UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549





FORM
10-K





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





For
the Fiscal Year Ended December 31, 2008





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


For the
Transition Period From _____________ to _____





Commission
File Number 001-13533





NOVASTAR
FINANCIAL, INC.


(Exact
Name of Registrant as Specified in its Charter)





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





2114
      Central Street, Suite 600, Kansas City, MO
              (Address
      of Principal Executive Office)
            64108
              (Zip
      Code)





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





Securities
Registered Pursuant to Section 12(b) of the Act:





None





Securities
Registered Pursuant to Section 12(g) of the Act:





Title
of Each Class


Common
Stock, $0.01 par value


Redeemable
Preferred Stock





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined by
Rule 405 of the Securities Act. Yes  ̈  Nox





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act. Yes  ̈  Nox





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





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




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


Large
      accelerated filer  ̈
              Non-accelerated
      filer  ̈
              Non-accelerated
      filer  ̈
              Small business
      filerx





Indicate by check mark whether the
registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes ̈Nox




The
aggregate market value of voting and non-voting stock held by non-affiliates of
the registrant as of June 30, 2008 was approximately $10,373,000, based upon the
closing sales price of the registrant’s common stock as reported on the New York
Stock Exchange on such date.





The
number of shares of the Registrant’s Common Stock outstanding on May 27, 2009
was 9,368,053.


Documents
Incorporated by Reference





Items 10,
11, 12, 13 and 14 of Part III are incorporated by reference to the NovaStar
Financial, Inc. definitive proxy statement to shareholders, which will be filed
with the Commission by May 31, 2009.




NOVASTAR
FINANCIAL, INC.


FORM
10-K


For
the Fiscal Year Ended December 31, 2008









TABLE OF
CONTENTS




Part
      IItem
      1.
                Business
                2Item
      1A.
                Risk
      Factors
                3Item
      1B.
                Unresolved
      Staff Comments
                9Item
      2.
                Properties
                9Item
      3.
                Legal
      Proceedings
                9Item
      4.
                Submission
      of Matters to a Vote of Security Holders
                12Part
      IIItem
      5.
                Market
      For Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases
      of Equity Securities
                12Item
      6.
                Selected
      Financial Data
                13Item
      7.
                Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                13Item
      7A.
                Quantitative
      and Qualitative Disclosures About Market Risk
                34Item
      8.
                Financial
      Statements and Supplementary Data
                35Item
      9.
                Changes
      in and Disagreements With Accountants on Accounting and Financial
      Disclosure
                86Item
      9A.
                Controls
      and Procedures
                86Item
      9B.
                Other
      Information
                88Part
      IIIItem
      10.
                Directors,
      Executive Officers and Corporate Governance
                88Item
      11.
                Executive
      Compensation
                88Item
      12.
                Security
      Ownership of Certain Beneficial Owners and Management and RelatedStockholder
      Matters
                89Item
      13.
                Certain
      Relationships and Related Transactions, and Director
      Independence
                89Item
      14.
                Principal
      Accounting Fees and Services
                8989Part
      IVItem
      15.
                Exhibits,
      Financial Statement Schedules
                90







Part
I





Safe
Harbor Statement





Statements
in this report regarding NovaStar Financial, Inc. and its business, which are
not historical facts, are “forward-looking statements” within the meaning of
Section 21E of the Securities Exchange Act of 1934, as
amended.  Forward looking statements are those that predict or
describe future events and that do not relate solely to historical matters and
include statements regarding management's beliefs, estimates, projections, and
assumptions with respect to, among other things, our future operations, business
plans and strategies, as well as industry and market conditions, all of which
are subject to change at any time without notice.  Words such as
"believe," "expect," "anticipate," "promise," "plan," and other expressions or
words of similar meanings, as well as future or conditional verbs such as
"would," "should," "could," or "may" are generally intended to identify
forward-looking statements. Actual results and operations for any future period
may vary materially from those discussed herein. Some important factors that
could cause actual results to differ materially from those anticipated include:
our ability to manage our business during this difficult period; our ability to
continue as a going concern; decreases in cash flows from our mortgage
securities; increases in the credit losses on mortgage loans underlying our
mortgage securities and our mortgage loans – held in portfolio; our ability to
remain in compliance with the agreements governing our indebtedness; impairments
on our mortgage assets; increases in prepayment or default rates on our mortgage
assets; the outcome of litigation actions pending against us or other legal
contingencies; our compliance with applicable local, state and federal laws and
regulations; compliance with new accounting pronouncements; the impact of
general economic conditions; and the risks that are from time to time included
in our filings with the Securities and Exchange Commission (“SEC”), including
this report on Form 10-K. Other factors not presently identified may also cause
actual results to differ. This report on Form 10-K speaks only as of its
date and we expressly disclaim any duty to update the information herein except
as required by federal securities laws.





Item
1. Business





NovaStar
Financial, Inc. (“NFI” or the “Company”) is a Maryland corporation formed
on September 13, 1996.  Prior to significant changes in our business
during 2007 and the first quarter of 2008, we originated, purchased,
securitized, sold, invested in and serviced residential nonconforming mortgage
loans and mortgage backed securities.  We retained, through our
mortgage securities investment portfolio, significant interests in the
nonconforming loans we originated and purchased, and through our servicing
platform, serviced all of the loans in which we retained
interests.  During 2007 and early 2008, we discontinued our mortgage
lending operations and sold our mortgage servicing rights which subsequently
resulted in the closure of our servicing operations.





Our
primary source of cash flow is from our mortgage securities
portfolio.  During 2008, we purchased a majority interest in
StreetLinks National Appraisal Services LLC, a residential appraisal management
company.  A fee for appraisal services is collected from lenders and
borrowers and passes through most of the fee to an independent residential
appraiser.  StreetLinks retains a portion of the fee to cover its
costs of managing the process of fulfilling the appraisal
order.   StreetLinks is currently not producing positive cash
flow.  Management believes that StreetLinks is situated to take
advantage of growth opportunities in the residential appraisal management
business.  We are developing the business and have established goals
for it to become a positive cash and earnings
contributor.  Development of the business is occurring through
increased appraisal order volume as we have added new lending customers during
2008 and into 2009.  While StreetLinks does not currently provide
positive cash flow to us, we believe it is uniquely positioned to produce
positive earnings and cash flow for us in the future.  Subsequent to
2008, we committed to acquire a majority interest in Advent Financial Services
LLC, a start up operation which will provide access to tailored banking
accounts, small dollar banking products and related services to meet the needs
of low and moderate income level individuals.





Historically,
we had elected to be taxed as a real estate investment trust (“REIT”) under the
Internal Revenue Code of 1986, as amended (the “Code”).  During 2007,
we announced that we would not be able to pay a dividend on our common stock
with respect to our 2006 taxable income, and as a result, our status as a REIT
terminated retroactive to January 1, 2006.  This retroactive
revocation of our REIT status resulted in us becoming taxable as a C corporation
for 2006 and subsequent years.




Our  consolidated
financial statements have been prepared on a going concern basis of accounting
which contemplates continuity of operations, realization of assets, liabilities
and commitments in the normal course of business.  There are
substantial doubts that we will be able to continue as a going concern and,
therefore, may be unable to realize our assets and discharge our liabilities in
the normal course of business.  The financial statements do not
reflect any adjustments relating to the recoverability and classification of
recorded asset amounts or to the amounts and classification of liabilities that
may be necessary should we be unable to continue as a going
concern.





Our
portfolio of mortgage securities includes interest-only, prepayment penalty, and
overcollateralization securities retained from our securitizations of
nonconforming, single-family residential mortgage loans which we have accounted
for as sales, under applicable accounting rules (collectively, the “residual
securities”). Our portfolio of mortgage securities also includes subordinated
mortgage securities retained from our securitizations and subordinated home
equity loan asset-backed securities (“ABS”) purchased from other ABS issuers
(collectively, the “subordinated securities”). While these securities have
increasingly become less valuable and are generating low  rates of
cash flow relative to historical levels, they continue to be our primary source
of cash.  We believe the cash from the securities will be sufficient
to cover our obligations for the near term, but their cash flow will need to be
replaced in order for us to continue operating.




2


The
credit performance and prepayment rates of the nonconforming loans underlying
our securities, as well as the loans classified as held-in-portfolio, directly
affect our cash flow and profitability. In addition, short-term interest rates
have a significant impact on our cash flow and profitability.





In the
event we are able to significantly increase our liquidity position (as to which
no assurance can be given), we may use excess cash to make certain investments
if we determine that such investments could provide attractive risk-adjusted
returns to shareholders, including, potentially investing in new or existing
operating companies.





The
long-term mortgage loan portfolio on our balance sheet consists of mortgage
loans classified as held-in-portfolio.  These loans were transferred
to trusts in securitization transactions.  Under Generally Accepted
Accounting Principles in the United States of America ("GAAP"), we consolidate
the balance sheets of the trusts.  The trusts have financed these
assets by issuing asset backed bonds (“ABB”).  At the time of these
securitizations, we owned significant beneficial interests in the trusts and we
serviced the mortgage loans.  During 2007, we sold all servicing
rights.  Currently, our ownership interests in the bonds issued by
these trusts have declined to an immaterial amount.  We have provided
financial statements for these trusts in this report under the heading Assets
and Liabilities of Securitization Trusts.




Personnel





As of
December 31, 2008, we employed 60 people in total between NFI and
StreetLinks.  Because of subsequent hiring at StreetLinks to staff for
additional business needs as of May 27, 2009 we employ approximately 363 people
in total between NFI, StreetLinks, and Advent. None of our employees are
represented by a union or covered by a collective bargaining
agreement.




Available
Information





Copies of
our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports
on Form 8-K and any amendments to these reports filed or furnished with the SEC
are available free of charge through our Internet site (www.novastarfinancial.com)
as soon as reasonably practicable after filing with the SEC. References to our
website do not incorporate by reference the information on such website into
this Annual Report on Form 10-K and we disclaim any such incorporation by
reference. Copies of our board committee charters, our board’s Corporate
Governance Guidelines, Code of Conduct, and other corporate governance
information are available at the Corporate Governance section of our Internet
site (www.novastarmortgage.com),
or by contacting us directly. Our investor relations contact information
follows.





Investor
Relations


2114
Central Street


Suite
600


Kansas
City, MO  64108


816.237.7424


Email:  ir@novastar1.com





Item
1A. Risk Factors




Risk
Factors




You
should carefully consider the risks described below in evaluating our business
and before investing in our publicly traded securities.  Any of the
risks we describe below or elsewhere in this report could negatively affect our
results of operations, financial condition, liquidity, business prospects and
ability to continue as a going concern.   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, inflation,
general economic conditions and geopolitical events.




Risks
Related to Recent Changes in Our Business





The
subprime mortgage loan market has largely ceased to operate, which has caused us
to discontinue all of our historical operations other than managing our existing
portfolio of mortgage securities and has adversely affected our ability to
continue as a going concern.





Due to a
number of market factors, including increased delinquencies and defaults on
residential mortgage loans, investor concerns over asset quality, a declining
housing market and the failure of subprime mortgage companies and hedge funds
that have invested in subprime loans, the subprime mortgage industry has been
severely disrupted and the secondary market for mortgage loans has been
unavailable to us since the middle of 2007.  As a result, we have
discontinued our mortgage lending business, have sold most of the loans that we
had not yet securitized, and have sold our mortgage servicing assets to generate
cash to repay indebtedness and to reduce cash requirements.  We also
have terminated all but a core group of our workforce.  Our historical
operations are now limited to managing our existing portfolio of mortgage
securities.




3


In light
of the nature and extent of the disruption subprime mortgage loan markets, there
can be no assurances that these markets will improve or return to past
levels.  Further, in light of our current financial condition, massive
reductions in our workforce, regulatory requirements, capital and financing
requirements, and other uncertainties, there can be no assurances that we would
be able to recommence mortgage lending, servicing or securitization activities
if and when the relevant markets improve, or that any such activities would be
at or near our historical levels.  Unless we are able to reestablish
profitable operations, either within our historical or new business areas, at
levels necessary to meet our existing and future expenses, we will not be able
to continue as a going concern.





Payments
on our mortgage securities are currently our only significant source of cash
flows and will continue to decrease in the next several months to a level that
is not sufficient to fund our existing expenses and continue as a going
concern.





Our
residual and subordinated mortgage securities are currently our only significant
source of cash flows.  Cash flows from our mortgage securities have
materially decreased and will continue to decrease in the next several months as
the underlying mortgage loans are repaid, and could be significantly less than
our current projections if losses on the underlying mortgage loans exceed our
current assumptions or if prepayment speeds continue to decline.  In
addition, we have significant operating expenses associated with office leases,
and other obligations relating to our discontinued operations, as well as
periodic interest payment obligations with respect to junior subordinated
debentures relating to the trust preferred securities of NovaStar Capital Trust
I and NovaStar Capital Trust II.  Our cash flows from mortgage
securities are likely to be insufficient to cover our existing expenses in the
near future.  If, as the cash flows from mortgage securities decrease,
we are unable to recommence or invest in profitable operations, and restructure
our unsecured debt, capital structure and contractual obligations, there can be
no assurance that we will be able to continue as a going concern and avoid
seeking the protection of applicable bankruptcy laws.





To
the extent that the mortgage loans underlying our residual and subordinated
securities continue to experience significant credit losses, or mortgage loan
prepayment rates continue to decline, our cash flows will be further and perhaps
abruptly reduced, which would adversely affect our liquidity and ability to
continue as a going concern.





Our
mortgage securities consist of certain residual securities retained from our
past securitizations of mortgage loans, which typically consist of
interest-only, prepayment penalty, and over collateralization bonds, and certain
investment grade and non-investment grade rated subordinated mortgage securities
retained from our past securitizations and purchased from other ABS issuers.
These residual and subordinated securities are generally unrated or rated below
investment grade and, as such, involve significant investment risk that exceeds
the aggregate risk of the full pool of securitized loans. By holding the
residual and subordinated securities, we generally retain the “first loss” risk
associated with the underlying pool of mortgage loans.  As a result,
losses on the underlying mortgage loans directly affect our returns on, and cash
flows from, these mortgage securities. In addition, if delinquencies and/or
losses on the underlying mortgage loans exceed specified levels, the level of
over-collateralization required for higher rated securities held by third
parties may be increased, further decreasing cash flows presently payable to
us.  Further, slower prepayment speeds reduce our prepayment penalty
cash flows.





Increased
delinquencies and defaults and slower prepayment rates on the mortgage loans
underlying our residual and subordinated mortgage securities have resulted in a
decrease in the cash flow we receive from these investments.  In the
event that decreases in cash flows from our mortgage securities are more severe
or abrupt than currently projected, our results of operations, financial
condition, and liquidity, and our ability to restructure existing obligations,
establish new business operations, and continue as a going concern, will be
adversely affected.





Our
ability to identify and establish or acquire, and profitably manage, operate and
grow, new operations is critical to our ability to continue as a going concern
and is subject to significant uncertainties and limitations.  If we
attempt to make any acquisitions, we will incur a variety of costs and may never
realize the anticipated benefits.





In light
of the current state of the subprime mortgage market and declining cash flows
from our mortgage securities, our ability to continue as a going concern is
dependent upon our ability to identify and establish or acquire new operations
that contribute sufficient additional cash flow to enable us to meet our current
and future expenses.  Our ability to start or acquire new businesses
is significantly constrained by our limited liquidity and our likely inability
to obtain debt financing or to issue equity securities as a result of our
current financial condition, including a shareholders’ deficit, as well as other
uncertainties and risks.  There can be no assurances that we will be
able to establish or acquire new business operations.




4


If we
pursue any new business opportunities, the process of establishing a new
business or negotiating the acquisition and integrating an acquired business may
result in operating difficulties and expenditures and may require significant
management attention.  Moreover, we may never realize the anticipated
benefits of any new business or acquisition.  We may not have, and may
not be able to acquire or retain, personnel with experience in any new business
we may establish or acquire.  In addition, future acquisitions could
result in contingent liabilities and/or amortization expenses related to
goodwill and other intangible assets, which could harm our results of
operations, financial condition and business prospects and ability to continue
as a going concern.




We
are unlikely to have access to financing on reasonable terms, or at all, that
may be necessary for us to continue to operate or to acquire new
businesses.





We do not
currently have in place any agreements or commitments for short-term financing
nor any agreements or commitments for additional long-term
financing.    In light of these factors and current market
conditions, our current financial condition, and our lack of significant
unencumbered assets, we are unlikely to be able to secure additional financing
for existing or new operations or for any acquisition.





Various
legal proceedings could adversely affect our financial condition, our results of
operations, liquidity and our ability to continue as a going
concern.





In the
course of our business, we are subject to various legal proceedings and claims.
See Part I “Item 3—Legal Proceedings.” In addition, as the subprime
mortgage industry has deteriorated, we have become subject to various securities
and derivative lawsuits, and participants in the industry, including the
Company, have and may continue to be subject to increased litigation
arising from foreclosures and other industry practices, in some cases on
the basis of novel legal theories. The resolution of these legal matters or
other legal matters could result in a material adverse impact on our results of
operations, liquidity, financial condition and ability to continue as a going
concern.





The
Securities and Exchange Commission (the “SEC”) has requested information from
issuers in our industry, including us, regarding accounting for mortgage loans
and other mortgage related assets. In addition, we have received requests or
subpoenas for information relating to our operations from various federal and
state regulators and law enforcement, including, without limitation, the United
States Department of Justice, the Federal Bureau of Investigation, the New York
Attorney General and the Department of Labor.  While we have provided,
or are in the process of providing, the requested information to the applicable
officials, we may be subject to further information requests from, or action by,
these or other regulators or law enforcement officials.  To the extent
we are subject to any actions, our financial condition, liquidity, and ability
to continue a going concern could be materially adversely affected.





There
can be no assurance that our common stock or Series C Preferred Stock will
continue to be traded in an active market.





Our
common stock and our Series C Preferred Stock were delisted by the New York
Stock Exchange (“NYSE”) in January 2008, as a result of failure to meet
applicable standards for continued listing on the NYSE.  Our common
stock and Series C Preferred Stock are currently quoted on the OTC Bulletin
Board and on the Pink Sheets.  However, there can be no assurance that
an active trading market will be maintained.  Trading of securities on
the OTC and Pink Sheets is generally limited and is effected on a less regular
basis than on exchanges, such as the NYSE, and accordingly investors who own or
purchase our stock will find that the liquidity or transferability of the stock
may be limited.





Additionally,
a shareholder may find it more difficult to dispose of, or obtain accurate
quotations as to the market value of, our stock.  If an active public
trading market cannot be sustained, the trading price of our common and
preferred stock could be adversely affected and your ability to transfer your
shares of our common and preferred stock may be limited.





We
are not likely to pay dividends to our common or preferred stockholders in the
foreseeable future.





We are
not required to pay out our taxable income in the form of dividends, as we are
no longer subject to a REIT distribution requirement. Instead, payment of
dividends is at the discretion of our board of directors.  To preserve
liquidity, our board of directors has suspended dividend payments on our Series
C Preferred Stock and Series D1 Preferred Stock.  Dividends on our
Series C Preferred Stock and D1 Preferred Stock continue to accrue and the
dividend rate on our Series D1 Preferred Stock increased from 9.0% to 13.0%,
compounded quarterly, effective January 16, 2008 with respect to all unpaid
dividends and subsequently accruing dividends.  No dividends can be
paid on any of our common stock until all accrued and unpaid dividends on our
Series C Preferred Stock and Series D1 Preferred Stock are paid in
full.  Accumulating dividends with respect to our preferred stock will
negatively affect the ability of our common stockholders to receive any
distribution or other value upon liquidation.




5


Risks
Related to Mortgage Asset Financing, Sale, and Investment
Activities





We
may be required to repurchase mortgage loans or indemnify mortgage loan
purchasers as a result of breaches of representations and warranties, borrower
fraud, or certain borrower defaults, which could further harm our liquidity and
ability to continue as a going concern.





When we
sold mortgage loans, whether as whole loans or pursuant to a securitization, we
made customary representations and warranties to the purchaser about the
mortgage loans and the manner in which they were originated. Our whole loan sale
agreements require us to repurchase or substitute mortgage loans in the event we
breach any of these representations or warranties. In addition, we may be
required to repurchase mortgage loans as a result of borrower, broker, or
employee fraud. Likewise, we are required to repurchase or substitute mortgage
loans if we breach a representation or warranty in connection with our
securitizations. We have received various repurchase demands as performance of
subprime mortgage loans has deteriorated.  A majority of repurchase
requests have been denied, otherwise a negotiated purchase price adjustment was
agreed upon with the purchaser.  Enforcement of repurchase obligations
against us would further harm our liquidity and ability to continue as a going
concern.





Differences
in our actual experience compared to the assumptions that we use to determine
the value of our residual mortgage securities and to estimate reserves could
further adversely affect our financial position.





Our
securitizations of mortgage loans that were structured as sales for financial
reporting purposes resulted in gain recognition at closing as well as the
recording of the residual mortgage securities we retained at fair
value.   The value of residual securities represents the present
value of future cash flows expected to be received by us from the excess cash
flows created in the securitization transaction. In general, future cash flows
are estimated by taking the coupon rate of the loans underlying the transaction
less the interest rate paid to the investors, less contractually specified
servicing and trustee fees, and after giving effect to estimated prepayments and
credit losses. We estimate future cash flows from these securities and value
them utilizing assumptions based in part on projected discount rates,
delinquency, mortgage loan prepayment speeds and credit losses. It is extremely
difficult to validate the assumptions we use in valuing our residual interests.
Even if the general accuracy of the valuation model is validated, valuations are
highly dependent upon the reasonableness of our assumptions and the
predictability of the relationships which drive the results of the model. Due to
deteriorating market conditions, our actual experience has differed
significantly from our assumptions, resulting in a reduction in the fair value
of these securities and impairments on these securities.  If our
actual experience continues to differ materially from the assumptions that we
used to determine the fair value of these securities, our financial condition,
results of operations, liquidity and ability to continue as a going concern will
continue to be negatively affected.





Risks
Related to Interest Rates and Our Hedging Strategies





Changes
in interest rates may harm our results of operations and equity
value.





Our
results of operations are likely to be harmed during any period of unexpected or
rapid changes in interest rates. Our primary interest rate exposures relate to
our mortgage securities, mortgage loans, floating rate debt obligations,
interest rate swaps, and interest rate caps. Interest rate changes could
adversely affect our cash flow, results of operations, financial condition,
liquidity, business prospects, and ability to continue as a going concern in the
following ways:





·
            interest
      rate fluctuations may harm our cash flow as the spread between the
      interest rates we pay on our borrowings and hedges and the interest rates
      we receive on our mortgage assets
narrows;


·
            the
      value of our residual and subordinated securities and the income we
      receive from them are based primarily on LIBOR, and an increase in LIBOR
      increases funding costs which reduces the cash flow we receive from, and
      the value of, these securities;


·
            existing
      borrowers with adjustable-rate mortgages or higher risk loan products may
      incur higher monthly payments as the interest rate increases, and
      consequently may experience higher delinquency and default rates,
      resulting in decreased cash flows from, and decreased value of, our
      mortgage securities; and


·
            mortgage
      prepayment rates vary depending on such factors as  mortgage
      interest rates and market conditions, and changes in prepayment rates may
      harm our earnings and the value of our mortgage
  securities.





In
addition, interest rate changes may also further impact our net book value as
our mortgage securities and related hedge derivatives are marked to market each
quarter. Generally, as interest rates increase, the value of our mortgage
securities decreases which decreases the book value of our equity.





Furthermore,
shifts in the yield curve, which represents the market’s expectations of future
interest rates, also affects the yield required for the purchase of our mortgage
securities and therefore their value. To the extent that there is an unexpected
change in the yield curve it could have an adverse effect on our mortgage
securities portfolio and our financial position and our ability to continue as a
going concern.





Risks
Related to Credit Losses





The
value of, and cash flows from, our mortgage securities may further decline due
to factors beyond our control.





There are
many factors that affect the value of, and cash flows from, our mortgage
securities, many of which are beyond our control.  For example, the
value of the homes collateralizing residential loans may decline due to a
variety of reasons beyond our control, such as weak economic conditions or
natural disasters.  Over the past year, residential property values in
most states have declined, in some areas severely, which has increased
delinquencies and losses on residential mortgage loans generally, especially
where the aggregate loan amounts (including any subordinate loans) are close to
or greater than the related property value.  A borrower’s ability to
repay a loan also may be adversely affected by factors beyond our control, such
as subsequent over-leveraging of the borrower, reductions in personal incomes,
and increases in unemployment.




6


In
addition, interest-only loans, negative amortization loans, adjustable-rate
loans, reduced documentation loans, home equity lines of credit and second lien
loans may involve higher than expected delinquencies and
defaults.  For instance, any increase in prevailing market interest
rates may result in increased payments for borrowers who have adjustable rate
mortgage loans. Moreover, borrowers with option ARM mortgage loans with a
negative amortization feature may experience a substantial increase in their
monthly payment, even without an increase in prevailing market interest rates,
when the loan reaches its negative amortization cap.  The current lack
of appreciation in residential property values and the adoption of tighter
underwriting standards throughout the mortgage loan industry may adversely
affect the ability of borrowers to refinance these loans and avoid
default.





Each of
these factors may be exacerbated by general economic slowdowns and by changes in
consumer behavior, bankruptcy laws, and other laws.





To the
extent that delinquencies or losses continue to increase for these or other
reasons, the value of our mortgage securities and the mortgage loans held in our
portfolio will be further reduced, which will adversely affect our operating
results, liquidity, cash flows, financial condition and ability to continue as a
going concern.





Further
delinquencies and losses with respect to residential mortgage loans,
particularly in the sub-prime sector, may cause us to recognize additional
losses, which would further adversely affect our operating results, liquidity,
financial condition, business prospects and ability to continue as a going
concern.





Delinquency
interrupts the flow of projected interest income from a mortgage loan, and
default can ultimately lead to a loss if the net realizable value of the real
property securing the mortgage loan is insufficient to cover the principal and
interest due on the loan and costs of sale. In the event of a borrower’s
bankruptcy, that borrower’s mortgage loan will be deemed to be secured only to
the extent of the value of the underlying collateral at the time of bankruptcy
(as determined by the bankruptcy court), and the lien securing the mortgage loan
may in some circumstances be subject to the avoidance powers of the bankruptcy
trustee under applicable state law.  Foreclosure of a mortgage loan
can be an expensive and lengthy process that can have a substantial negative
effect on our originally anticipated return on the foreclosed mortgage
loan.  Also, loans that are delinquent or in default may be
unmarketable or saleable only at a discount.





We have
experienced a significant increase in borrower delinquencies and defaults, which
has adversely affected our liquidity, cash flows, results of operations and
financial condition. Nearly all of our remaining loans held for sale are
delinquent or are in default.  In addition, our economic investment in
and cash flows from loans we have securitized continue to be exposed to
delinquencies and losses, either through residual securities that we retain in
securitizations structured as sales, or through the loans that remain on our
balance sheet in securitizations structured as financings.  To the
extent that loan delinquencies and defaults continue at their current rates or
become more severe, our results of operations, cash flows, liquidity, financial
condition and ability to continue as a going concern may be further adversely
affected.





Loans
made to nonconforming mortgage borrowers entail relatively higher delinquency
and default rates which will result in higher loan losses, which are likely to
be exacerbated during economic slowdowns.





Nonconforming
mortgage borrowers 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 higher risk of delinquency and foreclosure than
mortgage loans made to borrowers with better credit and, therefore, will result
in higher levels of realized losses than conventional loans.  General
economic slowdowns, such as that currently affecting the United States, are
likely to adversely affect nonconforming borrowers to a greater extent than
conforming borrowers and, consequently, are likely to have a greater negative
impact on delinquency and loss rates with respect to nonconforming
loans.





Risks
Related to the Legal and Regulatory Environment in Which We Operate





Failure
to comply with federal, state or local regulation of, or licensing requirements
with respect to, our discontinued businesses could harm our financial condition
and ability to recommence mortgage banking operations.





Our prior
mortgage lending, brokerage and loan servicing operations were subject to an
extensive body of federal, state and local laws and licensing
requirements.  Although we utilized systems and procedures designed to
facilitate compliance, these requirements were voluminous and, in some cases,
complex and subject to interpretation, and our compliance with these
requirements depended on the actions of a large number of
employees.  Investigations, enforcement actions, litigation, fines,
penalties and liability with respect to non-compliance with these requirements
may consume attention of key personnel, may adversely affect our future ability
to engage in regulated activities, and may materially and adversely affect our
financial condition, results of operations, liquidity and ability to continue as
a going concern.


7


Risks
Related to Our Capital Stock





The
market price and trading volume of our common and preferred stock may be
volatile, which could result in substantial losses for our
shareholders.





The
market price of our capital stock can be highly volatile and subject to wide
fluctuations. In addition, the trading volume in our capital stock may fluctuate
and cause significant price variations to occur. Investors may experience
volatile returns and material losses.   Some of the factors that
could negatively affect our share price or result in fluctuations in the price
or trading volume of our capital stock include:





·
            actual
      or perceived changes in our ability to continue as a going
      concern;


·
            actual
      or anticipated changes in the delinquency and default rates on mortgage
      loans, in general, and specifically on the loans we invest in through our
      mortgage securities;


·
            actual
      or anticipated changes in residential real estate
  values;


·
            actual
      or anticipated changes in market interest
rates;


·
            actual
      or anticipated changes in our earnings and cash
  flow;


·
            general
      market and economic conditions, including the operations and stock
      performance of other industry
participants;


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


·
            the
      impact of new state or federal legislation or adverse court
      decisions;


·
            the
      activities of investors who engage in short sales of our common
      stock;


·
            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 shareholders.





Our
charter permits us to issue additional equity without shareholder approval,
which could materially adversely affect our current shareholders.





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





·
            authorize
      the issuance of additional shares of common stock or preferred stock
      without shareholder 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 outstanding common stock
      with respect to voting;


·
            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; and


·
            issue
      additional shares of common stock or preferred stock in exchange for
      outstanding securities, with the consent of the holders of those
      securities.





In
connection with any capital restructuring or in order to raise additional
capital, we may issue, reclassify or exchange securities, including debt
instruments, preferred stock or common stock.  Any of these or similar
actions by us may dilute your interest in us or reduce the market price of our
capital 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 limit our ability to make a distribution to common shareholders.
Because our decision to issue, reclassify or exchange securities will depend on
negotiations with third parties, market conditions and other factors beyond our
control, we cannot predict or estimate the amount, timing or nature of our
future issuances, if any. Further, market conditions could require us to accept
less favorable terms for the issuance of our securities in the future. Thus, our
shareholders will bear the risk that our future issuances, reclassifications and
exchanges will reduce the market price of our stock and/or dilute their interest
in us.





Other
Risks Related to our Business





You
should exercise caution in reviewing our consolidated financial
statements.





Our
consolidated financial statements have been prepared on a going concern basis of
accounting which contemplates continuity of operations, realization of assets,
liabilities and commitments in the normal course of business.  The
financial statements do not reflect any adjustments that might result if we were
unable to continue as a going concern, as to which no assurances can be given.
In light of these facts, you should exercise caution in reviewing our financial
statements.




8


Our
ability to use our net operating loss carryforwards and net unrealized built-in
losses could be severely limited in the event of certain transfers of our voting
securities.





We
currently have recorded a significant net deferred tax asset, before valuation
allowance, almost all of which relates to certain loss carryforwards and net
unrealized built-in-losses. While we believe that it is more likely than not
that we will not be able to utilize such losses in the future, the net operating
loss carryforwards and net unrealized built-in losses could provide significant
future tax savings to us if we are able to use such losses. However, our ability
to use these tax benefits may be impacted, restricted or eliminated due to a
future “ownership change” within the meaning of Section 382 of the
Code.  We do not have the ability to prevent such an ownership change
from occurring.  Consequently, an ownership change could occur that
would severely limit our ability to use the tax benefits associated with the net
operating loss carryforwards and net unrealized built-in losses, which may
result in higher taxable income for us (and a significantly higher tax cost as
compared to the situation where these tax benefits are preserved).





Some
provisions of our charter, bylaws and Maryland law may deter takeover attempts,
which may limit the opportunity of our shareholders to sell their common stock
at favorable prices.





Certain
provisions of our charter, bylaws and Maryland law could discourage, delay or
prevent transactions that involve an actual or threatened change in control, and
may make it more difficult for a third party to acquire us, even if doing so may
be beneficial to our shareholders. For example, our board of directors is
divided into three classes with three year staggered terms of office. This makes
it more difficult for a third party to gain control of our board because a
majority of directors cannot be elected at a single meeting. Further, under our
charter, generally a director may only be removed for cause and only by the
affirmative vote of the holders of at least a majority of all classes of shares
entitled to vote in the election for directors together as a single class. Our
bylaws make it difficult for any person other than management to introduce
business at a duly called meeting requiring such other person to follow certain
advance notice procedures. Finally, Maryland law provides protection for
Maryland corporations against unsolicited takeover situations.





The
accounting for our mortgage assets may result volatility of our results of
operations and our financial statements.





The
accounting treatment applicable to our mortgage assets is dependent on various
factors outside of our control and may significantly affect our results of
operations and financial statements. As current turmoil in the subprime industry
continues to affect the characteristics of our mortgage assets we may be
required to adjust the accounting treatment of our assets.  As a
result of this, stockholders must undertake a complex analysis to understand our
earnings (losses), cash flows and financial condition.





Item
1B. Unresolved Staff Comments




None




Item
2. Properties




The
executive and administrative offices for NFI are located in Kansas City,
Missouri, and consist of approximately 12,142 square feet of leased office
space. The lease agreements on the premises expire in October 2013. The current
annual rent for these offices is approximately $200,000.





The
Company is in negotiations to settle the lease dispute on its former corporate
headquarters in Kansas City, Missouri.  See Item 3 Legal Proceedings
for more information related to this dispute.





As of
December 31, 2008, StreetLinks leases approximately 7,200 square feet of office
space in Indianapolis, Indiana.  The lease agreements on the premises
expire in September 2009. The current annual rent for these offices is
approximately $100,000.





We are
leasing office space in various other states which were used for operations
which were discontinued in 2007 and 2008.  The leases on these
premises expire from February 2009 through May 2012, and the current gross
annual rent on those premises not terminated as of May 27, 2009 is approximately
$1.4 million, although the majority of this space has been subleased which
reduces our costs significantly.




Item
3. Legal Proceedings




American
Interbanc Mortgage Litigation.  On March 17, 2008, the Company
and American Interbanc Mortgage, LLC (“Plaintiff”) entered into a Confidential
Settlement Term Sheet Agreement (the “Settlement Terms”) with respect to the
action Plaintiff’s filed in March 2002 against NovaStar Home Mortgage, Inc.
(“NHMI”), a wholly-owned subsidiary of the Company.  The action
resulted in a jury verdict on May 4, 2007, awarding Plaintiff $15.9 million. The
court trebled the award and entered a $46.1 million judgment against Defendants
on June 27, 2007 (the “Judgment”).  On January 23, 2008, Plaintiff
filed an involuntary petition for bankruptcy against NHMI under 11 U.S.C. Sec.
303, in the United States Bankruptcy Court for the Western District of Missouri
(the “Involuntary Bankruptcy”).




9


Pursuant
to the Settlement Terms agreed to on March 17, 2008, the Involuntary Bankruptcy
was dismissed on April 24, 2008 and on May 8, 2008, the Company paid Plaintiff
$2.0 million.  In addition to the initial payments made to the
Plaintiff following dismissal of the Involuntary Bankruptcy, the Company agreed
to pay Plaintiff $5.5 million if, prior to July 1, 2010, (i) NFI’s average
common stock market capitalization is at least $94.4 million over a period of
five consecutive business days, or (ii) the holders of NFI’s common stock are
paid $94.4 million in net asset value as a result of any sale of NFI or its
assets.  If NFI is sold prior to July 1, 2010 for less than $94.4
million and ceases to be a public company, then NFI will obligate the purchaser
to pay Plaintiff $5.5 million in the event the value of the company exceeds
$94.4 million prior to July 1, 2010 as determined by an independent valuation
company.  As a result of the settlement, during 2008 the
Company reversed a previously recorded liability of $45.2 million that was
included in the consolidated financial statements.





Trust Preferred
Settlement.See Note 6—Borrowings
for a detailed discussion of the settlement terms and restructuring of the
Company’s junior subordinated debentures, including the dismissal of the
involuntary Chapter 7 bankruptcy filed against NovaStar Mortgage, Inc. (Case No.
08-12125-CSS) by the holders of the trust preferred securities in U.S.
Bankruptcy Court for the District of Delaware in Wilmington.





Other
Litigation.  Since April 2004,
a number of substantially similar class action lawsuits have been filed and
consolidated into a single action in the United States District Court for the
Western District of Missouri. The consolidated complaint names the Company and
three of the Company’s current and former executive officers as defendants and
generally alleges that the defendants made public statements that were
misleading for failing to disclose certain regulatory and licensing matters. The
plaintiffs purport to have brought this consolidated action on behalf of all
persons who purchased the Company’s common stock (and sellers of put options on
the Company’s common stock) during the period October 29, 2003 through April 8,
2004. On January 14, 2005, the Company filed a motion to dismiss
this action, and on May 12, 2005, the court denied such motion. On February
8, 2007, the court certified the case as a class action. The Company has entered
into a settlement agreement to resolve these pending class action lawsuits. The
total amount of the settlement is $7.25 million, and it will be paid by the
Company’s insurance carriers. The settlement agreement contains no admission of
fault or wrongdoing by the Company or other defendants. On April 28, 2009, the
Court approved the settlement.




At this
time, the Company cannot predict the probable outcome of the following claims
and as such no amounts have been accrued in the consolidated financial
statements.





In
February 2007, a number of substantially similar putative class actions were
filed in the United States District Court for the Western District of Missouri.
The complaints name the Company and three of the Company’s former and current
executive officers as defendants and generally allege, among other things, that
the defendants made materially false and misleading statements regarding the
Company’s business and financial results. The plaintiffs purport to have brought
the actions on behalf of all persons who purchased or otherwise acquired the
Company’s common stock during the period May 4, 2006 through February 20, 2007.
Following consolidation of the actions, a consolidated amended complaint was
filed on October 19, 2007.  On December 29, 2007, the defendants moved
to dismiss all of plaintiffs’ claims.  On June 4, 2008, the Court
dismissed the plaintiffs’ complaints without leave to amend.  The
plaintiffs have filed an appeal of the Court’s ruling.




In May
2007, a lawsuit entitled National Community Reinvestment
Coalition v. NovaStar Financial, Inc., et al., was filed against the
Company in the United States District Court for the District of
Columbia.  Plaintiff, a non-profit organization, alleges that the
Company maintains corporate policies of not making loans on Indian reservations,
on dwellings used for adult foster care or on rowhouses in Baltimore, Maryland
in violation of the federal Fair Housing Act. The lawsuit seeks injunctive
relief and damages, including punitive damages, in connection with the
lawsuit.  On May 30, 2007, the Company responded to the lawsuit by
filing a motion to dismiss certain of plaintiff’s claims.  On March
31, 2008 that motion was denied by the Court.  The Company believes
that these claims are without merit and will vigorously defend against
them.





On
January 10, 2008, the City of Cleveland, Ohio filed suit against the Company and
approximately 20 other mortgage, commercial and investment bankers alleging a
public nuisance had been created in the City of Cleveland by the operation of
the subprime mortgage industry.   The case was filed in state
court and promptly removed to the United States District Court for the Northern
District of Ohio.  The plaintiff seeks damages for loss of property
values in the City of Cleveland, and for increased costs of providing services
and infrastructure, as a result of foreclosures of subprime
mortgages.  On October 8, 2008, the City of Cleveland filed an amended
complaint in federal court which did not include claims against the Company but
made similar claims against NovaStar Mortgage, Inc., a wholly owned subsidiary
of NFI. On November 24, 2008 the Company filed a motion to
dismiss.  On May 15, 2009 the Court granted Company’s motion to
dismiss.  The City of Cleveland has filed a notice of intent to
appeal.  The Company believes that these claims are without merit and will
vigorously defend against them.




10


On
January 31, 2008, two purported shareholders filed separate derivative actions
in the Circuit Court of Jackson County, Missouri against various former and
current officers and directors and named the Company as a nominal
defendant.  The essentially identical petitions seek monetary damages
alleging that the individual defendants breached fiduciary duties owed to the
Company, alleging insider selling and misappropriation of information, abuse of
control, gross mismanagement, waste of corporate assets, and unjust enrichment
between May 2006 and December 2007.    On June 24, 2008 a
third, similar case was filed in United States District Court for the Western
District of Missouri.  The Company believes that these claims are
without merit and will vigorously defend against them.





On May 6,
2008, the Company received a letter written on behalf of J.P. Morgan Mortgage
Acceptance Corp. and certain affiliates ("Morgan") demanding indemnification for
claims asserted against Morgan in a case entitled Plumbers & Pipefitters
Local #562 Supplemental Plan and Trust v. J.P. Morgan Acceptance Corp. et al,
filed in the Supreme Court of the State of New York, County of
Nassau.   The case seeks class action certification for alleged
violations by Morgan of sections 11 and 15 of the Securities Act of 1933, on
behalf of all persons who purchased certain categories of mortgage backed
securities issued by Morgan in 2006 and 2007.   Morgan's indemnity
demand alleges that any liability it might have to plaintiffs would be based, in
part, upon alleged misrepresentations made by the Company with respect to
certain mortgages that make up a portion of the collateral for the securities at
issue.  The Company believes it has meritorious defenses to this demand and
expects to defend vigorously any claims asserted.




On May
21, 2008, a purported class action case was filed in the Supreme Court of the
State of New York, New York County, by the New Jersey Carpenters' Health Fund,
on behalf of itself and all others similarly situated.   Defendants in
the case include NovaStar Mortgage Funding Corporation and its individual
directors, several securitization trusts sponsored by the Company, and several
unaffiliated investment banks and credit rating agencies.   The case
was removed to the United States District Court for the Southern District of New
York, and plaintiff has filed a motion to remand the case to state court. 
Plaintiff seeks monetary damages, alleging that the defendants violated sections
11, 12 and 15 of the Securities Act of 1933 by making allegedly false statements
regarding mortgage loans that served as collateral for securities purchased by
plaintiff and the purported class members.  Pursuant to a stipulation,
the Company has not yet filed its initial responsive pleading, and discovery is
not yet underway.   The Company believes it has meritorious defenses
to the case and expects to defend the case vigorously.




On July
7, 2008, plaintiff Jennifer Jones filed a purported class action case in the
United States District Court for the Western District of Missouri against the
Company, certain former and current officers of the Company, and unnamed members
of the Company's "Retirement Committee".   Plaintiff, a former
employee of the Company, seeks class action certification on behalf of all
persons who were participants in or beneficiaries of the Company's 401(k) plan
from May 4, 2006 until November 15, 2007 and whose accounts included investments
in the Company's common stock.  Plaintiff seeks monetary damages alleging
that the Company's common stock was an inappropriately risky investment option
for retirement savings, and that defendants breached their fiduciary duties by
allowing investment of some of the assets contained in the 401(k) plan to be
made in the Company's common stock.   On November 12, 2008, the
Company filed a motion to dismiss which was denied by the Court on February 11,
2009.  On April 6, 2009 the Court granted the plaintiff’s motion for
class certification.  The Company sought permission from the 8th Circuit
Court of Appeals to appeal the order granting class certification.  On May
11, 2009 the Court of Appeals granted the Company permission to appeal the class
certification order.  The Company believes it has meritorious defenses
to the case and expects to defend the case vigorously.





On
October 21, 2008, EHD Holdings, LLC, the purported owner of the building which
leases the Company its former principal office space in Kansas City, filed an
action for unpaid rent in the Circuit Court of Jackson County,
Missouri.    On April 24, 2009, EHD Holdings, LLC filed a
motion for summary judgment seeking approximately $3.3 million, in past due rent
and charges, included in the Accounts payable and other liabilities line
item of the balance sheet, plus accruing rent and charges for future periods,
plus attorney fees.





In
addition to those matters listed above, the Company is currently a party to
various other legal proceedings and claims, including, but not limited to,
breach of contract claims, tort claims, and claims for violations of federal and
state consumer protection laws.  Furthermore, the Company has received
indemnification and loan repurchase demands with respect to alleged violations
of representations and warranties made in loan sale and securitization
agreements.  These indemnification and repurchase demands have been
addressed without significant loss to the Company, but such claims can be
significant when multiple loans are involved.  Deterioration of the
housing market may increase the risk of such claims.





In
addition, the Company has received requests or subpoenas for information from
various regulators or law enforcement officials, including, without limitation
the Federal Bureau of Investigation and the Department of
Labor.  Management does not expect any significant negative impact to
the Company as a result of these requests and subpoenas.


11




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




None





PART
II





Item
5.  Market for Registrant’s Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities




Market Price of
and Dividends on the Registrant’s Common Equity and Related Stockholder
Matters.Our
common stock was traded on the NYSE under the symbol “NFI” through December 31,
2007. Our common stock was delisted from the NYSE on January 17, 2008 and is
currently quoted on the OTC Bulletin Board and on the Pink Sheets under the
symbol “NOVS”.  The following table sets forth the high and low sales
prices per share of common stock on the NYSE and the high and low bid prices as
reported by the OTC Bulletin Board and the Pink Sheets, as applicable, for the
periods indicated, and the cash dividends paid or payable per share of common
stock.   The Board of Directors declared a one-for-four reverse
stock split of its common stock, providing shareholders of record as of July 27,
2007, with one share of common stock for each four shares owned.  The
reduction in shares resulting from the split was effective on July 27, 2007
decreasing the number of common shares outstanding to 9.5 million.




DividendsHigh
                        
                        
                        Low
                        
                        
                        Date
                          Declared
                        
                        
                        Date Paid
                        
                        
                        Amount
                          Per Share2007First
      Quarter
                        
                        $
                        105.80
                        
                        
                        $
                        13.72
                        
                        
                        
                        N/A
                        
                        
                        
                        N/A
                        
                        
                        
                        N/ASecond
      Quarter
                        
                        
                        40.00
                        
                        
                        
                        19.56
                        
                        
                        
                        N/A
                        
                        
                        
                        N/A
                        
                        
                        
                        N/AThird
      Quarter
                        
                        
                        34.68
                        
                        
                        
                        5.10
                        
                        
                        
                        N/A
                        
                        
                        
                        N/A
                        
                        
                        
                        N/AFourth
      Quarter
                        
                        
                        9.32
                        
                        
                        
                        1.16
                        
                        
                        
                        N/A
                        
                        
                        
                        N/A
                        
                        
                        
                        N/A2008First
      Quarter
                        
                        $
                        3.44
                        
                        
                        $
                        1.10
                        
                        
                        
                        N/A
                        
                        
                        
                        N/A
                        
                        
                        
                        N/ASecond
      Quarter
                        
                        
                        2.03
                        
                        
                        
                        1.00
                        
                        
                        
                        N/A
                        
                        
                        
                        N/A
                        
                        
                        
                        N/AThird
      Quarter
                        
                        
                        1.99
                        
                        
                        
                        .28
                        
                        
                        
                        N/A
                        
                        
                        
                        N/A
                        
                        
                        
                        N/AFourth
      Quarter
                        
                        
                        1.01
                        
                        
                        
                        .22
                        
                        
                        
                        N/A
                        
                        
                        
                        N/A
                        
                        
                        
                        N/A









As of May
8, 2009, we had approximately 1,010 shareholders of
record of our common stock, including holders who are nominees for an
undetermined number of beneficial owners based upon a review of the securities
position listing provided by our transfer agent.





Dividend distributions will be made at
the discretion of the Board of Directors and will depend on earnings, financial
condition, cost of equity, investment opportunities and other factors as the
Board of Directors may deem relevant.  In addition, accrued and unpaid
dividends on our preferred stock must be paid prior to the declaration of any
dividends on our common stock.  We do not expect to declare any stock
dividend distributions for the near future.  See “Industry Overview
and Known Material Trends and Uncertainties” for further discussion regarding
future uncertainties.





Purchase
of Equity Securities by the Issuer


Issuer
Purchases of Equity Securities


(dollars
in thousands)


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)October
      1, 2008 – October 31, 2008
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                $
                                1,020November
      1, 2008 – November 30, 2008
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                1,020December
      1, 2008 – December 31, 2008
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                1,020


(A)
              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, bringing the total authorization to $9
  million.




12


Item
6. Selected Financial Data




As a
smaller reporting company, we are not required to provide the information
required by this Item.





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


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





Executive
Overview





Corporate Overview, Background and
Strategy - We are a Maryland corporation formed on September 13,
1996.  Prior to significant changes in our business during 2007 and
the first quarter of 2008, we originated, purchased, securitized, sold, invested
in and serviced residential nonconforming mortgage loans and mortgage backed
securities.  We retained, through our mortgage securities investment
portfolio, significant interests in the nonconforming loans we originated and
purchased, and through our servicing platform, serviced all of the loans in
which we retained interests.  During 2007 and early 2008, we
discontinued our mortgage lending operations and sold our mortgage servicing
rights which subsequently resulted in the closing of our servicing
operations.





Because
of severe declines in housing prices and national and internal economic crises,
we have suffered significant losses during 2007 and 2008 because of declining
values of our investments in mortgage loans and securities.  Liquidity
constraints during 2007 forced us to pair operations and administrative staff
and take measures to conserve cash.





During
2008, management focused on reducing operating cash uses, clearing follow-on
matters arising from our legacy lending and servicing operations and evaluating
investment opportunities.  Management made a significant step in the
rebuilding process by investing in StreetLinks National Appraisal Services LLC
(“StreetLinks”).  StreetLinks is a national residential appraisal
management company.  A fee for appraisal services is collected from
lenders and borrowers and passes through most of the fee to an independent
residential appraiser.  StreetLinks retains a portion of the fee to
cover its costs of managing the process of fulfilling the appraisal
order.   StreetLinks is currently not producing positive cash
flow.  Management believes that StreetLinks is situated to take
advantage of growth opportunities in the residential appraisal management
business.  We are developing the business and have established goals
for it to become a positive cash and earnings
contributor.  Development of the business is occurring through
increased appraisal order volume as we have added new lending customers during
2008 and into 2009.





Going Concern
Considerations -If the cash flows from our mortgage securities are less
than currently anticipated and we are unable to invest in profitable operations
and restructure our contractual obligations, there can be no assurance that we
will be able to continue as a going concern and avoid seeking the protection of
applicable federal and state bankruptcy laws.  Due to the fact that we
have a negative net worth, and that we do not currently have ongoing significant
business operations that are profitable, it is unlikely that we will be able to
obtain additional equity or debt financing on favorable terms, or at all, for
the foreseeable future.  To the extent we require additional liquidity
and cannot obtain it, we will be forced to file for bankruptcy.





Our
consolidated financial statements have been prepared on a going concern basis of
accounting which contemplates continuity of operations, realization of assets,
liabilities and commitments in the normal course of business.  There
is substantial doubt that we will be able to continue as a going concern and,
therefore, may be unable to realize our assets and discharge our liabilities in
the normal course of business.  The financial statements do not
reflect any adjustments relating to the recoverability and classification of
recorded asset amounts nor to the amounts and classification of liabilities that
may be necessary should we be unable to continue as a going
concern.





Strategy -Management is focused on building an operation or group of operations to
restore our financial strength.  If and when opportunities arise,
available cash resources will be used to invest in or start businesses that can
generate income and cash.  Additionally, management will attempt to
renegotiate and/or restructure the components of our equity in order to realign
the capital structure with our current business model.





The key
performance measures for executive management are:





·
            maintenance
      of adequate liquidity to sustain us and allow us to take advantage of
      investment opportunity, and


·
            generating
      income for our shareholders.





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


13





Table
1 — Summary of Financial Highlights and Key Performance Metrics


(dollars
in thousands; except per share amounts)





December
      31,2008
                      
                      2007Cash
      and cash equivalents, including restricted cash
                      
                      $
                      30,836
                      
                      
                      $
                      34,362Net
      loss income available to common shareholders, per diluted
      share
                      
                      
                      (72.37
                      )
                      
                      
                      (78.55
                      )










Liquidity –During 2008, we received $86.8 million in cash on our securities
portfolio.  However, we used significant amounts of cash to repay
outstanding borrowings, pay for costs related to our legacy mortgage lending and
servicing operations, pay for current administrative costs and invest in
StreetLinks.   As of December 31, 2008, we had $30.8 million in
cash, cash equivalents and restricted cash, a decrease of $3.5 million from
December 31, 2007.  As of May 27, 2009, we have $23.4 million in cash
and cash equivalents (including restricted cash).   We face
substantial liquidity risk and uncertainty, near-term and otherwise, which
threatens our ability to continue as a going concern and avoid
bankruptcy.  See “Liquidity and Capital Resources” for further
discussion of our liquidity position and steps we have taken to preserve
liquidity levels.





As part
of our near-term future strategy, we will focus on minimizing losses, preserving
liquidity and investing in opportunities that can contribute positively to our
liquidity position.  Our mortgage securities are our primary source of
new cash flows.  Based on the current projections, the cash flows from
our mortgage securities will decrease in the next several months as the
underlying mortgage loans are repaid and could be significantly less than the
current projections if losses on the underlying mortgage loans exceed the
current assumptions.  We have no outstanding lending facilities
available for liquidity purposes.  In addition, we have significant
outstanding obligations relating to our discontinued operations, as well as
payment obligations with respect to unsecured debt.  Our liquidity
consists solely of cash and cash equivalents.





Significant Recent Events–As
discussed above under Corporate Overview, Background and Strategy, during 2008
we acquired a majority interest in StreetLinks National Appraisal Services LLC
(“StreetLinks”), a residential appraisal management
company.  Subsequent to 2008, during April 2009, we renegotiated the
terms our junior subordinated debentures and we committed to acquire a majority
ownership in Advent Financial Services LLC.  Advent is in its start-up
phase and will provide access to tailored banking accounts, small dollar banking
products and related services to meet the needs of low and moderate income level
individuals.





Impact
of Consolidation of Securitized Mortgage Assets on Our Financial
Statements





The
discussions of our financial condition and results of operation below provide
analysis for the changes in our balance sheet and income statement as presented
using Generally Accepted Accounting Principles in the United States of America
("GAAP").  Mortgage loans – held-in-portfolio and certain of our
mortgage securities – trading are owned by trusts established when those assets
were securitized.  The trusts issued asset-backed bonds to finance the
assets.  In accordance with GAAP, we have consolidated these
trusts.  Due to significant events that have occurred subsequent to
the securitization of these assets, we no longer have a significant economic
benefit from these assets.  We have provided additional disclosure in
Management’s Discussion and Analysis of Financial Condition and Results of
Operations under the heading Assets and Liabilities of Consolidated
Securitization Trusts to demonstrate the impact of the trusts on our
consolidated financial statements.





Financial
Condition as of December 31, 2008 as Compared to December 31, 2007





Cash and Cash
Equivalents. See
“Liquidity and Capital Resources” for discussion of our cash and cash
equivalents.





Restricted
Cash.  Certain states required that we post surety bonds in
connection with our former mortgage lending operations.  During 2007,
the sureties required that we provide letters of credit to support our
reimbursement obligations to the sureties.  In order to arrange these
letters of credit, we were required to collateralize the letters of credit with
cash.  During the first quarter of 2008, we terminated the surety
bonds when we surrendered state lending licenses as a result of the
discontinuation of our mortgage lending operations.  The sureties
returned a portion of the cash collateral during 2008 ($3.0 million), but
continue to hold $6.0 million of the collateral as a hedge against any claims
that may be brought during the tail period.  The timing of the return
of the remaining cash is at the discretion of the sureties and is dependent upon
their interpretation of the tail period for filing claims under the various
state licensing regulations.  No claims have been made against the
surety bonds and none are expected to be brought, especially considering the
significant amount of time that has elapsed since the bonds were cancelled and
since we last originated any mortgage loans.  Management expects the
cash to be fully returned.  However, the timing for return is
unknown.




14


Mortgage Loans -
Held-in-Portfolio.Mortgage loans –
held-in-portfolio consist of subprime mortgage loans which have been securitized
and are owned by three separate trusts – NHES 2006-1, NHES 2006MTA-1 and NHES
2007-1.  We consolidate these trusts for GAAP reporting.





The
mortgage loans – held-in-portfolio balance has declined as their value has
decreased significantly.  The value is dependent largely in part on
their credit quality and performance.  The credit quality of the
portfolio continues to worsen and delinquencies have increased dramatically
during the past two years.  Therefore, we significantly increased the
allowance for losses on these loans.  The allowance has increased from
$22.5 million as of January 1, 2007 to $230.1 million as of December 31, 2007 to
$776.0 as of December 31, 2008.  Additionally, the balance of mortgage
loans – held-in-portfolio has decreased due to regular borrower
repayments.  During 2008 and 2007, respectively, the trusts received
repayments of the mortgage loans totaling $288.2 million and $824.1
million.  These balances will continue to decline either through
normal borrower repayments or through continued devaluation as delinquencies,
foreclosures and losses occur.





As
discussed under the heading Assets and Liabilities of Consolidated
Securitization Trusts, these assets have no economic benefit to us and we have
no control over these assets.  We have also provided the assets and
liabilities of the trusts on a separate and combined basis.





Mortgage
Securities – Trading and Available-for-Sale.  The securities we
own are generally securities we retained after the securitization of mortgage
loans we originated prior to 2007.  For all loan securitizations, we
retained the residual interest bond, which means we receive the net of the
principal and interest received on the underlying loans within the securitized
trust less the principal and interest paid on the bonds issued by the trust,
mortgage insurance premiums, servicing fees and other miscellaneous
fees.  For any loans that incur prepayment penalty fees, we receive
those fees through the residual interest.  In some securitization
transactions, we also retained regular principal and interest
bonds.  Generally, these bonds were the lowest rated bonds issued by
the trust or these bonds were not rated.  Additionally, we have
purchased some mortgage securities in the open market from unrelated
entities.  Upon acquisition of the bonds, we classified the securities
as either trading or available-for-sale.  No changes have been made to
the classifications.





Significant
deterioration in the quality of the mortgage loans serving as collateral for our
mortgage securities has caused a devaluation of the securities.  In
general, the default rate on the underlying loans has increased dramatically
over the past two years.  Defaults are the result of national economic
conditions that have led to job losses, severe declines in housing prices and
the inability for credit-challenged individuals to refinance mortgage
loans.  In many cases, the securities we own have ceased to generate
cash flow and we expect cash flow to continue to decline during the coming
year.  We have consistently written the value of our securities down
over the past two years.





The
following tables provide details of our mortgage securities.





Table
2 − Values of Individual Mortgage Securities – Available-for-Sale


(dollars
in thousands)





For
      the Year Ended December 31,2008
                                    
                                    
                                    2007Securitization
                                      Trust
      (A)
                                    
                                    EstimatedFairValue
                                    
                                    
                                    DiscountRate
                                    
                                    
                                    ConstantPre-paymentRate
                                    
                                    
                                    Expected
                                      Credit
                                      Losses
                                    
                                    
                                    EstimatedFairValue
                                    
                                    
                                    DiscountRate
                                    
                                    
                                    ConstantPre-paymentRate
                                    
                                    
                                    ExpectedCreditLossesNMFT
      Series :2002-3
                                    
                                    $
                                    2,041
                                    
                                    
                                    
                                    25
                                    %
                                    
                                    
                                    16
                                    %
                                    
                                    
                                    0.8
                                    %
                                    
                                    $
                                    1,932
                                    
                                    
                                    
                                    25
                                    %
                                    
                                    
                                    24
                                    %
                                    
                                    
                                    0.6
                                    %2003-1
                                    
                                    
                                    5,108
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    13
                                    
                                    
                                    
                                    2.0
                                    
                                    
                                    
                                    3,260
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    20
                                    
                                    
                                    
                                    1.72003-2
                                    
                                    
                                    2,272
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    12
                                    
                                    
                                    
                                    1.9
                                    
                                    
                                    
                                    2,817
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    18
                                    
                                    
                                    
                                    1.22003-3
                                    
                                    
                                    2,402
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    12
                                    
                                    
                                    
                                    2.7
                                    
                                    
                                    
                                    1,233
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    16
                                    
                                    
                                    
                                    1.22003-4
                                    
                                    
                                    1
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    13
                                    
                                    
                                    
                                    2.7
                                    
                                    
                                    
                                    1,279
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    20
                                    
                                    
                                    
                                    1.62004-1
                                    
                                    
                                    16
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    15
                                    
                                    
                                    
                                    3.4
                                    
                                    
                                    
                                    180
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    24
                                    
                                    
                                    
                                    2.42004-2
                                    
                                    
                                    27
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    14
                                    
                                    
                                    
                                    3.5
                                    
                                    
                                    
                                    180
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    23
                                    
                                    
                                    
                                    2.42004-3
                                    
                                    
                                    73
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    15
                                    
                                    
                                    
                                    4.4
                                    
                                    
                                    
                                    986
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    24
                                    
                                    
                                    
                                    3.02004-4
                                    
                                    
                                    11
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    16
                                    
                                    
                                    
                                    4.3
                                    
                                    
                                    
                                    48
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    26
                                    
                                    
                                    
                                    2.62005-1
                                    
                                    
                                    −
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    17
                                    
                                    
                                    
                                    6.2
                                    
                                    
                                    
                                    512
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    27
                                    
                                    
                                    
                                    3.62005-2
                                    
                                    
                                    −
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    16
                                    
                                    
                                    
                                    7.0
                                    
                                    
                                    
                                    642
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    24
                                    
                                    
                                    
                                    3.32005-3
                                    
                                    
                                    −
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    17
                                    
                                    
                                    
                                    9.3
                                    
                                    
                                    
                                    1,562
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    24
                                    
                                    
                                    
                                    3.62005-4
                                    
                                    
                                    3
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    18
                                    
                                    
                                    
                                    11.5
                                    
                                    
                                    
                                    1,556
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    27
                                    
                                    
                                    
                                    4.52006-2
                                    
                                    
                                    73
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    19
                                    
                                    
                                    
                                    17.0
                                    
                                    
                                    
                                    2,301
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    32
                                    
                                    
                                    
                                    6.82006-3
                                    
                                    
                                    125
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    20
                                    
                                    
                                    
                                    19.8
                                    
                                    
                                    
                                    2,994
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    31
                                    
                                    
                                    
                                    8.42006-4
                                    
                                    
                                    136
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    20
                                    
                                    
                                    
                                    20.0
                                    
                                    
                                    
                                    2,960
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    32
                                    
                                    
                                    
                                    8.22006-5
                                    
                                    
                                    214
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    20
                                    
                                    
                                    
                                    24.0
                                    
                                    
                                    
                                    4,217
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    31
                                    
                                    
                                    
                                    11.02006-6
                                    
                                    
                                    286
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    19
                                    
                                    
                                    
                                    24.4
                                    
                                    
                                    
                                    4,712
                                    
                                    
                                    
                                    25
                                    
                                    
                                    
                                    30
                                    
                                    
                                    
                                    10.0Total
                                    
                                    $
                                    12,788
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    $
                                    33,371





(A) We
established the trust upon securitization of the underlying loans, which
generally were originated by us.




15




Table
3 — Mortgage Securities - Trading


(dollars
in thousands)


As
of December 31, 2008


S&P
      Rating
                                          
                                          Original
      Face
                                          
                                          
                                          Amortized
      Cost
                                            Basis
                                          
                                          
                                          Fair
      Value
                                          
                                          
                                          Number
      of
                                            Securities
                                          
                                          
                                          Weighted
                                            Average
      YieldSubordinated
      Securities:Investment
      Grade (A)
                                          
                                          $
                                          12,505
                                          
                                          
                                          $
                                          11,891
                                          
                                          
                                          $
                                          833
                                          
                                          
                                          
                                          3
                                          
                                          
                                          
                                          6.25
                                          %Non-investment
      Grade (B)
                                          
                                          
                                          422,609
                                          
                                          
                                          
                                          406,125
                                          
                                          
                                          
                                          5,547
                                          
                                          
                                          
                                          87
                                          
                                          
                                          
                                          8.08Total
      Subordinated Securities
                                          
                                          
                                          435,114
                                          
                                          
                                          
                                          418,016
                                          
                                          
                                          
                                          6,380
                                          
                                          
                                          
                                          90
                                          
                                          
                                          
                                          7.84Residual
      Securities:Unrated
                                          
                                          
                                          59,500
                                          
                                          
                                          
                                          15,952
                                          
                                          
                                          
                                          705
                                          
                                          
                                          
                                          1
                                          
                                          
                                          
                                          25.00Total
                                          
                                          $
                                          494,614
                                          
                                          
                                          $
                                          433,968
                                          
                                          
                                          $
                                          7,085
                                          
                                          
                                          
                                          91
                                          
                                          
                                          
                                          9.55
                                          %




As
of December 31, 2007


S&P
      Rating
                                        
                                        Original
      Face
                                        
                                        
                                        Amortized
      Cost
                                          Basis
                                        
                                        
                                        Fair
      Value
                                        
                                        
                                        Number
      of
                                          Securities
                                        
                                        
                                        Weighted
                                          Average
      YieldSubordinated
      Securities:Investment
      Grade (A)
                                        
                                        $
                                        389,881
                                        
                                        
                                        $
                                        367,581
                                        
                                        
                                        $
                                        80,004
                                        
                                        
                                        
                                        91
                                        
                                        
                                        
                                        11.46
                                        %Non-investment
      Grade (B)
                                        
                                        
                                        45,233
                                        
                                        
                                        
                                        38,514
                                        
                                        
                                        
                                        4,458
                                        
                                        
                                        
                                        17
                                        
                                        
                                        
                                        17.05Total
      Subordinated Securities
                                        
                                        
                                        435,114
                                        
                                        
                                        
                                        406,095
                                        
                                        
                                        
                                        84,462
                                        
                                        
                                        
                                        108
                                        
                                        
                                        
                                        11.76Residual
      Securities:Unrated
                                        
                                        
                                        N/A
                                        
                                        
                                        
                                        41,275
                                        
                                        
                                        
                                        24,741
                                        
                                        
                                        
                                        1
                                        
                                        
                                        
                                        21.00Total
                                        
                                        $
                                        435,114
                                        
                                        
                                        $
                                        447,370
                                        
                                        
                                        $
                                        109,203
                                        
                                        
                                        
                                        109
                                        
                                        
                                        
                                        13.85
                                        %





(A)
            Investment
      grade includes all securities with S&P ratings above
    BB+.


(B)
            Non-investment
      grade includes all securities with S&P ratings below
    BBB-.





We
re-securitized, by way of a Collateralized Debt Obligation (CDO), some of the
mortgage securities – trading we own in the first quarter of 2007.  We
retained a residual interest in the CDO.  However, due to the poor
performance of the securities within the CDO, our residual interest in the CDO
is not providing any cash flow to us and has no value.  As discussed
under the heading Assets and Liabilities of Consolidated Securitization Trusts,
the assets in the CDO have no economic benefit to us and we have no control over
these assets.  We have also provided the assets and liabilities of the
trusts on a separate and combined basis.





Real Estate
Owned.  Real estate owned includes the value of properties for
foreclosed loans owned by securitization trusts, as discussed under Mortgage
Loans – Held-in-Portfolio.  We consolidate the assets and liabilities
as part of the securitization trust.  A servicer that is independent
from us and the trusts services the mortgage loans and processes defaults for
liquidation.  Proceeds from liquidation of this real estate will flow
through the trust and will generally be paid to third party
bondholders.  The amount of real estate owned is dependent upon the
number of the overall mortgage loans outstanding, the rate of defaults, the
timing of liquidations and the estimated value of the real
estate.  The decrease in the amount of real estate owned from December
31, 2007 to December 31, 2008 results from the declining number of total loans
as well as the decreasing estimated value of the real estate.





Under the
heading Assets and Liabilities of Consolidated Securitization Trusts, we have
provided the assets and liabilities of the trusts on a separate and combined
basis.




16


Accrued Interest
Receivable.Accrued interest
receivable includes the interest due from individual borrowers to the trusts who
own the mortgage loans – held-in-portfolio.  For all mortgage loans
that do not carry mortgage insurance, the accrual of interest on loans is
discontinued when, in management’s opinion, the interest is not collectible in
the normal course of business, but in no case beyond when a loan becomes 90 days
delinquent.  For mortgage loans that do carry mortgage insurance, the
accrual of interest is only discontinued when in management’s opinion, the
interest is not collectible.  Management generally deems all of the
accrued interest on loans with mortgage interest to be
collectible.  The quantity of delinquent loans has significantly
increased, as a percent of total loans outstanding, from December 31, 2007 to
December 31, 2008.  Therefore, the amount of accrued interest has also
increased.





Under the
heading Assets and Liabilities of Consolidated Securitization Trusts, we have
provided the assets and liabilities of the trusts on a separate and combined
basis.





Other
Assets.  Other assets includes the value of derivative
instruments owned by the CDO securitization trust, prepaid insurance,
capitalized furniture and office equipment, appraisal fee receivables and other
minor receivables.  Generally, these assets have declined as we have
decreased the size of our business operations.





Assets of
Discontinued Operations.  During 2007 and 2008, we discontinued
our mortgage lending operations.  As of December 31, 2007 and December
31, 2008, we owned mortgage loans – held-for-sale and real estate owned related
to the mortgage lending business.  The amount of these assets declined
during 2008 as the assets were either liquidated or were further devalued based
on the current market conditions.





Asset-backed
Bonds Secured by Mortgage Assets.  During 2006 and 2007, we
executed three mortgage loans securitizations and one mortgage security
re-securitization (a CDO).  We consolidate the assets and liabilities
of the securitization trusts under GAAP.  The asset-backed bonds are
obligations of the trusts and will be repaid using collections of the
securitized assets.  The trusts have no recourse to our other,
unsecuritized assets.  The assets securing these obligations are
discussed under the headings “Mortgage loans – held-in-portfolio” and “Mortgage
securities – trading.”  The balances of the asset-backed bonds have
decreased during 2008 as the bonds have repaid.  We record the value
of the bonds secured by loans at the value of the proceeds, less
repayments.  We record the CDO (secured by mortgage securities) at its
market value.  These balances will decrease going forward as the
underlying assets repay or may be charged off as the assets are deemed to be
insufficient to fully repay the bond obligations.





Under the
heading Assets and Liabilities of Consolidated Securitization Trusts, we have
provided the assets and liabilities of the trusts on a separate and combined
basis.





Short-term
Borrowings Secured by Mortgage Securities.  Prior to 2008, we
entered short-term lending facilities to finance our mortgage assets, other than
those securities that were owned by a securitization trust (see Asset-backed
Bonds Secured by Mortgage Assets).  As of December 31, 2007, we had an
aggregate of $45.5 million outstanding under three separate agreements with
aggregate borrowing capacity of $840 million.  During 2008, we repaid
all amounts outstanding and terminated the lending agreements.





Junior
Subordinated Debentures.  We have $78.1 million in principal
amount of unsecured notes payable to two unconsolidated trusts, the balance
sheet includes $77.3 million which is net of debt issuance
costs.  These notes secure trust preferred securities issued by the
trusts.  During 2008, these notes carried an interest rate of
three-month LIBOR plus 3.5%.





During
2008, we purchased trust preferred securities with a par value of $6.9 million
during 2008 for $0.6 million.  As a result, $6.9 million of principal
and accrued interest of $0.2 million of the notes was retired and the principal
amount, accrued interest, and related unamortized debt issuance costs were
removed from the balance sheet resulting in a gain of $6.4 million, recorded to
the “Gains on debt extinguishment” line item of the consolidated statements of
operations.





Due to
Servicer.  The mortgage loans – held-in-portfolio on our
balance sheet have been securitized and we consolidate the securitized
trust.  In accordance with the agreements for the securitized mortgage
loans, the servicer of the loans is required to make regularly scheduled
payments to the bondholders, regardless of whether the borrower has made
payments as required.  The servicer is required to make advances from
its own funds.  Upon liquidation of defaulted loans, the servicer is
repaid the advanced funds.  Until such time as the loans liquidate,
the trust has an obligation to the servicer, which we have classified as “Due to
Servicer” on the balance sheet.  The amount of the obligation is
dependent on the rate and timing of delinquencies of the individual
borrowers.  During 2007 and 2008, the trusts experienced a significant
increase in the amount of delinquencies, which increases the amount of advances
the servicer has made to the bondholders and therefore increases the liability
to the servicer.





Dividends
Payable.  During 2004, we issued $74.8 million in cumulative
redeemable preferred stock (Series C) with a dividend equivalent to
8.9%.  During 2007, we issued $50 million of redeemable preferred
stock (Series D-1) with a dividend equivalent to 9.0%. We have failed to make
all dividend payments since October 2007.  As a result, the Series D-1
dividend increased to an equivalent of 13.0%, retroactive and compounded to the
beginning of the first quarter in which the dividends were not
paid.  The unpaid dividends continue to accrue and have resulted in
the large increase in unpaid dividends recorded in our balance
sheet.




17


Accounts Payable
and Other Liabilities.  Accounts payable and other liabilities
includes the interest payable on borrowings, including the liabilities of the
securitization trusts we consolidate, the value of derivatives included owned by
the mortgage loan securitization trusts, taxes payable, obligations under our
corporate office lease and miscellaneous accrued general and administrative
expenses.  Generally, these liabilities have declined along with the
size of our business operations.


18





Table
4— Accounts Payable and Other Liabilities


(dollars
in thousands)


December
      31,2008
                              
                              
                              2007Interest
      payable
                              
                              $
                              10,177
                              
                              
                              $
                              6,879Value
      of derivatives owned by mortgage loan securitization
trusts
                              
                              
                              9,102
                              
                              
                              
                              6,896Obligations
      under office space lease
                              
                              
                              4,558
                              
                              
                              
                              1,457Taxes
      payable
                              
                              
                              3,893
                              
                              
                              
                              11,362Global
      facility financing fee
                              
                              
                              −
                              
                              
                              
                              11,814Accrued
      expenses and other liabilities
                              
                              
                              6,198
                              
                              
                              
                              14,984Total
                              
                              $
                              33,928
                              
                              
                              $
                              53,392








Liabilities of
Discontinued Operations.  During 2007 and 2008, we discontinued
our mortgage lending operations.  At the end of 2007, we had
significant outstanding obligations related to those operations.  As
discussed further in “Item 3 Legal Proceedings” we had recorded a liability of
$46.1 million for a judgment in a legal action arising in 2002.  The
legal action was taken against our subsidiary, NovaStar Home Mortgage, Inc., and
some of its officers.  During 2008, we settled this action and
therefore we removed the liability.  The majority of the change in the
liabilities of discontinued operations between December 31, 2007 and December
31, 2008 was related to the settlement of this obligation.  In the
normal course of operations in 2008, we paid most of the other liabilities and
obligations of the discontinued operations.





Stockholders’
Deficit.
As of December 31, 2007 our total liabilities exceeded our total assets under
GAAP by $211.5 million.  By December 31, 2008, the deficit increased
to $876.8 million.





The
liabilities of the securitization trusts exceed the assets of those trusts as of
December 31, 2008 and December 31, 2007 by $932.1 million and $271.6 million,
respectively.  These amounts do include any adjustments for
intercompany eliminations, see table 8 for further detail.  The severe
devaluation of the mortgage assets, as discussed in the respective categories
above, has resulted in the significant deficit of these trusts.  The
assets and liabilities of these trusts are consolidated under
GAAP.  Due to the significant impact to our financial statements of
these trusts, we have also provided the assets and liabilities of the trusts on
a separate and combined basis under the heading “Assets and Liabilities of
Consolidated Securitization Trusts.”





The
significant increase in our shareholders’ deficit during 2008 results from our
large net loss, driven primarily by valuation allowances taken on our mortgage
loans and securities and general and administrative expenses.




Results
of Operations – Consolidated Earnings Comparisons





Year
Ended December 31, 2008 as Compared to the Year Ended December 31,
2007





Net Interest
(Expense) Income.  As discussed above, in general, our mortgage
assets have been significantly impaired due to national and international
economic crises, housing price deterioration and mortgage loan credit
defaults.  Interest income has declined as these assets have declined
due to repayments and liquidations.  Interest expense has declined as
the related principals balances have declined.  Also, interest expense
is adjustable, generally based on a spread to LIBOR.  LIBOR was lower
during 2008 than 2007.


19





Table
5— Net Interest Expense


(dollars
in thousands)


For
      the Year Ended
                                    December
      31,2008
                                  
                                  
                                  2007Interest
      income:Mortgage
      securities
                                  
                                  $
                                  46,997
                                  
                                  
                                  $
                                  102,500Mortgage
      loans held-in-portfolio
                                  
                                  
                                  186,601
                                  
                                  
                                  
                                  258,663Other
      interest income
                                  
                                  
                                  1,411
                                  
                                  
                                  
                                  5,083Total
      interest income
                                  
                                  
                                  235,009
                                  
                                  
                                  
                                  366,246Interest
      expense:Short-term
      borrowings secured by mortgage securities
                                  
                                  
                                  436
                                  
                                  
                                  
                                  23,649Asset-backed
      bonds secured by mortgage loans
                                  
                                  
                                  95,012
                                  
                                  
                                  
                                  178,937Asset-backed
      bonds secured by mortgage securities
                                  
                                  
                                  13,271
                                  
                                  
                                  
                                  17,635Junior
      subordinated debentures
                                  
                                  
                                  6,261
                                  
                                  
                                  
                                  8,148Total
      interest expense
                                  
                                  
                                  114,980
                                  
                                  
                                  
                                  228,369Net
      interest income before provision for credit losses
                                  
                                  
                                  120,029
                                  
                                  
                                  
                                  137,877Provision
      for credit losses
                                  
                                  
                                  (707,364
                                  )
                                  
                                  
                                  (265,288
                                  )Net
      interest (expense)  income
                                  
                                  $
                                  (587,335
                                  )
                                  
                                  $
                                  (127,411
                                  )







Provision for
Credit Losses.The provision for credit
losses relates to mortgage loans which have been securitized.  As
discussed above, in general, the credit quality of the securitized mortgage
loans significantly deteriorated during 2007 and 2008 due to national and
international economic crises, housing price deterioration and mortgage loan
credit defaults.  A significant portion of the securitized loans have
become uncollectible or will only be partially collected. Approximately 5% of
our loans held in portfolio were greater than 90 days delinquent at December 31,
2007, and approximately 6% were in foreclosure.  As of December 31, 2008,
this delinquency percentage increased to approximately 20% while loans in
foreclosure also increased to approximately 20%.  As loans transition into
REO status, an estimated loss is recorded until the property is sold or
liquidated.  For the NHEL 0601 and MTA 0601 transactions, we valued REO
property at 55% and 55% of its current principal balance as of December 31,
2008, compared to 63% and 55% as of December 31, 2007, respectively. 
Because of the increased loss severity, NHEL 0701 property was valued at 40% in
2008; a 5% decrease from 2007. Provisions for these losses have increased
in connection with the declining credit quality of the loans.  We took
charges to income totaling $707.4 million and 265.3 million during 2008 and
2007, respectively.





Gains on Debt
Extinguishment.  See discussion under Financial Condition –
Junior Subordinated Debentures.





(Losses) Gains on
Derivative Instruments. We have entered into derivative instrument
contracts that do not meet the requirements for hedge accounting treatment, but
contribute to our overall risk management strategy by serving to reduce interest
rate risk related to short-term borrowing rates. The derivative instruments for
which the value is on our balance sheet are owned by securitization
trusts.  Derivative instruments transferred into a securitization
trust are administered by the trustee in accordance with the trust
documents.  These derivative instruments are used to mitigate interest
rate risk within the related securitization trust and will generally increase in
value as short-term interest rates increase and decrease in value as rates
decrease.





We also
entered into three credit default swaps (“CDS”) during 2007 as part of our CDO
transaction previously discussed.  The CDS had a notional amount of
$16.5 million and a fair value of $6.1 million at the date of purchase and are
pledged as collateral against the CDO ABB.





As a
result of declining interest rates and declining values of the CDS, the losses
on derivative instruments from continuing operations were $18.1 million and
$11.0 million for the years ended December 31, 2008 and 2007,
respectively.





Fair Value
Adjustments.Adjustment for changes in value on our trading securities
and the asset-backed bonds issued in our CDO transaction executed are recorded
as Fair Value Adjustments.  The significant value declines in 2008 and
2007 were a result of significant spread widening in the subprime mortgage
market for these types of asset-backed securities as well as poor credit
performance of the underlying mortgage loans.  By the end of 2007, the
total value of the trading securities and the asset-backed bonds had declined
significantly, resulting in a lower overall adjustment in 2008 when compared to
2007.




20


Impairment on
Mortgage Securities – Available-for-Sale.To the extent that the
cost basis of mortgage securities – available-for-sale exceeds the fair value
and the unrealized loss is considered to be other than temporary, an impairment
charge is recognized and the amount recorded in accumulated other comprehensive
income or loss is reclassified to earnings as a realized loss.  The
large impairments in 2008 and 2007 were primarily driven by an increase in
actual and projected losses due to the deteriorating credit quality of the loans
underlying the securities.  By the end of 2007, the total value of the
available-for-sale securities had declined significantly, resulting in a lower
overall impairment in 2008 when compared to 2007.





Premiums for
Mortgage Loan Insurance.  Premiums for mortgage insurance are
for credit default insurance for mortgage loans – held-in-portfolio, which have
been securitized and are owned by securitization trusts.  The premiums
are paid by the trust from the loan proceeds. Premiums are based on a percentage
of the individual loan principal outstanding.  The decrease in
premiums on mortgage loan insurance for 2008 as compared to 2007 is due to the
decrease in loans-held-in-portfolio.





Appraisal Fee
Income and Expense.  We acquired a majority interest in
StreetLinks on August 1, 2008.  Fees are collected from customers
(borrowers or lenders), a portion of which is paid to independent mortgage loan
appraisers.  Fee income and expense is recognized when the appraisal
is completed and delivered to the customer.





General and
Administrative Expenses.  During late 2007 and into early 2008,
we eliminated a significant portion of our administrative
overhead.  We terminated officers and staff in our executive,
information systems, legal, human resource and finance/accounting
departments.  We also terminated numerous contracts for professional
services.  One of management’s key focuses during 2008 was to reduce
or eliminate all unnecessary general and administrative expenses.  The
result of these efforts was a significant decline in the general administrative
expenses for 2008.  Total general and administrative expenses
decreased from $59.4 million during 2007 to $24.4 million during
2008.





Income
Taxes.  Prior to 2006, we elected to be treated as a REIT for
federal income tax purposes and, as a result, were not required to pay any
corporate level income taxes as long as we met requirements prescribed for REIT
qualification under the Internal Revenue Code.  During 2007, we were
unable to satisfy the REIT distribution requirement for the tax year ended
December 31, 2006, either in the form of cash or preferred
stock.  This action resulted in our loss of REIT status retroactive to
January 1, 2006.  Our failure to satisfy the REIT distribution test
resulted from demands on our liquidity and the substantial decline in our market
capitalization during 2007.  For 2007, we have filed a consolidated
federal income tax return and we intend to file a consolidated federal income
tax return for 2008.





During
2008, we recognized a tax benefit of $17.6 million from continuing
operations.  Of this benefit, $13.8 million is an offset to the tax
expense recorded on the gain in discontinued operations.   The
remaining $3.8 million of tax benefit is primarily attributed to the release of
tax liability related to uncertain tax positions due to the lapse of statute of
limitations and changes in management’s judgment regarding those
positions.  As discussed below, due to the valuation allowance
recorded against deferred tax assets, no tax benefit is recognized on tax losses
incurred in 2008.





During
2007, we recognized a tax expense of $66.5 million from continuing operations
primarily attributed to a valuation allowance recorded against deferred
taxes.





In
accordance with Statementof Financial
Accounting Standards 109, “Accounting for income taxes”, (“SFAS 109”), we
examine and weigh all available evidence (both positive and negative and both
historical and forecasted) in the process of determining whether it is more
likely than not that a deferred tax asset will be realized.  We
consider the relevancy of historical and forecasted evidence when there has been
a significant change in circumstances.  Additionally, we evaluate the
realization of our recorded deferred tax assets on an interim and annual
basis.  Based on the evidence available as of December 31, 2008 and
2007, including the significant pre-tax losses incurred, the liquidity issues we
face and our decision to close all of our mortgage lending operations, we
concluded that it is more likely than not that our entire net deferred tax asset
will not be realized.  Based on these conclusions, we recorded a
valuation allowance on 100% of the deferred tax asset as of December 31, 2008
and 2007.  In future periods, we will continue to monitor all factors
that impact positive and negative evidence relating to our deferred tax
assets.





As of
December 31, 2008, we reflect $3.8 million in taxes payable, which is recorded
in Accounts Payable and Other Liabilities.  This balance is primarily
comprised of tax liability on uncertain tax positions, interest and
penalties.





Contractual
Obligations





We have
entered into certain long-term debt, hedging and lease agreements, which
obligate us to make future payments to satisfy the related contractual
obligations.





The
following table summarizes our contractual obligations for both continuing and
discontinued operations, as of December 31, 2008, other than short-term
borrowing arrangements.


21





Table
6 — Contractual Obligations


(dollars
in thousands)





Payments
      Due by PeriodContractual
      Obligations
                      
                      Total
                      
                      
                      Less
      than1 Year
                      
                      
                      1-3
      Years
                      
                      
                      3-5
      Years
                      
                      
                      After
      5 YearsNon-recourse
      - long—term debt (A)
                      
                      $
                      3,553,299
                      
                      
                      $
                      696,611
                      
                      
                      $
                      988,857
                      
                      
                      $
                      531,767
                      
                      
                      $
                      1,336,064Junior
      subordinated debentures (B)
                      
                      
                      185,817
                      
                      
                      
                      8,862
                      
                      
                      
                      7,695
                      
                      
                      
                      7,695
                      
                      
                      
                      161,565Operating
      leases (C)
                      
                      
                      13,694
                      
                      
                      
                      6,184
                      
                      
                      
                      6,887
                      
                      
                      
                      436
                      
                      
                      
                      187Total,
      consolidated obligations
                      
                      
                      3,752,810
                      
                      
                      
                      711,657
                      
                      
                      
                      1,003,439
                      
                      
                      
                      539,898
                      
                      
                      
                      1,497,816Non-recourse
      obligations
                      
                      
                      (3,553,299
                      )
                      
                      
                      (696,611
                      )
                      
                      
                      (988,857
                      )
                      
                      
                      (531,767
                      )
                      
                      
                      (1,336,064
                      )Recourse
      obligations
                      
                      $
                      199,511
                      
                      
                      $
                      15,046
                      
                      
                      $
                      14,582
                      
                      
                      $
                      8,131
                      
                      
                      $
                      161,752





(A)
            The
      asset-backed bonds will be repaid only to the extent there is sufficient
      cash receipts on the underlying mortgage loans, which collateralize the
      debt.   The trusts that own these assets and asset-backed
      obligations have no recourse to us for any shortfall.  The
      timing of the repayment of these mortgage loans is affected by
      prepayments. These amounts include expected interest payments on the
      obligations. Interest obligations on our variable-rate long-term debt are
      based on the prevailing interest rate at December 31, 2008 for each
      respective obligation.


(B)
            The
      junior subordinated debentures are assumed to mature in 2035 and 2036 in
      computing the future payments. These amounts include expected interest
      payments on the obligations.  Interest obligations on our junior
      subordinated debentures are based on the prevailing interest rate at
      December 31, 2008 for each respective obligation.  On February
      18, 2009, the Company, NMI, NovaStar Capital Trust I and NovaStar Capital
      Trust II (the “Trusts”) and the trust preferred security holders
      entered into agreements to exchange the existing preferred obligations for
      new preferred obligations.  The new preferred obligations
      require quarterly distributions of interest to the holders at a rate equal
      to 1.0% per annum beginning January 1, 2009 through December 31, 2009,
      subject to reset to a variable rate equal to the three-month LIBOR plus
      3.5% upon the occurrence of an “Interest Coverage Trigger.”, see note 21
      to the consolidated financial statements for additional
      details.


(C)
            The
      operating lease obligations do not include rental income of $1.9 million
      to be received under sublease
contracts.





Liquidity
and Capital Resources





During
2007 and 2008, we have taken numerous actions to reduce our cash needs and
liquidity risk.  However, we continue to have going concern risk as a
as a result of the cash requirements for our continuing and discontinued
operations.





Our
residual and subordinated mortgage securities are our only source of significant
positive cash flows.  Based on the current projections, the cash flows
from our mortgage securities will decrease in the next several months as the
underlying mortgage loans are repaid, and could be significantly less than the
current projections if losses on the underlying mortgage loans exceed the
current assumptions or if short-term interest rates increase
significantly.  We have operating expenses associated with our
administration, as well as payment obligations with respect to unsecured debt,
including periodic interest payments with respect to junior subordinated
debentures.  As discussed in Item 3. Legal Proceedings we are the
subject of various legal proceedings, the outcome of which is
uncertain.  We may also face demands in the future that are unknown to
us today related to our legacy lending and servicing operations.  If
the cash flows from our mortgage securities are less than currently anticipated
and we are unable to invest in a profitable basis, restructure our unsecured
debt and contractual obligations, there can be no assurance that we will be able
to continue as a going concern and avoid seeking the protection of applicable
federal and state bankruptcy laws.





As of May
27, 2009, we had approximately $23.4 million in cash on hand (including
restricted cash).  In addition to our operating expenses, which currently
range from approximately $750,000 to $1.5 million per month we have quarterly
interest payments due on our trust preferred securities.  The next payment
on the trust preferred securities is due on June 30, 2009 and totals $0.4
million.  Our current projections indicate sufficient available cash and
cash flows from our mortgage assets to meet these payment needs.  However,
our mortgage asset cash flows are currently volatile and uncertain in nature,
and the amounts we receive could vary materially from our projections. 
Therefore, no assurances can be given that we will be able to meet our cash flow
needs, in which case we would be required to seek protection of applicable
bankruptcy laws.




22


Overview
of Cash Flow for the Year Ended December 31, 2008





During
2007 and early 2008, we discontinued our mortgage lending operations and sold
our mortgage servicing rights which subsequently resulted in the closing of our
servicing operations.  Prior to exiting the lending business, we sold
the majority of the loans we originated to securitization
trusts.  Three of these securitization trusts are consolidated for
financial reporting under GAAP, which means all of the assets and the
liabilities of the trust are included in our consolidated financial
statements.  Our results of operations and cash flows include the
activity of these trusts.  The cash proceeds from the repayment of the
loan collateral are owned by the trust and serve to only repay the obligations
of the trust.  We do not collect the cash and we are not responsible
for the obligations of the trust.  Principal and interest on the bonds
(securities) of the trust can only be paid if there is sufficient cash flow the
underlying collateral.  We own some of the securities issued by the
trust, which are our only source of available cash flow.  As a result
of the national economic crises, the loans within these trusts have very high
rates of default.  Therefore, the cash flow on the securities we own
has declined significantly within the past two years.





We have
provided a summary of the cash flow for the securitization trusts under the
heading Assets and Liabilities of Consolidated Securitization
Trusts.





Following
are the primary and simplified sources of cash receipts and disbursements,
excluding the impact of the securitization trusts.





(dollars
in thousands)





For
      the Year EndedDecember 31, 2008Primary
      sources:Payments
      received on mortgage securities
                                                
                                                $
                                                59,912Payments
      received on mortgage loans – held-for-sale
                                                
                                                
                                                4,024Primary
      uses:Repayment
      of short-term borrowings
                                                
                                                
                                                (45,488
                                                )Payment
      of general, administrative and capital expenditures
                                                
                                                
                                                (37,832
                                                )





Statement
of Cash Flows - Operating, Investing and Financing Activities





The
following table provides a summary of our operating, investing and financing
cash flows as taken from our consolidated statements of cash flows for years
ended December 31, 2008 and 2007.





Table
7 — Summary of Operating, Investing and Financing Cash Flows


(dollars
in thousands)


For
      the Years EndedDecember 31,2008
                                    
                                    2007Consolidated
      Statements of Cash Flows:Cash
      provided by (used in) operating activities
                                    
                                    $
                                    29,566
                                    
                                    
                                    $
                                    (445,788
                                    )Cash
      flows provided by investing activities
                                    
                                    
                                    493,803
                                    
                                    
                                    
                                    1,073,063Cash
      flows used in financing activities
                                    
                                    
                                    (523,719
                                    )
                                    
                                    
                                    (752,433
                                    )









Operating
Activities. Net
cash used in operating activities decreased by $475.4 million in 2008 as
compared to 2007.  We discontinued all servicing and lending operations and
therefore, used significantly less cash in operations.  The source of
this cash flow is income on our mortgage securities.





Investing
Activities. In
2008, net cash provided by investing activities decreased by $579.3 million as
compared to 2007.  Our mortgage loan portfolio declined significantly
and borrower defaults increased, resulting in lower repayments of our
mortgage loans held-in-portfolio.   Cash proceeds from the sale
of assets acquired through foreclosure have increased as our
foreclosed loan activity has increased significantly.  We also experienced
a decrease in paydowns on our mortgage securities – available-for-sale during
2008 as compared to 2007 as a result of poor credit performance of the
underlying loans.


23


Financing
Activities. Net
cash used in financing activities decreased by $228.7 million in 2008 as
compared 2007. The decrease is primarily due to the issuance of $2.1 billion of
asset-backed bonds during the first quarter of 2007 from a CDO and a loan
securitization both structured as financing transactions for accounting
purposes. This was somewhat offset by cash used in financing activities from
discontinued operations in 2007. All short term borrowings were also paid off in
2008 and we also experienced a decrease in paydowns of our asset-backed bonds
during the year.





Future
Sources and Uses of Cash





Primary
Sources of Cash





Cash Received
From Our Mortgage Securities Portfolio.A major driver of cash flows is
the proceeds we receive from our mortgage securities. For the year ended
December 31, 2008 we received $86.8 million in proceeds from repayments on
mortgage securities. The cash flows we receive on our mortgage
securities—available-for-sale are highly dependent on the interest rate spread
between the underlying collateral and the bonds issued by the securitization
trusts and default and prepayment experience of the underlying collateral. The
following factors have been the significant drivers in the overall fluctuations
in these cash flows:





·
            Higher
      credit losses have decreased cash available to distribute with respect to
      our securities,


·
            As
      short-term interest rates decline, the net spread to us increases and if
      short-term interest rates increase, the spread we receive will
      decline,


·
            We
      have lower average balances of our mortgage securities—available-for-sale
      portfolio as the securities have paid down and we have not acquired new
      bonds.





Collateral
Returned from Surety Bond Holders. See discussion under Restricted Cash.
We received $3.0 million in cash as collateral was returned from surety bond
holders during 2008. We have $6.0 million collateral outstanding for surety bond
holders. When the cash collateralizing the surety bond letters of credit is
released, it will become unrestricted and available for general corporate
purposes. We cannot predict the timing of the release.





Proceeds from
Repayments of Mortgage Loans. As we discussed above, significant cash is
collected by the securitization trusts from the payment of principal and
interest on securitized loans and securities. The cash is trapped by the trust
and is used to repay obligations (primarily to bondholders) of the trust. The
cash is not available to us and we are not responsible for the obligations of
the trust. For the year ended December 31, 2008 repayments on the mortgage loans
held-in-portfolio totaled $288.2 million compared to $824.1 million during
2007.





Primary
Uses of Cash





Payments of
General and Administrative Expenses. We continue to have significant
general and administrative expenses associated with managing and operating our
business. These expenses include staff and management compensation and related
benefit payments, professional expenses for audit, tax and related services,
legal services, rent and general office operational costs.





Investment in
Assets or Operating Businesses. To the extent we have cash available to
invest in assets or operating businesses, management intends to do so. During
2008, we invested $0.7 million in StreetLinks, subsequent to 2008 we paid an
additional $0.4 million due to certain performance targets being met and could
pay up to $3.3 million if additional performance targets are met. Subsequent to
2008, we executed agreements to invest $2 million to acquire Advent and to
further invest $2 million in Advent if performance targets are met.





Repayments of
Long-Term Borrowings. As of December 31, 2008, we had $78.1 million in
outstanding principal of junior subordinated debentures relating to the trust
preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II,
$77.3 million is included on the balance sheet which is net of debt issuance
costs. For 2008, we made periodic interest payments based on a variable interest
rate of three-month LIBOR plus 3.5% which resets quarterly. Subsequent to 2008,
we restructured our obligations under the junior subordinated debentures, which
we expect to reduce cash requirements for interest in the near term. See Table 6
for an estimate of our contractual obligations related to these junior
subordinated debentures.





Repayments of
Short-term Borrowings.During 2008, we repaid all short-term borrowings
that were outstanding as of December 31, 2007, totaling $45.5 million. We have
no outstanding borrowing arrangements and therefore no cash will be used to
repay borrowings.





Common and
Preferred Stock Dividend Payments. We did not declare any common stock
dividends for the year ended December 31, 2008. We do not expect to pay any
dividends for the foreseeable future.





Settlement of
Legal Disputes. See “Item 3. Legal Proceedings.” During 2008, we made
several payments to settle legal disputes resulting from our legacy lending and
servicing operations, including $2 million in settlement of a 2002 claim against
our subsidiary, NovaStar Home Mortgage, Inc. We have several pending legal
actions. For those actions where we are the defendant, we are contesting
plaintiffs’ claims. In the event we are not successful in our defense, we may be
required to make payments for settlements or judgments.




24




Expenses Related
to Discontinued Operations. We have ongoing expenses associated with our
discontinued operations, including obligations under multiple office leases,
software agreements, and other contractual obligations, that no longer
contribute to our revenue producing operations. See “Other Liquidity Factors”
for further discussion.





Off-Balance
Sheet Arrangements





As
discussed previously, historically, we have pooled the loans we originated and
purchased and typically securitized them to obtain long-term financing for the
assets. The loans were transferred to a trust where they serve as collateral for
asset-backed bonds, which the trust issued to the public. We often retained our
residual and subordinated securities issued by the trust. We also securitized
residual and subordinated securities that we retained from our securitizations
and that we purchased from third parties. Information about the revenues,
expenses, liabilities and cash flows we have in connection with our
securitization transactions, as well as information about the securities issued
and interests retained in our securitizations, are detailed in “Management’s
Discussion and Analysis of Financial Condition and Results of
Operations.”





In the
ordinary course of business, we have sold whole pools of loans to investors with
recourse for certain borrower defaults. We also have sold loans to
securitization trusts and guaranteed to cover losses suffered by the trust
resulting from defects in the loan origination process. See “Liquidity and
Capital Resources – Primary Uses of Cash – Loan Sale and Securitization
Repurchases” for further discussion of these guarantees and recourse
obligations.





Assets
and Liabilities of Consolidated Securitization Trusts





During
2006 and 2007, we executed loan securitization transactions that did not meet
the criteria necessary for derecognition of the securitized assets and
liabilities pursuant to Statement of Financial Accounting Standards No. 140,
“Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities – a replacement of FASB Statement No. 125” (“SFAS 140”) and
related authoritative accounting literature. As a result, the assets and
liabilities relating to this securitization are included in our consolidated
financial statements.





At the
time these loans were securitized, we owned significant beneficial interests in
the securitized loan pools, including various subordinated bond classes and the
residual interests in these pools. For the 2006 securitized loan pools, we owned
the right to unilaterally place certain derivative instruments into the
securitization trust and to repurchase a limited number of loans from the trust
for any reason and at any time. For the 2007 securitized loan pool, we
determined that it excessively benefited from the derivatives transferred to the
trust at inception.





During
2007, we also securitized certain mortgage securities through a Collateralized
Debt Obligation structure.





During
and prior to 2008, the following events occurred that have significantly changed
the economics of these securitized loan pools including:





1.
            We
      sold a portion of the beneficial interests we
  owned,


2.
            The
      credit losses on the securitized loans increased to the point where the
      remaining beneficial interests we own are not
  significant,


3.
            We
      sold the right to service all securitized
loans,


4.
            We
      executed amendments to the securitization agreements for the 2006 loan
      pools whereby we relinquished all rights to place certain derivative
      instruments into the securitization trust and to repurchase a limited
      number of loans from the trust for any reason and at any time,
      and


5.
            For
      the 2007 securitized loan pool, a significant portion of the derivatives
      placed into the trust have expired and the remaining derivatives will
      expire by the end of 2009.





While the
securities, loans and bond liabilities, along with miscellaneous related assets
and liabilities, remain on our balance sheet as presented in accordance with
accounting principles generally accepted in the United States of America, we
have no ability to control the assets, no obligations related to the trust
payables, and no significant economic benefit from our ownership interests
issued by the trust. Likewise, the income and expenses associated with these
assets and liabilities represent earnings and costs of the securitization trust,
but have no bearing on our performance due to the current economic condition of
the trusts.





Below is
financial information for each of the securitization trusts we consolidate and
for the total of all consolidated trust balance sheets.





The
discussion of the individual line items within this financial information is
included in the discussion of our consolidated financial statements in the
applicable forgoing sections of this report and is considered non-GAAP financial
information.




25





Table
8 – Assets and Liabilities of Securitization Trusts (A) (B)


(dollars
in thousands)




December
      31, 2008
                            
                            
                            December 31, 2007CDO
                            
                            
                            NHES
                              2006-1
                            
                            
                            NHES
                              2006
                              MTA1
                            
                            
                            NHES
                              2007-1
                            
                            
                            Total
                            
                            
                            CDO
                            
                            
                            NHES
                              2006-1
                            
                            
                            NHES
                              2006
                              MTA1
                            
                            
                            NHES
                              2007-1
                            
                            
                            TotalAssetsMortgage
      loans – held in portfolio, net of allowance
                            
                            $
                            −
                            
                            
                            $
                            411,146
                            
                            
                            $
                            523,183
                            
                            
                            $
                            847,962
                            
                            
                            $
                            1,782,291
                            
                            
                            $
                            
                            
                            
                            $
                            670,092
                            
                            
                            $
                            756,912
                            
                            
                            $
                            1,457,054
                            
                            
                            $
                            2,884,058Trading
      securities
                            
                            
                            5,199
                            
                            
                            
                            −
                            
                            
                            
                            −
                            
                            
                            
                            −
                            
                            
                            
                            5,199
                            
                            
                            
                            72,239
                            
                            
                            
                            −
                            
                            
                            
                            −
                            
                            
                            
                            −
                            
                            
                            
                            72,239Real
      estate owned
                            
                            
                            −
                            
                            
                            
                            23,289
                            
                            
                            
                            9,233
                            
                            
                            
                            37,958
                            
                            
                            
                            70,480
                            
                            
                            
                            −
                            
                            
                            
                            32,126
                            
                            
                            
                            4,851
                            
                            
                            
                            39,637
                            
                            
                            
                            76,614Accrued
      interest receivable
                            
                            
                            −
                            
                            
                            
                            22,566
                            
                            
                            
                            10,134
                            
                            
                            
                            44,592
                            
                            
                            
                            77,292
                            
                            
                            
                            −
                            
                            
                            
                            14,239
                            
                            
                            
                            14,090
                            
                            
                            
                            33,375
                            
                            
                            
                            61,704Other
      assets
                            
                            
                            2,043
                            
                            
                            
                            −
                            
                            
                            
                            −
                            
                            
                            
                            −
                            
                            
                            
                            2,043
                            
                            
                            
                            4,473
                            
                            
                            
                            −
                            
                            
                            
                            −
                            
                            
                            
                            −
                            
                            
                            
                            4,473Total
      assets
                            
                            $
                            7,242
                            
                            
                            $
                            457,001
                            
                            
                            $
                            542,550
                            
                            
                            $
                            930,512
                            
                            
                            $
                            1,937,305
                            
                            
                            $
                            76,712
                            
                            
                            $
                            716,457
                            
                            
                            $
                            775,853
                            
                            
                            $
                            1,530,066
                            
                            
                            $
                            3,099,088Liabilities
      and net deficiency in assetsLiabilities:Asset-backed
      bonds secured by mortgage loans
                            
                            $
                            −
                            
                            
                            $
                            566,577
                            
                            
                            $
                            700,335
                            
                            
                            $
                            1,398,115
                            
                            
                            $
                            2,665,027
                            
                            
                            $
                            −
                            
                            
                            $
                            735,235
                            
                            
                            $
                            765,361
                            
                            
                            $
                            1,644,534
                            
                            
                            $
                            3,145,130Asset-backed
      bonds secured by mortgage securities
                            
                            
                            5,384
                            
                            
                            
                            −
                            
                            
                            
                            −
                            
                            
                            
                            −
                            
                            
                            
                            5,384
                            
                            
                            
                            74,542
                            
                            
                            
                            −
                            
                            
                            
                            −
                            
                            
                            
                            −
                            
                            
                            
                            74,542Other
      liabilities
                            
                            
                            24,748
                            
                            
                            
                            47,418
                            
                            
                            
                            22,401
                            
                            
                            
                            104,439
                            
                            
                            
                            199,006
                            
                            
                            
                            21,945
                            
                            
                            
                            33,533
                            
                            
                            
                            22,356
                            
                            
                            
                            73,231
                            
                            
                            
                            151,065Total
      liabilities
                            
                            
                            30,132
                            
                            
                            
                            613,995
                            
                            
                            
                            722,736
                            
                            
                            
                            1,502,554
                            
                            
                            
                            2,869,417
                            
                            
                            
                            96,487
                            
                            
                            
                            768,768
                            
                            
                            
                            787,717
                            
                            
                            
                            1,717,765
                            
                            
                            
                            3,370,737Total
      net deficiency in assets
                            
                            
                            (22,890
                            )
                            
                            
                            (156,994
                            )
                            
                            
                            (180,186
                            )
                            
                            
                            (572,042
                            )
                            
                            
                            (932,112
                            )
                            
                            
                            (19,775
                            )
                            
                            
                            (52,311
                            )
                            
                            
                            (11,864
                            )
                            
                            
                            (187,699
                            )
                            
                            
                            (271,649
                            )Total
      liabilities and net deficiency in assets
                            
                            $
                            7,242
                            
                            
                            $
                            457,001
                            
                            
                            $
                            542,550
                            
                            
                            $
                            930,512
                            
                            
                            $
                            1,937,305
                            
                            
                            $
                            76,712
                            
                            
                            $
                            716,457
                            
                            
                            $
                            775,853
                            
                            
                            $
                            1,530,066
                            
                            
                            $
                            3,099,088


(A)
              Stand-alone
      balances do not include impact of intercompany
    eliminations.


(B)
            The
      above financial information is considered
  non-GAAP.




26




Table
9 - Operating Results of Securitization Trusts (A) (B)


(dollars
in thousands)





For the Year Ended December 31, 2008
                                
                                
                                For the Year Ended December 31, 2007CDO
                                
                                
                                NHES
                                  2006-1
                                
                                
                                NHES
                                  2006
                                  MTA1
                                
                                
                                NHES
                                  2007-1
                                
                                
                                Total
                                
                                
                                CDO
                                
                                
                                NHES
                                  2006-1
                                
                                
                                NHES
                                  2006
                                  MTA1
                                
                                
                                NHES
                                  2007-1
                                
                                
                                TotalInterest
      Income
                                
                                $
                                26,306
                                
                                
                                $
                                45,160
                                
                                
                                $
                                27,555
                                
                                
                                $
                                109,295
                                
                                
                                $
                                208,316
                                
                                
                                $
                                34,133
                                
                                
                                $
                                68,068
                                
                                
                                $
                                67,936
                                
                                
                                $
                                120,665
                                
                                
                                $
                                290,802Interest
      expense
                                
                                
                                13,124
                                
                                
                                
                                22,453
                                
                                
                                
                                25,843
                                
                                
                                
                                54,874
                                
                                
                                
                                116,294
                                
                                
                                
                                19,129
                                
                                
                                
                                49,298
                                
                                
                                
                                52,807
                                
                                
                                
                                86,521
                                
                                
                                
                                207,755Provision
      for credit losses
                                
                                
                                −
                                
                                
                                
                                (127,485
                                )
                                
                                
                                (165,063
                                )
                                
                                
                                (414,816
                                )
                                
                                
                                (707,364
                                )
                                
                                
                                −
                                
                                
                                
                                (43,620
                                )
                                
                                
                                (23,942
                                )
                                
                                
                                (197,726
                                )
                                
                                
                                (265,288
                                )Servicing
      fee expense
                                
                                
                                −
                                
                                
                                
                                3,129
                                
                                
                                
                                2,736
                                
                                
                                
                                7,732
                                
                                
                                
                                13,597
                                
                                
                                
                                −
                                
                                
                                
                                3,938
                                
                                
                                
                                3,210
                                
                                
                                
                                5,867
                                
                                
                                
                                13,015Mortgage
      insurance
                                
                                
                                −
                                
                                
                                
                                4,216
                                
                                
                                
                                292
                                
                                
                                
                                11,310
                                
                                
                                
                                15,818
                                
                                
                                
                                −
                                
                                
                                
                                5,409
                                
                                
                                
                                323
                                
                                
                                
                                10,730
                                
                                
                                
                                16,462Other
      income
                                
                                
                                (15,550
                                )
                                
                                
                                6,393
                                
                                
                                
                                −
                                
                                
                                
                                (4,844
                                )
                                
                                
                                (14,001
                                )
                                
                                
                                (25,513
                                )
                                
                                
                                (85
                                )
                                
                                
                                −
                                
                                
                                
                                (7,509
                                )
                                
                                
                                (33,107
                                )General
      and administrative expenses
                                
                                
                                747
                                
                                
                                
                                46
                                
                                
                                
                                42
                                
                                
                                
                                62
                                
                                
                                
                                897
                                
                                
                                
                                5,798
                                
                                
                                
                                7
                                
                                
                                
                                5
                                
                                
                                
                                11
                                
                                
                                
                                5,821Net
      loss before tax expense
                                
                                
                                (3,115
                                )
                                
                                
                                (105,776
                                )
                                
                                
                                (166,421
                                )
                                
                                
                                (384,343
                                )
                                
                                
                                (659,655
                                )
                                
                                
                                (16,307
                                )
                                
                                
                                (34,289
                                )
                                
                                
                                (12,351
                                )
                                
                                
                                (187,699
                                )
                                
                                
                                (250,646
                                )Tax
      expense
                                
                                
                                −
                                
                                
                                
                                −
                                
                                
                                
                                1,902
                                
                                
                                
                                −
                                
                                
                                
                                1,902
                                
                                
                                
                                3,469
                                
                                
                                
                                −
                                
                                
                                
                                −
                                
                                
                                
                                −
                                
                                
                                
                                3,469Net
      loss
                                
                                $
                                (3,115
                                )
                                
                                $
                                (105,776
                                )
                                
                                $
                                (168,323
                                )
                                
                                $
                                (384,343
                                )
                                
                                $
                                (661,557
                                )
                                
                                $
                                (19,776
                                )
                                
                                $
                                (34,289
                                )
                                
                                $
                                (12,351
                                )
                                
                                $
                                (187,699
                                )
                                
                                $
                                (254,115
                                )








(A)
                Stand-alone
      balances do not include impact of intercompany
    eliminations.
 (B)
              The
      above financial information is considered
  non-GAAP.




Table
10 - Cash Flows of Securitization Trusts (A) (B)


(dollars
in thousands)


For the Year Ended December 31, 2008
                                        
                                        For the Year Ended December 31, 2007Net cash flow from:
                                        
                                        CDO
                                        
                                        
                                        NHES
                                          2006-1
                                        
                                        
                                        NHES
                                          2006
                                          MTA1
                                        
                                        
                                        NHES
                                          2007-1
                                        
                                        
                                        Total
                                        
                                        
                                        
                                        CDO
                                        
                                        
                                        NHES
                                          2006-1
                                        
                                        
                                        NHES
                                          2006
                                          MTA1
                                        
                                        
                                        NHES
                                          2007-1
                                        
                                        
                                        TotalOperating
      activities
                                        
                                        $
                                        (7,441
                                        )
                                        
                                        $
                                        27,320
                                        
                                        
                                        $
                                        (4,415
                                        )
                                        
                                        $
                                        43,622
                                        
                                        
                                        $
                                        59,086
                                        
                                        
                                        
                                        $
                                        25,244
                                        
                                        
                                        $
                                        7,295
                                        
                                        
                                        $
                                        (39,748
                                        )
                                        
                                        $
                                        65,191
                                        
                                        
                                        $
                                        57,982Investing
      activities
                                        
                                        
                                        16,135
                                        
                                        
                                        
                                        135,777
                                        
                                        
                                        
                                        70,706
                                        
                                        
                                        
                                        195,954
                                        
                                        
                                        
                                        418,572
                                        
                                        
                                        
                                        
                                        (365,097
                                        )
                                        
                                        
                                        315,726
                                        
                                        
                                        
                                        321,479
                                        
                                        
                                        
                                        173,813
                                        
                                        
                                        
                                        445,921Financing
      activities
                                        
                                        
                                        (8,694
                                        )
                                        
                                        
                                        (163,097
                                        )
                                        
                                        
                                        (66,291
                                        )
                                        
                                        
                                        (239,576
                                        )
                                        
                                        
                                        (477,658
                                        )
                                        
                                        
                                        
                                        339,853
                                        
                                        
                                        
                                        (323,021
                                        )
                                        
                                        
                                        (281,731
                                        )
                                        
                                        
                                        (239,004
                                        )
                                        
                                        
                                        (503,903
                                        )Net
      cash flow
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -Cash,
      beginning of year
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -Cash,
      end of year
                                        
                                        $
                                        −
                                        
                                        
                                        $
                                        -
                                        
                                        
                                        $
                                        -
                                        
                                        
                                        $
                                        -
                                        
                                        
                                        $
                                        -
                                        
                                        
                                        
                                        $
                                        -
                                        
                                        
                                        $
                                        -
                                        
                                        
                                        $
                                        -
                                        
                                        
                                        $
                                        -
                                        
                                        
                                        $
                                        -








(A)
                Stand-alone
      balances do not include impact of intercompany
    eliminations.
 (B)
              The
      above financial information is considered
  non-GAAP.




27




Critical
Accounting Estimates





We
prepare our consolidated financial statements in conformity with GAAP and,
therefore, are required to make estimates regarding the values of our assets and
liabilities and in recording income and expenses. These estimates are based, in
part, on our judgment and assumptions regarding various economic conditions that
we believe are reasonable based on facts and circumstances existing at the time
of reporting. These estimates affect reported amounts of assets, liabilities and
accumulated other comprehensive income at the date of the 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 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. 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 combined the mortgage loans we originated and
purchased in pools to serve as collateral for asset-backed bonds. In a mortgage
security securitization (also known as a “resecuritization”), we combined
mortgage securities retained in previous loan securitization transactions to
serve as collateral for asset-backed bonds. The loans or mortgage securities
were transferred to a trust designed to serve only for the purpose of holding
the collateral. The trust is evaluated, on a routine basis, to determine if it
is considered a qualifying special purpose entity as defined by SFAS 140. 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.





To
determine proper accounting treatment for each securitization or
resecuritization, we periodically evaluate whether or not we retained or
surrendered control over the transferred assets by reference to the conditions
set forth in SFAS 140. All terms of these transactions are evaluated against the
conditions set forth in this statement. Some of the questions that must be
considered include:





·
            Have
      the transferred assets been isolated from the
  transferor?


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


·
            Is
      there a “call” agreement that requires the transfereeto return specific
      assets?


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


·
            Have
      any derivative instruments been
transferred?





When we
are deemed to have surrendered control over the collateral, the transfer is
accounted for as a sale. In accordance with SFAS 140, a gain or loss on the sale
was 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 as of the date we are no longer
deemed to control the collateral. In a securitization accounted for as a sale,
we retain certain mortgage securities issued by the trust. The gain recognized
upon a securitization structured as a sale depends on, among other things, the
estimated fair value of the components of the securitization – the loans or
mortgage securities and derivative instruments transferred, the securities
retained and the mortgage servicing rights. The estimated fair value of the
securitization components is considered a “critical accounting estimate” as 1)
these gains or losses have historically represented 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 used
two methodologies for determining the initial value of our residual securities:
1) the whole loan price methodology and 2) the discount rate methodology. We
generally tried to use the whole loan price methodology when significant open
market sales pricing data was available. Under this method, the initial value of
the loans transferred in a securitization accounted for as a sale is estimated
based on the expected open market sales price of a similar pool. In open market
transactions, the purchaser has the right to reject loans at its discretion. In
a loan securitization, loans generally cannot be rejected. As a result, we
adjusted the market price for the loans to compensate for the estimated value of
rejected loans. The market price of the securities retained was 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) was derived by taking the projected cash flows
generated using assumptions for prepayments, expected credit losses and interest
rates and then solving for the discount rate required to present value the cash
flows back to the initial value derived above. We then ascertained whether the
resulting discount rate was commensurate with current market conditions.
Additionally, the initial discount rate served as the initial accretable yield
used to recognize income on the securities.





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




28




For
purposes of valuing our residual securities, it is important to know that we
also transferred interest rate agreements to the securitization trust with the
objective of reducing interest rate risk within the trust. During the period
before loans were transferred in a securitization transaction we entered into
interest rate swap or cap agreements. Certain of these interest rate agreements
were then transferred into the trust at the time of securitization. Therefore,
the trust assumed the obligation to make payments and obtained the right to
receive payments under these agreements.





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





When we
had the ability to exert control over the transferred collateral in a
securitization, the assets remained on our financial statements and a liability
was recorded for the related asset-backed bonds. The servicing agreements that
we executed for loans we securitized include a removal of accounts provision
which gives the servicer the right, but not the obligation, to repurchase from
the trust loans that are 90 days to 119 days delinquent. While we retained these
servicing rights, we recorded 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. However, in November 2007 we sold all of
our mortgage servicing rights, including the removal of accounts rights, to a
third party, which resulted in the removal of the mortgage loans subject to the
removal of accounts provision from our balance sheet. In addition, we retained a
“clean up” call option that could be exercised when the aggregate principal
balance of the mortgage loans declined to ten percent or less of the original
aggregated mortgage loan principal balance. However, we subsequently sold all of
these clean up call rights, to the buyer of our mortgage servicing rights. We
did retain separate independent rights to require the buyer of our mortgage
servicing rights to repurchase loans from the trusts and subsequently sell them
to us; we do not expect to exercise any of the call rights that we
retained.





We are
required to periodically re-evaluate the accounting treatment for loan
securitizations. In certain circumstances, if the reasons and conditions
affecting the accounting treatment for a securitization have changed, we may be
required to adjust our financial statements accordingly at the time of the
re-evaluation. Securitizations previously treated as sales may need to be
brought back on to our financial statements as assets, along with the related
liabilities. Transfers where the assets and liabilities have been retained on
our financial statements may need to be removed. These transactions may result
in significant gains or losses and may cause significant changes in our
financial statements that may make period comparisons difficult.





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





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





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


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


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





The
subordinated securities we retained in our securitization transactions have a
stated principal amount and interest rate. The performance of the securities is
dependent upon the performance of the underlying pool of securitized mortgage
loans. The interest rates these securities earn are variable and are subject to
an available funds cap as well as a maximum rate cap. The securities receive
principal payments in accordance with a payment priority which is designed to
maintain specified levels of subordination to the senior bonds within the
respective securitization trust. Because the subordinated securities are rated
lower than AA, they are considered low credit quality and we account for the
securities based on guidance set forth from Emerging Issuance Task Force 99-20
“Recognition of Interest Income and Impairment on Purchased and Retained
Beneficial Interests in Securitized Financial Assets” (“EITF 99-20”) using the
effective yield method. The fair value of the subordinated securities is based
on quoted third-party market prices compared to estimates based on discounting
the expected future cash flows of the collateral and bonds.




29




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





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





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





At each
reporting period subsequent to the initial valuation of the residual securities,
the fair value of the residual securities is estimated based on the present
value of future expected cash flows to be received. Management’s best estimate
of key assumptions, including credit losses, prepayment speeds, expected call
dates, market discount rates and forward yield curves commensurate with the
risks involved, are used in estimating future cash flows. We estimate initial
and subsequent fair value for the subordinated securities based on quoted market
prices. See Note 3 to the consolidated financial statements for the residual
security sensitivity analysis and Note 4 to the consolidated financial
statements for the current fair value of our residual securities.





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.





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





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





Approximately
5% of our loans held in portfolio were greater than 90 days delinquent at
December 31, 2007, and approximately 6% were in foreclosure. As of December 31,
2008, this delinquency percentage increased to approximately 20% while loans in
foreclosure also increased to approximately 20%. As loans transition into REO
status, an estimated loss is recorded until the property is sold or liquidated.
For the NHEL 0601 and MTA 0601 transactions, we valued REO property at 55% and
55% of its current principal balance as of December 31, 2008, compared to 63%
and 55% as of December 31, 2007, respectively. Because of the increased loss
severity, NHEL 0701 property was valued at 40% in 2008; a 5% decrease from
2007.




30




Our
estimate of expected losses could increase if our actual loss experience is
different than originally estimated. In addition, our estimate of expected
losses could increase if economic factors change the value we could reasonably
expect to obtain from the sale of the property.





Real Estate OwnedReal estate owned, which consists of residential real estate acquired in
satisfaction of loans, is carried at the lower of cost or estimated fair value
less estimated selling costs. We estimate fair value at the asset’s liquidation
value less selling costs using management’s assumptions which are based on
historical loss severities for similar assets. Adjustments to the loan carrying
value required at time of foreclosure are charged against the allowance for
credit losses. Costs related to the development of real estate are capitalized
and those related to holding the property are expensed. Losses or gains from the
ultimate disposition of real estate owned are charged or credited to
earnings.





Derivative
Instruments and Hedging Activities.Our strategy for using
derivative instruments was to mitigate the risk of increased costs on our
variable rate liabilities during a period of rising rates (i.e. interest rate
risk), subject to cost and liquidity constraints. Our primary goals for managing
interest rate risk were 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. Generally the interest rate swap and interest
rate cap agreements we used had an active secondary market, and none were
obtained for a speculative nature. These interest rate agreements were 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 was 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” (“SFAS 133”)
standardizes the accounting for derivative instruments, including certain
instruments embedded in other contracts, by requiring that an entity recognize
those items as assets or liabilities in the balance sheet and measure them at
fair value. If certain conditions are met, an entity may elect to designate a
derivative instrument either as a cash flow hedge, a fair value hedge or a hedge
of foreign currency exposure. SFAS 133 requires derivative instruments to be
recorded at their fair value with hedge ineffectiveness recognized in
earnings.





Derivative
instruments that met the hedge accounting criteria of SFAS 133 were considered
cash flow hedges. We also had derivative instruments that do not meet the
requirements for hedge accounting. However, these derivative instruments
contributed to our overall risk management strategy by serving to reduce
interest rate risk on long-term borrowings collateralized by our loans
held-in-portfolio.





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.





CDO Asset-backed
Bonds (“CDO ABB”). We elected the fair value option for the asset-backed
bonds issued from NovaStar ABS CDO I in 2007. We elected the fair value option
for these liabilities to help reduce earnings volatility which otherwise would
arise if the accounting method for this debt was not matched with the fair value
accounting for the related mortgage securities - trading. Fair value is
estimated using quoted market prices of the underlying assets.





The
asset-backed bonds which are being carried at fair value are included in the
“Asset-backed bonds secured by mortgage securities“ line item on the
consolidated balance sheets. We recognize fair value adjustments for the change
in fair value of the bonds which are included in the “Fair value adjustments”
line item on the consolidated statements of operations. We calculate interest
expense for these asset-backed bonds based on the prevailing coupon rates of the
specific classes of debt and record interest expense in the period incurred.
Interest expense amounts are included in the “Interest expense” line item of the
consolidated statements of operations.





Deferred Tax
Asset, net. We recorded deferred tax assets and liabilities for the
future tax consequences attributable to differences between the GAAP carrying
amounts and their respective income tax bases. A deferred tax liability was
recognized for all future taxable temporary differences, while a deferred tax
asset was recognized for all future deductible temporary differences, operating
loss carryforwards and tax credit carryforwards. In accordance with Statement of
Financial Accounting Standards 109, “Accounting for income taxes”, (“SFAS 109”),
we recorded deferred tax assets and liabilities using the enacted tax rate that
is expected to apply to taxable income in the periods in which the deferred tax
asset or liability is expected to be realized.





In
determining the amount of deferred tax assets to recognize in the financial
statements, we evaluate the likelihood of realizing such benefits in future
periods. SFAS 109 requires the recognition of a valuation allowance if it is
more likely than not that all or some portion of the deferred tax asset will not
be realized. SFAS 109 indicates the more likely than not threshold is a level of
likelihood that is more than 50 percent.





Under
SFAS 109, companies are required to identify and consider all available
evidence, both positive and negative, in determining whether it is more likely
than not that all or some portion of its deferred tax assets will not be
realized. Positive evidence includes, but is not limited to the following:
cumulative earnings in recent years, earnings expected in future years, excess
appreciated asset value over the tax basis, and positive industry trends.
Negative evidence includes, but is not limited to the following: cumulative
losses in recent years, losses expected in future years, a history of operating
losses or tax credits carryforwards expiring, and adverse industry
trends.




31




The
weight given to the potential effect of negative and positive evidence should be
commensurate with the extent to which it can be objectively verified.
Accordingly, the more negative evidence that exists requires more positive
evidence to counter, thus making it more difficult to support a conclusion that
a valuation allowance is not needed for all or some of the deferred tax assets.
A cumulative loss in recent years is significant negative evidence that is
difficult to overcome when determining the need for a valuation allowance.
Similarly, cumulative earnings in recent years represents significant positive
objective evidence. If the weight of the positive evidence is sufficient to
support a conclusion that it is more likely than not that a deferred tax asset
will be realized, a valuation allowance should not be recorded.





We
examine and weigh all available evidence (both positive and negative and both
historical and forecasted) in the process of determining whether it is more
likely than not that a deferred tax asset will be realized. We consider the
relevancy of historical and forecasted evidence when there has been a
significant change in circumstances. Additionally, we evaluate the realization
of our recorded deferred tax assets on an interim and annual basis. We do not
record a valuation allowance if the weight of the positive evidence exceeds the
negative evidence and is sufficient to support a conclusion that it is more
likely than not that our deferred tax asset will be realized.





If the
weighted positive evidence is not sufficient to support a conclusion that it is
more likely than not that all or some of our deferred tax assets will be
realized, we consider all alternative sources of taxable income identified in
determining the amount of valuation allowance to be recorded. Alternative
sources of taxable income identified in SFAS 109 include the following: 1)
taxable income in prior carryback year, 2) future reversals of existing taxable
temporary differences, 3) future taxable income exclusive of reversing temporary
differences and carryforwards, and 4) tax planning strategies.





Impact
of Recently Issued Accounting Pronouncements





In
December 2007, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards No. 141 (R), “Business Combinations”
(“SFAS 141(R)”). In summary, SFAS 141(R) requires the acquirer of a business
combination to measure at fair value the assets acquired, the liabilities
assumed, and any non-controlling interest in the acquiree at the acquisition
date, with limited exceptions. In addition, this standard will require
acquisition costs to be expensed as incurred. The standard is effective for
fiscal years beginning after December 15, 2008, and is to be applied
prospectively, with no earlier adoption permitted. The adoption of this standard
may have an impact on the accounting for certain costs related to any future
acquisitions.





In
December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements” (“SFAS 160”), which requires consolidated net
income to be reported at amounts that include the amounts attributable to both
the parent and non-controlling interest. SFAS 160 is effective for fiscal years
beginning on or after December 15, 2008. The adoption of this standard may have
an impact on the accounting of net income attributed to StreetLinks and any
future acquisitions.





In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities” (“SFAS 161”). The new standard is intended to improve
financial reporting about derivative instruments and hedging activities by
requiring enhanced disclosures to enable investors to better understand their
effects on an entity’s financial position, financial performance, and cash
flows. It is effective for financial statements issued for fiscal years and
interim periods beginning after November 15, 2008, with early application
encouraged. The Company does not expect the adoption of SFAS 161 will impact its
consolidated financial statements but could result in additional
disclosures.





In April
2008, the FASB issued FASB Staff Position (“FSP”) No. SFAS 142-3, “Determination
of the Useful Life of Intangible Assets” (“FSP SFAS 142-3”). FSP SFAS 142-3
amends paragraph 11(d) of FASB Statement No. 142 “Goodwill and Other Intangible
Assets” (“SFAS 142”) which amends the factors that should be considered in
developing renewal or extension assumptions used to determine the useful life of
a recognized intangible asset under SFAS 142. FSP SFAS 142-3 is intended to
improve the consistency between the useful life of a recognized intangible asset
under SFAS 142 and the period of expected cash flows used to measure the fair
value of the asset. FSP SFAS 142-3 is effective for financial statements issued
for fiscal years beginning after December 15, 2008 and must be applied
prospectively to intangible assets acquired after the effective date. The
Company does not expect that adoption of FSP SFAS 142-3 will have a significant
impact on the Company’s consolidated financial statements.





In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles” (“SFAS 162”). SFAS 162 identifies the sources of
accounting principles and the framework for selecting principles to be used in
the preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles in the
United States. This statement is effective as of November 15, 2008, 60 days
following the SEC’s approval of the Public Company Accounting Oversight Board’s
amendments to the PCAOB’s Interim Auditing Standards (AU) section 411, “The
Meaning of Present Fairly in Conformity with Generally Accepted Accounting
Principles.” The adoption of SFAS 162 did not have a material impact on the
Company’s consolidated financial statements.




32




In June
2008, the FASB issued FASB Staff Position No. EITF 03-6-1 "Determining Whether
Instruments Granted in Share-Based Payment Transactions Are Participating
Securities" (FSP EITF -3-6-1). This FSP was issued to clarify that instruments
granted in share-based payment transactions can be participating securities
prior to the requisite service having been rendered. The guidance in this FSP
applies to the calculation of Earnings Per Share ("EPS") under Statement 128 for
share-based payment awards with rights to dividends or dividend equivalents.
Unvested share-based payment awards that contain non-forfeitable rights to
dividends or dividend equivalents (whether paid or unpaid) are participating
securities and shall be included in the computation of EPS pursuant to the
two-class method. This FSP is effective for financial statements issued for
fiscal years beginning after December 15, 2008, and interim periods within those
years. All prior-period EPS data presented shall be adjusted retrospectively
(including interim financial statements, summaries of earnings, and selected
financial data) to conform with the provisions of this FSP. The Company does not
expect the adoption of this EITF will have a material impact on its financial
condition or results of operation.




On
September 15, 2008, the FASB issued two exposure drafts proposing amendments to
SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities”, and FASB Interpretation No. 46R, “Consolidation
of Variable Interest Entities” (“FIN 46R”). Currently, the transfers of the
Company’s mortgage loans in securitization transactions qualify for sale
accounting treatment. The trusts used in the Company’s securitizations are not
consolidated for financial reporting purposed because the trusts are qualifying
special purpose entities (“QSPE”). Because the transfers qualify as sales and
the trusts are not subject to consolidation, the assets and liabilities of the
trusts are not reported on the balance sheet under GAAP. Under the proposed
amendments, the concept of a QSPE would be eliminated and could potentially
modify the consolidation conclusions. As proposed, these amendments would be
effective for the Company at the beginning of 2010. The proposed amendments, if
adopted, could require the Company to consolidate the assets and liabilities of
the Company’s securitization trusts. This could have a significant effect on our
financial condition as affected off-balance sheet loans and related liabilities
would be recorded on the balance sheet.





On
October 10, 2008, the FASB issued FSP No. 157-3, “Determining the Fair Value of
a Financial Asset When the Market for That Asset Is Not Active” (“FSP 157-3”).
FSP 157-3 clarifies the application of FAS 157 in a market that is not active
and provides an example to illustrate key consideration in determining the fair
value of a financial asset when the market for that financial asset is not
active. The issuance of FSP 157-3 did not have a material impact on the
Company’s determination of fair value for its financial assets.





In
December 2008, the FASB issued FSP FAS 140-4 and FIN 46(R)-8, Disclosures by
Public Entities (Enterprises) about Transfers of Financial Assets and Interests
in Variable Interest Entities (“FSP FAS 140-4 and FIN 46(R)-8”), which requires
expanded disclosures for transfers of financial assets and involvement with
variable interest entities (“VIEs”). Under this guidance, the disclosure
objectives related to transfers of financial assets now include providing
information on (i) the Company’s continued involvement with financial assets
transferred in a securitization or asset backed financing arrangement, (ii) the
nature of restrictions on assets held by the Company that relate to transferred
financial assets, and (iii) the impact on financial results of continued
involvement with assets sold and assets transferred in secured borrowing
arrangements. VIE disclosure objectives now include providing information on (i)
significant judgments and assumptions used by the Company to determine the
consolidation or disclosure of a VIE, (ii) the nature of restrictions related to
the assets of a consolidated VIE, (iii) the nature of risks related to the
Company’s involvement with the VIE and (iv) the impact on financial results
related to the Company’s involvement with the VIE. Certain disclosures are also
required where the Company is a non-transferor sponsor or servicer of a QSPE.
FSP FAS 140-4 and FIN 46(R)-8 is effective for the first reporting period ending
after December 15, 2008. See Note 3 to the consolidated financial statements for
the additional disclosures required by the FSP.





In
January 2009, the FASB issued FSP EITF 99-20-1, Amendments to the Impairment
Guidance of EITF Issue No. 99-20 (“FSP EITF 99-20-1”), which eliminates the
requirement that the holder’s best estimate of cash flows be based upon those
that a “market participant” would use. FSP EITF 99-20-1 was amended to require
recognition of other-than-temporary impairment when it is “probable” that there
has been an adverse change in the holder’s best estimate of cash flows from the
cash flows previously projected. This amendment aligns the impairment guidance
under EITF 99-20, Recognition of Interest Income and Impairment on Purchased
Beneficial Interests and Beneficial Interests That Continue to Be Held by a
Transferor in Securitized Financial Assets, with the guidance in SFAS No. 115.
FSP EITF 99-20-1 retains and re-emphasizes the other-than-temporary impairment
guidance and disclosures in pre-existing GAAP and SEC requirements. FSP EITF
99-20-1 is effective for interim and annual reporting periods ending after
December 15, 2008. The Company does not expect the adoption of FSP EITF 99-20-1
will have a material impact on its consolidated financial
statements.





In April
2009, the FASB issued FSP No. FAS 107-1 and APB 28-1, Interim Disclosures about
Fair Value of Financial Instruments, to require disclosures about fair value of
financial instruments for interim reporting periods of publicly traded companies
as well as in annual financial statements. This FSP also amends APB Opinion No.
28, Interim financial reporting, to require those disclosures in summarized
financial information at interim reporting periods. The Company will comply with
the additional disclosure requirements beginning in the second quarter of
2009.




33




In April
2009, the FASB issued FSP No. FAS 115-2 and FAS 124-2, Recognition and
Presentation of Other-Than-Temporary Impairments. This FSP amends the
other-than-temporary impairment guidance in U.S. GAAP for debt and equity
securities in the financial statements. This FSP does not amend existing
recognition and measurement guidance related to other-than-temporary impairments
of equity securities. The FSP shall be effective for interim and annual
reporting periods ending after June 15, 2009 , but early adoption is permitted
for interim periods ending after March 15, 2009. The Company plans to adopt the
provisions of this Staff Position during second quarter 2009; however its
adoption is not expected to have a material impact on its consolidated financial
statements.





In April
2009, the FASB issued FSP No. FAS 157-4, “Determining Fair Value When the Volume
and Level of Activity for the Asset or Liability Have Significantly Decreased
and Identifying Transactions That Are Not Orderly” (“FSP FAS 157-4”). FSP FAS
157-4 provides guidance on estimating fair value when market activity has
decreased and on identifying transactions that are not orderly. Additionally,
entities are required to disclose in interim and annual periods the inputs and
valuation techniques used to measure fair value. This FSP is effective for
interim and annual periods ending after June 15, 2009. The Company does not
expect the adoption of FSP FAS 157-4 will have a material impact on its
financial condition or results of operation, although it will require additional
disclosures.





In May
2009, the FASB issued FASB Staff Position No. APB 14-1 “Accounting for
Convertible Debt Instruments That May Be Settled in Cash upon Conversion
(Including Partial Cash Settlement).” FASB Staff Position No. APB 14-1 clarifies
that convertible debt instruments that may be settled in cash upon conversion
(including partial cash settlement) are not addressed by paragraph 12 of APB
Opinion No. 14, Accounting for Convertible Debt and Debt Issued with Stock
Purchase Warrants. Additionally, this FSP specifies that issuers of such
instruments should separately account for the liability and equity components in
a manner that will reflect the entity’s nonconvertible debt borrowing rate when
interest cost is recognized in subsequent periods. This FSP is effective for
financial statements issued for fiscal years beginning after December 15, 2008,
and interim periods within those fiscal years. The Company does not expect the
adoption of this FSP will have a material impact on its financial condition or
results of operation.





Inflation





Virtually
all of our assets and liabilities are financial in nature. As a result, interest
rates and other factors drive our 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 GAAP. As a result, financial activities and the balance sheet are measured
with reference to historical cost or fair market value without considering
inflation.





Item
7A. Quantitative and Qualitative Disclosures about Market Risk





As a
smaller reporting company, we are not required to provide the information
required by this Item.




34




Item
8. Financial Statements and Supplementary Data





NOVASTAR FINANCIAL,
INC.


CONSOLIDATED
BALANCE SHEETS


(dollars
in thousands, except share amounts)





December
      31,2008
              
              
              2007AssetsUnrestricted
      cash and cash equivalents
              
              $
              24,790
              
              
              $
              25,364Restricted
      cash
              
              
              6,046
              
              
              
              8,998Mortgage
      loans – held-in-portfolio, net of allowance of $776,001 and $230,138,
      respectively
              
              
              1,772,838
              
              
              
              2,870,013Mortgage
      securities -
      trading
              
              
              7,085
              
              
              
              109,203Mortgage
      securities -
      available-for-sale
              
              
              12,788
              
              
              
              33,371Real
      estate owned
              
              
              70,480
              
              
              
              76,614Accrued
      interest receivable
              
              
              77,292
              
              
              
              61,704Other
      assets
              
              
              5,704
              
              
              
              37,244Assets
      of discontinued operations
              
              
              1,441
              
              
              
              8,255Total
      assets
              
              $
              1,978,464
              
              
              $
              3,230,766Liabilities
      and Shareholders’ DeficitLiabilities:Asset-backed
      bonds secured by mortgage loans
              
              $
              2,599,351
              
              
              $
              3,065,746Asset-backed
      bonds secured by mortgage securities
              
              
              5,376
              
              
              
              74,385Short-term
      borrowings secured by mortgage securities
              
              
              -
              
              
              
              45,488Junior
      subordinated debentures
              
              
              77,323
              
              
              
              83,561Due
      to servicer
              
              
              117,635
              
              
              
              56,450Dividends
      payable
              
              
              19,088
              
              
              
              3,816Accounts
      payable and other liabilities
              
              
              33,928
              
              
              
              53,392Liabilities
      of discontinued operations
              
              
              2,536
              
              
              
              59,416Total
      liabilities
              
              
              2,855,237
              
              
              
              3,442,254Commitments
      and contingencies (Note 7)Shareholders’
      deficit:Capital
      stock, $0.01 par value, 50,000,000 shares authorized:Redeemable
      preferred stock, $25 liquidating preference per share; 2,990,000 shares,
      issued and outstanding
              
              
              30
              
              
              
              30Convertible
      participating preferred stock, $25 liquidating preference per share;
      2,100,000 shares, issued and outstanding
              
              
              21
              
              
              
              21Common
      stock, 9,368,053 and 9,439,273 shares, issued and outstanding,
      respectively
              
              
              94
              
              
              
              94Additional
      paid-in capital
              
              
              786,279
              
              
              
              786,342Accumulated
      deficit
              
              
              (1,671,984
              )
              
              
              (996,649
              )Accumulated
      other comprehensive income (loss)
              
              
              8,926
              
              
              
              (1,117
              )Other
              
              
              (139
              )
              
              
              (209
              )Total
      shareholders’ deficit
              
              
              (876,773
              )
              
              
              (211,488
              )Total
      liabilities and shareholders’ deficit
              
              $
              1,978,464
              
              
              $
              3,230,766




See notes
to consolidated financial statements.




35




NOVASTAR
FINANCIAL, INC.


CONSOLIDATED
STATEMENTS OF OPERATIONS


(dollars
in thousands, except share amounts)





For
      the Year Ended
                                              December
      31,2008
                                            
                                            
                                            2007Interest
      income
                                            
                                            $
                                            235,009
                                            
                                            
                                            $
                                            366,246Interest
      expense
                                            
                                            
                                            114,980
                                            
                                            
                                            
                                            228,369Net
      interest income before provision for credit losses
                                            
                                            
                                            120,029
                                            
                                            
                                            
                                            137,877Provision
      for credit losses
                                            
                                            
                                            (707,364
                                            )
                                            
                                            
                                            (265,288
                                            )Net
      interest expense after provision for credit losses
                                            
                                            
                                            (587,335
                                            )
                                            
                                            
                                            (127,411
                                            )Other
      operating expense:Gains
      on debt extinguishment
                                            
                                            
                                            6,418
                                            
                                            
                                            
                                            -Losses
      on derivative instruments
                                            
                                            
                                            (18,094
                                            )
                                            
                                            
                                            (10,997
                                            )Fair
      value adjustments
                                            
                                            
                                            (25,743
                                            )
                                            
                                            
                                            (85,803
                                            )Impairments
      on mortgage securities – available-for-sale
                                            
                                            
                                            (23,100
                                            )
                                            
                                            
                                            (98,692
                                            )Servicing
      fee expense
                                            
                                            
                                            (13,596
                                            )
                                            
                                            
                                            (2,592
                                            )Appraisal
      fee income
                                            
                                            
                                            2,524
                                            
                                            
                                            
                                            -Appraisal
      fee expense
                                            
                                            
                                            (1,693
                                            )
                                            
                                            
                                            -Premiums
      for mortgage loan insurance
                                            
                                            
                                            (15,847
                                            )
                                            
                                            
                                            (16,462
                                            )Other
      (expense) income, net
                                            
                                            
                                            (19
                                            )
                                            
                                            
                                            392Total
      other operating expense
                                            
                                            
                                            (89,150
                                            )
                                            
                                            
                                            (214,154
                                            )General
      and administrative expenses:Office
      administration
                                            
                                            
                                            9,407
                                            
                                            
                                            
                                            12,565Professional
      and outside services
                                            
                                            
                                            7,019
                                            
                                            
                                            
                                            21,811Compensation
      and benefits
                                            
                                            
                                            5,944
                                            
                                            
                                            
                                            27,688Other
      appraisal management expenses
                                            
                                            
                                            1,170
                                            
                                            
                                            
                                            -Other
      expense (income)
                                            
                                            
                                            881
                                            
                                            
                                            
                                            (2,644
                                            )Total
      general and administrative expenses
                                            
                                            
                                            24,421
                                            
                                            
                                            
                                            59,420Loss
      from continuing operations before income tax (benefit)
                                            
                                            
                                            (700,906
                                            )
                                            
                                            
                                            (400,985
                                            )Income
      tax (benefit) expense
                                            
                                            
                                            (17,594
                                            )
                                            
                                            
                                            66,512Loss
      from continuing operations
                                            
                                            
                                            (683,312
                                            )
                                            
                                            
                                            (467,497
                                            )Income
      (loss)from discontinued operations, net of income tax
                                            
                                            
                                            22,830
                                            
                                            
                                            
                                            (256,780
                                            )Net
      loss
                                            
                                            $
                                            (660,482
                                            )
                                            
                                            $
                                            (724,277
                                            )Basic
      earnings per share:Loss
      from continuing operations available to common
shareholders
                                            
                                            $
                                            (74.81
                                            )
                                            
                                            $
                                            (51.04
                                            )Income
      (loss) from discontinued operations, net of income tax
                                            
                                            
                                            2.44
                                            
                                            
                                            
                                            (27.51
                                            )Net
      loss available to common shareholders
                                            
                                            $
                                            (72.37
                                            )
                                            
                                            $
                                            (78.55
                                            )Diluted
      earnings per share:Loss
      from continuing operations available to common
shareholders
                                            
                                            $
                                            (74.81
                                            )
                                            
                                            $
                                            (51.04
                                            )Income
      (loss) from discontinued operations, net of income tax
                                            
                                            
                                            2.44
                                            
                                            
                                            
                                            (27.51
                                            )Net
      loss available to common shareholders
                                            
                                            $
                                            (72.37
                                            )
                                            
                                            $
                                            (78.55
                                            )Weighted
      average basic shares outstanding
                                            
                                            
                                            9,338,131
                                            
                                            
                                            
                                            9,332,405Weighted
      average diluted shares outstanding
                                            
                                            
                                            9,338,131
                                            
                                            
                                            
                                            9,332,405





See notes
to consolidated financial statements.




36




NOVASTAR
FINANCIAL, INC.


CONSOLIDATED
STATEMENTS OF SHAREHOLDERS’ DEFICIT


(dollars
in thousands, except share amounts)








Redeemable
                        Preferred
                        Stock
                      
                      
                      Convertible
                        Participating
                        Preferred
                        Stock
                      
                      
                      Common
                        Stock
                      
                      
                      Additional
                        Paid-in
                        Capital
                      
                      
                      Accumulated
                        Deficit
                      
                      
                      Accumulated
                        Other
                        Comprehensive
                        (Loss) Income
                      
                      
                      Other
                      
                      
                      Total
                        Share-
                        holders’
                        Equity
                        (Deficit)Balance,
      January 1, 2007
                      
                      $
                      30
                      
                      
                      $
                      -
                      
                      
                      $
                      93
                      
                      
                      $
                      742,028
                      
                      
                      $
                      (263,572
                      )
                      
                      $
                      36,548
                      
                      
                      $
                      (557
                      )
                      
                      $
                      514,570Cumulative
      effect adjustmentfrom
      adoption of SFAS 157
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      5,430
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      5,430Cumulative
      effect adjustmentfrom
      adoption of SFAS 159
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (1,131
                      )
                      
                      
                      1,131
                      
                      
                      
                      -
                      
                      
                      
                      -Cumulative
      effect adjustmentfrom
      adoption of FIN 48
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (1,072
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (1,072
                      )Forgiveness
      of founders’ notesreceivable
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      348
                      
                      
                      
                      348Issuance
      of preferred stock,2,100,000
      shares
                      
                      
                      -
                      
                      
                      
                      21
                      
                      
                      
                      -
                      
                      
                      
                      43,591
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      43,612Preferred
      stock beneficialconversion
      feature
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      3,825
                      
                      
                      
                      (3,825
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Issuance
      of common stock,35,094
      shares
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      3,190
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      3,190Issuance
      of stock under stockcompensation
      plans, 88,867shares
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1
                      
                      
                      
                      209
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      210Compensation
      recognizedunder
      stock compensationplans
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      707
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      707Dividends
      on preferred stock($1.67
      per share declared)
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      
                      
                      
                      
                      (8,805
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (8,805
                      )Reversal
      of tax benefit derivedfrom
      capitalization of affiliates
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (7,195
                      )
                      
                      
                      
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (7,195
                      )Other
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      
                      
                      
                      
                      (13
                      )
                      
                      
                      603
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      590Comprehensive
      loss:Net
      loss
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (724,277
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (724,277
                      )Other
      comprehensive loss
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (38,796
                      )
                      
                      
                      -
                      
                      
                      
                      (38,796
                      )Total
      comprehensive loss
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (763,073
                      )Balance,
      December 31, 2007
                      
                      $
                      30
                      
                      
                      $
                      21
                      
                      
                      $
                      94
                      
                      
                      $
                      786,342
                      
                      
                      $
                      (996,649
                      )
                      
                      $
                      (1,117
                      )
                      
                      $
                      (209
                      )
                      
                      $
                      (211,488
                      )





Continued




37




Redeemable
                              Preferred
                              Stock
                            
                            
                            Convertible
                              Participating
                              Preferred
                              Stock
                            
                            
                            Common
                              Stock
                            
                            
                            Additional
                              Paid-in
                              Capital
                            
                            
                            Accumulated
                              Deficit
                            
                            
                            Accumulated
                              Other
                              Comprehensive
                              (Loss)Income
                            
                            
                            Other
                            
                            
                            Total
                              Share-
                              holders’
                              DeficitBalance,
      January 1, 2008
                            
                            $
                            30
                            
                            
                            $
                            21
                            
                            
                            $
                            94
                            
                            
                            $
                            786,342
                            
                            
                            $
                            (996,649
                            )
                            
                            $
                            (1,117
                            )
                            
                            $
                            (209
                            )
                            
                            $
                            (211,488
                            )Forgiveness
      of founders’ notesreceivable
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            70
                            
                            
                            
                            70Compensation
      recognized understock
      compensation plans
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            (63
                            )
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            (63
                            )Accumulating
      dividends onpreferred
      stock
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            (15,273
                            )
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            (15,273
                            )Other
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            420
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            420Comprehensive
      loss:Net
      loss
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            (660,482
                            )
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            (660,482
                            )Other
      comprehensive loss
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            10,043
                            
                            
                            
                            -
                            
                            
                            
                            10,043Total
      comprehensive loss
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            (650,439
                            )Balance,
      December 31, 2008
                            
                            $
                            30
                            
                            
                            $
                            21
                            
                            
                            $
                            94
                            
                            
                            $
                            786,279
                            
                            
                            $
                            (1,671,984
                            )
                            
                            $
                            8,926
                            
                            
                            $
                            (139
                            )
                            
                            $
                            (876,773
                            )





See
      notes to consolidated financial statements.
                Concluded




38




NOVASTAR
FINANCIAL, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(dollars
in thousands)





For
      the Year Ended December 31,2008
                                  
                                  
                                  2007Cash
      flows from operating activities:Net
      loss
                                  
                                  $
                                  (660,482
                                  )
                                  
                                  $
                                  (724,277
                                  )Income
      (loss) from discontinued operations
                                  
                                  
                                  22,830
                                  
                                  
                                  
                                  (256,780
                                  )Loss
      from continuing operations
                                  
                                  
                                  (683,312
                                  )
                                  
                                  
                                  (467,497
                                  )Adjustments
      to reconcile loss from continuing operations to net cash used in operating
      activities:Impairment
      on mortgage securities - available-for-sale
                                  
                                  
                                  23,100
                                  
                                  
                                  
                                  98,692Losses
      on derivative instruments
                                  
                                  
                                  18,094
                                  
                                  
                                  
                                  10,997Depreciation
      expense
                                  
                                  
                                  1,124
                                  
                                  
                                  
                                  2,865Amortization
      of deferred debt issuance costs
                                  
                                  
                                  3,081
                                  
                                  
                                  
                                  1,696Compensation
      recognized under stock compensation plans
                                  
                                  
                                  (63
                                  )
                                  
                                  
                                  707Provision
      for credit losses
                                  
                                  
                                  707,364
                                  
                                  
                                  
                                  265,288Amortization
      of premiums on mortgage loans
                                  
                                  
                                  13,366
                                  
                                  
                                  
                                  4,805Interest
      capitalized on loans held-in-portfolio
                                  
                                  
                                  (19,858
                                  )
                                  
                                  
                                  (41,973
                                  )Forgiveness
      of founders’ promissory notes
                                  
                                  
                                  70
                                  
                                  
                                  
                                  348Provision
      for deferred income taxes
                                  
                                  
                                  (13,805
                                  )
                                  
                                  
                                  41,620Fair
      value adjustments
                                  
                                  
                                  25,743
                                  
                                  
                                  
                                  85,803Accretion
      of available-for-sale and trading securities
                                  
                                  
                                  (50,399
                                  )
                                  
                                  
                                  (99,773
                                  )Gains
      on debt extinguishment
                                  
                                  
                                  (6,418
                                  )
                                  
                                  
                                  -Changes
      in:Accrued
      interest receivable
                                  
                                  
                                  (15,588
                                  )
                                  
                                  
                                  (31,855
                                  )Derivative
      instruments, net
                                  
                                  
                                  673
                                  
                                  
                                  
                                  3,496Other
      assets
                                  
                                  
                                  5,654
                                  
                                  
                                  
                                  37,283Due
      to servicer
                                  
                                  
                                  61,185
                                  
                                  
                                  
                                  56,450Accounts
      payable and other liabilities
                                  
                                  
                                  (26,030
                                  )
                                  
                                  
                                  34,515Net
      cash provided by operating activities from continuing
      operations
                                  
                                  
                                  43,981
                                  
                                  
                                  
                                  3,467Net
      cash used in operating activities from discontinued
    operations
                                  
                                  
                                  (14,415
                                  )
                                  
                                  
                                  (449,255
                                  )Net
      cash provided by (used in) operating activities
                                  
                                  
                                  29,566
                                  
                                  
                                  
                                  (445,788
                                  )Cash
      flows from investing activities:Proceeds
      from paydowns on mortgage securities - available-for-sale
                                  
                                  
                                  26,899
                                  
                                  
                                  
                                  188,443Proceeds
      from paydowns of mortgage securities - trading
                                  
                                  
                                  59,912
                                  
                                  
                                  
                                  46,731Purchase
      of mortgage securities - trading
                                  
                                  
                                  -
                                  
                                  
                                  
                                  (21,957
                                  )Proceeds
      from sale of mortgage securities - trading
                                  
                                  
                                  -
                                  
                                  
                                  
                                  7,420Proceeds
      from repayments of mortgage loans held-in-portfolio
                                  
                                  
                                  288,243
                                  
                                  
                                  
                                  824,060Proceeds
      from sales of assets acquired through foreclosure
                                  
                                  
                                  114,194
                                  
                                  
                                  
                                  6,288Restricted
      cash proceeds (payments)
                                  
                                  
                                  2,952
                                  
                                  
                                  
                                  (8,998
                                  )Purchases
      of property and equipment
                                  
                                  
                                  (25
                                  )
                                  
                                  
                                  (3,132
                                  )Acquisition
      of businesses, net of cash acquired
                                  
                                  
                                  (710
                                  )
                                  
                                  
                                  -Net
      cash provided by investing activities
                                  
                                  
                                  491,465
                                  
                                  
                                  
                                  1,038,855Net
      cash provided by investing activities from discontinued
      operations
                                  
                                  
                                  2,114
                                  
                                  
                                  
                                  34,208Net
      cash provided by investing activities
                                  
                                  
                                  493,579
                                  
                                  
                                  
                                  1,073,063





Continued




39







For
      the Year Ended December 31,2008
                                
                                
                                2007Cash
      flows from financing activities:Proceeds
      from issuance of asset-backed bonds
                                
                                
                                -
                                
                                
                                
                                2,111,415Payments
      on asset-backed bonds
                                
                                
                                (477,662
                                )
                                
                                
                                (797,101
                                )Proceeds
      from issuance of capital stock and exercise of equity instruments, net of
      offering costs
                                
                                
                                -
                                
                                
                                
                                47,012Net
      change in short-term borrowings
                                
                                
                                (45,488
                                )
                                
                                
                                (458,192
                                )Repurchase
      of trust preferred debt
                                
                                
                                (550
                                )
                                
                                
                                -Dividends
      paid on vested options
                                
                                
                                -
                                
                                
                                
                                (405
                                )Dividends
      paid on preferred stock
                                
                                
                                -
                                
                                
                                
                                (6,653
                                )Net
      cash (used in) provided by financing activities from continuing
      operations
                                
                                
                                (523,700
                                )
                                
                                
                                896,076Net
      cash used in financing activities from discontinued
    operations
                                
                                
                                (19
                                )
                                
                                
                                (1,648,509
                                )Net
      cash (used in) provided by financing activities
                                
                                
                                (523,719
                                )
      )
                                
                                
                                (752,433
                                )Net
      decrease in cash and cash equivalents
                                
                                
                                (574
                                )
                                
                                
                                (125,158
                                )Cash
      and cash equivalents, beginning of period
                                
                                
                                25,364
                                
                                
                                
                                150,522Cash
      and cash equivalents, end of period
                                
                                $
                                24,790
                                
                                
                                $
                                25,364





SUPPLEMENTAL
DISCLOSURE OF CASH FLOW INFORMATION


(dollars
in thousands)





For
      the Years Ended December 31,2008
                        
                        
                        2007Cash
      paid for interest
                        
                        $
                        111,949
                        
                        
                        $
                        310,293Cash
      paid for income taxes
                        
                        
                        3,679
                        
                        
                        
                        6,012Cash
      received on mortgage securities – available-for-sale with no costbasis
                        
                        
                        3,401
                        
                        
                        
                        3,475Non-cash
      investing and financing activities:Transfer
      of loans to held-in-portfolio from held-for-sale
                        
                        
                        -
                        
                        
                        
                        1,880,340Transfer
      of mortgage securities available-for-sale to trading (A)
                        
                        
                        -
                        
                        
                        
                        46,683Assets
      acquired through foreclosure
                        
                        
                        108,172
                        
                        
                        
                        120,148Cost
      basis of securities retained in securitizations
                        
                        
                        -
                        
                        
                        
                        56,387Tax
      benefit derived from capitalization of affiliate
                        
                        
                        -
                        
                        
                        
                        7,195Preferred
      stock dividends accrued, not yet paid
                        
                        
                        15,273
                        
                        
                        
                        3,816
 
 (A) Transfer
      was made upon adoption of SFAS
159.





See
      notes to consolidated financial statements.
              Concluded




40




NOVASTAR
FINANCIAL, INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





Note
1. Basis of Presentation, Going Concern Considerations, Liquidity and Business
Plan





Description of
Operations - NovaStar Financial, Inc. and its subsidiaries (“NFI” or the
“Company”) hold certain non-conforming residential mortgage securities. A
majority-owned subsidiary of the Company, StreetLinks National Appraisal
Services LLC, is a residential mortgage appraisal management
company.





Effective
August 1, 2008, the Company acquired a 75 percent interest in StreetLinks
National Appraisal Services LLC (StreetLinks), a residential mortgage appraisal
company, for an initial cash purchase price of $750,000 plus future payments
contingent upon StreetLinks reaching certain earnings targets. Results of
operations from August 1, 2008 forward are included in the consolidated
statement of operations. Simultaneously with the acquisition, the Company
transferred ownership of 5 percent of StreetLinks to the Chief Executive Officer
of StreetLinks.





During
2009, the Company acquired a majority interest in Advent Financial Services LLC,
a start up operation which will provide access to tailored banking accounts,
small dollar banking products and related services to meet the needs of low and
moderate income level individuals. Management is continuing to evaluate
opportunities to invest excess cash as it is available.





Prior to
changes in its business in 2007, the Company originated, purchased, securitized,
sold, invested in and serviced residential nonconforming mortgage loans and
mortgage backed securities. The Company retained, through its mortgage
securities investment portfolio, significant interests in the nonconforming
loans it originated and purchased, and through its servicing platform, serviced
all of the loans in which it retained interests.





Financial
Statement Presentation-The Company’s consolidated financial statements have been prepared in
conformity with accounting principles generally accepted in the United States of
America and prevailing practices within the financial services industry. The
preparation of financial statements requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported amounts of income and expense
during the period. The Company uses estimates and employs the judgments of
management in determining the amount of its allowance for credit losses,
amortizing premiums or accreting discounts on its mortgage assets, establishing
the fair value of its mortgage securities, reserve for losses on third party
sales, derivative instruments, CDO debt and estimating appropriate accrual rates
on mortgage securities – available-for-sale. While the consolidated financial
statements and footnotes reflect the best estimates and judgments of management
at the time, actual results could differ significantly from those
estimates.





The
consolidated financial statements of the Company include the accounts of all
wholly-owned and majority- owned subsidiaries. Investments in entities for which
the Company has significant influence are accounted for under the equity method.
Intercompany accounts and transactions have been eliminated in
consolidation.





Going Concern
Considerations-As of
December 31, 2008, the Company’s total liabilities exceeded its total assets
under GAAP, resulting in a shareholders’ deficit. The Company’s losses, negative
cash flows, shareholders’ deficit, and lack of significant operations raise
substantial doubt about the Company’s ability to continue as a going concern
and, therefore, may not realize its assets and discharge its liabilities in the
normal course of business. There is no assurance that cash flows will be
sufficient to meet the Company’s obligations. The Company’s consolidated
financial statements have been prepared on a going concern basis of accounting
which contemplates continuity of operations, realization of assets, liabilities
and commitments in the normal course of business. The Company’s consolidated
financial statements do not reflect any adjustments relating to the
recoverability and classification of recorded asset amounts or to the amounts
and classification of liabilities that may be necessary should the Company be
unable to continue as a going concern.





Liquidity-The Company had $24.8 million in unrestricted cash and cash equivalents
at December 31, 2008, which was a decrease of $0.6 million from December 31,
2007. As of May 27, 2009, the Company had approximately $24.3 million in
available cash on hand (including restricted cash). In addition to the Company’s
operating expenses, the Company has quarterly interest payments due on its trust
preferred securities and intends to make payments in settlement of obligations
related to its discontinued lending and servicing operations. The Company’s
current projections indicate sufficient available cash and cash flows from its
mortgage securities to meet these payment needs. However, the cash flow from the
Company’s mortgage securities is volatile and uncertain in nature, and the
amounts the Company receives could vary materially from its projections.
Therefore, no assurances can be given that the Company will be able to meet its
cash flow needs, in which case it may seek protection of applicable bankruptcy
laws.





The
following summarizes the key sources and uses of cash for the Company during
2008:





·
              The
      Company received $42.8 million in cash from its unsecuritized mortgage
      securities portfolio.


·
              The
      Company used $45.5 million in cash to fully repay all secured borrowings
      and terminate all secured lending agreements. As a result, the Company has
      no short-term borrowing capacity or agreements currently
      available.




41




·
              The
      Company paid general and administrative expenses, including those related
      to its discontinued lending and servicing operations, totaling $37.1
      million.


·
              The
      Company invested $0.7 million in
StreetLinks.





Cash
flows from mortgage loans – held-in-portfolio are used to repay the asset-backed
bonds secured by mortgage loans and are not available to pay the Company’s other
debts, the asset-backed bonds are obligations of the securitization trusts and
will be repaid using collections of the securitized assets. The trusts have no
recourse to the Company’s other, unsecuritized assets.





Business Plan-The Company will continue to focus on minimizing losses, preserving
liquidity, and exploring operating company opportunities. The Company’s residual
and subordinated mortgage securities are currently its only significant source
of cash flows. Based on current projections, the cash flows from the mortgage
securities will decrease in the next several months as the underlying mortgage
loans are repaid, and could be significantly less than the current projections
if losses on the underlying mortgage loans exceed the current assumptions. In
addition, the Company has certain obligations relating to its discontinued
operations. The Company also has significant obligations with respect to junior
subordinated notes relating to the trust preferred securities. Subsequent to
2008, the Company restructured its obligations under the junior subordinated
notes relating to trust preferred securities. The details of the restructure are
discussed in Note 6.





As
discussed above, the Company acquired a majority interest in an appraisal
management company, StreetLinks, during the third quarter of 2008 and subsequent
to 2008, the Company acquired a majority interest in Advent Financial Services
LLC.





Note
2. Summary of Significant Accounting and Reporting Policies





Cash and Cash
Equivalents The Company considers investments with original maturities of
three months or less at the date of purchase to be cash equivalents. The Company
maintains cash balances at several major financial institutions in the United
States. Accounts at each institution are secured by the Federal Deposit
Insurance Corporation up to $250,000, temporarily increased from $100,000 to
$250,000 per depositor effective October 3, 2008 through December 31, 2009. At
December 31, 2008 and 2007, 43% and 71% of the Company’s cash and cash
equivalents, including restricted cash, were with one institution. The uninsured
balances of the Company’s unrestricted cash and cash equivalents and restricted
cash aggregated $29.8 million and $27.4 million as of December 31, 2008 and
2007, respectively.





Restricted
Cash Restricted cash includes funds the Company is required to post as
cash collateral for letters of credit it obtained in connection with the
purchase of surety bond coverage required for state licensing purposes. The cash
may not be released to the Company without the consent of the insurance company
which is at its discretion. The cash could be subject to the indemnification of
losses incurred by the insurance company.





Mortgage LoansMortgage loans include loans originated by the Company and acquired from
other originators. Mortgage loans are recorded net of deferred loan origination
fees and associated direct costs and are stated at amortized cost. Mortgage loan
origination fees and associated direct mortgage loan origination costs on
mortgage loans held-in-portfolio are deferred and recognized over the estimated
life of the loan as an adjustment to yield using the level yield method. The
Company uses actual and estimated cash flows, which consider the actual and
future estimated prepayments of the loans, to derive an effective level yield.
Mortgage loan origination fees and direct mortgage loan origination costs on
mortgage loans held-for-sale are deferred until the related loans are sold.
Mortgage loans held-for-sale are carried at the lower of cost or market
determined on an aggregate basis.





Interest
is recognized as revenue when earned according to the terms of the mortgage
loans and when, in the opinion of management, it is collectible. For all
mortgage loans that do not carry mortgage insurance, the accrual of interest on
loans is discontinued when, in management’s opinion, the interest is not
collectible in the normal course of business, but in no case beyond when a loan
becomes 90 days delinquent. For mortgage loans that do carry mortgage insurance,
the accrual of interest is only discontinued when in management’s opinion, the
interest is not collectible. Interest collected on non-accrual loans is
recognized as income upon receipt.





The
mortgage loan portfolio is collectively evaluated for impairment as the
individual loans are smaller-balance and are homogeneous in nature. For mortgage
loans held-in-portfolio, the Company maintains an allowance for credit losses
inherent in the portfolio at the balance sheet date. The allowance is based upon
the assessment by management of various factors affecting its mortgage loan
portfolio, including current economic conditions, the makeup of the portfolio
based on credit grade, loan-to-value, delinquency status, historical credit
losses, whether the Company purchased mortgage insurance and other factors
deemed to warrant consideration. The allowance is maintained through ongoing
adjustments to operating income. The assumptions used by management regarding
key economic indicators are highly uncertain and involve a great deal of
judgment.





An
internally developed migration analysis is the primary tool used in analyzing
the adequacy of the allowance for credit losses. This tool takes into
consideration historical information regarding foreclosure and loss severity
experience and applies that information to the portfolio at the reporting date.
Management also takes into consideration the use of mortgage insurance as a
method of managing credit risk. The Company pays mortgage insurance premiums on
loans maintained on the consolidated balance sheet and includes the cost of
mortgage insurance in the consolidated statements of income.




42




Management’s
estimate of expected losses could increase if the actual loss experience is
different than originally estimated. In addition, the estimate of expected
losses could increase if economic factors change the value that can be
reasonably expected to obtain from the sale of the property. If actual losses
increase, or if amounts reasonably expected to be obtained from property sales
decrease, the provision for losses would increase.





The
servicing agreements the Company executed for loans it securitized include a
removal of accounts provision which gave it the right, not the obligation, to
repurchase mortgage loans from the trust. The removal of accounts provision
could be exercised for loans that were 90 days to 119 days delinquent. The
Company recorded the mortgage loans subject to the removal of accounts provision
in mortgage loans held-for-sale at fair value. In conjunction with the mortgage
servicing rights sale in 2007, the removal of accounts provision was transferred
to the buyer which resulted in the removal of the mortgage loans subject to the
removal of accounts provision from the Company’s balance sheet. See Note 14 for
further discussion of the removal of accounts provision and sale of mortgage
servicing rights.





Mortgage
Securities-Available-for-SaleMortgage securities – available-for-sale represent
beneficial interests the Company retains in securitization and resecuritization
transactions which include residual interests (the “residual securities”). The
residual securities include interest-only mortgage securities, prepayment
penalty bonds and overcollateralization bonds. The subordinated securities
represent investment-grade and non-investment grade rated bonds which are senior
to the residual interests but subordinated to the bonds sold to third party
investors. Mortgage securities classified as available-for-sale are reported at
their estimated fair value with unrealized gains and losses reported in
accumulated other comprehensive income. To the extent that the cost basis of
mortgage securities 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. The specific identification method was used in
computing realized gains or losses.





Interest-only
mortgage securities represent the contractual right to receive excess interest
cash flows from a pool of securitized mortgage loans. Interest payments received
by the independent trust are first applied to the principal and interest bonds
(held by outside investors), servicing fees and administrative fees. The excess,
if any, is remitted to the Company related to its ownership of the interest-only
mortgage security. Prepayment penalty bonds give the holder the contractual
right to receive prepayment penalties collected by the independent trust on the
underlying mortgage loans. Overcollateralization bonds represent the contractual
right to excess principal payments resulting from over collateralization of the
obligations of the trust.





The
Company has designated two subordinated securities as mortgage securities –
available-for-sale as of December 31, 2006 and subsequently transferred those
securities to the trading classification on January 1, 2007 in accordance with
the adoption of Statement of Financial Accounting Standards No. 159, “The Fair
Value Option for Financial Assets and Financial Liabilities—including an
amendment of FASB Statement 115” (“SFAS 159”). The subordinated securities
retained by the Company in its securitization transactions have a stated
principal amount and interest rate. The performance of the securities is
dependent upon the performance of the underlying pool of securitized mortgage
loans. The interest rates these securities earn are variable and are subject to
an available funds cap as well as a maximum rate cap. The securities receive
principal payments in accordance with a payment priority which is designed to
maintain specified levels of subordination to the senior bonds within the
respective securitization trust. The Company accounts for the securities based
on EITF 99-20 which prescribes the effective yield method.





As
previously described, mortgage securities available-for-sale represent retained
beneficial interests in certain components of the cash flows of the underlying
mortgage loans to securitization trusts. As payments are received on both the
residual and subordinated securities, the payments are applied to the cost basis
of the related mortgage securities. 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 proprietary models the Company has developed. The accretable yield is
recorded as interest income with a corresponding increase to the cost basis of
the mortgage security.





The
initial value of the loans is estimated based on the expected open market sales
price of a similar pool (“the whole loan price methodology”). 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,
management adjusts the market price for loans to compensate for the estimated
value of rejected loans. The market price of the securities retained is derived
by deducting the 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.




The
Company uses the whole loan price methodology when it feels enough relevant
information is available through its internal bidding processes for purchasing
similar pools of loans in the market. When such information is not available,
the Company estimates the initial value of residual securities retained in a
whole loan securitization based on the present value of future expected cash
flows to be received (“the discount rate methodology”). Management’s best
estimate of key assumptions, including credit losses, prepayment speeds, market
discount rates and forward yield curves commensurate with the risks involved,
are used in estimating future cash flows.




43




For
purposes of valuing the retained residual securities at each reporting period
subsequent to the initial valuation, the Company uses the discount rate
methodology.





Mortgage
Securities - TradingMortgage securities – trading consist of mortgage securities purchased by
the Company as well as retained by the Company in its securitization
transactions. Trading securities are recorded at fair value with gains and
losses, realized and unrealized, included in earnings. The Company uses the
specific identification method in computing realized gains or
losses.





Mortgage
Securities – Trading consisted of one residual security at December 31, 2008 and
2007 with the remaining balance comprised of subordinated securities. See Mortgage Securities –
Available-for-Sale for further details of the Company’s residual and
subordinated securities.





The
Company estimated initial fair value for the subordinated securities based on
quoted market prices obtained from brokers. The Company estimates subsequent
fair value for the subordinated securities based on quoted market prices
obtained from brokers which are compared to internal discounted cash
flows.





Mortgage
Servicing RightsPrior to 2007, mortgage servicing rights were recorded at allocated cost
based upon the relative fair values of the transferred loans and the servicing
rights. In accordance with the adoption of SFAS 156,“Accounting for Servicing of
Financial Assets”, an amendment of SFAS 140 (“SFAS 156”), the Company initially
recorded mortgage servicing rights upon a securitization at fair value during
2007. Mortgage servicing rights were amortized in proportion to and over the
projected net servicing revenues. Periodically, the Company evaluated the
carrying value of mortgage servicing rights based on their estimated fair value.
If the estimated fair value, using a discounted cash flow methodology, was less
than the carrying amount of the mortgage servicing rights, the mortgage
servicing rights were written down to the amount of the estimated fair value.
For purposes of evaluating and measuring impairment of mortgage servicing
rights, the Company stratified the mortgage servicing rights based on their
predominant risk characteristics. The significant risk characteristic considered
by the Company was period of origination. The mortgage loans underlying the
mortgage servicing rights were pools of homogenous, nonconforming residential
loans.





The
Company sold its entire mortgage servicing rights portfolio on November 1, 2007.
See Note 14 for further discussion.





Servicing Related
AdvancesIn its capacity as loan servicer, the Company advanced funds on
behalf of borrowers for taxes, insurance and other customer service functions.
These advances were routinely assessed for collectibility and any uncollectible
advances were appropriately charged to earnings.





The
Company sold the servicing related advance balances attributable to the
securitization trusts comprising its mortgage servicing rights portfolio in
conjunction with the sale of its mortgage servicing rights portfolio on November
1, 2007.





Real Estate OwnedReal estate owned, which consists of residential real estate acquired in
satisfaction of loans, is carried at the lower of cost or estimated fair value
less estimated selling costs. Adjustments to the loan carrying value required at
time of foreclosure are charged against the allowance for credit losses. Costs
related to the development of real estate are capitalized and those related to
holding the property are expensed. Losses or gains from the ultimate disposition
of real estate owned are charged or credited to earnings.





Derivative
Instruments, netThe Company uses derivative instruments with the
objective of hedging interest rate risk. Interest rates on the Company’s
liabilities typically adjust more frequently than interest rates on the
Company’s assets. Derivative instruments are recorded at their fair value on the
consolidated balance sheet. For derivative instruments that qualify for hedge
accounting, any changes in fair value of derivative instruments related to hedge
effectiveness are reported in accumulated other comprehensive income. Gains and
losses reported as a component of accumulated other comprehensive (loss) income
are reclassified into earnings as the forecasted transactions occur. Changes in
fair value of derivative instruments related to hedge ineffectiveness and
non-hedge activity are recorded as adjustments to earnings through the gains
(losses) on derivative instruments line item of the Company’s consolidated
statements of operations. 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 through the gains (losses) on derivative instruments
line item of the Company’s consolidated statements of operations. The fair value
of the Company’s derivative instruments, along with any margin accounts
associated with the contracts, are included in other liabilities on the
Company’s balance sheet as of December 31, 2008 and other assets as of December
31, 2007.





Property and
Equipment, netLeasehold improvements, furniture and fixtures and office
and computer equipment are stated at cost less accumulated depreciation.
Depreciation is computed using the straight-line method over the estimated
useful lives of the related assets. The estimated useful lives of the assets are
leasehold improvements, lesser of 5 years or remaining lease term, furniture and
fixtures, 5 years, and office and computer equipment, 3 to 5 years.





Maintenance
and repairs are charged to expense. Major renewals and improvements are
capitalized. Gains and losses on dispositions are credited or charged to
earnings as incurred. Depreciation expense related to continuing operations for
the years ended December 31, 2008 and 2007 was $1.1 million and $2.9 million,
respectively. There was no depreciation expense related to discontinued
operations for the year ended December 31, 2008. For 2007, depreciation expense
related to discontinued operations was $6.0 million.




44




Due to
Securitization TrustsDue to securitization trusts represents the fair value of the mortgage
loans the Company had the right to repurchase from the securitization trusts.
The servicing agreements the Company executed for loans it had securitized
include a removal of accounts provision which gave it the right, not the
obligation, to repurchase mortgage loans from the trust. The removal of accounts
provision could be exercised for loans that are 90 days to 119 days delinquent.
Upon exercise of the call options, the related obligation to the trusts was
removed from the Company’s balance sheet.





In
conjunction with the mortgage servicing rights sale in 2007, the removal of
accounts provision was transferred to the buyer which resulted in the removal of
the related obligation from the Company’s balance sheet. See Note 14 for further
discussion of the removal of accounts provision and the sale of mortgage
servicing rights.





Premiums for
Mortgage Loan InsuranceThe Company uses lender paid mortgage insurance
to mitigate the risk of loss on loans that are originated. For those loans
held-in-portfolio and loans held-for-sale, the premiums for mortgage insurance
are expensed by the Company as the costs of the premiums are incurred. For those
loans sold in securitization transactions accounted for as a sale, the
independent trust assumes the obligation to pay the premiums and obtains the
right to receive insurance proceeds.





Transfers of
Assets A transfer of mortgage loans or mortgage securities in which the
Company surrenders control over the financial assets is accounted for as a sale.
When the Company retains control over transferred mortgage loans or mortgage
securities, the transaction is accounted for as a secured borrowing. When the
Company sells mortgage loans or mortgage securities in securitization and
resecuritization transactions, it may retain one or more bond classes and
servicing rights in the securitization. Gains and losses on the assets
transferred are 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.





The
initial value of the loans is estimated based on the whole loan price
methodology. 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, management adjusts the market price for loans to
compensate for the estimated value of rejected loans. The market price of the
securities retained is derived by deducting the 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 derived by taking the projected cash flows
generated using assumptions for prepayments, expected credit losses and interest
rates and then solving for the discount rate required to present value the cash
flows back to the initial value derived above. The Company then ascertains the
resulting discount rate is commensurate with current market conditions.
Additionally, the initial discount rate serves as the initial accretable yield
used to recognize income on the securities.




The
Company uses the whole loan price methodology when it feels enough relevant
information is available through its internal bidding processes for purchasing
similar pools of loans in the market. When such information is not available,
the Company estimates the initial value of residual securities retained in a
whole loan securitization based on the discount rate methodology. Management’s
best estimate of key assumptions, including credit losses, prepayment speeds,
market discount rates and forward yield curves commensurate with the risks
involved, are used in estimating future cash flows.





For
purposes of valuing the retained residual securities at each reporting period
subsequent to the initial valuation, the Company uses the discount rate
methodology.





The
Company also transfers 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 the Company enters 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.





A
significant factor in valuing the residual securities is the portion of the
underlying mortgage loan collateral that is covered by mortgage insurance. At
the time of a securitization transaction, the trust legally assumes the
responsibility to pay the mortgage insurance premiums associated with the loans
transferred and the rights to receive claims for credit losses. Therefore, the
Company has 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 severity of credit losses incurred
by the trust. Mortgage insurance claims on loans where a defect occurred in the
loan origination process will not be paid by the mortgage insurer. The
assumptions the Company uses to value its residual securities consider this
risk.





The
following is a description of the methods used by the Company to transfer assets
including the related accounting treatment under each method. There were no
assets transferred for the year ended December 31, 2008.





·
            Whole Loan Sales Whole
      loan sales represent loans sold to third parties with servicing released.
      Gains and losses on whole loan sales are recognized in the period the sale
      occurs and the Company has determined that the criteria for sales
      treatment has been achieved as it has surrendered control over the assets
      transferred. The Company generally has an obligation to repurchase whole
      loans sold in circumstances in which the borrower fails to make up to the
      first three payments due to the
buyer.




45




·
            Loans and Securities Sold
      Under Agreements to Repurchase (Repurchase Agreements)Repurchase agreements represent legal sales of loans or mortgage
      securities and a related agreement to repurchase the loans or mortgage
      securities at a later date. Repurchase agreements are accounted for as
      secured borrowings because the Company has not surrendered control of the
      transferred assets as it is both entitled and obligated to repurchase the
      transferred assets prior to their maturity. Repurchase agreements are
      classified as short-term borrowings in the Company’s consolidated balance
      sheet.





·
            Securitization
      TransactionsA
      securitization transaction is the transfer or sale of mortgage loans to
      independent trusts which issue securities to investors. As discussed
      above, the accounting treatment for transfers of assets upon
      securitization depends on whether or not the Company has retained control
      over the transferred assets. The securities are collateralized by the
      mortgage loans transferred into the independent trusts. The Company
      retains interests in some of the securities issued by the trust. Certain
      of the securitization agreements require the Company to repurchase loans
      that are found to have legal deficiencies subsequent to the date of
      transfer. The fair values of these recourse obligations are recorded upon
      the transfers of the mortgage loans and on an ongoing basis. The Company
      also retained the right, but not the obligation, to acquire loans when
      they are 90 to 119 days delinquent and at the time a property is
      liquidated, but transferred this right to the purchaser of the Company’s
      mortgage servicing rights in 2007. Prior to that transfer, the Company
      recorded an asset and a liability on the balance sheet for the aggregate
      fair value of delinquent loans that it had a right to call as of the
      balance sheet date when the securitization is accounted for as a
      sale.





·
            Resecuritization
      Transactions A resecuritization is the transfer or sale of mortgage
      securities that the Company has retained in previous securitization
      transactions to an independent trust. Similar to a securitization, the
      trust issues securities that are collateralized by the mortgage securities
      transferred to the trust. Resecuritization transactions are accounted for
      as either a sale or a secured borrowing based on whether or not the
      Company has retained or surrendered control over the transferred assets.
      In the resecuritization transaction, the Company may retain an interest in
      a security that represents the right to receive the cash flows on the
      underlying mortgage security collateral after the senior bonds, issued to
      third parties, have been repaid in
full.





Reserve for
Losses – Loans Sold to Third PartiesThe Company maintains a reserve for
the representation and warranty liabilities related to loans sold to third
parties, and for the contractual obligation to rebate a portion of any premium
paid by a purchaser when a borrower prepays a sold loan within an agreed period.
The reserve, which is recorded as a liability on the consolidated balance sheet,
is established when loans are sold, and is calculated as the estimated fair
value of losses reasonably estimated to occur over the life of the loan.
Management estimates inherent losses based upon historical loss trends and
frequency and severity of losses for similar loan product sales. The adequacy of
this reserve is evaluated and adjusted as required. The provision for losses
recognized at the sale date is included in the operating results of discontinued
operations as a reduction of gains (losses) on sales of mortgage
assets.





Due to
Servicer Principal and interest payments (the “monthly repayment
obligations”) on asset-backed bonds secured by mortgage loans recorded on the
Company’s balance sheet are remitted to bondholders on a monthly basis by the
securitization trust (the “remittance period”). Funds used for the monthly
repayment obligations are based on the monthly scheduled principal and interest
payments of the underlying mortgage loan collateral, as well as actual principal
and interest collections from borrower prepayments.  When a borrower
defaults on a scheduled principal and interest payment, the servicer must
advance the scheduled principal and interest to the securitization trust to
satisfy the monthly repayment obligations.  The servicer must continue
to advance all delinquent scheduled principal and interest payments each
remittance period until the loan is liquidated.  Upon liquidation, the
servicer may recover their advance through the liquidation
proceeds.  During the period the servicer has advanced funds to a
securitization trust which the Company accounts for as a financing, the Company
records a liability representing the funds due back to the
servicer.





Fee
Income  During the year ended December 31, 2008, the Company
received fee income from appraisal and broker fees.   For 2007,
the Company received fee income from broker, loan origination and service fees.
The following describes fee income sources and the related accounting
treatment:





·
            Appraisal
      Fees  Appraisal fees are collected as part of the
      appraisal management process performed by StreetLinks based on negotiated
      rates with each appraiser.  Revenue is recognized when the
      appraisal is completed and provided to the lender or borrower, depending
      on who placed the order.





·
            Broker FeesBroker
      fees are paid by other lenders for placing loans with third-party
      investors (lenders) and are based on negotiated rates with each lender to
      whom the Company brokers loans. Revenue is recognized upon loan
      origination and delivery.





·
            Loan Origination
      Fees  Loan origination fees represent fees paid to the
      Company by borrowers and are associated with the origination of mortgage
      loans. Loan origination fees are determined based on the type and amount
      of loans originated. Loan origination fees and direct origination costs on
      mortgage loans held-in-portfolio are deferred and recognized over the life
      of the loan using the level yield method. Loan origination fees and direct
      origination costs on mortgage loans held-for-sale are deferred and
      considered as part of the carrying value of the loan when
      sold.




46







·
            Service Fee
      Income  Service fees are paid to the Company by either
      the investor on mortgage loans serviced or the borrower. 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 and processing fees. Revenue is recognized on fees
      received from borrowers when an event occurs that generates the fee and
      they are considered to be
collectible.





Stock-Based
Compensation  At December 31, 2008, the Company had one
stock-based employee compensation plan, which is described more fully in Note 19
and is accounted for using FASB Statement No. 123(R) (“SFAS 123(R)”),
“Share-Based Payment.”




Income
TaxesHistorically, the
Company was taxed as a REIT under Section 857 of the Code. As a REIT, the
Company generally was not subject to federal income tax. To maintain its
qualification as a REIT, the Company had to distribute at least 90% of its REIT
taxable income to its shareholders and meet certain other tests relating to
assets, income and ownership. However, the Company had elected to treat NFI
Holding Corporation and its subsidiaries as taxable REIT subsidiaries
(collectively the “TRS”). In general, the TRS could hold assets that the Company
could not hold directly and generally could engage in any real estate or
non-real estate related business. The subsidiaries comprising the TRS were
subject to corporate federal and state income tax and were taxed as regular C
corporations.




During
2007, the Company was unable to satisfy the REIT distribution requirement for
the tax year ended December 31, 2006, either in the form of cash or preferred
stock.  This action resulted in the Company’s loss of REIT status
retroactive to January 1, 2006.  The failure to satisfy the REIT
distribution test resulted from demands on the Company’s liquidity and the
substantial decline in the Company’s market capitalization during
2007.





Since the
Company terminated its REIT status effective January 1, 2006 and was taxable as
a C corporation for 2007 and 2008, the Company recorded deferred taxes based on
the estimated cumulative temporary differences as of December 31, 2008 and
2007.





In
determining the amount of deferred tax assets to recognize in the financial
statements, the Company evaluates the likelihood of realizing such benefits in
future periods.  FASB Statement 109 “Accounting for Income Taxes”
(“SFAS 109”) requires the recognition of a valuation allowance if it is more
likely than not that all or some portion of the deferred tax asset will not be
realized.  SFAS 109 indicates the more likely than not threshold is a
level of likelihood that is more than 50 percent.





Under
SFAS 109, companies are required to identify and consider all available
evidence, both positive and negative, in determining whether it is more likely
than not that all or some portion of its deferred tax assets will not be
realized.  Positive evidence includes, but is not limited to the
following:  cumulative earnings in recent years, earnings expected in
future years, excess appreciated asset value over the tax basis, and positive
industry trends.  Negative evidence includes, but is not limited to
the following:  cumulative losses in recent years, losses expected in
future years, a history of operating losses or tax credits carryforwards
expiring, and adverse industry trends.





The
weight given to the potential effect of negative and positive evidence should be
commensurate with the extent to which it can be objectively verified.
Accordingly, the more negative evidence that exists requires more positive
evidence to counter, thus making it more difficult to support a conclusion that
a valuation allowance is not needed for all or some of the deferred tax
assets.  Cumulative losses in recent years is significant negative
evidence that is difficult to overcome when determining the need for a valuation
allowance.  Similarly, cumulative earnings in recent years represent
significant positive objective evidence.  If the weight of the
positive evidence is sufficient to support a conclusion that it is more likely
than not that a deferred tax asset will be realized, a valuation allowance
should not be recorded.





The
Company examines and weighs all available evidence (both positive and negative
and both historical and forecasted) in the process of determining whether it is
more likely than not that a deferred tax asset will be realized.  The
Company considers the relevancy of historical and forecasted evidence when there
has been a significant change in circumstances. Additionally, the Company
evaluates the realization of its recorded deferred tax assets on an interim and
annual basis.  The Company does not record a valuation allowance if
the weight of the positive evidence exceeds the negative evidence and is
sufficient to support a conclusion that it is more likely than not that its
deferred tax asset will be realized.





If the
weighted positive evidence is not sufficient to support a conclusion that it is
more likely than not that all or some of the Company’s deferred tax assets will
be realized, the Company considers all alternative sources of taxable income
identified in determining the amount of valuation allowance to be
recorded.  Alternative sources of taxable income identified in FAS 109
include the following: 1) taxable income in prior carryback year, 2) future
reversals of existing taxable temporary differences, 3) future taxable income
exclusive of reversing temporary differences and carryforwards, and 4) tax
planning strategies.


47


Effective
January 1, 2007, the Company adopted FASB Interpretation 48 (“FIN 48”),
“Accounting for Uncertainty in Income Taxes – an Interpretation of FASB
Statement 109”.  FIN 48 requires a company to evaluate whether a
tax position taken by the company will “more likely than not” be sustained upon
examination by the appropriate taxing authority.  It also provides guidance
on how a company should measure the amount of benefit that the company is to
recognize in its financial statements.  As a result of the implementation
of FIN 48, the Company recorded a $1.1 million net liability as an increase
to the opening balance of accumulated deficit.  It is the Company’s
policy to recognize interest and penalties related to income tax matters in
income tax expense (benefit).





Discontinued
Operations  As a result of the significant deterioration in the
subprime secondary markets, during 2007, the Audit Committee of the Board of
Directors of the Company committed to workforce reductions pursuant to plans of
termination (the "Exit Plans") as described in FASB Statement of Financial
Accounting Standards (“SFAS”) 146, “Accounting for Costs Associated with Exit or
Disposal Activities” (“SFAS 146”).  The Company undertook these Exit
Plans to align its organization and costs with its decision to discontinue its
mortgage lending and mortgage servicing activities. The Company considers an
operating unit to be discontinued upon its termination date, which is the point
in time when the operations substantially cease.  In accordance with
SFAS 144, the Company has reclassified the operating results of its entire
mortgage lending segment and loan servicing operations segment as discontinued
operations in the consolidated statements of operations for the year ended
December 31, 2008 and 2007.





On
November 4, 2005, the Company adopted a formal plan to terminate substantially
all of the branches operated by NovaStar Home Mortgage, Inc.
(“NHMI”).  By June 30, 2006, the Company had terminated all of the
remaining NHMI branches and related operations. The Company considers a branch
to be discontinued upon its termination date, which is the point in time when
the operations substantially cease. In accordance with SFAS 144, the Company has
presented the operating results of NHMI as discontinued operations in the
consolidated statements of operations for the years ended December 31, 2008 and
2007.





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





Commitments to
Originate Mortgage Loans  Commitments to originate mortgage
loans - held-for-sale meet the definition of a derivative and are recorded at
fair value and were classified as accounts payable and other liabilities in the
Company’s consolidated balance sheets. The Company used the Black-Scholes option
pricing model to determine the value of its commitments. Significant assumptions
used in the valuation determination include volatility, strike price, current
market price, expiration and one-month LIBOR.  There were no
commitments to originate mortgage loans for the years ended December 31, 2008
and 2007.





New Accounting
Pronouncements




In
December 2007, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards No. 141 (R), “Business Combinations”
(“SFAS 141(R)”).  In summary, SFAS 141(R) requires the acquirer of a
business combination to measure at fair value the assets acquired, the
liabilities assumed, and any non-controlling interest in the acquiree at the
acquisition date, with limited exceptions.  In addition, this standard
will require acquisition costs to be expensed as incurred.  The
standard is effective for fiscal years beginning after December 15, 2008, and is
to be applied prospectively, with no earlier
adoption permitted.  The adoption of this standard may have an
impact on the accounting for certain costs related to any future
acquisitions.





In
December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements” (“SFAS 160”), which requires
consolidated net income to be reported at amounts that include the amounts
attributable to both the parent and non-controlling interest.  SFAS
160 is effective for fiscal years beginning on or after December 15,
2008.  The minority interest related to the Streetlinks purchase is
shown as a component of shareholders’ deficit.  The adoption of this
standard may have an impact on the accounting of net income and shareholders’
deficit attributed to StreetLinks and any future acquisitions.





In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities” (“SFAS 161”).  The new standard is intended to
improve financial reporting about derivative instruments and hedging activities
by requiring enhanced disclosures to enable investors to better understand their
effects on an entity’s financial position, financial performance, and cash
flows. It is effective for financial statements issued for fiscal years and
interim periods beginning after November 15, 2008, with early application
encouraged.  The Company does not expect the adoption of SFAS 161 will
impact its consolidated financial statements but could result in additional
disclosures.





In April
2008, the FASB issued FASB Staff Position (“FSP”) No. SFAS 142-3, “Determination
of the Useful Life of Intangible Assets” (“FSP SFAS 142-3”). FSP SFAS 142-3
amends paragraph 11(d) of FASB Statement No. 142 “Goodwill and Other Intangible
Assets” (“SFAS 142”) which amends the factors that should be considered in
developing renewal or extension assumptions used to determine the useful life of
a recognized intangible asset under SFAS 142. FSP SFAS 142-3 is intended to
improve the consistency between the useful life of a recognized intangible asset
under SFAS 142 and the period of expected cash flows used to measure the fair
value of the asset. FSP SFAS 142-3 is effective for financial statements issued
for fiscal years beginning after December 15, 2008 and must be applied
prospectively to intangible assets acquired after the effective date. The
Company does not expect that adoption of FSP SFAS 142-3 will have a significant
impact on the Company’s consolidated financial statements.


48





In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles” (“SFAS 162”).  SFAS 162 identifies the sources of
accounting principles and the framework for selecting principles to be used in
the preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles in the
United States.  This statement is effective as of November 15, 2008, 60
days following the SEC’s approval of the Public Company Accounting Oversight
Board’s amendments to the PCAOB’s Interim Auditing Standards (AU) section 411,
“The Meaning of Present Fairly in Conformity with Generally Accepted Accounting
Principles.”  The adoption of SFAS 162 did not have a material
impact on the Company’s consolidated financial statements.





In June
2008, the FASB issued FASB Staff Position No. EITF 03-6-1 "Determining Whether
Instruments Granted in Share-Based Payment Transactions Are Participating
Securities" (FSP EITF -3-6-1). This FSP was issued to clarify that instruments
granted in share-based payment transactions can be participating securities
prior to the requisite service having been rendered. The guidance in this FSP
applies to the calculation of Earnings Per Share ("EPS") under Statement 128 for
share-based payment awards with rights to dividends or dividend equivalents.
Unvested share-based payment awards that contain non-forfeitable rights to
dividends or dividend equivalents (whether paid or unpaid) are participating
securities and shall be included in the computation of EPS pursuant to the
two-class method. This FSP is effective for financial statements issued for
fiscal years beginning after December 15, 2008, and interim periods within those
years. All prior-period EPS data presented shall be adjusted retrospectively
(including interim financial statements, summaries of earnings, and selected
financial data) to conform with the provisions of this FSP. The Company has not
determined the impact that the adoption of this EITF will have on its financial
condition or results of operation.




On
September 15, 2008, the FASB issued two exposure drafts proposing amendments to
SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities”, and FASB Interpretation No. 46R, “Consolidation
of Variable Interest Entities” (“FIN 46R”).  Currently, the transfers
of the Company’s mortgage loans in securitization transactions qualify for sale
accounting treatment.  The trusts used in the Company’s
securitizations are not consolidated for financial reporting purposed because
the trusts are qualifying special purpose entities (“QSPE”).  Because
the transfers qualify as sales and the trusts are not subject to consolidation,
the assets and liabilities of the trusts are not reported on the balance sheet
under GAAP.  Under the proposed amendments, the concept of a QSPE
would be eliminated and could potentially modify the consolidation
conclusions.  As proposed, these amendments would be effective for the
Company at the beginning of 2010.  The proposed amendments, if
adopted, could require the Company to consolidate the assets and liabilities of
the Company’s securitization trusts.  This could have a significant
effect on our financial condition as affected off-balance sheet loans and
related liabilities would be recorded on the balance sheet.





On
October 10, 2008, the FASB issued FSP No. 157-3, “Determining the Fair Value of
a Financial Asset When the Market for That Asset Is Not Active” (“FSP
157-3”).  FSP 157-3 clarifies the application of FAS 157 in a market
that is not active and provides an example to illustrate key consideration in
determining the fair value of a financial asset when the market for that
financial asset is not active.  The issuance of FSP 157-3 did not have
a material impact on the Company’s determination of fair value for its financial
assets.





In
December 2008, the FASB issued FSP FAS 140-4 and FIN 46(R)-8,
Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets
and Interests in Variable Interest Entities (“FSP FAS 140-4 and
FIN 46(R)-8”), which requires expanded disclosures for transfers of
financial assets and involvement with variable interest entities (“VIEs”). Under
this guidance, the disclosure objectives related to transfers of financial
assets now include providing information on (i) the Company’s continued
involvement with financial assets transferred in a securitization or asset
backed financing arrangement, (ii) the nature of restrictions on assets
held by the Company that relate to transferred financial assets, and
(iii) the impact on financial results of continued involvement with assets
sold and assets transferred in secured borrowing arrangements. VIE disclosure
objectives now include providing information on (i) significant judgments
and assumptions used by the Company to determine the consolidation or disclosure
of a VIE, (ii) the nature of restrictions related to the assets of a
consolidated VIE, (iii) the nature of risks related to the Company’s
involvement with the VIE and (iv) the impact on financial results related
to the Company’s involvement with the VIE. Certain disclosures are also required
where the Company is a non-transferor sponsor or servicer of a QSPE. FSP
FAS 140-4 and FIN 46(R)-8 is effective for the first reporting period
ending after December 15, 2008. See Note 3 to the consolidated financial
statements for the additional disclosures required by the
FSP.





In
January 2009, the FASB issued FSP EITF 99-20-1, Amendments to the
Impairment Guidance of EITF Issue No. 99-20 (“FSP EITF 99-20-1”),
which eliminates the requirement that the holder’s best estimate of cash flows
be based upon those that a “market participant” would use. FSP EITF 99-20-1
was amended to require recognition of other-than-temporary impairment when it is
“probable” that there has been an adverse change in the holder’s best estimate
of cash flows from the cash flows previously projected. This amendment aligns
the impairment guidance under EITF 99-20, Recognition of Interest Income
and Impairment on Purchased Beneficial Interests and Beneficial Interests That
Continue to Be Held by a Transferor in Securitized Financial Assets, with the
guidance in SFAS No. 115. FSP EITF 99-20-1 retains and
re-emphasizes the other-than-temporary impairment guidance and disclosures in
pre-existing GAAP and SEC requirements. FSP EITF 99-20-1 is effective for
interim and annual reporting periods ending after December 15, 2008. The
Company does not expect the adoption of FSP EITF 99-20-1 will have a
material impact on its consolidated financial statements.


49





In April
2009, the FASB issued FSP No. FAS 107-1 and APB 28-1, Interim Disclosures about
Fair Value of Financial Instruments, to require disclosures about fair value of
financial instruments for interim reporting periods of publicly traded companies
as well as in annual financial statements. This FSP also amends APB Opinion No.
28, Interim financial reporting, to require those disclosures in summarized
financial information at interim reporting periods.  The Company will
comply with the additional disclosure requirements beginning in the second
quarter of 2009.





In April
2009, the FASB issued FSP No. FAS 115-2 and FAS 124-2, Recognition and
Presentation of Other-Than-Temporary Impairments. This FSP amends the
other-than-temporary impairment guidance in U.S. GAAP for debt and


equity
securities in the financial statements. This FSP does not amend existing
recognition and measurement guidance related to other-than-temporary impairments
of equity securities. The FSP shall be effective for interim and annual
reporting periods ending after June 15, 2009 , but early adoption is permitted
for interim periods ending after March 15, 2009. The Company plans to adopt
the provisions of this Staff Position during second quarter 2009; however its
adoption is not expected to have a material impact on its consolidated financial
statements.





In April
2009, the FASB issued FSP No. FAS 157-4, “Determining Fair Value When the Volume
and Level of Activity for the Asset or Liability Have Significantly Decreased
and Identifying Transactions That Are Not Orderly” (“FSP FAS
157-4”).  FSP FAS 157-4 provides guidance on estimating fair value
when market activity has decreased and on identifying transactions that are not
orderly.  Additionally, entities are required to disclose in interim
and annual periods the inputs and valuation techniques used to measure fair
value.  This FSP is effective for interim and annual periods ending
after June 15, 2009.  The Company does not expect the adoption of FSP
FAS 157-4 will have a material impact on its financial condition or results of
operation, although it will require additional disclosures.





In May
2009, the FASB issued FASB Staff Position No. APB 14-1 “Accounting for
Convertible Debt Instruments That May Be Settled in Cash upon Conversion
(Including Partial Cash Settlement).”  FASB Staff Position No. APB
14-1 clarifies that convertible debt instruments that may be settled in cash
upon conversion (including partial cash settlement) are not addressed by
paragraph 12 of APB Opinion No. 14, Accounting for Convertible Debt and Debt
Issued with Stock Purchase Warrants. Additionally, this FSP specifies that
issuers of such instruments should separately account for the liability and
equity components in a manner that will reflect the entity’s nonconvertible debt
borrowing rate when interest cost is recognized in subsequent periods. This FSP
is effective for financial statements issued for fiscal years beginning after
December 15, 2008, and interim periods within those fiscal years.  The
Company does not expect the adoption of this FSP will have a material impact on
its financial condition or results of operation.





Note
3. Mortgage Loans – Held-in-Portfolio





Mortgage
loans – held-in-portfolio, all of which are secured by residential properties,
consisted of the following as of December 31, 2008 and 2007 (dollars in
thousands):





December 31,
                          2008
                        
                        
                        December 31,
                          2007Mortgage
      loans – held-in-portfolio:Outstanding
      principal
                        
                        $
                        2,529,791
                        
                        
                        $
                        3,067,737Net
      unamortized deferred origination costs
                        
                        
                        19,048
                        
                        
                        
                        32,414Amortized
      cost
                        
                        
                        2,548,839
                        
                        
                        
                        3,100,151Allowance
      for credit losses
                        
                        
                        (776,001
                        )
                        
                        
                        (230,138
                        )Mortgage
      loans – held-in-portfolio
                        
                        $
                        1,772,838
                        
                        
                        $
                        2,870,013Weighted
      average coupon
                        
                        
                        8.00
                        %
                        
                        
                        8.59
                        %





The
Company did not transfer any mortgage loans from its held-for-sale
classification to held-in-portfolio during 2008.  In 2007 the Company
transferred $1.9 billion of mortgage loans from its held-for-sale classification
to held-in-portfolio. These loans were either subsequently securitized in
transactions structured as financings or paid off.





Mortgage
loans held-in-portfolio include loans that the Company has securitized in
structures that are accounted for as financings. No securitization transactions
were completed during 2008.  During 2007, the Company executed one
securitization transaction, NovaStar Home Equity Series (“NHES”) 2007-1, which
was accounted for as a financing under SFAS 140.  During 2006, the
Company executed two securitization transactions accounted for as financings,
NHES 2006-1 and NHES 2006-MTA1.  See below for details of the
Company’s securitization transactions structured as financings during
2007.





The
actual static pool credit loss as of December 31, 2008 was 2.71% and the
cumulative projected static pool credit loss for the life of the securities is
27.5%. Static pool losses are calculated by summing the actual and projected
future credit losses and dividing them by the original balance of each pool of
assets.


50




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







For the Year Ended December 31,Total Principal Amount of
                    Loans (A)
                  
                  Principal Amount of
                    Loans 60 Days or More
                    Past Due
                  
                  Net Credit Losses
                    During the Year Ended
                    December 31, (B)2008
                  
                  2007
                  
                  2008
                  
                  2007
                  
                  2008
                  
                  2007Loans
      securitized
                  
                  $
                  8,121,668
                  
                  
                  $
                  10,087,692
                  
                  
                  $
                  3,371,720
                  
                  
                  $
                  1,806,141
                  
                  
                  $
                  469,182
                  
                  
                  $
                  231,814Loans
      held-in-portfolio
                  
                  
                  2,684,213
                  
                  
                  
                  3,215,695
                  
                  
                  
                  1,270,261
                  
                  
                  
                  572,943
                  
                  
                  
                  155,765
                  
                  
                  
                  15,458Total
      loans securitized or held-in-portfolio
                  
                  $
                  10,805,881
                  
                  
                  $
                  13,303,387
                  
                  
                  $
                  4,641,981
                  
                  
                  $
                  2,379,084
                  
                  
                  $
                  624,947
                  
                  
                  $
                  247,272







(A)
            Includes
      assets acquired through
foreclosure.


(B)
            Represents
      the realized losses as reported by the securitization trusts for each
      period presented.





These
securitizations are structured legally as sales, but for accounting purposes are
treated as financings 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 NHES 2006-1 and NHES 2006-MTA1
securitizations at inception did not meet the criteria necessary for
derecognition under SFAS 140 and related interpretations because after the loans
were securitized the securitization trusts may acquire derivatives relating to
beneficial interests retained by the Company; additionally, the Company, had the
unilateral ability to repurchase a limited number of loans back from the
trust.  These provisions were removed effective September 30,
2008.  Since the removal of these provisions did not substantively
change the transactions’ economics, the original accounting conclusion remains
the same.  The NHES 2007-1 securitization does not meet the qualifying
special purpose entity criteria necessary for derecognition under SFAS 140 and
related interpretations because of the excessive benefit the Company received at
inception from the derivative instruments delivered into the trust to counteract
interest rate risk.





Accordingly,
the loans in the NHES 2006-1, NHES 2006-MTA1, and NHES 2007-1 securitizations
remain on the balance sheet as “Mortgage loans
held-in-portfolio”.  Given this treatment, retained interests are not
created, and securitization bond financing is reflected on the balance sheet as
a liability. The Company records interest income on loans held-in-portfolio and
interest expense on the bonds issued in the securitizations over the life of the
securitizations. Deferred debt issuance costs and discounts related to the bonds
are amortized on a level yield basis over the estimated life of the
bonds.





Details
of the Company’s loan securitization transaction structured for accounting
purposes as financings which closed during the year ended December 31, 2007 are
as follows (dollars in thousands):







Securitization
                                Name
                              
                              Date Issued
                              
                              Principal
                                Balance of Loans
                                Pledged
                              
                              
                              Bonds Issued
                                (A)
                              
                              
                              Net Bond
                                Proceeds
                              
                              
                              Interest Rate Spread
                                Over One Month
                                LIBOR (A)(B)2007:NHES
      2007-1
                              
                              February
      28, 2007
                              
                              $
                              1,888,756
                              
                              
                              $
                              1,794,386
                              
                              
                              $
                              1,784,662
                              
                              
                              0.10%-1.75%







(A)
            The
      amounts shown do not include subordinated bonds retained by the
      Company.


(B)
            The
      interest rate for the A-2A2 bond is fixed at
  5.86%





Collateral
for 27% and 21% of the mortgage loans held-in-portfolio outstanding as of
December 31, 2008 was located in California and Florida,
respectively.  Collateral for 26% and 20% of the mortgage loans
held-in-portfolio outstanding as of December 31, 2007 was located in California
and Florida, respectively.  Interest only loan products made up 22%
and 7% of the loans classified as held-in-portfolio as of December 31, 2008 and
2007, respectively.  In addition, as of December 31, 2008, moving
treasury average (“MTA”) loan products made up 27% of the loans classified as
held-in-portfolio compared to 25% as of December 31, 2007. These MTA loans had
$19.9 million and $41.9 million in negative amortization during 2008 and 2007,
respectively. The Company has no other significant concentration of credit risk
on mortgage loans.





At
December 31, 2008 and 2007 all of the loans classified as held-in-portfolio were
pledged as collateral for financing purposes.





Mortgage
loans – held-in-portfolio that the Company has placed on non-accrual status
totaled $755.5 million and $402.7 million at December 31, 2008 and
2007, respectively. At December 31, 2008 the Company had $436.2 million in
mortgage loans – held-in-portfolio past due 90 days or more, which were still
accruing interest as compared to $169.8 million at December 31, 2007. These
loans carried mortgage insurance and the accrual will be discontinued when in
management’s opinion the interest is not collectible.





Activity
in the allowance for credit losses on mortgage loans – held-in-portfolio is as
follows for the two years ended December 31, 2008 (dollars in
thousands):


51





2008
                    
                    
                    2007Balance,
      beginning of period
                    
                    $
                    230,138
                    
                    
                    $
                    22,452Provision
      for credit losses
                    
                    
                    707,364
                    
                    
                    
                    265,288Charge-offs,
      net of recoveries
                    
                    
                    (161,501
                    )
                    
                    
                    (57,602
                    )Balance,
      end of period
                    
                    $
                    776,001
                    
                    
                    $
                    230,138





FSP
FAS 140-4 and FIN 46(R)-8, which was adopted by the Company on
December 31, 2008, provides the disclosure requirements for transactions
with variable interest entities (“VIEs”) or special purpose entities (“SPEs”)
and transfers of financial assets in securitizations or asset-backed financing
arrangements. Under this guidance, the Company is required to disclose
information for consolidated VIEs, for VIEs in which the Company is the sponsor
as defined below or is a significant variable interest holder
(“Sponsor/Significant VIH”) and for VIEs that are established for
securitizations and asset-backed financing arrangements. FSP FAS 140-4 and
FIN 46(R)-8 has expanded the population of VIEs for which disclosure is
required.




The
Company has defined “sponsor” to include all transactions where the Company has
transferred assets to a VIE and/or structured the VIE, regardless of whether or
not the asset transfer has met the sale conditions in
SFAS No. 140.  The Company discloses all instances where
continued involvement with the assets exposes it to potential economic
gain/(loss), regardless of whether or not that continued involvement is
considered to be a variable interest in the VIE.




The
Company’s only continued involvement, relating to these transactions, is
retaining interests in the VIEs.





For the
purposes of this disclosure, transactions with VIEs are categorized as
follows:




Securitization
transactions – For the purposes of this disclosure, securitization
transactions include transactions where the Company transferred mortgage loans
and accounted for the transfer as a sale. This category includes both QSPEs and
non-QSPEs and is reflected in the securitization section of this Note. QSPEs are
commonly used by the Company in securitization transactions as described below.
In accordance with SFAS No. 140 and FIN 46(R),the Company does not
consolidate QSPEs.


http://www.sec.gov/Archives/edgar/data/65100/000095012309003322/y74695e10vk.htm
- tocpage


MortgageLoan VIEs - The
Company consolidates securitization transactions that are structured legally as
sales, but for accounting purposes are treated as financings as defined by SFAS
140.  The NHES 2006-1 and NHES 2006-MTA1 securitizations at inception
did not meet the criteria necessary for derecognition under SFAS 140 and related
interpretations because after the loans were securitized the securitization
trusts may acquire derivatives relating to beneficial interests retained by the
Company; additionally, the Company, had the unilateral ability to repurchase a
limited number of loans back from the trust. These provisions were removed
effective September 30, 2008. Since the removal of these provisions did not
substantively change the transactions’ economics, the original accounting
conclusion remains the same. The NHES 2007-1 securitization does not meet the
qualifying special purpose entity criteria necessary for derecognition under
SFAS 140 and related interpretations because of the excessive benefit the
Company received at inception from the derivative instruments delivered into the
trust to counteract interest rate risk. These transactions could continue
to fail QSPE status and require consolidation and related disclosures. The
Company has no control over the mortgage loans held by these VIEs due to their
legal structure. Therefore, these mortgage loans have been pledged to the
bondholders in the VIEs, and these assets are included in the firm-owned assets
pledged balance reported in Note 3. In most instances, the beneficial
interest holders in these VIEs have no recourse to the general credit of the
Company; rather their investments are paid exclusively from the assets in the
VIE. Securitization VIEs that hold loan assets are typically financed through
the issuance of several classes of debt (i.e., tranches) with ratings that range
from AAA to unrated residuals.





Collateralized
Debt Obligations (CDO)- In the first quarter of 2007 the
Company closed a CDO. The collateral for this securitization consisted of
subordinated securities which the Company retained from its loan securitizations
as well as subordinated securities purchased from other issuers. This
securitization was structured legally as a sale, but for accounting purposes was
accounted for as a financing under SFAS 140. This securitization did not
meet the qualifying special purpose entity criteria under SFAS 140.
Accordingly, the securities remain on the Company’s balance sheet, retained
interests were not created, and securitization bond financing replaced the
short-term debt used to finance the securities. The Company is not the primary
beneficiary in this transaction.





Transactions
with these VIEs are reflected in the Sponsor/Significant VIH table in instances
where the Company has not transferred the assets to the VIE or in the
Securitization tables where the Company has transferred assets and has accounted
for the transfer as a sale.


52





Variable Interest
Entities




FIN 46(R)
requires an entity to consolidate a VIE if that entity holds a variable interest
that will absorb a majority of the VIE’s expected losses, receive a majority of
the VIE’s expected residual returns, or both. The entity required to consolidate
a VIE is known as the primary beneficiary. VIEs are reassessed for consolidation
when reconsideration events occur. Reconsideration events include, changes to
the VIEs’ governing documents that reallocate the expected losses/returns of the
VIE between the primary beneficiary and other variable interest holders or sales
and purchases of variable interests in the VIE. Refer to Note 1 for further
information.




There
were no material reconsideration events during the period, other than those
described in the Mortgage Loan VIEs section above.





The table
below provides the disclosure information required by FSP FAS 140-4 and
FIN 46(R)-8 for VIEs that are consolidated by the Company (dollars in
thousands):





Assets after intercompany
                  eliminations
              
              
              Liabilities after
                intercompany
              
              
              Recourse toConsolidated
      VIEs
              
              Total Assets
              
              
              Unrestricted
              
              
              Restricted(A)
              
              
              eliminations
              
              
              the Company(B)December
      31,  2008Mortgage
      Loan VIEs(C)
              
              $
              1,930,063
              
              
              
              -
              
              
              $
              1,920,610
              
              
              $
              2,730,280
              
              
              
              -CDOs(D)
              
              
              7,242
              
              
              
              -
              
              
              
              6,842
              
              
              
              8,557
              
              
              
              -





(A)
            Assets
      are considered restricted when they cannot be freely pledged or sold by
      the Company.


(B)
            This
      column reflects the extent, if any, to which investors have recourse to
      the Company beyond the assets held by the VIE and assumes a total loss of
      the assets held by the VIE.


(C)
            For
      Mortgage Loan VIEs, assets are primarily recorded in Mortgage loans –
      held-in-portfolio. Liabilities are primarily recorded in Asset-backed
      bonds secured by mortgage loans.


(D)
            For
      the CDO, assets are primarily recorded in Mortgage securities –
      trading and liabilities are recorded in Asset-backed bonds secured by
      mortgage securities.




Securitizations




Prior to
changes in its business in 2007, the Company securitized residential
nonconforming mortgage loans. The Company’s involvement with VIEs that are used
to securitize financial assets consists of owning securities issued by
VIEs.




The
following table relates to securitizations where the Company is retained
interest holder of assets issued by the entity (dollars in
thousands):





Size/Principal
                                      Outstanding (A)
                                    
                                    
                                    Assets
                                      on
                                      Balance
                                      Sheet(B)
                                    
                                    
                                    Liabilities
                                      on
                                      Balance
                                      Sheet(B)
                                    
                                    
                                    Maximum
                                      Exposure
                                      to Loss(C)
                                    
                                    
                                    2008
                                      Loss on
                                      Sale
                                    
                                    
                                    2008
                                      Cash
                                      FlowsResidential
      mortgage loans(D)
                                    
                                    $
                                    8,121,668
                                    
                                    
                                    $
                                    15,919
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    15,919
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    58,891





(A)
            Size/Principal
      Outstanding reflects the estimated principal of the underlying assets held
      by the VIE/SPEs.




(B)
            Assets
      and Liabilities on the Company’s Balance Sheet reflect the effect of
      FIN 39 balance sheet netting, if
  applicable.




(C)
            The
      maximum exposure to loss includes the following: the assets held by the
      Company – including the value of derivatives that are in an asset
      position and retained interests in the VIEs/SPEs; and the notional amount
      of liquidity and other support generally provided through total return
      swaps. The maximum exposure to loss for liquidity and other support
      assumes a total loss on the referenced assets held by the
    VIE.




(D)
            For
      Residential mortgage loans QSPEs, assets on balance sheet are primarily
      securities issued by the entity and are recorded in Mortgage
      securities-available-for-sale and Mortgage
    securities-trading.




In
certain instances, the Company retains interests in the subordinated tranche and
residual tranche of securities issued by VIEs that are created to securitize
assets. The gain or loss on the sale of the assets is determined with reference
to the previous carrying amount of the financial assets transferred, which is
allocated between the assets sold and the retained interests, if any, based on
their relative fair values at the date of transfer.


53





Generally,
retained interests are recorded in the Consolidated Balance Sheets at fair
value. To obtain fair values, observable market prices are used if available.
Where observable market prices are unavailable, the Company generally estimates
fair value based on the present value of expected future cash flows using
management’s best estimates of credit losses, prepayment rates, forward yield
curves, and discount rates, commensurate with the risks involved. Retained
interests are either held as trading assets, with changes in fair value http://www.sec.gov/Archives/edgar/data/65100/000095012309003322/y74695e10vk.htm
- tocpagerecorded in the Consolidated Statements of Earnings, or as
securities available-for-sale, with changes in fair value included in
accumulated other comprehensive loss.




Retained
interests are reviewed periodically for impairment.  Retained interests in
securitized assets held as available-for-sale and trading were approximately
$13.5 million and $58.1 million at December 31, 2008 and December 31,
2007, respectively.




The
following table presents information on retained interests excluding the
offsetting benefit of financial instruments used to hedge risks, held by the
Company as of December 31, 2008 arising from the Company’s residential
mortgage-related securitization transactions. The pre-tax sensitivities of the
current fair value of the retained interests to immediate 10% and 25% adverse
changes in assumptions and parameters are also shown (dollars in
thousands):





Carrying
      amount/fair value of residual interests
                  
                  $
                  13,493Weighted
      average life (in years)
                  
                  
                  2.7Weighted
      average prepayment speed assumption (CPR) (percent)
                  
                  
                  18Fair
      value after a 10% increase in prepayment speed
                  
                  $
                  12,721Fair
      value after a 25% increase in prepayment speed
                  
                  $
                  11,867Weighted
      average expected annual credit losses (percent of current collateral
      balance)
                  
                  
                  24.1Fair
      value after a 10% increase in annual credit losses
                  
                  $
                  11,842Fair
      value after a 25% increase in annual credit losses
                  
                  $
                  10,335Weighted
      average residual cash flows discount rate (percent)
                  
                  
                  24.1Fair
      value after a 500 basis point increase in discount rate
                  
                  $
                  12,859Fair
      value after a 1000 basis point increase in discount rate
                  
                  $
                  12,286Market
      interest rates:Fair
      value after a 100 basis point increase in market rates
                  
                  $
                  7,921Fair
      value after a 200 basis point increase in market rates
                  
                  $
                  5,098


The
preceding sensitivity analysis is hypothetical and should be used with caution.
In particular, the effect of a variation in a particular assumption on the fair
value of the retained interest is calculated independent of changes in any other
assumption; in practice, changes in one factor may result in changes in another,
which might magnify or counteract the sensitivities. Further, changes in fair
value based on a 10% or 25% variation in an assumption or parameter generally
cannot be extrapolated because the relationship of the change in the assumption
to the change in fair value may not be linear. Also, the sensitivity analysis
does not include the offsetting benefit of financial instruments that the
Company utilizes to hedge risks, including credit, interest rate, and prepayment
risk, that are inherent in the retained interests. These hedging strategies are
structured to take into consideration the hypothetical stress scenarios above,
such that they would be effective in principally offsetting the Company’s
exposure to loss in the event that these scenarios
occur.





Note
4. Mortgage Securities – Available-for-Sale





As of
December 31, 2008 and 2007, mortgage securities – available-for-sale consisted
entirely of the Company’s investment in the residual securities issued by
securitization trusts sponsored by the Company, but did not include the NMFT
Series 2007-2 residual security, which was designated as trading as a result of
the Company’s adoption of SFAS 155, “Accounting for Certain Hybrid Financial
Instruments”, an amendment of SFAS 133 and SFAS 140 (“SFAS 155”) on January 1,
2007.  As a result, the NMFT Series 2007-2, residual security
qualifies for the scope exception concerning bifurcation provided by SFAS
155.  Residual securities consist of interest-only, prepayment penalty
and overcollateralization bonds.  Management estimates the fair value
of the residual securities by discounting the expected future cash flows of the
collateral and bonds.





The
following table presents certain information on the Company’s portfolio of
mortgage securities – available-for-sale as of December 31, 2008 and December
31, 2007 (dollars in thousands):





Cost Basis
                  
                  
                  Unrealized
                    Gain
                  
                  
                  Unrealized Losses
                    Less Than Twelve
                    Months
                  
                  
                  Estimated Fair
                    Value
                  
                  
                  Average
                    Yield (A)As
      of December 31, 2008
                  
                  $
                  3,771
                  
                  
                  $
                  9,017
                  
                  
                  
                  -
                  
                  
                  $
                  12,788
                  
                  
                  
                  38.2
                  %As
      of December 31, 2007
                  
                  
                  33,302
                  
                  
                  
                  69
                  
                  
                  
                  -
                  
                  
                  
                  33,371
                  
                  
                  
                  26.9




54




(A)
            The
      average yield is calculated from the cost basis of the mortgage securities
      and does not give effect to changes in fair value that are reflected as a
      component of shareholders’ equity.





During
the years ended December 31, 2008 and 2007 management concluded that the decline
in value on certain securities in the Company’s mortgage securities –
available-for-sale portfolio were other-than-temporary. As a result, the Company
recognized impairments on mortgage securities – available-for-sale of
$23.1 million and $98.7 million during the years ended December 31, 2008
and 2007, respectively.





As of
December 31, 2008 and 2007, respectively, the Company had no available-for-sale
securities with unrealized losses and had no subordinated securities within its
mortgage securities – available-for-sale.





Maturities
of mortgage securities owned by the Company depend on repayment characteristics
and experience of the underlying financial instruments.




Note
5. Mortgage Securities – Trading





As of
December 31, 2008, mortgage securities – trading consisted of the NMFT Series
2007-2 residual security and subordinated securities retained by the Company
from securitization transactions as well as subordinated securities purchased
from other issuers in the open market.  Management estimates the fair
value of the residual securities bydiscounting the expected future cash flows of
the collateral and bonds.  The fair value of the subordinated
securities is estimated based on quoted market prices and compared to estimates
based on discounting the expected future cash flows of the collateral and
bonds.  Refer to Note 10 for a description of the valuation methods as
of December 31, 2008 and December 31, 2007.  The following table
summarizes the Company’s mortgage securities – trading as of December 31, 2008
and December 31, 2007 (dollars in thousands):







Original Face
                                
                                
                                Amortized Cost
                                  Basis
                                
                                
                                Fair Value
                                
                                
                                Average
                                  Yield (A)As
      of December 31, 2008Subordinated
      securities pledged to CDO
                                
                                $
                                332,489
                                
                                
                                $
                                321,293
                                
                                
                                $
                                4,798Other
      subordinated securities
                                
                                
                                102,625
                                
                                
                                
                                96,723
                                
                                
                                
                                1,582Residual
      securities
                                
                                
                                -
                                
                                
                                
                                15,952
                                
                                
                                
                                705Total
                                
                                $
                                435,114
                                
                                
                                $
                                433,968
                                
                                
                                $
                                7,085
                                
                                
                                
                                9.55
                                %As
      of December 31, 2007Subordinated
      securities pledged to CDO
                                
                                $
                                332,489
                                
                                
                                $
                                314,046
                                
                                
                                $
                                60,870Other
      subordinated securities
                                
                                
                                102,625
                                
                                
                                
                                92,049
                                
                                
                                
                                23,592Residual
      securities
                                
                                
                                -
                                
                                
                                
                                41,275
                                
                                
                                
                                24,741Total
                                
                                $
                                435,114
                                
                                
                                $
                                447,370
                                
                                
                                $
                                109,203
                                
                                
                                
                                13.85
                                %








(A)  Calculated
from the ending fair value of the securities.




The
Company recognized net trading losses of $88.7 million and $342.9 million
for the years ended December 31, 2008 and 2007, respectively, which are included
in the fair value adjustments line of the Company’s consolidated statements of
operations.




On
January 1, 2007 the Company transferred two securities with an aggregate fair
value of $46.7 million from “available-for-sale” to the “trading” classification
in accordance with the adoption of SFAS 159. The unrealized losses related to
these securities of $1.1 million were reclassified from other comprehensive
income to accumulated deficit on the consolidated balance sheet as a cumulative
effect adjustment.


55




During
the year ended December 31, 2007, the Company purchased four subordinated bonds
with a fair value at the date of purchase of $22.0 million to include in
NovaStar ABS CDO I.




The
Company sold three subordinated bonds to a third party during the year ended
December 31, 2007 with a fair value of $7.2 million.  The Company
realized losses on the sales of these securities of $3.1 million during the year
ended December 31, 2007, which is included in the fair value adjustments line on
the Company’s consolidated statements of operations.




As of
December 31, 2007 the Company had pledged all of its trading securities as
collateral for financing purposes.  On May 9, 2008, the short-term
borrowings collateralized by the Company’s trading securities were repaid and
the collateral was released back to the Company.  Other than the
subordinated securities pledged to the CDO, there were no trading securities
pledged as collateral as of December 31, 2008.




Note
6. Borrowings




Short-term Borrowings





On May 9,
2008, the Company fully repaid all outstanding borrowings with Wachovia and all
agreements were terminated effective the same day.  As a result, the
Company has no short-term borrowing capacity or agreements currently available
to it.





Junior
Subordinated Debentures





Trust
Preferred Obligations.  NFI’s wholly owned subsidiary NovaStar
Mortgage, Inc. (“NMI”) has approximately $77.3 million in principal amount of
unsecured notes (collectively, the “Notes”) outstanding to NovaStar Capital
Trust I and NovaStar Capital Trust II (collectively, the “Trusts”) which secure
trust preferred securities issued by the Trusts.  The foregoing is net
of amounts owed in respect of trust preferred securities of NovaStar Capital
Trust II having a par value of $6.9 million purchased by NMI on May 29, 2008 for
$0.6 million.  NFI has guaranteed NMI's obligations under the
Notes.





On May
29, 2008, NFI purchased trust preferred securities of NovaStar Capital Trust II
having a par value of $6.9 million for $0.6 million.  As a result,
$6.9 million of principal and accrued interest of $0.2 million of the Notes was
retired and the principal amount, accrued interest, and related unamortized debt
issuance costs related to these Notes were removed from the balance sheet
resulting in a gain of $6.4 million, recorded to the “Gains on debt
extinguishment” line item of the  consolidated statements of
operations.





NMI
failed to make quarterly interest payments that were due on March 30, April 30,
June 30, July 30, September 30, October 30 and December 30, 2008, and January 30
and March 30, 2009 totaling, for all payment dates combined, approximately $6.1
million on the Notes. As a result, NMI was in default under the related
indentures and NFI was in default under the related guarantees as of December
31, 2008.





On June
4, 2008 and August 14, 2008, the Company received written notices of
acceleration from the holders of the trust preferred securities of NovaStar
Capital Trust I and NovaStar Capital Trust II, respectively, which declared all
obligations of NMI under the related Notes and indenture  to be
immediately due and payable, and stated the intention of the trust preferred
security holders to pursue all available rights and remedies, including but not
limited to enforcing their rights under the related guarantee.  The
total principal and accrued interest owed under the Notes, net of amounts owed
in respect of the trust preferred securities held by NMI, was approximately
$84.0 million as of April 27, 2009. In addition, the Company is obligated to
reimburse the trustees for all reasonable expenses, disbursements and advances
in connection with the exercise of rights under the indentures.





On
September 12, 2008, a petition for involuntary Chapter 7 bankruptcy entitled In
re NovaStar Mortgage, Inc. (Case No. 08-12125-CSS) was filed against NMI by the
holders of the trust preferred securities in U.S. Bankruptcy Court for the
District of Delaware in Wilmington, Delaware.  The filing did not include
NFI or any other subsidiary or affiliate of NFI.





On
February 18, 2009, the Company, NMI, the Trusts and the trust preferred security
holders entered into agreements to settle the claims of the trust preferred
security holders arising from NMI’s failure to make the scheduled quarterly
interest payments on the Notes.  As part of the settlement, the
existing preferred obligations would be exchanged for new preferred
obligations.  The settlement and exchange were contingent upon, among
other things, the dismissal of the involuntary Chapter 7
bankruptcy.  On March 9, 2009, the Bankruptcy Court entered an order
dismissing the involuntary proceeding.  On April 24, 2009 (the
“Exchange Date”), the parties executed the necessary documents to complete the
Exchange.  On the Exchange Date, the Company paid interest due through
December 31, 2008, in the aggregate amount of $5.3 million.  In
addition, the Company paid $0.3 million in legal and administrative costs on
behalf of the Trusts.


56





The new
preferred obligations require quarterly distributions of interest to the holders
at a rate equal to 1.0% per annum beginning January 1, 2009 through December 31,
2009, subject to reset to a variable rate equal to the three-month LIBOR plus
3.5% upon the occurrence of an “Interest Coverage Trigger.”   For
purposes of the new preferred obligations, an Interest Coverage Trigger occurs
when the ratio of EBITDA for any quarter ending on or after December 31, 2008
and on or prior to December 31, 2009 to the product as of the last day of such
quarter, of the stated liquidation value of all outstanding 2009 Preferred
Securities (i) multiplied by 7.5%, (ii) multiplied by 1.5 and (iii) divided by
4, equals or exceeds 1.00 to 1.00.   Beginning January 1, 2010
until the earlier of  February 18, 2019 or the occurrence of an
Interest Coverage Trigger, the unpaid principal amount of the new preferred
obligations will bear interest at a rate of 1.0% per annum and, thereafter, at a
variable rate, reset quarterly, equal to the three-month LIBOR plus 3.5% per
annum.





Collateralized
Debt Obligation Issuance (“CDO”)




In the
first quarter of 2007 the Company closed a CDO. The collateral for this
securitization consisted of subordinated securities which the Company retained
from its loan securitizations as well as subordinated securities purchased from
other issuers. This securitization was structured legally as a sale, but for
accounting purposes was accounted for as a financing under SFAS 140. This
securitization did not meet the qualifying special purpose entity criteria under
SFAS 140. Accordingly, the securities remain on the Company’s balance
sheet, retained interests were not created, and securitization bond financing
replaced the short-term debt used to finance the securities. The Company records
interest income on the securities and interest expense on the bonds issued in
the securitization over the life of the related securities and
bonds.





The
Company elected the fair value option for the asset-backed bonds issued from
NovaStar ABS CDO I.. The election was made for these liabilities to help reduce
income statement volatility which otherwise would arise if the accounting method
for this debt was not matched with the fair value accounting for the mortgage
securities - trading.  Fair value is estimated using quoted market
prices. The Company recognized fair value adjustments of $63.0 and $257.1
million for the years ended December 31, 2008 and 2007, respectively, which is
included in the “Fair value adjustments” line item on the consolidated
statements of operations.





On
January 30, 2008, an event of default occurred under the CDO bond indenture
agreement due to the noncompliance of certain overcollateralization
tests.  As a result, the trustee, upon notice and at the direction of
a majority of the secured noteholders, may declare all of the secured notes to
be immediately due and payable including accrued and unpaid
interest.  No such notice has been given as of May 27,
2009.  As there is no recourse to the Company, it does not expect any
significant impact to its financial condition, cash flows or results of
operation as a result of the event of default.





Asset-backed Bonds
(“ABB”).  The Company issued ABB secured by its mortgage loans
and ABB secured by its mortgage securities - trading in certain transactions
treated as financings as a means for long-term non-recourse financing. For
financial reporting purposes, the mortgage loans held-in-portfolio and mortgage
securities - trading, as collateral, are recorded as assets of the Company and
the ABB are recorded as debt. Interest and principal on each ABB is payable only
from principal and interest on the underlying mortgage loans or mortgage
securities collateralizing the ABB. Interest rates reset monthly and are indexed
to one-month LIBOR. The estimated weighted-average months to maturity are based
on estimates and assumptions made by management. The actual maturity may differ
from expectations.





For ABB
secured by mortgage loans, the Company retained a “clean up” call option to
repay the ABB, and reacquire the mortgage loans, when the remaining unpaid
principal balance of the underlying mortgage loans falls below 10% of their
original amounts.  The Company subsequently sold all of these clean up
call rights, to the buyer of our mortgage servicing rights.  The
Company did retain separate independent rights to require the buyer of our
mortgage servicing rights to repurchase loans from the trusts and subsequently
sell them to us; the Company does not expect to exercise any of the call rights
that it retained.  The Company had no ABB transactions for the year
ended December 31, 2008.





The
following table summarizes the CDO and ABB transactions for the year ended
December 31, 2007 (dollars in thousands):





Date Issued
                                      
                                      Bonds Issued
                                        (A)(B)
                                      
                                      Interest Rate Spread
                                        Over LIBOR (A)
                                      
                                      Par Amount of
                                        Collateral
                                        Pledged2007:NovaStar
      ABS CDO I
                                      
                                      February 8, 2007
                                      
                                      $
                                      331,500
                                      
                                      0.32%-2.25%
                                      
                                      $
                                      374,862NHES Series 2007-1
                                      
                                      February 28,
      2007
                                      
                                      
                                      1,794,386
                                      
                                      0.10%-1.75%
                                      
                                      
                                      1,888,756





(A)
            The
      amounts shown do not include subordinated bonds retained by the
      Company.


(B)
            The
      bonds issued for the NHES 2006-MTA1 securitization include $19.2 million
      in Class X Notes. The Class X Notes are AAA-rated and are entitled to
      interest-only cash flows.


57





The
following is a summary of outstanding ABB and related loans (dollars in
thousands):





Asset-backed Bonds
                                      
                                      
                                      Mortgage LoansRemaining
                                        Principal
                                      
                                      
                                      Weighted
                                        Average
                                        Interest
                                        Rate
                                      
                                      
                                      Estimated
                                        Weighted
                                        Average
                                        Months
                                        to Call or
                                        Maturity
                                      
                                      
                                      Remaining
                                        Principal
                                      
                                      
                                      Weighted
                                        Average
                                        CouponAs
      of December 31, 2008:ABB
      Secured by Mortgage Loans:NHES
      Series 2006-1
                                      
                                      $
                                      553,668
                                      
                                      
                                      
                                      0.33
                                      %
                                      
                                      
                                      84
                                      
                                      
                                      $
                                      528,766
                                      
                                      
                                      
                                      8.95
                                      %NHES
      Series 2006-MTA1
                                      
                                      
                                      683,757
                                      
                                      
                                      
                                      0.75
                                      
                                      
                                      
                                      40
                                      
                                      
                                      
                                      680,127
                                      
                                      
                                      
                                      5.80NHES
      Series 2007-1
                                      
                                      
                                      1,372,015
                                      
                                      
                                      
                                      0.78
                                      
                                      
                                      
                                      116
                                      
                                      
                                      
                                      1,320,898
                                      
                                      
                                      
                                      8.76Unamortized
      debt issuance costs, net
                                      
                                      
                                      (10,090
                                      )$
                                      2,599,351ABB
      Secured by Mortgage Securities:NovaStar
      ABS CDO I
                                      
                                      $
                                      325,930
                                      (A)
                                      
                                      
                                      3.08
                                      %
                                      
                                      
                                      26
                                      
                                      
                                      
                                      (B)
                                      
                                      
                                      (B)As
      of December 31, 2007:ABB
      Secured by Mortgage Loans:NHES
      Series 2006-1
                                      
                                      $
                                      716,768
                                      
                                      
                                      
                                      5.17
                                      %
                                      
                                      
                                      24
                                      
                                      
                                      $
                                      694,101
                                      
                                      
                                      
                                      8.49
                                      %NHES
      Series 2006-MTA1
                                      
                                      
                                      750,048
                                      
                                      
                                      
                                      5.14
                                      
                                      
                                      
                                      19
                                      
                                      
                                      
                                      753,787
                                      
                                      
                                      
                                      8.23NHES
      Series 2007-1
                                      
                                      
                                      1,611,592
                                      
                                      
                                      
                                      5.17
                                      
                                      
                                      
                                      30
                                      
                                      
                                      
                                      1,619,849
                                      
                                      
                                      
                                      8.79Unamortized
      debt issuance costs, net
                                      
                                      
                                      (12,662
                                      )$
                                      3,065,746
                                      (A)ABB
      Secured by Mortgage Securities:NovaStar
      ABS CDO I
                                      
                                      $
                                      331,500
                                      
                                      
                                      
                                      5.56
                                      %
                                      
                                      
                                      32
                                      
                                      
                                      
                                      (B)
                                      
                                      
                                      (B)


(A)
              The
      NovaStar ABS CDO I ABB are carried at a fair value of $5.4 million and
      $74.4 million on the Company’s consolidated balance sheet at December 31,
      2008 and 2007, respectively.


(B)
              Collateral
      for the NovaStar ABS CDO I are subordinated mortgage
      securities.





The
following table summarizes the expected repayment requirements relating to the
securitization bond financing at December 31, 2008 (dollars in thousands).
Amounts listed as bond payments are based on anticipated receipts of principal
on underlying mortgage loan and security collateral using expected prepayment
speeds. Principal repayments on these ABB are payable only from the mortgage
loans and securities collateralizing the ABB.   In the event that
principal receipts from the underlying collateral are adversely impacted by
credit losses, there could be insufficient principal receipts available to repay
the ABB principal.




Asset-backed
                            Bonds2009
                          
                          $
                          660,4632010
                          
                          
                          556,2962011
                          
                          
                          371,5972012
                          
                          
                          332,8242013
                          
                          
                          147,498Thereafter
                          
                          
                          867,432$
                          2,936,110





Note
7. Commitments and Contingencies





Commitments. The Company
leases office space under various operating lease agreements. Rent expense for
2008 and 2007, under leases related to continuing operations, aggregated $4.8
million and $3.9 million, respectively. At December 31, 2008, future minimum
lease commitments under those leases are as follows (dollars in
thousands):


58





Lease
                        Obligations2009
                      
                      $
                      4,7182010
                      
                      
                      4,6562011
                      
                      
                      6772012
                      
                      
                      2252013
                      
                      
                      187$
                      10,463





The
Company has entered into various lease agreements pursuant to which the lessor
agreed to repay the Company for certain existing lease
obligations.  The Company has recorded deferred lease incentives
related to these payments which will be amortized into rent expense over the
life of the respective lease on a straight-line basis. There were no deferred
lease incentives related to continuing operations as of December 31,
2008.  The deferred lease incentives related to continuing operations
as of December 31, 2007 was $0.9 million.





There
were no sublease agreements included in continuing operations during 2008. The
Company entered into a sublease agreement during 2007 for office space formerly
occupied by the Company. The Company received approximately $44,000 in 2007
under this agreement.




Contingencies





American
Interbanc Mortgage Litigation.  On March 17, 2008, the Company
and American Interbanc Mortgage, LLC (“Plaintiff”) entered into a Confidential
Settlement Term Sheet Agreement (the “Settlement Terms”) with respect to the
action Plaintiff’s filed in March 2002 against NovaStar Home Mortgage, Inc.
(“NHMI”), a wholly-owned subsidiary of the Company.  The action
resulted in a jury verdict on May 4, 2007, awarding Plaintiff $15.9 million. The
court trebled the award and entered a $46.1 million judgment against Defendants
on June 27, 2007 (the “Judgment”).  On January 23, 2008, Plaintiff
filed an involuntary petition for bankruptcy against NHMI under 11 U.S.C. Sec.
303, in the United States Bankruptcy Court for the Western District of Missouri
(the “Involuntary Bankruptcy”).





Pursuant
to the Settlement Terms agreed to on March 17, 2008, the Involuntary Bankruptcy
was dismissed on April 24, 2008 and on May 8, 2008, the Company paid Plaintiff
$2.0 million.  In addition to the initial payments made to the
Plaintiff following dismissal of the Involuntary Bankruptcy, the Company agreed
to pay Plaintiff $5.5 million if, prior to July 1, 2010, (i) NFI’s average
common stock market capitalization is at least $94.4 million over a period of
five consecutive business days, or (ii) the holders of NFI’s common stock are
paid $94.4 million in net asset value as a result of any sale of NFI or its
assets.  If NFI is sold prior to July 1, 2010 for less than $94.4
million and ceases to be a public company, then NFI will obligate the purchaser
to pay Plaintiff $5.5 million in the event the value of the company exceeds
$94.4 million prior to July 1, 2010 as determined by an independent valuation
company.  As a result of the settlement, during 2008 the
Company reversed a previously recorded liability of $45.2 million that was
included in the consolidated financial statements.





Trust Preferred
Settlement.See Note 6—Borrowings
for a detailed discussion of the settlement terms and restructuring of the
Company’s junior subordinated debentures, including the dismissal of the
involuntary Chapter 7 bankruptcy filed against NovaStar Mortgage, Inc. (Case No.
08-12125-CSS) by the holders of the trust preferred securities in U.S.
Bankruptcy Court for the District of Delaware in Wilmington.





Other
Litigation.  Since April 2004,
a number of substantially similar class action lawsuits have been filed and
consolidated into a single action in the United States District Court for the
Western District of Missouri. The consolidated complaint names the Company and
three of the Company’s current and former executive officers as defendants and
generally alleges that the defendants made public statements that were
misleading for failing to disclose certain regulatory and licensing matters. The
plaintiffs purport to have brought this consolidated action on behalf of all
persons who purchased the Company’s common stock (and sellers of put options on
the Company’s common stock) during the period October 29, 2003 through April 8,
2004. On January 14, 2005, the Company filed a motion to dismiss
this action, and on May 12, 2005, the court denied such motion. On February
8, 2007, the court certified the case as a class action. The Company has entered
into a settlement agreement to resolve these pending class action lawsuits. The
total amount of the settlement is $7.25 million, and it will be paid by the
Company’s insurance carriers. The settlement agreement contains no admission of
fault or wrongdoing by the Company or other defendants. On April 28, 2009, the
Court approved the settlement.




At this
time, the Company cannot predict the probable outcome of the following claims
and as such no amounts have been accrued in the consolidated financial
statements.





In
February 2007, a number of substantially similar putative class actions were
filed in the United States District Court for the Western District of Missouri.
The complaints name the Company and three of the Company’s former and current
executive officers as defendants and generally allege, among other things, that
the defendants made materially false and misleading statements regarding the
Company’s business and financial results. The plaintiffs purport to have brought
the actions on behalf of all persons who purchased or otherwise acquired the
Company’s common stock during the period May 4, 2006 through February 20, 2007.
Following consolidation of the actions, a consolidated amended complaint was
filed on October 19, 2007.  On December 29, 2007, the defendants moved
to dismiss all of plaintiffs’ claims.  On June 4, 2008, the Court
dismissed the plaintiffs’ complaints without leave to amend.  The
plaintiffs have filed an appeal of the Court’s ruling.


59





In May
2007, a lawsuit entitled National Community Reinvestment
Coalition v. NovaStar Financial, Inc., et al., was filed against the
Company in the United States District Court for the District of
Columbia.  Plaintiff, a non-profit organization, alleges that the
Company maintains corporate policies of not making loans on Indian reservations,
on dwellings used for adult foster care or on rowhouses in Baltimore, Maryland
in violation of the federal Fair Housing Act. The lawsuit seeks injunctive
relief and damages, including punitive damages, in connection with the
lawsuit.  On May 30, 2007, the Company responded to the lawsuit by
filing a motion to dismiss certain of plaintiff’s claims.  On March
31, 2008 that motion was denied by the Court.  The Company believes
that these claims are without merit and will vigorously defend against
them.





On
January 10, 2008, the City of Cleveland, Ohio filed suit against the Company and
approximately 20 other mortgage, commercial and investment bankers alleging a
public nuisance had been created in the City of Cleveland by the operation of
the subprime mortgage industry.   The case was filed in state
court and promptly removed to the United States District Court for the Northern
District of Ohio.  The plaintiff seeks damages for loss of property
values in the City of Cleveland, and for increased costs of providing services
and infrastructure, as a result of foreclosures of subprime
mortgages.  On October 8, 2008, the City of Cleveland filed an amended
complaint in federal court which did not include claims against the Company but
made similar claims against NovaStar Mortgage, Inc., a wholly owned subsidiary
of NFI. On November 24, 2008 the Company filed a motion to
dismiss.  On May 15, 2009 the Court granted Company’s motion to
dismiss.  The City of Cleveland has filed a notice of intent to
appeal.  The Company believes that these claims are without merit and will
vigorously defend against them.





On
January 31, 2008, two purported shareholders filed separate derivative actions
in the Circuit Court of Jackson County, Missouri against various former and
current officers and directors and named the Company as a nominal
defendant.  The essentially identical petitions seek monetary damages
alleging that the individual defendants breached fiduciary duties owed to the
Company, alleging insider selling and misappropriation of information, abuse of
control, gross mismanagement, waste of corporate assets, and unjust enrichment
between May 2006 and December 2007.    On June 24, 2008 a
third, similar case was filed in United States District Court for the Western
District of Missouri.  The Company believes that these claims are
without merit and will vigorously defend against them.





On May 6,
2008, the Company received a letter written on behalf of J.P. Morgan Mortgage
Acceptance Corp. and certain affiliates ("Morgan") demanding indemnification for
claims asserted against Morgan in a case entitled Plumbers & Pipefitters
Local #562 Supplemental Plan and Trust v. J.P. Morgan Acceptance Corp. et al,
filed in the Supreme Court of the State of New York, County of
Nassau.   The case seeks class action certification for alleged
violations by Morgan of sections 11 and 15 of the Securities Act of 1933, on
behalf of all persons who purchased certain categories of mortgage backed
securities issued by Morgan in 2006 and 2007.   Morgan's indemnity
demand alleges that any liability it might have to plaintiffs would be based, in
part, upon alleged misrepresentations made by the Company with respect to
certain mortgages that make up a portion of the collateral for the securities at
issue.  The Company believes it has meritorious defenses to this demand and
expects to defend vigorously any claims asserted.




On May
21, 2008, a purported class action case was filed in the Supreme Court of the
State of New York, New York County, by the New Jersey Carpenters' Health Fund,
on behalf of itself and all others similarly situated.   Defendants in
the case include NovaStar Mortgage Funding Corporation and its individual
directors, several securitization trusts sponsored by the Company, and several
unaffiliated investment banks and credit rating agencies.   The case
was removed to the United States District Court for the Southern District of New
York, and plaintiff has filed a motion to remand the case to state court. 
Plaintiff seeks monetary damages, alleging that the defendants violated sections
11, 12 and 15 of the Securities Act of 1933 by making allegedly false statements
regarding mortgage loans that served as collateral for securities purchased by
plaintiff and the purported class members.  Pursuant to a stipulation,
the Company has not yet filed its initial responsive pleading, and discovery is
not yet underway.   The Company believes it has meritorious defenses
to the case and expects to defend the case vigorously.




On July
7, 2008, plaintiff Jennifer Jones filed a purported class action case in the
United States District Court for the Western District of Missouri against the
Company, certain former and current officers of the Company, and unnamed members
of the Company's "Retirement Committee".   Plaintiff, a former
employee of the Company, seeks class action certification on behalf of all
persons who were participants in or beneficiaries of the Company's 401(k) plan
from May 4, 2006 until November 15, 2007 and whose accounts included investments
in the Company's common stock.  Plaintiff seeks monetary damages alleging
that the Company's common stock was an inappropriately risky investment option
for retirement savings, and that defendants breached their fiduciary duties by
allowing investment of some of the assets contained in the 401(k) plan to be
made in the Company's common stock.   On November 12, 2008, the
Company filed a motion to dismiss which was denied by the Court on February 11,
2009.  On April 6, 2009 the Court granted the plaintiff’s motion for
class certification.  The Company sought permission from the 8th Circuit
Court of Appeals to appeal the order granting class certification.  On May
11, 2009 the Court of Appeals granted the Company permission to appeal the class
certification order.  The Company believes it has meritorious defenses
to the case and expects to defend the case vigorously.


60





On
October 21, 2008, EHD Holdings, LLC, the purported owner of the building which
leases the Company its former principal office space in Kansas City, filed an
action for unpaid rent in the Circuit Court of Jackson County,
Missouri.    On April 24, 2009, EHD Holdings, LLC filed a
motion for summary judgment seeking approximately $3.3 million, in past due rent
and charges, included in the Accounts payable and other liabilities line
item of the balance sheet, plus accruing rent and charges for future periods,
plus attorney fees.





In
addition to those matters listed above, the Company is currently a party to
various other legal proceedings and claims, including, but not limited to,
breach of contract claims, tort claims, and claims for violations of federal and
state consumer protection laws.  Furthermore, the Company has received
indemnification and loan repurchase demands with respect to alleged violations
of representations and warranties made in loan sale and securitization
agreements.  These indemnification and repurchase demands have been
addressed without significant loss to the Company, but such claims can be
significant when multiple loans are involved.  Deterioration of the
housing market may increase the risk of such claims.





In
addition, the Company has received requests or subpoenas for information from
various regulators or law enforcement officials, including, without limitation
the Federal Bureau of Investigation and the Department of
Labor.  Management does not expect any significant negative impact to
the Company as a result of these requests and subpoenas.





Note
8. Shareholders’ Equity





The Board
of Directors declared a one-for-four reverse stock split of the Company’s common
stock, providing shareholders of record as of July 27, 2007, with one share of
common stock in exchange for each four shares owned.  The reduction in
shares resulting from the split was effective on July 27, 2007 decreasing the
number of common shares outstanding to 9.5 million.  Current and prior
year share amounts and earnings per share disclosures have been restated to
reflect the reverse stock split.





On July
16, 2007, the Company entered into a Securities Purchase Agreement (the
“Securities Purchase Agreement”) pursuant to which certain investors purchased
for $48.8 million in cash 2,100,000 shares of the Company’s 9.00% Series D1
Mandatory Convertible Preferred Stock, having a par value $0.01 per share and
initial liquidation preference of $25.00 per share (“Series D1 Preferred
Stock”), in a private placement not registered under the Securities Act of
1933.  The Company used the proceeds from the sale of the Series D1
Preferred Stock under the Securities Purchase Agreement for general working
capital.





To preserve liquidity, the
Company’s Board of Directors has suspended the payment of dividends on its 8.9%
Series C Cumulative Redeemable Preferred Stock (the “Series C Preferred Stock”)
and its Series D1 Mandatory Convertible Preferred Stock (the “Series D1
Preferred Stock”).As a result, dividends continue to accrue
on the Series C Preferred Stock and Series D1 Preferred Stock.  The Company has total
accrued dividends payable related to the Series C Preferred Stock and Series D1
Preferred Stock of $25.1 million as of May 27, 2009.  All
accrued and unpaid dividends on the Company’s preferred stock must be paid prior
to any payments of dividends or other distributions on the Company’s common
stock.  In addition, if at any time dividends on the Series C
Preferred Stock are in arrears for six or more quarterly periods (whether or not
consecutive), the holders of the Series C Preferred Stock, voting as a single
class, have the right to elect two additional directors to the Company’s Board
of Directors.  The Company does not expect to pay any dividends for
the foreseeable future.





Dividends
on the Series C Preferred Stock are payable in cash and accrue at a rate of
8.90% annually.  Accrued and unpaid dividends payable related to the
Series C Preferred Stock were approximately $8.3 million as of December 31, 2008
and $11.0 million as of May 27, 2009.





On March
17, 2009, the Company notified the holders of the Series C Preferred Stock that
the Company would not make the dividend payment on the Series C Preferred Stock
due on March 31, 2009.  Because dividends on the Series C Preferred
Stock are presently in arrears for six quarters, under the terms of the Articles
Supplementary to the Company’s Charter that established the Series C Preferred
Stock, the holders of the Series C Preferred Stock had the right, as of March
31, 2009, to elect two additional directors to the Company’s board of
directors.  The notice also allowed the holders of the Series C
Preferred Stock to make nominations for the election of the two additional
directors to occur by vote of the holders of the Series C Preferred Stock at the
Company’s next annual meeting of stockholders.





Dividends
on the Series D1 Preferred Stock are payable in cash and accrue at a rate of
9.00% per annum, or 13.00% per annum if any such dividends are not declared and
paid when due.  In addition, holders of the Series D1 Preferred Stock
are entitled to participate in any common stock dividends on an as converted
basis.  The Company’s board of directors has suspended the payment of
dividends on the Company’s Series D1 Preferred Stock.  As a result,
dividends continue to accrue on the Series D1 Preferred Stock, and the dividend
rate on the Series D1 Preferred Stock increased from 9.0% to 13.0%, compounded
quarterly, effective October 16, 2007 with respect to all unpaid dividends and
subsequently accruing dividends.  Accrued and unpaid
dividends payable related to the Series D1 Preferred Stock were approximately
$10.8 million as of December 31, 2008 and $14.1 million as of May 27,
2009.


61





The
Series D1 Preferred Stock is convertible into the Company’s 9.00% Series D2
Mandatory Convertible Preferred Stock having a par value of $0.01 per share and
an initial liquidation preference of $25.00 per share (“Series D2 Preferred
Stock”) upon the later of (a) July 16, 2009, or (b) the date on which the
stockholders of the Company approve certain anti-dilution protection for the
Series D1 Preferred Stock and Series D2 Preferred Stock that, upon such
shareholder approval, would apply in the event the Company issues additional
common stock for a price below the price at which the Series D1 Preferred Stock
(or the Series D2 Preferred Stock into which the Series D1 Preferred Stock has
been converted, if any) may be converted into common stock.  The
rights, powers and privileges of the Series D2 Preferred Stock are substantially
similar to those of the Series D1 Preferred Stock, except that accrued and
unpaid dividends on the Series D2 Preferred Stock can be added to the common
stock conversion and liquidation valueof the Series D2
Preferred Stock in lieu of cash payment, and the dividend rate on the Series D2
Preferred Stock is fixed in all circumstances at 9.00%.





The
Series D1 Preferred Stock (or the Series D2 Preferred Stock into which the
Series D1 Preferred stock has been converted, if any) is convertible into the
Company’s common stock at any time at the option of the holders.  The
Series D1 Preferred Stock (or the Series D2 Preferred Stock into which the
Series D1 Preferred stock has been converted, if any) is currently
convertible into 1,875,000 shares (post-split) of common stock based upon an
initial conversion price of $28.00 per share (post-split), subject to adjustment
as provided above or certain other extraordinary events.  On or prior
to July 16, 2010, the Company may elect to convert all of the Series D1
Preferred Stock (or the Series D2 Preferred Stock into which the Series D1
Preferred stock has been converted, if any) into common stock, if at such time
the Company’s common stock is publicly traded and the common stock price is
greater than 200% of the then existing conversion price for 40 of 50 consecutive
trading days preceding delivery of the forced conversion notice.  On
July 16, 2016, the Series D1 Preferred Stock (or the Series D2 Preferred Stock
into which the Series D1 Preferred stock has been converted, if any) will
automatically convert into shares of common stock.





Because
the conversion price of $28.00 was less than the closing price of the Company’s
common stock on July 16, 2007 of $30.04, the conversion feature, as discussed
above, was considered to be in-the-money.  As a result, the Company
recorded a beneficial conversion feature of $3.8 million at the date of issuance
which represents the product of the closing price ($30.04) less the conversion
price ($28.00) multiplied by the conversion shares (1,875,000).  The
beneficial conversion was recorded to additional paid-in capital and accumulated
deficit which resulted in no change to total shareholders’ (deficit)
equity.





The
Company’s Direct Stock Purchase and Dividend Reinvestment Plan (“DRIP”) allows
for the purchase of stock directly from the Company and/or the automatic
reinvestment of all or a percentage of the dividends shareholders receive and
allows for a discount from market of up to 3%. During 2007 the Company sold
35,094 shares of its common stock under the DRIP at a weighted average discount
of 0%, resulting in net proceeds of $3.2 million. The Company suspended the DRIP
in 2007.





During
the year ended December 31, 2008 there were no shares of common stock issued
under the Company’s stock-based compensation plan.  For the year end
December 31, 2007,  88,867 shares of common stock, with proceeds of
$0.2 million, were issued under the Company’s stock-based compensation
plan,




The
Company’s Board of Directors has approved the purchase of up to $9 million of
the Company’s common stock. No shares were repurchased during 2008 and
2007.  Under Maryland law, shares purchased under this plan are to be
returned to the Company’s authorized but unissued shares of common stock. Common
stock purchased under this plan is charged against additional paid-in
capital.




Note
9. Comprehensive Income




Comprehensive
income includes revenues, expenses, gains and losses that are not included in
net income. The following is a rollforward of accumulated other comprehensive
income for the two years ended December 31, 2008 (dollars in
thousands):





For the Year Ended
                      December 31,2008
                    
                    
                    2007Net
      loss
                    
                    $
                    (660,482
                    )
                    
                    $
                    (724,277
                    )Other
      comprehensive income (loss):Change
      in unrealized loss on mortgage securities –
    available-for-sale
                    
                    
                    (14,152
                    )
                    
                    
                    (138,306
                    )Change
      in unrealized gain on derivative instruments used in cash flow
      hedges
                    
                    
                    (1,364
                    )
                    
                    
                    (736
                    )Impairment
      on mortgage securities - available-for-sale reclassified to
      earnings
                    
                    
                    23,100
                    
                    
                    
                    98,692Valuation
      allowance for deferred taxes
                    
                    
                    -
                    
                    
                    
                    1,855Net
      settlements of derivative instruments used in cash flow hedges
      reclassified to earnings
                    
                    
                    2,459
                    
                    
                    
                    (301
                    )Other
      comprehensive income (loss)
                    
                    
                    10,043
                    
                    
                    
                    (38,796
                    )Total
      comprehensive loss
                    
                    $
                    (650,439
                    )
                    
                    $
                    (763,073
                    )





62





Note
10. Fair Value Accounting





Effective
January 1, 2007, the Company adopted SFAS 157 and SFAS 159. Both
standards address aspects of the expanding application of fair value
accounting.





Fair
Value Measurements (SFAS 157)





SFAS 157
defines fair value, establishes a consistent framework for measuring fair value
and expands disclosure requirements about fair value measurements.
SFAS 157, among other things, requires the Company to maximize the use of
observable inputs and minimize the use of unobservable inputs when measuring
fair value.





These
valuation techniques are based upon observable and unobservable inputs.
Observable inputs reflect market data obtained from independent sources, while
unobservable inputs reflect the Company's market assumptions. These two types of
inputs create the following fair value hierarchy:





·
            Level
      1—Quoted prices for identical instruments in active
  markets


·
            Level
      2—Quoted prices for similar instruments in active markets; quoted prices
      for identical or similar instruments in markets that are not active; and
      model-derived valuations whose inputs are observable or whose significant
      value drivers are observable.


·
            Level
      3—Instruments whose significant value drivers are
      unobservable.





The
Company determines fair value based upon quoted prices when available or through
the use of alternative approaches, such as discounting the expected cash flows
using market interest rates commensurate with the credit quality and duration of
the investment. The methods the Company uses to determine fair value on an
instrument specific basis are detailed in the section titled “Valuation
Methods”, below.





The
Company recognized a cumulative-effect adjustment resulting from the Company’s
change in policies to measure fair value of trading securities upon adoption of
SFAS 157.  Specifically, the Company began using quoted market prices
which constitute the Company’s highest and best execution for its trading
securities as compared to the midpoint of mid-market pricing which was used at
December 31, 2006.





Detailed
below are the December 31, 2006 carrying values prior to adoption, the
transition adjustments recorded to opening accumulated deficit and the fair
values (that is, the carrying values at January 1, 2007 after adoption) for
the trading securities the Company held at January 1, 2007 (dollars in
thousands):





Description
                  
                  December 31,
                    2006 (Carrying
                    value prior to
                    adoption)
                  
                  
                  Cumulative-effect
                    Adjustment to
                    January 1, 2007
                    Accumulated Deficit
                  
                  
                  January 1, 2007
                    (Carrying value
                    after adoption)Mortgage
      securities – trading
                  
                  $
                  329,361
                  
                  
                  $
                  5,430
                  
                  
                  $
                  334,791





The
following tables present for each of the fair value hierarchy levels, the
Company’s assets and liabilities related to continuing operations which are
measured at fair value on a recurring basis as of December 31, 2008 and 2007
(dollars in thousands):





Fair Value Measurements at Reporting Date UsingDescription
                          
                          Fair Value at
                            December 31,
                            2008
                          
                          
                          Quoted Prices in
                            Active Markets
                            for Identical
                            Assets
                            (Level 1)
                          
                          
                          Significant
                            Other
                            Observable
                            Inputs (Level 2)
                          
                          
                          Significant
                            Unobservable
                            Inputs (Level 3)AssetsMortgage
      securities -trading
                          
                          $
                          7,085
                          
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          7,085Mortgage
      securities – available-for-sale
                          
                          
                          12,788
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          12,788Total
      Assets
                          
                          $
                          20,066
                          
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          20,066LiabilitiesAsset-backed
      bonds secured by mortgage securities
                          
                          $
                          5,376
                          
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          5,376Derivative
      instruments, net
                          
                          
                          9,102
                          
                          
                          
                          
                          
                          
                          
                          9,102Total
      Liabilities
                          
                          $
                          14,478
                          
                          
                          $
                          -
                          
                          
                          $
                          9,102
                          
                          
                          $
                          5,376





63





Description
                          
                          Fair Value at
                            December 31,
                            2007
                          
                          
                          Quoted Prices in
                            Active Markets
                            for Identical
                            Assets
                            (Level 1)
                          
                          
                          Significant
                            Other
                            Observable
                            Inputs (Level 2)
                          
                          
                          Significant
                            Unobservable
                            Inputs (Level 3)AssetsMortgage
      securities -trading
                          
                          $
                          109,203
                          
                          
                          $
                          -
                          
                          
                          $
                          84,462
                          
                          
                          $
                          24,741Mortgage
      securities – available-for-sale
                          
                          
                          33,371
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          33,371Derivative
      instruments, net
                          
                          
                          (6,896
                          )
                          
                          
                          -
                          
                          
                          
                          (6,896
                          )
                          
                          
                          -Total
      Assets
                          
                          $
                          135,678
                          
                          
                          $
                          -
                          
                          
                          $
                          77,566
                          
                          
                          $
                          58,112LiabilitiesAsset-backed
      bonds secured by mortgage securities
                          
                          $
                          74,385
                          
                          
                          $
                          -
                          
                          
                          $
                          74,385
                          
                          
                          $
                          -





The
following tables provides a reconciliation of the beginning and ending balances
for the Company’s mortgage securities – trading which are measured at fair value
on a recurring basis using significant unobservable inputs (Level 3) from
December 31, 2006 to December 31, 2008 (dollars in thousands):





Cost Basis
                      
                      
                      Unrealized
                        Loss
                      
                      
                      Estimated Fair
                        Value of
                        Mortgage
                        SecuritiesAs
      of December 31, 2007
                      
                      $
                      41,275
                      
                      
                      $
                      (16,534
                      )
                      
                      $
                      24,741Increases
      (decreases) to mortgage securities-trading:Securities
      transferred from level 2 to level 3
                      
                      
                      414,080
                      
                      
                      
                      (395,359
                      )
                      
                      
                      18,721Accretion
      of income
                      
                      
                      23,652
                      
                      
                      
                      -
                      
                      
                      
                      23,652Proceeds
      from paydowns of securities
                      
                      
                      (45,039
                      )
                      
                      
                      -
                      
                      
                      
                      (45,039
                      )Mark-to-market
      value adjustment
                      
                      
                      -
                      
                      
                      
                      (14,990
                      )
                      
                      
                      (14,990
                      )Net
      increase (decrease) to mortgage securities
                      
                      
                      392,693
                      
                      
                      
                      (410,349
                      )
                      
                      
                      (17,656
                      )As
      of  December 31, 2008
                      
                      $
                      433,968
                      
                      
                      $
                      (426,883
                      )
                      
                      $
                      7,085





Cost Basis
                      
                      
                      Unrealized
                        Loss
                      
                      
                      Estimated Fair
                        Value of
                        Mortgage
                        SecuritiesAs
      of December 31, 2006
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -Increases
      (decreases) to mortgage securities-trading:New
      securities retained in securitizations
                      
                      
                      56,387
                      
                      
                      
                      226
                      
                      
                      
                      56,613Accretion
      of income
                      
                      
                      3,102
                      
                      
                      
                      -
                      
                      
                      
                      3,102Proceeds
      from paydowns of securities
                      
                      
                      (18,214
                      )
                      
                      
                      -
                      
                      
                      
                      (18,214
                      )Mark-to-market
      value adjustment
                      
                      
                      -
                      
                      
                      
                      (16,760
                      )
                      
                      
                      (16,760
                      )Net
      increase (decrease) to mortgage securities
                      
                      
                      41,275
                      
                      
                      
                      (16,534
                      )
                      
                      
                      24,741As
      of  December 31, 2007
                      
                      $
                      41,275
                      
                      
                      $
                      (16,534
                      )
                      
                      $
                      24,741





The
following tables provide a reconciliation of the beginning and ending balances
for the Company’s mortgage securities – available-for-sale which are measured at
fair value on a recurring basis using significant unobservable inputs (Level 3)
from December 31, 2007 to December 31, 2008 and December 31, 2006 to December
31, 2007 (dollars in thousands):





Cost Basis
                  
                  
                  Unrealized
                    Gain
                  
                  
                  Estimated Fair
                    Value of
                    Mortgage
                    SecuritiesAs
      of December 31, 2007
                  
                  $
                  33,302
                  
                  
                  $
                  69
                  
                  
                  $
                  33,371Increases
      (decreases) to mortgage securities:Accretion
      of income (A)
                  
                  
                  7,988
                  
                  
                  
                  -
                  
                  
                  
                  7,988Proceeds
      from paydowns of securities (A) (B)
                  
                  
                  (14,419
                  )
                  
                  
                  -
                  
                  
                  
                  (14,419
                  )Impairment
      on mortgage securities - available-for-sale
                  
                  
                  (23,100
                  )
                  
                  
                  -
                  
                  
                  
                  (23,100
                  )Mark-to-market
      value adjustment
                  
                  
                  -
                  
                  
                  
                  8,948
                  
                  
                  
                  8,948Net
      decrease to mortgage securities
                  
                  
                  (29,531
                  )
                  
                  
                  8,948
                  
                  
                  
                  (20,583
                  )As
      of  December 31, 2008
                  
                  $
                  3,771
                  
                  
                  $
                  9,017
                  
                  
                  $
                  12,788





64





(A)
            Cash
      received on mortgage securities with no cost basis was $3.4 million for
      the year ended December 31, 2008.


(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, which are included in the other assets
      line on the Company’s consolidated balance sheets.  As of
      December 31, 2008 the Company had no receivables from securitization
      trusts related to mortgage securities available-for-sale with a remaining
      or zero cost basis.





Cost Basis
                        
                        
                        Unrealized
                          Gain
                        
                        
                        Estimated Fair
                          Value of
                          Mortgage
                          SecuritiesAs
      of December 31, 2006
                        
                        $
                        310,760
                        
                        
                        $
                        38,552
                        
                        
                        $
                        349,312Increases
      (decreases) to mortgage securities:Transfer
      to mortgage securities – trading upon adoption of SFAS 159
                        
                        
                        (47,814
                        )
                        
                        
                        1,131
                        
                        
                        
                        (46,683
                        )Accretion
      of income (A)
                        
                        
                        48,778
                        
                        
                        
                        -
                        
                        
                        
                        48,778Proceeds
      from paydowns of securities (A) (B)
                        
                        
                        (179,730
                        )
                        
                        
                        -
                        
                        
                        
                        (179,730
                        )Impairment
      on mortgage securities - available-for-sale
                        
                        
                        (98,692
                        )
                        
                        
                        98,692
                        
                        
                        
                        -Mark-to-market
      value adjustment
                        
                        
                        -
                        
                        
                        
                        (138,306
                        )
                        
                        
                        (138,306
                        )Net
      decrease to mortgage securities
                        
                        
                        (277,458
                        )
                        
                        
                        (38,483
                        )
                        
                        
                        (315,941
                        )As
      of  December 31, 2007
                        
                        $
                        33,302
                        
                        
                        $
                        69
                        
                        
                        $
                        33,371





(A)
            Cash
      received on mortgage securities with no cost basis was $3.5 million for
      the year ended December 31, 2007.


(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, which are included in the other assets
      line on the Company’s consolidated balance sheets.  As of
      December 31, 2007, the Company had receivables from securitization trusts
      of $12.5 million, related to mortgage securities available-for-sale with a
      remaining cost basis. At December 31, 2007 there were no receivables from
      securitization trusts related to mortgage securities with a zero cost
      basis.





The
following tables provides quantitative disclosures about the fair value
measurements for the Company’s assets related to continuing operations which are
measured at fair value on a nonrecurring basis as of December 31, 2008 and 2007
(dollars in thousands):




Fair Value Measurements at Reporting Date UsingDescription
                      
                      Fair Value at
                        December 31,
                        2008
                      
                      
                      Quoted Prices in
                        Active Markets
                        for Identical
                        Assets
                        (Level 1)
                      
                      
                      Significant
                        Other
                        Observable
                        Inputs (Level 2)
                      
                      
                      Significant
                        Unobservable
                        Inputs (Level 3)Real
      estate owned
                      
                      $
                      70,480
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      70,480





Description
                      
                      Fair Value at
                        December 31,
                        2007
                      
                      
                      Quoted Prices in
                        Active Markets
                        for IdenticalAssets
                        (Level 1)
                      
                      
                      SignificantOther
                        Observable
                        Inputs (Level 2)
                      
                      
                      Significant
                        Unobservable
                        Inputs (Level 3)Real estate
      owned
                      
                      $
                      76,614
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      76,614


65





At the
time a mortgage loan held-in-portfolio becomes real estate owned, the Company
records the property at the lower of its carrying amount or fair
value.  Upon foreclosure and through liquidation, the Company
evaluates the property's fair value as compared to its carrying amount
and records a valuation adjustment when the carrying amount exceeds fair
value.  Any valuation adjustments at the time the loan becomes real estate
owned is charged to the allowance for credit losses.





The
following table provides a summary of the impact to earnings for the year ended
December 31, 2008 from the Company’s assets and liabilities which are measured
at fair value on a recurring and nonrecurring basis as of December 31, 2008
(dollars in thousands):





Fair Value Adjustments
                                                For the Year Ended
                                                December 31Asset or Liability Measured at
                                                Fair Value
                                              
                                              Fair Value
                                                Measurement
                                                Frequency
                                              
                                              2008
                                              
                                              
                                              2007
                                              
                                              Statement of Operation Line
                                                Item ImpactedMortgage
      securities - trading
                                              
                                              Recurring
                                              
                                              $
                                              (88,715
                                              )
                                              
                                              $
                                              (342,918
                                              )
                                              Fair
      value adjustmentsMortgage
      securities – available-for-sale
                                              
                                              Recurring
                                              
                                              
                                              (23,100
                                              )
                                              
                                              
                                              (98,692
                                              )
                                              Impairment
      on mortgage securities – available-for-saleDerivative
      instruments, net
                                              
                                              Recurring
                                              
                                              
                                              (2,627
                                              )
                                              
                                              
                                              (14,027
                                              )
                                              (Losses)
      gains on derivative instrumentsAsset-backed
      bonds secured by mortgage securities
                                              
                                              Recurring
                                              
                                              
                                              62,973
                                              
                                              
                                              
                                              257,115
                                              
                                              Fair
      value adjustmentsTotal
      fair value gains (losses)
                                              
                                              
                                              
                                              $
                                              (51,469
                                              )
                                              
                                              $
                                              (198,522
                                              )





Valuation
Methods





Mortgage securities – trading.Trading securities are recorded at fair value with gains and losses,
realized and unrealized, included in earnings.  The Company uses the
specific identification method in computing realized gains or
losses.  Prior to September 30, 2008, the Company estimated fair value
for its subordinated securities solely from quoted market
prices.  Commencing September 30, 2008, the Company estimated fair
value for its subordinated securities based on quoted market prices compared to
estimates based on discounting the expected future cash flows of the collateral
and bonds.  The Company determined this change in valuation method
caused a change from Level 2 to Level 3 due to the unobservable inputs used by
the Company in determining the expected future cash flows.  The
Company determined its valuation methodology for residual securities would also
qualify as Level 3.





The
Company recorded a cumulative-effect adjustment to its accumulated deficit of
$5.4 million which represented a gain on its mortgage securities - trading as
part of the adoption of FAS 157 on January 1, 2007. This cumulative-effect
adjustment resulted from the Company’s change in policies to use quoted market
prices which constitute the Company’s highest and best execution as compared to
the midpoint of mid-market pricing at December 31, 2006.





In
addition, upon the closing of its NMFT Series 2007-2 securitization, the Company
classified the residual security it retained as trading.  Management
estimates the fair value of its residual securities by discounting the expected
future cash flows of the collateral and bonds.  Due to the
unobservable inputs used by the Company in determining the expected future cash
flows, the Company determined its valuation methodology for residual securities
would qualify as Level 3.  See “Mortgage securities –
available-for-sale" for further discussion of the Company’s valuation policies
relating to residual securities.





Mortgage securities –
available-for-sale.Mortgage securities – available-for-sale represent
beneficial interests theCompany retains in
securitization and resecuritization transactions which include residual
securities. The Company had no subordinated securities included within the
mortgage securities – available-for-sale classification as of December 31,
2008.  Mortgage securities classified as available-for-sale are
reported at their estimated fair value with unrealized gains and losses reported
in accumulated other comprehensive income. To the extent that the cost basis of
mortgage securities 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. The specific identification method is used in
computing realized gains or losses. The Company uses two methodologies for
determining the initial value of its residual securities 1) the whole loan price
methodology and 2) the discount rate methodology. The Company believes the best
estimate of the initial value of the residual securities it retains in its
securitizations accounted for as sales is derived from the market value of the
pooled loans. As such, the Company generally will try to use the whole loan
price methodology when significant open market sales pricing data is available.
Under this method, the initial value of the loans transferred in a
securitization accounted for as a sale is estimated based on the expected open
market sales price of a similar pool. In open market transactions, the purchaser
has the right to reject loans at its discretion. In a loan securitization, loans
generally cannot be rejected. As a result, the Company adjusts 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 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.


66





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





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





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





Derivative instruments.The
fair value of derivative instruments is estimated by discounting the projected
future cash flows using appropriate market rates.





Asset-backed bonds secured by
mortgage securities.See discussion under Fair Value Option for Financial
Assets and Financial Liabilities (SFAS 159).





Real estate owned.  Real estate owned is carried at the lower of cost or fair
value less estimated selling costs.  The Company estimates fair value
at the asset’s liquidation value less selling costs using management’s
assumptions which are based on historical loss severities for similar
assets.





Fair
Value Option for Financial Assets and Financial Liabilities
(SFAS 159)





Under
SFAS 159, the Company may elect to report most financial instruments and
certain other items at fair value on an instrument-by-instrument basis with
changes in fair value reported in earnings. After the initial adoption, the
election is made at the acquisition of an eligible financial asset, financial
liability, or firm commitment or when certain specified reconsideration events
occur. The fair value election may not be revoked once an election is
made.





Additionally,
the transition provisions of SFAS 159 permit a one-time election for
existing positions at the adoption date with a cumulative-effect adjustment
included in opening retained earnings and future changes in fair value reported
in earnings.





On
January 1, 2007, the Company adopted the provisions of SFAS 159. The Company
elected the fair value option for the asset-backed bonds issued from NovaStar
ABS CDO I, which closed in the first quarter of 2007. The Company elected the
fair value option for these liabilities to help reduce earnings volatility which
otherwise would arise if the accounting method for this debt was not matched
with the fair value accounting for the related mortgage securities -
trading.  The asset-backed bonds which are being carried at fair value
are included in the “Asset-backed bonds secured by mortgage securities“ line
item on the consolidated balance sheets.  The Company recognized a
fair value adjustment of $63.0 million and $257.1 million for the year ended
December 31, 2008 and 2007, respectively, which is included in the “Fair value
adjustments” line item on the consolidated statements of
operations.  The Company calculates interest expense for these
asset-backed bonds based on the prevailing coupon rates of the specific classes
of debt and records interest expense in the period incurred.  Interest
expense amounts are included in the “Interest expense” line item of the
consolidated statements of operations.





In
accordance with the Company’s adoption of SFAS 159, the Company redesignated two
mortgage securities with a fair value of $46.7 million from the
“available-for-sale” to the “trading” classification on January 1, 2007 and the
related unrealized losses of $1.1 million were reclassified from accumulated
other comprehensive income to accumulated deficit on the consolidated balance
sheet as a cumulative effect adjustment.





The
Company has not elected fair value accounting for any other balance sheet items
as allowed by SFAS 159.





The
following table shows the impact of electing the fair value option relating to
asset for the year ended December 31, 2008 and 2007 (dollars in
thousands):





Unpaid Principal
                    Balance
                  
                  
                  Gain
                    Recognized
                  
                  
                  Balance at Fair
                    ValueAs
      of December 31, 2008
                  
                  $
                  324,243
                  
                  
                  $
                  62,973
                  
                  
                  $
                  5,376As
      of December 31, 2007
                  
                  
                  331,500
                  
                  
                  
                  257,115
                  
                  
                  
                  74,385





67





There was
no cumulative-effect adjustment to accumulated deficit related to this
transaction as this CDO closed in the first quarter of 2007. Substantially all
of the $63.0 million and $257.1 million change in fair value of the asset-backed
bond for the years ended December 31, 2008 and 2007, respectively, are
considered to be related to specific credit risk as all of the bonds are
floating rate. The change in credit risk was caused by spreads widening in the
asset-backed securities market during the year ended December 31, 2008 and
2007.





In
accordance with SFAS 159, debt issuance costs are current period expenses and
are not amortized over the life of the debt on a level-yield basis. The $4.7
million in expenses the Company incurred as part of the issuance of NovaStar ABS
CDO I were included in the “Professional and outside services” line item on the
consolidated statements of operations for the year ended December 31,
2007.





Note
11.  Derivative Instruments and Hedging Activities





The
Company’s objective and strategy for using derivative instruments is to mitigate
the risk of increased costs on its variable rate liabilities during a period of
rising rates, subject to cost and liquidity risk constraints. The Company’s
primary goals for managing interest rate risk are to maintain the net interest
margin between its assets and liabilities and diminish the effect of changes in
general interest rate levels on the market value of the Company.





The
derivative instruments used by the Company to manage this risk are interest rate
caps and interest rate swaps. Interest rate caps are contracts in which the
Company pays either an upfront premium or monthly or quarterly premium to a
counterparty. In return, the Company receives payments from the counterparty
when interest rates rise above a certain rate specified in the contract. During
2008 and 2007, premiums paid pursuant to interest rate cap agreements related to
continuing operations aggregated $0.4 million and $0.8 million,
respectively. When premiums are financed by the Company, a liability is recorded
for the premium obligation. Premiums due to counterparties as of December 31,
2008 and 2007 were $0.1 million and $0.5 million, respectively, and had a
weighted average interest rate of 3.9% for both 2008 and 2007. The future
contractual maturities of premiums due to counterparties as of December 31, 2008
are $0.1 million due in 2009.  There is no future contractual
maturities premium due in 2010 or after. The interest rate swap agreements to
which the Company is party stipulate that the Company pay a fixed rate of
interest to the counterparty and the counterparty pays the company a variable
rate of interest based on the notional amount of the contract. The liabilities
the Company hedges are asset-backed bonds as discussed in Note 7.





During
2007, the Company entered into several inter-related transactions involving
credit default swaps (“CDS”) and other investments.  A CDS is an
agreement to provide credit event protection based on a specific security in
exchange for receiving an upfront premium and a fixed-rate fee over the life of
the contract.   The additional investments purchased bear yields
that mirror LIBOR.   The result of the transaction is to create
an instrument that mirrors the results of the referenced securities underlying
the CDS.  The CDS had a notional amount of $16.5 million and a fair
value of $6.1 million at the date of purchase and are pledged as collateral
against the CDO ABB.  The fair value was $0.2 million and $2.5 million
as of December 31, 2008 and 2007, respectively.  The Company recorded
losses related to fair value adjustments of $2.3 million and $3.6 million for
the years ended December 31, 2008 and 2007, respectively.   These
losses are included in the “(Losses) gains on derivative instruments” line item
of the Company’s consolidated statements of operations.





These CDS
are accounted for as non-cash flow hedging derivative instruments, reported at
fair value with the changes in fair value recognized through the Company’s
statements of operations. The value of these contracts decrease for a variety of
reasons, including when the probability of the occurrence of a specific credit
event increases, when the market’s perceptions of default risk in general
change, or when there are changes in the supply and demand of these
instruments.





The
Company’s derivative instruments that meet the hedge accounting criteria of SFAS
No. 133 are considered cash flow hedges. The Company also has derivative
instruments that do not meet the requirements for hedge accounting. However,
these derivative instruments do contribute to the Company’s overall risk
management strategy by serving to reduce interest rate risk on asset-backed
bonds collateralized by the Company’s loans held-in-portfolio.





The
following tables present derivative instruments as of December 31, 2008 and 2007
(dollars in thousands):





Notional Amount
                  
                  
                  Fair Value
                  
                  
                  Maximum
                    Days to
                    MaturityAs
      of December 31, 2008:Non-hedge
      derivative instruments
                  
                  $
                  461,500
                  
                  
                  $
                  (9,034
                  )
                  
                  
                  390Cash
      flow hedge derivative instruments
                  
                  
                  40,000
                  
                  
                  
                  (68
                  )
                  
                  
                  25As
      of December 31, 2007:Non-hedge
      derivative instruments
                  
                  $
                  1,101,500
                  
                  
                  $
                  (6,406
                  )
                  
                  
                  756Cash
      flow hedge derivative instruments
                  
                  
                  300,000
                  
                  
                  
                  (490
                  )
                  
                  
                  391





68





The
Company recognized net (income) expense of $2.5 million and $(0.3) million
during the years ended December 31, 2008 and 2007, respectively, on derivative
instruments qualifying as cash flow hedges, which is recorded as a component of
interest expense.





During
the two years ended December 31, 2008, hedge ineffectiveness was insignificant.
The net amount included in other comprehensive income expected to be
reclassified into earnings within the next twelve months is expense of
approximately $68,000.





The
Company’s derivative instruments involve, to varying degrees, elements of credit
and market risk in addition to the amount recognized in the consolidated
financial statements.





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





Market RiskThe potential for
financial loss due to adverse changes in market interest rates is a function of
the sensitivity of each position to changes in interest rates, the degree to
which each position can affect future earnings under adverse market conditions,
the source and nature of funding for the position, and the net effect due to
offsetting positions. The derivative instruments utilized leave the Company in a
market position that is designed to be a better position than if the derivative
instrument had not been used in interest rate risk management.




Other Risk ConsiderationsThe Company is
cognizant of the risks involved with derivative instruments and has policies and
procedures in place to mitigate risk associated with the use of derivative
instruments in ways appropriate to its business activities, considering its risk
profile as a limited end-user.




Note
12. Interest Income




The
following table presents the components of interest income related to continuing
operations for the years ended December 31, 2008 and 2007 (dollars in
thousands):





For the Year Ended December 31,2008
                        
                        2007Interest
      income:Mortgage
      securities
                        
                        $
                        46,997
                        
                        
                        $
                        102,500Mortgage
      loans held-in-portfolio
                        
                        
                        186,601
                        
                        
                        
                        258,663Other
      interest income (A)
                        
                        
                        1,411
                        
                        
                        
                        5,083Total
      interest income
                        
                        $
                        235,009
                        
                        
                        $
                        366,246





(A)
            Other
      interest income represents interest earned on corporate operating cash
      balances.




Note
13. Interest Expense





The
following table presents the components of interest expense related to
continuing operations for the years ended December 31, 2008 and 2007 (dollars in
thousands):





For the Year Ended December 31,2008
                        
                        2007Interest
      expense:Short-term
      borrowings secured by mortgage securities
                        
                        $
                        436
                        
                        
                        $
                        23,649Asset-backed
      bonds secured by mortgage loans
                        
                        
                        95,012
                        
                        
                        
                        178,937Asset-backed
      bonds secured by mortgage securities
                        
                        
                        13,271
                        
                        
                        
                        17,635Junior
      subordinated debentures
                        
                        
                        6,261
                        
                        
                        
                        8,148Total
      interest expense
                        
                        $
                        114,980
                        
                        
                        $
                        228,369





69




Note
14. Discontinued Operations





As
discussed in Note 2, the Company undertook Exit Plans to align its organization
and costs with its decision to discontinue its mortgage lending and mortgage
servicing activities. Implementation of the Exit Plans approved by the Audit
Committee in 2007 both began and concluded during the year ended December 31,
2007.





On
November 1, 2007, the Company sold all of its mortgage servicing
rights.  The loan servicing operations had ceased as of December 31,
2007.





The
Company considers an operating unit to be discontinued upon its termination
date, which is the point in time when the operations substantially
cease.  The provisions of SFAS 144 require the results of operations
associated with those operating units terminated to be classified as
discontinued operations and segregated from the Company’s continuing results of
operations for all periods presented.  In accordance with Statement
SFAS 144, the Company has reclassified the operating results of its entire
mortgage lending segment and servicing operations segment as discontinued
operations in the consolidated statements of operations for the year ended
December 31, 2008 and 2007.





As of
June 30, 2006, the Company had terminated all of the remaining NHMI branches and
related operations.  The Company has reclassified the operating
results of NHMI through December 31, 2008, as discontinued operations in the
consolidated statements of operations for the years ended December 31, 2008 and
2007 in accordance with SFAS 144.





The major
classes of assets and liabilities reported as discontinued operations as of
December 31, 2008 and 2007 are as follows (dollars in thousands):





December 31,
                        
                        
                        December
                          31,2008
                        
                        
                        
                        2007(A)AssetsMortgage
      loans -
      held-for-sale
                        
                        $
                        1,117
                        
                        
                        $
                        5,253Real
      estate owned
                        
                        
                        324
                        
                        
                        
                        2,574Other
      assets
                        
                        
                        -
                        
                        
                        
                        428Total
      assets
                        
                        $
                        1,441
                        
                        
                        $
                        8,255LiabilitiesShort-term
      borrowings secured by mortgage loans
                        
                        $
                        -
                        
                        
                        $
                        19Accounts
      payable and other liabilities
                        
                        
                        2,536
                        
                        
                        
                        59,397Total
      liabilities
                        
                        $
                        2,536
                        
                        
                        $
                        59,416





(A) The
accounts payable and other liabilities line includes a $45.2 million liability
as of December 31, 2007 recorded in connection with the judgment rendered
against NHMI in the California Action by AIM, the settlement of which became
final as of September 11, 2008.




The
operating results of all discontinued operations for the years ended December
31, 2008 and 2007 are summarized as follows (dollars in thousands):





For the Years Ended
                                December 31,2008
                              
                              
                              2007Interest
      income
                              
                              $
                              1,173
                              
                              
                              $
                              102,648Interest
      expense
                              
                              
                              (12
                              )
                              
                              
                              79,483Net
      interest income
                              
                              
                              1,185
                              
                              
                              
                              23,165Other
      operating (expense) income:Gains
      (losses) on sales of mortgage assets
                              
                              
                              1,281
                              
                              
                              
                              (2,579
                              )Gains
      (losses) on derivative instruments
                              
                              
                              -
                              
                              
                              
                              (4,913
                              )Valuation
      adjustment on mortgage loans – held-for-sale
                              
                              
                              (3,331
                              )
                              
                              
                              (101,125
                              )Fee
      income
                              
                              
                              903
                              
                              
                              
                              22,900Premiums
      for mortgage loan insurance
                              
                              
                              -
                              
                              
                              
                              (2,668
                              )Other
      income
                              
                              
                              409
                              
                              
                              
                              (6,777
                              )Total
      other operating expense
                              
                              
                              (738
                              )
                              
                              
                              (95,162
                              )General
      and administrative expenses (A)
                              
                              
                              36,187
                              
                              
                              
                              (184,783
                              )Gain
      (loss) from discontinued operations before income tax
    expense
                              
                              
                              36,634
                              
                              
                              
                              (256,780
                              )Income
      tax expense
                              
                              
                              13,804
                              
                              
                              
                              -Gain
      (loss) income from discontinued operations
                              
                              $
                              22,830
                              
                              
                              $
                              (256,780
                              )


70





(A)
            The
      general and administrative expenses line includes the reversal of a $45.2
      million liability during year ended December 31, 2008 which was recorded
      in connection with the judgment rendered against NHMI in the California
      Action by AIM, the settlement of which became final as of September 11,
      2008.




Mortgage
Loans – Held-for-Sale





Mortgage
loans – held-for-sale, all of which are secured by residential properties,
consisted of the following as of December 31, 2008 and December 31, 2007
(dollars in thousands):





December 31,
                          2008
                        
                        
                        December
                          31, 2007Mortgage
      loans – held-for-sale:Outstanding
      principal
                        
                        $
                        15,578
                        
                        
                        $
                        17,545Allowance
      for the lower of cost or fair value
                        
                        
                        (14,461
                        )
                        
                        
                        (12,292
                        )Mortgage
      loans – held-for-sale
                        
                        $
                        1,117
                        
                        
                        $
                        5,253Weighted
      average coupon
                        
                        
                        10.13
                        %
                        
                        
                        10.23
                        %





Activity
in the allowance for the lower of cost or fair value on mortgage loans –
held-for-sale is as follows for years ended December 31, 2008 and 2007,
respectively (dollars in thousands):





For the Year Ended December
                        31,2008
                      
                      
                      2007Balance,
      beginning of period
                      
                      $
                      12,292
                      
                      
                      $
                      5,006Valuation
      adjustment on mortgage loans - held-for-sale
                      
                      
                      3,331
                      
                      
                      
                      101,125Transfer
      from the reserve for loan repurchases
                      
                      
                      -
                      
                      
                      
                      23,206Transfer
      to cost basis of mortgage loans – held-in-portfolio
                      
                      
                      -
                      
                      
                      
                      (14,843
                      )Reduction
      due to loans securitized or sold to third parties
                      
                      
                      -
                      
                      
                      
                      (82,384
                      )Transfers
      to real estate owned
                      
                      
                      239
                      
                      
                      
                      (19,818
                      )Charge-offs,
      net of recoveries
                      
                      
                      (1,401
                      )
                      
                      
                      -Balance,
      end of period
                      
                      $
                      14,461
                      
                      
                      $
                      12,292





Loan
Securitizations and Loan Sales





Loan
Securitizations.  The Company executed loan securitization
transactions that are accounted for as sales of loans. Derivative instruments
were transferred into the trusts as part of each of these sales transactions to
reduce interest rate risk to the third-party bondholders.





There
were no securitizations structured as sales during the year ended December 31,
2008.  Details of the securitizations structured as sales during the
years ended December 31, 2007 are as follows (dollars in
thousands):





Allocated Value of
                            Retained InterestsNet Bond
                            Proceeds
                          
                          
                          Mortgage
                            Servicing
                            Rights
                          
                          
                          Subordinated
                            Bond
                            Classes
                          
                          Principal
                            Balance
                            of Loans
                            Sold
                          
                          
                          Fair Value
                            of
                            Derivative
                            Instruments
                            Transferred
                          
                          
                          Gain
                            RecognizedNMFT
      Series 2007-2
                          
                          $
                          1,331,299
                          
                          
                          $
                          9,766
                          
                          
                          $
                          56,387
                          
                          
                          $
                          1,400,000
                          
                          
                          $
                          4,161
                          
                          
                          $
                          4,981





71


In this
securitization, the Company retained residual securities (representing
interest-only securities, prepayment penalty bonds and overcollateralization
bonds) and certain subordinated securities representing subordinated interests
in the underlying cash flows and servicing responsibilities. The value of the
Company’s retained securities is subject to credit, prepayment, and interest
rate risks on the transferred financial assets.





During
2007, U.S. government-sponsored enterprises purchased 50% of the bonds sold to
the third-party investors in the Company’s securitization transaction. The
investors and securitization trusts have no recourse to the Company’s assets for
failure of borrowers to pay when due except when defects 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. Refer to Note 7 for further
discussion.





As
described in Note 1, fair value of the residual securities at the date of
securitization is either measured by the whole loan price methodology or the
discount rate methodology. For the whole loan price methodology, an implied
yield (discount rate) is calculated based on the value derived and using
projected cash flows generated using key economic assumptions. Comparatively,
under the discount rate methodology, the Company assumes a discount rate that it
believes is commensurate with current market conditions.





Key
economic assumptions used to project cash flows at the time of loan
securitization during the year ended December 31, 2007 were as
follows:





NovaStar Mortgage
                                                  Funding Trust Series
                                                
                                                Constant
                                                  Prepayment
                                                  Rate
                                                
                                                
                                                Average Life
                                                  (in Years)
                                                
                                                
                                                Expected Total Credit Losses, Net
                                                  of Mortgage Insurance (A)
                                                
                                                
                                                Discount
                                                  Rate2007-2
                                                
                                                
                                                34
                                                %
                                                
                                                
                                                2.31
                                                
                                                
                                                
                                                5.7
                                                %
                                                
                                                
                                                20
                                                %





(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.





Fair
value of the subordinated securities at the date of securitization is based on
quoted market prices.





Loan Sales.  The
Company executes all of its sales of loans to third parties with servicing
released. Gains and losses on whole loan sales are recognized in the period the
sale occurs.





The
Company sold no mortgage loans during 2008 as compared to approximately
$969.1 million during 2007.  The Company sold $668.8 million of
mortgage loans held-for-sale at a price of 91.5% of par to Wachovia during 2007
in an effort to reduce margin call risk.  In light of the 91.5% sale
price, a lower of cost or market valuation adjustment of approximately $47.0
million was recorded for the year ended December 31, 2007,
respectively.  These adjustments are included in the “Income (loss)
from discontinued operations, net of income tax” line item on the Company’s
consolidated statements of operations.





The
Company generally has an obligation to repurchase whole loans sold in
circumstances in which the borrower fails to make any of the first several
(generally not more than the first three) payments. Additionally, the Company is
also required to repay all or a portion of the premium it receives on the sale
of whole loans in the event that the loan is prepaid in its entirety in the
first year. The Company records a reserve for losses on repurchased loans upon
the sale of the mortgage loans which is included in the liabilities of
discontinued operations on the Company’s  consolidated balance
sheets.  The reserve for losses on repurchased loans is reversed
through the provision for repurchased loans when the repurchase time period
expires.





Activity
in the reserve for repurchases was as follows for the years ended December 31,
2008 and 2007 (dollars in thousands):





For the Years Ended
                            December 31,2008
                          
                          
                          2007Balance,
      beginning of period
                          
                          $
                          2,153
                          
                          
                          $
                          24,773Provision
      for repurchased loans
                          
                          
                          (1,782
                          )
                          
                          
                          3,254Transfer
      to the allowance for the lower of cost of fair value on mortgage loans –
      held for sale
                          
                          
                          -
                          
                          
                          
                          (23,206
                          )Charge-offs,
      net
                          
                          
                          (276
                          )
                          
                          
                          (2,668
                          )Balance,
      end of period
                          
                          $
                          95
                          
                          
                          $
                          2,153




Mortgage
Servicing Rights





The
Company recorded mortgage servicing rights arising from the transfer of loans to
securitization trusts.


72


The
Company sold all of its mortgage servicing rights and servicing advances
relating to its securitizations.  The transaction closed on November
1, 2007 and the Company received total proceeds of $154.9 million after
deduction of expenses.  The mortgage servicing rights and servicing
related advances sold for $95.0 million and $62.9 million,
respectively.  The Company removed $47.3 million of mortgage servicing
rights from its consolidated balance sheet and recorded a gain of $19.8 million
which is included in the Income (loss) from discontinued operations, net of
income tax line item of the consolidated statements of
operations.  The $95.0 million of proceeds also included $22.8 million
for mortgage servicing rights related to the Company’s securitizations
structured as financings where no mortgage servicing rights have been recorded
by the Company.




The
following schedule summarizes the carrying value of mortgage servicing rights
and the activity during the year ended December 31, 2007 (dollars in
thousands):





Balance,
      beginning of period
                    
                    $
                    62,830Amount
      capitalized in connection with transfer of loans to securitization
      trusts
                    
                    
                    9,766Amortization
                    
                    
                    (25,252
                    )Sale
      of mortgage servicing rights
                    
                    
                    (47,344
                    )Balance,
      end of period
                    
                    $
                    -





When the
Company was the servicer, it received annual servicing fees approximating 0.50%
of the outstanding balance and rights to future cash flows arising after the
investors in the securitization trusts have received the return for which they
contracted. Servicing fees received from the securitization trusts were $43.5
million for the year ended December 31, 2007. During the year ended December 31,
2007 the Company paid $32,000 to cover losses on delinquent or foreclosed loans
from securitizations in which the Company did not maintain control over the
mortgage loans transferred.




The
Company held, as custodian, principal and interest collected from borrowers on
behalf of the securitization trusts, as well as funds collected from borrowers
to ensure timely payment of hazard and primary mortgage insurance and property
taxes related to the properties securing the loans. These funds were not owned
by the Company and were held in trust.  The Company held no funds as
custodian as of December 31, 2008 and 2007.




Short-term
Borrowings





$1.9 Billion
Comprehensive Financing Facility.  In May 2007, the Company
executed a $1.9 billion comprehensive financing facility arranged by
Wachovia.  On May 9, 2008, the Company fully repaid all outstanding
borrowings with Wachovia and all agreements were terminated effective the same
day.





The
Company had no repurchase agreements used in connection with discontinued
operations as of December 31, 2008. The following table summarizes the Company’s
repurchase agreements used in connection with discontinued operations as of
December 31, 2007 (dollars in thousands):





Maximum
                                                Borrowing
                                                Capacity
                                              
                                              Rate
                                              
                                              Days to
                                                Reset
                                              
                                              BalanceDecember
      31, 2007Short-term
      borrowings (indexed to one-  monthLIBOR):Repurchase
      agreement expiring May 8, 2008 (A)
                                              $
                                              1,900,000
                                              
                                              4.57
                                              %
                                              1
                                              
                                              $
                                              19





(A)
            Eligible
      collateral for this agreement was both mortgage loans and mortgage
      securities.  The maximum borrowing capacity under this facility
      was reduced by the amount of borrowings outstanding from time to time with
      this lender under related
facilities.





The
following table presents certain information on the Company’s repurchase
agreements related to discontinued operations for the year ended December 31,
2007 (dollars in thousands):





2007
      (A)Maximum
      month-end outstanding balance during the period
                    
                    $
                    2,339,431Average
      balance outstanding during the period
                    
                    
                    865,495Weighted
      average rate for period
                    
                    
                    6.80
                    %Weighted
      average interest rate at period end
                    
                    
                    4.57
                    %


(A)
            Information
      pertaining to the year ended December 31, 2008, was not included as the
      outstanding balance was paid off during May
  2008.


73


The
Company’s mortgage loans and certain servicing related advances were pledged as
collateral on these borrowings.





Repurchase
agreements generally contain margin calls under which a portion of the
borrowings must be repaid if the fair value of the assets collateralizing the
repurchase agreements falls below a contractual ratio to the borrowings
outstanding.




There was
no accrued interest on the Company’s repurchase agreements used in connection
with discontinued operations as of December 31, 2008 and 2007.




Commitments
and Contingencies





The
Company had no outstanding commitments to originate, purchase or sell loans at
December 31, 2008 and December 31, 2007.




In the
ordinary course of the Company’s mortgage lending business, the Company sold
whole pools of loans with recourse for borrower defaults. When whole pools are
sold as opposed to securitized, the third party has recourse against the Company
for certain borrower defaults. Because the loans are no longer on the Company’s
balance sheet, the recourse component is considered a guarantee. During 2008 the
Company sold no loans with recourse for borrower defaults as compared to $912.9
million in 2007.  The Company maintained a reserve of $0.1 million
related to these guarantees as of December 31, 2008 compared with a reserve of
$2.2 million as of December 31, 2007. During 2008 and 2007, the Company paid
$0.1 million and $104.3 million, respectively, in cash to repurchase loans
sold to third parties.




In the
ordinary course of the Company’s mortgage lending business, the Company sold
loans to securitization trusts and guarantees losses suffered by the trusts
resulting from defects in the loan origination process. Defects may occur in the
loan documentation and underwriting process, either through processing errors
made by the Company or through intentional or unintentional misrepresentations
made by the borrower or agents during those processes. If a defect is
identified, the Company is required to repurchase the loan. As of December 31,
2008 and 2007 the Company had loans sold with recourse with an outstanding
principal balance of $8.1 billion and $10.1 billion, respectively.
Historically, repurchases of loans where a defect has occurred have been
insignificant; therefore, the Company has recorded no reserves related to these
guarantees.




Commitments. The Company
leases office space under various operating lease agreements. Rent expense for
2008 and 2007, under leases related to discontinued operations, aggregated $2.8
million and $9.3 million, respectively. At December 31, 2008, future minimum
lease commitments under those leases are as follows (dollars in
thousands):




Lease
                          Obligations2009
                        
                        $
                        1,4652010
                        
                        
                        1,0572011
                        
                        
                        4972012
                        
                        
                        212





The
Company has entered into various lease agreements pursuant to which the lessor
agreed to repay the Company for certain existing lease
obligations.  The Company has recorded deferred lease incentives
related to these payments which will be amortized into rent expense over the
life of the respective lease on a straight-line basis. There were no deferred
lease incentives related to discontinued operations as of December 31,
2008.   Deferred lease incentives related to discontinued
operations as of December 31, 2007 were $54,000.





The
Company has also entered into various sublease agreements for office space
formerly occupied by the Company. The Company received approximately
$0.5 million and $1.1 million in 2008 and 2007, respectively under these
agreements. At December 31, 2008, future minimum rental receipts under these
subleases are as follows (dollars in thousands):




Lease
                                  Receipts2009
                                
                                $
                                6812010
                                
                                
                                5762011
                                
                                
                                4192012
                                
                                
                                177





Fair
Value Accounting





Effective
January 1, 2007, the Company adopted SFAS 157 and SFAS 159. Both
standards address aspects of the expanding application of fair value
accounting.


74


Fair
Value Measurements (SFAS 157)





SFAS 157
defines fair value, establishes a consistent framework for measuring fair value
and expands disclosure requirements about fair value measurements.
SFAS 157, among other things, requires the Company to maximize the use of
observable inputs and minimize the use of unobservable inputs when measuring
fair value.





The
following tables provide quantitative disclosures about the fair value
measurements for the Company’s assets related to discontinued operations which
are measured at fair value on a nonrecurring basis as of December 31, 2008 and
2007(dollars in thousands):





Fair Value Measurements at Reporting Date UsingDescription
                          
                          Fair Value at
                            December 31,
                            2008
                          
                          Quoted Prices in
                            Active Markets for
                            Identical Assets
                            (Level 1)
                          
                          Significant Other
                            Observable Inputs
                            (Level 2)
                          
                          Significant
                            Unobservable Inputs
                            (Level 3)Mortgage
      loans-held-for-sale
                          
                          
                          $
                          1,117
                          
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          1,117Real
      estate owned
                          
                          
                          
                          324
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          324Total
                          
                          
                          $
                          1,441
                          
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          1,441







Description
                                  
                                  Fair Value at
                                    December 31,
                                    2007
                                  
                                  
                                  Quoted Prices in
                                    Active Markets for
                                    Identical Assets
                                    (Level 1)
                                  
                                  
                                  Significant Other
                                    Observable Inputs
                                    (Level 2)
                                  
                                  
                                  Significant
                                    Unobservable Inputs
                                    (Level 3)Mortgage
      loans-held-for-sale
                                  
                                  $
                                  5,253
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  5,253Real
      estate owned
                                  
                                  
                                  2,574
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  2,574Total
                                  
                                  $
                                  7,827
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  7,827




The
Company’s mortgage loans held-for-sale have a fair value lower than their cost
basis of $14.5 million and $12.3 million as of December 31, 2008 and 2007,
respectively.  Therefore, all mortgage loans held-for-sale have been
written down to fair value. The Company recorded valuation adjustments of $3.3
million and $101.1 million on mortgage loans – held-for-sale for the year ended
December 31, 2008 and 2007, respectively.  At the time a mortgage loan
held-for-sale becomes real estate owned, the Company records the property
at the lower of its carrying amount or fair value.  Upon
foreclosure and through liquidation, the Company evaluates the
property's fair value as compared to its carrying amount and records a
valuation adjustment when the carrying amount exceeds fair value.  For
mortgage loans held-for-sale, valuation adjustments for discontinued operations
are recorded in the “(Loss) income from discontinued operations, net of income
tax” line item of the Company's consolidated statements of
operations.





The
following table provides a summary of the impact to earnings for the years ended
December 31, 2008 and 2007 from the Company’s assets and liabilities which are
measured at fair value on a recurring and nonrecurring basis as of the periods
indicated (dollars in thousands):







Asset or Liability
                                              Measured at Fair
                                              Value
                                            
                                            Fair Value
                                              Measurement
                                              Frequency
                                            
                                            Fair Value
                                              Adjustments for
                                              the Year Ended
                                              December 31, 2008
                                            
                                            
                                            Fair Value
                                              Adjustments for the
                                              Year Ended
                                              December 31, 2007
                                            
                                            Statement of Operations
                                              Line Item ImpactedMortgage
      loansheld-for-sale
                                            
                                            Nonrecurring
                                            
                                            $
                                            (3,331
                                            )
                                            
                                            $
                                            (101,125
                                            )
                                            Valuation
      adjustment on mortgage loans – held-for-saleReal
      estate owned
                                            
                                            Nonrecurring
                                            
                                            
                                            (656
                                            )
                                            
                                            
                                            (6,250
                                            )
                                            (Losses)
      gains on sales of mortgage assetsTotal
      fair value losses
                                            
                                            
                                            
                                            $
                                            (3,987
                                            )
                                            
                                            $
                                            (107,375
                                            )





Valuation
Methods





Mortgage
loans - held-for-sale and real estate owned





Mortgage
loans - held-for-sale are carried at the lower of cost or fair value.  As
of December 31, 2008 and 2007, the Company estimated the fair value of its
mortgage loans – held-for-sale based on 2 categories.  All loans which had
mortgage insurance were marked down to a value which reflects current market
pricing for such assets.  In 2007, the Company received market bids for the
pool of assets with mortgage insurance and believes the market bids to be
indicative of the net realizable value of the loans.  All loans which did
not have mortgage insurance were valued at zero due to their nonperforming
characteristics.


75


Real
estate owned is carried at the lower of cost or fair value.  The Company
values individual real estate owned based on historical and expected loss
experience, taking into consideration whether or not the loan carries mortgage
insurance.





Derivative
Instruments and Hedging Activities





The
Company had terminated all of its derivative instruments related to discontinued
operations as of December 31, 2007.





The
Company’s derivative instruments included in discontinued operations did not
meet the requirements for hedge accounting. However, these derivative
instruments contributed to the Company’s overall risk management strategy by
serving to reduce interest rate risk on average short-term borrowings
collateralized by the Company’s loans held-for-sale.   The
Company used both interest rate cap and swap agreements related to its
discontinued operations.





No
premiums were paid related to interest rate cap agreements during
2008.   For 2007, premiums paid related to interest rate cap
agreements aggregated $1.9 million. When premiums are financed by the
Company, a liability is recorded for the premium obligation. The Company had no
premiums due to counterparties as of December 31, 2008 and 2007 related to its
discontinued operations.





Exit
or Disposal Activities





During
2007, management of the Company committed the Company to workforce reductions
pursuant to Exit Plans. The Company undertook these Exit Plans to align its
organization with changing conditions in the mortgage market and as a result of
the sale of its mortgage servicing rights portfolio. The Exit Plans resulted in
the elimination of approximately 1,316 positions in 2007. The Exit Plans were
approved and concluded in 2007.





During
the year ended December 31, 2007, the Company recorded pre-tax charges of $11.3
million related to one-time employment termination benefits for the Exit Plans.
These amounts are included in the “Income (loss) from discontinued operations,
net of income tax” line item of the Company’s consolidated statements of
operations.  The Company had no liability as of December 31, 2007
remaining to be paid under the Exit Plans.





The
Company also recorded charges related to the abandonment of property, plant and
equipment and termination costs related to leases for the Exit
Plans.  The charges related to property, plant and equipment for the
year ended December 31, 2007 aggregated approximately $12.2 million, while the
charges related to leases aggregated approximately $3.4 million during the year
ended December 31, 2007.





Fair
Value of Financial Instruments





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





The estimated fair values of the
Company’s financial instruments related to discontinued operations are as
follows as of December 31, 2008 and 2007 (dollars in
thousands):





2008
                      
                      
                      2007Carrying Value
                      
                      
                      Fair Value
                      
                      
                      Carrying
                        Value
                      
                      
                      Fair ValueFinancial
      assets:Mortgage
      loans – held-for-sale
                      
                      $
                      1,117
                      
                      
                      $
                      1,117
                      
                      
                      $
                      5,253
                      
                      
                      $
                      5,253Financial
      liabilities:Short-term
      borrowings
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      19
                      
                      
                      
                      19





Mortgage loans –
held-for-sale – The fair value of mortgage loans - held-for-sale is based
on two categories.  All loans that had mortgage insurance were marked
down to a value which reflects current market pricing for such
assets.  The Company received market bids for the pool of loans with
mortgage insurance and believes the market bids to be indicative of the net
realizable value of the loans.  All loans which did not have mortgage
insurance were valued at zero due to their nonperforming
characteristics.





Borrowings – The fair value
of short-term borrowings approximates their carrying value as the borrowings
were paid off during 2008 at their carrying value.


76


Note
15. Segment Reporting





As of
December 31, 2008, the Company reviews, manages and operates its business in one
segment: mortgage portfolio management. Mortgage portfolio management operating
results come from the income generated on the mortgage assets the Company
manages less associated costs. As discussed under Note 14, the Company
discontinued its mortgage lending and loan servicing segments during 2007 and
had discontinued its branch operations in 2006.  The mortgage
portfolio management segment’s operating results for the years ended December
31, 2008 and 2007 are the same as the Company’s  consolidated
statements of operations.





Note
16. Earnings Per Share





The
computations of basic and diluted earnings per share for the years ended
December 31, 2008 and 2007 are as follows (dollars in thousands, except per
share amounts):





For the Year Ended December
                                                  31,2008
                                                
                                                
                                                2007Numerator:Loss
      from continuing operations
                                                
                                                $
                                                (683,312
                                                )
                                                
                                                $
                                                (467,497
                                                )Dividends
      on preferred shares
                                                
                                                
                                                (15,273
                                                )
                                                
                                                
                                                (8,805
                                                )Loss
      from continuing operations available to common
shareholders
                                                
                                                
                                                (698,585
                                                )
                                                
                                                
                                                (476,302
                                                )Income
      (loss) from discontinued operations, net of income tax
                                                
                                                
                                                22,830
                                                
                                                
                                                
                                                (256,780
                                                )Loss
      available to common shareholders
                                                
                                                $
                                                (675,755
                                                )
                                                
                                                $
                                                (733,082
                                                )Denominator:Weighted
      average common shares outstanding – basic
                                                
                                                
                                                9,338,131
                                                
                                                
                                                
                                                9,332,405Weighted
      average common shares outstanding – dilutive:Weighted
      average common shares outstanding – basic
                                                
                                                
                                                9,338,131
                                                
                                                
                                                
                                                9,332,405Stock
      options
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -Restricted
      stock
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -Weighted
      average common shares outstanding – dilutive
                                                
                                                
                                                9,338,131
                                                
                                                
                                                
                                                9,332,405Basic
      earnings per share:Loss
      from continuing operations
                                                
                                                $
                                                (73.17
                                                )
                                                
                                                $
                                                (50.10
                                                )Dividends
      on preferred shares
                                                
                                                
                                                (1.64
                                                )
                                                
                                                
                                                (0.94
                                                )Loss
      from continuing operations available to common
shareholders
                                                
                                                
                                                (74.81
                                                )
                                                
                                                
                                                (51.04
                                                )Income
      (loss) from discontinued operations, net of income tax
                                                
                                                
                                                2.44
                                                )
                                                
                                                
                                                (27.51
                                                )Net
      loss available to common shareholders
                                                
                                                $
                                                (72.37
                                                )
                                                
                                                $
                                                (78.55
                                                )Diluted
      earnings per share:Loss
      from continuing operations
                                                
                                                $
                                                (73.17
                                                )
                                                
                                                $
                                                (50.10
                                                )Dividends
      on preferred shares
                                                
                                                
                                                (1.64
                                                )
                                                
                                                
                                                (0.94
                                                )Loss
      from continuing operations available to common
shareholders
                                                
                                                
                                                (74.81
                                                )
                                                
                                                
                                                (51.04
                                                )Income
      (loss) from discontinued operations, net of income tax
                                                
                                                
                                                2.44
                                                )
                                                
                                                
                                                (27.51
                                                )Net
      loss available to common shareholders
                                                
                                                $
                                                (72.37
                                                )
                                                
                                                $
                                                (78.55
                                                )





The
following stock options to purchase shares of common stock and shares of
restricted stock were outstanding during each period presented, but were not
included in the computation of diluted earnings per share because the effect
would be antidilutive (in thousands, except exercise prices):





For the Year Ended
                                  December 31,2008
                                
                                2007Number
      of stock options and restricted stock (in thousands)
                                
                                206
                                
                                
                                340Weighted
      average exercise price of stock options
                                $
                                57.36
                                
                                $
                                35.88





77


Note
17. Income Taxes





The
components of income tax expense (benefit) attributable to continuing operations
for the years ended December 31, 2008 and 2007 were as follows (dollars in
thousands):





For the Year Ended
                                December 31,2008
                              
                              
                              
                              2007(A)Current:Federal
                              
                              $
                              (2,804
                              )
                              
                              $
                              21,422State
      and local
                              
                              
                              (985
                              )
                              
                              
                              3,470Total
      current
                              
                              
                              (3,789
                              )
                              
                              
                              24,892Deferred:Federal
                              
                              
                              (12,293
                              )
                              
                              
                              36,706State
      and local
                              
                              
                              (1,512
                              )
                              
                              
                              4,914Total
      deferred
                              
                              
                              (13,805
                              )
                              
                              
                              41,620Total
      income tax expense (benefit)
                              
                              $
                              (17,594
                              )
                              
                              $
                              66,512





(A)
            Does
      not reflect the deferred tax effects of unrealized gains and losses on
      mortgage securities-available-for-sale and derivative financial
      instruments that are included in shareholders’ equity. As a result of
      these tax effects, shareholders’ equity increased by $1.9 million in
      2007.  Additionally, it does not reflect the deferred tax
      effects of a contribution of securities and the write-off of net operating
      losses related to equity based compensation recorded to additional
      paid-in-capital of $7.4 million for the year ended December 31,
      2007.





A
reconciliation of the expected federal income tax expense (benefit) using the
federal statutory tax rate of 35 percent to the Company’s actual income tax
expense (benefit) and resulting effective tax rate from continuing operations
for the years ended December 31, 2008 and 2007 were as follows (dollars in
thousands):





For the Year Ended
                        December 31,2008
                      
                      
                      2007Income
      tax at statutory rate
                      
                      $
                      (245,317
                      )
                      
                      $
                      (140,345
                      )State
      income taxes, net of federal tax benefit
                      
                      
                      (12,028
                      )
                      
                      
                      (29,618
                      )Tax
      effect of REIT termination effective January 1, 2006
                      
                      
                      -
                      
                      
                      
                      (51,476
                      )Valuation
      allowance
                      
                      
                      250,161
                      
                      
                      
                      276,967Interest
      and penalties
                      
                      
                      1,581
                      
                      
                      
                      8,132Tax
      benefit of gain recorded in discontinued operations
                      
                      
                      (13,804
                      )
                      
                      
                      -Other
                      
                      
                      1,813
                      
                      
                      
                      2,852Total
      income tax expense (benefit)
                      
                      $
                      (17,594
                      )
                      
                      $
                      66,512





Significant
components of the Company’s deferred tax assets and liabilities at December 31,
2008 and 2007 were as follows (dollars in thousands):


78




December 31,
                                2008
                              
                              
                              December 31,
                                2007Deferred
      tax assets:Basis
      difference – investments
                              
                              $
                              377,129
                              
                              
                              $
                              229,371Federal
      net operating loss carryforwards
                              
                              
                              93,783
                              
                              
                              
                              60,335Accrued
      litigation
                              
                              
                              75
                              
                              
                              
                              17,887Allowance
      for loan losses
                              
                              
                              106,073
                              
                              
                              
                              25,375State
      net operating loss carryforwards
                              
                              
                              13,922
                              
                              
                              
                              14,964Deferred
      compensation
                              
                              
                              -
                              
                              
                              
                              7,070Excess
      inclusion income
                              
                              
                              3,918
                              
                              
                              
                              4,932Loan
      sale recourse obligations
                              
                              
                              36
                              
                              
                              
                              811Other
                              
                              
                              9,980
                              
                              
                              
                              8,650Gross
      deferred tax asset
                              
                              
                              604,916
                              
                              
                              
                              369,395Valuation
      allowance
                              
                              
                              (601,110
                              )
                              
                              
                              (368,312
                              )Deferred
      tax asset
                              
                              
                              3,806
                              
                              
                              
                              1,083Deferred
      tax liabilities:Other
                              
                              
                              3,806
                              
                              
                              
                              1,083Deferred
      tax liability
                              
                              
                              3,806
                              
                              
                              
                              1,083Net
      deferred tax asset
                              
                              $
                              -
                              
                              
                              $
                              -





Based on
the evidence available as of December 31, 2008, including the significant
pre-tax losses incurred by the Company in 2008 and 2007, the liquidity issues
facing the Company and the decision by the Company to close all of its mortgage
lending and loan servicing operations, the Company believes that it is more
likely than not that the Company will not realize its deferred tax
assets.





In
determining the amount of valuation allowance to record as of December 31, 2008,
the Company concluded that it is more likely than not that the entire net
deferred tax asset will not be realized.  Based on these conclusions,
the Company recorded a valuation allowance of $601.1 million for deferred tax
assets as of December 31, 2008 compared to $368.3 million as of December
31, 2007.





As of
December 31, 2008, the Company had a federal net operating loss of approximately
$267.9 million.  The federal net operating loss may be carried forward
to offset future taxable income, subject to applicable provisions of the Code,
including substantial limitations in the event of an “ownership change” as
defined in Section 382 of the Code. If not used, this net operating loss will
expire in years 2025 through 2028.  The Company has state net
operating loss carryovers arising from both combined and separate filings from
as early as 2004.  The loss carryovers may expire as early as 2010 and
as late as 2028.





Effective
January 1, 2007, the Company adopted FIN 48.  FIN 48 requires a
company to evaluate whether a tax position taken by the company will “more
likely than not” be sustained upon examination by the appropriate taxing
authority.  It also provides guidance on how a company should measure the
amount of benefit that the company is to recognize in its financial
statements.  As a result of the implementation of FIN 48, the Company
recorded a $1.1 million net liability as an increase to the opening balance of
accumulated deficit.  As of January 1, 2007, the total gross amount of
unrecognized tax benefits was $1.0 million and the total amount of unrecognized
tax benefits that would impact the effective tax rate, if recognized, was $0.6
million.





As of
December 31, 2008, the total gross amount of unrecognized tax benefits was $0.5
million which also represents the total amount of unrecognized tax benefits that
would impact the effective tax rate.  The Company does not expect the
unrecognized tax benefit to change in the next twelve months.





During
2008, the Company requested the Internal Revenue Service to issue a closing
agreement or determination letter with respect to an uncertain tax position
taken by the Company in 2007.  The Company received a response from
the Internal Revenue Service and has adjusted the FIN 48 liability
accordingly.  The unrecognized tax benefit related to the uncertain
tax position was $5.4 million as of December 31, 2007.





It is the
Company’s policy to recognize interest and penalties related to income tax
matters in income tax expense.  Interest and penalties recorded in income
tax expense was $1.6 and $8.2 million for the year ended December 31, 2008
and 2007, respectively. Accrued interest and penalties was $2.0 million and $3.0
million as of December 31, 2008 and 2007, respectively.





The
Company and its subsidiaries are subject to U.S. federal income tax as well as
income tax of multiple state and local jurisdictions. Tax years 2006 to 2008
remain open to examination for U.S. federal income tax. Tax years 2005 – 2008
remain open for major state tax jurisdictions.


79


The
activity in the accrued liability for unrecognized tax benefits for the years
ended December 31, 2008 and 2007 was as follows (dollars in
thousands):





2008
                      
                      
                      2007Beginning
      balance
                      
                      $
                      6,329
                      
                      
                      $
                      962Gross
      decreases – tax positions in prior period
                      
                      
                      (5,367
                      )
                      
                      
                      -Gross
      increases – tax positions in current period
                      
                      
                      -
                      
                      
                      
                      5,367Lapse
      of statute of limitations
                      
                      
                      (482
                      )
                      
                      
                      -Ending
      balance
                      
                      $
                      480
                      
                      
                      $
                      6,329





Management
believes it has adequately provided for potential tax liabilities that may be
assessed for years in which the statute of limitations remains
open.  However, if there were an assessment of any material liability
it may adversely affect the Company’s financial condition, liquidity and ability
to continue as a going concern.





Note
18. Employee Benefit Plans




The
NovaStar Financial, Inc. 401(k) Plan (the “Plan”) is a defined contribution plan
which allows eligible employees to save for retirement through pretax
contributions. Under the Plan, employees of the Company may contribute up to the
statutory limit. The Company may elect to match a certain percentage of
participants’ contributions. The Company may also elect to make a discretionary
contribution, which is allocated to participants based on each participant’s
compensation. No company contributions were made to the Plan for the years ended
December 31, 2008 and 2007.  As a result of the Exit Plans described
in Note 14, the Plan was subject to a partial termination during
2007.





The
Company had a Deferred Compensation Plan (the “DCP”) that was a nonqualified
deferred compensation plan that benefited certain designated key members of
management and highly compensated employees and allowed them to defer payment of
a portion of their compensation to future years. Under the DCP, an employee
could defer up to 50% of their base salary, bonus and/or commissions on a pretax
basis. The Company could make both discretionary and/or matching contributions
to the DCP on behalf of DCP participants.  The Company made no
contributions to the DCP for the year ended December 31,
2007.   The DCP was terminated effective December 31, 2007 and
all assets, which included $7.5 million in cash and Company stock, were
distributed in January 2008 as a result of prior distribution elections and such
termination.





Note
19. Stock Compensation Plans





On June
8, 2004, the Company’s 1996 Stock Option Plan (the “1996 Plan”) was replaced by
the 2004 Incentive Stock Plan (the “2004 Plan”). The 2004 Plan provides for the
grant of qualified incentive stock options (“ISOs”), non-qualified stock options
(“NQSOs”), deferred stock, restricted stock, restricted stock units, performance
share awards, dividend equivalent rights (“DERs”) and stock appreciation awards
(“SARs”). The Company has granted ISOs, NQSOs, restricted stock, performance
share awards and DERs. ISOs may be granted to employees of the Company. NQSOs,
DERs, SARs and stock awards may be granted to the directors, officers,
employees, agents and consultants of the Company or any subsidiaries. The
Company registered 625,000 shares of common stock under the 2004 Plan, of which
approximately 536,000 shares were available for future issuances as of December
31, 2008. The 2004 Plan will remain in effect unless terminated by the Board of
Directors or no shares of stock remain available for awards to be granted. The
Company’s policy is to issue new shares upon option exercise.





Effective
January 1, 2006, the Company adopted provisions of SFAS No. 123(R). The Company
selected the modified prospective method of adoption. The Company recorded
stock-based compensation expense of $0.1 million and $0.7 million for the
years ended December 31, 2008 and 2007, respectively. There was no income tax
benefit recognized in the income statement for stock-based compensation
arrangements in 2008 and 2007.  As of December 31, 2008, there was
$0.7 million of total unrecognized compensation cost related to non-vested
share-based compensation arrangements granted. The cost is expected to be
amortized over a weighted average period of 1.68 years.





The
Company adopted an Equity Award Policy on February 12, 2007 governing the grant
of equity awards. In general, equity awards may be granted only at a meeting of
the Compensation Committee or the entire Board during the “Trading Window,” as
defined in the Company’s Insider Trading and Disclosure Policy for Designated
Insiders. The Trading Window for a particular quarter is open beginning on the
second business day following an earnings release with respect to the prior
quarter until the 15th day of
the third month of the quarter. The exercise price (if applicable) of all equity
awards will be equal to the price at which the Company’s common stock was last
sold on the date of grant.





On May
23, 2008 the Company granted 5,000 stock options to directors with an exercise
price of $1.65, which was the closing market price on the NYSE of the Company’s
common stock on the date of grant.  The options granted vested
immediately.





Grants of
long-term equity awards for 2007 were made on March14, 2007, in accordance
with the Company’s Equity Award Policy. On that date 206,096 stock options were
granted to employees with an exercise price of $16.72, which was the closing
market price on the NYSE of the Company’s common stock on that date. The options
granted are subject to a four year vesting period.


80


During
the second quarter of 2007 the Company granted 6,000 stock options to employees
with an exercise price of $25.68, which was the closing market price on the NYSE
of the Company’s common stock on May 3, 2007, the date of grant.  The
options granted are subject to a four year vesting period.





On May 7,
2007 the Company granted 5,000 stock options to directors with an exercise price
of $27.36, which was the closing market price on the NYSE of the Company’s
common stock on the date of grant.  The options granted vested
immediately.





All
options have been granted at exercise prices greater than or equal to the
estimated fair value of the underlying stock at the date of grant. Outstanding
options generally vest equally over four years and expire ten years after the
date of grant.





The
following table summarizes the weighted average fair value of options granted
for the years ended December 31, 2008 and 2007, respectively, determined using
the Black-Scholes option pricing model and the assumptions used in their
determination. Due to the unusual market conditions and significant volatility
in the Company’s stock price during 2007, the expected volatility for options
granted in 2007 was based on historical volatility of the Company’s
stock.  The historical volatility was estimated based on a period of
time during the Company’s past which management believed would be representative
of the expected volatility for the life of the options granted.  The
expected life is a significant assumption as it determines the period for which
the risk free interest rate, volatility and dividend yield must be applied. The
expected life is the period over which employees and directors are expected to
hold their options and is based on the Company’s historical experience with
similar grants. The Company’s options have DERs and accordingly, the assumed
dividend yield was zero for these options.





2008
                  
                  
                  2007Weighted
      average:Fair
      value, at date of grant
                  
                  $
                  1.40
                  
                  
                  $
                  10.06Expected
      life in years
                  
                  
                  10
                  
                  
                  
                  5Annual
      risk-free interest rate
                  
                  
                  3.84
                  %
                  
                  
                  4.46
                  %Volatility
                  
                  
                  84.3
                  %
                  
                  
                  65.0
                  %Dividend
      yield
                  
                  
                  0.0
                  %
                  
                  
                  0.0
                  %




The
following table summarizes activity, pricing and other information for the
Company’s stock options activity for the year ended December 31,
2008:


Stock Options
                                                                    
                                                                    Number of
                                                                      Shares
                                                                    
                                                                    Weighted
                                                                      Average
                                                                      Exercise Price
                                                                    
                                                                    Weighted Average
                                                                      Remaining
                                                                      Contractual Term
                                                                      (Years)
                                                                    
                                                                    Aggregate
                                                                      Intrinsic Value
                                                                      (in thousands)Outstanding
      at the beginning of the year
                                                                    
                                                                    267,342
                                                                    
                                                                    $
                                                                    47.81Granted
                                                                    
                                                                    5,000
                                                                    
                                                                    
                                                                    1.65Exercised
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    -Forfeited
      or expired
                                                                    
                                                                    (111,945
                                                                    )
                                                                    
                                                                    34.62Outstanding
      at the end of the year
                                                                    
                                                                    160,397
                                                                    
                                                                    $
                                                                    55.63
                                                                    
                                                                    5.01
                                                                    
                                                                    $
                                                                    (8,880
                                                                    )Exercisable
      at the end of the year
                                                                    
                                                                    114,612
                                                                    
                                                                    $
                                                                    65.32
                                                                    
                                                                    3.80
                                                                    
                                                                    $
                                                                    (7,456
                                                                    )Stock
      options expected to vest at the end of the year
                                                                    
                                                                    22,835
                                                                    
                                                                    $
                                                                    38.29
                                                                    
                                                                    8.05
                                                                    
                                                                    $
                                                                    (1,424
                                                                    )





The
following table summarizes activity, pricing and other information for the
Company’s stock options activity for the year ended December 31,
2007:


81





Stock Options
                                                          
                                                          Number of
                                                            Shares
                                                          
                                                          Weighted
                                                            Average
                                                            Exercise
                                                            Price
                                                          
                                                          Weighted
                                                            Average
                                                            Remaining
                                                            Contractual
                                                            Term (Years)
                                                          
                                                          Aggregate
                                                            Intrinsic
                                                            Value (in
                                                            thousands)Outstanding
      at the beginning of the year
                                                          
                                                          124,432
                                                          
                                                          $
                                                          94.60Granted
                                                          
                                                          217,101
                                                          
                                                          
                                                          15.08Exercised
                                                          
                                                          (6,875
                                                          )
                                                          
                                                          30.48Forfeited
      or expired
                                                          
                                                          (67,316
                                                          )
                                                          
                                                          37.41Outstanding
      at the end of the year
                                                          
                                                          267,342
                                                          
                                                          $
                                                          47.81
                                                          
                                                          7.94
                                                          
                                                          $
                                                          (12,009
                                                          )Exercisable
      at the end of the year
                                                          
                                                          81,499
                                                          
                                                          $
                                                          77.45
                                                          
                                                          5.52
                                                          
                                                          $
                                                          (6,076
                                                          )Stock
      options expected to vest at the end of the year
                                                          
                                                          41,468
                                                          
                                                          $
                                                          68.23
                                                          
                                                          8.56
                                                          
                                                          $
                                                          (2,710
                                                          )





There
were no options exercised during the year ended December 31,
2008.  The total intrinsic value of options exercised during the years
ended December 31, 2007 was $51,925. The total fair value of options vested
during the years ended December 31, 2008 and 2007 was 1.0 million and $0.8
million, respectively.





For
options that vested prior to January 1, 2005, a recipient is entitled to receive
additional shares of stock upon the exercise of options as a result of DERs
associated with the option. For employees, the DERs accrue at a rate equal to
the number of options outstanding times sixty percent of the dividends per share
amount at each dividend payment date. For directors, the DERs accrue at a rate
equal to the number of options outstanding times the dividends per share amount
at each dividend payment date. The accrued DERs convert to shares based on the
stock’s fair value on the dividend payment date. There were no options exercised
during 2008.  Certain of the options exercised in 2007 had DERs
payable in additional shares of stock attached to them when
issued.   As a result of these exercises, an additional 8,766
shares of common stock were issued in 2007.




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




The
Company did not grant and issue shares of restricted stock during
2008.  The Company granted and issued shares of restricted stock
during 2007.  These awards vest at the end of 5 years





During
2005, the Company granted restricted shares to employees and officers under
Performance Contingent Deferred Stock Award Agreements. Under the agreements,
the Company would have issued shares of restricted stock if certain performance
targets were achieved by the Company within a three-year period. As of December
31, 2007 which is the end of the three-year period, the targets were not
achieved and the shares were subsequently forfeited.





In
November 2004, the Company entered into a Performance Contingent Deferred Stock
Award Agreement with an executive of the Company. Under the agreement, the
Company will issue shares of restricted stock if certain performance targets
based on wholesale nonconforming origination volume are achieved by the Company
within a five-year period. The shares vest equally over four years upon
issuance. The agreement was terminated in 2007.





The
following tables present information on restricted stock outstanding as of
December 31, 2008 and 2007.





December 31, 2008
                                
                                
                                December 31, 2007Number of
                                  Shares
                                
                                
                                Weighted
                                  Average
                                  Grant Date
                                  Fair Value
                                
                                
                                Number
                                  of
                                  Shares
                                
                                
                                Weighted
                                  Average
                                  Grant Date
                                  Fair ValueOutstanding
      at the beginning of year
                                
                                
                                107,211
                                
                                
                                $
                                36.50
                                
                                
                                
                                55,219
                                
                                
                                $
                                111.52Granted
                                
                                
                                -
                                
                                
                                
                                -
                                
                                
                                
                                115,463
                                
                                
                                
                                16.72Vested
                                
                                
                                (1,745
                                )
                                
                                
                                185.68
                                
                                
                                
                                (2,237
                                )
                                
                                
                                185.68Forfeited
                                
                                
                                (71,220
                                )
                                
                                
                                33.96
                                
                                
                                
                                (61,234
                                )
                                
                                
                                28.55Outstanding
      at the end of period
                                
                                
                                34,246
                                
                                
                                $
                                38.38
                                
                                
                                
                                107,211
                                
                                
                                $
                                36.50





There was
no restricted stock granted during the year ended December 31,
2008.  The weighted average grant date fair value of restricted stock
granted during the years ended December 31, 2007 was
$16.72.


82


Note
20.  Fair Value of Financial Instruments





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





The estimated fair values of the
Company’s financial instruments related to continuing operations are as follows
as of December 31, 2008 and 2007 (dollars in
thousands):





2008
                            
                            2007Carrying
                              Value
                            
                            
                            Fair
                              Value
                            
                            Carrying
                              Value
                            
                            
                            Fair ValueFinancial
      assets:Cash
      and cash equivalents
                            
                            $
                            24,790
                            
                            
                            $
                            24,790
                            
                            
                            $
                            25,364
                            
                            
                            $
                            25,364Restricted
      cash
                            
                            
                            6,046
                            
                            
                            
                            5,595
                            
                            
                            
                            8,998
                            
                            
                            
                            8,998Mortgage
      loans - held-in-portfolio
                            
                            
                            1,772,838
                            
                            
                            
                            1,772,838
                            
                            
                            
                            2,870,013
                            
                            
                            
                            2,459,105Mortgage
      securities - trading
                            
                            
                            7,085
                            
                            
                            
                            7,085
                            
                            
                            
                            109,203
                            
                            
                            
                            109,203Mortgage
      securities - available-for-sale
                            
                            
                            12,788
                            
                            
                            
                            12,788
                            
                            
                            
                            33,371
                            
                            
                            
                            33,371Accrued
      interest receivable
                            
                            
                            77,292
                            
                            
                            
                            77,292
                            
                            
                            
                            61,704
                            
                            
                            
                            61,704Financial
      liabilities:Borrowings:Asset-backed
      bonds secured by mortgage loans
                            
                            
                            2,599,351
                            
                            
                            
                            1,772,838
                            
                            
                            
                            3,065,746
                            
                            
                            
                            2,410,894Asset-backed
      bonds secured by mortgage securities
                            
                            
                            5,376
                            
                            
                            
                            5,376
                            
                            
                            
                            74,385
                            
                            
                            
                            74,385Short-term
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            45,488
                            
                            
                            
                            45,488Junior
      subordinated debentures
                            
                            
                            77,323
                            
                            
                            
                            6,248
                            
                            
                            
                            83,561
                            
                            
                            
                            83,561Accrued
      interest payable
                            
                            
                            10,242
                            
                            
                            
                            10,242
                            
                            
                            
                            6,903
                            
                            
                            
                            6,903Derivative
      instruments:Interest
      rate cap agreements
                            
                            
                            (8
                            )
                            
                            
                            (8
                            )
                            
                            
                            (85
                            )
                            
                            
                            (85
                            )Interest
      rate swap agreements
                            
                            
                            9,302
                            
                            
                            
                            9,302
                            
                            
                            
                            9,441
                            
                            
                            
                            9,441Credit-default
      swap agreements
                            
                            
                            (193
                            )
                            
                            
                            (193
                            )
                            
                            
                            (2,460
                            )
                            
                            
                            (2,460
                            )





Cash and cash equivalents –
The fair value of cash and cash equivalents approximates its carrying
value.





Restricted Cash – The fair
value of restricted cash was estimated by discounting estimated future release
of the cash from restriction.





Mortgage loans – The fair
value for all loans is estimated by discounting the projected future cash flows
using market discount rates at which similar loans made to borrowers with
similar credit ratings and maturities would be discounted in the
market.





Mortgage securities –
available-for-sale – Mortgage securities – available-for-sale is made up
of residual securities and subordinated securities. The fair value of residual
securities is estimated by discounting future projected cash flows using a
discount rate commensurate with the risks involved.





Mortgage securities- trading
– Mortgage securities – trading is made up of residual securities and
subordinated securities. The fair value of residual securities is estimated by
discounting future projected cash flows using a discount rate commensurate with
the risks involved. The fair value of the subordinated securities is estimated
using quoted broker prices and compared to internal discounted cash
flows.





Borrowings – The fair value
of short-term borrowings approximates their carrying value as the borrowings
bear interest at rates that approximate market rates for similar borrowings. The
fair value of junior subordinated debentures approximates their carrying value
as the borrowings were restructured in 2009 and the principal balance did not
change. As of December 31, 2007, the fair value of junior subordinated
debentures approximates their carrying value as the borrowings bear interest at
rates that approximate market rates for similar borrowings.  The fair
value of asset-backed bonds secured by mortgage loans was estimated using the
fair value of mortgage loans – held-in-portfolio at December 31, 2008 as the
trusts have no recourse to the Company’s other, unsecuritized
assets.  The fair value of asset-backed bonds secured by mortgage
loans was estimated using observable market prices for similar borrowings at
December 31, 2007.  The fair value of asset-backed bonds secured by
mortgage securities is approximated using quoted market prices.


83





Derivative instruments – The
fair value of derivative instruments is estimated by discounting the projected
future cash flows using appropriate rates.





Accrued interest receivable and
payable – The fair value of accrued interest receivable and payable
approximates their carrying value.





Note
21.  Subsequent Events





Junior
Subordinated Debentures Settlement Agreement. On February 18, 2009,
the Company, NMI, NovaStar Capital Trust I and NovaStar Capital Trust II (the
“Trusts”) and the trust preferred security holders entered into agreements
to settle the claims of the trust preferred security holders arising from NMI’s
failure to make the scheduled quarterly interest payments on unsecured notes
(collectively, the “Notes”) outstanding to the Trusts which secure trust
preferred securities issued by the Trusts.  As part of the settlement,
the existing preferred obligations would be exchanged for new preferred
obligations.  The settlement and exchange were contingent upon, among
other things, the dismissal of the involuntary Chapter 7
bankruptcy.  On March 9, 2009, the Bankruptcy Court entered an order
dismissing the involuntary proceeding.  On April 27, 2009 (the
“Exchange Date”), the parties executed the necessary documents to complete the
Exchange.  On the Exchange Date, the Company paid interest due through
December 31, 2008, in the aggregate amount of $5.3 million.  In
addition, the Company paid $0.3 million in legal and administrative costs on
behalf of the Trusts.





The new
preferred obligations require quarterly distributions of interest to the holders
at a rate equal to 1.0% per annum beginning January 1, 2009 through December 31,
2009, subject to reset to a variable rate equal to the three-month LIBOR plus
3.5% upon the occurrence of an “Interest Coverage Trigger.”   For
purposes of the new preferred obligations, an Interest Coverage Trigger occurs
when the ratio of EBITDA for any quarter ending on or after December 31, 2008
and on or prior to December 31, 2009 to the product as of the last day of such
quarter, of the stated liquidation value of all outstanding 2009 Preferred
Securities (i) multiplied by 7.5%, (ii) multiplied by 1.5 and (iii) divided by
4, equals or exceeds 1.00 to 1.00.   Beginning January 1, 2010
until the earlier of  February 18, 2019 or the occurrence of an
Interest Coverage Trigger, the unpaid principal amount of the new preferred
obligations will bear interest at a rate of 1.0% per annum and, thereafter, at a
variable rate, reset quarterly, equal to the three-month LIBOR plus 3.5% per
annum.





Advent Securities
Purchase Agreement. On April 26, 2009, NovaStar Financial, Inc.
(“NovaStar”) entered into a Securities Purchase Agreement (the “Purchase
Agreement”) with Advent Financial Services, LLC (“Advent”) and Mark A. Ernst
(“Ernst”).  Advent is a start-up company with the goal of providing
tailored banking accounts and low cost small-dollar banking services to meet the
needs of underserved low- and moderate-income
consumers.   Pursuant to the Purchase Agreement, NovaStar will
acquire 70% of the fully diluted membership interests in Advent in exchange for
an initial payment of $2.0 million and, upon Advent’s achievement of certain
financial metrics for the twelve months ended April 30, 2010, an additional
payment of $2.0 million.


84


REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM




To the
Board of Directors and Shareholders of


NovaStar
Financial, Inc.


Kansas
City, Missouri




We have
audited the accompanying consolidated balance sheets of NovaStar Financial, Inc.
and subsidiaries (the "Company") as of December 31, 2008 and 2007, and the
related consolidated statements of operations, shareholders’ deficit, and cash
flows for the years then ended.  These financial statements are the
responsibility of the Company's management.  Our responsibility is to
express an opinion on these financial statements based on our
audits.




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




In our
opinion, such consolidated financial statements present fairly, in all material
respects, the financial position of the Company as of December 31, 2008 and
2007, and the results of its operations and its cash flows for the years then
ended in conformity with accounting principles generally accepted in the United
States of America.




The
accompanying financial statements have been prepared assuming that the Company
will continue as a going concern.  As discussed in Note 1 to the financial
statements, the Company's recurring losses, negative cash flows, shareholders’
deficit and the lack of significant operations raise substantial doubt about its
ability to continue as a going concern.  Management's plans concerning
these matters are also described in Note 1.  The financial statements do
not include any adjustments that might result from the outcome of this
uncertainty.




We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the Company's internal control over financial
reporting as of December 31, 2008, based on the criteria established in Internal Control—Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission and our report dated May 26, 2009 expressed an adverse
opinion on the Company's internal control over financial reporting because of a
material weakness.




/s/
Deloitte and Touche LLP




Kansas
City, Missouri


May 26,
2009


85


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





None





Item
9A. 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(d)) as of the end of the period covered by this report and
concluded that the Company’s controls and procedures were
effective.




Internal
Control over Financial Reporting





Management’s
Report on Internal Control over Financial Reporting





Management
of NovaStar Financial, Inc. and subsidiaries (the “Company”) is responsible for
establishing and maintaining adequate internal control over financial reporting
as defined in Rule 13a-15(f) of the Securities Exchange Act of 1934. This
internal control system has been designed to provide reasonable assurance to the
Company’s management and board of directors regarding the preparation and fair
presentation of the Company’s published financial statements.





All
internal control systems, no matter how well designed, have inherent
limitations. Therefore, even those systems determined to be effective can
provide only reasonable assurance with respect to financial statement
preparation and presentation.





Management
of the Company has assessed the effectiveness of the Company’s internal control
over financial reporting as of December 31, 2008. To make this assessment,
management used the criteria for effective internal control over financial
reporting described in Internal Control—Integrated
Framework, issued by the Committee of Sponsoring Organizations of the
Treadway Commission. Based on our assessment under the framework in Internal Control—Integrated
Framework, management concluded that the Company’s internal control over
financial reporting was not effective as of December 31, 2008 because of the
existence of a material weakness in internal controls over financial reporting
related to the lack of segregation of duties within our accounting
department





A
material weakness is a deficiency, or combination of deficiencies, in internal
controls over financial reporting, such that there is a reasonable possibility a
material misstatement of the company’s annual or interim financial statements
will not be prevented or detected on a timely basis.





The
Company identified a control deficiency that was deemed a material weakness in
internal controls over financial reporting at September 30, 2008. The deficiency
relates to the inadequate segregation of duties amongst the Company's employees
with respect to accounting, financial reporting and disclosure. The material
weakness was a result of the reduction in our accounting staff which occurred
during the third quarter ended September 30, 2008.  The material
weakness identified above did not result in the restatement of prior period
financial statements or any other related financial disclosure, nor did it
disclose any errors or misstatements.





Management
has taken steps to remedy the material weakness by hiring additional accounting
department staff, and reallocating duties, including responsibilities for
financial reporting, among the Company’s employees.   Based on
the lack of resources available to hire and train employees, this material
weakness was not remediated as of December 31, 2008.





Our
independent registered public accounting firm, Deloitte & Touche LLP, has
issued an attestation report, included herein, on the effectiveness of the
Company’s internal control over financial reporting as of December 31,
2008.





Changes
in Internal Control over Financial Reporting





Except
for the material weakness described above,there were no changes
in our internal controls over financial reporting as of December 31, 2008 that
have materially affected, or are reasonably likely to materially affect, our
internal controls over financial reporting.


86


Attestation Report of the Registered
Public Accounting Firm





REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM




To the
Board of Directors and Shareholders of


NovaStar
Financial, Inc.


Kansas
City, Missouri




We have
audited NovaStar Financial Inc. and subsidiaries' (the "Company") internal
control over financial reporting as of December 31, 2008, based on criteria
established in Internal
Control — Integrated Frameworkissued by the Committee of Sponsoring
Organizations of the Treadway Commission. The Company's management is
responsible for maintaining effective internal control over financial reporting
and for its assessment of the effectiveness of internal control over financial
reporting, included in the accompanying Management’s Report on Internal Control
over Financial Reporting. Our responsibility is to express an opinion on the
Company's internal control over financial reporting based on our
audit.




We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects.  Our audit included obtaining an understanding of
internal control over financial reporting, assessing the risk that a material
weakness exists, testing and evaluating the design and operating effectiveness
of internal control based on that risk, and performing such other procedures as
we considered necessary in the circumstances.  We believe that our audit
provides a reasonable basis for our opinion.




A
company's internal control over financial reporting is a process designed by, or
under the supervision of, the company's principal executive and principal
financial officers, or persons performing similar functions, and effected by the
company's board of directors, management, and other personnel 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.  A company's internal control
over financial reporting includes those policies and procedures that (1) pertain
to the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial
statements.




Because
of the inherent limitations of internal control over financial reporting,
including the possibility of collusion or improper management override of
controls, material misstatements due to error or fraud may not be prevented or
detected on a timely basis.  Also, projections of any evaluation of the
effectiveness of the internal control over financial reporting to future periods
are subject to the risk that the controls may become inadequate because of
changes in conditions, or that the degree of compliance with the policies or
procedures may deteriorate.




A
material weakness is a deficiency, or a combination of deficiencies, in internal
control over financial reporting, such that there is a reasonable possibility
that a material misstatement of the company’s annual or interim financial
statements will not be prevented or detected on a timely basis.  The
following material weakness has been identified and included in management's
assessment: internal control over financial reporting was not effective because
there was a lack of segregation of duties within the Company’s accounting
department. This material weakness was considered in determining the nature,
timing, and extent of audit tests applied in our audit of the consolidated
financial statements as of and for the year ended December 31, 2008, of the
Company and this report does not affect our report on such financial
statements.




In our
opinion, because of the effect of the material weakness identified above on the
achievement of the objectives of the control criteria, the Company has not
maintained effective internal control over financial reporting as of December
31, 2008, based on the criteria established in Internal Control — Integrated
Frameworkissued by the Committee of Sponsoring Organizations of the
Treadway Commission.




We have
also audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated financial statements as of and
for the year ended December 31, 2008, of the Company and our report dated May
26, 2009 expressed an unqualified opinion on those financial statements and
included an explanatory paragraph regarding the Company’s ability to continue as
a going concern.




/s/
Deloitte and Touche LLP




Kansas
City, Missouri


May 26,
2009


87


Item
9B. Other Information





None





PART
III





Item
10. Directors, Executive Officers and Corporate Governance





Information
with respect to Items 401,405 and 407(d)(4) and (d)(5) of Regulation S-K is
incorporated by reference to the information included in our Proxy Statement,
for the 2009 Annual Meeting of Shareholders.





Information
with respect to our corporate governance guidelines, charters of audit,
compensation, nominating and corporate governance committees, and code of
conduct may be obtained from the corporate governance section of our website
(www.novastarmortgage.com) or by contacting us directly. References to our
website do not incorporate by reference the information on such website into
this Annual Report on Form 10-K and we disclaim any such incorporation by
reference.




The code
of conduct applies to our principal executive officer, principal financial
officer, principal accounting officer, directors and other employees performing
similar functions. We intend to satisfy the disclosure requirements regarding
any amendment to, or waiver from, a provision of our code of conduct that
applies our principal executive officer, principal financial officer, principal
accounting officer, controller or persons performing similar functions by
disclosing such matters on our website.




Our
investor relations contact information follows:




Investor
Relations


2114
Central Street


Suite
600


Kansas
City, MO  64108


816.237.7000


Email:  ir@novastar1.com




NovaStar
Financial, Inc. has filed, as exhibits to last year’s Annual Report on Form 10-K
and is filing as exhibits to this Annual Report, the certifications of its chief
executive officer and chief financial officer required under Section 302 of the
Sarbanes-Oxley Act of 2002 to be filed with the Securities and Exchange
Commission regarding the quality of NovaStar Financial, Inc. public
disclosures.




Item
11. Executive Compensation




Information
with respect to Items 402 and 407(e)(4) and (e)(5) of Regulation S-K is
incorporated by reference to the information included in our Proxy Statement for
the 2009 Annual Meeting of Shareholders.


88


Item
12. Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters.




Information
with respect to Items 403 and 407(a) of Regulation S-K is incorporated by
reference to the information included in our Proxy Statement for the 2009 Annual
Meeting of Shareholders.




The following table sets forth
information as of December 31, 2008 with respect to compensation plans under
which our common stock may be issued.




Equity Compensation Plan InformationPlan Category
                                            
                                            Number of
                                              Securities to be
                                              Issued Upon
                                              Exercise of
                                              Outstanding
                                              Options,
                                              Warrants and
                                              Rights
                                            
                                            
                                            Weighted
                                              Average
                                              Exercise
                                              Price of
                                              Outstanding
                                              Options,
                                              Warrants
                                              and Rights
                                            
                                            Number of
                                              Securities
                                              Remaining
                                              Available for
                                              Future
                                              Issuance
                                              Under Equity
                                              Compensation
                                              Plans
                                              (Excluding
                                              Shares
                                              Reflected in
                                              the First
                                              Column)Equity
      compensation plans approved by stockholders
                                            
                                            160,397
                                            (A)
                                            
                                            $
                                            55.63
                                            
                                            535,594
                                            (B)Equity
      compensation plans not approved by stockholders
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            -Total
                                            
                                            160,397
                                            
                                            
                                            $
                                            55.63
                                            
                                            535,594





(A)
            Certain
      of the options have dividend equivalent rights (DERs) attached to them
      when issued. As of December 31, 2008, these options have 22,149 DERs
      attached.


(B)
            Represents
      shares that may be issued pursuant to the Company’s 2004 Incentive Stock
      Plan, which provides for the grant of qualified incentive stock options,
      non-qualified stock options, deferred stock, restricted stock, restricted
      stock units, performance share awards, dividend equivalent rights and
      stock appreciation awards.




Item
13. Certain Relationships and Related Transactions, and Director
Independence.




Information
with respect to Item 404 of Regulation S-K is incorporated by reference to the
information included in our Proxy Statement for the 2009 Annual Meeting of
Shareholders.




Item
14. Principal Accountant Fees and Services.




Information
with respect to Item 9(e) of Schedule 14A is incorporated by reference to the
information included in our Proxy Statement for the 2009 Annual Meeting of
Shareholders.


89


PART
IV




Item
15. Exhibits and Financial Statements Schedules




Financial
Statements and Schedules




(1)
              The
      financial statements as set forth under Item 8 of this report on Form 10-K
      are included herein.




(2)
            The
      required financial statement schedules are omitted because the information
      is disclosed elsewhere herein.




Exhibit
Listing


Exhibit
      No.
                    
                    Description
      of Document2.11
                    
                    Servicing
      Rights Transfer Agreement, dated as of October 12, 2007, between Saxon
      Mortgage Services, Inc. and NovaStar Mortgage, Inc.3.12
                    
                    Articles
      of Amendment and Restatement of NovaStar Financial, Inc.(including all
      amendmentsand
      applicable Articles Supplementary)3.1.13
                    
                    Certificate
      of Amendment of the Registrant3.24
                    
                    Amended
      and Restated Bylaws of the Registrant, adopted July 27,
    20054.15
                    
                    Specimen
      Common Stock Certificate4.26
                    
                    Specimen
      Preferred Stock Certificate10.17
                    
                    Employment
      Agreement, dated September 30, 1996, between the Registrant and Scott F.
      Hartman10.1.18
                    
                    Amendment
      dated December 20, 2006 to the Employment Agreement dated September 30,
      1996 between NovaStar Financial Inc., and Scott F.
  Hartman.10.29
                    
                    Employment
      Agreement, dated September 30, 1996, between the Registrant and W. Lance
      Anderson10.2.110
                    
                    Amendment
      dated December 20, 2006 to the Employment Agreement dated September 30,
      1996 between NovaStar Financial Inc., and W. Lance
    Anderson.10.311
                    
                    Employment
      Agreement between NovaStar Mortgage, Inc. and David A. Pazgan, Executive
      Vice President of NovaStar Mortgage, Inc.10.3.112
                    
                    Amendment
      dated December 20, 2006 to the Employment Agreement dated July 15, 2004
      between NovaStar Mortgage Inc., and Dave Pazgan.10.413
                    
                    Separation
      and Consulting Agreement, dated as of October 16, 2007 among NovaStar
      Mortgage and David A. Pazgan.10.514
                    
                    Employment
      Agreement between NovaStar Financial, Inc. and Jeffrey D. Ayers,Senior
      Vice President, General Counsel and Secretary10.615
                    
                    Employment
      Agreement between NovaStar Financial, Inc. and Gregory S. Metz, Senior
      Vice President and Chief Financial Officer10.6.116
                    
                    Amendment
      dated December 20, 2006 to the Employment Agreement dated July 15, 2004
      between NovaStar Financial Inc., and Gregory
  Metz.
  
  1
                Incorporated
      by reference to Exhibit 2.1 to Form 10-Q filed by the Registrant on
      November 14, 2007.
 2
                  Incorporated
      by reference to Exhibit 3.1 to Form 10-Q filed by the Registrant on August
      9, 2007.
 3
                  Incorporated
      by reference to Exhibit 3.1 to Form 8-K filed by the Registrant with the
      SEC on May 26, 2005.
 4
                  Incorporated
      by reference to Exhibit 3.3.1 to Form 10-Q filed by the Registrant with
      the SEC on August 5, 2005.
 5
                  Incorporated
      by reference to Exhibit 4.1 to Form 10-Q filed by the Registrant with the
      SEC on August 5, 2005.
 6
                  Incorporated
      by reference to Exhibit 4.3 to Form 8-A/A filed by the Registrant with the
      SEC on January 20, 2004.
 7
                  Incorporated
      by reference to Exhibit 10.8 to Form S-11 filed by the Registrant with the
      SEC on July 29, 1997.
 8
                  Incorporated
      by reference to Exhibit 10 to Form 8-K filed by the Registrant with the
      SEC on December 21, 2006.
 9
                  Incorporated
      by reference to Exhibit 10.9 to Form S-11 filed by the Registrant with the
      SEC on July 29, 1997.
 10
                  Incorporated
      by reference to Exhibit 10 to Form 8-K filed by the Registrant with the
      SEC on December 21, 2006.
 11
                  Incorporated
      by reference to Exhibit 10.27 to Form 8-K filed by the Registrant with the
      SEC on February 11, 2005.
 12
                  Incorporated
      by reference to an Exhibit 10 to Form 8-K filed by the Registrant with the
      SEC on December 21, 2006.
 13
                  Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on October 18, 2007
 14
                  Incorporated
      by reference to Exhibit 10.28 to Form 10-K filed by the Registrant with
      the SEC on March 1, 2007.
 15
                  Incorporated
      by reference to Exhibit 10.31to Form 8-K filed by the Registrant with the
      SEC on February 11, 2005.
 16
                  Incorporated
      by reference to Exhibit 10 to Form 8-K filed by the Registrant with the
      SEC on December 21,
2006.
  90
  Exhibit
      No.
                      
                      Description
      of Document10.717
                      
                      Separation
      and Consulting Agreement, dated as of January 3, 2008, by and between
      NovaStar Financial, Inc. and Gregory Metz.10.818
                      
                      Employment
      Agreement between NovaStar Financial, Inc. and Michael L. Bamburg,
      Executive President and Chief Investment Officer10.9
                      
                      Employment
      Agreement between NovaStar Financial, Inc. and Todd M. Phillips, dated
      December 17, 200710.10
                      
                      Retention
      Agreement, dated as of December 17, 2007, by and between NovaStar
      Financial, Inc. and Todd M. Phillips10.1119
                      
                      Employment
      Agreement, dated as of January 7, 2008, by and between NovaStar Financial,
      Inc. and Rodney E. Schwatken.10.1220
                      
                      Form
      of Indemnification Agreement for Officers and Directors of NovaStar
      Financial, Inc. and its Subsidiaries10.1321
                      
                      NovaStar
      Mortgage, Inc. Deferred Compensation Plan Amended and Restated Effective
      as of December 31, 200710.13.122
                      
                      Amended
      and Restated Trust Agreement for the NovaStar Mortgage, Inc. Deferred
      Compensation Plan10.13.223
                      
                      Amendment
      One to the Amended and Restated Trust Agreement for the NovaStar Mortgage,
      Inc. Deferred Compensation Plan10.1424
                      
                      1996
      Executive and Non-Employee Director Stock Option Plan, as last amended
      December 6, 199610.1525
                      
                      NovaStar
      Financial Inc. 2004 Incentive Stock Plan10.15.126
                      
                      Amendment
      One to the NovaStar Financial, Inc. 2004 Incentive Stock Option
      Plan10.15.227
                      
                      Stock
      Option Agreement under NovaStar Financial, Inc. 2004 Incentive Stock
      Plan10.15.328
                      
                      Restricted
      Stock Agreement under NovaStar Financial, Inc. 2004 Incentive Stock
      Plan10.15.429
                      
                      Performance
      Contingent Deferred Stock Award Agreement under NovaStar Financial, Inc.
      2004 Incentive Stock Plan10.1630
                      
                      NovaStar
      Financial, Inc. Executive Bonus Plan10.1731
                      
                      2005
      Compensation Plan for Independent Directors10.1832
                      
                      NovaStar
      Financial, Inc. Long Term Incentive Plan10.1933
                      
                      Purchase
      Agreement, dated March 15, 2005, among NovaStar Financial, Inc., NovaStar
      Mortgage, Inc., NovaStar Capital Trust I, Merrill Lynch International and
      Taberna Preferred Funding I, LTD10.2034
                      
                      Amended
      and Restated Trust Agreement, dated March 15, 2005, between NovaStar
      Financial, Inc., JPMorgan Chase Bank, Chase Bank USA and certain
      administrative trustees10.2135
                      
                      Junior
      Subordinated Indenture, dated March 15, 2005, between NovaStar Financial,
      Inc., and JPMorgan Chase
Bank
 
 
  17
              Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on January 8, 2008.
 18
                Incorporated
      by reference to Exhibit 10.32 to Form 8-K filed by the Registrant with the
      SEC on March 28, 2007.
 19
                Incorporated
      by reference to Exhibit 10.1 to Form 8-K/A filed by the Registrant with
      the SEC on January 10, 2008.
 20
                Incorporated
      by reference to Exhibit 10.10 to Form 8-K filed by the Registrant with the
      SEC on November 16, 2005.
 21
                Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on December 21, 2007.
 22
                Incorporated
      by reference to Exhibit 4.6 to Form S-8 filed by the Registrant with the
      SEC on November 29, 2006.
 23
                Incorporated
      by reference to Exhibit 10.45.1 to Form 10-Q filed by the Registrant with
      the SEC on May 10, 2007.
 24
                Incorporated
      by reference to Exhibit 10.14 to Form S-11 filed by the Registrant with
      the SEC on July 29, 1997.
 25
                Incorporated
      by reference to Exhibit 10.15 to Form S-8 filed by the Registrant with the
      SEC on June 30, 2004.
 26
                Incorporated
      by reference to Exhibit 10.46 to Form 10-Q filed by the Registrant with
      the SEC on May 10, 2007.
 27
                Incorporated
      by reference to Exhibit 10.25.1 to Form 8-K filed by the Registrant with
      the SEC on February 4, 2005.
 28
                Incorporated
      by reference to Exhibit 10.25.2 to Form 8-K filed by the Registrant with
      the SEC on February 4, 2005.
 29
                Incorporated
      by reference to Exhibit 10.25.3 to Form 8-K filed by the Registrant with
      the SEC on February 4, 2005.
 30
                Incorporated
      by reference to Exhibit 10.26 to Form 8-K filed by the Registrant with the
      SEC on March 15, 2007.
 31
                Incorporated
      by reference to Exhibit 10.30 to Form 8-K filed by the Registrant with the
      SEC on February 11, 2005.
 32
                Incorporated
      by reference to Exhibit 10.34 to Form 8-K filed by the Registrant with the
      SEC on February 14, 2006.
 33
                Incorporated
      by reference to Exhibit 10.34 to Form 10-Q filed by the Registrant with
      the SEC on May 5, 2005.
 34
                Incorporated
      by reference to Exhibit 4.4 to Form 10-Q filed by the Registrant with the
      SEC on May 5, 2005.
 35
                Incorporated
      by reference to Exhibit 4.5 to Form 10-Q filed by the Registrant with the
      SEC on May 5, 2005.
  91
  Exhibit
      No.
                    
                    Description
      of Document10.2236
                    
                    Parent
      Guarantee Agreement, dated March 15, 2005, between NovaStar Financial,
      Inc., and JP Morgan Chase Bank10.2337
                    
                    Purchase
      Agreement, dated April 18, 2006, among NovaStar Financial, Inc., NovaStar
      Mortgage, Inc., NovaStar Capital Trust II and Kodiak Warehouse
      LLC10.2438
                    
                    Amended
      and Restated Trust Agreement, dated April 18, 2006, between NovaStar
      Mortgage, Inc., JPMorgan Chase Bank, NA Chase Bank USA, NA and certain
      administrative trustees as well as the form of security representing the
      Junior Subordinated Notes and the form of Trust Preferred Securities
      Certificate10.2539
                    
                    Junior
      Subordinated Indenture, dated April 18, 2006 between NovaStar Mortgage,
      Inc., NovaStar Financial, Inc. and JPMorgan Chase Bank,
  NA10.2640
                    
                    Parent
      Guarantee Agreement, dated April 18, 2006, between NovaStar Financial,
      Inc. and JP Morgan Chase Bank, NA10.2741
                    
                    Master
      Repurchase Agreement (2007 Residual Securities), dated as of April 18,
      2007, among Wachovia  Investment Holdings, LLC, Wachovia Capital
      Markets, LLC, NovaStar Mortgage, Inc., NovaStar Certificates Financing LLC
      and NovaStar Certificates Financial Corporation10.27.142
                    
                    Amendment
      Number One to Master Repurchase Agreement (Residual Securities), dated as
      of May10,
      2007, among Wachovia Investment Holdings, LLC, Wachovia Capital Markets,
      LLC,NovaStar
      Mortgage, Inc., NovaStar Certificates Financing, LLC, NovaStar
      CertificatesFinancing
      Corporation, NovaStar Financial, Inc., NFI Holding Corporation and
      HomeView Lending, Inc.10.27.243
                    
                    Amendment  Number
      Two, dated as of September 7, 2007, to the Master Repurchase Agreement
      (2007 Residual Securities), dated as of April 18, 2007, among
      Wachovia  Investment Holdings, LLC, Wachovia Capital Markets
      LLC, NovaStar Mortgage,  Inc., NovaStar Certificates Financing
      LLC, NovaStar Certificates Financing Corp., NovaStar Financial, Inc. and
      NFI Holding Corporation10.27.344
                    
                    Letter
      Agreement (Release of Security Interest relating to Master Repurchase
      Agreement (2007 Residual Securities)), dated as of January 4, 2008, by and
      among NovaStar Mortgage, Inc., NovaStar Certificates Financing LLC,
      NovaStar Certificates Financing Corporation, NFI Holding Corporation,
      NovaStar Financial, Inc., HomeView Lending, Inc., Wachovia Investment
      Holdings, LLC, and Wachovia Capital Markets, LLC.10.2845
                    
                    Guaranty,
      dated as of April 18, 2007, made by NovaStar Financial, Inc., NFI Holding
      Corporation, NovaStar Mortgage Inc. and Homeview Lending,  Inc.
      in favor of Wachovia Investment Holdings, LLC10.2946
                    
                    Collateral  Security,
      Setoff and Netting Agreement, dated as of April 18, 2007, among Wachovia
      Bank,  NA, Wachovia Investment Holdings, LLC, Wachovia Capital
      Markets, LLC, NovaStar Financial, Inc.,  NovaStar Mortgage, Inc.
      and certain of their respective affiliates10.3047
                    
                    Master
      Repurchase Agreement (2007 Servicing Rights), dated as of April 25, 2007,
      among Wachovia Bank, N.A., Wachovia Capital Markets, LLC, and NovaStar
      Mortgage, Inc10.30.148
                    
                    Amendment
      Number One to Master Repurchase Agreement (2007 Servicing Rights), dated
      as ofMay
      10, 2007, among Wachovia Bank, N.A., Wachovia Capital Markets, LLC,
      NovaStarMortgage,
      Inc., NovaStar Financial, Inc., NovaStar Holding Corporation and HomeView
      Lending, Inc.10.30.249
                    
                    Amendment
      Number Two, dated as of September 7, 2007 to Master Repurchase Agreement(2007
      Servicing Rights), dated as of April 25, 2007, among Wachovia Bank, N.A.,
      WachoviaCapital
      Markets, LLC, NovaStar Mortgage, Inc., NovaStar Financial, Inc., NovaStarHolding
      Corporation and HomeView Lending,
Inc.
 
 
 36
                Incorporated
      by reference to Exhibit 4.6 to Form 10-Q filed by the Registrant with the
      SEC on May 5, 2005.
 37
                Incorporated
      by reference to Exhibit 10.38 to Form 8-K filed by the Registrant with the
      SEC on April 24, 2006.
 38
                Incorporated
      by reference to Exhibit 10.39 to Form 8-K filed by the Registrant with the
      SEC on April 24, 2006.
 39
                Incorporated
      by reference to Exhibit 10.40 to Form 8-K filed by the Registrant with the
      SEC on April 24, 2006.
 40
                Incorporated
      by reference to Exhibit 10.41exhibit to Form 8-K filed by the Registrant
      with the SEC on April 24,
2006.
 41
                Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on April 25, 2007.
 42
                Incorporated
      by reference to Exhibit 10.4 to Form 8-K filed by the Registrant with the
      SEC on May 15, 2007
 43
                Incorporated
      by reference to Exhibit 10.5 to Form 8-K filed by the Registrant with the
      SEC on September 12, 2007.
 44
                Incorporated
      by reference to Exhibit 10.2to Form 8-K filed by the Registrant with the
      SEC on January 10, 2008.
 45
                Incorporated
      by reference to Exhibit 10.2 to Form 8-K filed by the Registrant with the
      SEC on April 25, 2007.
 46
                Incorporated
      by reference to Exhibit 10.3 to Form 8-K filed by the Registrant with the
      SEC on April 25, 2007.
 47
                Incorporated
      by reference to Exhibit 10.2 to Form 8-K filed by the Registrant with the
      SEC on May 1, 2007.
 48
                Incorporated
      by reference to Exhibit 10.3 to Form 8-K filed by the Registrant with the
      SEC on May 15, 2007
 49
                Incorporated
      by reference to Exhibit 10.4 to Form 8-K filed by the Registrant with the
      SEC on September 12, 2007.
  92
  Exhibit
      No.
                    
                    Description
      of Document10.30.350
                    
                    Amendment
      Number Three, dated as of October 22, 2007, to the Master RepurchaseAgreement
      (2007 Servicing Rights), dated as of April 25, 2007, among Wachovia Bank,
      N.A.,as
      Buyer, Wachovia Capital Markets, LLC, as Agent, NovaStar Mortgage, Inc.,
      as Seller anda
      Guarantor, and NovaStar Financial, Inc., NFI Holding Corporation, and
      HomeView Lending, Inc.,as
      Guarantors.10.3151
                    
                    Guaranty
      and Pledge  Agreement, dated as of April 25, 2007, made by
      NovaStar Financial, Inc., NFI Holding Corporation, NovaStar Mortgage Inc.
      and HomeView Lending, Inc. in favor of Wachovia Bank,
  N.A.10.3252
                    
                    Amended
      and Restated Master Repurchase Agreement, dated January 5, 2007, among DB
      Structured Products, Inc., Aspen Funding Corp., and Newport Funding Corp.,
      as Buyers, and NovaStar Financial, Inc., NovaStar Mortgage, Inc., NovaStar
      Certificates Financing Corporation, NovaStar Certificates Financing LLC,
      Acceleron Lending, Inc., and HomeView Lending, Inc., as
      Sellers10.3353
                    
                    Master
      Repurchase Agreement, dated August 2, 2006, among Aspen Funding Corp.,
      Newport
                      Funding
      Corp., and Deutsche Bank Securities, Inc., as Buyers, and NovaStar
      Certificates Financing Corporation, NovaStar Certificates Financing LLC,
      and NovaStar Mortgage, Inc., as Sellers10.3454
                    
                    Guaranty
      dated August 2, 2006, by NovaStar Financial, Inc., as Guarantor, in favor
      of Buyers10.3555
                    
                    Amended
      and Restated Master Netting Agreement dated January 5, 2007, among DB
      Structured Products, Inc., Aspen Funding Corp., and Newport Funding Corp.,
      and NovaStar Financial, Inc., NovaStar Mortgage, Inc., NovaStar
      Certificates Financing Corporation, NovaStar Certificates Financing LLC,
      Acceleron Lending, Inc., and HomeView Lending, Inc.10.3656
                    
                    Master
      Repurchase Agreement dated May 19, 2006 between Greenwich Capital
      Financial Products, Inc., as Buyer, and NovaStar Mortgage, Inc., NovaStar
      Financial, Inc., NovaStar Home Mortgage, Inc., NovaStar Certificates
      Financing Corporation, NovaStar Certificates Financing LLC, HomeView
      Lending, Inc., and Acceleron Lending, Inc., as Sellers10.36.157
                    
                    Amendment
      Number One to Master Purchase Agreement, dated September 20, 2006, among
      NovaStar Mortgage, Inc., NovaStar Financial, Inc., NovaStar Home Mortgage,
      Inc., NovaStar Certificates Financing Corporation, NovaStar Certificates
      Financing LLC, HomeView Lending, Inc., and Acceleron Lending, Inc., as
      Sellers, and Greenwich Capital Financial Products, Inc., as
      Buyer10.36.258
                    
                    Amendment
      Number Two to Master Purchase Agreement, dated October 27, 2006, among
      NovaStar Mortgage, Inc., NovaStar Financial, Inc., NovaStar Home Mortgage,
      Inc., NovaStar Certificates Financing Corporation, NovaStar Certificates
      Financing LLC, HomeView Lending, Inc., and Acceleron Lending, Inc., as
      Sellers, and Greenwich Capital Financial Products, Inc., as
      Buyer10.36.359
                    
                    Amendment
      Number Three to Master Purchase Agreement, dated November 9, 2006, among
      NovaStar Mortgage, Inc., NovaStar Financial, Inc., NovaStar Home Mortgage,
      Inc., NovaStar Certificates Financing Corporation, NovaStar Certificates
      Financing LLC, HomeView Lending, Inc., and Acceleron Lending, Inc., as
      Sellers, and Greenwich Capital Financial Products, Inc., as
      Buyer10.3760
                    
                    Master
      Repurchase Agreement dated June 30, 2006 between Greenwich Capital
      Financial Products, Inc., as Buyer, and NovaStar Mortgage, Inc., NovaStar
      Certificates Financing LLC, and NovaStar Certificates Financing
      Corporation, as Sellers10.3861
                    
                    Guaranty
      dated June 30, 2006, by NovaStar Financial, Inc., as Guarantor, in favor
      of Buyer10.3962
                    
                    Sales
      Agreement between NovaStar Financial, Inc. and Cantor Fitzgerald &
      Co., dated September 8, 200610.4063
                    
                    Master
      Repurchase Agreement (2007 Whole Loan), dated as of May 9, 2007, among
      Wachovia Bank, N.A., NFI Repurchase Corporation, NMI Repurchase
      Corporation, HomeView Lending, Inc., NMI Property Financing, Inc.,
      NovaStar Financial, Inc., NFI Holding Corporation and NovaStar Mortgage,
      Inc.
  
  50
                Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on October 25, 2007.
 51
                  Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on May 1, 2007.
 52
                  Incorporated
      by reference to Exhibit 10.58 to Form 10-Q filed by the Registrant with
      the SEC on May 10, 2007.
 53
                  Incorporated
      by reference to Exhibit 10.59 to Form 10-Q filed by the Registrant with
      the SEC on May 10, 2007.
 54
                  Incorporated
      by reference to Exhibit 10.60 to Form 10-Q filed by the Registrant with
      the SEC on May 10, 2007.
 55
                  Incorporated
      by reference to Exhibit 10.61 to Form 10-Q filed by the Registrant with
      the SEC on May 10, 2007.
 56
                  Incorporated
      by reference to Exhibit 10.62 to Form 10-Q filed by the Registrant with
      the SEC on May 10, 2007.
 57
                  Incorporated
      by reference to Exhibit 10.62.1 to Form 10-Q filed by the Registrant with
      the SEC on May 10, 2007.
 58
                  Incorporated
      by reference to Exhibit 10.62.2 to Form 10-Q filed by the Registrant with
      the SEC on May 10, 2007.
 59
                  Incorporated
      by reference to Exhibit 10.62.3 to Form 10-Q filed by the Registrant with
      the SEC on May 10, 2007.
 60
                  Incorporated
      by reference to Exhibit 10.63 to Form 10-Q filed by the Registrant with
      the SEC on May 10, 2007.
 61
                  Incorporated
      by reference to Exhibit 10.64 to Form 10-Q filed by the Registrant with
      the SEC on May 10, 2007.
 62
                  Incorporated
      by reference to Exhibit 1.1 to Form 8-K filed by the Registrant with the
      SEC on September 8, 2006.
 63
                  Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on May 15, 2007
  93
 Exhibit
      No.
                    
                    Description
      of Document10.40.164
                    
                    Amendment
      Number One, dated as of September 7, 2007, to the Master Repurchase
      Agreement (2007 Whole Loan),  dated as of May 9, 2007, among
      Wachovia Bank, N.A., NFI Repurchase Corporation,  NMI Repurchase
      Corporation, HomeView Lending,  Inc., NMI Property Financing,
      Inc., NovaStar Financial, Inc., NFI Holding Corporation and NovaStar
      Mortgage, Inc.10.4165
                    
                    Guaranty,
      dated as of May 9, 2007, among NovaStar Financial, Inc., NFI Holding
      Corporation, NovaStar Mortgage, Inc., HomeView Lending, Inc. and Wachovia
      Bank, NA10.4266
                    
                    Master
      Repurchase Agreement (2007 Non-Investment Grade Securities), dated as of
      May 31, 2007, among Wachovia Investment Holdings, LLC, Wachovia Capital
      Markets, LLC, NovaStar Mortgage, Inc., NovaStar Certificates Financing,
      LLC, NovaStar Certificates Financing Corporation, NFI Holding Corporation
      and NovaStar Financial, Inc.10.42.167
                    
                    Amendment
      Number One, dated as of September 7, 2007, to the
      Master   Repurchase Agreement (Non-Investment Grade
      Securities), dated as of May 31, 2007, among  Wachovia
      Investment Holdings, LLC, Wachovia Capital Markets LLC, NovaStar Mortgage,
      Inc., NovaStar Certificates Financing LLC, and NovaStar Certificates
      Financing Corp.10.4368
                    
                    Guaranty,
      dated as of May 31, 2007, among NovaStar Financial, Inc., NFI Holding
      Corporation and Wachovia Investment Holdings, LLC10.4469
                    
                    Master
      Repurchase Agreement (2007 Investment Grade Securities), dated as of May
      31, 2007, among Wachovia Bank, N.A., Wachovia Capital Markets, LLC,
      NovaStar Mortgage, Inc., NovaStar Certificates Financing, LLC, NovaStar
      Certificates Financing Corporation, NFI Holding Corporation and NovaStar
      Financial, Inc.10.44.170
                    
                    Amendment
      Number One, dated as of September 7, 2007, to the Master Repurchase
      Agreement (Investment Grade Securities), dated as of May 31, 2007, among
      Wachovia Bank, N.A., Wachovia Capital Markets LLC,
      NovaStar  Mortgage,  Inc., NovaStar Certificates
      Financing LLC, NovaStar Certificates Financing Corp., and NovaStar
      Financial, Inc. and NFI Holding Corporation.10.4571
                    
                    Guaranty,
      dated as of May 31, 2007, among NovaStar Financial, Inc., NFI Holding
      Corporation and Wachovia Bank, N.A.10.4672
                    
                    Waiver
      Agreement dated August 17, 2007 by and among NovaStar Mortgage, Inc.,
      NovaStar Certificates Financing LLC, NovaStar Certificates Financing
      Corporation, NFI Repurchase Corporation, NMI Repurchase Corporation, NMI
      Property Financing, Inc., HomeView Lending, Inc., NovaStar Financial,
      Inc., NFI Holding Corporation, Wachovia Bank, N.A., Wachovia Capital
      Markets, LLC and Wachovia Investment Holdings, LLC.10.46.173
                    
                    Waiver
      Agreement, dated as of November 7, 2007, by and among NovaStar Mortgage,
      Inc., NovaStar Certificates Financing LLC, NovaStar Certificates Financing
      Corporation, NFI Repurchase Corporation, NMI Repurchase Corporation, NMI
      Property Financing, Inc., HomeView Lending, Inc., NovaStar Financial,
      Inc., NFI Holding Corporation, Wachovia Bank, N.A. and Wachovia Investment
      Holdings, LLC.10.46.274
                    
                    Waiver
      Agreement, dated as of November 30, 2007, by and among NovaStar Mortgage,
      Inc., NovaStar Certificates Financing LLC, NovaStar Certificates Financing
      Corporation, NFI Repurchase Corporation, NMI Repurchase Corporation, NMI
      Property Financing, Inc., HomeView Lending, Inc., NovaStar Financial,
      Inc., NFI Holding Corporation, Wachovia Bank, N.A. and Wachovia Investment
      Holdings, LLC.10.46.375
                    
                    Waiver
      Agreement, dated as of December 7, 2007, by and among NovaStar Mortgage,
      Inc., NovaStar Certificates Financing LLC, NovaStar Certificates Financing
      Corporation, NFI Repurchase Corporation, NMI Repurchase Corporation, NMI
      Property Financing, Inc., HomeView Lending, Inc., NovaStar Financial,
      Inc., NFI Holding Corporation, Wachovia Bank, N.A. and Wachovia Investment
      Holdings, LLC.
 
 
 64
                Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on September 12, 2007
 65
                Incorporated
      by reference to Exhibit 10.2 to Form 8-K filed by the Registrant with the
      SEC on May 15, 2007
 66
                Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on June 6, 2007
 67
                Incorporated
      by reference to Exhibit 10.3 to Form 8-K filed by the Registrant with the
      SEC on September 12, 2007
 68
                Incorporated
      by reference to Exhibit 10.2 to Form 8-K filed by the Registrant with the
      SEC on June 6, 2007
 69
                Incorporated
      by reference to Exhibit 10.3 to Form 8-K filed by the Registrant with the
      SEC on June 6, 2007
 70
                Incorporated
      by reference to Exhibit 10.2 to Form 8-K filed by the Registrant with the
      SEC on September 12, 2007
 71
                Incorporated
      by reference to Exhibit 10.4 to Form 8-K filed by the Registrant with the
      SEC on June 6, 2007
 72
                Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on August 23, 2007
 73
                Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on November 14, 2007.
 74
                Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on December 5, 2007.
 75
                Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on December 10, 2007.
  94
  Exhibit
      No.
                    
                    Description
      of Document10.46.476
                    
                    Waiver
      Agreement, dated as of January 4, 2008, by and among NovaStar Mortgage,
      Inc., NovaStar Certificates Financing LLC, NovaStar Certificates Financing
      Corporation, NFI Repurchase Corporation, NMI Repurchase Corporation, NMI
      Property Financing, Inc., HomeView Lending, Inc., NovaStar Financial,
      Inc., NFI Holding Corporation, Wachovia Bank, N.A. and Wachovia Investment
      Holdings, LLC.10.46.577
                    
                    Waiver
      Agreement, dated February 4, 2008, by and among NovaStar Mortgage, Inc.,
      NovaStar Certificates Financing LLC, NovaStar Certificates Financing
      Corporation, NFI Repurchase Corporation, NMI Repurchase Corporation, NMI
      Property Financing, Inc., HomeView Lending, Inc., NovaStar Financial,
      Inc., NFI Holding Corporation, Wachovia Bank, N.A. and Wachovia Investment
      Holdings, LLC.10.46.678
                    
                    Waiver
      Agreement, dated February 11, 2008, by and among NovaStar Mortgage, Inc.,
      NovaStar Certificates Financing LLC, NovaStar Certificates Financing
      Corporation, NFI Repurchase Corporation, NMI Repurchase Corporation, NMI
      Property Financing, Inc., HomeView Lending, Inc., NovaStar Financial,
      Inc., NFI Holding Corporation, Wachovia Bank, N.A. and Wachovia Investment
      Holdings, LLC.10.46.779
                    
                    Waiver
      Agreement, dated March 11, 2008, by and among NovaStar Mortgage, Inc.,
      NovaStar Certificates Financing LLC, NovaStar Certificates Financing
      Corporation, NFI Repurchase Corporation, NMI Repurchase Corporation, NMI
      Property Financing, Inc., HomeView Lending, Inc., NovaStar Financial,
      Inc., NFI Holding Corporation, Wachovia Bank, N.A. and Wachovia Investment
      Holdings, LLC.10.4780
                    
                    Securities
      Purchase Agreement, dated July 16, 2007, by and among NovaStar
      Financial,  Inc., Massachusetts Mutual Life Insurance Company,
      Jefferies Capital Partners IV L.P., Jefferies Employee Partners IV LLC and
      JCP Partners IV LLC10.4881
                    
                    Standby
      Purchase Agreement, dated July 16, 2007, by and among NovaStar
      Financial,  Inc.,  Massachusetts  Mutual
      Life Insurance Company,  Jefferies Capital Partners IV
      L.P.,  Jefferies Employee Partners IV LLC and JCP Partners IV
      LLC10.4982
                    
                    Registration
      Rights and Shareholders Agreement, dated July 16, 2007, by and among
      NovaStar Financial, Inc., Massachusetts Mutual Life Insurance Company,
      Jefferies Capital Partners IV L.P., Jefferies Employee Partners IV LLC and
      JCP Partners IV LLC10.5083
                    
                    Letter
      Agreement, dated July 16,  2007, by and
      among  NovaStar Financial,  Inc., Massachusetts Mutual
      Life Insurance Company, Jefferies Capital Partners IV L.P., Jefferies
      Employee Partners IV LLC and JCP Partners IV LLC, and Scott
      Hartman10.5184
                    
                    Letter
      Agreement, dated July 16,  2007, by and among NovaStar
      Financial, Inc., Massachusetts Mutual Life Insurance Company, Jefferies
      Capital Partners IV L.P.,  Jefferies Employee Partners IV LLC
      and JCP Partners IV LLC, and Lance Anderson10.5285
                    
                    Letter
      Agreement, dated July 16, 2007, by and among  NovaStar
      Financial, Inc., Massachusetts Mutual Life Insurance Company, Jefferies
      Capital Partners IV L.P., Jefferies Employee Partners IV LLC and JCP
      Partners IV LLC, and Mike Bamburg11.186
                    
                    Statement
      Regarding Computation of Per Share Earnings14.187
                    
                    NovaStar
      Financial, Inc. Code of Conduct21.1
                    
                    Subsidiaries
      of the Registrant23.1
                    
                    Consents
      of Deloitte & Touche LLP31.1
                    
                    Chief
      Executive Officer Certification - Section 302 of the Sarbanes-Oxley Act of
      200231.2
                    
                    Principal
      Financial Officer Certification - Section 302 of the Sarbanes-Oxley Act of
      200232.1
                    
                    Chief
      Executive Officer Certification - Section 906 of the Sarbanes-Oxley Act of
      200232.2
                    
                    Principal
      Financial Officer Certification - Section 906 of the Sarbanes-Oxley Act of
      2002
  76
                Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on January 10, 2008.
 77
                  Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on February 8, 2008.
 78
                  Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on February 15, 2008.
 79
                  Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on March 14, 2008.
 80
                  Incorporated
      by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with the
      SEC on July 20, 2007
 81
                  Incorporated
      by reference to Exhibit 10.2 to Form 8-K filed by the Registrant with the
      SEC on July 20, 2007
 82
                  Incorporated
      by reference to Exhibit 10.3 to Form 8-K filed by the Registrant with the
      SEC on July 20, 2007
 83
                  Incorporated
      by reference to Exhibit 10.4 to Form 8-K filed by the Registrant with the
      SEC on July 20, 2007
 84
                  Incorporated
      by reference to Exhibit 10.5 to Form 8-K filed by the Registrant with the
      SEC on July 20, 2007
 85
                  Incorporated
      by reference to Exhibit 10.6 to Form 8-K filed by the Registrant with the
      SEC on July 20, 2007
 86
                  See
      Note 16 to the  consolidated financial
  statements
 87
                  Incorporated
      by reference to the correspondingly numbered exhibit to Form 8-K filed by
      the Registrant with the SEC on February 14,
  2006.
  95
  Signatures
  Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.
  NOVASTAR
      FINANCIAL, INC(Registrant)DATE:
      May 27, 2009
                  /s/
      W. LANCE ANDERSONW.
      Lance Anderson, Chairman of the Boardof
      Directors and Chief Executive
Officer
 
 Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities and dates indicated.
  DATE:
      May 27, 2009
                  /s/
      W. LANCE ANDERSONW.
      Lance Anderson, Chairman of the Boardof
      Directors and Chief Executive Officer(Principal
      Executive Officer)DATE:
      May 27, 2009
                  /s/
      RODNEY E. SCHWATKENRodney
      E. Schwatken, Chief Financial Officer
                    and
      Chief Accounting Officer(Principal
      Financial Officer)DATE:
      May 27, 2009
                  /s/
      EDWARD W. MEHREREdward
      W. Mehrer, DirectorDATE:
      May 27, 2009
                  /s/
      GREGORY T. BARMOREGregory
      T. Barmore, DirectorDATE:
      May 27, 2009
                  /s/
      ART N. BURTSCHERArt
      N. Burtscher, DirectorDATE:
      May 27, 2009
                  /s/
      DONALD M. BERMANDonald
      M. Berman, Director
  96