NOVASTAR FINANCIAL INC - 10-Q Quarterly Report

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

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

For the quarterly period ended September 30, 2002.

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

For the transition period from to .

Commission File Number: 001-13533

NovaStar Financial, Inc.

(Exact name of registrant as specified in its charter)

Maryland		74-2830661
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

1901 W. 47^th Place, Suite 105, Westwood, KS 66205

(Address of principal executive offices)

(Zip Code)

(913) 362-1090

(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

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

The number of shares of the registrant’s common stock outstanding as of November 8, 2002 was 10,418,721

NOVASTAR FINANCIAL, INC.

FORM 10-Q

QUARTER ENDED SEPTEMBER 30, 2002

INDEX

		Page
PART I	FINANCIAL INFORMATION
Item 1.	Consolidated Financial Statements:
	Balance Sheets	1
	Statements of Income	2
	Statements of Cash Flows	3
	Notes to Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	10
	Table 1, Quarterly Mortgage Loan Sales	14
	Table 2, Quarterly Activity—Allowance for Credit Losses	15
	Table 3, Mortgage Loans by Credit Grade	16
	Table 4, Mortgage Loans by Geographic Concentration	17
	Table 5, Carrying Value of Mortgage loans by Product/Type	17
	Table 6, Mortgage Credit Analysis—Held-in-portfolio Loans	18
	Table 7, Loss Analysis—Held-in-portfolio Loans	19
	Table 8, Mortgage Loan Coupon and Prepayment Analysis	19
	Table 9, Mortgage Securities	21
	Table 10, Characteristics of Loan Collateral, Valuation of Individual Mortgage Securities and Assumptions	23
	Table 11, Loans Collateralizing Mortgage Securities by Credit Grade	24
	Table 12, Loans Collateralizing Mortgage Securities by Geographic Concentration	24
	Table 13, Loans Collateralizing Mortgage Securities by Product/Type	25
	Table 14, Loans Collateralizing Mortgage Securities, Coupon and Prepayment Analysis	25
	Table 15, Loans Collateralizing Mortgage Securities, Credit Analysis	26
	Table 16, Mortgage Loss Analysis—Loans Collateralizing Mortgage Securities	28
	Table 17, Asset-backed Bonds	29
	Table 18, Short-term Financing Resources	30
	Table 19, Non-conforming Loan Originations	31

		Page
	Table 20, Quarterly Mortgage Loan Originations by State	31
	Table 21, Mortgage Securities Interest Analysis	32
	Table 22, Interest Analysis	33
	Table 23, Loan Costs of Production	38
	Table 24, Divisional Operations—General and Administrative Expenses	38
	Table 25, Summary of Servicing Operations	40
	Table 26, Branch Operations—Non-LLC	40
	Table 27, Branch Operations—LLC	40
	Table 28, Branch Management	41
	Table 29, Taxable Net Income	41
Item 3	Quantitative and Qualitative Disclosures about Market Risk	43
.	Table 30, Interest Rate Sensitivity—Income	44
	Table 31, Interest Rate Sensitivity—Market Value	45
Item 4.	Controls and Procedures	47
PART II	OTHER INFORMATION
Item 1.	Legal Proceedings	48
Item 2.	Changes in Securities	48
Item 3.	Defaults Upon Senior Securities	48
Item 4.	Submission of Matters to a Vote of Security Holders	48
Item 5.	Other Information	48
Item 6.	Exhibits and Reports on Form 8-K	49
	Signatures	50
	Certifications	51
	Exhibit 99.1	53
	Exhibit 99.2	54

NOVASTAR FINANCIAL, INC.

CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except per share amounts)

	September 30, 2002			December 31, 2001
	(unaudited)
Assets
Cash and cash equivalents	$	43,802		$	30,817
Mortgage loans – held-for-sale		338,587			139,527
Mortgage securities – available-for-sale		179,600			71,584
Mortgage loans – held-in-portfolio		166,965			226,033
Mortgage servicing rights		7,839			6,445
Assets acquired through foreclosure		6,502			13,185
Accrued interest receivable		4,840			5,495
Other assets		35,469			19,294

Total assets	$	783,604		$	512,380


Liabilities and Stockholders’ Equity
Liabilities:
Short-term borrowings	$	410,751		$	143,350
Asset-backed bonds		159,948			219,048
Accounts payable and other liabilities		37,138			15,227
Dividends payable		10,419			4,758

Total liabilities		618,256			382,383

Commitments and contingencies

Stockholders’ equity:
Capital stock, $0.01 par value, 50,000,000 shares authorized:
Class B, convertible preferred stock, 4,285,714 shares issued and outstanding December 31, 2001		—			43
Common stock, 10,418,721 and 5,804,255 shares issued and outstanding, respectively		104			58
Additional paid-in capital		129,876			137,860
Accumulated deficit		(12,509	)		(15,887	)
Accumulated other comprehensive income		49,026			9,177
Notes receivable from founders		(1,149	)		(1,254	)

Total stockholders’ equity		165,348			129,997

Total liabilities and stockholders’ equity	$	783,604		$	512,380

See accompanying notes to consolidated financial statements.

NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF INCOME

(unaudited; in thousands except per share amounts)

	For the Nine Months Ended September 30,						For the Three Months Ended September 30,
	2002			2001			2002			2001
Interest income	$	70,854		$	45,259		$	26,640		$	18,552
Interest expense		28,801			23,540			9,974			9,148

Net interest income before provision for credit losses		42,053			21,719			16,666			9,404
Provision for credit losses		294			(2,772	)		303			(1,134	)

Net interest income		42,347			18,947			16,969			8,270
Fee income		23,617			17,791			9,227			5,501
Gain on derivative instruments and sales of mortgage assets		17,027			28,548			4,048			18,985
Prepayment penalty income		312			674			89			176
Premiums for mortgage loan insurance		(1,705	)		(2,163	)		(595	)		(1,034	)
Other income, net		2,343			1,471			1,321			680
General and administrative expenses:
Compensation and benefits.		31,497			21,267			10,001			8,198
Travel and public relations		7,807			5,866			2,945			1,909
Office administration		6,649			4,999			2,563			1,611
Loan expense		4,612			1,559			2,614			635
Professional and outside services		2,224			1,497			804			487
Other		1,820			2,237			773			802

Total general and administrative expenses		54,609			37,425			19,700			13,642

Income before income tax and cumulative effect of a change in accounting principle		29,332			27,843			11,359			18,936
Income tax benefit		2,178			—			840			—
Cumulative effect of a change in accounting principle		—			(1,706	)		—			—

Net income		31,510			26,137			12,199			18,936
Dividends on preferred shares		—			(3,587	)		—			(2,505	)

Net income available to common shareholders	$	31,510		$	22,550		$	12,199		$	16,431

Basic earnings per share	$	3.04		$	2.61		$	1.17		$	1.89

Diluted earnings per share	$	2.90		$	2.49		$	1.14		$	1.76

Weighted average basic shares outstanding		10,365			10,012			10,417			10,038

Weighted average diluted shares outstanding		10,878			10,506			10,680			10,783

Dividends declared per common share	$	2.70		$	0.49		$	1.00		$	0.36

See accompanying notes to consolidated financial statements.

NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited; in thousands)

	For the Nine Months Ended September 30,
	2002			2001
Cash flows from operating activities:
Net income	$	31,510		$	26,137
Adjustments to reconcile net income to net cash used in operating activities:
Cumulative effect of change in accounting principle		—			1,706
Amortization of premiums on mortgage assets		1,491			2,624
Amortization of mortgage servicing rights		3,316			1,169
Amortization of deferred debt costs		64			842
Forgiveness of founders’ promissory notes		104			104
Provision for credit losses		(294	)		2,772
Net change in mortgage loans held for sale		(234,939	)		(66,171	)
Gain on derivative instruments and sales of mortgage assets		(17,027	)		(28,548	)
Changes in:
Accrued interest receivable		655			2,888
Other assets		(44,577	)		(18,274	)
Other liabilities		(1,375	)		(925	)

Net cash used in operating activities		(261,072	)		(75,676	)

Cash flow from investing activities:
Mortgage loan repayments—held-in-portfolio		50,518			102,927
Sale of available-for-sale securities		—			28,626
Sales of assets acquired through foreclosure		12,956			17,463
Proceeds from paydowns on available-for-sale securities		32,797			19,242
Net assets acquired in acquisition of common stock of NFI Holding Corporation		—			872
Payment on founders’ promissory notes		—			641

Net cash provided by investing activities		96,271			169,771

Cash flow from financing activities:
Payments on asset-backed bonds		(59,164	)		(114,723	)
Change in short-term borrowings		267,401			33,847
(Redemption of) proceeds from issuance of capital stock and exercise of equity instruments, net of offering costs		(7,980	)		325
Dividends paid on preferred stock		(2,014	)		(1,607	)
Dividends paid on common stock		(20,457	)		(748	)
Common stock repurchases		—			(345	)

Net cash provided by (used in) financing activities		177,786			(83,251	)

Net increase in cash and cash equivalents		12,985			10,844
Cash and cash equivalents, beginning of period		30,817			2,518

Cash and cash equivalents, end of period	$	43,802		$	13,362

See accompanying notes to consolidated financial statements.

Supplemental disclosure of cash flow information:
Cash paid for interest	$	29,208		$	23,897

Surrender of warrants		13,172			—

Dividends payable		10,419			4,207

Cash paid for taxes		3,455			683


Non-cash operating and investing activities:
Retention of mortgage servicing rights		(4,710	)		(4,074	)

Assets acquired through foreclosure		(6,959	)		(16,392	)

Securities retained in securitizations		(73,743	)		(50,353	)


Non-cash activities related to the acquisition of common stock of NFI Holding Corporation on January 1, 2001:
Operating activities:
Increase in mortgage loans held-for-sale	$	—		$	(81,733	)

Increase in other assets	$	—		$	(11,132	)

Decrease in other liabilities	$	—		$	9,422

Investing activities:
Increase in real estate owned	$	—		$	(892	)

Increase in mortgage loans	$	—		$	(81,733	)

Decrease in investment in/advances to NFI Holding Corp.	$	—		$	48,307

Financing activities:
Increase in borrowings	$	—		$	36,900

Non-cash financing activities related to founders’ notes receivable:
Decrease in founders’ notes receivable	$	—		$	4,340

Decrease in additional paid-in capital	$	—		$	(4,340	)

See accompanying notes to consolidated financial statements.

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2002 (Unaudited)

Note 1. Financial Statement Presentation

The consolidated financial statements as of and for the periods ended September 30, 2002 and 2001 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 consolidated financial statements. 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, 2001.

The consolidated financial statements of NovaStar Financial include the accounts of all wholly owned subsidiaries. Significant intercompany accounts and transactions have been eliminated during consolidation.

Note 2. Mortgage Servicing

The Company records mortgage servicing rights arising from the transfer of loans to the securitization trusts. The following schedule summarizes the carrying value of mortgage servicing rights and the activity for the nine months ended September 30, 2002 and 2001 (in thousands).

	For the Nine Months Ended September 30,
	2002			2001
Balance, January 1	$	6,445		$	—
Amount acquired in purchase of common stock of NFI Holding Corporation, net of accumulated amortization of $2,968		—			2,923
Amount capitalized in connection with transfer of loans to securitization trusts		4,710			4,074
Amortization		(3,316	)		(1,169	)

Balance, September 30	$	7,839		$	5,828

The fair value is estimated by either discounting estimated future cash flows from the servicing assets using discount rates that approximate current market rates or obtaining third-party bids.

Mortgage servicing rights are amortized over the expected weighted average life of the related loans. The following table summarizes the estimated amortization expense for the next three years for mortgage servicing rights (in thousands). All mortgage servicing rights will be amortized by the end of 2005.

For October 1, 2002 through December 31, 2002	$	1,237
For the year ended December 31, 2003		4,269
For the year ended December 31, 2004		2,229
For the year ended December 31, 2005		104

	$	7,839

Note 3. NovaStar Mortgage Funding Trust Series 2002-1, 2002-2 and 2002-3

On March 28, 2002, June 28, 2002 and September 27, 2002, NovaStar Mortgage executed securitization transactions accounted for as sales of loans. In addition, derivative instruments with a fair value of $974,000, $(2,102,000) and $(8,720,000) were transferred into the 2002-1, 2002-2 and 2002-3 trusts, respectively. These instruments serve to reduce interest rate risk to the bondholders. Details of these transactions are as follows:

	Value of Asset- Backed Bonds Issued	Economic Residual Value as of September 30, 2002	Book Value of Collateral Sold	Gain Recognized
NMFT 2002-1	$487,500,100	$31,100,000	$499,998,000	$ 8,082,000
NMFT 2002-2	301,475,100	23,913,000	310,000,000	10,459,000
NMFT 2002-3 (A)	736,875,100	41,834,000	403,960,000	16,892,000

(A)

The remaining collateral for NMFT 2002-3 is scheduled to close by November 12, 2002 in which $346 million of loans will be delivered.

Note 4. Class B, Convertible Preferred Stock

Terms of the Class B, convertible preferred stock issued in 1999 allowed the Company to redeem the shares for $7.00 per share beginning April 1, 2002. In February 2002, the Company notified the preferred shareholders of its intent to redeem all of the outstanding preferred shares at the earliest possible time. On February 21, 2002, the preferred shareholders exercised their options to convert to common shares.

Note 5. Warrants

On January 30, 2002, warrant holders surrendered 350,000 warrants with an exercise price of $6.94 in a “cashless” exchange for 210,703 shares of the Company’s common stock valued at $17.43 per share.

On April 5, 2002, the Company acquired 812,731 warrants with an exercise price of $4.56 from warrant holders for $9.5 million.

Note 6. Comprehensive Income

Comprehensive income includes net income and revenues, expenses, gains and losses that are not included in net income. Following is a summary of comprehensive income for the nine months and three months ended September 30, 2002 and 2001 (in thousands).

	For the Nine Months Ended September 30,						For the Three Months Ended September 30,
	2002			2001			2002			2001
Net income	$	31,510		$	26,137		$	12,199		$	18,936
Other comprehensive income
Change in unrealized gain on available-for-sale securities, net of income taxes		43,779			(2,657	)		12,332			(15,637	)
Change in unrealized loss on derivative instruments used in cash flow hedges		(11,379	)		(9,549	)		(5,638	)		(8,286	)
Implementation of SFAS No. 133		—			34			—			—
Net settlements of derivative instruments used in cash flow hedges reclassified to earnings		7,526			542			2,720			807
Other amortization		(77	)		—			(26	)		—

Comprehensive income	$	71,359		$	14,507		$	21,587		$	(4,180	)

Note 7. Segment Reporting

The Company manages and operates in four business segments: mortgage portfolio management, mortgage lending and loan servicing, branch operations and branch management. Mortgage portfolio management 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. Following is a summary of the operating results of the Company’s primary operating units for the nine and three months ended September 30, 2002 and 2001 (in thousands).

Nine Months Ended September 30, 2002

	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing			Affiliated Branches						Total
	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing			Operations			Management			Total
Interest income	$	48,230		$	22,624		$	—		$	—		$	70,854
Interest expense		(11,307	)		(17,494	)		—			—			(28,801	)

Net interest income		36,923			5,130			—			—			42,053
Provision for losses		(19	)		313			—			—			294
Fee income		—			9,468			10,248			3,901			23,617
Gain on derivative instruments and sales of mortgage loans		(686	)		17,713			—			—			17,027
Other income (expense)		(417	)		1,328			—			39			950
General and administrative expenses		(3,264	)		(38,301	)		(10,248	)		(2,796	)		(54,609	)

Income before income tax		32,537			(4,349	)		0			1,144			29,332
Income tax benefit (expense)		—			3,152			—			(974	)		2,178

Net income (loss)	$	32,537		$	(1,197	)	$	0		$	170		$	31,510

Nine Months Ended September 30, 2001

	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing			Affiliated Branches						Total
	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing			Operations			Management			Total
Interest income	$	28,225		$	17,017		$	17		$	—		$	45,259
Interest expense		(15,246	)		(8,294	)		—			—			(23,540	)

Net interest income		12,979			8,723			17			—			21,719
Provision for losses		(2,637	)		(135	)		—			—			(2,772	)
Fee income		(479	)		2,891			13,306			2,073			17,791
Gain on derivative instruments and sales of mortgage loans		15,020			13,491			(17	)		54			28,548
Other income (expense)		926			(944	)		—			—			(18	)
General and administrative expenses		(2,283	)		(19,984	)		(13,337	)		(1,821	)		(37,425	)

Income before cumulative effect of a change in accounting principle		23,526			4,042			(31	)		306			27,843

Cumulative effect of a change in accounting principle		(1,385	)		(321	)		—			—			(1,706	)

Net income	$	22,141		$	3,721		$	(31	)	$	306		$	26,137

Three Months Ended September 30, 2002

	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing			Affiliated Branches						Total
	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing			Operations			Management			Total
Interest income	$	17,363		$	9,277		$	—		$	—		$	26,640
Interest expense		(3,800	)		(6,174	)		—			—			(9,974	)

Net interest income		13,563			3,103			—			—			16,666
Provision for losses		223			80			—			—			303
Fee income		—			3,925			3,733			1,569			9,227
Gain on derivative instruments and sales of mortgage loans		(229	)		4,277			—			—			4,048
Other income (expense)		(181	)		979			—			17			815
General and administrative expenses		833			(15,819	)		(3,733	)		(981	)		(19,700	)

Income before income tax		14,209			(3,455	)		0			605			11,359
Income tax benefit (expense)		—			1,181			—			(341	)		840

Net income (loss)	$	14,209		$	(2,274	)	$	0		$	264		$	12,199

Three Months Ended September 30, 2001

	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing			Affiliated Branches						Total
	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing			Operations			Management			Total
Interest income	$	9,162		$	9,373		$	17		$	—		$	18,552
Interest expense		(4,447	)		(4,701	)		—			—			(9,148	)

Net interest income		4,715			4,672			17			—			9,404
Provision for losses		(878	)		(256	)		—			—			(1,134	)
Fee income		—			720			3,896			885			5,501
Gain on derivative instruments and sales of mortgage loans		14,834			4,114			(17	)		54			18,985
Other income (expense)		(224	)		46			—			—			(178	)
General and administrative expenses		(1,091	)		(7,855	)		(3,949	)		(747	)		(13,642	)

Net income (loss)	$	17,356		$	1,441		$	(53	)	$	192		$	18,936

Intersegment revenues and expenses that were eliminated in consolidation were as follows for the nine and three months ended September 30, 2002 and 2001 (in thousands):

	For the Nine Months Ended September 30,						For the Three Months Ended September 30,
	2002			2001			2002			2001
Amounts paid to mortgage lending and loan servicing from mortgage portfolio:
Loan servicing fees	$	869		$	1,246		$	239		$	377
Administrative fees		437			525			27			171
Amounts received from mortgage lending and loan servicing to mortgage portfolio:
Intercompany interest income		(5,357	)		(2,898	)		(2,371	)		(1,291	)
Guaranty, commitment, loan sale, and securitization fees		(4,007	)		(3,103	)		(1,439	)		(1,446	)

Note 8. Earnings Per Share

The computations of basic and diluted EPS computations for the nine and three months ended September 30, 2002 and 2001, are as follows, including the cumulative effect of a change in accounting principle (in thousands except per share amounts):

	For the Nine Months Ended September 30,					For the Three Months Ended September 30,
	2002		2001			2002		2001
Numerator	$	31,510	$	26,137		$	12,199	$	18,936

Denominator:
Weighted average common shares outstanding—basic
Common shares outstanding		10,365		5,726			10,417		5,752
Convertible preferred stock		—		4,286			—		4,286

Weighted average common shares outstanding—basic		10,365		10,012			10,417		10,038


Weighted average common shares outstanding—dilutive
Stock options		261		150			263		210
Warrants		252		344			—		535

Weighted average common shares outstanding—dilutive		10,878		10,506			10,680		10,783


Basic earnings per share—before cumulative effect of a change in accounting principle	$	3.04	$	2.78		$	1.17	$	1.89
Basic loss per share due to cumulative effect of a change in accounting principle		—		(0.17	)		—		—

Basic earnings per share	$	3.04	$	2.61		$	1.17	$	1.89

Diluted earnings per share—before cumulative effect of a change in accounting principle	$	2.90	$	2.66		$	1.14	$	1.76
Diluted loss per share due to cumulative effect of a change in accounting principle		—		(0.17	)		—		—

Diluted earnings per share	$	2.90	$	2.49		$	1.14	$	1.76

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, 2001.

Safe Harbor Statement

“Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995: Statements in this discussion regarding NovaStar Financial, Inc. and its business, which are not historical facts, are “forward-looking statements” that involve risks and uncertainties. Certain matters discussed in this quarterly report may constitute forward-looking statements within the meaning of the federal securities laws that inherently include certain risks and uncertainties. Actual results and the time of certain events could differ materially from those projected in or contemplated by the forward-looking statements due to a number of factors, including general economic conditions, fluctuations in interest rates, fluctuations in prepayment speeds, fluctuations in losses due to defaults on mortgage loans, the availability of non-conforming residential mortgage loans, the availability and access to financing and liquidity resources, and other risk factors outlined in the annual report on Form 10-K for the fiscal year ended December 31, 2001. 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, 2001.

Description of Businesses

Mortgage Portfolio Management

•

We invest in assets generated primarily from our origination of nonconforming, single-family, residential mortgage loans.

•

We operate 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 and Loan Servicing

•

We originate conforming and non-conforming residential mortgage loans.

•

Our primary customer is the retail mortgage broker who deals with the borrower.

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Non-conforming borrowers are generally 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 also made via retail telemarketing centers through direct consumer contact.

•

We acquire pools of mortgages from correspondents.

•

We finance our loans through short-term warehouse facilities.

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Loans we originate are held for sale in either outright sales for cash or in securitization transactions.

•

We service the loans we originate.

Affiliated Branches

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Retail mortgage brokers that broker loans for 200 investors, including NovaStar Mortgage, Inc.

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Branches operate under policies we establish.

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

Significance of Estimates and Critical Accounting Policies

We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America and, therefore, are required to make estimates regarding the values of our assets and in recording income and expenses. These estimates are based, in part, on our judgment and assumptions regarding various economic conditions that we believe are reasonable based on facts and circumstances existing at the time of reporting. The result of these estimates affect reported amounts of assets at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the periods presented. The following summarizes the components of our consolidated financial statements where understanding accounting policies is critical to understanding and evaluating our reported financial results, especially given the significant estimates used in applying the policies. Our critical accounting estimates impact only two of our four reportable segments; our mortgage portfolio management and mortgage lending and loan servicing segments. Management has discussed the development and selection of these critical accounting estimates with the audit committee of our board of directors and the audit committee has reviewed our disclosure.

Mortgage Securities. Our mortgage securities primarily consist of the right to receive the future cash flows from a pool of securitized mortgage loans. Our interest in these securities consists of:

—The interest spread between the coupon on the underlying loans and the cost of financing.

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

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

The cash flows we receive are highly dependent upon the interest rate environment. The cost of financing for the securitized loans is indexed to short-term interest rates, while the loan coupons are less interest sensitive. As a result, as rates rise and fall, our cash flows will fall and rise, which in turn will increase or decrease the value of our mortgage securities. Likewise, increasing or decreasing cash flows will increase or decrease the yield on our securities. We adjust our yield (rate of income recognition) prospectively based on the expectation for cash flows on the securities.

We believe the accounting estimates related to the valuation of our mortgage securities and establishing the rate of income recognition on mortgage securities are “critical accounting estimates” because they can materially effect net income and require us to forecast interest rates, mortgage principal payments, prepayments, and loan default assumptions which are highly

uncertain and require a large degree of judgment. The rate used to discount the projected cash flows is also critical in the valuation of our mortgage securities. Management uses internal, historical collateral performance data and published forward yield curves when modeling future expected cash flows and establishing the rate of income recognized on mortgage securities. We believe the value of our mortgage securities is fair, but can provide no assurance that future prepayment and loss experience or changes in their required market discount rate will not require write-downs of the residual assets. Write-downs would reduce income of future periods.

During 2002, we increased the accrual rates on our mortgage securities portfolio due to better cash flow performance as a result of the widening spread between the coupon rates on the mortgage loan collateral and the floating rate bond liability rates. Our average security yield has increased to 74.0% for the nine months ended September 30, 2002 from 20.7% for the same period of 2001. This resulted in a corresponding increase in our mortgage securities income recognized during the first nine months of 2002 compared with the same period of 2001. The effect of the increasing yield on our mortgage securities is shown in Table 22. If the rates used to accrue income on our mortgage securities for the nine months ended September 30, 2002 had been increased or decreased by 10%, net income during the first nine months of 2002 would have increased by $4.9 million and decreased by $5.3 million, respectively.

As of September 30, 2002 and December 31, 2001, the weighted average discount rate used in valuing our mortgage securities is 27%. The weighted-average constant prepayment rate used in valuing our mortgage securities as of September 30, 2002 was 39 versus 35 as of December 31, 2001. If the discount rate used in valuing our mortgage securities as of September 30, 2002 had been increased by 500 basis points, the value of our mortgage securities would have decreased by $10.3 million. If we had decreased the discount rate used in valuing our mortgage securities by 500 basis points, the value of our mortgage securities would have increased by $11.7 million.

Transfers of Assets (Loan Securitization) and Related Gains. We combine the mortgage loans we originate and mortgage securities in pools to serve as collateral for asset-backed bonds that are issued to the public. The loans or securities are transferred to a trust designed to serve only for the purpose of holding the collateral. The owners of the asset-backed bonds have no recourse to us in the event the collateral does not perform as planned. When these transfers are executed in a manner such that we have no control over the collateral, the transfer is accounted for as a sale. We do retain the right to service the underlying mortgage loans and we also retain certain mortgage securities issued by the trust (see Mortgage Securities above). A gain or loss on the sale is recorded. The gain recognized upon securitization depends on, among other things, the estimated fair value of the components of the securitization – the loans or securities transferred, the securities retained and the mortgage servicing rights. The estimated fair value of the securitization components is considered a “critical accounting estimate” as 1) these gains or losses represent a significant portion of our operating results and 2) the valuation assumptions used regarding economic conditions and the make-up of the collateral, including interest rates, principal payments, prepayments and loan defaults are highly uncertain and require a large degree of judgment. The valuation of mortgage securities is based on the present value of future expected cash flows to be received (See Mortgage Securities discussion above). The rate used to discount the cash flow projections is critical in the evaluation of our mortgage securities. Management uses internal, historical collateral performance data and published forward yield curves when modeling future expected cash flows.

The discount rates used in the initial valuation of mortgage securities for the nine months ended September 30, 2002 compared with same period of 2001 were 30% and 23%. The increase in discount rates in 2002 compared with 2001 was due to spreads widening and returns on our securities increasing between the two periods. If the discount rate used in the initial valuation of our mortgage securities in 2002 had been increased by 500 basis points, the initial value of our

mortgage securities would have decreased by $6.3 million and the gain recognized on the transfer of mortgage loans in securitizations would have decreased by $6.0 million. If we would have decreased the discount rate used in the initial valuation of our mortgage securities by 500 basis points, the value of our mortgage securities would have increased by $7.1 million and the gain recognized on the transfer of mortgage loans in securitizations would have increased by $5.3 million.

Information regarding the assumptions we used is discussed under “Mortgage Securities” in the preceding and following discussion.

When we do have the ability to exert control over the transferred collateral, the assets remain on our financial records and a liability is recorded for the related asset-backed bonds.

Mortgage Loans, Allowance for Credit Losses and Assets Acquired through Foreclosure. Mortgage loans that are not held-for-sale are recorded at their cost, adjusted for the amortization of deferred costs and for credit losses inherent in the portfolio. An allowance is maintained for credit losses.

Assets acquired through foreclosure are carried at the lower-of-cost or estimated fair value less estimated selling costs. The carrying value of the loan is adjusted at the time of foreclosure using a charge to the allowance for credit losses.

The allowance, and therefore the related charge to income, is based on the assessment by management of various factors affecting our mortgage loan portfolio, including current economic conditions, the makeup of the portfolio based on credit grade, loan-to-value, delinquency status, mortgage insurance we purchase and other relevant factors. The allowance is maintained through ongoing provisions charged to operating income. The accounting estimate of the allowance for credit losses is considered a “critical accounting estimate” as significant changes in the mortgage loan portfolio, our ability to obtain mortgage insurance and/or economic conditions may affect the allowance for credit losses and net income. The assumptions used by management regarding these key economic indicators are highly uncertain and involve a great deal of judgment. An internally developed migration analysis is the primary tool used in analyzing our allowance for credit losses. This tool takes into consideration historical information regarding foreclosure and loss severity experience and applies that information to the portfolio at the reporting date.

The allowance for credit losses was $3.5 million as of September 30, 2002 compared to $5.7 million at December 31, 2001. The majority of the decline is due to the decline in mortgage loans—held-in-portfolio. Additionally, $400,000 was included in the December 31, 2001 reserve balance for the expected loss on one loan. The loss on this loan was realized in June, and the reserve was reduced by $400,000. The allowance for credit losses as a percent of mortgage loans—held-in-portfolio was 2.1% as of September 30, 2002 compared with 2.5% as of December 31, 2001. No loans have been added to our portfolio since our last asset-backed bond transaction treated as a financing transaction in 1998. If we were to assume the estimate of credit losses as a percent of outstanding principal increased or decreased by 10%, the allowance for credit losses and related provision as of and for the nine months ended September 30, 2002, respectively, would increase or decrease by $1.3 million. Mortgage insurance as a percentage of our mortgage loans - held-in-portfolio is 83.6% as of September 30, 2002 compared to 81.6% as of December 31, 2001. The make-up of our mortgage loan portfolio is discussed below under “Mortgage Loans”. The allowance for credit losses is discussed below under that heading. We discuss purchased mortgage insurance under the heading “Premiums Paid for Mortgage Insurance.”

Table 1—Quarterly Mortgage Loan Sales (A)

(dollars in thousands)

	Outright Mortgage Loan Sales
	Principal Amount		Percent Of Total Sales		Net Gain (Loss) Recognized			Weighted Average Price To Par
2002
Third quarter	$	13,727	3.3	%	$	(151	)	100.2
Second quarter		80,421	16.2	%		1,332		103.0
First quarter		47,025	10.6	%		1,155		103.5

Total	$	141,173	10.4	%	$	2,336		102.9

2001
Fourth quarter	$	25,524	7.1	%	$	235		101.7
Third quarter		19,511	4.0	%		84		102.0
Second quarter		17,516	7.9	%		373		102.3
First quarter		10,773	4.8	%		262		102.9

Total	$	73,324	5.7	%	$	954		102.1


	Mortgage Loans Transferred in Securitizations
									Assumptions Underlying Initial Value of Mortgage Security
	Principal Amount		Percent Of Total Sales		Net Gain Recognized		Initial Value of Mortgage Security		Constant Prepayment Rate	Discount Rate		Expected Total Credit Losses, Net of Mortgage Insurance
2002
Third quarter	$	403,960	96.7	%	$	16,893	$	22,532	22	30	%	1.00	%
Second quarter		414,874	83.8	%		14,959		29,048	25	30	%	1.61	%
First quarter		395,124	89.4	%		3,581		23,942	28	30	%	1.65	%

Total	$	1,213,958	89.6	%	$	35,433	$	75,522	25	30	%	1.42	%

2001
Fourth quarter	$	334,501	92.9	%	$	5,497	$	15,784	28	25	%	1.20	%
Third quarter		465,532	96.0	%		7,330		21,966	28	25	%	1.20	%
Second quarter		203,647	92.1	%		3,959		12,321	28	20	%	1.20	%
First quarter		211,420	95.2	%		4,944		12,791	28	20	%	1.20	%

Total	$	1,215,100	94.3	%	$	21,730	$	62,862	28	23	%	1.20	%

(A)

Does not include conforming loan sales.

Table 2—Quarterly Activity—Allowance for Credit Losses

(in thousands)

	2002									2001
	September 30			June 30			March 31			December 31			September 30			June 30			March 31
Beginning balance	$	4,157		$	5,518		$	5,711		$	5,969		$	6,419		$	6,825		$	7,944
Provision for credit losses		(303	)		(135	)		144			1,001			1,134			1,119			519
Amounts charged off, net of recoveries		(366	)		(1,226	)		(337	)		(1,259	)		(1,584	)		(1,525	)		(1,638	)

Ending balance	$	3,488		$	4,157		$	5,518		$	5,711		$	5,969		$	6,419		$	6,825

Mortgage loans—held-in-portfolio, net	$	166,965		$	184,335		$	207,379		$	226,033		$	253,053		$	290,365		$	332,766

Weighted-average loan-to-value—held-in-portfolio		79.3	%		79.3	%		79.3	%		79.3	%		79.5	%		79.8	%		79.7	%
Weighted-average delinquency—held-in-portfolio		13.4	%		13.6	%		15.2	%		11.5	%		15.2	%		14.7	%		14.3	%
Mortgage insurance as a percent of held-in-portfolio		83.6	%		79.4	%		81.1	%		81.6	%		81.6	%		45.1	%		34.1	%

Financial Condition as of September 30, 2002 and December 31, 2001

Mortgage Loans. We classify our mortgage loans into two categories: “held-for-sale” and “held-in-portfolio.” Loans that serve as collateral for our asset-backed bonds are classified as “held-in-portfolio.” The carrying value of “held-in-portfolio” mortgage loans as of September 30, 2002 was $167 million compared to $226 million as of December 31, 2001. The decrease in the balance is due to principal paydowns as no loans have been added to our portfolio.

Loans we have originated, but have not yet sold or 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. As such, the fluctuations in mortgage loans—held for sale and short-term borrowings between September 30, 2002 and December 31, 2001 is dependent on loans we have originated during the period as well as loans we have sold outright or through securitization transactions. Details regarding loan originations during 2002 as well as mortgage loans sold can be found in the “Mortgage Loan Production” and “Gain on Derivative Instruments and Sales of Mortgage Assets” sections of this document, respectively.

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 5 and 8 provide information to analyze 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 8 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 such as credit grade, coupon, loan-to-value, prepayment speeds and delinquency statistics are provided in Tables 3 through 8. These characteristics are important as they provide key indicators of the credit and prepayment risks inherent in our mortgage loan portfolio, which have a direct impact on our past and future

operating performance. 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 3—Mortgage Loans by Credit Grade

(dollars in thousands)

				September 30, 2002						December 31, 2001
Credit Grade	Allowed Mortgage Lates (A)	Maximum Loan- to-value		Current Principal		Weighted Average Coupon		Weighted Average Loan-to- Value (%)		Current Principal		Weighted Average Coupon		Weighted Average Loan-to- Value (%)
Held-in-portfolio:
AA	0 x 30	95		$	25,605	9.39	%	82.3	%	$	35,922	9.59	%	82.1	%
A	1 x 30	90			67,083	9.71		79.5			90,775	10.05		79.1
A-	2 x 30	90			38,915	10.21		81.3			53,971	10.52		81.5
B	3 x30 1x 60, 5 x 30, 2 x 60	85			21,494	10.64		77.4			28,400	11.05		77.4
C	1 x 90	75			11,718	11.24		71.8			15,122	11.53		72.3
D	6 x 30, 3 x 60, 2 x 90	65			2,126	11.28		65.1			2,770	12.15		64.8

				$	166,941	10.02		79.3		$	226,960	10.34		79.3

Held-for-sale:
Alt A	0 x 30	97	(B)	$	41,458	7.50	%	77.6	%	$	11,662	8.74	%	85.8	%
AAA	0 x 30	97	(B)		2,789	13.00		22.3			28,892	8.70		74.5
AA	0 x 30	95			32,713	9.60		84.7			32,352	9.14		78.9
A+	0 x 30	95			99,556	8.32		78.3			—	—		—
A	1 x 30	90			59,369	9.17		85.3			25,218	9.21		79.1
A-	2 x 30	90			35,150	8.90		82.6			10,964	9.21		79.1
B	3 x 30, 1x 60, 5 x 30, 2 x 60	85			34,772	9.16		78.5			8,828	9.33		74.8
C	1 x 90	75			6,382	10.09		72.3			599	11.77		75.1
Other	Varies	97			22,820	8.93		89.0			19,713	9.33		86.1

				$	335,009	8.76		80.7		$	138,228	9.08		79.4

(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 only; all other maximum of 95%.

Table 4—Mortgage Loans by Geographic Concentration

Percent Current Principal

	September 30, 2002				December 31, 2001
	Held-in-portfolio		Held-for-sale		Held-in-portfolio		Held-for-sale
Collateral Location
Florida	15	%	13	%	16	%	11	%
California…	13		23		13		23
Washington	5		2		6		1
Oregon	5		1		5		2
Texas	5		3		5		3
Indiana	5		2		5		2
Ohio	4		5		4		5
Michigan	3		5		3		7
Colorado	1		4		1		4
All other states	44		42		42		42

Total	100	%	100	%	100	%	100	%

Table 5—Carrying Value of Mortgage Loans by Product/Type

(in thousands)

Product/Type	September 30, 2002			December 31, 2001
Held-in-portfolio:
30/15-year fixed and balloon	$	96,146		$	128,299
Two and three-year fixed		61,401			85,145
Six-month LIBOR and one-year CMT		9,394			13,516

Outstanding principal		166,941			226,960
Deferred broker premium and costs		3,336			4,630
Allowance for credit losses		(3,312	)		(5,557	)

Carrying value	$	166,965		$	226,033

Carrying value as a percent of principal		100.01	%		99.59	%


Held-for-sale:
30/15-year fixed and balloon	$	83,684		$	49,013
Two and three-year fixed		250,989			89,215
Six-month LIBOR and one-year CMT		336			—

Outstanding principal		335,009			138,228
Deferred broker premium and costs		3,754			1,453
Allowance for credit losses		(176	)		(154	)

Carrying value	$	338,587		$	139,527

Carrying value as a percent of principal		101.07	%		100.94	%

Table 6—Mortgage Credit Analysis – Held-in-portfolio Loans

(dollars in thousands)

September 30, 2002						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	$	8,511	72.0	—	1.1	4.2	5.3
A-		73,499		5,836	77.6	—	—	5.3	5.3
B		53,812		4,309	71.3	—	—	13.8	13.8
C		23,065		2,320	71.0	10.6	1.4	5.1	17.1
D		9,021		859	70.4	—	—	25.0	25.0
NovaStar Home Equity Series 1997-2:
AA	$	3,153	$	98	90.0	—	—	—	—
A		104,582		11,133	80.5	—	4.1	5.1	9.2
A-		63,660		7,755	81.8	0.6	—	10.8	11.4
B		36,727		3,598	77.8	—	2.1	6.5	8.6
C		11,354		1,952	70.1	—	—	6.5	6.5
D		1,529		406	60.5	—	—	—	—
NovaStar Home Equity Series 1998-1:
AA	$	59,213	$	9,360	82.6	—	—	8.1	8.1
A		113,457		19,283	81.2	2.8	1.0	10.4	14.2
A-		63,100		8,878	81.3	0.5	0.5	10.3	11.3
B		38,249		4,960	78.7	2.3	—	5.2	7.5
C		23,029		3,430	75.0	5.8	—	14.6	20.4
D		5,495		544	63.2	—	—	39.2	39.2
NovaStar Home Equity Series 1998-2:
AA	$	64,851	$	16,147	81.6	1.0	0.5	4.0	5.5
A		113,557		28,156	80.6	3.6	1.2	4.8	9.6
A-		70,399		16,446	82.7	0.5	2.0	10.2	12.7
B		40,818		8,627	79.3	2.2	2.6	14.6	19.4
C		22,335		4,016	71.2	1.0	0.7	11.3	13.0
D		2,951		317	61.7	—	22.2	—	22.2

Total	$	1,115,760	$	166,941


December 31, 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 Home Equity Series 1997-1:
A	$	117,904	$	12,946	73.1	—	2.8	4.3	7.1
A-		73,499		9,119	77.3	.2	8.2	12.1	20.5
B		53,812		5,445	72.7	1.5	3.1	16.0	20.6
C		23,065		2,855	70.7	—	0.9	—	0.9
D		9,021		971	69.4	—	—	—	—
NovaStar Home Equity Series 1997-2:
AA	$	3,153	$	347	86.4	—	—	—	—
A		104,582		14,505	79.3	1.2	0.8	9.9	11.9
A-		63,660		9,384	83.0	0.7	1.4	4.2	6.3
B		36,727		5,011	79.0	4.3	0.7	15.7	20.7
C		11,354		2,376	69.7	—	—	6.3	6.3
D		1,529		422	60.4	—	—	8.4	8.4
NovaStar Home Equity Series 1998-1:
AA	$	59,213	$	12,633	83.3	2.5	0.5	12.1	15.1
A		113,457		25,397	80.7	2.8	2.4	11.6	16.8
A-		63,100		13,666	82.0	1.0	0.7	13.3	15.0
B		38,249		7,464	78.4	4.7	2.5	11.5	18.7
C		23,029		4,469	75.4	2.6	1.9	17.6	22.1
D		5,495		739	63.6	—	25.5	6.4	31.9
NovaStar Home Equity Series 1998-2:
AA	$	64,851	$	22,942	81.5	2.0	0.4	3.2	5.6
A		113,557		37,927	80.6	1.4	1.3	9.5	12.2
A-		70,399		21,802	83.2	1.1	4.0	7.1	12.2
B		40,818		10,495	80.0	3.1	1.7	20.8	25.6
C		22,335		5,407	72.5	2.3	1.9	14.6	18.8
D		2,951		638	61.5	—	—	7.6	7.6

Total	$	1,115,760	$	226,960

Table 7—Loss Analysis—Held-in-portfolio Loans

(dollars in thousands)

September 30, 2002
	Cumulative Losses As Reported, as Percent of Original Balance		Loans Repurchased From Trusts
			Loss Amount		Loss As a % of Original Balance		Total Losses
NHES 1997-1	2.19	%	$	3,411	1.23	%	3.42	%
NHES 1997-2	2.66			6,321	2.86		5.52
NHES 1998-1	3.00			7,987	2.64		5.64
NHES 1998-2	2.73			2,362	0.75		3.48

December 31, 2001
	Cumulative Losses As Reported, as Percent of Original Balance		Loans Repurchased From Trusts
			Loss Amount		Loss As a % of Original Balance		Total Losses
NHES 1997-1	1.78	%	$	3,522	1.27	%	3.05	%
NHES 1997-2	2.01			6,299	2.85		4.86
NHES 1998-1	2.16			7,685	2.54		4.70
NHES 1998-2	2.03			2,425	0.77		2.80

Table 8—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)
	Issue Date	Original Principal		Current Principal		Premium		Percent with Prepayment Penalty		Coupon			Three- month	Twelve- Month	Life
As of September 30, 2002
Held-in-portfolio—serving as collateral for NovaStar Home Equity Series asset backed bonds:
Series 1997-1	October 1, 1997	$	277,301	$	21,835	$	960	0	%	10.26	%	—	51	41	40
Series 1997-2	December 11, 1997		221,005		24,942		502	8		10.51		0.02	23	29	36
Series 1998-1	April 30, 1998		302,543		46,455		763	24		10.00		0.12	30	35	33
Series 1998-2	August 18, 1998		314,911		73,709		1,111	30		9.80		0.23	29	34	29

Total		$	1,115,760	$	166,941	$	3,336	21	%	10.02	%	0.14


Held-for-sale:				$	335,009	$	3,754	85	%	8.76	%	2.33	Not meaningful


As of December 31, 2001
Held-in-portfolio—serving as collateral for NovaStar Home Equity Series asset backed bonds:
Series 1997-1	October 1, 1997	$	277,301	$	31,336	$	1,453	19	%	10.90	%	0.09	26	37	39
Series 1997-2	December 11, 1997		221,005		32,045		652	22		10.79		0.18	23	37	37
Series 1998-1	April 30, 1998		302,543		64,368		1,050	24		10.45		0.29	34	40	33
Series 1998-2	August 18, 1998		314,911		99,211		1,475	31		10.18		0.48	39	37	28

Total		$	1,115,760	$	226,960	$	4,630	26	%	10.34	%	0.33


Held-for-sale:				$	138,228	$	1,453	79	%	9.08	%	2.35	Not meaningful

Mortgage Securities—available-for-sale. Since 1998, we have pooled the majority of the loans we have originated to serve as collateral for asset-backed bonds that are treated as sales for accounting and tax purposes. In these transactions, the loans are removed from our balance sheet. However, we retained interest-only securities, which are AAA rated. We also retain the prepayment penalty and subordinated principal securities. Additionally, we service the loans sold in these securitizations (see Mortgage Servicing Rights under the header “Financial Condition as of September 30, 2002 and December 31, 2001). As of September 30, 2002 and December 31, 2001, the fair value of mortgage securities was $179.6 million and $71.6 million, respectively. During 2002, we executed securitizations totaling $1.2 billion in mortgage loans. We retained mortgage securities with a value of $96.8 million, which served to increase our mortgage securities balance. Cash received on securities serves to decrease our mortgage securities, which has been offset by market value adjustments as the securities are stated at their fair value.

The value of our securities 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 owns 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. Table 9 summarizes our mortgage securities and the underlying collateral and senior asset-backed bonds. Table 10 provides 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.

The performance of the loans serving as collateral for our mortgage securities is critical to the return our mortgage securities will generate and their valuation. Credit quality and prepayment experience 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 11 through 16.

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.”

During the third quarter of 2001, we resecuritized AAA-rated interest-only and prepayment penalty securities issued in 2000. This transaction, CAPS 2001-1, was structured as a sale for financial reporting and income tax purposes. Cash will be paid on the bond we retained only when the senior bond is fully repaid.

Table 9—Mortgage Securities

(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
September 30, 2002
NMFT 1999-1
Subordinated securities (non-investment grade)	$	4,069	$	39,353	4.81	%	$	45,852		9.86	%	28

NMFT 2000-1
Interest only (AAA-rated)		—
Prepayment penalty (AAA-rated)		—
Subordinated securities (non-investment grade)		500

		500		89,455	2.28			92,671		10.12		37

NMFT 2000-2
Interest only (AAA-rated		—
Prepayment penalty (AAA-rated)		—
Subordinated securities (non-investment grade)		755

		755		162,882	2.21			168,385		10.55		21

NMFT 2001-1
Interest only (AAA-rated)		14,110
Prepayment penalty (AAA-rated)		2,476
Subordinated securities (non-investment grade)		1,861

		18,447		279,126	2.18			285,407		10.33		24

NMFT 2001-2
Interest only (AAA-rated)		35,913
Prepayment penalty (AAA-rated)		6,190
Subordinated securities (non-investment grade)		3,354

		45,457		652,632	2.14			665,037		9.66		33

NMFT 2002-1
Interest only (AAA-rated)		23,235
Prepayment penalty (AAA-rated)		3,265
Subordinated securities (non-investment grade)		4,600

		31,100		456,053	2.17			468,867		8.77		58

NMFT 2002-2
Interest only (AAA-rated)		18,763
Prepayment penalty (AAA-rated)		2,072
Subordinated securities (non-investment grade)		3,078

		23,913		296,951	2.16			305,653		8.85		78

NMFT 2002-3
Interest only (AAA-rated)		34,479
Prepayment penalty (AAA-rated)		3,488
Subordinated securities (non-investment grade)		3,867

		41,834		736,131	2.17			403,876		8.32		93

CAPS 2001-C1
Subordinated securities (non-investment grade)		13,525		—	7.25			(A	)	(A	)	(A	)

Total	$	179,600	$	2,712,583			$	2,435,748

	Estimated Fair Value of Mortgage Securities			Asset-Backed Bonds				Mortgage Loans
											Weighted Average
				Remaining Principal		Interest Rate		Remaining Principal			Coupon		Estimated Months to Call
December 31, 2001
NMFT 1999-1
Subordinated securities (non-investment grade)	$	3,661		$	56,541	4.58	%	$	62,665		10.23	%	46

NMFT 2000-1
Interest only (AAA-rated)		– (A	)
Prepayment penalty (AAA-rated)		– (A	)
Subordinated securities (non-investment grade)		560

		560			145,538	2.18			149,400		10.16		44

NMFT 2000-2
Interest only (AAA-rated)		– (A	)
Prepayment penalty (AAA-rated)		– (A	)
Subordinated securities (non-investment grade)		997

		997			252,995	2.18			259,037		10.59		41

NMFT 2001-1
Interest only (AAA-rated)		14,132
Prepayment penalty (AAA-rated)		3,648
Subordinated securities (non-investment grade)		1,016

		18,796			367,468	2.28			373,949		10.35		50

NMFT 2001-2
Interest only (AAA-rated)		31,428
Prepayment penalty (AAA-rated)		6,130
Subordinated securities (non-investment grade)		1,813

		39,371			772,296	2.09			784,617		9.70		61

CAPS 2001-C1
Subordinated securities (non-investment grade)		8,199			19,241	7.25			(A	)	(A	)	(A	)

Total	$	71,584		$	1,614,079			$	1,629,668

(A)

Collateral for the CAPS 2001-C1 security is the AAA-IO and prepayment penalty mortgage securities of NMFT 2000-1 and 2000-2. The performance of the mortgage loan collateral underlying these securities, as presented in this table, directly affects the performance of the CAPS 2001-C1 security.

Table 10—Characteristics of Loan Collateral, Valuation of Individual Mortgage Securities and Assumptions (dollars in thousands)

September 30, 2002
NovaStar Mortgage Funding Trust Series:
	1999-1			2000-1		2000-2		2001-1		2001-2		2002-1			2002-2		2002-3			CAPS 2001-C1			Total
Discount rate (%)		25			40		40		25		25		25			25		30			40
Constant prepayment rate (%)		38			51		63		58		51		35			27		22			(A	)
As a percent of mortgage loan principal (%):
Delinquent loans (30 days and greater)		10.2			8.1		3.4		4.0		3.1		1.5			0.6		0.2			(A	)
Loans in foreclosure		4.9			2.0		2.0		2.3		1.8		0.5			0.1		—			(A	)
Real estate owned		6.4			4.9		3.7		2.8		1.0		0.1			—		—			(A	)
Cumulative losses (as reported)		2.6			0.3		0.2		0.1		—		—			—		—			(A	)
Cost basis of individual mortgage securities:
Interest only (AAA- rated)	$	—		$	—	$	—	$	464	$	13,077	$	18,178		$	17,711	$	26,666		$	—		$	76,096
Prepayment penalty (AAA- rated)		—			—		—		2,115		2,265		2,131			1,449		1,836			—			9,796
Subordinated securities (non-investment grade)		5,762			328		671		603		206		3,867			937		(6,446	)		3,826			9,754
Unrealized gain (loss)		(1,693	)		172		84		15,265		29,909		6,924			3,816		19,778			9,699			83,954

Fair Value (Carrying Value)	$	4,069		$	500	$	755	$	18,447	$	45,457	$	31,100		$	23,913	$	41,834		$	13,525		$	179,600

December 31, 2001
NovaStar Mortgage Funding Trust Series:
	1999-1			2000-1		2000-2		2001-1		2001-2		CAPS 2001-C1			Total
Discount rate (%)		25			40		40		25		25		40
Constant prepayment rate (%)		30			41		44		39		31		43
As a percent of mortgage loan principal (%):
Delinquent loans (30 days and greater)		8.8			3.7		1.9		2.2		—		(A	)
Loans in foreclosure		6.0			2.8		2.6		1.1		—		(A	)
Real estate owned		5.5			1.7		0.8		0.1		—		(A	)
Cumulative losses (as reported)		1.8			0.1		—		—		—		(A	)
Cost basis of individual mortgage securities:
Interest only (AAA- rated)	$	—		$	—	$	—	$	9,272	$	26,783	$	—		$	36,055
Prepayment penalty (AAA- rated)		—			—		—		3,325		4,640		—			7,965
Subordinated securities (non-investment grade)		5,366			413		661		619		421		3,094			10,574
Unrealized gain (loss)		(1,705	)		147		336		5,580		7,527		5,105			16,990

Fair Value (Carrying Value)	$	3,661		$	560	$	997	$	18,796	$	39,371	$	8,199		$	71,584

(A)

Collateral for the CAPS 2001-C1 security is the AAA-IO and prepayment penalty mortgage securities of NMFT 2000-1 and 2000-2. The performance of the mortgage loan collateral underlying these securities, as presented in this table, directly effects the performance of the CAPS 2001-C1 security.

The default and prepayment assumptions of the CAPS 2001-C1 bond are consistent with our valuation of the underlying mortgage loan collateral of the securities sold in the CAPS 2001-C1 transaction. The discount rate reflects the uncertain nature of the cash flow on the bond we retained.

Table 11—Loans Collateralizing Mortgage Securities by Credit Grade

(dollars in thousands)

September 30, 2002
Credit Grade	Allowed Mortgage Lates (A)	Maximum Loan- to-value		Current Principal		Weighted Average Coupon		Weighted Average Loan-to- Value (%)
Alt A	0 x 30	97	(B)	$	165,419	8.31	%	84.3	%
AAA	0 x 30	97	(B)		430,052	8.71		80.6
AA	0 x 30	95			603,074	9.38		82.4
A+	0 x 30	95			91,285	7.96		80.6
A	1 x 30	90			400,630	9.56		80.0
A-	2 x 30	90			199,336	9.68		78.6
B	3 x 30, 1x 60 5 x 30, 2 x 60	85			157,999	9.88		76.1
C	1 x 90	75			25,175	10.66		66.0
D	6 x 30, 3 x 60, 2 x 90	65			697	11.53		59.8
Other	Varies	97			362,081	9.99		89.7

				$	2,435,748	9.33	%	81.9	%


December 31, 2001
Credit Grade	Allowed Mortgage Lates (A)	Maximum Loan- to-value		Current Principal		Weighted Average Coupon		Weighted Average Loan-to- Value (%)
Alt A	0 x 30	97	(B)	$	–	–	%	–	%
AAA	0 x 30	97	(B)		319,360	9.64		81.0
AA	0 x 30	95			482,718	10.17		83.9
A	1 x 30	90			302,271	10.36		81.6
A-	2 x 30	90			190,054	10.52		81.0
B	3 x 30, 1x 60 5 x 30, 2 x 60	85			124,052	10.85		78.0
C	1 x 90	75			29,549	11.43		68.4
D	6 x 30, 3 x 60, 2 x 90	65			1,425	12.29		62.3
Other	Varies	97			180,239	11.51		93.5

				$	1,629,668	10.37	%	82.9	%

(A)

(B)

97% on fixed-rate purchases; all other maximum of 95%.

Table 12—Loans Collateralizing Mortgage Securities by Geographic Concentration

Percent of Current Principal

	September 30, 2002		December 31, 2001
Collateral Location
California	19	%	13	%
Florida	14		14
Michigan	6		9
Ohio	5		6
Nevada	4		5
Arizona	4		5
Colorado	4		4
All other states	44		44

Total	100	%	100	%

Table 13—Loans Collateralizing Mortgage Securities

Carrying Value of Loans by Product/Type (in thousands)

Product/Type	September 30, 2002		December 31, 2001
Two and three-year fixed	$	1,792,150	$	1,236,328
Six-month LIBOR and one-year CMT		1,208		2,607
30/15-year fixed and balloon		642,390		390,733

Outstanding principal	$	2,435,748	$	1,629,668

Mortgage securities retained	$	179,600	$	71,584

Table 14—Loans Collateralizing Mortgage Securities

Mortgage Loan Coupon and Prepayment Penalties (dollars in thousands)

	Issue Date	Original Principal		Current Principal		Percent with Prepayment Penalty		Coupon		Remaining Prepayment Penalty Period (in years) for Loans with Penalty	Constant Prepayment Rate (Annual Percent)
	Issue Date	Original Principal		Current Principal		Percent with Prepayment Penalty		Coupon			Three- month	Twelve- Month	Life
September 30, 2002
NovaStar Mortgage Funding Trust Series:
1999-1	January 29, 1999	$	164,995	$	45,852	39	%	9.86	%	0.43	27	34	29
2000-1 (A)	March 31, 2000		230,138		92,671	70		10.12		1.24	46	44	29
2000-2 (A)	September 28, 2000		339,688		168,385	66		10.55		1.10	51	41	28
2001-1	March 31, 2001		415,067		285,407	91		10.33		1.37	33	27	21
2001-2	September 25, 2001		800,033		665,037	89		9.66		1.66	27	16	15
2002-1	March 28, 2002		499,998		468,867	87		8.77		2.13	16	–	10
2002-2	June 28, 2002		310,000		305,653	86		8.85		2.24	5	–	4
2002-3	September 27, 2002		403,960		403,876	83		8.32		2.27	–	–	–

Total		$	3,163,879	$	2,435,748	84	%	9.33	%	1.81


December 31, 2001
NovaStar Mortgage Funding Trust Series:
1999-1	January 29, 1999	$	164,995	$	62,665	42	%	10.23	%	0.76	37	37	27
2000-1 (A)	March 31, 2000		230,138		149,400	88		10.16		1.65	35	30	21
2000-2 (A)	September 28, 2000		339,688		259,037	93		10.59		1.71	31	22	18
2001-1	March 31, 2001		415,067		373,949	89		10.35		2.02	18	–	11
2001-2	September 25, 2001		800,033		784,617	86		9.70		2.25	7	–	6

Total		$	1,949,921	$	1,629,668	87	%	10.37	%	2.00

(A)

Collateral for the CAPS 2001-C1 security is the AAA-IO and prepayment penalty mortgage securities of NMFT 2000-1 and 2000-2. The performance of the mortgage loan collateral underlying these securities, as presented in this table, directly effects the performance of the CAPS 2001-C1 security.

Table 15—Loans Collateralizing Mortgage Securities

Mortgage Credit Analysis (dollars in thousands)

September 30, 2002						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	$	1,823	76.4	3.3	—	11.0	14.3
AA		30,772		8,908	87.0	—	2.0	5.7	7.7
A		50,693		13,046	82.1	—	0.3	8.0	8.3
A-		38,953		11,297	82.0	2.3	2.1	12.7	17.1
B		23,135		6,710	79.3	0.8	3.9	15.5	20.2
C		12,959		3,403	69.5	1.9	3.0	18.9	23.8
C-		47		—	—	—	—	—	—
D		4,412		665	64.6	10.0	—	24.9	34.9
NovaStar Mortgage Funding Trust Series 2000-1: (A)
AAA	$	85,222	$	33,371	80.3	2.3	1.0	5.0	8.3
AA		55,874		21,849	83.0	0.7	2.9	4.4	8.0
A		36,422		16,680	81.3	1.3	1.5	12.2	15.0
A-		23,329		10,034	80.1	0.5	3.2	6.4	10.1
B		13,089		4,554	79.7	—	3.6	10.4	14.0
C		5,922		2,183	66.3	—	8.4	9.9	18.3
C-		335		—	—	—	—	—	—
D		51		32	58.0	—	—	—	—
Other		9,894		3,968	91.6	—	—	12.3	12.3
NovaStar Mortgage Funding Trust Series 2000-2: (A)
AAA	$	57,846	$	26,650	81.1	1.3	—	2.7	4.0
AA		103,454		53,675	83.7	2.6	0.6	7.9	11.1
A		60,735		30,767	81.8	1.7	1.1	7.1	9.9
A-		39,939		17,488	81.1	1.6	0.5	9.0	11.1
B		19,843		8,616	77.6	3.1	—	9.7	12.8
C		4,275		3,297	65.5	2.4	—	20.4	22.8
C-		388		499	75.7	—	—	—	—
Other		53,208		27,393	93.0	0.6	0.6	5.6	6.8
NovaStar Mortgage Funding Trust Series 2001-1:
AAA	$	70,652	$	45,455	82.0	—	0.4	6.1	6.5
AA		130,278		92,982	84.5	1.6	0.6	5.6	7.8
A		75,748		53,347	82.1	0.9	0.7	6.5	8.1
A-		43,418		30,181	81.0	1.2	1.6	7.1	9.9
B		38,186		25,445	77.6	0.4	1.7	5.7	7.8
C		4,863		3,225	66.3	3.2	—	1.0	4.2
C-		50		—	—	—	—	—	—
Other		51,872		34,772	94.5	2.1	1.5	6.9	10.5
NovaStar Mortgage Funding Trust Series 2001-2:
Alt. A	$	40,980	$	35,034	87.3	0.7	0.1	2.1	2.9
AAA		120,365		101,095	80.8	0.1	0.1	1.7	1.9
AA		234,977		195,984	82.9	0.5	0.3	1.4	2.2
A		152,307		128,887	81.3	1.1	0.9	2.1	4.1
A-		69,915		56,377	79.9	1.6	0.3	1.6	3.5
B		56,493		46,482	77.2	1.2	1.1	2.5	4.8
C		9,890		7,086	66.1	0.9	—	—	0.9
C-		222		217	55.3	—	—	—	—
Other		114,884		93,875	90.6	1.0	0.1	0.7	1.8
NovaStar Mortgage Funding Trust Series 2002-1:
Alt. A	$	36,390	$	34,830	84.4	—	—	—	—
AAA		113,230		104,272	80.7	—	0.1	0.8	0.9
AA		126,174		117,532	81.1	0.7	0.1	0.6	1.4
A		70,182		67,690	78.6	0.6	—	0.8	1.4
A-		32,549		31,672	75.5	—	—	0.3	0.3
B		27,999		25,773	73.8	0.2	0.9	—	1.1
C		1,401		1,352	61.4	—	—	—	—
C-		415		401	60.7	—	—	—	—
Other		91,658		85,345	87.7	0.5	0.1	0.5	1.1
NovaStar Mortgage Funding Trust Series 2002-2:
Alt. A	$	28,813	$	28,463	83.2	—	—	—	—
AAA		67,794		66,593	80.2	—	—	0.1	0.1
AA		78,122		76,572	79.7	0.1	—	0.1	0.2
A+		258		254	90.0	—	—	—	—
A		45,280		45,177	77.8	0.2	—	—	0.2
A-		20,034		19,561	77.5	—	—	—	—
B		15,978		15,857	76.8	—	—	0.3	0.3
C		1,683		1,431	70.2	15.1	—	3.0	18.1
C-		829		828	68.2	—	—	—	—
Other		51,209		50,917	88.6	—	—	—	—

						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 2002-3:
Alt. A	$	67,106	$	67,092	83.1	—	—	—	—
AAA		50,804		50,793	80.0	—	—	—	—
AA		35,579		35,572	81.0	—	—	—	—
A+		91,050		91,031	80.6	—	—	—	—
A		45,045		45,036	76.8	—	—	—	—
A-		22,732		22,726	73.9	—	—	—	—
B		22,176		22,171	71.9	—	—	—	—
B-		2,391		2,391	65.1	—	—	—	—
C		1,150		1,150	51.7	—	—	—	—
C-		103		103	34.6	—	—	—	—
Other		65,824		65,811	88.4	—	—	—	—

	$	3,163,879	$	2,435,748


December 31, 2001
NovaStar Mortgage Funding Trust Series 1999-1:
AAA	$	4,024	$	2,071	78.3	—	2.9	—	2.9
AA		30,772		12,437	85.3	0.8	1.6	5.3	7.7
A		50,693		19,018	83.8	3.9	1.8	6.3	12.0
A-		38,953		15,076	82.4	0.9	1.2	10.8	12.9
B		23,135		8,581	79.5	2.6	10.4	17.2	30.2
C		12,959		4,759	71.3	3.3	1.9	28.4	33.6
C-		47		—	—	—	—	—	—
D		4,412		723	62.8	—	—	13.1	13.1
NovaStar Mortgage Funding Trust Series 2000-1: (A)
AAA	$	85,222	$	55,395	80.6	—	1.4	3.2	4.6
AA		55,874		37,708	83.2	3.0	—	4.6	7.6
A		36,422		24,730	80.9	3.0	2.3	7.1	12.4
A-		23,329		14,329	80.4	1.3	—	5.4	6.7
B		13,089		7,277	80.0	—	—	10.9	10.9
C		5,922		3,446	68.6	1.7	—	18.0	19.7
C-		335		—	—	—	—	—	—
D		51		48	58.0	—	—	—	—
Other		9,894		6,467	92.0	1.6	0.8	2.4	4.8
NovaStar Mortgage Funding Trust Series 2000-2: (A)
AAA	$	57,846	$	43,593	81.2	2.4	0.2	1.3	3.9
AA		103,454		80,428	83.9	0.6	0.9	5.2	6.7
A		60,735		45,658	81.5	2.0	0.8	4.4	7.2
A-		39,939		29,522	81.4	—	1.5	5.2	6.7
B		19,843		15,387	77.0	0.7	—	4.9	5.6
C		4,275		3,094	67.1	—	—	10.1	10.1
C-		388		532	74.7	—	—	—	—
Other		53,208		40,823	92.8	0.7	—	4.3	5.0
NovaStar Mortgage Funding Trust Series 2001-1:
AAA	$	70,652	$	63,821	81.3	0.4	0.1	0.6	1.1
AA		130,278		118,813	84.4	1.4	—	1.4	2.8
A		75,748		67,834	81.6	1.6	—	3.2	4.8
A-		43,418		39,920	80.5	0.8	0.3	4.1	5.2
B		38,186		33,806	77.8	0.5	0.2	2.6	3.3
C		4,863		4,190	66.7	—	—	1.9	1.9
C-		50		48	65.0	—	—	—	—
Other		51,872		45,517	94.3	1.1	0.2	2.9	4.2
NovaStar Mortgage Funding Trust Series 2001-2:
Alt. A	$	40,980	$	40,190	86.5	—	—	—	—
AAA		120,365		118,047	80.9	—	—	0.3	0.3
AA		234,977		230,450	82.6	0.2	0.1	0.6	0.9
A		152,307		149,370	81.1	0.6	0.1	0.6	1.3
A-		69,915		68,568	79.6	0.9	—	0.4	1.3
B		56,493		55,404	77.3	1.1	—	1.5	2.6
C		9,890		9,699	66.8	—	—	—	—
C-		222		218	55.3	—	—	—	—
Other		114,884		112,671	90.5	0.5	—	0.1	0.6

	$	1,949,921	$	1,629,668

(A)

Collateral for the CAPS 2001-C1 security is the AAA-IO and prepayment penalty mortgage securities of NMFT 2000-1 and 2000-2. The performance of the mortgage loan collateral underlying these securities, as presented in this table, directly effects the performance of the CAPS 2001-C1 security.

Table 16—Mortgage Loss Analysis—Loans Collateralizing Mortgage Securities

(dollars in thousands)

September 30, 2002
			Loans Repurchased From Trusts
	Cumulative Losses As Reported		Losses		Loss as a % of Original Balance		Total Losses
NMFT 1999-1	2.64	%	$	759	0.46	%	3.10	%
NMFT 2000-1 (A)	0.32			23	0.01		0.33
NMFT 2000-2 (A)	0.21			34	0.01		0.22
NMFT 2001-1	0.08			—	—		0.08
NMFT 2001-2	0.03			—	—		0.03
NMFT 2002-1	—			—	—		—
NMFT 2002-2	—			—	—		—
NMFT 2002-3	—			—	—		—

December 31, 2001
			Loans Repurchased From Trusts
	Cumulative Losses As Reported		Losses		Loss as a % of Original Balance		Total Losses
NMFT 1999-1	1.76	%	$	775	0.47	%	2.23	%
NMFT 2000-1 (A)	0.09			23	0.01		0.10
NMFT 2000-2 (A)	0.01			34	0.01		0.02
NMFT 2001-1	—			—	—		—
NMFT 2001-2	—			—	—		—

(A)

Collateral for the CAPS 2001-C1 security is the AAA-IO and prepayment penalty mortgage securities of NMFT 2000-1 and 2000-2. The performance of the mortgage loan collateral underlying these securities, as presented in this table, directly effects the performance of the CAPS 2001-C1 security.

Assets Acquired through Foreclosure. As of September 30, 2002, we had 85 properties in real estate owned with a carrying value of $6.5 million compared to 181 properties with a carrying value of $13.2 million as of December 31, 2001. The primary reason for the decline in real estate owned between December 31, 2001 and September 30, 2002 is due to liquidations of properties during the first nine months of 2002. As the loans in our portfolio mature and pay down, the total volume of loans decreases and the percentage of non-performing loans decreases as the probability of default is higher in the early years of a loan’s life. Additionally, our mortgage insurance serves to mitigate our exposure to loan losses (see Mortgage Insurance Premiums). Losses recognized on liquidations of the real estate we have acquired through foreclosures are detailed under the heading “Gain on Derivative Instruments and Sales of Mortgage Assets”.

Mortgage Servicing Rights. As discussed under Mortgage Securities—Available for Sale, we retain the right to service mortgage loans we originate and have securitized. Servicing rights for loans we sell to third parties is not retained and we have not purchased the right to service loans. As of September 30, 2002, we have $7.8 million in capitalized mortgage servicing rights compared with $6.4 million as of December 31, 2001. The value of the mortgage servicing rights we retained in our securitizations during 2002 was $4.7 million. Amortization of mortgage servicing rights was $3.3 million and $1.2 million for the nine months ended September 30, 2002 and September 30, 2001, respectively.

Other Assets. Included in other assets as of September 30, 2002 are advances on behalf of borrowers for taxes, insurance, foreclosures and other customer service functions, collateral required under the terms of our derivative instrument contracts and other miscellaneous assets. Advances on behalf of borrowers for taxes, insurance and other customer service functions are made by NovaStar Mortgage, Inc, and aggregated $10.3 million as of September 30, 2002 compared with $6.8 million as of December 31, 2001. These balances will generally increase as our assets and loan servicing balances increase. Also included in other assets are deposits with our derivative counterparties in the amount of $23.4 million as of September 30, 2002 compared with $18.0 million as of December 31, 2001. The value of the interest rate swaps offset the deposits by $17.7 million and $9.8 million, as of

September 30, 2002 and December 31, 2001, respectively. These balances will generally decrease as interest rates rise and increase when interest rates fall.

Asset-backed Bonds. During 1997 and 1998, we completed the securitization of loans in transactions that were structured as financing arrangements for accounting purposes. 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. We have not exercised our right to repurchase any loans and repay bond obligations.

Table 17 provides details for all asset-backed bonds, and the related collateral that we have issued. As we have not issued any asset-backed bonds structured as financing arrangements since 1998, the decrease in the balance relates solely to principal repayments.

Table 17—Asset-backed Bonds

(in thousands)

	Asset-backed Bonds					Mortgage Loans
	Remaining Principal			Interest Rate		Remaining Principal (A)		Weighted Average Coupon		Estimated Weighted Average Months to Call
As of September 30, 2002:
NovaStar Home Equity Series:
Issue 1997-1	$	20,152		2.28	%	$	22,277	10.34	%	—
Issue 1997-2		23,179		2.31			25,470	10.59		—
Issue 1998-1		44,003		2.21			48,983	10.08		—
Issue 1998-2		72,614		2.03			76,543	9.88		—

	$	159,948


As of December 31, 2001:
NovaStar Home Equity Series:
Issue 1997-1	$	29,942		2.41	%	$	33,035	10.90	%	—
Issue 1997-2		30,629		2.44			33,525	10.79		—
Issue 1998-1		59,751		2.33			68,326	10.45		—
Issue 1998-2		98,790		2.31			104,855	10.18		9
Unamortized debt issuance costs, net		(64	)

	$	219,048

(A)

Includes assets acquired through foreclosure.

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. Repurchase agreements are used as interim, short-term financing before loans are transferred in our securitization transactions. Amounts outstanding and available for borrowing are listed below. The balances outstanding under our short-term arrangements fluctuate based on lending volume, cash flow from operating, investing and other financing activities and equity transactions.

Table 18—Short-term Financing Resources

September 30, 2002

(in thousands)

	Credit Limit		Lending Value of Collateral		Borrowings		Availability
Unrestricted cash							$	43,802
Lines of credit and mortgage and securities repurchase facilities	$	950,000	$	422,855	$	410,751	$	12,104

Total.	$	950,000	$	422,855	$	410,751	$	55,906

Stockholders’ Equity. The increase in our stockholders’ equity as of September 30, 2002 compared to December 31, 2001 is a result of the following:

•

$31.5 million increase due to net income recognized for the nine months ended September 30, 2002.

•

$8.0 million decrease due to exercise of stock options and acquisition of warrants

•

$43.8 million increase in unrealized gains on mortgage securities classified as available-for-sale

•

$11.4 million decrease in unrealized losses on derivative instruments used in cash flow hedges

•

$7.5 million increase due to net settlements of derivative instruments reclassified to earnings used in cash flow hedges

•

$28.1 million decrease due to dividends on common stock.

Mortgage Loan Production

The volume and cost of our loan production is critical to our financial results. The loans we produce serve as collateral for our mortgage securities and have generated gains as they are sold or securitized. The cost of our production is also critical to our financial results as it is a significant factor in the gains we recognize.

Our non-conforming loans are originated through a network of mortgage brokers throughout the United States. Approximately 3,200 brokers are active customers and approximately 9,800 are approved. Loans are underwritten and funded in a centralized facility. We increased our sales force from 112 on January 1, 2002 to 165 on September 30, 2002. Our sales force operates in 47 states, which allows us to mitigate the risk of geographical concentrations of credit risk.

The following tables summarize our loan production. The gains we have recognized are discussed under “Results of Operations.” Additionally, we discuss our cost of production under “General and Administrative Expenses” under “Results of Operations.”

Table 19—Non-conforming Loan Originations

(dollars in thousands, except for average loan balance)

	Number	Principal		Average Loan Balance		Price Paid to Broker		Weighted Average					Percent with Prepayment Penalty
	Number	Principal		Average Loan Balance		Price Paid to Broker		Loan to Value		Credit Rating (A)	Coupon		Percent with Prepayment Penalty
2002:
Third quarter	4,271	$	570,138	$	133,490	101.2	%	80	%	5.50	8.4	%	81	%
Second quarter	3,983		500,617		125,688	101.0		80		5.56	9.1		81
First quarter	3,602		471,994		131,037	101.0		80		5.45	9.0		84

Total	11,856	$	1,542,749	$	130,124	101.1	%	80	%	5.50	8.8	%	82	%


2001:
Fourth quarter	2,944	$	374,261	$	127,127	101.0	%	80	%	5.45	9.3	%	82	%
Third quarter	3,179		370,349		116,499	101.0		81		5.43	10.0		81
Second quarter	2,930		344,892		117,710	101.0		81		5.38	10.0		82
First quarter	2,078		243,864		117,355	101.1		82		5.41	10.4		82
Total	11,131	$	1,333,366	$	119,788	101.0	%	81	%	5.42	9.9	%	82	%

(A)

AAA=7, AA=6, A=5, A–=4, B=3, C=2, D=1

Table 20—Quarterly Mortgage Loan Originations by State (based on original principal)

	2002						2001
Collateral Location	Third		Second		First		Fourth		Third		Second		First
California	22	%	22	%	22	%	22	%	20	%	18	%	16	%
Florida	14		12		12		12		12		16		13
Michigan	4		5		5		6		7		8		9
Ohio	4		5		4		5		4		5		6
Colorado	4		4		5		4		3		4		3
Texas	4		4		3		3		2		2		2
All other states	48		48		49		48		52		47		51

Results of Operations for the Nine and Three Months Ended September 30, 2002 Compared with the Nine and Three Months Ended September 30, 2001

During the nine and three months ended September 30, 2002, we earned net income of $31.5 million, $2.90 per diluted share and $12.2 million, $1.14 per diluted share, respectively, compared with net income of $26.1 million, $2.49 per diluted share and $18.9 million, $1.76 per diluted share, for the same period of 2001.

Our primary sources of revenue are interest earned on our mortgage loan and securities portfolios, fees from borrowers and gains on derivative instruments and the sales and securitizations of mortgage loans. Earnings increased during the nine months ended September 30, 2002 as compared to the same period of 2001 due primarily to higher volume of average mortgage securities held and increased accrual rates on our mortgage securities portfolio due to better cash flow performance as a result of the widening spread between the coupon rates on the mortgage loan collateral and the floating rate bond liability rates. The effect of the higher volume and increasing yield on our mortgage securities is displayed in Table 21 and Table 22. Our average security income increased from 20.7% in 2001 to 74.0% in 2002.

Even though earnings increased for the nine months ended September 30, 2002 as compared to the same period of 2001, we experienced a decrease in earnings for the three months ended September 30, 2002 as compared to the same period of 2001. This decrease was a result of a $13.2 million loss on derivative instruments recognized in the third quarter of 2002. This loss is reflective of the corresponding decrease in fair value of these non-hedge instruments during the

quarter. In addition, during the third quarter of 2001 we had a $29 million resecuritization that created a $14.9 million gain.

Net Interest Income

Below is a summary of the interest income and expense related to our mortgage securities and the related yields as a percentage of the fair market value of these securities for the nine and three months ended September 30, 2002 and 2001.

Table 21—Mortgage Securities Interest Analysis

(dollars in thousands)

	For the nine months ended September 30,				For the three months ended September 30,
	2002		2001		2002		2001
Average fair market value	$	125,592	$	59,125	$	158,738	$	71,750

Interest income		35,658		7,043		13,872		3,085
Interest expense		1,553		1,612		647		596

Net interest income	$	34,105	$	5,431	$	13,225	$	2,489

Yields:
Interest income		37.86%		15.88%		34.96%		17.20%
Interest expense		0.69%		1.34%		1.63%		3.32%

Net interest spread		37.17%		14.54%		33.33%		13.88%

Table 22 is a summary of the average interest-earning assets, average interest-bearing liabilities and the related yields and rates thereon for the nine and three months ended September 30, 2002 and 2001. This table is presented to assist the reader in understanding the fluctuation in our net interest income from period to period.

Table 22—Interest Analysis

(dollars in thousands)

	Mortgage Loans						Mortgage Securities						Average Balance		Total Interest Income/ Expense		Annual Yield/ Rate
	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
Nine months ended September 30, 2002
Held-in-portfolio
Interest-earning mortgage assets	$	180,910	$	13,304	9.81	%							$	180,910	$	13,304	9.81	%

Interest-bearing liabilities:
Asset-backed bonds	$	188,392		3,375	2.39	%							$	188,392		3,375	2.39	%
Other borrowings		—		—										—		—

Cost of derivative financial instruments hedging liabilities				6,378												6,378


Total borrowings	$	188,392		9,753	6.90								$	188,392		9,753	6.90

Net interest income			$	3,551											$	3,551

Net interest spread					2.91												2.91

Net yield					2.62												2.62


Held-for-sale
Interest-earning mortgage assets	$	324,781	$	21,892	8.99	%	$	64,276	$	35,658	73.97	%	$	389,057	$	57,550	19.72	%

Interest-bearing liabilities:
Asset-backed bonds		—		—				—		—				—		—
Other borrowings	$	273,539		6,636	3.23	%		77,126		1,553	2.68	%		350,665		8,189	3.11	%

Cost of derivative financial instruments hedging liabilities				10,859						—						10,859


Total borrowings	$	273,539		17,495	8.53		$	77,126		1,553	2.68		$	350,665		19,048	7.24

Net interest income			$	4,397					$	34,105					$	38,502

Net interest spread					0.46						71.29						12.48

Net yield					1.81						70.75						13.19


Nine months ended September 30, 2001
Held-in-portfolio
Interest-earning mortgage assets	$	282,428	$	21,193	10.01	%							$	282,428	$	21,193	10.01	%

Interest-bearing liabilities:
Asset-backed bonds	$	303,016		12,993	5.72	%							$	303,016		12,993	5.72	%
Other borrowings		—		—										—		—

Cost of derivative financial instruments hedging liabilities				668												668


Total borrowings	$	303,016		13,661	6.01								$	303,016		13,661	6.01

Net interest income			$	7,532											$	7,532

Net interest spread					4.00												4.00

Net yield					3.56												3.56


Held-for-sale
Interest-earning mortgage assets	$	221,315	$	17,023	10.26	%	$	45,447	$	7,043	20.66	%	$	266,762	$	24,066	12.03	%

Interest-bearing liabilities:
Asset-backed bonds		—		—				—		—				—		—
Other borrowings	$	179,328		7,763	5.77	%		36,479		1,612	5.89	%		215,807		9,375	5.79	%

Cost of derivative financial instruments hedging liabilities				504						—						504


Total borrowings	$	179,328		8,267	6.15		$	36,479		1,612	5.89		$	215,807		9,879	6.10

Net interest income			$	8,756					$	5,431					$	14,187

Net interest spread					4.11						14.77						5.93

Net yield					5.28						15.93						7.09

	Mortgage Loans						Mortgage Securities						Average Balance		Total Interest Income/ Expense		Annual Yield/ Rate
	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 September 30, 2002
Held-in-portfolio
Interest-earning mortgage assets	$	164,352	$	3,942	9.59	%							$	164,352	$	3,942	9.59	%

Interest-bearing liabilities:
Asset-backed bonds	$	168,430		1,008	2.39	%							$	168,430		1,008	2.39	%
Other borrowings		—		—										—		—

Cost of derivative financial instruments hedging liabilities				2,145												2,145

Total borrowings	$	168,430		3,153	7.49								$	168,430		3,153	7.49

Net interest income			$	789											$	789

Net interest spread					2.10												2.10

Net yield					1.92												1.92


Held-for-sale
Interest-earning mortgage assets	$	378,015	$	8,826	9.34	%	$	82,243	$	13,872	67.47	%	$	460,258	$	22,698	19.73	%

Interest-bearing liabilities:
Asset-backed bonds		—		—				—		—				—		—
Other borrowings	$	344,916		2,521	2.92	%		94,229		647	2.75	%		439,145		3,168	2.89	%

Cost of derivative financial instruments hedging liabilities				3,653						—						3,653

Total borrowings	$	344,916		6,174	7.16		$	94,229		647	2.75		$	439,145		6,821	6.21

Net interest income			$	2,652					$	13,225					$	15,877

Net interest spread					2.18						64.72						13.52

Net yield					2.81						64.32						13.80


Three months ended September 30, 2001
Held-in-portfolio
Interest-earning mortgage assets	$	246,686	$	6,088	9.87	%							$	246,686	$	6,088	9.87	%

Interest-bearing liabilities:
Asset-backed bonds	$	264,589		3,044	4.60	%							$	264,589		3,044	4.60	%
Other borrowings		—		—										—		—

Cost of derivative financial instruments hedging liabilities				807												807

Total borrowings	$	264,589		3,851	5.82								$	264,589		3,851	5.82

Net interest income			$	2,237											$	2,237

Net interest spread					4.05												4.05

Net yield					3.63												3.63


Held-for-sale
Interest-earning mortgage assets	$	372,700	$	9,379	10.07	%	$	48,074	$	3,085	25.67	%	$	420,774	$	12,464	11.85	%

Interest-bearing liabilities:
Asset-backed bonds		—		—				—		—				—		—
Other borrowings	$	379,554		4,313	4.55	%		45,953		596	5.19	%		425,507		4,909	4.61	%

Cost of derivative financial instruments hedging liabilities				388						—						388

Total borrowings	$	379,554		4,701	4.95		$	45,953		596	5.19		$	425,507		5,297	4.98

Net interest income			$	4,678					$	2,489					$	7,167

Net interest spread					5.12						20.48						6.87

Net yield					5.02						20.71						6.81

The mortgage loans we originate and own have relatively high coupons and generally, in the aggregate, the coupon is not volatile. As a result, the average yield on our loans has been consistent. Rates on our financing arrangements adjust monthly, primarily indexed to one-month LIBOR. As a result, the cost of financing increases and decreases with short-term market conditions. Short-term market rates declined steadily in 2002 and, therefore, our net interest margin on loans has decreased. The cost of our interest rate agreements, discussed below, offsets our net interest spread. Interest income on mortgage loans in the future will depend on the volume of loans we own. Generally, we expect to increase our loan portfolio as our origination volume increases. The net margin on our loans will depend on the coupons on the loans and short-term borrowing rates, which are a function of market demand and economic conditions.

Our securities primarily represent our ownership in the net cash flow of underlying mortgage loan collateral in excess of bond expenses and cost of funding. The cost of funding is indexed to one-month LIBOR. As one-month LIBOR has decreased over the past 18 months, the net cash flow we are receiving has increased correspondingly. Therefore, our yield (rate of accrual) on these securities has increased. We experienced average income on our securities of 20.7% and 25.7% for the nine and three months ended September 30, 2001. The income increased to 74.0% and 67.5% during the same respective periods of 2002 to reflect the increase in cash flow. If rates continue to remain low, we anticipate the cash flow to continue to be high on our securities and further increases in income will be generated. Future interest income will, however, be largely dependent on economic conditions. We also expect to increase the amount of mortgage securities we own as we securitize the mortgage loans we originate.

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 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. Due to the steady decline in short-term interest rates in 2002, our expense related to interest rate agreements increased.

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.

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 nine months ended September 30, 2002, we made provisions for losses of ($294,000) and incurred net charge-offs of $1.9 million compared to $2.8 million and $4.7 million,

respectively during the same period of 2001. Table 2 presents a quarterly rollforward of our allowance for credit losses.

Fee Income

Fee income primarily consists of fees from three sources — servicing fees from investors and borrowers, broker fees from loan investors and branch management fees. As a loan servicer, we collect normal fees for servicing loans that collateralize asset-backed bonds and mortgage securities. 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.

We generate management fees from our branches for providing administrative functions related to accounting, human resources, license/registration and loan investor management. Additional discussion is under the “Affiliated Branches” heading.

Gain on Derivative Instruments and Sales of Mortgage Assets

Our gain on derivative instruments and sales of mortgage assets is made up of the following components:

	For the Nine Months ended September 30,						For the Three Months ended September 30,
	2002			2001			2002			2001
Gain on sales of mortgage loans transferred in securitizations	$	35,433		$	16,233		$	16,892		$	7,330
Gain on sales of mortgage loans to third parties		3,169			757			630			122
Gain on sale of mortgage securities		—			14,945			—			14,945
Loss on derivative instruments		(20,889	)		(3,255	)		(13,245	)		(3,255	)
Loss on sales of real estate owned		(686	)		(132	)		(229	)		(157	)

	$	17,027		$	28,548		$	4,048		$	18,985

Loss on derivative instruments. We have entered into derivative instrument contracts that do not meet the requirements for hedge accounting treatment, but contribute to our overall risk management strategy by serving to reduce interest rate related to short-term borrowing rates. Changes in the fair value of these derivative instruments are credited or charged to current earnings. As interest rates decreased from December 31, 2001 to September 30, 2002, we recognized a loss of $20.9 million, reflective of the corresponding decrease in fair value of these non-hedge derivative instruments during the year.

Gain on sales of mortgage loans. 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. These transactions are structured as sales for accounting and income tax reporting. Whole loan sales have also been executed whereby we sell loans to third parties. In the outright sales of mortgage loans, we retain no assets or servicing rights. Table 1 provides a summary of mortgage loans sold outright and transferred in securitizations. 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

servicing assets are determined by discounting estimated future cash flows using the cash out method. The weighted average assumptions used for the valuation of our retained assets at the time of securitization were a constant prepayment rate of 27, projected losses of 1.3% and a discount rate of 24.7%.

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. Prepayment penalty income was $312,000 and $674,000 during the nine months ended September 30, 2002 and 2001 compared with $89,000 and $176,000 for the three months ended September 30, 2002 and 2001. The decrease is due to shrinking of the portfolio and the expiration of prepayment penalties.

Premiums for Mortgage Loan Insurance

The use of mortgage insurance is one method of managing the credit risk in the mortgage asset portfolio. As of September 30, 2002, approximately 82% of the loans we service are covered by mortgage insurance. 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”. These premiums totaled $1.7 million and $2.2 million for the nine months ended September 30, 2002 and 2001 compared with $595,000 and $1.0 million for the three months ended September 30, 2002 and 2001.

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 premiums for mortgage loan insurance expense in our statement of income.

We intend to continue to purchase mortgage insurance coverage on the majority of newly originated loans as they are securitized. However, we have the risk that mortgage insurance providers will revise their guidelines to an extent where we will no longer be able to acquire coverage on all of our new production. Similarly, the providers may also increase insurance premiums to a point where the cost of coverage outweighs its benefit. We monitor the mortgage insurance market and currently anticipate being able to obtain affordable coverage on a substantial portion of our future production.

General and Administrative Expenses

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

The increase in general and administrative expenses is primarily the result of an increase in the number of employees and stock compensation expense related to our variable stock options. Excluding our branch personnel, we employed 732 people as of September 30, 2002, compared with 323 as of September 30, 2001. This increase in headcount is attributable to our new conforming and retail business, growth in our wholesale business including the opening of an

office in Cleveland and our expanding servicing operations. Stock compensation expense for the nine months ended September 30, 2002 when compared to September 30, 2001 increased $931,000 due to the rise in our stock price. If our stock price falls, the stock compensation expense will decrease.

Our fees and expenses related to our branch operations decreased in 2002 due to fewer non-LLC branches as shown in the affiliated branches section.

The loan costs of production table below includes all costs paid and fees collected during the loan origination cycle, including loans that do not fund. This distinction is important as we can only capitalize as deferred broker premium and costs, those costs (net of fees) directly associated with a “funded” loan. Costs associated with loans that do not fund are recognized immediately as a component of general and administrative expenses. Deferred net costs are recognized over the life of the loan, serving to reduce either interest income (at receipt of monthly payment, payoff or transfer to real estate owned) or gain on sales of mortgage assets (when sold outright or transferred in securitization). Increased efficiencies in the non-conforming lending operation correlate to lower general and administrative costs and higher interest income and gain on sales of mortgage assets.

Table 23—Loan Costs of Production, as a Percent of Principal

	Gross Loan Production Cost	Premium Paid to Broker, Net of Fees Collected	Total Acquisition Cost
2002:
Third quarter	2.03	0.86	2.89
Second quarter	2.13	0.58	2.71
First quarter	2.01	0.61	2.62

2001:
Fourth quarter	1.91	0.65	2.56
Third quarter	1.92	0.56	2.48
Second quarter	1.86	0.61	2.47
First quarter	2.37	0.74	3.11

During the first quarter of 2002 we opened a second wholesale processing office in Cleveland, Ohio. This second production office was staffed ahead of the production demand and as a result we experienced a slight increase in our average cost to originate a loan.

Table 24—Divisional Operations–General and Administrative Expenses

Nine Months Ended September 30, 2002 (in thousands)

	Mortgage Portfolio Management		Mortgage Lending and Loan Servicing		Affiliated Branches				Total
	Mortgage Portfolio Management		Mortgage Lending and Loan Servicing		Operations		Management		Total
Compensation and benefits	$	2,342	$	24,230	$	3,351	$	1,574	$	31,497
Travel and public relations		54		2,318		5,151		284		7,807
Office administration		319		5,391		479		460		6,649
Loan expense		—		4,398		209		5		4,612
Professional and outside services		535		1,245		372		72		2,224
Other		14		719		686		401		1,820

Total	$	3,264	$	38,301	$	10,248	$	2,796	$	54,609

Nine Months Ended September 30, 2001 (in thousands)

	Mortgage Portfolio Management		Mortgage Lending and Loan Servicing		Affiliated Branches				Total
	Mortgage Portfolio Management		Mortgage Lending and Loan Servicing		Operations		Management		Total
Compensation and benefits	$	1,141	$	12,981	$	6,133	$	1,012	$	21,267
Travel and public relations		42		1,095		4,582		147		5,866
Office administration		312		3,451		958		278		4,999
Loan expense		—		1,329		219		11		1,559
Professional and outside services		584		828		46		39		1,497
Other		204		300		1,399		334		2,237

Total	$	2,283	$	19,984	$	13,337	$	1,821	$	37,425

Three Months Ended September 30, 2002 (in thousands)

	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing		Affiliated Branches				Total
	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing		Operations		Management		Total
Compensation and benefits	$	(1,133	)	$	9,501	$	1,068	$	565	$	10,001
Travel and public relations		12			899		1,951		83		2,945
Office administration		142			2,131		128		162		2,563
Loan expense		—			2,550		62		2		2,614
Professional and outside services		160			520		99		25		804
Other		(14	)		218		425		144		773

Total	$	(833	)	$	15,819	$	3,733	$	981	$	19,700

Three Months Ended September 30, 2001 (in thousands)

	Mortgage Portfolio Management		Mortgage Lending and Loan Servicing		Affiliated Branches				Total
	Mortgage Portfolio Management		Mortgage Lending and Loan Servicing		Operations		Management		Total
Compensation and benefits	$	604	$	5,427	$	1,722	$	445	$	8,198
Travel and public relations		17		339		1,474		79		1,909
Office administration		88		1,183		232		108		1,611
Loan expense		—		528		99		8		635
Professional and outside services		192		255		24		16		487
Other		190		123		398		91		802

Total	$	1,091	$	7,855	$	3,949	$	747	$	13,642

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 25—Summary of Servicing Operations

(dollars in thousands except per loan cost)

	2002
	September 30			June 30				March 31
	Amount		%	Amount			%	Amount		%
Unpaid principal	$	2,911,263		$	2,558,407			$	2,307,620

Number of loans		23,757			21,379				19,593

Servicing income, net of amortization of mortgage servicing rights	$	2,261	0.31	$	1,773		0.28	$	1,675	0.29
Costs of servicing		2,194	0.30		1,791		0.28		1,538	0.27

Net servicing income	$	67	0.01	$	(18	)	0.00	$	137	0.02

Annualized costs of servicing per unit	$	369.41		$	335.10			$	313.99

	2001
	December 31			September 30			June 30			March 31
	Amount		%	Amount		%	Amount		%	Amount		%
Unpaid principal	$	1,994,448		$	1,756,523		$	1,501,844		$	1,263,773

Number of loans		17,425			15,916			13,916			11,999

Servicing income, net of amortization of mortgage servicing rights	$	1,560	0.31	$	1,691	0.39	$	1,366	0.36	$	1,465	0.46
Costs of servicing		1,303	0.26		1,269	0.29		1,166	0.31		1,238	0.39

Net servicing income	$	257	0.05	$	422	0.10	$	200	0.05	$	227	0.07

Annualized costs of servicing per unit	$	299.11		$	318.92		$	335.15		$	412.70

Affiliated Branches

We operate our mortgage brokerage unit under the name NovaStar Home Mortgage, Inc. (NHMI). Our first branch was opened in December 1999. Many of the original branches were opened as wholly owned subsidiaries of NHMI, and, therefore, are part of our consolidated financial statements. Branches are currently being opened as limited liability companies (LLCs). As such, the LLCs are not part of our consolidated financial statements as we have no controlling interest in these companies. We have only a minority interest in these companies. Following is a summary of the operations segregated by LLC and non-LLC.

Table 26—Branch Operations—Non-LLC

(dollars in thousands)

	2002						2001
	September 30		June 30		March 31		December 31		September 30		June 30		March 31
Branches (end of quarter)		8		10		19		15		22		22		77
Loans originated		588		498		752		776		744		722		1,126
Fee income	$	3,733	$	2,978	$	3,537	$	2,974	$	3,896	$	4,570	$	4,840
General and administrative costs	$	3,733	$	2,978	$	3,537	$	3,014	$	3,949	$	4,548	$	4,840
Personnel		188		151		159		189		200		217		288

Table 27—Branch Operations—LLC

(dollars in thousands)

	2002						2001
	September 30		June 30		March 31		December 31		September 30		June 30		March 31
Branches (end of quarter)		176		152		123		108		83		64		—
Loans originated		3,863		3,052		2,432		2,115		1,403		1,189		—
Fee income	$	16,845	$	13,180	$	9,713	$	9,224	$	5,388	$	3,088	$	—
General and administrative costs	$	16,042	$	12,373	$	8,990	$	9,647	$	5,278	$	2,799	$	—
Personnel		854		724		546		405		271		138		—

Under our agreements with branch managers, fee income generated by the branches net of operating expenses and 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 28—Branch Management

(dollars in thousands)

	2002			2001
	September 30	June 30	March 31	December 31	September 30	June 30	March 31
Fee income	$1,569	$1,247	$1,085	$1,336	$885	$738	$450
General and administrative costs	$ 981	$ 988	$ 827	$1,016	$747	$580	$494
Personnel	28	28	21	32	15	16	15

Income Taxes

NovaStar Financial, Inc. intends to operate and qualify as a Real Estate Investment Trust (REIT) under the requirements of the Internal Revenue Code. Therefore, it will generally not be subject to federal income taxes at the corporate level on taxable income distributed to stockholders. Requirements for qualification as a REIT include various restrictions on common stock ownership and the nature of the assets and sources of income.

Below is a summary of the taxable net income for NovaStar Financial, Inc. for the nine and three months ended September 30, 2002 and September 30, 2001.

Table 29—Taxable Net Income

(dollars in thousands)

	For the Nine Months Ended September 30,						For the Three Months Ended September 30,
	2002			2001			2002			2001
Net income	$	31,510		$	26,137		$	12,199		$	18,936
Equity in net income of NFI Holding Corp.		9,610			(475	)		5,687			792
Stock Compensation Payable		836			161			(1,092	)		77
Cumulative effect of a change in accounting principle		—			1,384			—			—
Interest rate agreement amortization		(277	)		(831	)		(87	)		(193	)
Residual purchase commitment fee		(1,200	)		(1,230	)		(400	)		(400	)
Credit losses, net of provision		(2,245	)		(2,024	)		(702	)		(632	)
Other		(246	)		44			2			(6	)
Use of capital loss carryforward		—			(14,946	)		—			(14,946	)
Use of net operating loss carryforward		—			(2,718	)		—			—

Taxable net income before preferred dividends		37,988			5,502			15,607			3,628
Preferred dividends		—			(2,625	)		—			(1,543	)
Surrender of warrants		(13,172	)		—			—			—

Taxable net income available to common shareholders	$	24,816		$	2,877		$	15,607		$	2,085

Taxable net income per common shareholder	$	2.38		$	0.49		$	1.50		$	0.36

NFI Holding Corporation, a wholly owned subsidiary of NovaStar Financial, Inc., has not elected REIT-status and files a consolidated federal income tax return with its subsidiaries. NFI Holding Corporation reported a net loss before income taxes of $11.8 million for the nine months ended September 30, 2002, which resulted in an income tax benefit of $2.2 million as shown in our income statement. We did not report income tax (expense) benefit for the nine months ended September 30, 2001 due to the immaterial nature of the pre-tax income reported at NFI Holding Corporation.

During the first quarter of 2002, we recognized a charge to taxable income of $3.7 million for the value of warrants converted by warrant holders (see Note 5 to our consolidated financial statements). A charge of $9.5 million was recognized in the second quarter for the warrants converted by RFC.

NovaStar incurred capital and operating losses in years prior to 2001. These losses were carried forward to 2001 where they were used to offset the capital gains and operating income that NovaStar realized in 2001. The capital loss carryforward and net operating loss carryforward were fully utilized in 2001, resulting in no carryforward to 2002.

Liquidity and Capital Resources

Liquidity means the need for, access to and uses of cash. Our 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. As shown in Table 18, we have $55.9 million in immediately available funds, including $43.8 million in cash.

Mortgage lending requires significant cash to fund loan originations. Our warehouse lending arrangements, including repurchase agreements, support the mortgage lending operation. Our warehouse mortgage lenders allow us to borrow the greater of the market value of the loans or 98% of the outstanding principal. Funding for the difference—generally 2% of the principal—must come from other cash inflows. We use operating cash inflow in the form of cash flow from mortgage securities, principal and interest on mortgage loans and fee income to support loan originations. In addition, proceeds from equity offerings have been used to support operations. Our immediately available funds would support funding more than $2.7 billion in loans, assuming no other demands on cash and assuming a 2% “haircut”.

Loans financed with warehouse and repurchase credit facilities are subject to changing market valuation and margin calls. The market value of our loans are dependent on a variety of economic conditions, including interest rates (and borrower demand) and end investor desire and capacity. Market values have been consistent over the past three years. However, there is no guaranty that the prices will remain constant. To the extent the value of the loans declines significantly, we would be required to repay portions of the amounts we have borrowed. The value of our “recourse” loans (classified as held-for-sale) as of September 30, 2002 would need to decline by nearly 50% before we would use all immediately available funds, assuming no other constraints on our immediately available funds.

We have no recourse for loans financed with asset-backed bonds and, as such, there is minimal liquidity risk.

The derivative financial instruments we use also subject us to “margin call” risk. Under our interest rate swaps, we pay a fixed rate to the counterparties while they pay us a floating rate. While floating rates are low, on a net basis we are paying the counterparty. In order to mitigate credit exposure to us, the counterparty required us to post margin deposits with them. As of September 30, 2002, we have approximately $23.4 million on deposit. Further declining interest rates would subject us to additional exposure for cash margin calls. However, the asset side of the balance sheet should increase in value in a further declining interest rate scenario. Incoming cash on our mortgage loans and securities is a principal source of cash. The volume of cash depends on, among other things, interest rates. While short-term interest rates (the basis for our funding costs) are low and the coupon rates on our loans are high, our net interest margin (and therefore incoming cash flow) is high. Severe and immediate changes in interest rates will impact the volume of our incoming cash flow. To the extent rates increase dramatically, our funding costs will increase quickly. While many of our loans are adjustable, they typically will not reset as quickly as our funding costs. This circumstance would temporarily reduce incoming cash flow. As noted above, derivative financial instruments are used to mitigate the effect of interest rate volatility. In this rising rate situation, our interest rate swaps and caps would provide additional cash flows to mitigate the lower cash on loans and securities.

Loans we originate can be sold to a third party, which also generates cash to fund on-going operations. When market prices exceed our cost to originate, we believe we can operate in this manner, provided that the level of loan originations is at or near the capacity of its production

infrastructure. In 1999, we sold a substantial portion of the loans we originated. We securitized much of our loan production in 2001 and 2002. Selling loans to third parties provides another means for cash flow, should we need additional liquidity.

Cash activity during the nine months ended September 30, 2002 and 2001 is presented in the consolidated statement of cash flows.

As noted above, proceeds from equity offerings have supported our operations. Since inception, we have raised $143 million in net proceeds through private and public equity offerings. Equity offerings provide another avenue as a future liquidity source.

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 accounting principles generally accepted in the United States of America 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, 2001 describes certain recently issued accounting pronouncements. Management believes the implementation of these pronouncements and others that have gone into effect since the date of these reports will not have a material impact on the consolidated financial statements.

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. To the extent we choose to sell loans, financial results will depend on the ability to find purchasers for the loans at prices that cover origination expenses and earn a profit. Loans will be sold based on the returns that can be earned by holding the loans at cost while taking into consideration the amount of capital that must be held against them versus the return implied by market bid prices. Loans may be sold if returns are determined to be too low for the risks that are being taken.

Interest Rate Risk. When interest rates on our assets do not adjust at the same rates as our liabilities or when the assets have fixed rates and the liabilities are adjusting, future earnings potential is affected. We express this interest rate risk as 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. We assess the risk based on the change in market values given increases and decreases in interest rates. We also assess the risk based on the impact to net income in changing interest rate environments.

Management primarily uses financing sources where the interest rate resets frequently. As of September 30, 2002, 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 significantly affected, as the asset rate resets would lag the borrowing rate resets.

To assess interest sensitivity 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.

Table 30—Interest Rate Sensitivity-Income

(dollars in thousands)

	Basis Point Increase (Decrease) in Interest Rate (A)
	(200) (D)	(100)			Base			100			200
As of September 30, 2002
Income (expense) from:
Assets	N/A	$	234,001		$	238,250		$	242,019		$	244,847
Liabilities (B)	N/A		(60,049	)		(86,182	)		(113,266	)		(140,929	)
Interest rate agreements	N/A		(50,171	)		(34,434	)		(18,697	)		804

Net interest income	N/A	$	123,781		$	117,634		$	110,056		$	104,722

Percent change in net interest income from base	N/A		5.2			—			(6.4	)		(11.0	)

Percent change of capital (C)	N/A		3.7			—			(4.6	)		(7.8	)


As of December 31, 2001
Income (expense) from:
Assets	N/A	$	133,173		$	135,196		$	136,598		$	141,106
Liabilities (B)	N/A		(35,336	)		(51,896	)		(68,801	)		(86,099	)
Interest rate agreements	N/A		(21,647	)		(14,636	)		(7,624	)		(612	)

Net interest income	N/A	$	76,190		$	68,664		$	60,173		$	54,395

Percent change in net interest income from base	N/A		11.0			—			(12.4	)		(20.8	)

Percent change of capital (C)	N/A		5.8			—			(6.5	)		(11.0	)

(A)

Income of asset, liability or interest rate agreement in a parallel shift in the yield curve, up and down 1% and 2%.

(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 September 30, 2002 and December 31, 2001.

(D)

A decrease in interest rates by 200 basis points (2%) would imply rates on liabilities at or below zero.

Table 31—Interest Rate Sensitivity—Market Value

(dollars in thousands)

	Basis Point Increase (Decrease) in Interest Rate(A)
	(200) (C)	(100)			100			200
As of September 30, 2002
Change in market values of:
Assets	N/A	$	11,084		$	(38,136	)	$	(91,708	)
Liabilities	N/A		(2,317	)		2,481			5,027
Interest rate agreements	N/A		(26,342	)		25,857			51,249

Cumulative change in market value	N/A	$	(17,575	)	$	(9,798	)	$	(35,432	)

Percent change of market value portfolio equity (B)	N/A		(9.4	)%		(5.2	)%		(18.9	)%


As of December 31, 2001
Change in market values of:
Assets	N/A	$	13,158		$	(28,771	)	$	(67,162	)
Liabilities	N/A		(2,245	)		2,382			6,414
Interest rate agreements	N/A		(15,505	)		15,218			30,236

Cumulative change in market value	N/A	$	(4,592	)	$	(11,171	)	$	(30,512	)

Percent change of market value portfolio equity (B)	N/A		(3.0	)%		(7.3	)%		(19.8	)%

(A)

Change in market value of assets, liabilities or interest rate agreements in a parallel shift in the yield curve, up and down 1% and 2%.

(B)

Total change in estimated market value as a percent of market value portfolio equity as of September 30, 2002 and December 31, 2001.

(C)

A decrease in interest rates by 200 basis points (2%) would imply rates on liabilities at or below zero.

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 September 30, 2002. The values under the headings “100”, “200”, “(100)” and “(200)” 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 and 200 basis points, or 1 and 2 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 September 30, 2002.

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

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, loan-to-value, 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 8 are weighted average speeds of all loans in each deal.

As shown in Table 8, 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. 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 Real Estate Investment Trust (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. 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- or three-month LIBOR on a set notional amount.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures. The undersigned, principal executive officer and principal financial officer of Novastar Financial, Inc. conclude that the disclosure controls and procedures of Novastar Financial, Inc. are effective based on their evaluation of these controls and procedures as of a date within 90 days of the filing date of this report.

Changes in Internal Controls. There have been no significant changes in the internal controls of Novastar Financial, Inc. or in other factors that could significantly affect these controls subsequent to the date of the evaluation of these controls by the undersigned principal executive officer and principal financial officer of Novastar Financial, Inc.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

As of September 30, 2002, 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

Not applicable

Item 5. Other Information

None

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

99.1		Statement Under Oath of Chief Executive Officer

99.2		Statement Under Oath of Principal Accounting Officer

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 10-K filed by the Registrant with the SEC on March 20, 2000.

(b) NovaStar Financial filed no Form 8-K’s during the three months ended September 30, 2002.

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: November 13, 2002

/S/ SCOTT F. HARTMAN

Scott F. Hartman

Chairman of the Board, Secretary and

Chief Executive Officer

(Principal Executive Officer)

DATE: November 13, 2002

/S/ RODNEY E. SCHWATKEN

Rodney E. Schwatken

Vice President, Treasurer and Controller

(Principal Accounting Officer)

CERTIFICATION

I, Scott F. Hartman, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Novastar Financial, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) Designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) Presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) All significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: November 13, 2002


By:		/S/ SCOTT F. HARTMAN

Name: Scott F. Hartman

Title: Chairman of the Board,

Secretary and Chief

Executive Officer

(Principal Executive Officer)

CERTIFICATION

I, Rodney E. Schwatken, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Novastar Financial, Inc.;

b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) Presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

Date: November 13, 2002


By:		/S/ RODNEY E. SCHWATKEN

Name: Rodney E. Schwatken

Title: Vice President

Treasurer and Controller

(Principal Financial Officer)