% in 1999 versus 3.4% during the 1998, the details of which are presented in Table 23. As a result, NovaStar Mortgage capitalized a lower percentage of origination costs during 1999—which under GAAP are amortized as an adjustment of the yield over the life of the loan versus expensed in the period incurred.

    Liquidity and Capital Resources

         Liquidity means the need for, access to and uses of cash. The primary needs for cash include the acquisition of mortgage loans, principal repayment and interest on borrowings, operating expenses and dividend payments. Substantial cash is required to support the operating activities of the business, especially the mortgage origination operation. Mortgage asset sales, principal, interest and fees collected on mortgage assets and interest-only and subordinated securities will serve to support cash needs. Drawing upon various borrowing arrangements typically satisfies major cash requirements. NovaStar Mortgage requires substantial cash to fund loan originations and operating costs.

         As of December 31, 2000, NFI Holding owned $78.8 million of non-conforming mortgage loans. NFI Holding provided financing for these loans through warehouse and repurchase credit facilities with First Union and GMAC/RFC. Loans financed with warehouse and repurchase credit facilities are subject to changing market valuation and margin calls. Management expects to continue selling loans originated by NovaStar Mortgage or securitizing those loans to meet the significant cash needs of the wholesale loan operation. Management believes NovaStar Financial can operate indefinitely in this manner, provided that the level of loan originations is at or near the capacity of its production infrastructure.

         Table 27 is a summary of cash, financing arrangements and available borrowing capacity for NovaStar Financial and NovaStar Mortgage, on a combined basis, as of December 31, 2000:

    Table 27
    Liquidity Resources
    December 31, 2000
    (in thousands)

    Maturity
    Maximum
    Borrowing
    Limit
    Lending
    Value of
    Collateral
    Borrowings
    Availability
    Resource                  
    		   
    Cash
    		   
    		         
    		  $
    3,760
    Committed facilities with First Union National Bank (A):
    		   
    		   
    		   
    		   
          Warehouse line of credit
    7/27/01
    		   $
    75,000
    		   $
    53,878
    		   $
    24,326
    		     29,552
          Secured whole loan repurchase agreement
    7/27/01
    		    
    175,000
    		    
    517
    		    
    517
    		    
    —
          Residual financing available
    12/17/01
    		    
    25,000
    		    
    (B)
    		    
    25,000
    		    
    —
    Committed facility with GMAC/Residential Funding
    		   
    		   
    		   
    		   
       Corporation (A):
    		   
    		   
    		   
    		   
          Warehouse line of credit
    12/27/00
    		    
    50,000
    		    
    17,212
    		    
    12,057
    		    
    5,155
     
    		 
    		 
    		 
    		 
            Total.
    		  $ 325,000   $ 71,607   $ 61,900   $ 38,467
     
    		 
    		 
    		 
    		 

    (A)
          		     Value of collateral and borrowings include amounts for NovaStar Financial and NovaStar Mortgage, as they are co-borrowers under the arrangements with First Union National Bank and GMAC/RFC.
    (B)   Management estimates the value of the interest-only and subordinated securities range from $60 to $75 million and does not include the value of mortgage servicing rights.

         The warehouse line of credit and whole loan repurchase agreements with First Union National Bank expire on July 27, 2001.

         In the opinion of management, the available liquidity resources are sufficient to cover expected future production of NovaStar Mortgage.

         Cash activity during the years ended December 31, 2000, 1999 and 1998 are presented in the consolidated statement of cash flows.

    The capital of NovaStar Financial has come from

    • a private placement offering of preferred stock, raising net proceeds of $47 million.

    • an initial public offering of common stock, raising net proceeds of $67 million, and

    • a private offering of convertible preferred stock, raising net proceeds of $29 million.

         NovaStar Financial uses capital when financing loans on a long-term basis. Under short-term financing arrangements, NovaStar can borrow up to the lessor of 98% of the face amount or 95% of the market value of the loans it owns. In long-term financing (i.e. in the form of asset-backed bonds) NovaStar can finance approximately 95% of the market value of the loans. NovaStar must use its own capital resources to “finance” the difference between the financed portion and the full loan cost.

         During 1999 and 2000, most of the loans originated by NovaStar Mortgage were sold to third parties and in securitization transactions treated as sales for tax and financial reporting purposes. When selling loans to third parties, NovaStar does not use capital. In fact, if the sales prices are above the full cost to originate loans, this method of operation will generate capital for NovaStar.

         During 2001, management expects to securitize 75% of the loans produced by NovaStar Mortgage. The remainder will be sold to third parties. NovaStar currently has excess capital available to support this mode of operation during 2001. When NovaStar Financial fully deploys its capital, management expects to either raise more equity from the capital markets or sell enough loans so that it operates without the need for additional capital.

    Inflation

         Virtually all assets and liabilities of NovaStar Financial are financial in nature. As a result, interest rates and other factors drive company performance far more than does inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. The financial statements of NovaStar Financial are prepared in accordance with generally accepted accounting principles and the dividends are based on taxable income. In each case, financial activities and balance sheet are measured with reference to historical cost or fair market value without considering inflation.

    Impact of Recently Issued Accounting Pronouncements

         Note 1 to the consolidated financial statements describes certain recently issued accounting pronouncements.

    Item 8.   Financial Statements and Supplementary Data

    NOVASTAR FINANCIAL, INC.
    CONSOLIDATED BALANCE SHEETS
    (Dollars in thousands, except share amounts)
    December 31,
    2000 1999
    Assets
       Cash and cash equivalents $ 2,518 $ 2,395
       Mortgage loans 375,927    620,406
       Mortgage securities – available-for-sale 46,650 6,775
       Advances to and investment in NFI Holding Corporation 45,415 29,278
       Assets acquired through foreclosure 13,054 16,891
       Accrued interest receivable 9,151 12,452
       Other assets 1,767 1,230
                         Total assets $ 494,482 $ 689,427
    Liabilities and Stockholders' Equity
       Liabilities:
          Borrowings $ 382,437 $ 586,868
          Accounts payable and other liabilities 3,601 1,873
          Dividends payable 525 525
                      Total liabilities 386,563 589,266
       Commitments and contingencies
       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 as of December 31, 2000 43 43
             Common stock, 6,094,595 and 7,460,523 shares issued
                and outstanding, respectively 61 75
          Additional paid-in capital 141,997 147,587
          Accumulated deficit (37,976 ) (41,502 )
          Accumulated other comprehensive income 10,168 242
          Notes receivable from founders (6,374 ) (6,284 )
                      Total stockholders' equity 107,919 100,161
                         Total liabilities and stockholders' equity $ 494,482 $ 689,427

    See accompanying notes to consolidated financial statements.

    NOVASTAR FINANCIAL, INC.
    CONSOLIDATED STATEMENTS OF OPERATIONS
    (Dollars in thousands, except per share amounts)

    For the Year Ended
    December 31,
     
    		 
    2000
    1999
    1998
    Interest income on mortgage loans $ 44,676   $ 66,324   $ 76,751  
    Interest expense on mortgage loans   33,964     46,758     58,174  
     
                       
    Net interest income   10,712     19,566     18,577  
    Prepayment penalty income   1,776     3,143     1,985  
    Provision for credit losses   (5,449 ) (22,078 )   (7,430 )
    Premiums for mortgage loan insurance   (1,272 )   (1,731 )   (744 )
    Loan servicing fees paid to NFI Holding Corporation   (2,502 )   (3,886 )   (3,803 )
     
                       
    Net loan portfolio income (loss)   3,265     (4,986 )   8,585  
                       
    Interest income on mortgage-backed securities   2,951     389     23,996  
    Interest expense on mortgage-backed securities   732     —     22,620  
     
    Net interest income on mortgage-backed securities   2,219     389     1,376  
                       
    Net fees for other services provided to (by) NFI                  
       Holding Corporation   2,481     (145 )   (2,683 )
    Gain (loss) on sales of mortgage assets   (826 )   351     (14,962 )
    Loss on termination of interest rate agreements   —     —     (7,977 )
    Other income   381     801     1,203  
                       
    Equity in net income (loss) of NFI Holding Corporation   1,123     88     (2,984 )
                       
    General and administrative expenses:                  
       Compensation and benefits   1,485     1,804     1,785  
       Office administration   751     804     903  
       Professional and outside services   690     801     1,117  
       Other   91     181     574  
     
       Total general and administrative expenses   3,017     3,590     4,379  
     
                       
    Net income (loss)   5,626     (7,092 )   (21,821 )
     
                       
    Dividends on preferred shares   2,100     1,606     —  
     
                       
    Net income (loss) available to common shareholders $ 3,526   $ (8,698 ) $ (21,821 )
     
    Earnings (loss) per share:                  
       Basic $ 0.51   $ (1.08 ) $ (2.71 )
       Diluted $ 0.50   $ (1.08 ) $ (2.71 )
                       
    Weighted average shares outstanding:                  
       Basic   6,851     8,032     8,057  
       Diluted   11,143     8,032     8,057  

    See accompanying notes to consolidated financial statements.

    NOVASTAR FINANCIAL, INC.
    CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
    (Dollars in thousands, except share amounts)

     
    Convertible
    Preferred
    Stock
     
    Common
    Stock
     
    Additional
    Paid-in
    Capital
    		 
    Accumulated
    Deficit
     
    Accumulated Other 
    Comprehensive Income
     
    Notes Receivable
    from Founders
    Total Stockholders' Equity
    		  
    Balance, January 1, 1998  
    		 
    $
    		 78    
    $
    		 117,201    
    $
    		 (2,859 )  
    $
    		 4,353    
    $
    		 (3,047 )  
    $
    		 115,726  
    Initial public offering of common stock issuance costs  
    		    —       (88 )  
    		—    
    		—       —       (88 )
    Exercise of stock options and warrants  
    		    3       5,184    
    		—    
    		—       (4,340 )     847  
    Issuance of additional notes receivable from founders  
    		    —       —    
    		—    
    		—       (80 )     (80 )
    Interest accrued on notes receivable from founders, net of payments  
    		    —       —    
    		—    
    		—       (260 )     (260 )
    Change in fair value of restricted stock awards underlying forgivable notes  
    		    —       (1,390 )  
    		—    
    		—       1,390       —  
    Dividends on common stock ($1.00 per share)  
    		    —       —    
    		(8,124 )  
    		—       —       (8,124 )
       
    		 
    		   
    		   
    		 
    		     
    		   
    		 
       
    		                         
    		                   
       Comprehensive loss:  
    		                         
    		                   
          Net loss  
    		                  (21,821 )  
    		—               (21,821 )
             Other comprehensive loss—change in unrealized gain (loss) on available-for-sale securities  
    		                   
    —
    		    
    		(4,353 )             (4,353 )
       
    		                 
    		   
    		           
    		 
                   Total comprehensive loss  
    		                  (21,821 )     (4,353 )             (26,174 )
       
    		                 
    		   
    		           
    		 
    Balance, December 31, 1998  
    		    81       120,907     (32,804 )     —       (6,337 )     81,847  
    Proceeds from preferred stock issuance, net of costs of $1,323  
    $
    43
    		     —       28,635       —       —       —       28,678  
    Exercise of stock options and warrants  
    —
    		     —       8       —       —       —       8  
    Issuance of additional notes receivable from founders  
    —
    		     —       —       —       —       (70 )     (70 )
    Warrants issued  
    —
    		     —       350       —       —       —       350  
    Common stock repurchased, 673,400 shares  
    —
    		     (6 )     (1,871 )     —       —       —       (1,877 )
    Interest accrued on notes receivable from founders, net of payments  
    —
    		     —       —       —       —       (319 )     (319 )
    Change in fair value of restricted stock awards underlying forgivable notes  
    —
    		     —       (442 )     —       —       442       —  
    Dividends on preferred stock ($0.37 per share)  
    —
    		     —       —       (1,606 )     —       —       (1,606 )
       
    		 
    		   
    		   
    		   
    		   
    		   
    		 
       
    		                                               
       Comprehensive income (loss):  
    		                                               
          Net loss  
    		                    (7,092 )     —               (7,092 )
             Other comprehensive income—change in unrealized gain (loss)  
    		                                               
                on available-for-sale securities  
    		                    —       242               242  
       
    		                 
    		   
    		           
    		 
                   Total comprehensive income (loss)  
    		                    (7,092 )     242               (6,850 )
       
    		                 
    		   
    		           
    		 
       
    		                                               
    Balance, December 31, 1999  
    43
    		     75       147,587       (41,502 )     242       (6,284 )     100,161  
       
    		 
    		   
    		   
    		   
    		   
    		   
    		 
    Exercise of stock options and warrants  
    —
    		     —       24       —       —       —       24  
    Common stock repurchased, 1,376,766 shares  
    —
    		     (14 )     (5,704 )     —       —       —       (5,718 )
    Change in fair value of restricted stock awards underlying forgivable notes  
    —
    		     —       90       —       —       (90 )     —  
    Dividends on preferred stock ($0.49 per share)  
    —
    		     —       —       (2,100 )     —       —       (2,100 )
       
    		 
    		   
    		   
    		   
    		   
    		   
    		 
       
    		 
    		                                           
       Comprehensive income:    
    		                                               
          Net income    
    		                    5,626       —               5,626  
             Other comprehensive income—change in unrealized gain    
    		                                               
                on available-for-sale securities    
    		                    —       9,926               9,926  
         
    		                 
    		   
    		           
    		 
                   Total comprehensive income    
    		                    5,626       9,926               15,552  
         
    		                 
    		   
    		           
    		 
    Balance, December 31, 2000  
    $
    43
    		   $ 61    
    $
    		 141,997    
    $
    		 (37,976 )   $ 10,168    
    $
    		 (6,374 )  
    $
    		 107,919  
       
    		 
    		   
    		   
    		   
    		   
    		   
    		 
         
    		                                               
    See accompanying notes to consolidated financial statements.    
    		                                               
    NOVASTAR FINANCIAL, INC.
    CONSOLIDATED STATEMENTS OF CASH FLOWS
    (In thousands)
    For the Year Ended December 31,
    2000 1999 1998
    Cash flow from operating activities:
    Net income (loss) $ 5,626   $ (7,092 ) $ (21,821 )
    Adjustments to reconcile net income (loss) to cash provided by operating activities:
       Amortization of premiums on mortgage assets 4,944 8,088 7,620
       Amortization of deferred debt costs 1,141 2,271 4,562
       Provision for credit losses 5,449 22,078 7,430
       Equity in net loss (income) of NFI Holding Corporation (1,123 ) (88 ) 2,984
       Losses (gains) on sales of mortgage assets 826 (351 ) 14,962
       Loss on terminations of interest rate agreements — — 7,977
       Change in:
          Accrued interest receivable 3,301 5,156 (6,807 )
          Other assets (814 ) 73 (1,638 )
          Other liabilities 1,869 (300 ) (9,219 )
             Net cash provided by operating activities 21,219 29,835 6,050
    Cash flow from investing activities:
       Mortgage loans purchased from NovaStar Mortgage, Inc — — (556,158 )
       Mortgage loans sold to others — 4,932 8,307
       Mortgage loan repayments 201,880 260,109 161,237
       Proceeds from sales of assets acquired through foreclosure 35,263 24,228 6,815
       Proceeds from sales of available-for-sale securities — — 705,906
       Proceeds from paydowns on available-for-sale securities 3,653 882 165,233
       Investment in NFI Holding Corporation — (7,000 ) (990 )
       Net change in advances to NFI Holding Corporation (48,526 ) (8,127 ) (390,919 )
             Net cash provided by investing activities 192,270 275,024 99,431
    Cash flow from financing activities:
       Proceeds from issuance of asset-backed bonds — — 665,000
       Payments on asset-backed bonds (230,572 ) (307,318 ) (179,851 )
       Debt issuance costs paid on asset-backed bonds — — (2,821 )
       Change in short-term borrowings 25,000 (18,029 ) (581,693 )
       Proceeds from issuance of capital stock and exercise of equity         instruments, net of offering costs 24 28,686 (54 )
                   
         
       Common stock repurchases (5,718 ) (1,877 ) —
       Dividends paid on preferred stock (2,100 ) (1,081 ) —
       Dividends paid on common stock — (2,845 ) (6,062 )
    		 
             Net cash used in financing activities (213,366 ) (302,464 ) (105,481 )
    		 
    Net increase in cash and cash equivalents 123 2,395 —
    Cash and cash equivalents, beginning of year 2,395 — —
    Cash and cash equivalents, end of year $ 2,518   $ 2,395 $ —
    		 
    Supplemental disclosure of cash flow information:
       Cash paid for interest $ 34,610   $ 48,397 $ 80,604
    		 
       Purchases of available-for-sale securities $ (33,371 )   $ — $ (375,051 )
    		 
       Note received in exchange for options exercised by founders $ —   $ — $ 4,591
    		 
       Issuance of warrants $ —   $ 350 $ 813
    		 
       Dividends payable $ 525   $ 525 $ 2,845
    		 
       Assets acquired through foreclosure $ 34,596   $ 30,966 $ 17,242
     
    		   
    		 
    		 
                         
    See accompanying notes to consolidated financial statements.                    

    NOVASTAR FINANCIAL, INC.
    NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
    December 31, 2000

    Note 1.  Summary of Significant Accounting Policies

         NovaStar Financial, Inc. (the Company) is a Maryland corporation formed on September 13, 1996. The Company manages a portfolio of mortgage assets primarily consisting of non-conforming mortgage loans.

         Financial Statement Presentation The Company's financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and prevailing practices within the financial services industry. The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of income and expense during the period. The Company uses estimates and employs the judgements of management in determining the amount of its allowance for credit losses, amortizing premiums or accreting discounts on its mortgage assets, and establishing the fair value of its mortgage securities. While the financial statements and footnotes reflect the best estimates and judgments of management at the time, actual results could differ from those estimates. For example, it is possible that credit losses or prepayments could rise to levels that would adversely affect profitability if those levels were sustained for more than brief periods.

         The Company owns 100% of the common stock of three special purpose entities – NovaStar Assets Corporation, NovaStar Mortgage Funding Corporation and NovaStar Certificates Financing Corporation. The Company formed these entities in connection with the issuance of asset-backed bonds. The consolidated financial statements of the Company include the accounts of these entities. Significant intercompany accounts and transactions have been eliminated during consolidation.

         The Company also owns 100% of the nonvoting preferred stock of NFI Holding Corporation, for which it receives 99% of any dividends paid by NFI Holding Corporation. The founders of the Company own 100% of the common stock of NFI Holding Corporation and serve as officers and directors of NFI Holding Corporation and its subsidiaries. The Company accounts for its investment in NFI Holding Corporation using the equity method. The preferred stock was purchased in February 1997 for $1,980,000 and the Company contributed $7,000,000 and $990,000 of capital to NFI Holding Corporation during 1999 and 1998, respectively. As discussed in Note 15, the common stock of NFI Holding Corporation was acquired by the Company subsequent to December 31, 2000.

         NFI Holding Corporation owns 100% of the outstanding common stock of NovaStar Mortgage, Inc. NovaStar Mortgage originated a substantial portion of the non-conforming residential mortgage loans owned by the Company and services all of the loans owned by the Company.

         Cash and Cash Equivalents The Company considers investments with maturities of three months or less at the date of purchase to be cash equivalents.

         Mortgage Loans Mortgage loans include loans acquired from NovaStar Mortgage and in bulk pools from other originators and securities dealers. Mortgage loans are generally purchased at a premium over the outstanding principal balance and are stated at amortized cost. Premiums are amortized and discounts accreted as yield adjustments over the estimated lives of the loans using a method that approximates the interest method. Amortization includes the effect of prepayments.

         Interest is recognized as revenue when earned according to the terms of the mortgage loans and when, in the opinion of management, it is collectible. The accrual of interest on loans is discontinued when, in management's opinion, the interest is not collectible in the normal course of business, but in no case beyond when a loan becomes ninety days delinquent. Interest collected on non-accrual loans is recognized as income upon receipt.

         The Company maintains an allowance for credit losses inherent in the portfolio at the balance sheet date. The allowance is based upon the assessment by management of various factors affecting its mortgage loan portfolio, including current and projected economic conditions, the makeup of the portfolio based on credit grade, loan-to-value, delinquency status, Company purchased mortgage insurance and other factors deemed to warrant consideration. The allowance is maintained through ongoing provisions charged to operating income and is reduced by loans that are charged off.

         Mortgage Securities The Company classifies all of its mortgage securities as available-for-sale and, therefore, reports them at their estimated fair value with unrealized gains and losses reported as a separate component of stockholders' equity. Premiums are amortized and discounts are accreted as yield adjustments over the estimated lives of the securities using the interest method. Amortization includes the effect of prepayments. Gains or losses on sales of securities are recognized using the specific identification method.

         Assets Acquired Through Foreclosure Real estate owned, which consists of residential real estate acquired in satisfaction of loans, is carried at the lower of cost or estimated fair value less estimated selling costs. Adjustments to the loan carrying value required at time of foreclosure are charged against the allowance for credit losses. Losses or gains from the ultimate disposition of real estate owned are charged or credited to operating income.

     

         Transfers of Assets The Company uses the financial components approach when accounting for transfers of mortgage loans in repurchase and securitization transactions. When the Company retains control over the loans, repurchase and securitization transactions are accounted for as secured borrowings rather than as sales. The borrowings under repurchase agreements and asset-backed bonds included in the accompanying consolidated balance sheets represent the remaining principal amount of funds received in the transfer.

         Retained Interests in Securitizations The Company typically purchases retained interests in securitizations of residential mortgage loans offered by its affiliate, NovaStar Mortgage, Inc. To determine the fair value of these retained interests, the Company generally estimates fair value based on the present value of future expected cash flows estimated using management’s best estimate of the key assumptions – credit losses, prepayment speeds, forward yield curves, and discount rates commensurate with the risks involved.

         Stock-based Compensation Compensation expense for services the Company receives as consideration for stock issued through its employee stock option plans is measured by the quoted market price of the stock at the measurement date less the amount, if any, that the employee is required to pay.

         Income Taxes The Company intends to operate and qualify as a Real Estate Investment Trust (REIT) under the requirements of the Internal Revenue Code. Therefore, the Company, and its qualified REIT subsidiaries, will generally not be subject to federal income taxes at the corporate level on taxable income distributed to stockholders. Requirements for qualification as a REIT include various restrictions on common stock ownership and the nature of assets and sources of income. In addition, a REIT must distribute at least 95% of its annual taxable income to its stockholders. As a result of a change in IRS Tax Code, beginning January 1, 2001, the Company will be required to distribute 90% of its annual taxable income to its stockholders in order to retain its REIT status. If in any tax year, the Company does not qualify as a REIT, it will be taxed as a corporation and distributions to stockholders will not be deductible in computing taxable income. If the Company fails to qualify as a REIT in any tax year, it will not be permitted to qualify for the succeeding four years. The most significant difference between earnings as presented herein and taxable income relates to provisions made to the allowance for credit losses, which are not deductible for income tax purposes. NFI Holding Corporation has not elected REIT-status and files a consolidated federal income tax return with its subsidiaries.

         Net income (Loss) Per Share Basic income (loss) per share excludes dilution and is computed by dividing net income (loss) available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. Diluted EPS is calculated assuming all options and warrants on the Company’s common stock have been exercised and the convertible preferred stock is converted, unless the exercise would be anti-dilutive.

         Financial Instruments with Off-balance-sheet Risk The Company has entered into interest rate swap and cap agreements designed to, in effect, alter the interest rates on its funding costs to more closely match the yield on interest-earning assets. Net income earned from or expense incurred on interest rate swap and cap agreements is accounted for on the accrual method and is recorded as an adjustment of interest expense. The gain or loss on early termination, sale or disposition of an interest rate swap or cap agreement is recognized in current earnings if the matched funding source is also extinguished. If the matched funding source is not extinguished, the unrealized gain or loss on the related interest rate swap or cap agreement is deferred and amortized as a component of interest expense over the remaining term of the matched funding source. Unmatched swap or cap agreements are recorded at fair value with changes in the unrealized gains or losses recorded in current earnings.

         New Accounting Pronouncements During 1998, the Financial Accounting Standards Board (FASB) issued SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”. As amended by SFAS No. 137, “Accounting for Derivative Instruments and Hedging Activities—Deferral of the Effective Date of FASB Statement No. 133” and SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of FASB Statement No. 133,” 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 requires derivative instruments to be recorded at their fair value with hedge ineffectiveness recognized in earnings.

         Management has reviewed all financial instruments of NovaStar Financial and has determined that NovaStar Financial’s interest rate cap agreements are derivative instruments as defined by 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. The Company adopted SFAS 133 on January 1, 2001 and the transition adjustment is discussed in Note 5.

     

             During September 2000, the FASB issued SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – a replacement of FASB Statement No. 125”. Although SFAS No. 140 revises many of the rules regarding securitizations, it continues to require an entity to recognize the financial and servicing assets it controls and the liabilities it has incurred and to derecognize financial assets when control has been surrendered in accordance with the criteria provided in the Statement. This statement is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001 and is effective for recognition and reclassification of collateral for fiscal years ending after December 15, 2000. Disclosure about securitizations 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. Implementation of the recognition and classification portion of SFAS No. 140 had no impact on the financial statements of the Company. Accounting for future transfers of assets will be evaluated based on the terms of individual transactions.

            During 1999, the FASB issued EITF No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets.” Effective the second quarter of 2001, EITF No. 99-20 provides guidance on the recognition of interest income from, and measurement of retained beneficial interests. Management does not believe the implementation of EITF No. 99-20 will have a material effect on the Company’s consolidated financial statements.

    Reclassifications Certain reclassifications of prior year amounts have been made to conform to current year presentation.

    Note 2. Mortgage Loans

             Mortgage loans, all of which are secured by residential properties, consisted of the following as of December 31 (in thousands).

      2000 1999  
      Outstanding principal $ 375,872 $ 618,822  
      Net unamortized premium 7,745 12,689
    Amortized cost 383,617 631,511
    Allowance for credit losses (7,690 ) (11,105 )
     
    $ 375,927 $ 620,406
    		 

             Activity in the allowance for credit losses is as follows for the three years ended December 31, 2000 (in thousands)

      2000 1999 1998
      Balance, January 1 $ 11,105 $ 3,573 $ 2,313
      Provision for credit losses 5,449 22,078 7,430
    Amounts charged off, net of recoveries (8,864 ) (14,546 ) (6,170 )
     
    Balance, December 31 $ 7,690 $ 11,105 $ 3,573

               Recoveries for the three years ended December 31, 2000 were insignificant.

             All mortgage loans serve as collateral for borrowing arrangements discussed in Note 4. The weighted-average interest rate on loans as of December 31, 2000 and 1999 was 11.02% and 10.30%, respectively.

            Collateral for 16%, 15% and 6% of the mortgage loans outstanding as of December 31, 2000 was located in Florida, California and Washington, respectively. The Company has no other significant concentration of credit risk.

    Note 3. Mortgage Securities – available-for-sale

             As of December 31, 2000, available-for-sale mortgage securities consisted of the Company’s investment in the subordinated and interest-only bond portions of NovaStar Mortgage Funding Trust, Series 2000-2, 2000-1, and 1999-1 (NMFT 2000-2, 2000-1, and 1999-1) which were issued by NovaStar Mortgage as Real Estate Mortgage Investment Conduits. The primary (A-class) bonds were sold to parties independent of the Company and its affiliates. The Company purchased the subordinated and interest-only bonds from NovaStar Mortgage. No active trading market for the purchase and sale of the retained securities exists. Therefore, management estimates their value by discounting the expected future cash flow of the collateral and bonds.

             As of December 31, 2000, key economic assumptions and the sensitivity of the current fair value of retained interests owned by the Company to immediate adverse changes in those assumptions are as follows (dollars in thousands):

     

    NMFT 2000-2 NMFT 2000-1 NMFT 1999-1   Total
    Carrying amount/fair value of retained interests $ 24,800   $ 14,950   $ 6,900   $ 46,650
    Weighted-average life (in years) 2.47   2.49   2.46   
    Prepayment speed assumption (annual rate) 32 %    32 %    32 %  
                                 
       Fair value after a 10% adverse change $ 24,000   $ 14,475   $ 6,675   $ 45,150
       Fair value after a 20% adverse change 23,320   14,040   6,470   43,830
    Expected credit losses (annual rate) 1.02 %   1.07 %   2.48 %  
         
       Fair value after a 10% adverse change $ 24,765   $ 14,850   $ 6,740   $ 46,355
       Fair value after a 20% adverse change 24,550   14,700   6,500     45,750
    Residual cash flows discount rate (annual) 15 %   14.8 %   16.5 %  
         
       Fair value after a 200 basis point adverse change $ 24,656   $ 14,770   $ 6,810   $ 46,236
       Fair value after a 400 basis point adverse change 24,170   14,540   6,695   45,405
    Interest rates on variable and adjustable contracts Forward one-month LIBOR yield curve plus contracted spread
     
       Fair value after a 50 basis point adverse change $ 22,735   $ 13,750   $ 6,935   $ 43,420
       Fair value after a 100 basis point adverse change 19,570   12,700   6,925     39,195

         These sensitivities are hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 10% variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table the effect of a variation in a particular assumption on the fair value of the retained interest is calculated without changing any other assumption; in reality, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments and increased credit losses), which might magnify or counteract the sensitivities.

          Actual and projected static pool credit losses in retained interests are as follows:

    Credit Losses (%) NMFT 2000-2 NMFT 2000-1 NMFT 1999-1
               
    Projected as of December 31, 2002
       0.24%
       0.30%
    		  
    2.12%
     
    		 
    Projected as of December 31, 2001
       0.03%
       0.13%
    		  
    1.79%
               
    Actual as of December 31, 2000
    —
    —
    		  
    0.94%

         Static pool losses are calculated by summing the actual and projected future credit losses and dividing them by the original balance of each pool of assets.

         The table below presents quantitative information about delinquencies, net credit losses, and components of securitized financial assets and other assets managed together with them (in thousands):

      December 31,
    		   
      Total Principal
    Amount of Loans
    		  Principal Amount of
    Loans 30 Days or
    More Past Due
    		  Net Credit Losses
    During the Year
    Ended December 31
      2000
    		  1999
    		  2000
    		  1999
    		  2000
    		  1999
    NMFT 2000-2 $ 333,865   $
         —
    		   $   3,401   $
        —
    		   $
       —
    		   $ —
    NMFT 2000-1   216,216          —     11,719         —        —    
    —
    NMFT 1999-1   103,968     143,328     14,371     14,496     1,184    
    —

     

     

    Note 4. Borrowings

             Asset-backed Bonds (ABB) The Company also issued ABB secured by its mortgage loans as a means for long-term financing. For financial reporting and tax purposes, the mortgage loans held as collateral are recorded as assets of the Company and the ABB are recorded as debt. Interest and principal on each ABB is payable only from principal and interest on the underlying mortgage loans collateralizing the ABB. Interest rates reset monthly and are indexed to one-month LIBOR. The estimated weighted-average months to maturity is based on estimates and assumptions made by management. The actual maturity may differ from expectations. However, the Company retains the option to repay the ABB, and reacquire the mortgage loans, when the remaining unpaid principal balance of the underlying mortgage loans falls below 35% of their original amounts for issue 1997-1 and 25% on 1997-2, 1998-1 and 1998-2. Following is a summary of outstanding ABB and related loans (dollars in thousands):

      Asset-backed Bonds
    		  Mortgage Loans
      Remaining
    Principal     		  Interest
    Rate     		  Remaining
    Principal
    (A)     		  Weighted
    Average
    Coupon     		  Estimated
    Weighted
    Average Months
    to Call
    As of December 31, 2000:                            
       NovaStar Home Equity Series:                            
          Issue 1997-1   $ 48,121   7.13 %   $ 52,910   11.80 % —  
          Issue 1997-2     51,114   6.91       55,736   11.55   1  
          Issue 1998-1     105,780   6.92   117,121   11.03   11  
          Issue 1998-2     153,508   6.86   163,039   10.57   23  
          Unamortized debt                            
             issuance costs, net     (1,086 )                    
       
    		                     
        $ 357,437                      
       
    		                     
    As of December 31, 1999:                            
    NovaStar Home Equity Series:                            
          Issue 1997-1   $ 75,580   6.94 %   $ 87,534   11.04 % —  
          Issue 1997-2     95,053   6.72   104,851   10.90   13  
          Issue 1998-1   186,493   6.55   200,625   10.08   23  
          Issue 1998-2   231,969   6.71   244,109   9.97   35  
          Unamortized debt                            
          Issuance costs, net     (2,227 )                    
       
    		                     
        $ 586,868                      
       
    		                     

    __________________
    (A)   Includes assets acquired through foreclosure.

             Short-term Financing Arrangements   The Company is a co-borrower with NovaStar Mortgage under warehouse lending and master repurchase agreements with First Union National Bank. The Company and NovaStar Mortgage can borrow up to $75 million under the warehouse lending agreement and $175 million under the master repurchase agreement. As of December 31, 2000 and 1999, the Company had no borrowings outstanding and NovaStar Mortgage had borrowings of $24,843,000 and $78,448,000 outstanding under these arrangements, respectively. Borrowings are secured by mortgage loans owned by NovaStar Mortgage. The interest rate on borrowings under the warehouse lending arrangement is indexed to the Federal funds rate. Under the master repurchase agreement, borrowings are indexed to one-month LIBOR. These agreements expire on July 27, 2001. Upon expiration, the Company expects to renew these arrangements on substantially the same terms.

             Under the terms of two additional repurchase agreements, the Company and/or NovaStar Mortgage can borrow up to $25 million from First Union National Bank secured by subordinated classes of asset-backed bonds issued by the Company, its affiliates or subsidiaries. Borrowings under these arrangements generally bear interest at one-month LIBOR plus a spread depending on the nature of the collateral. These agreements expire on December 17, 2001. The Company had $25,000,000 outstanding under these agreements as of December 31, 2000. In connection with the execution of the financing agreements with First Union, the Company issued First Union warrants for the purchase of the Company’s stock (see Note 7.).

             The Company is also a co-borrower under a warehouse lending agreement with GMAC/Residential Funding Corporation (GMAC/RFC). The Company and/or NovaStar Mortgage can borrow up to $50 million under this agreement. NovaStar Mortgage had borrowings of $12,057,000 under this agreement as of December 31, 2000. Borrowings are secured by mortgage loans owned by the Company or NovaStar Mortgage and bear interest at a rate indexed to one-month LIBOR. The agreement expires on February 28, 2001.

     

           The Company had a short-term financing arrangement with GMAC/RFC secured by residual interests in the Company’s ABB. In 1998, the Company borrowed $15 million from GMAC/RFC. As discussed in Note 7, in connection with the agreement, the Company issued warrants to GMAC/RFC for the purchase of the Company’s stock. The financing fee and the estimated value of the warrants ($813,000) were recognized as additional interest expense in 1998. All amounts were repaid in February 1999.

         Average daily balances for short-term borrowings of the Company were as follows (in thousands).

        2000     1999     1998
    Repurchase agreements secured by mortgage securities $
    9,172
    		   $
    —
    		   $
    392,854
    Borrowings under warehouse lines of credit  
    —
    		    
    —
    		    
    14,991
    Repurchase agreements secured by mortgage loans  
    —
    		    
    —
    		    
    118,380
    Other short-term borrowings  
    —
    		    
    4,206
    		    
    3,945

         All short-term financing arrangements require the Company and NovaStar Mortgage to maintain minimum tangible net worth, meet a minimum equity ratio test and comply with other customary debt covenants. The Company and NovaStar Mortgage complied with all debt covenants through December 31, 2000.

    Note 5. Financial Instruments with Off-balance-sheet Risk

         The Company’s interest rate cap agreements result in off-balance-sheet risk. These instruments involve, to varying degrees, elements of credit and market risk in addition to the amount recognized in the financial statements.

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

         Market Risk The potential for financial loss due to adverse changes in market interest rates is a function of the sensitivity of each position to changes in interest rates, the degree to which each position can affect future earnings under adverse market conditions, the source and nature of funding for the position, and the net effect due to offsetting positions. The synthetic product of these transactions is a "matched" position for the Company. The combination of off-balance-sheet instruments with on-balance-sheet liabilities leaves the Company in a market risk position that is designed to be a better position than if the derivative had not been used in interest rate risk management. Derivatives instruments used in matched transactions as described above are classified as derivatives held for purposes other than trading. No derivatives were held for trading purposes during the three years ended December 31, 2000.

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

         Information regarding the Company’s financial instruments with off-balance-sheet risk is as follows (dollars in thousands).

      Notional   Unrealized
    		Weighted
    Days to     		Weighted
    Average
      Value   Gains   Losses Maturity Cap Rate
    As of December 31, 2000:                  
       Interest rate cap agreements $
    340,000
    		   $
    —
    		   $
    1,349
    400
    6.76%
     
    		 
    		 
    As of December 31, 1999:                
       Interest rate cap agreements $
    430,000
    		   $
    778
    		   $
    —
    578
    6.45%
     
    		 
    		 
    		 

         During the three years ended December 31, 2000, the Company recognized $4,000, $2,254,000, and $2,891,000, respectively, in interest expense relating to off-balance-sheet financial instruments. In 1998, the Company terminated interest rate agreements with an aggregate notional value of $469 million because of the sale of the Company’s portfolio of mortgage securities and repayment of the related financing under repurchase agreements, incurring net losses of $7,977,000.

         The Company adopted SFAS 133 on January 1, 2001. The transition adjustment recognized upon adoption decreased earnings $1.4 million and increased accumulated other comprehensive income $34,000, which represents the difference between the interest rate caps’ carrying value at January 1, 2001 and their fair value. The Company is required to exclude from its assessment of hedge effectiveness changes in the time value of its interest rate caps, which must be adjusted through earnings as hedge ineffectiveness. Changes in intrinsic value are adjusted through other comprehensive income. The Company’s interest rate caps are effective as cash flow hedges. Therefore, the transition adjustment to earnings of $1.4 million resulted from the difference between the recorded time value of the interest rate caps and their estimated time value based on market information on January 1, 2001, rather than an adjustment of their intrinsic value for any ineffectiveness.

    Note 6.  Fair Value of Financial Instruments

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

         The estimated fair values of the Company's financial instruments are as follows as of December 31 (in thousands).

     
    2000
    1999
    		 
     
    Carrying
    Value
     
    Fair
    Value
     
    Carrying
    Value
     
    Fair
    Value
    Financial assets:                        
       Mortgage loans
    $
    		 375,927  
    $
    		 371,904   $ 620,406  
    $
    		 612,144  
       Mortgage securities - available-for-sale
    		46,650  
    		46,650     6,775  
    		6,775  
       Financial liabilities:
    		   
    		         
    		   
       Borrowings
    		382,437  
    		382,646     586,868  
    		587,245  
       Off-balance-sheet financial instruments
    		1,510  
    		161     594  
    		1,372  

         The fair value of all financial instruments is estimated by discounting projected future cash flows, including projected prepayments for mortgage assets, at current market rates. The fair value of cash and cash equivalents and accrued interest receivable and payable approximates its carrying value.

    Note 7.  Stockholders’ Equity

         On March 29, 1999, the Company completed a private placement of preferred stock by issuing 4,285,714 shares of class B, 7% cumulative convertible preferred stock for $7 per share and received net proceeds of $28.7 million. The preferred stock pays a dividend equal to the greater of 7% or the dividend rate paid on common stock. Each share of preferred stock is convertible, at the option of the holder, into one share of common stock and is redeemable for $7 per share by the Company any time after March 31, 2002.

         As of December 31, 2000, the Company has the following warrants outstanding for the purchase of Company common stock.

    Quantity
    Exercise
    Price
         
    Expiration
    Date
               
    4,014,800
    $
    		 11.62 2001
    350,000
    		6.94 2002
    812,731
    		4.56 2003
        
    5,177,531

         The founders of the Company were issued 261,866 of the warrants expiring in 2001 (see Note 8). The warrants that expire in 2002 and 2003 were issued to First Union and GMAC/RFC, respectively, in connection with the execution of short-term financing arrangements as discussed in Note 4.

     

         The Company’s Board of Directors has approved the purchase of up to $9,000,000 of the Company’s common stock. During the year ended December 31, 2000 and 1999, 1,376,766 and 673,400 shares, respectively, were purchased. The aggregate purchase price for these shares was $5,718,000 and $1,877,000, respectively. The purchased shares have been returned to the Company’s authorized but unissued shares of common stock. All common stock purchases are charged against additional paid-in capital.

    Note 8.   Transactions with Founders

         In connection with the initial formation and capitalization of the Company, the founders acquired 216,666 shares of common stock along with warrants to acquire 216,666 additional shares in exchange for non-recourse forgivable promissory notes. Pursuant to the terms of the agreements, the notes were to be forgiven if certain incentive targets were met. The targets were met in 1997, and notes related to 72,222 shares were forgiven. The incentive targets were not met in 1998, 1999, or 2000 and, accordingly, no debt forgiveness occurred in those years. For accounting purposes, the arrangement has been accounted for as a restricted stock award, and the notes receivable included in the accompanying consolidated balance sheets have been adjusted to an amount equal to the fair value of the remaining unearned shares at each balance sheet date. The Company rolled $260,000 of accrued interest recognized in 1997 on these notes from the founders into principal of new notes.

         During 1998, the founders exercised options to acquire 289,332 shares of common stock in exchange for non-recourse promissory notes aggregating $4,340,000.

         The Company advanced $584,000 to the founders for the payment of their personal tax liability arising from the 1997 forgiveness referred to above and advanced $70,000 in order for the founders to inject capital into NFI Holding Corporation in 1999. Additionally, accrued interest balances related to the borrowings above aggregated $579,000 at December 31, 2000 and December 31, 1999.

         No interest was recorded or received by the Company during 2000 relating to the above notes. Interest income recorded by the Company related to the notes aggregated $496,000 and $441,000 in 1999 and 1998, respectively. Interest paid by the founders aggregated $177,000 in 1999.

         Amounts outstanding under the arrangement described above have been classified as a reduction of stockholders’ equity in the accompanying consolidated balance sheets and may be summarized as follows (in thousands):

    December 31
    2000
      
    1999
    Forgivable notes, as adjusted for changes in fair value of
    underlying Company common shares $ 541 $ 451
    Non-recourse notes 4,340 4,340
    Tax notes 584 584
    Capitalization notes 70 70
    1997 accrued interest notes 260 260
    Accrued interest 579 579
    $ 6,374 $ 6,284

         On January 1, 2001, the Company and its founders entered into a series of transactions, which resulted in a significant modification of the transactions described above. The founders returned the 289,332 shares of common stock acquired in 1998 and the Company cancelled the related non-recourse debt. Additionally, the Company purchased the voting common stock of NFI Holding Corporation from the founders for $370,000. As a result, effective January 1, 2001, NFI Holding Corporation became a wholly-owned subsidiary of the Company. The Company also repurchased the 72,222 shares acquired by the founders in 1997, paying $271,000.

         The founders used the $641,000 received from the sale of NFI Holding Corporation and Company common stock to repay a portion of their obligations described above. The remaining obligations, aggregating $1,393,000 have been rewritten into new non-recourse, non interest-bearing promissory notes. Those notes will be forgiven and charged to expense in equal installments over 10 years as long as the Company employs the founders on December 31st of each year. The notes will be forgiven in full in the event of a change in control. The founders have each pledged 72,222 shares of common stock as collateral for these loans.

     

    Activity subsequent to December 31, 2000 can be summarized as follows (in thousands):

    Balance of forgivable notes, December 31, 2000     
    $
    		 6,374
    Cash received from founders
    		(641 )
    Return of shares subject to non-recourse notes
    		(4,340 )
    Balance of forgivable notes, January 1, 2001
    $
    		 1,393

    Note 9.  Stock Option Plan

         The Company's 1996 Stock Option Plan (the Plan) provides for the grant of qualified incentive stock options (ISOs), non-qualified stock options (NQSOs), deferred stock, restricted stock, performance shares, stock appreciation and limited stock awards, and dividend equivalent rights (DERs). ISOs may be granted to the officers and employees of the Company. NQSOs and awards may be granted to the directors, officers, employees, agents and consultants of the Company or any subsidiaries. Under the terms of the Plan, the number of shares available for issuance is equal to 10 % of the Company’s outstanding common stock. Unless previously terminated by the Board of Directors, the Plan will terminate on September 1, 2006.

         All options have been granted at exercise prices greater than or equal to the estimated fair value of the underlying stock at the date of grant. Outstanding options vest over four years and expire ten years after the date of grant. The following table summarizes option activity under the 1996 Plan for 2000, 1999 and 1998, respectively:

    2000
    1999
    1998
    Shares
       
    Weighted
    Average
    Price
       
    Shares
       
    Weighted
    Average
    Price
       
    Shares
       
    Weighted
    Average
    Price
    Outstanding at the beginning of year
    357,720
    $
    10.16
    384,060
    		$ 13.37
    557,472
    $
    15.22
    Granted
    249,500
    3.74
    119,000
    		6.94
    148,000
    9.38
    Exercised
    (10,000
    )
    1.26
    (3,750
    )
    		 1.67
    (300,582
    )
    14.51
    Canceled
    (55,310
    )
    7.57
    (141,590
    )
    		 16.39
    (20,830
    )
    18.00
    Outstanding at the end of year
    541,910
    $
    7.63
    		 357,720
    		$
    10.16
    384,060
    $
    13.37
    Exercisable at the end of year
    184,745
    $
    11.63
    141,890
    		 $
    11.10
    61,685
    $
    15.70

         Pursuant to a resolution of the Company’s compensation committee of the Board of Directors dated December 21, 1999, the exercise price for 104,000 stock options issued to employees was decreased to $7.00. These options are included in the granted and canceled amounts during 1999 in the table above. Of these, 69,000 were issued originally in 1997 with an exercise price of $18.00 per common share and 35,000 were issued in 1998 at an exercise price of $17.01 per share. No changes were made to the vesting periods or expiration dates. The market price of the Company’s stock was below the adjusted exercise price of the options as of the adjustment date and through December 31, 2000.

    Therefore, no compensation expense was recorded. If the price of the Company’s stock exceeds $7.00 per share in future periods, the Company will record compensation expense.

         Certain options granted during 2000, 1999 and 1998 were granted with DERs. Under the terms of the DERs, a recipient is entitled to receive additional shares of stock upon the exercise of options. The DERs accrue at a rate equal to the number of options outstanding times the dividends per share amount at each dividend date. The accrued DERs convert to shares based on the stock’s fair value on the dividend declaration date. Certain of the options exercised in 2000, 1999 and 1998 had DERs attached to them. As a result of these exercises, an additional 838, 104 and 641 shares of common stock were issued in 2000, 1999 and 1998, respectively. As discussed in Note 8, the Company’s two founders exercised options to acquire 289,332 shares of common stock in 1998, which were returned to the Company subsequent to December 31, 2000.

     

    The following table presents information on stock options outstanding as of December 31, 2000.

    Outstanding
    Exercisable
    Exercise
    Price
    Quantity
    Weighted
    Average
    Remaining
    Contractual Life
    (years)
    Weighted
    Average
    Exercise
    Price
    Quantity
    Weighted
    Average
    Exercise
    Price
    $0.01– $3.75
    		   258,250 9.82
    $
    		 3.68 8,750   
    $
    		 2.14
    $5.88 – 7.00
    		   171,000 7.57
    		6.68 92,750
    		6.72
    $18.00 – $20.81
    		   112,660 6.87
    		18.12 83,245
    		18.08
       
    		 
    		 
        541,910 8.50
    $
    		 7.63 184,745
    $
    		 11.63
       
    		  
    		  
    		  
    		  

         In accordance with accounting principles generally accepted in the United States of America, the Company has chosen to not record the fair value of stock options at their grant date. If the expense had been recorded the Company’s diluted earnings (loss) per share for the three years ended December 31, 2000 would have been $0.49, $(1.10), and $(2.72). The following table summarizes the weighted average fair value of the granted options, determined using the Black-Scholes option pricing model and the assumptions used in their determination.

    2000
    1999
    1998
    Weighted average:
       Fair value $ 2.63 $ 2.39 $ 4.47
       Expected life in years 7 7 7
       Annual risk-free interest rate 5.1 % 6.0 % 5.1 %
       Volatility 3.5 4.1 4.0
       Dividend yield 5.0 % 5.0 % 5.0 %

    Note 10. Income Taxes

         The Company has elected to be taxed as a REIT and accordingly has deducted for income tax purposes, all dividends paid on its common and preferred stock. Because the Company has paid or will pay dividends in amounts approximating its taxable income or has incurred net operating losses, no provision for income taxes has been provided in the accompanying financial statements.

    Note 11. Commitments and Contingencies

         In the normal course of its business, the Company is subject to various legal proceedings and claims, the resolution of which, in the opinion of management, will not have a material adverse effect on the Company's financial condition or results of operations.

    Note 12. Transactions With and Condensed Financial Statements of NFI Holding Corporation and Subsidiaries

         Under the terms of loan servicing agreements, NovaStar Mortgage services loans owned by the Company. Individual agreements have been executed for each pool of loans serving as collateral for the Company’s ABB. During 1998, the Company and NovaStar Mortgage were parties to a mortgage loan purchase and sale agreement. Under the terms of the agreement, the Company purchased mortgage loans originated by NovaStar Mortgage at prices that varied with the nature and terms of the underlying mortgage loans. The agreement was modified effective January 1, 1998 to include a purchase commitment fee. If NovaStar Mortgage chose to retain the mortgage loans it originated or sold them to third parties, it paid a fee to the Company for not delivering its loan production under the purchase commitment. During 1998, NovaStar Mortgage originated loans with a principal amount of $870 million, of which the Company acquired $541 million.

         Under the terms of an administrative outsourcing services agreement, the Company paid NovaStar Mortgage a fee for providing certain services, including the development of loan products and information systems, underwriting, funding, and quality control. The agreement was terminated effective March 31, 1999.

         Effective April 1, 1999, the Company entered an intercompany loan and guarantee agreement with NovaStar Mortgage. Under the terms of this agreement, NovaStar Mortgage pays interest on amounts it borrows from the Company. As of December 31, 2000 and 1999, NovaStar Mortgage had $2,729,000 and $27,663,000 in borrowings from the Company outstanding, respectively. Interest on the borrowings accrues at the Federal funds rate plus 1.75%. In addition, NovaStar Mortgage is required to pay guaranty fees in the amount 0.25% of the loans sold by NovaStar Mortgage for which the Company has guaranteed the performance of NovaStar Mortgage.

           Effective July 1, 2000, NovaStar Mortgage entered into the following intercompany agreements with the Company:

    • Servicing support fee: NovaStar Mortgage pays the Company a fee equal to five basis points of the weighted average mortgage loan servicing principal.
    • Financing commitment fee: NovaStar Mortgage pays the Company a fee equal to 25 basis points on a $150 million annual commitment
    • Residual purchase commitment fee: NovaStar Mortgage pays the Company a fee at each securitization close equal to 20 basis points of the collateral principal value.
    • Securitization consulting fee: NovaStar Mortgage pays the Company a fee at each securitization close equal to 12.5 basis points of the collateral principal value.
    • Guaranty spread fee: NovaStar Mortgage pays the Company a fee equal to one basis point of the weighted average mortgage loan warehouse and repurchase borrowings.

         The Company provides liquidity resources for all operations and enhances the creditworthiness of NovaStar Mortgage. In addition, the Company assists 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.

           Following is a summary of the fees paid to (received from) NovaStar Mortgage (in thousands).

       
    Year Ended December 31,
    2000
    1999
    1998
    Amounts paid to NovaStar Mortgage:    
    		   
    		   
       Loan servicing fees   $
    2,502
    		  $
    3,886
    		  $
    3,803
       
    		 
    		 
         
    		   
    		   
       Administrative fees    
    625
    		   
    1,258
    		   
    7,800
    Amounts received from NovaStar Mortgage:                      
        Intercompany interest income    
    (395
    )
    		    
    (1,113
    )
    		    
    —
        Guaranty, commitment, loan sale and securitization fees    
    (2,711
    )
    		    
    —
    		   
    (5,117
    )
       
    		   
    		   
    		 
        $ (2,481 )   $ 145       2,683
       
    		   
    		   

         Following are the condensed consolidated balance sheets and statements of operations of NFI Holding Corporation (in thousands):

     

    NFI Holding Corporation
    Condensed Consolidated Balances Sheets
    		 
    December 31,
    2000
    1999
    Assets
       Cash and cash equivalents
    $
    		 1,242      
    $
    		 1,466
       Mortgage loans
    		78,812
    		107,916
       Other assets
    		11,764
    		10,061
             Total assets
    $
    		 91,818
    $
    		 119,443
    Liabilities and Stockholders' Equity
       Liabilities:
          Borrowings
    $
    		 36,900
    $
    		 78,448
          Due to NovaStar Financial, Inc.
    		37,316
    		22,161
          Accounts payable and other liabilities
    		9,421
    		11,787
             Total liabilities
    		83,637
    		112,396
          Stockholders' equity
    		8,181
    		7,047
             Total liabilities and stockholders' equity
    $
    		 91,818
    $
    		 119,443

    NFI Holding Corporation
    Condensed Consolidated Statements of Operations
      Year Ended December 31,
                        
        2000      1999   1998  
    Interest income $ 14,485   $ 11,473   $ 11,812  
    Interest expense   8,211     5,942     7,501  
     
    		 
    		 
    		 
       Net interest income   6,274     5,531     4,311  
    Provision for credit losses   174     860     210  
     
    		 
    		 
    		 
    Net interest income after provision for credit                  
    losses   6,100     4,671     4,101  
    Other income:                  
       Fees from third parties   9,908     905     2,829  
       Fees received from, net of paid to, NovaStar                  
          Financial, Inc.   21     4,031     6,486  
       Net gain on sales of mortgage assets   14,793     11,767     3,148  
     
    		 
    		 
    		 
          Total other income   24,722     16,703     12,463  
    General and administrative expenses   29,689     21,285     19,579  
     
    		 
    		 
    		 
                       
    Net income (loss) $ 1,133   $ 89   $ (3,015 )
     
    		 
    		 
    		 

    Note 13. Earnings Per Share

         The computations of basic and diluted EPS computations for the years ended December 31, 2000, 1999 and 1998 are as follows (in thousands except per share amounts):

     

    Year Ended December 31,
    2000
    1999
    1998
    Numerator:
    Net income (loss) $ 5,626 $ (7,092 ) $ (21,821 )
    Less: Preferred stock dividends (2,100 ) (1,606 ) —
    Income (loss) available to common
          stockholders -basic $ 3,526 $ (8,698 ) $ (21,821 )
    Plus: Preferred stock dividends 2,100 — —
    Income (loss) available to common
          stockholders -diluted $ 5,626 $ (8,698 ) $ (21,821 )
    Denominator:
    Weighted average common
          shares outstanding -basic 6,851 8,032 8,057
    Convertible preferred stock 4,286 — —
    Stock options 6 — —
    Warrants — — —
    Weighted average common
       shares outstanding - dilutive 11,143 8,032 8,057
    Basic earnings (loss) per share $ 0.51 $ (1.08 ) $ (2.71 )
    Diluted earnings (loss) per share $ 0.50 $ (1.08 ) $ (2.71 )

         The following stock options and warrants to purchase shares of common stock were outstanding during each period presented, but were not included in the computation of diluted earnings per share because the exercise price was greater than the average market price of the common shares for the periods presented, therefore, the effect would be antidilutive:

     
    Year Ended December 31,
    		 
    2000
    1999
    1998
    Number of stock
    		               
       options and warrants (in thousands)
    		5,706     4,700     245  
    Weighted average
    		               
       exercise price
    $
    		 9.97   $ 11.21   $ 17.92  

    Note 14. Condensed Quarterly Financial Information (unaudited)

         Following is condensed consolidated quarterly operating results for the Company (in thousands, except per share amounts):

    2000 Quarters
    1999 Quarters
    First
    Second
    Third
    Fourth
    First
    Second
    Third
    Fourth
    Net interest income $   3,114   $ 2,835   $ 2,151   $ 2,612   $   6,341   $ 5,447   $ 4,489   $ 3,678  
    Provision for credit losses   1,579     1,213     1,212     1,445     2,299     3,566     5,634   10,579  
    Net income (loss)   1,212     146     1,978     2,290     1,726     1,845   (1,537 ) (9,126 )
    Dividends on preferred stock   525     525     525     525     31     525     525     525  
    Net income (loss) available to common shareholders   686     (379 )   1,453     1,765     1,695     1,320   (2,062 ) (9,651 )
    Basic earnings (loss) per share   0.09     (0.05 )   0.21     0.29     0.21     0.16     (0.25 )   (1.25 )
    Diluted earnings (loss) per share   0.09     (0.05 )   0.18     0.22     0.20     0.15     (0.25 )   (1.25 )

    Note 15. Subsequent Events.

         As a result of the transaction discussed in Note 8 above, the Company owns 100% of the outstanding common shares of NFI Holding Corporation as of January 1, 2001. A pro forma condensed consolidated balance sheet as of December 31, 2000, reflecting the results of those transactions is as follows (in thousands):

    NovaStar Financial, Inc.
    Pro Forma Condensed Consolidated Balance Sheet
    (unaudited)
    December
    31,
    2000
    Assets
       Cash and cash equivalents $ 3,760
       Mortgage assets 498,294
       Other assets 39,120
             Total assets 541,174
    Liabilities and Stockholders' Equity
       Liabilities:
          Borrowings 419,336
          Accounts payable and other liabilities 13,549
             Total liabilities 432,885
          Stockholders' equity 108,289
             Total liabilities and stockholders' equity 541,174

     

    INDEPENDENT AUDITORS' REPORT

    The Board of Directors
    NovaStar Financial, Inc.:

         We have audited the accompanying consolidated balance sheets of NovaStar Financial, Inc. and subsidiaries as of December 31, 2000 and 1999 and the related consolidated statements of operations, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2000. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

         We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

         In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of NovaStar Financial, Inc. and subsidiaries as of December 31, 2000 and 1999 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2000 in conformity with accounting principles generally accepted in the United States of America.

    KPMG LLP

    Kansas City, Missouri
    February 9, 2001

    Item 9.  Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

        None

    PART III

    Item 10.  Directors and Executive Officers of the Registrant

         Information with respect to Item 401 of Regulation S-K is incorporated by reference to the information included on NovaStar Financial’s Proxy Statement dated March 19, 2001, for the Annual Meeting of Shareholders to be held at May 24, 2001 at 10:00 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 1901 W. 47th Place, Suite 100, Westwood, Kansas 66205.

    Item 11.  Executive Compensation

         Information with respect to Item 402 of Regulation S-K is incorporated by reference to the information included on NovaStar Financial’s Proxy Statement dated March 19, 2001, for the Annual Meeting of Shareholders to be held at May 24, 2001 at 10:00 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 1901 W. 47th Place, Suite 100, Westwood, Kansas 66205.

    Item 12.  Security Ownership of Certain Beneficial Owners and Management

         Information with respect to Item 403 of Regulation S-K is incorporated by reference to the information included on NovaStar Financial’s Proxy Statement dated March 19, 2001, for the Annual Meeting of Shareholders to be held at May 24, 2001 at 10:00 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 1901 W. 47th Place, Suite 100, Westwood, Kansas 66205.

    Item 13.  Certain Relationships and Related Transactions.

         Information with respect to Item 404 of Regulation S-K is incorporated by reference to the information included on NovaStar Financial’s Proxy Statement dated March 19, 2001, for the Annual Meeting of Shareholders to be held at May 24, 2001 at 10:00 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 1901 W. 47th Place, Suite 100, Westwood, Kansas 66205.

    PART IV

    Item 14.  Exhibits, Financial Statement Schedules and Reports on Form 8-K

    (a) Financial Statements and Schedules
             
        (1) The financial statements as set forth under Item 8 of this report on Form 10-K are included herein.
             
        (2)  The required financial statement schedules are omitted because they are not applicable to NovaStar Financial.
             
    (b) Reports on Form 8K
             
       

    •

    		 NovaStar Financial has filed no Form 8-K’s during the fourth quarter of 2000.
        • NovaStar Financial filed one Form 8-K on January 2, 2001 relating to acquisition of 100% of outstanding voting securities of NFI Holding Corporation by NovaStar Financial, Inc. and restructuring of promissory notes with founders.
             
    (c) Exhibit Listing
       Exhibit No.
     
    Description of Document
         
    3.1*   Articles of Amendment and Restatement of the Registrant
         
    3.2*   Articles Supplementary of the Registrant
         
    3.3*   Bylaws of the Registrant
         
    3.3a***** Amendment to Bylaws of the Registrant, adopted February 2, 2000
         
    3.4****   Articles Supplementary of NovaStar Financial, Inc. dated as of March 24, 1999, as filed with the Maryland Department of Assessment and Taxation.
    4.1*   Specimen Common Stock Certificate
         
    4.2*   Specimen Warrant Certificate
         
    4.3****   Specimen certificate for Preferred Stock
         
    10.1*   Purchase Terms Agreement, dated December 6, 1996, between the Registrant and the Placement Agent.
         
    10.2*   Registration Rights Agreement, dated December 9, 1996, between the Registrant and the Placement Agent.
         
    10.3*   Warrant Agreement, dated December 9, 1996, between the Registrant and the Holders of the Warrants Acting Through the Registrant as the Initial Warrant Agent.
     
    10.4*   Founders Registration Rights Agreement, dated December 9, 1996, between the Registrant and the original holders of Common Stock of the Registrant.
         
    10.5*   Commitment Letter dated October 3, 1996 from General Electric Capital Group accepted by the Registrant.
         
    10.6*   Form of Master Repurchase Agreement for mortgage loan financing
         
    10.7*   Mortgage Loan Warehousing Agreement dated as of November 24, 1997 between First Union National Bank of North Carolina, NovaStar Mortgage, Inc. and the Registrant.
         
    10.7a*** Amendment No. 6 dated as of February 12, 1999 to Mortgage Loan Warehousing
      Agreement dated as of February 20, 1997 between First Union National Bank and Registrant.
       
    10.7b*****   Amendment No. 7 dated as of December 17, 1999 to Mortgage Loan Warehousing Agreement dated as of February 20, 1997 between First Union National Bank and Registrant.
         
    10.7c******   Amendment No. 10 dated as of July 28, 2000 to Mortgage Loan WarehousingAgreement dated as of February 20, 1997 between First Union National Bank and Registrant.
       
    10.8*   Employment Agreement dated September 30, 1996, between the Registrant and Scott F. Hartman.
       
    10.9*   Employment Agreement, dated September 30, 1996, between the Registrant and W. Lance Anderson.
       
    10.10*   Promissory Note by Scott F. Hartman to the Registrant, dated December 9, 1996.
       
    10.11*   Promissory Note by W. Lance Anderson to the Registrant, dated December 9, 1996.
       
    10.12*   Stock Pledge Agreement between Scott F. Hartman and the Registrant, dated December 9, 1996.
       
    10.13*   Stock Pledge Agreement between W. Lance Anderson and the Registrant, dated December 9, 1996.
       
    10.14*   1996 Executive and Non-Employee Director Stock Option Plan, as last amended December 6, 1996.
       
    10.15*   Administrative Services Outsourcing Agreement, dated June 30, 1997, between the Registrant and NovaStar Mortgage, Inc.
       
    10.16*   Mortgage Loan Sale and Purchase Agreement, dated as of June 30, 1997, between the Registrant and NovaStar Mortgage, Inc.
     
    10.17*   Flow Loan Subservicing Agreement, dated as of June 30, 1997, between the Registrant and NovaStar Mortgage, Inc.
       
    10.18*   Certificate of Incorporation of NFI Holding Corporation.  
    10.19*   Agreement of Shareholders of Common Stock NFI Holding Corporation.
         
    10.20**   Term Loan and Security Agreement between NovaStar Certificates Financing Corporation and Reliance Funding Corporation dated as of October 13, 1998 and related agreements including Guaranty of even date by Registrant.
         
    10.21***   Addendum to Master Repurchase Agreement dated as of February 12, 1999 among NovaStar Financial, Inc., NovaStar Capital, Inc. and NovaStar Mortgage, Inc., as sellers, and First Union National Bank, as buyer.
     
    10.22***   Form of Addendum to Master Repurchase Agreement dated as of February 12, 1999 between Registrant’s taxable affiliate, as seller, and First Union Bank, as buyer, with respect to the residual interest on certain asset-backed bonds.
         
    10.23***   Warrant Agreement dated as of February 12, 1999 between the Registrant and FirstUnion National Bank.
         
    10.24****   Warrant Agreement, dated as of March 10, 1999, by and between NovaStar Financial, Inc. and Residential Funding Corporation , and related Guaranty Warrant, Tag Along Warrant and Registration Rights Agreement as filed with April 6, 1999 8-K of NovaStar Financial, Inc.
         
    10.25****   Registration Rights Agreement dated March 25, 1999 among NovaStar Financial and Stifel, Nicolaus & Company, Incorporated.
         
    10.26*****   Warehousing Credit and Security Agreement, dated as of December 29, 1999, between NovaStar Financial, Inc., NovaStar Mortgage, Inc., NovaStar Capital, Inc. and Residential Funding Corporation.
         
    10.27****** Mortgage Loan Sale and Securitization Transaction Administration Personnel and Facilities Agreement, dated as of July 1, 2000 between the Registrant and NovaStar Mortgage, Inc.
         
    10.28****** Lending and Credit Support Agreement, dated as of July 1, 2000 between theRegistrant and NovaStar Mortgage, Inc.
         
    10.29******   Software License Agreement, dated as of July 1, 2000 between the Registrant and NovaStar Mortgage, Inc.
         
    10.30******   Amendment dated as of July 28, 2000 to the Master Repurchase Agreement, dated as of February 12, 1999 between First Union National Bank and the Registrant.
             
    11.1 Statement regarding computation of per share earnings.
         
    21.1   Subsidiaries of the Registrant
             
    23.4   Consent of KPMG, LLP
             
    		 
    *   Incorporated by reference to the correspondingly numbered exhibit to the Registration Statement on Form S-11 (373-32327) filed by the Registrant with the SEC on July 29 1997, as amended.
         
    **   Incorporated by reference to the correspondingly numbered exhibit to Form 8-K filed by the Registrant with the SEC on December 22, 1998.
              
    ***   Incorporated by reference to the correspondingly numbered exhibit to Form 8-K filed by the Registrant with the SEC on February 23, 1999.
         
    ****   Incorporated by reference to the correspondingly numbered exhibit to Form 8-K filed by the Registrant with the SEC on April 5, 1999.
         
    *****   Incorporated by reference to the correspondingly numbered exhibit to the Annual Report on Form 10-K filed by the Registrant with the SEC on March 20, 2000.
         
    ******   Incorporated by reference to the correspondingly numbered exhibit to the Quarterly Report on Form 10-Q filed by the Registrant with the SEC on November 13, 2000.
    Signatures

         Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

    NovaStar Financial, Inc.
    (Registrant)
     
     
    Date:   March 20, 2001
    		     By:            /s/ SCOTT F. HARTMAN
              Scott F. Hartman, Chairman of the Board
    of Directors and Chief Executive Officer
     
    Date:   March 20, 2001
    		  By:            /s/ W. LANCE ANDERSON
          W. Lance Anderson, President,
    Chief Operating Officer and Director
     
    Date:   March 20, 2001
    		  By:           /s/ RODNEY E. SCHWATKEN
          Rodney E. Schwatken, Vice President,
    Controller and Treasurer
    (Chief Accounting Officer)
     
    Date:   March 20, 2001
    		  By:           /s/ EDWARD W. MEHRER
          Edward W. Mehrer, Director
     
    Date:   March 20, 2001
    		  By:           /s/ GREGORY T. BARMORE
          Gregory T. Barmore, Director
     
    Date:   March 20, 2001
    		  By:           /s/ ART N. BURTSCHER
          Art N. Burtscher, Director