NOVASTAR FINANCIAL INC (Form: 10-Q, Received: 08/05/2005 15:31:43)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

For the Quarterly Period Ended June 30, 2005

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

For the Transition Period From to to

Commission File Number 001-13533

NOVASTAR FINANCIAL, INC.

(Exact Name of Registrant as Specified in its Charter)


Maryland (State or Other Jurisdiction of Incorporation or Organization)		74-2830661 (I.R.S. Employer Identification No.)

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

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

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes x No ¨

The number of shares of the Registrant’s Common Stock outstanding on August 4, 2005 was 30,641,615.

NOVASTAR FINANCIAL, INC.

FORM 10-Q

For the Quarterly Period Ended June 30, 2005

TABLE OF CONTENTS


Part I	Financial Information

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

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18
	Table 1, Nonconforming Loan Originations and Purchases	30
	Table 2, Carrying Value of Mortgage Loans	30
	Table 3, Valuation of Individual Mortgage Securities – Available-for-Sale and Assumptions	32
	Table 4, Summary of Mortgage Securities – Available-for-Sale Retained by Year of Issue	37
	Table 5, Short-term Financing Resources	38
	Table 6, Mortgage Securities Interest Analysis	41
	Table 7, Mortgage Portfolio Management Net Interest Income Analysis	42
	Table 8, Gains on Sales of Mortgage Assets and Gains (Losses) on Derivative Instruments	46
	Table 9, Mortgage Loan Securitizations	46
	Table 10, Wholesale Loan Costs of Production, as a Percent of Principal	49
	Table 11, Reconciliation of Wholesale Overhead Costs, Non-GAAP Financial Measure	49
	Table 12, Taxable Net Income	50
	Table 13, Summary of Servicing Operations	51
	Table 14, Contractual Obligations	54

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	67
	Table 15, Interest Rate Sensitivity – Market Value	69
	Table 16, Interest Rate Risk Management Contracts	70

Item 4.	Controls and Procedures	70

Part II	Other Information

Item 1.	Legal Proceedings	71

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	72

Item 3.	Defaults Upon Senior Securities	72

Item 4.	Submission of Matters to a Vote of Security Holders	72

Item 5.	Other Information	72

Item 6.	Exhibits	73

PART I. FINANCIAL INFORMATION

Item 1.

Financial Statements

NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited; dollars in thousands, except share amounts)


	June 30, 2005			December 31, 2004
Assets
Cash and cash equivalents	$	317,591		$	268,563
Mortgage loans – held-for-sale		1,074,108			747,594
Mortgage loans – held-in-portfolio		48,569			59,527
Mortgage securities – available-for-sale		543,911			489,175
Mortgage securities – trading		–			143,153
Mortgage servicing rights		49,657			42,010
Servicing related advances		20,854			20,190
Property and equipment, net		14,765			15,476
Derivative instruments, net		12,934			18,841
Other assets		66,703			56,782

Total assets	$	2,149,092		$	1,861,311

Liabilities and Stockholders’ Equity
Liabilities:
Short-term borrowings secured by mortgage loans	$	1,044,100		$	720,791
Short-term borrowings secured by mortgage securities		20,781			184,737
Asset-backed bonds secured by mortgage loans		43,189			53,453
Asset-backed bonds secured by mortgage securities		286,575			336,441
Junior subordinated debentures		48,507			–
Dividends payable		42,898			73,431
Due to securitizations trusts		26,692			20,930
Accounts payable and other liabilities		55,731			45,184

Total liabilities		1,568,473			1,434,967
Commitments and contingencies (Note 8)
Stockholders’ equity:
Capital stock, $0.01 par value, 50,000,000 shares authorized:
Redeemable preferred stock, $25 liquidating preference per share; 2,990,000 shares authorized, issued and outstanding		30			30
Common stock, 30,641,615 and 27,709,984 shares authorized, issued and outstanding, respectively		306			277
Additional paid-in capital		537,508			433,107
Accumulated deficit		(98,471	)		(85,354	)
Accumulated other comprehensive income		142,012			79,120
Other		(766	)		(836	)

Total stockholders’ equity		580,619			426,344

Total liabilities and stockholders’ equity	$	2,149,092		$	1,861,311

See notes to condensed consolidated financial statements.

NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(unaudited; dollars in thousands, except per share amounts)


	For the Six Months Ended June 30,						For the Three Months Ended June 30,
	2005			2004			2005			2004
Interest income:
Mortgage securities	$	89,036		$	65,333		$	48,573		$	32,137
Mortgage loans held-for-sale		41,709			34,910			21,430			19,794
Mortgage loans held-in-portfolio		2,441			3,792			1,128			1,745

Total interest income		133,186			104,035			71,131			53,676
Interest expense:
Short-term borrowings secured by mortgage loans		21,378			10,992			11,115			6,237
Short-term borrowings secured by mortgage securities		1,557			2,343			757			1,151
Asset-backed bonds secured by mortgage loans		845			691			428			327
Asset-backed bonds secured by mortgage securities		8,623			4,843			3,816			2,495
Net settlements of derivative instruments used in cash flow hedges		180			2,581			–			519
Junior subordinated debentures		1,046			–			906			–

Total interest expense		33,629			21,450			17,022			10,729

Net interest income before provision for credit losses		99,557			82,585			54,109			42,947
Provision for credit losses		(719	)		(661	)		(100	)		(515	)

Net interest income		98,838			81,924			54,009			42,432
Gains on sales of mortgage assets		50,771			76,954			32,525			25,174
Fee income		31,747			29,159			15,371			12,742
Gains (losses) on derivative instruments		6,753			1,717			(7,848	)		27,115
Premiums for mortgage loan insurance		(1,982	)		(1,581	)		(1,040	)		(955	)
Impairment on mortgage securities – available-for-sale		(1,738	)		(6,117	)		(126	)		(6,117	)
Other income, net		8,394			2,614			4,807			1,506
General and administrative expenses:
Compensation and benefits		66,075			53,790			33,949			27,672
Office administration		16,789			15,876			8,363			8,833
Professional and outside services		9,431			5,796			5,086			3,440
Marketing		8,171			13,266			3,559			6,631
Loan expense		7,969			8,405			4,376			5,843
Other		10,772			7,362			5,917			3,376

Total general and administrative expenses		119,207			104,495			61,250			55,795

Income from continuing operations before income tax expense (benefit)		73,576			80,175			36,448			46,102
Income tax expense (benefit)		(2,199	)		9,821			(3,065	)		8,335

Income from continuing operations		75,775			70,354			39,513			37,767
(Loss) income from discontinued operations, net of income tax		(1,053	)		(3,803	)		6			(2,141	)

Net income		74,722			66,551			39,519			35,626
Dividends on preferred shares		(3,326	)		(2,938	)		(1,663	)		(1,663	)

Net income available to common shareholders	$	71,396		$	63,613		$	37,856		$	33,963

Continued


	For the Six Months Ended June 30,						For the Three Months Ended June 30,
	2005			2004			2005		2004
Basic earnings per share:
Income from continuing operations available to common shareholders	$	2.56		$	2.71		$	1.31	$	1.45
Loss from discontinued operations, net of income tax		(0.04	)		(0.15	)		–		(0.09	)

Net income available to common shareholders	$	2.52		$	2.56		$	1.31	$	1.36

Diluted earnings per share:
Income from continuing operations available to common shareholders	$	2.53		$	2.66		$	1.29	$	1.42
Loss from discontinued operations, net of income tax		(0.04	)		(0.15	)		–		(0.08	)

Net income available to common shareholders	$	2.49		$	2.51		$	1.29	$	1.34

Weighted average basic shares outstanding		28,361			24,817			28,944		24,978

Weighted average diluted shares outstanding		28,709			25,338			29,295		25,377

Dividends declared per common share	$	2.80		$	2.70		$	1.40	$	1.35

See notes to condensed consolidated financial statements.

Concluded

NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

(unaudited; dollars in thousands, except share amounts)


	Preferred Stock		Common Stock		Additional Paid-in Capital			Accumulated Deficit			Accumulated Other Comprehensive Income		Other			Total Stockholders’ Equity
Balance, January 1, 2005	$	30	$	277	$	433,107		$	(85,354	)	$	79,120	$	(836	)	$	426,344
Forgiveness of founders’ notes receivable		—		—		—			—			—		70			70
Issuance of common stock, 2,861,524 shares		—		28		101,556			—			—		—			101,584
Issuance of stock under stock compensation plans, 70,107 shares		—		1		533			—			—		—			534
Compensation recognized under stock compensation plans		—		—		1,120			—			—		—			1,120
Dividend equivalent rights (DERs) on vested options		—		—		1,195			(1,195	)		—		—			—
Dividends on common stock ($2.80 per share)		—		—		—			(83,318	)		—		—			(83,318	)
Dividends on preferred stock ($1.12 per share)		—		—		—			(3,326	)		—		—			(3,326	)
Tax benefit derived from stock compensation plans		—		—		(3	)		—			—		—			(3	)

Comprehensive income:
Net income									74,722			—					74,722
Other comprehensive income									—			62,892					62,892

Total comprehensive income																	137,614

Balance, June 30, 2005	$	30	$	306	$	537,508		$	(98,471	)	$	142,012	$	(766	)	$	580,619

See notes to condensed consolidated financial statements.

NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited; in thousands)


	For the Six Months Ended June 30,
	2005			2004
Cash flows from operating activities:
Income from continuing operations	$	75,775		$	70,354
Adjustments to reconcile income from continuing operations to net cash used in operating activities:
Amortization of mortgage servicing rights		12,737			7,137
Impairment on mortgage securities – available-for-sale		1,738			6,117
Gains on derivative instruments		(6,753	)		(1,717	)
Depreciation expense		3,626			2,749
Amortization of deferred debt issuance costs		3,076			1,517
Compensation recognized under stock compensation plans		1,120			875
Provision for credit losses		719			661
Amortization of premiums on mortgage loans		221			417
Forgiveness of founders’ promissory notes		70			70
Accretion of available-for-sale securities		(82,330	)		(46,051	)
Originations and purchases of mortgage loans held-for-sale		(4,359,049	)		(3,831,348	)
Proceeds from repayments of mortgage loans held-for-sale		1,746			6,536
Proceeds from sale of mortgage loans held-for-sale to third parties		252,390			39,008
Proceeds from sale of mortgage loans held-for-sale in securitizations		3,700,654			3,031,769
Gains on sales of mortgage assets		(50,771	)		(76,954	)
Proceeds from sale of mortgage securities—trading		143,153			—
Changes in:
Servicing related advances		(704	)		(1,435	)
Derivative instruments, net		3,869			13,030
Other assets		(27,305	)		(21,440	)
Accounts payable and other liabilities		9,000			(2,712	)

Net cash used in operating activities from continuing operations		(317,018	)		(801,417	)
Net cash used in operating activities from discontinued operations		(2,624	)		(771	)

Net cash used in operating activities		(319,642	)		(802,188	)
Cash flows from investing activities:
Proceeds from paydowns on mortgage securities – available-for-sale		231,573			140,743
Proceeds from repayments of mortgage loans held-in-portfolio		9,247			17,746
Proceeds from sales of assets acquired through foreclosure		1,435			3,277
Purchases of property and equipment		(2,914	)		(1,952	)

Net cash provided by investing activities		239,341			159,814
Cash flows from financing activities:
Proceeds from issuance of asset-backed bonds, net of debt issuance costs		128,921			154,025
Payments on asset-backed bonds		(192,128	)		(96,995	)
Proceeds from issuance of capital stock and exercise of equity instruments, net of offering costs		94,696			84,731
Tax benefit derived from stock compensation plans		(3	)		—
Net change in short-term borrowings		159,353			640,002
Proceeds from issuance of junior subordinated debentures		48,507			—
Dividends paid on capital stock		(110,017	)		(66,278	)

Net cash provided by financing activities		129,329			715,485

Net increase in cash and cash equivalents		49,028			73,111
Cash and cash equivalents, beginning of period		268,563			118,180

Cash and cash equivalents, end of period	$	317,591		$	191,291

					Continued


	For the Six Months Ended June 30,
	2005		2004
Supplemental disclosure of cash flow information:
Cash paid for interest	$	32,568	$	20,422

Cash paid for income taxes	$	68	$	14,639

Cash received on mortgage securities – available-for-sale with no cost basis	$	6,765	$	19,282

Non-cash operating, investing and financing activities:
Cost basis of securities retained in securitizations	$	146,217	$	159,350

Retention of mortgage servicing rights	$	20,384	$	13,894

Change in loans under removal of accounts provision	$	5,762	$	5,517

Change in due to securitization trusts	$	5,762	$	5,517

Assets acquired through foreclosure	$	1,325	$	2,345

Dividends payable	$	42,898	$	33,741

Dividend reinvestment plan	$	7,160	$	1,016

Restricted stock issued in satisfaction of prior year accrued bonus	$	262	$	1,816

See notes to condensed consolidated financial statements.
Concluded

NOVASTAR FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2005 (Unaudited)

Note 1. Financial Statement Presentation

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

The Company’s condensed consolidated financial statements as of June 30, 2005 and for the six and three months ended June 30, 2005 and 2004 are unaudited. In the opinion of management, all necessary adjustments have been made, which were of a normal and recurring nature, for a fair presentation of the condensed consolidated financial statements. Certain reclassifications to prior year amounts have been made to conform to current year presentation.

The Company’s condensed consolidated financial statements should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements of the Company and the notes thereto, included in the Company’s annual report to stockholders and annual report on Form 10-K for the fiscal year ended December 31, 2004.

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

Note 2. New Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (“FASB”) issued a revision of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123(R)”). This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. Entities no longer have the option to use the intrinsic value method of APB 25 that was provided in SFAS No. 123 as originally issued, which generally resulted in the recognition of no compensation cost. Under SFAS No. 123(R), the cost of employee services received in exchange for an equity award must be based on the grant-date fair value of the award. The cost of the awards under SFAS No. 123(R) will be recognized over the period an employee provides service, typically the vesting period. No compensation cost is recognized for equity instruments in which the requisite service is not provided. For employee awards that are treated as liabilities, initial cost of the awards will be measured at fair value. The fair value of the liability awards will be remeasured subsequently at each reporting date through the settlement date with changes in fair value during the period an employee provides service recognized as compensation cost over that period. As discussed in Note 1 to the 2004 annual report on Form 10-K, the Company implemented the fair value provisions of SFAS No. 123 during 2003. As such, the adoption of this Statement is not anticipated to have a significant impact on the Company’s condensed consolidated financial statements.

In March 2005, SEC Staff Accounting Bulletin (“SAB”) No. 107, Application of FASB No. 123 (revised 2004), Accounting for Stock-Based Compensation was released. This release summarizes the SEC staff position regarding the interaction between FASB No. 123 (revised 2004), Share-Based Payment and certain SEC rules and regulations and provides the SEC’s views regarding the valuation of share-based payment arrangements for public companies. The adoption of this release is not anticipated to have a significant impact on the Company’s condensed consolidated financial statements.

In May 2005, the FASB issued Statement No. 154, Accounting Changes and Error Corrections, a Replacement of APB Opinion No. 20 and FASB Statement No. 3 . This Statement changes the requirements

for the accounting and reporting of a change in accounting principle, reporting entity, accounting estimate and correction of an error. SFAS No. 154 applies to (a) financial statements of business enterprises and not-for-profit organizations and (b) historical summaries of information based on primary financial statements that include an accounting period in which an accounting change or error correction is reflected and is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date the Statement was issued.

The adoption of this Statement in not anticipated to have a significant impact on the Company’s condensed consolidated financial statements.

Note 3. Loan Securitizations

On February 22, 2005 and May 27, 2005, the Company executed securitization transactions, NovaStar Mortgage Funding Trust (“NMFT”) Series 2005-1 and NMFT Series 2005-2, respectively, accounted for as sales of loans. In these transactions, derivative instruments were transferred into the trusts to reduce interest rate risk to the bondholders. Details of these transactions are as follows (dollars in thousands):


			Allocated Value of Retained Interests				Principal Balance of Loans Sold		Fair Value of Derivative Instruments Transferred		Gain Recognized
	Net Bond Proceeds		Mortgage Servicing Rights		Subordinated Bond Classes		Principal Balance of Loans Sold		Fair Value of Derivative Instruments Transferred		Gain Recognized
NMFT Series 2005-1	$	2,066,840	$	11,448	$	88,433	$	2,100,000	$	13,669	$	18,136
NMFT Series 2005-2 (A)		1,633,814		8,936		57,784		1,649,289		1,553		27,748

(A)	On July 21, 2005, the remaining $150.7 million in loans collateralizing NMFT Series 2005-2 were delivered. The Company received $150.7 million in proceeds on July 21, 2005, which was held in escrow by the trustee.

In these securitizations, the Company retained interest-only, prepayment penalty and other subordinated interests in the underlying cash flows and servicing responsibilities from the financial assets transferred. The value of the Company’s retained interests is subject to credit, prepayment, and interest rate risks on the transferred financial assets.

Note 4. Mortgage Securities – Available-for-Sale

Mortgage securities–available-for-sale consisted of the Company’s investment in the interest-only, prepayment penalty and other subordinated securities that the securitization trust issued. The primary bonds were sold to parties independent of the Company. Management estimates their fair value of the mortgage securities retained by discounting the expected future cash flow of the collateral and bonds. The average annualized yield on mortgage securities is the interest income for the period as a percentage of the average fair market value of the mortgage securities. The cost basis, unrealized gains, estimated fair value and average yield of mortgage securities as of June 30, 2005 and December 31, 2004 were as follows (dollars in thousands):


	Cost Basis		Unrealized Gain		Estimated Fair Value		Average Yield
As of June 30, 2005	$	401,899	$	142,012	$	543,911	34.2	%
As of December 31, 2004		409,946		79,229		489,175	31.4

The following table is a rollforward of mortgage securities – available-for-sale from January 1, 2004 to June 30, 2005 (in thousands):


	Cost Basis			Unrealized Gain			Estimated Fair Value of Mortgage Securities
As of January 1, 2004	$	294,562		$	87,725		$	382,287

Increases (decreases) to mortgage securities:
New securities retained in securitizations		381,833			6,637			388,470
Accretion of income (A)		100,666			—			100,666
Proceeds from paydowns of securities (A) (B)		(351,213	)		—			(351,213	)
Impairment on mortgage securities—available-for-sale		(15,902	)		15,902			—
Mark-to-market value adjustment		—			(31,035	)		(31,035	)

Net increase (decrease) to mortgage securities		115,384			(8,496	)		106,888

As of December 31, 2004		409,946			79,229			489,175

Increases (decreases) to mortgage securities:
New securities retained in securitizations		146,217			1,697			147,914
Accretion of income (A)		82,330			—			82,330
Proceeds from paydowns of securities (A) (B)		(234,856	)		—			(234,856	)
Impairment on mortgage securities—available-for-sale		(1,738	)		1,738			—
Mark-to-market value adjustment		—			59,348			59,348

Net increase (decrease) to mortgage securities		(8,047	)		62,783			54,736

As of June 30, 2005	$	401,899		$	142,012		$	543,911

(A)	Cash received on mortgage securities with no cost basis was $6.8 million for the six months ended June 30, 2005 and $32.2 million for the year ended December 31, 2004.

(B)

For mortgage securities with a remaining cost basis, the Company reduces the cost basis by the amount of cash that is contractually due from the securitization trusts. In contrast, for mortgage securities in which the cost basis has previously reached zero, the Company records in interest income the amount of cash that is contractually due from the securitization trusts. In both cases, there are instances where the Company may not receive a portion of this cash until after the balance sheet reporting date. Therefore, these amounts are recorded as receivables from the securitization trusts and included in other assets. As of June 30, 2005 and December 31, 2004, the Company had receivables from securitization trusts of $7.3 million and $4.1 million, respectively, related to mortgage securities with a remaining cost basis. Also, the Company had receivables from securitization trusts of $0.7 million related to mortgage securities with a zero cost basis as of June 30, 2005 and December 31, 2004.

Note 5. NovaStar NIM 2005-N1

On June 22, 2005, the Company issued NovaStar Net Interest Margin Certificates (“NIM”) in the amount of $130.9 million, raising $128.9 million in net proceeds. This NIM is secured by the Company’s mortgage securities – available-for-sale retained from NMFT Series 2005-1 and NMFT Series 2005-2 as a means for long-term financing. For financial reporting and tax purposes, the mortgage securities available-for-sale collateral are recorded as assets of the Company and the asset-backed bonds are recorded as debt. The performance of the mortgage loan collateral underlying these securities directly affects the performance of these bonds. The bonds are non-recourse and pay a fixed interest rate of 4.78%. The estimated weighted average months to maturity are based on estimates and assumptions made by management.

Note 6. Junior Subordinated Debentures

On March 15, 2005, the Company completed the issuance of $50.0 million in unsecured floating rate trust preferred securities through a newly formed statutory trust, NovaStar Capital Trust I (“NCTI”), organized under Delaware law. The trust preferred securities require quarterly interest payments. The interest rate is floating at the three-month LIBOR rate plus 3.5% and resets quarterly. The trust preferred securities are

redeemable, at the Company’s option, in whole or in part, anytime without penalty on or after March 15, 2010, but are mandatorily redeemable when they mature on March 15, 2035. If they are redeemed on or after March 15, 2010, but prior to maturity, the redemption price will be 100% of the principal amount plus accrued and unpaid interest.

NCTI was formed for the sole purpose of issuing these trust preferred securities. The proceeds from the issuance of the trust preferred securities and from the sale of 100% of the voting common stock of NCTI to the Company were loaned to the Company in exchange for junior subordinated debentures of $51.6 million, which are the sole assets of NCTI. The terms of the junior

subordinated debentures match the terms of the trust preferred securities. The debentures are subordinate and junior in right of payment to all present and future senior indebtedness and certain other financial obligations of the Company. The Company also entered into a guarantee, which together with its obligations under the junior subordinated debentures, provides full and unconditional guarantees of the trust preferred securities. Following payment by the Company of offering costs, the Company’s net proceeds from the offering aggregated $48.4 million.

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

Note 7. UBS Borrowings

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

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

•

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

•

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

•

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

•

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

•

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

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

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

As of June 30, 2005, NovaStar Trust had the following assets:

whole loans: $366.4 million

real estate owned properties: $0, and

cash and cash equivalents: $1.6 million.

As of June 30, 2005, NovaStar Trust had the following liabilities and equity:

short-term debt due to UBS: $365.8 million, and

$2.2 million in members’ equity investment.

Note 8. Commitments and Contingencies

Commitments. The Company has commitments to borrowers to fund residential mortgage loans as well as commitments to purchase and sell mortgage loans to third parties. At June 30, 2005, the Company had outstanding commitments to originate, purchase and sell loans of $558.4 million, $22.2 million and $187.5 million, respectively. At December 31, 2004, the Company had outstanding commitments to originate loans of $361.2 million. The Company had no commitments to purchase or sell loans at December 31, 2004. The commitments to originate and purchase loans do not necessarily represent future cash requirements, as some portion of the commitments are likely to expire without being drawn upon.

In the ordinary course of business, the Company sells loans with recourse for borrower defaults. For loans that have been sold with recourse and are no longer on the Company’s balance sheet, the recourse component is considered a guarantee. During the first six months of 2005, the Company sold $227.2 million of loans with recourse for borrower defaults compared to none in 2004. The Company maintained a $419,000 reserve related to these guarantees as of June 30, 2005 compared with a reserve of $45,000 as of December 31, 2004.

In the ordinary course of business, the Company sells loans with recourse where a defect occurred in the loan origination process. This recourse is considered a guarantee to cover investor losses should origination defects occur. Defects may occur in the loan documentation and underwriting process, either through processing errors made by the Company or through intentional or unintentional misrepresentations made by the borrower or agents during those processes. If a defect is identified, the Company is required to repurchase the loan. As of June 30, 2005 and December 31, 2004, the Company had loans sold with recourse with an outstanding principal balance of $12.3 billion and $11.4 billion, respectively. Repurchases of loans where a defect has occurred have been insignificant; therefore, the Company has not recorded a reserve.

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

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

In July 2004, an employee of NovaStar Home Mortgage, Inc. (“NHMI”), a wholly-owned subsidiary of the Company, filed a class and collective action lawsuit against NHMI and NMI in California Superior Court for the County of Los Angeles. Subsequently, NHMI and NMI removed the matter to the United States District Court for the Central District of California. The plaintiff brought this class and collective action on behalf of herself and all past and present employees of NHMI and NMI who were employed since May 1, 2000 in the capacity generally described as Loan Officer. The plaintiff alleged that NHMI and NMI failed to pay her and the members of the class she purported to represent overtime premium and minimum wage as required by the Fair Labor Standards Act (“FSLA”) and California state laws for the period commencing May 1, 2000. In 2005, the plaintiff and NHMI agreed upon a nationwide settlement in the amount of $3.3 million on behalf of a class of all NHMI Loan Officers nationwide. The settlement, which is subject to court approval, covers all minimum wage and overtime claims going back to July 30, 2001, and includes the dismissal with prejudice of the claims against NMI. Since not all class members will elect to be part of the settlement, the Company estimated the probable obligation related to the settlement to be in a range of $1.5 million to $1.9 million. In accordance with SFAS No. 5, Accounting for Contingencies , the Company recorded a charge to earnings of $1.5 million in 2004.

proceedings and claims, individually and in the aggregate, will not have a material adverse effect on the Company’s financial condition or results of operations, litigation is subject to inherent uncertainties. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on the results of operations for the period in which the ruling occurs.

In April 2004, the Company also received notice of an informal inquiry from the Securities and Exchange Commission requesting that it provide various documents relating to its business. The Company has cooperated fully with the Commission’s inquiry and provided it with the requested information. The Company last provided information to the Commission in October 2004. The Company has received no additional requests or inquiries from the Commission since that time.

The Company recently discovered that they may have inadvertently sold up to approximately 50,000 shares under their 401(k) plan and up to approximately 287,000 shares under their Direct Stock Purchase and Dividend Reinvestment Plan in the last twelve months in a manner that may not have complied with the registration requirements of applicable securities laws. As a result, the holders of unregistered shares may have rescission rights or the right to recover damages if they no longer own such shares. As a result, the Company could be required to repurchase the shares for an amount equal to the sale price of all shares sold less dividends paid, which the Company currently estimates to be $12.8 million, exclusive of any interest or other costs. This amount could be higher if it is ultimately determined that additional unregistered shares were sold. Furthermore, the Company could be subject to monetary fines or other regulatory sanctions as provided under applicable securities laws.

Note 9. Issuance of Capital Stock

The Company sold 1,136,524 shares of its common stock during the six months ended June 30, 2005 under its Direct Purchase and Dividend Reinvestment Plan. Net proceeds of $43.7 million were raised under these sales of common stock.

During the six months ended June 30, 2005, 70,107 shares of common stock were issued under the Company’s stock-based compensation plan. Proceeds of $0.5 million were received under these issuances.

On June 2, 2005, the Company completed a public offering of 1,725,000 shares of its common stock at $35 per share. The Company raised $57.9 million in net proceeds from this offering.

Note 10. 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 six and three months ended June 30, 2005 and 2004 (in thousands).


	For the Six Months Ended June 30,					For the Three Months Ended June 30,
	2005		2004			2005		2004
Net income	$	74,722	$	66,551		$	39,519	$	35,626
Other comprehensive income (loss):
Change in unrealized gain on mortgage securities—available-for-sale		61,045		(44,105	)		30,629		(28,661	)
Change in unrealized loss on derivative instruments used in cash flow hedges, net of related tax effects		—		(3	)		—		100
Impairment on mortgage securities —available-for-sale reclassified to earnings		1,738		6,117			126		6,117
Net settlements of derivative instruments used in cash flow hedges reclassified to earnings		109		2,198			—		400
Other amortization		—		(26	)		—		—

Other comprehensive income (loss)		62,892		(35,819	)		30,755		(22,044	)

Total comprehensive income	$	137,614	$	30,732		$	70,274	$	13,582

Note 11. Branch Operations

As the demand for conforming loans declined significantly during 2004 and into 2005, many branches have not been able to generate sufficient mortgage loan volume to produce sufficient fees to meet operating expense demands. As a result of these conditions, a significant number of branch managers have voluntarily terminated employment with the Company. The Company has also terminated branches when loan production results were substandard. The Company considers a branch to be discontinued upon its termination date, which is the point in time when the operations cease. The discontinued operations apply to the branch operations segment presented in Note 12. The operating results for these discontinued operations have been segregated from the continuing operating results of the Company. The operating results of all discontinued operations are summarized as follows (in thousands):


	For the Six Months Ended June 30,						For the Three Months Ended June 30,
	2005			2004			2005			2004
Fee income	$	8,194		$	59,210		$	1,319		$	30,229
General and administrative expenses		(9,906	)		(65,394	)		(1,309	)		(33,711	)

(Loss) income before income tax (benefit) expense		(1,712	)		(6,184	)		10			(3,482	)
Income tax (benefit) expense		(659	)		(2,381	)		4			(1,341	)

(Loss) income from discontinued operations	$	(1,053	)	$	(3,803	)	$	6		$	(2,141	)

As of June 30, 2005, the Company has $0.6 million in cash, $0.1 million in receivables included in other assets and $0.7 million in payables included in accounts payable and other liabilities pertaining to discontinued operations, which are included in the condensed consolidated balance sheets. As of December 31, 2004, the Company had $2.2 million in cash, $1.6 million in receivables included in other assets and $3.8 million in payables included in accounts payable and other liabilities pertaining to discontinued operations.

Note 12. Segment Reporting

The Company reviews, manages and operates its business in three segments. These business segments are: mortgage portfolio management, mortgage lending and loan servicing and branch operations. Mortgage portfolio management operating results are driven from the income generated on the assets the Company manages less associated management costs. Mortgage lending and loan servicing operations include the marketing, underwriting and funding of loan production. Servicing operations represent the income and costs to service the Company’s on and off-balance sheet loans. Branch operations include the collective income generated by the Company’s wholly-owned subsidiary, NHMI, brokers and the associated operating costs. Also, the corporate-level income and costs to support the NHMI branches are represented in the branch operations segment. Branches that have terminated in 2004 and in the first and second quarters of 2005 have been segregated from the results of the ongoing operations of the Company for the six and three months ended June 30, 2005 and 2004. Following is a summary of the operating results of the Company’s primary operating units for the six and three months ended June 30, 2005 and 2004 (in thousands):

For the Six Months Ended June 30, 2005


	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing			Branch Operations			Eliminations			Total
Interest income	$	91,477		$	41,512		$	198		$	(1	)	$	133,186
Interest expense		11,025			26,691			68			(4,155	)		33,629

Net interest income before provision for credit losses		80,452			14,821			130			4,154			99,557
Provision for credit losses		(719	)		—			—			—			(719	)
Gains on sales of mortgage assets		291			42,243			—			8,237			50,771
Fee income		—			15,878			34,528			(18,659	)		31,747
Gains on derivative instruments		523			6,230			—			—			6,753
Impairment on mortgage securities – available- for-sale		(1,738	)		—			—			—			(1,738	)
Other income (expense)		10,311			63			45			(4,007	)		6,412
General and administrative expenses		(7,754	)		(82,822	)		(37,508	)		8,877			(119,207	)

Income (loss) from continuing operations before income tax expense (benefit)		81,366			(3,587	)		(2,805	)		(1,398	)		73,576
Income tax expense (benefit)		—			(1,220	)		(1,094	)		115			(2,199	)

Income (loss) from continuing operations		81,366			(2,367	)		(1,711	)		(1,513	)		75,775
Loss from discontinued operations, net of income tax		—			—			(818	)		(235	)		(1,053	)

Net income (loss)	$	81,366		$	(2,367	)	$	(2,529	)	$	(1,748	)	$	74,722

For the Six Months Ended June 30, 2004


	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing			Branch Operations			Eliminations			Total
Interest income	$	69,123		$	34,930		$	—		$	(18	)	$	104,035
Interest expense		9,434			16,358			36			(4,378	)		21,450

Net interest income (loss) before provision for credit losses		59,689			18,572			(36	)		4,360			82,585
Provision for credit losses		(661	)		—			—			—			(661	)
Gains on sales of mortgage assets		409			59,891			—			16,654			76,954
Fee income		—			14,703			35,841			(21,385	)		29,159
Gains on derivative instruments		582			1,135			—			—			1,717
Impairment on mortgage securities – available- for-sale		(6,117	)		—			—			—			(6,117	)
Other income (expense)		8,919			(3,831	)		20			(4,075	)		1,033
General and administrative expenses		(3,604	)		(69,706	)		(36,387	)		5,202			(104,495	)

Income (loss) from continuing operations before income tax expense (benefit)		59,217			20,764			(562	)		756			80,175
Income tax expense (benefit)		—			9,776			(219	)		264			9,821

Income (loss) from continuing operations		59,217			10,988			(343	)		492			70,354
Loss from discontinued operations, net of income tax		—			—			(1,584	)		(2,219	)		(3,803	)

Net income (loss)	$	59,217		$	10,988		$	(1,927	)	$	(1,727	)	$	66,551

For the Three Months Ended June 30, 2005


	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing			Branch Operations			Eliminations			Total
Interest income	$	49,701		$	21,310		$	119		$	1		$	71,131
Interest expense		5,001			14,380			28			(2,387	)		17,022

Net interest income before provision for credit losses		44,700			6,930			91			2,388			54,109
Provision for credit losses		(100	)		—			—			—			(100	)
Gains on sales of mortgage assets		177			28,497			—			3,851			32,525
Fee income		—			7,235			18,285			(10,149	)		15,371
Gains (losses) on derivative instruments		575			(8,423	)		—			—			(7,848	)
Impairment on mortgage securities – available- for-sale		(126	)		—			—			—			(126	)
Other income (expense)		5,059			996			29			(2,317	)		3,767
General and administrative expenses		(4,581	)		(41,497	)		(20,238	)		5,066			(61,250	)

Income (loss) from continuing operations before income tax benefit		45,704			(6,262	)		(1,833	)		(1,161	)		36,448
Income tax benefit		—			(2,253	)		(715	)		(97	)		(3,065	)

Income (loss) from continuing operations		45,704			(4,009	)		(1,118	)		(1,064	)		39,513
Income (loss) from discontinued operations, net of income tax		—			—			28			(22	)		6

Net income (loss)	$	45,704		$	(4,009	)	$	(1,090	)	$	(1,086	)	$	39,519

For the Three Months Ended June 30, 2004


	Mortgage Portfolio Management			Mortgage Lending and Loan Servicing			Branch Operations			Eliminations			Total
Interest income	$	33,880		$	19,804		$	—		$	(8	)	$	53,676
Interest expense		4,188			8,647			17			(2,123	)		10,729

Net interest income (loss) before provision for credit losses		29,692			11,157			(17	)		2,115			42,947
Provision for credit losses		(515	)		—			—			—			(515	)
Gains on sales of mortgage assets		24			12,959			—			12,191			25,174
Fee income		—			6,932			18,691			(12,881	)		12,742
Gains on derivative instruments		1,772			25,343			—			—			27,115
Impairment on mortgage securities – available- for-sale		(6,117	)		—			—			—			(6,117	)
Other income (expense)		4,738			(2,207	)		10			(1,990	)		551
General and administrative expenses		(1,655	)		(37,056	)		(18,832	)		1,748			(55,795	)

Income (loss) from continuing operations before income tax expense (benefit)		27,939			17,128			(148	)		1,183			46,102
Income tax expense (benefit)		—			7,948			(57	)		444			8,335

Income (loss) from continuing operations		27,939			9,180			(91	)		739			37,767
Loss from discontinued operations, net of income tax		—			—			(960	)		(1,181	)		(2,141	)

Net income (loss)	$	27,939		$	9,180		$	(1,051	)	$	(442	)	$	35,626

Intersegment revenues and expenses that were eliminated in consolidation were as follows for the six and three months ended June 30, 2005 and 2004 (in thousands):


	For the Six Months Ended June 30,						For the Three Months Ended June 30,
	2005			2004			2005			2004
Amounts paid to (received from) mortgage portfolio received from (paid to) mortgage lending and loan servicing:
Loan servicing fees	$	(147	)	$	(246	)	$	(72	)	$	(116	)
Interest income on intercompany debt		4,129			4,342			2,384			2,106
Guaranty, commitment, loan sale and securitization fees		3,619			4,463			1,185			2,451
Interest income on warehouse borrowings		25			—			5			—
Gains on sale of mortgage securities – available-for-sale retained in securitizations		(1,696	)		—			(897	)		—
Amounts paid to (received from) branch operations received from (paid to) mortgage lending and loan servicing:
Lender premium		8,638			13,625			4,555			7,048
Subsidized fees		—			21			—			—
Interest income on warehouse line		(1	)		(18	)		1			(8	)
Fee income on warehouse line		(1	)		(18	)		—			(9	)

Based on SFAS No. 91, “ Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases ”, the Company defers certain nonrefundable fees and direct costs associated with the origination of loans in the branch operations segment which are subsequently brokered to the mortgage lending and servicing segment. The mortgage lending and servicing segment ultimately funds the loans and then sells the loans either through securitizations or outright sales to third parties. The net deferred cost (income) becomes part of the cost basis of the loans and serves to either increase (net deferred income) or decrease (net deferred cost) the gain or loss recognized by the mortgage lending and servicing segment. These transactions are accounted for in the eliminations column of the Company’s segment reporting. The following table summarizes these amounts for the six and three months ended June 30, 2005 and 2004 (in thousands):


	For the Six Months Ended June 30,						For the Three Months Ended June 30,
	2005			2004			2005			2004
Gains on sales of mortgage assets	$	874		$	4,998		$	302		$	4,998
Fee income		(11,291	)		(18,989	)		(5,704	)		(11,729	)
General & administrative expenses		9,913			13,108			5,212			5,848

Note 13. Earnings Per Share

The computations of basic and diluted earnings per share for the six and three months ended June 30, 2005 and 2004 are as follows (in thousands, except per share amounts):


	For the Six Months Ended June 30,						For the Three Months Ended June 30,
	2005			2004			2005			2004
Numerator :
Income from continuing operations	$	75,775		$	70,354		$	39,513		$	37,767
Dividends on preferred shares		(3,326	)		(2,938	)		(1,663	)		(1,663	)

Income from continuing operations available to common shareholders		72,449			67,416			37,850			36,104
(Loss) income from discontinued operations, net of income tax		(1,053	)		(3,803	)		6			(2,141	)

Net income available to common shareholders	$	71,396		$	63,613		$	37,856		$	33,963


Denominator:
Weighted average common shares outstanding – basic		28,361			24,817			28,944			24,978

Weighted average common shares outstanding – dilutive:
Weighted average common shares outstanding – basic		28,361			24,817			28,944			24,978
Stock options		341			505			343			399
Restricted stock		7			16			8			—

Weighted average common shares outstanding – dilutive		28,709			25,338			29,295			25,377


Basic earnings per share:
Income from continuing operations	$	2.67		$	2.83		$	1.37		$	1.51
Dividends on preferred shares		(0.11	)		(0.12	)		(0.06	)		(0.06	)

Income from continuing operations available to common shareholders		2.56			2.71			1.31			1.45
Loss from discontinued operations, net of income tax		(0.04	)		(0.15	)		—			(0.09	)

Net income available to common shareholders	$	2.52		$	2.56		$	1.31		$	1.36


Diluted earnings per share:
Income from continuing operations	$	2.64		$	2.78		$	1.35		$	1.49
Dividends on preferred shares		(0.11	)		(0.12	)		(0.06	)		(0.07	)

Income from continuing operations available to common shareholders		2.53			2.66			1.29			1.42
Loss from discontinued operations, net of income tax		(0.04	)		(0.15	)		—			(0.08	)

Net income available to common shareholders	$	2.49		$	2.51		$	1.29		$	1.34

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


	For the Six Months Ended June 30,				For the Three Months Ended June 30,
	2005		2004		2005		2004
Number of stock options and restricted stock (in thousands)		119		15		119		71
Weighted average exercise price	$	30.59	$	33.59	$	30.59	$	11.85

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

The following discussion should be read in conjunction with the preceding unaudited condensed consolidated financial statements of NovaStar Financial, Inc. and its subsidiaries (the “Company” or “NovaStar Financial”) and the notes thereto as well as NovaStar Financial’s annual report to stockholders and annual report on Form 10-K for the fiscal year ended December 31, 2004.

Safe Harbor Statement

“Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995: Statements in this discussion regarding NovaStar Financial, Inc. (“NovaStar Financial” or “NFI”) and its business, which are not historical facts, are “forward-looking statements” that involve risks and uncertainties. Forward looking statements are those that predict or describe future events and that do not relate solely to historical matters. Certain matters discussed in this quarterly report may constitute forward-looking statements within the meaning of the federal securities laws that inherently include certain risks and uncertainties. Actual results and the timing of certain events could differ materially from those projected in or contemplated by the forward-looking statements due to a number of factors, including our ability to generate sufficient liquidity on favorable terms; the size and frequency of our securitizations; interest rate fluctuations on our assets that differ from our liabilities; increases in prepayment or default rates on our mortgage assets; changes in assumptions regarding estimated loan losses and fair value amounts; changes in origination and resale pricing of mortgage loans; our compliance with applicable local, state and federal laws and regulations and the impact of new local, state or federal legislation or regulations or court decisions on our operations; the initiation of margin calls under our credit facilities; the ability of our servicing operations to maintain high performance standards and maintain appropriate ratings from rating agencies; our ability to expand origination volume while maintaining an acceptable level of overhead; our ability to adapt to and implement technological changes; the stability of residential property values; the outcome of litigation or regulatory actions pending against us; the impact of general economic conditions; and other risk factors set forth below under the heading “Risk Factors”. 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.

Overview of Performance

During the six and three months ended June 30, 2005, we reported net income available to common shareholders of $71.4 million and $37.9 million, or $2.49 and $1.29 per diluted share, respectively, as compared to $63.6 million and $34.0 million, or $2.51 and $1.34 per diluted share, for the same periods in 2004.

Our net income available to common shareholders was driven largely by the income generated by our mortgage securities—available-for-sale portfolio, which increased from $389.1 million as of June 30, 2004 to $543.9 million as of June 30, 2005. These securities are retained in the securitization of the mortgage loans we originate and purchase. We securitized $3.7 billion and $1.6 billion of mortgage loans for the six and three months ended June 30, 2005, respectively, as compared to $3.1 billion and $1.4 billion for the same periods in 2004. The increased volume of mortgage loans we securitized is directly attributable to the increase in our loan origination and purchase volume. During the six and three months ended June 30, 2005, we originated and purchased $4.3 billion and $2.4 billion, respectively, in nonconforming, residential mortgage loans, compared to $3.8 billion and $2.0 billion for the same periods in 2004. Although we securitized approximately $600 million more of nonconforming, residential mortgage loans for the six months ended June 30, 2005 as compared to the same period in 2004, our net income available to common shareholders increased only $7.8 million as a result of the decline in profit margins in our mortgage lending and loan servicing segment.

Profit margins within our mortgage lending and loan servicing segment continued to tighten in the first and second quarters of 2005 as short-term rates continued to rise while the coupons on the mortgage loans we originated and purchased remained flat from 2004. One-month LIBOR and the two-year swap rate increased from 1.37% and 3.09%, respectively, at June 30, 2004 to 3.34% and 3.98%, respectively, at June 30, 2005 while the weighted average coupon on our nonconforming originations and purchases for the six months ended June 30, 2005 was 7.6% as compared to 7.6% for the same period in 2004. These factors contributed to the whole loan price used in valuing our mortgage securities at the time of securitization to significantly decrease throughout 2004 and into the first six months of 2005, which is directly correlated to the decrease in gains on

sales of mortgage loans as a percentage of the loans securitized. For the six months and three months ended June 30, 2005, the weighted average net whole loan price used in the initial valuation of our retained securities was 102.55 and 102.86, respectively, compared to 104.01 and 103.14 for the same periods of 2004. For the six months and three months ended June 30, 2005 the weighted average gain on securitization as a percentage of the collateral securitized was 1.2% and 1.7%, respectively, compared to 2.5% and 1.8% for the same periods of 2004.

As a result of the strong whole-loan pricing environment, we sold $227.2 million in non-conforming mortgage loans to third parties during the six and three months ended June 30, 2005. We recognized a net gain of $4.7 million from these sales. The weighted average price to par of the loans sold was 103.07. There were no non-conforming mortgage loan sales to third parties during 2004.

Additionally, as a result of our interest rate risk management strategies, we recognized gains (losses) on derivative instruments which did not qualify for hedge accounting of $6.8 million and ($7.8) million for the six and three months ended June 30, 2005, respectively, compared to $1.7 million and $27.1 million for the same periods of 2004. During periods of rising rates, these derivative instruments help maintain the net interest margin between our assets and liabilities as well as diminish the effect of changes in general interest rate levels on the market value of our mortgage assets. Of the $6.8 million in gains on derivative instruments for the six months ended June 30, 2005, $5.3 million was related to mark-to-market gains on derivatives transferred into the NMFT Series 2005-1 and 2005-2 securitizations, while $0.4 million was related to mark-to-market gains on derivatives that were still owned by us at June 30, 2005. The remaining difference is attributable to net settlements paid to counterparties.

Summary of Operations and Key Performance Measurements

Our net income is highly dependent upon our mortgage securities—available-for-sale portfolio, which is generated from the securitization of nonconforming loans we have originated and purchased. These mortgage securities represent the right to receive the net future cash flows from a pool of nonconforming loans. Generally speaking, the more nonconforming loans we originate and purchase, the larger our securities portfolio and, therefore, the greater earnings potential. As a result, earnings are related to the volume of nonconforming loans and related performance factors for those loans, including their average coupon, borrower default rate and borrower prepayment rate. Information regarding our lending volume is presented under the heading “Financial Condition as of June 30, 2005 and December 31, 2004—Mortgage Loans.”

The primary function of our mortgage lending operations is to generate nonconforming loans, the majority of which will serve as collateral for our mortgage securities—available-for-sale. While our mortgage lending operations generate sizable revenues in the form of gains on sales of mortgage loans and fee income from borrowers and third party investors, the revenue serves largely to offset the related costs.

We also service the mortgage loans we originate and purchase and that serve as collateral for our mortgage securities—available-for-sale. The servicing function is critical to the management of credit risk (risk of borrower default and the related economic loss) within our mortgage portfolio. Again, while this operation generates significant fee revenue, its revenue serves largely to offset the cost of this function.

The key performance measures for management are:

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net income available to common shareholders

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dollar volume of nonconforming mortgage loans originated and purchased

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relative cost of the loans originated and purchased

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characteristics of the loans (coupon, credit quality, etc.), which will indicate their expected yield, and

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return on our mortgage asset investments and the related management of interest rate risk.

Management’s discussion and analysis of financial condition and results of operations, along with other portions of this report, are designed to provide information regarding our performance and these key performance measures.

Known Material Trends

Over the last ten years, the nonconforming lending market has grown from less than $50 billion annually to approximately $530 billion in 2004 as estimated by the National Mortgage News. A significant portion of these

loans are made to borrowers who are using equity in their primary residence to consolidate low-balance, installment or consumer debt. The nonconforming market has grown through a variety of interest rate environments. One of the main drivers of growth in this market has been the rise in housing prices which gives borrowers the opportunity to use the equity in their home to consolidate their high interest rate, short-term, non-tax deductible consumer or installment debt into lower interest rate, long-term, often tax deductible mortgage debt. Management estimates that NovaStar Financial has a 1-2% share of the non-conforming loan market. While management cannot predict consumer spending and borrowing habits, nor the future value of the residential home market, historical trends indicate that the market in which we operate is relatively stable and should continue to experience long-term growth.

We depend on the capital markets to finance the mortgage loans we originate and purchase. The primary bonds we issue in our loan securitizations are sold to large, institutional investors and United States of America government-sponsored enterprises. The capital markets also provide us with capital to operate our business. The trend has been favorable in the capital markets for the types of securitization transactions we execute. Investor appetite for the bonds created by securitizations has been strong. Additionally, commercial and investment banks have provided significant liquidity to finance our mortgage lending operations through warehouse repurchase facilities. While management cannot predict the future liquidity environment, we are unaware of any material trend that would disrupt continued liquidity support in the capital markets for our business. See the “Liquidity and Capital Resources” section of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for further discussion of liquidity risks and resources available to us.

The continued tightening of margins in the mortgage banking industry could continue to impact our profitability. Competitive pressures are holding mortgage loan coupons generally flat while short-term interest rates continue to increase. See the “Overview of Performance” section for discussion regarding the impact this trend has had on recent performance.

Within the past two years, the mortgage real estate investments trust (“REIT”) industry has seen a significant increase in the desire for raising public capital. Additionally, there have been several new entrants to the mortgage REIT business and other mortgage lenders that have converted to (or that are considering conversion to) REIT status. This increased reliance on the capital markets and increase in number of mortgage REITs may decrease the pricing and increase the underwriting costs of raising equity in the mortgage REIT industry.

State and local governing bodies are focused on the nonconforming lending business and are concerned about borrowers paying “excessive fees” in obtaining a mortgage loan – generally termed “predatory lending”. In several instances, states or local governing bodies have imposed strict laws on lenders to curb predatory lending. To date, these laws have not had a significant impact on our business. We have capped fee structures consistent with those adopted by federal mortgage agencies and have implemented rigid processes to ensure that our lending practices are not predatory in nature.

Description of Businesses

Mortgage Portfolio Management

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

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We operate as a long-term mortgage securities portfolio investor.

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Financing is provided by issuing asset-backed bonds and capital stock and entering into repurchase agreements.

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Earnings are generated from the return on our mortgage securities – available-for-sale and mortgage loan portfolio.

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Our mortgage securities – available-for-sale include AAA- and non-rated interest-only, prepayment penalty, overcollateralization and other subordinated mortgage securities.

Earnings from our portfolio of mortgage loans and securities generate a substantial portion of our earnings. Gross interest income was $133.2 million and $71.1 million for the six and three months ended June 30, 2005, respectively, compared to $104.0 million and $53.7 million for the same periods of 2004. Net interest income before provision for credit losses from the portfolio was $99.6 million and $54.1 million for the six and three months ended June 30, 2005, respectively, compared to $82.6 million and $42.9 million during the same periods of 2004. See our discussion of interest income under the heading “Results of Operations—Net Interest Income”. See Note 12 to our condensed consolidated financial statements for a summary of operating results for mortgage portfolio management.

A significant risk to our operations, relating to our portfolio management, is the risk that interest rates on our assets will not adjust at the same times or amounts that rates on our liabilities adjust. Many of the loans in our portfolio have fixed rates of interest for a period of time ranging from 2 to 30 years. Our funding costs are generally not constant or fixed. We use derivative instruments to mitigate the risk of our cost of funding increasing or decreasing at a faster rate than the interest on the loans (both those on the balance sheet and those that serve as collateral for mortgage securities – available-for-sale).

In certain circumstances, because we enter into interest rate agreements that do not meet the hedging criteria set forth in accounting principles generally accepted in the United States of America, we are required to record the change in the value of derivatives as a component of earnings even though they may reduce our interest rate risk. In times when short-term rates rise or drop significantly, the value of our agreements will increase or decrease, respectively. As a result, we recognized gains (losses) on these derivatives of $6.8 million and ($7.8) million during the six and three months ended June 30, 2005, respectively, compared to $1.7 million and $27.1 million for the same periods in 2004.

Mortgage Lending and Loan Servicing

The mortgage lending operation is significant to our financial results as it produces the loans that ultimately collateralize the mortgage securities – available-for-sale that we hold in our portfolio. During the six and three months ended June 30, 2005, we originated and purchased $4.3 billion and $2.4 billion, respectively, in nonconforming, residential mortgage loans, compared to $3.8 billion and $2.0 billion for the same periods in 2004. The majority of these loans were retained in our servicing portfolio and serve as collateral for our securities. The loans we originate and purchase are sold, either in securitization transactions or in outright sales to third parties. We securitized $3.7 billion and $1.6 billion of mortgage loans for the six and three months ended June 30, 2005, respectively, as compared to $3.1 billion and $1.4 billion for the same periods in 2004. We sold $227.2 million in non-conforming mortgage loans to third parties during the six and three months ended June 30, 2005. There were no non-conforming mortgage loan sales during 2004. We recognized gains on sales of mortgage assets totaling $50.8 million and $32.5 million during the six and three months ended June 30, 2005, respectively, compared to $77.0 million and $25.2 million during the six and three months ended June 30, 2004, respectively. In securitization transactions accounted for as sales, we retain interest-only, prepayment penalty, overcollateralization and other subordinated securities, along with the right to service the loans. See Note 12 to our condensed consolidated financial statements for a summary of operating results for mortgage lending and loan servicing.

Our wholly-owned subsidiary, NovaStar Mortgage, Inc. (“NovaStar Mortgage”), originates and purchases primarily nonconforming, single-family residential mortgage loans. In our nonconforming lending operations, we lend to individuals who generally do not qualify for agency/conventional lending programs because of a lack of available documentation or previous credit difficulties. These types of borrowers are generally willing to pay higher mortgage loan origination fees and interest rates than those charged by conventional lending sources. Because these borrowers typically use the proceeds of the mortgage loans to consolidate debt and to finance home improvements, education and other consumer needs, loan volume is generally less dependent on general levels of interest rates or home sales and therefore less cyclical than conventional mortgage lending.

Our nationwide loan origination network includes wholesale loan brokers, correspondent institutions and direct to consumer operations. We have developed a nationwide network of wholesale loan brokers and mortgage lenders who submit mortgage loans to us. Except for NovaStar Home Mortgage brokers described below, these brokers and mortgage lenders are independent from any of the NovaStar Financial entities. Our sales force, which includes account executives in 40 states, develops and maintains relationships with this network of independent retail brokers. Our correspondent origination channel consists of a network of institutions from which we purchase nonconforming mortgage loans on a bulk or flow basis. Our direct to consumer origination channel consists of call centers, which use telemarketing and internet loan lead sources to originate mortgage loans.

We underwrite, process, fund and service the nonconforming mortgage loans sourced through our broker network in centralized facilities. Further details regarding the loan originations are discussed under the “Financial Condition as of June 30, 2005 and December 31, 2004—Mortgage Loans”.

A significant risk to our mortgage lending operations is liquidity risk – the risk that we will not have financing facilities and cash available to fund and hold loans prior to their sale or securitization. We maintain lending facilities with large banking and investment institutions to reduce this risk. On a short-term basis, we finance mortgage loans using warehouse repurchase agreements. In addition, we have access to facilities secured by our mortgage securities – available-for-sale. Details regarding available financing arrangements and amounts outstanding under those arrangements are included in “Liquidity and Capital Resources”.

For long-term funding, we pool our mortgage loans and issue asset-backed bonds (“ABB”). Primary bonds – AAA through BBB rated – are issued to the public. We retain the interest-only, prepayment penalty, overcollateralization and other subordinated bonds. We also retain the right to service the loans. Prior to 1999, our ABB transactions were executed and designed to meet accounting rules that resulted in securitizations being treated as financing transactions. The mortgage loans and related debt continue to be presented on our condensed consolidated balance sheets, and no gain was recorded. Beginning in 1999, our securitization transactions have been structured to qualify as sales for accounting and income tax purposes. The loans and related bond liability are not recorded in our condensed consolidated financial statements. We do, however, record the value of the securities and servicing rights we retain. Details regarding ABBs we issued can be found in “Financial Condition as of June 30, 2005 and December 31, 2004 – Asset-backed Bonds”.

Loan servicing remains a critical part of our business operation. In the opinion of management, maintaining contact with our borrowers is critical in managing credit risk and in borrower retention. Nonconforming borrowers are more prone to late payments and are more likely to default on their obligations than conventional borrowers. By servicing our loans, we strive to identify problems with borrowers early and take quick action to address problems. Borrowers may be motivated to refinance their mortgage loans either by improving their personal credit or due to a decrease in interest rates. By keeping in close touch with borrowers, we can provide them with information about NovaStar Financial products to encourage them to refinance with us. Mortgage servicing yields fee income for us in the form of fees paid by the borrowers for normal customer service and processing fees. In addition we receive contractual fees approximating 0.50% of the outstanding balance. We serviced $13.6 billion loans as of June 30, 2005 compared to $12.2 billion loans as of December 31, 2004. We recognized $29.5 million and $15.0 million in loan servicing fee income from the securitization trusts during the six and three months ended June 30, 2005, respectively, compared to $18.1 million and $9.7 million for the same periods of 2004. Loan servicing fee income should continue to grow as our servicing portfolio grows. Also, see “Results of Operations—Mortgage Loan Servicing” for further discussion and analysis of the servicing operations.

Branch Operations

In 1999, we opened our retail mortgage broker business operating under the name NHMI. Prior to 2004, many of these NHMI branches were operated as limited liability companies (“LLC”) in which we owned a minority interest in the LLC and the branch manager was the majority interest holder. In December 2003, we decided to terminate the LLC’s effective January 1, 2004. As of January 1, 2004, continuing branches that formerly operated as LLC’s became wholly-owned operating units of NHMI and their financial results are included in our condensed consolidated financial statements. Branch offices offer conforming and nonconforming loans to potential borrowers. Loans are brokered for approved investors, including NovaStar Mortgage. The NHMI branches are considered departmental functions of NHMI under which the branch manager (department head) is an employee of NHMI and receives compensation based on the profitability of the branch (department) as bonus compensation. See Note 12 to our condensed consolidated financial statements for a summary of operating results for our branches.

We routinely close branches and branch managers voluntarily terminate their employment with us, which generally results in the branch’s closure. As the demand for conforming loans declined significantly during 2004 and into 2005, many branches were not able to produce sufficient fees to meet operating expense demands. As a result of these conditions, a significant number of branch managers voluntarily terminated employment with us. We have also terminated many branches when loan production results were substandard. In these terminations, the branch and all operations are eliminated. Note 11 to our condensed consolidated financial statements provides detail regarding the impact of the discontinued operations and modifications to our branch program.

The branch business provides an additional source for mortgage loan originations that, in most cases, we will eventually sell, either in securitizations or in outright sales to third parties. During the six and three months ended June 30, 2005, our branches brokered $882.0 million and $400.7 million in nonconforming loans, respectively, compared to $1.9 billion and $1.1 billion during the same periods in 2004. Of these brokered nonconforming loans, we funded $448.8 million and $250.4 million during the six and three months ended June 30, 2005, respectively compared to $872.1 million and $460.3 million during the same periods in 2004.

Following is a diagram of the industry in which we operate and our loan production including nonconforming and conforming during the first six months of 2005 (in thousands).

LOGO

(A)

A portion of the loans securitized or sold to unrelated parties as of June 30, 2005 were originated prior to 2005, but due to timing were not yet securitized or sold at the end of 2004. Loans originated and purchased during the first six months of 2005 that we have not securitized or sold to unrelated parties as of June 30, 2005 are included in our mortgage loans held-for-sale.

(B)

The AAA-BBB rated securities from the NMFT Series 2005-1 and 2005-2 securitizations were purchased by bond investors during the first six months of 2005.

(C)

The excess cash flow and subordinated bonds retained by NovaStar Financial are from the NMFT Series 2005-1 and 2005-2 securitization transactions, which occurred during the first six months of 2005.

Critical Accounting Estimates

We prepare our condensed 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 liabilities and in recording income and expenses. These estimates are based, in part, on our judgment and assumptions regarding various economic conditions that we believe are reasonable based on facts and circumstances existing at the time of reporting. These estimates affect reported amounts of assets, liabilities and accumulated other comprehensive income at the date of the condensed consolidated financial statements and the reported amounts of income, expenses and other comprehensive income during the periods presented. The following summarizes the components of our condensed consolidated financial statements where understanding accounting policies is critical to understanding and evaluating our reported financial results, especially given the significant estimates used in applying the policies. The discussion is intended to demonstrate the significance of estimates to our financial statements and the related accounting policies. Detailed accounting policies are provided in Note 1 to our 2004 consolidated financial statements contained in our annual report on Form 10-K for the fiscal year ended December 31, 2004. Our critical accounting estimates impact only two of our three 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.

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

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

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Have the transferred assets been isolated from the transferor?

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

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

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Is there an agreement that both obligates and entitles the transferor to repurchase or redeem the transferred assets prior to maturity?

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Have any derivative instruments been transferred?

Generally, we intend to structure our securitizations so that control over the collateral is transferred and the transfer is accounted for as a sale. For resecuritizations, we intend to structure these transactions to be accounted for as secured borrowings.

When these transfers are executed in a manner such that we have surrendered control over the collateral, the transfer is accounted for as a sale. In accordance with SFAS No. 140, a gain or loss on the sale is recognized based on the carrying amount of the financial assets involved in the transfer, allocated between the assets transferred and the retained interests based on their relative fair value at the date of transfer. In a loan securitization, we do retain the right to service the underlying mortgage loans and we also retain certain mortgage securities—available-for-sale issued by the trust (see Mortgage Securities – Available-for-Sale below). As previously discussed, the gain recognized upon securitization depends on, among other things, the estimated fair value of the components of the securitization – the loans or mortgage securities—available-for-sale 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.

We believe the best estimate of the initial value of the securities we retain in a whole loan securitization is derived from the market value of the pooled loans. The initial value of the loans is estimated based on the expected open market sales price of a similar pool. In open market transactions, the purchaser has the right to reject loans at its discretion. In a loan securitization, loans cannot generally be rejected. As a result, we adjust the market price for the loans to compensate for the estimated value of rejected loans. The market price of the securities retained is derived by deducting the percent of net proceeds received in the securitization (i.e. the economic value of the loans transferred) from the estimated adjusted market price for the entire pool of the loans.

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

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

In valuing our mortgage securities—available-for-sale it is also important to understand what portion of the underlying mortgage loan collateral is covered by mortgage insurance. The trust legally assumes the responsibility to pay the mortgage insurance premiums and the rights to receive claims for credit losses. Therefore, we have no obligation to pay these insurance premiums. The cost of the insurance is paid by the trust from proceeds the trust receives from the underlying collateral. This information is significant for valuation as the mortgage insurance significantly reduces the credit losses born by the owner of the loan. Mortgage insurance claims on loans where a defect occurred in the loan origination process will not be paid by the mortgage insurer. The assumptions we use to value our mortgage securities—available-for-sale consider this risk. We discuss mortgage insurance premiums under the heading “Results of Operations—Premiums for Mortgage Loan Insurance”.

For the six months and three months ended June 30, 2005, the weighted average net whole loan price used in the initial valuation of our retained securities was 102.55 and 102.86, respectively, compared to 104.01 and 103.14 for the same periods of 2004. The weighted average initial implied discount rate for the six and three months ended June 30, 2005 was 14% and 13%, respectively, compared to 22% and 24% for the same periods of 2004. As discussed in “Overview of Performance”, the increase in short-term interest rates has caused the whole loan price used in the initial valuation of our retained securities to decrease. If the whole loan market price used in the initial valuation of our mortgage securities—available-for-sale for the six and three months ended June 30, 2005 had increased or decreased by 50 basis points, the initial value of our mortgage securities—available-for-sale and the gain we recognized would have increased or decreased by $18.7 million and $8.3 million, respectively. Information regarding the assumptions we used is discussed under “Mortgage Securities – Available-for-Sale” below.

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

Mortgage Securities – Available-for-Sale. Our mortgage securities – available-for-sale represent beneficial interests we retain in mortgage loan securitization transactions. The beneficial interests we retain in these securitization transactions primarily consist of the right to receive the future cash flows from a pool of securitized mortgage loans which include:

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

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

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

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

As payments are received, they are applied to the cost basis of the mortgage related security. Each period, the accretable yield for each mortgage security is evaluated and, to the extent there has been a change in the estimated cash flows, it is adjusted and applied prospectively. The estimated cash flows change as management’s assumptions for credit losses, borrower prepayments and interest rates are updated. The assumptions are established using internally developed models. We prepare analyses of the yield for each security using a range of these assumptions. The accretable yield used in recording interest income is generally set within a range of base assumptions. The accretable yield is recorded as interest income with a corresponding increase to the cost basis of the mortgage security.

At each reporting period subsequent to the initial valuation of the retained securities, the fair value of mortgage securities—available-for-sale is estimated based on the present value of future expected cash flows to be received. Management’s best estimate of key assumptions, including credit losses, prepayment speeds, the market discount rates and forward yield curves commensurate with the risks involved, are used in estimating future cash flows. To the extent that the cost basis of mortgage securities—available-for-sale exceeds the fair value and the unrealized loss is considered to be other than temporary, an impairment charge is recognized and the amount recorded in accumulated other comprehensive income or loss is reclassified to earnings as a realized loss. During the six and three months ended June 30, 2005, we recorded an impairment loss of $1.7 million and $0.1 million, respectively, compared to $6.1 million and $6.1 million during the same periods of 2004. The impairments were a result of the increase in short-term interest rates during 2004 and the first six months of 2005. While we do use forward yield curves in valuing our securities, the increase in two-year and three-year swap rates during 2004 and the first six months of 2005 was greater than the forward yield curve had anticipated, thus causing a greater than expected decline in value. See Table 3 for a quarterly summary of the cost basis, unrealized gain and fair value of our mortgage securities—available-for-sale.

During 2005, our average security yield has increased to 34.2% and 36.2% for the six and three months ended June 30, 2005, respectively, from 33.4% and 32.4% for the same periods of 2004. The increase is a result of lower than expected credit losses we are experiencing on the loans underlying our mortgage securities, which has led us to adjust the credit loss assumptions on certain securities. The low credit losses can be attributed primarily to the substantial rise in housing prices in recent years. The positive impact of low credit losses has been able to offset the negative impact of the increase in short-term interest rates and prepayment rates. Mortgage securities – available-for-sale income has increased from $65.3 million and $32.1 million for the six and three months ended June 30, 2004, respectively, to $89.0 million and $48.6 million for the same periods of 2005 due to the increase in the average balance of our securities portfolio. If the rates used to accrue income on our mortgage securities during 2005 had increased by 10%, net income during the six and three months ended June 30, 2005 would have increased by $33.8 million and $21.1 million, respectively. If the rates used to accrue income on our mortgage securities during 2005 had decreased by 10%, net income during the six and three months ended June 30, 2005 would have decreased by $14.6 million and $5.3 million, respectively.

As of June 30, 2005, the weighted average discount rate used in valuing our mortgage securities—available-for-sale was 18% as compared to 22% as of December 31, 2004. The weighted-average constant prepayment rate used in valuing our mortgage securities – available-for-sale as of June 30, 2005 was 44 versus 39 as of December 31, 2004. If the discount rate used in valuing our mortgage securities—available-for-sale as of June 30, 2005 had been increased by 5%, the value of our mortgage securities- available-for-sale would have decreased by $28.0 million. If we had decreased the discount rate used in valuing our mortgage securities—available-for-sale by 5%, the value of our mortgage securities—available-for-sale would have increased by $31.1 million.

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

The allowance for credit losses on mortgage loans held-in-portfolio, and therefore the related adjustment to income, is based on the assessment by management of 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 adjustments to operating income. The assumptions used by management regarding key economic indicators are highly uncertain and involve a great deal of judgment.

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

SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (as amended), standardizes the accounting for derivative instruments, including certain instruments embedded in other contracts, by requiring that an entity recognize those items as assets or liabilities in the balance sheet and measure them at fair value. If certain conditions are met, an entity may elect to designate a derivative instrument either as a cash flow hedge, a fair value hedge or a hedge of foreign currency exposure. SFAS No. 133 requires derivative instruments to be recorded at their fair value with hedge ineffectiveness recognized in earnings.

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

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

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

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

Financial Condition as of June 30, 2005 and December 31, 2004

Mortgage Loans. We classify our mortgage loans into two categories: “held-for-sale” and “held-in-portfolio”. Loans we have originated and purchased, 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 repurchase agreements to finance our held-for-sale loans. As such, the fluctuations in mortgage loans held-for-sale and short-term borrowings between December 31, 2004 and June 30, 2005 are dependent on loans we have originated and purchased during the period as well as loans we have sold outright or through securitization transactions.

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—available-for-sale and generate 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. The following table summarizes our loan production for the first two quarters of 2005 and all of 2004. We discuss our cost of production under “Results of Operations—General and Administrative Expenses”. Also, details regarding mortgage loans securitized and the gains recognized during the first six months of 2005 and all of 2004 can be found in Table 9.

Table 1 — Nonconforming Loan Originations and Purchases

(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		FICO Score	Coupon		Percent with Prepayment Penalty
2005:
First quarter	13,100	$	1,947,851	$	148,691	101.2	%	82	%	629	7.6	%	66	%
Second Quarter	15,288		2,357,632		154,215	101.1		82		632	7.6		64

Total	28,388	$	4,305,483	$	151,666	101.2	%	82	%	631	7.6	%	65	%

2004:
First Quarter	12,137	$	1,783,119	$	146,916	101.3	%	82	%	622	7.4	%	74	%
Second Quarter	13,400		1,978,801		147,672	101.2		83		621	7.7		74
Third Quarter	15,825		2,427,412		153,391	101.4		82		621	7.7		74
Fourth Quarter	14,612		2,235,029		152,711	101.3		82		625	7.7		68

Total	55,974	$	8,424,361	$	150,505	101.3	%	82	%	622	7.6	%	72	%

A portion of the mortgage loans on our balance sheet serve as collateral for asset-backed bonds we have issued (that are not accounted for as sales) and are classified as “held-in-portfolio.” The carrying value of “held-in-portfolio” mortgage loans as of June 30, 2005 was $48.6 million compared to $59.5 million as of December 31, 2004.

Premiums to brokers are paid on substantially all mortgage loans. Premiums on mortgage loans held-in-portfolio are amortized as a reduction of interest income over the estimated lives of the loans. For mortgage loans held-for-sale, premiums are deferred until the related loans are sold. To mitigate the effect of prepayments on interest income from mortgage loans, we generally strive to originate and purchase 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. Nonconforming borrowers, as they update their credit rating and as housing prices increase, are more likely to refinance their mortgage loan to obtain a lower interest rate.

The operating performance of our mortgage loan portfolio, including net interest income, allowance for credit losses and effects of hedging, are discussed under “Results of Operations.” Gains on the sales of mortgage loans, including impact of securitizations treated as sales, is also discussed under “Results of Operations.”

Table 2 — Carrying Value of Mortgage Loans

(dollars in thousands)


	June 30, 2005			December 31, 2004
Held-in-portfolio:
Current principal	$	48,482		$	58,859

Premium	$	954		$	1,175

Coupon		10.0	%		10.0	%

Held-for-sale:
Current principal	$	1,036,315		$	719,904

Premium	$	11,101		$	6,760

Coupon		7.5	%		7.7	%

Percent with prepayment penalty		62	%		65	%

Mortgage Securities – Available-for-Sale . Since 1998, we have pooled the majority of the loans we have originated or purchased to serve as collateral for asset-backed bonds in securitizations that are treated as sales for accounting and tax purposes. In these transactions, the loans are removed from our balance sheet. However, we retain excess interest, prepayment penalty and subordinated principal securities. Additionally, we service the loans sold in these securitizations. See “Mortgage Servicing Rights” below. As of June 30, 2005 and December 31, 2004, the fair value of our mortgage securities – available-for-sale was $543.9 million and $489.2 million, respectively. During the first six months of 2005 and 2004 we executed securitizations totaling $3.7 billion and $3.1 billion, respectively, in mortgage loans and retained mortgage securities with a cost basis of $146.2 million and $159.4 million, respectively. See Note 4 to the condensed consolidated financial statements for a summary of the activity in our mortgage securities portfolio.

The value of our mortgage 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 – available-for-sale, 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 judgments about the nature of the loans. The cash flows we receive on our mortgage securities – available-for-sale will be the net of the gross coupon and the bond cost less administrative costs (servicing and trustee fees) and the cost of mortgage insurance. Additionally, if the trust is a party to interest rate agreements, our cash flow will include (exclude) payments from (to) the interest rate agreement counterparty. Table 3 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 – available-for-sale.

In 2002 and 2003, interest expense on asset-backed bonds was unexpectedly low. As a result, the spread between the coupon interest and the bond cost was unusually high and our cost basis in many of our older mortgage securities was significantly reduced. For example, our cost basis in NMFT Series 2000-2, 2001-1 and 2001-2 has been reduced to zero (see Table 3). When our cost basis in the retained securities (interest-only, prepayment penalty and subordinated securities) reaches zero, the remaining future cash flows received on the securities are recognized entirely as income.

The operating performance of our mortgage securities – available-for-sale portfolio, including net interest income and effects of hedging are discussed under “Results of Operations.”

Table 3 — Valuation of Individual Mortgage Securities – Available-for-Sale and Assumptions

(dollars in thousands)


							Current Assumptions						Assumptions at Trust Securitization
	Cost		Unrealized Gain		Estimated Fair Value of Mortgage Securities		Discount Rate		Constant Prepayment Rate		(A) Expected Credit Losses		Discount Rate		Constant Prepayment Rate		(A) Expected Credit Losses
June 30, 2005:
NMFT 1999-1
Subordinated securities	$	7,389	$	3	$	7,392	5	%	32	%	5.0	%	17	%	30	%	2.5	%

NMFT 2000-1
Interest-only		471		837		1,308
Prepayment penalty		—		—		—
Subordinated securities		201		37		238

		672		874		1,546	15		37		1.4		15		27		1.0
NMFT 2000-2
Interest-only		—		1,200		1,200
Prepayment penalty		—		41		41
Subordinated securities		—		122		122

		—		1,363		1,363	15		37		1.0		15		28		1.0
NMFT 2001-1
Interest-only		—		683		683
Prepayment penalty		—		66		66
Subordinated securities		—		858		858

		—		1,607		1,607	20		43		1.1		20		28		1.2
NMFT 2001-2
Interest-only		—		2,630		2,630
Prepayment penalty		—		248		248
Subordinated securities		—		2,684		2,684

		—		5,562		5,562	20		35		0.7		25		28		1.2
NMFT 2002-1
Interest-only		883		1,374		2,257
Prepayment penalty		131		181		312
Subordinated securities		—		3,211		3,211

		1,014		4,766		5,780	20		40		0.7		20		32		1.7
NMFT 2002-2
Interest-only		1,587		75		1,662
Prepayment penalty		—		219		219
Subordinated securities		2,886		966		3,852

		4,473		1,260		5,733	20		43		1.4		25		27		1.6


				Current Assumptions			Assumptions at Trust Securitization
	Cost	Unrealized Gain	Estimated Fair Value of Mortgage Securities	Discount Rate	Constant Prepayment Rate	(A) Expected Credit Losses	Discount Rate	Constant Prepayment Rate	(A) Expected Credit Losses
NMFT 2002-3
Interest-only	4,684	—	4,684
Prepayment penalty	—	740	740
Subordinated securities	4,961	3,636	8,597

	9,645	4,376	14,021	20	43	0.4	20	30	1.0
NMFT 2003-1
Interest-only	10,037	—	10,037
Prepayment penalty	1,163	829	1,992
Subordinated securities	16,794	13,612	30,406

	27,994	14,441	42,435	20	41	1.1	20	28	3.3
NMFT 2003-2
Interest-only	8,551	7,477	16,028
Prepayment penalty	1,450	1,600	3,050
Subordinated securities	3,588	6,333	9,921

	13,589	15,410	28,999	20	42	0.7	28	25	2.7
NMFT 2003-3
Interest-only	11,108	7,382	18,490
Prepayment penalty	2,063	3,426	5,489
Subordinated securities	9,221	6,281	15,502

	22,392	17,089	39,481	20	42	0.8	20	22	3.6
NMFT 2003-4
Interest-only	14,037	3,220	17,257
Prepayment penalty	1,407	5,199	6,606
Subordinated securities	—	9,942	9,942

	15,444	18,361	33,805	20	49	1.1	20	30	5.1
NMFT 2004-1
Interest-only	23,267	2,020	25,287
Prepayment penalty	2,110	6,996	9,106
Subordinated securities	—	11,622	11,622

	25,377	20,638	46,015	20	49	1.7	20	33	5.9
NMFT 2004-2
Interest-only	18,644	4,162	22,806
Prepayment penalty	2,064	6,647	8,711
Subordinated securities	4,675	7,771	12,446

	25,383	18,580	43,963	20	49	1.9	26	31	5.1


	Cost		Unrealized Gain		Estimated Fair Value of Mortgage Securities		Current Assumptions			Assumptions at Trust Securitization
	Cost		Unrealized Gain		Estimated Fair Value of Mortgage Securities		Discount Rate	Constant Prepayment Rate	(A) Expected Credit Losses	Discount Rate	Constant Prepayment Rate	(A) Expected Credit Losses
NMFT 2004-3 (B)		57,697		11,378		69,075	19	48	2.5	19	34	4.5

NMFT 2004-4 (B)		60,451		6,302		66,753	20	45	2.6	26	35	4.0

NMFT 2005-1 (B)		72,045		1		72,046	15	42	3.2	15	37	3.6

NMFT 2005-2 (B)		58,334		1		58,335	13	39	2.1	13	39	2.1

Total	$	401,899	$	142,012	$	543,911

(A)	Represents expected credit losses for the life of the securitization up to the expected date in which the related asset-backed bonds can be called.

(B)	The interest-only, prepayment penalty and subordinated securities are packaged in one bond.


	Cost		Unrealized Gain		Estimated Fair Value of Mortgage Securities		Current Assumptions						Assumptions at Trust Securitization
	Cost		Unrealized Gain		Estimated Fair Value of Mortgage Securities		Discount Rate		Constant Prepayment Rate		(A) Expected Credit Losses		Discount Rate		Constant Prepayment Rate		(A) Expected Credit Losses
December 31, 2004:
NMFT 1999-1
Subordinated securities	$	7,001	$	—	$	7,001	17	%	33	%	4.8	%	17	%	30	%	2.5	%

NMFT 2000-1
Interest-only		—		352		352
Prepayment penalty		—		28		28
Subordinated securities		681		158		839

		681		538		1,219	15		46		1.2		15		27		1.0
NMFT 2000-2
Interest-only		—		2,019		2,019
Prepayment penalty		—		105		105
Subordinated securities		—		166		166

		—		2,290		2,290	15		34		1.0		15		28		1.0

NMFT 2001-1
Interest-only		—		2,262		2,262
Prepayment penalty		—		161		161
Subordinated securities		—		688		688

		—		3,111		3,111	20		37		1.1		20		28		1.2

NMFT 2001-2
Interest-only		—		6,182		6,182
Prepayment penalty		—		458		458
Subordinated securities		—		1,961		1,961

		—		8,601		8,601	25		33		0.8		25		28		1.2

NMFT 2002-1
Interest-only		3,553		242		3,795
Prepayment penalty		111		457		568
Subordinated securities		1,314		5,413		6,727

		4,978		6,112		11,090	20		42		0.9		20		32		1.7

NMFT 2002-2
Interest-only		2,713		—		2,713
Prepayment penalty		151		251		402
Subordinated securities		2,184		1,391		3,575

		5,048		1,642		6,690	25		40		1.4		25		27		1.6


	Cost		Unrealized Gain		Estimated Fair Value of Mortgage Securities		Current Assumptions			Assumptions at Trust Securitization
	Cost		Unrealized Gain		Estimated Fair Value of Mortgage Securities		Discount Rate	Constant Prepayment Rate	(A) Expected Credit Losses	Discount Rate	Constant Prepayment Rate	(A) Expected Credit Losses
NMFT 2002-3
Interest-only		8,148		—		8,148
Prepayment penalty		509		686		1,195
Subordinated securities		2,387		3,131		5,518

		11,044		3,817		14,861	20	41	0.7	20	30	1.0
NMFT 2003-1
Interest-only		17,963		363		18,326
Prepayment penalty		2,316		956		3,272
Subordinated securities		11,783		3,912		15,695

		32,062		5,231		37,293	20	39	1.8	20	28	3.3
NMFT 2003-2
Interest-only		15,404		2,422		17,826
Prepayment penalty		4,089		2,133		6,222
Subordinated securities		2,487		3,368		5,855

		21,980		7,923		29,903	28	38	1.5	28	25	2.7

NMFT 2003-3
Interest-only		20,825		3,449		24,274
Prepayment penalty		5,108		3,427		8,535
Subordinated securities		6,842		2,363		9,205

		32,775		9,239		42,014	20	37	1.6	20	22	3.6

NMFT 2003-4
Interest-only		21,466		5,480		26,946
Prepayment penalty		4,994		5,408		10,402
Subordinated securities		—		6,839		6,839

		26,460		17,727		44,187	20	44	1.7	20	30	5.1

NMFT 2004-1
Interest-only		35,731		—		35,731
Prepayment penalty		6,816		5,968		12,784
Subordinated securities		—		1,335		1,335

		42,547		7,303		49,850	20	43	3.5	20	33	5.9

NMFT 2004-2
Interest-only		31,062		—		31,062
Prepayment penalty		5,313		4,814		10,127
Subordinated securities		3,481		881		4,362

		39,856		5,695		45,551	26	41	3.8	26	31	5.1

NMFT 2004-3 (B)		89,442		—		89,442	19	39	3.9	19	34	4.5

NMFT 2004-4 (B)		96,072		—		96,072	26	36	3.7	26	35	4.0

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

(A) Represents expected credit losses for the life of the securitization up to the expected date in which the related asset-backed bonds can be called.

(B) The interest-only, prepayment penalty and subordinated securities are packaged in one bond.

The following table summarizes the cost basis, unrealized gain and fair value of our mortgage securities—available-for-sale grouped by year of issue. For example, under the “Y ear of Issue for Mortgage Securities Retained” column, the year 2003 is a combination of NMFT Series 2003-1, NMFT Series 2003-2, NMFT Series 2003-3 and NMFT Series 2003-4.

Table 4 — Summary of Mortgage Securities – Available-for-Sale Retained by Year of Issue

(in thousands)


Year of Issue for Mortgage Securities Retained	2005
	As of June 30						As of March 31
	Cost		Unrealized Gain		Fair Value		Cost		Unrealized Gain		Fair Value
1999	$	7,389	$	3	$	7,392	$	7,150	$	32	$	7,182
2000		672		2,237		2,909		800		2,307		3,107
2001		—		7,169		7,169		—		9,129		9,129
2002		15,132		10,402		25,534		19,112		12,283		31,395
2003		79,419		65,301		144,720		91,112		54,209		145,321
2004		168,908		56,898		225,806		213,694		33,297		246,991
2005		130,379		2		130,381		87,453		—		87,453

Total	$	401,899	$	142,012	$	543,911	$	419,321	$	111,257	$	530,578


Year of Issue for Mortgage Securities Retained	2004
	As of December 31						As of September 30						As of June 30						As of March 31
	Cost		Unrealized Gain		Fair Value		Cost		Unrealized Gain		Fair Value		Cost		Unrealized Gain		Fair Value		Cost		Unrealized Gain		Fair Value
1999	$	7,001	$	—	$	7,001	$	6,818	$	—	$	6,818	$	6,597	$	—	$	6,597	$	6,353	$	185	$	6,538
2000		681		2,828		3,509		539		3,046		3,585		412		5,161		5,573		1,298		8,194		9,492
2001		—		11,712		11,712		—		16,064		16,064		321		20,910		21,231		233		27,579		27,812
2002		21,070		11,571		32,641		23,978		14,181		38,159		29,202		14,067		43,269		36,201		18,899		55,100
2003		113,277		40,120		153,397		142,796		28,458		171,254		184,097		8,841		192,938		226,676		16,090		242,766
2004		267,917		12,998		280,915		218,898		7,709		226,607		118,684		758		119,442		60,961		1,334		62,295

Total	$	409,946	$	79,229	$	489,175	$	393,029	$	69,458	$	462,487	$	339,313	$	49,737	$	389,050	$	331,722	$	72,281	$	404,003

Mortgage Securities – Trading. Mortgage securities – trading consists of mortgage securities purchased by us that we intend to sell in the near term. These securities are recorded at fair value with gains and losses, realized and unrealized, included in earnings. As of December 31, 2004, mortgage securities—trading consisted of an adjustable-rate mortgage-backed security with a fair market value of $143.2 million. For the year ended December 31, 2004, we recorded no gains or losses related to the security. As of December 31, 2004, we had pledged the security as collateral for financing purposes. During the first quarter of 2005, we sold this security. No gain or loss was recognized on this security during the six months ended June 30, 2005.

Mortgage Servicing Rights . As discussed under “Mortgage Securities – Available for Sale” above, we retain the right to service mortgage loans we originate, purchase and have securitized. Servicing rights for loans we sell to third parties are not retained and we have not purchased the right to service loans. As of June 30, 2005, we have $49.7 million in capitalized mortgage servicing rights compared with $42.0 million as of December 31, 2004. The carrying value of the mortgage servicing rights we retained in our securitizations during the first six months of 2005 and 2004 was $20.4 million and $13.9 million, respectively. Amortization of

mortgage servicing rights was $12.7 million and $7.0 million for the six and three months ended June 30, 2005, respectively, compared to $7.1 million and $3.9 million for the same periods of 2004.

Servicing Related Advances. Advances on behalf of borrowers for taxes, insurance and other customer service functions are made by NovaStar Mortgage and aggregated $20.9 million as of June 30, 2005 compared with $20.2 million as of December 31, 2004.

Property and equipment, net. Property and equipment primarily includes office and computer equipment, furniture and fixtures and leasehold improvements. Property and equipment, net decreased to $14.8 million as of June 30, 2005 from $15.5 million as of December 31, 2004.

Derivative Instruments, net. Derivative instruments, net decreased from $18.8 million at December 31, 2004 to $12.9 million at June 30, 2005. These amounts include the collateral (margin deposits) required under the terms of our derivative instrument contracts, net of the derivative instrument market values. Due to the nature of derivative instruments we use, the margin deposits required will generally increase as interest rates decline and decrease as interest rates rise. On the other hand, the market value of our derivative instruments will decline as interest rates decline and increase as interest rates rise.

Other Assets . Included in other assets are receivables from securitizations, warehouse loans receivable, tax assets and other miscellaneous assets. Our receivables from securitizations were $8.1 million and $4.8 million at June 30, 2005 and December 31, 2004, respectively. These receivables represent cash due to us on our mortgage securities—available-for-sale. As of June 30, 2005 we had warehouse loans receivable of $11.5 million, compared to $5.9 as of December 31, 2004. In 2004, we began lending to independent mortgage loan brokers in an effort to strengthen our relationships with these brokers and, in turn, increase our nonconforming loan production. As of June 30, 2005, we had a deferred tax asset of $13.9 million compared to $11.2 million as of December 31, 2004. As of June 30, 2005, we had a current tax receivable of $17.3 million compared to $17.2 million as of December 31, 2004.

Short-term Borrowings. Mortgage loan originations and purchases are funded with various financing facilities prior to securitization. Repurchase agreements are used as interim, short-term financing before loans are transferred in our securitization transactions. The balances outstanding under our short-term repurchase agreements fluctuate based on lending volume, equity issuances, financing activities and cash flows from other operating and investing activities. As shown in Table 5, we have $343.4 million in immediately available funds as of June 30, 2005. We have borrowed approximately $1.1 billion of the $3.7 billion in mortgage securities and mortgage loans repurchase facilities, leaving approximately $2.6 billion available to support the mortgage lending and mortgage portfolio operations. See “Liquidity and Capital Resources” for a further discussion of liquidity risks and resources available to us.

Table 5 — Short-term Financing Resources

(in thousands)


	Credit Limit		Lending Value of Collateral		Borrowings		Immediately Available Funds
Unrestricted cash							$	317,591
Mortgage securities and mortgage loans repurchase facilities.	$	3,650,000	$	1,080,685	$	1,054,889		25,796
Other.		50,000		9,992		9,992		—

Total.	$	3,700,000	$	1,090,677	$	1,064,881	$	343,387

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 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. While the principal balances have fallen below the required thresholds, we have not exercised our right to repurchase any loans and repay bond obligations. As of June 30, 2005 and December 31, 2004, we had asset-backed bonds secured by mortgage loans outstanding of $43.2 million and $53.5 million, respectively.

During the first six months of 2005, we issued asset-backed bonds, Net Interest Margin Securities, totaling $130.9 million. This NIM is secured by the interest-only, prepayment penalty and subordinated mortgage securities of our mortgage securities – available-for-sale and is a form of long-term financing. The resecuritization was structured as a secured borrowing for financial reporting and income tax purposes. In accordance with SFAS No. 140, control over the transferred assets was not surrendered and thus the transaction was considered a financing for the mortgage securities—available-for-sale transferred. Therefore, the mortgage securities are recorded as assets and the asset-backed bonds are recorded as debt. As of June 30, 2005 and December 31, 2004 we had asset-backed bonds secured by mortgage securities – available-for-sale outstanding of $286.6 million and $336.4 million, respectively.

Junior subordinated debentures. During 2005, we issued unsecured floating rate trust preferred securities to obtain low cost long-term funds. The trust preferred securities are redeemable, at our option, in whole or in part, anytime without penalty on or after March 15, 2010, but are mandatorily redeemable when they mature on March 15, 2035. As of June 30, 2005, our liability related to the junior subordinated debentures was $48.5 million. See Note 6 to our condensed consolidated financial statements for additional detail regarding this transaction.

Dividends Payable. As of June 30, 2005, our dividends payable was $42.9 million compared to $73.4 million as of December 31, 2004. The number of common shares outstanding as of the end of the period and the dividend declared per common share determines the amount of this liability.

Due to securitization trusts. Due to securitization trusts represents the fair value of the loans we have the right to repurchase from the securitization trusts. The servicing agreements we execute for loans we have securitized include a removal of accounts provision which gives us the right, not the obligation, to repurchase mortgage loans from the trust. The removal of accounts provision can be exercised for loans that are 90 days to 119 days delinquent. As of June 30, 2005 and December 31, 2004, our liability related to this provision was $26.7 million and $20.9 million, respectively.

Accounts Payable and Other Liabilities . Included in accounts payable and other liabilities are accrued payroll, interest rate cap agreements premium payable, lease obligations and other liabilities. Our accrued payroll decreased from $24.5 million at December 31, 2004 to $23.9 million at June 30, 2005. Our payable regarding interest rate cap agreement premiums increased from $1.9 million at December 31, 2004 to $5.8 million at June 30, 2005 because we have purchased more interest rate cap agreements as a result of the current and expected interest rate environment. Our lease obligations and deferred lease incentive increased to $5.5 million at June 30, 2005 from $5.2 million at December 31, 2004.

Stockholders’ Equity . The increase in our stockholders’ equity as of June 30, 2005 compared to December 31, 2004 is a result of the following increases and decreases.

Stockholders’ equity increased by:

•

$101.6 million due to issuance of common stock

•

$74.7 million due to net income recognized for the six months ended June 30, 2005

•

$61.0 million due to increase in unrealized gains on mortgage securities classified as available-for-sale

•

$1.7 million due to impairment on mortgage securities – available for sale reclassified to earnings

•

$1.1 million due to compensation recognized under stock option plan

•

$0.5 million due to issuance of stock under stock compensation plans

•

$0.1 million due to forgiveness of founders’ notes receivable, and

•

$0.1 million due to net settlements on cash flow hedges reclassified to earnings.

Stockholders’ equity decreased by:

•

$83.3 million due to dividends accrued or paid on common stock, and

•

$3.3 million due to dividends accrued or paid on preferred stock.

Results of Operations

Continuing Operations . During the six and three months ended June 30, 2005, we earned income from continuing operations available to common shareholders of $72.4 million and $37.9 million, or $2.53 and

$1.29 per diluted share, respectively, compared with income from continuing operations available to common shareholders of $67.4 million and $36.1 million, or $2.66 and $1.42 per diluted share, for the same periods of 2004.

Our primary sources of revenue are interest earned on our mortgage loan and securities portfolios, fee income and gains on sales from the securitizations of mortgage loans. As discussed under “Overview of Performance,” income from continuing operations available to common shareholders increased during the first six months of 2005 as compared to the same period of 2004 due primarily to higher volumes of average mortgage securities - available-for-sale held as a result of higher mortgage loan originations and purchases securitized. The effects of the higher mortgage security volume are displayed in Table 6. Details regarding higher mortgage loan origination and purchase volumes and gains on securitization of these assets are shown in Tables 1, 8 and 9.

Within our mortgage portfolio management segment, we earned income from continuing operations of $81.4 million and $45.7 million for the six and three months ended June 30, 2005, respectively, compared to $59.2 million and $27.9 million for the same periods of 2004. This increase is primarily attributable to the increase in our net interest income on our mortgage securities - available-for-sale which is driven by the increase in our mortgage securities – available-for-sale retained. Our mortgage lending and loan servicing segment reported (loss) income from continuing operations of $(2.4) million and $(4.0) million for the six and three months ended June 30, 2005, respectively, compared to $11.0 million and $9.2 million for the same periods of 2004. This decrease is primarily attributable to the decrease in profit margins as discussed in “Overview of Performance”. Our branch operations segment reported a loss from continuing operations of $1.7 million and $1.1 million for the six and three months ended June 30, 2005, respectively, compared to $0.3 million and $0.1 million for the same periods of 2004. Note 12 to the condensed consolidated financial statements presents an income statement for our three segments.

Discontinued Operations. As the demand for conforming loans declined significantly during 2004 and into 2005, many branches have not been able to produce sufficient fees to meet operating expense demands. As a result of these conditions, a significant number of branch managers voluntarily terminated employment with us. We also terminated branches when loan production results were substandard. In these terminations, the branch and all operations are eliminated. The operating results for these discontinued operations have been segregated from our on-going operating results. Our (loss) income from discontinued operations net of income tax for the six and three months ended June 30, 2005 was $(1.1) million and approximately $6,000, respectively, compared with $(3.8) million and $(2.1) million for the same periods in 2004. Note 11 to our condensed consolidated financial statements provides detail regarding the impact of the discontinued operations.

Net Interest Income. Our mortgage securities available-for-sale primarily represent our ownership in the net cash flows of the underlying mortgage loan collateral in excess of bond expenses and cost of funding. The cost of funding is indexed to one-month LIBOR and resets monthly while the coupon on the mortgage loan collateral adjusts more slowly depending on the contractual terms of the loan. In 2002, we began transferring interest rate agreements at the time of securitization into the securitization trusts to help provide protection to the third-party bondholders from interest rate risk. These agreements reduce interest rate risk within the trust and, as a result, the cash flows we receive on our interest-only securities are less volatile as interest rates change. As discussed under the heading “Mortgage Securities - Available-for-Sale” in the “Critical Accounting Estimates” section, the fact that we adjusted the credit loss assumptions on certain of our mortgage securities - available-for-sale because we have been experiencing much lower than expected credit losses has caused an increase in the average net yield on our securities from 29.7% and 28.7% for the six and three months ended June 30, 2004, respectively, to 30.3% and 32.8% for the same periods of 2005, as shown in Table 6.

While the spreads on our securities have decreased, the overall interest income continues to be high due to the sizeable increase in our mortgage securities - available-for-sale retained. As shown in Tables 6 and 7, the average value of our mortgage securities - available-for-sale increased from $391.8 million and $396.5 million during the six and three months ended June 30, 2004, respectively, to $521.2 million and $537.2 million during the six and three months ended June 30, 2005, respectively. The average balance of mortgage loans collateralizing our securities increased from $7.3 billion and $7.8 billion for the six and three months ended June 30, 2004, respectively, to $11.8 billion and $12.1 billion for the same periods in 2005. We expect to increase the amount of mortgage securities - available-for-sale we own as we securitize the mortgage loans we originate and purchase.

Table 6 is a summary of the interest income and expense related to our mortgage securities – available-for-sale and the related yields as a percentage of the fair market value of these securities for the six and three months ended June 30, 2005 and 2004.

Table 6 — Mortgage Securities Interest Analysis

(dollars in thousands)


	For the Six Months Ended June 30,						For the Three Months Ended June 30,
	2005			2004			2005			2004
Average fair market value of mortgage securities – available-for-sale	$	521,221		$	391,780		$	537,245		$	396,527
Average borrowings		322,497			309,568			289,481			333,926

Interest income		89,036			65,333			48,573			32,137
Interest expense		10,180			7,186			4,573			3,646

Net interest income	$	78,856		$	58,147		$	44,000		$	28,491

Yields:
Interest income		34.2	%		33.4	%		36.2	%		32.4	%
Interest expense		6.3			4.6			6.3			4.4

Net interest spread		27.9	%		28.8	%		29.9	%		28.0	%

Net Yield		30.3	%		29.7	%		32.8	%		28.7	%

Net interest income on mortgage loans represents income on loans held-for-sale during their warehouse period as well as loans held-in-portfolio, which are maintained on our balance sheet as a result of the four securitization transactions we executed in 1997 and 1998. The net interest income from mortgage loans is primarily driven by loan volume and the amount of time held-for-sale loans are in the warehouse. Net interest income on mortgage loans before other expense decreased from $24.4 million and $14.5 million for the six and three months ended June 30, 2004, respectively, to $21.7 million and $11.0 million for the same periods in 2005. The decrease is a result of rising short-term rates while the coupons on the mortgage loans we originated and purchased remained flat from 2004.

Future net interest income will be dependent upon the size and volume of our mortgage securities—available-for-sale and loan portfolios and economic conditions.

Our portfolio income comes from mortgage loans either directly (mortgage loans held-in-portfolio) or indirectly (mortgage securities). Table 7 attempts to look through the balance sheet presentation of our portfolio income and present income as a percentage of average assets under management. The net interest income for mortgage securities – available-for-sale, mortgage loans held-for-sale and mortgage loans held-in-portfolio reflects the income after interest expense, hedging, prepayment penalty income and credit expense (mortgage insurance and credit losses). This metric allows us to be more easily compared to other finance companies or financial institutions that use on balance sheet portfolio accounting, where return on assets is a common performance calculation.

Our portfolio net interest yield on assets was 1.53% and 1.68% for the six and three months ended June 30, 2005, respectively, as compared to 1.69% and 1.64% for the same periods of 2004. The decrease in yield for the comparable six-month period is a result of the increase in short-term interest rates from 2004 to 2005. The slight increase in yield for the comparable three-month period can be attributed to the lower than expected credit losses which resulted in the lowering of our credit loss assumptions on certain mortgage securities available-for-sale as previously discussed. Table 7 shows the net interest yield in assets under management and the return on assets during the six and three months ended June 30, 2005 and 2004.

Table 7 — Mortgage Portfolio Management Net Interest Income Analysis

(dollars in thousands)


	Mortgage Securities – Available-for-Sale			Mortgage Loans Held-for-Sale			Mortgage Loans Held-in-Portfolio			Total
For the Six Months Ended:	Mortgage Securities – Available-for-Sale			Mortgage Loans Held-for-Sale			Mortgage Loans Held-in-Portfolio			Total
June 30, 2005
Interest income	$	89,036		$	41,709		$	2,441		$	133,186
Interest expense:
Short-term borrowings (A)		1,557			21,378			—			22,935
Asset-backed bonds		8,623			—			845			9,468
Cash flow hedging net settlements		—			180			—			180

Total interest expense (B)		10,180			21,558			845			32,583

Mortgage portfolio net interest income before other expense		78,856			20,151			1,596			100,603
Other income (expense) (C)		1,652			(2,524	)		(781	)		(1,653	)

Mortgage portfolio net interest income	$	80,508		$	17,627		$	815		$	98,950

Average balance of the underlying loans	$	11,830,353		$	1,066,092		$	52,040		$	12,948,485
Net interest yield on assets		1.36	%		3.31	%		3.13	%		1.53	%

June 30, 2004
Interest income	$	65,333		$	34,910		$	3,792		$	104,035
Interest expense:
Short-term borrowings (A)		2,343			10,992			—			13,335
Asset-backed bonds		4,843			—			691			5,534
Cash flow hedging net settlements		—			1,023			1,558			2,581

Total interest expense (B)		7,186			12,015			2,249			21,450

Mortgage portfolio net interest income before other expense		58,147			22,895			1,543			82,585
Other expense (C)		—			(11,460	)		(954	)		(12,414	)

Mortgage portfolio net interest income	$	58,147		$	11,435		$	589		$	70,171

Average balance of the underlying loans	$	7,292,642		$	918,592		$	80,319		$	8,291,553
Net interest yield on assets		1.59	%		2.49	%		1.47	%		1.69	%


	Mortgage Securities – Available-for-Sale			Mortgage Loans Held-for-Sale			Mortgage Loans Held-in-Portfolio			Total
For the Three Months Ended:	Mortgage Securities – Available-for-Sale			Mortgage Loans Held-for-Sale			Mortgage Loans Held-in-Portfolio			Total
June 30, 2005
Interest income	$	48,573		$	21,430		$	1,128		$	71,131
Interest expense:
Short-term borrowings (A)		757			11,115			—			11,872
Asset-backed bonds		3,816			—			428			4,244
Cash flow hedging net settlements		—			—			—			—

Total interest expense (B)		4,573			11,115			428			16,116

Mortgage portfolio net interest income before other expense		44,000			10,315			700			55,015
Other income (expense) (C)		936			(356	)		(63	)		517

Mortgage portfolio net interest income	$	44,936		$	9,959		$	637		$	55,532

Average balance of the underlying loans	$	12,123,339		$	1,080,136		$	49,650		$	13,253,125
Net interest yield on assets		1.48	%		3.69	%		5.13	%		1.68	%

June 30, 2004
Interest income	$	32,137		$	19,794		$	1,745		$	53,676
Interest expense:
Short-term borrowings (A)		1,151			6,237			—			7,388
Asset-backed bonds		2,495			—			327			2,822
Cash flow hedging net settlements		—			304			215			519

Total interest expense (B)		3,646			6,541			542			10,729

Mortgage portfolio net interest income before other expense		28,491			13,253			1,203			42,947
Other expense (C)		—			(5,605	)		(663	)		(6,268	)

Mortgage portfolio net interest income	$	28,491		$	7,648		$	540		$	36,679

Average balance of the underlying loans	$	7,814,961		$	1,057,906		$	76,612		$	8,949,479
Net interest yield on assets		1.46	%		2.89	%		2.82	%		1.64	%

(A) Primarily includes mortgage loan and securities repurchase agreements.

(B) Does not include interest expense related to the junior subordinated debentures.

(C) Other expense includes net settlements on non-cash flow hedges and credit expense (mortgage insurance and provision for credit losses).

Impact of Interest Rate Agreements. We have executed interest rate agreements designed to mitigate exposure to interest rate risk on short-term borrowings. Interest rate cap agreements require us to pay either a one-time “up front” premium or a monthly or quarterly premium, while allowing us to receive a rate that adjusts with LIBOR when rates rise above a certain agreed-upon rate. Interest rate swap agreements allow us to pay a fixed rate of interest while receiving a rate that adjusts with one-month LIBOR. These agreements are used to alter, in effect, the interest rates on funding costs to more closely match the yield on interest-earning assets. We incurred expenses of $0.2 million and zero related to net settlements of our interest rate agreements classified as cash flow hedges for the six and three months ended June 30, 2005, respectively, compared to $2.6 million and $0.5 million for the same periods of 2004. We received $1.0 million and $1.7 million related to net settlements of our interest rate agreements classified as non-cash flow hedges for the six and three months ended June 30, 2005, respectively. Comparatively, we incurred expenses of $10.2 million and $4.8 million for the six and three months ended June 30, 2004, respectively. Fluctuations in these expenses are solely dependent upon the movement in LIBOR as well as our average notional amount outstanding.

Provision for Credit Losses. We originate, purchase and own loans in which the borrower possesses credit risk higher than that of conforming borrowers. Delinquent loans and losses are expected to occur. We

maintain an allowance for credit losses for our mortgage loans – held-in-portfolio. Provisions for credit losses are made in amounts considered necessary to maintain an allowance at a level sufficient to cover probable losses inherent in the loan portfolio. Charge-offs are recognized at the time of foreclosure by recording the value of real estate owned property at its estimated realizable value. One of the principal methods used to determine probable losses is a delinquency migration analysis. This analysis takes into consideration historical information regarding foreclosure and loss severity experience and applies that information to the portfolio at the reporting date.

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

During the six and three months ended June 30, 2005 we recognized provision for credit losses of $0.7 million and $0.1 million, respectively, compared with provision for credit losses of $0.7 million and $0.5 million for the six and three months ended June 30, 2004, respectively. We incurred net charge-offs of $0.4 million and $0.2 million for the six and three months ended June 30, 2005, respectively, compared to $1.1 million and $0.8 million for the same periods of 2004.

Fee Income. Fee income primarily consists of broker fees and service fee income. Due to the elimination of the LLC’s and their subsequent inclusion in the condensed consolidated financial statements, branch management fees are eliminated in consolidation.

Broker fees are received from third party investors for placing loans with them and are based on negotiated rates with each lender to whom we broker loans. Revenue is recognized upon loan origination.

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

Overall, fee income increased from $29.2 million and $12.7 million for the six and three months ended June 30, 2004, respectively, to $31.7 million and $15.4 million for the same periods of 2005 primarily due to the increase in our servicing portfolio from $9.6 billion as of June 30, 2004 to $13.6 billion as of June 30, 2005. The increase in fee income as a result of the increase in our servicing portfolio was offset by the decline in broker fees, which resulted from lower retail origination volume placed with third-party investors.

Gains on Sales of Mortgage Assets and Gains (Losses) on Derivative Instruments. We execute securitization transactions in which we transfer mortgage loan collateral to an independent trust. The trust holds the mortgage loans as collateral for the securities it issues to finance the sale of the mortgage loans. In those transactions, certain securities are issued to entities unrelated to us, and we retain the interest-only, prepayment penalty and non-investment grade subordinated securities. In addition, we continue to service the loan collateral. These transactions were structured as sales for accounting and income tax reporting during the six and three months ended June 30, 2005 and 2004. 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 9 provides a summary of mortgage loans transferred in securitizations.

We sold $227.2 million in non-conforming mortgage loans to third parties during the three months ended June 30, 2005. We recognized a net gain of $4.7 million from these sales. The weighted average price to par of the loans sold was 103.07. There were no non-conforming mortgage loan sales during the first quarter of 2005 or during 2004.

We have entered into derivative instrument contracts that do not meet the requirements for hedge accounting treatment, but contribute to our overall risk management strategy by serving to reduce interest

rate risk related to short-term borrowing rates. Changes in the fair value of these derivative instruments are credited or charged to current earnings. We recognized gains of $6.8 million and losses of $7.8 million during the six and three months ended June 30, 2005, respectively, compared to gains of $1.7 million and $27.1 million for the same periods of 2004.

Table 8 provides the components of our gains on sales of mortgage assets and gains (losses) on derivative instruments.

Table 8 — Gains on Sales of Mortgage Assets and Gains (Losses) on Derivative Instruments

(in thousands)


	For the Six Months Ended June 30,				For the Three Months Ended June 30,
	2005		2004		2005			2004
Gains on sales of mortgage loans transferred in securitizations	$	45,884	$	75,980	$	27,748		$	24,888
Gains on sales of mortgage loans to third parties – nonconforming		4,724		—		4,724			—
Gains on sales of mortgage loans to third parties – conforming		147		851		—			365
(Losses) gains on sales of real estate owned		16		123		53			(79	)

Gains on sales of mortgage assets		50,771		76,954		32,525			25,174
Gains (losses) on derivatives		6,753		1,717		(7,848	)		27,115

Net gains on sales of mortgage assets and derivative instruments	$	57,524	$	78,671	$	24,677		$	52,289

Table 9 — Mortgage Loan Securitizations

(dollars in thousands)


	Mortgage Loans Transferred in Securitizations
For the Year Ended December 31,	Principal Amount		Net Gain Recognized		Initial Cost Basis of Mortgage Securities		Weighted Average Assumptions Underlying Initial Value of Mortgage Securities – Available-for-Sale
For the Year Ended December 31,	Principal Amount		Net Gain Recognized		Initial Cost Basis of Mortgage Securities		Constant Prepayment Rate		Discount Rate		Expected Total Credit Losses, Net of Mortgage Insurance
2005:
First quarter	$	2,100,000	$	18,136	$	88,433	37	%	15	%	3.63	%
Second quarter		1,649,289		27,748		57,784	39		13		2.10

Total	$	3,749,289	$	45,884	$	146,217	38	%	14	%	2.96	%


2004:
First quarter	$	1,702,658	$	51,092	$	82,785	32	%	20	%	5.69	%
Second quarter		1,367,430		24,888		76,565	32		24		5.42
Third quarter		2,759,716		46,551		127,572	33		21		4.61
Fourth quarter		2,500,000		21,721		94,911	35		26		3.98

Total	$	8,329,804	$	144,252	$	381,833	33	%	22	%	4.77	%

Table 9 further illustrates the fact that housing prices have enjoyed substantial appreciation in recent years which has resulted in prepayment rates increasing while credit losses are decreasing. Also illustrated by Table 9 is the fact that profit margins are down as the market discount rates we are using to initially value our mortgage securities have declined from 2004.

Even though profit margins are down considerably from 2004, we were able to increase our profit margins from the first quarter of 2005. We recognized a higher net gain as a percentage of the principal amount in the second quarter of 2005 as compared to the first quarter of 2005 as a result of the decrease in short-term interest rates and the decrease in our cost of production in the second quarter of 2005. The net gain recognized in the second quarter of 2005 was 1.68% as compared to 0.86% in the first quarter of 2005.

Premiums for Mortgage Loan Insurance. The use of mortgage insurance is one method of managing the credit risk in the mortgage asset portfolio. Premiums for mortgage insurance on loans maintained on our balance sheet are paid by us and are recorded as a portfolio cost and included in the income statement under the caption “Premiums for Mortgage Loan Insurance”. These premiums totaled $2.0 million and $1.0 million for the six and three months ended June 30, 2005, respectively, compared to $1.6 million and $1.0 million for the same periods of 2004. We received mortgage insurance proceeds on claims filed of $0.4 million and $0.2 million for the six and three months ended June 30, 2005, respectively, compared to $1.5 million and $0.4 million for the same periods of 2004.

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

We intend to continue to use mortgage insurance coverage as a credit management tool as we continue to originate, purchase and securitize mortgage loans. Mortgage insurance claims on loans where a defect occurred in the loan origination process will not be paid by the mortgage insurer. The assumptions we use to value our mortgage securities—available-for-sale consider this risk. For the NMFT Series 2005-1 and 2005-2 securitizations, the mortgage loans that were transferred into the trust had mortgage insurance coverage at the time of transfer of 44% and 69% of total principal, respectively. As of June 30, 2005, 48% of the total principal of our securitized loans had mortgage insurance coverage compared to 45% as of December 31, 2004.

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

Other Income, net. Included in other income, net is primarily interest income on our cash accounts and deposits with derivative instrument counterparties (swap margin). Other income, net increased from $2.6 million and $1.5 million for the six and three months ended June 30, 2004, respectively, to $8.4 million and $4.8 million for the same periods of 2005. This increase is a result of higher average cash balances in bank accounts where we earn income on the average collected balances. In addition, we are earning higher rates on these balances due to the increase in short-term interest rates.

General and Administrative Expenses. The main categories of our general and administrative expenses are compensation and benefits, loan expense, marketing, office administration and professional and outside services. Compensation and benefits includes employee base salaries, benefit costs and incentive compensation awards. Loan expense primarily includes expenses relating to the underwriting of mortgage loans that do not fund successfully and servicing costs. Marketing primarily includes costs of purchased loan leads, advertising and business promotion. Office administration includes items such as rent, depreciation, telephone, office supplies, postage, delivery, maintenance and repairs. Professional and outside services include fees for legal, accounting and other consulting services.

The increase in general and administrative expenses from $104.5 million and $55.8 million for the six and three months ended June 30, 2004, respectively, to $119.2 million and $61.3 million for the same periods in 2005 is primarily attributable to growth in our wholesale, correspondent and servicing operations. We employed 2,276 people as of June 30, 2005 compared with 2,141 as of June 30, 2004.

Note 12 to the condensed consolidated financial statements presents an income statement for our three segments, setting forth our expenses by segment.

The wholesale loan costs of production table below includes all costs paid and fees collected during the wholesale loan origination cycle, including loans that do not fund. This distinction is important as we can only capitalize as deferred broker premium and costs, those costs (net of fees) directly associated with a “funded” loan. Costs associated with loans that do not fund are recognized immediately as a component of general and administrative expenses. For loans held-for-sale, deferred net costs are recognized when

the related loans are sold outright or transferred in securitizations. For loans held-in-portfolio, deferred net costs are recognized over the life of the loan as a reduction to interest income. The cost of our production is also critical to our financial results as it is a significant factor in the gains we recognize. Increased efficiencies in the nonconforming lending operation correlate to lower general and administrative costs and higher gains on sales of mortgage assets.

Table 10 — Wholesale Loan Costs of Production, as a Percent of Principal


	Overhead Costs		Premium Paid to Broker, Net of Fees Collected		Total Acquisition Cost
2005:
Second quarter	1.79	%	0.68	%	2.47	%
First quarter	2.11	%	0.67	%	2.78	%

2004:
Fourth quarter	1.95	%	0.71	%	2.66	%
Third quarter	1.68	%	0.73	%	2.41	%
Second quarter	1.71	%	0.72	%	2.43	%
First quarter	1.84	%	0.82	%	2.66	%

The following table is a reconciliation of our wholesale overhead costs included in our cost of wholesale production to general and administrative expenses of the mortgage lending and loan servicing segment as shown in Note 12 to the condensed consolidated financial statements, presented in accordance with accounting principles generally accepted in the United States of America (GAAP). The reconciliation does not address premiums paid to brokers since they are deferred at origination under GAAP and recognized when the related loans are sold or securitized. We believe this presentation of wholesale overhead costs provides useful information to investors regarding our financial performance because it more accurately reflects the direct costs of loan production and allows us to monitor the performance of our core operations, which is more difficult to do when looking at GAAP financial statements, and provides useful information regarding our financial performance. Management uses this measure for the same purpose. However, this presentation is not intended to be used as a substitute for financial results prepared in accordance with GAAP.

Table 11 – Reconciliation of Wholesale Overhead Costs, Non-GAAP Financial Measure

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


	For the Six Months Ended June 30,						For the Three Months Ended June 30,
	2005			2004			2005			2004
Mortgage lending and loan servicing general and administrative expenses (A)	$	82,822		$	69,706		$	41,497		$	37,056
Direct origination costs classified as a reduction in gain-on-sale		21,427			20,744			11,206			11,086
Costs of servicing		(14,711	)		(10,267	)		(7,823	)		(5,160	)
Other lending expenses		(17,296	)		(21,140	)		(7,952	)		(12,497	)

Wholesale overhead costs	$	72,242		$	59,043		$	36,928		$	30,485

Wholesale production, principal (B)	$	3,731,459		$	3,331,518		$	2,061,529		$	1,779,547
Wholesale overhead, as a percentage		1.94	%		1.77	%		1.79	%		1.71	%

(A)	Mortgage lending and loan servicing general and administrative expenses are presented in Note 12 to the condensed consolidated financial statements.

(B)	Includes loans originated through NovaStar Home Mortgage, Inc. and purchased by our wholesale division in NovaStar Mortgage, Inc. Only the costs borne by our wholesale division are included in the total cost of wholesale production.

Income Taxes . Since our inception, NFI has elected to be treated as a REIT for federal income tax purposes. As a REIT, NFI is not required to pay any corporate level income taxes as long as we distribute 100 percent of our taxable income in the form of dividend distributions to our shareholders. To maintain our REIT status, NFI must meet certain requirements prescribed by the Internal Revenue Code. We intend to operate NFI in a manner that allows us to meet these requirements.

Below is a summary of the taxable net income available to common shareholders for the six and three months ended June 30, 2005 and 2004.

Table 12 — Taxable Net Income

(dollars in thousands)


	For the Six Months Ended June 30,						For the Three Months Ended June 30,
	2005			2004			2005			2004
	Estimated			Estimated			Estimated			Estimated
Consolidated net income	$	74,722		$	66,551		$	39,519		$	35,626
Equity in net loss (income) of NFI Holding Corp.		4,947			(7,335	)		5,288			(7,688	)
Consolidation eliminations between the REIT and TRS		1,696			—			897			—

REIT net income		81,365			59,216			45,704			27,938
Adjustments to net income to compute taxable income		59,444			40,989			25,557			28,287

Taxable net income before preferred dividends		140,809			100,205			71,261			56,225
Preferred dividends		(3,326	)		(2,938	)		(1,663	)		(1,663	)

Taxable net income available to common shareholders	$	137,483		$	97,267		$	69,598		$	54,562

Taxable net income per common share (A)	$	4.49		$	3.89		$	2.27		$	2.18

(A)	The common shares outstanding as of the end of each period presented is used in calculating the taxable income per common share.

The primary difference between consolidated net income and taxable income is due to differences in the recognition of income on our portfolio of interest-only mortgage securities – available-for-sale. Generally, the accrual of interest on interest-only securities is accelerated for income tax purposes. This is the result of the current original issue discount rules as promulgated under Internal Revenue Code Sections 1271 through 1275. During the quarter, we made changes to our securitization model. We expect to utilize the current securitization model for all future deals. We anticipate that on new deals using the new securitization model should have the effect of narrowing the spread between net income available to common shareholders per our condensed consolidated statements of income and taxable net income available to common shareholders in future periods. Table 12 incorporates the estimated changes to taxable income through June 30, 2005. On September 30, 2004, the IRS released Announcement 2004-75. This Announcement describes rules that may be included in proposed regulations regarding the timing of income and/or deductions attributable to interest-only securities. No proposed regulations that would impact income for 2005 have been issued.

To maintain our qualification as a REIT, NFI is required to declare dividend distributions of at least 90 percent of our taxable income by the filing date of our federal tax return, including extensions. Any taxable income that has not been declared to be distributed by this date is subject to corporate income taxes. At this time, NFI intends to declare dividends equal to 100 percent of our taxable income for 2004 and 2005 by the required distribution dates. Accordingly, we have not accrued any corporate income tax for NFI for the six and three months ended June 30, 2005.

As a REIT, NFI may be subject to a federal excise tax. An excise tax is incurred if NFI distributes less than 85 percent of its taxable income by the end of the calendar year. As part of the amount distributed by the end of the calendar year, NFI may include dividends that were declared in October, November or December and paid on or before January 31 of the following year. To the extent that 85 percent of our taxable income exceeds our dividend distributions in any given year, an excise tax of 4 percent is due and payable on the shortfall. For the six

and three months ended June 30, 2005, we have provided for excise tax of $3.8 million and $2.2 million, respectively, compared to $1.2 million and $0.6 million during the same periods of 2004. Excise taxes are reflected as a component of general and administrative expenses on our condensed consolidated statements of income. As of June 30, 2005 and December 31, 2004, accrued excise tax payable was $3.0 million and $1.8 million, respectively. The excise tax payable is reflected as a component of accounts payable and other liabilities on our condensed consolidated balance sheets.

NFI Holding Corporation, a wholly-owned subsidiary of NFI, and its subsidiaries (collectively known as “the TRS”) are treated as “taxable REIT subsidiaries.” The TRS is subject to corporate income taxes and files a consolidated federal income tax return. The TRS reported net (loss) income from continuing operations before income taxes of $(6.1) million and $(8.4) million for the six and three months ended June 30, 2005, respectively, compared with $21.0 million and $18.2 million for the same periods of 2004. As shown in our statement of income, this resulted in an income tax expense (benefit) of $(2.2) million and $(3.1) million for the six and three months ended June 30, 2005, respectively, and $9.8 million and $8.3 million for the same periods of 2004. Additionally, the TRS reported a net (loss) income from discontinued operations before income taxes of $(1.7) million and approximately $10,000 for the six and three months ended June 30, 2005, respectively, compared to $(6.2) million and $(3.5) million for the same periods of 2004. This resulted in an income tax expense (benefit) of $(0.7) million and approximately $4,000 for the six and three months ended June 30, 2005, respectively, and $(2.4) million and $(1.3) million for the six and three months ended June 30, 2004, respectively.

During the past five years, we believe that a minority of our shareholders have been non-United States holders. Accordingly, we anticipate that NFI will qualify as a “domestically-controlled REIT” for United States federal income tax purposes. Investors who are non-United States holders should contact their tax advisor regarding the United States federal income tax consequences of dispositions of shares of a “domestically-controlled REIT.”

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. Nonconforming 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. Our annualized costs of servicing per unit increased from $291 at June 30, 2004 to $320 at June 30, 2005.

Table 13 — Summary of Servicing Operations

(in thousands, except per unit cost)


	2005
	June 30 Amount			Per Unit			March 31 Amount			Per Unit
Unpaid principal	$	13,607,366					$	12,860,740

Number of loans		97,857						92,827

Servicing income, before amortization of mortgage servicing rights	$	15,479		$	633		$	14,483		$	624
Costs of servicing		(7,823	)		(320	)		(6,888	)		(297	)

Net servicing income, before amortization of mortgage servicing rights		7,656			313			7,595			327
Amortization of mortgage servicing rights		(6,990	)		(286	)		(5,746	)		(248	)

Net servicing income	$	666		$	27		$	1,849		$	79

	2004
	December 31 Amount			Per Unit			September 30 Amount			Per Unit			June 30 Amount			Per Unit			March 31 Amount			Per Unit
Unpaid principal	$	12,151,196					$	11,073,505					$	9,604,342					$	8,428,852

Number of loans		87,543						80,324						70,942						62,600

Servicing income, before amortization of mortgage servicing rights	$	12,413		$	567		$	9,929		$	494		$	8,954		$	505		$	8,644		$	552
Costs of servicing		(6,768	)		(309	)		(5,810	)		(289	)		(5,160	)		(291	)		(5,107	)		(326	)

Net servicing income, before amortization of mortgage servicing rights		5,645			258			4,119			205			3,794			214			3,537			226
Amortization of mortgage servicing rights		(5,321	)		(243	)		(4,476	)		(223	)		(3,854	)		(217	)		(3,283	)		(210	)

Net servicing income (loss)	$	324		$	15		$	(357	)	$	(18	)	$	(60	)	$	(3	)	$	254		$	16

Liquidity and Capital Resources Liquidity means the need for, access to and uses of cash. Our primary needs for cash include the origination and acquisition of mortgage loans, principal repayment and interest payments on borrowings, operating expenses and dividend payments. Substantial cash is required to support the operating activities of the business, especially the mortgage origination operation. Additionally, we must comply with various tests to continue to qualify as a REIT for federal income tax purposes, including the requirement that we distribute 90% of taxable income to our stockholders. If we do not have sufficient cash, or our ability to declare and pay dividends is restricted, our REIT status could be at risk. Mortgage asset sales and the collection of principal, interest and fees on mortgage assets helps support cash needs. Drawing upon our various borrowing arrangements also satisfies major cash requirements. As shown in Table 5, we have $343.4 million in immediately available funds.

Mortgage lending requires significant cash to fund loan originations and purchases. Our warehouse lending arrangements, which include repurchase agreements, support the mortgage lending operation. Our warehouse mortgage lenders allow us to borrow between 98% and 100% of the outstanding principal. Funding for the difference – generally 2% of the principal – must come from cash on hand. Of the $3.7 billion in mortgage securities and mortgage loans repurchase facilities, we have approximately $2.6 billion available to support the mortgage lending and mortgage portfolio operations.

Loans financed with warehouse repurchase credit facilities are subject to changing market valuation and margin calls. The market value of our loans is dependent on a variety of economic conditions, including interest rates (and borrower demand) and end investor desire and capacity. Market values of our loans have declined over the past year, but have remained well in excess of par. However, there is no certainty that the prices will remain in excess of par. 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 loans held-for-sale, excluding the loans under removal of accounts provision, as of June 30, 2005 would need to decline by approximately 33% before we would use all immediately available funds, assuming no other constraints on our immediately available funds.

In the ordinary course of business, we sell loans with recourse where a defect occurred in the loan origination process and guarantee to cover investor losses should origination defects occur. Historically, repurchases of loans where a defect has occurred have been insignificant, as such; there is minimal liquidity risk. For additional detail, refer to “Off Balance Sheet Arrangements”.

Loans we originate and purchase 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.

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 requires us to post margin deposits with them. As of June 30, 2005, we have approximately $3.0 million on deposit. A decline in interest rates would subject us to additional exposure for cash margin calls. However, when 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 which should offset any requirement to post additional collateral. 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 flows on loans and securities.

Proceeds from equity issuances have provided the equity capital to support our operations and are a future liquidity source. Since inception, we have raised $420 million in net proceeds through private and public equity offerings. During 2005, we completed a public offering of 1,725,000 shares of common stock raising $57.9 million in net proceeds. Additionally, we sold 1,136,524 shares of common stock under the Direct Purchase and Dividend Reinvestment Plan raising $43.7 million in net proceeds and 70,107 shares of common stock under the stock-based compensation plan raising $0.5 million during 2005.

Resecuritizations provide another source of cash. During 2005, we issued asset-backed bonds in the amount of $130.9 million secured by our mortgage securities – available-for-sale as a means for long-term financing, which raised $128.9 million in net proceeds.

For the six months ended June 30, 2005, we had a net increase in cash and cash equivalents of $49.0 million compared to $73.1 million for the same period of 2004. Our net cash used in operating activities decreased to $319.6 million for the six months ended June 30, 2005 from $802.2 million for the same period of 2004 primarily due to the increase in our sale of mortgage loans in securitizations, sales of loans to third parties and the sale of mortgage securities—trading. These increases are offset by the increase in originations and purchase of mortgage loans. Net cash provided by investing activities increased to $239.3 million for the six months ended June 30, 2005 from $159.8 million for the same period of 2004 primarily due to the increase in paydowns on our mortgage securities – available-for-sale. Net cash provided by financing activities decreased to $129.3 million for the six months ended June 30, 2005 from $715.5 million for the same period of 2004 primarily due to the increase in payments on our asset-backed bonds, increase in dividends paid on capital stock, decrease in our proceeds from the issuance of asset-backed bonds and decrease in our change in short-term borrowings. Additional cash activity during the six months ended June 30, 2005 and 2004 is presented in the condensed consolidated statement of cash flows.

Off Balance Sheet Arrangements

As discussed previously, we pool the loans we originate and purchase and securitize them to obtain long-term financing for the assets. The loans are transferred to a trust where they serve as collateral for asset-backed bonds, which the trust issues to the public. Our ability to use the securitization capital market is critical to the operations of our business. Table 3 summarizes our off balance sheet securitizations.

External factors that are reasonably likely to affect our ability to continue to use this arrangement would be those factors that could disrupt the securitization capital market. A disruption in the market could prevent us from being able to sell the securities at a favorable price, or at all. Factors that could disrupt the securitization market include an international liquidity crisis such as occurred in the fall of 1998, a terrorist attack, outbreak of war or other significant event risk, and market specific events such as a default of a comparable type of securitization. If we were unable to access the securitization market, we may still be able to finance our mortgage operations by selling our loans to investors in the whole loan market. We were able to do this following the liquidity crisis in 1998.

Specific items that may affect our ability to use the securitizations to finance our loans relate primarily to the performance of the loans that have been securitized. Extremely poor loan performance may lead to poor bond performance and investor unwillingness to buy bonds supported by our collateral. Historically, our financial performance and condition has little impact on our ability to securitize, as evidenced by our ability to securitize in 1998, 1999 and 2000 when our financial trend was weak. There, however, are no assurances that we will be able to securitize loans in the future when we have poor loan performance.

We have commitments to borrowers to fund residential mortgage loans as well as commitments to purchase and sell mortgage loans to third parties. At June 30, 2005, the Company had outstanding commitments to originate, purchase and sell loans of $558.4 million, $22.2 million and $187.5 million, respectively. As of December 31, 2004, we had outstanding commitments to originate loans of $361.2 million. We had no commitments to purchase or sell loans at December 31, 2004. The commitments to originate and purchase loans do not necessarily represent future cash requirements, as some portion of the commitments are likely to expire without being drawn upon or may be subsequently declined for credit or other reasons.

In the ordinary course of business, we sell loans with recourse where a defect occurred in the loan origination process and guarantee to cover investor losses should origination defects occur. Defects may occur in the loan documentation and underwriting process, either through processing errors made by us or through intentional or unintentional misrepresentations made by the borrower or agents during those

processes. If a defect is identified, we are required to repurchase the loan. As of June 30, 2005 and December 31, 2004, we had loans sold with recourse with an outstanding principal balance of $12.3 billion and $11.4 billion, respectively. Historically, repurchases of loans where a defect has occurred have been insignificant.

On May 27, 2005, we executed a securitization transaction accounted for as a sale of loans. We delivered $1.6 billion in loans collateralizing NMFT Series 2005-2 (see Note 3 of the condensed consolidated financial statements). On July 21, 2005, we delivered an additional $150.7 million in loans collateralizing NMFT Series 2005-2.

Contractual Obligations

We have entered into certain long-term debt and lease agreements, which obligate us to make future payments to satisfy the related contractual obligations. Notes 5, 6, 7 and 8 of the condensed consolidated financial statements discuss these obligations in further detail.

Since December 31, 2004, we have issued junior subordinated debentures as discussed in Note 6. The following table summarizes our contractual obligations with regard to our long-term debt and lease agreements as of June 30, 2005.

Table 14 — Contractual Obligations

(in thousands)


	Payments Due by Period
Contractual Obligations	Total		Less than 1 Year		1-3 Years		4-5 Years		After 5 Years
Short-term borrowings	$	1,064,881	$	1,064,881		—		—		—
Long-term debt (A)	$	344,880	$	252,245	$	83,768	$	8,867		—
Junior subordinated debentures (B)	$	153,976	$	3,495	$	6,990	$	6,990	$	136,501
Operating leases (C)	$	52,133	$	10,002	$	18,603	$	17,048	$	6,480
Premiums due to counterparties related to interest rate cap agreements	$	5,768	$	3,269	$	2,054	$	445		—

(A)

Repayment of the asset-backed bonds is dependent upon payment of the underlying mortgage loans, which collateralize the debt. The repayment of these mortgage loans is affected by prepayments. Interest obligations on our variable-rate long-term debt are based on the prevailing interest rate at June 30, 2005 for each respective obligation.

(B)	The junior subordinated debentures are assumed to mature in 2035 in computing the future payments. Interest obligations on our junior subordinated debentures are based on the prevailing interest rate at June 30, 2005 for each respective obligation.

(C)	Does not include rental income of $2.8 million to be received under a sublease contract.

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 the balance sheet are measured with reference to historical cost or fair market value without considering inflation.

Impact of Recently Issued Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board issued a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation (“SFAS No. 123 (R)). This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. As discussed in Note 1 to the 2004 annual report on Form 10-K, the Company implemented the fair value provisions of SFAS No. 123 during 2003. As such, the adoption of this Statement is not anticipated to have a significant impact on the Company’s condensed consolidated financial statements.

In March 2005, SAB No. 107, Application of FASB No. 123 (revised 2004), Accounting for Stock-Based Compensation was released. This release summarizes the SEC staff position regarding the interaction between FASB No. 123 (revised 2004), Share-Based Payment and certain SEC rules and regulations and provides the SEC’s views regarding the valuation of share-based payment arrangements for public companies. As discussed in Note 1 to the 2004 annual report on Form 10-K, the Company implemented the fair value provisions of the original SFAS No. 123 during 2003. As such, the adoption of this release is not anticipated to have a significant impact on the Company’s condensed consolidated financial statements.

In May 2005, the FASB issued Statement No. 154, Accounting Changes and Error Corrections, a Replacement of APB Opinion No. 20 and FASB Statement No. 3 . This Statement changes the requirements for the accounting and reporting of a change in accounting principle, reporting entity, accounting estimate and correction of an error. SFAS No. 154 applies to (a) financial statements of business enterprises and not-for-profit organizations and (b) historical summaries of information based on primary financial statements that include an accounting period in which an accounting change or error correction is reflected and is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date the Statement was issued. The adoption of this Statement in not anticipated to have a significant impact on the Company’s condensed consolidated financial statements.

Risk Factors

You should carefully consider the risks described below before investing in our publicly traded securities. The risks described below are not the only ones facing us. Our business is also subject to the risks that affect many other companies, such as competition, technological obsolescence, labor relations, general economic conditions and geopolitical events. Additional risks not currently known to us or that we currently believe are immaterial also may impair our business operations and our liquidity.

If we fail to maintain REIT status, we would be subject to tax as a regular corporation. We conduct a substantial portion of our business through our taxable REIT subsidiaries, which creates additional compliance requirements. We must comply with various tests to continue to qualify as a REIT for federal income tax purposes, including the requirement that we distribute 90% of taxable income to our stockholders. If we do not have sufficient cash, or our ability to declare and pay dividends is restricted, our REIT status could be at risk. We conduct a substantial portion of our business through taxable REIT subsidiaries, such as NovaStar Mortgage. Despite our qualification as a REIT, our taxable REIT subsidiaries must pay federal income tax on their taxable income. Our income from, and investments in, our taxable REIT subsidiaries do not constitute permissible income or investments for some of the REIT qualification tests. While we attempt to ensure that our dealings with our taxable REIT subsidiaries will not adversely affect our REIT qualification, no assurance can be given that we will successfully achieve that result. Furthermore, we

may be subject to a 100% penalty tax, or our taxable REIT subsidiaries may be denied deductions, to the extent that our dealings with our taxable REIT subsidiaries are deemed not to be arm’s length in nature.

Our cash balances and cash flows may become limited relative to our cash needs, which may ultimately affect our REIT status or solvency. We use cash for our operating expenses, minimum REIT dividend distribution requirements, and other operating needs. Cash is also required to pay interest on our outstanding indebtedness and may be required to pay down indebtedness in the event that the market values of the assets collateralizing our debt decline, the terms of short-term debt become less attractive or for other reasons. If our income as calculated for tax purposes significantly exceeds our cash flows from operations, our minimum REIT dividend distribution requirements could exceed the amount of our available cash. In the event that our liquidity needs exceed our access to liquidity, we may need to sell assets at an inopportune time, thus adversely affecting our financial condition and results of operations. Furthermore, in an adverse cash flow situation, our REIT status or our solvency could be threatened.

Market factors may limit our ability to acquire mortgage assets at yields that are favorable relative to borrowing costs. Despite our experience in the acquisition of mortgage assets and our relationships with various mortgage suppliers, we face the risk that we might not be able to acquire mortgage assets which earn interest rates greater than our cost of funds or that we might not be able to acquire a sufficient number of such mortgage assets to maintain our profitability.

Our efforts to manage credit risk may not be successful in limiting delinquencies and defaults in underlying loans or losses on our mortgage securities—available-for-sale, and as a result, our results of operations may be affected. Despite our efforts to manage credit risk, there are many aspects of credit that we cannot control, and there can be no assurance that our quality control and loss mitigation operations will be successful in limiting future delinquencies, defaults and losses. While we have what we believe to be a comprehensive underwriting process, it may not be effective in mitigating our risk of loss on the underlying loan. Further, the value of the homes collateralizing residential loans may decline due to a variety of reasons beyond our control, such as weak economic conditions, natural disasters, over-leveraging of the borrower, and reduction in personal incomes. The frequency of defaults, and the loss severity on loans upon default, may be greater than we anticipated. Interest-only loans, negative amortization loans, adjustable-rate loans, reduced documentation loans, sub-prime loans, home equity lines of credit and second lien loans may involve higher than expected delinquencies and defaults. Changes in consumer behavior, bankruptcy laws, and other laws may exacerbate loan losses. Expanded loss mitigation efforts in the event that defaults increase could increase our operating costs. To the extent that unforeseen or uncontrollable events increase loan delinquencies and defaults, our results of operations may be adversely affected.

Mortgage insurers may in the future change their pricing or underwriting guidelines or may not pay claims resulting in increased credit losses. From time to time we use mortgage insurance to mitigate our risk of credit losses. Our decision to obtain mortgage insurance coverage is dependent, in part, on pricing trends. In the future there can be no assurance that mortgage insurance coverage on our new mortgage loan production will be available at rates that we believe are economically viable for us or if the insurers change their underwriting guidelines, at all. We also face the risk that our mortgage insurers might not have the financial ability to pay all claims presented by us or may deny a claim if the loan is not properly serviced, has been improperly originated, is the subject of fraud, or for other reasons. Any of those events could increase our credit losses and thus adversely affect our results of operations.

Changes in prepayment rates of mortgage loans could reduce our earnings, dividends, cash flows, access to liquidity and results of operations. The economic returns we expect to earn from most of the mortgage assets we own are affected by the rate of prepayment of the underlying mortgage loans. If the loans underlying our mortgage securities—available-for-sale prepay at a rate faster than we have anticipated, our economic returns on those assets will be lower than we have assumed which would reduce our earnings, dividends, and cash flows. Adverse changes in cash flows from a mortgage asset would likely reduce the asset’s market value, which would likely reduce our access to liquidity if we borrowed against that asset and may cause a market value write-down for GAAP purposes, which would reduce our reported earnings. Changes in loan prepayment patterns can affect us in a variety of other ways that can be complex and difficult to predict. In addition, our exposure to prepayment changes over time. As a result, changes in prepayment rates will likely cause volatility in our financial results in ways that are not necessarily obvious or predictable and that may adversely affect our results from operations.

Geographic concentration of mortgage loans we originate or purchase increases our exposure to risks in those areas, especially in California and Florida. Over-concentration of loans we originate or purchase in any one geographic area increases our exposure to the economic and natural hazard risks associated with that area. Declines in the residential real estate markets in which we are concentrated may reduce the values of the properties collateralizing our mortgages which in turn may increase the risk of delinquency, foreclosure, bankruptcy, or losses from those loans. To the extent that a large number of loans are impaired, our financial condition and results of operations may be adversely affected. Furthermore, if borrowers are not insured for natural disasters, which are typically not covered by standard hazard insurance policies, then they may not be able to repair the property or may stop paying their mortgages if the property is damaged. A natural disaster that results in a significant number of delinquencies would cause increased foreclosures and decrease our ability to recover losses on properties affected by such disasters and would harm our financial condition and results of operations.

Loans made to nonconforming mortgage borrowers entail relatively higher delinquency and loss rates. Lenders in the nonconforming mortgage banking industry make loans to borrowers who have impaired or limited credit histories, limited documentation of income and higher debt-to-income ratios than traditional mortgage lenders allow. Mortgage loans made to nonconforming mortgage loan borrowers generally entail a relatively higher risk of delinquency and foreclosure than mortgage loans made to borrowers with better credit and, therefore, may result in higher levels of realized losses. Any failure by us to adequately address the risks of nonconforming lending could harm our financial condition and results of operations.

Various legal proceedings could adversely affect our financial condition or results of operations . In the course of our business, we are subject to various legal proceedings and claims. Since April 2004, a number of substantially similar securities class action lawsuits have been filed and consolidated into a single action in the United States District Court of the Western District of Missouri and several derivative lawsuits have been filed in the United States District Court in Kansas City and in Missouri and Maryland state courts against us and/or several of our executive officers and/or directors. The complaints generally claim that the defendants are liable for making or failing to prevent alleged misstatements or omissions in our public disclosures. On January 14, 2005, we filed a motion to dismiss the securities class action lawsuit, and on May 12, 2005, the court denied such motion. In April 2004, we received notice of an informal inquiry from the Commission requesting that we provide various documents relating to our business. We have cooperated fully with the Commission’s inquiry and provided it with the requested information. We last provided information to the Commission in October 2004. We have received no additional requests or inquiries from the Commission since that time. In January 2005, we agreed upon a settlement in the class and collective action regarding the allegation that NovaStar Home Mortgage failed to pay members of the class overtime premium and minimum wage as required by the Fair Labor Standards Act and California state laws. The settlement is subject to court approval. The resolution of these legal matters or other legal matters could result in material adverse impact on our results of operations, financial condition and business prospects.

A prolonged economic slowdown or a decline in the real estate market could harm our results of operations. A substantial portion of our mortgage assets consist of single-family mortgage loans or mortgage securities—available-for-sale evidencing interests in single-family mortgage loans. Because we make a substantial number of loans to credit-impaired borrowers, the actual rates of delinquencies, foreclosures and losses on these loans could be higher during economic slowdowns. Any sustained period of increased delinquencies, foreclosures or losses could also harm our ability to sell loans, the prices we receive for our loans, the values of our mortgage loans held for sale or our residual interests in securitizations, which could harm our financial condition and results of operations. In addition, any material decline in real estate values would weaken our collateral loan-to-value ratios and increase the possibility of loss if a borrower defaults. In such event, we will be subject to the risk of loss on such mortgage asset arising from borrower defaults to the extent not covered by third-party credit enhancement.

Regulation as an investment company could harm our business; efforts to avoid regulation as an investment company could limit our operations. We intend to conduct our business so as not to become regulated as an investment company under the Investment Company Act of 1940, as amended, or the Investment Company Act. The Investment Company Act, if deemed applicable to us, would prevent us from conducting our business as described in this document by, among other things, substantially limiting our ability to use leverage. The Investment Company Act does not regulate entities that are primarily engaged, directly or indirectly, in a business “other than that of investing, reinvesting, owning, holding or trading in securities,” or that are primarily engaged in the business of “purchasing or otherwise acquiring

mortgages and other liens on and interests in real estate.” Under the Commission’s current interpretation, in order to qualify for the latter exemption we must maintain at least 55% of our assets directly in “qualifying real estate interests” and at least an additional 25% of our assets in other real estate-related assets or additional qualifying real estate interests. Although we believe that it should not be difficult to maintain at least 80% of our assets in real estate-related assets, the requirement that at least 55% of our assets constitute qualifying assets is more limiting. For example, the Commission has taken the position that mortgage-backed securities for which we do not own all of the securities issued and with respect to which we do not obtain the right to foreclose on the related mortgage loans do not constitute “qualifying real estate interests” for purposes of the 55% test, even if they are treated more favorably under the REIT tax rules. If we rely on this exemption from registration as an investment company under the Investment Company Act, our ability to invest in assets that would otherwise meet our investment strategies will be limited. If we are subject to the Investment Company Act and fail to qualify for an applicable exemption from the Investment Company Act, we could not operate our business efficiently under the regulatory scheme imposed on investment companies under the Investment Company Act. Accordingly, we could be required to restructure our activities which could materially adversely affect our financial condition and results of operations.

Our failure to comply with federal, state or local regulation of, or licensing requirements with respect to, mortgage lending, loan servicing, broker compensation programs, local branch operations or other aspects of our business could harm our operations and profitability. As a mortgage lender, loan servicer and broker, we are subject to an extensive body of both state and federal law. The volume of new or modified laws and regulations has increased in recent years and, in addition, some individual municipalities have begun to enact laws that restrict loan origination and servicing activities. As a result, it may be more difficult to comprehensively identify and accurately interpret all of these laws and regulations and to properly program our technology systems and effectively train our personnel with respect to all of these laws and regulations, thereby potentially increasing our exposure to the risks of noncompliance with these laws and regulations. Also, in our branch operations, we allow our branch managers relative autonomy, which could result in our facing greater exposure to third-party claims if our compliance programs are not strictly adhered to.

Our failure to comply with these laws can lead to:

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civil and criminal liability;

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loss of licensure;

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damage to our reputation in the industry;

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inability to sell or securitize our loans;

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demands for indemnification or loan repurchases from purchasers of our loans;

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fines and penalties and litigation, including class action lawsuits; or

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administrative enforcement actions.

Any of these results could harm our results of operations, financial condition and business prospects.

We face loss exposure due to fraudulent and negligent acts on the part of loan applicants, employees, mortgage brokers and other third parties. When we originate or purchase mortgage loans, we rely heavily upon information provided to us by third parties, including information relating to the loan application, property appraisal, title information and employment and income documentation. If any of this information is fraudulently or negligently misrepresented to us and such misrepresentation is not detected by us prior to loan funding, the value of the loan may be significantly lower than we expected. Whether a misrepresentation is made by the loan applicant, the loan broker, one of our employees, or any other third party, we generally bear the risk of loss associated with it. A loan subject to misrepresentation typically cannot be sold and subject to repurchase by us if it is sold prior to our detection of the misrepresentation. Even though we may have rights against the person(s) who knew or made the misrepresentation, we may not be able to recover against such persons the amount of the monetary loss we incurred as a result of the misrepresentation.

New legislation could restrict our ability to make mortgage loans, which could harm our earnings. Several states, cities or other government entities are considering or have passed laws, regulations or ordinances aimed at curbing predatory lending practices. The federal government is also considering legislative and regulatory proposals in this regard. In general, these proposals involve lowering the existing thresholds for defining a “high-cost” loan and establish enhanced protections and remedies for borrowers who receive such loans. Passage of these laws and rules could reduce our loan origination volume. In addition, many whole loan buyers may elect not to purchase any loan labeled as a “high cost” loan under any local, state or federal law or regulation. Rating agencies likewise may refuse to rate securities backed by such loans. Accordingly, these laws and rules could severely restrict the secondary market for a significant portion of our loan production. This would effectively preclude us from continuing to originate loans either in jurisdictions unacceptable to the rating agencies or that exceed the newly defined thresholds which could harm our results of operations and business prospects.

New legislation related to corporate governance may increase our costs of compliance and our liability. Recently enacted and proposed laws, regulations and standards relating to corporate governance and disclosure requirements applicable to public companies, including the Sarbanes-Oxley Act of 2002, new Commission regulations and New York Stock Exchange rules have increased the costs of corporate governance, reporting and disclosure practices. These costs may increase in the future due to our continuing implementation of compliance programs mandated by these requirements. In addition, these new laws, rules and regulations create new legal bases for administrative enforcement, civil and criminal proceedings against us in case of non-compliance, thereby increasing our risks of liability and potential sanctions.

Intense competition in the nonconforming mortgage loan industry may harm our financial condition. We face intense competition, primarily from commercial banks, savings and loans, and other independent mortgage lenders, including internet-based lending companies and other mortgage REITs. Competitors with lower costs of capital have a competitive advantage over us. In addition, establishing a mortgage lending operation such as ours requires a relatively small commitment of capital and human resources, which permits new competitors to enter our markets quickly and to effectively compete with us. Furthermore, national banks, thrifts and their operating subsidiaries are generally exempt from complying

with many of the state and local laws that affect our operations, such as the prohibition on prepayment penalties. Thus, they may be able to provide more competitive pricing and terms than we can offer. Any increase in the competition among lenders to originate nonconforming mortgage loans may result in either reduced income on mortgage loans compared to present levels, or revised underwriting standards permitting higher loan-to-value ratios on properties securing nonconforming mortgage loans, either of which could adversely affect our results of operations, financial condition or business prospects. In addition, the government-sponsored entities, Fannie Mae and Freddie Mac, may also expand their participation in the subprime mortgage industry. To the extent they materially expand their purchase of subprime loans, our ability to profitably originate and purchase mortgage loans may be adversely affected because their size and cost-of-funds advantage allows them to purchase loans with lower rates or fees than we are willing to offer. The intense competition in the subprime mortgage industry has also led to rapid technological developments, evolving industry standards and frequent releases of new products and enhancements. As mortgage products are offered more widely through alternative distribution channels, such as the internet, we may be required to make significant changes to our current wholesale and retail structures and information systems to compete effectively. Our inability to continue enhancing our current internet capabilities, or to adapt to other technological changes in the industry, could adversely affect our results of operations and business prospects.

Our business could be adversely affected if we experienced an interruption in or breach of our communication or information systems or if we were unable to safeguard the security and privacy of the personal financial information we receive. We rely heavily upon communications and information systems to conduct our business. Any material interruption or breach in security of our communication or information systems or the third-party systems on which we rely could cause underwriting or other delays and could result in fewer loan applications being received, slower processing of applications and reduced efficiency in loan servicing. Additionally, in connection with our loan file due diligence reviews, we have access to the personal financial information of the borrowers which is highly sensitive and confidential, and subject to significant federal and state regulation. If a third party were to misappropriate this information, we potentially could be subject to both private and public legal actions. Although we have policies and procedures designed to safeguard confidential information, we cannot assure you that these policies and safeguards are sufficient to prevent the misappropriation of confidential information, that our policies and safeguards will be deemed compliant with any existing federal or state laws or regulations governing privacy, or with those laws or regulations that may be adopted in the future.

Our reported GAAP financial results differ from the taxable income results that drive our dividend distributions, and our consolidated balance sheet, income statement, and statement of cash flows as reported for GAAP purposes may be difficult to interpret. We manage our business based on long-term opportunities to earn cash flows. Our dividend distributions are driven by our dividend distribution requirements under the REIT tax laws and our profits as calculated for tax purposes pursuant to the Code. Our reported results for GAAP purposes differ materially, however, from both our cash flows and our taxable income. We transfer mortgage loans or mortgage securities—available-for-sale into securitization trusts to obtain long-term non-recourse funding for these assets. When we surrender control over the transferred mortgage loans or mortgage securities—available-for-sale, the transaction is accounted for as a sale. When we retain control over the transferred mortgage loans or mortgage securities available-for-sale, the transaction is accounted for as a secured borrowing. These securitization transactions do not differ materially in their structure or cash flow generation characteristics, yet under GAAP accounting these transactions are recorded differently. In a securitization transaction accounted for as a sale, we record a gain or loss on the assets transferred in our income statement and we record the retained interests at fair value on our balance sheet. In a securitization transaction accounted for as a secured borrowing, we consolidate all the assets and liabilities of the trust on our financial statements (and thus do not show the retained interest we own as an asset). As a result of this and other accounting issues, stockholders and analysts must undertake a complex analysis to understand our economic cash flows, actual financial leverage, and dividend distribution requirements. This complexity may cause trading in our stock to be relatively illiquid or may lead observers to misinterpret our results.

Market values for our mortgage assets and hedges can be volatile. For GAAP purposes, we mark-to-market our non-hedging derivative instruments through our GAAP consolidated income statement and we mark-to-market our mortgage securities—available-for-sale through our GAAP consolidated balance sheet through other comprehensive income unless the mortgage securities are in an unrealized loss position which has been deemed as an other-than-temporary impairment. An other-than-temporary impairment is recorded through the income statement in the period incurred. Additionally, we do not mark-to-market our loans held for sale as they are carried at lower of cost or market, as such, any change in market value

would not be recorded through our income statement until the related loans are sold. If we sell an asset that has not been marked-to-market through our income statement at a reduced market price relative to its basis, our reported earnings will be reduced. A decrease in market value of our mortgage assets may or may not result in a deterioration in future cash flows. As a result, changes in our GAAP consolidated income statement and balance sheet due to market value adjustments should be interpreted with care.

The inability to attract and retain qualified employees could significantly harm our business. We depend on the continued service of our top executives, including our chief executive officer and president. To the extent that one or more of our top executives are no longer employed by us, our operations and business prospects may be adversely affected. We also depend on our wholesale account executives and retail loan officers to attract borrowers by, among other things, developing relationships with financial institutions, other mortgage companies and brokers, real estate agents, borrowers and others. The market for skilled account executives and loan officers is highly competitive and historically has experienced a high rate of turnover. Competition for qualified account executives and loan officers may lead to increased hiring and retention costs. If we are unable to attract or retain a sufficient number of skilled account executives at manageable costs, we will be unable to continue to originate quality mortgage loans that we are able to sell for a profit, which would harm our results of operations, financial condition and business prospects.

We are subject to the risk that provisions of our loan agreements may be unenforceable. Our rights and obligations with respect to our loans are governed by written loan agreements and related documentation. It is possible that a court could determine that one or more provisions of a loan agreement are unenforceable, such as a loan prepayment provision or the provisions governing our security interest in the underlying collateral. If this were to happen with respect to a material asset or group of assets, we could be required to repurchase these loans and may not be able to sell or liquidate the loans.

If many of our borrowers become subject to the Servicemembers Civil Relief Act of 2003, cash flows from our mortgage securities—available-for-sale may be harmed. Under the Servicemembers Civil Relief Act, a borrower who enters military service or who was on reserve status and is called to active duty after origination of the mortgage loan generally may not be charged interest above an annual rate of 6% during the period of the borrower’s active duty status. A prolonged, significant military mobilization as part of the war on terrorism or the war in Iraq could reduce the interest payments collected from those borrowers. To the extent a significant number of borrowers are subject to the Act, the cash flows we receive from loans underlying our mortgage securities—available-for-sale would be reduced, which could cause us to reduce the carrying value of such securities and could decrease our earnings. In addition, the Act limits the ability of the servicer to foreclose on an affected mortgage loan during the borrower’s period of active duty status, and, under certain circumstances, during an additional three month period thereafter. Any resulting reduction in our cash flows or impairment in our performance could harm our results of operations, financial condition and business prospects.

We are exposed to the risk of environmental liabilities with respect to properties to which we take title. In the course of our business, we occasionally foreclose and take title to residential properties and as a result could become subject to environmental liabilities associated with these properties. We may be held liable for property damage, personal injury, investigation, and cleanup costs incurred in connection with environmental contamination. These costs could be substantial. If we ever become subject to significant environmental liabilities, our financial condition and results of operations could be adversely affected.

Current loan performance data may not be indicative of future results. When making capital budgeting and other decisions, we use projections, estimates and assumptions based on our experience with mortgage loans. Actual results and the timing of certain events could differ materially in adverse ways from those projected, due to factors including changes in general economic conditions, fluctuations in interest rates, fluctuations in mortgage loan prepayment rates and fluctuations in losses due to defaults on mortgage loans. These differences and fluctuations could rise to levels that may adversely affect our profitability.

Changes in Internal Revenue Service regulations regarding the timing of income recognition and/or deductions could materially adversely affect the amount of our dividends. On September 30, 2004, the Internal Revenue Service, or the IRS, released Announcement 2004-75, which describes rules that may be included in proposed IRS regulations regarding the timing of recognizing income and/or deductions attributable to interest-only securities. We believe the effect of these regulations, if adopted, may narrow the spread between book income and taxable income on the interest-only securities we hold and would thus reduce our taxable income. A significant portion of our mortgage securities—available-for-sale consist

of interest-only securities. If regulations are adopted by the IRS that reduce our taxable income, our dividend may be reduced because the amount of our dividend is entirely dependent upon our taxable income.

We may be subject to tax if we do not comply with certain distribution requirements. To the extent that a REIT satisfies the 90% distribution requirement, but distributes less than 100% of its taxable income, it will be subject to federal corporate income tax on its undistributed income. In addition, a REIT will incur a 4% nondeductible excise tax on the amount, if any, by which its distributions in any calendar year are less than the sum of:

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85% of its REIT ordinary income for that year; plus

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95% of its REIT capital gain net income for that year; plus

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100% of its undistributed taxable income from prior years.

We expect that we will be subject to that 4% excise tax in some years, if not every year.

Risks Related to Our Borrowing and Securitization Activities

Our growth is dependent on leverage, which may create other risks. Our success is dependent, in part, upon our ability to grow our assets through the use of leverage. Leverage creates an opportunity for increased net income, but at the same time creates risks. For example, leveraging magnifies changes in our net worth. We will incur leverage only when there is an expectation that it will enhance returns, although there can be no assurance that our use of leverage will prove to be beneficial. Moreover, there can be no assurance that we will be able to meet our debt service obligations and, to the extent that we cannot, our ability to make expected minimum REIT dividend requirements to stockholders will be adversely affected. Furthermore, if we were to liquidate, our debt holders and lenders will receive a distribution of our available assets before any distributions are made to our common stockholders.

Possible market developments could cause our lenders to require us to pledge additional assets as collateral; if our assets are insufficient to meet such collateral requirements, then we may be compelled to liquidate particular assets at an inopportune time, which could jeopardize our REIT status or cause us to incur losses. Possible market developments, including a sharp rise in interest rates, a change in prepayment rates or increasing market concern about the value or liquidity of the types of mortgage assets in our portfolio, may reduce the market value of our portfolio, which may cause our lenders to require additional collateral or otherwise limit our ability to borrow. This requirement for additional collateral may compel us to liquidate our assets at a disadvantageous time. If the sales are made at prices lower than the amortized cost of such investments, we would incur losses. In addition, by changing our mix of investments, we might jeopardize our status as a REIT or federal tax purposes, or an exemption from the Investment Company Act.

An interruption or reduction in the securitization market or change in terms offered by this market would hurt our financial position. We are dependent on the securitization market for the sale of our loans because we securitize loans directly and many of our whole loan buyers purchase our loans with the intention to securitize. The securitization market is dependent upon a number of factors, including general economic conditions, conditions in the securities market generally and in the asset-backed securities market specifically. Similarly, poor performance of our previously securitized loans could harm our access to the securitization market. In addition, a court recently found a lender and securitization underwriter liable for consumer fraud committed by a company to whom they provided financing and underwriting services. In the event other courts or regulators adopted the same liability theory, lenders and underwriters could be named as defendants in more litigation and as a result they may exit the business or charge more for their services, all of which could have a negative impact on our ability to securitize the loans we originate and the securitization market in general. A decline in our ability to obtain long-term funding for our mortgage loans in the securitization market in general, or in our ability to obtain attractive terms or in the market’s demand for our loans could harm our results of operations, financial condition and business prospects.

Failure to renew or obtain adequate funding under warehouse repurchase agreements may harm our lending operations. We are currently dependent upon a number of credit facilities for funding of our mortgage loan originations and acquisitions. Any failure to renew or obtain adequate funding under these financing arrangements for any reason, including our inability to meet the covenants contained in such arrangements, could harm our lending operations and our overall performance. An increase in the cost of financing in excess of any change in the income derived from our mortgage assets could also harm our earnings and reduce the cash available for distribution to our stockholders. In October 1998, the subprime mortgage loan market faced a liquidity crisis with respect to the availability of short-term borrowings from major lenders and long-term borrowings through securitization. At that time, we faced significant liquidity constraints which harmed our business and our profitability. We can provide no assurance that those adverse circumstances will not recur.

Financing with repurchase agreements may lead to margin calls if the market value of our mortgage assets declines. We use repurchase agreements to finance our acquisition of mortgage assets in the short-term. In a repurchase agreement, we sell an asset and agree to repurchase the same asset at some point in time in the future. Generally, the repurchase agreements we enter into provide that we must repurchase the asset in 30 days. For financial accounting purposes, these arrangements are treated as secured financings. We retain the assets on our balance sheet and record an obligation to repurchase the asset. The amount we may borrow under these arrangements is generally 95% to 100% of the asset market value with respect to mortgage loans and 65% to 80% of the asset market value with respect to mortgage securities—available-for-sale. When asset market values decrease, we are required to repay the margin, or difference in market value. To the extent the market values of assets financed with repurchase agreements decline rapidly, we will be required to meet cash margin calls. If cash is unavailable to meet margin calls, or if we fail to satisfy

certain financial covenants set forth in the repurchase agreements, we may default on our obligations under the applicable repurchase agreement. In that event, the lender retains the right to liquidate the collateral we provided to it to settle the amount due from us.

We have credit exposure with respect to loans we sell to the whole loan market and loans we sell to securitization entities. We have potential credit and liquidity exposure for loans that are the subject of fraud, irregularities in their loan files or process, or that result in our breaching the representations and warranties in the contract of sale. In addition, when we sell loans to the whole loan market we have exposure for loans that default. In these cases, we may be obligated to repurchase loans at principal value, which could result in a significant decline in our available cash. When we purchase loans from a third party that we sell into the whole loan market or to a securitization trust, we obtain representations and warranties from the counter-parties that sold the loans to us that generally parallel the representations and warranties we provided to our purchasers. As a result, we believe we have the potential for recourse against the seller of the loans. However, if the representations and warranties are not parallel, or if the original seller is not in a financial position to be able to repurchase the loan, we may have to use cash resources to repurchase loans which could adversely affect our liquidity.

Competition in the securitization market may negatively affect our net income. Competition in the business of sponsoring securitizations of the type we focus on is increasing as Wall Street broker-dealers, mortgage REITs, investment management companies, and other financial institutions expand their activities or enter this field. Increased competition could reduce our securitization margins if we have to pay a higher price for the long-term funding of these assets. To the extent that our securitization margins erode, our results of operations will be negatively impacted.

Differences in our actual experience compared to the assumptions that we use to determine the value of our mortgage securities—available-for-sale could adversely affect our financial position. Currently, our securitization of mortgage loans are structured to be treated as sales for financial reporting purposes and, therefore, result in gain recognition at closing. Delinquency, loss, prepayment and discount rate assumptions have a material impact on the amount of gain recognized and on the carrying value of the retained mortgage securities—available-for-sale. The gain on sale method of accounting may create volatile earnings in certain environments, including when loan securitizations are not completed on a consistent schedule. If our actual experience differs materially from the assumptions that we use to determine the value of our mortgage securities—available-for-sale, future cash flows, and results of operations could be negatively affected.

Changes in accounting standards might cause us to alter the way we structure or account for securitizations. Changes could be made to the current accounting standards which could affect the way we structure or account for securitizations. For example, if changes were made in the types of transactions eligible for gain on sale treatment, we may have to change the way we account for securitizations, which may harm our results of operations or financial condition.

Risks Related to Interest Rates and Our Hedging Strategies

Changes in interest rates may harm our results of operations. Our results of operations are likely to be harmed during any period of unexpected or rapid changes in interest rates. Interest rate changes could affect us in the following ways:

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a substantial or sustained increase in interest rates could harm our ability to originate or acquire mortgage loans in expected volumes, which could result in a decrease in our cash flow and in our ability to support our fixed overhead expense levels;

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interest rate fluctuations may harm our earnings as a result of potential changes in the spread between the interest rates on our borrowings and the interest rates on our mortgage assets;

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mortgage prepayment rates vary depending on such factors as mortgage interest rates and market conditions, and changes in anticipated prepayment rates may harm our earnings; and

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when we securitize loans, the value of the residual interests we retain and the income we receive from them are based primarily on the London Inter-Bank Offered Rate, or LIBOR, and an increase in LIBOR reduces the net income we receive from, and the value of, these residual interests.

Any of the foregoing results from changing interest rates may adversely affect our results from operations.

Hedging against interest rate exposure may adversely affect our earnings, which could adversely affect cash available for distribution to our stockholders. We may enter into interest rate swap agreements or pursue other interest rate hedging strategies. Our hedging activity will vary in scope based on interest rates, the type of mortgage assets held, and other changing market conditions. Interest rate hedging may fail to protect or could adversely affect us because, among other things:

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interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates;

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hedging instruments involve risk because they often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities; consequently, there are no requirements with respect to record keeping, financial responsibility or segregation of customer funds and positions, and the enforceability of agreements underlying derivative transactions may depend on compliance with applicable statutory, commodity and other regulatory requirements;

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available interest rate hedging may not correspond directly with the interest rate risk for which protection is sought;

•

the duration of the hedge may not match the duration of the related liability or asset;

•

the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction;

•

the party owing money in the hedging transaction may default on its obligation to pay, and a default by a party with whom we enter into a hedging transaction may result in the loss of unrealized profits; and

•

we may not be able to dispose of or close out a hedging position without the consent of the hedging counterparty, and we may not be able to enter into an offsetting contract in order to cover our risks.

Any hedging activity we engage in may adversely affect our earnings, which could adversely affect cash available for distribution to our stockholders. Therefore, while we may enter into such transactions to seek to reduce interest rate risks, unanticipated changes in interest rates may result in poorer overall investment performance than if we had not engaged in any such hedging transactions.

Complying with REIT requirements may limit our ability to hedge effectively. We attempt to minimize exposure to interest rate fluctuations by hedging. The REIT provisions of the Code limit our ability to hedge mortgage assets and related borrowings by requiring us to limit our income in each year from any qualified hedges, together with any other income not generated from qualified real estate assets, to no more than 25% of our gross income. The fair market value of a hedging instrument will not be counted as a qualified asset for the purposes of satisfying this requirement. In addition, we must limit our aggregate income from non-qualified hedging transactions and from other non-qualifying sources to no more than 5% of our annual gross income. As a result, we may have to limit our use of advantageous hedging techniques. This could result in greater risks associated with changes in interest rates than we would otherwise want to incur. If we violate the 5% or 25% limitations, we may have to pay a penalty tax equal to the amount of income in excess of those limitations, multiplied by a fraction intended to reflect our profitability. In addition, if we fail to observe these limitations, we could lose our REIT status for federal income tax purposes unless our failure was due to reasonable cause and not due to willful neglect.

Risks Related to Our Capital Stock

Investors in our common stock may experience losses, volatility and poor liquidity, and we may reduce or delay payment of our dividends in a variety of circumstances. Our earnings, cash flow, book value and dividends can be volatile and difficult to predict. Investors should not rely on predictions or management beliefs. Although we seek to pay a regular common stock dividend at a rate that is sustainable, we may reduce our dividend payments in the future for a variety of reasons. We may not provide public warnings of such dividend reductions or payment delays prior to their occurrence. Fluctuations in our current and prospective earnings, cash flow and dividends, as well as many other factors such as perceptions, economic conditions, stock market conditions, and the like, can affect the price of our common stock. Investors may experience volatile returns and material losses. In addition, liquidity in the trading of our

common stock may be insufficient to allow investors to sell their stock in a timely manner or at a reasonable price.

Restrictions on ownership of capital stock may inhibit market activity and the resulting opportunity for holders of our capital stock to receive a premium for their securities. In order for us to meet the requirements for qualification as a REIT, our charter generally prohibits any person from acquiring or holding, directly or indirectly, (i) shares of our common stock in excess of 9.8% (in value or number of shares, whichever is more restrictive) of the aggregate of the outstanding shares of our common stock or (ii) shares of our capital stock in excess of 9.8% in value of the aggregate of the outstanding shares of our capital stock. These restrictions may inhibit market activity and the resulting opportunity for the holders of our capital stock to receive a premium for their stock that might otherwise exist in the absence of such restrictions.

The market price of our common stock and trading volume may be volatile, which could result in substantial losses for our stockholders. The market price of our common stock may be highly volatile and subject to wide fluctuations. In addition, the trading volume in our common stock may fluctuate and cause significant price variations to occur. Some of the factors that could negatively affect our share price or result in fluctuations in the price or trading volume of our common stock include:

•

general market and economic conditions;

•

actual or anticipated changes in our future financial performance;

•

actual or anticipated changes in market interest rates;

•

actual or anticipated changes in the amount of our dividend or any delay in the payment of a dividend;

•

competitive developments, including announcements by us or our competitors of new products or services;

•

the operations and stock performance of our competitors;

•

developments in the mortgage lending industry or the financial services sector generally;

•

the impact of new state or federal legislation or court decisions restricting the activities of lenders or suppliers of credit in our market;

•

fluctuations in our quarterly operating results;

•

actual or anticipated changes in financial estimates by securities analysts;

•

sales, or the perception that sales could occur, of a substantial number of shares of our common stock by insiders;

•

additions or departures of senior management and key personnel; and

•

actions by institutional stockholders.

We cannot assure you that the market price of our common stock will not fluctuate or decline significantly in the future. In addition, the stock market in general can experience considerable price and volume fluctuations.

There is no assurance of an active public trading market. Our common stock’s trading volume is relatively low compared to the securities of many other companies listed on the New York Stock Exchange. There is no assurance that an active public trading market for our common stock will be sustained in which case the trading price of our common stock could be adversely affected and your ability to transfer your shares of our common stock may be limited.

We may issue additional shares that may cause dilution and may depress the price of our common stock.

Our charter permits our board of directors, without stockholder approval, to:

•

authorize the issuance of additional shares of common stock or preferred stock without stockholder approval, including the issuance of shares of preferred stock that have preference rights over the common stock with respect to dividends, liquidation, voting and other matters or shares of common stock that have preference rights over our common stock with respect to voting; and

•

classify or reclassify any unissued shares of common stock or preferred stock and to set the preferences, rights and other terms of the classified or reclassified shares.

In the future, we will seek to access the capital markets from time to time by making additional offerings of securities, including debt instruments, preferred stock or common stock, or warrants to purchase preferred stock or common stock. Additional equity offerings by us may dilute your interest in us or reduce the market price of our common stock, or both. Our outstanding shares of preferred stock have, and any additional series of preferred stock may also have, a preference on distribution payments that could limit our ability to make a distribution to you. Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Further, market conditions could require us to accept less favorable terms for the issuance of our securities in the future. Thus, you will bear the risk of our future offerings reducing the market price of our common stock and diluting your interest in us.

Past issuances of our common stock pursuant to our 401(k) plan and our Direct Stock Purchase and Dividend Reinvestment Plan may not have complied with the registration requirements of the securities laws. To the extent that registration requirements were not met, purchasers of certain of these shares could require us to repurchase such shares. We maintain a number of equity-based compensation plans for our employees, including a 401(k) plan, and a Direct Stock Purchase and Dividend Reinvestment Plan for our employees and the public. We have recently discovered that we may have inadvertently sold up to approximately 50,000 shares under our 401(k) plan and up to approximately 287,000 shares under our Direct Stock Purchase and Dividend Reinvestment Plan in the last twelve months in a manner that may not have complied with the registration requirements of applicable securities laws. In connection with sales under our 401(k) plan, the shares were purchased in the open market and as a result we did not receive any proceeds from such transactions, which may not be deemed to be sales for these purposes. In connection with sales of up to approximately 287,000 shares that were not registered under our Direct Stock Purchase and Dividend Reinvestment Plan in May 2005, we received approximately $10.8 million in net proceeds. As a result, the holders of unregistered shares may have rescission rights or the right to recover damages if they no longer own such shares. As a result of these potential rescission rights, we could be required to repurchase the shares for an amount equal to the sale price of all shares sold less dividends paid, which we currently estimate to be $12.8 million, exclusive of any interest or other costs. This amount could be higher if it is ultimately determined that additional unregistered shares were sold. Furthermore, we could be subject to monetary fines or other regulatory sanctions as provided under applicable securities laws. We are currently evaluating whether an offer of rescission to those persons who received unregistered shares of our common stock is advisable.

Item 3. Quantitative and Qualitative Disclosures About 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 our market value

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 have adjustable rates, 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 June 30, 2005, borrowings under all financing arrangements adjust daily or monthly. 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 and impairments may be incurred, as the asset rate resets would lag the borrowing rate resets.

Interest Rate Sensitivity Analysis . 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 a market value basis.

The following table summarizes management’s estimates of the changes in market value of our mortgage assets and interest rate agreements assuming interest rates were 100 and 200 basis points, or 1 and 2 percent higher or lower. The cumulative change in market value represents the change in market value of mortgage assets, net of the change in market value of interest rate agreements. The change in market value of the liabilities on our balance sheet due to a change in interest rates is insignificant since the liabilities are so short term.

Table 15—Interest Rate Sensitivity—Market Value

(dollars in thousands)


	Basis Point Increase (Decrease) in Interest Rate (A)
	(200)			(100)			100			200
As of June 30, 2005:
Change in market values of:
Assets	$	65,545		$	32,619		$	(29,142	)	$	(63,044	)
Interest rate agreements		(19,549	)		(11,154	)		16,721			36,452

Cumulative change in market value	$	45,996		$	21,465		$	(12,421	)	$	(26,592	)

Percent change of market value portfolio equity (B)		7.7	%		3.6	%		(2.1	)%		(4.5	)%

As of December 31, 2004:
Change in market values of:
Assets	$	70,438		$	33,198		$	(34,045	)	$	(72,840	)
Interest rate agreements		(54,085	)		(28,046	)		27,832			55,113

Cumulative change in market value	$	16,353		$	5,152		$	(6,213	)	$	(17,727	)

Percent change of market value portfolio equity (B)		3.3	%		1.0	%		(1.3	)%		(3.6	)%

(A)	Change in market value of assets 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 June 30, 2005 and December 31, 2004.

Hedging . In order to address a mismatch of interest rate indices and adjustment periods on our 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 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 our best interest, given the cost and risk of hedging transactions and the need to maintain REIT status as our ability to hedge is limited by the REIT laws.

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 “counterparty”. The counterparty agrees to make payments to us in the future should the one-month LIBOR interest rate rise above the strike rate specified in the contract. We make either quarterly or monthly premium payments or have chosen to pay the premiums at the beginning to the counterparties under contract. Each contract has either a fixed or amortizing notional face amount on which the interest is computed, and a set term to maturity. When the referenced LIBOR interest rate rises above the contractual strike rate, we earn cap income. Payments on an annualized basis equal the contractual notional face amount times the difference between actual LIBOR and the strike rate. Interest rate swaps have similar characteristics. However, interest rate swap agreements allow us to pay a fixed rate of interest while receiving a rate that adjusts with one-month LIBOR.

The following table summarizes the key contractual terms associated with our interest rate risk management contracts. Substantially all of the pay-fixed swaps and interest rate caps are indexed to one-month LIBOR.

We have determined the following estimated net fair value amounts by using available market information and valuation methodologies we deem appropriate as of June 30, 2005.

Table 16—Interest Rate Risk Management Contracts

(dollars in thousands)


	Maturity Range
	Net Fair Value		Total Notional Amount			2005			2006			2007			2008
Pay-fixed swaps:
Contractual maturity	$	3,042	$	660,000		$	310,000		$	150,000		$	160,000		$	40,000
Weighted average pay rate				2.7	%		2.0	%		2.8	%		3.8	%		4.0	%
Weighted average receive rate				3.3	%		(A	)		(A	)		(A	)		(A	)

Interest rate caps:
Contractual maturity	$	6,882	$	1,050,000		$	150,000		$	200,000		$	580,000		$	120,000
Weighted average strike rate				3.3	%		1.6	%		2.0	%		4.0	%		4.1	%

(A) The pay-fixed swaps receive rate is indexed to one-month LIBOR.

Item 4. Controls and Procedures

Disclosure Controls and Procedures . The Company maintains a system of disclosure controls and procedures which are designed to ensure that information required to be disclosed by the Company in reports that it files or submits under the federal securities laws, including this report, is recorded, processed, summarized and reported on a timely basis. These disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed under the federal securities laws is accumulated and communicated to the Company’s management on a timely basis to allow decisions regarding required disclosure. The Company’s principal executive officer and principal financial officer evaluated the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report and concluded that the Company’s controls and procedures were effective.

Changes in Internal Controls over Financial Reporting. There were no changes in our internal controls over financial reporting during the quarter ended June 30, 2005 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

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

In July 2004, an employee of NHMI filed a class and collective action lawsuit against NHMI and NMI in California Superior Court for the County of Los Angeles. Subsequently, NHMI and NMI removed the matter to the United States District Court for the Central District of California. The plaintiff brought this class and collective action on behalf of herself and all past and present employees of NHMI and NMI who were employed since May 1, 2000 in the capacity generally described as Loan Officer. The plaintiff alleged that NHMI and NMI filed to pay her and the members of the class she purported to represent overtime premium and minimum wage as required by the FSLA and California state laws for the period commencing May 1, 2000. In 2005, the plaintiff and NHMI agreed upon a nationwide settlement in the amount of $3.3 million on behalf of a class of all NHMI Loan Officers nationwide. The settlement, which is subject to court approval, covers all minimum wage and overtime claims going back to July 30, 2001, and includes the dismissal with prejudice of the claims against NMI. Since not all class members will elect to be part of the settlement, the Company estimated the probable obligation related to the settlement to be in a range of $1.5 million to $1.9 million. In accordance with SFAS No. 5, Accounting for Contingencies , the Company recorded a charge to earnings of $1.5 million in 2004.

In addition to those matters listed above, the Company is currently party to various other legal proceedings and claims, including, but not limited to, breach of contract claims, claims seeking to rescind mortgage insurance coverage, as well as class action and individual claims for violations of the Real Estate Settlement Procedures Act, FSLA, federal and state laws prohibiting employment discrimination and federal and state licensing and consumer protection laws. While management, including internal counsel, currently believes that the ultimate outcome of these proceedings and claims, individually and in the aggregate, will not have a material adverse effect on the Company’s financial condition or results of operations, litigation is subject to inherent uncertainties. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on the results of operations for the period in which the ruling occurs.

In April 2004, the Company also received notice of an informal inquiry from the Securities and Exchange Commission requesting that it provide various documents relating to its business. The Company has cooperated fully with the Commission’s inquiry and provided it with the requested information. The Company last provided information to the Commission in October 2004. We have received no additional requests or inquiries from the Commission since that time.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Issuer Purchases of Equity Securities


	Total Number of Shares Purchased	Average Price Paid per Share	Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	Approximate Dollar value of Shares that May Yet Be Purchased Under the Plans or Programs (A)
April 1, 2005 – April 30, 2005	—	—	—	$	1,020,082
May 1, 2005 – May 31, 2005	—	—	—	$	1,020,082
June 1, 2005 – June 30, 2005	—	—	—	$	1,020,082

(A) Current report on Form 8-K was filed on October 2, 2000 announcing that the Board of Directors authorized the company to repurchase its common shares, in an amount not to exceed $9 million.

Item 3. Defaults Upon Senior Securities

None

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

The 2005 annual meeting of shareholders of NovaStar Financial, Inc. was held on May 20, 2005 and Scott F. Hartman was elected as director. W. Lance Anderson, Gregory T. Barmore, Art N. Burtscher and Edward W. Mehrer terms of office as directors continued after the meeting.

The following matters were voted on at the annual meeting:


	Vote
	For	Against	Abstain	Broker Non-Votes
1. Election of Director, Scott F. Hartman (term expiring in 2008)	25,746,328	—	217,150	1,936,242
2. Ratification of Deloitte & Touche LLP as NovaStar Financial, Inc.’s independent public accountants for 2005	25,737,343	128,720	97,415	1,936,242

Item 5. Other Information

None

Item 6. Exhibits

Exhibit Listing


Exhibit No.		Description of Document

3.1 ⁽¹⁾		Articles of Amendment and Restatement of the Registrant

3.3.1		Amended and Restated Bylaws of NovaStar Financial, Inc.

4.1		Specimen Common Stock Certificate

10.1 ⁽¹⁾		NovaStar Mortgage, Inc. Deferred Compensation Plan

10.10A ⁽²⁾		Hartman Promissory Note

10.11A ⁽²⁾		Anderson Promissory Note

11.1 ⁽³⁾		Statement Regarding Computation of Per Share Earnings

21.1		Subsidiaries of the Registrant

31.1		Chief Executive Officer Certification - Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Principal Financial Officer Certification - Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Chief Executive Officer Certification - Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Principal Financial Officer Certification - Section 906 of the Sarbanes-Oxley Act of 2002

(1)	Incorporated by reference to the correspondingly numbered exhibit to the Registration Statement on Form S-3 (333-126699) filed by the Registrant with the SEC on July 19, 2005.

(2)	Incorporated by reference to the correspondingly numbered exhibit to Form 10-Q filed by the Registrant with the SEC on May 15, 2001.

(3)	See Note 13 to the condensed consolidated financial statement.

NOVASTAR FINANCIAL, INC.

SIGNATURES

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


NOVASTAR FINANCIAL, INC.

DATE: August 5, 2005				/s/ Scott F. Hartman
				Scott F. Hartman Chairman of the Board, Secretary and Chief Executive Officer

DATE: August 5, 2005				/s/ Gregory S. Metz
				Gregory S. Metz Chief Financial Officer

Exhibit 3.3.1

BYLAWS

NOVASTAR FINANCIAL, INC.

As of July 27, 2005

ARTICLE I

STOCKHOLDERS

SECTION 1. Annual Meeting . The Corporation shall hold an annual meeting of its stockholders to elect directors and transact any other business within its power, either at 10:00 a.m. on the fourth Tuesday of April in each year if not a legal holiday, or at such time on such day falling on or before the 30 ^th day thereafter as shall be set by the Board of Directors; provided , however , that the 1996 annual meeting shall be held at 10:00 a.m. on October 1, 1996, or at such other time on such other day falling on or before the 30 ^th day thereafter as shall be set by the Board of Directors. Except as the Charter or statute provides otherwise, any business may be considered at an annual meeting without the purpose of the meeting having been specified in the notice. Failure to hold an annual meeting does not invalidate the Corporation’s existence or affect any otherwise valid corporate acts. Meetings of stockholders shall be held at the principal office of the Corporation or at such place in the United States as is set forth from time to time by the Board of Directors.

SECTION 2. Special Meetings . Special meetings of the stockholders for any purpose or purposes may be called at any time by the President, the Board of Directors or the written request of stockholders entitled to cast a majority of the votes which all stockholders are entitled to cast at the particular meeting, addressed to the Secretary and then the Secretary shall proceed to call a special meeting only as may be required by law.

SECTION 3. Notices . Notice of the annual meeting and of any special meeting of stockholders shall, at least ten days but not more than ninety days prior to the date thereof, be given to each stockholder entitled to vote thereat and each other stockholder entitled to notice of the meeting. Notice is given to a stockholder when it is personally delivered to it, left at its residence or usual place of business, or mailed to it at its address as it appears on the records of the Corporation. Notwithstanding the foregoing provisions, each person who is entitled to notice waives notice if, before or after the meeting, such stockholder signs a waiver of notice which is filed with the records of the stockholders’ meeting, or is present at the meeting in person or by proxy. Every notice of an annual meeting or a special meeting shall state the time and place of the meeting. If the meeting is a special meeting or notice of the purpose or purposes is required by statute, the notice shall also briefly state the purpose or purposes thereof, and no business, other than that specified in such notice and matters germane thereto, shall be transacted at the meeting without further notice to stockholders not present in person or by proxy.

SECTION 4. Quorum; Manner of Acting and Adjournment . Unless statute or the Charter provides otherwise, at a meeting of stockholders the presence in person or by proxy of stockholders entitled to cast a majority of all the votes entitled to be cast at the meeting constitutes a quorum, and a majority of all the votes cast at a meeting at which a quorum is present is sufficient to approve any matter which properly comes before the meeting, except that a plurality of all the votes cast at a meeting at which a quorum is present is sufficient to elect a director.

Whether or not a quorum is present, a meeting of stockholders convened on the date for which it was called may be adjourned from time to time without further notice by a majority vote of the stockholders present in person or by proxy to a date not more than 120 days after the original record date. Any business which might have been transacted at the meeting as originally notified may be deferred and transacted at any such adjourned meeting at which a quorum shall be present.

SECTION 5. Organization . At every meeting of the stockholders, the Chairman of the Board, if there be one, shall conduct the meeting or, in the case of vacancy in office or absence of the Chairman of the Board, one of the following officers present shall conduct the meeting in the order stated: the Vice Chairman of the Board, if there be one, the President, the Vice Presidents in their order of rank and seniority, or a Chairman chosen by the stockholders entitled to cast a majority of the votes which all stockholders present in person or by proxy are entitled to cast, shall act as Chairman, and the Secretary or, in his or her absence, an assistant secretary, or in the absence of both Secretary and assistant secretaries, a person appointed by the Chairman, shall act as Secretary.

SECTION 6. Voting . Unless the Charter provides for a greater or lesser number of votes per share or limits or denies voting rights, each outstanding share of stock, regardless of class, is entitled to one vote on each matter submitted to a vote at a meeting of stockholders. In all elections for directors, each share of stock may be voted for as many individuals as there are directors to be elected and for whose election the share is entitled to be voted, but cumulative voting is not permitted.

SECTION 7. Proxies . A stockholder may vote the stock the stockholder owns of record either in person or by proxy. A stockholder may sign a writing authorizing another person to act as proxy. Signing may be accomplished by the stockholder or the stockholder’s authorized agent signing the writing or causing the stockholder’s signature to be affixed to the writing by any reasonable means, including facsimile signature. A stockholder may authorize another person to act as proxy by transmitting, or authorizing the transmission of, a telegram, cablegram, datagram, or other means of electronic transmission to the person authorized to act as proxy or to a proxy solicitation firm, proxy support service organization, or other person authorized by the person who will act as proxy to receive the transmission. Unless a proxy provides otherwise, it is not valid more than 11 months after its date. A proxy is revocable by a stockholder at any time without condition or qualification unless the proxy states that it is irrevocable and the proxy is coupled with an interest. A proxy may be made irrevocable for so long as it is coupled with an interest. The interest with which a proxy may be coupled includes an interest in the stock to be voted under the proxy or another general interest in the Corporation or its assets or liabilities.

SECTION 8. Voting Lists . At each meeting of stockholders, a full, true and complete list of all stockholders entitled to vote at such meeting, showing the number and class of shares held by each and certified by the transfer agent for such class or by the Secretary, shall be furnished by the Secretary.

SECTION 9. Informal Action by Stockholders . Unless otherwise provided by law, any action required to be taken at a meeting of the stockholders, or any other action which may be taken at a meeting of the stockholders, may be taken without a meeting if a consent in writing, setting forth the action so taken, shall be signed by all of the stockholders entitled to vote with respect to the subject matter thereof.

SECTION 10. Meeting by Conference Telephone . Stockholders may participate in a meeting by means of a conference telephone or similar communications equipment if all persons participating in the meeting can hear each other at the same time. Participation in a meeting by these means constitutes presence in person at a meeting.

SECTION 11. Stockholder Proposals . For any stockholder proposal to be presented in connection with an annual meeting of stockholders of the Corporation, including any proposal relating to the nomination of a director to be elected to the Board of Directors of the Corporation, the stockholder putting forth such proposal must have given timely notice thereof in writing to the Secretary of the Corporation. To be timely, a stockholder’s notice shall be delivered to the Secretary at the principal executive offices of the Corporation not less than 90 days before the first anniversary of the mailing date of the notice of the preceding year’s annual meeting. Such stockholder’s notice shall set forth (a) as to each person whom the stockholder proposes to nominate for election or reelection as a director all information relating to such person that is required to be disclosed in solicitations of proxies for election of directors pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) (including such person’s written consent to being named in the proxy statement as a nominee and to serving as a director if elected); (b) as to any other business that the stockholder proposes to bring before the meeting, a brief description of the business desired to be brought before the meeting, the reasons for conducting such business at the meeting and any material interest in such business of such stockholder and of the beneficial owner, if any, on whose behalf the proposal is made; and (c) as to the stockholder giving the notice and the beneficial owner, if any, on whose behalf the nomination or proposal is made, (i) the name and address of such stockholder, as they appear on the Corporation’s books, and of such beneficial owner and

(ii) the class and number of shares of stock of the Corporation which are owned beneficially and of record by such stockholder and such beneficial owner. This Section shall not apply to the 1996 annual meeting. For the 1997 annual meeting the previous year’s meeting shall be deemed to have taken place on May 29, 1996; provided that this sentence shall cease to be a part of the Bylaws after holding the 1997 annual meeting and any adjournments thereof.

ARTICLE II

DIRECTORS

SECTION 1. Number, Classification, Election and Term . The affairs of the Corporation shall be under the direction and control of a Board of Directors which shall be initially composed of three (3) members who shall hold office until its successors are duly chosen and qualified. The directors shall be divided into three Classes, designated Class I, Class II and Class III. Each class shall consist, as nearly as may be possible, of one-third of the total number of directors constituting the entire Board of Directors. The term of the initial Class I directors shall terminate on the date of the annual meeting of stockholders held in 1997; the term of the initial Class II directors shall terminate on the date of the annual meeting of stockholders held in 1998; and the term of the initial Class III directors shall terminate on the date of the annual meeting of stockholders held in 1999. At each annual meeting of stockholders beginning in 1997, successors to the class of directors whose term expires at that annual meeting shall be elected for a three-year term. The number of directors shall be increased or decreased from time to time by vote of a majority of the entire Board of Directors; provided, however, that the number of directors may not exceed fifteen (15) nor be less than three (3) except as permitted by law. If the number of directors is changed, any increase or decrease shall be apportioned among the classes so as to maintain the number of directors in each class as nearly equal as possible. A director elected by stockholders shall hold office until the annual meeting for the year in which his or her term expires and until his or her successor shall be elected and shall qualify, subject, however, to prior death, resignation, retirement, disqualification or removal from office.

At all times subsequent to the first closing in the Corporation’s initial private placement of its Capital Stock (the “Private Placement”), except in the case of a vacancy, a majority of the Board of Directors shall be Independent Directors (as hereinafter defined). For the purposes of these Bylaws, “Independent Director” shall mean a director of the Corporation who is not an officer or employee of the Corporation or any subsidiary or affiliate of the Corporation. General Electric Capital Corporation and its affiliates, including GE Capital Mortgage Corporation, shall not be deemed to be affiliates of the Corporation for purposes of this definition. Directors need not be stockholders in the Corporation.

Whenever the holders of any one or more series of preferred stock of the Corporation shall have the right, voting separately as a class, to elect one or more directors of the Corporation, the Board of Directors shall consist of said directors so elected in addition to the number of directors fixed as provided above in the first paragraph of this Section 1. Notwithstanding the foregoing, and except as otherwise may be required by law, whenever the holders of any one or more series of preferred stock of the Corporation shall have the right, voting separately as a class, to elect one or more directors of the Corporation, the terms of the director or directors elected by such holders shall expire at the next succeeding annual meeting of stockholders.

SECTION 2. Function of Directors . The business and affairs of the Corporation shall be managed under the direction of the Board of Directors. All the powers of the Corporation are vested in and shall be exercised by or under the authority of the Board of Directors except as otherwise prescribed by statute, by the Charter or by these Bylaws.

SECTION 3. Vacancies . Subject to the rights of the holders of any class of stock separately entitled to one or more directors, any vacancy occurring on the Board of Directors for any cause other than by reason of an increase in the number of directors may, subject to the provisions of Section 5, be filled by a majority of the remaining members of the Board of Directors, regardless of whether such majority of the remaining members of the Board of Directors is less than a quorum; provided, however, that if the Corporation has completed its Private Placement and, in accordance with Section 1, a majority of the Board of Directors are required to be Independent Directors, then Independent Directors shall nominate replacements for vacancies among the Independent Directors, which replacements must be elected by a majority of the directors, including a majority of the Independent Directors. Subject to the rights of the holders of any class of stock separately entitled to elect one or more directors, any vacancy occurring by reason of an increase in the number of directors may be filled by action of a majority of the entire Board of Directors including, following the Private Placement, a majority of the Independent Directors. The stockholders may fill any vacancy occurring on the Board of Directors for any reason, subject to the requirement for Independent Directors, if applicable. If the stockholders of any class or series are entitled separately to elect one or more directors, a majority of the remaining directors elected by that class or series or the sole remaining director elected by that class or series may fill any vacancy among the number of directors elected by that class or series. A director elected by the Board of Directors to fill a

vacancy shall be elected to hold office until the next annual meeting of stockholders or until his successor is elected and qualified.

SECTION 4. Resignations . Any director or member of a committee may resign at any time. Such resignation shall be made in writing and shall take effect at the time specified therein, or if no time be specified, at the time of the receipt by the Chairman of the Board, the President or the Secretary. Acceptance of a resignation shall not be necessary to make it effective.

SECTION 5. Removal . Any director or the entire Board of Directors may be removed only in accordance with the Charter.

SECTION 6. Committees of the Board of Directors . The Board of Directors may appoint from among its members an Executive Committee, an Audit Committee, a Compensation Committee and other committees composed of one or more directors and delegate to these committees any of the powers of the Board of Directors, except the power to authorize dividends of stock, elect directors, issue stock other than as provided in the next sentence, recommend to the stockholders any action which requires stockholder approval, amend these Bylaws, or approve any merger or share exchange which does not require stockholder approval. At least a majority of all committees of the Board shall be comprised of Independent Directors. If the Board of Directors has given general authorization for the issuance of stock providing for or establishing a method or procedure for determining the maximum number of shares to be issued, a committee of the Board, in accordance with that general authorization or any stock option or other plan or program adopted by the Board of Directors, may authorize or fix the terms of stock subject to classification or reclassification and the terms on which any stock may be issued, including all terms and conditions required or permitted to be established or authorized by the Board of Directors.

Each committee may fix rules of procedure for its business. One-third of the members of a committee shall constitute a quorum for the transaction of business and the act of a majority of those present at a meeting at which a quorum is present shall be the act of the committee. The members of a committee present at any meeting, whether or not they constitute a quorum, may appoint a director to act in the place of an absent member; provided , however , that in the event of the absence or disqualification of any Independent Director, such appointee shall be an Independent Director. Any action required or permitted to be taken at a meeting of a committee may be taken without a meeting, if an unanimous written consent which sets forth the action is signed by each member of the committee and filed with the minutes of the committee. The members of a committee may conduct any meeting thereof by conference telephone in accordance with the provisions of Section 8 of this Article.

Subject to the provisions hereof, the Board of Directors shall have the power at any time to change the membership of any committee, to fill all vacancies, to designate alternative members to replace any absent or disqualified member, or to dissolve any such committee.

SECTION 7. Meetings of the Board of Directors . Meetings of the Board of Directors, regular or special, may be held at any place in or out of the State of Maryland as the Board of Directors may from time to time determine or as shall be specified in the notice of such meeting.

Members of the Board of Directors may participate in a meeting by means of a conference telephone or similar communications equipment if all persons participating in the meeting can hear each other at the same time. Participation in a meeting by such means constitutes presence in person at a meeting.

The first meeting of each newly elected Board of Directors shall be held as soon as practicable after the annual meeting of the stockholders at which the directors were elected. The meeting may be held at such time and place as shall be specified in a notice given as hereinafter provided for special meetings of the Board of Directors, or as shall be specified in a written waiver signed by all of the directors as provided in this Section 7, except that no notice shall be necessary if such meeting is held immediately after the adjournment, and at the site, of the annual meeting of stockholders.

Regular meetings of the Board of Directors may be held without notice at such time and place as shall from time to time be determined by the Board of Directors. Special meetings of the Board of Directors may be called at any

time by two (2) or more directors or by a majority of the members of the executive committee, if one be constituted, in writing with or without a meeting of such committee, or by the Chairman of the Board of Directors or the President.

Special meetings may be held at such place or places in or out of the State of Maryland as may be designated from time to time by the Board of Directors; in the absence of such designation, such meetings shall be held at such places as may be designated in the notice of meeting.

Notice of the place and time of every special meeting of the Board of Directors shall be delivered by the Secretary to each director either personally or by telephone, telegraph, overnight courier or facsimile, or by leaving the same at his residence or usual place of business at least twenty-four (24) hours before the time at which such meeting is to be held or, if by first-class mail, at least 72 hours before the time of such meeting. If mailed, such notice shall be deemed to be given when deposited in the United States Mail addressed to the director at his post office address as it appears on the records of the Corporation, with postage thereon paid. Unless the Bylaws or a resolution of the Board of Directors provides otherwise, the notice need not state the business to be transacted at, or the purposes of, any special meeting of the Board of Directors. No notice of any special meeting of the Board of Directors need be given to any director who attends except where a director attends a meeting for the express purpose of objecting to the transaction of any business because the special meeting is not lawfully called or convened, or to any director who, in writing executed and filed with the records of the meeting either before or after the holding thereof, waives such notice.

Any meeting of the Board of Directors, regular or special, may adjourn from time to time to reconvene at the same or some other place, and no notice need be given of any such adjourned meeting other than by announcement.

SECTION 8. Informal Action by Directors . Unless otherwise provided by law, any action required to be taken at a meeting of the directors or any other action which may be taken at a meeting of the directors may be taken without a meeting if a consent in writing, setting forth the action so taken, shall be signed by all of the directors.

SECTION 9. Quorum and Voting . At all meetings of the Board of Directors, a majority of the entire Board of Directors shall constitute a quorum for the transaction of business, and the action of a majority of the directors present at any meeting at which a quorum is present shall be the action of the Board of Directors unless the concurrence of a greater proportion is required for such action by law, the Charter or these Bylaws. If a quorum shall not be present at any meeting of directors, the directors present thereat may, by a majority vote, adjourn the meeting from time to time, without notice other than announcement at the meeting, until a quorum shall be present.

SECTION 10. Organization . The Chairman of the Board shall preside at each meeting of the Board of Directors. In the absence or inability of the Chairman of the Board to preside at a meeting, the President or, in his absence or inability to act, another director chosen by a majority of the directors present, shall act as chairman of the meeting and preside thereat. The Secretary (or, in his absence or inability to act, any person appointed by the chairman of the meeting) shall act as Secretary of the meeting and keep the minutes thereof.

SECTION 11. Compensation of Directors . Independent Directors shall receive compensation for their services, and expenses of attendance for attendance at each regular or special meeting of the Board of Directors, or of any committee thereof or both, as may be determined from time to time by the Board of Directors. Nothing herein contained shall be construed to preclude any director from serving the Corporation in any other capacity and receiving compensation therefor.

SECTION 12. Investment Policies and Restrictions . The Board of Directors, including a majority of the Independent Directors, shall approve the investment policies of the Corporation. The investment policies and compliance therewith shall be reviewed by the Independent Directors at least annually to determine that the policies then being followed by the Corporation are in the best interest of the stockholders of the Corporation. Each such determination and the basis therefor shall be set forth in the minutes of the meeting of the Board of Directors.

It shall be the duty of the Board of Directors to ensure that the purchase, sale, retention and disposal of the Corporation’s assets, and the investment policies of the Corporation and the limitations thereon or amendment thereof are at all times in compliance with the restrictions applicable to real estate investment trusts pursuant to the Internal Revenue Code of 1986, as amended.

SECTION 13. Presumption of Assent . A director of the Corporation who is present at a meeting of the Board of Directors at which action on any corporate matter is taken shall be presumed to have assented to the action taken unless his or her dissent or abstention shall be entered in the minutes of the meeting or unless he or she shall file his or her written dissent to such action with the person acting as the secretary of the meeting before the adjournment thereof or shall forward such dissent by registered mail to the Secretary of the Corporation immediately after the adjournment of the meeting. Such right to dissent shall not apply to any director who votes in favor of such action.

SECTION 14. Advisory Directors . The Board of Directors may by resolution appoint advisory directors to the Board, who may also serve as directors emeriti, and shall have such authority and receive such compensation and reimbursement as the Board of Directors shall provide. Advisory directors or directors emeriti shall not have the authority to participate by vote in the transaction of business.

ARTICLE III

OFFICERS

SECTION 1. Officers . The officers of the Corporation shall be a Chairman of the Board, a President, a Treasurer and a Secretary, who shall be elected by the Board of Directors to serve during the pleasure of the Board and until their respective successors are elected and qualified, except as otherwise provided in any employment agreement between the Corporation and any officer. The Board of Directors may also appoint one or more Vice Presidents. The same person may hold any two or more offices except those of President and Vice President.

SECTION 2. Subordinate Officers, Committees and Agents . The Board of Directors may from time to time elect such other officers and appoint such committees, employees or other agents as the business of the Corporation may require, including one or more assistant secretaries, and one or more assistant treasurers, each of whom shall hold office for such period, have such authority, and perform such duties as are provided in these Bylaws, or as the Board of Directors may from time to time determine. The Board of Directors may delegate to any officer or committee the power to elect subordinate officers and to retain or appoint employees or other agents.

SECTION 3. Chairman of the Board . The Chairman of the Board shall preside at all meetings of the stockholders and the Board of Directors at which he or she is present. Unless otherwise specified by the Board of Directors, the Chairman of the Board shall also be the Chief Executive Officer of the Corporation and perform the duties customarily performed by chief executive officers, and shall perform such other duties as may from time to time be requested of him or her by the Board of Directors.

SECTION 4. President . Unless otherwise provided by resolution of the Board of Directors, the President, in the absence of the Chairman of the Board, shall preside at all meetings of the Board of Directors and of the stockholders at which he shall be present. The President shall, subject to the control of the Board of Directors, in general supervise and control all of the business and affairs of the Corporation. The President may sign, with the Secretary or any other proper officer of the Corporation thereunto authorized by the Board of Directors, certificates for shares of the Corporation, any deeds, mortgages, bonds, contracts, or other instruments which the Board of Directors have authorized to be executed, except in cases where the signing and execution thereof shall be expressly delegated by the Board of Directors or by these Bylaws to some other officer or agent of the Corporation, or shall be required by law to be otherwise signed or executed; and in general shall perform all duties incident to the office of president and such other duties as may be prescribed by the Board of Directors from time to time.

SECTION 5. Vice Presidents . In the absence of the President or in event of his or her death, inability or refusal to act, or at the request of the Chief Executive Officer or President, the Vice President or Vice Presidents shall perform the duties and exercise all the powers of the President and be subject to all the restrictions upon the President. The Vice President or Vice Presidents shall perform such other duties as from time to time may be assigned to him or her or them by the President or by the Board of Directors.

SECTION 6. Secretary . The Secretary shall keep the minutes of the stockholders’ and of the Board of Directors’ meetings in one or more books provided for that purpose, see that all notices are duly given in accordance with the provisions of these Bylaws or as required by law, be custodian of the corporate records and of the seal of the Corporation and keep a register of the post office address of each stockholder which shall be furnished to the

Secretary by such stockholder, have general charge of the stock transfer books of the Corporation and, in general, perform all duties incident to the office of Secretary and such other duties as from time to time may be assigned to him or her by the President, the Chief Executive Officer or the Board of Directors.

SECTION 7. Treasurer . The Treasurer shall have charge and custody of and be responsible for all funds and securities of the Corporation, receive and give receipts for moneys due and payable to the Corporation from any source whatsoever, and deposit all such moneys in the name of the Corporation in such banks, trust companies or other depositories as shall be selected in accordance with these Bylaws and in general perform all of the duties incident to the office of Treasurer and such other duties as from time to time may be assigned to him or her by the President, the Chief Executive Officer, the Chief Financial Officer or by the Board of Directors.

SECTION 8. Other Officers . The other officers of the Corporation shall perform such duties as the President may from time to time assign to them.

SECTION 9. Removal . Any officer elected by the Board of Directors may be removed, either for or without cause, at any time upon the vote of a majority of the Board of Directors. Any other employee of the Corporation may be removed or dismissed at any time by the President. The removal of an officer does not prejudice any of his or her contract rights.

SECTION 10. Resignation . Any officer or agent may resign at any time by giving written notice to the Board of Directors, or to the President or to the Secretary of the Corporation. Any such resignation shall take effect at the date of the receipt of such notice or at any later time specified therein and, unless otherwise specified therein, the acceptance of such resignation shall not be necessary to make it effective.

SECTION 11. Vacancies . A vacancy in any office because of death, resignation, removal, disqualification, or any other cause, shall be filled by the Board of Directors or by the officer or remaining members of the committee to which the power to fill such office has been delegated pursuant to Section 2 of this Article, as the case may be, and if the office is one for which these Bylaws prescribe a term, shall be filled for the unexpired portion of the term.

SECTION 12. Salaries . The salaries, if any, of the officers elected by the Board of Directors shall be fixed from time to time by the Board of Directors or by such officer as may be designated by resolution of the Board of Directors. The salaries or other compensation of any other officers, employees and other agents shall be fixed from time to time by the officer or committee to which the power to elect such officers or to retain or appoint such employees or other agents has been delegated pursuant to Section 2 of this Article. No officer shall be prevented from receiving such salary or other compensation by reason of the fact that he is also a director of the Corporation.

ARTICLE IV

STOCK

SECTION 1. Certificates . Each stockholder shall be entitled to a certificate or certificates which shall represent and certify the number and kind and class of shares owned by it in the Corporation. Each certificate shall be signed by the Chairman of the Board or the President or a Vice President and countersigned by the Secretary or an assistant secretary or the Treasurer or an assistant treasurer.

The signatures may be either manual or facsimile signatures. In case any officer who has signed any certificate ceases to be an officer of the Corporation before the certificate is issued, the certificate may nevertheless be issued by the Corporation with the same effect as if the officer had not ceased to be such officer as of the date of its issue. Each stock certificate shall include on its face the name of the Corporation, the name of the stockholder and the class of stock and number of shares represented by the certificate. If the Corporation has authority to issue stock of more than one class, the stock certificate shall contain on its face or back a full statement or summary of the designations and any preferences, conversion and other rights, voting powers, restrictions, limitations as to dividends, qualifications and terms and conditions of redemption of the stock of each class which the Corporation is authorized to issue and if the Corporation is authorized to issue any preferred or special class in series, the differences in the relative rights and preferences between the shares of each series to the extent they have been set, and the authority of the Board of Directors to set the relative rights and preferences of subsequent series. In lieu of such full statement or summary, there

may be set forth upon the face or back of the certificate a statement that the Corporation will furnish to any stockholder upon request and without charge, a full statement of such information. Such request may be made to the Secretary or to the Corporation’s transfer agent. Every stock certificate representing shares of stock which are restricted as to transferability by the Corporation shall contain a full statement of the restriction or state that the Corporation will furnish information about the restriction to the stockholder on request and without charge. A stock certificate may not be issued until the stock represented by it is fully paid, except in the case of stock purchased under an option plan as permitted by law.

SECTION 2. Lost Certificates . The Board of Directors may order a new certificate or certificates of stock to be issued in place of any certificates shown to have been lost or destroyed under such terms and conditions as to it may seem reasonable. When authorizing such issue of a new certificate or certificates, the Board of Directors may, in its discretion and as a condition precedent to the issuance thereof, require the owner of such stolen, lost or destroyed certificate or certificates, or his legal representative, to advertise the same in such manner as it shall require and/or to give the Corporation a bond, with sufficient surety to the Corporation to indemnify it against any loss or claim which may arise by reason of the issuance of a new certificate.

SECTION 3. Transfer Agents and Registrars . At such time as the Corporation lists its securities on a national securities exchange or the Nasdaq National Market, or such earlier time as the Board of Directors may elect, the Board of Directors shall appoint one or more banks or trust companies in such city or cities as the Board of Directors may deem advisable, from time to time, to act as transfer agents and/or registrars of the shares of stock of the Corporation; and, upon such appointments being made, no certificate representing shares shall be valid until countersigned by one of such transfer agents and registered by one of such registrars.

SECTION 4. Transfer of Stock . No transfers of shares of stock of the Corporation shall be made if (i) void ab initio pursuant to the Charter, or (ii) the Board of Directors, pursuant to the Charter, shall have refused to transfer such shares; provided, however, that nothing contained in these Bylaws shall impair the settlement of transactions entered into on the facilities of the New York Stock Exchange or any other national securities exchange or automated inter-dealer quotation system. Permitted transfers of shares of stock of the Corporation shall be made on the stock records of the Corporation only upon the instruction of the registered holder thereof, or by his attorney thereunto authorized by power of attorney duly executed and filed with the Secretary or with a transfer agent or transfer clerk, and upon surrender of the certificate or certificates, if issued, for such shares properly endorsed or accompanied by a duly executed stock transfer power and the payment of all taxes thereon. Upon surrender to the Corporation or the transfer agent of the Corporation of a certificate for shares duly endorsed or accompanied by proper evidence of succession, assignment or authority to transfer, as to any transfers not prohibited by the Charter or by action of the Board of Directors thereunder, it shall be the duty of the Corporation to issue a new certificate to the person entitled thereto, cancel the old certificate and record the transaction upon its books.

SECTION 5. Fixing of Record Dates . The Board of Directors may fix, in advance, a date as the record date for the purpose of determining stockholders entitled to notice of, or to vote at, any meeting of stockholders, or stockholders entitled to receive payment of any dividend or the allotment of any rights, or in order to make a determination of stockholders for any other proper purpose. Such date, in any case, may not be prior to the close of business on the day the record date is fixed nor, subject to Section 4 of Article I, more than ninety (90) days, or in case of a meeting of stockholders, less than ten (10) days, prior to the date on which the particular action requiring such determination of stockholders is to be taken.

SECTION 6. Registered Stockholders . The Corporation shall be entitled to recognize the exclusive right of a person registered on its books as the owner of shares to receive dividends, and to vote as such owner, and to hold liable for calls and assessments, if any, a person registered on its books as the owner of shares, and shall not be bound to recognize any equitable or other claim to or interest in such share or shares on the part of any other person, whether or not it shall have express or other notice thereof, except as otherwise provided by law or the Charter.

SECTION 7. Regulations . The Board of Directors may make such additional rules and regulations, not inconsistent with the Bylaws or the Charter, as it may deem expedient concerning the issue, transfer and registration of certificates for shares of stock of the Corporation.

ARTICLE V

SEAL

The Board of Directors may provide a suitable seal for the Corporation, which may be either facsimile or any other form of seal and shall remain in the custody of the Secretary. If the Board of Directors so provides, it shall be affixed to all certificates of the Corporation’s stock and to other instruments requiring a seal. If the Corporation is required to place its corporate seal to a document, it is sufficient to meet the requirement of any law, rule, or regulation relating to a corporate seal to place the word “Seal” adjacent to the signature of the person authorized to sign the document on behalf of the Corporation.

ARTICLE VI

SIGNATURES

SECTION 1. Checks, Drafts, Etc . All checks, drafts and orders for the payment of money, notes and other evidences of indebtedness, issued in the name of the Corporation, shall, unless otherwise provided by resolution of the Board of Directors, be signed by the President, a Vice President or an Assistant Vice President and countersigned by the Treasurer, an Assistant Treasurer, the Secretary or an Assistant Secretary.

SECTION 2. Stock Transfer . All endorsements, assignments, stock powers or other instruments of transfer of securities standing in the name of the Corporation shall be executed for and in the name of the Corporation by the President or Vice President or by such officer as the Board of Directors may designate.

ARTICLE VII

FISCAL YEAR

The fiscal year of the Corporation shall be the twelve calendar months period ending December 31 in each year, unless otherwise provided by the Board of Directors.

SECTION VIII

INDEMNIFICATION

SECTION 1. Procedure . Any indemnification shall be made within 10 days after a determination is made that the director or officer requesting indemnification (the “Indemnified Party”) is entitled to such indemnification. Any payment of expenses in advance of the final disposition of any proceeding shall be made within 10 days after the receipt by the Corporation of a written statement from an Indemnified Party requesting such advance. The right to indemnification and advances shall be enforceable by the Indemnified Party in any court of competent jurisdiction, if (i) the Corporation denies a written request for indemnification, in whole or in part, (ii) payment is not timely made, or (iii) the Corporation fails to make a determination as to the Indemnified Party’s right to indemnification within 30 days after receipt by the Company of a written request for indemnification from the Indemnified Party. The Indemnified Party’s costs and expenses incurred in connection with successfully establishing his or her right to indemnification in any such action shall also be reimbursed by the Corporation. It shall be a defense to any action for advance for expenses if the statement received by the Corporation requesting such advance does not contain (i) a written affirmation by the Indemnified Party of such Indemnified Party’s good faith belief that the standard of conduct necessary for indemnification by the Corporation has been met, and (ii) an undertaking as required by law to reimburse the portion of any advances relating to proceedings for which it is ultimately determined that the standard of conduct has not been met and which have not been successfully resolved.

SECTION 2. Exclusivity, Etc . The indemnification and advance of expenses provided by the Charter and these Bylaws shall not be deemed exclusive of any other rights to which a person seeking indemnification or advance of expenses may be entitled under any law (common or statutory), or any agreement, vote of stockholders or disinterested directors or other provision that is consistent with law, both as to action in his or her official capacity and as to action in another capacity while holding office or while employed by or acting as agent for the Corporation, shall continue in respect of all events occurring while a person was a director or officer after such person has ceased to be a director or officer, and shall inure to the benefit of the estate, heirs, executors and administrators of such

person. All rights to indemnification and advance of expenses under the Charter of the Corporation and hereunder shall be deemed to be a contract between the Corporation and each director or officer of the Corporation who serves or served in such capacity at any time while this Bylaw is in effect. Nothing herein shall prevent the amendment of this Bylaw, provided that no such amendment shall diminish the rights of any person hereunder with respect to events occurring or claims made before its adoption or as to claims made after its adoption in respect of events occurring before its adoption. Any repeal or modification of this Bylaw shall not in any way diminish any rights to indemnification or advance of expenses of such director or officer or the obligations of the Corporation arising hereunder with respect to events occurring, or claims made, while this Bylaw or any provision hereof is in force.

SECTION 3. Severability; Definitions . The invalidity or unenforceability of any provision of this Article VIII shall not affect the validity or enforceability of any other provision hereof. The phrase “this Bylaw” in this Article VIII means this Article VIII in its entirety.

SECTION IX

SUNDRY PROVISIONS

SECTION 1. Books and Records . The Corporation shall keep correct and complete books and records of its accounts and transactions and minutes of the proceedings of its stockholders and Board of Directors and of any executive or other committee when exercising any of the powers of the Board of Directors. The books and records of the Corporation may be in written form or in any other form which can be converted within a reasonable time into written form for visual inspection. Minutes shall be recorded in written form but may be maintained in the form of a reproduction. The original or a certified copy of the Bylaws shall be kept at the principal office of the Corporation.

SECTION 2. Voting Upon Shares in Other Corporations . Stock of other corporations or associations, registered in the name of the Corporation, may be voted by the President, a Vice President, or a proxy appointed by either of them. The Board of Directors, however, may by resolution appoint some other person to vote such shares, in which case such person shall be entitled to vote such shares upon the production of a certified copy of such resolution.

SECTION 3. Exemption from Control Share Acquisition Statute . The provisions of Sections 3-701 to 3-709 of the Corporations and Associations Article of the Annotated Code of Maryland shall not apply to any share of capital stock of the Corporation now or hereafter outstanding. Such shares of capital stock are exempted from such Sections to the fullest extent permitted by Maryland law.

SECTION 4. Annual Statement of Affairs . The President or chief accounting officer shall prepare annually a full and correct statement of the affairs of the Corporation, to include a balance sheet and a financial statement of operations for the preceding fiscal year. The statement of affairs shall be submitted at the annual meeting of the stockholders and, within 20 days after the meeting, placed on file at the Corporation’s principal office.

SECTION 5. Mail . Except as herein expressly provided, any notice or other document which is required by these Bylaws to be mailed shall be deposited in the United States mails, postage prepaid.

SECTION 6 Reliance . Each director, officer, employee and agent of the Corporation shall, in the performance of his or her duties with respect to the Corporation, be fully justified and protected with regard to any act or failure to act in reliance in good faith upon the books of account or other records of the Corporation, upon the opinion of counsel or upon reports made to the Corporation by any of its officers or employees or by the adviser, accountants, appraisers or other experts or consultants selected by the Board of Directors or officers of the Corporation, regardless of whether such counsel or expert may also be a director.

SECTION 7. Certain Rights of Directors, Officers, Employees and Agents . The directors shall have no responsibility to devote their full time to the affairs of the Corporation. Any director or officer, employee or agent of the Corporation, in his or her personal capacity or in a capacity as an affiliate, employee or agent of any other person, or otherwise, may have business interests and engage in business activities similar to or in addition to those of or relating to the Corporation.

SECTION X

AMENDMENTS

These Bylaws may be amended or replaced, or new Bylaws may be adopted, either (1) by the vote of the stockholders entitled to cast at least a majority of the votes which all stockholders are entitled to cast thereon at any duly organized annual or special meeting of stockholders, or (2), with respect to those matters which are not by statute reserved exclusively to the stockholders, by vote of a majority of the Board of Directors, including a majority of the Independent Directors of the Corporation, in office at any regular or special meeting of the Board of Directors; provided , however , that Section 2 of Article I and Sections 1 through 14 of Article II of these Bylaws may only be amended or modified by the vote of at least 66 2/3% of the votes which all stockholders are entitled to cast thereon. It shall not be necessary to set forth such proposed amendment, repeal or new Bylaws, or a summary thereof, in any notice of such meeting, whether annual, regular or special.

Exhibit 4.1

LOGO

NovaStar Financial, Inc.

INCORPORATED UNDER THE LAWS OF THE STATE OF MARYLAND

THIS CERTIFICATE IS TRANSFERABLE IN THE CITY OF KANSAS CITY, MO OR NEW YORK, NY.

CUSIP 669947 40 0

SEE REVERSE FOR CERTAIN DEFINITIONS

This Certifies that

Is the Registered Holder of

FULLY PAID AND NON-ASSESSABLE SHARES OF COMMON STOCK, PAR VALUE $.01 PER SHARE, OF

NovaStar Financial, Inc.

transferable on the books of the Corporation by the holder hereof in person or by a duly authorized attorney upon surrender of this Certificate properly endorsed. This Certificate is not valid unless countersigned and registered by the Transfer Agent and Registrar. Witness the facsimile seal of the Corporation and the facsimile signatures of its duly authorized officers.

Dated:

COUNTERSIGNED AND REGISTERED

UMB BANK, N.A.

TRANSFER AGENT

AND REGISTRAR

AUTHORIZED SIGNATURE

NovaStar Financial, Inc. CORPORATE SEAL 1996 MARYLAND

CHAIRMAN OF THE BOARD AND

CHIEF EXECUTIVE OFFICER

PRESIDENT AND

ASSISTANT SECRETARY

CXXXXXX NovaStar, ADR, E Rev. 1 07/21/05 RT

LOGO

NovaStar Financial, Inc.

The securities represented by this certificate are subject to restrictions on Beneficial Ownership and Constructive Ownership and Transfer for the purpose of the Corporation’s maintenance of its status as a Real Estate Investment Trust under the Internal Revenue Code of 1986, as amended (the “Code”). Subject to certain further restrictions and except as expressly provided in the Corporation’s Charter, (i) no Person may Beneficially Own or Constructively Own shares of the Corporation’s Common Stock in excess of 9.8 percent (in value or number of shares) of the outstanding shares of Common Stock of the Corporation unless such Person is an Excepted Holder (in which case the Excepted Holder Limit shall be applicable); (ii) no Person may Beneficially Own or Constructively Own shares of Capital Stock of the Corporation in excess of 9.8 percent of the value of the total outstanding shares of Capital Stock of the Corporation, unless such Person is an Excepted Holder (in which case the Excepted Holder Limit shall be applicable); (iii) no Person may Beneficially or Constructively Own Capital Stock that would result in the Corporation being “closely held” under Section 856(h) of the Code or otherwise cause the Corporation to fail to qualify as a REIT; and (iv) no Person may Transfer shares of Capital Stock if such Transfer would result in the Capital Stock of the Corporation being owned by fewer than 100 Persons. Any Person who Beneficially Owns or Constructively Owns or attempts to Beneficially Own or Constructively Own shares of Capital Stock which causes or will cause a Person to Beneficially Own or Constructively Own shares of Capital Stock in excess or in violation of the above limitations must immediatley notify the Corporation. Attempted transfers of ownership in violation of these restrictions shall be null and void ab initio. In addition, if any of the restrictions on transfer or ownership are violated, the shares of Capital Stock represented hereby may be automatically transferred to a Trustee of a Trust for the benefit of one or more Charitable Beneficiaries. In addition, upon the occurrence of certain events, attempted Transfers in violation of the restrictions described above may be void ab initio. All capitalized terms in this legend have the meanings defined in the Charter of the Corporation, as the same may be amended from time to time, a copy of which, including the restrictions on transfer and ownership, will be furnished to each holder of Capital Stock of the Corporation on request and without charge.

In addition, the Corporation will furnish to any stockholder on request and without charge a full statement or summary of the designations and any preferences, conversion and other rights, voting powers, restrictions, limitations as to dividends, qualifications and terms and conditions of redemption of the stock of each class which the Corporation is authorized to issue and the differences in the relative rights and preferences between the shares of each series, if any, to the extent they have been set, and of the authority of the Board of Directors to set the relative rights and preferences of subsequent series. Such request may be made to the Secretary of the Corporation or to the Corporation’s Transfer Agent.

The following abbreviations, when used in the inscription on the face of this certificate, shall be construed as though they were written out in full according to applicable laws or regulations:

TEN COM - as tenants in common

TEN ENT - as tenants by the entireties

JT TEN - as joint tenants with right of survivorship and not as tenants in common

UNIF GIFT MIN ACT - Custodian (Cust) (Minor) under Uniform Gifts to Minors Act (State)

Additional abbreviations may also be used though not in the above list. hereby sell, assign and transfer unto

For Value received

PLEASE INSERT SOCIAL SECURITY OR OTHER IDENTIFYING NUMBER OF ASSIGNEE

(PLEASE PRINT OR TYPE NAME AND ADDRESS INCLUDING ZIP CODE OF ASSIGNEE)

Shares of the capital stock represented by the within Certificate and do hereby irrevocably constitute and appoint

Attorney to transfer the said stock on the books of the within named Corporation with full power of substitution in the premises.

Dated

NOTICE: THE SIGNATURE TO THIS ASSIGNMENT MUST CORRESPOND WITH THE

NAME AS WRITTEN UPON THE FACE OF THE CERTIFICATE IN EVERY PARTICULAR, WITHOUT ALTERATION OR ENLARGEMENT, OR ANY SUCH CHANGE WHATEVER.

SIGNATURE(S) GUARANTEED

By:

THE SIGNATURE(S) SHOULD BE GUARANTEED BY AN ELIGIBLE GUARANTOR INSTITUTION. (Banks, Stockbrokers, Savings and Loan Associations and Credit Unions) WITH MEMBERSHIP IN AN APPROVED SIGNATURE GUARANTEE MEDALLION PROGRAM PURSUANT TO S.E.C. RULE 17Ad-15.

EXHIBIT 21.1

SUBSIDIARIES OF THE REGISTRANT

NovaStar Financial, Inc., a Maryland corporation, and its subsidiaries

•

NovaStar Assets Corp., a Delaware corporation

•

NovaStar Certificates Financing Corporation, a Delaware corporation

•

NovaStar Capital Access Corp., a Delaware corporation

•

NFI Repurchase Corporation, a Delaware corporation

•

NFI Holding Corporation, a Delaware corporation, and its subsidiaries

NovaStar Capital, Inc., a Delaware corporation

AmPro Financial Services, Inc., a Delaware corporation

NovaStar Credit Services, Inc., a Delaware corporation

NovaStar Mortgage, Inc., a Virginia corporation, and its subsidiaries

NovaStar Mortgage Funding Corporation, a Delaware corporation

NovaStar Mortgage Funding Corporation II, a Delaware corporation

NovaStar Mortgage Funding Corporation III, a Delaware corporation

NovaStar REMIC Financing Corporation, a Delaware corporation

NMI Repurchase Corporation, a Delaware corporation

NMI Repurchase Corporation II, a Delaware corporation

NovaStar Home Mortgage, Inc., a Delaware corporation, and its subsidiaries

NovaStar Home Mortgage of South Carolina, Inc., a Delaware corporation

NovaStar Mortgage Financing Corp., a Delaware corporation

Acceleron Lending, Inc., a Delaware corporation

Exhibit 31.1

CERTIFICATION

I, Scott F. Hartman, certify that:

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

Based on my knowledge, this 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 report;

Based on my knowledge, the financial statements, and other financial information included in this 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 report;

The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, 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 report is being prepared;

Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls over financial reporting.


Date : August 5, 2005

By:		/s/ S COTT F. H ARTMAN
Name:		Scott F. Hartman
Title:		Chairman of the Board of Directors and Chief Executive Officer

Exhibit 31.2

CERTIFICATION

I, Gregory S. Metz, certify that:

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

Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls over financial reporting.


Date : August 5, 2005

By:		/s/ G REGORY S. M ETZ
Name:		Gregory S. Metz
Title:		Chief Financial Officer

Exhibit 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES – OXLEY ACT OF 2002

In connection with the Quarterly Report of NovaStar Financial, Inc. (the “Company”) on Form 10-Q for the period ended June 30, 2005, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Scott F. Hartman, Chairman of the Board and Chief Executive Officer of the Company certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes – Oxley Act of 2002, that:

(1)

The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2)

The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ S COTT F. H ARTMAN

Scott F. Hartman

Chairman of the Board of Directors and
Chief Executive Officer

August 5, 2005

This certification is made solely for purpose of 18 U.S.C. Section 1350, subject to the knowledge standard contained therein, and not for any other purpose.

Exhibit 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES – OXLEY ACT OF 2002

In connection with the Quarterly Report of NovaStar Financial, Inc. (the “Company”) on Form 10-Q for the period ended June 30, 2005, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Gregory S. Metz, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes – Oxley Act of 2002, that:

(1)

The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2)

The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/ S / G REGORY S. M ETZ

Gregory S. Metz

Chief Financial Officer

August 5, 2005

This certification is made solely for purpose of 18 U.S.C. Section 1350, subject to the knowledge standard contained therein, and not for any other purpose.