10-Q 1 d10q.htm FORM 10-Q Form 10-Q
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


FORM 10-Q

 


 

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

For the Quarterly Period Ended September 30, 2006

or

 

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

For the Transition Period From              to             

Commission File Number 001-13533

 


NOVASTAR FINANCIAL, INC.

(Exact Name of Registrant as Specified in its Charter)

 


 

Maryland   74-2830661

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

8140 Ward Parkway, Suite 300, Kansas City, MO   64114
(Address of Principal Executive Office)   (Zip Code)

Registrant’s Telephone Number, Including Area Code: (816) 237-7000

 


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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  x    Accelerated filer  ¨    Non-accelerated filer  ¨

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

The number of shares of the Registrant’s Common Stock outstanding on October 31, 2006 was 36,995,202.

 



Table of Contents

NOVASTAR FINANCIAL, INC.

FORM 10-Q

For the Quarterly Period Ended September 30, 2006

TABLE OF CONTENTS

 

Part I

   Financial Information   

Item 1.

   Financial Statements    1
   Condensed Consolidated Balance Sheets    1
   Condensed Consolidated Statements of Income    2
   Condensed Consolidated Statement of Shareholders’ Equity    4
   Condensed Consolidated Statements of Cash Flows    5
   Notes to Condensed Consolidated Financial Statements    7

Item 2.

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

Item 3.

   Quantitative and Qualitative Disclosures About Market Risk    65

Item 4.

   Controls and Procedures    67

Part II

   Other Information   

Item 1.

   Legal Proceedings    67

Item 1A.

   Risk Factors    69

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds    86

Item 3.

   Defaults Upon Senior Securities    86

Item 4.

   Submission of Matters to a Vote of Security Holders    86

Item 5.

   Other Information    86

Item 6.

   Exhibits    87


Table of Contents

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited; dollars in thousands, except share amounts)

 

     September 30,
2006
    December 31,
2005
 

Assets

    

Cash and cash equivalents

   $ 182,157     $ 264,694  

Mortgage loans – held-for-sale

     1,532,755       1,291,556  

Mortgage loans – held-in-portfolio, net of allowance of $17,654 and $699, respectively

     2,391,914       28,840  

Mortgage securities - available-for-sale

     428,787       505,645  

Mortgage securities - trading

     270,925       43,738  

Warehouse notes receivable

     59,756       25,390  

Mortgage servicing rights

     60,483       57,122  

Deferred income tax asset, net

     41,642       30,780  

Servicing related advances

     33,030       26,873  

Derivative instruments, net

     14,201       12,765  

Accrued interest receivable

     37,296       4,866  

Property and equipment, net

     8,978       13,132  

Other assets

     74,212       30,333  
                

Total assets

   $ 5,136,136     $ 2,335,734  
                

Liabilities and Shareholders’ Equity

    

Liabilities:

    

Short-term borrowings secured by mortgage loans

   $ 1,500,117     $ 1,238,122  

Short-term borrowings secured by mortgage securities

     404,809       180,447  

Other short-term borrowings

     15,045       —    

Asset-backed bonds secured by mortgage loans

     2,323,160       26,949  

Asset-backed bonds secured by mortgage securities

     19,554       125,630  

Junior subordinated debentures

     82,908       48,664  

Dividends payable

     105,008       45,070  

Due to securitization trusts

     73,795       44,382  

Accounts payable and other liabilities

     69,092       62,250  
                

Total liabilities

     4,593,488       1,771,514  

Commitments and contingencies (Note 9)

    

Shareholders’ equity:

    

Capital stock, $0.01 par value, 50,000,000 shares authorized:

    

Redeemable preferred stock, $25 liquidating preference per share; 2,990,000 shares issued and outstanding

     30       30  

Common stock, 36,314,691 and 32,193,101 shares issued and outstanding, respectively

     363       322  

Additional paid-in capital

     714,760       581,580  

Accumulated deficit

     (247,031 )     (128,554 )

Accumulated other comprehensive income

     75,118       111,538  

Other

     (592 )     (696 )
                

Total shareholders’ equity

     542,648       564,220  
                

Total liabilities and shareholders’ equity

   $ 5,136,136     $ 2,335,734  
                

See notes to condensed consolidated financial statements.

 

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Table of Contents

NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(unaudited; dollars in thousands, except share amounts)

 

     For the Nine Months
Ended September 30,
    For the Three Months
Ended September 30,
 
     2006     2005     2006     2005  

Interest income:

        

Mortgage securities

   $ 125,875     $ 139,655     $ 41,887     $ 50,619  

Mortgage loans held-for-sale

     121,062       77,680       50,272       36,169  

Mortgage loans held-in-portfolio

     94,294       3,531       45,885       1,090  
                                

Total interest income

     341,231       220,866       138,044       87,878  

Interest expense:

        

Short-term borrowings secured by mortgage loans

     97,049       40,781       31,248       19,471  

Short-term borrowings secured by mortgage securities

     7,411       1,649       4,609       92  

Other short-term borrowings

     242       —         221       —    

Asset-backed bonds secured by mortgage loans

     54,305       1,439       36,633       414  

Asset-backed bonds secured by mortgage securities

     3,598       12,682       575       4,059  

Junior subordinated debentures

     4,952       2,046       2,080       1,000  
                                

Total interest expense

     167,557       58,597       75,366       25,036  
                                

Net interest income before provision for credit losses

     173,674       162,269       62,678       62,842  

Provision for credit losses

     19,876       1,050       10,286       331  
                                

Net interest income

     153,798       161,219       52,392       62,511  

Gains on sales of mortgage assets

     51,027       60,462       27,709       9,691  

Gains (losses) on derivative instruments

     7,854       13,275       (6,877 )     6,522  

Impairment on mortgage securities – available-for-sale

     (13,249 )     (10,066 )     (6,796 )     (8,328 )

Fee income

     22,129       24,845       7,671       7,448  

Premiums for mortgage loan insurance

     (9,295 )     (4,008 )     (3,145 )     (2,026 )

Other income, net

     27,143       14,168       8,396       5,543  

General and administrative expenses:

        

Compensation and benefits

     94,025       76,572       32,872       24,320  

Office administration

     19,970       21,363       6,592       7,076  

Professional and outside services

     15,076       12,767       4,798       4,054  

Loan expense

     4,239       10,438       1,055       3,449  

Other

     14,361       19,526       3,735       5,510  
                                

Total general and administrative expenses

     147,671       140,666       49,052       44,409  
                                

Income from continuing operations before income tax expense

     91,736       119,229       30,298       36,952  

Income tax expense (benefit)

     2,677       (693 )     1,813       (1,708 )
                                

Income from continuing operations

     89,059       119,922       28,485       38,660  

(Loss) income from discontinued operations, net of income tax

     (1,717 )     (8,907 )     94       (2,367 )
                                

Net income

     87,342       111,015       28,579       36,293  

Dividends on preferred shares

     (6,653 )     (4,989 )     (3,327 )     (1,663 )
                                

Net income available to common shareholders

   $ 80,689     $ 106,026     $ 25,252     $ 34,630  
                                

Continued

 

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Table of Contents
     For the Nine Months
Ended September 30,
    For the Three Months
Ended September 30,
 
     2006     2005     2006    2005  

Basic earnings per share:

         

Income from continuing operations available to common shareholders

   $ 2.47     $ 3.95     $ 0.73    $ 1.21  

(Loss) income from discontinued operations, net of income tax

     (0.05 )     (0.31 )     —        (0.08 )
                               

Net income available to common shareholders

   $ 2.42     $ 3.64     $ 0.73    $ 1.13  
                               

Diluted earnings per share:

         

Income from continuing operations available to common shareholders

   $ 2.45     $ 3.90     $ 0.73    $ 1.20  

(Loss) income from discontinued operations, net of income tax

     (0.05 )     (0.30 )     —        (0.08 )
                               

Net income available to common shareholders

   $ 2.40     $ 3.60     $ 0.73    $ 1.12  
                               

Weighted average basic shares outstanding

     33,303       29,121       34,427      30,617  
                               

Weighted average diluted shares outstanding

     33,559       29,468       34,694      30,962  
                               

Dividends declared per common share

   $ 5.60     $ 4.20     $ 2.80    $ 1.40  
                               

Concluded

See notes to condensed consolidated financial statements

 

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NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(unaudited; dollars in thousands, except share amounts)

 

     Preferred
Stock
   Common
Stock
   Additional
Paid-in
Capital
    Accumulated
Deficit
    Accumulated
Other
Comprehensive
Income
    Other     Total
Shareholders’
Equity
 

Balance, January 1, 2006

   $ 30    $ 322    $ 581,580     $ (128,554 )   $ 111,538     $ (696 )   $ 564,220  

Forgiveness of founders’ notes receivable

     —        —        —         —         —         104       104  

Issuance of common stock, 4,024,453 shares

     —        40      122,027       —         —         —         122,067  

Issuance of stock under stock compensation plans, 97,630 shares

     —        1      560       —         —         —         561  

Compensation recognized under stock compensation plans

     —        —        1,972       —         —         —         1,972  

Dividend equivalent rights (DERs) on vested options

     —        —        818       (3,079 )     —         —         (2,261 )

Dividends on common stock ($5.60 per share)

     —        —        —         (196,087 )     —         —         (196,087 )

Dividends on preferred stock ($2.23 per share)

     —        —        —         (6,653 )     —         —         (6,653 )

Common stock repurchased, 493 shares

     —        —        (17 )     —         —         —         (17 )

Tax benefit derived from capitalization of affiliate

     —        —        7,858       —         —         —         7,858  

Write-off of deferred tax asset related to stock compensation plans

     —        —        (38 )     —         —         —         (38 )
                                                      

Comprehensive income:

                

Net income

             87,342           87,342  

Other comprehensive income

               (36,420 )       (36,420 )
                      

Total comprehensive income

                   50,922  
                                                      

Balance, September 30, 2006

   $ 30    $ 363    $ 714,760     $ (247,031 )   $ 75,118     $ (592 )   $ 542,648  
                                                      

See notes to condensed consolidated financial statements.

 

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Table of Contents

NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited; dollars in thousands)

 

     For the Nine Months Ended
September 30,
 
     2006     2005  

Cash flows from operating activities:

    

Net Income

   $ 87,342     $ 111,015  

Loss from discontinued operations

     1,717       8,907  
                

Income from continuing operations

     89,059       119,922  

Adjustments to reconcile income from continuing operations to net cash used in operating activities:

    

Amortization of mortgage servicing rights

     23,469       19,663  

Retention of mortgage servicing rights

     (26,957 )     (33,102 )

Impairment on mortgage securities – available-for-sale

     13,249       10,066  

Gains on derivative instruments

     (7,854 )     (13,275 )

Depreciation expense

     5,661       5,464  

Amortization of deferred debt issuance costs

     2,141       4,525  

Compensation recognized under stock compensation plans

     1,972       1,574  

Provision for credit losses

     19,876       1,050  

Amortization of premiums on mortgage loans

     5,101       324  

Forgiveness of founders’ promissory notes

     104       105  

Provision for deferred income taxes

     (5,625 )     424  

Accretion on available-for-sale and trading securities

     (121,570 )     (129,462 )

Gains on sales of mortgage assets

     (51,027 )     (60,462 )

Gains on trading securities

     (2,862 )     —    

Originations and purchases of mortgage loans held-for-sale

     (8,683,608 )     (7,163,120 )

Proceeds from repayments of mortgage loans held-for-sale

     79,214       5,413  

Repurchase of mortgage loans due from securitization trust

     (114,260 )     (6,784 )

Proceeds from sales of mortgage loans held-for-sale to third parties

     1,524,432       747,434  

Proceeds from sales of mortgage loans held-for-sale in securitizations

     4,176,943       5,797,615  

Purchase of mortgage securities - trading

     (163,661 )     —    

Proceeds from paydowns of mortgage securities - trading

     4,301       —    

Proceeds from sale of mortgage securities - trading

     11,223       143,153  

Changes in:

    

Servicing related advances

     (7,000 )     (979 )

Accrued interest receivable

     (58,050 )     (29,704 )

Derivative instruments, net

     780       (16 )

Other assets

     (47,367 )     (20,782 )

Accounts payable and other liabilities

     6,943       22,090  
                

Net cash used in operating activities from continuing operations

     (3,325,373 )     (578,864 )

Net cash used in operating activities from discontinued operations

     (444 )     (2,870 )
                

Net cash used in operating activities

     (3,325,817 )     (581,734 )
                

Cash flows from investing activities:

    

Proceeds from paydowns on mortgage securities – available-for-sale

     252,329       352,000  

Purchase of mortgage securities – available-for-sale

     (1,922 )     —    

Proceeds from repayments of mortgage loans held-in-portfolio

     290,992       14,263  

Proceeds from sales of assets acquired through foreclosure

     1,277       1,665  

Purchases of property and equipment

     (1,538 )     (4,701 )
                

Net cash provided by investing activities

     541,138       363,227  
                

Cash flows from financing activities:

    

Proceeds from issuance of asset-backed bonds

     2,505,457       128,921  

Payments on asset-backed bonds

     (317,137 )     (290,933 )

Proceeds from issuance of capital stock and exercise of equity instruments, net of offering costs

     119,098       94,753  

Net change in short-term borrowings

     508,845       333,426  

Proceeds from issuance of junior subordinated debentures

     33,917       48,428  

Repurchase of common stock

     (17 )     —    

Dividends paid on vested options

     (1,021 )     —    

Dividends paid on preferred stock

     (3,326 )     (4,989 )

Dividends paid on common stock

     (136,231 )     (147,320 )
                

Net cash provided by financing activities from continuing operations

     2,709,585       162,286  

Net cash (used in) provided by financing activities from discontinued operations

     (7,443 )     10,551  
                

Net cash (used in) provided by financing activities

     2,702,142       172,837  
                

Net decrease in cash and cash equivalents

     (82,537 )     (45,670 )

Cash and cash equivalents, beginning of period

     264,694       268,563  
                

Cash and cash equivalents, end of period

   $ 182,157     $ 222,893  
                

Continued

 

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SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

(unaudited; dollars in thousands)

 

     For the Nine Months Ended
September 30,
     2006    2005

Cash paid for interest

   $ 173,617    $ 56,021
             

Cash paid for income taxes

     9,902      297
             

Cash received on mortgage securities – available-for-sale with no cost basis

     4,305      10,923
             

Cash received for dividend reinvestment plan

     3,246      3,042
             

Non-cash operating, investing and financing activities:

     

Cost basis of securities retained in securitizations

     121,025      246,057
             

Change in loans under removal of accounts provision

     29,414      12,605
             

Transfer of cost basis of residual securities and mortgage servicing rights to mortgage loans held-for-sale due to securitization calls

     2,450      7,423
             

Transfer of loans to held-in-portfolio from held-for-sale

     2,684,515      —  
             

Assets acquired through foreclosure

     14,969      2,782
             

Dividends payable

     105,008      43,053
             

Tax benefit derived from capitalization of affiliate

     7,858      —  
             

Restricted stock issued in satisfaction of prior year accrued bonus

     283      262
             

Concluded

See notes to condensed consolidated financial statements.

 

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NOVASTAR FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2006 (Unaudited)

Note 1. Financial Statement Presentation

NovaStar Financial, Inc. and subsidiaries (the “Company”) operate as a specialty finance company that originates, purchases, sells, invests in and services residential nonconforming loans. The Company offers a wide range of mortgage loan products to borrowers, commonly referred to as “nonconforming borrowers,” who generally do not satisfy the credit, collateral, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers, including United States of America government-sponsored entities such as Fannie Mae or Freddie Mac. The Company retains significant interests in the nonconforming loans originated and purchased through its mortgage securities investment portfolio. Historically, the Company has serviced all of the loans in which it retains interests through its servicing platform.

The Company’s condensed consolidated financial statements as of September 30, 2006 and for the nine and three months ended September 30, 2006 and 2005 are unaudited. In the opinion of management, all necessary adjustments have been made, which were of a normal and recurring nature, for a fair presentation of the condensed consolidated financial statements. Reclassifications to prior year amounts have been made to conform to current year presentation. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, the Company has reclassified the operating results of NovaStar Home Mortgage, Inc (NHMI) and its branches through September 30, 2006, as discontinued operations in the Condensed Consolidated Statements of Income for the nine and three months ended September 30, 2006 and 2005.

The Company’s condensed consolidated financial statements should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements of the Company and the notes thereto, included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005.

The condensed consolidated financial statements of the Company include the accounts of all wholly-owned subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation. Interim results are not necessarily indicative of results for a full year.

The Financial Accounting Standards Board (“FASB”) has been deliberating on a technical interpretation of GAAP with respect to the accounting for transactions where assets are purchased and simultaneously financed through a repurchase agreement with the same party and whether these transactions create derivatives requiring a “net” presentation instead of the acquisition of assets and related financing obligation. The Company’s current accounting for these transactions is to record the transactions as an acquisition of assets and related financing obligation. The alternative accounting treatment would be to record any net cash representing the “haircut” amount as a deposit and the forward leg of the repurchase agreement (that is, the obligation to purchase the financial asset(s) at the end of the repo term) as a derivative. Because the FASB has not issued any guidance on this matter as of the filing date of this report, the Company has not changed its accounting treatment for this item. During the three months ended March 31, 2006, the Company had purchased approximately $1.0 billion of mortgage loans from counterparties which were subsequently financed through repurchase agreements with that same counterparty. As of March 31, 2006, the entire $1.0 billion of mortgage loans purchased during the first quarter remained on the Company’s condensed consolidated balance sheet. The $1.0 billion of mortgage loans purchased in the first quarter of 2006 also remained on the Company’s balance sheet as of September 30, 2006, but they were no longer financed with repurchase agreements as they had been securitized in transactions structured as financings and the short-term repurchase agreements were replaced with asset backed bond financing. Additionally, during the nine months ended September 30, 2006 the Company purchased $39.2 million of securities from counterparties which were subsequently financed through repurchase agreements with the same counterparties. As of September 30, 2006 the market value of these securities which remained on the Company’s condensed consolidated balance sheet was $39.7 million. If the Company would be required to change its current accounting based on this interpretation the Company does not believe that there would be a material impact on its condensed consolidated statements of income, however, total assets and total liabilities would be reduced by approximately $31.0 million, $20.5 million and $1 billion at September 30, 2006, June 30, 2006 and March 31, 2006, respectively. In addition, cash flows from operating and financing activities would be reduced by approximately $31.0 million and $20.5 million and $1.0 billion for the three months ended September 30, 2006, June 30, 2006 and March 31, 2006, respectively. The Company believes its liquidity, and ability to pay a dividend would be unchanged, and it does not believe the economics of the transactions or its taxable income or status as a REIT would be affected.

 

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Note 2. New Accounting Pronouncements

At September 30, 2006, the Company had one stock-based employee compensation plan, which is described more fully in Note 15. From January 1, 2004 through December 31, 2005, the Company accounted for the plan under the recognition and measurement provisions of FASB Statement No. 123 (“SFAS 123”), Accounting for Stock-Based Compensation. Effective January 1, 2006, the Company adopted the fair value recognition provisions of FASB Statement No. 123(R) (“SFAS 123(R)”), Share-Based Payment, using the modified-prospective-transition method. Because the Company was applying the provisions of SFAS 123 prior to January 1, 2006, the adoption of SFAS 123(R) had no material impact on the condensed consolidated financial statements.

Prior to adoption of SFAS 123(R), the Company presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the Statement of Cash Flows. SFAS 123(R) requires the cash flows resulting from the tax benefits of tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. Additionally, the write-off of deferred tax assets relating to the excess of recognized compensation cost over the tax deduction resulting from the award will continue to be reflected within operating cash flows. Any excess tax benefits the Company recorded during the nine and three months ended September 30, 2006 are considered to have no material impact on the condensed consolidated financial statements.

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments”, an amendment of FASB Statements No. 133 and SFAS No. 140 (“SFAS 155”). This statement permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. It also clarifies which interest-only strips and principal-only strips are not subject to FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). The statement also establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or hybrid financial instruments that contain an embedded derivative requiring bifurcation. The statement also clarifies that concentration of credit risks in the form of subordination are not embedded derivatives, and it also amends SFAS 140 to eliminate the prohibition on a Qualifying Special Purpose Entity (“QSPE”) from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Early adoption of this statement is allowed. The Company is still evaluating the impact the adoption of this statement will have on its condensed consolidated financial statements.

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets”, an amendment of SFAS No. 140 (“SFAS 156”). This statement requires that an entity separately recognize a servicing asset or a servicing liability when it undertakes an obligation to service a financial asset under a servicing contract in certain situations. Such servicing assets or servicing liabilities are required to be initially measured at fair value, if practicable. SFAS 156 also allows an entity to choose one of two methods when subsequently measuring its servicing assets and servicing liabilities: (1) the amortization method or (2) the fair value measurement method. The amortization method existed under SFAS 140 and remains unchanged in (1) allowing entities to amortize their servicing assets or servicing liabilities in proportion to and over the period of estimated net servicing income or net servicing loss and (2) requiring the assessment of those servicing assets or servicing liabilities for impairment or increased obligation based on fair value at each reporting date. The fair value measurement method allows entities to measure their servicing assets or servicing liabilities at fair value each reporting date and report changes in fair value in earnings in the period the change occurs. SFAS 156 introduces the notion of classes and allows companies to make a separate subsequent measurement election for each class of its servicing rights. In addition, SFAS 156 requires certain comprehensive roll-forward disclosures that must be presented for each class. The Statement is effective as of the beginning of an entity’s first fiscal year that begins after September 15, 2006. Earlier adoption is permitted as of the beginning of an entity’s fiscal year, so long as the entity has not yet issued financial statements, including financial statements for any interim period, for that fiscal year. The Company is still evaluating the impact the adoption of this statement will have on its condensed consolidated financial statements.

In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109”. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or to be taken on a tax return. This interpretation also provides additional guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation is effective for fiscal years after December 15, 2006. The Company is currently evaluating the potential impact of this interpretation on its consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 establishes a framework for measuring fair value and requires expanded disclosures regarding fair value measurements. This accounting standard is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company is still evaluating the impact the adoption of this statement will have on its condensed consolidated financial statements.

In September 2006, the Securities and Exchange Commission “SEC” issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial

 

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Statements (“SAB No. 108”). SAB No. 108 provides guidance regarding the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of materiality assessments. The method established by SAB No. 108 requires each of the Company’s financial statements and the related financial statement disclosures to be considered when quantifying and assessing the materiality of the misstatement. The provisions of SAB 108 are effective for financial statements issued for fiscal years beginning after December 31, 2006. The Company is still evaluating the impact the adoption of this statement will have on its condensed consolidated financial statements.

Note 3. Mortgage Loans

Mortgage loans, all of which are secured by residential properties, consisted of the following as of September 30, 2006 and December 31, 2005 (dollars in thousands):

 

     September 30,
2006
    December 31,
2005
 

Mortgage loans – held-for-sale:

    

Outstanding principal

   $ 1,459,870     $ 1,238,689  

Loans under removal of accounts provision

     73,795       44,382  

Net premium

     6,072       12,015  

Allowance for the lower of cost or fair value

     (6,982 )     (3,530 )
                

Mortgage loans – held-for-sale

   $ 1,532,755     $ 1,291,556  
                

Weighted average coupon

     9.05 %     8.11 %
                

Percent with prepayment penalty

     55 %     65 %
                

Mortgage loans – held-in-portfolio:

    

Outstanding principal

   $ 2,366,692     $ 29,084  

Net unamortized premium

     42,876       455  
                

Amortized cost

     2,409,568       29,539  

Allowance for credit losses

     (17,654 )     (699 )
                

Mortgage loans – held-in-portfolio

   $ 2,391,914     $ 28,840  
                

Weighted average coupon

     8.23 %     9.85 %
                

During the first nine months of 2006 the Company transferred $2.7 billion of mortgage loans from its held-for-sale classification to held-in-portfolio. These loans were subsequently securitized in transactions structured as financings.

Activity in the allowance for credit losses on mortgage loans – held-in-portfolio is as follows for the nine and three months ended September 30, 2006 and 2005, respectively (dollars in thousands):

 

     For the Nine Months
Ended September 30,
    For the Three Months
Ended September 30,
 
     2006     2005     2006     2005  

Balance, beginning of period

   $ 699     $ 507     $ 9,899     $ 866  

Provisions for credit losses

     19,876       1,050       10,286       331  

Charge-offs, net of recoveries

     (2,921 )     (689 )     (2,531 )     (329 )
                                

Balance, end of period

   $ 17,654     $ 868     $ 17,654     $ 868  
                                

 

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Note 4. Loan Securitizations

On August 29, 2006 and September 28, 2006 the Company executed securitization transactions, NovaStar Mortgage Funding Trust (“NMFT”) Series 2006-4 and NMFT Series 2006-5, respectively, which were accounted for as sales of loans. Derivative instruments were also transferred into the trusts as part of each of these sales transactions to reduce interest rate risk to the third-party bondholders. Details of the transactions structured as sales for the nine months ended September 30, 2006 are as follows (dollars in thousands):

 

    

Net Bond
Proceeds

   Allocated Value of
Retained Interests
   

Principal
Balance of
Loans Sold

  

Fair Value of
Derivative
Instruments
Transferred

  

Gain
Recognized

        Mortgage
Servicing
Rights
  

Subordinated
Bond

Classes

         

NMFT Series 2005-4

   $ 378,944    $ 2,258    $ 9,416 (A)   $ 378,944    $ 259    $ 1,203

NMFT Series 2006-2

     999,790      6,041      40,858 (B)     1,021,102      6,015      11,942

NMFT Series 2006-3

     1,072,258      6,516      47,408 (C)     1,100,000      5,073      10,209

NMFT Series 2006-4

     993,841      7,040      51,956 (D)     1,025,359      1,818      14,401

NMFT Series 2006-5

     704,979      5,102      40,206 (E)     740,283      690      7,824
                                          
   $ 4,149,812    $ 26,957    $ 189,844     $ 4,265,688    $ 13,855    $ 45,579
                                          

(A) On January 20, 2006, the Company delivered the remaining $378.9 million of loans into the NMFT Series 2005-4 securitization trust. All of the bonds were issued to the third-party investors at the date of initial close, but the Company did not receive the escrowed proceeds related to the final close until January 20, 2006.
(B) The NMFT Series 2006-2 subordinated bond classes includes the Class M-9 and M-10 certificates, which were retained by the Company. Class M-9 and M-10 collectively represent $11.9 million in principal. Class M-9 is rated BBB/BBB- by S&P and Fitch, respectively. The Class M-10 is rated BB+ by both S&P and Fitch.
(C) The NMFT Series 2006-3 subordinated bond classes includes the Class M-9, M-10 and M-11 certificates, which were retained by the Company. Class M-9, M-10 and M-11 collectively represent $16.4 million in principal. Class M-9 is rated BBB/BBB- by S&P and Fitch, respectively. The Class M-10 is rated BBB- by S&P. Class M-11 is rated BB+ by S&P.
(D) The NMFT Series 2006-4 subordinated bond classes includes the Class M-7, M-10, M-11 and M-12 certificates, which were retained by the Company. Class M-7, M-10, M-11 and M-12 collectively represent $20.4 million in principal. Class M-7 is rated A/Baa1/BBB+ by S&P, Moody’s and Fitch, respectively. The Class M-10 is rated BBB/BBB- by S&P and Fitch, respectively. Class M-11 is rated BBB- by S&P. Class M-12 is rated BB+ by S&P.
(E) The NMFT Series 2006-5 subordinated bond classes includes the Class M-10, M-11 and M-12 certificates, which were retained by the Company. Class M-10, M-11 and M-12 collectively represent $20.3 million in principal. The Class M-10, M-11 and M-12 certificates are rated BBB-, BB+ and BB by S&P, respectively. On October 20, 2006, $559.7 million in loans collateralizing NMFT Series 2006-5 were delivered to the trust. The Company received $559.7 million in proceeds, which had been held in escrow by the trustee.

The Company retained interest-only, prepayment penalty and other subordinated interests in the underlying cash flows and servicing responsibilities from the financial assets transferred as part of the NMFT Series 2005-4, 2006-2, 2006-3, 2006-4 and 2006-5 securitizations. The value of the Company’s retained interests is subject to credit, prepayment, and interest rate risks on the transferred financial assets.

On April 28, 2006 and June 8, 2006, the Company executed securitization transactions, NovaStar Home Equity Series (“NHES”) 2006-1 and NHES 2006-MTA1, respectively, which were accounted for as financings. Details of the transactions structured as financings are as follows (dollars in thousands):

 

     Net Bond Proceeds    Principal Balance of
Loans Financed

NHES Series 2006-1

   $ 1,317,346    $ 1,364,147

NHES Series 2006-MTA1

     1,188,111      1,199,913
             
   $ 2,505,457    $ 2,564,060
             

 

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Note 5. Mortgage Securities – Available-for-Sale

Mortgage securities – available-for-sale consist of the Company’s investment in the residual securities and subordinated securities issued by securitization trusts sponsored by the Company. Residual securities consist of interest-only, prepayment penalty and overcollaterilization bonds. Subordinated securities consist of rated bonds which are lower on the capital structure. Management estimates the fair value of the residual securities by discounting the expected future cash flows of the collateral and bonds. Fair value of the subordinated securities is based on quoted market prices. The cost basis, unrealized gains and losses and estimated fair value of mortgage securities – available-for-sale as of September 30, 2006 and December 31, 2005 were as follows (dollars in thousands):

 

     Cost Basis    Unrealized
Gain
  

Unrealized Losses
Less Than

Twelve Months

    Estimated
Fair Value
   Average
Yield
 

As of September 30, 2006

   $ 350,027    $ 78,760    $ —       $ 428,787    30.65 %

As of December 31, 2005

     394,107      113,785      (2,247 )     505,645    34.54  

During the nine and three months ended September 30, 2006 and 2005, management concluded that the decline in value on certain securities in the Company’s mortgage securities portfolio were other-than-temporary. As a result, the Company recognized an impairment on mortgage securities – available-for-sale of $13.2 and $6.8 million during the nine and three months ended September 30, 2006, respectively, as compared to $10.1 million and $8.3 million during the same periods of 2005.

As of December 31, 2005, the Company had two subordinated available-for-sale securities with fair values aggregating $42.8 million that were deemed to be temporarily impaired.

The servicing agreements the Company executes for loans it has securitized include a “clean up” call option which gives it the right, not the obligation, to repurchase mortgage loans from the trust. The clean up call option can be exercised when the aggregate principal balance of the mortgage loans has declined to ten percent or less of the original aggregated mortgage loan principal balance. During the three months ended September 30, 2006, the Company exercised the “clean up” call option on NMFT Series 2000-1, NMFT Series 2000-2, NMFT Series 2001-1 and NMFT Series 2001-2 and repurchased loans with a remaining principal balance of $120.5 million from these trusts for $114.2 million in cash. The trusts distributed the $114.2 million to retire the bonds held by third parties. Along with the cash paid to the trusts, any remaining cost basis of the related mortgage securities and mortgage servicing rights, $2.5 million, became part of the cost basis of the repurchased mortgage loans. The repurchased mortgage loans are included in the mortgage loans held-for-sale classification on the Company’s condensed consolidated balance sheets and it is the Company’s intention to sell or securitize these loans.

At September 30, 2006, the Company had the right, not the obligation, to repurchase $75.8 million of mortgage loans from the NMFT Series 2002-1 and NMFT 2002-2 securitization trusts under the Company’s clean up call options. As discussed in Note 16, on October 25, 2006 the Company exercised its call right for the NMFT Series 2002-1.

 

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The following table is a rollforward of mortgage securities – available-for-sale from January 1, 2005 to September 30, 2006 (in thousands):

 

    

Cost

Basis

    Unrealized
Gain
   

Estimated

Fair Value of

Mortgage
Securities

 

As of January 1, 2005

   $ 409,946     $ 79,229     $ 489,175  

Increases (decreases) to mortgage securities:

      

New securities retained in securitizations

     289,519       2,073       291,592  

Accretion of income (A)

     171,734       —         171,734  

Proceeds from paydowns of securities (A) (B)

     (452,050 )     —         (452,050 )

Impairment on mortgage securities - available-for-sale

     (17,619 )     17,619       —    

Transfer of securities to mortgage loans held-for-sale due to repurchase of mortgage loans from securitization trust (C)

     (7,423 )     —         (7,423 )

Mark-to-market value adjustment

     —         12,617       12,617  
                        

Net (decrease) increase to mortgage securities

     (15,839 )     32,309       16,470  
                        

As of December 31, 2005

     394,107       111,538       505,645  
                        

Increases (decreases) to mortgage securities:

      

New securities retained in securitizations

     121,025       1,877       122,902  

Purchase of securities

     1,922       —         1,922  

Accretion of income (A)

     112,903       —         112,903  

Proceeds from paydowns of securities (A) (B)

     (264,358 )     —         (264,358 )

Impairment on mortgage securities - available-for-sale

     (13,249 )     13,249       —    

Transfer of securities to mortgage loans held-for-sale due to repurchase of mortgage loans from securitization trusts (D)

     (2,323 )     (5,015 )     (7,338 )

Mark-to-market value adjustment

     —         (42,889 )     (42,889 )
                        

Net decrease to mortgage securities

     (44,080 )     (32,778 )     (76,858 )
                        

As of September 30, 2006

   $ 350,027     $ 78,760     $ 428,787  
                        

(A) Cash received on mortgage securities with no cost basis was $4.3 million for the nine months ended September 30, 2006 and $17.6 million for the year ended December 31, 2005.
(B) For mortgage securities with a remaining cost basis, the Company reduces the cost basis by the amount of cash that is contractually due from the securitization trusts. In contrast, for mortgage securities in which the cost basis has previously reached zero, the Company records in interest income the amount of cash that is contractually due from the securitization trusts. In both cases, there are instances where the Company may not receive a portion of this cash until after the balance sheet reporting date. Therefore, these amounts are recorded as receivables from the securitization trusts. As of September 30, 2006 and December 31, 2005, the Company had receivables from securitization trusts of $18.1 million and $2.4 million, respectively, related to mortgage securities available-for-sale with a remaining cost basis.
(C) The remaining loans in the NMFT Series 1999-1 securitization trust were called on September 25, 2005.
(D) The remaining loans in the NMFT Series 2000-1, NMFT Series 2000-2, NMFT Series 2001-1 and NMFT Series 2001-2 securitization trusts were called during the three months ended September 30, 2006.

Maturities of mortgage securities owned by the Company depend on repayment characteristics and experience of the underlying financial instruments. The Company expects the securities it owns as of September 30, 2006 to mature in one to five years.

 

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Note 6. Mortgage Securities - Trading

As of September 30, 2006, mortgage securities – trading consisted of certain subordinated securities retained by the Company from securitization transactions as well as subordinated securities purchased from other issuers in the open market. Management estimates their fair value based on quoted market prices. The following table summarizes the Company’s mortgage securities – trading as of September 30, 2006 (dollars in thousands):

 

S&P Rating

        Original Face    Amortized
Cost Basis
   Fair Value    Number of
Securities
  

Weighted

Average
Yield

 

A+

     $ 2,199    $ 2,201    $ 2,199    1    6.27 %

A

       15,692      15,440      15,645    3    6.31  

A-

       13,432      12,262      12,538    4    10.14  

BBB+

       49,580      47,195      47,762    12    8.06  

BBB

       71,300      65,508      66,940    17    9.14  

BBB-

       108,973      96,685      97,437    21    11.27  

BB+

       26,733      21,702      21,780    7    14.33  

BB

       8,500      6,563      6,624    2    16.48  
                              

Total

     $ 296,409    $ 267,556    $ 270,925    67    10.17 %
                                  

The Company recognized net trading gains (losses) of $2.9 million and $(1.4) million for the nine and three months ended September 30, 2006, respectively.

On February 23, 2006, the Company sold the M-9 bond class security which it had retained from its NMFT Series 2005-4 securitization, to a third party and recognized a gain on the sale of approximately $351,000.

As of September 30, 2006, the Company had pledged all of its trading securities as collateral for financing purposes.

Note 7. Junior Subordinated Debentures

In April 2006, the Company established NovaStar Capital Trust II (“NCTII”), a statutory trust organized under Delaware law for the sole purpose of issuing trust preferred securities. NovaStar Mortgage, Inc. (“NMI”) owns all of the common securities of NCTII. On April 18, 2006, NCTII issued $35 million in unsecured floating rate trust preferred securities to other investors. The trust preferred securities require quarterly interest payments. The interest rate is floating at the three-month LIBOR rate plus 3.5% and resets quarterly. The trust preferred securities are redeemable, at NCTII’s option, in whole or in part, anytime without penalty on or after June 30, 2011, but are mandatorily redeemable when they mature on June 30, 2036. If they are redeemed on or after June 30, 2011, but prior to maturity, the redemption price will be 100% of the principal amount plus accrued and unpaid interest.

The proceeds from the issuance of the trust preferred securities and the common securities of NCTII were loaned to NMI in exchange for $36.1 million of junior subordinated debentures of NMI, which are the sole assets of NCTII. The terms of the junior subordinated debentures match the terms of the trust preferred securities. The debentures are subordinate and junior in right of payment to all present and future senior indebtedness and certain other financial obligations of the Company. The Company entered into a guarantee for the purpose of guaranteeing the payment of any amounts to be paid by NMI under the terms of the debentures. Following payment by the Company of offering costs, the Company’s net proceeds from the offering aggregated $33.9 million.

The assets and liabilities of NCTII are not consolidated into the consolidated financial statements of the Company. Accordingly, the Company’s equity interest in NCTII is accounted for using the equity method. Interest on the junior subordinated debt is included in the Company’s consolidated statements of income as interest expense—subordinated debt and the junior subordinated debentures are presented as a separate category on the consolidated balance sheets.

 

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Note 8. UBS Borrowings

In connection with the lending agreement with UBS Warburg Real Estate Securities, Inc. (“UBS”), NovaStar Mortgage SPV I (“NovaStar Trust”), a Delaware statutory trust, has been established by NMI as a wholly owned special-purpose warehouse finance subsidiary whose assets and liabilities are included in the Company’s condensed consolidated financial statements.

NovaStar Trust has agreed to issue and sell to UBS mortgage notes (the “Notes”). Under the agreements that document the issuance and sale of the Notes:

 

    all assets which are from time to time owned by NovaStar Trust are legally owned by NovaStar Trust and not by NMI.

 

    NovaStar Trust is a legal entity separate and distinct from NMI and all other affiliates of NMI.

 

    the assets of NovaStar Trust are legally assets only of NovaStar Trust, and are not legally available to NMI and all other affiliates of NMI or their respective creditors, for pledge to other creditors or to satisfy the claims of other creditors.

 

    none of NMI or any other affiliate of NMI is legally liable on the debts of NovaStar Trust, except for an amount limited to 10% of the maximum dollar amount of the Notes permitted to be issued.

 

    the only assets of NMI resulting from the issuance and sale of the Notes are:

 

  1) any cash portion of the purchase price paid from time to time by NovaStar Trust in consideration of Mortgage Loans sold to NovaStar Trust by NMI; and

 

  2) the value of NMI’s net equity investment in NovaStar Trust.

As of September 30, 2006, NovaStar Trust had the following assets:

 

  1) whole loans: $371.0 million

 

  2) cash and cash equivalents: $4.3 million.

As of September 30, 2006, NovaStar Trust had the following liabilities and equity:

 

  1) short-term debt due to UBS: $369.5 million, and

 

  2) $5.8 million in members’ equity investment.

Note 9. Commitments and Contingencies

Commitments. The Company has commitments to borrowers to fund residential mortgage loans as well as commitments to purchase and sell mortgage loans to third parties. At September 30, 2006, the Company had outstanding commitments to originate, purchase and sell loans of $860.9 million, $5.0 million and $372.3 million, respectively. At December 31, 2005, the Company had outstanding commitments to originate, purchase and sell loans of $545.4 million, $33.4 million and $93.6 million, respectively. The commitments to originate and purchase loans do not necessarily represent future cash requirements, as some portion of the commitments are likely to expire without being drawn upon.

In the ordinary course of business, the Company sells whole pools of loans with recourse for borrower defaults. When whole pools are sold as opposed to securitized, the third party has recourse against the Company for certain borrower defaults. Because the loans are no longer on the Company’s balance sheet, the recourse component is considered a guarantee. During the nine months ended September 30, 2006, the Company sold $1.5 billion of loans with recourse for borrower defaults. The Company maintained a $4.7 million reserve related to these guarantees as of September 30, 2006. During the nine months ended September 30, 2006 the Company paid $15.9 million in cash to repurchase loans sold to third parties.

In the ordinary course of business, the Company sells loans to securitization trusts and guarantees losses suffered by the trusts resulting from defects in the loan origination process. Defects may occur in the loan documentation and underwriting process, either through processing errors made by the Company or through intentional or unintentional misrepresentations made by the borrower or agents during those processes. If a defect is identified, the Company is required to repurchase the loan. As of September 30, 2006 and December 31, 2005, the Company had loans sold with recourse with an outstanding principal balance of $12.4 billion and $12.7 billion, respectively. Historically, repurchases of loans where a defect has occurred have been insignificant; therefore, the Company has recorded no reserves related to these guarantees.

 

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During the third quarter of 2006 the Company’s primary loan origination unit NovaStar Mortgage Inc. (“NMI”) entered into an agreement to acquire up to 21 retail mortgage lending locations and certain other assets of Oak Street Mortgage LLC. NMI will create a new retail division and expand its retail mortgage lending business beyond the current focus on customer retention programs. The transaction is expected to close late in the fourth quarter of 2006. The Company expects this expansion into the retail market will enable it to substantially increase its loan production. While Oak Street’s retail channel is already an efficient loan origination operation, the elimination of duplicate overhead should further reduce the Company’s cost of production.

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

In the wake of the securities class action, the Company has also been named as a nominal defendant in several derivative actions brought against certain of our officers and directors in Missouri and Maryland. The complaints in these actions generally claim that the defendants are liable to the Company for failing to monitor corporate affairs so as to ensure compliance with applicable state licensing and regulatory requirements.

In July 2004, an employee of NHMI, a wholly-owned subsidiary of the Company, filed a class and collective action lawsuit against NHMI and NMI in California Superior Court for the County of Los Angeles. Subsequently, NHMI and NMI removed the matter to the United States District Court for the Central District of California and NMI was removed from the lawsuit. The putative class is comprised of all past and present employees of NHMI who were employed from July 30, 2001 (2000 in California) through November 18, 2005 in the capacity generally described as Loan Officer. The plaintiffs alleged that NHMI failed to pay them overtime and minimum wage as required by the Fair Labor Standards Act (“FLSA”) and California state laws. In January 2005, the plaintiffs and NHMI agreed upon a nationwide settlement in the amount of $3.3 million on behalf of a class of all NHMI Loan Officers covering the period commencing July 30, 2001 (2000 in California) to May 1, 2006. The settlement covers all claims for minimum wage, overtime, meal and rest periods, record-keeping, and penalties under California and federal law during the class period, and was approved by the Court on May 1, 2006. Since not all class members elected to be part of the settlement, the Company obligation related to the settlement is approximately $1.7 million. Prior to 2006, in accordance with SFAS No. 5, Accounting for Contingencies, the Company recorded a charge to earnings of $1.5 million. In 2006 the Company recorded an additional charge to earnings of $200,000 as the estimated probable obligation increased to $1.7 million. A majority of this settlement has been paid out by September 30, 2006.

In April 2005, three putative class actions filed against NHMI and certain of its affiliates were consolidated for pre-trial proceedings in the United States District Court for the Southern District of Georgia entitled In Re NovaStar Home Mortgage, Inc. Mortgage Lending Practices Litigation. These cases allege that NHMI improperly shared settlement service fees with limited liability companies in which NHMI had an interest (the “LLCs”) alleging violations of the fee splitting and anti-referral provisions of the federal Real Estate Settlement Procedures Act (“RESPA”), and alleging certain violations of state law and civil conspiracy. Plaintiffs seek treble damages with respect to the RESPA claims, disgorgement of fees with respect to the state law claims as well as other damages, injunctive relief and attorney fees. In addition, two other related class actions have been filed in state courts. Miller v. NovaStar Financial, Inc. et al., was filed in October 2004 in the Circuit Court of Madison County, Illinois and Jones et al. v. NovaStar Home Mortgage, Inc. et al., was filed in December 2004 in the Circuit Court for Baltimore City, Maryland. In the Miller case, plaintiffs allege a violation of the Illinois Consumer Fraud and Deceptive Practices Act and civil conspiracy alleging certain LLCs provided settlement services without the borrower’s knowledge. The plaintiffs in the Miller case seek a disgorgement of fees, other damages, injunctive relief and attorney’s fees on behalf of the class of plaintiffs. In the Jones case, the plaintiffs allege the LLCs violated the Maryland Mortgage Lender Law by acting as lenders and/or brokers in Maryland without proper licenses and allege this arrangement amounted to a civil conspiracy. The plaintiffs in the Jones’ case seek a disgorgement of fees and attorney’s fees. On July 7, 2006, the court in the Jones’ case denied cross-motions for summary judgment on the grounds that material factual issues existed. The court granted plaintiffs’ motion to certify a statewide Maryland class. The Company believes that all of these claims are without merit and intend to vigorously defend against them.

 

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In December 2005, a putative class action was filed against NovaStar Mortgage in the United States District Court for the Western District of Washington entitled Pierce et al. v. NovaStar Mortgage, Inc. Plaintiffs contend that NovaStar Mortgage failed to disclose prior to closing that a broker payment would be made on their loans, which was an unfair and deceptive practice in violation of the Washington Consumer Protection Act. The plaintiffs seek excess interest charged, and treble damages as provided in the Washington Consumer Protection Act and attorney’s fees. On October 31, 2006, the court granted plaintiffs’ motion to certify a Washington state class. The Company believes that these claims are without merit and intends to vigorously defend against them.

In December 2005, a putative class action was filed against NHMI in the United States District Court for the Middle District of Louisiana entitled Pearson v. NovaStar Home Mortgage, Inc. Plaintiff contends that NHMI violated the federal Fair Credit Reporting Act (“FCRA”) in connection with its use of pre-approved offers of credit. Plaintiff seeks (on his own behalf, as well as for others similarly situated) statutory damages, other nominal damages, punitive damages and attorney’s fees and costs. The Company believes that these claims are without merit and intends to vigorously defend against them.

In addition to those matters listed above, the Company is currently a party to various other legal proceedings and claims, including, but not limited to, breach of contract claims, class action or individual claims for violations of the RESPA, FLSA, federal and state laws prohibiting employment discrimination, federal and state laws prohibiting discrimination in lending and federal and state licensing and consumer protection laws.

While management, including internal counsel, currently believes that the ultimate outcome of all these proceedings and claims will not have a material adverse effect on our financial condition or results of operations, litigation is subject to inherent uncertainties. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on our financial condition and results of operations.

In April 2004, the Company received notice of an informal inquiry from the Commission requesting that the Company provide various documents relating to our business. The Company has cooperated fully with the Commission’s inquiry and provided it with the requested information.

Note 10. Issuance and Repurchase of Capital Stock

The Company sold 2,566,453 shares of its common stock during the nine months ended September 30, 2006 under its Direct Stock Purchase and Dividend Reinvestment Plan (“DRIP”). Net proceeds of $76.9 million were raised under these sales of common stock. The Company also sold 1,458,000 shares of its common stock during the nine months ended September 30, 2006 in a registered controlled equity offering. The Company raised $41.9 million in proceeds from these sales, which were net of $0.4 million in expenses related to the offering.

During the nine months ended September 30, 2006, 97,630 shares of common stock were issued under the Company’s stock-based compensation plan. Proceeds of $0.3 million were received under these issuances.

On January 20, 2006, the Company initiated offers to rescind certain shares of its common stock issued pursuant to its 401(k) plan and DRIP that may have been sold in a manner that may not have complied with the registration requirements of applicable securities laws. The Company repurchased 493 shares of its common stock from eligible investors who accepted the rescission offers as of March 31, 2006, the date the rescission offers expired.

 

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Note 11. Comprehensive Income

Comprehensive income includes net income and revenues, expenses, gains and losses that are not included in net income. Following is a summary of comprehensive income for the nine and three months ended September 30, 2006 and 2005 (in thousands).

 

     For the Nine Months Ended
September 30,
   For the Three Months Ended
September 30,
 
     2006     2005    2006     2005  

Net Income

   $ 87,342     $ 111,015    $ 28,579     $ 36,293  

Other comprehensive (loss) income:

         

Change in unrealized gain on mortgage securities – available-for-sale, net of tax

     (43,595 )     34,666      (8,629 )     (26,379 )

Change in unrealized gain on mortgage securities – available-for-sale due to repurchase of mortgage loans from securitization trusts

     (5,015 )     —        (5,015 )     —    

Impairment on mortgage securities - available-for-sale reclassified to earnings

     13,249       10,066      6,796       8,328  

Reclassification adjustment into income for derivatives used in cash flow hedges

     (8 )     109      250       —    

Change in unrealized gain on derivative instruments used in cash flow hedges

     (1,051 )     —        (4,646 )     —    
                               

Other comprehensive (loss) income

     (36,420 )     44,841      (11,244 )     (18,051 )
                               

Total comprehensive income

   $ 50,922     $ 155,856    $ 17,335     $ 18,242  
                               

Note 12. Discontinued Operations

By June 30, 2006, the Company had terminated all of the remaining NHMI branches and related operations. The Company considers a branch to be discontinued upon its termination date, which is the point in time when the operations cease. The Company has presented the operating results of NHMI as discontinued operations in the condensed consolidated statements of income for the nine and three months ended September 30, 2006 and 2005. The operating results of all discontinued operations are summarized as follows (dollars in thousands):

 

     For the Nine Months Ended
September 30,
    For the Three Months Ended
September 30,
 
     2006     2005     2006     2005  

Interest income

   $ 148     $ 403     $ 12     $ 205  

Interest expense

     (194 )     (76 )     2       (8 )

Gains on sales of mortgage assets

     1,490       1,322       298       1,138  

Fee income

     5,850       32,668       256       8,642  

Other income

     220       80       28       35  

General and administrative expenses

     (10,248 )     (48,579 )     (446 )     (13,781 )
                                

(Loss) income before income tax (benefit) expense

     (2,734 )     (14,182 )     150       (3,769 )

Income tax (benefit) expense

     (1,017 )     (5,275 )     56       (1,402 )
                                

(Loss) income from discontinued operations

   $ (1,717 )   $ (8,907 )   $ 94     $ (2,367 )
                                

As of September 30, 2006, the Company had $1.0 million in cash, $1.0 million in deferred income tax asset, net, $5.9 million in other assets and $667,000 in payables included in accounts payable and other liabilities pertaining to discontinued operations, which are included in the condensed consolidated balance sheets. As of December 31, 2005, the Company had $5.6 million in cash, $7.4 million in mortgage loans held-for-sale, $4.6 million in deferred income tax asset, net, $1.5 million in other assets, $7.4 million in short-term borrowings secured by mortgage loans and $5.2 million in payables included in accounts payable and other liabilities pertaining to discontinued operations, which are included in the condensed consolidated balance sheets.

 

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Note 13. Segment Reporting

The Company reviews, manages and operates its business in three segments: mortgage portfolio management, mortgage lending and loan servicing. The Company’s branch operations segment was discontinued as of June 30, 2006, therefore the Company no longer considers it as a segment. The branch operations are now included as part of the mortgage lending segment and are presented as discontinued operations. The prior period results have been restated to reflect this change. Mortgage portfolio management operating results are driven from the income generated on the assets the Company manages less associated costs. Mortgage lending operations include the marketing, underwriting and funding of loan production as well as the results of NHMI, a wholly owned subsidiary of the Company, which has been presented as a discontinued operation. Loan servicing operations represent the income and costs to service the Company’s portfolio of loans. Following is a summary of the operating results of the Company’s segments for the nine and three months ended September 30, 2006 and 2005, as reclassified to reflect the change in segment structure and the results of the discontinued operations for the nine and three months ended September 30, 2006 and September 30, 2005 (dollars in thousands):

For the Nine Months Ended September 30, 2006

 

     Mortgage
Portfolio
Management
    Mortgage
Lending
    Loan
Servicing
    Eliminations     Total  

Interest income

   $ 220,169     $ 121,062     $ —       $ —       $ 341,231  

Interest expense

     83,433       95,222       —         (11,098 )     167,557  
                                        

Net interest income before provision for credit losses

     136,736       25,840       —         11,098       173,674  

Provision for credit losses

     (19,876 )     —         —         —         (19,876 )

Gains on sales of mortgage assets

     528       72,000       —         (21,501 )     51,027  

Premiums for mortgage loan insurance

     (4,401 )     (4,894 )     —         —         (9,295 )

Fee income

     2,287       4,439       19,336       (3,933 )     22,129  

Gains on derivative instruments

     109       7,745       —         —         7,854  

Impairment on mortgage securities – available- for-sale

     (13,249 )     —         —         —         (13,249 )

Other income (expense), net

     17,410       (4,054 )     20,952       (7,165 )     27,143  

General and administrative expenses

     (11,666 )     (110,139 )     (25,866 )     —         (147,671 )
                                        

Income (loss) from continuing operations before income tax expense

     107,878       (9,063 )     14,422       (21,501 )     91,736  

Income tax expense (benefit)

     8,733       (3,494 )     5,452       (8,014 )     2,677  
                                        

Income (loss) from continuing operations

     99,145       (5,569 )     8,970       (13,487 )     89,059  

Loss from discontinued operations, net of income tax

     —         (1,717 )     —         —         (1,717 )
                                        

Net income (loss)

   $ 99,145     $ (7,286 )   $ 8,970     $ (13,487 )   $ 87,342  
                                        

 

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For the Nine Months Ended September 30, 2005

 

     Mortgage
Portfolio
Management
    Mortgage
Lending
    Loan
Servicing
    Eliminations     Total  

Interest income

   $ 143,186     $ 77,680     $ —       $ —       $ 220,866  

Interest expense

     15,770       51,713       —         (8,886 )     58,597  
                                        

Net interest income before provision for credit losses

     127,416       25,967       —         8,886       162,269  

Provision for credit losses

     (1,050 )     —         —         —         (1,050 )

Gains on sales of mortgage assets

     82       62,380       —         (2,000 )     60,462  

Premiums for mortgage loan insurance

     (277 )     (3,731 )     —         —         (4,008 )

Fee income

     —         7,330       17,722       (207 )     24,845  

Gains on derivative instruments

     511       12,764       —         —         13,275  

Impairment on mortgage securities – available- for-sale

     (10,066 )     —         —         —         (10,066 )

Other income (expense), net

     15,886       (5,232 )     12,192       (8,678 )     14,168  

General and administrative expenses

     (11,929 )     (103,552 )     (25,185 )     —         (140,666 )
                                        

Income (loss) from continuing operations before income tax expense

     120,573       (4,074 )     4,729       (1,999 )     119,229  

Income tax (benefit) expense

     —         (1,682 )     1,725       (736 )     (693 )
                                        

Income (loss) from continuing operations

     120,573       (2,392 )     3,004       (1,263 )     119,922  

Loss from discontinued operations, net of income tax

     —         (8,907 )     —         —         (8,907 )
                                        

Net income (loss)

   $ 120,573     $ (11,299 )   $ 3,004     $ (1,263 )   $ 111,015  
                                        

 

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Table of Contents

For the Three Months Ended September 30, 2006

 

     Mortgage
Portfolio
Management
    Mortgage
Lending
    Loan
Servicing
    Eliminations     Total  

Interest income

   $ 87,772     $ 50,272     $ —       $ —       $ 138,044  

Interest expense

     41,973       38,711       —         (5,318 )     75,366  
                                        

Net interest income before provision for credit losses

     45,799       11,561       —         5,318       62,678  

Provision for credit losses

     (10,286 )     —         —         —         (10,286 )

Gains on sales of mortgage assets

     168       28,614       —         (1,073 )     27,709  

Premiums for mortgage loan insurance

     (2,124 )     (1,021 )     —         —         (3,145 )

Fee income

     2,051       1,356       6,789       (2,525 )     7,671  

Loss on derivative instruments

     —         (6,877 )     —         —         (6,877 )

Impairment on mortgage securities – available- for-sale

     (6,796 )     —         —         —         (6,796 )

Other income (expense), net

     5,540       (2,298 )     7,947       (2,793 )     8,396  

General and administrative expenses

     (2,640 )     (38,741 )     (7,671 )     —         (49,052 )
                                        

Income (loss) from continuing operations before income tax expense (benefit)

     31,712       (7,406 )     7,065       (1,073 )     30,298  

Income tax expense (benefit)

     2,362       (2,878 )     2,746       (417 )     1,813  
                                        

Income (loss) from continuing operations

     29,350       (4,528 )     4,319       (656 )     28,485  

Income from discontinued operations, net of income tax

     —         94       —         —         94  
                                        

Net income (loss)

   $ 29,350     $ (4,434 )   $ 4,319     $ (656 )   $ 28,579  
                                        

 

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Table of Contents

For the Three Months Ended September 30, 2005

 

     Mortgage
Portfolio
Management
    Mortgage
Lending
    Loan
Servicing
    Eliminations     Total  

Interest income

   $ 51,709     $ 36,169     $ —       $ —       $ 87,878  

Interest expense

     4,565       25,439       —         (4,968 )     25,036  
                                        

Net interest income before provision for credit losses

     47,144       10,730       —         4,968       62,842  

Provision for credit losses

     (331 )     —         —         —         (331 )

(Losses) gains on sales of mortgage assets

     (209 )     10,204       —         (304 )     9,691  

Premiums for mortgage loan insurance

     (83 )     (1,943 )     —         —         (2,026 )

Fee income

     —         2,640       4,869       (61 )     7,448  

(Losses) gains on derivative instruments

     (12 )     6,534       —         —         6,522  

Impairment on mortgage securities – available- for-sale

     (8,328 )     —         —         —         (8,328 )

Other income (expense), net

     8,202       (3,631 )     5,879       (4,907 )     5,543  

General and administrative expenses

     (4,174 )     (31,704 )     (8,531 )     —         (44,409 )
                                        

Income (loss) from continuing operations before income tax expense (benefit)

     42,209       (7,170 )     2,217       (304 )     36,952  

Income tax (benefit) expense

     —         (2,390 )     791       (109 )     (1,708 )
                                        

Income (loss) from continuing operations

     42,209       (4,780 )     1,426       (195 )     38,660  

Loss from discontinued operations, net of income tax

     —         (2,367 )     —         —         (2,367 )
                                        

Net income (loss)

   $ 42,209     $ (7,147 )   $ 1,426     $ (195 )   $ 36,293  
                                        

 

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Intersegment revenues and expenses that were eliminated in consolidation were as follows for the nine and three months ended September 30, 2006 and 2005 (in thousands):

 

    

For the Nine Months
Ended

September 30,

    For the Three Months
Ended
September 30,
 
     2006     2005     2006     2005  

Amounts paid to (received from) mortgage portfolio management from (to) mortgage lending:

        

Interest income on intercompany debt

   $ 11,098     $ 8,861     $ 5,318     $ 4,968  

Guaranty, commitment, loan sale and securitization fees

     3,639       7,103       1,422       2,820  

Interest income on warehouse borrowings

     —         25       —         —    

Gains on sales of mortgage securities – available-for-sale retained in securitizations

     (1,875 )     (2,000 )     (1,160 )     (304 )

(Gains) losses on sales of mortgage loans

     (19,626 )     —         87       —    

Amounts paid to (received from) mortgage portfolio management from (to) loan servicing:

        

Loan servicing fees

   $ (3,900 )   $ (207 )   $ (2,503 )   $ (61 )

Amounts paid to (received from) mortgage lending from (to) loan servicing:

        

Loan servicing fees

   $ (33 )   $ —       $ (22 )   $ —    

 

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Note 14. Earnings Per Share

The computations of basic and diluted earnings per share for the nine and three months ended September 30, 2006 and 2005 are as follows (in thousands, except per share amounts):

 

    

For the Nine Months

Ended September 30,

    For the Three Months
Ended September 30,
 
     2006     2005     2006     2005  

Numerator:

        

Income from continuing operations

   $ 89,059     $ 119,922     $ 28,485     $ 38,660  

Dividends on preferred shares

     (6,653 )     (4,989 )     (3,327 )     (1,663 )
                                

Income from continuing operations available to common shareholders

     82,406       114,933       25,158       36,997  

(Loss) income from discontinued operations, net of income tax

     (1,717 )     (8,907 )     94       (2,367 )
                                

Net income available to common shareholders

   $ 80,689     $ 106,026     $ 25,252     $ 34,630  
                                

Denominator:

        

Weighted average common shares outstanding – basic

     33,303       29,121       34,427       30,617  
                                

Weighted average common shares outstanding – dilutive:

        

Weighted average common shares outstanding – basic

     33,303       29,121       34,427       30,617  

Stock options

     235       339       243       336  

Restricted stock

     21       8       24       9  
                                

Weighted average common shares outstanding – dilutive

     33,559       29,468       34,694       30,962  
                                

Basic earnings per share:

        

Income from continuing operations

   $ 2.67     $ 4.12     $ 0.83     $ 1.26  

Dividends on preferred shares

     (0.20 )     (0.17 )     (0.10 )     (0.05 )
                                

Income from continuing operations available to common shareholders

     2.47       3.95       0.73       1.21  

(Loss) income from discontinued operations, net of income tax

     (0.05 )     (0.31 )     —         (0.08 )
                                

Net income available to common shareholders

   $ 2.42     $ 3.64     $ 0.73     $ 1.13  
                                

Diluted earnings per share:

        

Income from continuing operations

   $ 2.65     $ 4.07     $ 0.83     $ 1.25  

Dividends on preferred shares

     (0.20 )     (0.17 )     (0.10 )     (0.05 )
                                

Income from continuing operations available to common shareholders

     2.45       3.90       0.73       1.20  

(Loss) income from discontinued operations, net of income tax

     (0.05 )     (0.30 )     —         (0.08 )
                                

Net income available to common shareholders

   $ 2.40     $ 3.60     $ 0.73     $ 1.12  
                                

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

 

     For the Nine Months
Ended September 30,
   For the Three Months
Ended September 30,
     2006    2005    2006    2005

Number of stock options and restricted stock (in thousands)

     239      79      268      92

Weighted average exercise price

   $ 35.28    $ 40.45    $ 35.00    $ 40.61

 

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Note 15. Stock Compensation Plans

On June 8, 2004, the Company’s 1996 Stock Option Plan (the “1996 Plan”) was replaced by the 2004 Incentive Stock Plan (“the 2004 Plan”). The 2004 Plan provides for the grant of qualified incentive stock options (“ISOs”), non-qualified stock options (“NQSOs”), deferred stock, restricted stock, performance share awards, dividend equivalent rights (“DERs”) and stock appreciation awards (“SARs”). The Company has granted ISOs, NQSOs, restricted stock, performance share awards and DERs. ISOs may be granted to employees of the Company. NQSOs, DERs, SARs and stock 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 grant is equal to 2.5 million shares of common stock. The Plan will remain in effect unless terminated by the Board of Directors or no shares of stock remain available for awards to be granted. The Company’s policy is to issue new shares upon option exercise.

Effective January 1, 2006, the Company adopted provisions of SFAS No. 123(R). The Company selected the modified prospective method of adoption. The Company recorded stock-based compensation expense of $2.0 million and $1.6 million for the nine months ended September 30, 2006 and 2005, respectively. As of September 30, 2006, there was $4.5 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted. The cost is expected to be amortized over a weighted average period of 3.50 years.

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 generally vest equally over four years and expire ten years after the date of grant. The total intrinsic value of options exercised during the nine months ended September 30, 2006 and 2005 was $0.6 million and $2.7 million, respectively. The total fair value of options vested during the nine months ended September 30, 2006 and 2005 was $1.5 million and $0.4 million, respectively.

The following table summarizes stock option activity for the nine months ended September 30, 2006 and 2005, respectively:

 

     2006    2005

Stock Options

   Shares     Weighted
Average
Price
   Aggregate
Intrinsic
Value
   Shares     Weighted
Average
Price
   Aggregate
Intrinsic
Value

Outstanding at the beginning of period

   401,168     $ 18.39       433,600     $ 10.16   

Granted

   162,040       31.74       99,128       41.07   

Exercised

   (29,500 )     9.41       (82,500 )     4.43   

Forfeited

   (6,480 )     20.86       (19,310 )     19.02   
                       

Outstanding at the end of period

   527,228     $ 22.96    $ 3,283,307    430,918     $ 17.97    $ 6,472,143
                                       

Exercisable at the end of period

   265,679     $ 16.24    $ 3,441,738    169,350     $ 12.39    $ 3,487,972
                                       

Pursuant to a resolution of the Company’s compensation committee of the Board of Directors dated December 14, 2005, 227,455 and 70,363 options issued to employees and directors, respectively, were modified. The Company modified all options which were either unvested as of January 1, 2005 or were granted during 2005. For employee options, the rate in which DERs accrue was modified from sixty percent of the dividend per share amount to one hundred percent and the form for which DERs will be paid was modified from stock to cash upon vesting. For director options, only the form for which DERs will be paid was modified from stock to cash upon vesting. These options were granted and canceled during the fourth quarter of 2005. No modifications were made to the exercise prices, vesting periods or expiration dates. At the date of modification, the canceled options were revalued and the modified options were initially valued. The incremental difference between the value of the modified option and the canceled option will be amortized into compensation expense over the remaining vesting period.

 

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For options which vested prior to January 1, 2005, a recipient is entitled to receive additional shares of stock upon the exercise of options as a result of DERs associated with the option. For employees, the DERs accrue at a rate equal to the number of options outstanding times sixty percent of the dividends per share amount at each dividend payment date. For directors, the DERs accrue at a rate equal to the number of options outstanding times the dividends per share amount at each dividend payment date. The accrued DERs convert to shares based on the stock’s fair value on the dividend payment date. Certain of the options exercised during the nine months ended September 30, 2006 and 2005 had DERs payable in additional shares of stock attached to them when issued. As a result of these exercises, an additional 12,479 and 8,187 shares of common stock were issued during the nine months ended September 30, 2006 and 2005, respectively.

For options granted after January 1, 2005, a recipient is entitled to receive DERs paid in cash upon vesting of the options. The DERs accrue at a rate equal to the number of options outstanding times the dividends per share amount at each dividend payment date. The DERs begin accruing immediately upon grant, but are not paid until the options vest.

The following table presents information on stock options outstanding as of September 30, 2006.

 

     Outstanding    Exercisable

Exercise Price

   Quantity   

Weighted

Average
Remaining
Contractual
Life (Years)

   Weighted
Average
Exercise
Price
   Quantity    Weighted
Average
Exercise
Price

$1.53 – $7.16

   83,500    5.12    $ 5.63    83,500    $ 5.63

$7.91 - $12.97

   160,350    6.22      11.89    109,350      11.74

$22.66 - $33.59

   172,040    9.23      30.67    18,750      27.03

$35.53 - $42.13

   111,338    8.91      40.00    54,079      37.97
                  
   527,228    7.60    $ 22.96    265,679    $ 16.24
                            

The following table summarizes the weighted average fair value of options granted during the nine months ended September 30, 2006 and 2005, respectively, determined using the Black-Scholes option pricing model and the assumptions used in their determination. Expected volatilities are based on implied volatilities from traded options on the Company’s common stock.

 

     2006     2005  

Weighted average:

    

Fair value, at date of grant

   $ 12.48     $ 12.59  

Expected life in years

     5       5  

Annual risk-free interest rate

     4.7 %     4.1 %

Volatility

     37.5 %     42.8 %

Dividend yield

     0.0 %     3.7 %

The Company granted and issued shares of restricted stock during the nine months ended September 30, 2006 and 2005. The 2006 restricted stock awards vest at the end of 5 years while the 2005 restricted stock awards vest at the end of 10 years.

During the first nine months of 2005, the Company also granted restricted shares to employees and officers under Performance Contingent Deferred Stock Award Agreements. Under the agreements, the Company will issue shares of restricted stock if certain performance targets are achieved by the Company within a three-year period. The shares vest equally over two years upon issuance. No shares were issued under these agreements during the first nine months of 2006 or 2005. The total number of shares which can be issued in the future under these agreements is 20,655 as of September 30, 2006.

 

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In November 2004, the Company entered into a Performance Contingent Deferred Stock Award Agreement with an executive of the Company. Under the agreement, the Company will issue shares of restricted stock if certain performance targets based on wholesale nonconforming origination volume are achieved by the Company within a five-year period. The shares vest equally over four years upon issuance. No shares were issued related to this agreement in 2005 or 2006 and the total number of shares that can be issued in the future is 100,000 as of September 30, 2006.

The following table summarizes restricted stock activity for the first nine months of 2006 and 2005, respectively:

 

     2006
Shares
    2005
Shares
 

Outstanding at the beginning of year

   169,969     140,300  

Granted

   62,182     53,565  

Vested

   (9,714 )   (17,591 )

Forfeited

   (1,560 )   (5,440 )
            

Outstanding at the end of period

   220,877     170,834  
            

Note 16. Subsequent Events

The Company sold 542,000 shares of common stock in a registered controlled equity offering in October of 2006. Net proceeds of $15.7 million were raised under these sales.

The servicing agreements the Company executes for loans it has securitized include a “clean up” call option which gives it the right, not the obligation, to repurchase mortgage loans from the trust. The clean up call option can be exercised when the aggregate principal balance of the mortgage loans has declined to ten percent or less of the original aggregated mortgage loan principal balance. In October of 2006, the Company exercised the “clean up” call option on NMFT Series 2002-1and repurchased loans with a remaining principal balance of $46.3 million from these trusts for $46.3 million in cash. The trusts distributed the $46.3 million to retire the bonds held by third parties. Along with the cash paid to the trusts, the cost basis of the NMFT Series 2002-1 mortgage security, $2.5 million, became part of the cost basis of the repurchased mortgage loans.

 

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

The following discussion should be read in conjunction with the preceding unaudited condensed consolidated financial statements of NovaStar Financial, Inc. and its subsidiaries (the “Company” ,”NovaStar Financial”, “NFI” , “we” or “us”) and the notes thereto as well as NovaStar Financial’s annual report to shareholders and annual report on Form 10-K for the fiscal year ended December 31, 2005.

Safe Harbor Statement

Statements in this report regarding NovaStar Financial, Inc. and its business, which are not historical facts, are “forward-looking statements” that involve risks and uncertainties. Forward looking statements are those that predict or describe future events and that do not relate solely to historical matters. Certain matters discussed in this quarterly report may constitute forward-looking statements within the meaning of the federal securities laws that inherently include certain risks and uncertainties. Actual results and the timing of certain events could differ materially from those projected in or contemplated by the forward-looking statements due to a number of factors, including our ability to generate sufficient liquidity on favorable terms; the size, frequency and structure of our securitizations; interest rate fluctuations on our assets that differ from our liabilities; increases in prepayment or default rates on our mortgage assets; changes in assumptions regarding estimated loan losses and fair value amounts; changes in origination and resale pricing of mortgage loans; our compliance with applicable local, state and federal laws and regulations or opinions of counsel relating thereto and the impact of new local, state or federal legislation or regulations, or opinions of counsel relating thereto, or court decisions on our operations; the initiation of margin calls under our credit facilities; the ability of our servicing operations to maintain high performance standards and maintain appropriate ratings from rating agencies; our ability to expand origination volume while maintaining an acceptable level of overhead; our ability to adapt to and implement technological changes; the stability of residential property values; the outcome of litigation or regulatory actions pending against us; compliance with new accounting pronouncements; the impact of general economic conditions; and the risks that are outlined from time to time in our filings with the Commission, including this report on Form 10-Q. Other factors not presently identified may also cause actual results to differ. This document only speaks as of its date and we expressly disclaim any duty to update the information herein.

 

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Executive Overview of Performance

The following selected key performance metrics are derived from our condensed consolidated financial statements for the periods presented and should be read in conjunction with the more detailed information therein and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Table 1 — Summary of Financial Highlights and Key Performance Metrics

(dollars in thousands; except per share amounts)

 

    

For the Nine Months

Ended September 30,

   

For the Three Months

Ended September 30,

 
     2006     2005     2006     2005  

Net income available to common shareholders

   $ 80,689     $ 106,026     $ 25,252     $ 34,630  

Net income available to common shareholders, per diluted share

   $ 2.40     $ 3.60     $ 0.73     $ 1.12  

Estimated taxable net income available to common shareholders (A)

   $ 154,450     $ 219,689     $ 59,130     $ 62,105  

Estimated taxable net income available to common shareholders, per share (A)

   $ 4.25     $ 7.14     $ 1.63     $ 2.02  

Cash dividends declared per common share

   $ 5.60     $ 4.20     $ 2.80     $ 1.40  

Nonconforming originations and purchases (B)

   $ 7,587,290     $ 7,084,799     $ 2,935,879     $ 2,779,316  

Weighted average coupon of nonconforming originations and purchases (B)

     8.74 %     7.58 %     8.93 %     7.50 %

Nonconforming loans securitized

   $ 4,265,688     $ 5,889,460     $ 2,174,900     $ 2,140,171  

Nonconforming loans sold to third parties

   $ 1,486,832     $ 717,262     $ 693,776     $ 490,067  

Gains on sales of mortgage assets

   $ 51,027     $ 60,462     $ 27,709     $ 9,691  

Net interest yield on assets (C)

     1.25 %     1.63 %     1.12 %     1.81 %

Net yield on mortgage securities (D)

     27.97 %     30.57 %     24.39 %     34.28 %

Weighted average whole loan price used in the initial valuation of residual interests

     102.07       102.22       102.20       101.66  

Costs of wholesale production, as a percent of principal (E)

     1.90 %     2.43 %     1.79 %     2.18 %

(A) The common shares outstanding at the end of each period presented are used in calculating the taxable income per common share.
(B) Does not include bulk purchased MTA loans during the period.
(C) This metric is defined in Table 3.
(D) This metric is defined in Table 2.
(E) This metric is defined in Table 9.

Nine Months Ended September 30, 2006 as Compared to the Nine Months Ended September 30, 2005

Net income available to common shareholders declined by approximately $25.3 million during the nine months ended September 30, 2006 as compared to the same period of 2005. The following factors contributed to the decline:

 

    Shift in securitization strategies to add qualified assets to our balance sheet to insure our status as a real estate investment trust (“REIT”). This decision ultimately resulted in a decrease in securitization sales transaction volume from $5.9 billion for the nine months ended September 30, 2005 to $4.3 billion for the same period of 2006. During the second quarter of 2006, we structured the NHES Series 2006-1 securitization as well as the NHES 2006-MTA1 securitization as financing transactions instead of our typical sales transactions. As a result of the decline in the volume of loans securitized in sales transactions, our gains on sales of mortgage assets declined to $51.0 million during the nine months ended September 30, 2006 from $60.5 million during the same period of 2005.

 

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    The decline in interest income due to our mortgage securities – available-for-sale portfolio decreasing to $428.8 million as of September 30, 2006 from $541.9 million as of September 30, 2005 as well as the net yield on the portfolio decreasing by 2.6% from 2005. The decrease in our mortgage securities – available-for-sale portfolio is primarily related to the execution of two securitizations structured as financings as well as expected erosion of the portfolio due to tightening margins and normal paydowns. The net yield on our mortgage securities decreased during 2006 due to the addition of lower-yielding mortgage securities to our portfolio. The mortgage securities – available-for-sale (residual interests) we retained from our most recent securitizations are accreting income at lower yields than many of our older securities due to margin compression. We also began retaining and purchasing certain subordinated mortgage securities from securitizations at the end of 2005 with the intent to finance these assets in the collateralized debt obligation (“CDO”) market. These securities have been classified as trading and aggregated $270.9 million as of September 30, 2006. The yields on our trading securities are generally lower than the yields on our mortgage securities – available-for-sale. Our portfolio management focus continues to be on managing a portfolio to deliver attractive risk-adjusted returns. Assuming all other factors unchanged, because of industry margin compression, the net yield on our mortgage securities portfolio should generally decrease as our older higher-yielding securities pay down and we add new lower-yielding securities.

 

    The increase in the provision for credit losses for the nine months ended September 30, 2006 from the same period in 2005. We increased our provision for credit losses by approximately $18.8 million for the nine months ended September 30, 2006 from the same period in 2005 due to $2.7 billion of securitizations structured as financing transactions we executed in 2006. Our provision for credit losses significantly offset the positive impact to interest income yielded by these transactions.

 

    Higher expected credit losses due to housing appreciation concerns contributed to impairments increasing by $3.2 million in 2006 from 2005. As can be seen by our increase in credit loss assumptions as well as our high provision for credit losses, we are beginning to see the effects of a cooling housing market on mortgage credit quality.

 

    The rise in short-term interest rates in 2006 was much less than 2005. This resulted in a $5.4 million decrease in the gains we recognized on derivative instruments which did not qualify for hedge accounting during the nine months ended September 30, 2006 compared to the same period of 2005.

Three Months Ended September 30, 2006 as Compared to the Three Months Ended September 30, 2005

Net income available to common shareholders declined by approximately $9.4 million during the three months ended September 30, 2006 as compared to the same period of 2005. The following factors contributed to the decline:

 

    The increase in the provision for credit losses for the three months ended September 30, 2006 from the same period in 2005. We increased our provision for credit losses by approximately $10.0 million for the three months ended September 30, 2006 from the same period in 2005 due to $2.7 billion of securitizations structured as financing transactions we executed in 2006. Our provision for credit losses significantly offset the positive impact to interest income yielded by these transactions.

 

    The rise in short-term interest rates in 2006 was much less than 2005. This resulted in a $13.4 million decrease in the gains we recognized on derivative instruments which did not qualify for hedge accounting during the three months ended September 30, 2006 compared to the same period of 2005.

Dividends

On September 11, 2006, the Board of Directors of NovaStar announced the declaration of remaining common and preferred dividends for 2006:

 

    a common stock dividend of $1.40 per share, payable November 30, 2006, to shareholders of record as of November 20, 2006

 

    a common stock dividend of $1.40 per share, payable December 29, 2006, to shareholders of record as of December 19, 2006

 

    a quarterly dividend of $.55625 per share on our 8.90% Class C Cumulative Redeemable Preferred Stock, payable January 2, 2007, to holders of record as of December 5, 2006

 

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We anticipate these common dividends will result in a distribution of 100% distribution of our 2005 taxable income. The payment of the common dividend in December represents an acceleration of the fourth quarter payment. Historically, this dividend has been declared in December and paid in January.

Our fourth quarter 2006 preferred dividend is payable in January of 2007, and would typically reduce income available to common shareholders in the fourth quarter. Because we declared this dividend in the third quarter, it is reflected in our third quarter results and reduces income available to common shareholders for the third quarter by $1.7 million, or approximately $0.05 per diluted share. Also, it should be noted that in the fourth quarter we do not anticipate a reduction to net income available to common shareholders for preferred dividends.

The early declaration of our common dividend had a similar effect on ending shareholders’ equity in the third quarter. In the normal course of business, we accrue for our anticipated quarterly common dividend distribution. As such, our ending book value reflects our financial position as if the corresponding quarterly dividend had been declared in the quarter. However, given the early declaration of our fourth quarter 2006 common dividend, ending shareholders’ equity for the third quarter includes a reduction of $50.8 million for our estimated fourth quarter dividend distribution.

Industry Overview and Known Material Trends

Described below are some of the marketplace conditions and known material trends that may impact our future results of operations.

As we move into the fourth quarter of 2006, we believe the nonconforming mortgage market continues to offer a mix of opportunities and challenges. The following trends have become evident in the business environment in which we operate and could have a significant impact on our financial condition, results of operations and cash flows:

 

    Various industry publications predict that growth in the nonconforming origination market will be relatively flat for the remainder of 2006 and beginning of 2007 with some publications predicting a decline. Our ability to increase the size of our securitized mortgage loan portfolio, which drives our mortgage securities portfolio, at growth rates experienced in recent years, could be impaired under these tighter conditions. We continue to pursue opportunities to increase our market share in the nonconforming market, including through development of new business or acquisitions of existing businesses. To the extent that we acquire an existing business we may be required to incur additional debt or sell additional equity securities, which could be dilutive to our shareholders.

 

    Mortgage banking profit margins have lowered as a result of interest rates rising faster than the coupons on newly originated mortgage loans. The spread between funding costs and loan coupons has narrowed by more than 200 basis points since 2004. Some relief was evident in the first half of 2006 as the industry began to raise coupons on new originations, and we began to see more attractive whole loan prices. However, margins could continue to tighten if short-term interest rates increase and competitive pressures hold coupons on mortgage loans flat. If we sell our mortgage loans either in whole pools to third parties or in securitizations, we could continue to experience depressed gains and even losses on sales of mortgage loans. Additionally, the mortgage securities we are currently adding to our portfolio are yielding lower returns than our older securities as a result of these compressed margins. Increasing the size of our portfolio is one of our top priorities but not at the expense of long-term risk-adjusted returns or risk management.

 

    Rising home prices have begun to cool along with housing growth rates after a multiyear boom. Increasing prices have been fueling the volume of home refinancing, as well as, reducing the risk of existing mortgage loans by improving loan-to-value ratios. For the remainder of 2006, many economists are expecting slower home-price growth, perhaps even declines in some markets which had experienced substantial growth. This could have a significant impact on origination growth in our mortgage lending segment, as well as, prepayment speed and credit loss assumptions on the mortgage securities held by our mortgage portfolio management segment.

 

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While we continue to believe our best economic execution is realized from structuring a securitization as a sale for both GAAP and tax purposes, the current economic environment has made it necessary to add additional qualified assets to our REIT balance sheet. To provide qualifying income and assets to the REIT for purposes of these tests, we structured our NHES Series 2006-1 and NHES 2006-MTA1 securitizations as financing transactions at the REIT level instead of our typical sales transactions at the taxable REIT subsidiary level. The mortgage loans securitized under this structure came from our normal origination and purchase channels as well as from our MTA bulk loan purchases of approximately $1.0 billion which occurred in the first quarter of 2006. The MTA bulk loan purchase was, and future whole pool purchases could be, much larger in size as compared to our typical correspondent purchases. We would also expect these purchases to be eligible for financing through our warehouse repurchase agreements until they are securitized. See “Financial Condition – Short-term Borrowings” as well as “Liquidity and Capital Resources” for discussion of our financing facilities and other liquidity sources.

We generally expect to execute most of our future securitizations as sales transactions but we may continue to execute financing transactions from time to time depending on future economic as well as general business conditions.

In a securitization structured as a financing, no gain is recognized at the time of securitization, the mortgage loans remain on the balance sheet and the asset-backed bonds issued to third parties are recorded as debt on the balance sheet. These are clearly much different accounting dynamics than our historical securitizations structured as sales. In a sale, a gain is recognized at the time of securitization, the mortgage loans are removed from the balance sheet and new mortgage securities (retained interests) are recorded. Net income for any quarter in which we structure a securitization as a financing generally will be significantly lower than if the securitization were structured as a sale because there is no gain recognition associated with a financing. This initial difference in net income will reverse itself over the remaining life of the securitization resulting in no significant difference in net income recognized under either structure over the life of the securitization.

Additionally, structuring a securitization as a financing generally gives rise to excess inclusion income. If we incur excess inclusion income at the REIT, it will be allocated among our shareholders. A shareholder’s share of excess inclusion income (i) would not be allowed to be offset by any net operating losses otherwise available to the shareholder, (ii) would be subject to tax as unrelated business taxable income in the hands of most types of shareholders that are otherwise generally exempt from federal income tax, and (iii) would result in the application of U.S. federal income tax withholding at the maximum rate (i.e., 30%), without reduction for any otherwise applicable income tax treaty, to the extent allocable to most types of foreign shareholders. How such income is to be reported to shareholders is not clear under current law. The amounts of excess inclusion income in any given year from these transactions could be significant. Tax-exempt investors, foreign investors, and taxpayers with net operating losses should carefully consider the tax consequences of having excess inclusion income allocated to them and are urged to consult their tax advisors.

Another strategy we executed in the first quarter of 2006 to ensure we maintain our REIT qualification was the contribution of certain bonds from the REIT to NFI Holding Corporation, a wholly-owned subsidiary of NFI, and its subsidiaries (collectively known as the “TRS”). Certain of the residual securities that historically have been held at the REIT generate interest income based on cash flows received from excess interest spread, prepayment penalties and derivatives (i.e., interest rate swap and cap contracts). The cash flows received from the derivatives does not represent qualified income for the REIT income tests requirements of the Code. The Code limits the amount of income from derivative income together with any income not generated from qualified REIT assets to no more than 25% of our gross income. In addition, under the Code, we must limit our aggregate income from derivatives (that are non-qualified tax hedges) and from other non-qualifying sources to no more than 5% of our annual gross income. Because of the magnitude of the derivative income projected for 2006 it was highly likely that we would not satisfy the REIT income tests. In order to resolve this REIT qualification issue, we isolated cash flows received from the residual securities and created a separate security for certain of the bonds that generate derivative income (the “CT Bonds”) and then contributed the CT Bonds from the REIT to our taxable REIT subsidiary. This transaction may add volatility to future reported GAAP earnings because both the interest only residual bonds (“IO Bonds”) and CT Bonds will be evaluated separately for impairment. Historically, the CT Bonds have acted as an economic hedge for the IO Bonds that are retained at the REIT, thus mitigating the impairment risk to the IO Bonds in a rising interest rate environment. As a result of transferring the CT Bonds to the TRS, the IO and CT Bonds will be valued separately creating the risk of earnings volatility resulting from other-than-temporary impairment charges. For example, in a rising rate environment, the IO bond will generally decrease in value while the CT Bond will increase in value. If the decrease in value of the IO Bond is deemed to be other than temporary in nature, we would record an impairment charge through the income statement for such decrease. At the same time, any increase in value of the CT Bond would be recorded in accumulated other comprehensive income. See Table 8 for a summary of impairments on our mortgage securities – available-for-sale.

 

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During late 2005 and the first three quarters of 2006 we have retained various subordinate investment-grade securities from our securitization transactions that were previously held in the form of overcollateralization bonds. We have also purchased subordinated securities from other asset-backed securities (“ABS”) issuers. We will continue to retain, acquire and aggregate various types of ABS as well as synthetic assets with the intention of securing non-recourse term financing through securitizations while retaining the risk of the underlying securities by investing in the equity and subordinated debt pieces of the collateralized debt obligation (“CDO”). CDO equity securities bear the first-loss and second-loss credit risk with respect to the securities owned by the securitization entity. Our goal is to leverage our extensive portfolio management experience for shareholders by purchasing securities that are higher in the capital structure than our residual securities and executing CDOs for long-term non-recourse financing, thereby generating good risk-adjusted returns for shareholders. We anticipate executing our first CDO in the late 2006 to early 2007 timeframe depending on market conditions and we have not yet determined how these transactions will be structured for GAAP and tax purposes.

During the third quarter of 2006 our primary loan origination unit, NovaStar Mortgage Inc. entered into an agreement to acquire up to 21 retail mortgage lending locations and certain other assets of Oak Street Mortgage LLC. NMI will create a new retail division and expand its retail mortgage lending business beyond the current focus on customer retention programs. The transaction is expected to close late in the fourth quarter of 2006. We expect this expansion into the retail market to enable us to substantially increase our loan production. While Oak Street’s retail channel is already an efficient loan origination operation, the elimination of duplicate overhead should further reduce our cost of production.

Company Overview

We operate as a specialty finance company that originates, purchases, securitizes, sells, invests in and services residential nonconforming loans. We offer a wide range of mortgage loan products to borrowers, commonly referred to as “nonconforming borrowers,” who generally do not satisfy the credit, collateral, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers, including United States of America government-sponsored entities such as Fannie Mae or Freddie Mac.

We operate three core businesses:

 

  Mortgage portfolio management

 

  Mortgage lending

 

  Loan servicing

We no longer include our branch operations as a core business as it was discontinued as of June 30, 2006.

Mortgage Portfolio Management

We operate as a long-term mortgage securities and mortgage loan portfolio investor. We invest in assets generated primarily from our originations and purchases of nonconforming, single-family, residential mortgage loans. These assets we invest in consist primarily of beneficial interests we retain from our securitization transactions accounted for as sales as well as mortgage loans we have classified as held-in-portfolio related to our securitizations treated as financings.

Our portfolio of mortgage securities includes interest-only, prepayment penalty, overcollateralization securities retained from our securitizations (collectively, the “residual securities”), subordinated mortgage securities also retained from our securitizations as well as bonds we have purchased from other issuers (collectively, the “subordinated securities”). We finance our investment in these mortgage securities by issuing asset-backed bonds (“ABB”), debt and capital stock and entering into repurchase agreements.

The long-term mortgage loan portfolio on our balance sheet consists of mortgage loans classified as held-in-portfolio resulting from securitization transactions treated as financings from 1998 (NHES Series 1998-1 and NHES Series 1998-2) as well as two securitizations completed in the second and third quarters of 2006 (NHES Series 2006-1 and NHES Series 2006-MTA1). We have financed our investment in these loans by issuing ABB.

Our mortgage portfolio management operations generate earnings primarily from the return on our mortgage securities and mortgage loan portfolio.

A significant risk relating to our mortgage portfolio management segment is interest rate risk - the risk that interest rates on the mortgage loans which underly our mortgage securities will not adjust at the same times or in the same amounts that interest rates on the liabilities adjust. Most of the loans in our portfolio have fixed rates of interest for a period of time ranging from 2 to 30 years. Our funding costs generally adjust monthly off the one-month LIBOR rate. We use derivative instruments to mitigate the risk of our cost of funding increasing at a faster rate than the interest on the loans (both those on the balance sheet and those that serve as collateral for mortgage securities).

 

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In 2002, we began transferring interest rate agreements at the time of securitization into the securitization trusts to protect the third-party bondholders from interest rate risk and to decrease the volatility of future cash flows related to the securitized mortgage loans. We enter into these interest rate agreements as we originate and purchase mortgage loans in our mortgage lending segment. See “Mortgage Lending” for discussion of the impact of these interest rate agreements on our operating results. At the time of securitization, the interest rate agreements are transferred to the securitization trust and removed from our balance sheet. The trust assumes the obligation to make payments and obtains the right to receive payments under these agreements. Generally, net settlement obligations paid by the trust for these interest rate agreements reduce the excess interest cash flows to our residual securities. Net settlement receipts from these interest rate agreements are either used to: cover any interest shortfalls on the third-party primary bonds or are used to provide credit enhancement. Any remaining funds then flow to our residual securities.

We execute securitizations of mortgage loans intended to be treated as both sales and financings per the accounting rules. Prior to 1999 our securitizations were treated as financing transactions. From 1999 through 2005 each of the loan securitization transactions we executed was treated as a sale for accounting purposes. During the second and third quarters of 2006 we executed two securitizations treated as financings and four securitizations treated as a sale of loans. In the future we may execute securitization transactions of mortgage loans intended to be treated as either sales or financings for accounting purposes.

In securitizations treated as financings the mortgage loans and debt related to these securitizations are presented on our consolidated balance sheets and retained interests are not created. We record interest income and a provision for credit losses on the mortgage loans, interest expense on the debt securities, as well as ancillary fees, over the life of the securitization, instead of recognizing a gain on sale upon closing of the securitization.

In securitizations treated as sales the loans and related bond liability are not recorded in our consolidated financial statements. A gain on sale is recorded to the income statement upon closing of the securitization. In addition, we record the value of the residual and subordinated securities and servicing rights we retain on our balance sheet.

Mortgage Lending

The mortgage lending operation is significant to our financial results as it produces the loans that ultimately collateralize the mortgage securities that we hold in our portfolio. The loans we originate and purchase are sold, either in securitization transactions structured as sales or financing transactions, or are sold outright to third parties. We finance the loans we originate and purchase by using warehouse repurchase agreements on a short-term basis. For long-term financing, we securitize our mortgage loans and issue ABB.

Our mortgage lending operations generate earnings primarily from securitizing and selling loans for a premium. We also earn revenue from fees from loan originations and interest income on mortgage loans held-for-sale. The timing, size and structure of our securitization transactions have a significant impact on the gain on sale recognized and ultimately the profitability of this operation. In addition the market prices for whole loans and short-term interest rates have a significant impact on this operation’s profitability.

Our wholly-owned subsidiary, NMI, originates and purchases primarily nonconforming, single-family residential mortgage loans. Our mortgage lending operation continues to innovate in loan origination. We adhere to three disciplines which underly our lending decisions:

 

  Originating loans that perform in line with expectations,

 

  Maintaining economically sound pricing (profitable coupons), and

 

  Controlling costs of origination.

In our nonconforming lending operations, we lend to individuals who generally do not qualify for agency/conventional lending programs because of a lack of available documentation or previous credit difficulties. These types of borrowers are generally willing to pay higher mortgage loan origination fees and interest rates than those charged by conventional lenders. Because these borrowers typically use the proceeds of the mortgage loans to consolidate debt and to finance home improvements, education and other consumer needs, loan volume is generally less dependent on general levels of interest rates or home sales and therefore less cyclical than conventional mortgage lending.

 

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Our nationwide loan origination network includes wholesale loan brokers, mortgage lenders, correspondent institutions and direct to consumer operations. These brokers and mortgage lenders are independent from any of the NovaStar Financial entities. Our sales force, which includes account executives in 41 states, develops and maintains relationships with this network of independent retail brokers. Our correspondent origination channel consists of a network of institutions from which we purchase nonconforming mortgage loans on a bulk or flow basis. Our direct to consumer operations channel consists of call centers where we contact potential borrowers.

We underwrite, process, fund and service the nonconforming mortgage loans sourced through our network of wholesale loan brokers and mortgage lenders and our direct to consumer operations in centralized facilities.

A significant risk to our mortgage lending operations is the risk that we will not have financing facilities and cash available to fund and hold loans prior to their sale or securitization. We maintain lending facilities with large banking and investment institutions to reduce this risk. On a short-term basis, we finance mortgage loans using warehouse repurchase agreements. In addition, we have access to facilities secured by our mortgage securities.

As discussed under “Company Overview - Mortgage Portfolio Management,” interest rate risk is a significant risk to our mortgage lending operations as well as our mortgage portfolio management operations. Prior to securitization, we enter into interest rate agreements as we originate and purchase mortgage loans to help mitigate interest rate risk. At the time of securitization structured as a sale, we transfer interest rate agreements into the securitization trusts and they are removed from our balance sheet. For securitizations structured as financings the derivatives will remain on our balance sheet. Generally, these interest rate agreements do not meet the hedging criteria set forth in GAAP while they are on our balance sheet; therefore, we are required to record their change in value as a component of earnings even though they may reduce our interest rate risk. In times when short-term rates rise or drop significantly, the value of our agreements will increase or decrease, respectively. Occasionally, we enter into interest rate agreements that do meet the hedging criteria set forth in GAAP. In these instances we record their change in value, if effective, directly to other comprehensive income on our statement of shareholder’s equity.

To mitigate the effect of prepayments on interest income from mortgage loans, we generally strive to originate and purchase mortgage loans with prepayment penalties. Prepayment penalties have decreased since 2004 due to increased regulation specifically aimed at reducing prepayment penalties that can be charged by lenders. Because more borrowers can now refinance their mortgages at any time with no penalty, we would expect prepayment speeds to be slightly faster as a result of the reduction in these penalties. 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. Nonconforming borrowers, as they update their credit rating and as housing prices increase, are more likely to refinance their mortgage loan to obtain a lower interest rate or take advantage of the additional borrowing capacity in their homes.

Loan Servicing

Management believes loan servicing remains a critical part of our business operation because maintaining contact with our borrowers is critical in managing credit risk and for borrower retention. Nonconforming borrowers are more prone to late payments and are more likely to default on their obligations than conventional borrowers. By servicing our loans, we strive to identify problems with borrowers early and take quick action to address problems. 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, we can provide them with information about NovaStar Financial products to encourage them to refinance with us.

We retain the servicing rights with respect to the loans we securitize. Mortgage servicing yields fee income for us in the form of fees paid by the borrowers for normal customer service and processing fees. In addition we receive contractual fees of approximating 0.50% of the outstanding balance for loans we service that we do not own.

 

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Critical Accounting Estimates

We prepare our condensed consolidated financial statements in conformity with GAAP and, therefore, are required to make estimates regarding the values of our assets and liabilities and in recording income and expenses. These estimates are based, in part, on our judgment and assumptions regarding various economic conditions that we believe are reasonable based on facts and circumstances existing at the time of reporting. These estimates affect reported amounts of assets, liabilities and accumulated other comprehensive income at the date of the condensed consolidated financial statements and the reported amounts of income, expenses and other comprehensive income during the periods presented. The following summarizes the components of our condensed consolidated financial statements where understanding accounting policies is critical to understanding and evaluating our reported financial results, especially given the significant estimates used in applying the policies. The discussion is intended to demonstrate the significance of estimates to our financial statements and the related accounting policies. Detailed accounting policies are provided in Note 1 to our Form 10-K for the fiscal year ended December 31, 2005. Our critical accounting estimates impact each of our three reportable segments; our mortgage portfolio management, mortgage lending and loan servicing segments. Management has discussed the development and selection of these critical accounting estimates with the audit committee of our Board of Directors and the audit committee has reviewed our disclosure.

Transfers of Assets (Loan and Mortgage Security Securitizations) and Related Gains. In a loan securitization, we combine the mortgage loans we originate and purchase in pools to serve as collateral for issued asset-backed bonds. In a mortgage security securitization (also known as a “resecuritization”), we combine mortgage securities retained in previous loan securitization transactions to serve as collateral for asset-backed bonds. The loans or mortgage securities are transferred to a trust designed to serve only for the purpose of holding the collateral. The trust is considered a qualifying special purpose entity as defined by SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – a replacement of FASB Statement No. 125. The owners of the asset-backed bonds have no recourse to us in the event the collateral does not perform as planned except where defects have occurred in the loan documentation and underwriting process.

In order for us to determine proper accounting treatment for each securitization or resecuritization, we evaluate whether or not we have retained or surrendered control over the transferred assets by reference to the conditions set forth in SFAS No. 140. All terms of these transactions are evaluated against the conditions set forth in this statement. Some of the questions that must be considered include:

 

    Have the transferred assets been isolated from the transferor?

 

    Does the transferee have the right to pledge or exchange the transferred assets?

 

    Is there a “call” agreement that requires the transferor to return specific assets?

 

    Is there an agreement that both obligates and entitles the transferee to return the transferred assets prior to maturity?

 

    Have any derivative instruments been transferred?

When these transfers are executed in a manner such that we have surrendered control over the collateral, the transfer is accounted for as a sale. In accordance with SFAS No. 140, a gain or loss on the sale is recognized based on the carrying amount of the financial assets involved in the transfer, allocated between the assets transferred and the retained interests based on their relative fair value at the date of transfer. In a securitization accounted for as a sale, we retain the right to service the underlying mortgage loans and we also retain certain mortgage securities issued by the trust. As previously discussed, the gain recognized upon a securitization structured as a sale depends on, among other things, the estimated fair value of the components of the securitization – the loans or mortgage securities – available-for-sale and derivative instruments transferred, the securities retained and the mortgage servicing rights. The estimated fair value of the securitization components is considered a “critical accounting estimate” as 1) these gains or losses can represent a significant portion of our operating results and 2) the valuation assumptions used regarding economic conditions and the make-up of the collateral, including interest rates, principal payments, prepayments and loan defaults are highly uncertain and require a large degree of judgment.

We use two methodologies for determining the initial value of our residual securities 1) the whole loan price methodology and 2) the discount rate methodology. We believe the best estimate of the initial value of the residual securities we retain in our securitizations accounted for as a sale is derived from the market value of the pooled loans. As such, we generally will try to use the whole loan price methodology when significant open market sales pricing data is available. Under this method, the initial value of the loans transferred in a securitization accounted for as a sale is estimated based on the expected open market sales price of a similar pool. In open market transactions, the purchaser has the right to reject loans at its discretion. In a loan securitization, loans generally cannot be rejected. As a result, we adjust the market price for the loans to compensate for the estimated value of rejected loans. The market price of the securities retained is derived by deducting the percent of net proceeds received in the securitization (i.e. the economic value of the loans transferred) from the estimated adjusted market price for the entire pool of the loans.

 

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

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

For purposes of valuing our residual securities, it is important to know that in recent securitization transactions we not only have transferred loans to the trust, but we have also transferred interest rate agreements to the trust with the objective of reducing interest rate risk within the trust. During the period before loans are transferred in a securitization transaction we enter into interest rate swap or cap agreements. Certain of these interest rate agreements are then transferred into the trust at the time of securitization. Therefore, the trust assumes the obligation to make payments and obtains the right to receive payments under these agreements.

In valuing our residual securities, it is also important to understand what portion of the underlying mortgage loan collateral is covered by mortgage insurance. At the time of a securitization transaction, the trust legally assumes the responsibility to pay the mortgage insurance premiums associated with the loans transferred and the rights to receive claims for credit losses. Therefore, we have no obligation to pay these insurance premiums. The cost of the insurance is paid by the trust from proceeds the trust receives from the underlying collateral. This information is significant for valuation as the mortgage insurance significantly reduces the credit losses born by the owner of the loan. Mortgage insurance claims on loans where a defect occurred in the loan origination process will not be paid by the mortgage insurer. The assumptions we use to value our residual securities consider this risk.

The weighted average net whole loan market price used in the initial valuation of our retained securities was 102.07 and 102.20 for the nine and three months ended September 30, 2006, respectively, compared to 102.22 and 101.66 for the same periods of 2005. The weighted average initial implied discount rate for the nine and three months ended September 30, 2006 was 15% as compared to 14% and 15% for the same periods of 2005, respectively. If the whole loan market price used in the initial valuation of our residual securities for the nine and three months ended September 30, 2006 had been increased or decreased by 50 basis points, the initial value of our residual securities and the gain we recognized would have increased or decreased by $21.3 million and $10.9 million, respectively.

When we do have the ability to exert control over the transferred collateral in a securitization, the assets remain on our financial statements and a liability is recorded for the related asset-backed bonds. The servicing agreements that we execute for loans we have securitized includes a removal of accounts provision which gives us the right, but not the obligation, to repurchase mortgage loans from the trust. The removal of accounts provision can be exercised for loans that are 90 days to 119 days delinquent. We record the mortgage loans subject to the removal of accounts provision in mortgage loans held-for-sale at fair value and the related repurchase obligation as a liability. In addition, we have a “clean up” call option that can be exercised when the aggregate principal balance of the mortgage loans has declined to ten percent or less of the original aggregated mortgage loan principal balance.

Mortgage Securities – Available-for-Sale and Trading. Our mortgage securities – available-for-sale and trading represent beneficial interests we retain in securitization and resecuritization transactions which include residual securities and subordinated securities as well as bonds issued by others which we have purchased. The residual securities include interest-only mortgage securities, prepayment penalty bonds and over-collateralization bonds. All of the residual securities retained by us have been classified as available-for-sale. The subordinated securities represent bonds which are senior to the residual securities but are subordinated to the bonds sold to third party investors. We have classified certain of our subordinated securities in both the available-for-sale and trading categories.

The residual securities we retain in securitization transactions structured as sales primarily consist of the right to receive the future cash flows from a pool of securitized mortgage loans which include:

 

    The interest spread between the coupon net of servicing fees on the underlying loans, the cost of financing, mortgage insurance, payments or receipts on or from derivative contracts and bond administrative costs.

 

    Prepayment penalties received from borrowers who payoff their loans early in their life.

 

    Overcollateralization which is designed to protect the primary bondholder from credit loss on the underlying loans.

 

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The subordinated securities we retain in our securitization transactions have a stated principal amount and interest rate and have been retained at a market discount from the stated principal amount. The performance of the securities is dependent upon the performance of the underlying pool of securitized mortgage loans. The interest rates these securities earn are variable and are subject to an available funds cap as well as a maximum rate cap. The securities receive principal payments in accordance with a payment priority which is designed to maintain specified levels of subordination to the senior bonds within the respective securitization trust. Because the subordinated securities are rated lower than AA, they are considered low credit quality and we account for the securities based on the effective yield method. The fair value of the subordinated securities is based on third-party quotes.

The cash flows we receive are highly dependent upon the interest rate environment. The interest rates on the bonds issued by the securitization trust are indexed to short-term interest rates, while the coupons on the pool of loans held by the securitization trust are less interest rate sensitive. As a result, as rates rise and fall, our cash flows will fall and rise, because the cash we receive on our residual securities is dependent on this interest rate spread. As our cash flows fall and rise, the value of our residual securities will decrease or increase. Additionally, the cash flows we receive are dependent on the default and prepayment experience of the borrowers of the underlying mortgage security collateral. Increasing or decreasing cash flows will increase or decrease the yield on our securities.

We believe the accounting estimates related to the valuation of our mortgage securities – available-for-sale and establishing the rate of income recognition on the mortgage securities – available-for-sale and trading are “critical accounting estimates”, because they can materially affect net income and shareholders’ equity and require us to forecast interest rates, mortgage principal payments, prepayments and loan default assumptions which are highly uncertain and require a large degree of judgment. The rate used to discount the projected cash flows is also critical in the valuation of our residual securities. We use internal, historical collateral performance data and published forward yield curves when modeling future expected cash flows and establishing the rate of income recognized on mortgage securities. We believe the value of our residual securities is fair, but can provide no assurance that future changes in interest rates, prepayment and loss experience or changes in the market discount rate will not require write-downs of the residual assets. For mortgage securities classified as available-for-sale, impairments would reduce income in future periods when deemed other-than-temporary.

As previously described, our mortgage securities available-for-sale and trading represent retained beneficial interests in certain components of the cash flows of the underlying mortgage loans to securitization trusts. Income recognition for our mortgage securities – available-for-sale and trading is based on the effective yield method. Under the effective yield method, as payments are received, they are applied to the cost basis of the mortgage related security. Each period, the accretable yield for each mortgage security is evaluated and, to the extent there has been a change in the estimated cash flows, it is adjusted and applied prospectively. The estimated cash flows change as management’s assumptions about credit losses, borrower prepayments and interest rates are updated. The assumptions are established using internally developed models. We prepare analyses of the yield for each security using a range of these assumptions. The accretable yield used in recording interest income is generally set within a range of assumptions. The accretable yield is recorded as interest income with a corresponding increase to the cost basis of the mortgage security.

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

To the extent that the cost basis of mortgage securities – available-for-sale exceeds the fair value and the unrealized loss is considered to be other than temporary, an impairment charge is recognized and the amount recorded in accumulated other comprehensive income or loss is reclassified to earnings as a realized loss. When we retain new residual securities during a period when short-term interest rate increases are greater than anticipated by the forward yield curve, we generally are more susceptible to impairments on our newer mortgage securities as they do not have sizable unrealized gains to help offset the decline in value.

Housing prices have enjoyed substantial appreciation in recent years, which has resulted in increasing prepayment rates. The market discount rates we are using to initially value our residual securities have declined from 2005. As of September 30, 2006, the weighted average discount rate used in valuing our residual securities was 16% as compared to 18% as of September 30, 2005. The weighted-average constant prepayment rate used in valuing our residual securities as of September 30, 2006 was 48% versus 45% as of September 30, 2005. If the discount rate used in valuing our residual securities as of September 30, 2006 had been increased by 5%, the value of our mortgage securities- available-for-sale would have decreased by $18.6 million. If we had decreased the discount rate used in valuing our residual securities by 5%, the value of our residual securities would have increased by $20.2 million.

 

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Mortgage Loans. Mortgage loans held-for-sale are recorded at the lower of cost or market determined on an aggregate basis. Mortgage loan origination fees and direct costs on mortgage loans held-for-sale are deferred until the related loans are sold. Premiums paid to acquire mortgage loans held-for-sale are also deferred until the related loans are sold. Mortgage loans held-in-portfolio are recorded at their cost, adjusted for the amortization of net deferred costs and for credit losses inherent in the portfolio. Mortgage loan origination fees and associated direct costs on mortgage loans held-in-portfolio are deferred and recognized over the life of the loan as an adjustment to yield using the level yield method. Premiums paid to acquire mortgage loans held-in-portfolio are also deferred and recognized over the life of the loan as an adjustment to yield using the level yield method.

Allowance for Credit Losses. An allowance for credit losses is maintained for mortgage loans held-in-portfolio. The allowance for credit losses on mortgage loans held-in-portfolio, and therefore the related adjustment to income, is based on the assessment by management of probable losses incurred based on various factors affecting our mortgage loan portfolio, including current economic conditions, the makeup of the portfolio based on credit grade, loan-to-value ratios, delinquency status, mortgage insurance we purchase and other relevant factors. The allowance is maintained through ongoing adjustments to operating income. The assumptions used by management regarding key economic indicators are highly uncertain and involve a great deal of judgment.

An internally developed migration analysis is the primary tool used in analyzing our allowance for credit losses. This tool takes into consideration historical information regarding foreclosure and loss severity experience and applies that information to the portfolio at the reporting date. We also take into consideration our use of mortgage insurance as a method of managing credit risk. We pay mortgage insurance premiums on loans maintained on our balance sheet and have included the cost of mortgage insurance in our income statement.

Our estimate of expected losses could increase if our actual loss experience is different than originally estimated. In addition our estimate of expected losses could increase if economic factors change the value we could reasonably expect to obtain from the sale of the property. If actual losses increase or if values reasonably expected to be obtained from property sales decrease, the provision for losses would increase. Any increase in the provision for losses would adversely affect our results of operations.

Derivative Instruments and Hedging Activities. Our strategy for using derivative instruments is to mitigate the risk of increased costs on our variable rate liabilities during a period of rising rates (i.e. interest rate risk). Our primary goals for managing interest rate risk are to maintain the net interest margin spread between our assets and liabilities and diminish the effect of changes in general interest rate levels on our market value. The interest rate swap and interest rate cap agreements we use have an active secondary market, and none are obtained for a speculative nature. These interest rate agreements are intended to provide income and cash flows to offset potential reduced net interest income and cash flows under certain interest rate environments. The determination of effectiveness is the primary assumption and estimate used in hedging. At trade date, these instruments and their hedging relationship are identified, designated and documented.

SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (as amended), 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. SFAS No. 133 requires derivative instruments to be recorded at their fair value with hedge ineffectiveness recognized in earnings.

Derivative instruments that meet the hedge accounting criteria of SFAS No. 133 are considered cash flow hedges. We also have derivative instruments that do not meet the requirements for hedge accounting. However, these derivative instruments do contribute to our overall risk management strategy by serving to reduce interest rate risk on average short-term borrowings collateralized by our loans held-for-sale.

Any changes in fair value of derivative instruments related to hedge effectiveness are reported in accumulated other comprehensive income. Changes in fair value of derivative instruments related to hedge ineffectiveness and non-hedge activity are recorded as adjustments to earnings. For those derivative instruments that do not qualify for hedge accounting, changes in the fair value of the instruments are recorded as adjustments to earnings.

 

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Mortgage Servicing Rights (“MSRs”). MSRs are recorded at allocated cost based upon the relative fair values of the transferred loans, derivative instruments and the servicing rights. MSRs are amortized in proportion to and over the projected net servicing revenues. Periodically, we evaluate the carrying value of originated MSRs based on their estimated fair value. If the estimated fair value, using a discounted cash flow methodology, is less than the carrying amount of the mortgage servicing rights, the mortgage servicing rights are written down to the amount of the estimated fair value. For purposes of evaluating and measuring impairment of MSRs we stratify the mortgage servicing rights based on their predominant risk characteristics. The most predominant risk characteristic considered is period of origination. The mortgage loans underlying the MSRs are pools of homogeneous, nonconforming residential loans.

The fair value of MSRs is highly sensitive to changes in assumptions. Changes in prepayment speed assumptions have the greatest impact on the fair value of MSRs. Generally, as interest rates decline, prepayments accelerate due to increased refinance activity, which results in a decrease in the fair value of MSRs. As interest rates rise, prepayments typically slow down, which generally results in an increase in the fair value of MSRs. All assumptions are reviewed for reasonableness on a quarterly basis and adjusted as necessary to reflect current and anticipated market conditions. Thus, any measurement of the fair value of MSRs is limited by the existing conditions and the assumptions utilized as of a particular point in time. Those same assumptions may not be appropriate if applied at a different point in time.

Impact of Recently Issued Accounting Pronouncements

At September 30, 2006, we had one stock-based employee compensation plan, which is described more fully in Note 15. From January 1, 2004 through December 31, 2005, we accounted for the plan under the recognition and measurement provisions of Financial Accounting Standards Board (“FASB”) Statement No. 123 (“SFAS 123”), Accounting for Stock-Based Compensation. Effective January 1, 2006, we adopted the fair value recognition provisions of FASB Statement No. 123(R) (“SFAS 123(R)”), “Share-Based Payments”, using the modified-prospective-transition method. Because we were applying the provisions of SFAS 123 prior to January 1, 2006, the adoption of SFAS 123(R) had no material impact on the condensed consolidated financial statements.

Prior to adoption of SFAS 123(R), we presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the Statement of Cash Flows. SFAS 123(R) requires the cash flows resulting from the tax benefits of tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. Additionally, the write-off of deferred tax assets relating to the excess of recognized compensation cost over the tax deduction resulting from the award will continue to be reflected within operating cash flows. Any excess tax benefits we recorded during the nine and three months ended September 30, 2006 are considered to have no material impact on the condensed consolidated financial statements.

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments”, an amendment of FASB Statements No. 133 and SFAS No. 140 (“SFAS 155”). This statement permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. It also clarifies which interest-only strips and principal-only strips are not subject to FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). The statement also establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or hybrid financial instruments that contain an embedded derivative requiring bifurcation. The statement also clarifies that concentration of credit risks in the form of subordination are not embedded derivatives, and it also amends SFAS 140 to eliminate the prohibition on a QSPE from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. SFAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Early adoption of this statement is allowed. We are still evaluating the impact the adoption of this statement will have on our condensed consolidated financial statements.

 

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In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets”, an amendment of SFAS No. 140 (“SFAS 156”). This statement requires that an entity separately recognize a servicing asset or a servicing liability when it undertakes an obligation to service a financial asset under a servicing contract in certain situations. Such servicing assets or servicing liabilities are required to be initially measured at fair value, if practicable. SFAS 156 also allows an entity to choose one of two methods when subsequently measuring its servicing assets and servicing liabilities: (1) the amortization method or (2) the fair value measurement method. The amortization method existed under Statement 140 and remains unchanged in (1) allowing entities to amortize their servicing assets or servicing liabilities in proportion to and over the period of estimated net servicing income or net servicing loss and (2) requiring the assessment of those servicing assets or servicing liabilities for impairment or increased obligation based on fair value at each reporting date. The fair value measurement method allows entities to measure their servicing assets or servicing liabilities at fair value each reporting date and report changes in fair value in earnings in the period the change occurs. SFAS 156 introduces the notion of classes and allows companies to make a separate subsequent measurement election for each class of its servicing rights. In addition, Statement 156 requires certain comprehensive roll-forward disclosures that must be presented for each class. The Statement is effective as of the beginning of an entity’s first fiscal year that begins after September 15, 2006. Earlier adoption is permitted as of the beginning of an entity’s fiscal year, so long as the entity has not yet issued financial statements, including financial statements for any interim period, for that fiscal year. We are still evaluating the impact the adoption of this statement will have on our condensed consolidated financial statements.

In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109”. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or to be taken on a tax return. This interpretation also provides additional guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation is effective for fiscal years after December 15, 2006. We are currently evaluating the potential impact of this interpretation on our consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS No. 157”). SFAS No. 157 establishes a framework for measuring fair value and requires expanded disclosures regarding fair value measurements. This accounting standard is effective for financial statements issued for fiscal years beginning after November 15, 2007. We are still evaluating the impact the adoption of this statement will have on its condensed consolidated financial statements.

In September 2006, the Securities and Exchange Commission “SEC” issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB No. 108”). SAB No. 108 provides guidance regarding the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of materiality assessments. The method established by SAB No. 108 requires each of our financial statements and the related financial statement disclosures to be considered when quantifying and assessing the materiality of the misstatement. The provisions of SAB 108 are effective for financial statements issued for fiscal years beginning after December 31, 2006. We are still evaluating the impact the adoption of this statement will have on our condensed consolidated financial statements.

 

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Results of Operations – Consolidated Earnings Comparisons

Nine Months Ended September 30, 2006 as Compared to the Nine Months Ended September 30, 2005

During the nine months ended September 30, 2006 we earned net income available to common shareholders of $80.7 million, or $2.40 per diluted share compared with $106.0 million or $3.60 per diluted share for the same period in 2005.

As discussed under “Executive Overview of Performance,” net income available to common shareholders decreased during the nine months ended September 30, 2006 as compared to the same period in 2005 due primarily to:

 

    A $1.6 billion decrease in loans securitized as sales transactions from 2005 which resulted in a decline in gains on sales of mortgage assets of $9.4 million.

 

    Increase in provision for credit losses of $18.8 million due to the securitization of $2.7 billion of mortgage loans during the second and third quarters of 2006 structured as financings. An allowance for loan losses was recorded for estimated probable losses within the mortgage loans.

 

    Decrease in gains on derivative instruments of $5.4 million. This is primarily driven by the movement in 2-year swap rates during these periods.

Three Months Ended September 30, 2006 as Compared to the Three Months Ended September 30, 2005

During the three months ended September 30, 2006, we earned net income available to common shareholders of $25.3 million, or $0.73 per diluted share, compared with net income of $34.6 million, or $1.12 per diluted share for the same period of 2005.

As discussed under “Executive Overview of Performance,” net income available to common shareholders decreased during the three months ended September 30, 2006 as compared to the same period in 2005 due primarily to:

 

    Increase in provision for credit losses of $10.0 million due to the securitization of $2.7 billion of mortgage loans during the second and third quarters of 2006 structured as financings. An allowance for loan losses was recorded for estimated probable losses within the mortgage loans.

 

    Decrease in gains (losses) on derivative instruments of $13.4 million. This is primarily a reflection of the movement in 2-year swap rates in these periods.

Net Interest Income. We earn interest income primarily on our mortgage assets which include mortgage securities available-for-sale, mortgage securities trading, mortgage loans held-in-portfolio and mortgage loans held-for-sale. Interest expense consists primarily of interest paid on borrowings on mortgage assets, which includes warehouse repurchase agreements and asset backed bonds.

Our net interest income decreased to $153.8 million for the nine months ended September 30, 2006 from $161.2 million from the same period of 2005. For the three months ended September 30, 2006 our net interest income decreased to $52.4 million from $62.5 million for the same period of 2005. While our interest income increased in 2006 due to higher average mortgage loan balances, this increase was offset by an increase in our interest expense as a result of higher average outstanding debt balances as well as increases in the cost of this financing, due to increasing short-term interest rates. In addition, the significant increase in our allowance for loan losses due the two securitizations structured as financings in 2006 also reduced our net interest income for the nine and three months ended September 30, 2006 from the same periods of 2005.

Our average security yield decreased to 30.65% and 27.83% for the nine and three months ended September 30, 2006, respectively, from 34.06% and 37.34% for the same periods of 2005. The decrease in our average security yield is primarily a result of margin compression as well as our purchase of lower-yielding subordinated securities from third parties.

 

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Table 2 is a summary of the interest income and expense related to our mortgage securities and the related yields as a percentage of the fair market value of these securities for the nine and three months ended September 30, 2006 and September 30, 2005.

Table 2 — Mortgage Securities Interest Analysis

(dollars in thousands)

 

     For the Nine Months
Ended September 30,
    For the Three Months
Ended September 30,
 
     2006     2005     2006     2005  

Average fair market value of mortgage securities

   $ 547,549     $ 546,653     $ 602,020     $ 542,230  

Average borrowings

     227,826       302,987       318,436       242,406  

Interest income – mortgage securities

     125,875       139,655       41,887       50,619  

Interest expense – short term borrowings secured by mortgage securities

     7,411       1,649       4,609       92  

Interest expense – asset backed bonds secured by mortgage securities

     3,598       12,682       575       4,059  
                                

Net interest income – mortgage securities

   $ 114,866     $ 125,324     $ 36,703     $ 46,468  
                                

Yields:

        

Interest income

     30.65 %     34.06 %     27.83 %     37.34 %

Interest expense

     6.44 %     6.30 %     6.51 %     6.85 %
                                

Net interest spread

     24.21 %     27.76 %     21.32 %     30.49 %
                                

Net Yield

     27.97 %     30.57 %     24.39 %     34.28 %
                                

Our portfolio income comes from mortgage loans either directly (mortgage loans held-in-portfolio and mortgage loans held-for-sale) or indirectly (mortgage securities). Table 3 attempts to look through the balance sheet presentation of our portfolio income and present income as a percentage of average assets under management. The net interest income for mortgage securities, mortgage loans held-in-portfolio and mortgage loans held-for-sale reflects the income after interest expense, hedging and credit expense (mortgage insurance and provision for credit losses). This metric allows us to be more easily compared to other finance companies or financial institutions that use on balance sheet portfolio accounting, where return on assets is a common performance calculation.

Our portfolio net interest yield on assets was 1.25% and 1.12% for the nine and three months ended September 30, 2006 as compared to 1.63% and 1.81% for the same periods of 2005. The decrease in yield for the comparable nine and three-month periods can be attributed partly to recording a higher provision for credit losses in 2006 related to an increase of $2.3 billion in our mortgage loans held-in-portfolio as of September 30, 2006 compared to 2005. In addition, we earned less interest income on our mortgage securities – available-for-sale in 2006 compared to 2005 due to the addition of lower yielding mortgage securities to our portfolio.

We generally expect our net interest yield on portfolio assets to be in the range of 1% to 1.25% over the long-term. Table 3 shows the net interest yield on assets under management during the nine and three months ended September 30, 2006 and 2005.

 

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Table 3 — Mortgage Portfolio Management Net Interest Income Analysis

(dollars in thousands)

 

    

Mortgage
Securities –
Available-for-

Sale

   

Mortgage

Loans Held-

in-Portfolio

   

Mortgage
Loans
Held-for-

Sale

    Total  

For the Nine Months Ended: September 30, 2006

        

Interest income (A)

   $ 107,913     $ 94,294     $ 121,062     $ 323,269  

Interest expense:

        

Short-term borrowings (B)

     3,226       18,120       78,929       100,275  

Asset-backed bonds

     3,598       54,305       —         57,903  
                                

Total interest expense (C)

     6,824       72,425       78,929       158,178  
                                

Mortgage portfolio net interest income before other expense

     101,089       21,869       42,133       165,091  

Other (expense) income (D)

     —         (24,277 )     3,511       (20,766 )
                                

Mortgage portfolio net interest income (expense)

   $ 101,089     $ (2,408 )   $ 45,644     $ 144,325  
                                

Average balance of the underlying loans

   $ 11,919,248     $ 1,643,763     $ 1,774,290     $ 15,337,301  

Net interest yield on assets

     1.13 %     (0.20 )%     3.43 %     1.25 %
                                

September 30, 2005

        

Interest income (A)

   $ 139,655     $ 3,531     $ 77,680     $ 220,866  

Interest expense:

        

Short-term borrowings (B)

     1,649       —         40,781       42,430  

Asset-backed bonds

     12,682       1,439       —         14,121  
                                

Total interest expense (C)

     14,331       1,439       40,781       56,551  
                                

Mortgage portfolio net interest income before other expense

     125,324       2,092       36,899       164,315  

Other income (expense) (D)

     1,651       (1,063 )     (2,843 )     (2,255 )
                                

Mortgage portfolio net interest income

   $ 126,975     $ 1,029     $ 34,056     $ 162,060  
                                

Average balance of the underlying loans

   $ 11,870,121     $ 49,306     $ 1,333,200     $ 13,252,627  

Net interest yield on assets

     1.43 %     2.78 %     3.41 %     1.63 %
                                

(A) Does not include interest income from securities classified as trading and subordinated securities classified as available-for-sale.
(B) Includes mortgage loan and securities repurchase agreements. Does not include interest expense on trading securities repurchase agreements.
(C) Does not include interest expense related to the junior subordinated debentures and interest expense on other short-term borrowings.
(D) Other expense includes net settlements on non-cash flow hedges and credit expense (mortgage insurance and provision for credit losses).

 

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Mortgage
Securities –
Available-for-

Sale

   

Mortgage

Loans Held-

in-Portfolio

   

Mortgage
Loans
Held-for-

Sale

    Total  

For the Three Months Ended: September 30, 2006

        

Interest income (A)

   $ 31,404     $ 45,885     $ 50,272     $ 127,561  

Interest expense:

        

Short-term borrowings (B)

     1,924       156       31,092       33,172  

Asset-backed bonds

     575       36,633       —         37,208  
                                

Total interest expense (C)

     2,499       36,789       31,092       70,380  
                                

Mortgage portfolio net interest income before other expense

     28,905       9,096       19,180       57,181  

Other (expense) income (D)

     —         (12,409 )     1,139       (11,270 )
                                

Mortgage portfolio net interest income (expense)

   $ 28,905     $ (3,313 )   $ 20,319     $ 45,911  
                                

Average balance of the underlying loans

   $ 12,022,890     $ 2,354,519     $ 1,961,402     $ 16,338,811  

Net interest yield on assets

     0.96 %     (0.56 )%     4.14 %     1.12 %
                                

September 30, 2005

        

Interest income (A)

   $ 50,619     $ 1,090     $ 36,169     $ 87,878  

Interest expense:

        

Short-term borrowings (B)

     92       —         19,471       19,563  

Asset-backed bonds

     4,059       414       —         4,473  
                                

Total interest expense (C)

     4,151       414       19,471       24,036  
                                

Mortgage portfolio net interest income before other expense

     46,468       676       16,698       63,842  

Other expense (D)

     —         (282 )     (319 )     (601 )
                                

Mortgage portfolio net interest income

   $ 46,468     $ 394     $ 16,379     $ 63,241  
                                

Average balance of the underlying loans

   $ 12,047,745     $ 43,928     $ 1,880,434     $ 13,972,107  

Net interest yield on assets

     1.54 %     3.59 %     3.48 %     1.81 %
                                

(A) Does not include interest income from securities classified as trading and subordinated securities classified as available-for-sale.
(B) Primarily includes mortgage loan and securities repurchase agreements. Does not include interest expense on trading securities repurchase agreements.
(C) Does not include interest expense related to the junior subordinated debentures.
(D) Other expense includes net settlements on non-cash flow hedges and credit expense (mortgage insurance and provision for credit losses).

Impact of Interest Rate Agreements. We have executed interest rate agreements designed to mitigate exposure to interest rate risk on our borrowings. Interest rate cap agreements require us to pay either a one-time “up front” premium or a monthly or quarterly premium, while allowing us to receive a rate that adjusts with LIBOR when rates rise above a certain agreed-upon rate. Interest rate swap agreements allow us to pay a fixed rate of interest while receiving a rate that adjusts with one-month LIBOR. These agreements are used to alter, in effect, the interest rates on funding costs to more closely match the yield on interest-earning assets. We received income of $1.5 million and $1.2 million related to net settlements of our interest rate agreements used in cash flow hedges for the nine and three months ended September 30, 2006, respectively, compared to incurring an expense of $0.2 million for the nine months ended September 30, 2005. We did not recognize any income or expense for the three months ended September 30, 2005 related to cash flow hedges. We received $8.4 million and $2.2 million related to net settlements of our interest rate agreements classified as non-cash flow hedges for the nine and three months ended September 30, 2006, respectively. Comparatively, we received $2.8 million and $1.8 million for the nine and three months ended September 30, 2005, respectively. Fluctuations in these expenses are solely dependent upon the movement in LIBOR as well as our average notional amount outstanding.

 

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Provision for Credit Losses. During the nine and three months ended September 30, 2006 we recognized a provision for credit losses of $19.9 million and $10.3 million, respectively, compared with a provision for credit losses of $1.1 million and $0.3 million for the nine and three months ended September 30, 2005, respectively. The year over year increases are due to the transfer of $2.7 billion of mortgage loans from the held-for-sale classification to the held-in-portfolio classification during the first quarter of 2006 as a result of securitizing these loans in transactions structured as financings, which were completed during the third quarter of 2006. A provision for loan losses was recorded for estimated probable losses within the mortgage loans. Our allowance for credit losses will be impacted in the future by our securitization strategies as well as delinquency and loss rates in our portfolio of mortgage loans held-in-portfolio.

Gains on Sales of Mortgage Assets. The following table shows the changes and makeup of our gains on sales of mortgage assets for the nine and three months ended September 30, 2006 and September 30, 2005.

Table 4 — Gains on Sales of Mortgage Assets

(dollars in thousands)

 

     For the Nine Months
Ended September 30,
    For the Three Months
Ended September 30,
 
     2006     2005     2006     2005  

Gains on sales of mortgage loans transferred in securitizations

   $ 45,579     $ 53,188     $ 26,051     $ 7,304  

Gains on sales of mortgage loans to third parties – nonconforming

     10,772       9,161       4,948       4,253  

Gains on sales of mortgage loans to third parties – conforming

     —         164       —         17  

Losses on sales of real estate owned

     (4,185 )     (729 )     (2,992 )     (745 )

Gains on sales of trading securities

     351       —         —         —    

Elimination of gains from discontinued operations

     (1,490 )     (1,322 )     (298 )     (1,138 )
                                

Gains on sales of mortgage assets

   $ 51,027     $ 60,462     $ 27,709     $ 9,691  
                                

Gains on sales of mortgage assets were $51.0 million and $27.7 million for the nine and three months ended September 30, 2006, respectively, compared to $60.5 million and $9.7 million for the same periods of 2005, respectively. The decrease in gains recognized between the nine months ended September 30, 2006 and 2005 resulted primarily from the $1.6 billion decline in volume of loans securitized in transactions structured as sales. The increase in gains recognized between the three months ended September 30, 2006 and 2005 was primarily a result of an increase of whole loan prices in the secondary market during 2006. We use market based whole loan prices in the initial valuation of our retained interests at the time of securitization, which ultimately impacts our gain on sale.

The following table provides a summary of our mortgage securitizations treated as sales by quarter with the significant assumptions used at the time of securitization to value the residual securities we retained.

 

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Table 5 — Mortgage Loans Transferred in Securitizations Structured as Sales

(dollars in thousands)

 

     Principal
Amount
   Whole Loan
Price Used in
the Initial
Valuation of
Retained
Interests
   Net Gain
Recognized
  

Initial
Cost

Basis of
Residual
Securities

  

Weighted Average Assumptions
Underlying Initial Value of
Mortgage Securities –Available-

for-Sale

 
               Constant
Prepayment
Rate
    Discount
Rate
    Expected
Total
Credit
Losses,
Net of
Mortgage
Insurance
 

2006:

                  

First quarter

   $ 378,944    101.49    $ 1,203    $ 9,485    43 %   15 %   2.36 %

Second quarter

     1,711,844    102.03      18,325      49,905    44 %   15 %   2.53 %

Third quarter

     2,174,900    102.20      26,051      61,635    43 %   15 %   3.44 %
                              

Total

   $ 4,265,688    102.07    $ 45,579    $ 121,025    43 %   15 %   2.98 %
                                            

2005:

                  

First quarter

   $ 2,100,000    102.30    $ 18,136    $ 88,433    37 %   15 %   3.63 %

Second quarter

     1,649,289    102.86      27,748      57,784    39 %   13 %   2.10 %

Third quarter

     2,140,171    101.66      7,304      99,840    41 %   15 %   2.01 %
                              

Total

   $ 5,889,460    102.22    $ 53,188    $ 246,057    39 %   14 %   2.61 %
                                            

The following table summarizes our sales of nonconforming loans to third parties during the first three quarters of 2006 as compared to the same periods in 2005. This table shows the impact of the lower whole loan sales prices on the gains recognized. We will continue to sell loans to third parties which do not possess the economic characteristics which meet our long-term portfolio management objectives.

Table 6 — Mortgage Loan Sales to Third Parties – Nonconforming

(dollars in thousands)

 

     Principal
Amount
   Net Gain (Loss)
Recognized
    Weighted Average
Price to Par of the
Loans Sold
 

2006:

       

First Quarter

   $ 358,991    $ (173 )   101.16 %

Second Quarter

     434,065      5,997     101.63 %

Third Quarter

     693,776      4,948     101.50 %
                 

Total

   $ 1,486,832    $ 10,772     101.46 %
                     

2005

       

First Quarter

   $ —      $ —       —    

Second Quarter

     227,195      4,908     103.07 %

Third Quarter

     490,067      4,253     102.14 %
                 

Total

   $ 717,262    $ 9,161     102.44 %
                     

 

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Gains (Losses) on Derivative Instruments. We have entered into derivative instrument contracts that do not meet the requirements for hedge accounting treatment, but contribute to our overall risk management strategy by serving to reduce interest rate risk related to short-term borrowing rates. Additionally, we transfer certain of these derivative instruments into our securitization trusts when they are structured as sales to provide interest rate protection to the third-party bondholders. Prior to the date when we transfer these derivatives, changes in the fair value of these derivative instruments and net settlements with counterparties are credited or charged to current earnings. The derivative instruments we use to mitigate interest rate risk will generally increase in value as short-term interest rates increase and decrease in value as rates decrease. Fair value, at the date of securitization, of the derivative instruments transferred into securitizations structured as sales is included as part of the cost basis of the mortgage loans securitized. Derivative instruments transferred into a securitization trust are administered by the trustee in accordance with the trust documents. Any cash flows from these derivatives projected to flow to our residual securities are included in the valuation. The gains (losses) on derivative instruments can be summarized for the nine and three months ended September 30, 2006 and 2005 as follows:

Table 7—Gains (Losses) on Derivative Instruments

(dollars in thousands)

 

     For the Nine Months Ended
September 30,
    For the Three Months Ended
September 30
 
     2006     2005     2006     2005  

Increase (decrease) in fair value

   $ 1,003     $ 12,050     $ (8,894 )   $ 5,763  

Net settlements

     8,404       2,802       2,160       1,755  

Decrease in fair value of commitments to originate mortgage loans

     (1,553 )     (1,577 )     (143 )     (996 )
                                

Gains (losses) on derivative instruments

   $ 7,854     $ 13,275     $ (6,877 )   $ 6,522  
                                

Impairment on Mortgage Securities – Available-for-Sale. To the extent that the cost basis of mortgage securities – available-for-sale exceeds the fair value and the unrealized loss is considered to be other than temporary, an impairment charge is recognized and the amount recorded in accumulated other comprehensive income or loss is reclassified to earnings as a realized loss. During the nine and three months ended September 30, 2006, we recorded an impairment loss of $13.2 million and $6.8 million, respectively, compared to $10.1 million and $8.3 during the same periods of 2005. The impairments were primarily a result of our expectations for credit losses increasing due to a housing price appreciation concerns. As can be seen by Table 8, the impairments on our residual securities for the first nine months of 2006 and 2005 primarily related to the residual securities that were retained within a year of the respective period. As we retain new residual securities during a period when short-term interest rate increases are greater than anticipated by the forward yield curve, we generally are more susceptible to impairments on our newer mortgage securities as they do not have sizable unrealized gains to help offset the decline in value. Also contributing to the impairment recognized on our NMFT Series 2005-4 mortgage security during the second quarter of 2006 was the transfer of the CT Bonds in the first quarter of 2006. See “Industry Overview and Known Material Trends” for further discussion. The following table summarizes the impairment on our mortgage securities – available-for-sale by mortgage security for the nine and three months ended September 30, 2006 and September 30, 2005.

 

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Table 8 — Impairment on Mortgage Securities – Available-for-Sale by Mortgage Security

(dollars in thousands)

 

     For the Nine Months Ended
September 30,
   For the Three Months Ended
September 30,
     2006    2005    2006    2005

Mortgage Securities – Available-for-Sale:

           

NMFT Series 1999-1

   $ —      $ 117    $ —      $ —  

NMFT Series 2004-4

     —        1,495      —        —  

NMFT Series 2005-1

     —        1,426      —        1,300

NMFT Series 2005-2

     —        7,028      —        —  

NMFT Series 2005-3

     531      —        531      —  

NMFT Series 2005-4

     7,738      —        1,286      7,028

NMFT Series 2006-2

     2,483      —        2,483      —  

NMFT Series 2006-3

     2,497      —        2,496      —  
                           

Impairment on mortgage securities – available-for-sale

   $ 13,249    $ 10,066    $ 6,796    $ 8,328

Fee Income. Fee income primarily consists of service fee income. Service fees are paid to us by either the investor or the borrower on mortgage loans serviced. Fees paid by investors on loans serviced are determined as a percentage of the principal collected for the loans serviced and are recognized in the period in which payments on the loans are received. These fees are approximately 0.50% of the outstanding balance of the loans being serviced. Fees paid by borrowers on loans serviced are considered ancillary fees related to loan servicing and include late fees, processing fees and, for loans held-in-portfolio, prepayment penalties. Revenue is recognized on fees received from borrowers when an event occurs that generates the fee and they are considered to be collectible.

Origination fees are received from borrowers at the time of loan closing is deferred until the related loans are sold or securitized in transactions structured as sales. For securitizations structured as financings this fee income is deferred and amortized into interest income over the life of the loans using a level yield method.

The amortization of mortgage servicing rights is also included in fee income. Mortgage servicing rights are amortized in proportion to and over the estimated period of net servicing income. Generally, as the size of our servicing portfolio increases the amortization expense will increase. In addition the amortization of mortgage servicing rights is impacted by our assumptions regarding prepayment speeds for the loans being serviced for investors. During periods of increasing loan prepayments, the amortization on our mortgage servicing rights generally will increase. See Table 14 for a summary of our expected prepayment rate assumptions by securitization trust.

Servicing fees received from the securitization trusts were $44.5 million and $14.7 million for the nine and three months ended September 30, 2006, respectively, compared with $44.6 million and $15.0 million for the same periods of 2005. Amortization of mortgage servicing rights increased to $23.5 million and $8.0 million for the nine and three months ended September 30, 2006, respectively, from $19.7 million and $6.9 million for the same periods in 2005.

As a result of the factors discussed above, overall, fee income decreased to $22.1 million for the nine months ended September 30, 2006 from $24.8 million for the same period of 2005. Fee income increased to $7.7 million for the three months ended September 30, 2006 from $7.4 million for the same period of 2005.

Premiums for Mortgage Loan Insurance. The use of mortgage insurance is one method of managing the credit risk in the mortgage asset portfolio. Premiums for mortgage insurance on loans maintained on our balance sheet are paid by us and are recorded as a portfolio cost and included in the income statement under the caption “Premiums for Mortgage Loan Insurance”. These premiums totaled $9.3 million and $3.1 million for the nine and three months ended September 30, 2006, respectively, compared to $4.0 million and $2.0 million for the same periods of 2005. The increase in premiums on mortgage loan insurance for the nine and three months ended September 30, 2006 as compared to the prior year is due to the increase in loans-held-in-portfolio as a result of structuring two securitizations as financings during the second quarter of 2006.

 

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Some of the mortgage loans that serve as collateral for our mortgage securities – available-for-sale carry mortgage insurance. When loans are securitized in transactions treated as sales, the obligation to pay mortgage insurance premiums is legally assumed by the trust. Therefore, we have no obligation to pay for mortgage insurance premiums on these loans.

We intend to continue to use mortgage insurance coverage as a credit management tool as we continue to originate, purchase and securitize mortgage loans. Mortgage insurance claims on loans where a defect occurred in the loan origination process will not be paid by the mortgage insurer. The assumptions we use to value our mortgage securities – available-for-sale consider this risk. For the NMFT Series 2006-2, 2006-3, 2006-4, and 2006-5 securitizations, the mortgage loans that were transferred into the trust had mortgage insurance coverage at the time of transfer of 56%, 54%, 64%, and 56% of total principal, respectively. As of September 30, 2006, 52% of the total principal of our securitized loans, excluding NHES 2006-MTA1, had mortgage insurance coverage compared to 51% as of September 30, 2005.

We have the risk that mortgage insurance providers will revise their guidelines to an extent where we will no longer be able to acquire coverage on all of our new production. Similarly, the providers may also increase insurance premiums to a point where the cost of coverage outweighs its benefit. We monitor the mortgage insurance market and currently anticipate being able to obtain affordable coverage to the extent we deem it is warranted.

Other Income, net. Other income, net primarily consists of interest income on cash accounts and gains (losses) on trading securities. Other income, net increased to $27.1 million and $8.4 million for the nine and three months ended September 30, 2006, respectively, from $14.2 million and $5.5 million for the same periods of 2005. These comparative increases are primarily the result of higher interest rates we earned on our cash accounts due to the increase in short-term rates and higher average balances in these cash accounts due to increased loan origination volume. These cash balances primarily consist of servicing funds held as custodian.

General and Administrative Expenses. The main categories of our general and administrative expenses are compensation and benefits, loan expense, office administration and professional and outside services. Compensation and benefits includes employee base salaries, benefit costs and incentive compensation awards. Loan expense primarily consists of expenses relating to the underwriting of mortgage loans that do not fund successfully and servicing costs. Office administration includes items such as rent, depreciation, telephone, office supplies, postage, delivery, maintenance and repairs. Professional and outside services include fees for legal, accounting and other consulting services. General and administrative expenses increased to $147.7 million and $49.1 million for the nine and three months ended September 30, 2006, respectively, from $140.7 and $44.1 million for the same periods of 2005. The increase is primarily related to increased commissions expenses due to higher origination volumes.

 

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Cost of Production. The wholesale loan cost of production table below includes all costs paid and fees collected during the wholesale loan origination cycle, including loans that do not fund. This distinction is important as we can only capitalize as deferred broker premium and costs, those costs (net of fees) directly associated with a “funded” loan. Costs associated with loans that do not fund are recognized immediately as a component of general and administrative expenses. For loans held-for-sale, deferred net costs are recognized when the related loans are sold outright or transferred in securitizations. For loans held-in-portfolio, deferred net costs are recognized over the life of the loan as a reduction to interest income. The cost of our production is also critical to our financial results as it is a significant factor in the gains we recognize. Increased efficiencies in the nonconforming lending operation correlate to lower general and administrative costs and higher gains on sales of mortgage assets.

Table 9 — Wholesale Cost of Production, as a Percent of Principal

 

     Overhead
Costs
    Premium Paid to
Broker, Net of
Fees Collected
    Total
Acquisition Cost
 

2006:

      

First quarter

   1.86 %   0.42 %   2.28 %

Second quarter

   1.28 %   0.50 %   1.78 %

Third quarter

   1.23 %   0.56 %   1.79 %

Year to Date

   1.40 %   0.50 %   1.90 %

2005:

      

First quarter

   2.03 %   0.72 %   2.75 %

Second quarter

   1.73 %   0.72 %   2.46 %

Third quarter

   1.46 %   0.72 %   2.18 %

Year to Date

   1.71 %   0.72 %   2.43 %

The following table is a reconciliation of our lending division’s overhead costs included in our wholesale cost of production to general and administrative expenses of the mortgage lending and loan servicing segment as shown in Note 13 to the condensed consolidated financial statements, presented in accordance with accounting principles generally accepted in the United States of America (GAAP). The reconciliation does not address premiums paid to brokers since they are deferred at origination under GAAP and recognized when the related loans are sold or securitized. We believe this presentation of our wholesale overhead costs provides useful information to investors regarding our financial performance because it more accurately reflects the direct costs of loan production and allows us to monitor the performance of our core operations, which is more difficult to do when looking at GAAP financial statements, and provides useful information regarding our financial performance. Management uses this measure for the same purpose. However, this presentation is not intended to be used as a substitute for financial results prepared in accordance with GAAP.

Table 10 – Reconciliation of Overhead Costs, Non-GAAP Financial Measure

(dollars in thousands, except lending overhead as a percentage)

 

    

For the Nine Months

Ended September 30,

   

For the Three Months

Ended September 30,

 
     2006     2005     2006     2005  

Mortgage lending general and administrative expenses (A)

   $ 110,139     $ 103,552     $ 38,741     $ 31,704  

Direct origination costs classified as a reduction in gain-on-sale

     16,201       29,565       5,273       11,497  

Other lending expenses (B)

     (35,195 )     (27,627 )     (11,953 )     (8,782 )
                                

Wholesale overhead costs

   $ 91,145     $ 105,490     $ 32,061     $ 34,419  
                                

Wholesale production, principal (C)

   $ 6,531,096     $ 6,173,552     $ 2,603,516     $ 2,365,296  

Wholesale overhead, as a percentage

     1.40 %     1.71 %     1.23 %     1.46 %

(A) Mortgage lending and general and administrative expenses are presented in Note 13 to the condensed consolidated financial statements.
(B) Consists of expenses related to our retail and correspondent origination channels as well as other non-wholesale overhead.
(C) Includes loans originated through NovaStar Home Mortgage, Inc. and purchased by our wholesale division in NovaStar Mortgage, Inc. Only the costs borne by our wholesale division are included in the total cost of wholesale production.

 

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Mortgage Loan Servicing. Servicing income, before amortization of mortgage servicing rights includes fee income and other income, which consists primarily of interest income earned on custodial bank accounts. The costs of servicing include the general and administrative expenses incurred by our servicing operation as well as allocated corporate expenses.

Our annualized servicing income per loan before tax per unit increased to $186 and $266 for the nine and three months ended September 30, 2006 from $64 and $91 for the same periods in 2005, respectively. These increases are due largely to higher interest income earned on funds held as custodian.

Table 11 — Summary of Servicing Operations

(dollars in thousands, except per loan cost)

 

     For the Nine Months Ended September 30,  
     2006     2005  
     Amount     Per Loan
(B)
    Amount     Per Loan
(B)
 

Unpaid principal at period end (A)

   $ 16,355,553       $ 14,094,048    
                    

Number of loans at period end (A)

     106,049         97,954    
                    

Average unpaid principal during the period (A)

   $ 15,477,714       $ 13,347,663    
                    

Average number of loans during the period (A)

     103,055         95,855    
                    

Servicing income, before amortization of mortgage servicing rights

   $ 63,756     $ 825     $ 49,579     $ 675  

Costs of servicing

     (25,866 )     (335 )     (25,185 )     (343 )
                                

Net servicing income, before amortization of mortgage servicing rights

     37,890       490       24,394       332  

Amortization of mortgage servicing rights

     (23,469 )     (304 )     (19,663 )     (268 )
                                

Servicing income before income tax

   $ 14,421     $ 186     $ 4,731     $ 64  
                                

(A) Includes loans we have sold and are still servicing on an interim basis.
(B) Per unit amounts are calculated using the average number of loans during the period presented.

 

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     For the Three Months Ended September 30,  
     2006     2005  
     Amount     Per Loan
(B)
    Amount     Per Loan
(B)
 

Unpaid principal at period end (A)

   $ 16,355,553       $ 14,094,048    
                    

Number of loans at period end (A)

     106,049         97,954