10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2001.

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	(I.R.S. Employer Identification No.)
incorporation or organization)

1901 W. 47^th Place, Suite 105, Westwood, KS 66205
(Address of principal executive offices) (Zip Code)

(913) 362-1090
(Registrant’s telephone number, including area code)
______________________________________________
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  X   No__

The number of shares of the registrant’s common stock outstanding as of August 10, 2001 was 5,752,845.

NOVASTAR FINANCIAL, INC.
FORM 10-Q
QUARTER ENDED JUNE 30, 2001
INDEX

		Page
PART I	FINANCIAL INFORMATION
Item 1.	Consolidated Financial Statements:
	Balance Sheets	1
	Statements of Operations	2
	Statements of Cash Flows	3
	Notes	4
Item 2.	Management’s Discussion and Analysis of Financial
	Condition and Results of Operations	7
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	32
PART II	OTHER INFORMATION
Item 1.	Legal Proceedings	37
Item 2.	Changes in Securities	37
Item 3.	Defaults Upon Senior Securities	37
Item 4.	Submission of Matters to a Vote of Security Holders	37
Item 5.	Other Information	37
Item 6.	Exhibits and Reports on Form 8-K	38
	Signatures	39

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

		June 30, 2001 (unaudited)			December 31, 2000
Assets
Cash and cash equivalents	$	13,887		$	2,518
Mortgage loans – held-in-portfolio		290,365			375,927
Mortgage loans – held-for-sale		228,544			–
Mortgage securities – available-for-sale		71,900			46,650
Accrued interest receivable		7,370			9,151
Advances to and investment in NFI Holding
Corporation		–			45,415
Assets acquired through foreclosure		13,282			13,054
Other assets		12,457			1,767
Total assets	$	637,805		$	494,482
Liabilities and Stockholders’ Equity
Liabilities:
Warehouse borrowings	$	41,227		$	–
Asset-backed bonds		279,176			357,437
Mortgage securities repurchase agreements		178,050			25,000
Accounts payable and other liabilities		12,898			3,601
Dividends payable		1,300			525
Total liabilities		512,651			386,563
Stockholders’ equity:
Capital stock, $0.01 par value, 50,000,000 shares
authorized:
Class B, convertible preferred stock, 4,285,714
shares issued and outstanding, respectively		43			43
Common stock, 5,717,095 and 6,094,595 shares
issued and outstanding, respectively		57			61
Additional paid-in capital		137,325			141,997
Accumulated deficit		(32,601	)		(37,976	)
Accumulated other comprehensive income		21,654			10,168
Notes receivable from founders		(1,324	)		(6,374	)
Total stockholders’ equity		125,154			107,919
Total liabilities and stockholders’ equity	$	637,805		$	494,482

See accompanying notes to consolidated financial statements.

1

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

		For the Six Months Ended June 30,						For the Three Months Ended June 30,
		2001			2000			2001			2000
Interest income:
Mortgage loans	$	22,749		$	24,590		$	10,009		$	11,778
Mortgage securities		3,958			878			2,608				612
Total interest income		26,707			25,468			12,617			12,390
Interest expense:
Financing on mortgage loans		13,376			18,641			5,340			8,943
Financing on mortgage securities		1,016			151			536				151
Interest expense		14,392			18,792			5,876			9,094
Net interest income before provision for credit losses		12,315			6,676			6,741			3,296
Provision for credit losses		1,638			2,792			1,119			1,213
Net interest income		10,677			3,884			5,622			2,083
Prepayment penalty income		498			983			248				494
Premiums for mortgage loan insurance		(1,129	)		(707	)		(692	)			(342		)
Loan servicing income (expenses)		12,290			(1,383	)		6,086				(687		)
Gain (loss) on sale of mortgage assets		9,563			(38	)		4,540					54
Other income		791			176			344					86
Equity in net income (loss) of NFI Holding Corporation		–			(141	)		–				(840		)
General and administrative expenses:
Net fees for other services provided by NovaStar
Mortgage, Inc.		–			(2	)		–					(5	)
Compensation and benefits		13,069			717			6,384				333
Travel and public relations		3,957			–			2,060					–
Office administration		3,388			401			1,598				230
Loan expense		924			–			405					–
Professional and outside services		1,010			257			596				127
Other		1,435			43			917					17
Total general and administrative expenses		23,783			1,416			11,960				702
Income before cumulative effect of a change in accounting principle		8,907			1,358			4,188				146
Cumulative effect of a change in accounting principle		(1,706	)		–			–					–
Net income		7,201			1,358			4,188				146
Dividends on preferred shares		(1,082	)		(1,050	)		(557	)			(525		)
Net income (loss) available to common shareholders	$	6,119		$	308		$	3,631		$		(379		)
Basic earnings (loss) per share – before cumulative effect of a change in
accounting principle	$	0.89		$	0.04		$	0.42			$	(0	.05	)
Diluted earnings (loss) per share – before cumulative effect of a change
in accounting principle	$	0.87		$	0.04		$	0.40			$	(0	.05	)
Basic loss per share due to the cumulative effect of a change in
accounting principle	$	(0.17	)	$	–		$	–			$		–
Diluted loss per share due to the cumulative effect of a change in
accounting principle	$	(0.17	)	$	–		$	–			$		–
Basic earnings (loss) per share	$	0.72		$	0.04		$	0.42			$	(0	.05	)
Diluted earnings per share	$	0.70		$	0.04		$	0.40			$	(0	.05	)
Weighted average basic shares outstanding		10,005			7,181			10,002				7,020
Weighted average diluted shares outstanding		10,350			7,189			10,491				7,020
Dividends declared per common share	$	0.13		$	–		$	0.13			$		–
See accompanying notes to consolidated financial statements.

2

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

		For the Six Months Ended June 30,
		2001				2000
Net cash provided by (used in) operating activities:	$	(138,881		)	$	9,523
Cash flow from investing activities:
Mortgage loan repayments			70,811		110,960
Transfer of available-for-sale securities			(19,102	)		(13,233	)
Sales of assets acquired through foreclosure			12,975			14,926
Proceeds from paydowns on available-for-sale securities			6,921			826
Net assets acquired during acquisition of NFI Holding Corporation			1,242			–
Net change in advance to NFI Holding Corporation			–			(11,233	)
Net cash provided by investing activities			72,847		102,246
Cash flow from financing activities:
Payments on asset-backed bonds		(78,856		)	(108,563		)
Change in short-term borrowings		157,377				–
Proceeds from issuance of capital stock and exercise of equity instruments,
net of offering costs			6			25
Dividends paid on preferred stock			(1,050	)		(1,050	)
Common stock repurchases			(74	)		(2,025	)
Net cash used in financing activities			77,403		(111,613		)
Net increase (decrease) in cash and cash equivalents			11,369			156
Cash and cash equivalents, beginning of period			2,518			2,395
Cash and cash equivalents, end of period		$	13,887		$	2,551
Supplemental disclosure of cash flow information:
Cash paid for interest	$		14,402		$	18,778
Dividends payable	$		1,300		$	525
Non-cash activities related to purchase of NFI Holding Corporation:
Operating activities:
Increase in real estate owned	$		(892	)	$	–
Increase in other assets	$	(11,132		)	$	–
Decrease in other liabilities	$		9,422		$	–
Investing activities:
Cash received in purchase	$		(872	)	$	–
Increase in mortgage loans	$	(81,733		)	$	–
Decrease in investment in/advances to NFI Holding Corp	$		48,307		$	–
Investing activities:
Increase in borrowings	$		36,900		$	–
Increase in additional paid-in capital	$		370		$	–
Non-cash financing activities related to founders’ notes receivable:
Decrease in founders’ notes receivable	$		(4,611	)	$	–
Increase in additional paid-in capital	$		4,611		$	–
See accompanying notes to consolidated financial statements.

3

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2001 (Unaudited)

Note 1. Financial Statement Presentation

     The consolidated financial statements as of and for the periods ended June 30, 2001 and 2000 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 balance sheets and results of operations. The consolidated financial statements should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements of NovaStar Financial and the notes thereto, included in NovaStar Financial’s annual report to shareholders and annual report on Form 10-K for the fiscal year ended December 31, 2000.

     NovaStar Financial, Inc. owns 100 percent of the common stock of three special purpose entities — NovaStar Assets Corporation, NovaStar Certificates Financing Corporation and NovaStar Mortgage Funding Corporation. NovaStar Financial formed these entities in connection with the issuance of asset-backed bonds.

     The consolidated financial statements of NovaStar Financial include the accounts of these entities. Significant intercompany accounts and transactions have been eliminated during consolidation.

     On January 1, 2001, NovaStar Financial purchased 100 percent of the voting common stock of NFI Holding Corporation (Holding). Prior to January 1, 2001 the Chief Executive Officer and Chief Operating Officer of NovaStar Financial each owned one-half of these shares. NovaStar Mortgage, Inc., NovaStar Home Mortgage, Inc., and NovaStar Capital, Inc. are wholly owned subsidiaries of Holding. NovaStar Mortgage Funding Corporation II, NovaStar Mortgage Funding Corporation III and NovaStar REMIC Financing Corporation are subsidiaries of NovaStar Mortgage. Prior to January 1, 2001, NovaStar Financial, Inc. owned all of the preferred shares of Holding, which were non-voting and retired on January 1, 2001. Prior to January 1, 2001, NovaStar Financial, Inc. recorded its investment in Holding using the equity method. Beginning January 1, 2001, the financial condition and results of operations of Holding and NovaStar Financial, Inc. are consolidated.

Note 2. Implementation of Accounting Pronouncements

     During 1998, the Financial Accounting Standards Board (FASB) issued SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” As amended by SFAS No. 137, “Accounting for Derivative Instruments and Hedging Activities—Deferral of the Effective Date of FASB Statement No. 133” and SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of FASB Statement No. 133,” SFAS No. 133 standardizes the accounting for derivative instruments, including certain instruments embedded in other contracts, by requiring that an entity recognize those items as assets or liabilities in the balance sheet and measure them at fair value. If certain conditions are met, an entity may elect to designate a derivative instrument either as a cash flow hedge, a fair value hedge or a hedge of foreign currency exposure. Generally, SFAS No. 133 requires derivative instruments to be recorded at their fair value with hedge ineffectiveness recognized in earnings. In addition, the pronouncement requires that the time value of purchased options be recorded at fair value as an adjustment directly to earnings. The Company adopted SFAS No. 133 on

4

January 1, 2001 and recorded a charge to earnings of $1.7 million. The transition adjustment resulted from adjusting the carrying value of certain interest rate cap agreements to their fair value.

     The Company uses derivative instruments with the objective of hedging interest rate risk. Interest rates on liabilities of the Company adjust daily or annually, while interest rates on the Company’s assets adjust annually, or not at all. The Company has determined that all of our derivative instruments (interest rate caps and swaps) qualify as cashflow hedges and accounts for these instruments accordingly. As discussed above, a $1.7 million transition adjustment resulting from the adoption of SFAS No. 133 was recorded on the income statement as a separate line item. In addition, the Company recorded an additional derivatives loss of $243,000 during the first six months of 2001. This amount is included in the amount reported as “Financing on mortgage loans” on the income statement. The amount of the cash flow hedges’ ineffectiveness was immaterial as of June 30, 2001.

     During September 2000, the FASB issued SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – a replacement of FASB Statement No. 125.” Although SFAS No. 140 revises many of the rules regarding securitizations, it continues to require an entity to recognize the financial and servicing assets it controls and the liabilities it has incurred and to derecognize financial assets when control has been surrendered in accordance with the criteria provided in the Statement. This statement was effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001 and was effective for recognition and reclassification of collateral for fiscal years ending after December 15, 2000. Disclosure about securitizations and collateral accepted need not be reported for periods ending on or before December 15, 2000, for which financial statements are presented for comparative purposes. Implementation of the recognition and classification portion of SFAS No. 140 had no impact on the financial statements of the Company. Accounting for future transfers of assets will be evaluated based on the terms of the individual transactions.

     On June 29, 2001, the Financial Accounting Standards Board approved Statement of Financial Accounting Standard No. 141, “Business Combinations”, and SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No.141 prohibits using the pooling-of-interests method in accounting for business combinations and, therefore, the purchase method must be used. The provisions of the statement apply to all business combinations initiated after June 30, 2001.

     SFAS 142 supersedes Accounting Principals Board (APB) Opinion No. 17, “Intangible Assets” and will carry forward provisions in APB Opinion No.17 related to internally developed intangible assets. The statement ceases the amortization of goodwill. The statement is effective for fiscal years beginning after December 15, 2001 to all goodwill and other intangible assets recognized in an entity's statement of financial position at that date, regardless of when those assets were initially recognized.

     Adoption of SFAS No. 141 and 142 will not have a material effect on our consolidated financial statements.

     During 1999, the FASB issued EITF No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets.” Effective April 1, 2001, EITF No. 99-20 provides guidance on the recognition of interest income from, and measurement of retained beneficial interests. The implementation of EITF 99-20 did not have a material effect on our consolidated financial statements.

     During 2001, the FASB issued EITF D-95, “Effect of Participating Convertible Securities on the Computation of Basic Earnings Per Share.” EITF D-95 requires participating securities

5

that are convertible into common stock be included in the computation of basic EPS. In accordance with the requirements of this standard, previously reported earnings per share have been restated.

Note 3. NovaStar Mortgage Funding Trust Series 2001-1

     On March 29, 2001, NovaStar Mortgage executed a securitization transaction that, for financial reporting and tax purposes, was treated as a sale. As part of this transaction, NovaStar Mortgage sold $415 million in loans. The loans were sold to NovaStar Mortgage Funding Trust Series (NMFT) 2001-1, which issued asset-backed bonds of $415 million. NovaStar Financial retained the AAA-rated interest only and subordinated securities that were issued by NMFT 2001-1, with a carrying value of $31.2 million as of June 30, 2001. A gain of $8.9 million was recognized on this transaction.

6

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

     The following discussion should be read in conjunction with the preceding consolidated financial statements of NovaStar Financial and the notes thereto as well as NovaStar Financial’s annual report to shareholders and annual report on Form 10-K for the fiscal year ended December 31, 2000.

Safe Harbor Statement

     “Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995: Statements in this discussion regarding NovaStar Financial, Inc. and its business, which are not historical facts, are “forward-looking statements” that involve risks and uncertainties. Certain matters discussed in this annual report may constitute forward-looking statements within the meaning of the federal securities laws that inherently include certain risks and uncertainties. Actual results and the time of certain events could differ materially from those projected in or contemplated by the forward-looking statements due to a number of factors, including general economic conditions, fluctuations in interest rates, fluctuations in prepayment speeds, fluctuations in losses due to defaults on mortgage loans, the availability of non-conforming residential mortgage loans, the availability and access to financing and liquidity resources, and other risk factors outlined in the annual report on Form 10-K for the fiscal year ended December 31, 2000. Other factors not presently identified may also cause actual results to differ. Management continuously updates and revises these estimates and assumptions based on actual conditions experienced. It is not practicable to publish all revisions and, as a result, no one should assume that results projected in or contemplated by the forward-looking statements will continue to be accurate in the future. Risks and uncertainties, which could cause results to differ from those discussed in the forward-looking statements herein, are listed in the “Risk Management” section of the annual report on Form 10-K for the fiscal year ended December 31, 2000.

Basis of Presentation

     The subsidiaries of NovaStar Financial, Inc. are presented in Note 1 to the consolidated financial statements.

Recent Developments

     Federal Tax Legislation. Recently adopted legislation allows a real estate investment trust (REIT) to own directly all of the stock of taxable subsidiaries beginning in the tax year 2001. The value of all taxable subsidiaries of a REIT will be limited to 20% of the total value of the REIT’s assets. NovaStar Financial acquired all of the common stock of NFI Holding Corporation from Scott Hartman and Lance Anderson on January 1, 2001.

     Also, effective beginning with the 2001 tax year, the minimum dividend distributions of a REIT will have to equal 90% of taxable income, down from 95% of taxable income under current law. These and other federal tax legislation changes and proposals are discussed further in NovaStar Financial’s Annual Report on Form 10K under “Federal Income Tax Consequences”.

7

Description of Businesses
Investment Portfolio

• Invest in assets generated primarily from our wholesale origination of nonconforming, single-family, residential mortgage loans;
• Operates as a long-term portfolio investor;
  
• Financing is provided by issuing asset-backed bonds and entering into reverse repurchase agreements;
  
• Earnings are generated from return on mortgage securities and spread income on the mortgage loan portfolio;

Residential Mortgage Lending

• Primary customer is the retail mortgage broker who deals with the borrower. NovaStar Mortgage's account executives work with more than 5,800 brokers to solicit loans.
  
• Borrowers generally are individuals or families who do not qualify for agency/conventional lending programs because of a lack of available documentation or previous credit difficulties.
  
• Loans are financed through short-term warehouse facilities.
  
• Loans are held for sale in either outright sales for cash or in securitization transactions accounted for as sales.

Branch Operations

• Retail mortgage brokers and their staffs operate under the NovaStar Home Mortgage name and are employees of NovaStar Home Mortgage.
  
• Branches operate under a strict set of established policies.
  
• Branch can broker loans to any approved investor, including NovaStar Mortgage, Inc.
  
• Net operating income for the branch is returned as compensation to the branch “owner/manager.”
  
• As of June 30, 2001, there were 86 active branches in 34 states operating under the NovaStar Home Mortgage name.

Financial Condition of NovaStar Financial, Inc. as of June 30, 2001 and December 31, 2000

     Mortgage Loans. Our balance sheet consists primarily of mortgage loans we have originated. We classify our mortgage loans into two categories: “held-for-sale” and “held-in-portfolio.” A majority of our loans serve as collateral for asset-backed bonds we have issued and are classified as “held-in-portfolio.” The carrying value of “held-in-portfolio” mortgage loans as of June 30, 2001 was $290 million compared to $376 million as of December 31, 2000.
     Loans we have originated, but have not yet securitized, are classified as “held-for-sale.” We expect to sell these loans outright in third party transactions or in securitization transactions that will be, for tax and accounting purposes, recorded as sales. We use warehouse lines of credit and mortgage repurchase agreements to finance our held-for-sale loans.
     Premiums are paid on substantially all mortgage loans. Premiums are amortized as a reduction of interest income over the estimated lives of the assets. Tables 3 and 6 provide information to analyze

8

the impact of principal payments on amortization. To mitigate the effect of prepayments on interest income from mortgage loans, we generally strive to originate mortgage loans with prepayment 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. Non-conforming borrowers, as they update their credit rating, are more likely to refinance their mortgage loan to obtain a lower interest rate.

     Prepayment rates in Table 6 represent the annualized principal prepayment rate in the most recent one, three and twelve month periods and over the life of the pool of loans. This information has not been presented for held-for-sale loans as we do not expect to own the loans for a period long enough to experience material repayments.

     Characteristics of the mortgage loans we own are provided in Tables 1 through 6. The operating performance of our mortgage loan portfolio, including net interest income, allowances for credit losses and effects of hedging are discussed under “Results of Operations” and “Interest Rate/Market Risk.” Gains on the sales of mortgage loans, including impact of securitizations treated as sales, is also discussed under “Results of Operations.”

Table 1 — Mortgage Loans by Credit Grade
(dollars in thousands)
						June 30, 2001						December 31, 2000
									Weighted						Weighted
	Allowed	Maximum					Weighted		Average				Weighted		Average
Credit	Mortgage	Loan-		Current			Average		Loan-to-		Current		Average		Loan-to-
Grade	Lates (A)	to-value		Principal			Coupon		Value		Principal		Coupon		Value
Held-in-portfolio:
AA	0 x 30	95		$	44,646		9.90	%	82.3	%	$	56,463	10.17	%	82.6	%
A	1 x 30	90		118,313			10.40		79.7		152,621		10.66		79.4
A-	2 x 30	90			69,386		11.05		81.7			88,617	11.30		81.7
B	3 x 30, 1x 60	85			37,078		11.61		78.2			51,001	11.80		78.1
	5 x 30, 2 x 60
C	1 x 90	75			17,896		12.09		72.6			22,902	12.30		72.8
D	6 x 30, 3 x 60, 2 x 90	65			3,458		12.82		65.1			4,268	13.13		63.8
				$	290,777		10.66		79.8		$	375,872	11.02		79.7
Held-for-
sale:
AAA	0 x 30	97	(B)	$	46,051		9.63	%	74.7	%	$	15,696	9.83	%	73.8	%
AA	0 x 30	95			73,122		9.82		79.3			25,335	10.07		81.4
A	1 x 30	90			42,493		10.18		80.0			15,209	10.35		80.3
A-	2 x 30	90			17,573		10.03		80.4			6,812	10.27		80.4
B	3 x 30, 1x 60,5 x 30, 2 x 60	85			15,087		10.15		75.3			5,719	10.54		78.0
C	1 x 90	75			2,005		10.72		67.8			740	10.77		69.7
D	6 x 30, 3 x 60,2 x 90	65			—		—		—			—	—		—
Other	Varies	97			29,738		10.72		67.8			7,823	11.95		93.8
				$	226,069		9.98		79.7		$	77,334	10.27		80.5

(A)	Represents the number of times a prospective borrower is allowed to be late more than 30, 60 or 90 days. For instance, a 3x30, 1x60 category would afford the prospective borrower to be more than 30 days late on three separate occasions and 60 days late no more than one time.
(B)	97% on fixed-rate purchases; all other maximum of 95%.

9

Table 2 — Mortgage Loans
Geographic Concentration
Percent Current Principal as of June 30, 2001

	Held-for-sale		Held-in-portfolio
Collateral Location
California	18	%	13	%
Florida	16		16
Michigan	7		3
Ohio	5		4
Nevada	4		4
Tennessee	4		4
Washington	3		6
Oregon	2		4
Texas	2		5
All other states	39		41
Total	100	%	100	%

Table 3 — Carrying Value of Mortgage Loans by Product/Type
(in thousands)

Product/Type	June 30, 2001			December 31, 2000
Held-in-portfolio:
Two and three-year fixed	$	114,782		$	166,627
Six-month LIBOR and one-year CMT		18,320			23,428
30/15-year fixed and balloon		157,675		185,817
Outstanding principal		290,777		375,872
Premium		5,886			7,745
Allowance for credit losses		(6,298	)		(7,690	)
Carrying Value	$	290,365		$	375,927
Carrying value as a percent of principal		99.86	%		100.01	%
Held-for-sale:
Two and three-year fixed	$	166,607		$	54,500
Six-month LIBOR and one-year CMT		—			—
30/15-year fixed and balloon		59,462			22,834
Outstanding principal		226,069			77,334
Premium		2,596			997
Allowance for credit losses		(121	)		(254	)
Carrying Value	$	228,544		$	78,077
Carrying value as a percent of principal		101.09	%		100.96	%

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Table 4 — Mortgage Credit Analysis – Held-in-portfolio Loans June 30, 2001 (dollars in thousands)
							Defaults as Percent of Current Principal
Credit    Grade		Original Balance		Current Principal		Weighted Average Loan- to-Value Ratio	60-89 days	90 days and greater	Foreclosure and REO	Total
NovaStar Home Equity Series 1997-1:
A		$	117,904	$	17,629	75.6	1.5	1.6	4.6	7.8
A-			73,499		11,841	77.6	0.6	2.5	10.0	13.2
B			53,812		7,071	73.2	5.4	3.8	5.7	14.9
C			23,065		3,176	71.0	17.6	0.9	2.0	20.5
D			9,021		1,248	69.4	—	—	7.2	7.2
NovaStar Home Equity Series 1997-2:
AA		$	3,153	$	357	86.5	—	—	—	—
A		104,582			18,577	79.1	3.2	1.1	9.6	13.8
A-			63,660		10,871	83.1	0.6	5.1	6.0	11.7
B			36,727		6,328	79.5	1.6	3.6	15.7	20.9
C			11,354		2,651	69.8	—	—	5.7	5.7
D			1,529		512	59.7	9.3	—	7.3	16.5
NovaStar Home Equity Series 1998-1:
AA		$	59,213		16,328	83.4	0.4	1.4	7.5	9.3
A		113,457			33,183	80.9	1.4	1.4	8.9	11.6
A-			63,100		18,539	81.8	2.3	4.2	11.7	18.1
B			38,249		9,251	78.7	5.9	1.1	14.4	21.4
C			23,029		5,112	75.0	8.8	7.3	10.9	27.1
D			5,495		1,001	64.3	—	20.2	5.5	25.7
NovaStar Home Equity Series 1998-2:
AA		$	64,851		27,125	81.6	0.4	1.4	4.6	6.5
A		113,557			48,337	80.8	1.4	0.9	8.4	10.7
A-			70,399		27,512	83.0	3.7	4.0	8.6	16.4
B			40,818		16,167	80.0	3.3	6.3	18.1	27.7
C			22,335		7,070	72.8	3.8	3.9	14.8	22.6
D			2,951		891	63.0	—	—	19.4	19.4
Total	$	1,115,760		$	290,777

Table 5 — Loss Analysis – Held-in-portfolio Loans June 30, 2001 (dollars in thousands)
		Loans Repurchased From Trusts
	Cumulative Losses As Reported	Loss Amount	As a % of Original Balance	Total Losses
NHES 1997-1	1.75%	$3,355	1.21%	2.96%
NHES 1997-2	1.93	6,210	2.81	4.74
NHES 1998-1	1.54	7,715	2.55	4.09
NHES 1998-2	1.53	2,267	0.72	2.25

11

 

Table 6 — Mortgage Loan Coupon and Prepayment Analysis (dollars in thousands)
	Issue Date		Original Principal		Current Principal		Premium	Percent with Prepayment Penalty		Coupon		Remaining Prepayment Penalty Period (in years) for Loans with Penalty
													Constant Prepayment Rate (Annual Percent)
													Three- month	Twelve- Month	Life
As of June 30, 2001
Held-in-portfolio – serving as collateral for NovaStar Home Equity Series asset backed bonds:
Series 1997-1	October 1, 1997	$	277,301	$	40,965	$	1,865	27	%	11.20	%	0.20	37	37	39
Series 1997-2	December 11, 1997		221,005		39,296		766	20		11.06		0.25	41	45	38
Series 1998-1	April 30, 1998		302,543		83,414		1,356	22		10.69		0.35	44	42	32
Series 1998-2	August 18, 1998		314,911		127,102		1,899	33		10.35		0.57	37	37	26
Total		$	1,115,760	$	290,777	$	5,886	27	%	10.66	%	0.41
Held-for-sale:				$	226,069	$	2,596	84	%	9.98	%	2.31	Not meaningful
As of December 31, 2000
Held-in-portfolio – serving as collateral for NovaStar Home Equity Series asset backed bonds:
Series 1997-1	October 1, 1997	$	277,301	$	52,282	$	2,494	25	%	11.80	%	0.30	40	39	40
Series 1997-2	December 11, 1997		221,005		53,727		1,040	16		11.55		0.28	46	45	37
Series 1998-1	April 30, 1998		302,543		114,367		1,877	33		11.03		0.46	41	41	31
Series 1998-2	August 18, 1998		314,911		155,496		2,334	60		10.57		0.85	33	35	25
Total		$	1,115,760	$	375,872	$	7,745	40	%	11.02	%	0.57
Held-for-sale:				$	77,334	$	997	81	%	10.27	%	3.19	Not meaningful

     Mortgage Securities — available-for-sale. During 2001, 2000 and 1999, $415 million, $570 million, and $165 million in loans were pooled in securitization transactions. These transactions were treated as sales for accounting and tax purposes. We service the loans sold in these securitizations and we retained the AAA-rated, interest-only and other subordinated securities issued in the securitizations. Under the section “Mortgage Loan Sales” we discuss the details of the loan securitization transactions.

     As of June 30, 2001 and December 31, 2000, the carrying value of mortgage securities was $71.9 million and $46.6 million, respectively. This value represents the present value of the securities’ cash flows that we expect to receive over their lives, considering estimated prepayment speeds and credit losses of the underlying loans, discounted at an appropriate risk-adjusted market rate of return. The cash flows are realized over the life of the loan collateral as cash distributions are received from the trust that manages the collateral. In estimating the fair value of our mortgage securities, management must make assumptions regarding the future performance and cash flow of the mortgage loans collateralizing the securities. These estimates are based on management’s judgements about the nature of the loans. We believe the value of the securities is fair, but can provide no assurance that future prepayment and loss experience or changes in the required market discount rate will not require write-downs of the residual asset. Write-downs would reduce income of future periods. Table 7 summarizes our mortgage securities and the underlying collateral and senior asset-backed bonds. Table 8 and 9 provide a summary of the critical assumptions used in estimating the cash flows of the collateral and the resulting estimated fair value of the mortgage securities.

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Table 7 — Mortgage Securities June 30, 2001 and December 31, 2000 (dollars in thousands)
		Estimated Fair Value of Mortgage Securities		Asset-Backed Bonds			Mortgage Loans
								Weighted Average
				Remaining Principal	Interest Rate		Remaining Principal	Coupon	Estimated Months to Call
June 30, 2001
NMFT 1999-1	$	5,500	$	75,081	5.47	$	78,234	10.46	44
NMFT 2000-1		12,500		178,438	4.21		182,315	10.20	68
NMFT 2000-2		22,700		298,155	4.10		304,082	10.60	60
NMFT 2001-1		31,200		406,172	4.15		406,342	10.36	69
Total	$	71,900	$	957,846		$	970,973
December 31, 2000
NMFT 1999-1	$	$6,900	$	96,521	6.23	$	103,968	10.67	50
NMFT 2000-1		14,950		210,261	6.11		216,216	10.21	74
NMFT 2000-2		24,800		328,025	6.12		333,865	10.61	66
Total	$	46,650	$	634,807		$	654,049

Table 8 —Valuation of Individual Mortgage Securities and Assumptions (dollars in thousands)
	June 30, 2001					December 31, 2000
NovaStar Mortgage Funding Trust Series:	1999-1	2000-1	2000-2	2001-1	Total	1999-1	2000-1	2000-2	Total
Discount rate	25.0	25.0	25.0	25.0	25.0	16.5	16.5	16.5	16.5
Cost basis of individual mortgage securities:
Interest only (AAA- rated)	¯	6,016	11,446	16,465	38,771	5,265	8,961	15,607	29,833
Prepayment penalty (AAA- rated)	¯	1,367	3,373	3,649	8,389	¯	1,912	3,758	5,670
Subordinated securities (non-investment grade)	4,884	338	642	612	1,592	¯	338	642	980
Total	4,844	7,721	15,461	20,726	48,752	5,265	11,211	20,007	36,483
Estimated fair value of individual mortgage securities:
Interest only (AAA- rated)	¯	10,367	18,761	26,872	61,500	6,900	11,697	19,745	38,342
Prepayment penalty (AAA- rated)	¯	1,801	3,293	3,851	8,945	¯	2,533	3,729	6,262
Subordinated securities (non-investment grade)	5,500	332	646	477	1,455	¯	720	1,326	2,046
Total	5,500	12,500	22,700	31,200	71,900	6,900	14,950	24,800	46,650

Table 9 — Characteristics of Loan Collateral and Valuation Assumptions
	June 30, 2001				December 31, 2000
NovaStar Mortgage Funding Trust Series:	1999-1	2000-1	2000-2	2001-1	1999-1	2000-1	2000-2
Constant prepayment rate (%)	27	29	29	26	32	32	32
Discount rate	25.0	25.0	25.0	25.0	16.5	14.8	15.0
As a percent of mortgage loan principal:
Delinquent loans (30 days and greater)	11.0	3.7	1.5	0.8	17.0	5.7	1.1
Loans in foreclosure	4.2	2.4	1.6	0.2	5.5	1.6	0.3
Real Estate Owned	5.1	1.6	0.4	¯	4.2	0.1	¯
Cumulative losses	1.2	¯	¯	¯	1.0	¯	¯

The performance of the loans serving as collateral for our mortgage securities is critical to the return our mortgage securities will generate. Credit quality and prepayment experience

13

characteristics of the loan collateral, among others, are important to properly analyze the performance of our mortgage securities. We have presented characteristics of the loans collateralizing our mortgage securities in Tables 9 through 15. The operating performance of our mortgage securities portfolio, including net interest income and effects of hedging are discussed under “Results of Operations” and “Interest Rate/Market Risk.”

Table 10 — Loans Collateralizing Mortgage Securities Credit Grade (dollars in thousands)
			June 30, 2001						December 31, 2000
	Allowed Mortgage Lates (A)	Maximum Loan- to-value			Weighted Average Coupon		Weighted Average Loan-to- Value				Weighted Average Coupon		Weighted Average Loan-to- Value
Credit Grade			Current Principal						Current Principal
AAA	0 x 30	97(B)	$	188,906	9.68	%	81.1	%	$	143,673	9.71	%	80.9	%
AA	0 x 30	95		283,483	10.20		83.8			175,068	10.25		83.5
A	1 x 30	90		180,340	10.47		81.6			130,027	10.54		81.2
A-	2 x 30	90		115,215	10.62		81.0			86,660	10.65		81.3
B	3 x 30, 1x 60 5 x 30, 2 x 60	85		75,717	10.91		78.1			44,487	11.16		79.3
C	1 x 90	75		18,781	11.51		69.0			18,398	11.69		70.1
D	6 x 30, 3 x 60, 2 x 90	65		855	12.51		61.2			1,568	12.69		61.6
Other	Varies	97		107,676	11.52		93.4			54,168	11.44		92.7
			$	970,973	10.43				$	654,049	10.66

(A)	Represents the number of times a prospective borrower is allowed to be late more than 30, 60 or 90 days. For instance, a 3x30, 1x60 category would afford the prospective borrower to be more than 30 days late on three separate occasions and 60 days late no more than one time.
(B)	97% on fixed-rate purchases; all other maximum of 95%.

Table 11— Loans Collateralizing Mortgage Securities Percent of Current Principal as of June 30, 2001
Collateral Location
Florida	14	%
California	13
Michigan	9
Nevada	6
Ohio	6
Tennessee	5
Arizona	5
Washington	4
Colorado	4
All other states	34
Total	100	%

Table 12 — Loans Collateralizing Mortgage Securities Carrying Value of Loans by Product/Type (in thousands)
Product/Type	June 30, 2001	December 31, 2001
Two and three-year fixed	$733,015	$465,976
Six-month LIBOR and one-year CMT	1,638	2,492
30/15-year fixed and balloon	236,320	185,581
Outstanding principal	$970,973	$654,049
Mortgage securities retained	$  71,900	$  46,650

14

Table 13 — Loans Collateralizing Mortgage Securities Mortgage Loan Coupon and Prepayment Penalties (dollars in thousands)
										Remaining Prepayment Penalty Period (in years) for Loans with Penalty	Constant Prepayment Rate (Annual Percent)
						Percent with Prepayment Penalty
			Original Principal	Current Principal							Three- month	Twelve- Month	Life
	Issue Date							Coupon
June 30, 2001
NovaStar Mortgage Funding Trust Series:
1999-1	January 29, 1999	$	164,995	$	78,234	58		10.46	%	1.11	38	38	26
2000-1	March 31, 2000		230,138		182,315	94		10.20		2.20	33	19	16
2000-2	September 28, 2000		339,688		304,082	92		10.60		2.28	22	–	12
2001-1	March 29, 2001		415,067		406,342	87		10.36		2.50	6	–	6
Total		$	1,149,888	$	970,973	88	%	10.43	%	2.19
December 31, 2000
NovaStar Mortgage Funding Trust Series:
1999-1	January 29, 1999	$	164,995	$	103,968	60		10.66		1.23	38	28	21
2000-1	March 31, 2000		230,138		216,216	94		10.03		2.43	10	–	8
2000-2	September 28, 2000		339,688		333,865	90		10.57		2.49	5	–	5
Total		$	734,821	$	654,049	70	%	10.66	%	1.65

15

Table 14 — Loans Collateralizing Mortgage Securities Mortgage Credit Analysis June 30, 2001
						Defaults as Percent Of Current Principal
Credit Grade	Original Balance		Current Principal		Weighted Average Loan-to-Value Ratio	60-89 days	90 days and greater	Foreclosure and REO	Total
NovaStar Mortgage Funding Trust Series 1999-1:
AAA	$	4,024	$	2,358	90.0	—	—	—	—
AA		30,772		15,362	79.4	2.2	0.8	4.5	7.5
A		50,693		23,919	85.0	1.4	2.1	7.3	10.9
A-		38,953		18,467	82.2	2.3	4.2	8.6	15.1
B		23,135		11,121	82.5	1.5	3.5	23.5	28.5
C		12,959		5,929	79.8	6.2	2.6	18.6	27.4
C-		47		45	71.5	—	—	—	—
D		4,412		1,033	49.0	—	—	17.7	17.7
NovaStar Mortgage Funding Trust Series 2000-1:
AAA	$	85,222	$	65,514	80.5	0.3	0.4	2.0	2.7
AA		55,874		45,849	83.0	0.8	0.2	3.4	4.5
A		36,422		29,712	80.5	0.2	0.77	5.7	6.0
A-		23,329		18,961	80.4	1.1	—	9.4	11.0
B		13,089		9,517	80.4	6.4	0.6	9.3	15.7
C		5,922		4,393	69.2	4.3	—	10.3	14.7
C-		335		177	50.7	—	—	—	—
D		51		48	58.0	—	—	—	—
Other		9,894		8,144	92.0	3.3	—	0.9	4.2
NovaStar Mortgage Funding Trust Series 2000-2:
AAA	$	57,846	$	50,458	81.4	0.4	—	0.9	1.3
AA	103,454		93,760		83.4	1.5	0.7	0.7	2.9
A		60,735		52,844	81.3	1.1	—	2.3	3.4
A-		39,939		35,995	81.4	0.2	0.4	3.3	4.0
B		19,843		18,651	76.6	—	—	0.5	0.5
C		4,275		3,538	67.4	—	—	—	—
C-		388		541	74.7	—	—	—	—
Other		53,208		48,295	92.9	0.7	0.1	1.5	2.3
NovaStar Mortgage Funding Trust Series 2001-1:
AAA	$	70,652	$	69,167	81.3	—	—	—	—
AA	130,278		127,540		84.1	0.1	—	—	0.1
A		75,748		74,155	81.3	0.5	—	0.1	0.6
A-		43,418		42,505	80.3	0.5	—	—	0.5
B		38,186		37,383	77.7	—	—	—	—
C		4,863		4,761	67.6	—	—	—	—
C-		50		49	65.0	—	—	—	—
Other		51,872		50,782	94.2	—	—	0.3	0.3

Table 15 — Mortgage Loss Analysis – Loans Collateralizing Mortgage Securities June 30, 2001 (dollars in thousands)
		Loans Repurchased From Trusts
	Cumulative Losses As Reported	Loss Amount	As a % of Original Balance	Total Losses
NMFT 1999-1	1.21%	$808	0.49%	1.70%
NMFT 2000-1	0.02	–	0.00	0.02
NMFT 2000-2	–	68	0.02	0.02
NMFT 2001-1	–	–	–	–

16

     Assets Acquired through Foreclosure. As of June 30, 2001, we had 168 properties in real estate owned with a carrying value of $13.3 million (principal of $15.2 million) compared to 192 properties with a carrying value of $16.9 million (principal of $24.4 million) as of December 31, 2000.
     Short-term Financing Arrangements Mortgage loan originations are funded with various financing facilities prior to securitization. Loans originated are funded initially through one of two committed warehouse lines of credit. Amounts outstanding and available for borrowing are listed below.

Table 16 — Short-term Financing Resources June 30, 2001 (in thousands)
	Maximum Borrowing Limit	Lending Value of Collateral	Borrowings	Availability
Unrestricted cash				$9,767
Warehouse, mortgage and securities repurchase facilities	435,000	272,813	219,277	53,536
Total	$435,000	$272,813	$219,277	$63,303

     Long-term Financing Arrangements On a long-term basis, we finance mortgage loans by issuing asset-backed bonds. Investors in asset-backed bonds are repaid based on the performance of the mortgage loans collateralizing the bonds. These non-recourse financing arrangements match the loans with the financing arrangement for long periods of time, as compared to lines of credit and repurchase agreements that mature frequently with interest rates that reset frequently and have liquidity risk in the form of margin calls. Under the terms of our asset-backed bonds we are entitled to repurchase the mortgage loan collateral and repay the remaining bond obligations when the aggregate collateral principal balance falls below 35% of their original balance for the loans in NHES 97-01 and 25% for the loans in NHES 97-02, 98-01 and 98-02.
     Table 17 provides details for all asset-backed bonds, and the related collateral that we have issued.

 

Table 17 — Asset-backed Bonds June 30, 2001 and December 31, 2000 (dollars in thousands)
	Asset-Backed Bonds					Mortgage Loans
								Weighted Average
	Remaining Principal			Interest Rate		Remaining Principal (A)			Coupon	Estimated Months to Call
June 30, 2001
NHES 1997-1	$	38,515		4.28	%	$	42,140		11.20	0
NHES 1997-2		37,784		4.31			41,195		11.06	0
NHES 1998-1		78,118		4.08			87,197		10.69	0
NHES 1998-2		125,249		4.02			133,095		10.35	15
Unamortized debt issuance costs, net		(490	)
Total	$	279,176

 17

	Asset-Backed Bonds					Mortgage Loans
								Weighted Average
	Remaining Principal			Interest Rate		Remaining Principal (A)			Coupon	Estimated Months to Call
December 31, 2000
NHES 1997-1		48,121		7.13	%		52,910		11.80%	0
NHES 1997-2		51,114		6.91			55,736		10.55	1
NHES 1998-1		105,780		6.92			117,121		11.05	6
NHES 1998-2		153,508		6.86			163,039		10.55	21
Unamortized debt issuance costs, net		(1,086	)
Total	$	357,437

(A)    Including assets acquired through foreclosure.      

     Stockholders' Equity. The increase in our stockholders’ equity as of June 30, 2001 compared to December 31, 2000 is a result of the following:

• $7.2 million increase due to net income recognized for the six months ended June 30, 2001.
• $370,000 net increase due to the restructuring of founders notes receivable and purchase of NFI Holding Corporation on January 1, 2001. This transaction resulted in a $5 million increase in equity due to a decrease in founders notes receivable with a corresponding $4.6 million decrease in equity as a result of repurchases of common stock. Refer to the December 31, 2000 Form 10-K for more detail regarding this transaction. As of June 30, 2001, we have purchased 2,429,645 shares of our common stock.
• $11.5 million increase in unrealized gains on mortgage securities classified as available-for-sale.
• $1.1 million decrease due to dividends on Class B 7% cumulative convertible preferred stock.
  

Mortgage Loan Production

     Our non-conforming loans are originated through a network of mortgage brokers throughout the United States. Approximately 1,000 brokers are active customers and approximately 5,800 are approved. Loans are underwritten and funded in a centralized facility by our employees. We increased our sales force from 85 on January 1, 2001 to 99 on June 30, 2001. The increase has contributed to our significant increase in mortgage loan originations. Our sales force operates in 44 states, which allows us to mitigate the risk of geographical concentrations of credit risk.

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Table 18 — Wholesale Loan Originations (dollars in thousands, except for average loan balance)
									Weighted Average
					Average Loan Balance									Percent with Prepayment Penalty
							Price Paid to Broker		Loan to Value		Credit Rating (A)
	Number		Principal									Coupon
2001:
Second quarter	2,966	$		348,569	$	117,522	101.0	%	81	%	5.43	10.0	%	83	%
First quarter	2,087			244,639		117,220	101.1		82		5.41	10.4		82
Total	5,053	$		593,208	$	117,397	101.0	%	81	%	5.42	10.2	%	82	%
2000:
Fourth quarter	1,768	$		208,232	$	117,778	101.1	%	82	%	5.12	10.7	%	86	%
Third quarter	1,793			207,662		115,818	101.1		84		5.20	10.7		90
Second quarter	1,473			171,375		116,344	101.0		82		5.32	10.5		91
First quarter	1,232			132,072		107,201	101.1		80		5.45	10.2		93
Total	6,266	$		719,341	$	114,801	101.1		82		5.28	10.5		90
(A)  AAA=7, AA=6, A=5, A-=4, B=3, C=2, D=1

Table 19 — Quarterly Mortgage Loan Originations by State (based on original principal)
	2001				2000
Collateral Location	Second		First			Fourth		Third		Second		First
California	18	%	17	%		11	%	11	%	10	%	10	%
Florida	16		15			14		12		13		14
Michigan	8		8			9		10		11		11
Ohio	5		5			6		7		8		7
Tennessee	4		4			4		4		6		7
Arizona	3		6			4		5		5		5
Washington	3		3			3		5		5		5
All other states	43		42			49		46		42		41

     The following table presents a summary of our mortgage loan during 2001 and 2000 as a percent of the respective quarter’s beginning principal of mortgage loans held in warehouse and loan origination principal.

Table 20 — Mortgage Loan Activity

	Sold to Third Parties		Sold in Securitizations		Held in Warehouse		Payments		Total
2001
Second quarter	4	%	46	%	50	%	<1	%	100	%
First quarter	3		66		30		1		100
2000
Fourth quarter	9		55		34		2		100
Third quarter	9		60		30		1		100
Second quarter	12		44		43		1		100
First quarter	20		53		26		1		100

19

Results of Operations

Presentation

On January 1, 2001, we purchased the voting common shares of NFI Holding Corporation. Previously, two members of NovaStar management owned these securities. The assets and liabilities and operating results of NFI Holding Corporation were not consolidated with that of NovaStar Financial. Beginning January 1, 2001, the financial statements of NFI Holding Corporation are consolidated with those of NovaStar Financial. For comparative purposes, we have presented prior period information as if the financial results of NFI Holding had been consolidated with those of NovaStar Financial in relevant analyses that follow. In these cases, we have marked the proforma information accordingly. Table 21 is a presentation of proforma consolidated operating results.

Table 21 - NOVASTAR FINANCIAL, INC.
PROFORMA CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands except per share amounts)

	For the Six Months						For the Three Months
		Ended June 30,						Ended June 30,
	2001			Pro Forma			2001			Pro Forma
				2000						2000
Interest income:
Mortgage loans	$	22,749		$	31,173		$	10,009		$	14,969
Mortgage securities		3,958			878			2,608			612
Total interest income	26,707				32,051		12,617			15,581
Interest expense:
Financing on mortgage loans	13,376				22,668			5,340		10,931
Financing on mortgage securities		1,016			151			536			151
Interest expense	14,392				22,819			5,876		11,082
Net interest income before provision for credit losses	12,315				9,232			6,741			4,499
Provision for credit losses		1,638			2,775			1,119			1,345
Net interest income	10,677				6,457			5,622			3,154
Prepayment penalty income		498			983			248			494
Premiums for mortgage loan insurance	(1,129		)		(870	)		(692	)		(498	)
Loan servicing income	12,290				3,372			6,086			1,526
Gain on sale of mortgage assets		9,563			4,795			4,540			2,163
Other income		791			698			344			332
General and administrative expenses:
Compensation and benefits	13,069				6,981			6,384			3,693
Travel and public relations		3,957			857			2,060			581
Office administration		3,388			3,175			1,598			1,651
Loan expense		924			468			405			283
Professional and outside services		1,010			1,091			596			570
Other		1,435			1,505			917			247
Total general and administrative expenses	23,783				14,077		11,960				7,025
Net income before cumulative effect of a change in accounting principle		8,907			1,358			4,188			146
Cumulative effect of a change in accounting principle		(1,706	)		–			–			–
Net income		7,201			1,358			4,188			146
Dividends on preferred shares		(1,082	)		(1,050	)		(557	)		(525	)
Net income (loss) available to common shareholders	$	6,119		$	308		$	3,631		$	(379	)

20

     Pro forma net income per share, including the cumulative effect of a change in accounting principal is the same for the six and three months ended June 30, 2000.

     Table 22 is a summary of income by our primary operating units. Mortgage portfolio operating results are driven from the income generated on the assets we manage less associated management costs. Mortgage lending and servicing operations include the marketing, underwriting and funding of loan production. Servicing operations represent the income and costs to service our on and off-balance sheet loans. Branch operations include the collective income generated by NovaStar Home Mortgage brokers and the associated operating costs. Branch management costs include the corporate-level income and costs to support branch operations. Each of these operations is discussed below.

Table 22 — Divisional Operations
Six Months Ended June 30, 2001

	Mortgage Portfolio		Mortgage Lending and Servicing		Branch Operations		Branch Management		Total
Net interest income	$8,264		$4,051		–		–		$12,315
Provision for losses	(1,759	)	121		–		–		(1,638	)
Prepayment penalty income	498		–		–		–		498
Mortgage insurance	(804	)	(325	)	–		–		(1,129	)
Gains (loss) on sales of loans	186		9,377		–		–		9,563
Fee income (expense)	(480	)	2,172		9,410		1,188		12,290
Other income (expense)	72		(987	)	–		–		(915
General and administrative expenses	(1,190	)	(12,131		(9,388	)	(1,074	)	(23,783	)
Net income	$4,787		$2,278		$22		$114		$7,201

Three Months Ended June 30, 2001

	Mortgage Portfolio		Mortgage Lending and Servicing		Branch Operations		Branch Management		Total
Net interest income	$4,753		1,988		–		–		$6,741
Provision for losses	(1,279	)	160		–		–		(1,119	)
Prepayment penalty income	248		–		–		–		248
Mortgage insurance	(564	)	(128	)	–		–		(692	)
Gains (loss) on sales of loans	208		4,332		–		–		4,540
Fee income	–		778		4,570		738		6,086
Other income	20		324		–		–		344
General and administrative expenses	(432	)	(6,400	)	(4,548	)	(580	)	(11,960	)
Net income	$2,954		$1,054		$22		$158		$4,188

     During the six months ended June 30, 2001, we earned net income of $7.2 million, $0.70 per diluted share, compared with net income of $1.4 million, $0.04 per diluted share, for the same period of 2000. Net income earned for the three months ended June 30, 2001 was $4.2 million, $0.40 per diluted share, compared with $146,000, $(0.05) per diluted share, for the three months ended June 30, 2000.

     Our primary sources of revenue are interest earned on our mortgage loan portfolio and securities, prepayment penalty income and gains from the sales and securitizations of mortgage loans. Earnings increased in 2001 over 2000 due to three main factors: 1) increase in accrual rates on our mortgage securities portfolio due to better cash flow performance than initial estimates, 2) substantially lower all-in loan origination costs of production and 3) a lower interest rate environment, which widened the interest spread between loans in warehouse and the cost of our financing facilities.

21

Net Interest Income

     Table 23 presents a summary of the average interest-earning assets, average interest-bearing liabilities and the related yields and rates thereon for the six months ended June 30, 2001 and 2000 and the three months ended June 30, 2001 and 2000.

Table 23 — Interest Analysis (dollars in thousands)

	Mortgage Loans							Mortgage Securities								Total Interest Income/ Expense
			Interest Income/ Expense			Annual Yield/ Rate				Interest Income/ Expense		Annual Yield/ Rate							Annual Yield/ Rate
	Average Balance							Average Balance						Average Balance
Six months ended June 30, 2001
Held-in-portfolio
Interest-earning mortgage assets	$	300,596	$	15,106		10.05	%							$	300,596	$	15,106		10.05	%
Interest-bearing liabilities:
Asset-backed bonds	$	325,029		9,949		6.09	%							$	325,029		9,949		6.09	%
Other borrowings		–		–											–		–
Cost of derivative financial instruments
hedging liabilities				(162	)												(162	)
Total borrowings	$	325,029		9,787		5.99								$	325,029		9,787		5.99
Net interest income			$	5,319												$	5,319
Net interest spread						4.06													4.06
Net yield						3.54													3.54
Held-for-sale
Interest-earning mortgage assets	$	144,368	$	7,643		10.59	%	$	43,596	$	3,958	18.16	%	$	187,964	$	11,601		12.34	%
Interest-bearing liabilities:
Asset-backed bonds		–		–					–		–				–		–
Other borrowings	$	106,644		3,473		6.48	%		31,605		1,016	6.39			138,248		4,489		6.46
Cost of derivative financial instruments
hedging liabilities				116													116
Total borrowings	$	106,644		3,589		6.69			31,605		1,016	6.39			138,248		4,605		6.63
Net interest income			$	4,054						$	2,942					$	6,996
Net interest spread						3.90						11.77							5.71
Net yield						5.62						13.50							7.44
Six months ended June 30, 2000 (pro forma)
Held-in-portfolio
Interest-earning mortgage assets	$	504,522	$	24,591		9.75	%							$	504,522	$	24,591		9.75	%
Interest-bearing liabilities:
Asset-backed bonds	$	528,478		18,198		6.81	%							$	528,478		18,198		6.81	%
Other borrowings		–		–											–		–
Cost of derivative financial instruments
hedging liabilities				319													319
Total borrowings	$	528,478		18,517		6.93								$	528,478		18,517		6.93
Net interest income			$	6,074												$	6,074
Net interest spread						2.82													2.82
Net yield						2.41													2.41
Held-for-sale
Interest-earning mortgage assets	$	131,175	$	6,582		10.04	%	$	11,205	$	878	15.93	%	$	142,199	$	7,460		10.49	%
Interest-bearing liabilities:
Asset-backed bonds		–		–					–		–				–		–
Other borrowings	$	101,956		4,116		7.99	%		4,487		151	6.66			106,443		4,267		7.93
Cost of derivative financial instruments
hedging liabilities				35													35
Total borrowings	$	101,956		4,151		8.05			4,487		151	6.66			106,443		4,302		7.99
Net interest income			$	2,431						$	727					$	3,158
Net interest spread						1.99						9.27							2.50
Net yield						3.71						13.19							4.44

22

	Mortgage Loans								Mortgage Securities
	Average Balance		Interest Income/ Expense			Annual Yield/ Rate			Average Balance		Interest Income/ Expense		Annual Yield/ Rate			Average Balance		Total Interest Income/ Expense			Annual Yield/ Rate
Three months ended June 30, 2001
Held-in-portfolio
Interest-earning mortgage assets	$	280,329	$	6,979			9.96	%								$	280,329	$	6,979			9.96	%
Interest-bearing liabilities:
Asset-backed bonds	$	307,831		4,186			5.32	%								$	307,831		4,186			5.32	%
Other borrowings		—		—													—		—
Cost of derivative financial instruments
hedging liabilities				112															112
Total borrowings	$	307,831		4,298			5.46									$	307,831		4,298			5.46
Net interest income			$	2,681														$	2,681
Net interest spread.							4.50															4.50
Net yield							3.83															3.83
Held-for-sale
Interest-earning mortgage assets.	$	116,957	$	3,030			10.36	%	$	51,580	$	2,608		20.22	%	$	168,537	$	5,638			13.38	%
Interest-bearing liabilities:
Asset-backed bonds		—		—						—		—					—		—
Other borrowings		79,120		1,043			5.16			38,524		536		5.48			117,374		1,579			5.26
Cost of derivative financial instruments
hedging liabilities				(1	)														(1	)
Total borrowings	$	79,120		1,042			5.15			38,524		536		5.48			117,374		1,578			5.26
Net interest income			$	1,988							$	2,072						$	4,060
Net interest spread.							5.21							14.74								8.12
Net yield							6.80							16.07								9.64
Three months ended June 30, 2000
(pro forma)
Held-in-portfolio
Interest-earning mortgage assets.	$	476,082	$	11,779			9.90	%								$	476,082	$	11,779			9.90	%
Interest-bearing liabilities:
Asset-backed bonds	$	500,518		8,862			6.93	%								$	500,518		8,862			6.93	%
Other borrowings		—		—						—		—					—		—
Cost of derivative financial instruments
hedging liabilities				18															18
Total borrowings	$	500,518		8,880			6.94									$	500,518		8,880			6.94
Net interest income			$	2,899														$	2,899
Net interest spread.							2.96															2.96
Net yield							2.43															2.43
Held-for-sale
Interest-earning mortgage assets.	$	126,099	$	3,190			10.12	%	$	15,674	$	612		15.62	%	$	141,773	$	3,802			10.73	%
Interest-bearing liabilities:
Asset-backed bonds		—		—						—		—					—		—
Other borrowings		94,352		2,016			8.37			8,974		151		6.58			103,326		2,167			8.21
Cost of derivative financial instruments
hedging liabilities				35															35
Total borrowings	$	94,352		2,051			8.51			8,974		151		6.58			103,326		2,202			8.34
Net interest income			$	1,139							$	461						$	1,600
Net interest spread.							1.61							9.04								2.39
Net yield							3.61							11.76								4.51

23

     As noted in Table 23, interest income is a function of volume and rates. Increasing the volume of assets will cause future increases in interest income, while declining balances will reduce interest income. Market interest rates will also affect future interest income on adjustable-rate mortgages.

     Our asset-backed bonds are indexed to LIBOR. During the six months ended June 30, 2001, one-month LIBOR averaged 4.91% compared with 6.19% for same period of 2000. As with interest income, the cost of funds in the future will largely depend on market conditions, most notably levels of short-term interest rates. Rates on other borrowings generally fluctuate with short-term market interest rates, such as LIBOR or the federal funds rate.

     Impact of Interest Rate Agreements. We have executed interest rate agreements designed to mitigate exposure to interest rate risk. Interest rate cap agreements require us to pay either a one-time “up front” premium or a 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.

Table 24 — Taxable Net Income
(dollars in thousands)

							For the Six
	For the Three Months Ended						Months Ended
	March 31, 2001			June 30, 2001			June 30, 2001
GAAP net income	$	3,013		$	4,188		$	7,201
Equity in net income of NFI Holding Corp	(1,182		)		(85	)	(1,267		)
Cumulative effect of a change in accounting principle		1,384			—		1,384
Interest rate agreement amortization		(427	)		(211	)	(638		)
Residual purchase commitment fee		(423	)		(407	)	(830		)
Credit losses, net of provision	(1,058		)		(334	)	(1,392		)
Other		39			95			134
Use of net operating loss carryforward		(821	)		(1,897	)	(2,718		)
Taxable net income before preferred dividends		525			1,349		1,874
Preferred dividends		(525	)		(557	)	(1,082		)
Taxable net income available to common shareholders	$	—		$	792		$	792
Taxable net income per common shareholder	$	—		$	0.13		$	0.13

     Comparative data for the three-month periods ended March 31, 2000, and June 30, 2000, and for the six-month period ended June 30, 2000, is not meaningful as we were in a net operating loss position for taxable income during those time periods. As of June 30, 2001, we had a capital loss carryforward of approximately $15 million available to off set future capital gains.

24

Provisions for Credit Losses

     We originate and own loans in which the borrower possesses credit risk higher than that of conforming borrowers. Delinquent loans and losses are expected to occur. Provisions for credit losses are made in amounts considered necessary to maintain an allowance at a level sufficient to cover probable losses inherent in the loan portfolio. Charge-offs are recognized at the time of foreclosure by recording the value of real estate owned property at its estimated realizable value. One of the principal methods used to estimate expected losses is a delinquency migration analysis. This analysis takes into consideration historical information regarding foreclosure and loss severity experience and applies that information to the portfolio at the reporting date.

     We use several techniques to mitigate credit losses, including pre-funding audits by quality control personnel and in-depth appraisal reviews. Another loss mitigation technique allows a borrower to sell their property for less than the outstanding loan balance prior to foreclosure in transactions known as short sales, when it is believed that the resulting loss is less than what would be realized through foreclosure. Loans are charged off in full when the cost of pursuing foreclosure and liquidation exceed recorded balances. While short sales have served to reduce the overall severity of losses incurred, they also accelerate the timing of losses. As discussed further under the caption “Premiums for Mortgage Loan Insurance”, lender paid mortgage insurance is also used as a means of managing credit risk exposure. Generally, the exposure to credit loss on insured loans is considered minimal. Management also believes aggressive servicing is an important element to managing credit risk.

     During the six months ended June 30, 2001, we made provisions for losses of $1.6 million and incurred net charge-offs of $3.2 million, compared to $2.8 million and $4.8 million during the same period of 2000. The following table presents a quarterly rollforward of our allowance for credit losses.

Table 25 — Quarterly Activity - Allowance for Credit Losses
(in thousands)

	2001						2000
		June 30			March 31			December 31			September 30			June 30			March 31
Beginning balance	$	6,825		$	7,944		$	8,701		$	9,770		$	10,230		$	11,817
Provision for credit losses		1,119			519			1,460			1,252			1,336			1,430
Amounts charged off, net of recoveries	(	1,525	)	(	1,638	)	(	2,217	)	(	2,321	)	(	1,796	)	(	3,017	)
Ending balance	$	6,419		$	6,825		$	7,944		$	8,701		$	9,770		$	10,230

Prepayment Penalty Income

     A large percentage of the loans we originate require the borrower to pay a cash penalty if they pay off their loan early in the loan’s life, generally within two years of origination. This income serves to mitigate and offset prepayment risk and the amortization expense of premiums we paid to loan brokers. The penalty is generally six months of interest on 80% of the unpaid principal at prepayment. During the six months ended June 30, 2001, 82% of the mortgage loans we originated had prepayment penalties, as compared to 92% during the same period of 2000. As of June 30, 2001, 73% our mortgage loan portfolio had prepayment penalties. Prepayment penalty income was $498,000 and $983,000 during the six months ended June 30, 2001 and 2000 compared with

25

$248,000 and $494,000 for the three months ended June 30, 2001 and 2000. The decrease is due to the seasoning of the portfolio and expiration of prepayment penalties.

Premiums for Mortgage Loan Insurance

     We purchase mortgage insurance on substantially all of the loans we originate. The use of mortgage insurance is one method of managing the credit risk in the mortgage asset portfolio. As of June 30, 2001, approximately 93% of the loans we service are covered by mortgage insurance compared with 72% as of December 31, 2000.

     Premiums for mortgage insurance on loans maintained on our balance sheet are recorded as a portfolio cost and included in the income statement under the caption “Premiums for Mortgage Loan Insurance.”

     It is important to note that substantially all of the mortgage loans that serve as collateral for our mortgage securities carry mortgage insurance. This serves to reduce credit loss exposure in those mortgage pools. Insurance premiums on these loans are paid from the collateral proceeds and, therefore, are not included in the amount of total premium expense in our statement of operations.

Sales of Mortgage Loans

     During 2001 and 2000, we executed securitization transactions in which we transferred mortgage loan collateral to an independent trust. In those transactions, we retained the AAA-rated interest-only and non-investment grade subordinated securities. In addition, we continue to service the loan collateral. Accounting principles require us to record these transactions as loan sales. Whole loan sales have also been executed whereby we sell loans outright.

Table 26 — Quarterly Mortgage Loan Sales
(dollars in thousands)

	Outright Mortgage Loan Sales									Mortgage Loans Transferred in Securitizations
							Weighted
							Average
		Principal			Net Gain		Price To			Principal			Net Gain
		Amount	Percent		Recognized		Par			Amount	Percent		Recognized
2001:
Second quarter	$	17,516	7.9	%	$	369	102.9	(A)	$	203,647	92.1	%	$	3,963
First quarter		10,773	4.8			262	102.9	(A)		211,420	95.2			4,944
Total	$	28,289	6.4	%	$	631	102.9		$	415,067	93.6	%	$	8,907
2000:
Fourth quarter	$	46,158	23.4	%	$	1,666	104.6		$	151,277	76.6	%	$	3,227
Third quarter		50,334	21.1			1,552	104.4			188,734	78.9			3,584
Second quarter		27,799	21.5			661	103.8			101,675	78.5			1,392
First quarter		48,548	27.5			1,204	104.0			128,171	72.5			1,544
Total	$	172,839	23.3	%	$	5,083	104.2		$	569,857	76.7	%	$	9,747

(A) Includes sales of loans in our highest credit category, which have relatively low coupons. Average price of 102.9 represent market prices for similar loans, but are lower than market prices for high coupon loans such as those sold in prior quarters.

26

     In the outright sales of mortgage loans, we retain no assets or servicing rights. For mortgage loans transferred in securitizations, we allocate our basis in the mortgage loans between the portion of the mortgage loans sold and the retained assets, securities and servicing rights, based on the relative fair values of those portions at the time of sale. The values of these assets are determined by discounting estimated future cash flows using the cash out method. The following table details the significant assumptions used to determine the value of the resulting retained assets at the time of securitization.

Table 27 — Mortgage Loans Transferred in Securitizations — Valuation Assumptions at Closing
	Constant Prepayment Rate	Total Projected Default Rate (% of original principal) (A)	Discount Rate
NovaStar Mortgage Funding Trust Series:
1999-01	25 to 30	2.5%	16.5%
2000-01	25 to 30	1.0	14.8
2000-02	25 to 30	1.0	15.0
2001-01	25 to 30	1.2	20.0
(A) After the effect of mortgage insurance.

Fee Income

     Fee income primarily consists of fees from two sources – servicing fees from investors and borrowers and broker fees from loan investors. As a loan servicer, we collect normal fees for servicing loans that collateralize asset-backed bonds. These fees are generated at the rate of 50 basis points of the principal balance and are earned as interest is collected from borrowers. In addition, we collect fees directly from the borrower in the normal course of servicing loans for such items as late payment assessments and processing fees for special handling.

     Loan investors who fund the loans we broker pay fees to our branches. These fees constitute standard broker “premiums” for the types of loans we broker. As discussed below under Branch Operations, the net income of the branches accrues to the branch manager.

General and Administrative Expenses

Table 28 — General and Administrative Expenses
(dollars in thousands)

	Six Months Ended				Three Months Ended
	June 30,				June 30,
	2001		2000		2001			2000
			(pro forma)					(pro forma)
Compensation and benefits	$	13,069	$	6,981	$	6,384	$	3,693
Travel and entertainment		3,957		857		2,060		581
Office administration		3,388		3,175		1,598		1,651
Loan expense		924		468		405		283
Professional and outside services		1,010		1,091		596		570
Other		1,435		1,505		917		247
Total general and administrative expenses	$	23,783	$	14,077	$	11,960	$	7,025

     Compensation and benefits includes employee base salaries, benefit costs and incentive compensation awards.

27

     Professional and outside services include fees for legal and accounting services. In the normal course of business, fees are incurred for professional services related to general corporate matters and specific transactions. Office administration includes items such as rent, depreciation, telephone, office supplies, postage, delivery, maintenance and repairs.

     Cost of production. Our quarter-to-quarter wholesale loan production costs steadily declined as a result of increased efficiencies in the mortgage lending operation. During the third quarter of 1999, we introduced Internet Underwriter® "IU", a web-based origination system that has allowed us to increase production volumes without adding proportionate infrastructure. Account executive costs typically are higher in the first few months of employment and are expected to decline as the sales force becomes more productive with added experience and exposure to our loan products and markets.

Table 29 — Wholesale Loan Costs of
Production, as a Percent of Principal

	Gross Loan Production	Premium paid to broker, net of fees collected	Total Acquisition Cost
2001:
Second quarter	1.9	0.5	2.4
First quarter	2.4	0.5	2.9
2000:
Fourth quarter	2.8	0.5	3.3
Third quarter	2.6	0.5	3.1
Second quarter	3.0	0.5	3.5
First quarter	3.3	0.5	3.8

Table 30 — Divisional Operations – General and Administrative Expenses

Six Months Ended June 30, 2001

			Mortgage Lending and Servicing
	Mortgage Portfolio				Branch Operations		Branch Management
									Total
Compensation and benefits	$	537	$	7,554	$	4,411	$	567	$	13,069
Travel and entertainment		25		758		3,106		68		3,957
Office administration		225		2,267		726		170		3,388
Loan expense		–		801		120		3		924
Professional and outside services		391		572		24		23		1,010
Other		12		179		1,001		243		1,435
Total	1,190		12,131			9,388	1,074			23,783

28

Three Months Ended June 30, 2001

		Mortgage Lending and Servicing
	Mortgage Portfolio		Branch Operations	Branch Management
					Total
Compensation and benefits	$95	$4,041	$1,936	$312	$6,384
Travel and entertainment	14	446	1,559	41	2,060
Office administration	101	1,103	313	81	1,598
Loan expense	–	340	62	3	405
Professional and outside services	197	366	19	14	596
Other	25	104	659	129	917
Total	432	6,400	4,548	580	11,960

     Mortgage Loan Servicing

     Loan servicing is a critical part of our business. In the opinion of management, maintaining contact with borrowers is vital in managing credit risk and in borrower retention. Non-conforming borrowers are prone to late payments and are more likely to default on their obligations than conventional borrowers. We strive to identify issues and trends with borrowers early and take quick action to address such matters.

Table 31 — Summary of Servicing Operations

	2001						2000
		June 30			March 31				December 31			September 30			June 30			March 31
		Amount	%		Amount	%			Amount	%		Amount	%		Amount	%		Amount	%
Unpaid principal	$	1,414,683		$	1,263,773			$	1,112,615		$	1,016,951		$	970,026		$	872,702
Units		13,219			11,999				10,774			10,041			9,683			8,919
Servicing income, net of amortization
of mortgage servicing rights		$1,366	0.39		$1,465	0.46		$	1,473	0.53	$	1,392	0.55	$	1,321	0.54	$	1,219	0.56
Costs of servicing		1,166	0.33		1,238	0.39			1,185	0.43		1,095	0.43		1,015	0.42		1,064	0.49
Net servicing income	$	200	0.06	$	227	0.07		$	288	0.10	$	297	0.12	$	306	0.12	$	155	0.07
Annualized costs of servicing per unit ..		$352.86			$412.70				$439.95			$436.2141			$419.29			$477.18

     Branch Operations

          We operate our mortgage brokerage unit under the name NovaStar Home Mortgage, Inc. Our first branch was opened in December 1999. Following is a summary of the operations.

Table 32 — Branch Operations (dollars in thousands)
	2001		2000
	June 30	March 31	December 31	September 30	June 30	March 31
Branches (end of quarter)	86	77	63	48	24	16
Loans originated	2,612	1,126	867	533	272	103
Fee income	$4,570	$4,840	$3,955	$2,283	$1,093	$330
General and administrative costs	$4,548	$4,840	$3,662	$2,277	$1,093	$328
Personnel	355	288	252	162	107	81

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     Under our agreements with branch managers, fee income generated by the branches, excluding our management fee, is paid to the branch manager as compensation. Fees we retain are designed to cover our management costs and generate a profit. For the fees we retain, we provide administrative functions for the branches, including accounting, human resources, license/registration and loan investor management. The following table summarizes the branch management fee income and costs.

Table 33 — Branch Management
(dollars in thousands)

	2001				2000
	June 30		March 31		December 31		September 30		June 30		March 31
Fee income	$	738	$	450	$	343	$	210	$	101	$	31
General and administrative costs .	$	580	$	494	$	590	$	362	$	219	$	93
Personnel		16		15		12		11		6		5

Liquidity and Capital Resources

     Liquidity means the need for, access to and uses of cash. The primary needs for cash include the acquisition of mortgage loans, principal repayment and interest on borrowings, operating expenses and dividend payments. Substantial cash is required to support the operating activities of the business, especially the mortgage origination operation. Mortgage asset sales, principal, interest and fees collected on mortgage assets support cash needs. Drawing upon various borrowing arrangements typically satisfies major cash requirements.
     Mortgage lending requires significant cash to fund loan originations and for operating costs. Our warehouse lending arrangements, including repurchase agreements, are used to support the mortgage lending operation. Loans financed with warehouse and repurchase credit facilities are subject to changing market valuation and margin calls. Loans we originate can be sold to third a party, which also generates cash to fund on-going operations. We believe we can operate indefinitely in this manner, provided that the level of loan originations is at or near the capacity of its production infrastructure. Our liquidity position is shown under “Financial Condition – Short-term Financing Arrangements.”
     Cash activity during the six months ended June 30, 2001 and 2000 are presented in the consolidated statement of cash flows.
     Since inception, our capital has come from  
     • a private placement offering of preferred stock, raising net proceeds of $47 million.
     • an initial public offering of common stock, raising net proceeds of $67 million, and
     • a private offering of convertible preferred stock, raising net proceeds of $29 million.
     We use capital when financing loans on a long-term basis. Under short-term financing arrangements, we can borrow up to the lessor of 98% of the face amount or 95% of the market value of our loans. In long-term financing (i.e. in the form of asset-backed bonds) we can finance approximately 95% of the market value of the loans. Capital is used to fund the difference between the financed portion and the full loan cost.
     During 2000 and 2001, a portion of the loans we originated were sold to third parties and in securitization transactions treated as sales for tax and financial reporting purposes. In doing so, we do not use capital. In fact, if the sales prices are above the full cost to originate loans, this method of operation will generate capital.
     During 2001, we expect to finance 75% or more of the loans we produce. The remainder will be sold to third parties. We currently have excess capital to support this mode of operation. When we Inflation

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

Impact of Recently Issued Accounting Pronouncements

     Note 1 of the consolidated financial statements contained in the annual report on Form 10-K for the fiscal year ended December 31, 2000 and Note 2 of the consolidated financial statements included in this report describe certain recently issued accounting pronouncements. Management believes the implementation of these pronouncements and others that have gone into effect since the date of these reports will not have a material impact on the consolidated financial statements.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Interest Rate/Market Risk

     Our investment policy sets the following general goals:
      (1)Maintain the net interest margin between assets and liabilities, and
      (2)Diminish the effect of changes in interest rate levels on the market value of NovaStar Financial.

     Loan Price Volatility. Under our current mode of operation, we depend heavily on the market for wholesale non-conforming mortgage loans. To conserve capital, we may sell loans we originate. Financial results will depend, in part, on the ability to find purchasers for the loans at prices that cover origination expenses. Exposure to loan price volatility is reduced as we resume acquisition and retention of mortgage loans.

     Interest Rate Risk. Interest rate risk is the risk that the market value of assets will increase or decrease at different rates than that of the liabilities. Expressed another way, this is the risk that net asset value will experience an adverse change when interest rates change. When interest rates on the assets do not adjust at the same rates as the liabilities or when the assets are fixed rates and the liabilities are adjusting, future earnings potential is affected. Management primarily uses financing sources where the interest rate resets frequently. As of June 30, 2001 borrowings under all financing arrangements adjust daily, monthly, or quarterly. On the other hand, very few of the mortgage assets we own, adjust on a monthly or daily basis. Most of the mortgage loans contain features where their rates are fixed for some period of time and then adjust frequently thereafter. For example, one of our loan products is the “2/28” loan. This loan is fixed for its first two years and then adjusts every six months thereafter.

     While short-term borrowing rates are low and long-term asset rates are high, this portfolio structure produces good results. However, if short-term interest rates rise rapidly, earning potential is

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significantly affected, as the asset rate resets would lag the borrowing rate resets. The converse can be true when sharp declines in short-term interest rates cause interest costs to fall faster than asset rate resets, thereby increasing earnings.

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

The following are summaries of the analysis as of June 30, 2001.

Table 34 — Interest Rate Sensitivity-Income
(dollars in thousands)

	Basis Point Increase (Decrease) in Interest Rate(A)
As of June 30, 2001
	(100)				Base			100
Income (expense) from:
Assets	$	114,316		$	116,081		$	117,717
Liabilities (B)		(57,492	)		(68,290	)		(79,272	)
Interest rate agreements		(7,202	)		(4,240	)		(1,315	)
Net interest income	$	49,622		$	43,551		$	37,130
Percent change in net interest income from base		13.9			--			(14.7	)
Percent change of capital (C)		4.9			--			(5.1	)
As of December 31, 2000
Income (expense) from:
Assets	$	91,334		$	93,189		$	95,138
Liabilities (B)		(60,327	)		(68,686	)		(77,207	)
Interest rate agreements		(1,587	)		(1,424	)		( 119	)
Net interest income	$	29,420		$	23,079		$	17,812
Percent change in net interest income from base		27.5			--			(22.8	)
Percent change of capital (C)		5.8			--			(4.8	)

(A)	Income of asset, liability or interest rate agreement in a parallel shift in the yield curve, up and down 1%.
(B)	Includes debt issuance costs, amortization of loan premiums, mortgage insurance premiums and provisions for credit losses.
(C)	Total change in estimated spread income as a percent of total stockholders' equity as of June 30, 2001 and December 31, 2000.

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Table 35 — Interest Rate Sensitivity—Market Value
(dollars in thousands)

	Basis Point Increase (Decrease) in Interest Rate(A)
As of June 30, 2001	(100)		100
Change in market values of:
Assets	$6,981		$(17,339	)
Liabilities	(1,894	)	2,072
Interest rate agreements	(6,985	)	7,036
Cumulative change in market value	$(1,898	)	$(8,231	)
Percent change of market value portfolio equity (B)	(1.7	)%	(7.3	)%
As of December 31, 2000
Change in market values of:
Assets	$2,448		$(9,763	)
Liabilities	(1,624	)	1,865
Interest rate agreements	(524	)	2,220
Cumulative change in market value	$300		$(5,678	)
Percent change of market value portfolio equity (B)	0.3	%	(5.7	)%

(A)	Change in market value of assets, liabilities or interest rate agreements in a parallel shift in the yield curve, up and down 1%.
(B)	Total change in estimated market value as a percent of market value portfolio equity as of June 30, 2001 and December 31, 2000

     Interest Rate Sensitivity Analysis. The values under the heading “Base” are management's estimates of spread income for assets, liabilities and interest rate agreements on June 30, 2001. The values under the headings “100” and “(100)” are management's estimates of the income and change in market value of those same assets, liabilities and interest rate agreements assuming that interest rates were 100 basis points, or 1 percent higher and lower. The cumulative change in income or market value represents the change in income or market value of assets, net of the change in income or market value of liabilities and interest rate agreements.
     The interest sensitivity analysis is prepared monthly. If the analysis demonstrates that a 100 basis point shift, up or down, in interest rates would result in 25 percent or more cumulative decrease in income from base, or a 10% cumulative decrease in market value from base, policy requires management to adjust the portfolio by adding or removing interest rate cap or swap agreements. The Board of Directors reviews and approves our interest rate sensitivity and hedged position quarterly. Although management also evaluates the portfolio using interest rate increases and decreases less than and greater than one percent, management focuses on the one percent increase.
     Assumptions Used in Interest Rate Sensitivity Analysis. Management uses a variety of estimates and assumptions in determining the income and market value of assets, liabilities and interest rate agreements. The estimates and assumptions have a significant impact on the results of the interest rate sensitivity analysis, the results of which are shown as of June 30, 2001.
     Management's analysis for assessing interest rate sensitivity on its mortgage loans relies significantly on estimates for prepayment speeds. A prepayment model has been internally developed based upon four main factors:

•   Refinancing incentives (the interest rate of the mortgage compared with the current mortgage rates available to the borrower)
•   Borrower credit grades
•   Loan-to-value ratios
•   Prepayment penalties, if any

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

     These factors are weighted based on management's experience and an evaluation of the important trends observed in the non-conforming mortgage origination industry. Actual results may differ from the estimates and assumptions used in the model and the projected results as shown in the sensitivity analyses.

     Projected prepayment rates in each interest rate scenario start at a prepayment speed less than 5% in month one and increase to a long-term prepayment speed in nine to 18 months, to account for the seasoning of the loans. The long-term prepayment speed ranges from 20% to 40% and depends on the characteristics of the loan which include type of product (ARM or fixed rate), note rate, credit grade, LTV, gross margin, weighted average maturity and lifetime and periodic caps and floors. This prepayment curve is also multiplied by a factor of 60% on average for periods when a prepayment penalty is in effect on the loan. Prepayment assumptions are also multiplied by a factor of greater than 100% during periods around rate resets and prepayment penalty expirations. These assumptions change with levels of interest rates. The actual historical speeds experienced on NovaStar Financial's loans shown in Table 6 are weighted average speeds of all loans in each deal.

     As shown in Table 6, actual prepayment rates on loans that have been held in portfolio for shorter periods are slower than long term prepayment rates used in the interest rate sensitivity analysis. This table also indicates that as pools of loans held in portfolio season, the actual prepayment rates are more consistent with the long term prepayment rates used in the interest sensitivity analysis.

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

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

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

     Interest rate cap agreements are legal contracts between us and a third party firm or “counter-party”. The counter-party agrees to make payments to us in the future should the one- or three-month LIBOR interest rate rise above the strike rate specified in the contract. We make either quarterly premium payments or have chosen to pay the premiums upfront to the counterparties under contract.

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Each contract has a fixed notional face amount on which the interest is computed, and a set term to maturity. When the referenced LIBOR interest rate rises above the contractual strike rate, we earn cap income. Payments on an annualized basis equal the contractual notional face amount times the difference between actual LIBOR and the strike rate.

     Interest rate swaps have similar characteristics. However, interest rate swap agreements allow us to pay a fixed rate of interest while receiving a rate that adjusts with one-month LIBOR.

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PART II. OTHER INFORMATION
Item 1.	Legal Proceedings
	As of June 30, 2001, there were no material legal proceedings pending to which we were a party or of which any of our property was subject.
Item 2.	Changes in Securities
	Not applicable
Item 3.	Defaults upon Senior Securities
	Not applicable
Item 4.	Submission of Matters of Vote of Security Holders
	(a)	The 2001 annual meeting of shareholders of NovaStar Financial, Inc. was held on May 24, 2001.
	(b)	The following matters were voted on at the annual meeting:

					Vote
			For	Against	Abstain		Broker Non-Votes
1	.	Election of Directors
		W. Lance Anderson	4,916,324	—	53,825		751,792
		Gregory T. Barmore	4,918,324	—	51,825		751,792
		Art N. Burtscher	4,918,324	—	51,825		751,792
					Vote
			For	Against	Abstain	Broker Non-Votes
2.		Ratification of KPMG LLP as NovaStar Financial, Inc.’s independent public accountants for 2001	4,944,949	8,700	16,500		751,792

Item 5. Other Information

None

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Item 6. Exhibits and Reports on Form 8-K
(a)	Exhibit Listing
	Exhibit No.
		Description of Document
	3.1*	Articles of Amendment and Restatement of the Registrant
	3.2*	Articles Supplementary of the Registrant
	3.3*	Bylaws of the Registrant
	3.3a***	Amendment to Bylaws of the Registrant, adopted February 2, 2000
	3.4**	Articles Supplementary of NovaStar Financial, Inc. dated as of March 24, 1999, as filed with the Maryland Department of Assessment and Taxation.
	11.1	Statement regarding computation of per share earnings.
	*	Incorporated by reference to the correspondingly numbered exhibit to the Registration Statement on Form S-11 (373-32327) filed by the Registrant with the SEC on July 29 1997, as amended.
	**	Incorporated by reference to the correspondingly numbered exhibit to Form 8-K filed by the Registrant with the SEC on April 5, 1999.
	***	Incorporated by reference to the correspondingly numbered exhibit to Annual Report on Form 10K filed by the Registrant with the SEC on March 20, 2000.
	NovaStar Financial filed a Form 8-K on July 26, 2001 regarding NovaStar Financial, Inc.’s change in principal accountants from KPMG LLP to Deloitte & Touche LLP.

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NOVASTAR FINANCIAL, INC.
SIGNATURES

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

NOVASTAR FINANCIAL, INC.

DATE: August 14, 2001	/s/ Scott F. Hartman
	Scott F. Hartman
	Chairman of the Board, Secretary and
	Chief Executive Officer
	(Principal Executive Officer)
DATE: August 14, 2001	/s/ Rodney E. Schwatken
	Rodney E. Schwatken
	Vice President, Treasurer and Controller
	(Principal Accounting Officer)

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EX-11.1

Exhibit 11.1

Schedule Regarding Computation of Per Share Earnings
(OOO’s except per share data)

	Six Months							Three Months
	Ended June 30,							Ended June 30,
		2001			2000			2001			2000
Net income	$	7,201			$	1,358		$	4,188		$	146
Less: preferred stock dividends	(1,082			)	(1,050		)		(557	)		(525	)
Income availabe to common
stockholders	$	6,119			$	308		$	3,631		$	(379	)
Weighted average common shares	10,005				7,181			10,002			7,020
Common equivalent shares:
Dilutive warrants			235			-			340			-
Dilutive stock options			110			8			149			-
Dilutive weighted average shares outstanding			10,350			7,189		10,491				7,020
Basic earnings per share			$0.72			$0.04			$0.42			$(0.05	)
Diluted earnings per share			$0.70			$0.04			$0.40			$(0.05	)