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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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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, 2003



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



For the Transition Period From
 to



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Commission File Number 001-13533



NOVASTAR FINANCIAL, INC.

(Exact name of registrant as specified in its charter)



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Maryland                                                       |  | 74-2830661                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|8140 Ward Parkway, Suite 300, Kansas City, MO                  |  | 64114                               
|(Address of principal executive office)                        |  | (Zip Code)                          



Registrants
telephone number, including area code: (816) 237-7000



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Securities registered pursuant to Section 12(b) of the Act:



|                              |  |                                          
|----------------------------- |  | -----------------------------------------
|Title of Each Class           |  | Name of Each Exchange on Which Registered
|Common Stock, $0.01 par value |  | New York Stock Exchange                  



Securities
registered pursuant to Section 12(g) of the Act:



None



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.



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



The aggregate market value of voting stock held by
non-affiliates of the registrant as of February 29, 2004 was approximately $1,310,178,823 as reported by the New York Stock Exchange Composite Transactions on such date.



The number of shares of the Registrants Common Stock outstanding on February 29, 2004 was 24,790,517.



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 no later than 120 days after December 31, 2003.



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##### Table of Contents

NOVASTAR FINANCIAL, INC.



FORM 10-K

For the Fiscal Year Ended December 31, 2003



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TABLE OF CONTENTS



|         |  |                                                                                                              |  |   
|-------- |  | ------------------------------------------------------------------------------------------------------------ |  | --
|PART I   |  |                                                                                                              |  |   
|Item 1.  |  | Business                                                                                                     |  | 2 
|Item 2.  |  | Properties                                                                                                   |  | 13
|Item 3.  |  | Legal Proceedings                                                                                            |  | 13
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                                          |  | 13
|         |  |                                                                                                             
|PART II  |  |                                                                                                              |  |   
|Item 5.  |  | Market For Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |  | 14
|Item 6.  |  | Selected Financial Data                                                                                      |  | 15
|Item 7.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                        |  | 16
|Item 7A. |  | Quantitative and Qualitative Disclosures About Market Risk                                                   |  | 37
|Item 8.  |  | Financial Statements and Supplementary Data                                                                  |  | 38
|Item 9.  |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                         |  | 68
|Item 9A. |  | Controls and Procedures                                                                                      |  | 68
|         |  |                                                                                                             
|PART III |  |                                                                                                              |  |   
|Item 10. |  | Directors and Executive Officers of the Registrant                                                           |  | 68
|Item 11. |  | Executive Compensation                                                                                       |  | 68
|Item 12. |  | Security Ownership of Certain Beneficial Owners and Management                                               |  | 69
|Item 13. |  | Certain Relationships and Related Transactions                                                               |  | 69
|Item 14. |  | Principal Accountant Fees and Services                                                                       |  | 69
|         |  |                                                                                                             
|PART IV  |  |                                                                                                              |  |   
|Item 15. |  | Exhibits, Financial Statement Schedules, and Reports on Form 8-K                                             |  | 70





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##### Table of Contents

PART I



Item 1. Business



Overview



We are a Maryland corporation formed on September 13,
1996 as a specialty finance company that originates, invests in and services residential nonconforming loans. We operate through three separate but inter-related unitsmortgage lending and loan servicing, mortgage portfolio management and
branch operations. We offer a wide range of mortgage loan products to borrowers, commonly referred to as nonconforming borrowers, who generally do not satisfy the credit, collateral, documentation or other underwriting standards
prescribed by conventional mortgage lenders and loan buyers, including government-sponsored entities such as Fannie Mae or Freddie Mac. We retain significant interests in the nonconforming loans we originate through our mortgage securities
investment portfolio. Through our servicing platform, we then service all of the loans we retain interests in, in order to better manage the credit performance of those loans.



We have elected to be taxed as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended.
Management believes the tax-advantaged structure of a REIT maximizes the after-tax returns from mortgage assets. We must meet numerous rules established by the Internal Revenue Service to retain our status as a REIT. In summary, they require us to:



| | Restrict investments to certain real estate related assets,
|- | -----------------------------------------------------------



| | Avoid certain investment trading and hedging activities, and
|- | ------------------------------------------------------------



| | Distribute virtually all taxable income to stockholders.
|- | --------------------------------------------------------



As long as we maintain our REIT status, distributions to stockholders will generally be deductible by us for income tax purposes. This deduction
effectively eliminates corporate level income taxes. Management believes it has and will continue to meet the requirements to maintain our REIT status.



Mortgage Portfolio Management



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



| | We operate as a long-term portfolio investor.
|- | ---------------------------------------------



| | Financing is provided by issuing asset-backed bonds and entering into reverse repurchase agreements.
|- | ----------------------------------------------------------------------------------------------------



| | Earnings are generated from the return on our mortgage securities and spread income on the mortgage loan portfolio.
|- | -------------------------------------------------------------------------------------------------------------------



| | Our mortgage securities include AAA- and non-rated interest only, prepayment penalty, overcollateralization and other subordinated mortgage securities.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------



Earnings from our portfolio of mortgage loans and securities generate a
substantial portion of our earnings. Gross interest income was $170.4 million, $107.1 million and $57.9 million in the three years ended December 31, 2003, 2002 and 2001, respectively. Net interest income from the portfolio was $130.1 million, $79.4
million and $30.5 million in the three years ended December 31, 2003, 2002 and 2001, respectively. See our discussion of interest income under the heading Results of Operations and Net Interest Income.



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



In certain
circumstances, because we enter into interest rate agreements that do not meet the hedging criteria set forth in accounting principles generally accepted in the United States of America, we are required to record the change in the value of
derivatives as a component of earnings even though they may reduce our interest rate risk. In times where short-term rates drop significantly, the value of our agreements will decrease. As a result, we recognized losses on these derivatives of $30.8
million, $36.8 million and $4.0 million in 2003, 2002 and 2001, respectively.



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Mortgage Lending and Loan Servicing



The mortgage lending operation is significant to our financial results as it produces the loans that ultimately
collateralize the mortgage securities that we hold in our portfolio. During 2003, we originated $5.3 billion in nonconforming mortgage loans, the majority of which were retained in our servicing portfolio and serve as collateral for our securities.
The loans we originate are sold, either in securitization transactions or in outright sales to third parties. We recognized gains on sales of mortgage assets totaling $144.0 million, $53.3 million and $37.3 million during the three years ended
December 31, 2003, 2002 and 2001, respectively. In securitization transactions accounted for as sales, we retain interest-only, prepayment penalty, overcollateralization and other subordinated securities, along with the right to service the loans.



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



We have developed
a nationwide network of wholesale loan brokers and mortgage lenders who submit mortgage loans to us. Except for NovaStar Home Mortgage brokers described below, these brokers and mortgage lenders are independent from any of the NovaStar entities. Our
sales force, which includes 281 account executives in 39 states, develops and maintains relationships with this network of independent retail brokers. As of December 31, 2003, approximately 5,800 brokers are active customers and approximately 13,000
are approved customers.



We underwrite, process, fund and
service the nonconforming mortgage loans sourced through our broker network in centralized facilities. Further details regarding the loan originations are discussed under the Mortgage Loans section of Managements Discussion
and Analysis of Financial Condition and Results of Operations.



A significant risk to our mortgage lending operations is liquidity risk  the risk that we will not have financing facilities and cash available to fund and hold loans prior to their sale or securitization. We maintain committed
lending facilities with large banking and investment institutions to reduce this risk. On a short-term basis, we finance mortgage loans using warehouse lines of credit and repurchase agreements. In addition, we have access to facilities secured by
our mortgage securities. Details regarding available financing arrangements and amounts outstanding under those arrangements are included in Managements Discussion and Analysis of Financial Condition and Results of Operations and
Note 6 to the consolidated financial statements.



For long-term
financing, we fund our mortgage loans using asset-backed bonds (ABB). Primary bonds  AAA through BBB rated  are issued to the public. We retain the interest only, prepayment penalty, overcollateralization and other subordinated bonds. We
also retain the right to service the loans. Prior to 1999, our ABB transactions were executed and designed to meet accounting rules that resulted in securitizations being treated as financing transactions. The mortgage loans and related debt
continue to be presented on our consolidated balance sheets, and no gain was recorded. Beginning in 1999, our securitization transactions have been structured to qualify as sales for accounting and income tax purposes. The loans and related bond
liability are not recorded in our consolidated financial statements. We do, however, record the value of the securities and servicing rights we retain. Details regarding ABBs we issued can be found in Managements Discussion and Analysis
of Financial Condition and Results of Operations and in Notes 3 and 6 to our consolidated financial statements.



Loan servicing remains a critical part of our business operation. In the opinion of management, maintaining contact with our borrowers is critical in
managing credit risk and in borrower retention. Nonconforming borrowers are more prone to late payments and are more likely to default on their obligations than conventional borrowers. By servicing our loans, we strive to identify problems with
borrowers early and take quick action to address problems. Borrowers may be motivated to refinance their mortgage loans either by improving their personal credit or due to a decrease in interest rates. By keeping in close touch with borrowers, we
can provide them with information about company products to encourage them to refinance with us. Mortgage servicing yields fee income for us in the form of normal customer service and processing fees. We recognized $21.1 million, $10.0 million and
$4.9 million in loan servicing fee income from the securitization trusts during the three years ended December 31, 2003, 2002 and 2001, respectively. See also Mortgage Loan Servicing under Managements Discussion and Analysis
of Financial Condition and Results of Operations for further discussion and analysis of the servicing operations.



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Branch Operations



In 1999, we opened our retail mortgage broker business operating under the name NovaStar Home Mortgage, Inc., or NovaStar Home Mortgage. Branch offices
offer conforming and nonconforming loans to potential borrowers. Loans are brokered for approved investors, including NovaStar Mortgage. The branches must adhere to a strict set of established policies regarding their operations. Net income of the
branch is returned to the branch owner/manager. We provide administrative functions, including accounting, payroll and human resources, loan investor management and license management services for each branch under separate contractual
agreements and we receive a fee for providing these services. As of December 31, 2003 we had 432 active branches in 39 states as compared to 216 active branches in 35 states as of December 31, 2002.



The branch business provides an additional source for mortgage loan
originations that, in most cases, we will eventually sell, either in securitizations or in outright sales to third parties. During 2003 and 2002, our branches brokered $6.4 billion and $2.6 billion, respectively, in loans, of which we funded $1.2
billion and $376 million, respectively, in nonconforming loans. While the branches are not required to use NovaStar Mortgage as their nonconforming lender, they more often choose NovaStar Mortgage over external lenders. We believe the branch
personnel will use NovaStar Mortgage so long as NovaStar Mortgage offers a competitive loan product and quality customer service. NovaStar Mortgage is the lender for a significantly higher percent of nonconforming loans initially brokered by the
branches as compared to loans brokered by independent retailers.



Following is a diagram of the nonconforming industry in which we operate and our loan production during 2003 (in thousands).



LOGO



|(A) | A portion of the loans securitized or sold to unrelated parties as of December 31, 2003 originated prior to 2003, but due to timing were not yet securitized or sold at the end of
2002. Loans originated in 2003 that we have not securitized or sold to unrelated parties as of December 31, 2003 are included in our mortgage loans held-for-sale.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Market in Which NovaStar Operates and Competes



We face intense competition in the business of originating, purchasing, selling and securitizing mortgage loans. The number
of market participants is believed to be well in excess of 100 companies who originate nonconforming loans. No single participant holds a dominant share of the lending market. We compete for borrowers with consumer finance companies, conventional
mortgage bankers, commercial banks, credit unions, thrift institutions and other independent wholesale mortgage lenders. Our principal competition in the business of holding mortgage loans and mortgage securities are life insurance companies,
institutional investors such as mutual funds and pension funds, other well-capitalized publicly-owned mortgage lenders and certain other mortgage acquisition companies structured as REITs. Many of these competitors are substantially larger than we
are and have considerably greater financial resources than we do.



Competition among industry participants can take many forms, including convenience in obtaining a loan, amount and term of the loan, customer service, marketing/distribution channels, loan origination fees and interest rates. To the extent
any competitor significantly expands their activities in the nonconforming and subprime market, we could be materially adversely affected.



One of our key competitive strengths is our employees and the level of service they are able to provide our borrowers. We service our nonconforming loans
and, in doing so, we are able to stay in close contact with our borrowers and identify potential problems early.



Another key competitive strength is our branch operation. While the branches are free to broker loans for any approved investor, frequently NovaStar
Mortgage is the lender for the branch loans. During 2003, the branches brokered $6.4 billion in residential mortgage loans.



We also believe we compete successfully due to our:



| | experienced management team;
|- | ----------------------------



| | use of technology to enhance customer service and reduce operating costs;
|- | -------------------------------------------------------------------------



| | tax advantaged status as a REIT;
|- | --------------------------------



| | freedom from depository institution regulation;
|- | -----------------------------------------------



| | vertical integration  we broker and/or originate, fund, service and manage mortgage loans;
|- | -------------------------------------------------------------------------------------------



| | access to capital markets to securitize our assets.
|- | ---------------------------------------------------



Risk Management



Management recognizes the following primary risks associated with the business and industry in which it operates.



| | Interest Rate/Market
|- | --------------------



| | Liquidity/Funding
|- | -----------------



| | Credit
|- | ------



| | Prepayment
|- | ----------



Interest Rate/Market Risk



Our investment policy sets the following general goals:



| | (1) | Maintain the net interest margin between assets and liabilities, and
| | --- | --------------------------------------------------------------------



| | (2) | Diminish the effect of changes in interest rate levels on our market value
| | --- | --------------------------------------------------------------------------



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



Interest Rate Risk. When interest rates
on our assets do not adjust at the same rates as our liabilities or when the assets have fixed rates and the liabilities are adjusting, future earnings potential is affected. We express this interest rate risk as the risk that the market value of
assets will increase or decrease at different rates than that of the liabilities. Expressed another way, this is the risk that net asset value will experience an adverse change when interest rates change. We assess the risk based on the change in
market values given increases and decreases in interest rates. We also assess the risk based on the impact to net income in changing interest rate environments.



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Management primarily uses financing sources where the interest rate resets frequently. As of December 31,
2003, borrowings under all financing arrangements adjust daily or monthly. On the other hand, very few of the mortgage assets we own adjust on a monthly or daily basis. Most of the mortgage loans contain features where their rates are fixed for some
period of time and then adjust frequently thereafter. For example, one of our loan products is the 2/28 loan. This loan is fixed for its first two years and then adjusts every six months thereafter.



While short-term borrowing rates are low and long-term asset rates are high,
this portfolio structure produces good results. However, if short-term interest rates rise rapidly, earning potential is significantly affected, as the asset rate resets would lag the borrowing rate resets.



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



Interest Rate Sensitivity - Income

(dollars in thousands)

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|                                                |  |                                                      |  |       |        |   |     |   |         |     |  |   |         |   
|----------------------------------------------- |  | ---------------------------------------------------- |  | ----- | ------ | - | --- | - | ------- | --- |  | - | ------- | --
|                                                |  | Basis Point Increase (Decrease) in Interest Rate (A) | 
|                                                |  | (200) (C)                                            |  | (100) |        |   | 100 |   |         | 200 | 
|As of December 31, 2003:                        |  |                                                      |  |       |        |   |     |   |         |     |  |   |         |   
|Net interest income                             |  | N/A                                                  |  | $     | 15,546 |   |     | $ | (11,393 | )   |  | $ | (20,777 | ) 
|                                                |  |                                                      |  |       |        |   |     |   |         |     |  |   |         |   
|Percent change in net interest income from base |  | N/A                                                  |  |       | 5.6    | % |     |   | (4.1    | )%  |  |   | (7.5    | )%
|                                                |  |                                                      |  |       |        |   |     |   |         |     |  |   |         |   
|Percent change of capital (B)                   |  | N/A                                                  |  |       | 5.2    | % |     |   | (3.8    | )%  |  |   | (6.9    | )%
|                                                |  |                                                      |  |       |        |   |     |   |         |     |  |   |         |   
|As of December 31, 2002:                        |  |                                                      |  |       |        |   |     |   |         |    
|Net interest income                             |  | N/A                                                  |  | $     | 8,894  |   |     | $ | (6,946  | )   |  | $ | (13,277 | ) 
|                                                |  |                                                      |  |       |        |   |     |   |         |     |  |   |         |   
|Percent change in net interest income from base |  | N/A                                                  |  |       | 7.6    | % |     |   | (5.9    | )%  |  |   | (11.3   | )%
|                                                |  |                                                      |  |       |        |   |     |   |         |     |  |   |         |   
|Percent change of capital (B)                   |  | N/A                                                  |  |       | 4.9    | % |     |   | (3.8    | )%  |  |   | (7.2    | )%
|                                                |  |                                                      |  |       |        |   |     |   |         |     |  |   |         |   

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|(A) | Net interest income (income from assets less expense from liabilities and expense from interest rate agreements) in a parallel shift in the yield curve, up and down 1% and 2%.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(B) | Total change in estimated spread income as a percent of total stockholders equity as of December 31.
|--- | -----------------------------------------------------------------------------------------------------



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



Interest Rate Sensitivity - Market Value

(dollars in thousands)

---



|                                                    |  |                                                      |  |       |         |    |     |   |          |     |  |   |          |   
|--------------------------------------------------- |  | ---------------------------------------------------- |  | ----- | ------- | -- | --- | - | -------- | --- |  | - | -------- | --
|                                                    |  | Basis Point Increase (Decrease) in Interest Rate (A) | 
|                                                    |  | (200) (C)                                            |  | (100) |         |    | 100 |   |          | 200 | 
|As of December 31, 2003:                            |  |                                                      |  |       |         |    |     |   |          |     |  |   |          |   
|Change in market values of:                         |  |                                                      |  |       |         |    |     |   |          |     |  |   |          |   
|Assets                                              |  | N/A                                                  |  | $     | 99,164  |    |     | $ | (135,872 | )   |  | $ | (296,278 | ) 
|Liabilities                                         |  | N/A                                                  |  |       | (5,325  | )  |     |   | 6,245    |     |  |   | 12,627   |   
|Interest rate agreements                            |  | N/A                                                  |  |       | (90,590 | )  |     |   | 98,484   |     |  |   | 208,805  |   
|                                                    |  |                                                      |  |       |         |    |     |   |          |     |  |   |          |   
|Cumulative change in market value                   |  | N/A                                                  |  | $     | 3,249   |    |     | $ | (31,143  | )   |  | $ | (74,846  | ) 
|                                                    |  |                                                      |  |       |         |    |     |   |          |     |  |   |          |   
|Percent change of market value portfolio equity (B) |  | N/A                                                  |  |       | 1.0     | %  |     |   | (9.1     | )%  |  |   | (21.9    | )%
|                                                    |  |                                                      |  |       |         |    |     |   |          |     |  |   |          |   
|As of December 31, 2002:                            |  |                                                      |  |       |         |    |     |   |          |     |  |   |          |   
|Change in market values of:                         |  |                                                      |  |       |         |    |     |   |          |     |  |   |          |   
|Assets                                              |  | N/A                                                  |  | $     | 16,449  |    |     | $ | (49,343  | )   |  | $ | (119,232 | ) 
|Liabilities                                         |  | N/A                                                  |  |       | (2,311  | )  |     |   | 2,451    |     |  |   | 4,969    |   
|Interest rate agreements                            |  | N/A                                                  |  |       | (36,249 | )  |     |   | 37,930   |     |  |   | 76,873   |   
|                                                    |  |                                                      |  |       |         |    |     |   |          |     |  |   |          |   
|Cumulative change in market value                   |  | N/A                                                  |  | $     | (22,111 | )  |     | $ | (8,962   | )   |  | $ | (37,390  | ) 
|                                                    |  |                                                      |  |       |         |    |     |   |          |     |  |   |          |   
|Percent change of market value portfolio equity (B) |  | N/A                                                  |  |       | (10.9   | )% |     |   | (4.4     | )%  |  |   | (18.4    | )%
|                                                    |  |                                                      |  |       |         |    |     |   |          |     |  |   |          |   

---

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



|(B) | Total change in estimated market value as a percent of market value portfolio equity as of December 31.
|--- | -------------------------------------------------------------------------------------------------------



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



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##### Table of Contents

The values under the headings 100, 200, (100) and (200)
are managements estimates of the income and change in market value of those same assets, liabilities and interest rate agreements assuming that interest rates were 100 and 200 basis points, or 1 and 2 percent higher and lower. The cumulative
change in income or market value represents the change in income or market value of assets, net of the change in income or market value of liabilities and interest rate agreements.



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



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



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



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



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



We have determined the following estimated
net fair value amounts by using available market information and appropriate valuation methodologies as of December 31, 2003.



Interest Rate Risk Management Contracts

(dollars in thousands)

---



|                              |  |                |        |   |                     |   |           |      |  |   |         |   |  |      |         |   |  |   |         |  
|----------------------------- |  | -------------- | ------ | - | ------------------- | - | --------- | ---- |  | - | ------- | - |  | ---- | ------- | - |  | - | ------- | -
|                              |  | Maturity Range |       
|                              |  | Net FairValue  |        |   | TotalNotionalAmount |   |           | 2004 |  |   | 2005    |   |  | 2006 |        
|Pay-fixed swaps:              |  | $              | (8,648 | ) |                     |   |           |      |  |   |         |   |  |      |         |   |  |   |         |  
|Contractual maturity          |  |                |        |   |                     | $ | 1,530,000 |      |  | $ | 265,000 |   |  | $    | 800,000 |   |  | $ | 465,000 |  
|Weighted average pay rate     |  |                |        |   |                     |   | 2.9       | %    |  |   | 4.9     | % |  |      | 2.3     | % |  |   | 2.8     | %
|Weighted average receive rate |  |                |        |   |                     |   | 1.1       | %    |  |   | (A      | ) |  |      | (A      | ) |  |   | (A      | )
|Interest rate caps:           |  | $              | 6,679  |   |                     |   |           |      |  |   |         |   |  |      |         |   |  |   |         |  
|Contractual maturity          |  |                |        |   |                     | $ | 805,144   |      |  | $ | 155,144 |   |  | $    | 450,000 |   |  | $ | 200,000 |  
|Weighted average strike rate  |  |                |        |   |                     |   | 1.7       | %    |  |   | 1.8     | % |  |      | 1.6     | % |  |   | 2.0     | %

---

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



Liquidity/Funding Risk



See the Liquidity and Capital Resources section of Managements Discussion and Analysis of Financial Condition and Results of
Operations for a discussion of liquidity risks and resources available to us.



Credit Risk



Credit risk is the risk that we
will not fully collect the principal we have invested in mortgage loans or securities. Nonconforming mortgage loans comprise substantially our entire mortgage loan portfolio and serve as



7



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collateral for our mortgage securities. Our nonconforming borrowers include individuals who do not qualify for agency/conventional lending programs because
of a lack of conventional documentation or previous credit difficulties, but have considerable equity in their homes. Often, they are individuals or families who have built up high-rate consumer debt and are attempting to use the equity in their
home to consolidate debt and reduce the amount of money it takes to service their monthly debt obligations. Our underwriting guidelines are intended to evaluate the credit history of the potential borrower, the capacity and willingness of the
borrower to repay the loan, and the adequacy of the collateral securing the loan.



Underwriting staff work under the credit policies established by our Chief Credit Officer. Underwriters are given approval authority only after their work has been reviewed for a period of at least two weeks.
Thereafter, the Chief Credit Officer re-evaluates the authority levels of all underwriting personnel on an ongoing basis. All loans in excess of $350,000 currently require the approval of an underwriting supervisor. Our Chief Credit Officer or our
President must approve loans in excess of $500,000.



The
underwriting guidelines take into consideration the number of times the potential borrower has recently been late on a mortgage payment and whether that payment was 30, 60 or 90 days past due. Factors such as FICO score, bankruptcy and foreclosure
fillings, debt-to-income ratio, and loan-to-value ratio are also considered. The credit grade that is assigned to the borrower is a reflection of the borrowers historical credit and the loan-to-value determined by the amount of documentation
the borrower could produce to support income. Maximum loan-to-value ratios for each credit grade depend on the level of income documentation provided by the potential borrower. In some instances, when the borrower exhibits strong compensating
factors, exceptions to the underwriting guidelines may be approved.



Key to our successful underwriting process is the use of NovaStarIS®. NovaStarIS® is the
second generation of our proprietary automated underwriting system. IS provides more consistency in underwriting loans and allows underwriting personnel to focus more of their time on loans that are not initially accepted by the IS system.



Our mortgage loan portfolio by credit grade, all of which are
nonconforming can be accessed via our website at www.novastarmortgage.com.



A tool for managing credit risk is to diversify the markets in which we originate and own mortgage loans. Presented via our website at www.novastarmortgage.com is a breakdown of the geographic diversification of our
loans. Detail regarding loans charged off are disclosed in Note 2 to the Financial Statements and Supplementary Data.



We have purchased mortgage insurance on many of the loans that are held in our portfolio  on the balance sheet and those that serve as collateral
for our mortgage securities. Our mortgage insurance provides for coverage to a loan-to-value of 50-55%, which serves to substantially limit our exposure to credit risk. The use of mortgage insurance is discussed under Premiums for Mortgage
Loan Insurance in Managements Discussion and Analysis of Financial Condition and Results of Operations.



Prepayment Risk



Generally speaking, when market interest rates decline, borrowers are more likely to refinance their mortgages. The higher the interest rate a borrower
currently has on his or her mortgage the more incentive he or she has to refinance the mortgage when rates decline. In addition, the higher the credit grade, the more incentive there is to refinance when credit ratings improve. When a borrower has a
low loan-to-value ratio, he or she is more likely to do a cash-out refinance. Each of these factors increases the chance for higher prepayment speeds during the term of the loan.



The majority of our securities are interest-only in nature. These
securities represent the net cash flow  interest income  on the underlying loans in excess of the cost to finance the loans. When borrowers repay the principal on their mortgage loans early, the effect is to shorten the period over which
interest is earned, and therefore, reduce the cash flow and yield on our securities.



We mitigate prepayment risk by originating loans that are originated with a penalty if the borrower repays the loan in the early months of the loans life. For the majority of our loans, a prepayment penalty is
charged equal to 80% of six months interest on the principal balance that is to be paid in full. As of December 31, 2003, 65% of our loans had a prepayment penalty. Of the loans that serve as collateral for our mortgage securities, 74% had
prepayment penalties as of December 31, 2003. During 2003, 77% of the loans we originated had prepayment penalties.



8



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##### Table of Contents

Other Risk Factors



Although management considers the risk components set forth above to be its primary business risks, the following are other risks that should be
considered by our investors. Further information regarding these risks is included in our registration statements filed with the Commission.



| | Failure to renew or obtain adequate funding under warehouse facilities and repurchase agreements may harm our lending operations.We are currently dependent upon a limited
number of primary credit facilities for funding of our mortgage loan originations and acquisitions. Any failure to renew or obtain adequate funding under these financing arrangements could harm our lending operations and our overall performance. An
increase in the cost of financing in excess of any change in the income derived from our mortgage assets could also harm our earnings and reduce the cash available for distributions to our stockholders. In October 1998, the subprime mortgage loan
market faced a liquidity crisis with respect to the availability of short-term borrowings from major lenders and long-term borrowings through securitization. We faced significant liquidity constraints which harmed our business and our profitability.
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | An interruption or reduction in the securitization and whole loan markets or change in terms offered by these markets would hurt our financial position. We are dependent on
the securitization market for the sale of our loans because we securitize loans directly and many of our whole loan buyers purchase our loans with the intention to securitize. The securitization market is dependent upon a number of factors,
including general economic conditions, conditions in the securities market generally and conditions in the asset-backed securities market specifically. In addition, poor performance of our previously securitized loans could harm our access to the
securitization market. Accordingly, a decline in the securitization market, the ability to obtain attractive terms or a change in the markets demand for our loans could have a material adverse effect on our results of operations, financial
condition and business prospects.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Financing with repurchase agreements may lead to margin calls if the market value of mortgage assets declines.We use repurchase agreements to finance the acquisition of
mortgage assets in the short-term. In a repurchase agreement, we sell an asset and agree to repurchase the same asset at some period in the future. Generally, the repurchase agreements we entered into stipulate that we must repurchase the asset in
30 days. For financial accounting purposes, these arrangements are treated as secured financings. We retain the assets on our balance sheet and record an obligation to repurchase the asset. The amount we may borrow under these arrangements is
generally 96% to 98% of the asset market value. When asset market values decrease, we are required to repay the margin, or difference in market value. To the extent the market values of assets financed with repurchase agreements decline rapidly, we
will be required to meet cash margin calls. If cash is unavailable, we may be forced to default under the terms of the repurchase agreement. In that event, the lender retains the right to liquidate the collateral to settle the amount due from us.
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Limited access to additional capital may ultimately curtail growth.Cash is required to fund loans we originate as financing arrangements allow us to borrow a percentage,
typically 98%, of the mortgage note amount. If we are unable to obtain sufficient cash resources, we may not sustain asset growth.
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Changes in interest rates may harm our results of operations. Our results of operations are likely to be harmed during any period of unexpected or rapid changes in interest
rates. For example, a substantial or sustained increase in interest rates could harm our ability to acquire mortgage loans in expected volumes. This could result in a decrease in our earnings and our ability to support our fixed overhead expense
levels. Interest rate fluctuations may harm our earnings as a result of potential changes in the spread between the interest rates on our borrowings and the interest rates on our mortgage assets. In addition, mortgage prepayment rates vary depending
on such factors as mortgage interest rates and market conditions. Changes in anticipated prepayment rates may harm our earnings.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Failure to hedge effectively against interest rate changes may harm our results of operations.We attempt to minimize exposure to interest rate fluctuations by hedging.
Asset/liability management hedging strategies involve risk and may not be effective in reducing our exposure to interest rate changes. Moreover, compliance with the REIT provisions of the Code may prevent us from effectively implementing the
strategies that we determine, absent such compliance, would best insulate us from the risks associated with changing interest rates.
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Mortgage insurers may not pay claims resulting in increased credit losses or may in the future change their pricing or underwriting guidelines.We have
placed reliance on mortgage insurance to mitigate the risk of credit losses.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | However there can be no assurance that the mortgage insurers will continue to have the financial ability to pay all claims presented. In addition, insurers
have the right to deny a claim if the loan is not properly serviced or has been improperly originated. We have the risk that mortgage insurance providers will revise their guidelines to an extent where we will no longer be able to acquire coverage
on all of our new production. Similarly, the providers may also increase insurance premiums to a point where the cost of coverage outweighs its benefit.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| | Changes in accounting standards might cause us to alter the way we structure or account for securitizations. Changes could be made to current accounting standards which would
limit the types of transactions eligible for gain on sale treatment. These changes could cause us to alter the way we either structure or account for securitizations.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | We face loss exposure due to the underlying real estate.A substantial portion of our mortgage assets consist of single family mortgage loans or mortgage securities
evidencing interests in single family mortgage loans. Any material decline in real estate values would weaken our collateral loan-to-value ratios and increase the possibility of loss if a borrower defaults. In such event, we will be subject to the
risk of loss on such mortgage assets arising from borrower defaults to the extent not covered by third-party credit enhancement.
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| | Current loan performance data may not be indicative of future results.Management uses estimates and assumptions based on actual experience with the mortgage loans. Actual
results and the timing of certain events could differ materially from those projected, due to factors including general economic conditions, fluctuations in interest rates, fluctuations in prepayment speeds and fluctuations in losses due to defaults
on mortgage loans. These fluctuations could rise to levels that would harm our profitability.
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Market factors may limit our ability to acquire mortgage assets at yields that are favorable relative to borrowing costs. Despite managements experience in the
acquisition of mortgage assets and its relationships with various mortgage suppliers, there can be no assurance that we will be able to acquire sufficient mortgage assets from mortgage suppliers which earn interest rates greater than our cost of
funds and at levels sufficient to maintain our profitability.
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Intense competition in the nonconforming mortgage loan industry may result in reduced net income or in revised underwriting standards that would harm our operations. We face
intense competition, primarily from commercial banks, thrifts, other independent mortgage lenders and other mortgage REITs. The government-sponsored entities Fannie Mae and Freddie Mac are also expanding their participation in the subprime mortgage
industry. Any increase in the competition among lenders to originate or purchase nonconforming mortgage loans may result in either reduced interest income on such mortgage loans compared to present levels which may reduce net income or revised
underwriting standards permitting higher loan-to-value ratios on properties securing nonconforming mortgage loans which may harm our operations.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Our failure to comply with federal, state or local regulation of mortgage lending, of broker compensation programs or of our local branch operations could
adversely affect our operations and profitability.As a mortgage lender, we are subject to many laws and regulations. Any failure to comply with these rules and their interpretations or with any future interpretations or judicial decisions could
harm our profitability or cause a change in the way we do
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | business. For example, several lawsuits have been filed challenging types of payments made by lenders to brokers, which payments are similar in type to the
payments we make to our independent brokers. Similarly, in our branch operations, we allow our branch managers considerable autonomy which could result in greater exposure to third-party claims if our compliance programs are not strictly adhered to.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | New legislation could restrict our ability to make mortgage loans, which could adversely impact our earnings.Several states and cities are considering or have passed laws,
regulations or ordinances aimed at curbing predatory lending practices. The federal government is also considering legislative and regulatory proposals in this regard. In general, these proposals involve lowering the existing federal Homeownership
and Equity Protection Act thresholds for defining a high-cost loan, and establishing enhanced protections and remedies for borrowers who receive such loans. Passage of these laws and rules could reduce our loan origination volume. In
addition, many whole loan buyers may elect not to purchase any loan labeled as a high cost loan under any local, state or federal law or regulation. Rating agencies likewise may refuse to rate securities backed by such loans.
Accordingly, these laws and rules could severely restrict the secondary market for a significant portion of our loan production. This would effectively preclude us from continuing to originate loans that fit within the newly defined thresholds and
could have a material adverse effect on our business.
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Should we fail to maintain REIT status, we would be subject to tax as a regular corporation. We conduct a substantial portion of our business through our taxable REIT
subsidiaries which creates additional compliance requirements. We must comply with various tests to continue to qualify as a REIT for federal income tax purposes. We conduct a substantial portion of our business through taxable REIT
subsidiaries, such as NovaStar Mortgage. Despite our qualification as a REIT, our taxable REIT subsidiaries must pay federal income tax on their taxable income. Our income from and investments in our taxable REIT subsidiaries generally do not
constitute permissible income and investments for some of the REIT qualification tests. While we attempt to ensure that our dealings with our taxable REIT subsidiaries will not adversely affect our REIT qualification, no assurance can be given that
we will successfully achieve that result. Furthermore, we may be subject to a 100% penalty tax, or our taxable REIT subsidiary may be denied deductions, to the extent that our dealings with our taxable REIT subsidiaries (such as our receipt of loan
guarantee payments) are deemed not to be arms length in nature.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | We have a limited operating history and incurred significant net losses in 1999 and 1998.We have not yet developed an extensive earnings history or experienced a wide
variety of interest rate or market conditions. Historical operating performance may be of limited relevance in predicting future performance. We incurred significant net losses in 1999 and 1998.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Restrictions on ownership of capital stock may inhibit market activity and the resulting opportunity for holders of our capital stock to receive a premium for their securities.In order for us to meet the requirements for qualification as a REIT, our charter generally prohibits any person from acquiring or holding, directly or indirectly, shares of capital stock in excess of 9.8% of the outstanding shares. This
restriction may inhibit market activity and the resulting opportunity for the holders of our capital stock to receive a premium for their stock that might otherwise exist in the absence of such restrictions.
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | The recent adoption of tax relief legislation could negatively impact the attractiveness of REIT stock as an investment. The recently enacted Jobs and Growth Tax Relief
Reconciliation Act of 2003, Pub. Law 108-27, contains a provision to reduce from 38.6% to 15% the maximum rate of income taxation for individuals on dividends paid by most types of tax-paying corporations. Dividends paid by REITs are not eligible
for such treatment except in limited circumstances which we do not expect will apply in our case to a material extent. The adoption of this tax relief provision may reduce the appeal of REITs to investors and may have a negative effect on the market
value of our stock.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Federal Income Tax Consequences



General. We believe we have complied, and intend
to comply in the future, with the requirements for qualification as a REIT under the Code. To the extent that we qualify as a REIT for federal income tax purposes, we generally will not be subject to federal income tax on the amount of income or
gain that is distributed to shareholders. However, origination and broker operations are conducted through NovaStar Mortgage and NovaStar Home Mortgage, which are owned by NFI Holding  a taxable REIT subsidiary (TRS). Consequently, all of the
taxable income of NFI Holding is subject to federal and state corporate income taxes. In general, a TRS may hold assets that a REIT cannot hold directly and generally may engage in any real estate or non-real estate related business. However,
special rules do apply to certain activities between a REIT and its TRS. For example, a TRS



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will be subject to earnings stripping limitations on the deductibility of interest paid to its REIT. In addition, a REIT will be subject to a 100% excise tax
on certain excess amounts to ensure that (i) tenants who pay a TRS for services are charged an arms-length amount by the TRS, (ii) fees paid to a REIT by its TRS are reflected at fair market value and (iii) interest paid by a TRS to its REIT
is commercially reasonable.



The REIT rules generally require
that a REIT invest primarily in real estate related assets, its activities be passive rather than active and it distribute annually to its shareholders substantially all of its taxable income. We could be subject to a number of taxes if we failed to
satisfy those rules or if we acquired certain types of income-producing real property through foreclosure. Although no complete assurance can be given, we do not expect that we will be subject to material amounts of such taxes.



Failure to satisfy certain Code requirements could cause loss of REIT status.
If we fail to qualify as a REIT for any taxable year, we would be subject to federal income tax (including any applicable minimum tax) at regular corporate rates and would not receive deductions for dividends paid to shareholders. As a result, the
amount of after-tax earnings available for distribution to shareholders would decrease substantially. While we intend to operate in a manner that will enable it to qualify as a REIT in future taxable years, there can be no certainty that such
intention will be realized. Loss of REIT status would reduce the amount of any distributions by taxes due, but the character of such distributions for tax purposes should be unaffected.



Qualification as a REIT. Qualification as a REIT requires that we satisfy a variety of tests relating to income,
assets, distributions and ownership. The significant tests are summarized below. We will make available more detailed information regarding our compliance with the REIT rules upon request.



Sources of Income. We must satisfy two tests with respect to the
sources of income: the 75% income test, and the 95% income test. The 75% income test requires that we derive at least 75% of gross income, excluding gross income from prohibited transactions, from certain real estate-related sources. In order to
satisfy the 95% income test, at least an additional 20% of gross income for the taxable year must consist either of income that qualifies under the 75% income test or dividends and interest. Management believes that income qualified for both of the
income tests during 2003.



Nature and Diversification of
Assets. As of the last day of each calendar quarter, we must meet four asset tests. Under the 75% of assets test, at least 75% of the value of our total assets must represent cash or cash items (including receivables), government securities or
real estate assets. Securities of the TRS do constitute non-real estate assets for purposes of the 75% test. Under the 10% asset test, we may not own more than 10% of the outstanding securities of any single non-governmental issuer, if these
securities do not qualify under the 75% asset test. There is an exception for electing corporations of which we own at least 35% of the outstanding securities. We intend to make this election. Under the 5% asset test, ownership of any stocks or
securities that do not qualify under the 75% asset test must be limited, in respect of any single non-governmental issuer, to an amount not greater than 5% of the value of our total assets. Under the 20% asset test, no more than 20% of our total
assets can consist of securities of one or more taxable REIT subsidiaries. The definition of security for this purpose includes financial contracts and instruments that we acquire in the normal course of business.



If we inadvertently fail to satisfy one or more of the asset tests at the end
of a calendar quarter, such failure would not cause us to lose our REIT status. We still could avoid disqualification by eliminating any discrepancy within 30 days after the close of the calendar quarter in which the discrepancy arose. Management
believes that we complied with the asset tests for all quarters during 2003.



Ownership of Common Stock. Our capital stock must be held by a minimum of 100 persons for at least 335 days of each year. In addition, at all times during the second half of each taxable year, no more than 50%
in value of our capital stock may be owned directly or indirectly by 5 or fewer individuals. We use the calendar year as our taxable year for income tax purposes. The Code requires us to send annual information questionnaires to specified
shareholders in order to assure compliance with the ownership tests. Management believes that we have complied with these stock ownership tests for 2003.



Distributions. We must distribute at least 90% of our taxable income and any after-tax net income from certain types of foreclosure property less
any non-cash income. No distributions are required in periods in which there is no income.



Taxable Income. We use the calendar year for both tax and financial reporting purposes. However, there may be differences between taxable income and income computed in accordance with accounting principles
generally accepted in the United States of America (GAAP). These differences primarily arise from timing and character differences in the recognition of revenue and expense and gains and losses for tax and GAAP purposes. Additionally, taxable income
does not include the taxable income of our taxable subsidiary, although the subsidiarys operating results are included in our GAAP results.



12



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##### Table of Contents

Personnel



As of December 31, 2003, we employed 1,476 people. Of these, 1,363 were employed in our mortgage lending and servicing operations and the remainder in our
portfolio management and branch administrative functions. Our branches employed 3,122 people as of December 31, 2003.



Item 2.Properties



Our
executive, administrative and loan servicing offices are located in Kansas City, Missouri, and consist of approximately 129,000 square feet of leased office space. The lease agreements on the premises expire in February 2009. The current annual rent
for these offices is approximately $2.6 million.



We lease
office space for our mortgage lending operations in Orange County, California, Independence, Ohio, Troy, Michigan, Columbia, Maryland and Vienna, Virginia. Currently, these offices consist of approximately 189,000 square feet. The leases on the
premises expire from April 2005 through September 2010, and the current annual rent is approximately $2.8 million.



Item 3. Legal Proceedings



We occasionally become involved in litigation arising in the normal course of business. Management believes that any liability with respect to such legal actions, individually or in the aggregate, will not have a material adverse effect on
its financial position or results of operations.



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



None



13



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##### Table of Contents

PART II



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



a.Market Price of and Dividends on the Registrants Common Equity and Related Stockholder Matters



The common stock of NovaStar Financial is traded on the
NYSE under the symbol NFI. The following table sets forth, for the periods indicated, the high and low sales prices per share of common stock on the NYSE and the cash dividends paid or payable per share of capital stock.



|                    |  |                |       |     |   |               |  |                 |          |  |                  |  |                  |  |   |           
|------------------- |  | -------------- | ----- | --- | - | ------------- |  | --------------- | -------- |  | ---------------- |  | ---------------- |  | - | ----------
|Common Stock Prices |  | Cash Dividends
|                    |  | High           |       | Low |   | Class ofStock |  |                 | Declared |  | Paid or Payable  |  | Amount Per Share
|1/1/01 to 3/31/01   |  | $              | 3.10  |     | $ | 1.88          |  | Preferred       |          |  | 4/27/01          |  | 5/10/01          |  | $ | 0.12      
|4/1/01 to 6/30/01   |  |                | 4.20  |     |   | 2.78          |  | PreferredCommon |          |  | 7/26/017/26/01   |  | 8/10/018/10/01   |  |   | 0.130.065 
|7/1/01 to 9/30/01   |  |                | 5.85  |     |   | 4.05          |  | PreferredCommon |          |  | 10/25/0110/25/01 |  | 11/10/0111/10/01 |  |   | 0.360.18  
|10/1/01 to 12/31/01 |  |                | 8.96  |     |   | 5.24          |  | PreferredCommon |          |  | 12/19/0112/19/01 |  | 1/10/021/14/02   |  |   | 0.470.235 
|1/1/02 to 3/31/02   |  |                | 9.70  |     |   | 7.91          |  | Common          | (A)      |  | 4/23/02          |  | 5/7/02           |  |   | 0.40      
|4/1/02 to 6/30/02   |  |                | 17.88 |     |   | 9.63          |  | Common          |          |  | 7/24/02          |  | 8/6/02           |  |   | 0.45      
|7/1/02 to 9/30/02   |  |                | 17.00 |     |   | 10.06         |  | Common          |          |  | 10/15/02         |  | 11/7/02          |  |   | 0.50      
|10/1/02 to 12/31/02 |  |                | 16.34 |     |   | 9.41          |  | Common          |          |  | 12/18/02         |  | 1/15/03          |  |   | 0.80      
|1/1/03 to 3/31/03   |  |                | 17.93 |     |   | 14.30         |  | CommonCommon    |          |  | 1/29/034/23/03   |  | 2/11/035/15/03   |  |   | 0.1651.125
|4/1/03 to 6/30/03   |  |                | 29.90 |     |   | 17.15         |  | Common          |          |  | 7/30/03          |  | 8/20/03          |  |   | 1.25      
|7/1/03 to 9/30/03   |  |                | 37.22 |     |   | 25.30         |  | Common          |          |  | 10/29/03         |  | 11/19/03         |  |   | 1.25      
|10/1/03 to 12/31/03 |  |                | 45.25 |     |   | 29.87         |  | Common          |          |  | 12/17/03         |  | 1/6/04           |  |   | 1.25      

---

|(A) | We issued the class B 7% convertible preferred stock in March 1999, which converted to common stock in February 2002.
|--- | ---------------------------------------------------------------------------------------------------------------------



As of February 29, 2004, approximately 22,000 stockholders held our
24,790,517 shares of common stock as provided by third party brokers and transfer agent reports.



We intend to make distributions to stockholders of all or substantially all of taxable income in each year, subject to certain adjustments, so as to
qualify for the tax benefits accorded to a REIT under the Code. All distributions will be made at the discretion of the Board of Directors and will depend on earnings, financial condition, maintenance of REIT status and other factors as the Board of
Directors may deem relevant.



b. Recent Sales of
Unregistered Securities



None.



c. Purchases of Equity Securities by the Issuer



None.



d. Filings with the Securities and Exchange Commission



A copy of the filings we have made with the Securities and Exchange
Commission (SEC) may be obtained on our website (www.novastarmortgage.com), through the website of the SEC (www.sec.gov) or by contacting us directly. Our investor relations contact information follows.



Investor Relations

8140 Ward Parkway, Suite 300

Kansas City, MO
64114

816.237.7000

Email:
ir@novastar1.com



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Item 6. Selected Financial Data



The following selected consolidated financial data is derived from our audited consolidated financial statements for the periods presented and should be read in conjunction with the more detailed information therein
and Managements Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this annual report. Operating results are not necessarily indicative of future performance.



Selected Consolidated Financial and Other Data

(dollars in thousands, except per share amounts)



|                                                      |  |                                 |           |   |          |   |           |          |  |   |           |   |  |      |           |   |  |   |         |   
|----------------------------------------------------- |  | ------------------------------- | --------- | - | -------- | - | --------- | -------- |  | - | --------- | - |  | ---- | --------- | - |  | - | ------- | --
|                                                      |  | For the Year Ended December 31, |          
|                                                      |  | 2003 (A)                        |           |   | 2002 (A) |   |           | 2001 (A) |  |   | 2000      |   |  | 1999 |          
|Consolidated Statement of Operations Data:            |  |                                 |           |   |          |   |           |          |  |   |           |   |  |      |           |   |  |   |         |   
|Interest income                                       |  | $                               | 170,420   |   |          | $ | 107,143   |          |  | $ | 57,904    |   |  | $    | 47,627    |   |  | $ | 66,713  |   
|Interest expense                                      |  |                                 | 40,364    |   |          |   | 27,728    |          |  |   | 27,366    |   |  |      | 34,696    |   |  |   | 46,758  |   
|Net interest income before credit recoveries (losses) |  |                                 | 130,056   |   |          |   | 79,415    |          |  |   | 30,538    |   |  |      | 12,931    |   |  |   | 19,955  |   
|Credit recoveries (losses)                            |  |                                 | 389       |   |          |   | 432       |          |  |   | (3,608    | ) |  |      | (5,449    | ) |  |   | (22,078 | ) 
|Gains (losses) on sales of mortgage assets            |  |                                 | 144,005   |   |          |   | 53,305    |          |  |   | 37,347    |   |  |      | (826      | ) |  |   | 351     |   
|Losses on derivative instruments                      |  |                                 | (30,837   | ) |          |   | (36,841   | )        |  |   | (3,953    | ) |  |      |          |   |  |   |        |   
|General and administrative expenses                   |  |                                 | 174,408   |   |          |   | 84,594    |          |  |   | 46,505    |   |  |      | 3,017     |   |  |   | 3,590   |   
|Net income (loss)                                     |  |                                 | 111,996   |   |          |   | 48,761    |          |  |   | 32,308    |   |  |      | 5,626     |   |  |   | (7,092  | ) 
|Basic income (loss) per share (C)                     |  | $                               | 5.04      |   |          | $ | 2.35      |          |  | $ | 1.61      |   |  | $    | 0.26      |   |  | $ | (0.54   | ) 
|Diluted income (loss) per share (C)                   |  | $                               | 4.91      |   |          | $ | 2.25      |          |  | $ | 1.51      |   |  | $    | 0.25      |   |  | $ | (0.54   | ) 
|                                                      | 
|                                                      |  | As of December 31,              |          
|                                                      |  | 2003 (A)                        |           |   | 2002 (A) |   |           | 2001 (A) |  |   | 2000      |   |  | 1999 |          
|Consolidated Balance Sheet Data:                      |  |                                 |           |   |          |   |           |          |  |   |           |   |  |      |           |   |  |   |         |   
|Mortgage Assets:                                      |  |                                 |           |   |          |   |           |          |  |   |           |   |  |      |           |   |  |   |         |   
|Mortgage loans                                        |  | $                               | 792,709   |   |          | $ | 1,133,509 |          |  | $ | 365,560   |   |  | $    | 375,927   |   |  | $ | 620,406 |   
|Mortgage securities                                   |  |                                 | 382,287   |   |          |   | 178,879   |          |  |   | 71,584    |   |  |      | 46,650    |   |  |   | 6,775   |   
|Total assets                                          |  |                                 | 1,399,957 |   |          |   | 1,452,497 |          |  |   | 512,380   |   |  |      | 494,482   |   |  |   | 689,427 |   
|Borrowings                                            |  |                                 | 1,005,516 |   |          |   | 1,225,228 |          |  |   | 362,398   |   |  |      | 382,437   |   |  |   | 586,868 |   
|Stockholders equity                                  |  |                                 | 300,224   |   |          |   | 183,257   |          |  |   | 129,997   |   |  |      | 107,919   |   |  |   | 100,161 |   
|                                                      | 
|                                                      |  | For the Year Ended December 31, |          
|                                                      |  | 2003                            |           |   | 2002     |   |           | 2001     |  |   | 2000      |   |  | 1999 |          
|Other Data:                                           |  |                                 |           |   |          |   |           |          |  |   |           |   |  |      |           |   |  |   |         |   
|Loans originated, principal                           |  | $                               | 5,994,492 |   |          | $ | 2,781,539 |          |  | $ | 1,333,366 |   |  | $    | 719,341   |   |  | $ | 452,554 |   
|Loans securitized, principal                          |  | $                               | 5,319,435 |   |          | $ | 1,560,001 |          |  | $ | 1,215,100 |   |  | $    | 584,350   |   |  | $ | 167,176 |   
|Nonconforming loans sold, principal                   |  | $                               | 151,210   |   |          | $ | 142,159   |          |  | $ | 73,324    |   |  | $    | 172,839   |   |  | $ | 390,827 |   
|Loan servicing portfolio, principal                   |  | $                               | 7,206,113 |   |          | $ | 3,657,640 |          |  | $ | 1,994,448 |   |  | $    | 1,112,615 |   |  | $ | 859,938 |   
|Branches, end of year                                 |  |                                 | 432       |   |          |   | 216       |          |  |   | 123       |   |  |      | 63        |   |  |   | 1       |   
|Loans brokered through branches                       |  | $                               | 6,381,432 |   |          | $ | 2,622,950 |          |  | $ | 1,087,971 |   |  | $    | 193,191   |   |  | $ |        |   
|Annualized return on assets                           |  |                                 | 9.93      | % |          |   | 6.05      | %        |  |   | 6.03      | % |  |      | 0.97      | % |  |   | (0.83   | )%
|Annualized return on equity                           |  |                                 | 58.90     | % |          |   | 30.30     | %        |  |   | 27.04     | % |  |      | 5.50      | % |  |   | (6.71   | )%
|Taxable income (loss)                                 |  | $                               | 136,495   |   |          | $ | 48,473    |          |  | $ | 5,242     |   |  | $    | (2        | ) |  | $ | (90     | ) 
|Taxable income (loss) per share (B) (C)               |  | $                               | 5.58      |   |          | $ | 2.32      |          |  | $ | 0.46      |   |  | $    |          |   |  | $ | (0.01   | ) 
|Dividends declared per common share (B) (C)           |  | $                               | 5.04      |   |          | $ | 2.15      |          |  | $ | 0.48      |   |  | $    |          |   |  | $ |        |   
|Dividends declared per preferred share                |  | $                               |          |   |          | $ |          |          |  | $ | 1.08      |   |  | $    | 0.49      |   |  | $ | 0.37    |   
|Number of account executives                          |  |                                 | 281       |   |          |   | 249       |          |  |   | 112       |   |  |      | 85        |   |  |   | 47      |   

---

|(A) | Includes the assets, liabilities, equity and results of operations for NFI Holding Corporation. The common stock of NFI Holding Corporation was acquired on January 1, 2001.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(B) | On January 29, 2003, a $0.165 special dividend related to 2002 taxable income was declared per common share.
|--- | ------------------------------------------------------------------------------------------------------------



|(C) | Per share amounts for all years have been adjusted for the 2-for-1 stock split on December 1, 2003.
|--- | ---------------------------------------------------------------------------------------------------



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



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



Safe Harbor Statement



Safe Harbor statement under the Private Securities Litigation
Reform Act of 1995: Statements in this discussion regarding NovaStar Financial, Inc. and its business, which are not historical facts, are forward-looking statements that involve risks and uncertainties. Certain matters discussed in this
report may constitute forward-looking statements within the meaning of the federal securities laws that inherently include certain risks and uncertainties. Actual results and the time of certain events could differ materially from those projected in
or contemplated by the forward-looking statements due to a number of factors, including general economic conditions, fluctuations in interest rates, fluctuations in prepayment speeds, fluctuations in losses due to defaults on mortgage loans, the
availability of nonconforming residential mortgage loans, the availability and access to financing and liquidity resources, and other risk factors previously outlined in this annual report on Form 10-K for the fiscal year ended December 31, 2003.
Other factors not presently identified may also cause actual results to differ. Management continuously updates and revises these estimates and assumptions based on actual conditions experienced. It is not practicable to publish all revisions and,
as a result, no one should assume that results projected in or contemplated by the forward-looking statements will continue to be accurate in the future.



Overview of Performance



During 2003, we reported net income of $112.0 million, or $4.91 per diluted share, as compared to $48.8 million, or $2.25 per diluted share in 2002. Our
earnings were driven largely by the income generated by our mortgage securities portfolio, which increased from $178.9 million as of December 31, 2002 to $382.3 million as of December 31, 2003. These securities are retained in securitizations of the
mortgage loans we originate. We securitized $5.3 billion of mortgage loans in 2003 as compared to $1.6 billion in 2002. The increased volume of mortgage loans we securitized is directly attributable to the increase in our loan origination volume.
During 2003 and 2002, we originated $5.3 billion and $2.5 billion, respectively, in nonconforming, residential mortgage loans. We increased our loan production through adding sales personnel and branch offices primarily in new and underserved
markets.



Summary of Operations and Key Performance Measurements



Virtually all of our net income is generated from our
mortgage securities portfolio, which is generated from the securitization of nonconforming loans we have originated. These mortgage securities represent the right to receive the net future cash flows from a pool of nonconforming loans. Generally
speaking, the more nonconforming loans we originate, the larger our securities portfolio and, therefore, the greater earnings potential. As a result, earnings are largely dependent on the volume of nonconforming loans and related performance factors
for those loans, including their average coupon, borrower default and borrower prepayment. Information regarding our lending volume is presented under the heading Mortgage Loans.



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



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



The key performance measures for management are:



| | dollar volume of nonconforming mortgage loans originated
|- | --------------------------------------------------------



| | relative cost of the loans originated
|- | -------------------------------------



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



| | return on our mortgage asset investments and the related management of interest rate risk
|- | -----------------------------------------------------------------------------------------



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



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Known Material Trends



Over the last ten years, the nonconforming lending market has grown by approximately $265 billion to a market of approximately $290 billion in 2003 as
estimated by the National Mortgage News. A significant portion of these loans are made to borrowers who are using equity in their primary residence to consolidate low-balance, installment or consumer debt. Additionally, this market has been very
stable and growing through all interest rate environments, meaning that while interest rates have increased and decreased dramatically over that period, the base market for nonconforming loans has not increased or decreased in relationship to
interest rates. Management estimates that NovaStar has a 2-3% market share. While management cannot predict consumer spending and borrowing habits, historical trends indicate that the market in which we operate is relatively stable and growing.



We depend on the capital markets to finance the mortgage loans
we originate. The primary bonds we issue in our loan securitizations are sold to large, institutional investors. In the short-term, we finance our mortgage loans using warehouse lines of credit provided by commercial and investment
banks. The equity marketplace provides capital to operate our business. The trend has been favorable in the capital markets for the types of securitization transactions we execute. Investor appetite for the bonds created has been strong.
Additionally, commercial and investment banks have provided significant liquidity to finance our mortgage lending operations through warehouse facilities. While management cannot predict the future liquidity environment, we are unaware of any
material reason to prevent continued liquidity support in the capital markets for our business. See the Liquidity and Capital Resources section of Managements Discussion and Analysis of Financial Condition and Results of
Operations for further discussion of liquidity risks and resources available to us.



Within the past year, the mortgage REIT industry has seen a significant increase in the desire for raising public capital. Additionally, there have been several new entrants to the mortgage REIT business and other
mortgage lender conversions (or proposed conversions) to REIT status. This increased activity may impact the pricing and underwriting guidelines within the nonconforming marketplace. We have not changed our guidelines or pricing in response to this
activity nor do we have any plans to make such changes.



The
net interest margin between the coupon on the mortgage loans and the cost of funding, largely tied to one-month LIBOR, provides the cash flow and yield on our mortgage securities. Generally, when short-term rates fall, our cash flow and yield is
higher. During 2001 and 2002, short-term rates fell dramatically, which correspondingly increased our cash flow and yield. As mortgage interest rates leveled-off in 2003, the spread on our mortgage securities has returned to expected or normal
levels. Additionally, in 2002 we began transferring interest rate agreements, at the time of securitization, into the securitization trusts to help reduce interest rate risk. While the interest rate agreements served to decrease the yield in 2003,
they are expected to decrease the volatility of the future cash flows on our mortgage securities. As a result, future interest income on our mortgage securities is expected to be less volatile. We expect the cash flow and yield to continue to be at
these normalized levels. On the other hand, the increased loan origination, leading to a larger securities portfolio, will compensate for the decreased yield. See Net Interest Income under the Results of Operations section
for further discussion and analysis of our mortgage asset yields.



State and local governing bodies are focused on the nonconforming lending business and the fees borrowers incur in obtaining a mortgage loan  generally termed predatory lending within the mortgage industry. In several
instances, states or local governing bodies have imposed strict laws on lenders to curb predatory lending. To date, these laws have had an insignificant impact on our business. We have capped fee structures consistent with those adopted by federal
mortgage agencies and have implemented rigid processes to ensure that our lending practices are not predatory in nature.



Significance of Estimates and Critical Accounting Policies



We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America and,
therefore, are required to make estimates regarding the values of our assets and 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. The results of 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. Detailed accounting policies are provided in Note 1 to our consolidated financial statements. Our critical accounting estimates impact only two of our three reportable segments; our mortgage portfolio management
and mortgage lending and loan servicing segments. Management has



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discussed the development and selection of these critical accounting estimates with the audit committee of our board of directors and the audit committee has
reviewed our disclosure.



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



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



| | Have the transferred assets been isolated from the transferor?
|- | --------------------------------------------------------------



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



| | Is there a call agreement that requires the transferor to return specific assets?
|- | -----------------------------------------------------------------------------------



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



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



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



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



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



For purposes of valuing our mortgage securities, it is important to know that in recent securitization transactions we not
only have transferred loans to the trust, but we have also transferred interest rate agreements to the trust with the objective of reducing interest rate risk within the trust. During the period before loans are transferred in a securitization
transaction, as discussed under Net Interest Income, Interest Rate/Market Risk and Hedging, we enter into interest rate swap or cap agreements to reduce interest rate risk. We use interest rate cap and swap
contracts to mitigate the risk of the cost of variable rate liabilities increasing at a faster rate than the earnings on assets during a period of rising rates. Certain interest rate agreements are then transferred into the trust at the time of
securitization. The trust assumes the interest rate agreements and, therefore, the trust assumes the obligation to make payments and obtains the right to receive payments under these agreements.



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In valuing our mortgage securities it is also important to understand what portion of the underlying
mortgage loan collateral is covered by mortgage insurance. The cost of the insurance is paid by the trust from proceeds the trust receives from the underlying collateral. The trust legally assumes the responsibility to pay the mortgage insurance
premiums and the rights to receive claims for credit losses. Therefore, we have no obligation to pay these insurance premiums. This information is significant for valuation as the mortgage insurance significantly reduces the credit losses born by
the owner of the loan. We discuss mortgage insurance premiums under the heading Premiums for Mortgage Loan Insurance.



The weighted average whole loan market price used in the initial valuation of our retained securities was 103.71 and 103.49 during 2003 and 2002,
respectively. The weighted average implied discount rate for the twelve months ended December 31, 2003 and 2002 was 22% and 21%, respectively. If the whole loan market price used in the initial valuation of our mortgage securities in 2003 had been
increased or decreased by 50 basis points, the initial value of our mortgage securities and the gain we recognized would have increased or decreased by $26.6 million.



Information regarding the assumptions we used is discussed under Mortgage Securities in the following
discussion.



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



Mortgage Securities. Our mortgage securities represent beneficial interests we retain in securitization transactions. The beneficial interests we
retain in securitization transactions 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 on the underlying loans and the cost of financing.
|- | -----------------------------------------------------------------------------------------



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



| | Overcollateralization and other subordinated securities, which are designed to protect the primary bondholder from credit loss on the underlying loans.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------



The beneficial interests we retain in resecuritization transactions represent
the right to receive the remaining cash flows from the underlying mortgage security collateral after the obligations to outside bondholders have been satisfied.



The cash flows we receive are highly dependent upon the interest rate environment. The cost of financing for the securitized loans is indexed to
short-term interest rates, while the loan coupons are less interest sensitive. As a result, as rates rise and fall, our cash flows will fall and rise, which in turn will decrease or increase the value of our mortgage securities. Additionally, the
cash flows we receive are dependent on the default and prepayment experience of the borrowers in 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 and establishing the rate of income recognition on mortgage securities are critical accounting estimates because they can materially affect net income and stockholders equity and require us to forecast interest rates,
mortgage principal payments, prepayments and loan default assumptions which are highly uncertain and require a large degree of judgment. The rate used to discount the projected cash flows is also critical in the valuation of our mortgage securities.
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 mortgage
securities is fair, but can provide no assurance that future prepayment and loss experience or changes in their required market discount rate will not require write-downs of the residual assets. Write-downs would reduce income of future periods.



We estimate fair value for the securities we retain in a
resecuritization transaction based on the present value of future expected cash flows estimated using managements best estimate of the key assumptions, including credit losses, prepayment speeds, forward yield curves, and discount rates
commensurate with the risks involved.



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



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



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During 2003, our average security yield has decreased to 34.3% for the year ended December 31, 2003 from
42.7% for the same period of 2002. This decrease is a result in the decline in loan coupon rates of the underlying collateral of our newer securities compared with our older securities. Also contributing to the decrease in yield is the fact that in
2002 we began transferring interest rate agreements, at the time of securitization, into the securitization trusts to help reduce interest rate risk. While the interest rate agreements served to decrease the yield in 2003, they are expected to
decrease the volatility of the future cash flows on our mortgage securities. As a result, future interest income on our mortgage securities is expected to be less volatile. Mortgage securities income has increased from $56.5 million for the twelve
months ended December 31, 2002 to $98.8 million for the same period of 2003 due to the increase in the average balance of our securities portfolio. If the rates used to accrue income on our mortgage securities during 2003 had been increased or
decreased by 10%, net income during the twelve months ended 2003 would have increased by $19.5 million and decreased by $20.6 million, respectively.



As of December 31, 2003 and 2002, the weighted average discount rate used in valuing our mortgage securities was 22% and 21%, respectively. The
weighted-average constant prepayment rate used in valuing our mortgage securities as of December 31, 2003 was 29 versus 46 as of December 31, 2002. If the discount rate used in valuing our mortgage securities as of December 31, 2003 had been
increased by 500 basis points, the value of our mortgage securities would have decreased by $22.0 million. If we had decreased the discount rate used in valuing our mortgage securities by 500 basis points, the value of our mortgage securities would
have increased by $25.0 million.



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



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



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



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



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



The fair value of our derivative instruments along with any margin accounts associated with the contracts are included in
other assets. Any changes in fair value of derivative instruments related to hedge effectiveness are reported in accumulated other comprehensive income. Changes in fair value of derivative instruments related to hedge ineffectiveness and non-hedge
activity are recorded as adjustments to earnings. For those derivative instruments that do not qualify for hedge accounting, changes in the fair value of the instruments are recorded as adjustments to earnings.



Mortgage Servicing Rights (MSR). Originated MSR are recorded at
allocated cost based upon the relative fair values of the transferred loans and the servicing rights. MSR are amortized in proportion to the projected net



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servicing revenue over the expected life of the related mortgage loans. Periodically, we evaluate the carrying value of originated MSR based on their
estimated fair value. If the estimated fair value, using a discounted cash flow methodology, is less than the carrying amount of the mortgage servicing rights, the mortgage servicing rights are written down to the amount of the estimated fair value.
For purposes of evaluating and measuring impairment of MSR we stratify the mortgage servicing rights based on their predominant risk characteristics. The significant risk characteristic considered is period of origination. The mortgage loans
underlying the MSR are pools of homogenous, nonconforming residential loans.



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



Stock-Based Compensation Prior to 2003, we accounted for our stock-based compensation plan using the recognition and measurement principles of
Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations. We accounted for stock options based on the specific terms of the options granted. Options with variable terms, including
those options for which the strike price has been adjusted and options issued by us with attached dividend equivalent rights, resulted in adjustments to compensation expense to the extent the market price of the common stock changed. No expense was
recognized for options with fixed terms.



During the fourth
quarter of 2003, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation. SFAS No. 123 requires that all options be valued at the date of grant
and expensed over their vesting period. We use the Black-Scholes option pricing model to value options granted.



Additionally, we selected the modified prospective method of adoption described in SFAS No. 148, Accounting for Stock-Based Compensation-Transition and
Disclosure. Under this method, the change is retroactive to January 1, 2003 and compensation cost recognized in 2003 is the same as that which would have been recognized had the fair value method of SFAS No. 123 been applied from its original
effective date. The pretax impact of adopting the provisions under the modified prospective method for the nine months ended September 30, 2003 was a decrease to compensation expense of $7.1 million. In accordance with the modified prospective
method of adoption, results for prior years have not been restated. SFAS No. 123 states that the adoption of the fair value based method is a change to a preferable method of accounting. We believe that use of the fair value based method to record
stock-based compensation expense is consistent with the accounting for all other forms of compensation.



In accordance with the provisions of SFAS No. 123 and SFAS No. 148, $1.3 million was recorded for total stock-based compensation expense in 2003. In
accordance with APB No. 25, total stock-based compensation expense was $2.5 million and $0.7 million, respectively, for the years ended December 31, 2002 and 2001.



Financial Condition as of December 31, 2003 and 2002



Mortgage Loans. We classify our mortgage loans into two categories: held-for-sale and
held-in-portfolio. Loans we have originated, but have not yet sold or securitized, are classified as held-for-sale. We expect to sell these loans outright in third party transactions or in securitization transactions that
will be, for tax and accounting purposes, recorded as sales. We use warehouse lines of credit and mortgage repurchase agreements to finance our held-for-sale loans. As such, the fluctuations in mortgage loans  held-for-sale and short-term
borrowings between December 31, 2003 and December 31, 2002 is dependent on loans we have originated during the period as well as loans we have sold outright or through securitization transactions.



The volume and cost of our loan production is critical to our financial
results. The loans we produce serve as collateral for our mortgage securities and generate gains as they are sold or securitized. The cost of our production is also critical to our financial results as it is a significant factor in the gains we
recognize. The following table summarizes our loan production for 2003 and 2002. We discuss our cost of production under General and Administrative Expenses under Results of Operations. Also, details regarding mortgage loans
sold or securitized and the gains recognized during 2003 can be found in the Gains on Sales of Mortgage Assets and Losses on Derivative Instruments section of this document.



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Table 1  Nonconforming Loan Originations

(dollars in thousands, except for average loan balance)

---



|     |  |        |  |           |              |                      |   |                      |  |        |                  |  |    |                                 |  |     |  |     |   |  |    |  
|---- |  | ------ |  | --------- | ------------ | -------------------- | - | -------------------- |  | ------ | ---------------- |  | -- | ------------------------------- |  | --- |  | --- | - |  | -- | -
|     |  | Number |  | Principal |              | Average Loan Balance |   | Price Paid to Broker |  |        | Weighted Average |  |    | Percent with Prepayment Penalty | 
|     |  |        |  |           | Loan toValue |                      |   | FICO Score           |  | Coupon |                  | 
|2003 |  | 36,911 |  | $         | 5,250,978    |                      | $ | 142,261              |  | 101.2  | %                |  | 78 | %                               |  | 638 |  | 7.3 | % |  | 77 | %
|     |  |        |  |           |              |                      |   |                      |  |        |                  |  |    |                                 |  |     |  |     |   |  |    |  
|2002 |  | 18,453 |  | $         | 2,492,767    |                      | $ | 135,087              |  | 101.1  | %                |  | 79 | %                               |  | 628 |  | 8.3 | % |  | 80 | %
|     |  |        |  |           |              |                      |   |                      |  |        |                  |  |    |                                 |  |     |  |     |   |  |    |  



A portion of the
mortgage loans on our balance sheet serve as collateral for asset-backed bonds we have issued and are classified as held-in-portfolio. The carrying value of held-in-portfolio mortgage loans as of December 31, 2003 was $94.7
million compared to $149.9 million as of December 31, 2002.



Premiums are paid on substantially all mortgage loans. Premiums on mortgage loans held-in-portfolio are amortized as a reduction of interest income over the estimated lives of the loans. For mortgage loans held-for-sale, premiums are
deferred until the related loans are sold. To mitigate the effect of prepayments on interest income from mortgage loans, we generally strive to originate mortgage loans with prepayment penalties.



In periods of decreasing interest rates, borrowers are more likely to
refinance their mortgages to obtain a better interest rate. Even in rising rate environments, borrowers tend to repay their mortgage principal balances earlier than is required by the terms of their mortgages. Nonconforming borrowers, as they update
their credit rating, are more likely to refinance their mortgage loan to obtain a lower interest rate.



The operating performance of our mortgage loan portfolio, including net interest income, allowance for credit losses and effects of hedging, are discussed
under Results of Operations and Interest Rate/Market Risk. Gains on the sales of mortgage loans, including impact of securitizations treated as sales, is also discussed under Results of Operations. Additional
information relating to our loans held-in-portfolio and loans held-for-sale can be accessed via our website at www.novastarmortgage.com. Such information includes a summary of our loans held-in-portfolio and loans held-for-sale by FICO score and
geographic concentration. For held-in-portfolio loans, loan performance characteristics such as credit quality and prepayment experience are also available.



Table 2  Carrying Value of Mortgage Loans

(dollars in
thousands)

---



|                                |  |                  |         |   |                  |   |         |  
|------------------------------- |  | ---------------- | ------- | - | ---------------- | - | ------- | -
|                                |  | December 31,2003 |         |   | December 31,2002 |  
|Held-in-portfolio:              |  |                  |         |   |                  |   |         |  
|Current principal               |  | $                | 94,162  |   |                  | $ | 149,918 |  
|                                |  |                  |         |   |                  |   |         |  
|Premium                         |  | $                | 1,874   |   |                  | $ | 2,994   |  
|                                |  |                  |         |   |                  |   |         |  
|Coupon                          |  |                  | 10.0    | % |                  |   | 10.0    | %
|                                |  |                  |         |   |                  |   |         |  
|Percent with prepayment penalty |  |                  |        | % |                  |   | 18      | %
|                                |  |                  |         |   |                  |   |         |  
|Held-for-sale:                  |  |                  |         |   |                  |   |         |  
|Current principal               |  | $                | 687,880 |   |                  | $ | 972,360 |  
|                                |  |                  |         |   |                  |   |         |  
|Premium                         |  | $                | 10,112  |   |                  | $ | 11,273  |  
|                                |  |                  |         |   |                  |   |         |  
|Coupon                          |  |                  | 7.7     | % |                  |   | 8.0     | %
|                                |  |                  |         |   |                  |   |         |  
|Percent with prepayment penalty |  |                  | 74      | % |                  |   | 81      | %
|                                |  |                  |         |   |                  |   |         |  



Mortgage Securities Available-for-Sale.Since 1998, we have pooled the majority of the loans we have originated to serve as collateral for asset-backed bonds in securitizations that are treated as sales for accounting and tax purposes. In these
transactions, the loans are removed from our balance sheet. However, we retain excess interest, prepayment penalty and subordinated principal securities. Additionally, we service the loans sold in these securitizations (see Mortgage Servicing
Rights under the header Financial Condition as of December 31, 2003 and 2002). As of December 31, 2003 and 2002, the fair value of our mortgage securities was $382.3 million and $178.9 million, respectively. During 2003 and 2002,
we executed securitizations totaling $5.3 billion and $1.6 billion, respectively, in mortgage loans and retained mortgage securities with a value of $299.8 million and $92.9 million, respectively. See Table 3 for a summary of the activity in our
mortgage securities portfolio.



The value of our securities
represents the present value of the securities cash flows that we expect to receive over their lives, considering estimated prepayment speeds and credit losses of the underlying loans, discounted at an appropriate risk-adjusted market rate of
return. The cash flows are realized over the life of the loan collateral as cash distributions are received from the trust that owns the collateral.



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In estimating the fair value of our mortgage securities, management must make assumptions regarding the
future performance and cash flow of the mortgage loans collateralizing the securities. These estimates are based on managements judgments about the nature of the loans. The cash flows we receive on our mortgage securities will be the net of
the gross coupon and the bond cost less administrative costs (servicing and trustee fees) and the cost of mortgage insurance. Additionally, the trust is a party to interest rate agreements. Our cash flow will include (exclude) payments from (to) the
interest rate agreement counterparty. Table 4 provides a summary of the critical assumptions used in estimating the cash flows of the collateral and the resulting estimated fair value of the mortgage securities.



During the past two years, interest expense on asset-backed bonds has been
unexpectedly low. As a result, the spread between the coupon interest and the bond cost has been unusually high. As a result, our cost basis in many of our mortgage securities has been significantly reduced. For example, our cost basis in NMFT
Series 2001-1 has been reduced to zero (see Table 4). When our cost basis in the retained securities (interest only, prepayment penalty and subordinated securities) reaches zero, the remaining future cash flows received on the securities are
recognized entirely as income.



The operating performance of
our mortgage securities portfolio, including net interest income and effects of hedging are discussed under Results of Operations and Interest Rate/Market Risk. Additional information relating to our loans collateralizing our
mortgage securities can be accessed via our website at www.novastarmortgage.com. Such information includes a summary of our loans collateralizing our mortgage securities by FICO score and geographic concentration, as well as, loan performance
characteristics such as credit quality and prepayment experience.



Table 3
 Rollforward of Mortgage Securities

(in thousands)

---



|                                               |  |      |          |   |                     |   |                                          |  |   |          |  
|---------------------------------------------- |  | ---- | -------- | - | ------------------- | - | ---------------------------------------- |  | - | -------- | -
|                                               |  | Cost |          |   | Net unrealized gain |   | Estimated fairvalue ofmortgagesecurities | 
|As of January 1, 2002                          |  | $    | 54,594   |   |                     | $ | 16,990                                   |  | $ | 71,584   |  
|                                               |  |      |          |   |                     |   |                                          |  |   |          |  
|Increases (decreases) to mortgage securities:  |  |      |          |   |                     |   |                                          |  |   |          |  
|New securities retained in securitizations     |  |      | 90,785   |   |                     |   | 2,118                                    |  |   | 92,903   |  
|Accretion of income                            |  |      | 56,481   |   |                     |   |                                         |  |   | 56,481   |  
|Proceeds from paydowns of securities           |  |      | (99,195  | ) |                     |   |                                         |  |   | (99,195  | )
|Mark-to-market value adjustment                |  |      |         |   |                     |   | 57,106                                   |  |   | 57,106   |  
|                                               |  |      |          |   |                     |   |                                          |  |   |          |  
|Net increase to mortgage securities            |  |      | 48,071   |   |                     |   | 59,224                                   |  |   | 107,295  |  
|                                               |  |      |          |   |                     |   |                                          |  |   |          |  
|As of December 31, 2002                        |  | $    | 102,665  |   |                     | $ | 76,214                                   |  | $ | 178,879  |  
|                                               |  |      |          |   |                     |   |                                          |  |   |          |  
|Increases (decreases) to mortgage securities:  |  |      |          |   |                     |   |                                          |  |   |          |  
|New securities retained in securitizations (A) |  |      | 292,675  |   |                     |   | 7,077                                    |  |   | 299,752  |  
|Accretion of income                            |  |      | 98,804   |   |                     |   |                                         |  |   | 98,804   |  
|Proceeds from paydowns of securities           |  |      | (199,582 | ) |                     |   |                                         |  |   | (199,582 | )
|Mark-to-market value adjustment                |  |      |         |   |                     |   | 4,434                                    |  |   | 4,434    |  
|                                               |  |      |          |   |                     |   |                                          |  |   |          |  
|Net increase to mortgage securities            |  |      | 191,897  |   |                     |   | 11,511                                   |  |   | 203,408  |  
|                                               |  |      |          |   |                     |   |                                          |  |   |          |  
|As of December 31, 2003                        |  | $    | 294,562  |   |                     | $ | 87,725                                   |  | $ | 382,287  |  
|                                               |  |      |          |   |                     |   |                                          |  |   |          |  

---

|(A) | See Note 3 of the consolidated financial statements for further discussion.
|--- | ---------------------------------------------------------------------------



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Table 4  Valuation of Individual Mortgage Securities and Assumptions

(dollars in thousands)

---



|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|----------------------- |  | ---- | ------- | ------------------------ | - | ------ | --------------------------------------- |  | ----------------------- | ------- |  | -------------------------------------- | - |  | ----------------------- | - |  | ------------ | - |  | ---------------------- | - |  | ----------------------- | - |  | --- | -
|                        |  |      |         |                          |   |        |                                         |  | Current Assumptions (B) |         |  | Assumptions at TrustSecuritization (B) |  
|                        |  | Cost |         | NetUnrealizedGain (Loss) |   |        | EstimatedFair ValueofMortgageSecurities |  | DiscountRate            |         |  | ConstantPrepaymentRate                 |   |  | ExpectedCreditLosses(A) |   |  | DiscountRate |   |  | ConstantPrepaymentRate |   |  | ExpectedCreditLosses(A) |  
|December 31, 2003:      |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|NMFT 1999-1             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  | $    | 6,119   |                          | $ | (101   | )                                       |  | $                       | 6,018   |  | 17                                     | % |  | 39                      | % |  | 5.2          | % |  | 17                     | % |  | 30                      | % |  | 2.5 | %
|                        |  |      |         |                          |   |        |                                         |  |                        
|NMFT 2000-1             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      |        |                          |   | 1,942  |                                         |  |                         | 1,942   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      |        |                          |   | 244    |                                         |  |                         | 244     |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      | 299     |                          |   | 708    |                                         |  |                         | 1,007   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      | 299     |                          |   | 2,894  |                                         |  |                         | 3,193   |  | 15                                     |   |  | 57                      |   |  | 1.3          |   |  | 15                     |   |  | 27                      |   |  | 1.0 |  
|NMFT 2000-2             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      |        |                          |   | 3,074  |                                         |  |                         | 3,074   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      |        |                          |   | 274    |                                         |  |                         | 274     |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      | 754     |                          |   | 1,993  |                                         |  |                         | 2,747   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      | 754     |                          |   | 5,341  |                                         |  |                         | 6,095   |  | 15                                     |   |  | 63                      |   |  | 1.0          |   |  | 15                     |   |  | 28                      |   |  | 1.0 |  
|NMFT 2001-1             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      |        |                          |   | 6,386  |                                         |  |                         | 6,386   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      |        |                          |   | 518    |                                         |  |                         | 518     |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      |        |                          |   | 1,629  |                                         |  |                         | 1,629   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |        |                          |   | 8,533  |                                         |  |                         | 8,533   |  | 20                                     |   |  | 53                      |   |  | 1.1          |   |  | 20                     |   |  | 28                      |   |  | 1.2 |  
|NMFT 2001-2             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      |        |                          |   | 16,343 |                                         |  |                         | 16,343  |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      |        |                          |   | 1,469  |                                         |  |                         | 1,469   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      | 185     |                          |   | 3,164  |                                         |  |                         | 3,349   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      | 185     |                          |   | 20,976 |                                         |  |                         | 21,161  |  | 25                                     |   |  | 41                      |   |  | 0.9          |   |  | 25                     |   |  | 28                      |   |  | 1.2 |  
|NMFT 2002-1             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      | 8,437   |                          |   | 5,285  |                                         |  |                         | 13,722  |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      | 550     |                          |   | 937    |                                         |  |                         | 1,487   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      | 1,183   |                          |   | 3,444  |                                         |  |                         | 4,627   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      | 10,170  |                          |   | 9,666  |                                         |  |                         | 19,836  |  | 20                                     |   |  | 35                      |   |  | 1.3          |   |  | 20                     |   |  | 32                      |   |  | 1.7 |  
|NMFT 2002-2             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      | 7,093   |                          |   | 1,489  |                                         |  |                         | 8,582   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      | 582     |                          |   | 678    |                                         |  |                         | 1,260   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      | 1,750   |                          |   | 1,315  |                                         |  |                         | 3,065   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      | 9,425   |                          |   | 3,482  |                                         |  |                         | 12,907  |  | 25                                     |   |  | 36                      |   |  | 1.8          |   |  | 25                     |   |  | 27                      |   |  | 1.6 |  
|NMFT 2002-3             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      | 20,801  |                          |   | 5,362  |                                         |  |                         | 26,163  |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      | 1,348   |                          |   | 1,662  |                                         |  |                         | 3,010   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      | 2,225   |                          |   | 1,847  |                                         |  |                         | 4,072   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      | 24,374  |                          |   | 8,871  |                                         |  |                         | 33,245  |  | 20                                     |   |  | 32                      |   |  | 0.9          |   |  | 20                     |   |  | 30                      |   |  | 1.0 |  
|NMFT 2003-1             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      | 47,352  |                          |   | 2,280  |                                         |  |                         | 49,632  |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      | 3,949   |                          |   | 1,814  |                                         |  |                         | 5,763   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      | 6,698   |                          |   | 2,877  |                                         |  |                         | 9,575   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      | 57,999  |                          |   | 6,971  |                                         |  |                         | 64,970  |  | 20                                     |   |  | 23                      |   |  | 2.8          |   |  | 20                     |   |  | 28                      |   |  | 3.3 |  
|NMFT 2003-2             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      | 58,709  |                          |   | 4,863  |                                         |  |                         | 63,572  |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      | 3,042   |                          |   | 2,513  |                                         |  |                         | 5,555   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      | 25      |                          |   | 265    |                                         |  |                         | 290     |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      | 61,776  |                          |   | 7,641  |                                         |  |                         | 69,417  |  | 28                                     |   |  | 26                      |   |  | 2.6          |   |  | 28                     |   |  | 25                      |   |  | 2.7 |  
|MFT 2003-3              |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      | 72,637  |                          |   | 3,128  |                                         |  |                         | 75,765  |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      | 3,098   |                          |   | 1,830  |                                         |  |                         | 4,928   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      | 1,628   |                          |   | 3,535  |                                         |  |                         | 5,163   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      | 77,363  |                          |   | 8,493  |                                         |  |                         | 85,856  |  | 20                                     |   |  | 23                      |   |  | 3.4          |   |  | 20                     |   |  | 22                      |   |  | 3.6 |  
|NMFT 2003-4             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      | 41,668  |                          |   | 4,107  |                                         |  |                         | 45,775  |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      | 4,430   |                          |   | 61     |                                         |  |                         | 4,491   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      |        |                          |   | 790    |                                         |  |                         | 790     |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      | 46,098  |                          |   | 4,958  |                                         |  |                         | 51,056  |  | 20                                     |   |  | 30                      |   |  | 5.3          |   |  | 20                     |   |  | 30                      |   |  | 5.1 |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Total                   |  | $    | 294,562 |                          | $ | 87,725 |                                         |  | $                       | 382,287 |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  



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



|(B) | The current discount rate and assumptions and those at trust securitization, which were previously disclosed, have been adjusted to reflect managements revised estimates for
volatility and risk associated with the underlying mortgage loan collateral. These revisions do not impact previously recorded amounts.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



24



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##### Table of Contents

|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|----------------------- |  | ---- | ------- | ------------------------ | - | ------ | --------------------------------------- |  | ----------------------- | ------- |  | -------------------------------------- | - |  | ----------------------- | - |  | ------------ | - |  | ---------------------- | - |  | ----------------------- | - |  | --- | -
|                        |  |      |         |                          |   |        |                                         |  | Current Assumptions (B) |         |  | Assumptions at Trust Securitization(B) |  
|                        |  | Cost |         | NetUnrealizedGain (Loss) |   |        | EstimatedFair ValueofMortgageSecurities |  | DiscountRate            |         |  | ConstantPrepaymentRate                 |   |  | ExpectedCreditLosses(A) |   |  | DiscountRate |   |  | ConstantPrepaymentRate |   |  | ExpectedCreditLosses(A) |  
|December 31, 2002:      |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|NMFT 1999-1             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  | $    | 5,791   |                          | $ | (1,541 | )                                       |  | $                       | 4,250   |  | 17                                     | % |  | 26                      | % |  | 4.8          | % |  | 17                     | % |  | 30                      | % |  | 2.5 | %
|                        |  |      |         |                          |   |        |                                         |  |                        
|NMFT 2000-1             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      | 984     |                          |   | 3,089  |                                         |  |                         | 4,073   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      | 273     |                          |   | 370    |                                         |  |                         | 643     |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      | 299     |                          |   | 1,041  |                                         |  |                         | 1,340   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      | 1,556   |                          |   | 4,500  |                                         |  |                         | 6,056   |  | 15                                     |   |  | 67                      |   |  | 0.7          |   |  | 15                     |   |  | 27                      |   |  | 1.0 |  
|NMFT 2000-2             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      | 1,355   |                          |   | 5,331  |                                         |  |                         | 6,686   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      | 379     |                          |   | 620    |                                         |  |                         | 999     |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      | 792     |                          |   | 1,629  |                                         |  |                         | 2,421   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      | 2,526   |                          |   | 7,580  |                                         |  |                         | 10,106  |  | 15                                     |   |  | 70                      |   |  | 0.7          |   |  | 15                     |   |  | 28                      |   |  | 1.0 |  
|NMFT 2001-1             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      | 1,766   |                          |   | 10,263 |                                         |  |                         | 12,029  |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      | 311     |                          |   | 1,806  |                                         |  |                         | 2,117   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      | 324     |                          |   | 1,886  |                                         |  |                         | 2,210   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      | 2,401   |                          |   | 13,955 |                                         |  |                         | 16,356  |  | 20                                     |   |  | 68                      |   |  | 1.0          |   |  | 20                     |   |  | 28                      |   |  | 1.2 |  
|NMFT 2001-2             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      | 10,295  |                          |   | 20,806 |                                         |  |                         | 31,101  |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      | 2,007   |                          |   | 4,055  |                                         |  |                         | 6,062   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      | 1,315   |                          |   | 2,658  |                                         |  |                         | 3,973   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      | 13,617  |                          |   | 27,519 |                                         |  |                         | 41,136  |  | 25                                     |   |  | 58                      |   |  | 1.0          |   |  | 25                     |   |  | 28                      |   |  | 1.2 |  
|NMFT 2002-1             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      | 14,925  |                          |   | 6,306  |                                         |  |                         | 21,231  |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      | 2,491   |                          |   | 1,053  |                                         |  |                         | 3,544   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      | 3,343   |                          |   | 1,413  |                                         |  |                         | 4,756   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      | 20,759  |                          |   | 8,772  |                                         |  |                         | 29,531  |  | 20                                     |   |  | 48                      |   |  | 1.2          |   |  | 20                     |   |  | 32                      |   |  | 1.7 |  
|NMFT 2002-2             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      | 13,941  |                          |   | 3,650  |                                         |  |                         | 17,591  |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      | 1,764   |                          |   | 462    |                                         |  |                         | 2,226   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      | 2,443   |                          |   | 639    |                                         |  |                         | 3,082   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      | 18,148  |                          |   | 4,751  |                                         |  |                         | 22,899  |  | 25                                     |   |  | 30                      |   |  | 1.6          |   |  | 25                     |   |  | 27                      |   |  | 1.6 |  
|NMFT 2002-3             |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Interest only           |  |      | 31,729  |                          |   | 8,947  |                                         |  |                         | 40,676  |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Prepayment penalty      |  |      | 3,057   |                          |   | 862    |                                         |  |                         | 3,919   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Subordinated securities |  |      | 3,081   |                          |   | 869    |                                         |  |                         | 3,950   |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      | 37,867  |                          |   | 10,678 |                                         |  |                         | 48,545  |  | 20                                     |   |  | 30                      |   |  | 1.0          |   |  | 20                     |   |  | 30                      |   |  | 1.0 |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Total                   |  | $    | 102,665 |                          | $ | 76,214 |                                         |  | $                       | 178,879 |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                        |  |      |         |                          |   |        |                                         |  |                         |         |  |                                        |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  



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



|(B) | The current discount rate and assumptions and those at trust securitization, which were previously disclosed, have been adjusted to reflect managements revised estimates for
volatility and risk associated with the underlying mortgage loan collateral. These revisions do not impact previously recorded amounts.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



25



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Servicing Related Advances.Advances on behalf of borrowers for taxes, insurance and other
customer service functions are made by NovaStar Mortgage, Inc. and aggregated $19.3 million as of December 31, 2003 compared with $11.9 million as of December 31, 2002. These balances will generally increase as our assets and loan servicing balances
increase.



Mortgage Servicing Rights. As discussed under
Mortgage Securities  Available for Sale, we retain the right to service mortgage loans we originate and have securitized. Servicing rights for loans we sell to third parties are not retained and we have not purchased the right to service
loans. As of December 31, 2003, we have $19.7 million in capitalized mortgage servicing rights compared with $7.9 million as of December 31, 2002. The value of the mortgage servicing rights we retained in our securitizations during 2003 and 2002 was
$20.8 million and $6.1 million, respectively. Amortization of mortgage servicing rights was $9.0 million and $4.6 million for years ended December 31, 2003 and 2002, respectively.



Assets Acquired through Foreclosure.As of December 31, 2003, we had 53 properties in real estate owned
with a carrying value of $3.2 million compared to 69 properties with a carrying value of $5.9 million as of December 31, 2002. Losses or gains from the ultimate disposition of real estate owned are charged or credited to operating income and are
detailed under the heading Gains on Sales of Mortgage Assets and Losses on Derivative Instruments.



Other Assets. Included in other assets is collateral required under the terms of our derivative instrument contracts, derivative instrument market
values, fixed assets, receivables from securitizations, deferred tax asset and other miscellaneous assets. Deposits with our derivative counterparties were $20.9 million as of December 31, 2003 compared with $30.3 million as of December 31, 2002.
The market value of the derivative instruments offset the deposits by $2.0 million and $18.2 million as of December 31, 2003 and December 31, 2002, respectively. These balances will generally decrease as interest rates rise and increase when
interest rates fall. Also included in other assets at December 31, 2003 and December 31, 2002 are fixed assets, net of accumulated depreciation of $14.5 million and $5.4 million, respectively. Fixed assets have increased primarily due to purchases
of furniture and fixtures, computer equipment and office equipment related to the growth in the number of our employees. Our receivables from securitizations were $6.2 million and $0.6 million at December 31, 2003 and December 31, 2002,
respectively. These receivables represent cash due to us when we delivered the remaining $479.8 million in loans collateralizing NMFT 2003-4 in January 2004 as well as cash due to us on our mortgage securities. As of December 31, 2003 and 2002, we
had a net deferred tax asset of $10.5 million and $2.5 million, respectively. See Note 9 of the consolidated financial statements for details of the deferred tax asset.



Short-term Financing Arrangements. Mortgage loan originations are funded with various financing facilities prior to
securitization. Repurchase agreements are used as interim, short-term financing before loans are transferred in our securitization transactions. The balances outstanding under our short-term arrangements fluctuate based on lending volume, cash flows
from operating, investing and other financing activities and equity transactions. As shown in Table 5, we have $130.1 million in immediately available funds, including $118.2 million in cash. We have borrowed approximately $873 million of the $2.9
billion in committed lines of credit and mortgage securities repurchase facilities, leaving approximately $2.0 billion available to support the mortgage lending and mortgage portfolio operations. See the Liquidity and Capital Resources
section of Managements Discussion and Analysis of Financial Condition and Results of Operations for a further discussion of liquidity risks and resources available to us.



Table 5  Short-term Financing Resources

(in thousands)

---

|                                                                  |  |              |           |                             |   |            |  |              |         |  |   |        
|----------------------------------------------------------------- |  | ------------ | --------- | --------------------------- | - | ---------- |  | ------------ | ------- |  | - | -------
|                                                                  |  | Credit Limit |           | Lending Value of Collateral |   | Borrowings |  | Availability
|Unrestricted cash                                                 |  |              |           |                             |   |            |  |              |         |  | $ | 118,180
|Lines of credit and mortgage and securities repurchase facilities |  | $            | 2,875,000 |                             | $ | 884,438    |  | $            | 872,536 |  | $ | 11,902 
|                                                                  |  |              |           |                             |   |            |  |              |         |  |   |        
|Total                                                             |  | $            | 2,875,000 |                             | $ | 884,438    |  | $            | 872,536 |  | $ | 130,082
|                                                                  |  |              |           |                             |   |            |  |              |         |  |   |        



Asset-backed
Bonds. During 1997 and 1998, we completed the securitization of loans in transactions that were structured as financing arrangements for accounting purposes. These non-recourse financing arrangements match the loans with the financing
arrangement for long periods of time, as compared to lines of credit and repurchase agreements that mature frequently with interest rates that reset frequently and have liquidity risk in the form of margin calls. Under the terms of our asset-backed
bonds we are entitled to repurchase the mortgage loan collateral and repay the remaining bond obligations when the aggregate collateral principal balance falls below 35% of their original balance for the loans in NHES 97-01 and 25% for the loans in
NHES 97-02, 98-01 and 98-02. We have not exercised our right to repurchase any loans and repay bond obligations.



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On November 5, 2002 we resecuritized interest-only and prepayment penalty securities and issued NovaStar
CAPS Certificate Series 2002-C1 in the amount of $68 million. On July 2, 2003, we resecuritized interest-only, prepayment penalty and subordinated mortgage securities of NMFT 2003-2 and issued NovaStar NIMS Certificate Series 2003-N1 in the amount
of $54 million. The resecuritizations were structured as secured borrowings for financial reporting and income tax purposes. In accordance with SFAS No. 140, control over the transferred assets was not surrendered and thus the transaction was
considered financing for the mortgage securities.



Accounts
Payable and Other Liabilities. Included in accounts payable and other liabilities is the provision for removal of loans from securitization trusts, accrued payroll, income taxes payable and other liabilities. A provision within the trust for
each of our securitization transactions gives us the right, not the obligation, to repurchase loans from the trust that are between 90 and 119 days delinquent. In accordance with SFAS No. 140, we are required to record the loans that meet this
definition and a corresponding liability to the trust on our balance sheet at fair value. As of December 31, 2003 and December 31, 2002, our liability related to this provision was $14.5 million and $11.5 million, respectively. This liability should
generally increase as we continue to securitize the loans we originate. Our accrued payroll increased from $9.2 million at December 31, 2002 to $18.1 million at December 31, 2003 due primarily to our growth in number of employees. Our current income
tax liability was $7.9 million and $0.9 million as of December 31, 2003 and December 31, 2002, respectively. This increase is attributable to the increase in income before taxes of NFI Holding Corporation.



Stockholders Equity.The Board of Directors declared a
two-for-one split of its common stock, providing shareholders of record as of November 17, 2003, with one additional share of common stock for each share owned. The additional shares resulting from the split were issued on December 1, 2003
increasing the number of common shares outstanding to 24.1 million shares. Prior year share amounts and earnings per share disclosures have been restated to reflect the stock split.



The increase in our stockholders equity as of December 31, 2003 compared to December 31, 2002 is a result of the
following:



| |  | $112.0 million increase due to net income recognized for the year ended December 31, 2003.
| | - | ------------------------------------------------------------------------------------------



| |  | $15.1 million increase due to increase in unrealized gains on mortgage securities classified as available-for-sale.
| | - | -------------------------------------------------------------------------------------------------------------------



| |  | $9.5 million increase due to net settlements on cash flow hedges reclassified to earnings.
| | - | ------------------------------------------------------------------------------------------



| |  | $2.2 million decrease due to increase in unrealized losses on derivative instruments used in cash flow hedges.
| | - | --------------------------------------------------------------------------------------------------------------



| |  | $93.9 million increase due to issuance of common stock.
| | - | -------------------------------------------------------



| |  | $1.3 million increase due to compensation recognized under stock option plan.
| | - | -----------------------------------------------------------------------------



| |  | $1.6 million increase due to exercise of stock options.
| | - | -------------------------------------------------------



| |  | $114.3 million decrease due to dividends accrued or paid on common stock.
| | - | -------------------------------------------------------------------------



| |  | $0.1 million increase due to forgiveness of founders notes receivable.
| | - | -----------------------------------------------------------------------



Results of Operations



During the year ended December 31, 2003, we earned net income of $112.0 million, $4.91 per diluted share, compared with net income of $48.8 million, $2.25
per diluted share and of $32.3 million, $1.51 per diluted share, for the same periods of 2002 and 2001, respectively.



Our primary sources of revenue are interest earned on our mortgage loan and securities portfolios, fees from borrowers and gains on the sales and
securitizations of mortgage loans. Earnings increased during 2003 as compared to 2002 and 2001 due primarily to higher volumes of average mortgage securities held and mortgage loan originations securitized. The effects of the higher mortgage
security volume is displayed in Table 6. Details regarding higher mortgage loan origination volumes and gains on securitization of these assets are shown in Tables 1, 8 and 9.



As discussed under Significance of Estimates and Critical Accounting Policies, prior to 2003, we accounted for
stock-based compensation plans under the recognition and measurement provisions of APB No. 25 and related interpretations. During the fourth quarter of 2003, we adopted the fair value recognition provisions of SFAS No. 123. We selected the modified
prospective method of adoption described in SFAS No. 148. Under this method, the change is retroactive to January 1, 2003 and compensation cost recognized in 2003 is the same as that which would have been recognized had the fair value method of SFAS
No. 123 been applied from its original effective date. In adopting SFAS No. 123 retroactive to January 1, 2003, we recorded a net credit (reversal of expense) to compensation and benefits expense of $7.1 million relating to the nine months ended
September 30, 2003. Results for prior years have not been restated.



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Net Interest Income



Our securities primarily represent our ownership in the net cash flows of underlying mortgage loan collateral in excess of bond expenses and cost of
funding. The cost of funding is indexed to one-month LIBOR. As one-month LIBOR decreased dramatically in 2001 and 2002, the net cash flows we received increased correspondingly. On the other hand, the coupon on the mortgage loan collateral has
adjusted more slowly. Therefore, the accretable yield (interest rate) on our older securities significantly increased during 2001 and 2002. Our older securities continue to experience unusually high yields. The spread on our new mortgage loans has
returned to expected or normal levels as the coupon on the mortgage securities has adjusted downward. Additionally, in 2002 we began transferring interest rate agreements, at the time of securitization, into the securitization trusts to help reduce
interest rate risk and to decrease the volatility of the future cash flows on our mortgage securities. As a result, future interest income on our mortgage securities is expected to be less volatile.



While the spreads on the newer securities have decreased, the overall
interest income continues to be high due to the sizeable increase in our mortgage securities retained. Based on these factors, as shown in Table 6, we experienced a decrease in the average net yield on our securities from 40.6% for the year ended
December 31, 2002 to 31.3% for the same period of 2003. Mortgage security net yield for the year ended December 31, 2001 was 14.5%



The overall dollar volume of interest income has increased primarily because the size of our mortgage securities portfolio has increased significantly
during the past year. As shown in Tables 6 and 7, the average value of our mortgage securities increased from $132.3 million and $67.6 million during the years ended December 31, 2002 and 2001, respectively, to $288.4 million during the year ended
December 31, 2003. The average balance of mortgage loans collateralizing our securities increased from $2.1 billion in 2002 to $4.3 billion in 2003. We expect to increase the amount of mortgage securities we own as we securitize the mortgage loans
we originate.



As previously discussed, the trust that issues
our interest-only securities owns interest rate agreements. These agreements reduce interest rate risk within the trust and, as a result, the cash flows we receive on our interest-only securities are less volatile as interest rates change.



Net interest income on mortgage loans represents income on
loans held-for-sale during their warehouse period as well as loans held-in-portfolio, which are maintained on our balance sheet as a result of the four securitization transactions we executed in 1997 and 1998. Net interest income on mortgage loans
before other expense increased from $25.8 million and $20.7 million for the years ended December 31, 2002 and 2001, respectively to $39.9 million for the same period of 2003. The net interest income from mortgage loans is primarily driven by loan
volume and the amount of time held-for-sale loans are in the warehouse.



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



Table 6 is a summary of the interest income and expense related to our mortgage securities and the related yields as a percentage of the fair market value
of these securities for the three years ended December 31, 2003.



Table 6
 Mortgage Securities Interest Analysis

(dollars in thousands)

---

|                                                 |  |              |         |   |      |   |         |      |  |   |        |  
|------------------------------------------------ |  | ------------ | ------- | - | ---- | - | ------- | ---- |  | - | ------ | -
|                                                 |  | December 31, |        
|                                                 |  | 2003         |         |   | 2002 |   |         | 2001 | 
|Average fair market value of mortgage securities |  | $            | 288,361 |   |      | $ | 132,250 |      |  | $ | 67,588 |  
|Average borrowings                               |  |              | 222,653 |   |      |   | 89,612  |      |  |   | 37,004 |  
|                                                 |  |              |        
|Interest income                                  |  |              | 98,804  |   |      |   | 56,481  |      |  |   | 11,706 |  
|Interest expense                                 |  |              | 8,676   |   |      |   | 2,834   |      |  |   | 1,911  |  
|                                                 |  |              |         |   |      |   |         |      |  |   |        |  
|Net interest income                              |  | $            | 90,128  |   |      | $ | 53,647  |      |  | $ | 9,795  |  
|                                                 |  |              |         |   |      |   |         |      |  |   |        |  
|Yields:                                          |  |              |         |   |      |   |         |      |  |   |        |  
|Interest income                                  |  |              | 34.3    | % |      |   | 42.7    | %    |  |   | 17.3   | %
|Interest expense                                 |  |              | 3.9     |   |      |   | 3.2     |      |  |   | 5.2    |  
|                                                 |  |              |         |   |      |   |         |      |  |   |        |  
|Net interest spread                              |  |              | 30.4    | % |      |   | 39.5    | %    |  |   | 12.1   | %
|                                                 |  |              |         |   |      |   |         |      |  |   |        |  
|Net Yield                                        |  |              | 31.3    | % |      |   | 40.6    | %    |  |   | 14.5   | %
|                                                 |  |              |         |   |      |   |         |      |  |   |        |  



All of NovaStars
portfolio income comes from mortgage loans either directly (mortgage loans held-in-portfolio) or indirectly (mortgage securities). Table 7 attempts to look through the balance sheet presentation of the Companys portfolio income and present
income as a percentage of average assets under management. This metric



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allows the Company to be more easily compared to other finance companies or financial institutions that use on balance sheet portfolio accounting, where
return on assets is a common performance calculation.



The net
interest income for mortgage securities, mortgage loans held-for-sale and mortgage loans held-in-portfolio reflect the income after interest expense, hedging, servicing, prepayment penalty income and credit expense (mortgage insurance and provision
to loss reserve). Table 7 shows the net yield in both assets under management and the return on assets during the three years ended December 31, 2003.



Table 7  Mortgage Portfolio Management Net Interest Income Analysis

(dollars in thousands)

---

|                                                            |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|----------------------------------------------------------- |  | ------------------ | --------- | - | -------------------------- | - | ------- | ------------------------------ |  | - | ------- | - |  | - | --------- | -
|                                                            |  | MortgageSecurities |           |   | MortgageLoansHeld-for-Sale |   |         | MortgageLoansHeld-in-Portfolio |  |   | Total   |  
|For the Year Ended:                                         |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|December 31, 2003                                           |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Interest income                                             |  | $                  | 98,804    |   |                            | $ | 60,878  |                                |  | $ | 10,738  |   |  | $ | 170,420   |  
|Interest expense:                                           |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Short-term borrowings (A)                                   |  |                    | 3,450     |   |                            |   | 20,060  |                                |  |   |        |   |  |   | 23,510    |  
|Asset-backed bonds                                          |  |                    | 5,226     |   |                            |   |        |                                |  |   | 2,269   |   |  |   | 7,495     |  
|Cash flow hedging net settlements                           |  |                    |          |   |                            |   | 2,871   |                                |  |   | 6,488   |   |  |   | 9,359     |  
|                                                            |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Total interest expense                                      |  |                    | 8,676     |   |                            |   | 22,931  |                                |  |   | 8,757   |   |  |   | 40,364    |  
|                                                            |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Mortgage portfolio net interest income before other expense |  |                    | 90,128    |   |                            |   | 37,947  |                                |  |   | 1,981   |   |  |   | 130,056   |  
|Other expense (B)                                           |  |                    |          |   |                            |   | (11,507 | )                              |  |   | (895    | ) |  |   | (12,402   | )
|                                                            |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Mortgage portfolio net interest income                      |  | $                  | 90,128    |   |                            | $ | 26,440  |                                |  | $ | 1,086   |   |  | $ | 117,654   |  
|                                                            |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Average balance of the underlying loans                     |  | $                  | 4,316,599 |   |                            | $ | 792,991 |                                |  | $ | 116,048 |   |  | $ | 5,225,638 |  
|Net interest yield on assets                                |  |                    | 2.09      | % |                            |   | 3.33    | %                              |  |   | 0.94    | % |  |   | 2.25      | %
|                                                            |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|December 31, 2002                                           |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Interest income                                             |  | $                  | 56,481    |   |                            | $ | 33,736  |                                |  | $ | 16,926  |   |  | $ | 107,143   |  
|Interest expense:                                           |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Short-term borrowings (A)                                   |  |                    | 2,107     |   |                            |   | 10,406  |                                |  |   |        |   |  |   | 12,513    |  
|Asset-backed bonds                                          |  |                    | 727       |   |                            |   |        |                                |  |   | 4,195   |   |  |   | 4,922     |  
|Cash flow hedging net settlements                           |  |                    |          |   |                            |   | 1,672   |                                |  |   | 8,621   |   |  |   | 10,293    |  
|                                                            |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Total interest expense                                      |  |                    | 2,834     |   |                            |   | 12,078  |                                |  |   | 12,816  |   |  |   | 27,728    |  
|                                                            |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Mortgage portfolio net interest income before other expense |  |                    | 53,647    |   |                            |   | 21,658  |                                |  |   | 4,110   |   |  |   | 79,415    |  
|Other expense (B)                                           |  |                    |          |   |                            |   | (11,782 | )                              |  |   | (1,624  | ) |  |   | (13,406   | )
|                                                            |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Mortgage portfolio net interest income                      |  | $                  | 53,647    |   |                            | $ | 9,876   |                                |  | $ | 2,486   |   |  | $ | 66,009    |  
|                                                            |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Average balance of the underlying loans                     |  | $                  | 2,080,955 |   |                            | $ | 395,394 |                                |  | $ | 172,954 |   |  | $ | 2,649,303 |  
|Net interest yield on assets                                |  |                    | 2.58      | % |                            |   | 2.50    | %                              |  |   | 1.44    | % |  |   | 2.49      | %
|                                                            |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|December 31, 2001                                           |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Interest income                                             |  | $                  | 11,706    |   |                            | $ | 19,507  |                                |  | $ | 26,691  |   |  | $ | 57,904    |  
|Interest expense:                                           |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Short-term borrowings (A)                                   |  |                    | 1,911     |   |                            |   | 8,546   |                                |  |   |        |   |  |   | 10,457    |  
|Asset-backed bonds                                          |  |                    |          |   |                            |   |        |                                |  |   | 14,874  |   |  |   | 14,874    |  
|Cash flow hedging net settlements                           |  |                    |          |   |                            |   |        |                                |  |   | 2,035   |   |  |   | 2,035     |  
|                                                            |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Total interest expense                                      |  |                    | 1,911     |   |                            |   | 8,546   |                                |  |   | 16,909  |   |  |   | 27,366    |  
|                                                            |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Mortgage portfolio net interest income before other expense |  |                    | 9,795     |   |                            |   | 10,961  |                                |  |   | 9,782   |   |  |   | 30,538    |  
|Other expense (B)                                           |  |                    |          |   |                            |   | (1,599  | )                              |  |   | (6,156  | ) |  |   | (7,755    | )
|                                                            |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Mortgage portfolio net interest income                      |  | $                  | 9,795     |   |                            | $ | 9,362   |                                |  | $ | 3,626   |   |  | $ | 22,783    |  
|                                                            |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  
|Average balance of the underlying loans                     |  | $                  | 1,037,352 |   |                            | $ | 266,287 |                                |  | $ | 191,972 |   |  | $ | 1,495,611 |  
|Net interest yield on assets                                |  |                    | 0.94      | % |                            |   | 3.52    | %                              |  |   | 1.89    | % |  |   | 1.52      | %
|                                                            |  |                    |           |   |                            |   |         |                                |  |   |         |   |  |   |           |  

---

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



|(B) | Other expense includes servicing expense, prepayment penalty income, net settlements on non-cash flow hedges and credit expense (mortgage insurance and provision to loss reserve).
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------





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Impact of Interest Rate Agreements.We have executed interest rate agreements designed to mitigate
exposure to interest rate risk on short-term borrowings. Interest rate cap agreements require us to pay either a one-time up front premium or a quarterly premium, while allowing us to receive a rate that adjusts with LIBOR when rates
rise above a certain agreed-upon rate. Interest rate swap agreements allow us to pay a fixed rate of interest while receiving a rate that adjusts with one-month LIBOR. These agreements are used to alter, in effect, the interest rates on funding
costs to more closely match the yield on interest-earning assets. We incurred expenses of $9.4 million, $10.3 million and $2.0 million related to these agreements for the three years ended December 31, 2003, 2002, and 2001, respectively.
Fluctuations in these expenses are solely dependent upon the movement in LIBOR as well as our average notional amount outstanding.



Credit Recoveries (Losses)



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



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



During the years ended December 31, 2003, 2002 and 2001 we recognized credit recoveries (losses) of $0.4 million, $0.4 million and $(3.6) million,
respectively and incurred net charge-offs of $1.3 million, $2.1 million and $5.7 million, respectively. A rollforward of the allowance for credit losses for the three years ended December 31, 2003 is presented in Note 2 to the consolidated financial
statements.



Fee Income



Fee income primarily consists of fees from five sources: broker fees, loan
origination fees, service fee income, branch management fees and prepayment penalty income.



Broker fees are paid by borrowers and other lenders for placing loans with third party investors (lenders) and are based on negotiated rates with each lender to whom we broker loans. Revenue is recognized upon loan
origination.



Loan origination fees represent
fees paid to us 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.



Service fees are paid to us 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, processing fees and, for loans held-in-portfolio, prepayment penalties. Revenue is recognized on fees received from
borrowers when an event occurs that generates the fee and they are considered to be collectible.



Affiliated branch management fees are charged to affiliated mortgage brokers to manage their administrative operations, which include providing
accounting, payroll, human resources, loan investor management and license management. The amount of the fees is agreed upon when entering a contractual agreement with affiliated mortgage brokers and are recognized as services are rendered.



Prepayment penalty income are the fees we require the borrower
to pay if they pay off their loan early in the loans life, generally within two years of origination. This income serves to mitigate and offset prepayment risk and the amortization expense of premiums we paid to loan brokers. The penalty is
generally six months of interest on



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80% of the unpaid principal at prepayment. Prepayment penalty income was $311,000, $432,000 and $790,000 during the years ended December 31, 2003, 2002 and
2001, respectively.



Fee income increased from $36.0 million
and $21.0 million for the twelve months ended December 31, 2002 and 2001, respectively, to $68.3 million for the same period of 2003 due to the following reasons:



| |  | Loans originated, including conforming loans, increased from $2.8 billion and $1.3 billion for the twelve months ended December 31, 2002 and 2001, respectively, to $6.0 billion for
the same period of 2003.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Our servicing portfolio increased from $3.7 billion and $2.0 billion for the year ended December 31, 2002 and 2001, respectively, to $7.2 billion for the year ended December 31,
2003.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The number of NHMI LLC branches increased from 207 and 108 at December 31, 2002 and 2001, respectively, to 423 at December 31, 2003.
| | - | ------------------------------------------------------------------------------------------------------------------------------------



Gains on Sales of Mortgage Assets and Losses on Derivative Instruments



We execute securitization transactions in which we transfer mortgage loan
collateral to an independent trust. The trust holds the mortgage loans as collateral for the securities it issues to finance the sale of the mortgage loans. In those transactions, certain securities are issued to entities unrelated to us, and we
retain the interest-only and non-investment grade subordinated securities. In addition, we continue to service the loan collateral. These transactions were structured as sales for accounting and income tax reporting during the years ended December
31, 2003, 2002 and 2001. Whole loan sales have also been executed whereby we sell loans to third parties. In the outright sales of mortgage loans, we retain no assets or servicing rights. Table 9 provides a summary of mortgage loans sold outright
and transferred in securitizations.



During the third quarter
of 2001, we resecuritized AAA-rated interest-only and prepayment penalty securities issued in 2000. This transaction, CAPS 2001-1, was structured as a sale for financial reporting and income tax purposes. Senior bonds in the amount of $29.3 million
were sold to the public. We retained a subordinated interest, the CAPS 2001-1 C1 bond, and recognized a gain of $14.9 million. For tax purposes, this gain was capital in nature and offsets existing capital losses we incurred in 1998. In October
2002, the senior bond was fully repaid and the AAA-rated interest-only and prepayment penalty securities were transferred back to us by the trust.



We have entered into derivative instrument contracts that do not meet the requirements for hedge accounting treatment, but contribute to our overall risk
management strategy by serving to reduce interest rate risk related to short-term borrowing rates. Changes in the fair value of these derivative instruments are credited or charged to current earnings. As interest rates have decreased since December
31, 2001, we recognized losses of $30.8 million and $36.8 million in 2003 and 2002, respectively, reflective of the corresponding decrease in fair value of these non-hedge derivative instruments. Our loss on derivative instruments during 2001 was
$4.0 million.



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



Table 8
 Gains on Sales of Mortgage Assets and Losses on Derivative Instruments

(in thousands)

---

|                                                                  |  |                                 |         |   |      |   |         |      |  |   |        |  
|----------------------------------------------------------------- |  | ------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------ | -
|                                                                  |  | For the Year Ended December 31, |        
|                                                                  |  | 2003                            |         |   | 2002 |   |         | 2001 | 
|Gains on sales of mortgage loans transferred in securitizations   |  | $                               | 136,302 |   |      | $ | 47,894  |      |  | $ | 21,730 |  
|Gains on sales of mortgage loans to third parties  nonconforming |  |                                 | 3,404   |   |      |   | 2,299   |      |  |   | 954    |  
|Gains on sales of mortgage loans to third parties  conforming    |  |                                 | 6,942   |   |      |   | 3,903   |      |  |   | 171    |  
|Gain on sale of mortgage securities                               |  |                                 |        |   |      |   |        |      |  |   | 14,946 |  
|Losses on sales of real estate owned                              |  |                                 | (2,643  | ) |      |   | (791    | )    |  |   | (454   | )
|                                                                  |  |                                 |         |   |      |   |         |      |  |   |        |  
|Gains on sales of mortgage assets                                 |  |                                 | 144,005 |   |      |   | 53,305  |      |  |   | 37,347 |  
|Losses on derivatives                                             |  |                                 | (30,837 | ) |      |   | (36,841 | )    |  |   | (3,953 | )
|                                                                  |  |                                 |         |   |      |   |         |      |  |   |        |  
|Net gains on sales of mortgage assets and derivative instruments  |  | $                               | 113,168 |   |      | $ | 16,464  |      |  | $ | 33,394 |  
|                                                                  |  |                                 |         |   |      |   |         |      |  |   |        |  



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Table 9  Mortgage Loan Sales and Securitizations

(dollars in thousands)

---

|                                |  |                                  |         |                        |     |   |                            |   |                               |  |      
|------------------------------- |  | -------------------------------- | ------- | ---------------------- | --- | - | -------------------------- | - | ----------------------------- |  | -----
|                                |  | Outright Mortgage Loan Sales (A)
|For the Year Ended December 31, |  | PrincipalAmount                  |         | Percent of Total Sales |     |   | Net Gain (Loss) Recognized |   | Weighted Average Price To Par
|2003                            |  | $                                | 151,210 |                        | 2.8 | % |                            | $ | 3,404                         |  | 104.1
|                                |  |                                  |         |                        |     |   |                            |   |                               |  |      
|2002                            |  | $                                | 142,159 |                        | 8.4 | % |                            | $ | 2,299                         |  | 102.9
|                                |  |                                  |         |                        |     |   |                            |   |                               |  |      
|2001                            |  | $                                | 73,324  |                        | 5.7 | % |                            | $ | 954                           |  | 102.1
|                                |  |                                  |         |                        |     |   |                            |   |                               |  |      



|                                |  |                                               |           |                        |      |   |                     |   |                                    |  |                                                                            |         |              |    |  |                                                     |   |  |      |  
|------------------------------- |  | --------------------------------------------- | --------- | ---------------------- | ---- | - | ------------------- | - | ---------------------------------- |  | -------------------------------------------------------------------------- | ------- | ------------ | -- |  | --------------------------------------------------- | - |  | ---- | -
|                                |  |                                               |          
|                                |  | Mortgage Loans Transferred in Securitizations |          
|                                |  |                                               |           |                        |      |   |                     |   |                                    |  | Weighted Average AssumptionsUnderlying Initial Value of MortgageSecurities |        
|For the Year Ended December 31, |  | Principal Amount                              |           | Percent of Total Sales |      |   | Net Gain Recognized |   | Initial Value ofMortgageSecurities |  | ConstantPrepaymentRate                                                     |         | DiscountRate |    |  | Expected TotalCredit Losses,Net ofMortgageInsurance |  
|2003                            |  | $                                             | 5,319,435 |                        | 97.2 | % |                     | $ | 136,302                            |  | $                                                                          | 299,752 |              | 26 |  | 22                                                  | % |  | 3.61 | %
|                                |  |                                               |           |                        |      |   |                     |   |                                    |  |                                                                            |         |              |    |  |                                                     |   |  |      |  
|2002                            |  | $                                             | 1,560,001 |                        | 91.6 | % |                     | $ | 47,894                             |  | $                                                                          | 92,903  |              | 29 |  | 21                                                  | % |  | 1.50 | %
|                                |  |                                               |           |                        |      |   |                     |   |                                    |  |                                                                            |         |              |    |  |                                                     |   |  |      |  
|2001                            |  | $                                             | 1,215,100 |                        | 94.3 | % |                     | $ | 21,730                             |  | $                                                                          | 62,862  |              | 28 |  | 23                                                  | % |  | 1.20 | %
|                                |  |                                               |           |                        |      |   |                     |   |                                    |  |                                                                            |         |              |    |  |                                                     |   |  |      |  

---

|(A) | Does not include conforming loan sales.
|--- | ---------------------------------------



Premiums for Mortgage Loan Insurance



The use of mortgage insurance is one method of managing the credit risk in the mortgage asset portfolio. Premiums for mortgage insurance on loans
maintained on our balance sheet are paid by us and are recorded as a portfolio cost and included in the income statement under the caption Premiums for Mortgage Loan Insurance. These premiums totaled $3.1 million, $2.3 million and $2.7
million in 2003, 2002 and 2001, respectively. We received mortgage insurance proceeds on claims filed of $1.9 million, $2.1 million and $3.7 million in 2003, 2002 and 2001, respectively.



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



We intend to continue to use mortgage insurance coverage as a credit
management tool as we continue to originate and securitize mortgage loans. The percentage of loans with mortgage insurance has decreased in 2003 and generally should be lower than 50% in the future. For the 2003-1, 2003-2, 2003-3 and 2003-4
securitizations, the mortgage loans that were transferred into the trusts had mortgage insurance coverage at the time of transfer of 64%, 48%, 46% and 27%, respectively. We have the risk that mortgage insurance providers will revise their guidelines
to an extent where we will no longer be able to acquire coverage on all of our new production. Similarly, the providers may also increase insurance premiums to a point where the cost of coverage outweighs its benefit. We monitor the mortgage
insurance market and currently anticipate being able to obtain affordable coverage on a substantial portion of our future production to the extent we deem it is warranted.



General and Administrative Expenses



The main categories of our general and administrative expenses are compensation and benefits, loan expense, travel and public relations, office
administration and professional and outside services. Compensation and benefits includes employee base salaries, benefit costs and incentive compensation awards. For discussion on stock-based compensation expense included in compensation and
benefits, see discussion of the adoption of SFAS No. 123 under Significance of Estimates and Critical Accounting Policies and Results of Operations. Loan expense primarily includes expenses relating to the underwriting of
mortgage loans that do not fund successfully. Travel and



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



The increase in general and administrative expenses from $46.5 million in 2001 to $84.6 million in 2002 and to $174.4 million in 2003 is attributable to our new retail lines of business, growth in our wholesale
business, our expanding servicing operations and growth in our branch operations. As a result of this growth, we employed 1,476 people as of December 31, 2003, compared with 944 and 379 as of December 31, 2002 and 2001, respectively. Note 12 to the
consolidated financial statements presents a condensed income statement for our three segments, detailing our expenses by segment.



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



Table 10  Loan Costs of Production, as a Percent of Principal

---

|     |  |                     |  |                                            |  |                      
|---- |  | ------------------- |  | ------------------------------------------ |  | ---------------------
|     |  | GrossLoanProduction |  | Premium Paidto Broker, Netof FeesCollected |  | Total AcquisitionCost
|2003 |  | 1.69                |  | 0.71                                       |  | 2.40                 
|2002 |  | 1.93                |  | 0.78                                       |  | 2.71                 
|2001 |  | 1.98                |  | 0.63                                       |  | 2.61                 



Mortgage Loan Servicing



Loan servicing is a critical part of our business. In the
opinion of management, maintaining contact with borrowers is vital in managing credit risk and in borrower retention. Nonconforming borrowers are prone to late payments and are more likely to default on their obligations than conventional borrowers.
We strive to identify issues and trends with borrowers early and take quick action to address such matters. Our annualized costs of servicing per unit decreased from $286 and $267 at December 31, 2001 and 2002, respectively, to $263 at December 31,
2003.



Table 11  Summary of Servicing Operations

(dollars in thousands, except per loan cost)

---

|                                                                       |  |        |           |   |         |   |      |        |  |         |           |        |   |         |  |   |           |  |   |    
|---------------------------------------------------------------------- |  | ------ | --------- | - | ------- | - | ---- | ------ |  | ------- | --------- | ------ | - | ------- |  | - | --------- |  | - | ---
|                                                                       |  | 2003   |           |   | 2002    |   | 2001
|                                                                       |  | Amount |           |   | PerUnit |   |      | Amount |  | PerUnit |           | Amount |   | PerUnit
|Unpaid principal                                                       |  | $      | 7,206,113 |   |         |   |      |        |  | $       | 3,657,640 |        |   |         |  | $ | 1,994,448 |  |   |    
|                                                                       |  |        |           |   |         |   |      |        |  |         |           |        |   |         |  |   |           |  |   |    
|Number of loans                                                        |  |        | 54,196    |   |         |   |      |        |  |         | 28,849    |        |   |         |  |   | 17,425    |  |   |    
|                                                                       |  |        |           |   |         |   |      |        |  |         |           |        |   |         |  |   |           |  |   |    
|Servicing income, before amortization of mortgage servicing rights     |  | $      | 20,486    |   |         | $ | 378  |        |  | $       | 12,796    |        | $ | 444     |  | $ | 8,213     |  | $ | 471
|Costs of servicing                                                     |  |        | 14,261    |   |         |   | 263  |        |  |         | 7,703     |        |   | 267     |  |   | 4,976     |  |   | 286
|                                                                       |  |        |           |   |         |   |      |        |  |         |           |        |   |         |  |   |           |  |   |    
|Net servicing income, before amortization of mortgage servicing rights |  |        | 6,225     |   |         |   | 115  |        |  |         | 5,093     |        |   | 177     |  |   | 3,237     |  |   | 185
|Amortization of mortgage servicing rights                              |  |        | 8,995     |   |         |   | 166  |        |  |         | 4,609     |        |   | 160     |  |   | 2,131     |  |   | 122
|                                                                       |  |        |           |   |         |   |      |        |  |         |           |        |   |         |  |   |           |  |   |    
|Net servicing income (loss)                                            |  | $      | (2,770    | ) |         | $ | (51  | )      |  | $       | 484       |        | $ | 17      |  | $ | 1,106     |  | $ | 63 
|                                                                       |  |        |           |   |         |   |      |        |  |         |           |        |   |         |  |   |           |  |   |    



Branches



We operate our mortgage brokerage unit under the name NovaStar Home
Mortgage, Inc. (NHMI). Branch operations (offices) are divided into two groups: 1) branches operating under NHMI, and 2) branches operating as



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separate companies with an administrative relationship with NHMI, identified as NHMI LLC (Limited Liability Company) branches.



The NHMI branches are considered departmental functions of NHMI under which
the branch manager (department head) is an employee of NHMI and receives compensation based on the profitability of the branch (department) as bonus compensation. NHMI branches are included in the NovaStar Financial consolidated financial
statements.



LLC branches are established through LLC
agreements entered into between solicited brokers and NHMI. The LLC agreements provide for initial capitalization and membership interests of 99.9% to the broker (branch manager) and 0.1% to NHMI. NHMI provides accounting, payroll, human resources,
loan investor management and license management in conjunction with separate contractual agreements. We account for our minority interest in the LLC agreements using the equity method of accounting.



As of December 31, 2003 there were a total of 432 active branches, 9 of these
were NHMI branches and 423 were NHMI LLC branches. As of December 31, 2002 there were a total of 216 active branches, 9 of these were NHMI branches and 207 were NHMI LLC branches.



The NHMI and LLC branch offices offer conforming and nonconforming loans to potential borrowers. Loans are brokered for
approved investors, including NovaStar Mortgage, Inc. (NMI). Of the $5.3 billion and $2.8 billion nonconforming loans we originated, 23% and 20% were brokered to NMI from the branches in 2003 and 2002, respectively.



Income Taxes



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



Below is a summary of the taxable net income available to common shareholders for the years ended December 31, 2003, 2002 and 2001.



Table 12  Taxable Net Income

(dollars in thousands)

---

|                                                          |  |                                 |         |   |      |   |        |      |  |   |         |  
|--------------------------------------------------------- |  | ------------------------------- | ------- | - | ---- | - | ------ | ---- |  | - | ------- | -
|                                                          |  | For the Year Ended December 31, |        
|                                                          |  | 2003                            |         |   | 2002 |   |        | 2001 | 
|Consolidated net income                                   |  | $                               | 111,996 |   |      | $ | 48,761 |      |  | $ | 32,308  |  
|Equity in net income of NFI Holding Corp.                 |  |                                 | (20,051 | ) |      |   | 9,013  |      |  |   | (1,723  | )
|                                                          |  |                                 |         |   |      |   |        |      |  |   |         |  
|REIT net income                                           |  |                                 | 91,945  |   |      |   | 57,774 |      |  |   | 30,585  |  
|Adjustments to net income to compute taxable income       |  |                                 | 44,550  |   |      |   | (9,301 | )    |  |   | (20,179 | )
|                                                          |  |                                 |         |   |      |   |        |      |  |   |         |  
|Taxable income before preferred dividends                 |  |                                 | 136,495 |   |      |   | 48,473 |      |  |   | 10,406  |  
|Preferred dividends                                       |  |                                 |        |   |      |   |       |      |  |   | (5,164  | )
|                                                          |  |                                 |         |   |      |   |        |      |  |   |         |  
|Estimated taxable income available to common shareholders |  | $                               | 136,495 |   |      | $ | 48,473 |      |  | $ | 5,242   |  
|                                                          |  |                                 |         |   |      |   |        |      |  |   |         |  
|Estimated taxable income per common shareholder           |  | $                               | 5.58    |   |      | $ | 2.32   |      |  | $ | 0.46    |  
|                                                          |  |                                 |         |   |      |   |        |      |  |   |         |  



In order to qualify as
a REIT, we must distribute 90 percent of our taxable income before the due date of our federal tax return, including extensions. Additionally, for the REIT to avoid paying federal income tax, there are two other distribution requirements. First, in
order to avoid a 4 percent excise tax, the REIT must generally distribute at least 85 percent of its taxable income (plus undistributed prior year amounts) no later than December 31 of the current year (or no later than 30 days after year end if
certain requirements are met). Alternatively, in order to avoid paying an income tax at the REIT level, we must distribute all of our taxable income before the timely filing of our tax return. This second distribution requirement may be met by
designating certain dividends paid in the following year as applying to the current year (spillover dividends). This spillover dividend rule allows a REIT to pay dividends at regular intervals and amounts and avoid volatility in its
dividend policy.



The dividend policy adopted by our Board
applies the spillover dividend rules for purposes of managing the REIT distribution requirement and in computing REIT taxable income. This policy better aligns dividends with economic income and allows us to better manage volatility in our dividend
payments.



We declared dividends of $2.15 per common share in
2002. Since it was our intent to distribute approximately 100% of our taxable income in 2002, we declared a special dividend related to 2002 taxable income of $0.165 per common share on January 29, 2003.



NFI Holding Corporation, a wholly-owned subsidiary of NovaStar Financial,
Inc., has not elected REIT-status and files a consolidated federal income tax return with its subsidiaries. NFI Holding Corporation reported a net



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income (loss) before income taxes of $50.6 million and ($11.0) million for the years ended December 31, 2003 and 2002, respectively. As shown in our
statement of income, this resulted in an income tax expense (benefit) of $22.9 million and $(2.0) million for the years ended December 31, 2003 and 2002, respectively. We did not report income tax expense (benefit) for the year ended December 31,
2001 due to the immaterial nature of the pretax income reported at NFI Holding Corporation.



Liquidity and Capital Resources



Liquidity means the need for, access to and uses of cash. Our primary needs for cash include the acquisition of mortgage loans, principal repayment and interest on borrowings, operating expenses and dividend payments. Substantial cash is
required to support the operating activities of the business, especially the mortgage origination operation. Mortgage asset sales, principal, interest and fees collected on mortgage assets support cash needs. Drawing upon various borrowing
arrangements typically satisfies major cash requirements. As shown in Table 5, we have $130.1 million in immediately available funds, including $118.2 million in cash.



Mortgage lending requires significant cash to fund loan originations. Our warehouse lending arrangements, including
repurchase agreements, support the mortgage lending operation. Our warehouse mortgage lenders allow us to borrow between 98% and 100% of the outstanding principal. Funding for the difference  generally 2% of the principalmust come from
other cash inflows. We use operating cash inflow in the form of cash flow from mortgage securities, principal and interest on mortgage loans and fee income to support loan originations. In addition, proceeds from equity offerings have been used to
support operations. Our immediately available funds would support funding more than $6.5 billion in loans, assuming no other demands on cash and assuming a 2% haircut.



Loans financed with warehouse and repurchase credit facilities are subject to changing market valuation and margin calls.
The market value of our loans is dependent on a variety of economic conditions, including interest rates (and borrower demand) and end investor desire and capacity. Market values have been consistent over the past three years. However, there is no
certainty that the prices will remain constant. To the extent the value of the loans declines significantly, we would be required to repay portions of the amounts we have borrowed. The value of our recourse loans (classified as
held-for-sale) as of December 31, 2003 would need to decline by nearly 19% before we would use all immediately available funds, assuming no other constraints on our immediately available funds.



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



The derivative financial
instruments we use also subject us to margin call risk. Under our interest rate swaps, we pay a fixed rate to the counterparties while they pay us a floating rate. While floating rates are low, on a net basis we are paying the
counterparty. In order to mitigate credit exposure to us, the counterparty required us to post margin deposits with them. As of December 31, 2003, we have approximately $20.9 million on deposit. Further declining interest rates would subject us to
additional exposure for cash margin calls. However, the asset side of the balance sheet should increase in value in a further declining interest rate scenario. Incoming cash on our mortgage loans and securities is a principal source of cash. The
volume of cash depends on, among other things, interest rates. While short-term interest rates (the basis for our funding costs) are low and the coupon rates on our loans are high, our net interest margin (and therefore incoming cash flow) is high.
Severe and immediate changes in interest rates will impact the volume of our incoming cash flow. To the extent rates increase dramatically, our funding costs will increase quickly. While many of our loans are adjustable, they typically will not
reset as quickly as our funding costs. This circumstance would temporarily reduce incoming cash flow. As noted above, derivative financial instruments are used to mitigate the effect of interest rate volatility. In this rising rate situation, our
interest rate swaps and caps would provide additional cash flows to mitigate the lower cash on loans and securities.



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



Cash activity during the years ended December 31, 2003, 2002 and 2001 is presented in the consolidated statement of cash flows.



As noted above, proceeds from equity offerings have supported our operations.
Since inception, we have raised $220 million in net proceeds through private and public equity offerings. Equity offerings provide another avenue as a future liquidity source.



Off Balance Sheet Arrangements



As discussed previously, we pool the loans we originate and securitize them to obtain long-term financing for the assets. The loans are transferred to a
trust where they serve as collateral for asset-backed bonds, which the trust issues to the public. Our ability to use the securitization capital market is critical to the operations of our business. Table 4 summarizes our off balance sheet
securitizations.



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



Specific items that may affect our ability to use the securitizations to
finance our loans relate primarily to the performance of the loans that have been securitized. Extremely poor loan performance may lead to poor bond performance and investor unwillingness to buy bonds supported by our collateral. Our financial
performance and condition has little impact on our ability to securitize, as evidenced by our ability to securitize in 1998, 1999 and 2000 when our financial trend was weak.



We have commitments to borrowers to fund residential mortgage loans as well as commitments to purchase and sell mortgage
loans to third parties. As nonconforming mortgage loans are not readily convertible to cash and cannot readily be settled net, commitments to originate and purchase such loans do not meet the definition of a derivative under accounting principles
generally accepted in the United States of America. Accordingly, they are not recorded in the consolidated financial statements. As of December 31, 2003, we had outstanding commitments to originate and purchase loans of $228 million and $60 million,
respectively. We had no commitments to sell loans to third parties at December 31, 2003. As of December 31, 2002, we had outstanding commitments to originate, purchase and sell loans of $108 million, $16 million and $98 million, respectively.



On November 20, 2003, we executed a securitization transaction
accounted for as a sale of loans. We delivered $1.0 billion in loans collateralizing NMFT Series 2003-4 (see Note 3 of the consolidated financial statements). On January 14, 2004, we delivered an additional $479.8 million in loans collateralizing
NMFT Series 2003-4.



Contractual Obligations



We have entered into certain long-term debt and lease agreements, which
obligate us to make future payments to satisfy the related contractual obligations. Notes 6 and 15 of the consolidated financial statements discuss these obligations in further detail.



The following table summarizes our contractual obligations with regard to our long-term debt and lease agreements as of
December 31, 2003.



Table 13  Contractual Obligations

(in thousands)

---



|                                                                       |  |                        |         |                 |   |           |  |           |        |              |   |        |  |   |      
|---------------------------------------------------------------------- |  | ---------------------- | ------- | --------------- | - | --------- |  | --------- | ------ | ------------ | - | ------ |  | - | -----
|                                                                       |  | Payments Due by Period
|                                                                       |  | Total                  |         | Less than 1Year |   | 1-3 Years |  | 4-5 Years |        | After 5Years
|Contractual Obligations                                                |  |                        |         |                 |   |           |  |           |        |              |   |        |  |   |      
|Short-term borrowings                                                  |  | $                      | 872,536 |                 | $ | 872,536   |  |           |       |              |   |       |  |   |     
|Long-term debt (A)                                                     |  | $                      | 132,980 |                 | $ | 82,346    |  | $         | 28,909 |              | $ | 12,745 |  | $ | 8,980
|Mortgage loan purchase commitments                                     |  | $                      | 60,000  |                 | $ | 60,000    |  |           |       |              |   |       |  |   |     
|Operating leases                                                       |  | $                      | 31,543  |                 | $ | 6,425     |  | $         | 10,855 |              | $ | 10,698 |  | $ | 3,565
|Premiums due to counterparties related to interest rate cap agreements |  | $                      | 3,459   |                 | $ | 1,568     |  | $         | 1,891  |              |   |       |  |   |     

---

|(A) | Repayment of the asset-backed bonds is dependent upon payment of the underlying mortgage loans, which collateralize the debt. The repayment of these mortgage loans is affected by
prepayments.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The Company has entered into
various lease agreements in which the lessor agreed to repay the Company for certain existing lease obligations. The Company received approximately $2.3 million and $62,000 related to these agreements in 2003 and 2002, respectively, and expects to
receive approximately $1.0 million in future payments through 2004 from the lessor unless the properties we previously occupied are subleased. We entered into various sublease agreements for office space formerly occupied by us. We received
approximately $537,000 in 2003 related to these agreements and expect to receive approximately $61,000 in future payments through 2004.



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Inflation



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



Impact of Recently Issued Accounting Pronouncements



Note 1 of the consolidated financial statements describe certain recently
issued accounting pronouncements. Management believes the implementation of these pronouncements and others that have gone into effect since the date of these reports will not have a material impact on the consolidated financial statements.



Item 7A.Quantitative and Qualitative Disclosures About Market Risk



See discussion under Interest Rate/Market Risk in Item 1. Business.



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Item 8.Financial Statements and Supplementary Data



NOVASTAR FINANCIAL, INC.

CONSOLIDATED BALANCE SHEETS

(dollars in thousands, except share amounts)

---



|                                                                                    |  |              |           |   |      |   |           |  
|----------------------------------------------------------------------------------- |  | ------------ | --------- | - | ---- | - | --------- | -
|                                                                                    |  | December 31, |          
|                                                                                    |  | 2003         |           |   | 2002 |  
|Assets                                                                              |  |              |           |   |      |   |           |  
|Cash and cash equivalents                                                           |  | $            | 118,180   |   |      | $ | 79,742    |  
|Mortgage loans  held-for-sale                                                      |  |              | 697,992   |   |      |   | 983,633   |  
|Mortgage loans  held-in-portfolio                                                  |  |              | 94,717    |   |      |   | 149,876   |  
|Mortgage securities  available-for-sale                                            |  |              | 382,287   |   |      |   | 178,879   |  
|Servicing related advances                                                          |  |              | 19,281    |   |      |   | 11,875    |  
|Mortgage servicing rights                                                           |  |              | 19,685    |   |      |   | 7,906     |  
|Accrued interest receivable                                                         |  |              | 3,739     |   |      |   | 7,673     |  
|Assets acquired through foreclosure                                                 |  |              | 3,192     |   |      |   | 5,935     |  
|Other assets                                                                        |  |              | 60,884    |   |      |   | 26,978    |  
|                                                                                    |  |              |           |   |      |   |           |  
|Total assets                                                                        |  | $            | 1,399,957 |   |      | $ | 1,452,497 |  
|                                                                                    |  |              |           |   |      |   |           |  
|Liabilities and Stockholders Equity                                                |  |              |           |   |      |   |           |  
|Liabilities:                                                                        |  |              |           |   |      |   |           |  
|Short-term borrowings secured by mortgage loans                                     |  | $            | 639,852   |   |      | $ | 927,472   |  
|Short-term borrowings secured by mortgage securities                                |  |              | 232,684   |   |      |   | 98,064    |  
|Asset-backed bonds secured by mortgage loans                                        |  |              | 89,384    |   |      |   | 143,459   |  
|Asset-backed bonds secured by mortgage securities                                   |  |              | 43,596    |   |      |   | 56,233    |  
|Accounts payable and other liabilities                                              |  |              | 63,658    |   |      |   | 27,244    |  
|Dividends payable                                                                   |  |              | 30,559    |   |      |   | 16,768    |  
|                                                                                    |  |              |           |   |      |   |           |  
|Total liabilities                                                                   |  |              | 1,099,733 |   |      |   | 1,269,240 |  
|Commitments and contingencies                                                       |  |              |           |   |      |   |           |  
|Stockholders equity:                                                               |  |              |           |   |      |   |           |  
|Capital stock, $0.01 par value, 50,000,000 shares authorized:                       |  |              |           |   |      |   |           |  
|Common stock, 24,447,315 and 20,959,820 shares issued and outstanding, respectively |  |              | 245       |   |      |   | 210       |  
|Additional paid-in capital                                                          |  |              | 231,294   |   |      |   | 133,253   |  
|Accumulated deficit                                                                 |  |              | (15,522   | ) |      |   | (12,026   | )
|Accumulated other comprehensive income                                              |  |              | 85,183    |   |      |   | 62,935    |  
|Other                                                                               |  |              | (976      | ) |      |   | (1,115    | )
|                                                                                    |  |              |           |   |      |   |           |  
|Total stockholders equity                                                          |  |              | 300,224   |   |      |   | 183,257   |  
|                                                                                    |  |              |           |   |      |   |           |  
|Total liabilities and stockholders equity                                          |  | $            | 1,399,957 |   |      | $ | 1,452,497 |  
|                                                                                    |  |              |           |   |      |   |           |  



See
notes to consolidated financial statements.



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NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in thousands, except per share amounts)

---



|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|---------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------ | -
|                                                                                                     |  | For the Year Ended December 31, |        
|                                                                                                     |  | 2003                            |         |   | 2002 |   |         | 2001 | 
|Interest income:                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|Mortgage securities                                                                                  |  | $                               | 98,804  |   |      | $ | 56,481  |      |  | $ | 11,706 |  
|Mortgage loans held-for-sale                                                                         |  |                                 | 60,878  |   |      |   | 33,736  |      |  |   | 19,507 |  
|Mortgage loans held-in-portfolio                                                                     |  |                                 | 10,738  |   |      |   | 16,926  |      |  |   | 26,691 |  
|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|Total interest income                                                                                |  |                                 | 170,420 |   |      |   | 107,143 |      |  |   | 57,904 |  
|Interest expense:                                                                                    |  |                                 |         |   |      |   |         |      |  |   |        |  
|Short-term borrowings secured by mortgage loans                                                      |  |                                 | 20,060  |   |      |   | 10,406  |      |  |   | 8,546  |  
|Short-term borrowings secured by mortgage securities                                                 |  |                                 | 3,450   |   |      |   | 2,107   |      |  |   | 1,911  |  
|Asset-backed bonds secured by mortgage loans                                                         |  |                                 | 2,269   |   |      |   | 4,195   |      |  |   | 14,874 |  
|Asset-backed bonds secured by mortgage securities                                                    |  |                                 | 5,226   |   |      |   | 727     |      |  |   |       |  
|Net settlements of derivative instruments used in cash flow hedges                                   |  |                                 | 9,359   |   |      |   | 10,293  |      |  |   | 2,035  |  
|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|Total interest expense                                                                               |  |                                 | 40,364  |   |      |   | 27,728  |      |  |   | 27,366 |  
|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|Net interest income before credit recoveries (losses)                                                |  |                                 | 130,056 |   |      |   | 79,415  |      |  |   | 30,538 |  
|Credit recoveries (losses)                                                                           |  |                                 | 389     |   |      |   | 432     |      |  |   | (3,608 | )
|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|Net interest income                                                                                  |  |                                 | 130,445 |   |      |   | 79,847  |      |  |   | 26,930 |  
|Gains on sales of mortgage assets                                                                    |  |                                 | 144,005 |   |      |   | 53,305  |      |  |   | 37,347 |  
|Losses on derivative instruments                                                                     |  |                                 | (30,837 | ) |      |   | (36,841 | )    |  |   | (3,953 | )
|Fee income                                                                                           |  |                                 | 68,341  |   |      |   | 35,983  |      |  |   | 20,994 |  
|Premiums for mortgage loan insurance                                                                 |  |                                 | (3,102  | ) |      |   | (2,326  | )    |  |   | (2,655 | )
|Other income, net                                                                                    |  |                                 | 412     |   |      |   | 1,356   |      |  |   | 1,856  |  
|General and administrative expenses:                                                                 |  |                                 |         |   |      |   |         |      |  |   |        |  
|Compensation and benefits                                                                            |  |                                 | 89,954  |   |      |   | 49,060  |      |  |   | 26,934 |  
|Loan expense                                                                                         |  |                                 | 26,174  |   |      |   | 8,002   |      |  |   | 1,865  |  
|Travel and public relations                                                                          |  |                                 | 23,339  |   |      |   | 11,400  |      |  |   | 7,008  |  
|Office administration                                                                                |  |                                 | 22,945  |   |      |   | 10,092  |      |  |   | 6,394  |  
|Professional and outside services                                                                    |  |                                 | 7,482   |   |      |   | 3,402   |      |  |   | 1,989  |  
|Other                                                                                                |  |                                 | 4,514   |   |      |   | 2,638   |      |  |   | 2,315  |  
|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|Total general and administrative expenses                                                            |  |                                 | 174,408 |   |      |   | 84,594  |      |  |   | 46,505 |  
|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|Income before income tax expense (benefit) and cumulative effect of a change in accounting principle |  |                                 | 134,856 |   |      |   | 46,730  |      |  |   | 34,014 |  
|Income tax expense (benefit)                                                                         |  |                                 | 22,860  |   |      |   | (2,031  | )    |  |   |       |  
|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|Income before cumulative effect of a change in accounting principle                                  |  |                                 | 111,996 |   |      |   | 48,761  |      |  |   | 34,014 |  
|Cumulative effect of a change in accounting principle                                                |  |                                 |        |   |      |   |        |      |  |   | (1,706 | )
|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|Net income                                                                                           |  |                                 | 111,996 |   |      |   | 48,761  |      |  |   | 32,308 |  
|Dividends on preferred shares                                                                        |  |                                 |        |   |      |   |        |      |  |   | (5,025 | )
|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|Net income available to common shareholders                                                          |  | $                               | 111,996 |   |      | $ | 48,761  |      |  | $ | 27,283 |  
|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|Basic earnings per share  before cumulative effect of a change in accounting principle              |  | $                               | 5.04    |   |      | $ | 2.35    |      |  | $ | 1.69   |  
|Basic loss per share due to cumulative effect of a change in accounting principle                    |  |                                 |        |   |      |   |        |      |  |   | (0.08  | )
|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|Basic earnings per share                                                                             |  | $                               | 5.04    |   |      | $ | 2.35    |      |  | $ | 1.61   |  
|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|Diluted earnings per share  before cumulative effect of a change in accounting principle            |  | $                               | 4.91    |   |      | $ | 2.25    |      |  | $ | 1.59   |  
|Diluted loss per share due to cumulative effect of a change in accounting principle                  |  |                                 |        |   |      |   |        |      |  |   | (0.08  | )
|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|Diluted earnings per share                                                                           |  | $                               | 4.91    |   |      | $ | 2.25    |      |  | $ | 1.51   |  
|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|Weighted average basic shares outstanding                                                            |  |                                 | 22,220  |   |      |   | 20,758  |      |  |   | 20,050 |  
|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|Weighted average diluted shares outstanding                                                          |  |                                 | 22,821  |   |      |   | 21,660  |      |  |   | 21,382 |  
|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  
|Dividends declared per common share                                                                  |  | $                               | 5.04    |   |      | $ | 2.15    |      |  | $ | 0.48   |  
|                                                                                                     |  |                                 |         |   |      |   |         |      |  |   |        |  



See
notes to consolidated financial statements.



39



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##### Table of Contents

NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY

(Dollars in thousands, except share amounts)

---



|                                                                             |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   |          |  
|---------------------------------------------------------------------------- |  | ------------------------- | --- | - | ----------- | - | --- | ------------------------ |  | - | ------------------ | - |  | ----------------------------------- | -------- | - | ----- | - | ------ | ------------------------ |  | - | ------ | - |  | - | -------- | -
|                                                                             |  | ConvertiblePreferredStock |     |   | CommonStock |   |     | AdditionalPaid-inCapital |  |   | AccumulatedDeficit |   |  | AccumulatedOtherComprehensiveIncome |          |   | Other |   |        | TotalStockholdersEquity | 
|Balance, January 1, 2001                                                     |  | $                         | 43  |   |             | $ | 122 |                          |  | $ | 141,936            |   |  | $                                   | (37,976  | ) |       | $ | 10,168 |                          |  | $ | (6,374 | ) |  | $ | 107,919  |  
|Common stock repurchased, 230,294 shares                                     |  |                           |    |   |             |   | (2  | )                        |  |   | (652               | ) |  |                                     |         |   |       |   |       |                          |  |   |       |   |  |   | (654     | )
|Return of common stock underlying founders notes receivable, 578,664 shares |  |                           |    |   |             |   | (6  | )                        |  |   | (4,334             | ) |  |                                     |         |   |       |   |       |                          |  |   | 4,340  |   |  |   |         |  
|Forgiveness of founders notes receivable                                    |  |                           |    |   |             |   |    |                          |  |   |                   |   |  |                                     |         |   |       |   |       |                          |  |   | 139    |   |  |   | 139      |  
|Payment of founders notes receivable                                        |  |                           |    |   |             |   |    |                          |  |   |                   |   |  |                                     |         |   |       |   |       |                          |  |   | 641    |   |  |   | 641      |  
|Exercise of stock options, 228,278 shares                                    |  |                           |    |   |             |   | 2   |                          |  |   | 852                |   |  |                                     |         |   |       |   |       |                          |  |   |       |   |  |   | 854      |  
|Dividends on common stock ($0.48 per share)                                  |  |                           |    |   |             |   |    |                          |  |   |                   |   |  |                                     | (5,194   | ) |       |   |       |                          |  |   |       |   |  |   | (5,194   | )
|Dividends on preferred stock ($1.08 per share)                               |  |                           |    |   |             |   |    |                          |  |   |                   |   |  |                                     | (5,025   | ) |       |   |       |                          |  |   |       |   |  |   | (5,025   | )
|                                                                             |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   |          |  
|Comprehensive income:                                                        |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   |          |  
|Net income                                                                   |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     | 32,308   |   |       |   |       |                          |  |   |        |   |  |   | 32,308   |  
|Other comprehensive income                                                   |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |         |   |       |   | (991   | )                        |  |   |        |   |  |   | (991     | )
|                                                                             |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   |          |  
|Total comprehensive income                                                   |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   | 31,317   |  
|                                                                             |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   |          |  
|Balance, December 31, 2001                                                   |  |                           | 43  |   |             |   | 116 |                          |  |   | 137,802            |   |  |                                     | (15,887  | ) |       |   | 9,177  |                          |  |   | (1,254 | ) |  |   | 129,997  |  
|                                                                             |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   |          |  
|Conversion of preferred stock to common, 8,571,428 shares                    |  |                           | (43 | ) |             |   | 86  |                          |  |   | (43                | ) |  |                                     |         |   |       |   |       |                          |  |   |       |   |  |   |         |  
|Acquisition of warrants, 812,731                                             |  |                           |    |   |             |   |    |                          |  |   | (9,499             | ) |  |                                     |         |   |       |   |       |                          |  |   |       |   |  |   | (9,499   | )
|Conversion of 350,000 warrants for 421,406 shares of common stock            |  |                           |    |   |             |   | 4   |                          |  |   | (4                 | ) |  |                                     |         |   |       |   |       |                          |  |   |       |   |  |   |         |  
|Forgiveness of founders notes receivable                                    |  |                           |    |   |             |   |    |                          |  |   |                   |   |  |                                     |         |   |       |   |       |                          |  |   | 139    |   |  |   | 139      |  
|Exercise of stock options, 358,476 shares                                    |  |                           |    |   |             |   | 4   |                          |  |   | 1,782              |   |  |                                     |         |   |       |   |       |                          |  |   |       |   |  |   | 1,786    |  
|Compensation recognized under stock option plan                              |  |                           |    |   |             |   |    |                          |  |   | 3,215              |   |  |                                     |         |   |       |   |       |                          |  |   |       |   |  |   | 3,215    |  
|Dividends on common stock ($2.15 per share)                                  |  |                           |    |   |             |   |    |                          |  |   |                   |   |  |                                     | (44,900  | ) |       |   |       |                          |  |   |       |   |  |   | (44,900  | )
|Increase in common stock held in rabbi trusts                                |  |                           |    |   |             |   |    |                          |  |   |                   |   |  |                                     |         |   |       |   |       |                          |  |   | (911   | ) |  |   | (911     | )
|Increase in deferred compensation obligation                                 |  |                           |    |   |             |   |    |                          |  |   |                   |   |  |                                     |         |   |       |   |       |                          |  |   | 911    |   |  |   | 911      |  
|                                                                             |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   |          |  
|Comprehensive income:                                                        |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   |          |  
|Net income                                                                   |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     | 48,761   |   |       |   |       |                          |  |   |        |   |  |   | 48,761   |  
|Other comprehensive income                                                   |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |         |   |       |   | 53,758 |                          |  |   |        |   |  |   | 53,758   |  
|                                                                             |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   |          |  
|Total comprehensive income                                                   |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   | 102,519  |  
|                                                                             |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   |          |  
|Balance, December 31, 2002                                                   |  |                           |    |   |             |   | 210 |                          |  |   | 133,253            |   |  |                                     | (12,026  | ) |       |   | 62,935 |                          |  |   | (1,115 | ) |  |   | 183,257  |  
|                                                                             |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   |          |  
|Forgiveness of founders notes receivable                                    |  |                           |    |   |             |   |    |                          |  |   |                   |   |  |                                     |         |   |       |   |       |                          |  |   | 139    |   |  |   | 139      |  
|Issuance of common stock, 3,188,620 shares                                   |  |                           |    |   |             |   | 32  |                          |  |   | 93,889             |   |  |                                     |         |   |       |   |       |                          |  |   |       |   |  |   | 93,921   |  
|Exercise of stock options, 298,875 shares                                    |  |                           |    |   |             |   | 3   |                          |  |   | 1,644              |   |  |                                     |         |   |       |   |       |                          |  |   |       |   |  |   | 1,647    |  
|Compensation recognized under stock option plan                              |  |                           |    |   |             |   |    |                          |  |   | 1,310              |   |  |                                     |         |   |       |   |       |                          |  |   |       |   |  |   | 1,310    |  
|Dividend equivalent rights (DERs) on vested options                          |  |                           |    |   |             |   |    |                          |  |   | 1,198              |   |  |                                     | (1,198   | ) |       |   |       |                          |  |   |       |   |  |   |         |  
|Dividends on common stock ($5.04 per share)                                  |  |                           |    |   |             |   |    |                          |  |   |                   |   |  |                                     | (114,294 | ) |       |   |       |                          |  |   |       |   |  |   | (114,294 | )
|Increase in common stock held in rabbi trusts                                |  |                           |    |   |             |   |    |                          |  |   |                   |   |  |                                     |         |   |       |   |       |                          |  |   | (3,145 | ) |  |   | (3,145   | )
|Increase in deferred compensation obligation                                 |  |                           |    |   |             |   |    |                          |  |   |                   |   |  |                                     |         |   |       |   |       |                          |  |   | 3,145  |   |  |   | 3,145    |  
|                                                                             |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   |          |  
|Comprehensive income:                                                        |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   |          |  
|Net income                                                                   |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     | 111,996  |   |       |   |       |                          |  |   |        |   |  |   | 111,996  |  
|Other comprehensive income                                                   |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |         |   |       |   | 22,248 |                          |  |   |        |   |  |   | 22,248   |  
|                                                                             |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   |          |  
|Total comprehensive income                                                   |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   | 134,244  |  
|                                                                             |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   |          |  
|Balance, December 31, 2003                                                   |  | $                         |    |   |             | $ | 245 |                          |  | $ | 231,294            |   |  | $                                   | (15,522  | ) |       | $ | 85,183 |                          |  | $ | (976   | ) |  | $ | 300,224  |  
|                                                                             |  |                           |     |   |             |   |     |                          |  |   |                    |   |  |                                     |          |   |       |   |        |                          |  |   |        |   |  |   |          |  



See
notes to consolidated financial statements.



40



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##### Table of Contents

NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

---



|                                                                                                  |  |                                 |            |   |      |   |            |      |  |   |            |  
|------------------------------------------------------------------------------------------------- |  | ------------------------------- | ---------- | - | ---- | - | ---------- | ---- |  | - | ---------- | -
|                                                                                                  |  | For the Year Ended December 31, |           
|                                                                                                  |  | 2003                            |            |   | 2002 |   |            | 2001 | 
|Cash flows from operating activities:                                                             |  |                                 |            |   |      |   |            |      |  |   |            |  
|Net income                                                                                        |  | $                               | 111,996    |   |      | $ | 48,761     |      |  | $ | 32,308     |  
|Adjustments to reconcile net income to net cash provided by (used in) operating activities:       |  |                                 |            |   |      |   |            |      |  |   |            |  
|Cumulative effect of change in accounting principle                                               |  |                                 |           |   |      |   |           |      |  |   | 1,706      |  
|Amortization of premiums on mortgage assets                                                       |  |                                 | 1,120      |   |      |   | 1,930      |      |  |   | 3,208      |  
|Amortization of mortgage servicing rights                                                         |  |                                 | 8,995      |   |      |   | 4,609      |      |  |   | 2,131      |  
|Accretion of available-for-sale securities                                                        |  |                                 | (98,804    | ) |      |   | (56,481    | )    |  |   | (11,706    | )
|Amortization of deferred debt issuance costs                                                      |  |                                 | 1,100      |   |      |   | 172        |      |  |   | 1,022      |  
|Forgiveness of founders promissory notes                                                         |  |                                 | 139        |   |      |   | 139        |      |  |   | 139        |  
|Credit (recoveries) losses                                                                        |  |                                 | (389       | ) |      |   | (432       | )    |  |   | 3,608      |  
|Provision for deferred income taxes                                                               |  |                                 | (5,848     | ) |      |   | (4,652     | )    |  |   |           |  
|Proceeds from sale of mortgage loans held-for-sale in securitizations                             |  |                                 | 5,207,233  |   |      |   | 1,532,483  |      |  |   | 1,191,977  |  
|Proceeds from sale of mortgage loans held-for-sale to third parties                               |  |                                 | 966,537    |   |      |   | 391,506    |      |  |   | 110,879    |  
|Originations of mortgage loans held-for-sale                                                      |  |                                 | (6,066,002 | ) |      |   | (2,811,315 | )    |  |   | (1,403,289 | )
|Repayments of mortgage loans held-for-sale                                                        |  |                                 | 18,474     |   |      |   | 10,943     |      |  |   | 1,731      |  
|Gains on sales of mortgage assets                                                                 |  |                                 | (144,005   | ) |      |   | (53,305    | )    |  |   | (37,347    | )
|Losses on derivative instruments                                                                  |  |                                 | 30,837     |   |      |   | 36,841     |      |  |   | 3,953      |  
|Compensation recognized under stock option plan                                                   |  |                                 | 1,310      |   |      |   | 3,215      |      |  |   |           |  
|Depreciation expense                                                                              |  |                                 | 3,872      |   |      |   | 1,203      |      |  |   | 940        |  
|Changes in:                                                                                       |  |                                 |            |   |      |   |            |      |  |   |            |  
|Other assets                                                                                      |  |                                 | (61,618    | ) |      |   | (56,085    | )    |  |   | (26,532    | )
|Other liabilities                                                                                 |  |                                 | 33,394     |   |      |   | (3,114     | )    |  |   | 1,325      |  
|                                                                                                  |  |                                 |            |   |      |   |            |      |  |   |            |  
|Net cash provided by (used in) operating activities                                               |  |                                 | 8,341      |   |      |   | (953,582   | )    |  |   | (123,947   | )
|Cash flows from investing activities:                                                             |  |                                 |            |   |      |   |            |      |  |   |            |  
|Mortgage loan repaymentsheld-in-portfolio                                                        |  |                                 | 49,101     |   |      |   | 65,505     |      |  |   | 125,198    |  
|Proceeds from paydowns on available-for-sale securities                                           |  |                                 | 200,024    |   |      |   | 100,071    |      |  |   | 40,190     |  
|Proceeds from sales of available-for-sale securities                                              |  |                                 |           |   |      |   |           |      |  |   | 28,626     |  
|Proceeds from sales of assets acquired through foreclosure                                        |  |                                 | 6,719      |   |      |   | 14,876     |      |  |   | 20,466     |  
|Net assets acquired in acquisition of common stock of NFI Holding Corporation                     |  |                                 |           |   |      |   |           |      |  |   | 872        |  
|Payment on founders promissory notes                                                             |  |                                 |           |   |      |   |           |      |  |   | 641        |  
|                                                                                                  |  |                                 |            |   |      |   |            |      |  |   |            |  
|Net cash provided by investing activities                                                         |  |                                 | 255,844    |   |      |   | 180,452    |      |  |   | 215,993    |  
|Cash flows from financing activities:                                                             |  |                                 |            |   |      |   |            |      |  |   |            |  
|Payments on asset-backed bonds                                                                    |  |                                 | (120,083   | ) |      |   | (86,434    | )    |  |   | (139,411   | )
|Proceeds from asset-backed bonds                                                                  |  |                                 | 52,271     |   |      |   | 66,906     |      |  |   |           |  
|Change in short-term borrowings                                                                   |  |                                 | (153,000   | ) |      |   | 882,186    |      |  |   | 81,450     |  
|Proceeds from issuance of capital stock and exercise of equity instruments, net of offering costs |  |                                 | 94,321     |   |      |   | 1,786      |      |  |   | 854        |  
|Repurchase of warrants                                                                            |  |                                 |           |   |      |   | (9,499     | )    |  |   |           |  
|Dividends paid on preferred stock                                                                 |  |                                 |           |   |      |   | (2,014     | )    |  |   | (3,150     | )
|Dividends paid on common stock                                                                    |  |                                 | (99,256    | ) |      |   | (30,876    | )    |  |   | (2,836     | )
|Common stock repurchases                                                                          |  |                                 |           |   |      |   |           |      |  |   | (654       | )
|                                                                                                  |  |                                 |            |   |      |   |            |      |  |   |            |  
|Net cash provided by (used in) financing activities                                               |  |                                 | (225,747   | ) |      |   | 822,055    |      |  |   | (63,747    | )
|                                                                                                  |  |                                 |            |   |      |   |            |      |  |   |            |  
|Net increase in cash and cash equivalents                                                         |  |                                 | 38,438     |   |      |   | 48,925     |      |  |   | 28,299     |  
|Cash and cash equivalents, beginning of year                                                      |  |                                 | 79,742     |   |      |   | 30,817     |      |  |   | 2,518      |  
|                                                                                                  |  |                                 |            |   |      |   |            |      |  |   |            |  
|Cash and cash equivalents, end of year                                                            |  | $                               | 118,180    |   |      | $ | 79,742     |      |  | $ | 30,817     |  
|                                                                                                  |  |                                 |            |   |      |   |            |      |  |   |            |  



See
notes to consolidated financial statements.



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NOVASTAR FINANCIAL, INC.



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---



Note 1. Summary of Significant Accounting and Reporting Policies



Financial Statement PresentationThe 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, amortizing mortgage servicing rights and establishing the fair value of its mortgage securities, derivative instruments,
mortgage servicing rights and estimating appropriate accrual rates on mortgage securities. 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. For example, it is possible that credit losses or prepayments could rise to levels that would adversely affect profitability if those levels were sustained for more than brief periods.



The consolidated financial statements of the Company include the accounts of
all wholly-owned subsidiaries. Intercompany accounts and transactions have been eliminated during consolidation.



Unconsolidated AffiliatesThe Company is party to limited liability company agreements (LLCs), formed to facilitate the
operation of retail mortgage broker businesses as branch affiliates. The LLC agreements provide for initial capitalization and membership interests of 99.9% to a branch manager and 0.1% to the Company. The LLCs broker loans to mortgage investors,
including a subsidiary of the Company. The Company provides accounting, payroll, human resources, loan investor management and license management in conjunction with separate contractual agreements. The Company accounts for its interest in the LLC
agreements using the equity method of accounting.



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.



Mortgage LoansMortgage loans include loans originated by the Company and acquired in bulk pools from other originators and
securities dealers. 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. 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 held-for-sale and only mortgage loans held-in-portfolio which 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 ninety days delinquent. For mortgage loans held-in-portfolio, which do carry mortgage insurance, the accrual of interest is only discontinued when in managements opinion, the
interest is not collectible in the ordinary course of business. Interest collected on non-accrual loans is recognized as income upon receipt.



The mortgage loan portfolio is collectively evaluated for impairment as the loans are smaller-balance and are homogeneous in nature. 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, Company purchased mortgage insurance and other factors deemed to warrant consideration.



Mortgage SecuritiesMortgage securities represent beneficial
interests the Company retains in securitization and resecuritization transactions and include interest-only mortgage securities, prepayment penalty bonds, over-collateralization bonds and other subordinated securities. 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.
Subordinated securities retained in resecuritizations represent the contractual right to receive the remaining cash flows from the trust after the obligations to the outside bond



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holders have been satisfied. When those obligations have been satisfied, the trust returns the transferred securities to the subordinated interest holders.



Mortgage securities are classified as available for sale and,
accordingly, are reported at their estimated fair value with unrealized gains and losses reported in accumulated other comprehensive income.



As previously described, mortgage securities represent the retained interests in certain components of the cash flows of the underlying mortgage loans or
mortgage securities transferred to securitization trusts. As payments are received the payments are applied to the cost basis of the mortgage related security. Each period, the accretable yield for each mortgage security is evaluated and, to the
extent there has been a change in the estimated cash flows, it is adjusted and applied prospectively. The estimated cash flows change as managements assumptions for credit losses, borrower prepayments and interest rates are updated. The
assumptions are established using sophisticated 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.



At each reporting period subsequent to the initial valuation of the retained
securities, the fair value of mortgage 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. 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.



Servicing related advancesThe Company advances funds on behalf of borrowers for taxes, insurance and other
customer service functions. These advances are routinely assessed for collectibility and any uncollectible advances are appropriately charged to earnings.



Mortgage Servicing Rights Originated mortgage servicing rights are recorded at allocated cost based upon the relative fair values of the
transferred loans and the servicing rights. Mortgage servicing rights are amortized in proportion to the projected net servicing revenue over the expected life of the related mortgage loans. Periodically, the Company evaluates the carrying value of
originated mortgage servicing rights based on their estimated fair value. If the estimated fair value, using a discounted cash flow methodology, is less than the carrying amount of the mortgage servicing rights, the mortgage servicing rights are
written down to the amount of the estimated fair value. For purposes of evaluating and measuring impairment of mortgage servicing rights the Company stratifies the mortgage servicing rights based on their predominant risk characteristics. The
significant risk characteristic considered by the Company is period of origination. The mortgage loans underlying the mortgage servicing rights are pools of homogenous, nonconforming residential loans.



Assets Acquired Through Foreclosure Real 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
operating income.



Property and Equipment
Leasehold improvements, furniture and fixtures and office and computer equipment are stated at cost less accumulated depreciation. Net property and equipment is included in other assets. 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 as follows:



|                              |  |        
|----------------------------- |  | -------
|Leasehold improvements        |  | 5 years
|                              | 
|Furniture and fixtures        |  | 5 years
|                              | 
|Office and computer equipment |  | 3 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.



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 the premiums for mortgage insurance are expensed by the Company as the cost 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



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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.



Management believes the best estimate of the initial value of the securities it retains in a whole loan securitization is
derived from the market value of the pooled loans. The initial value of the loans is estimated based on the expected open market sales price of a similar pool. The Company regularly accepts bids on its whole loans in order to test the market price.
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 percent of net proceeds received in the securitization (i.e. the economic value of the loans transferred) from the estimated adjusted market price for
the entire pool of the loans.



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



The Company estimates fair value for the securities it retains in a resecuritization transaction based on the present value of future expected cash flows
estimated using managements best estimate of the key assumptions, including credit losses, prepayment speeds, forward yield curves, and discount rates commensurate with the risks involved.



The following is a description of the methods used by the Company to transfer
assets, including the related accounting treatment under each method:



| |  | Whole Loan Sales Whole loan sales represent loans sold 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 the first payment. 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 prepays in its entirety in the first year. The Company
records the fair value of recourse obligations upon the sale of the mortgage loans. See Note 15.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Loans and Securities Sold Under Agreements to Repurchase (Repurchase Agreements)Repurchase agreements represent legal sales of loans or mortgage securities and an
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.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Securitization TransactionsThe Company regularly securitizes mortgage loans by transferring mortgage loans to independent trusts which issue securities to investors.
The securities are collateralized by the mortgage loans transferred into the independent trusts. The Company generally 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 Company is also required to buy back any loan for which the borrower converts from an adjustable rate to a fixed rate. The fair values of these
recourse obligations are recorded upon the transfers of the mortgage loans and on an ongoing basis. The Company also has 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. 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 Company records an asset and a liability on the balance
sheet for the aggregate fair value of loans that it has a right to call as of the balance sheet date.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Resecuritization Transactions The Company also engages in 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.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Fee Income The Company receives fee income from several sources. The following describes
significant fee income sources and the related accounting treatment:



| |  | 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.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | 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, processing fees and, for loans held-in-portfolio, prepayment penalties. Revenue is recognized on fees received from borrowers when an event occurs that generates the fee and they are considered to be collectible.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Affiliated Branch Management Fees These fees are charged to affiliated mortgage brokers to manage their administrative operations, which include providing accounting,
payroll, human resources, loan investor management and license management. The amount of the fees is agreed upon when entering a contractual agreement with affiliated mortgage brokers and is recognized as services are rendered.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Stock-Based Compensation Prior to
2003, the Company accounted for its stock-based compensation plan using the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations. The
Company accounted for stock options based on the specific terms of the options granted. Options with variable terms, including those options for which the strike price has been adjusted and options issued by the Company with attached dividend
equivalent rights, resulted in adjustments to compensation expense to the extent the market price of the common stock changed. No expense was recognized for options with fixed terms.



During the fourth quarter of 2003, the Company adopted the fair value recognition provisions of Statement of Financial
Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation. The Company selected the modified prospective method of adoption described in SFAS No. 148, Accounting for Stock-Based Compensation-Transition and
Disclosure. Under this method, the change is retroactive to January 1, 2003 and compensation cost recognized in 2003 is the same as that which would have been recognized had the fair value method of SFAS No. 123 been applied from its original
effective date. In accordance with the modified prospective method of adoption, results for prior years have not been restated. SFAS No. 123 states that the adoption of the fair value based method is a change to a preferable method of accounting.
Management believes that use of the fair value based method to record stock-based compensation expense is consistent with the accounting for all other forms of compensation.



The following table illustrates the effect on net income and earnings per share as if the fair value method had been applied
to all outstanding and unvested awards in each period (in thousands, except per share amounts):



|                                                                                                                                            |  |                                 |         |   |      |   |        |      |  |   |        |  
|------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------- | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                                                                                                            |  | For the Year Ended December 31, |        
|                                                                                                                                            |  | 2003                            |         |   | 2002 |   |        | 2001 | 
|Net income, as reported                                                                                                                     |  | $                               | 111,996 |   |      | $ | 48,761 |      |  | $ | 32,308 |  
|Add: Stock-based employee compensation expense included in reported net income, net of related tax effects                                  |  |                                 | 1,310   |   |      |   | 2,473  |      |  |   | 704    |  
|Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax
effects |  |                                 | (1,310  | ) |      |   | (600   | )    |  |   | (318   | )
|                                                                                                                                            |  |                                 |         |   |      |   |        |      |  |   |        |  
|Pro forma net income                                                                                                                        |  | $                               | 111,996 |   |      | $ | 50,634 |      |  | $ | 32,694 |  
|                                                                                                                                            |  |                                 |         |   |      |   |        |      |  |   |        |  
|Earnings per share:                                                                                                                         |  |                                 |         |   |      |   |        |      |  |   |        |  
|Basic  as reported                                                                                                                         |  | $                               | 5.04    |   |      | $ | 2.35   |      |  | $ | 1.61   |  
|                                                                                                                                            |  |                                 |         |   |      |   |        |      |  |   |        |  
|Basic  pro forma                                                                                                                           |  | $                               | 5.04    |   |      | $ | 2.44   |      |  | $ | 1.63   |  
|                                                                                                                                            |  |                                 |         |   |      |   |        |      |  |   |        |  
|Diluted  as reported                                                                                                                       |  | $                               | 4.91    |   |      | $ | 2.25   |      |  | $ | 1.51   |  
|                                                                                                                                            |  |                                 |         |   |      |   |        |      |  |   |        |  
|Diluted  pro forma                                                                                                                         |  | $                               | 4.91    |   |      | $ | 2.34   |      |  | $ | 1.53   |  
|                                                                                                                                            |  |                                 |         |   |      |   |        |      |  |   |        |  



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The following table summarizes the weighted average fair value of the granted options, determined using
the Black-Scholes option pricing model and the assumptions used in their determination.



|                               |  |      |       |   |      |   |       |      |  |   |      |  
|------------------------------ |  | ---- | ----- | - | ---- | - | ----- | ---- |  | - | ---- | -
|                               |  | 2003 |       |   | 2002 |   |       | 2001 | 
|Weighted average:              |  |      |       |   |      |   |       |      |  |   |      |  
|Fair value, at date of grant   |  | $    | 22.48 |   |      | $ | 10.29 |      |  | $ | 5.88 |  
|Expected life in years         |  |      | 7     |   |      |   | 7     |      |  |   | 7    |  
|Annual risk-free interest rate |  |      | 3.3   | % |      |   | 4.1   | %    |  |   | 5.0  | %
|Volatility                     |  |      | 2.0   |   |      |   | 2.1   |      |  |   | 2.3  |  
|Dividend yield                 |  |      | 0.0   | % |      |   | 2.2   | %    |  |   | 1.8  | %



Income
TaxesThe Company is taxed as a Real Estate Investment Trust (REIT) under Section 856(c) of the Code. As a REIT, the Company generally is not subject to federal income tax. To maintain its qualification as a REIT, the Company must
distribute at least 90% of its REIT taxable income to its stockholders and meet certain other tests relating to assets and income. If the Company fails to qualify as a REIT in any taxable year, the Company will be subject to federal income tax on
its taxable income at regular corporate rates. The Company may also be subject to certain state and local taxes. Under certain circumstances, even though the Company qualifies as a REIT, federal income and excise taxes may be due on its
undistributed taxable income. Because the Company has paid or will pay dividends in amounts approximating its taxable income, no provision for income taxes has been provided in the accompanying financial statements related to the REIT. However, NFI
Holding Corporation, a wholly-owned subsidiary, has not elected REIT-status and files a consolidated federal income tax return with its subsidiaries.



The Company has elected to treat NFI Holding Corporation and its subsidiaries as taxable REIT subsidiaries (each a TRS). In general, a TRS of
the Company may hold assets that the Company cannot hold directly and generally may engage in any real estate or non-real estate related business. A TRS is subject to corporate federal income tax and will be taxed as a regular C corporation.
However, special rules do apply to certain activities between a REIT and a TRS. For example, a TRS will be subject to earnings stripping limitations on the deductibility of interest paid to its REIT. In addition, a REIT will be subject to a 100%
excise tax on certain excess amounts to ensure that (i) tenants who pay a TRS for services are charged an arms-length amount by the TRS, (ii) fees paid to a REIT by its TRS are reflected at fair market value and (iii) interest paid by a TRS to
its REIT is commercially reasonable. Securities of a TRS will constitute non-real estate assets for purposes of determining whether at least 75% of a REITs assets consist of real estate. Under current law, no more than 20% of a REITs
total assets can consist of securities of one or more taxable REIT subsidiaries. As of December 31, 2003, the amount of the Companys assets attributable to its taxable REIT subsidiaries was less than 20%.



With respect to the Companys taxable REIT subsidiaries, the Company
records deferred tax assets and liabilities for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective income tax bases. The Company believes
the deferred tax asset recorded is recoverable and, therefore, no valuation allowance has been recorded. The deferred tax asset is included in other assets on the consolidated balance sheet.



Earnings Per Share (EPS)Basic earnings per share
excludes dilution and is computed by dividing net income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share 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 and warrants
on the Companys common stock have been exercised and the convertible preferred stock is converted, unless the exercise would be antidilutive.



Derivative Instruments and Hedging Activities Derivative instruments are recorded at their fair value with hedge ineffectiveness recognized
in earnings. The Company adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (as amended), on January 1, 2001 and recorded a charge to earnings of $1.7 million and an increase in accumulated other comprehensive
income of $34,000. The transition adjustments resulted from adjusting the carrying value of certain interest rate cap agreements to their fair value.



The Company uses derivative instruments with the objective of hedging interest rate risk. Interest rates on liabilities of the Company adjust frequently,
while interest rates on the Companys assets adjust annually, or not at all. The fair value of the Companys derivative instruments along with any margin accounts associated with the contracts are included in other assets. 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



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those derivative instruments that do not qualify for hedge accounting, changes in the fair value of the instruments are recorded as adjustments to earnings.



Commitments to Originate, Purchase and Sell Mortgage
Loans As nonconforming mortgage loans are not readily convertible to cash and cannot readily be settled net, commitments to originate and purchase such loans do not meet the definition of a derivative under accounting principles generally
accepted in the United States of America. Accordingly, they are not recorded in the consolidated financial statements. Commitments to originate and sell conforming mortgage loans meet the definition of a derivative and are recorded at fair value in
the consolidated financial statements.



New Accounting
PronouncementsIn December 2002, the Financial Accounting Standards Board (FASB) issued SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, which amends SFAS No. 123. SFAS No. 148 provides alternative
methods of transition for a voluntary change to the fair value based method of accounting for stock-based compensation. Under the fair value based method, compensation cost for stock options is measured when options are issued. In addition, SFAS No.
148 amends the disclosure requirements of SFAS No. 123 to require more prominent and more frequent disclosures in financial statements of the effects of stock-based compensation. The transition guidance and annual disclosure provisions of SFAS No.
148 were effective for fiscal years ending after December 15, 2002, with earlier application permitted in certain circumstances. The interim disclosure provisions were effective for financial reports containing financial statements for interim
periods beginning after December 15, 2002. As discussed previously in Note 1, the Company applied the transition provisions of SFAS No. 148 in the implementation of SFAS No. 123 during 2003.



In May 2003, the FASB issued SFAS No. 149, Amendments of Statement 133 on
Derivative Instruments andHedging Activities. This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging
activities under SFAS No. 133. This statement was effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. SFAS No. 133 Implementation Issues that are effective for fiscal
quarters beginning prior to June 15, 2003 will continue to be effective based on their respective effective dates, and the paragraphs relating to forward purchases or sales of when issued or other securities that do not yet exist would
be applicable to both existing transactions as well as new transactions entered into after June 30, 2003. The Companys adoption of SFAS No. 149 did not have a significant impact on its consolidated financial statements.



In May 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity. This statement establishes standards for how an issuer classifies and measures certain financial instruments that are within its scope as a liability (or an asset in some
circumstances). This Statement was effective for financial instruments entered into or modified after May 31, 2003, and otherwise was effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatorily
redeemable financial instruments of nonpublic entities. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of the Companys second quarter
consolidated financial statements. The Companys adoption of SFAS No. 150 did not have a significant impact on its consolidated financial statements.



In November 2002, the FASB issued Financial Interpretation (FIN) No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others, which expands on the accounting guidance of Statements No. 5, 57 and 107 and incorporates without change the provisions of FIN No. 34, which is being superseded. FIN No. 45 requires a guarantor to
recognize, at the inception of the guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. It also provides additional guidance on the disclosure of guarantees. The recognition and measurement provisions were
effective for guarantees made or modified after December 31, 2002. The disclosure provisions were effective for fiscal periods ending after December 15, 2002. The Companys adoption of FIN No. 45 did not have a significant impact on its
consolidated financial statements. Significant guarantees that have been entered into by the Company are discussed in Note 15.



In January 2003, the FASB issued FIN No. 46, Consolidation of Variable Interest Entities, which was replaced by FIN No. 46 (Revised December 2003),
Consolidation of Variable Interest Entities(FIN No. 46(R)). FIN No. 46 requires consolidation by business enterprises of variable interest entities that meet certain requirements. FIN No. 46(R) changes the effective date of FIN No. 46 for
certain entities. Public companies shall apply either FIN No. 46 or FIN No. 46(R) to their interests in special purpose entities (SPEs) as of the first interim or annual period ending after December 15, 2003. The decision to apply FIN No. 46 or FIN
No. 46(R) may be made on an SPE by SPE basis. The Companys adoption of FIN No. 46 and FIN No. 46(R) did not have a significant impact on its consolidated financial statements.



Reclassifications Reclassifications to prior year amounts have been made to conform to current year
presentation.



47



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Note 2. Mortgage Loans



Mortgage loans, all of which are secured by residential properties, consisted of the following as of December 31, (in thousands):



|                                    |  |      |         |   |      |   |         |  
|----------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|                                    |  | 2003 |         |   | 2002 |  
|Mortgage loans  held-in-portfolio: |  |      |         |   |      |   |         |  
|Outstanding principal               |  | $    | 94,162  |   |      | $ | 149,918 |  
|Net unamortized premium             |  |      | 1,874   |   |      |   | 2,994   |  
|                                    |  |      |         |   |      |   |         |  
|Amortized cost                      |  |      | 96,036  |   |      |   | 152,912 |  
|Allowance for credit losses         |  |      | (1,319  | ) |      |   | (3,036  | )
|                                    |  |      |         |   |      |   |         |  
|Mortgage loans  held-in-portfolio  |  | $    | 94,717  |   |      | $ | 149,876 |  
|                                    |  |      |         |   |      |   |         |  
|Mortgage loans  held-for-sale:     |  |      |         |   |      |   |         |  
|Outstanding principal               |  | $    | 687,880 |   |      | $ | 972,360 |  
|Net premium                         |  |      | 10,112  |   |      |   | 11,273  |  
|                                    |  |      |         |   |      |   |         |  
|Mortgage loans  held-for-sale      |  | $    | 697,992 |   |      | $ | 983,633 |  
|                                    |  |      |         |   |      |   |         |  



Activity in the
allowance for credit losses is as follows for the three years ended December 31, (in thousands):



|                                       |  |      |        |   |      |   |        |      |  |   |        |  
|-------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                       |  | 2003 |        |   | 2002 |   |        | 2001 | 
|Balance, January 1                     |  | $    | 3,036  |   |      | $ | 5,557  |      |  | $ | 7,690  |  
|Credit (recoveries) losses             |  |      | (389   | ) |      |   | (432   | )    |  |   | 3,608  |  
|Amounts charged off, net of recoveries |  |      | (1,328 | ) |      |   | (2,089 | )    |  |   | (5,741 | )
|                                       |  |      |        |   |      |   |        |      |  |   |        |  
|Balance, December 31                   |  | $    | 1,319  |   |      | $ | 3,036  |      |  | $ | 5,557  |  
|                                       |  |      |        |   |      |   |        |      |  |   |        |  



All mortgage loans
serve as collateral for borrowing arrangements discussed in Note 6. The weighted-average interest rate on mortgage loans as of December 31, 2003 and 2002 was 7.94% and 8.29%, respectively.



Collateral for 22% and 17% of the mortgage loans outstanding as of December
31, 2003 was located in California and Florida, respectively. The Company has no other significant concentration of credit risk.



48



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Details of loan securitization transactions on the date of the securitization are as follows (in
thousands):



|                              |  |                  |           |                                      |   |                          |  |                               |         |  |                |           |     |  |   |        
|----------------------------- |  | ---------------- | --------- | ------------------------------------ | - | ------------------------ |  | ----------------------------- | ------- |  | -------------- | --------- | --- |  | - | -------
|                              |  |                  |           | Allocated Value ofRetained Interests |   |                          |  |                               |        
|                              |  | Net BondProceeds |           | MortgageServicingRights              |   | SubordinatedBond Classes |  | PrincipalBalance ofLoans Sold |         |  | GainRecognized
|Year ended December 31, 2003: |  |                  |           |                                      |   |                          |  |                               |         |  |                |           |     |  |   |        
|NMFT Series 2003-4            |  | $                | 1,476,818 |                                      | $ | 3,986                    |  | $                             | 47,499  |  | $              | 1,019,922 | (A) |  | $ | 22,035 
|NMFT Series 2003-3            |  |                  | 1,472,920 |                                      |   | 5,829                    |  |                               | 84,268  |  |                | 1,499,374 |     |  |   | 34,544 
|NMFT Series 2003-2            |  |                  | 1,476,358 |                                      |   | 5,843                    |  |                               | 78,686  |  |                | 1,499,998 |     |  |   | 50,109 
|NMFT Series 2003-1            |  |                  | 1,253,820 |                                      |   | 5,116                    |  |                               | 82,222  |  |                | 1,300,141 |     |  |   | 29,614 
|                              |  |                  |           |                                      |   |                          |  |                               |         |  |                |           |     |  |   |        
|                              |  | $                | 5,679,916 |                                      | $ | 20,774                   |  | $                             | 292,675 |  | $              | 5,319,435 |     |  | $ | 136,302
|                              |  |                  |           |                                      |   |                          |  |                               |         |  |                |           |     |  |   |        
|Year ended December 31, 2002: |  |                  |           |                                      |   |                          |  |                               |         |  |                |           |     |  |   |        
|NMFT Series 2002-3            |  | $                | 734,584   |                                      | $ | 2,939                    |  | $                             | 39,099  |  | $              | 750,003   |     |  | $ | 29,353 
|NMFT Series 2002-2            |  |                  | 300,304   |                                      |   | 1,173                    |  |                               | 22,021  |  |                | 310,000   |     |  |   | 10,459 
|NMFT Series 2002-1            |  |                  | 485,824   |                                      |   | 1,958                    |  |                               | 29,665  |  |                | 499,998   |     |  |   | 8,082  
|                              |  |                  |           |                                      |   |                          |  |                               |         |  |                |           |     |  |   |        
|                              |  | $                | 1,520,712 |                                      | $ | 6,070                    |  | $                             | 90,785  |  | $              | 1,560,001 |     |  | $ | 47,894 
|                              |  |                  |           |                                      |   |                          |  |                               |         |  |                |           |     |  |   |        
|Year ended December 31, 2001: |  |                  |           |                                      |   |                          |  |                               |         |  |                |           |     |  |   |        
|NMFT Series 2001-2            |  | $                | 785,509   |                                      | $ | 3,817                    |  | $                             | 36,942  |  | $              | 800,033   |     |  | $ | 12,745 
|NMFT Series 2001-1            |  |                  | 407,372   |                                      |   | 1,837                    |  |                               | 22,628  |  |                | 415,067   |     |  |   | 8,985  
|                              |  |                  |           |                                      |   |                          |  |                               |         |  |                |           |     |  |   |        
|                              |  | $                | 1,192,881 |                                      | $ | 5,654                    |  | $                             | 59,570  |  | $              | 1,215,100 |     |  | $ | 21,730 
|                              |  |                  |           |                                      |   |                          |  |                               |         |  |                |           |     |  |   |        



|(A) | On January 14, 2004, the remaining $479.8 million in loans collateralizing NMFT Series 2003-4 were delivered and a gain of $9.0 million was recognized.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------



In the securitizations, the Company retains interest-only and other
subordinated interests in the underlying cash flows and servicing responsibilities. The Company receives 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. The investors and securitization trusts have no recourse to the Companys assets for failure of borrowers to pay when due. The value of the Companys interests is
subject to credit, prepayment, and interest rate risks on the transferred financial assets.



Servicing fees received from the securitization trusts were $21.1 million, $10.0 million and $4.9 million for the years ended December 31, 2003, 2002 and 2001, respectively. No purchases of delinquent or foreclosed
loans were made on securitizations in which the Company did not maintain control over the mortgage loans transferred during the three years ended December 31, 2003.



Fair value of the subordinated bond classes at the date of securitization is measured by estimating the open market sales
price of a similar loan pool. An implied yield (discount rate) is calculated based on the value derived and using projected cash flows generated using key economic assumptions. Key economic assumptions used to project cash flows at the time of loan
securitization during the three years ended December 31, 2003 were as follows:



|                                                              |  |                                                                     |   |  |        |   |  |        |   |  |        |   |  |        |   |  |        |   |  |        |   |  |        |   |  |        |  
|------------------------------------------------------------- |  | ------------------------------------------------------------------- | - |  | ------ | - |  | ------ | - |  | ------ | - |  | ------ | - |  | ------ | - |  | ------ | - |  | ------ | - |  | ------ | -
|                                                              |  | Mortgage Loan Collateral for NovaStar Mortgage Funding Trust Series |  
|                                                              |  | 2003-4                                                              |   |  | 2003-3 |   |  | 2003-2 |   |  | 2003-1 |   |  | 2002-3 |   |  | 2002-2 |   |  | 2002-1 |   |  | 2001-2 |   |  | 2001-1 |  
|Constant prepayment rate(B)                                   |  | 30                                                                  | % |  | 22     | % |  | 25     | % |  | 28     | % |  | 30     | % |  | 27     | % |  | 32     | % |  | 28     | % |  | 28     | %
|Average life (in years)                                       |  | 3.06                                                                |   |  | 3.98   |   |  | 3.54   |   |  | 3.35   |   |  | 3.09   |   |  | 3.13   |   |  | 2.60   |   |  | 2.61   |   |  | 2.54   |  
|Expected total credit losses, net of mortgage insurance(A)(B) |  | 5.1                                                                 | % |  | 3.6    | % |  | 2.7    | % |  | 3.3    | % |  | 1.0    | % |  | 1.6    | % |  | 1.7    | % |  | 1.2    | % |  | 1.2    | %
|Discount rate(B)                                              |  | 20                                                                  | % |  | 20     | % |  | 28     | % |  | 20     | % |  | 20     | % |  | 25     | % |  | 20     | % |  | 25     | % |  | 20     | %



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

|(B) | The current discount rate and assumptions and those at trust securitization, which were previously disclosed, have been adjusted to reflect managements revised estimates for
volatility and risk associated with the underlying mortgage loan collateral. These revisions do not impact previously recorded amounts.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Note 3. Mortgage Securities  Available-for-Sale



Available-for-sale mortgage securities consisted of the Companys
investment in the interest-only, prepayment penalty and other subordinated securities that the trust issued. The primary bonds were sold to parties independent of the Company. Management estimates their fair value by discounting the expected future
cash flow of the collateral and bonds. The average yield on mortgage securities is the interest income for the year as a percentage of the average fair market value on mortgage securities. The cost basis, unrealized gains and losses and estimated
fair value and average yield of mortgage securities as of December 31, 2003 and 2002 were as follows (dollars in thousands):



|                        |  |            |         |                  |        |                     |  |              |       |  |   |         |  |      |  
|----------------------- |  | ---------- | ------- | ---------------- | ------ | ------------------- |  | ------------ | ----- |  | - | ------- |  | ---- | -
|                        |  | Cost Basis |         | Gross Unrealized |        | EstimatedFair Value |  | AverageYield |      
|                        |  |            | Gains   |                  | Losses |                     | 
|As of December 31, 2003 |  | $          | 294,562 |                  | $      | 87,826              |  | $            | 101   |  | $ | 382,287 |  | 34.3 | %
|As of December 31, 2002 |  |            | 102,665 |                  |        | 77,755              |  |              | 1,541 |  |   | 178,879 |  | 42.7 |  



Maturities of mortgage
securities owned by the Company depend on repayment characteristics and experience of the underlying financial instruments. The Company expects the securities it owns as of December 31, 2003 to mature in one to five years.



All mortgage securities owned by the Company are pledged for borrowings as
discussed in Note 6.



On July 2, 2003, the Company securitized
the interest-only, prepayment penalty and subordinated securities of NMFT 2003-2 and issued NovaStar NIMS Certificate Series 2003-N1 in the amount of $54,000,000. The resecuritization was accounted for as a secured borrowing. In accordance with SFAS
No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, control over the transferred assets was not surrendered and thus the transaction was recorded as financing for the mortgage securities.



On November 5, 2002, the Company securitized the interest-only
and prepayment penalty securities of NMFT 2001-1 and NMFT 2001-2 and issued NovaStar CAPS Certificate Series 2002-C1 in the amount of $68,000,000. The resecuritization was accounted for as a secured borrowing. In accordance with SFAS No. 140,
control over the transferred assets was not surrendered and thus the transaction was recorded as financing for the mortgage securities.



On September 26, 2001, the Company securitized interest-only and prepayment penalty securities and issued NovaStar CAPS Certificates Series 2001-C1 in the
amount of $29,250,000. A gain of $14.9 million was recognized on this transaction. A subordinated security, valued by the Company at $8.2 million, was retained entitling the Company to receive cash flows of the collateral once the primary bonds are
paid. On October 25, 2002, the primary bonds were paid off and the interest-only and prepayment penalty securities were transferred back to the Company by the trust.



As of December 31, 2003, key economic assumptions and the sensitivity of the current fair value of retained interests owned
by the Company to immediate adverse changes in those assumptions are as follows, on average for the portfolio (dollars in thousands):



|                                                                      |  |   |        
|--------------------------------------------------------------------- |  | - | -------
|Carrying amount/fair value of retained interests                      |  | $ | 382,287
|Average life (in years)                                               |  |   | 3.0    
|Prepayment speed assumption (CPR)                                     |  |   | 29     
|Fair value after a 10% increase                                       |  | $ | 371,496
|Fair value after a 25% increase                                       |  | $ | 358,031
|Expected annual credit losses (percent of current collateral balance) |  |   | 3.2    
|Fair value after a 10% increase                                       |  | $ | 374,446
|Fair value after a 25% increase                                       |  | $ | 364,128
|Residual cash flows discount rate (%)                                 |  |   | 22     
|Fair value after a 500 basis point increase                           |  | $ | 360,240
|Fair value after a 1000 basis point increase                          |  | $ | 341,303
|Market interest rates                                                 |  |   |        
|Fair value after a 100 basis point increase                           |  | $ | 351,292
|Fair value after a 200 basis point increase                           |  | $ | 313,298



These sensitivities
are hypothetical and should be used with caution. As the analysis indicates, changes in fair value based on a 10% variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair
value may not be linear. Also, in this table the effect of a variation in a



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##### Table of Contents

particular assumption on the fair value of the retained interest is calculated without changing any other assumption; in reality, changes in one factor may
result in changes in another (for example, increases in market interest rates may result in lower prepayments and increased credit losses), which might magnify or counteract the sensitivities.



The actual static pool credit loss as of December 31, 2003 was 0.19% and the
cumulative projected static pool credit loss for the remaining life of the securities is 2.55%. 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.



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



|                                   |  |                                    |           |                                                  |   |                                                    |  |      |         |      |   |         |      |   |        |     |  |   |        |    
|---------------------------------- |  | ---------------------------------- | --------- | ------------------------------------------------ | - | -------------------------------------------------- |  | ---- | ------- | ---- | - | ------- | ---- | - | ------ | --- |  | - | ------ | ---
|                                   |  | December 31,                       |           |                                                  |  
|                                   |  | Total Principal Amount ofLoans (A) |           | Principal Amount ofLoans 30 Days or MorePast Due |   | Net Credit LossesDuring the YearEnded December 31, | 
|                                   |  | 2003                               |           | 2002                                             |   | 2003                                               |  | 2002 |         | 2003 |   |         | 2002 |  
|Loans securitized                  |  | $                                  | 6,428,364 |                                                  | $ | 2,586,493                                          |  | $    | 201,774 |      | $ | 125,700 |      | $ | 7,700  |     |  | $ | 4,558  |    
|Loans held-for-sale                |  |                                    | 688,506   |                                                  |   | 973,224                                            |  |      | 3,125   |      |   | 37,466  |      |   | 498    |     |  |   | 484    |    
|Loans held-in-portfolio            |  |                                    | 96,729    |                                                  |   | 155,683                                            |  |      | 15,313  |      |   | 28,743  |      |   | 4,402  | (B) |  |   | 7,857  | (B)
|                                   |  |                                    |           |                                                  |   |                                                    |  |      |         |      |   |         |      |   |        |     |  |   |        |    
|Total loans managed or securitized |  | $                                  | 7,213,599 |                                                  | $ | 3,715,400                                          |  | $    | 220,212 |      | $ | 191,909 |      | $ | 12,600 |     |  | $ | 12,899 |    
|                                   |  |                                    |           |                                                  |   |                                                    |  |      |         |      |   |         |      |   |        |     |  |   |        |    

---

|(A) | Includes assets acquired through foreclosure.
|--- | ---------------------------------------------



|(B) | Excludes mortgage insurance proceeds on policies paid by the Company and includes interest accrued in excess of 120 days for which the Company had discontinued interest accrual.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Note 4. Mortgage Servicing



The Company records mortgage servicing rights arising from the transfer of
loans to the securitization trusts. The following schedule summarizes the carrying value of mortgage servicing rights and the activity during 2003, 2002 and 2001 (in thousands):



|                                                                                 |  |      |        |   |      |   |        |      |  |   |        |  
|-------------------------------------------------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                                                 |  | 2003 |        |   | 2002 |   |        | 2001 | 
|Balance, January 1                                                               |  | $    | 7,906  |   |      | $ | 6,445  |      |  | $ |       |  
|Amount acquired in purchase of common stock of NFI Holding Corporation           |  |      |       |   |      |   |       |      |  |   | 2,922  |  
|Amount capitalized in connection with transfer of loans to securitization trusts |  |      | 20,774 |   |      |   | 6,070  |      |  |   | 5,654  |  
|Amortization                                                                     |  |      | (8,995 | ) |      |   | (4,609 | )    |  |   | (2,131 | )
|                                                                                 |  |      |        |   |      |   |        |      |  |   |        |  
|Balance, December 31                                                             |  | $    | 19,685 |   |      | $ | 7,906  |      |  | $ | 6,445  |  
|                                                                                 |  |      |        |   |      |   |        |      |  |   |        |  



The estimated fair
value of the servicing assets aggregated $33.4 million and $12.6 million at December 31, 2003 and December 31, 2002, respectively. The fair value is estimated by discounting estimated future cash flows from the servicing assets using discount rates
that approximate current market rates. The fair value as of December 31, 2003 was determined utilizing a 15% discount rate, credit losses net of mortgage insurance (as a percent of current principal balance) of 2.8% and an annual prepayment rate of
26%. The fair value as of December 31, 2002 was determined utilizing a 15% discount rate, credit losses net of mortgage insurance (as a percent of current principal balance) of 1.8% and an annual prepayment rate of 40%.



Mortgage servicing rights are amortized in proportion to and over the
estimated period of net servicing income. The estimated amortization expense for 2004, 2005, 2006 and 2007 is $10.9 million, $6.7 million, $1.6 million and $0.5 million, respectively.



The Company holds, as custodian, 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 are not owned by the Company and are held in trust. The Company held $20.9 million and $9.1 million in escrow for borrowers at December 31, 2003 and 2002,
respectively.



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Note 5. Property and Equipment, Net



Property and equipment consisted of the following at December 31, (in thousands):



|                              |  |      |        |      |   |       
|----------------------------- |  | ---- | ------ | ---- | - | ------
|                              |  | 2003 |        | 2002
|Office and computer equipment |  | $    | 13,617 |      | $ | 7,691 
|Furniture and fixtures        |  |      | 7,209  |      |   | 2,770 
|Leasehold improvements        |  |      | 3,048  |      |   | 838   
|                              |  |      |        |      |   |       
|                              |  |      | 23,874 |      |   | 11,299
|Less accumulated depreciation |  |      | 9,337  |      |   | 5,889 
|                              |  |      |        |      |   |       
|Property and equipment, net   |  | $    | 14,537 |      | $ | 5,410 
|                              |  |      |        |      |   |       



Depreciation expense for the years
ended December 31, 2003, 2002 and 2001 was $3.9 million, $1.2 million and $0.9 million, respectively.



Note 6. Borrowings



Short-term Borrowings The following tables summarize the Companys repurchase agreements and warehouse agreements as of December 31, 2003 and 2002 (dollars in thousands):



|                                                                           |  |                          |           |      |      |   |               |       |         |   |                                     |  |                                           |         |  |                                        |   |  |   |          
|-------------------------------------------------------------------------- |  | ------------------------ | --------- | ---- | ---- | - | ------------- | ----- | ------- | - | ----------------------------------- |  | ----------------------------------------- | ------- |  | -------------------------------------- | - |  | - | ---------
|                                                                           |  | MaximumBorrowingCapacity |           | Rate |      |   | Days to Reset |       | Balance |   | AverageDaily BalanceDuring the Year |  | WeightedAverageInterestRateDuringthe Year |         |  | MaximumAmountOutstandingDuring theYear
|December 31, 2003                                                          |  |                          |           |      |      |   |               |       |         |   |                                     |  |                                           |         |  |                                        |   |  |   |          
|Short-term borrowings (indexed to one-month LIBOR):                        |  |                          |           |      |      |   |               |       |         |   |                                     |  |                                           |         |  |                                        |   |  |   |          
|Repurchase agreement expiring March 31, 2004                               |  | $                        | 600,000   |      | 2.91 | % |               | 22    |         | $ | 100,161                             |  |                                           |         |  |                                        |   |  |   |          
|Repurchase agreement expiring June 5, 2004                                 |  |                          | 600,000   |      | 1.87 |   |               | 16    |         |   | 431,515                             |  |                                           |         |  |                                        |   |  |   |          
|Repurchase agreement expiring April 30, 2004                               |  |                          | 300,000   |      | 1.64 |   |               | 26    |         |   | 28,179                              |  |                                           |         |  |                                        |   |  |   |          
|Repurchase agreement expiring September 8, 2004                            |  |                          | 500,000   |      |     |   |               |      |         |   |                                    |  |                                           |         |  |                                        |   |  |   |          
|Repurchase agreement expiring May 22, 2004                                 |  |                          | 300,000   |      | 2.25 |   |               | 15    |         |   | 214,899                             |  |                                           |         |  |                                        |   |  |   |          
|Repurchase agreement expiring October 23, 2004                             |  |                          | 575,000   |      | 2.17 |   |               | 15    |         |   | 97,782                              |  |                                           |         |  |                                        |   |  |   |          
|                                                                           |  |                          |           |      |      |   |               |       |         |   |                                     |  |                                           |         |  |                                        |   |  |   |          
|Total short-term borrowings                                                |  | $                        | 2,875,000 |      |      |   |               |       |         | $ | 872,536                             |  | $                                         | 915,689 |  | 2.57                                   | % |  | $ | 1,574,156
|                                                                           |  |                          |           |      |      |   |               |       |         |   |                                     |  |                                           |         |  |                                        |   |  |   |          
|December 31, 2002                                                          |  |                          |           |      |      |   |               |       |         |   |                                     |  |                                           |         |  |                                        |   |  |   |          
|Short-term borrowings (indexed to one-month LIBOR):                        |  |                          |           |      |      |   |               |       |         |   |                                     |  |                                           |         |  |                                        |   |  |   |          
|Repurchase agreement expiring March 31, 2003                               |  | $                        | 50,000    |      | 1.88 | % |               | 29    |         | $ | 40,650                              |  |                                           |         |  |                                        |   |  |   |          
|Repurchase agreement expiring September 18, 2003                           |  |                          | 50,000    |      | 1.88 |   |               | 24    |         |   | 46,500                              |  |                                           |         |  |                                        |   |  |   |          
|Repurchase agreement expiring October 28, 2003                             |  |                          | 50,000    |      | 1.88 |   |               | 27    |         |   | 10,914                              |  |                                           |         |  |                                        |   |  |   |          
|Repurchase agreement expiring March 31, 2003                               |  |                          | 200,000   |      | 2.38 |   |               | 13    |         |   | 84,320                              |  |                                           |         |  |                                        |   |  |   |          
|Repurchase agreement expiring September 18, 2003                           |  |                          | 150,000   |      | 2.38 |   |               | 1     |         |   | 107,705                             |  |                                           |         |  |                                        |   |  |   |          
|Repurchase agreement expiring October 28, 2003                             |  |                          | 300,000   |      | 2.42 |   |               | 10    |         |   | 264,658                             |  |                                           |         |  |                                        |   |  |   |          
|Repurchase agreement expiring December 6, 2003                             |  |                          | 200,000   |      | 2.51 |   |               | Daily |         |   | 117,312                             |  |                                           |         |  |                                        |   |  |   |          
|Warehouse agreement expiring March 3, 2003 (indexed to Federal funds rate) |  |                          | 125,000   |      | 2.74 |   |               | Daily |         |   | 123,317                             |  |                                           |         |  |                                        |   |  |   |          
|Warehouse agreement expiring September 29, 2003                            |  |                          | 250,000   |      | 2.98 |   |               | Daily |         |   | 230,160                             |  |                                           |         |  |                                        |   |  |   |          
|                                                                           |  |                          |           |      |      |   |               |       |         |   |                                     |  |                                           |         |  |                                        |   |  |   |          
|Total short-term borrowings                                                |  | $                        | 1,375,000 |      |      |   |               |       |         | $ | 1,025,536                           |  | $                                         | 410,951 |  | 3.04                                   | % |  | $ | 1,025,536
|                                                                           |  |                          |           |      |      |   |               |       |         |   |                                     |  |                                           |         |  |                                        |   |  |   |          



The Companys
mortgage loans and securities are pledged as collateral on borrowings. All short-term financing arrangements require the Company to maintain minimum tangible net worth, meet a minimum equity ratio test and comply with other customary debt covenants.
Management believes the Company is in compliance with all debt covenants.



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Repurchase agreements generally contain margin calls under which a portion of the borrowings must be
repaid if the fair value of the mortgage securities or mortgage loans collateralizing the repurchase agreements falls under a predefined ratio to the borrowings outstanding.



Asset-backed Bonds (ABB) The Company issued ABB secured by its mortgage loans as a means for long-term
financing. For financial reporting and tax purposes, the mortgage loans held-in-portfolio 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 collateralizing the ABB. Interest rates reset monthly and are indexed to one-month LIBOR. The estimated weighted-average months to maturity is based on estimates and assumptions made by management. The
actual maturity may differ from expectations. However, the Company retains the option to repay the ABB, and reacquire the mortgage loans, when the remaining unpaid principal balance of the underlying mortgage loans falls below 35% of their original
amounts for issue 1997-1 and 25% on 1997-2, 1998-1 and 1998-2.



On July 2, 2003, the Company issued ABB in the amount of $54 million secured by the interest-only, prepayment penalty and subordinated mortgage securities of NMFT 2003-2 as a means for long-term financing. The mortgage securities are
recorded as assets of the Company and the ABB are recorded as debt. The performance of the mortgage loan collateral underlying these securities, as presented in Note 2 directly affects the performance of the 2003-N1 bond. The interest rate is fixed
at 7.385% and the estimated weighted average months to maturity is based on estimates and assumptions made by management. The actual maturity may differ from expectations.



On November 5, 2002, the Company issued ABB in the amount of $68 million secured by the AAA-IO and prepayment penalty
mortgage securities of NMFT 2001-1 and NMFT 2001-2 as a means for long-term financing. The mortgage securities are recorded as assets of the Company and the ABB are recorded as debt. The performance of the mortgage loan collateral underlying these
securities, as presented in Note 2 directly affects the performance of the 2002-C1 bond. The interest rate is fixed at 7.15% and the estimated weighted average months to maturity is based on estimates and assumptions made by management. The actual
maturity may differ from expectations.



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



|                                     |  |                    |         |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|------------------------------------ |  | ------------------ | ------- | - | -------------- | ---- | ---- | ----------------------- | - | ------ | ---------------------- |  | ----- | -------------------------------------- |  | - | ---
|                                     |  | Asset-backed Bonds |         |   | Mortgage Loans |     
|                                     |  | RemainingPrincipal |         |   | Interest Rate  |      |      | Remaining Principal (A) |   |        | Weighted AverageCoupon |  |       | EstimatedWeightedAverage Monthsto Call | 
|As of December 31, 2003:             |  |                    |         |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|NovaStar Home Equity Series:         |  |                    |         |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|Collateralizing Mortgage Loans:      |  |                    |         |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|Issue 1997-1                         |  | $                  | 10,249  |   |                | 1.63 | %    |                         | $ | 11,721 |                        |  | 10.17 | %                                      |  |  |    
|Issue 1997-2                         |  |                    | 13,177  |   |                | 1.63 |      |                         |   | 14,629 |                        |  | 10.51 |                                        |  |  |    
|Issue 1998-1                         |  |                    | 24,337  |   |                | 1.54 |      |                         |   | 27,118 |                        |  | 9.94  |                                        |  |  |    
|Issue 1998-2                         |  |                    | 41,621  |   |                | 1.55 |      |                         |   | 43,261 |                        |  | 9.87  |                                        |  |  |    
|                                     |  |                    |         |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|                                     |  | $                  | 89,384  |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|                                     |  |                    |         |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|Collateralizing Mortgage Securities: |  |                    |         |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|Issue 2002-C1                        |  | $                  | 7,070   |   |                | 7.15 | %(B) |                         |   |        | (B)                    |  |       | (B)                                    |  |   | (B)
|Issue 2003-N1                        |  |                    | 38,100  |   |                | 7.39 | (C)  |                         |   |        | (C)                    |  |       | (C)                                    |  |   | (C)
|Unamortized debt issuance costs, net |  |                    | (1,574  | ) |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|                                     |  |                    |         |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|                                     |  | $                  | 43,596  |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|                                     |  |                    |         |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|As of December 31, 2002:             |  |                    |         |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|NovaStar Home Equity Series:         |  |                    |         |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|Collateralizing Mortgage Loans:      |  |                    |         |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|Issue 1997-1                         |  | $                  | 17,147  |   |                | 1.88 | %    |                         | $ | 19,076 |                        |  | 10.27 | %                                      |  |  |    
|Issue 1997-2                         |  |                    | 20,714  |   |                | 1.88 |      |                         |   | 22,812 |                        |  | 10.51 |                                        |  |  |    
|Issue 1998-1                         |  |                    | 39,692  |   |                | 1.82 |      |                         |   | 44,363 |                        |  | 10.02 |                                        |  |  |    
|Issue 1998-2                         |  |                    | 65,906  |   |                | 1.63 |      |                         |   | 69,432 |                        |  | 9.85  |                                        |  |  |    
|                                     |  |                    |         |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|                                     |  | $                  | 143,459 |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|                                     |  |                    |         |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|Collateralizing Mortgage Securities: |  |                    |         |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|Issue 2002-C1                        |  | $                  | 57,219  |   |                | 7.15 | %(B) |                         |   |        | (B)                    |  |       | (B)                                    |  |   | (B)
|Unamortized debt issuance costs, net |  |                    | (986    | ) |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|                                     |  |                    |         |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|                                     |  | $                  | 56,233  |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    
|                                     |  |                    |         |   |                |      |      |                         |   |        |                        |  |       |                                        |  |   |    



|(A) | Includes assets acquired through foreclosure.
|--- | ---------------------------------------------



|(B) | Collateral for the 2002-C1 asset backed bond is the AAA-IO and prepayment penalty mortgage securities of NMFT 2001-1 and NMFT 2001-2.
|--- | -------------------------------------------------------------------------------------------------------------------------------------



|(C) | Collateral for the 2003-N1 asset backed bond is the interest-only, prepayment penalty and subordinated mortgage securities of NMFT 2003-2.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------



The following table summarizes the expected repayment requirements relating
to the securitization bond financing at December 31, 2003. Amounts listed as bond payments are based on anticipated receipts of principal and interest on underlying mortgage loan collateral using historical prepayment speeds (in thousands):



|           |  |                   |       
|---------- |  | ----------------- | ------
|           |  | Asset-backedBonds
|2004       |  | $                 | 82,346
|2005       |  |                   | 18,584
|2006       |  |                   | 10,325
|2007       |  |                   | 6,558 
|2008       |  |                   | 6,187 
|Thereafter |  |                   | 8,980 



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Note 7. Stockholders Equity



The Board of Directors declared a two-for-one split of its common stock, providing shareholders of record as of November 17,
2003, with one additional share of common stock for each share owned. The additional shares resulting from the split were issued on December 1, 2003 increasing the number of common shares outstanding to 24.1 million. Prior year share amounts and
earnings per share disclosures have been restated to reflect the stock split.



On May 21, 2003, the Company completed a public offering of 1,207,500 shares of its common stock at $22.13 per share. The Company raised $25.2 million in net proceeds from this offering. The Company completed another
public offering of 1,403,000 shares of its common stock at $38.50 per share on November 7, 2003, resulting in $51.7 million in net proceeds.



On May 2, 2003, the Company established a direct stock purchase and dividend reinvestment plan. The Plan 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. The Plan allows for a discount from market of up to 3%. Under the Plan, the Company sold 578,120 shares of its common stock during 2003 at a
weighted average discount of 1.9%. Net proceeds of $17.0 million were raised under these sales of common stock.



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



As of December 31, 2001, the Company had
1,162,731 warrants outstanding for the purchase of Company common stock. On January 30, 2002, warrant holders surrendered 350,000 warrants with an exercise price of $6.94 in a cashless exchange for 421,406 shares of the Companys
common stock valued at $8.72 per share. On April 5, 2002, the Company acquired the remaining 812,731 warrants with an exercise price of $4.56 from warrant holders for $9.5 million.



The Companys Board of Directors has approved the purchase of up to $9 million of the Companys common
stock. No shares were purchased in 2002 or 2003. During the year ended December 31, 2001, 230,294 shares were purchased with an aggregate purchase price of $655,000. The purchased shares have been returned to the Companys authorized but
unissued shares of common stock. All common stock purchases are charged against additional paid-in capital.



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The following is a rollforward of accumulated other comprehensive income for the three years ended
December 31, 2003 (in thousands):



|                                         |  |                              |         |   |                                             |   |         |       |  |   |         |  
|---------------------------------------- |  | ---------------------------- | ------- | - | ------------------------------------------- | - | ------- | ----- |  | - | ------- | -
|                                         |  | Available-for-saleSecurities |         |   | DerivativeInstrumentsUsed inCash FlowHedges |   |         | Total | 
|Balance, January 1, 2001                 |  | $                            | 10,168  |   |                                             | $ |        |       |  | $ | 10,168  |  
|Change in unrealized gain (loss)         |  |                              | 21,768  |   |                                             |   | (9,882  | )     |  |   | 11,886  |  
|Implementation of SFAS No. 133           |  |                              |        |   |                                             |   | 34      |       |  |   | 34      |  
|Net settlements reclassified to earnings |  |                              |        |   |                                             |   | 2,087   |       |  |   | 2,087   |  
|Realized gain reclassified to earnings   |  |                              | (14,946 | ) |                                             |   |        |       |  |   | (14,946 | )
|Other amortization                       |  |                              |        |   |                                             |   | (52     | )     |  |   | (52     | )
|                                         |  |                              |         |   |                                             |   |         |       |  |   |         |  
|Other comprehensive income (loss)        |  |                              | 6,822   |   |                                             |   | (7,813  | )     |  |   | (991    | )
|                                         |  |                              |         |   |                                             |   |         |       |  |   |         |  
|Balance, December 31, 2001               |  |                              | 16,990  |   |                                             |   | (7,813  | )     |  |   | 9,177   |  
|                                         |  |                              |         |   |                                             |   |         |       |  |   |         |  
|Change in unrealized gain (loss)         |  |                              | 55,649  |   |                                             |   | (12,184 | )     |  |   | 43,465  |  
|Net settlements reclassified to earnings |  |                              |        |   |                                             |   | 10,396  |       |  |   | 10,396  |  
|Other amortization                       |  |                              |        |   |                                             |   | (103    | )     |  |   | (103    | )
|                                         |  |                              |         |   |                                             |   |         |       |  |   |         |  
|Other comprehensive income (loss)        |  |                              | 55,649  |   |                                             |   | (1,891  | )     |  |   | 53,758  |  
|                                         |  |                              |         |   |                                             |   |         |       |  |   |         |  
|Balance, December 31, 2002               |  |                              | 72,639  |   |                                             |   | (9,704  | )     |  |   | 62,935  |  
|                                         |  |                              |         |   |                                             |   |         |       |  |   |         |  
|Change in unrealized gain (loss)         |  |                              | 15,086  |   |                                             |   | (2,197  | )     |  |   | 12,889  |  
|Net settlements reclassified to earnings |  |                              |        |   |                                             |   | 9,462   |       |  |   | 9,462   |  
|Other amortization                       |  |                              |        |   |                                             |   | (103    | )     |  |   | (103    | )
|                                         |  |                              |         |   |                                             |   |         |       |  |   |         |  
|Other comprehensive income               |  |                              | 15,086  |   |                                             |   | 7,162   |       |  |   | 22,248  |  
|                                         |  |                              |         |   |                                             |   |         |       |  |   |         |  
|Balance, December 31, 2003               |  | $                            | 87,725  |   |                                             | $ | (2,542  | )     |  | $ | 85,183  |  
|                                         |  |                              |         |   |                                             |   |         |       |  |   |         |  



Prior to 2001, the
Company and its founders entered into a series of transactions which resulted in non-recourse forgivable promissory notes (the Notes) payable to the Company aggregating $6.4 million and the founders owning 723,108 shares of common stock of the
Company. On January 1, 2001, the Company and its founders entered into another series of transactions, which resulted in a significant reduction in the balance of the Notes. The founders returned 578,664 shares of the common stock and the Company
cancelled the related non-recourse debt. The Company then repurchased the remaining 144,444 shares of common stock. The Company also purchased all of the voting common stock of NFI Holding Corporation from the founders. As a result of this purchase,
NFI Holding Corporation became a wholly-owned subsidiary of the Company on January 1, 2001.



The founders used the proceeds received from the sale of NFI Holding Corporation and Company common stock to repay a portion of their obligations described above. The remaining obligations, aggregating $1,393,000,
were rewritten into new non-recourse, non interest-bearing promissory notes. Those notes will be forgiven and charged to expense in equal installments over 10 years as long as the Company employs the founders on December 31stof each year. The notes will be forgiven in full in the event of a change in control. During the years ended December 31,
2003, 2002 and 2001, the Company recognized $139,000 in compensation expense related to these notes. The founders have each pledged 144,444 shares of common stock as collateral for these loans.



Note 8. 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. 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 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 2003, 2002 and
2001, premiums paid related to interest rate cap agreements aggregated $7.4 million, $1.2 million and $3.7 million, respectively. When premiums are



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financed by the Company, a liability is recorded for the premium obligation. Premiums due to counterparties as of December 31, 2003 and 2002 were $3.5
million and $171,000, respectively, and bear a weighted average interest rate of 1.9% and 7.1%, respectively. The future contractual maturities of premiums due to counterparties as of December 31, 2003 are $1.6 million, $1.4 million and $0.5 million
due in 2004, 2005 and 2006, respectively. 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 and borrowings under its warehouse, mortgage loan and mortgage security repurchase agreements as discussed in Note 6.



All of 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 instruments also contribute to the Companys overall risk
management strategy by serving to reduce interest rate risk on average short-term borrowings used to fund loans held-for-sale. The following tables present derivative instruments as of December 31, 2003 and 2002 (dollars in thousands):



|                                       |  |                |           |           |   |         |                          |  |      
|-------------------------------------- |  | -------------- | --------- | --------- | - | ------- | ------------------------ |  | -----
|                                       |  | NotionalAmount |           | FairValue |   |         | Maximum Days to Maturity
|As of December 31, 2003:               |  |                |           |           |   |         |                          |  |      
|Cash flow hedge derivative instruments |  | $              | 250,000   |           | $ | (3,224  | )                        |  | 450  
|Non-hedge derivative instruments       |  |                | 2,085,144 |           |   | 1,255   |                          |  | 1,090
|                                       |  |                |           |           |   |         |                          |  |      
|Total derivative instruments           |  | $              | 2,335,144 |           | $ | (1,969  | )                        |  |      
|                                       |  |                |           |           |   |         |                          |  |      
|As of December 31, 2002:               |  |                |           |           |   |         |                          |  |      
|Cash flow hedge derivative instruments |  | $              | 435,000   |           | $ | (11,267 | )                        |  | 815  
|Non-hedge derivative instruments       |  |                | 1,648,486 |           |   | (6,977  | )                        |  | 1,090
|                                       |  |                |           |           |   |         |                          |  |      
|Total derivative instruments           |  | $              | 2,083,486 |           | $ | (18,244 | )                        |  |      
|                                       |  |                |           |           |   |         |                          |  |      



During the three years
ended December 31, 2003, the Company recognized $9.4 million, $10.3 million and $2.0 million, respectively, in net expense on derivative instruments qualifying as cash flow hedges, which is recorded as a component of interest expense.



The net amount included in other comprehensive income expected to be
reclassified into earnings within the next twelve months is a charge to earnings of approximately $3.1 million.



The derivative financial instruments we use also subject us to margin call risk. The Companys deposits with derivative counterparties
were $20.9 million and $30.3 million as of December 31, 2003 and 2002, respectively.



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 limited to the cost of replacing 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 Risk The 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 Considerations The 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.



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Note 9. Income Taxes



The components of income tax expense (benefit) allocated to earnings are as follows (in thousands):



|                                   |  |                                 |        |   |      |   |        |  
|---------------------------------- |  | ------------------------------- | ------ | - | ---- | - | ------ | -
|                                   |  | For the Year Ended December 31, |       
|                                   |  | 2003                            |        |   | 2002 |  
|Current                            |  | $                               | 28,708 |   |      | $ | 2,621  |  
|Deferred                           |  |                                 | (5,848 | ) |      |   | (4,652 | )
|                                   |  |                                 |        |   |      |   |        |  
|Total income tax expense (benefit) |  | $                               | 22,860 |   |      | $ | (2,031 | )
|                                   |  |                                 |        |   |      |   |        |  



The difference between
expected income tax benefit computed at the federal statutory rate of 35% and actual income tax benefit recorded at the taxable REIT subsidiary is as follows (in thousands):



|                                                       |  |                                 |        |      |   |        |  
|------------------------------------------------------ |  | ------------------------------- | ------ | ---- | - | ------ | -
|                                                       |  | For the Year Ended December 31, |       
|                                                       |  | 2003                            |        | 2002 |  
|Income tax at statutory rate (taxable REIT subsidiary) |  | $                               | 18,102 |      | $ | (3,755 | )
|State income taxes                                     |  |                                 | 1,549  |      |   | (442   | )
|Nondeductible expenses                                 |  |                                 | 228    |      |   | 117    |  
|Taxable gain on security sale to REIT                  |  |                                 | 2,761  |      |   | 805    |  
|Other                                                  |  |                                 | 220    |      |   | 1,244  |  
|                                                       |  |                                 |        |      |   |        |  
|Total income tax expense (benefit)                     |  | $                               | 22,860 |      | $ | (2,031 | )
|                                                       |  |                                 |        |      |   |        |  



The tax effects of
temporary differences that give rise to the significant portions of the deferred tax assets and liabilities are as follows (in thousands):



|                                                        |  |              |        |      |   |      
|------------------------------------------------------- |  | ------------ | ------ | ---- | - | -----
|                                                        |  | December 31,
|                                                        |  | 2003         |        | 2002
|Deferred tax assets:                                    |  |              |        |      |   |      
|Mark-to-market adjustment on held-for-sale loans        |  | $            | 7,724  |      | $ |     
|Unrealized loss on derivative instruments               |  |              |       |      |   | 3,108
|Excess inclusion income                                 |  |              | 10,242 |      |   | 2,383
|Net operating loss carryforwards                        |  |              |       |      |   | 1,368
|Unrealized loss on derivatives used in cash flow hedges |  |              |       |      |   | 1,396
|Deferred compensation plan contributions                |  |              | 1,893  |      |   |     
|Fixed assets                                            |  |              |       |      |   | 138  
|Other                                                   |  |              | 1,956  |      |   | 853  
|                                                        |  |              |        |      |   |      
|Deferred tax asset                                      |  |              | 21,815 |      |   | 9,246
|Deferred tax liabilities:                               |  |              |        |      |   |      
|Unrealized gain on available for sale securities        |  |              |       |      |   | 3,575
|Mortgage servicing rights                               |  |              | 7,677  |      |   | 3,004
|Fixed assets                                            |  |              | 2,319  |      |   |     
|Other                                                   |  |              | 1,364  |      |   | 201  
|                                                        |  |              |        |      |   |      
|Deferred tax liability                                  |  |              | 11,360 |      |   | 6,780
|                                                        |  |              |        |      |   |      
|Net deferred tax asset                                  |  | $            | 10,455 |      | $ | 2,466
|                                                        |  |              |        |      |   |      



Note 10. 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. Contributions to the Plan by the Company for the years ended December
31, 2003, 2002 and 2001 were $2.0 million, $806,000 and $472,000, respectively.





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The Companys Deferred Compensation Plan (the Plan) is a nonqualified deferred compensation plan
that benefits certain designated key members of management and highly compensated employees and allows them to defer payment of a portion of their compensation to future years. Under the Plan, an employee may defer up to 50% of his or her base
salary, bonus and/or commissions on a pretax basis. The Company may make both voluntary and/or matching contributions to the Plan on behalf of Plan participants. All Plan assets are corporate assets rather than individual property and are therefore
subject to creditors claims against the Company. The Company made contributions to the Plan for the years ended December 31, 2003 and 2002 of $643,000 and $482,000, respectively.



Note 11. Stock Option Plan



The Companys 1996 Stock Option Plan (the Plan) provides for the grant of qualified incentive stock options (ISOs), non-qualified stock options
(NQSOs), deferred stock, restricted stock, performance shares, stock appreciation and limited stock awards and dividend equivalent rights (DERs). Since inception of the Plan, the Company has granted only ISOs, NQSOs and DERs. ISOs may be granted to
the officers and employees of the Company. NQSOs and awards may be granted to the directors, officers, employees, agents and consultants of the Company or any subsidiaries. Under the terms of the Plan, the number of shares available for issuance is
equal to 10% of the Companys outstanding common stock. Individuals who receive awards under the Plan will vest in those awards ratably over a four-year period. Unless previously terminated by the Board of Directors, the Plan will terminate on
September 1, 2006.



Prior to 2003, the Company accounted for
stock-based compensation plans under the recognition and measurement provisions of APB No. 25 and related interpretations. Effective January 1, 2003, the Company adopted the fair value recognition provisions of SFAS No. 123. The Company selected the
modified prospective method of adoption described in SFAS No. 148. Compensation cost recognized in 2003 is the same as that which would have been recognized had the fair value method of SFAS No. 123 been applied from its original effective date. See
Note 1.



In accordance with the provisions of SFAS No. 123 and
SFAS No. 148, $1.3 million was recorded for total stock-based compensation expense in 2003. In accordance with APB No. 25, total stock-based compensation expense was $2.5 million and $0.7 million, respectively, for the years ended December 31, 2002
and 2001.



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 vest over four years and expire ten years after the date of grant. The following table summarizes option activity under the 1996 Plan
for 2003, 2002 and 2001, respectively:



|                                     |  |           |   |      |                      |       |        |           |   |                      |   |        |  |           |                      |  |   |     
|------------------------------------ |  | --------- | - | ---- | -------------------- | ----- | ------ | --------- | - | -------------------- | - | ------ |  | --------- | -------------------- |  | - | ----
|                                     |  | 2003      |   | 2002 |                      | 2001 
|                                     |  | Shares    |   |      | WeightedAveragePrice |       | Shares |           |   | WeightedAveragePrice |   | Shares |  |           | WeightedAveragePrice
|Outstanding at the beginning of year |  | 1,032,670 |   |      | $                    | 7.40  |        | 1,078,840 |   |                      | $ | 4.69   |  | 1,083,820 |                      |  | $ | 3.82
|Granted                              |  | 15,000    |   |      |                      | 22.66 |        | 314,000   |   |                      |   | 12.05  |  | 225,000   |                      |  |   | 6.73
|Exercised                            |  | (275,390  | ) |      |                      | 5.98  |        | (355,250  | ) |                      |   | 3.05   |  | (226,500  | )                    |  |   | 2.80
|Canceled                             |  | (25,480   | ) |      |                      | 7.79  |        | (4,920    | ) |                      |   | 8.25   |  | (3,480    | )                    |  |   | 9.00
|                                     |  |           |   |      |                      |       |        |           |   |                      |   |        |  |           |                      |  |   |     
|                                     |  |           |   |      |                      |      
|Outstanding at the end of year       |  | 746,800   |   |      | $                    | 8.22  |        | 1,032,670 |   |                      | $ | 7.40   |  | 1,078,840 |                      |  | $ | 4.69
|                                     |  |           |   |      |                      |       |        |           |   |                      |   |        |  |           |                      |  |   |     
|                                     |  |           |   |      |                      |      
|Exercisable at the end of year       |  | 275,050   |   |      | $                    | 7.67  |        | 294,420   |   |                      | $ | 7.63   |  | 406,090   |                      |  | $ | 6.19
|                                     |  |           |   |      |                      |       |        |           |   |                      |   |        |  |           |                      |  |   |     



Certain options
granted during 2003, 2002 and 2001 were granted with DERs. In December 2001, the Companys Board of Directors approved that certain existing and all future stock option grants have DERs attached to them. Under the terms of the DERs, a recipient
is entitled to receive additional shares of stock upon the exercise of options. For employees, the DERs accrue at a rate equal to the number of options outstanding times sixty percent of the dividends per share amount at each dividend payment date.
For directors, the DERs accrue at a rate equal to the number of options outstanding times the dividends per share amount at each dividend payment date. The accrued DERs convert to shares based on the stocks fair value on the dividend payment
date. Certain of the options exercised in 2003, 2002 and 2001 had DERs attached to them when issued. As a result of these exercises, an additional 23,485, 3,226 and 1,778 shares of common stock were issued in 2003, 2002 and 2001, respectively.



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The following table presents information on stock options outstanding as of December 31, 2003.



|                |  |             |  |                                                  |  |                              |       |          |         |                              |   |      
|--------------- |  | ----------- |  | ------------------------------------------------ |  | ---------------------------- | ----- | -------- | ------- | ---------------------------- | - | -----
|                |  | Outstanding |  | Exercisable                                     
|Exercise Price  |  | Quantity    |  | WeightedAverageRemainingContractual Life (Years) |  | WeightedAverageExercisePrice |       | Quantity |         | WeightedAverageExercisePrice
|$1.53 - $7.16   |  | 349,250     |  | 7.40                                             |  | $                            | 4.27  |          | 120,500 |                              | $ | 4.55 
|$7.91 - $10.41  |  | 114,500     |  | 4.43                                             |  |                              | 8.92  |          | 103,250 |                              |   | 9.03 
|$12.22 - $22.66 |  | 283,050     |  | 8.96                                             |  |                              | 12.81 |          | 51,300  |                              |   | 12.28
|                |  |             |  |                                                  |  |                              |       |          |         |                              |   |      
|                |  | 746,800     |  | 7.53                                             |  | $                            | 8.22  |          | 275,050 |                              | $ | 7.67 
|                |  |             |  |                                                  |  |                              |       |          |         |                              |   |      



Note 12. Segment Reporting



The Company reviews, manages and operates its business in
three segments. These business segments are: mortgage portfolio management, mortgage lending and loan servicing and branches. Mortgage portfolio management operating results are driven from the income generated on the assets we manage less
associated management costs. Mortgage lending and loan servicing operations include the marketing, underwriting and funding of loan production. Servicing operations represent the income and costs to service on and off-balance sheet loans (See Note
2). Branches include the collective income generated by NovaStar Home Mortgage brokers and the associated operating costs. The corporate-level income and costs to support the NovaStar Home Mortgage, Inc (NHMI) branches as well as the LLC branches is
represented in the branches segment.



The Companys
operations were restructured into this decentralized organization structure beginning January 1, 2001 as the branches became more significant to the overall performance of the Company. Certain reclassifications have been made to prior year amounts
to conform with current year segment presentation. Following is a summary of income and assets by the Companys primary operating units for the year ended December 31, 2003, 2002 and 2001 (in thousands):



|                                             |  |                                      |         |   |                                  |   |          |          |  |   |              |   |  |       |         |   |  |   |           |  
|-------------------------------------------- |  | ------------------------------------ | ------- | - | -------------------------------- | - | -------- | -------- |  | - | ------------ | - |  | ----- | ------- | - |  | - | --------- | -
|                                             |  | For the Year Ended December 31, 2003 |        
|                                             |  | MortgagePortfolioManagement          |         |   | MortgageLendingand LoanServicing |   |          | Branches |  |   | Eliminations |   |  | Total |        
|Interest income                              |  | $                                    | 109,542 |   |                                  | $ | 60,878   |          |  | $ |             |   |  | $     |        |   |  | $ | 170,420   |  
|Interest expense                             |  |                                      | 17,433  |   |                                  |   | 31,055   |          |  |   |             |   |  |       | (8,124  | ) |  |   | 40,364    |  
|                                             |  |                                      |         |   |                                  |   |          |          |  |   |              |   |  |       |         |   |  |   |           |  
|Net interest income before credit recoveries |  |                                      | 92,109  |   |                                  |   | 29,823   |          |  |   |             |   |  |       | 8,124   |   |  |   | 130,056   |  
|Credit recoveries                            |  |                                      | 389     |   |                                  |   |         |          |  |   |             |   |  |       |        |   |  |   | 389       |  
|Gains (losses) on sales of mortgage assets   |  |                                      | (1,911  | ) |                                  |   | 140,870  |          |  |   |             |   |  |       | 5,046   |   |  |   | 144,005   |  
|Fee income                                   |  |                                      | 65      |   |                                  |   | 37,505   |          |  |   | 40,290       |   |  |       | (9,519  | ) |  |   | 68,341    |  
|Losses on derivative instruments             |  |                                      | (894    | ) |                                  |   | (29,943  | )        |  |   |             |   |  |       |        |   |  |   | (30,837   | )
|Other income (expense)                       |  |                                      | 15,934  |   |                                  |   | (14,563  | )        |  |   | 53           |   |  |       | (4,114  | ) |  |   | (2,690    | )
|General and administrative expenses          |  |                                      | (6,667  | ) |                                  |   | (133,196 | )        |  |   | (34,545      | ) |  |       |        |   |  |   | (174,408  | )
|                                             |  |                                      |         |   |                                  |   |          |          |  |   |              |   |  |       |         |   |  |   |           |  
|Income before income tax                     |  |                                      | 99,025  |   |                                  |   | 30,496   |          |  |   | 5,798        |   |  |       | (463    | ) |  |   | 134,856   |  
|Income tax expense                           |  |                                      |        |   |                                  |   | 20,580   |          |  |   | 2,280        |   |  |       |        |   |  |   | 22,860    |  
|                                             |  |                                      |         |   |                                  |   |          |          |  |   |              |   |  |       |         |   |  |   |           |  
|Net income                                   |  | $                                    | 99,025  |   |                                  | $ | 9,916    |          |  | $ | 3,518        |   |  | $     | (463    | ) |  | $ | 111,996   |  
|                                             |  |                                      |         |   |                                  |   |          |          |  |   |              |   |  |       |         |   |  |   |           |  
|December 31, 2003:                           |  |                                      |         |   |                                  |   |          |          |  |   |              |   |  |       |         |   |  |   |           |  
|Total assets                                 |  | $                                    | 563,930 |   |                                  | $ | 834,980  |          |  | $ | 17,276       |   |  | $     | (16,229 | ) |  | $ | 1,399,957 |  
|                                             |  |                                      |         |   |                                  |   |          |          |  |   |              |   |  |       |         |   |  |   |           |  



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|                                                                           |  |                                      |         |   |                                   |   |           |          |  |   |              |   |  |       |        |   |  |   |           |  
|-------------------------------------------------------------------------- |  | ------------------------------------ | ------- | - | --------------------------------- | - | --------- | -------- |  | - | ------------ | - |  | ----- | ------ | - |  | - | --------- | -
|                                                                           |  | For the Year Ended December 31, 2002 |        
|                                                                           |  | MortgagePortfolioManagement          |         |   | Mortgage Lending andLoanServicing |   |           | Branches |  |   | Eliminations |   |  | Total |       
|Interest income                                                            |  | $                                    | 73,407  |   |                                   | $ | 33,736    |          |  | $ |             |   |  | $     |       |   |  | $ | 107,143   |  
|Interest expense                                                           |  |                                      | 15,650  |   |                                   |   | 20,715    |          |  |   |             |   |  |       | (8,637 | ) |  |   | 27,728    |  
|                                                                           |  |                                      |         |   |                                   |   |           |          |  |   |              |   |  |       |        |   |  |   |           |  
|Net interest income before credit recoveries                               |  |                                      | 57,757  |   |                                   |   | 13,021    |          |  |   |             |   |  |       | 8,637  |   |  |   | 79,415    |  
|Credit recoveries                                                          |  |                                      | 432     |   |                                   |   |          |          |  |   |             |   |  |       |       |   |  |   | 432       |  
|Gains (losses) on sales of mortgage assets                                 |  |                                      | (791    | ) |                                   |   | 52,282    |          |  |   |             |   |  |       | 1,814  |   |  |   | 53,305    |  
|Fee income                                                                 |  |                                      | 432     |   |                                   |   | 18,084    |          |  |   | 21,495       |   |  |       | (4,028 | ) |  |   | 35,983    |  
|Losses on derivative instruments                                           |  |                                      | (2,282  | ) |                                   |   | (34,559   | )        |  |   |             |   |  |       |       |   |  |   | (36,841   | )
|Other income (expense)                                                     |  |                                      | 12,466  |   |                                   |   | (6,532    | )        |  |   | 62           |   |  |       | (6,966 | ) |  |   | (970      | )
|General and administrative expenses                                        |  |                                      | (6,991  | ) |                                   |   | (59,306   | )        |  |   | (18,840      | ) |  |       | 543    |   |  |   | (84,594   | )
|                                                                           |  |                                      |         |   |                                   |   |           |          |  |   |              |   |  |       |        |   |  |   |           |  
|Income (loss) before income tax                                            |  |                                      | 61,023  |   |                                   |   | (17,010   | )        |  |   | 2,717        |   |  |       |       |   |  |   | 46,730    |  
|Income tax expense (benefit)                                               |  |                                      |        |   |                                   |   | (3,372    | )        |  |   | 1,341        |   |  |       |       |   |  |   | (2,031    | )
|                                                                           |  |                                      |         |   |                                   |   |           |          |  |   |              |   |  |       |        |   |  |   |           |  
|Net income (loss)                                                          |  | $                                    | 61,023  |   |                                   | $ | (13,638   | )        |  | $ | 1,376        |   |  | $     |       |   |  | $ | 48,761    |  
|                                                                           |  |                                      |         |   |                                   |   |           |          |  |   |              |   |  |       |        |   |  |   |           |  
|December 31, 2002:                                                         |  |                                      |         |   |                                   |   |           |          |  |   |              |   |  |       |        |   |  |   |           |  
|Total assets                                                               |  | $                                    | 387,600 |   |                                   | $ | 1,053,477 |          |  | $ | 11,814       |   |  | $     | (394   | ) |  | $ | 1,452,497 |  
|                                                                           |  |                                      |         |   |                                   |   |           |          |  |   |              |   |  |       |        |   |  |   |           |  
|                                                                           | 
|                                                                           |  | For the Year Ended December 31, 2001 |        
|                                                                           |  | MortgagePortfolioManagement          |         |   | Mortgage Lending andLoanServicing |   |           | Branches |  |   | Eliminations |   |  | Total |       
|Interest income                                                            |  | $                                    | 38,394  |   |                                   | $ | 19,425    |          |  | $ | 85           |   |  | $     |       |   |  | $ | 57,904    |  
|Interest expense                                                           |  |                                      | 18,996  |   |                                   |   | 12,301    |          |  |   |             |   |  |       | (3,931 | ) |  |   | 27,366    |  
|                                                                           |  |                                      |         |   |                                   |   |           |          |  |   |              |   |  |       |        |   |  |   |           |  
|Net interest income before credit losses                                   |  |                                      | 19,398  |   |                                   |   | 7,124     |          |  |   | 85           |   |  |       | 3,931  |   |  |   | 30,538    |  
|Credit losses                                                              |  |                                      | (3,608  | ) |                                   |   |          |          |  |   |             |   |  |       |       |   |  |   | (3,608    | )
|Gains on sales of mortgage assets                                          |  |                                      | 14,745  |   |                                   |   | 22,431    |          |  |   | 171          |   |  |       |       |   |  |   | 37,347    |  
|Fee income                                                                 |  |                                      | 790     |   |                                   |   | 2,088     |          |  |   | 19,689       |   |  |       | (1,573 | ) |  |   | 20,994    |  
|Losses on derivative instruments                                           |  |                                      |        |   |                                   |   | (3,953    | )        |  |   |             |   |  |       |       |   |  |   | (3,953    | )
|Other income (expense)                                                     |  |                                      | 4,789   |   |                                   |   | (2,436    | )        |  |   | (1           | ) |  |       | (3,151 | ) |  |   | (799      | )
|General and administrative expenses                                        |  |                                      | (4,386  | ) |                                   |   | (26,573   | )        |  |   | (16,339      | ) |  |       | 793    |   |  |   | (46,505   | )
|                                                                           |  |                                      |         |   |                                   |   |           |          |  |   |              |   |  |       |        |   |  |   |           |  
|Income (loss) before cumulative effect of a change in accounting principle |  |                                      | 31,728  |   |                                   |   | (1,319    | )        |  |   | 3,605        |   |  |       |       |   |  |   | 34,014    |  
|Cumulative effect of a change in accounting principle                      |  |                                      | 1,384   |   |                                   |   | 322       |          |  |   |             |   |  |       |       |   |  |   | 1,706     |  
|                                                                           |  |                                      |         |   |                                   |   |           |          |  |   |              |   |  |       |        |   |  |   |           |  
|Net income (loss)                                                          |  | $                                    | 30,344  |   |                                   | $ | (1,641    | )        |  | $ | 3,605        |   |  | $     |       |   |  | $ | 32,308    |  
|                                                                           |  |                                      |         |   |                                   |   |           |          |  |   |              |   |  |       |        |   |  |   |           |  
|December 31, 2001:                                                         |  |                                      |         |   |                                   |   |           |          |  |   |              |   |  |       |        |   |  |   |           |  
|Total assets                                                               |  | $                                    | 344,676 |   |                                   | $ | 152,593   |          |  | $ | 15,111       |   |  | $     |       |   |  | $ | 512,380   |  
|                                                                           |  |                                      |         |   |                                   |   |           |          |  |   |              |   |  |       |        |   |  |   |           |  



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Intersegment revenues and expenses that were eliminated in consolidation were as follows (in thousands):



|                                                                                                    |  |      |       |   |      |   |        |      |  |   |        |  
|--------------------------------------------------------------------------------------------------- |  | ---- | ----- | - | ---- | - | ------ | ---- |  | - | ------ | -
|                                                                                                    |  | 2003 |       |   | 2002 |   |        | 2001 | 
|Amounts paid (received) to (from) mortgage portfolio from (to) mortgage lending and loan servicing: |  |      |       |   |      |   |        |      |  |   |        |  
|Loan servicing fees                                                                                 |  | $    | (685  | ) |      | $ | (1,074 | )    |  | $ | (1,573 | )
|Administrative fees                                                                                 |  |      |      |   |      |   | (449   | )    |  |   | (704   | )
|Intercompany interest income                                                                        |  |      | 8,124 |   |      |   | 8,637  |      |  |   | 3,931  |  
|Guaranty, commitment, loan sale and securitization fees                                             |  |      | 9,244 |   |      |   | 6,001  |      |  |   | 3,871  |  
|Amounts paid (received) to (from) branches from (to) mortgage lending and loan servicing:           |  |      |       |   |      |   |        |      |  |   |        |  
|Lender premium                                                                                      |  |      | 5,509 |   |      |   | 1,814  |      |  |   |       |  
|Subsidized fees                                                                                     |  |      | 3,325 |   |      |   | 1,139  |      |  |   |       |  
|Administrative fees                                                                                 |  |      |      |   |      |   | (94    | )    |  |   | (88    | )



Note 13. 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 are as follows as of December 31, (in thousands):



|                                         |  |               |         |   |            |   |         |               |  |   |            |   |  |   |           |  
|---------------------------------------- |  | ------------- | ------- | - | ---------- | - | ------- | ------------- |  | - | ---------- | - |  | - | --------- | -
|                                         |  | 2003          |         |   | 2002       |  
|                                         |  | CarryingValue |         |   | Fair Value |   |         | CarryingValue |  |   | Fair Value |  
|Financial assets:                        |  |               |         |   |            |   |         |               |  |   |            |   |  |   |           |  
|Cash and cash equivalents                |  | $             | 118,180 |   |            | $ | 118,180 |               |  | $ | 79,742     |   |  | $ | 79,742    |  
|Mortgage loans:                          |  |               |         |   |            |   |         |               |  |   |            |   |  |   |           |  
|Held-for-sale                            |  |               | 697,992 |   |            |   | 716,006 |               |  |   | 983,633    |   |  |   | 995,320   |  
|Held-in-portfolio                        |  |               | 94,717  |   |            |   | 96,455  |               |  |   | 149,876    |   |  |   | 151,954   |  
|Mortgage securities - available-for-sale |  |               | 382,287 |   |            |   | 382,287 |               |  |   | 178,879    |   |  |   | 178,879   |  
|Mortgage servicing rights                |  |               | 19,685  |   |            |   | 33,788  |               |  |   | 7,906      |   |  |   | 12,617    |  
|Deposits with counterparties             |  |               | 20,900  |   |            |   | 20,900  |               |  |   | 30,310     |   |  |   | 30,310    |  
|Financial liabilities:                   |  |               |         |   |            |   |         |               |  |   |            |   |  |   |           |  
|Borrowings:                              |  |               |         |   |            |   |         |               |  |   |            |   |  |   |           |  
|Short-term                               |  |               | 872,536 |   |            |   | 872,536 |               |  |   | 1,025,536  |   |  |   | 1,025,536 |  
|Asset-backed bonds                       |  |               | 132,980 |   |            |   | 132,980 |               |  |   | 199,692    |   |  |   | 199,352   |  
|Derivative instruments:                  |  |               |         |   |            |   |         |               |  |   |            |   |  |   |           |  
|Interest rate cap agreements             |  |               | 6,679   |   |            |   | 6,679   |               |  |   | 1,200      |   |  |   | 1,200     |  
|Interest rate swap agreements            |  |               | (8,648  | ) |            |   | (8,648  | )             |  |   | (19,444    | ) |  |   | (19,444   | )



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



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
- The fair value of mortgage securities is estimated by discounting future projected cash flows using a discount rate commensurate with the risks involved.



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Mortgage servicing rights  The fair value of mortgage servicing rights is calculated based on a discounted
cash flow methodology incorporating numerous assumptions, including servicing income, servicing costs, market discount rates and prepayment speeds.



Borrowings  The fair value of all borrowings approximates carrying value as the borrowings bear interest at rates that approximate current market rates for
similar borrowings.



Derivative instruments  The fair value of
derivative instruments is estimated by discounting the projected future cash flows using appropriate rates. The fair value of deposits with counterparties approximates its carrying value.



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



Note 14. Supplemental Disclosure of Cash Flow Information



|                                       |  |      |         |      |   |        |  |   |       
|-------------------------------------- |  | ---- | ------- | ---- | - | ------ |  | - | ------
|(in thousands)                         |  | 2003 |         | 2002 |   | 2001  
|Cash paid for interest                 |  | $    | 41,058  |      | $ | 37,546 |  | $ | 28,918
|                                       |  |      |         |      |   |        |  |   |       
|Cash paid for income taxes             |  | $    | 18,831  |      | $ | 3,581  |  | $ | 684   
|                                       |  |      |         |      |   |        |  |   |       
|Non-cash items:                        |  |      |         |      |   |        |  |   |       
|Dividends payable                      |  | $    | 30,559  |      | $ | 16,768 |  | $ | 4,758 
|                                       |  |      |         |      |   |        |  |   |       
|Securities retained in securitizations |  | $    | 292,675 |      | $ | 90,785 |  | $ | 59,570
|                                       |  |      |         |      |   |        |  |   |       
|Retention of mortgage servicing rights |  | $    | 20,774  |      | $ | 6,070  |  | $ | 5,654 
|                                       |  |      |         |      |   |        |  |   |       
|Surrender of warrants                  |  | $    |        |      | $ | 3,673  |  | $ |      
|                                       |  |      |         |      |   |        |  |   |       
|Assets acquired through foreclosure    |  | $    | 6,619   |      | $ | 8,417  |  | $ | 20,159
|                                       |  |      |         |      |   |        |  |   |       
|Dividend reinvestment plan program     |  | $    | 1,247   |      | $ |       |  | $ |      
|                                       |  |      |         |      |   |        |  |   |       



Non-cash activities
related to the acquisition of common stock of NFI Holding Corporation on January 1, 2001 were as follows (in thousands):



|                                                                     |  |      |         |  
|-------------------------------------------------------------------- |  | ---- | ------- | -
|                                                                     |  | 2001 |        
|Operating activities:                                                |  |      |         |  
|Increase in mortgage loans held-for-sale                             |  | $    | (81,733 | )
|                                                                     |  |      |         |  
|Increase in other assets                                             |  | $    | (11,132 | )
|                                                                     |  |      |         |  
|Decrease in other liabilities                                        |  | $    | (9,422  | )
|                                                                     |  |      |         |  
|Investing activities:                                                |  |      |         |  
|Increase in real estate owned                                        |  | $    | (892    | )
|                                                                     |  |      |         |  
|Financing activities:                                                |  |      |         |  
|Increase in borrowings                                               |  | $    | 36,900  |  
|                                                                     |  |      |         |  
|Non-cash financing activities related to founders notes receivable: |  |      |         |  
|Decrease in founders notes receivable                               |  | $    | 4,340   |  
|                                                                     |  |      |         |  
|Decrease in additional paid-in capital                               |  | $    | (4,340  | )
|                                                                     |  |      |         |  



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Note 15. Commitments, Guarantees and Contingencies



The Company makes commitments to borrowers to fund residential mortgage loans as well as commitments to purchase and sell
mortgage loans to third parties. At December 31, 2003, the Company had outstanding commitments to originate, purchase and sell loans of $228 million, $60 million and $0, respectively. The Company had outstanding commitments to originate, purchase
and sell loans of $108 million, $16 million and $98 million, respectively as of December 31, 2002.



The Company leases office space under various operating lease agreements. Rent expense for 2003, 2002 and 2001, aggregated $7.5 million, $2.4 million and
$1.5 million respectively. Future minimum lease commitments under those leases are as follows (in thousands):



|           |  |                   |      
|---------- |  | ----------------- | -----
|           |  | Lease Obligations
|2004       |  | $                 | 6,425
|2005       |  |                   | 5,523
|2006       |  |                   | 5,332
|2007       |  |                   | 5,349
|2008       |  |                   | 5,349
|Thereafter |  |                   | 3,565



The Company has
entered into various lease agreements in which the lessor agreed to repay the Company for certain existing lease obligations. The Company received approximately $2.3 million and $62,000 related to these agreements in 2003 and 2002, respectively, and
expects to receive approximately $1.0 million in future payments through 2004 from the lessor unless the properties previously occupied are subleased.



The Company has also entered into various sublease agreements for office space formerly occupied by the Company. The Company received approximately
$537,000, $704,000 and $846,000 in 2003, 2002 and 2001, respectively, related to these agreements and expects to receive approximately $61,000 in future payments through 2004.



In the ordinary course of business, the Company sells loans with recourse for borrower defaults. For loans that have been
sold with recourse and are no longer on the Companys balance sheet, the recourse component is considered a guarantee. The Company sold loans with recourse for borrower defaults totaling $151.2 million and $142.2 million in 2003 and 2002,
respectively. The Companys reserve related to these guarantees totaled $41,000 and $29,000 as of December 31, 2003 and 2002, respectively.



In the ordinary course of business, the Company sells loans with recourse where a defect occurred in the loan origination process. The Company typically
guarantees to cover investor losses should origination defects occur. The defects are categorized as documentation and underwriting errors, judgments, early payment defaults and fraud. If a defect is identified, the Company is required to repurchase
the loan. As of December 31, 2003, the Company had loans sold with recourse with an outstanding principal balance of $6.4 billion.



In connection with various regulatory lending requirements, certain wholly-owned subsidiaries of the Company are required to maintain minimum levels of
net worth. The wholly-owned subsidiaries were in compliance with these requirements as of December 31, 2003.



In the normal course of its business, the Company is subject to various legal proceedings and claims, the resolution of which, in the opinion of
management, will not have a material adverse effect on the Companys financial condition or results of operations.



Note 16. Affiliated Branches



As discussed in Note 1, the Company is party to LLC agreements for the purpose of establishing affiliated branches. As of December 31, 2003 and 2002,
there were 423 and 207 such affiliated branches. For the years ended December 31, 2003, 2002 and 2001, the Company recorded fee income aggregating $12.8 million, $5.2 million and $1.9 million respectively, for providing administrative services for
affiliated branches. During 2003, 2002 and 2001, the aggregate amount of loans brokered by affiliated branches were approximately $5.7 billion, $2.2 billion and $710.3 million, respectively. Of those amounts, approximately $1.3 billion, $399.6
million and $110.5 million, respectively, were acquired by the Companys mortgage subsidiary. The aggregate premiums paid by the Company for loans brokered by the affiliated branches were approximately $15.1 million, $5.1 million and $1.2
million for the years ended December 31, 2003, 2002 and 2001, respectively. In conjunction with the use of the Companys mortgage broker license, the Company is contingently liable for limited representations and warrantees of the affiliated
branches as well as certain operating liabilities in the event that the LLCs are unable to meet their obligations upon dissolution. The Company requires that the branch managers maintain a reserve with



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the Company to cover such obligations. Historically, the amounts that the Company has been required to pay as a result of these arrangements have been
insignificant. The Company records an estimate of obligations regarding affiliated branch arrangements in the consolidated financial statements.



Note 17. Earnings Per Share



The computations of basic and diluted earnings per share for the years ended December 31, 2003, 2002 and 2001 are as follows (in thousands, except
per share amounts):



|                                                      |  |                                 |         |      |   |        |  |   |       
|----------------------------------------------------- |  | ------------------------------- | ------- | ---- | - | ------ |  | - | ------
|                                                      |  | For the Year Ended December 31,
|                                                      |  | 2003                            |         | 2002 |   | 2001  
|Numerator                                             |  | $                               | 111,996 |      | $ | 48,761 |  | $ | 32,308
|                                                      |  |                                 |         |      |   |        |  |   |       
|Denominator:                                          |  |                                 |         |      |   |        |  |   |       
|Weighted average common shares outstanding  basic    |  |                                 |         |      |   |        |  |   |       
|Common shares outstanding                             |  |                                 | 22,220  |      |   | 20,758 |  |   | 11,478
|Convertible preferred stock                           |  |                                 |        |      |   |       |  |   | 8,572 
|                                                      |  |                                 |         |      |   |        |  |   |       
|Weighted average common shares outstanding  basic    |  |                                 | 22,220  |      |   | 20,758 |  |   | 20,050
|                                                      |  |                                 |         |      |   |        |  |   |       
|Weighted average common shares outstanding  dilutive |  |                                 |         |      |   |        |  |   |       
|Stock options                                         |  |                                 | 601     |      |   | 524    |  |   | 378   
|Warrants                                              |  |                                 |        |      |   | 378    |  |   | 954   
|                                                      |  |                                 |         |      |   |        |  |   |       
|Weighted average common shares outstanding  dilutive |  |                                 | 22,821  |      |   | 21,660 |  |   | 21,382
|                                                      |  |                                 |         |      |   |        |  |   |       
|Basic earnings per share                              |  | $                               | 5.04    |      | $ | 2.35   |  | $ | 1.61  
|                                                      |  |                                 |         |      |   |        |  |   |       
|Diluted earnings per share                            |  | $                               | 4.91    |      | $ | 2.25   |  | $ | 1.51  
|                                                      |  |                                 |         |      |   |        |  |   |       



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



|                                                    |  |                                |       |      |   |       |  |   |     
|--------------------------------------------------- |  | ------------------------------ | ----- | ---- | - | ----- |  | - | ----
|                                                    |  | For the Year EndedDecember 31,
|                                                    |  | 2003                           |       | 2002 |   | 2001 
|Number of stock options and warrants (in thousands) |  |                                | 15    |      |   | 300   |  |   | 420 
|Weighted average exercise price                     |  | $                              | 22.66 |      | $ | 12.50 |  | $ | 8.17



Note 18. Subsequent Events



On January 16, 2004, the Company sold 2.6 million shares
of Series C Cumulative Redeemable Perpetual Preferred Stock, raising $62.9 million in net proceeds. The shares have a liquidation value of $25.00 per share and will pay an annual coupon of 8.90%. The Company has granted its underwriters an option,
exercisable for 30 days, to purchase up to an additional 390,000 shares to cover over-allotments, if any. On February 6, 2004, the underwriters exercised their options for 390,000 shares in over-allotments resulting in net proceeds of $9.4 million.



During February 2004, the Company notified the branch managers
of the limited liability companies described in Notes 1 and 16 to the consolidated financial statements, that the Company was terminating these agreements effective January 1, 2004. Branches that formerly operated under these agreements either
become independent of the Company, or will become operating units of the Company. As operating units of the Company, their financial results will be included in the consolidated financial statements.



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Note 19. Condensed Quarterly Financial Information (unaudited)



Following is condensed consolidated quarterly operating results for the
Company (in thousands, except per share amounts):



|                                                      |  |               |        |   |               |   |         |       |  |   |        |   |  |       |        |   |        |   |        |       |  |   |         |   |  |   |         |   |  |   |        |  
|----------------------------------------------------- |  | ------------- | ------ | - | ------------- | - | ------- | ----- |  | - | ------ | - |  | ----- | ------ | - | ------ | - | ------ | ----- |  | - | ------- | - |  | - | ------- | - |  | - | ------ | -
|                                                      |  | 2003 Quarters |        |   | 2002 Quarters |  
|                                                      |  | First         |        |   | Second        |   |         | Third |  |   | Fourth |   |  | First |        |   | Second |   |        | Third |  |   | Fourth  |  
|Net interest income before credit recoveries (losses) |  | $             | 28,687 |   |               | $ | 31,547  |       |  | $ | 33,469 |   |  | $     | 36,353 |   |        | $ | 12,943 |       |  | $ | 18,873  |   |  | $ | 19,690  |   |  | $ | 27,909 |  
|Credit recoveries (losses)                            |  |               | 92     |   |               |   | 171     |       |  |   | 875    |   |  |       | (749   | ) |        |   | (133   | )     |  |   | 379     |   |  |   | 383     |   |  |   | (197   | )
|Gains on sales of mortgage assets                     |  |               | 29,443 |   |               |   | 44,031  |       |  |   | 34,188 |   |  |       | 36,343 |   |        |   | 4,630  |       |  |   | 15,993  |   |  |   | 17,293  |   |  |   | 15,389 |  
|Gains (losses) on derivative instruments              |  |               | (9,149 | ) |               |   | (15,037 | )     |  |   | (8,144 | ) |  |       | 1,493  |   |        |   | 1,438  |       |  |   | (15,766 | ) |  |   | (16,349 | ) |  |   | (6,164 | )
|Income before income tax benefit (expense)            |  |               | 27,100 |   |               |   | 32,904  |       |  |   | 30,952 |   |  |       | 43,900 |   |        |   | 10,221 |       |  |   | 7,752   |   |  |   | 11,359  |   |  |   | 17,398 |  
|Income tax benefit (expense)                          |  |               | (4,141 | ) |               |   | (4,183  | )     |  |   | (5,844 | ) |  |       | (8,692 | ) |        |   | (1,300 | )     |  |   | 2,638   |   |  |   | 840     |   |  |   | (147   | )
|Net income                                            |  |               | 22,959 |   |               |   | 28,721  |       |  |   | 25,108 |   |  |       | 35,208 |   |        |   | 8,921  |       |  |   | 10,390  |   |  |   | 12,199  |   |  |   | 17,251 |  
|                                                      |  |               |        |   |               |   |         |      
|Basic earnings per share                              |  | $             | 1.09   |   |               | $ | 1.32    |       |  | $ | 1.12   |   |  | $     | 1.49   |   |        | $ | 0.43   |       |  | $ | 0.50    |   |  | $ | 0.59    |   |  | $ | 0.83   |  
|                                                      |  |               |        |   |               |   |         |       |  |   |        |   |  |       |        |   |        |   |        |       |  |   |         |   |  |   |         |   |  |   |        |  
|Diluted earnings per share                            |  | $             | 1.07   |   |               | $ | 1.28    |       |  | $ | 1.09   |   |  | $     | 1.45   |   |        | $ | 0.40   |       |  | $ | 0.49    |   |  | $ | 0.57    |   |  | $ | 0.81   |  
|                                                      |  |               |        |   |               |   |         |       |  |   |        |   |  |       |        |   |        |   |        |       |  |   |         |   |  |   |         |   |  |   |        |  



Effective January 1,
2003, the Company adopted the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation. The Company selected the modified prospective method of adoption as described in SFAS No. 148, Accounting for
Stock-Based Compensation-Transition and Disclosure. In adopting SFAS No. 123 retroactive to January 1, 2003, results for the quarters previously reported in the 2003 Quarterly Reports on Form 10-Q were restated to the amounts noted above for the
modified prospective method of adoption. The pretax impact of adopting the provisions under the modified prospective method for the three months ended March 31, 2003, June 30, 2003 and September 30, 2003 was a decrease to compensation expense of
$0.6 million, $5.6 million and $0.8 million, respectively. Results for prior years have not been restated. See Note 1.



The following amounts from the Companys financial statements for the three months ended March 31, June 30 and September 30, 2003 have been revised
from amounts previously reported to account for stock compensation expense under the fair value method prescribed by SFAS No. 123, in accordance with the modified prospective method of SFAS No. 148 (in thousands, except per share amounts):



|                                           |  |                      |         |   |               |   |         |                      |  |   |            |   |  |                      |         |   |            |   |         |   |  |   |         |  
|------------------------------------------ |  | -------------------- | ------- | - | ------------- | - | ------- | -------------------- |  | - | ---------- | - |  | -------------------- | ------- | - | ---------- | - | ------- | - |  | - | ------- | -
|                                           |  | March 31, 2003       |         |   | June 30, 2003 |   |         | September 30, 2003   | 
|                                           |  | AsPreviouslyReported |         |   | AsAdjusted    |   |         | AsPreviouslyReported |  |   | AsAdjusted |   |  | AsPreviouslyReported |         |   | AsAdjusted |  
|Additional paid-in capital (A)             |  | $                    | 134,448 |   |               | $ | 133,811 |                      |  | $ | 166,512    |   |  | $                    | 160,273 |   |            | $ | 180,746 |   |  | $ | 173,672 |  
|Accumulated deficit                        |  |                      | (16,818 | ) |               |   | (16,181 | )                    |  |   | (21,737    | ) |  |                      | (15,498 | ) |            |   | (26,010 | ) |  |   | (18,936 | )
|Stockholders equity                       |  |                      | 194,597 |   |               |   | 194,597 |                      |  |   | 230,469    |   |  |                      | 230,469 |   |            |   | 236,242 |   |  |   | 236,242 |  
|Compensation and benefits expense          |  |                      | 19,442  |   |               |   | 18,805  |                      |  |   | 30,419     |   |  |                      | 24,817  |   |            |   | 26,287  |   |  |   | 25,452  |  
|Income before income tax expense (benefit) |  |                      | 26,463  |   |               |   | 27,100  |                      |  |   | 27,302     |   |  |                      | 32,904  |   |            |   | 30,117  |   |  |   | 30,952  |  
|Net income                                 |  |                      | 22,322  |   |               |   | 22,959  |                      |  |   | 23,119     |   |  |                      | 28,721  |   |            |   | 24,273  |   |  |   | 25,108  |  
|                                           |  |                      |         |   |               |  
|Basic earnings per share (A)               |  | $                    | 1.06    |   |               | $ | 1.09    |                      |  | $ | 1.06       |   |  | $                    | 1.32    |   |            | $ | 1.08    |   |  | $ | 1.12    |  
|                                           |  |                      |         |   |               |   |         |                      |  |   |            |   |  |                      |         |   |            |   |         |   |  |   |         |  
|Diluted earnings per share (A)             |  | $                    | 1.04    |   |               | $ | 1.07    |                      |  | $ | 1.03       |   |  | $                    | 1.28    |   |            | $ | 1.05    |   |  | $ | 1.09    |  
|                                           |  |                      |         |   |               |   |         |                      |  |   |            |   |  |                      |         |   |            |   |         |   |  |   |         |  

---

|(A) | Additional paid-in capital, basic earnings per share and diluted earnings per share as reported have been adjusted to reflect the Companys two-for-one stock split on December
1, 2003.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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INDEPENDENT AUDITORS REPORT



To the Board of Directors and Stockholders 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, 2003 and 2002, and
the related consolidated statements of income, stockholders equity, and cash flows for each of the three years in the period ended December 31, 2003. 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 auditing standards generally accepted in the United States of America. 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, 2003 and 2002, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America.



As discussed in Note 1 to the consolidated financial statements, the Company
changed its method of accounting for stock-based compensation to conform to Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation effective January 1, 2003.



/s/ Deloitte & Touche LLP



Kansas City, Missouri

March 3, 2004



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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.



Changes in Internal Control over Financial Reporting.There has been no change in NovaStar Financial, Inc.s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of
Exchange Act Rule 13a-15 that occurred during the quarter ended December 31, 2003 that has materially affected, or is reasonably likely to materially affect, NovaStar Financial, Inc.s internal control over financial reporting.



PART III



Item 10.Directors and Executive Officers of the Registrant



Information with respect to Item 401 and Item 405 of Regulation S-K is incorporated by reference to the information included on NovaStar Financials
Proxy Statement dated March 18, 2004, for the Annual Meeting of Shareholders to be held at May 25, 2004 at 10:00 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 8401 Ward Parkway, Kansas City, Missouri 64114.



The Board of Directors has determined that Edward W. Mehrer
qualifies as an audit committee financial expert; as such term is defined in recently adopted rules of the Securities and Exchange Commission implementing requirements of the Sarbanes-Oxley Act of 2002.



Information with respect to our corporate governance guidelines, charters of
audit, compensation, nominating and corporate governance committees, and code of conduct may be obtained on our website (www.novastarmortgage.com) or by contacting us directly. The code of conduct applies to our principal executive officer,
principal financial officer, directors and other employees performing similar functions. A Form 8-K will be filed and a posting on our website will be made upon any amendment to or waiver from a provision of the code of conduct that applies to any
officer or director. Our investor relations contact information follows.



Investor Relations

8140 Ward Parkway, Suite 300

Kansas City, MO 64114

816.237.7000

Email: ir@novastar1.com



Item 11.Executive Compensation



Information with respect to Item 402 of Regulation S-K is incorporated by reference to the information included on NovaStar Financials Proxy Statement dated March 18, 2004, for the Annual Meeting of Shareholders to be held at May 25,
2004 at 10:00 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 8401 Ward Parkway, Kansas City, Missouri 64114.



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Item 12.Security Ownership of Certain Beneficial Owners and Management



Information with respect to Item 403 of Regulation S-K is incorporated by reference to the information included on NovaStar Financials Proxy
Statement dated March 18, 2004, for the Annual Meeting of Shareholders to be held at May 25, 2004 at 10:00 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 8401 Ward Parkway, Kansas City, Missouri 64114.



The following table sets forth information as of December 31, 2003 with
respect to compensation plans under which our common stock may be issued.



|                                                       |  |                                                                                  |     |  |                                                                        |      |                                                                                                                                  |        
|------------------------------------------------------ |  | -------------------------------------------------------------------------------- | --- |  | ---------------------------------------------------------------------- | ---- | -------------------------------------------------------------------------------------------------------------------------------- | -------
|Equity Compensation Plan Information                  
|Plan Category                                          |  | Number ofShares to beIssued UponExercise ofOutstandingOptions,Warrants andRights |     |  | Weighted AverageExercise Price ofOutstandingOptions,Warrants andRights |      | Number of SharesRemainingAvailable forFuture IssuanceUnder EquityCompensationPlans (ExcludingShares Reflectedin the
FirstColumn)
|Equity compensation plans approved by stockholders     |  | 746,800                                                                          | (A) |  | $                                                                      | 8.22 |                                                                                                                                  | 207,128
|Equity compensation plans not approved by stockholders |  |                                                                                 |     |  |                                                                        |     |                                                                                                                                  |       
|                                                       |  |                                                                                  |     |  |                                                                        |      |                                                                                                                                  |        
|Total                                                  |  | 746,800                                                                          |     |  | $                                                                      | 8.22 |                                                                                                                                  | 207,128
|                                                       |  |                                                                                  |     |  |                                                                        |      |                                                                                                                                  |        

---

|(A) | Certain of the options have dividend equivalent rights (DERs) attached to them when issued. As of December 31, 2003, these options have 90,522 DERs attached.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------



Item 13.Certain Relationships and Related Transactions.



Information with respect to Item 404 of Regulation S-K is incorporated by reference to the information included on NovaStar Financials Proxy
Statement dated March 18, 2004, for the Annual Meeting of Shareholders to be held at May 25, 2004 at 10:00 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 8401 Ward Parkway, Kansas City, Missouri 64114.



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 on NovaStar Financials Proxy
Statement dated March 18, 2004, for the Annual Meeting of Shareholders to be held at May 25, 2004 at 10:00 a.m., Central Daylight Time, at the NovaStar Financial, Inc. Corporate Offices, 8401 Ward Parkway, Kansas City, Missouri 64114.



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PART IV



Item 15.Exhibits, Financial Statement Schedules and Reports on Form 8-K



|(a) | 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.
| | --- | -------------------------------------------------------------------------------------------------------------



|(b) | Reports on Form 8-K
|--- | -------------------



NovaStar Financial, Inc. filed the following Form 8-Ks during the fourth quarter of 2003.



| | (1) | Press Release, dated October 29, 2003 Novastar Announces Third Quarter Earnings Per Share of $2.11, a Two for One Stock Split and Dividend of $2.50. Current report on
Form 8-K was filed on October 30, 2003.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (2) | Underwriting Agreement dated November 6, 2003, by and among NovaStar Financial, Inc., JMP Securities LLC and Flagstone Securities, LLC. Opinion of Tobin & Tobin, dated November
13, 2003, as to legal matters in connection with the Common Stock Offering. Opinion of Falk, Shaff & Ziebell, LLP, dated November 13, 2003, as to federal income tax matter in connection with the Common Stock Offering. Underwriting Agreement
dated May 7, 2003, by and among NovaStar Financial, Inc., JMP Securities LLC and Flagstone Securities, LLC (the May Underwriting Agreement, with the Opinion of Tobin & Tobin, dated May 13, 2003, as to legal matters, and the Opinion
of Falk, Shaff & Ziebell, LLP, dated May 13, 2003, as to federal income tax matters, as required pursuant to the May Underwriting Agreement. Current report on Form 8-K was filed on November 13, 2003.
| | --- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (3) | Press Release, dated December 17, 2003 Novastar Announces Dividend and Adoption of New Dividend Policy and SFAS No. 123 for Stock Compensation. Current report on Form
8-K was filed on December 19, 2003.
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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|(c) | Exhibit Listing
|--- | ---------------



|            |  |                                                                                                                                                                                                                                                                          
|----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Document                                                                                                                                                                                                                                                  
|3.1*        |  | Articles of Amendment and Restatement of the Registrant                                                                                                                                                                                                                  
|            | 
|3.3*        |  | Bylaws of the Registrant                                                                                                                                                                                                                                                 
|            | 
|3.3a*****   |  | Amendment to Bylaws of the Registrant, adopted February 2, 2000                                                                                                                                                                                                          
|            | 
|3.4****     |  | Articles Supplementary of NovaStar Financial, Inc. dated as of March 24, 1999, as filed with the Maryland Department of Assessment and Taxation.                                                                                                                         
|            | 
|4.1*        |  | Specimen Common Stock Certificate                                                                                                                                                                                                                                        
|            | 
|4.3****     |  | Specimen certificate for Preferred Stock                                                                                                                                                                                                                                 
|            | 
|10.6*       |  | Form of Master Repurchase Agreement for mortgage loan financing                                                                                                                                                                                                          
|            | 
|10.7*       |  | Mortgage Loan Warehousing Agreement dated as of November 24, 1997 between First Union National Bank of North Carolina, NovaStar Mortgage, Inc. and the Registrant.                                                                                                       
|            | 
|10.14*      |  | 1996 Executive and Non-Employee Director Stock Option Plan, as last amended December 6, 1996.                                                                                                                                                                            
|            | 
|10.23***    |  | Warrant Agreement dated as of February 12, 1999 between the Registrant and First Union National Bank.                                                                                                                                                                    
|            | 
|10.24****   |  | Warrant Agreement, dated as of March 10, 1999, by and between NovaStar Financial, Inc. and Residential Funding Corporation, and related Guaranty Warrant, Tag Along Warrant and Registration
Rights Agreement as filed with April 6, 1999 8-K of NovaStar Financial, Inc.
|            | 
|11.1******  |  | Statement regarding computation of per share earnings                                                                                                                                                                                                                    
|            | 
|21.1        |  | Subsidiaries of the Registrant                                                                                                                                                                                                                                           
|            | 
|23.1        |  | Consents of Deloitte & Touche LLP                                                                                                                                                                                                                                        
|            | 
|31.1        |  | Chief Executive Officer CertificationSection 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                      
|            | 
|31.2        |  | Principal Financial Officer CertificationSection 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                  
|            | 
|32.1        |  | Chief Executive Officer CertificationSection 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                      
|            | 
|32.2        |  | Principal Financial Officer CertificationSection 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                  

---

|   |  |                                                                                                                                                                                            
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|*  |  | Incorporated by reference to the correspondingly numbered exhibit to the Registration Statement on Form S-11 (373-32327) filed by the Registrant with the SEC on July 29, 1997, as
amended.
|   | 
|** |  | Incorporated by reference to the correspondingly numbered exhibit to Form 8-K filed by the Registrant with the SEC on December 22, 1998.                                                   





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|       |  |                                                                                                                                                            
|------ |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------
|***    |  | Incorporated by reference to the correspondingly numbered exhibit to Form 8-K filed by the Registrant with the SEC on February 23, 1999.                   
|       | 
|****   |  | Incorporated by reference to the correspondingly numbered exhibit to Form 8-K filed by the Registrant with the SEC on April 5, 1999.                       
|       | 
|*****  |  | Incorporated by reference to the correspondingly numbered exhibit to the Annual Report on Form 10-K filed by the Registrant with the SEC on March 20, 2000.
|       | 
|****** |  | See Note 17 to the consolidated financial statements.                                                                                                      



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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: March 5, 2004 |  |  |  | By: |  | /s/    SCOTT F. HARTMAN                                                                
|                    |  |  |  |     |  |                                                                                        
|                    |  |  |  |     |  | Scott F. Hartman, Chairman of the Board of Directors and Chief Executive Officer       
|                    |  |  | 
|Date: March 5, 2004 |  |  |  | By: |  | /s/    W. LANCE ANDERSON                                                               
|                    |  |  |  |     |  |                                                                                        
|                    |  |  |  |     |  | W. Lance Anderson, President, Chief Operating Officer and Director                     
|                    |  |  | 
|Date: March 5, 2004 |  |  |  | By: |  | /s/    RODNEY E. SCHWATKEN                                                             
|                    |  |  |  |     |  |                                                                                        
|                    |  |  |  |     |  | Rodney E. Schwatken, Vice President, Secretary and Treasurer (Chief Accounting Officer)
|                    |  |  | 
|Date: March 5, 2004 |  |  |  | By: |  | /s/    EDWARD W. MEHRER                                                                
|                    |  |  |  |     |  |                                                                                        
|                    |  |  |  |     |  | Edward W. Mehrer, Director                                                             
|                    |  |  | 
|Date: March 5, 2004 |  |  |  | By: |  | /s/    GREGORY T. BARMORE                                                              
|                    |  |  |  |     |  |                                                                                        
|                    |  |  |  |     |  | Gregory T. Barmore, Director                                                           
|                    |  |  | 
|Date: March 5, 2004 |  |  |  | By: |  | /s/    ART N. BURTSCHER                                                                
|                    |  |  |  |     |  |                                                                                        
|                    |  |  |  |     |  | Art N. Burtscher, Director                                                             



73