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UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
____________________ FORM 10-K




x
            
            ANNUAL REPORT PURSUANT TO SECTION
      13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934For the Fiscal Year Ended December
      31, 2009o
            
            TRANSITION REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF
    1934


For the Transition Period From
___________ to ________________________________




Commission File Number
001-13533




NOVASTAR FINANCIAL,
INC. (Exact Name
of Registrant as Specified in its Charter)




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


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


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




Securities Registered Pursuant to Section
12(b) of the Act:None




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




Title of Each ClassCommon
Stock, $0.01 par valueRedeemable Preferred Stock




Indicate by check
mark if the registrant is a well-known seasoned issuer, as defined by Rule 405
of the Securities Act. Yes o No x




Indicate by check
mark if the registrant is not required to file reports pursuant to Section 13 or
Section 15(d) of the Act. Yes o No x




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 o




Indicate by check
mark whether the registrant has submitted electronically and posted on its
corporate Web site, if any, every Interactive Data File required to be submitted
and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter)
during the preceding 12 months (or for such shorter period that the registrant
was required to submit and post such files). Yes o No o




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




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




Large accelerated filer
      o
            Accelerated filer o
            Non-accelerated filer o
            Smaller reporting company x


Indicate by check
mark whether the registrant is a shell company (as defined in Exchange Act Rule
12b-2). Yes o No x




The aggregate
market value of voting and non-voting stock held by non-affiliates of the
registrant as of June 30, 2009 was approximately $11,309,000, based upon the
closing sales price of the registrant’s common stock as reported on the OTC
Bulletin Board and on the Pink Sheets on such date.




The number of
      shares of the Registrant’s Common Stock outstanding on March 31, 2010 was
      9,368,053.





Documents Incorporated by
Reference




Items 10, 11,
12, 13 and 14 of Part III are incorporated by reference to the NovaStar
Financial, Inc. definitive proxy statement to shareholders, which will be filed
with the Commission no later than 120 days after December 31, 2009.




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NOVASTAR FINANCIAL,
      INC.FORM 10-KFor the Fiscal Year Ended December
      31, 2009


TABLE OF CONTENTSPart IItem 1.
            
            Business
            2Item 1A.
            
            Risk Factors
            3Item 1B.
            
            Unresolved Staff Comments
            10Item 2.
            
            Properties
            10Item 3.
            
            Legal Proceedings
            10Item 4.
            
            Removed and Reserved
            12Part IIItem 5.
            
            Market For Registrant’s Common Equity,
      Related Stockholder Matters and IssuerPurchases of Equity Securities
            12Item 6.
            
            Selected Financial Data
            12Item 7.
            
            Management’s Discussion and Analysis of
      Financial Condition and Results of Operations
            13Item 7A.
            
            Quantitative and Qualitative Disclosures
      About Market Risk
            30Item 8.
            
            Financial Statements and Supplementary
      Data
            31Item 9.
            
            Changes in and Disagreements With
      Accountants on Accounting and Financial Disclosure
            65Item 9A.
            
            Controls and Procedures
            65Item 9B.
            
            Other Information
            67Part IIIItem 10.
            
            Directors, Executive Officers and
      Corporate Governance
            67Item 11.
            
            Executive Compensation
            67Item 12.
            
            Security Ownership of Certain Beneficial
      Owners and Management and RelatedStockholder Matters
            68Item 13.
            
            Certain Relationships and Related
      Transactions, and Director Independence
            68Item 14.
            
            Principal Accounting Fees and
      Services
            68Part IVItem 15.
            
            Exhibits, Financial Statement
      Schedules
            69


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Part I




Safe Harbor Statement




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




Item 1. Business




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




During 2008, we
purchased a 75% interest in StreetLinks National Appraisal Services LLC
(“StreetLinks”), a residential appraisal management company. The Company has
contributed additional capital to StreetLinks subsequent to our initial
acquisition, bringing the Company’s total ownership to 88%. StreetLinks collects
a fee for appraisal services from lenders and borrowers and passes through most
of the fee to an independent residential appraiser. StreetLinks retains a
portion of the fee to cover its costs of managing the process of fulfilling the
appraisal order and performing a quality control review of each appraisal. We
are developing the business and have established goals for it to become a
positive cash and earnings contributor. Development of the business is occurring
through increased appraisal order volume as we add new lending
customers.




During 2009, we
acquired a 70% interest in Advent Financial Services LLC (“Advent”), a start up
operation which provides access to tailored banking accounts, small dollar
banking products and related services to meet the needs of low and moderate
income level individuals. Advent began its operations in December 2009. Through
this start-up period, management is evaluating the Advent business model to
determine its long-term viability.




Management is
continuing to evaluate opportunities to invest excess cash as it is available.




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




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




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




2




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




Our consolidated
financial statements have been prepared on a going concern basis of accounting
which contemplates continuity of operations, realization of assets, liabilities
and commitments in the normal course of business. The Company has experienced
significant losses over the past several years and has a significant deficit in
stockholders’ equity. Notwithstanding these negative factors, management
believes that its current operations and its cash availability is sufficient for
the Company to discharge its liabilities and meet its commitments in the normal
course of business. Our current liquidity and the impact thereon of recent
operations is discussed in the Liquidity section of Item 7. Management’s
Discussion and Analysis of Financial Condition and Results of Operations.




Personnel




As of December 31,
2009, we employed 240 people in total between NFI, StreetLinks, and Advent. None
of our employees are represented by a union or covered by a collective
bargaining agreement.




Available Information




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




Investor
Relations2114 Central StreetSuite 600Kansas City, MO
64108816.237.7424 Email: ir@novastarfinancial.com




You may read and
copy any materials that we file with the SEC at the SEC’s Public Reference Room
at 100 F Street, NE, Room 1580, Washington, DC 20549. You may obtain information
on the operation of the Public Reference Room by calling the SEC at
1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy
and information statements, and other information regarding issuers that file
electronically with the SEC at www.sec.gov. Information on our website is not
incorporated by reference into this report and does not otherwise form a part of
this report.




Item 1A. Risk Factors




Risk Factors




You should carefully consider the risks
described below in evaluating our business and before investing in our publicly
traded securities. Any of the risks we describe below or elsewhere in this
report could negatively affect our results of operations, financial condition,
liquidity and business prospects. The risks described below are not the only
ones facing us. Our business is also subject to the risks that affect many other
companies, such as competition, inflation, general economic conditions and
geopolitical events.




Risks Related to our Business




Payment on our mortgage securities will
continue to decrease as underlying mortgage loans are repaid and if the mortgage
loans underlying our residual and subordinated securities continue to experience
significant credit losses, which will reduce our cash flows, perhaps abruptly,
and adversely affect our liquidity.




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




3




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




Our cash flows from
mortgage securities are likely to be insufficient to cover our existing expenses
in the near future.




As payments on our mortgage securities
continue to decrease we will become more dependent on the operations and cash
flows of our subsidiaries to meet our obligations.




Our principal
assets are our equity interests in our operating subsidiaries, approximately
$7.1 million in cash and cash equivalents, and $5.3 million in restricted cash.
The cash flows from our mortgage securities have materially decreased and will
continue to decrease as the underlying mortgage loans are repaid. As this
occurs, we will become more dependent on cash flows generated by Streetlinks and
Advent, and will rely on distributions and other payments from StreetLinks and
Advent and any new operations we may establish or acquire, to pay our operating
expenses and meet our other obligations. If our subsidiaries are unable to make
distributions or other payments to us, our ability to meet our obligations will
be materially and adversely affected. Payments to us by our subsidiaries, in
turn, depends upon their results of operations and cash flows.




Our ability to profitably manage, operate
and grow operations is critical to our ability to pay our operating expenses and
meet our other obligations and is subject to significant uncertainties and
limitations. If we attempt to make any acquisitions, we will incur a variety of
costs and may never realize the anticipated benefits.




In light of the
current state of declining cash flows from our mortgage securities, our ability
to pay our operating expenses and meet our other obligations is dependent upon
our ability to successfully operate and grow operations such that they generate
positive cash flow. Our ability to start or acquire new businesses is
significantly constrained by our limited liquidity and our likely inability to
obtain debt financing or to issue equity securities as a result of our current
financial condition, including a shareholders’ deficit, as well as other
uncertainties and risks. There can be no assurances that we will be able to
successfully operate and grow operations or establish or acquire new business
operations.




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




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




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




Attempts to renegotiate and/or
restructure the components of our equity in order to realign the capital
structure with our current business model may be unsuccessful.




We expect to
attempt to renegotiate and/or restructure the components of our equity in order
to realign the capital structure with our current business model. In the event
we are unsuccessful, we may not be able to pay the accumulated dividends on our
preferred stock or redeem such stock.




4




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Renegotiating and/or restructuring our
equity may involve the issuance of a substantial number of shares of our common
stock.





To successfully
renegotiate and/or restructure our equity we may have to issue a substantial
number of shares our common stock. Such an issuance will dilute our existing
common stockholders and may depress the market value and price of our common
stock. We cannot predict the price at which our common stock would trade
following such an issuance.




Various legal proceedings could adversely
affect our financial condition, our results of operations and liquidity.




In the course of
our business, we are subject to various legal proceedings and claims. See Item
3. Legal Proceedings. In addition, we have become subject to various securities
and derivative lawsuits, and we may continue to be subject to additional
litigation, in some cases on the basis of novel legal theories. The resolution
of these legal matters or other legal matters could result in a material adverse
impact on our results of operations, liquidity and financial
condition.




Risks Related to Our Operating
Subsidiaries




A prolonged decline in the number of home
sales and the originations and refinancings of home loans would decrease
appraisal order volume and adversely affect the revenues and profitability of
Streetlinks.




Streetlinks, our
residential appraisal management company, retains a portion of the fee for
appraisal services collected from lenders and borrowers for an independent
residential appraisal to cover its costs of managing the process of fulfilling
the appraisal order. A prolonged decline in the number of home sales and the
originations and refinancings of home loans would cause a decrease in the demand
for appraisals. The decreased demand for appraisals would have an adversely
affect the revenues and profitability of Streetlinks.




Streetlinks may be unable to maintain its
relationships with its existing lending customers and may be unable to add new
lending customers which would decrease appraisal order volume and adversely
affect the revenues and profitability of Streetlinks.




Streetlinks has
increased its appraisal order volume by adding lending customers and intends to
further develop its business through the addition of new lending customers.
There is no assurance that Streetlinks will be able to maintain the
relationships with its existing lending customers or add new lending customers
which would decrease appraisal order volume and adversely affect the revenues
and profitability of Streetlinks.




Government agencies and regulatory
authorities may change or eliminate current restrictions and requirements for
appraisals.




Streetlinks’
appraisal order volume has increased, in part, as a result of increased
restrictions and requirements for appraisals established by government agencies
and regulatory authorities such as the Federal Housing Finance Agency and the
United States Department of Housing and Urban Development that, among other
things, require appraiser independence. Changes in or elimination of these
restrictions and requirements could adversely affect the demand for StreetLinks’
services and the viability of its business model.




Advent may be unable to develop systems
and a network of business partners to successfully distribute its products and
services.




The success of
Advent, our start up operation which will provide access to tailored banking
accounts, small dollar banking products and related services to meet the needs
of low and moderate income level individuals, will in large part depend on its
ability to develop systems and a network of business partners for the
distribution of its products services. To the extent Advent is unable to develop
systems and a network of business partners to successfully distribute Advent’s
products and services, it will have an adverse effect on Advent’s business,
financial condition and results of operations.




Advent’s ability to distribute its
financial products is, to some extent, dependent on the success of its business
partners.




Advent anticipates
distributing its financial products through business partners such as tax
preparation offices and is to some extent dependent on the success of these
business partners. To the extent there is a decrease in the demand for the
products or services of Advent’s business partners, there may be a decrease in
demand for Advent’s products and services, which would have an adverse effect on
Advent’s business, financial condition and results of operations.




Federal and state legislators and
regulators have increasingly taken an active role in regulating financial
products of the type Advent anticipates offering, and the continuation of this
trend could impede or prevent Advent’s ability to facilitate these financial
products and harm its business.




From time to time,
government officials at the federal and state levels introduce and enact
legislation and regulations proposing to regulate or prevent the facilitation of
financial products. Certain of the proposed legislation and regulations could,
if adopted, increase costs to Advent and its business partners that provide its
financial products, or could negatively impact or eliminate the ability of
Advent to provide financial products through Advent’s business partners such as
tax return preparation offices, which could have an adverse effect on Advent’s
business, financial condition and results of operations.




Many states have
statutes regulating, through licensing and other requirements, the activities of
brokering loans and providing credit repair services to consumers as well as
payday loan laws and local usury laws. Certain state regulators are interpreting
these laws in a manner that could adversely affect the manner in which financial
products are facilitated or
permitted. If Advent is required to change business practices or otherwise
comply with these statutes it could have a material adverse effect on its
business, financial condition and results of operations.




5




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Legal proceedings against our operating
subsidiaries could adversely affect their business, financial condition and
results of operations.




In the course of
their business, our operating subsidiaries may become subject to legal
proceedings and claims and could experience significant losses as a result of
litigation defense and resolution costs which would have an adverse effect on
their business, financial condition and results of operations.




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




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




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




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




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




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




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




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




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




6




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




Nonconforming
mortgage borrowers have impaired or limited credit histories, limited
documentation of income and higher debt-to-income ratios than traditional
mortgage lenders allow. Mortgage loans made to nonconforming mortgage loan
borrowers generally entail a higher risk of delinquency and foreclosure than
mortgage loans made to borrowers with better credit and, therefore, will result
in higher levels of realized losses than conventional loans. General economic
slowdowns, such as that currently affecting the United States, are likely to
adversely affect nonconforming borrowers to a greater extent than conforming
borrowers and, consequently, are likely to have a greater negative impact on
delinquency and loss rates with respect to nonconforming loans.




Risks Related to Our Discontinued
Operations




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




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




Risks Related to Interest
Rates




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




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


- interest rate fluctuations
  may harm our cash flow as the spread between the interest rates we pay on our
  borrowings and hedges and the interest rates we receive on our mortgage assets
  narrows;
- the value of our residual and
  subordinated securities and the income we receive from them are based
  primarily on LIBOR, and an increase in LIBOR increases funding costs which
  reduces the cash flow we receive from, and the value of, these
  securities;
- existing borrowers with
  adjustable-rate mortgages or higher risk loan products may incur higher
  monthly payments as the interest rate increases, and consequently may
  experience higher delinquency and default rates, resulting in decreased cash
  flows from, and decreased value of, our mortgage securities; and
- mortgage prepayment rates
  vary depending on such factors as mortgage interest rates and market
  conditions, and changes in prepayment rates may harm our earnings and the
  value of our mortgage securities.

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




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




7




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Risks Related to our Capital Stock




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




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




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




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




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




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




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


- actual or perceived changes
  in our ability to continue as a going concern;
- actual or anticipated changes
  in the delinquency and default rates on mortgage loans, in general, and
  specifically on the loans we invest in through our mortgage securities;
- actual or anticipated changes
  in residential real estate values;
- actual or anticipated changes
  in market interest rates;
- actual or anticipated changes
  in our earnings and cash flow;
- general market and economic
  conditions, including the operations and stock performance of other industry
  participants;
- developments in the subprime
  mortgage lending industry or the financial services sector generally;
- the impact of new state or
  federal legislation or adverse court decisions;
- the activities of investors
  who engage in short sales of our common stock;
- actual or anticipated changes
  in financial estimates by securities analysts;
- sales, or the perception that
  sales could occur, of a substantial number of shares of our common stock by
  insiders;
- additions or departures of
  senior management and key personnel; and
- actions by institutional
  shareholders.

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




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


- authorize the issuance of
  additional shares of common stock or preferred stock without shareholder
  approval, including the issuance of shares of preferred stock that have
  preference rights over the common stock with respect to dividends,
  liquidation, voting and other matters or shares of common stock that have
  preference rights over our outstanding common stock with respect to voting;
- classify or reclassify any
  unissued shares of common stock or preferred stock and to set the preferences,
  rights and other terms of the classified or reclassified shares; and
- issue additional shares of
  common stock or preferred stock in exchange for outstanding securities, with
  the consent of the holders of those securities.

8




---



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




Other Risks Related to our Business




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




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




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




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




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




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




Changes in accounting standards,
subjective assumptions and estimates used by management related to complex
accounting matters could have an adverse effect on results of operations.




Generally accepted
accounting principles in the United States and related accounting
pronouncements, implementation guidance and interpretations with regard to a
wide range of matters, such as stock-based compensation, asset impairment,
valuation reserves, income taxes and fair value accounting, are highly complex
and involve many subjective assumptions, estimates and judgments by management.
Changes in these rules or their interpretations or changes in underlying
assumptions, estimates or judgments by management could significantly change our
reported results.




9




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Item 1B. Unresolved Staff
Comments





None




Item 2. Properties




The executive and
administrative offices for NFI are located in Kansas City, Missouri, and consist
of approximately 12,142 square feet of leased office space. The lease agreements
on the premises expire in October 2013. The current annual rent for these
offices is approximately $0.2 million.




As of December 31,
2009, StreetLinks leases approximately 33,692 square feet of office space in
Indianapolis, Indiana. The lease agreements on the premises expire in February
2014. The current annual rent for these offices is approximately $0.4 million.




We are leasing
office space in various other states which were used for operations which were
discontinued in 2007 and 2008. The leases on these premises expire from June
2010 through May 2012, and the current gross annual rent on those premises not
terminated as of March 30, 2010 is approximately $0.8 million, although the
majority of this space has been subleased which reduces our costs significantly.




Item 3. Legal
Proceedings




At this time, the Company does
not believe that an adverse ruling against the Company is probable for the
following claims and as such no amounts have been accrued in the consolidated
financial statements.




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




On January 31,
2008, two purported shareholders filed separate derivative actions in the
Circuit Court of Jackson County, Missouri against various former and current
officers and directors and named the Company as a nominal defendant. The
essentially identical petitions seek monetary damages alleging that the
individual defendants breached fiduciary duties owed to the Company, alleging
insider selling and misappropriation of information, abuse of control, gross
mismanagement, waste of corporate assets, and unjust enrichment between May 2006
and December 2007. On June 24, 2008 a third, similar case was filed in United
States District Court for the Western District of Missouri. On July 13, 2009 the
Company filed a motion to dismiss the plaintiff’s claims. On November 24, 2009
the Company reached a settlement with the plaintiffs which provided for certain
corporate governance changes and a payment of $300,000 for attorney fees, the
payment being covered by insurance. A hearing for Court approval of the
settlement is set for April 5, 2010.




On May 21, 2008, a
purported class action case was filed in the Supreme Court of the State of New
York, New York County, by the New Jersey Carpenters' Health Fund, on behalf of
itself and all others similarly situated. Defendants in the case include
NovaStar Mortgage Funding Corporation and its individual directors, several
securitization trusts sponsored by the Company, and several unaffiliated
investment banks and credit rating agencies. The case was removed to the United
States District Court for the Southern District of New York. On June 16, 2009,
the plaintiff filed an amended complaint. Plaintiff seeks monetary damages,
alleging that the defendants violated sections 11, 12 and 15 of the Securities
Act of 1933 by making allegedly false statements regarding mortgage loans that
served as collateral for securities purchased by plaintiff and the purported
class members. On August 31, 2009 the Company filed a motion to dismiss the
plaintiff’s claims. The Company believes it has meritorious defenses to the case
and expects to defend the case vigorously.




On July 7, 2008,
plaintiff Jennifer Jones filed a purported class action case in the United
States District Court for the Western District of Missouri against the Company,
certain former and current officers of the Company, and unnamed members of the
Company's "Retirement Committee". Plaintiff, a former employee of the Company,
seeks class action certification on behalf of all persons who were participants
in or beneficiaries of the Company's 401(k) plan from May 4, 2006 until November
15, 2007 and whose accounts included investments in the Company's common stock.
Plaintiff seeks monetary damages alleging that the Company's common stock was an
inappropriately risky investment option for retirement savings, and that
defendants breached their fiduciary duties by allowing investment of some of the
assets contained in the 401(k) plan to be made in the Company's common stock. On
November 12, 2008, the Company filed a motion to dismiss which was denied by the
Court on February 11, 2009. On April 6, 2009 the Court granted the plaintiff’s
motion for class certification. The Company sought permission from the 8thCircuit Court of Appeals to appeal the
order granting class certification. On May 11, 2009 the Court of Appeals granted
the Company permission to appeal the class certification order. On November 9,
2009 the Company reached a settlement with the plaintiffs. The settlement
provides for payment by the Company’s insurer of $925,000. A hearing for Court
approval of the settlement is set for April 22, 2010.




10




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On December 31,
2009, ITS Financial, LLC (“ITS”) filed a complaint against Advent and the
Company alleging breach of a contract with Advent for services related to tax
refund anticipation loans and early season loans. ITS does business as Instant
Tax Service. The defendants removed the case to the United States District Court
for the Southern District of Ohio. The complaint alleges that the Company worked
in tandem and as one entity with Advent in all material respects. The complaint
also alleges fraud in the inducement, tortious interference by the Company with
the contract, breach of good faith and fair dealing, fraudulent and negligent
misrepresentation, and liability of the Company by piercing the corporate veil
and joint and several liability, The plaintiff references a $3 million loan made
by the Company to plaintiff and seeks a judgment declaring that this loan be
subject to an offset by the plaintiff’s damages. The litigation is currently
stayed pending resolution of the Company’s motion to
transfer the case to the United States District Court for the Western District
of Missouri. The Company believes that the defendants have meritorious defenses
to this case and expects to defend the case vigorously.




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




11




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Item 4. Removed and
Reserved




PART II




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




Market Price of and Dividends on the
Registrant’s Common Equity and Related Stockholder
Matters . Our common stock
was traded on the NYSE under the symbol “NFI” through January 17, 2008. Our
common stock was delisted from the NYSE on January 17, 2008 and is currently
quoted on the OTC Bulletin Board and on the Pink Sheets under the symbol
“NOVS.PK”. The following table sets forth the high and low sales prices per
share of common stock on the NYSE and the high and low bid prices as reported by
the OTC Bulletin Board and the Pink Sheets, as applicable, for the periods
indicated, and the cash dividends paid or payable per share of common
stock.




DividendsHigh
            
            Low
            
            Date Declared
            
            Date Paid
            
            Amount Per
Share2008First Quarter
            
            $
            3.44
            
            $
            1.10
            
            N/A
            
            N/A
            
            N/ASecond Quarter
            
            
            2.03
            
            
            1.00
            
            N/A
            
            N/A
            
            N/AThird Quarter
            
            
            1.99
            
            
            0.28
            
            N/A
            
            N/A
            
            N/AFourth Quarter
            
            
            1.01
            
            
            0.22
            
            N/A
            
            N/A
            
            N/A2009First Quarter
            
            $
            0.65
            
            $
            0.20
            
            N/A
            
            N/A
            
            N/ASecond Quarter
            
            
            1.74
            
            
            0.55
            
            N/A
            
            N/A
            
            N/AThird Quarter
            
            
            1.35
            
            
            0.75
            
            N/A
            
            N/A
            
            N/AFourth Quarter
            
            
            1.28
            
            
            0.81
            
            N/A
            
            N/A
            
            N/A


As of March 26,
2010, we had approximately 797 shareholders of record of our common stock,
including holders who are nominees for an undetermined number of beneficial
owners based upon a review of the securities position listing provided by our
transfer agent.




Dividend
distributions will be made at the discretion of the Board of Directors and will
depend on earnings, financial condition, cost of equity, investment
opportunities and other factors as the Board of Directors may deem relevant. In
addition, accrued and unpaid dividends on our preferred stock must be paid prior
to the declaration of any dividends on our common stock. We do not expect to
declare any stock dividend distributions in the near future.




Purchase of Equity Securities by
      the IssuerIssuer Purchases of Equity
      Securities(dollars in
    thousands)Total Number ofShares
            
            Approximate
  DollarPurchased as
            
            Value of Shares
    thatTotal
            
            
            
            Part of Publicly
            
            May Yet BeNumber of
            
            Average
            
            Announced
            
            Purchased Under
  theShares
            
            Price Paid
            
            Plans or
            
            Plans or
  ProgramsPurchased
            
            per Share
            
            Programs
            
            (A)October 1, 2009 – October 31,
      2009
            
            -
            
            -
            
            -
            
            $
            1,020November 1, 2009 – November 30, 2009
            
            -
            
            -
            
            -
            
            
            1,020December 1, 2009 – December 31,
      2009
            
            -
            
            -
            
            -
            
            
            1,020


(A)
            
            A
      current report on Form 8-K was filed on October 2, 2000 announcing that
      the Board of Directors authorized the Company to repurchase its common
      shares, bringing the total authorization to $9
  million.





Item 6. Selected Financial
Data




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




12




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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 our consolidated financial statements and the notes thereto
included elsewhere in this report.




Executive Overview




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




Because of severe
declines in housing prices and national and international economic crises, we
have suffered significant losses during 2008 and 2009 because of declining
values of our investments in mortgage loans and securities.




During 2008 and
2009, management continued its focus on reducing operating cash uses, clearing
follow-on matters arising from our legacy lending and servicing operations and
evaluating investment opportunities. Management made a step in the rebuilding
process by investing in StreetLinks National Appraisal Services LLC
(“StreetLinks”). StreetLinks is a national residential appraisal management
company. A fee for appraisal services is collected from lenders and borrowers
and most of the fee is passed through to an independent residential appraiser.
StreetLinks retains a portion of the fee to cover its costs of managing the
process of fulfilling the appraisal order and performing a quality control
review of all appraisals. Management believes that StreetLinks is situated to
take advantage of growth opportunities in the residential appraisal management
business. We are growing StreetLinks customer base and have established goals
for it to become a positive cash and earnings contributor commencing in the
first quarter of fiscal 2010. Development of the business continues through
increased appraisal order volume as we add new lending customers.




During 2009, the
Company invested in Advent Financial Services LLC (“Advent”), a start up
operation which provides access to tailored banking accounts, small dollar
banking products and related services to meet the needs of low and moderate
income level individuals. Advent began its operations beginning in December
2009. Through this start-up period, management is evaluating the Advent business
model to determine its long-term viability and does not anticipate that Advent
will be a significant use or source of cash in fiscal 2010.




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




The key performance
measures for executive management are:


- maintenance of adequate liquidity
  to sustain us and allow us to take advantage of investment opportunity, and
- generating income for our
  shareholders.

The following
selected key performance metrics are derived from our consolidated financial
statements for the periods presented and should be read in conjunction with the
more detailed information therein and with the disclosure included elsewhere in
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations.” Management’s discussion and analysis of financial condition and
results of operations, along with other portions of this report, are designed to
provide information regarding our performance and these key performance
measures.




Table 1 — Summary of Financial
      Highlights and Key Performance Metrics(dollars in thousands; except per
      share amounts)December 31,2009
            
            2008Cash and cash equivalents,
      including restricted cash
            $
            12,446
            
            
            $
            30,836Net loss available to common shareholders, per diluted
    share
            
            (20.97
            )
            
            
            (72.37
            )


Liquidity – During 2009 the Company continued its
strategy of developing StreetLinks and significantly increased its appraisal
volume. For the year ended December 31, 2009, StreetLinks had revenues of $31.1
million, as compared to $2.5 million in 2008. StreetLinks incurred significant
start-up expenses to develop its infrastructure in 2009, which are not expected
to recur. As a result, management expects StreetLinks to produce positive net
cash and earnings commencing in the first quarter of fiscal 2010. During 2009,
we received $18.5 million in cash on our securities portfolio, however, we
anticipate that the amount of cash received in fiscal 2010 will be significantly
less than the amount received in fiscal 2009.




13




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During 2009, we
used significant amounts of cash to pay for costs related to our legacy mortgage
lending and servicing operations, pay for current administrative costs and
invest in StreetLinks and Advent. We intend to continue to invest in Advent in
2010 while we evaluate its business model, however we will limit the negative
impact on liquidity and do not believe that Advent will be a significant use or
source of cash during 2010.




As of March 30,
2010, we have $15.5 million in cash and cash equivalents (including $1.8 million
of restricted cash).




As part of our
near-term future strategy, we will focus on growing StreetLinks customer base,
minimizing operating costs and expenses, and preserving liquidity. StreetLinks
and our mortgage securities are our primary source of cash flows. The cash flows
from our mortgage securities will continue to decrease as the underlying
mortgage loans are repaid and could be significantly less than the current
projections if losses on the underlying mortgage loans exceed the current
assumptions. Our liquidity consists solely of cash and cash equivalents.




Our consolidated
financial statements have been prepared on a going concern basis of accounting
which contemplates continuity of operations, realization of assets, liabilities
and commitments in the normal course of business. The Company has experienced
significant losses over the past several years and has a significant deficit in
stockholders’ equity. Notwithstanding these negative factors, management
believes that its current operations and its cash availability is sufficient for
the Company to discharge its liabilities and meet its commitments in the normal
course of business. See “Liquidity and Capital Resources” for further discussion
of our liquidity position and steps we have taken to preserve liquidity
levels.




Impact of Consolidation of Securitized
Mortgage Assets on Our Financial Statements




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




As discussed in
Note 20 to our consolidated financial statements, events occurred during January
2010 that resulted in a reevaluation of the accounting for the securitized
mortgage loans – held-in-portfolio and related assets and liabilities of the
securitization trusts. Based on our analysis, we have deconsolidated the assets
and liabilities of the trusts that own these loans in January 2010, see Table 10
for principal assets and liabilities of securitization trusts as of December 31,
2009.




Financial Condition as of December 31,
2009 as Compared to December 31, 2008




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




Restricted Cash. Certain states
required that we post surety bonds in connection with our former mortgage
lending operations. During 2007, the sureties required that we provide letters
of credit to support our reimbursement obligations to the sureties. In order to
arrange these letters of credit, we were required to collateralize the letters
of credit with cash. During the first quarter of 2008, we terminated the surety
bonds when we surrendered state lending licenses as a result of the
discontinuation of our mortgage lending operations. The sureties returned a
portion of the cash collateral during 2009 ($2.0 million) and 2008 ($3.0
million), but continue to hold $3.8 million as of December 31, 2009 as
collateral against any claims that may be brought during the tail period. The
sureties returned $2.9 million of this amount subsequent to December 31, 2009.
The timing of the return of the remaining cash is at the discretion of the
sureties and is dependent upon their interpretation of the tail period for
filing claims under the various state licensing regulations. No claims have been
made against the surety bonds and none are expected to be brought, especially
considering the significant amount of time that has elapsed since the bonds were
cancelled and since we last originated any mortgage loans. Management expects
the cash to be fully returned. However, the timing for return is unknown.




One of Advent’s
counterparties requires that we set up a restricted account in order to cover
certain operating expenses to be incurred during the first quarter of 2010. As
of December 31, 2009, the Company had approximately $1.0 million in the
restricted cash account, $0.9 million was returned in January of
2010.




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




14




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The mortgage loans
– held-in-portfolio balance has declined as their value has decreased
significantly. The value is dependent largely in part on their credit quality
and performance. The credit quality of the portfolio continues to worsen and
delinquencies have increased dramatically during the past two years. Therefore,
we continue to increase the allowance for losses as a percentage of loan
principal of those remaining in the portfolio. The allowance has decreased from
$776.0 million as of December 31, 2008 to $712.6 million as of December 31, 2009
due to the principal balance declining by a greater amount which was mainly due
to borrower repayments and foreclosures. During 2009 and 2008, respectively, the
trusts received repayments of the mortgage loans totaling $98.9 million and
$288.2 million. These balances will continue to decline either through normal
borrower repayments or through continued devaluation as delinquencies,
foreclosures and losses occur.




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




Mortgage Securities – Trading and
Available-for-Sale. The securities we own are generally securities we retained after the
securitization of mortgage loans we originated prior to 2008. For all loan
securitizations, we retained the residual interest bond, which means we receive
the net of the principal and interest received on the underlying loans within
the securitized trust less the principal and interest paid on the bonds issued
by the trust, mortgage insurance premiums, servicing fees and other
miscellaneous fees. For any loans that incur prepayment penalty fees, we receive
those fees through the residual interest. In some securitization transactions,
we also retained regular principal and interest bonds. Generally, these bonds
were the lowest rated bonds issued by the trust or these bonds were not rated.
Additionally, we have purchased some mortgage securities in the open market from
unrelated entities. Upon acquisition of the bonds, we classified the securities
as either trading or available-for-sale. No changes have been made to the
classifications.




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




The following
tables provide details of our mortgage securities.




Table 2 — Values of Individual
      Mortgage Securities – Available-for-Sale(dollars in
    thousands)For the Year Ended December
      31,2009
            
            2008Constant
            
            Expected
            
            
            
            
            
            
            
            Constant
            
            ExpectedSecuritization
            
            Estimated
            
            Discount
            
            Pre-payment
            
            Credit
            
            Estimated
            
            Discount
            
            Pre-payment
            
            CreditTrust (A)
            
            Fair Value
            
            Rate
            
            Rate
            
            Losses
            
            Fair Value
            
            Rate
            
            Rate
            
            LossesNMFT Series :2002-3
            
            $
            1,997
            
            25
            %
            
            15
            %
            
            1.0
            %
            
            $
            2,041
            
            25
            %
            
            16
            %
            
            0.8
            %2003-1
            
            
            3,469
            
            25
            
            
            13
            
            
            2.1
            
            
            
            5,108
            
            25
            
            
            13
            
            
            2.02003-2
            
            
            -
            
            25
            
            
            12
            
            
            1.9
            
            
            
            2,272
            
            25
            
            
            12
            
            
            1.92003-3
            
            
            1,436
            
            25
            
            
            10
            
            
            2.7
            
            
            
            2,402
            
            25
            
            
            12
            
            
            2.7Other (B)
            
            
            1
            
            25
            
            
            17
            
            
            12.5
            
            
            
            138
            
            25
            
            
            18
            
            
            11.3Total
            
            $
            6,903
            
            
            
            
            
            
            
            
            
            
            $
            12,788


(A)     We established the trust upon
securitization of the underlying loans, which generally were originated by
us. (B)Other than Estimated Fair Value, amounts consist
of weighted averages of multiple securities.




15




---



Table 3 — Mortgage Securities -
      Trading(dollars in
    thousands)As of December 31,
      2009Amortized Cost
            
            
            
            
            Number of
            
            WeightedS&P Rating
            
            Original Face
            
            Basis
            
            Fair Value
            
            Securities
            
            Average YieldSubordinated Securities:Non-investment
      Grade (B)
            
            $
            435,114
            
            $
            103,638
            
            $
            959
            
            89
            
            2.10
            %Residual Securities:Unrated
            
            
            59,500
            
            
            374
            
            
            128
            
            1
            
            25.00Total
            
            $
            494,614
            
            $
            104,012
            
            $
            1,087
            
            90
            
            4.79
            %As of December 31,
      2008Amortized Cost
            
            
            
            
            Number of
            
            WeightedS&P Rating
            
            Original Face
            
            Basis
            
            Fair Value
            
            Securities
            
            Average YieldSubordinated Securities:Investment
      Grade (A)
            
            $
            12,505
            
            $
            11,891
            
            $
            833
            
            3
            
            6.25
            %Non-investment
      Grade (B)
            
            
            422,609
            
            
            406,125
            
            
            5,547
            
            87
            
            8.08Total Subordinated
    Securities
            
            
            435,114
            
            
            418,016
            
            
            6,380
            
            90
            
            7.84Residual Securities:Unrated
            
            
            59,500
            
            
            15,952
            
            
            705
            
            1
            
            25.00Total
            
            $
            494,614
            
            $
            433,968
            
            $
            7,085
            
            91
            
            9.55
            %


(A)
            
            Investment grade includes all securities with S&P ratings above
      BB+.(B)
            
            Non-investment grade includes all securities with S&P ratings
      below BBB-.





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




Real Estate Owned. Real estate owned includes the
value of properties for foreclosed loans owned by securitization trusts, as
discussed under “Mortgage Loans – Held-in-Portfolio”. We consolidate the assets
and liabilities as part of the securitization trust. A servicer that is
independent from us and the trusts services the mortgage loans and processes
defaults for liquidation. Proceeds from liquidation of this real estate will
flow through the trust and will generally be paid to third party bondholders.
The amount of real estate owned is dependent upon the number of the overall
mortgage loans outstanding, the rate of defaults, the timing of liquidations and
the estimated fair value of the real estate. The decrease in the amount of real
estate owned from December 31, 2008 to December 31, 2009 results from the
declining number of total loans as well as the decreasing estimated value of the
real estate.




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




Accrued Interest
Receivable. Accrued interest receivable includes the interest due from individual
borrowers to the trusts who own the mortgage loans – held-in-portfolio. For all
mortgage loans that do not carry mortgage insurance, the accrual of interest on
loans is discontinued when, in management’s opinion, the interest is not
collectible in the normal course of business, but in no case beyond when a loan
becomes 90 days delinquent. For mortgage loans that do carry mortgage insurance,
the accrual of interest is only discontinued when in management’s opinion, the
interest is not collectible. Management generally deems all of the accrued
interest on loans with mortgage insurance to be collectible. Potential losses
related to accrued interest receivable are factored into the severity of losses
as part of the allowance for doubtful accounts calculation. The quantity of
delinquent loans has significantly increased, as a% of total loans outstanding,
from December 31, 2008 to December 31, 2009. Therefore, the amount of accrued
interest has also decreased, although the amounts increased in relation to the
percentage of the outstanding principal.




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




Other Assets. Other assets include prepaid insurance,
capitalized furniture and office equipment, appraisal fee receivables and other
notes receivables. This balance increased in 2009 compared to 2008 due to notes
receivable and an increase in appraisal fee receivables, which was caused by
higher volume.




Asset-backed Bonds Secured by Mortgage
Assets. During
2006 and 2007, we executed three mortgage loans securitizations and one mortgage
security re-securitization (a CDO). We consolidate the assets and liabilities of
the securitization trusts under GAAP. The asset-backed bonds are obligations of
the trusts and will be repaid using collections of the securitized assets. The
trusts have no recourse to our other, unsecuritized assets. The assets securing
these obligations are discussed under “Mortgage Loans – Held-in-Portfolio” and
“Mortgage Securities –Trading.” The balances of the asset-backed bonds have
decreased during 2009 as the bonds have repaid. We record the value of the bonds
secured by loans at the value of the proceeds, less repayments. We record the
CDO (secured by mortgage securities) at its fair value. These balances will
decrease going forward as the underlying assets repay or may be charged off as
the assets are deemed to be insufficient to fully repay the bond
obligations.




16




---



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




Junior Subordinated Debentures. We have $78.1
million in principal amount of unsecured notes payable to two unconsolidated
trusts, the Consolidated Balance Sheets includes $77.8 million which is net of
debt issuance costs. These notes secure trust preferred securities issued by the
trusts.




During 2009, the
Company executed the necessary documents to complete an exchange of the Notes
for new preferred obligations. The Company paid interest due through December
31, 2008, in the aggregate amount of $5.3 million. In addition, the Company paid
$0.3 million in legal and administrative costs on behalf of the Trusts which
were recorded in the “Professional and outside services” line item on the
Consolidated Statements of Operations.




The new preferred
obligations require quarterly distributions of interest to the holders at a rate
equal to 1.0% per annum beginning January 1, 2009 through December 31, 2009,
subject to reset to a variable rate equal to the three-month LIBOR plus 3.5%
upon the occurrence of an “Interest Coverage Trigger.” For purposes of the new
preferred obligations, an Interest Coverage Trigger occurs when the ratio of
EBITDA for any quarter ending on or after December 31, 2008 and on or prior to
December 31, 2009 to the product as of the last day of such quarter, of the
stated liquidation value of all outstanding 2009 Preferred Securities (i)
multiplied by 7.5%, (ii) multiplied by 1.5 and (iii) divided by 4, equals or
exceeds 1.00 to 1.00. The Company did not trigger the Interest
Coverage Trigger as of December 31, 2009, although it could be triggered during
2010 under certain of our projections. Beginning January 1, 2010 until the
earlier of February 18, 2019 or the occurrence of an Interest Coverage Trigger,
the unpaid principal amount of the new preferred obligations will bear interest
at a rate of 1.0% per annum and, thereafter, at a variable rate, reset
quarterly, equal to the three-month LIBOR plus 3.5% per annum.




During 2008, these
notes carried an interest rate of three-month LIBOR plus 3.5%. During 2008, we
purchased trust preferred securities with a par value of $6.9 million for $0.6
million. As a result, $6.9 million of principal and accrued interest of $0.2
million of the notes was retired and the principal amount, accrued interest, and
related unamortized debt issuance costs were removed from the Consolidated
Balance Sheets resulting in a gain of $6.4 million, recorded to the “Gains on
debt extinguishment” line item of the Consolidated Statements of Operations.




Due to Servicer. The mortgage
loans – held-in-portfolio on our Consolidated Balance Sheets have been
securitized and we consolidate the securitized trust. In accordance with the
agreements for the securitized mortgage loans, the servicer of the loans is
required to make regularly scheduled payments to the bondholders, regardless of
whether the borrower has made payments as required. The servicer is required to
make advances from its own funds. Upon liquidation of defaulted loans, the
servicer is repaid the advanced funds. Until such time as the loans liquidate,
the trust has an obligation to the servicer, which we have classified as “Due to
servicer” on the Consolidated Balance Sheets. The amount of the obligation is
dependent on the rate and timing of delinquencies of the individual borrowers.
During 2008 and 2009, the trusts experienced a significant increase in the
amount of delinquencies, which increases the amount of advances the servicer has
made to the bondholders and therefore increases the liability to the servicer.




Dividends Payable. During 2004,
we issued $74.8 million in Series C Preferred Stock with a dividend equivalent
to 8.9%. During 2007, we issued $50 million of Series D1 Preferred Stock with a
dividend equivalent to 9.0%. We have failed to make all dividend payments since
October 2007. As a result, the Series D1 Preferred Stock dividend increased to
an equivalent of 13.0%, retroactive and compounded to the beginning of the first
quarter in which the dividends were not paid. The unpaid dividends continue to
accrue and have resulted in the large increase in unpaid dividends recorded in
our Consolidated Balance Sheets.




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




17




---



Table 4— Accounts Payable and Other
      Liabilities(dollars in
    thousands)December 31,2009
            
            2008Accrued expenses and other
      liabilities
            $
            10,248
            
            $
            6,198Taxes payable
            
            4,245
            
            
            3,893Interest payable
            
            751
            
            
            10,177Value of derivatives owned by mortgage loan securitization
      trusts
            
            157
            
            
            9,102Obligations under office space
      lease
            
            -
            
            
            4,558Total
            $
            15,401
            
            $
            33,928


Liabilities of Discontinued
Operations. During 2007 and 2008, we discontinued our mortgage lending operations. In
the normal course of operations in 2009, we paid the liabilities and obligations
of the discontinued operations and therefore had no liabilities of discontinued
operations as of December 31, 2009.




Stockholders’
Deficit. As of
December 31, 2009 and 2008 our total liabilities exceeded our total assets under
GAAP by $1.1 billion and $876.8 million, respectively.




The liabilities of
the securitization trusts exceed the assets of those trusts as of December 31,
2009 and December 31, 2008 by $1.0 billion and $932.1 million, respectively.
These amounts do not include any adjustments for intercompany eliminations, see
Table 8 for further detail. The severe devaluation of the mortgage assets, as
discussed in the respective categories above, has resulted in the significant
deficit of these trusts. The assets and liabilities of these trusts are
consolidated under GAAP. Due to the significant impact to our financial
statements of these trusts, we have also provided the assets and liabilities of
the trusts on a separate and combined basis under “Assets and Liabilities of
Consolidated Securitization Trusts.”




The significant
increase in our shareholders’ deficit during 2009 results from our large net
loss, driven primarily by valuation allowances taken on our mortgage
loans.




Results of Operations – Consolidated
Earnings Comparisons




Year Ended December 31, 2009 as Compared
to the Year Ended December 31, 2008




Net Interest (Expense)
Income. As
discussed above, in general, our mortgage assets have been significantly
impaired due to national and international economic crises, housing price
deterioration and mortgage loan credit defaults. Interest income has declined as
these assets have declined due to repayments and liquidations. Interest expense
has declined as the related principal balances have declined. Also, interest
expense is adjustable, generally based on a spread to LIBOR. LIBOR was lower
during 2009 than 2008.




18




---



Table 5— Net Interest
      Expense(dollars in
    thousands)For the Year
  EndedDecember 31,2009
            
            2008Interest income:Mortgage
      securities
            $
            21,656
            
            
            $
            46,997Mortgage loans
      held-in-portfolio
            
            131,301
            
            
            
            186,601Other interest
      income
            
            887
            
            
            
            1,411Total interest
      income
            
            153,844
            
            
            
            235,009Interest expense:Short-term
      borrowings secured by mortgage securities
            
            -
            
            
            
            436Asset-backed
      bonds secured by mortgage loans
            
            21,290
            
            
            
            95,012Asset-backed
      bonds secured by mortgage securities
            
            2,129
            
            
            
            13,271Junior
      subordinated debentures
            
            1,128
            
            
            
            6,261Total interest
      expense
            
            24,547
            
            
            
            114,980Net interest
      income before provision for credit losses
            
            129,297
            
            
            
            120,029Provision for credit
    losses
            
            (260,860
            )
            
            
            (707,364
            )Net interest (expense)
            $
            (131,563
            )
            
            $
            (587,335
            )


Provision for Credit
Losses. The
provision for credit losses relates to mortgage loans which have been
securitized. As discussed above, in general, the credit quality of the
securitized mortgage loans significantly deteriorated during 2008 and 2009 due
to national and international economic crises, housing price deterioration and
mortgage loan credit defaults. A significant portion of the securitized loans
have become uncollectible or will only be partially collected. Approximately 20%
of our loans held in portfolio were greater than 90 days delinquent at December
31, 2008, and approximately 20% were in foreclosure. As of December 31, 2009,
this delinquency percentage decreased to approximately 16% while loans in
foreclosure increased to approximately 36%. As loans transition into REO status,
an estimated loss is recorded until the property is sold or liquidated. For the
NHEL 0601 and MTA 0601 transactions, we valued REO property at 50% of its
current principal balance as of December 31, 2009, compared to 55% as of
December 31, 2008. Because of the increased loss severity, NHEL 0701 property
was valued at 35% in 2009; a 5% decrease from 2008. Provisions for these losses
have increased in connection with the declining credit quality of the loans. We
took charges to income totaling $260.9 million and $707.4 million during the
year ended December 31, 2009 and 2008, respectively.




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




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




As a result of
declining interest rates and declining values of the credit default swaps
(“CDS”), the losses on derivative instruments from continuing operations were
$4.7 million and $18.1 million for the years ended December 31, 2009 and 2008,
respectively. The losses decreased in 2009 as compared to 2008 due to the
expiration of many of the derivative instrument contracts during 2008 and
2009.




Fair Value
Adjustments. Adjustment for changes in value on our trading securities and the
asset-backed bonds issued in our CDO transaction executed are recorded as Fair
Value Adjustments. The significant value declines in 2009 and 2008 were a result
of significant spread widening in the subprime mortgage market for these types
of asset-backed securities as well as poor credit performance of the underlying
mortgage loans. By the end of 2008, the total value of the trading securities
and the asset-backed bonds had declined significantly, resulting in a lower
overall adjustment in 2009 when compared to 2008.




Impairment on Mortgage Securities –
Available-for-Sale. To the extent that the cost basis of mortgage securities –
available-for-sale exceeds the fair value and the unrealized loss is considered
to be other than temporary, an impairment charge is recognized and the amount
recorded in accumulated other comprehensive income or loss is reclassified to
earnings as a realized loss. The large impairments in 2009 and 2008 were
primarily driven by an increase in actual and projected losses due to the deteriorating
credit quality of the loans underlying the securities. By the end of 2008, the
total value of the available-for-sale securities had declined significantly,
resulting in a lower overall impairment in 2009 when compared to 2008.




19




---



Premiums for Mortgage Loan Insurance. Premiums for
mortgage insurance are for credit default insurance for mortgage loans –
held-in-portfolio, which have been securitized and are owned by securitization
trusts. The premiums are paid by the trust from the loan proceeds. Premiums are
based on a percentage of the individual loan principal outstanding. The decrease
in premiums on mortgage loan insurance for 2009 as compared to 2008 is due to
the decrease in the principal balance of mortgage
loans-held-in-portfolio.




Appraisal Fee Income and Expense. Fees are
collected from customers (borrowers or lenders), a portion of which is paid to
independent mortgage loan appraisers. Fee income and expense is recognized when
the appraisal is completed and delivered to the customer. During the year ended
December 31, 2009, the unit volume appraisal services increased significantly,
resulting in revenue and expense increasing significantly when comparing to the
year ended December 31, 2008. We acquired a 75% interest in StreetLinks on
August 1, 2008, and therefore recognized minimal revenue and incurred minimal
expense for appraisal management services during the year ended December 31,
2008. Following is a summary of the unit count of completed orders:




Table 6 — Appraisals Completed
      2009First quarter
            4,809Second quarter
            27,440Third quarter
            26,960Fourth quarter
            24,965Year ended December 31, 2009
            84,174


General and Administrative Expenses. Total general
and administrative expenses increased from $24.4 million during 2008 to $31.6
million during 2009 due to the additional general and administrative expenses
resulting from a full year of operations from StreetLinks. During late 2007 and
into early 2008, we eliminated a significant portion of our administrative
overhead. We terminated officers and staff in our executive, information
systems, legal, human resource and finance/accounting departments. We also
terminated numerous contracts for professional services. One of management’s key
focuses during 2008 was to reduce or eliminate all unnecessary general and
administrative expenses. The result of these efforts was a significant decline
in the corporate general administrative expenses for 2008 and 2009. Excluding
the impact of StreetLinks, general and administrative expenses declined by $5.5
million.




Income Taxes. During 2009, we recognized tax expense of
$1.1 million from continuing operations. $1.6 million of this was due to taxes
related to excess inclusion income, net of $0.5 million of income tax benefit
primarily attributed to the release of tax liability related to uncertain tax
positions due to the lapse of statute of limitations and changes in management’s
judgment regarding those positions.




During 2008, we
recognized a tax benefit of $17.6 million from continuing operations. Of this
benefit, $13.8 million is an offset to the tax expense recorded on the gain in
discontinued operations. The remaining $3.8 million of tax benefit is primarily
attributed to the release of tax liability related to uncertain tax positions
due to the lapse of statute of limitations and changes in management’s judgment
regarding those positions.




Due to the
valuation allowance recorded against deferred tax assets, no tax benefit is
recognized on tax losses incurred in 2009 and 2008.




As of December 31,
2009 and 2008, we reflect $4.2 million and $3.8 million in other tax liability,
respectively which are recorded in “Accounts Payable and Other Liabilities”.
This balance is primarily comprised of tax liability on uncertain tax positions,
interest and penalties and a portion of this amount is an obligation of one of
the Company’s securitization trusts and as such will be paid out of the trust’s
assets.




Contractual
Obligations




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




20




---



The following table summarizes
our contractual obligations, as of December 31, 2009, other than short-term
borrowing arrangements.




Table 7 — Contractual
      Obligations(dollars in thousands)Payments Due by PeriodLess thanContractual
      Obligations
            Total
            
            1 Year
            
            1-3 Years
            
            3-5 Years
            
            After 5 YearsEstimated long-term debt
      payments(A)
            $
            2,677,742
            
            
            $
            290,465
            
            
            $
            476,342
            
            
            $
            735,727
            
            
            $
            1,175,208Junior subordinated debentures (B)
            
            98,192
            
            
            
            781
            
            
            
            1,563
            
            
            
            1,563
            
            
            
            94,285Operating leases (C)
            
            4,568
            
            
            
            1,711
            
            
            
            2,160
            
            
            
            624
            
            
            
            73Total, consolidated obligations
            
            2,780,502
            
            
            
            292,957
            
            
            
            480,065
            
            
            
            737,914
            
            
            
            1,269,566Non-recourse obligations
            
            (2,677,742
            )
            
            
            (290,465
            )
            
            
            (476,342
            )
            
            
            (735,727
            )
            
            
            (1,175,208
            )Recourse obligations
            $
            102,760
            
            
            $
            2,492
            
            
            $
            3,723
            
            
            $
            2,187
            
            
            $
            94,358


(A)
            The
      asset-backed bonds will be repaid only to the extent there is sufficient
      cash receipts on the underlying mortgage loans, which collateralize the
      debt. The trusts that own these assets and asset-backed obligations have
      no recourse to us for any shortfall. The timing of the repayment of these
      mortgage loans is affected by prepayments. These amounts include expected
      interest payments on the obligations. Interest obligations on our
      variable-rate long-term debt are based on the prevailing interest rate at
      December 31, 2009 for each respective obligation.(B)
            The junior
      subordinated debentures are assumed to mature in 2035 and 2036 in
      computing the future payments. These amounts include expected interest
      payments on the obligations. Interest obligations on our junior
      subordinated debentures are based on the prevailing interest rate at
      December 31, 2009 for each respective obligation. On February 18, 2009,
      the Company, NMI, NovaStar Capital Trust I and NovaStar Capital Trust II
      and the trust preferred security holders entered into agreements to
      exchange the existing preferred obligations for new preferred obligations.
      The new preferred obligations require quarterly distributions of interest
      to the holders at a rate equal to 1.0% per annum beginning January 1, 2009
      through December 31, 2016, subject to reset to a variable rate equal to
      the three-month LIBOR plus 3.5% upon the occurrence of an “Interest
      Coverage Trigger”.(C)
            The
      operating lease obligations do not include rental income of $1.2 million
      to be received under sublease contracts.




Liquidity and Capital
Resources




Although
StreetLinks was not cash flow-positive during 2009, largely due to costs
associated with infrastructure development, gross appraisal fee income is
expected to be a substantial source of our cash flows in 2010. We are currently
projecting an increase in cash flows over the course of the next year as we
continued to grow our customer base. New regulations issued by federal agencies,
especially those effective in the first quarter of 2010, have positively
impacted StreetLinks sales efforts. With StreetLinks infrastructure in place and
added efficiencies gained through automation, we expect the general and
administrative expenses to decrease in proportion to the increased production.
Continued increases in appraisal volume and relatively lower operating costs
will drive positive earnings and cash flow from StreetLinks during
2010.




Our residual and
subordinated mortgage securities are a significant source of positive cash
flows. Based on the current projections, the cash flows from our mortgage
securities will decrease in the next several months as the underlying mortgage
loans are repaid, and could be significantly less than the current projections
if losses on the underlying mortgage loans exceed the current assumptions or if
short-term interest rates increase significantly.




As of March 30,
2010, we had approximately $15.5 million in cash on hand (including restricted
cash of $1.8 million). In addition to our operating expenses, which currently
approximate $0.7 million per month, we have quarterly interest payments due on
our trust preferred securities. The next payment on the trust preferred
securities is due on March 30, 2010 and totals $0.1 million. Advent does not
currently have any significant cash inflows or outflows and management is
continuing to evaluate it as a viable business and management does not believe
that cash flows or outflows will be significant during fiscal 2010. Our current
projections indicate sufficient available cash and cash flows to meet these
payment needs. However, our mortgage securities cash flows are volatile and
uncertain in nature, and the amounts we receive could vary materially from our
projections though we believe that the increased cash flows from StreetLinks
will offset any reduction in our mortgage securities cash flows.




As discussed in
Item 3. Legal Proceedings we are the subject of various legal proceedings, the
outcome of which is uncertain. We may also face demands in the future that are
unknown to us today related to our legacy lending and servicing operations. If
the cash flows from StreetLinks and our mortgage securities are less than
currently anticipated, it would negatively affect our results of operations,
financial condition, liquidity and business prospects. However management
believes that its current operations and its cash availability are sufficient
for the Company to discharge its liabilities and meet its commitments in the
normal course of business.




21




---



Overview of Cash Flow for the Year Ended
December 31, 2009
  During 2007 and
early 2008, we discontinued our mortgage lending operations and sold our
mortgage servicing rights which subsequently resulted in the closing of our
servicing operations. Prior to exiting the lending business, we sold the
majority of the loans we originated to securitization trusts. Three of these
securitization trusts are consolidated for financial reporting under GAAP, which
means all of the assets and the liabilities of the trust are included in our
consolidated financial statements. Our results of operations and cash flows
include the activity of these trusts. The cash proceeds from the repayment of
the loan collateral are owned by the trust and serve to only repay the
obligations of the trust. We do not collect the cash and we are not responsible
for the obligations of the trust. Principal and interest on the bonds
(securities) of the trust can only be paid if there is sufficient cash flow from
the underlying collateral. We own some of the securities issued by the trust,
which are a significant source of possible cash flow. As a result of the
national economic crises, the loans within these trusts have very high rates of
default. Therefore, the cash flow on the securities we own has declined
significantly within the past two years.




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




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




Table 8 — Primary Sources of Cash
      Receipts and Disbursements(dollars in
    thousands)For the Years
  EndedDecember 31,2009
            
            2008Primary sources:Fees received for appraisal
      management services
            $
            30,607
            
            
            $
            2,263Cash flows received from mortgage securities
            
            18,479
            
            
            
            59,912Primary uses:Payment of corporate, general and
      administrativeexpenses
            
            (25,739
            )
            
            
            (37,832
            )Payments for appraisals and related administrativeexpenses
            
            (30,140
            )
            
            
            (3,453
            )Payments for Advent’s startup and
      other expenses
            
            (4,255
            )
            
            
            -Issuance of notes and other receivables
            
            (4,277
            )
            
            
            -Repayment of short-term
      borrowings
            
            -
            
            
            
            (45,488
            )


Statement of Cash Flows - Operating,
Investing and Financing Activities




The following table
provides a summary of our operating, investing and financing cash flows from our
consolidated statements of cash flows for years ended December 31, 2009 and
2008.




Table 9 — Summary of Operating,
      Investing and Financing Cash Flows(dollars in
    thousands)For the Years
  EndedDecember 31,2009
            
            2008Consolidated Statements of Cash
      Flows:Cash provided by operating
      activities
            $
            67,218
            
            
            $
            29,566Cash flows provided by investing activities
            
            246,616
            
            
            
            493,579Cash flows used in financing
      activities
            
            (331,520
            )
            
            
            (523,719
            )


Operating
Activities . Net cash provided by operating
activities increased by $37.7 million in 2009 as compared to 2008. The increase
in cash provided by operating activities was substantially related to the
increase in the balance of the amounts due to servicer. Operating activities,
other than the cash flow of the securitized loan trusts, generated a net use of
cash during the year ended December 31, 2009. See a discussion of the impact of
the consolidated loan trusts under “Assets and Liabilities of Consolidated
Securitization Trusts.”




22




---



Investing
Activities . In 2009, net cash provided by investing
activities decreased by $247.0 million as compared to 2008. Substantially all of
the cash flow from investing activities relates to either payments on
securitized loans or sales upon foreclosure of securitized loans. Our mortgage
loan portfolio declined significantly and borrower defaults increased, resulting
in lower repayments of our mortgage loans held-in-portfolio and lower cash
proceeds from the sale of assets acquired through foreclosure. We also
experienced a decrease in payments received on our mortgage securities during
2009 as compared to 2008 as a result of poor credit performance of the
underlying loans.




Financing
Activities . Net cash used in financing activities
decreased by $192.2 million in 2009 as compared to 2008. All short term
borrowings were paid off in 2008 and we also experienced a decrease in paydowns
of our asset-backed bonds during the year.




Future Sources and Uses of Cash




Primary Sources of
Cash




Cash Received From Our Mortgage
Securities Portfolio. A significant source of cash flows is the proceeds we receive from our
mortgage securities. The cash flows we receive on our mortgage
securities—available-for-sale are highly dependent on the interest rate spread
between the underlying collateral and the bonds issued by the securitization
trusts and default and prepayment experience of the underlying collateral. The
following factors have been the significant drivers in the overall fluctuations
in these cash flows:


- Higher credit losses have
  decreased cash available to distribute with respect to our securities,
- As short-term interest rates
  decline, the net spread to us increases and if short-term interest rates
  increase, the spread we receive will decline,
- We have lower average
  balances of our mortgage securities—available-for-sale portfolio as the
  securities have paid down and we have not acquired new bonds

Cash Received From StreetLinks.During
      2009, StreetLinks significantly increased its customer base and with a
      full year of operations received cash of $30.6 million in gross
      proceeds for appraisal management services compared to $2.3 million during
      2008. We are currently projecting an increase in these cash flows during
      fiscal 2010 as we continue to increase our customer base. New regulations
      issued by federal agencies, especially those effective in the first
      quarter of 2010, have positively impacted StreetLinks sales efforts. With
      StreetLinks infrastructure in place and added efficiencies gained through
      automation, we expect the general and administrative expenses to decrease
      in proportion to the increased production. Continued increases in
      appraisal volume and relatively lower operating costs will result in
      positive earnings and cash flow from StreetLinks.
              
              Collateral Returned from Surety
      Bond Holders.See discussion under Restricted Cash. We have $3.8 million
      collateral outstanding for surety bond holders. When the cash
      collateralizing the surety bond letters of credit is released, it will
      become unrestricted and available for general corporate purposes. We
      cannot predict the timing of the release. Subsequent to December 31, 2009,
      $2.9 million in collateral was released and as of March 30, 2010 $1.8
      million remains restricted.
              
              Proceeds from Repayments of
      Mortgage Loans. As we discussed above, significant cash is collected by the
      securitization trusts from the payment of principal and interest on
      securitized loans and securities. The cash is retained by the trust and is
      used to repay obligations (primarily to bondholders) of the trust. The
      cash is not available to us and we are not responsible for the obligations
      of the trust. For the year ended December 31, 2009 repayments on the
      mortgage loans held-in-portfolio totaled $98.9 million compared to $288.2
      million during 2008.




Primary Uses of
Cash






Payments of General and
      Administrative Expenses.We continue to have significant
      general and administrative expenses associated with managing and operating
      our business. These expenses include staff and management compensation and
      related benefit payments, professional expenses for audit, tax and related
      services, legal services, rent and general office operational costs.
              
              Repayments of Long-Term Borrowings
      and Interest.As of December 31, 2009, we had $78.1 million in outstanding
      principal of junior subordinated debentures relating to the trust
      preferred securities of NovaStar Capital Trust I and NovaStar Capital
      Trust II, $77.8 million is included on the Consolidated Balance Sheets
      which is net of debt issuance costs. For 2008, periodic interest payments
      were based on a variable interest rate of three-month LIBOR plus 3.5%
      which resets quarterly. During 2009, we restructured our obligations under
      the junior subordinated debentures, which we expect to reduce cash
      requirements for interest in the near term. Beginning January 1, 2010
      until the earlier of February 18, 2019 or the occurrence of an Interest
      Coverage Trigger, the unpaid principal amount of the new preferred
      obligations will bear interest at a rate of 1.0% per annum and,
      thereafter, at a variable rate, reset quarterly, equal to the three-month
      LIBOR plus 3.5% per annum, see Note 6 to the consolidated financial
      statements for further details. See Table 6 for an estimate of our
      contractual obligations related to these junior subordinated debentures.
              
              Repayments of Short-term
      Borrowings.During 2008, we repaid all short-term borrowings that were
      outstanding as of December 31, 2008, totaling $45.5 million. We have no
      outstanding borrowing arrangements and therefore no cash will be used to
      repay borrowings.




23




---



Settlement of Legal Disputes.See Item
      3. Legal Proceedings. During 2008 and 2009, we made several payments to
      settle legal disputes resulting from our legacy lending and servicing
      operations. We have several pending legal actions. For those actions where
      we are the defendant, we are contesting plaintiffs’ claims. In the event
      we are not successful in our defense, we may be required to make payments
      for settlements or judgments that are not covered by insurance.
              
              Investment in Advent.During
      2009, we invested capital in Advent in order to acquire and develop
      Advent’s business model. We will continue to invest in Advent in 2010
      while we evaluate its business model, however we will limit the negative
      impact on liquidity and do not believe that Advent will be a significant
      use or source of cash during 2010.




Consolidated Securitization Trusts




During 2006 and
2007, we executed loan securitization transactions that did not meet the
criteria necessary for derecognition of the securitized assets and liabilities
pursuant to Accounting for Transfers of Financial Assets and Repurchase
Financing Transactions  and related
authoritative accounting literature. As a result, the assets and liabilities
relating to this securitization are included in our consolidated financial
statements.




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




During 2007, we
also securitized certain mortgage securities through a CDO structure.




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




1.
            We sold a
      portion of the beneficial interests we owned,2.
            The credit
      losses on the securitized loans increased to the point where the remaining
      beneficial interests we own are not significant,3.
            We sold the
      right to service all securitized loans,4.
            We executed
      amendments to the securitization agreements for the 2006 loan pools
      whereby we relinquished all rights to place certain derivative instruments
      into the securitization trust and to repurchase a limited number of loans
      from the trust for any reason and at any time, and5.
            For the 2007
      securitized loan pool, a significant portion of the derivatives placed
      into the trust have expired and the remaining derivatives will expire by
      January 2010.




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




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




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




24




---



Table 10 –PrincipalAssetsandLiabilitiesofSecuritizationTrusts(A)(dollarsinthousands)December 31, 2009
            
            December 31,
  2008NHES
            
            
            
            
            
            
            
            
            
            
            
            
            
            NHESNHES
            
            2006
            
            NHES
            
            
            
            
            
            
            
            NHES
            
            2006
            
            NHESCDO
            
            2006-1
            
            MTA1
            
            2007-1
            
            Total
            
            CDO
            
            2006-1
            
            MTA1
            
            2007-1
            
            TotalAssetsMortgage loans – held in portfolio,
      netof allowance
            $
            -
            
            $
            292,417
            
            $
            397,212
            
            $
            608,016
            
            $
            1,297,645
            
            $
            -
            
            $
            411,146
            
            $
            523,183
            
            $
            847,962
            
            $
            1,782,291Trading
    securities
            
            961
            
            
            -
            
            
            -
            
            
            -
            
            
            961
            
            
            5,199
            
            
            -
            
            
            -
            
            
            -
            
            
            5,199Real estate
    owned
            
            -
            
            
            20,490
            
            
            14,327
            
            
            29,184
            
            
            64,001
            
            
            -
            
            
            23,289
            
            
            9,233
            
            
            37,958
            
            
            70,480Accrued interest
      receivable
            
            -
            
            
            21,053
            
            
            6,503
            
            
            46,470
            
            
            74,026
            
            
            -
            
            
            22,566
            
            
            10,134
            
            
            44,592
            
            
            77,292LiabilitiesAsset-backed bonds
      secured bymortgage
      loans
            $
            -
            
            $
            495,383
            
            $
            618,931
            
            $
            1,241,501
            
            $
            2,355,815
            
            $
            -
            
            $
            572,970
            
            $
            700,335
            
            $
            1,398,115
            
            $
            2,671,420Asset-backed bonds
      secured bymortgage
      securities
            
            961
            
            
            -
            
            
            -
            
            
            -
            
            
            961
            
            
            5,384
            
            
            -
            
            
            -
            
            
            -
            
            
            5,384Other
    liabilities
            
            22,199
            
            
            46,335
            
            
            28,366
            
            
            108,085
            
            
            204,985
            
            
            24,748
            
            
            47,418
            
            
            22,401
            
            
            104,439
            
            
            199,006


(A)
            Stand-alonebalancesdo notincludeimpact ofintercompanyeliminations.


25




---



Table 11 -PrincipalRevenuesandExpensesofSecuritizationTrusts(A)(dollarsinthousands)For the Year Ended December 31,
      2009
            
            For the Year Ended December 31,
      2008NHESNHES
            
            2006
            
            NHES
            
            
            
            
            
            
            
            
            
            NHES
            
            NHES
            
            
            NHESCDO
            
            2006-1
            
            MTA1
            
            2007-1
            
            Total
            
            CDO
            
            2006-1
            
            2006 MTA1
            
            
            2007-1
            
            TotalInterest Income
            $
            9,445
            
            
            $
            31,002
            
            
            $
            20,630
            
            
            $
            78,385
            
            
            $
            139,462
            
            
            $
            26,306
            
            
            $
            45,160
            
            
            $
            27,555
            
            
            $
            109,295
            
            
            $
            208,316Interest expense
            
            3,002
            
            
            
            4,166
            
            
            
            7,151
            
            
            
            12,733
            
            
            
            27,052
            
            
            
            13,124
            
            
            
            22,453
            
            
            
            25,843
            
            
            
            54,874
            
            
            
            116,294Provision for credit
    losses
            
            -
            
            
            
            (68,183
            )
            
            
            (59,882
            )
            
            
            (132,795
            )
            
            
            (260,860
            )
            
            
            -
            
            
            
            (127,485
            )
            
            
            (165,063
            )
            
            
            (414,816
            )
            
            
            (707,364
            )Servicing fee expense
            
            -
            
            
            
            2,292
            
            
            
            2,401
            
            
            
            5,946
            
            
            
            10,639
            
            
            
            -
            
            
            
            3,129
            
            
            
            2,736
            
            
            
            7,732
            
            
            
            13,597Mortgage insurance
            
            -
            
            
            
            798
            
            
            
            171
            
            
            
            5,072
            
            
            
            6,041
            
            
            
            -
            
            
            
            4,216
            
            
            
            292
            
            
            
            11,310
            
            
            
            15,818Other income (expense)
            
            (5,194
            )
            
            
            -
            
            
            
            -
            
            
            
            (4,544
            )
            
            
            (9,738
            )
            
            
            (15,550
            )
            
            
            -
            
            
            
            -
            
            
            
            (4,844
            )
            
            
            (20,394
            )


(A)
            Stand-alonebalancesdo notincludeimpact ofintercompanyeliminations.


Table 12 –Summaryof Cash Flows ofSecuritizationTrusts(A)(dollarsinthousands)For the Year Ended December 31,
      2009
            
            For the Year Ended December 31,
      2008NHESNHES
            
            2006
            
            NHES
            
            
            
            
            
            
            
            
            
            NHES
            
            NHES
            
            NHESNet cash flow
from:
            CDO
            
            2006-1
            
            MTA1
            
            2007-1
            
            Total
            
            CDO
            
            2006-1
            
            2006 MTA1
            
            2007-1
            
            TotalOperating activities
            $
            (2,222
            )
            
            $
            20,142
            
            
            $
            21,301
            
            
            $
            43,455
            
            
            $
            82,676
            
            
            $
            (7,441
            )
            
            $
            20,927
            
            
            $
            (4,415
            )
            
            $
            43,622
            
            
            $
            52,693Investing activities
            
            3,396
            
            
            
            51,774
            
            
            
            60,389
            
            
            
            115,925
            
            
            
            231,484
            
            
            
            16,135
            
            
            
            135,777
            
            
            
            70,706
            
            
            
            195,954
            
            
            
            418,572Financing activities
            
            (1,174
            )
            
            
            (71,916
            )
            
            
            (81,690
            )
            
            
            (159,380
            )
            
            
            (314,160
            )
            
            
            (8,694
            )
            
            
            (156,704
            )
            
            
            (66,291
            )
            
            
            (239,576
            )
            
            
            (471,265
            )


(A)
            Stand-alonebalancesdo notincludeimpact ofintercompanyeliminations.


26




---



Critical Accounting
Estimates




We prepare our
consolidated financial statements in conformity with GAAP and, therefore, are
required to make estimates regarding the values of our assets and liabilities
and in recording income and expenses. These estimates are based, in part, on our
judgment and assumptions regarding various economic conditions that we believe
are reasonable based on facts and circumstances existing at the time of
reporting. These estimates affect reported amounts of assets, liabilities and
accumulated other comprehensive income at the date of the consolidated financial
statements and the reported amounts of income, expenses and other comprehensive
income during the periods presented. The following summarizes the components of
our consolidated financial statements where understanding accounting policies is
critical to understanding and evaluating our reported financial results,
especially given the significant estimates used in applying the policies. The
discussion is intended to demonstrate the significance of estimates to our
financial statements and the related accounting policies. Management has
discussed the development and selection of these critical accounting estimates
with the Audit Committee of our Board of Directors and the Audit Committee has
reviewed our disclosure.




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




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


- The interest spread between
  the coupon net of servicing fees on the underlying loans, the cost of
  financing, mortgage insurance, payments or receipts on or from derivative
  contracts and bond administrative costs.
- Prepayment penalties received
  from borrowers who pay off their loans early in their life.
- Overcollateralization which
  is designed to protect the primary bondholder from credit loss on the
  underlying loans.

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




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




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




27




---



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




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




To the extent that
the cost basis of mortgage securities – available-for-sale exceeds the fair
value and the unrealized loss is considered to be other than temporary, an
impairment charge is recognized and the amount recorded in accumulated other
comprehensive income or loss is reclassified to earnings as a realized
loss.




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




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




Approximately 20%
of our loans held in portfolio were greater than 90 days delinquent at December
31, 2008, and approximately 20% were in foreclosure. As of December 31, 2009,
this delinquency percentage decreased to approximately 16% while loans in
foreclosure increased to approximately 36%. As loans transition into REO status,
an estimated loss is recorded until the property is sold or liquidated. For the
NHEL 0601 and MTA 0601 transactions, we valued REO property at 50% of its
current principal balance as of December 31, 2009, compared to 55% as of
December 31, 2008. Because of the increased loss severity, NHEL 0701 property
was valued at 35% in 2009; a 5% decrease from 2008.Our estimate of expected
losses could increase if our actual loss experience is different than originally
estimated. In addition, our estimate of expected losses could increase if
economic factors change the value we could reasonably expect to obtain from the
sale of the property.




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




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




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




28




---



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




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




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




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




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




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




Impact of Recently Issued Accounting
Pronouncements




In June 2009, the
Financial Accounting Standards Board (“FASB”) issued Statement of Financial
Accounting Standards (“SFAS”) No. 166, Accounting for the Transfers of Financial
Assets, an Amendment of FASB Statement No. 140; this statement was codified in
December, 2009 as Accounting Standards Codification (“ASC”) 860. This guidance
is effective for financial asset transfers beginning on January 1, 2010 and will
be used to determine whether the transfer is accounted for as a sale under GAAP
or as a secured borrowing. In addition, also in June, 2009, the FASB issued SFAS
No. 167, Amendments to FASB Interpretation No. 46 (R); this statement was also
codified in December 2009 as ASC 810 and governs the consolidation of variable
interest entities. The consolidation guidance will become effective for all VIEs
the Company held as of January 1, 2010. As part of the Company’s adoption of the
amended consolidation guidance, it was required to reconsider the Company’s
previous consolidation conclusions pertaining to the Company’s variable
interests in VIEs, including: (i) whether an entity is a VIE; and (ii) whether
the Company is the primary beneficiary. Based on the Company’s assessment of its
involvement in VIEs at January 1, 2010, in accordance with the amended
consolidation guidance, the Company determined that it is not the primary
beneficiary of any mortgage loan securitization entities in which it held a
variable interest, as the Company does not have the power to direct the
activities that most significantly impact the economic performance of these
entities. The adoption of the amended consolidation guidance will therefore not
result in the Company consolidating or deconsolidating any VIEs for which it has
involvement. It should be noted, however, that the new guidance also requires
the Company to reassess these conclusions, based upon changes in the facts and
circumstances pertaining to the Company’s VIEs, on an ongoing basis; thus the
Company’s assessments may therefore change and could result in a material impact
to the Company’s financial statements during subsequent reporting periods. The
Company will provide the presentation and disclosure requirements in the amended
consolidation guidance in its financial statements for the three month period
ending March 31, 2010.




Subsequent to
December 31, 2009, there were certain events which the Company has determined
should result in a reassessment of the consolidation of the NHEL 2006-1, MTA
2006-1, and NHEL 2007-1 securitizations. Based on the provisions of the amended
guidance and the conclusion by Company management that a new transfer date has
occurred for the NHEL 2006-1, MTA 2006-1, and NHEL 2007-1 securitizations, the
Company anticipates that it will deconsolidate the assets and liabilities of the
NHEL 2006-1, MTA 2006-1, and NHEL 2007-1 securitization trusts and will record a
gain during the three month period
ending March 31, 2010. See Note 20 to the consolidated financial statements for
further details.




29




---



As a result of the analysis,
the Company does not anticipate any impact to the Company’s financial statements
upon the Company’s initial adoption of the amended Transfers and Servicing
guidance and the amended Consolidation guidance on January 1, 2010. However, as
discussed above, the Company re-evaluated the NHEL 2006-1, MTA 2006-1, and NHEL
2007-1 securitization transactions and determined that based on the occurrence
of certain events during 2010, the application of the amended Transfers and
Servicing guidance will result in the Company reflecting as sales of financial
assets and extinguishment of liabilities the assets and liabilities of the
securitization trusts during the three month period ending March 31, 2010. See
Note 20 to the consolidated financial statements for further details.




Improving Disclosures about Fair Value
Measurements. In
January 2010, the FASB issued new fair value disclosure guidance. The ASU
requires disclosing the amounts of significant transfers in and out of Level 1
and 2 fair value measurements and to describe the reasons for the transfers. The
disclosures are effective for reporting periods beginning after December 15,
2009. Additionally, disclosures of the gross purchases, sales, issuances and
settlements activity in Level 3 fair value measurements will be required for
fiscal years beginning after December 15, 2010.




Inflation




Virtually all of
our assets and liabilities are financial in nature. As a result, interest rates
and other factors drive our performance far more than does inflation. Changes in
interest rates do not necessarily correlate with inflation rates or changes in
inflation rates. Our financial statements are prepared in accordance with GAAP.
As a result, financial activities and the Consolidated Balance Sheets are
measured with reference to historical cost or fair market value without
considering inflation.




Item 7A. Quantitative and Qualitative
Disclosures about Market Risk




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




30




---



Item 8. Financial Statements and
Supplementary Data




NOVASTAR FINANCIAL,
      INC.CONSOLIDATED BALANCE
      SHEETS(dollars in thousands, except share
      amounts)December 31,2009
            
            2008AssetsUnrestricted
      cash and cash equivalents
            $
            7,104
            
            
            $
            24,790Restricted
      cash
            
            5,342
            
            
            
            6,046Mortgage loans
      – held-in-portfolio, net of allowance of $712,614 and
              $776,001,
      respectively
            
            1,289,474
            
            
            
            1,772,838Mortgage
      securities – trading
            
            1,087
            
            
            
            7,085Mortgage
      securities – available-for-sale
            
            6,903
            
            
            
            12,788Real estate
      owned
            
            64,179
            
            
            
            70,480Accrued
      interest receivable
            
            74,025
            
            
            
            77,292Other
      assets
            
            11,377
            
            
            
            5,704Assets of
      discontinued operations
            
            -
            
            
            
            1,441Total
      assets
            $
            1,459,491
            
            
            $
            1,978,464Liabilities and Shareholders’
      DeficitLiabilities:Asset-backed
      bonds secured by mortgage loans
            $
            2,270,602
            
            
            $
            2,599,351Asset-backed
      bonds secured by mortgage securities
            
            968
            
            
            
            5,376Junior
      subordinated debentures
            
            77,815
            
            
            
            77,323Due to
      servicer
            
            136,855
            
            
            
            117,635Dividends
      payable
            
            34,402
            
            
            
            19,088Accounts
      payable and other liabilities
            
            15,401
            
            
            
            33,928Liabilities of
      discontinued operations
            
            -
            
            
            
            2,536Total
      liabilities
            
            2,536,043
            
            
            
            2,855,237Commitments and
      contingencies (Note 7)Shareholders’
      deficit:Capital stock,
      $0.01 par value, 50,000,000 shares authorized:Redeemable
      preferred stock, $25 liquidating preferenceper share;
      2,990,000 shares, issued and outstanding
            
            30
            
            
            
            30Convertible
      participating preferred stock, $25 liquidating preferenceper share;
      2,100,000 shares, issued and outstanding
            
            21
            
            
            
            21Common stock,
      9,368,053 and 9,368,053 shares,
              issued and
      outstanding, respectively
            
            94
            
            
            
            94Additional
      paid-in capital
            
            786,989
            
            
            
            786,279Accumulated
      deficit
            
            (1,868,398
            )
            
            
            (1,671,984
            )Accumulated
      other comprehensive income
            
            5,111
            
            
            
            8,926Other
            
            (70
            )
            
            
            (139
            )Total NovaStar
      shareholders’ deficit
            
            (1,076,223
            )
            
            
            (876,773
            )Noncontrolling
      interests
            
            (329
            )
            
            
            -Total
      shareholders’ deficit
            
            (1,076,552
            )
            
            
            (876,773
            )Total
      liabilities and shareholders’ deficit
            $
            1,459,491
            
            
            $
            1,978,464


See notes to
consolidated financial statements.




31




---



NOVASTAR FINANCIAL,
      INC.CONSOLIDATED STATEMENTS OF
      OPERATIONS(dollars in thousands, except share
      amounts)For the Year
  EndedDecember 31,2009
            
            2008Interest income
            $
            153,844
            
            
            $
            235,009Interest expense
            
            24,547
            
            
            
            114,980Net interest income before
      provision for credit losses
            
            129,297
            
            
            
            120,029Provision for credit losses
            
            (260,860
            )
            
            
            (707,364
            )Net interest expense after
      provision for credit losses
            
            (131,563
            )
            
            
            (587,335
            )Other operating expense:Gains on debt
    extinguishment
            
            -
            
            
            
            6,418Losses on derivative instruments
            
            (4,665
            )
            
            
            (18,094
            )Fair value adjustments
            
            (6,743
            )
            
            
            (25,743
            )Impairments on mortgage securities – available-for-sale
            
            (1,198
            )
            
            
            (23,100
            )Servicing fee expense
            
            (10,639
            )
            
            
            (13,596
            )Appraisal fee income
            
            31,106
            
            
            
            2,524Appraisal fee expense
            
            (21,467
            )
            
            
            (1,693
            )Premiums for mortgage loan insurance
            
            (6,178
            )
            
            
            (15,847
            )Other (expense) income,
    net
            
            876
            
            
            
            (19
            )Total other operating expense
            
            (18,908
            )
            
            
            (89,150
            )General and administrative expenses:Office
      administration
            
            4,774
            
            
            
            9,407Professional
      and outside services
            
            7,081
            
            
            
            7,019Compensation
      and benefits
            
            5,594
            
            
            
            5,944Other appraisal
      management expenses
            
            12,633
            
            
            
            1,170Other
            
            1,495
            
            
            
            881Total general and administrative expenses
            
            31,577
            
            
            
            24,421Loss from continuing operations
      before income tax provision
            
            (182,048
            )
            
            
            (700,906
            )Income tax provision expense (benefit)
            
            1,108
            
            
            
            (17,594
            )Loss from continuing
      operations
            
            (183,156
            )
            
            
            (683,312
            )Income from discontinued operations, net of income tax
            
            -
            
            
            
            22,830Net loss
            
            (183,156
            )
            
            
            (660,482
            )Less net loss attributable to noncontrolling interests
            
            (2,054
            )
            
            
            -Net loss available to common
      shareholders
            $
            (181,102
            )
            
            $
            (660,482
            )Basic earnings
      per share:Loss from
      continuing operations available to common shareholders
            $
            (20.97
            )
            
            $
            (74.81
            )Income from
      discontinued operations, net of income tax
            
            -
            
            
            
            2.44Net loss
      available to common shareholders
            $
            (20.97
            )
            
            $
            (72.37
            )Diluted earnings per share:Loss from
      continuing operations available to common shareholders
            $
            (20.97
            )
            
            $
            (74.81
            )Income from
      discontinued operations, net of income tax
            
            -
            
            
            
            2.44Net loss
      available to common shareholders
            $
            (20.97
            )
            
            $
            (72.37
            )Weighted average basic shares outstanding
            
            9,368,053
            
            
            
            9,338,131Weighted average diluted shares
      outstanding
            
            9,368,053
            
            
            
            9,338,131


See notes to
consolidated financial statements.




32




---



NOVASTAR  FINANCIAL, INC. CONSOLIDATED  STATEMENTS OF SHAREHOLDERS’  DEFICIT  (dollars in thousands,  except share amounts)




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







33




---



Total NovaStar Financial, Inc.
      Shareholders’ DeficitConvertible
            
            
            
            
            
            
            
            
            
            
            
            AccumulatedRedeemable
            
            Participating
            
            
            
            
            Additional
            
            
            
            
            
            Other
            
            
            
            
            
            
            
            
            
            TotalPreferred
            
            Preferred
            
            Common
            
            Paid-in
            
            Accumulated
            
            Comprehensive
            
            
            
            
            
            Noncontrolling
            
            Shareholders’Stock
            
            Stock
            
            Stock
            
            Capital
            
            Deficit
            
            Income
            
            Other
            
            Interest
            
            DeficitBalance, January 1,
      2009
            $
            30
            
            $
            21
            
            $
            94
            
            $
            786,279
            
            $
            (1,671,984
            )
            
            $
            8,926
            
            
            $
            (139
            )
            
            $
            -
            
            
            $
            (876,773
            )Forgiveness of founder’s notesreceivable
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            
            -
            
            
            
            69
            
            
            
            -
            
            
            
            69Compensation recognized
    understock
      compensation plans
            
            -
            
            
            -
            
            
            -
            
            
            710
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            710Accumulating dividends onpreferred stock
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (15,312
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (15,312
            )Contribution from noncontrolling
      interests
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            525
            
            
            
            525Acquisition of noncontrolling
    interests
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            1,200
            
            
            
            1,200Comprehensive loss:Net
      loss
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            (181,102
            )
            
            
            -
            
            
            
            -
            
            
            
            (2,054
            )
            
            
            (183,156
            )Other
      comprehensive loss
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            
            (3,815
            )
            
            
            -
            
            
            
            -
            
            
            
            (3,815
            )Total
      comprehensive loss
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (186,971
            )Balance, December 31,
      2009
            $
            30
            
            $
            21
            
            $
            94
            
            $
            786,989
            
            $
            (1,868,398
            )
            
            $
            5,111
            
            
            $
            (70
            )
            
            $
            (329
            )
            
            $
            (1,076,552
            )See notes to consolidated financial
      statements.
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            Concluded


34




---



NOVASTAR FINANCIAL,
      INC.CONSOLIDATED STATEMENTS OF CASH
      FLOWS(dollars in
    thousands)For the Year Ended December
      31,2009
            
            2008Cash flows from operating
      activities:Net loss
            $
            (183,156
            )
            
            $
            (660,482
            )Income from discontinued operations
            
            -
            
            
            
            22,830Loss from continuing
      operations
            
            (183,156
            )
            
            
            (683,312
            )Adjustments to reconcile loss from continuing operations to net
      cashused in operating activities:Impairment on mortgage securities -
      available-for-sale
            
            1,198
            
            
            
            23,100Losses on
      derivative instruments
            
            4,665
            
            
            
            18,094Depreciation expense
            
            869
            
            
            
            1,124Amortization of deferred debt issuance
costs
            
            2,239
            
            
            
            3,081Compensation recognized under stock compensation
      plans
            
            710
            
            
            
            (63
            )Provision
      for credit losses
            
            260,860
            
            
            
            707,364Amortization of premiums on mortgage loans
            
            2,443
            
            
            
            13,366Interest capitalized on loans
      held-in-portfolio
            
            (1,550
            )
            
            
            (19,858
            )Forgiveness of founders’ promissory notes
            
            69
            
            
            
            70Provision
      for deferred income taxes
            
            -
            
            
            
            (13,805
            )Fair
      value adjustments
            
            6,743
            
            
            
            25,743Accretion of available-for-sale and
      trading securities
            
            (23,528
            )
            
            
            (50,399
            )Gains on
      debt extinguishment
            
            -
            
            
            
            (6,418
            )Changes
      in:Accrued interest receivable
            
            3,267
            
            
            
            (15,588
            )Other assets
            
            (4,170
            )
            
            
            6,327Due to servicer
            
            19,220
            
            
            
            61,185Accounts payable and other
liabilities
            
            (21,566
            )
            
            
            (26,030
            )Net cash provided by operating activities from
      continuingoperations
            
            68,313
            
            
            
            43,981Net cash used in operating activities from discontinued
      operations
            
            (1,095
            )
            
            
            (14,415
            )Net cash provided by operating
    activities
            
            67,218
            
            
            
            29,566Cash flows from investing
      activities:Proceeds from mortgage securities - available-for-sale
            
            13,594
            
            
            
            26,899Proceeds from mortgage securities -
      trading
            
            4,885
            
            
            
            59,912Proceeds from mortgage loans held-in-portfolio
            
            98,933
            
            
            
            288,243Proceeds from sales of assets
      acquired through foreclosure
            
            129,815
            
            
            
            114,194Restricted cash proceeds, net
            
            705
            
            
            
            2,952Purchases of property and
      equipment
            
            (1,324
            )
            
            
            (25
            )Proceeds from disposal of property and equipment
            
            6
            
            
            
            -Acquisition of businesses, net of
      cash acquired
            
            2
            
            
            
            (710
            )Net cash
      provided by investing activities
            
            246,616
            
            
            
            491,465Net cash
      provided by investing activities from discontinued
      operations
            
            -
            
            
            
            2,114Net cash
      provided by investing activities
            
            246,616
            
            
            
            493,579Continued


35




---



For the Year Ended December
      31,2009
            
            2008Cash flows from financing
      activities:Payments on asset-backed bonds
            
            (331,670
            )
            
            
            (477,662
            )Contributions from noncontrolling
      interest
            
            150
            
            
            
            -Net change in short-term borrowings
            
            -
            
            
            
            (45,488
            )Repurchase of trust preferred
      debt
            
            -
            
            
            
            (550
            )Net cash used
      in financing activities from continuing operations
            
            (331,520
            )
            
            
            (523,700
            )Net cash used
      in financing activities from discontinued operations
            
            -
            
            
            
            (19
            )Net cash used
      in financing activities
            
            (331,520
            )
            
            
            (523,719
            )Net decrease in cash and cash
      equivalents
            
            (17,686
            )
            
            
            (574
            )Cash and cash equivalents, beginning of year
            
            24,790
            
            
            
            25,364Cash and cash
      equivalents, end of year
            $
            7,104
            
            
            $
            24,790SUPPLEMENTAL DISCLOSURE OF CASH
      FLOW INFORMATION(dollars in
      thousands)For the Year Ended December
      31,2009
            
            2008Cash paid for interest
            $
            33,726
            
            
            $
            111,949Cash (refunded) paid for income taxes
            
            (38
            )
            
            
            3,679Cash received on mortgage
      securities – available-for-sale with no costbasis
            
            1,872
            
            
            
            3,401Non-cash investing and financing activities:Assets
      acquired through foreclosure
            
            123,190
            
            
            
            108,172Preferred
      stock dividends accrued, not yet paid
            
            15,312
            
            
            
            15,273See notes to consolidated financial
      statements.
            
            
            
            
            
            Concluded


36




---



NOVASTAR FINANCIAL, INC.NOTES TO CONSOLIDATED FINANCIAL
      STATEMENTS





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




Description of
Operations -
NovaStar Financial, Inc. and its subsidiaries (“NFI” or the “Company”) hold
certain nonconforming residential mortgage securities. StreetLinks National
Appraisal Services LLC (“StreetLinks”), a majority-owned subsidiary of the
Company, is a residential mortgage appraisal management company. Advent
Financial Services LLC (“Advent”), a majority-owned subsidiary of the Company,
provides access to tailored banking accounts, small dollar banking products and
related services to meet the needs of low and moderate income level individuals.




Effective August 1,
2008, the Company acquired a 75% interest in StreetLinks for an initial cash
purchase price of $750,000 plus future payments contingent upon StreetLinks
reaching certain earnings targets. Results of operations from August 1, 2008
forward are included in the consolidated statement of operations. Simultaneously
with the acquisition, the Company transferred ownership of 5% of StreetLinks to
the Chief Executive Officer of StreetLinks. The Company has contributed
additional capital to StreetLinks subsequent to our initial acquisition,
bringing the Company’s total ownership to 88%. If StreetLinks achieves certain
performance targets by December 31, 2010, the Company will transfer 8% of its
membership interest in StreetLinks to certain existing members and employees.




On April 26, 2009,
the Company acquired a 70% interest in Advent for an initial cash contribution
into Advent of $2 million plus future contributions contingent upon Advent
reaching certain earnings and other performance targets. Results of operations
from April 26, 2009 forward are included in the consolidated statement of
operations.




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




Financial Statement
Presentation - The Company’s consolidated financial
statements have been prepared in conformity with accounting principles generally
accepted in the United States of America (“GAAP”) and prevailing practices
within the financial services industry. The preparation of financial statements
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities at the date of the financial statements and
the reported amounts of income and expense during the period. The Company uses
estimates and employs the judgments of management in determining the amount of
its allowance for credit losses, amortizing premiums or accreting discounts on
its mortgage assets, establishing the fair value of its mortgage securities,
reserve for losses on third party sales, derivative instruments, CDO debt and
estimating appropriate accrual rates on mortgage securities –
available-for-sale. While the consolidated financial statements and footnotes
reflect the best estimates and judgments of management at the time, actual
results could differ significantly from those estimates. In accordance with
Subsequent Event guidance, the Company evaluated all events or transactions that
occurred after December 31, 2009 through the date of the issuance of these
financial statements. Subsequent events are discussed in Note 20 to the
financial statements.




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




Business Plan -  As discussed above, the Company acquired
a majority interest in an appraisal management company, StreetLinks, during the
third quarter of 2008 and increased its ownership percentage in the fourth
quarter of 2009. In addition, the Company acquired a majority interest in Advent
in April 2009. Management continues to grow and develop these operating
entities. Additionally, the Company will continue to focus on minimizing
expenses, preserving liquidity, and exploring additional investments in
operating companies.




StreetLinks and the
Company’s residual mortgage securities are currently the significant source of
cash flows. The Company expects the cash flows from the mortgage securities to
decrease during 2010 as the underlying mortgage loans are repaid, and could be
significantly less than recent experience if losses on the underlying mortgage
loans exceed the current assumptions. The Company expects the cash flows from
StreetLinks to continue to increase as partially attributable to new legislation
which went into effect in the first quarter of 2010 that will positively impact
StreetLinks business. The Company also expects cash flows to increase due to a
larger customer base and operating efficiencies.




Liquidity -  The Company had $7.1 million in
unrestricted cash and cash equivalents at December 31, 2009, which was a
decrease of $17.7 million from December 31, 2008. As of March 30, 2010, the
Company had approximately $15.5 million in available cash on hand (including
$1.8 million of restricted cash). In addition to the Company’s operating
expenses, the Company has quarterly interest payments due on its trust preferred
securities. The Company’s current projections indicate sufficient available cash
and cash flows from StreetLinks and its mortgage securities to meet these
payment needs.




37




---



During 2009, the
Company continued its strategy of growing and developing StreetLinks and
significantly increased its appraisal volume. For the year ended December 31,
2009, StreetLinks had revenues of $31.1 million, as compared to $2.5 million in
2008. StreetLinks incurred significant start-up expenses to develop its
infrastructure in 2009, which are not expected to be recurring. As a result,
management expects StreetLinks to produce positive net cash flows and
earnings going forward.




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




During 2009, the
Company used significant amounts of cash to pay for costs related to our legacy
mortgage lending and servicing operations, pay for current administrative costs
and invest in StreetLinks and Advent. The Company will continue to evaluate the
Advent business model, however the Company does not believe that Advent will be
a significant source or use of cash during 2010.




The Company’s
consolidated financial statements have been prepared on a going concern basis of
accounting which contemplates continuity of operations, realization of assets,
liabilities and commitments in the normal course of business. The Company has
experienced significant losses over the past several years and has a significant
deficit in stockholders’ equity. Notwithstanding these negative factors,
management believes that its current operations and its cash availability are
sufficient for the Company to discharge its liabilities and meet its commitments
in the normal course of business.




Note 2. Summary of Significant Accounting
and Reporting Policies




Cash and Cash Equivalents The Company
considers investments with original maturities of three months or less at the
date of purchase to be cash equivalents. The Company maintains cash balances at
several major financial institutions in the United States. Accounts at each
institution are secured by the Federal Deposit Insurance Corporation up to
$250,000, through December 31, 2013. At December 31, 2009 and 2008, 41% and 43%
of the Company’s cash and cash equivalents, including restricted cash, were with
one institution. The uninsured balances of the Company’s unrestricted cash and
cash equivalents and restricted cash aggregated $11.3 million and $29.8 million
as of December 31, 2009 and 2008, respectively.




Restricted Cash Restricted
cash includes funds the Company is required to post as cash collateral or
transfer to escrow accounts and its release is subject to contractual
requirements and time restrictions. The cash may not be released to the Company
without the consent of the counterparties, which is generally at their
discretion. The cash could also be subject to the indemnification of losses
incurred by the counterparties. The Company received approximately $2.9 million
during February 2010.




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




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




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




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




38




---



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




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




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




As previously
described, mortgage securities-available-for-sale represent retained beneficial
interests in certain components of the cash flows of the underlying mortgage
loans to securitization trusts. As payments are received on both the residual
and subordinated securities, the payments are applied to the cost basis of the
related mortgage securities. Each period, the accretable yield for each mortgage
security is evaluated and, to the extent there has been a change in the
estimated cash flows, it is adjusted and applied prospectively. The estimated
cash flows change as management’s assumptions for credit losses, borrower
prepayments and interest rates are updated. The assumptions are established
using proprietary models the Company has developed. The accretable yield is
recorded as interest income with a corresponding increase to the cost basis of
the mortgage security.




The Company
estimates the fair value of its residual securities retained 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, market
discount rates and forward yield curves commensurate with the risks involved,
are used in estimating future cash flows.




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




Mortgage Securities
– Trading consisted of one residual security at December 31, 2009 and 2008 with
the remaining balance comprised of subordinated securities. See Mortgage Securities –
Available-for-Sale for further details of the Company’s residual and subordinated securities.




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




Real Estate Owned 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 earnings.




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




Maintenance and
repairs are charged to expense. Major renewals and improvements are capitalized.
Gains and losses on dispositions are credited or charged to earnings as
incurred. Depreciation expense related to continuing operations for the years
ended December 31, 2009 and 2008 was $0.8 million and $1.1 million,
respectively. There was no depreciation expense related to discontinued
operations for the years ended December 31, 2009 and 2008.




39




---



Premiums for Mortgage Loan Insurance The 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 costs of the premiums are incurred.
For those loans sold in securitization transactions accounted for as a sale, the
independent trust assumes the obligation to pay the premiums and obtains the
right to receive insurance proceeds.




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




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




Stock-Based Compensation At December
31, 2009, the Company had one stock-based employee compensation plan, which is
described more fully in Note 18 and is accounted for using Share-Based Payment
guidance.




Income Taxes In determining the amount of deferred tax
assets to recognize in the financial statements, the Company evaluates the
likelihood of realizing such benefits in future periods. The Income Taxes
guidance requires the recognition of a valuation allowance if it is more likely
than not that all or some portion of the deferred tax asset will not be
realized. Income Taxes guidance indicates the more likely than not threshold is
a level of likelihood that is more than 50%.




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




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




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




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




The Company
evaluates whether a tax position taken by the company will “more likely than
not” be sustained upon examination by the appropriate taxing authority. The
company measures the amount of benefit to recognize in its financial statements
as the largest amount of benefit that is greater than 50% likely of being
realized upon ultimate settlement. It is the Company’s policy to recognize
interest and penalties related to income tax matters in income tax expense
(benefit).




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




40




---



New Accounting
Pronouncements




In June 2009, the
Financial Accounting Standards Board (“FASB”) issued Statement of Financial
Accounting Standards (“SFAS”) No. 166, Accounting for the Transfers of Financial
Assets, an Amendment of FASB Statement No. 140; this statement was codified in
December, 2009 as Accounting Standards Codification (“ASC”) 860. This guidance
is effective for financial asset transfers beginning on January 1, 2010 and will
be used to determine whether the transfer is accounted for as a sale under GAAP
or as a secured borrowing. In addition, also in June, 2009, the FASB issued SFAS
No. 167, Amendments to FASB Interpretation No. 46 (R); this statement was also
codified in December 2009 as ASC 810 and governs the consolidation of variable
interest entities. The consolidation guidance will become effective for all VIEs
the Company held as of January 1, 2010. As part of the Company’s adoption of the
amended consolidation guidance, it was required to reconsider the Company’s
previous consolidation conclusions pertaining to the Company’s variable
interests in VIEs, including: (i) whether an entity is a VIE; and (ii) whether
the Company is the primary beneficiary. Based on the Company’s assessment of its
involvement in VIEs at January 1, 2010, in accordance with the amended
consolidation guidance, the Company determined that it is not the primary
beneficiary of any mortgage loan securitization entities in which it held a
variable interest, as the Company does not have the power to direct the
activities that most significantly impact the economic performance of these
entities. The adoption of the amended consolidation guidance will therefore not
result in the Company consolidating or deconsolidating any VIEs for which it has
involvement. It should be noted, however, that the new guidance also requires
the Company to reassess these conclusions, based upon changes in the facts and
circumstances pertaining to the Company’s VIEs, on an ongoing basis; thus the
Company’s assessments may therefore change and could result in a material impact
to the Company’s financial statements during subsequent reporting periods. The
Company will provide the presentation and disclosure requirements in the amended
consolidation guidance in its financial statements for the three month period
ending March 31, 2010.




Subsequent to
December 31, 2009, there were certain events which the Company has determined
should result in a reassessment of the consolidation of the NHEL 2006-1, MTA
2006-1, and NHEL 2007-1 securitizations. Based on the provisions of the amended
guidance and the conclusion by Company management that a new transfer date has
occurred for the NHEL 2006-1, MTA 2006-1, and NHEL 2007-1 securitizations, the
Company believes that it will deconsolidate the assets and liabilities of
the NHEL 2006-1, MTA 2006-1, and NHEL 2007-1 securitization trusts and will
record a gain during the three month period ending March 31, 2010. See Note 20
to the consolidated financial statements for further details.




As a result of the
analysis, the Company does not anticipate any impact to the Company’s financial
statements upon the Company’s initial adoption of the amended Transfers and
Servicing guidance and the amended Consolidation guidance on January 1, 2010.
However, as discussed above, the Company re-evaluated the NHEL 2006-1, MTA
2006-1, and NHEL 2007-1 securitization transactions and determined that based on
the occurrence of certain events during 2010, the application of the amended
Transfers and Servicing guidance will result in the Company reflecting as sales
of financial assets and extinguishment of liabilities the assets and liabilities
of the securitization trusts during the three month period ending March 31,
2010. See Note 20 to the consolidated financial statements for further details.




Improving Disclosures about Fair Value
Measurements. In
January 2010, the Financial Accounting Standards Board (“FASB”) issued new fair
value disclosure guidance. The new guidance requires disclosing the amounts of
significant transfers in and out of Level 1 and 2 fair value measurements and to
describe the reasons for the transfers. The disclosures are effective for
reporting periods beginning after December 15, 2009. Additionally, disclosures
of the gross purchases, sales, issuances and settlements activity in Level 3
fair value measurements will be required for fiscal years beginning after
December 15, 2010.




Note 3. Mortgage Loans –
Held-in-Portfolio




Mortgage loans –
held-in-portfolio, all of which are secured by residential properties, consisted
of the following as of December 31, 2009 and 2008 (dollars in thousands):




December 31,
            
            December 31,2009
            
            2008Mortgage loans –
      held-in-portfolio:Outstanding principal
            $
            1,985,483
            
            
            $
            2,529,791Net unamortized deferred origination
      costs
            
            16,605
            
            
            
            19,048Amortized
      cost
            
            2,002,088
            
            
            
            2,548,839Allowance for credit losses
            
            (712,614
            )
            
            
            (776,001
            )Mortgage
      loans – held-in-portfolio
            $
            1,289,474
            
            
            $
            1,772,838Weighted average coupon
            
            6.94
            %
            
            
            8.00
            %


Mortgage loans
held-in-portfolio consist of loans that the Company has securitized in
structures that are accounted for as financings. These securitizations are
structured legally as sales, but for accounting purposes are treated as
financings under the “Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities” guidance. See below for details of the
Company’s securitization transactions structured as financings.




41




---



At inception the
NHES 2006-1 and NHES 2006-MTA1 securitizations did not meet the qualifying
special purpose entity criteria necessary for derecognition because after the
loans were securitized the securitization trusts were able to acquire
derivatives relating to beneficial interests retained by the Company;
additionally, the Company had the unilateral ability to repurchase a limited
number of loans back from these two trusts. The NHES 2007-1 securitization does
not meet the qualifying special purpose entity criteria necessary for
derecognition because of the excessive benefit the Company received at inception
from the derivative instruments delivered into the trust to counteract interest
rate risk.




Accordingly, the
loans in these securitizations remain on the Consolidated Balance Sheets as
“Mortgage loans – held-in-portfolio”. Given this treatment, retained interests
are not created, and securitization bond financing is reflected on the
Consolidated Balance Sheets as a liability. The Company records interest income
on loans held-in-portfolio and interest expense on the bonds issued in the
securitizations over the life of the securitizations. Deferred debt issuance
costs and discounts related to the bonds are amortized using an effective yield
basis over the estimated life of the bonds.




Mortgage loans –
held-in-portfolio are serviced by a third party entity. During the year ended
December 31, 2009, the servicer modified loans totaling $230.0 million in
principal with weighted-average interest rates of 8.59% and 4.87% before and
after modification, respectively. The modifications are offered to borrowers
experiencing financial difficulties and serve to reduce monthly payments and
defer unpaid interest. The Company’s estimates for the allowance for loan losses
and related provision include the projected impact of the modified loans.




At December 31,
2009 all of the loans classified as held-in-portfolio were pledged as collateral
for financing purposes.




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




For the Year Ended December
      31,Principal Amount
of
            
            Net Credit
  LossesTotal Principal Amount
      of
            
            Loans 60 Days or
    More
            
            During the Year
    EndedLoans (A)
            
            Past Due
            
            December 31,
(B)2009
            
            2008
            
            2009
            
            2008
            
            2009
            
            2008Loans securitized
            
            $
            6,570,308
            
            $
            8,121,668
            
            $
            3,296,863
            
            $
            3,371,720
            
            $
            735,892
            
            $
            469,182Loans held-in-portfolio
            
            
            2,138,500
            
            
            2,684,213
            
            
            1,243,731
            
            
            1,270,261
            
            
            321,097
            
            
            155,765Total loans securitized or
      held-in-portfolio
            
            $
            8,708,808
            
            $
            10,805,881
            
            $
            4,540,594
            
            $
            4,641,981
            
            $
            1,056,989
            
            $
            624,947


(A)
            
            Includes assets acquired through foreclosure.(B)
            
            Represents the realized losses as reported by the securitization
      trusts for each period presented.




Collateral for 25%
and 23% of the mortgage loans held-in-portfolio outstanding as of December 31,
2009 was located in California and Florida, respectively. Collateral for 27% and
21% of the mortgage loans held-in-portfolio outstanding as of December 31, 2008
was located in California and Florida, respectively. Interest only loan products
made up 10% and 22% of the loans classified as held-in-portfolio as of December
31, 2009 and 2008, respectively. In addition, as of December 31, 2009, moving
treasury average (“MTA”) loan products made up 26% of the loans classified as
held-in-portfolio compared to 27% as of December 31, 2008. These MTA loans had
$1.6 million and $19.9 million in negative amortization during 2009 and 2008,
respectively. The Company has no other significant concentration of credit risk
on mortgage loans.




Mortgage loans –
held-in-portfolio that the Company has placed on non-accrual status totaled
$712.6 million and $755.5 million at December 31, 2009 and 2008, respectively.
At December 31, 2009 the Company had $433.4 million in mortgage loans –
held-in-portfolio past due 90 days or more, which were still accruing interest
as compared to $436.2 million at December 31, 2008. These loans carried mortgage
insurance and the accrual will be discontinued when in management’s opinion the
interest is not collectible.




Activity in the
allowance for credit losses on mortgage loans – held-in-portfolio is as follows
for the two years ended December 31, 2009 (dollars in thousands):




2009
            
            2008Balance, beginning of
    period
            $
            776,001
            
            
            $
            230,138Provision for credit losses
            
            260,860
            
            
            
            707,364Charge-offs, net of recoveries
            
            (324,247
            )
            
            
            (161,501
            )Balance, end of period
            $
            712,614
            
            
            $
            776,001


42




---



The FASB Staff
Position, Disclosures by Public Entities
(Enterprises) about Transfers of Financial Assets and Interests in Variable
Interest Entities (“VIE Guidance”), which was adopted by the Company on December 31, 2008,
provides the disclosure requirements for transactions with VIEs or special
purpose entities and transfers of financial assets in securitizations or
asset-backed financing arrangements. Under the VIE Guidance, the Company is
required to disclose information for consolidated VIEs, for VIEs in which the
Company is the sponsor as defined below or is a significant variable interest
holder (“Sponsor/Significant VIH”) and for VIEs that are established for
securitizations and asset-backed financing arrangements. The VIE Guidance has
expanded the population of VIEs for which disclosure is required.




The Company has
defined “sponsor” to include all transactions where the Company has transferred
assets to a VIE and/or structured the VIE, regardless of whether or not the
asset transfer has met the sale conditions in the previous guidance. The Company
discloses all instances where continued involvement with the assets exposes it
to potential economic gain/(loss), regardless of whether or not that continued
involvement is considered to be a variable interest in the VIE.




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




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




Securitization
transactions .
For the purposes of this disclosure, securitization transactions include
transactions where the Company transferred mortgage loans and accounted for the
transfer as a sale. This category includes QSPEs and is reflected in the
securitization section of this Note. QSPEs are commonly used by the Company in
securitization transactions as described below. In accordance with VIE
Guidance , the Company does not consolidate
QSPEs.




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




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




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




Variable Interest
Entities




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




There were no
material reconsideration events during the period.




43




---



The table below
provides the disclosure information required by the VIE guidance for VIEs that
are consolidated by the Company (dollars in thousands):




Assets After
      IntercompanyEliminationsLiabilities AfterIntercompany
            
            Recourse to theConsolidated VIEs
            
            Total Assets
            
            Unrestricted
            
            Restricted (A)
            
            Eliminations
            
            Company (B)December 31, 2009Mortgage Loan VIEs(C)
            
            $
            1,435,671
            
            $
            -
            
            $
            1,427,501
            
            $
            2,453,181
            
            $
            -CDO(D)
            
            
            1,389
            
            
            -
            
            
            1,387
            
            
            1,387
            
            
            -December 31, 2008Mortgage Loan VIEs(C)
            
            $
            1,930,063
            
            $
            -
            
            $
            1,920,610
            
            $
            2,730,280
            
            $
            -CDO(D)
            
            
            7,435
            
            
            -
            
            
            7,035
            
            
            8,557
            
            
            -


(A)
            
            Assets are considered restricted when they cannot be freely pledged
      or sold by the Company.(B)
            
            This column reflects the extent, if any, to which investors have
      recourse to the Company beyond the assets held by the VIE and assumes a
      total loss of the assets held by the VIE.(C)
            
            For Mortgage Loan VIEs, assets are primarily recorded in Mortgage
      loans – held-in-portfolio. Liabilities are primarily recorded in
      Asset-backed bonds secured by mortgage loans.(D)
            
            For the CDO, assets are primarily recorded in Mortgage securities –
      trading and liabilities are recorded in Asset-backed bonds secured by
      mortgage securities.




Securitizations




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




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




Size/Principal
            
            Assets on
            
            Liabilities on
            
            Maximum
            
            Year toOutstanding
            
            Balance
            
            Balance
            
            Exposure to
            
            Date Loss
            
            Year to Date(A)
            
            Sheet
            
            Sheet
            
            Loss(B)
            
            on Sale
            
            Cash FlowsDecember 31, 2009Residential mortgageloans(C)
            
            $
            6,570,308
            
            $
            7,031
            
            $
            -
            
            $
            7,031
            
            $
            -
            
            $
            15,867December 31, 2008Residential mortgageloans(C)
            
            $
            8,121,668
            
            $
            15,919
            
            $
            -
            
            $
            15,919
            
            $
            -
            
            $
            58,891


(A)
            
            Size/Principal Outstanding reflects the estimated principal of the
      underlying assets held by the VIE/SPEs.(B)
            
            The maximum exposure to loss includes the following: the assets
      held by the Company retained interests in the VIEs/SPEs. The maximum
      exposure to loss assumes a total loss on the referenced assets held by the
      VIE.(C)
            
            For residential mortgage loans QSPEs, assets on balance sheet are
      primarily securities issued by the entity and are recorded in Mortgage
      securities-available-for-sale and Mortgage
  securities-trading.




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




Retained interests
are recorded in the Consolidated Balance Sheets at fair value. The Company
estimates fair value for the retained residual securities based on the present
value of expected future cash flows using management’s best estimates of credit
losses, prepayment rates, forward yield curves, and discount rates, commensurate
with the risks involved. The fair value of retained subordinated securities is
estimated using quoted market prices compared to internal discounted cash flows.
Retained interests are either held as mortgage securities – trading, with
changes in fair value recorded in the Consolidated Statements of Operations, or
as mortgage securities – available-for-sale, with changes in fair value included
in accumulated other comprehensive income.




Retained interests
are reviewed periodically for impairment. The retained interests consisted of
$6.9 million of residual interests as of December 31, 2009 and $13.5 million of
residual interests and $2.4 million of retained subordinated interests as of
December 31, 2008, respectively.




The following table
presents information on retained interests excluding the offsetting benefit of
financial instruments used to hedge risks, held by the Company as of December
31, 2009 arising from the Company’s residential mortgage-related securitization
transactions. The pre-tax sensitivities of the current fair value of the
retained interests to immediate 10% and 25% adverse changes in assumptions and
parameters are also shown (dollars in thousands):




44




---



Carrying amount/fair value of
      residual interests
            $
            7,031Weighted average life (in years)
            
            3.72Weighted average prepayment speed
      assumption (CPR) (percent)
            
            17.0Fair value after a 10% increase in
      prepayment speed
            $
            6,816Fair value
      after a 25% increase in prepayment speed
            $
            6,249Weighted average expected annual credit losses (percent of current
      collateral balance)
            
            25.7Fair value
      after a 10% increase in annual credit losses
            $
            6,833Fair value after a 25% increase in annual
      credit losses
            $
            6,572Weighted average residual cash
      flows discount rate (percent)
            
            25.0Fair value after a 500 basis point
      increase in discount rate
            $
            6,811Fair value after a 1000 basis point
      increase in discount rate
            $
            6,604Market interest rates:Fair value after a 100 basis point
      increase in market rates
            $
            4,873Fair value after a 200 basis point
      increase in market rates
            $
            2,910


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




Note 4. Mortgage Securities –
Available-for-Sale




As of December 31,
2009 and 2008, mortgage securities – available-for-sale consisted entirely of
the Company’s investment in the residual securities issued by securitization
trusts sponsored by the Company, but did not include the NMFT Series 2007-2
residual security. Residual securities consist of interest-only, prepayment
penalty and overcollateralization bonds. Management estimates the fair value of
the residual securities by discounting the expected future cash flows of the
collateral and bonds.




The following table
presents certain information on the Company’s portfolio of mortgage securities –
available-for-sale as of December 31, 2009 and December 31, 2008 (dollars in
thousands):




Unrealized LossesUnrealized
            
            Less Than Twelve
            
            Estimated Fair
            
            AverageCost Basis
            
            Gain
            
            Months
            
            Value
            
            Yield (A)As of December 31, 2009
            
            $
            1,792
            
            $
            5,111
            
            -
            
            $
            6,903
            
            132.90
            %As of December 31, 2008
            
            
            3,771
            
            
            9,017
            
            -
            
            
            12,788
            
            38.2


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




During the years
ended December 31, 2009 and 2008 management concluded that the decline in value
on certain securities in the Company’s mortgage securities – available-for-sale
portfolio were other-than-temporary. As a result, the Company recognized
impairments on mortgage securities – available-for-sale of $1.2 million and
$23.1 million during the years ended December 31, 2009 and 2008,
respectively.




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




Note 5. Mortgage Securities – Trading




Mortgage securities
– trading consist of the NMFT Series 2007-2 residual security, and subordinated
securities retained by the Company from securitization transactions and
subordinated securities purchased from other issuers in the open market.
Management estimates the fair value of the residual securities by discounting
the expected future cash flows of the collateral and bonds. The fair value of
the subordinated securities is estimated based on quoted market prices and
compared to estimates based on discounting the expected future cash flows of the
collateral and bonds. Refer to Note 10 for a description of the valuation
methods as of December 31, 2009 and December 31, 2008. The following table
summarizes the Company’s mortgage securities – trading as of December 31, 2009
and December 31, 2008 (dollars in thousands):




45




---



Amortized Cost
            
            
            
            
            AverageOriginal Face
            
            Basis
            
            Fair Value
            
            Yield (A)As of December 31,
      2009Subordinated securities pledged to
      CDO
            
            $
            332,489
            
            $
            103,638
            
            $
            959Other subordinated securities
            
            
            102,625
            
            
            -
            
            
            -Residual securities
            
            
            -
            
            
            374
            
            
            128Total
            
            $
            435,114
            
            $
            104,012
            
            $
            1,087
            
            4.79
            %As of December 31,
      2008Subordinated securities pledged to
      CDO
            
            $
            332,489
            
            $
            321,293
            
            $
            4,798Other subordinated securities
            
            
            102,625
            
            
            96,723
            
            
            1,582Residual securities
            
            
            -
            
            
            15,952
            
            
            705Total
            
            $
            435,114
            
            $
            433,968
            
            $
            7,085
            
            9.55
            %


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


The Company
recognized net trading losses of $11.8 million and $88.7 million for the years
ended December 31, 2009 and 2008, respectively, which are included in the fair
value adjustments line of the Company’s Consolidated Statements of
Operations.




Note 6. Borrowings




Junior Subordinated
Debentures




NFI’s wholly owned
subsidiary NovaStar Mortgage, Inc. (“NMI”) has approximately $77.8 million in
principal amount of unsecured notes (collectively, the “Notes”) outstanding to
NovaStar Capital Trust I and NovaStar Capital Trust II (collectively, the
“Trusts”) which secure trust preferred securities issued by the Trusts. NFI has
guaranteed NMI's obligations under the Notes. NMI failed to make quarterly
interest payments that were due on all payment dates in 2008 and through April
24, 2009 on these Notes.




On April 24, 2009
(the “Exchange Date”), the parties executed the necessary documents to complete
an exchange of the Notes for new preferred obligations. On the Exchange Date,
the Company paid interest due through December 31, 2008, in the aggregate amount
of $5.3 million. In addition, the Company paid $0.3 million in legal and
administrative costs on behalf of the Trusts which was recorded in the
“Professional and outside services” line item on the Consolidated Statements of
Operations.




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




Collateralized Debt Obligation Issuance
(“CDO”)




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




The Company elected
the fair value option for the asset-backed bonds issued from NovaStar ABS CDO I.
The election was made for these liabilities to help reduce income statement
volatility which otherwise would arise if the accounting method for this debt
was not matched with the fair value accounting for the mortgage securities -
trading. Fair value is estimated using quoted market prices. The Company
recognized fair value adjustments of $5.1 and $63.0 million for the years ended
December 31, 2009 and 2008, respectively, which is included in the “Fair value
adjustments” line item on the Consolidated Statements of
Operations.




46




---



On January 30,
2008, an event of default occurred under the CDO bond indenture agreement due to
the noncompliance of certain overcollateralization tests. As a result, the
trustee, upon notice and at the direction of a majority of the secured
noteholders, may declare all of the secured notes to be immediately due and
payable including accrued and unpaid interest. No such notice has been given as
of March 30, 2010. As there is no recourse to the Company, it does not expect
any significant impact to its financial condition, cash flows or results of
operation as a result of the event of default.




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




For ABB secured by
mortgage loans, the Company retained a “clean up” call option to repay the ABB,
and reacquire the mortgage loans, when the remaining unpaid principal balance of
the underlying mortgage loans falls below 10% of their original amounts. The
Company subsequently sold all of these clean up call rights, to the buyer of our
mortgage servicing rights. The Company did retain separate independent rights to
require the buyer of our mortgage servicing rights to repurchase loans from the
trusts and subsequently sell them to us; the Company does not expect to exercise
any of the call rights that it retained. The Company had no ABB transactions for
the year ended December 31, 2009.




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




Asset-backed Bonds
            
            Mortgage LoansEstimatedWeightedWeighted
            
            AverageAverage
            
            Months
            
            
            
            
            
            WeightedRemaining
            
            Interest
            
            to Call or
            
            Remaining
            
            AveragePrincipal
            
            Rate
            
            Maturity
            
            Principal
            
            CouponAs of December 31,
      2009:ABB Secured by Mortgage Loans:NHES Series
      2006-1
            
            $
            475,360
            
            
            0.52
            %
            
            72
            
            $
            399,913
            
            
            8.03
            %NHES Series
      2006-MTA1
            
            
            602,068
            
            
            0.48
            
            
            51
            
            
            532,696
            
            
            3.84NHES Series
      2007-1
            
            
            1,201,517
            
            
            0.50
            
            
            106
            
            
            1,052,873
            
            
            6.99Unamortized debt
      issuance costs, net
            
            
            (8,343
            )$
            2,270,602ABB Secured by Mortgage Securities:NovaStar ABS CDO
      I
            
            $
            323,999
            (A)
            
            0.80
            %
            
            16
            
            
            
            (B)
            
            
            (B)As of December 31,
      2008:ABB Secured by Mortgage Loans:NHES Series
      2006-1
            
            $
            553,669
            
            
            0.33
            %
            
            84
            
            $
            528,766
            
            
            8.95
            %NHES Series
      2006-MTA1
            
            
            683,757
            
            
            0.75
            
            
            40
            
            
            680,127
            
            
            5.80NHES Series
      2007-1
            
            
            1,372,015
            
            
            0.78
            
            
            116
            
            
            1,320,898
            
            
            8.76Unamortized debt
      issuance costs, net
            
            
            (10,090
            )$
            2,599,351ABB Secured by Mortgage Securities:NovaStar
      ABS CDO I
            
            $
            325,930
            (A)
            
            3.08
            %
            
            26
            
            
            
            (B)
            
            
            (B)


(A)
            
            The NovaStar ABS CDO I ABB are carried at a fair value of $1.0
      million and $5.4 million on the Company’s Consolidated Balance Sheets at
      December 31, 2009 and 2008, respectively.(B)
            
            Collateral for the NovaStar ABS CDO I are subordinated mortgage
      securities.




The following table
summarizes the expected repayment requirements relating to the securitization
bond financing at December 31, 2009 (dollars in thousands). Amounts listed as
bond payments are based on anticipated receipts of principal on underlying
mortgage loan and security collateral using expected prepayment speeds.
Principal repayments on these ABB are payable only from the mortgage loans and
securities collateralizing the ABB. In the event that principal receipts from
the underlying collateral are adversely impacted by credit losses, there could
be insufficient principal receipts available to repay the ABB principal.




47




---



Asset-backed
  Bonds2010
            $
            533,8892011
            
            351,6222012
            
            288,9442013
            
            207,8912014
            
            251,883Thereafter
            
            829,887$
            2,464,116


Short-term Borrowings




On May 9, 2008, the
Company fully repaid all outstanding borrowings with Wachovia and all agreements
were terminated effective the same day.




Note 7. Commitments and
Contingencies




Commitments. The Company leases office space under
various operating lease agreements. Rent expense for 2009 and 2008, under leases
related to continuing operations, aggregated $1.9 million and $4.8 million,
respectively. At December 31, 2009, future minimum lease commitments under those
leases are as follows (dollars in thousands):




LeaseObligations2010
            $
            1,7112011
            
            1,2872012
            
            8732013
            
            6242014
            
            73$
            4,568


The Company had
entered into various lease agreements pursuant to which the lessor agreed to
repay the Company for certain existing lease obligations. The Company has
recorded deferred lease incentives related to these payments which will be
amortized into rent expense over the life of the respective lease on a
straight-line basis. There were no deferred lease incentives related to
continuing operations as of December 31, 2009. The deferred lease incentives
related to continuing operations as of December 31, 2008 was $0.9 million.




The Company has
sublease agreements for office space formerly occupied by the Company and
received approximately $0.7 million during 2009. There were no sublease
agreements included in continuing operations during 2008.




Contingencies




At this time, the Company does
not believe that an adverse ruling against the Company is probable for the
following claims and as such no amounts have been accrued in the consolidated
financial statements.




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




On January 31,
2008, two purported shareholders filed separate derivative actions in the
Circuit Court of Jackson County, Missouri against various former and current
officers and directors and named the Company as a nominal defendant. The
essentially identical petitions seek monetary damages alleging that the
individual defendants breached fiduciary duties owed to the Company, alleging
insider selling and misappropriation of information, abuse of control, gross
mismanagement, waste of corporate assets, and unjust enrichment between May 2006
and December 2007. On June 24, 2008 a third, similar case was filed in United
States District Court for the Western District of Missouri. On July 13, 2009 the
Company filed a motion to dismiss the plaintiff’s claims. On November 24, 2009
the Company reached a settlement with the plaintiffs which provided for certain
corporate governance changes and a payment of $300,000 for attorney fees, the
payment being covered by insurance. A hearing for Court approval of the
settlement is set for April 5, 2010.




48




---



On May 21, 2008, a
purported class action case was filed in the Supreme Court of the State of New
York, New York County, by the New Jersey Carpenters' Health Fund, on behalf of
itself and all others similarly situated. Defendants in the case include
NovaStar Mortgage Funding Corporation and its individual directors, several
securitization trusts sponsored by the Company, and several unaffiliated
investment banks and credit rating agencies. The case was removed to the United
States District Court for the Southern District of New York. On June 16, 2009,
the plaintiff filed an amended complaint. Plaintiff seeks monetary damages,
alleging that the defendants violated sections 11, 12 and 15 of the Securities
Act of 1933 by making allegedly false statements regarding mortgage loans that
served as collateral for securities purchased by plaintiff and the purported
class members. On August 31, 2009 the Company filed a motion to dismiss the
plaintiff’s claims. The Company believes it has meritorious defenses to the case
and expects to defend the case vigorously.




On July 7, 2008,
plaintiff Jennifer Jones filed a purported class action case in the United
States District Court for the Western District of Missouri against the Company,
certain former and current officers of the Company, and unnamed members of the
Company's "Retirement Committee". Plaintiff, a former employee of the Company,
seeks class action certification on behalf of all persons who were participants
in or beneficiaries of the Company's 401(k) plan from May 4, 2006 until November
15, 2007 and whose accounts included investments in the Company's common stock.
Plaintiff seeks monetary damages alleging that the Company's common stock was an
inappropriately risky investment option for retirement savings, and that
defendants breached their fiduciary duties by allowing investment of some of the
assets contained in the 401(k) plan to be made in the Company's common stock. On
November 12, 2008, the Company filed a motion to dismiss which was denied by the
Court on February 11, 2009. On April 6, 2009 the Court granted the plaintiff’s
motion for class certification. The Company sought permission from the
8 th Circuit Court of Appeals to appeal the
order granting class certification. On May 11, 2009 the Court of Appeals granted
the Company permission to appeal the class certification order. On November 9,
2009 the Company reached a settlement with the plaintiffs. The settlement
provides for payment by the Company’s insurer of $925,000. A hearing for Court
approval of the settlement is set for April 22, 2010.




On December 31,
2009, ITS Financial, LLC (“ITS”) filed a complaint against Advent and the
Company alleging breach of a contract with Advent for services related tax
refund anticipation loans and early season loans. ITS does business as Instant
Tax Service. The defendants removed the case to the United States District Court
for the Southern District of Ohio. The complaint alleges that the Company worked
in tandem and as one entity with Advent in all material respects. The complaint
also alleges fraud in the inducement, tortious interference by the Company with
the contract, breach of good faith and fair dealing, fraudulent and negligent
misrepresentation, and liability of the Company by piercing the corporate veil
and joint and several liability, The plaintiff references a $3 million loan made
by the Company to plaintiff and seeks a judgment declaring that this loan be
subject to an offset by the plaintiff’s damages. The litigation is currently
stayed pending resolution of the Company’s motion to
transfer the case to the United States District Court for the Western District
of Missouri. The Company believes that the defendants have meritorious defenses
to this case and expects to defend the case vigorously.




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




Note 8. Shareholders’
Equity




To preserve
liquidity, the Company’s Board of Directors has suspended the payment of
dividends on its 8.9% Series C Cumulative Redeemable Preferred Stock (the
“Series C Preferred Stock”) and its Series D1 Mandatory Convertible Preferred
Stock (the “Series D1 Preferred Stock”). As a result, dividends continue to
accrue on the Series C Preferred Stock and Series D1 Preferred Stock. The
Company has total accrued dividends payable related to the Series C Preferred
Stock and Series D1 Preferred Stock of $38.4 million as of March 30, 2010. All
accrued and unpaid dividends on the Company’s preferred stock must be paid prior
to any payments of dividends or other distributions on the Company’s common
stock. In addition, since dividends on the Series C Preferred Stock were in
arrears for six or more quarterly periods (whether or not consecutive), the
holders of the Series C Preferred Stock, voting as a single class, elected two
additional directors to the Company’s Board of Directors, as described. The
Company does not expect to pay any dividends for the foreseeable
future.




On March 17, 2009,
the Company notified the holders of the Series C Preferred Stock that the
Company would not make the dividend payment on the Series C Preferred Stock due
on March 31, 2009. Because dividends on the Series C Preferred Stock are
presently in arrears for six quarters, under the terms of the Articles
Supplementary to the Company’s Charter that established the Series C Preferred
Stock, the holders of the Series C Preferred Stock had the right, as of March
31, 2009, to elect two additional directors to the Company’s board of directors.
At the Company’s Annual Meeting of Shareholders on June 25, 2009, the holders of
the Series C Preferred Stock elected two additional directors of the Company to
serve until such time that that all dividends accumulated and due on the Series
C Preferred Stock have been paid fully paid.




49




---



Dividends on the
Series C Preferred Stock are payable in cash and accrue at a rate of 8.90%
annually. Accrued and unpaid dividends payable related to the Series C Preferred
Stock were approximately $15.0 million and $8.3 million as of December 31, 2009
and 2008, respectively and $16.6 million as of March 30, 2010 .




Dividends on the
Series D1 Preferred Stock are payable in cash and accrue at a rate of 9.00% per
annum, or 13.00% per annum if any such dividends are not declared and paid when
due. In addition, holders of the Series D1 Preferred Stock are entitled to
participate in any common stock dividends on an as converted basis. The
Company’s board of directors has suspended the payment of dividends on the
Company’s Series D1 Preferred Stock. As a result, dividends continue to accrue
on the Series D1 Preferred Stock, and the dividend rate on the Series D1
Preferred Stock increased from 9.0% to 13.0%, compounded quarterly, effective
October 16, 2007 with respect to all unpaid dividends and subsequently accruing
dividends. Accrued and unpaid dividends payable related to the Series D1
Preferred Stock were approximately $19.4 million as of December 31, 2009 and
$21.8 million as of March 30, 2010.




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




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




During the years
ended December 31, 2009 and 2008 there were no shares of common stock issued
under the Company’s stock-based compensation plan.




The Company’s Board
of Directors has approved the purchase of up to $9 million of the Company’s
common stock. No shares were repurchased during 2009 and 2008. Under Maryland
law, shares purchased under this plan are to be returned to the Company’s
authorized but unissued shares of common stock. Common stock purchased under
this plan is charged against additional paid-in capital.




Note 9. Comprehensive Income




Comprehensive
income includes revenues, expenses, gains and losses that are not included in
net income. The following is a roll-forward of accumulated other comprehensive
income for the years ended December 31, 2009 and 2008 (dollars in thousands):




For the Year
  EndedDecember 31,2009
            
            2008Net loss
            $
            (183,156
            )
            
            $
            (660,482
            )Other comprehensive (loss) income:Change in unrealized loss on
      mortgage securities – available-for-sale
            
            (5,106
            )
            
            
            (14,152
            )Change in unrealized gain (loss) on derivative instruments used in
      cash flow hedges
            
            8
            
            
            
            (1,364
            )Impairment on mortgage securities -
      available-for-sale reclassified to earnings
            
            1,198
            
            
            
            23,100Net settlements of derivative
      instruments used in cash flow hedges reclassified toearnings
            
            85
            
            
            
            2,459Other comprehensive income (loss)
            
            (3,815
            )
            
            
            10,043Total comprehensive loss
            
            (186,971
            )
            
            
            (650,439
            )Comprehensive loss attributable to noncontrolling
    interests
            
            2,054
            
            
            
            -Total comprehensive loss attributable to
      NovaStar Financial, Inc.
            $
            (184,917
            )
            
            $
            (650,439
            )


50




---



Note 10. Fair Value
Accounting




For financial
reporting purposes, the Company follows a fair value hierarchy that is used to
measure the fair value of assets and liabilities. This hierarchy prioritizes
relevant market inputs in order to determine an “exit price”, or the price at
which an asset could be sold or a liability could be transferred in an orderly
process that is not a forced liquidation or distressed sale at the date of
measurement.




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


- Level 1—Quoted prices
  for identical instruments in active markets
- Level 2—Quoted prices
  for similar instruments in active markets; quoted prices for identical or
  similar instruments in markets that are not active; and model-derived
  valuations whose inputs are observable or whose significant value drivers are
  observable.
- Level 3—Instruments
  whose significant value drivers are unobservable.

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




The following
tables present for each of the fair value hierarchy levels, the Company’s assets
and liabilities related to continuing operations which are measured at fair
value on a recurring basis as of December 31, 2009 and 2008 (dollars in
thousands):




Fair Value Measurements at
      Reporting Date UsingQuoted Prices inFair Value at
            
            Active Markets for
            
            Significant Other
            
            SignificantDecember 31,
            
            Identical Assets
            
            Observable Inputs
            
            UnobservableDescription
            
            2009
            
            (Level 1)
            
            (Level 2)
            
            Inputs (Level
3)AssetsMortgage
    securities-trading
            
            $
            1,087
            
            $
            -
            
            $
            -
            
            $
            1,087Mortgage securities – available-for-sale
            
            
            6,903
            
            
            -
            
            
            -
            
            
            6,903Total
      Assets
            
            $
            7,990
            
            $
            -
            
            $
            -
            
            $
            7,990LiabilitiesAsset-backed bonds secured
    bymortgage
      securities
            
            $
            968
            
            $
            -
            
            $
            -
            
            $
            968Derivative instruments, net
            
            
            157
            
            
            -
            
            
            157
            
            
            -Total Liabilities
            
            $
            1,125
            
            $
            -
            
            $
            157
            
            $
            968Fair Value Measurements at
      Reporting Date UsingQuoted Prices inFair Value at
            
            Active Markets for
            
            Significant Other
            
            SignificantDecember 31,
            
            Identical Assets
            
            Observable Inputs
            
            UnobservableDescription
            
            2008
            
            (Level 1)
            
            (Level 2)
            
            Inputs (Level
3)AssetsMortgage
    securities-trading
            
            $
            7,085
            
            $
            -
            
            $
            -
            
            $
            7,085Mortgage securities – available-for-sale
            
            
            12,788
            
            
            -
            
            
            -
            
            
            12,788Total
      Assets
            
            $
            19,873
            
            $
            -
            
            $
            -
            
            $
            19,873LiabilitiesAsset-backed bonds secured
    bymortgage
      securities
            
            $
            5,376
            
            $
            -
            
            $
            -
            
            $
            5,376Derivative instruments, net
            
            
            9,102
            
            
            -
            
            
            9,102
            
            
            -Total Liabilities
            
            $
            14,478
            
            $
            -
            
            $
            9,102
            
            $
            5,376


51




---



The following
tables provides a reconciliation of the beginning and ending balances for the
Company’s mortgage securities – trading which are measured at fair value on a
recurring basis using significant unobservable inputs (Level 3) from December
31, 2007 to December 31, 2009 (dollars in thousands):




Estimated FairUnrealized
            
            Value of
  MortgageCost Basis
            
            Loss
            
            SecuritiesAs of December 31, 2008
            
            $
            433,968
            
            
            $
            (426,883
            )
            
            $
            7,085Increases
      (decreases) to mortgage securities-trading:Accretion of
      income
            
            
            10,713
            
            
            
            -
            
            
            
            10,713Proceeds from
      paydowns of securities
            
            
            (4,885
            )
            
            
            -
            
            
            
            (4,885
            )Other than
      temporary impairments
            
            
            (335,783
            )
            
            
            335,783
            
            
            
            -Mark-to-market
      value adjustment
            
            
            -
            
            
            
            (11,826
            )
            
            
            (11,826
            )Net increase (decrease) to mortgage
      securities
            
            
            (329,955
            )
            
            
            323,957
            
            
            
            (5,998
            )As of December 31, 2009
            
            $
            104,013
            
            
            $
            (102,926
            )
            
            $
            1,087Estimated FairUnrealized
            
            Value of
  MortgageCost Basis
            
            Loss
            
            SecuritiesAs of December 31, 2007
            
            $
            41,275
            
            
            $
            (16,534
            )
            
            $
            24,741Increases
      (decreases) to mortgage securities-trading:Securities
      transferred from level 2 to level 3
            
            
            414,080
            
            
            
            (395,359
            )
            
            
            18,721Accretion of
      income
            
            
            23,652
            
            
            
            -
            
            
            
            23,652Proceeds from
      paydowns of securities
            
            
            (45,039
            )
            
            
            -
            
            
            
            (45,039
            )Mark-to-market
      value adjustment
            
            
            -
            
            
            
            (14,990
            )
            
            
            (14,990
            )Net increase (decrease) to mortgage
      securities
            
            
            392,693
            
            
            
            (410,349
            )
            
            
            (17,656
            )As of December 31, 2008
            
            $
            433,968
            
            
            $
            (426,883
            )
            
            $
            7,085


The following
tables provide a reconciliation of the beginning and ending balances for the
Company’s mortgage securities – available-for-sale which are measured at fair
value on a recurring basis using significant unobservable inputs (Level 3) from
December 31, 2008 to December 31, 2009 and December 31, 2007 to December 31,
2008 (dollars in thousands):




Estimated FairUnrealized
            
            Value of
  MortgageCost Basis
            
            Gain
            
            SecuritiesAs of December 31, 2008
            
            $
            3,771
            
            
            $
            9,017
            
            
            $
            12,788Increases
      (decreases) to mortgage securities:Accretion of
      income (A)
            
            
            12,815
            
            
            
            -
            
            
            
            12,815Proceeds from
      paydowns of securities (A) (B)
            
            
            (13,594
            )
            
            
            -
            
            
            
            (13,594
            )Impairment on
      mortgage securities - available-for-sale
            
            
            (1,198
            )
            
            
            -
            
            
            
            (1,198
            )Mark-to-market
      value adjustment
            
            
            -
            
            
            
            (3,908
            )
            
            
            (3,908
            )Net decrease to mortgage securities
            
            
            (1,977
            )
            
            
            (3,908
            )
            
            
            (5,885
            )As of December 31, 2009
            
            $
            1,794
            
            
            $
            5,109
            
            
            $
            6,903


(A)
            
            Cash received on mortgage securities with no cost basis was $1.9
      million for the year ended December 31, 2009.(B)
            
            For mortgage securities with a remaining cost basis, the Company
      reduces the cost basis by the amount of cash that is contractually due
      from the securitization trusts. In contrast, for mortgage securities in
      which the cost basis has previously reached zero, the Company records in
      interest income the amount of cash that is contractually due from the
      securitization trusts. In both cases, there are instances where the
      Company may not receive a portion of this cash until after the
      Consolidated Balance Sheets reporting date. Therefore, these amounts are
      recorded as receivables from the securitization trusts, which are included
      in the other assets line on the Company’s Consolidated Balance Sheets. As
      of December 31, 2009 the Company had no receivables from securitization
      trusts related to mortgage securities available-for-sale with a remaining
      or zero cost basis.


52




---



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


(A)
            
            Cash received on mortgage securities with no cost basis was $3.4
      million for the year ended December 31, 2008.(B)
            
            For mortgage securities with a remaining cost basis, the Company
      reduces the cost basis by the amount of cash that is contractually due
      from the securitization trusts. In contrast, for mortgage securities in
      which the cost basis has previously reached zero, the Company records in
      interest income the amount of cash that is contractually due from the
      securitization trusts. In both cases, there are instances where the
      Company may not receive a portion of this cash until after the
      Consolidated Balance Sheets reporting date. Therefore, these amounts are
      recorded as receivables from the securitization trusts, which are included
      in the other assets line on the Company’s Consolidated Balance Sheets. As
      of December 31, 2008, the Company had receivables from securitization
      trusts of $12.5 million, related to mortgage securities available-for-sale
      with a remaining cost basis. At December 31, 2008 there were no
      receivables from securitization trusts related to mortgage securities with
      a zero cost basis.





The following
tables provides quantitative disclosures about the fair value measurements for
the Company’s assets related to continuing operations which are measured at fair
value on a nonrecurring basis as of December 31, 2009 and 2008 (dollars in
thousands):




Fair Value Measurements at
      Reporting Date UsingQuoted Prices inActive Markets for
            
            Significant Other
            
            SignificantReal Estate
            
            Identical Assets
            
            Observable Inputs
            
            Unobservable
  InputsFair Value at
            
            Owned
            
            (Level 1)
            
            (Level 2)
            
            (Level 3)December 31, 2009
            
            $
            64,179
            
            $
            -
            
            $
            -
            
            $
            64,179December 31, 2008
            
            
            70,480
            
            
            -
            
            
            -
            
            
            70,480


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




The following table
provides a summary of the impact to earnings for the year ended December 31,
2009 from the Company’s assets and liabilities which are measured at fair value
on a recurring and nonrecurring basis as of December 31, 2009 (dollars in
thousands):




Fair Value Adjustments
      Forthe Year Ended December
      31,Fair ValueAsset or Liability Measured
      at
            
            Measurement
            
            
            
            
            
            
            
            
            
            Statement of Operation
      LineFair Value
            
            Frequency
            
            2009
            
            2008
            
            Item ImpactedMortgage securities -
    trading
            
            Recurring
            
            $
            (11,826
            )
            
            $
            (88,715
            )
            
            Fair value adjustmentsMortgage securities –
            
            
            
            
            
            
            
            
            
            
            
            Impairment on mortgageavailable-for-sale
            
            Recurring
            
            
            (1,198
            )
            
            
            (23,100
            )
            
            securities – available-for-saleReal estate owned
            
            Nonrecurring
            
            
            (9,164
            )
            
            
            (7,831
            )
            
            Provision for credit
    lossesDerivative instruments, net
            
            Recurring
            
            
            (7,361
            )
            
            
            (2,627
            )
            
            Losses on derivative instrumentsAsset-backed bonds securedby mortgage
      securities
            
            Recurring
            
            
            5,083
            
            
            
            62,973
            
            
            Fair value adjustmentsTotal fair value losses
            
            
            
            $
            (24,466
            )
            
            $
            (59,300
            )


Valuation
Methods




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




53




---



In addition, upon
the closing of its NMFT Series 2007-2 securitization, the Company classified the
residual security it retained as trading. Management estimates the fair value of
its residual securities by discounting the expected future cash flows of the
collateral and bonds. Due to the unobservable inputs used by the Company in
determining the expected future cash flows, the Company determined its valuation
methodology for residual securities qualify as Level 3.




Mortgage securities –
available-for-sale. Mortgage securities – available-for-sale represent residual securities
the Company retained in
securitization and resecuritization transactions. Mortgage securities classified
as available-for-sale are reported at their estimated fair value with unrealized
gains and losses reported in accumulated other comprehensive income. To the
extent that the cost basis of mortgage securities exceeds the fair value and the
unrealized loss is considered to be other than temporary, an impairment charge
is recognized and the amount recorded in accumulated other comprehensive income
or loss is reclassified to earnings as a realized loss. The specific
identification method is used in computing realized gains or losses. The Company
uses the discount rate methodology for determining the fair value of its
residual securities. The fair value of the residual securities is estimated
based on the present value of future expected cash flows to be received.
Management’s best estimate of key assumptions, including credit losses,
prepayment speeds, the market discount rates and forward yield curves
commensurate with the risks involved, are used in estimating future cash
flows.




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




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




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




Fair Value Option for Financial Assets
and Financial Liabilities




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




The Company elected
the fair value option for the asset-backed bonds issued from the CDO, which the
Company closed in the first quarter of 2007. The Company elected the fair value
option for these liabilities to help reduce earnings volatility which otherwise
would arise if the accounting method for this debt was not matched with the fair
value accounting for the related mortgage securities - trading. The asset-backed
bonds which are being carried at fair value are included in the “Asset-backed
bonds secured by mortgage securities“ line item on the Consolidated Balance
Sheets. The change in the asset-backed bonds balance is due to the fair value
adjustments since adoption of the guidance. The Company has not elected fair
value accounting for any other Consolidated Balance Sheets items as allowed by
the guidance from Fair Value Option for Financial Assets and Financial
Liabilities.




The following table
shows the difference between the unpaid principal balance and the fair value of
the asset-backed bonds secured by mortgage securities for which the Company has
elected fair value accounting as of December 31, 2009 and December 31, 2008
(dollars in thousands):




Unpaid Principal Balance
            
            Balance at Fair
    ValueAs of December 31, 2009
            
            $
            323,999
            
            $
            968As of December 31, 2008
            
            
            324,243
            
            
            5,376


Substantially all
of the $5.1 million and $63.0 million change in fair value of the asset-backed
bond for the years ended December 31, 2009 and 2008, respectively, are
considered to be related to specific credit risk as all of the bonds are
floating rate. The change in credit risk was caused by the severe decline in the
value of the trust’s assets during the years ended December 31, 2009 and
2008.







54




---






Note 11. Derivative Instruments and
Hedging Activities




The following
tables present derivative instruments as of December 31, 2009 and 2008 (dollars
in thousands):


MaximumDays toNotional Amount
            
            Fair Value
            
            MaturityAs of December 31,
      2009:Non-hedge
      derivative instruments
            
            $
            40,000
            
            $
            (157
            )
            
            25As of December 31,
      2008:Non-hedge
      derivative instruments
            
            $
            461,500
            
            $
            (9,034
            )
            
            390Cash flow hedge
      derivative instruments
            
            
            40,000
            
            
            (68
            )
            
            25


The Company
recognized net expense of $0.1 million and $2.5 million during the years ended
December 31, 2009 and 2008, respectively, on derivative instruments qualifying
as cash flow hedges, which is recorded as a component of interest
expense.




During the two
years ended December 31, 2009, hedge ineffectiveness was insignificant. There is
no amount included in other comprehensive income expected to be reclassified
into earnings within the next twelve months.




Note 12. Interest
Income




The following table
presents the components of interest income related to continuing operations for
the years ended December 31, 2009 and 2008 (dollars in thousands):




For the Year Ended December
      31,2009
            
            2008Interest income:Mortgage
      securities
            
            $
            21,656
            
            $
            46,997Mortgage loans
      held-in-portfolio
            
            
            131,301
            
            
            186,601Other interest
      income (A)
            
            
            887
            
            
            1,411Total interest income
            
            $
            153,844
            
            $
            235,009


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




Note 13. Interest
Expense




The following table
presents the components of interest expense related to continuing operations for
the years ended December 31, 2009 and 2008 (dollars in thousands):




For the Year Ended December
      31,2009
            
            2008Interest expense:Asset-backed
      bonds secured by mortgage loans
            
            $
            21,290
            
            $
            95,012Asset-backed
      bonds secured by mortgage securities
            
            
            2,129
            
            
            13,271Junior
      subordinated debentures
            
            
            1,128
            
            
            6,261Short-term
      borrowings secured by mortgage securities
            
            
            -
            
            
            436Total interest expense
            
            $
            24,547
            
            $
            114,980


Note 14. Segment
Reporting




The Company
reviews, manages and operates its business in three segments: securitization
trusts, corporate and appraisal management. Securitization trusts’ operating
results are driven from the income generated on the on-balance sheet
securitizations less associated costs. Corporate operating results include
income generated from mortgage securities retained from securitizations,
corporate general and administrative expenses and Advent. Appraisal management
operations include the appraisal fee income and related expenses from the
Company’s majority-owned subsidiary StreetLinks.




55




---



Following is a
summary of the operating results of the Company’s segments for the years ended
December 31, 2009 and 2008 (dollars in thousands):




For the Year Ended December 31,
      2009Securitization
            
            
            
            
            
            AppraisalTrusts
            
            Corporate
            
            Management
            
            Eliminations
            
            TotalInterest income
            
            $
            139,462
            
            
            $
            13,098
            
            
            $
            -
            
            
            $
            1,284
            
            
            $
            153,844Interest expense
            
            
            27,052
            
            
            
            (1,344
            )
            
            
            5
            
            
            
            (1,166
            )
            
            
            24,547Net interest income (loss) beforeprovision for credit
    losses
            
            
            112,410
            
            
            
            14,442
            
            
            
            (5
            )
            
            
            2,450
            
            
            
            129,297Provision for credit losses
            
            
            260,860
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            260,860Losses on derivative
      instruments
            
            
            (4,665
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (4,665
            )Fair value adjustments
            
            
            (5,072
            )
            
            
            (1,671
            )
            
            
            -
            
            
            
            -
            
            
            
            (6,743
            )Impairments on mortgagesecurities –
      available-for-sale
            
            
            -
            
            
            
            (1,198
            )
            
            
            -
            
            
            
            -
            
            
            
            (1,198
            )Servicing fee expense
            
            
            (10,639
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (10,639
            )Appraisal fee income
            
            
            -
            
            
            
            -
            
            
            
            31,106
            
            
            
            -
            
            
            
            31,106Appraisal fee expense
            
            
            -
            
            
            
            -
            
            
            
            (21,467
            )
            
            
            -
            
            
            
            (21,467
            )Premiums for mortgage loan
      insurance
            
            
            (6,041
            )
            
            
            (137
            )
            
            
            -
            
            
            
            -
            
            
            
            (6,178
            )Other income, net
            
            
            -
            
            
            
            2,893
            
            
            
            -
            
            
            
            (2,017
            )
            
            
            876General and administrative
      expenses
            
            
            238
            
            
            
            20,723
            
            
            
            12,633
            
            
            
            (2,017
            )
            
            
            31,577Loss from continuing operationsbefore income tax expense
            
            
            (175,105
            )
            
            
            (6,394
            )
            
            
            (2,999
            )
            
            
            2,450
            
            
            
            (182,048
            )Income tax expense
            
            
            64
            
            
            
            1,044
            
            
            
            -
            
            
            
            -
            
            
            
            1,108Loss from continuing operations
            
            
            (175,169
            )
            
            
            (7,438
            )
            
            
            (2,999
            )
            
            
            2,450
            
            
            
            (183,156
            )Less loss available to
              noncontrolling
      interests
            
            
            -
            
            
            
            (1,225
            )
            
            
            (829
            )
            
            
            -
            
            
            
            (2,054
            )Net loss available to
      common
              shareholders
            
            $
            (175,169
            )
            
            $
            (6,213
            )
            
            $
            (2,170
            )
            
            $
            2,450
            
            
            $
            (181,102
            )December 31, 2009:Total
      assets
            
            $
            1,437,059
            
            
            $
            26,706
            
            
            $
            4,164
            
            
            $
            (8,438
            )
            
            $
            1,459,491For the Year Ended December 31,
      2008Securitization
            
            
            
            
            
            AppraisalTrusts
            
            Corporate
            
            Management
            
            Eliminations
            
            TotalInterest income
            
            $
            203,724
            
            
            $
            26,694
            
            
            $
            -
            
            
            $
            4,591
            
            
            $
            235,009Interest expense
            
            
            116,294
            
            
            
            3,316
            
            
            
            2
            
            
            
            (4,632
            )
            
            
            114,980Net interest income (loss) beforeprovision for credit
    losses
            
            
            87,430
            
            
            
            23,378
            
            
            
            (2
            )
            
            
            9,223
            
            
            
            120,029Provision for credit losses
            
            
            707,364
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            707,364Gains on debt
    extinguishment
            
            
            -
            
            
            
            6,418
            
            
            
            -
            
            
            
            -
            
            
            
            6,418Losses on derivative instruments
            
            
            (18,094
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (18,094
            )Fair value adjustments
            
            
            (13,417
            )
            
            
            (12,326
            )
            
            
            -
            
            
            
            -
            
            
            
            (25,743
            )Impairments on mortgagesecurities – available-for-sale
            
            
            -
            
            
            
            (23,100
            )
            
            
            -
            
            
            
            -
            
            
            
            (23,100
            )Servicing fee expense
            
            
            (13,596
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (13,596
            )Appraisal fee income
            
            
            -
            
            
            
            -
            
            
            
            2,524
            
            
            
            -
            
            
            
            2,524Appraisal fee expense
            
            
            -
            
            
            
            -
            
            
            
            (1,693
            )
            
            
            -
            
            
            
            (1,693
            )Premiums for mortgage loan insurance
            
            
            (15,818
            )
            
            
            (29
            )
            
            
            -
            
            
            
            -
            
            
            
            (15,847
            )Other income, net
            
            
            -
            
            
            
            (19
            )
            
            
            -
            
            
            
            -
            
            
            
            (19
            )General and administrative expenses
            
            
            896
            
            
            
            22,355
            
            
            
            1,170
            
            
            
            -
            
            
            
            24,421Loss from continuing operationsbefore income tax benefit
            
            
            (681,755
            )
            
            
            (28,033
            )
            
            
            (341
            )
            
            
            9,223
            
            
            
            (700,906
            )Income tax benefit
            
            
            -
            
            
            
            (17,594
            )
            
            
            -
            
            
            
            -
            
            
            
            (17,594
            )Loss from continuing
      operations
            
            
            (681,755
            )
            
            
            (10,439
            )
            
            
            (341
            )
            
            
            9,223
            
            
            
            (683,312
            )Income from discontinuedoperations, net of income tax
            
            
            -
            
            
            
            22,830
            
            
            
            -
            
            
            
            -
            
            
            
            22,830Net (loss) income availableto common shareholders
            
            $
            (681,755
            )
            
            $
            12,391
            
            
            $
            (341
            )
            
            $
            9,223
            
            
            $
            (660,482
            )December 31, 2008:Total
      assets
            
            $
            1,937,306
            
            
            $
            50,806
            
            
            $
            515
            
            
            $
            (10,163
            )
            
            $
            1,978,464


56




---



Note 15. Earnings Per
Share




The computations of
basic and diluted earnings per share for the years ended December 31, 2009 and
2008 are as follows (dollars in thousands, except per share
amounts):




For the Year
  EndedDecember 31,2009
            
            2008Numerator:Loss from
      continuing operations
            
            $
            (183,156
            )
            
            $
            (683,312
            )Dividends on
      preferred shares
            
            
            (15,312
            )
            
            
            (15,273
            )Less loss
      attributable to noncontrolling interests
            
            
            (2,054
            )
            
            
            -Loss from
      continuing operations available to common shareholders
            
            
            (196,414
            )
            
            
            (698,585
            )Income from
      discontinued operations, net of income tax
            
            
            -
            
            
            
            22,830Loss available
      to common shareholders
            
            $
            (196,414
            )
            
            $
            (675,755
            )Denominator:Weighted average common shares
      outstanding – basic and diluted
            
            
            9,368,053
            
            
            
            9,338,131Basic earnings per
      share:Loss from
      continuing operations
            
            $
            (19.55
            )
            
            $
            (73.17
            )Less loss
      attributable to noncontrolling interests
            
            
            (0.22
            )
            
            
            -Dividends on
      preferred shares
            
            
            (1.64
            )
            
            
            (1.64
            )Loss from
      continuing operations available to common shareholders
            
            
            (20.97
            )
            
            
            (74.81
            )Income from
      discontinued operations, net of income tax
            
            
            -
            
            
            
            2.44Net loss
      available to common shareholders
            
            $
            (20.97
            )
            
            $
            (72.37
            )Diluted earnings per
      share:Loss from
      continuing operations
            
            $
            (19.55
            )
            
            $
            (73.17
            )Less loss
      attributable to noncontrolling interests
            
            
            (0.22
            )
            
            
            -Dividends on
      preferred shares
            
            
            (1.64
            )
            
            
            (1.64
            )Loss from
      continuing operations available to common shareholders
            
            
            (20.97
            )
            
            
            (74.81
            )Income from
      discontinued operations, net of income tax
            
            
            -
            
            
            
            2.44Net loss
      available to common shareholders
            
            $
            (20.97
            )
            
            $
            (72.37
            )


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




For the Year
  EndedDecember 31,2009
            
            2008Number of stock options (in
      thousands)
            
            
            114
            
            
            206Weighted average exercise price of stock options
            
            $
            52.98
            
            $
            57.36


57




---



Note 16. Income Taxes




The components of
income tax expense (benefit) attributable to continuing operations for the years
ended December 31, 2009 and 2008 were as follows (dollars in
thousands):




For the Year
  EndedDecember 31,2009
            
            2008Current:Federal
            
            $
            1,192
            
            
            $
            (2,804
            )State and local
            
            
            (84
            )
            
            
            (985
            )Total current
            
            
            1,108
            
            
            
            (3,789
            )Deferred:Federal
            
            
            -
            
            
            
            (12,293
            )State and local
            
            
            -
            
            
            
            (1,512
            )Total deferred
            
            
            -
            
            
            
            (13,805
            )Total income tax benefit
            
            $
            1,108
            
            
            $
            (17,594
            )


A reconciliation of
the expected federal income tax expense (benefit) using the federal statutory
tax rate of 35% to the Company’s actual income tax expense (benefit) and
resulting effective tax rate from continuing operations for the years ended
December 31, 2009 and 2008 were as follows (dollars in thousands):




For the Year
  EndedDecember 31,2009
            
            2008Income tax at statutory
    rate
            
            $
            (62,998
            )
            
            $
            (245,317
            )State income taxes, net of federal tax benefit
            
            
            (3,201
            )
            
            
            (12,028
            )Valuation allowance
            
            
            72,119
            
            
            
            250,161Interest and penalties
            
            
            (218
            )
            
            
            1,581Change in state tax rate
            
            
            (7,768
            )
            
            
            -Adjustment to net operating loss
            
            
            2,079
            
            
            
            -Tax benefit of gain recorded in
      discontinued operations
            
            
            -
            
            
            
            (13,804
            )Other
            
            
            1,095
            
            
            
            1,813Total income tax benefit
            
            $
            1,108
            
            
            $
            (17,594
            )


Significant
components of the Company’s deferred tax assets and liabilities at December 31,
2009 and 2008 were as follows (dollars in thousands):




December 31,
            
            December 31,2009
            
            2008Deferred tax
    assets:Basis
      difference – investments
            
            $
            389,027
            
            
            $
            377,129Federal net
      operating loss carryforwards
            
            
            163,280
            
            
            
            93,783Allowance for
      loan losses
            
            
            93,715
            
            
            
            106,073State net
      operating loss carryforwards
            
            
            18,719
            
            
            
            13,922Excess
      inclusion income
            
            
            2,291
            
            
            
            3,918Other
            
            
            9,801
            
            
            
            10,091Gross deferred tax asset
            
            
            676,833
            
            
            
            604,916Valuation
      allowance
            
            
            (674,823
            )
            
            
            (601,110
            )Deferred tax asset
            
            
            2,010
            
            
            
            3,806Deferred tax
      liabilities:Other
            
            
            2,010
            
            
            
            3,806Deferred tax liability
            
            
            2,010
            
            
            
            3,806Net deferred tax asset
            
            $
            -
            
            
            $
            -


58




---



Based on the
evidence available as of December 31, 2009, including the significant pre-tax
losses incurred by the Company in 2009 and 2008 overall cumulative losses, the
liquidity issues facing the Company and the decision by the Company to close all
of its mortgage lending and loan servicing operations, the Company believes that
it is more likely than not that the Company will not realize its deferred tax
assets. Based on this conclusion, the Company recorded a valuation allowance of
$674.8 million for deferred tax assets as of December 31, 2009 compared to
$601.1 million as of December 31, 2008.




As of December 31,
2009, the Company had a federal net operating loss of approximately $466.5
million. The federal net operating loss may be carried forward to offset future
taxable income, subject to applicable provisions of the Code, including
substantial limitations in the event of an “ownership change” as defined in
Section 382 of the Code. If not used, this net operating loss will expire in
years 2025 through 2029. The Company has state net operating loss carryovers
arising from both combined and separate filings from as early as 2004. The loss
carryovers may expire as early as 2010 and as late as 2029.




The guidance for
uncertain tax positions requires a company to evaluate whether a tax position
taken by the company will “more likely than not” be sustained upon examination
by the appropriate taxing authority. It also provides guidance on how a company
should measure the amount of benefit that the company is to recognize in its
financial statements. The activity in the accrued liability for unrecognized tax
benefits for the years ended December 31, 2009 and 2008 was as follows (dollars
in thousands):




2009
            
            2008Beginning balance
            
            $
            480
            
            
            $
            6,329Gross decreases – tax positions in prior period
            
            
            -
            
            
            
            (5,367
            )Gross increases – tax positions in
      current period
            
            
            674
            
            
            
            -Lapse of statute of limitations
            
            
            (248
            )
            
            
            (482
            )Ending balance
            
            $
            906
            
            
            $
            480


As of December 31,
2009 and 2008, the total gross amount of unrecognized tax benefits was $0.9
million and $0.5 million, respectively, which also represents the total amount
of unrecognized tax benefits that would impact the effective tax rate. The
Company anticipates a reduction of unrecognized tax benefits in the amount of
$0.2 million due the lapse of statute of limitations in the next twelve months.
The Company does not expect any other significant change in the liability for
unrecognized tax benefits in the next twelve months.




During 2008, the
Company requested the Internal Revenue Service to issue a closing agreement or
determination letter with respect to an uncertain tax position taken by the
Company in 2007. The Company received a response from the Internal Revenue
Service and adjusted the uncertain tax position accordingly. As of December 31,
2008 there was no unrecognized tax benefit related to this uncertain tax
position.




It is the Company’s
policy to recognize interest and penalties related to income tax matters in
income tax expense. Interest and penalties recorded in income tax expense was
($0.2 million) and $1.6 million for the years ended December 31, 2009 and 2008,
respectively. Accrued interest and penalties was $1.9 million and $2.0 million
as of December 31, 2009 and 2008, respectively.




The Company and its
subsidiaries are subject to U.S. federal income tax as well as income tax of
multiple state and local jurisdictions. Tax years 2006 to 2009 remain open to
examination for U.S. federal income tax. Tax years 2005 – 2009 remain open for
major state tax jurisdictions.




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




Note 17. Employee Benefit
Plans




Eligible employees
may save for retirement through pretax contributions in defined contribution
plans offered by the Company. Employees of the Company may contribute up to the
statutory limit. The Company may elect to match a certain percentage of
participants’ contributions. $0.1 million in contributions were made to the
plans for the year ended December 31, 2009. There were no contributions made to
the plans for the year ended December 31, 2008. The Company may also elect to
make a discretionary contribution, which is allocated to participants based on
each participant’s compensation.




59




---



During the year
ended December 31, 2009, $0.4 million was contributed to the plan’s
participants, all of which came from the plan’s forfeitures account, there were
no contributions made during 2008.




Note 18. Stock Compensation
Plans




The 2004 Incentive
Stock Plan (the “2004 Plan”). The 2004 Plan provides for the grant of qualified
incentive stock options (“ISOs”), non-qualified stock options (“NQSOs”),
deferred stock, restricted stock, restricted stock units, performance share
awards, dividend equivalent rights (“DERs”) and stock appreciation awards
(“SARs”). The Company has granted ISOs, NQSOs, restricted stock, performance
share awards and DERs. ISOs may be granted to employees of the Company. NQSOs,
DERs, SARs and stock awards may be granted to the directors, officers,
employees, agents and consultants of the Company or any subsidiaries. The
Company registered 625,000 shares of common stock under the 2004 Plan, of which
approximately 393,000 shares were available for future issuances as of December
31, 2009. The 2004 Plan will remain in effect unless terminated by the Board of
Directors or no shares of stock remain available for awards to be granted. The
Company’s policy is to issue new shares upon option exercise.




The Company follows
the provisions of the Share-Based Payment guidance using the modified
prospective method of adoption. The Company recorded stock-based compensation
expense of $0.7 million and $0.1 million for the years ended December 31, 2009
and 2008, respectively. There was no income tax benefit recognized in the income
statement for stock-based compensation arrangements in 2009 and 2008. As of
December 31, 2009, there was $0.5 million of total unrecognized compensation
cost related to non-vested share-based compensation arrangements granted. The
cost is expected to be amortized over a weighted average period of 1.54
years.




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




On June 26, 2009,
the Company granted 10,000 stock options to directors with an exercise price of
$1.25, which was the closing market price of the Company’s common stock on the
date of grant. 5,000 of the options granted vested immediately and 5,000 of the
options are subject to a four year vesting period.




During the fourth
quarter of 2009 the Company granted 150,000 stock options to an employee with an
exercise price of $0.97, which was the closing market price of the Company’s
common stock on November 10, 2009, the date of grant. The options granted are
subject to a four year vesting period.




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




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




The following table
summarizes the weighted average fair value of options granted for the years
ended December 31, 2009 and 2008, respectively, determined using the
Black-Scholes option pricing model and the assumptions used in their
determination. The expected life is a significant assumption as it determines
the period for which the risk free interest rate, volatility and dividend yield
must be applied. The expected life is the period over which employees and
directors are expected to hold their options and is based on the Company’s
historical experience with similar grants. The annual risk-free rate of return
is estimated using US treasury rates commensurate with the expected life. The
volatility is calculated using the fluctuations of the historical stock prices
of the Company. The Company’s options have DERs and accordingly, the assumed
dividend yield was zero for these options.




2009
            
            2008Weighted average:Fair value, at date of grant
            
            $
            0.89
            
            
            $
            1.40Expected life in years
            
            
            5
            
            
            
            10Annual risk-free interest rate
            
            
            2.39
            %
            
            
            3.84
            %Volatility
            
            
            145.43
            %
            
            
            84.3
            %Dividend yield
            
            
            0.0
            %
            
            
            0.0
            %


60




---



The following table
summarizes activity, pricing and other information for the Company’s stock
options activity for the year ended December 31, 2009:




Weighted AverageWeighted
            
            Remaining
            
            AggregateNumber of
            
            Average
            
            Contractual Term
            
            Intrinsic ValueStock Options
            
            Shares
            
            Exercise Price
            
            (Years)
            
            (in thousands)Outstanding at the beginning of the
      year
            
            160,397
            
            
            $
            55.63Granted
            
            160,000
            
            
            
            0.99Forfeited or
      expired
            
            (42,910
            )
            
            
            44.00Outstanding at the end of the year
            
            277,487
            
            
            $
            22.22
            
            8.11
            
            $
            (5,915
            )Exercisable at the end of the
      year
            
            93,912
            
            
            $
            56.58
            
            5.55
            
            $
            (5,287
            )Stock options expected to vest at the endof the
      year
            
            183,575
            
            
            $
            4.64
            
            9.43
            
            $
            (686
            )


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




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


There were no
options exercised during the years ended December 31, 2009 or 2008. The total
fair value of options vested during the years ended December 31, 2009 and 2008
was $0.3 million and $1.0 million, respectively.




For options that
vested prior to January 1, 2005, a recipient is entitled to receive additional
shares of stock upon the exercise of options as a result of DERs associated with
the option. For employees, the DERs accrue at a rate equal to the number of
options outstanding times 60% of the dividends per share amount at each dividend
payment date. For directors, the DERs accrue at a rate equal to the number of
options outstanding times the dividends per share amount at each dividend
payment date. The accrued DERs convert to shares based on the stock’s fair value
on the dividend payment date. There were no options exercised during 2008 or
2009.




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




The Company did not
grant and issue any shares of restricted stock during 2009 or 2008.




The following
tables present information on restricted stock outstanding as of December 31,
2009 and 2008.




December 31, 2009
            
            December 31,
  2008Weighted
            
            
            
            
            WeightedNumber of
            
            Average Grant
            
            Number of
            
            Average GrantShares
            
            Date Fair Value
            
            Shares
            
            Date Fair ValueOutstanding at the beginning of
      year
            
            34,246
            
            
            $
            38.38
            
            107,211
            
            
            $
            36.50Vested
            
            -
            
            
            
            -
            
            (1,745
            )
            
            
            185.68Forfeited
            
            (2,775
            )
            
            
            38.38
            
            (71,220
            )
            
            
            33.96Outstanding at the end of
    period
            
            31,471
            
            
            $
            38.38
            
            34,246
            
            
            $
            38.38


61




---



Note 19. Fair Value of Financial
Instruments




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




The estimated fair
values of the Company’s financial instruments related to continuing operations
are as follows as of December 31, 2009 and 2008 (dollars in
thousands):




2009
            
            
            2008Carrying Value
            
            
            Fair Value
            
            Carrying Value
            
            Fair ValueFinancial assets:Cash and cash
      equivalents
            
            $
            7,104
            
            
            $
            7,104
            
            
            $
            24,790
            
            $
            24,790Restricted cash
            
            
            5,342
            
            
            
            5,206
            
            
            
            6,046
            
            
            5,595Mortgage loans - held-in-portfolio
            
            
            1,289,474
            
            
            
            1,160,527
            
            
            
            1,772,838
            
            
            1,772,838Mortgage securities - trading
            
            
            1,087
            
            
            
            1,087
            
            
            
            7,085
            
            
            7,085Mortgage securities - available-for-sale
            
            
            6,903
            
            
            
            6,903
            
            
            
            12,788
            
            
            12,788Accrued interest receivable
            
            
            74,025
            
            
            
            74,025
            
            
            
            77,292
            
            
            77,292Financial
    liabilities:Borrowings:Asset-backed bonds secured bymortgage loans
            
            
            2,270,602
            
            
            
            1,297,980
            
            
            
            2,599,351
            
            
            1,772,838Asset-backed bonds secured bymortgage securities
            
            
            968
            
            
            
            968
            
            
            
            5,376
            
            
            5,376Junior subordinated debentures
            
            
            77,815
            
            
            
            6,225
            
            
            
            77,323
            
            
            6,248Accrued interest payable
            
            
            751
            
            
            
            751
            
            
            
            10,242
            
            
            10,242Derivative
      instruments:
            
            
            (157
            )
            
            
            (157
            )
            
            
            9,101
            
            
            9,101


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




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




Mortgage loans – held-in-portfolio – The fair value of
mortgage loans – held-in-portfolio was estimated using the carrying value less a
market discount. The internal rate of return is less than what an outside
investor would require due to the embedded credit risk, therefore a market
discount is required to get to the fair value. The fair value of mortgage loans
– held-in-portfolio approximated its carrying value at December 31,
2008.




Mortgage securities- trading
– See Note 10 to the
consolidated financial statements for fair value method utilized.




Mortgage securities –
available-for-sale –
See Note 10 to the consolidated financial statements for fair value method
utilized.




Accrued interest
receivable – The fair
value of accrued interest receivable approximates its carrying value.




Asset-backed bonds secured by mortgage
loans – The fair
value of asset-backed bonds secured by mortgage loans and the related accrued
interest payable was estimated using the fair value of mortgage loans –
held-in-portfolio as the trusts have no recourse to the Company’s other,
unsecuritized assets.




Asset-backed bonds secured by mortgage
securities –The fair
value of asset-backed bonds secured by mortgage securities and the related
accrued interest payable is approximated using quoted market prices.




Junior subordinated debentures – The fair value of
junior subordinated debentures is estimated using the price from the repurchase
transaction that the Company completed during 2008 as it is greater than an
estimate of discounting future projected cash flows using a discount rate
commensurate with the risks involved.




62




---



Accrued interest
payable – The fair
value of accrued interest payable approximates its carrying value.




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




Note 20. Subsequent
Events




During January of
2010, the final derivative of the 2007-1 securitization trust expired. The
expiration of this derivative is a reconsideration event. Accordingly, the
Company will deconsolidate the assets and liabilities of the securitization
trust and will record a gain during the three month period ending March 31,
2010.




Subsequent to
December 31, 2009, certain events prevented the Company’s attempt to sell
certain mezzanine-level bonds from its 2006-1 and 2006-1 MTA securitization
trusts, which prompted a reconsideration of the Company’s conclusion with
respect to the trusts’ consolidation . Accordingly, the Company will
deconsolidate the assets and liabilities of the trust and record a gain during
the three month period ending March 31, 2010.




63




---



REPORT OF INDEPENDENT REGISTERED PUBLIC
ACCOUNTING FIRM




To the Board of
Directors and Stockholders ofNovaStar 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, 2009 and 2008, and the related
consolidated statements of operations, shareholders’ deficit, and cash flows for
the years then ended. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.




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




In our opinion,
such consolidated financial statements present fairly, in all material respects,
the financial position of the Company as of December 31, 2009 and 2008, and the
results of its operations and its cash flows for the years then ended in
conformity with accounting principles generally accepted in the United States of
America.




We have also
audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the Company's internal control over financial
reporting as of December 31, 2009, based on the criteria established in Internal Control – Integrated
Framework issued by
the Committee of Sponsoring Organizations of the Treadway Commission and our
report dated March 31, 2010 expressed an adverse opinion on the Company’s
internal control over financial reporting because of a material weakness.




/s/ DELOITTE &
TOUCHE LLP


Kansas City,
MissouriMarch 31, 2010




64




---



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, within the time periods specified
in the applicable rules and forms, and that it is accumulated and communicated
to our management, including our principal executive officer and principal
financial officer, as appropriate to allow timely decisions regarding required
disclosure. These disclosure controls and procedures include controls and
procedures designed to ensure that information required to be disclosed under
the federal securities laws is accumulated and communicated to the Company’s
management on a timely basis to allow decisions regarding required disclosure.
The Company’s principal executive officer and principal financial officer
evaluated the Company’s disclosure controls and procedures (as defined in
Exchange Act Rules 13a-15(e) and 15d-15(d)) as of the end of the period covered
by this report and concluded that the Company’s controls and procedures were
effective.




Internal Control over Financial Reporting




Management’s Report on Internal Control
over Financial Reporting




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




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




Management of the
Company has assessed the effectiveness of the Company’s internal control over
financial reporting as of December 31, 2009. To make this assessment, management
used the criteria for effective internal control over financial reporting
described in Internal Control—Integrated
Framework , issued by
the Committee of Sponsoring Organizations of the Treadway Commission. Based on
its assessment , management concluded that the Company’s
internal control over financial reporting was not effective as of December 31,
2009 because of the existence of a material weakness in internal controls over
accounting, financial reporting and disclosure. A material weakness is a
deficiency, or combination of deficiencies, in internal controls over financial
reporting, such that it is reasonably possible that a material misstatement in
the company’s annual or interim financial statements and related disclosures
will not be prevented or detected on a timely basis.




The Company’s
material weakness results from the significant reduction in our accounting staff
beginning in 2008 and continuing through the end of 2009, which was necessary to
reduce operating and overhead costs. This reduction in staff has led to
inadequate segregation of duties, particularly as they relate to the preparation
and review of financial statements and disclosures. The material weakness did
not result in the restatement of prior period financial statements or
disclosures. No errors or misstatements in the Company’s financial statements or
disclosures have been identified.




Our independent
registered public accounting firm, Deloitte & Touche LLP, has issued an
attestation report, included herein, on the effectiveness of the Company’s
internal control over financial reporting as of December 31, 2009.




Changes in Internal Control over
Financial Reporting




There were no
changes in our internal controls over financial reporting during the three
months ended December 31, 2009 that have materially affected, or are reasonably
likely to materially affect, our internal controls over financial
reporting.




65




---



Attestation Report of the Registered
Public Accounting Firm




REPORT OF INDEPENDENT REGISTERED PUBLIC
ACCOUNTING FIRM




To the Board of
Directors and Stockholders ofNovaStar Financial, Inc. Kansas City, Missouri




We have audited
NovaStar Financial, Inc. and subsidiaries’ (the "Company") internal control over
financial reporting as of December 31, 2009, based on criteria established in Internal Control — Integrated
Framework issued by
the Committee of Sponsoring Organizations of the Treadway Commission. The
Company's management is responsible for maintaining effective internal control
over financial reporting and for its assessment of the effectiveness of internal
control over financial reporting, included in the accompanying Management’s
Report on Internal Control over Financial Reporting. Our responsibility is to
express an opinion on the Company's internal control over financial reporting
based on our audit.




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




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




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




A material weakness
is a deficiency, or a combination of deficiencies, in internal control over
financial reporting, such that there is a reasonable possibility that a material
misstatement of the company's annual or interim financial statements will not be
prevented or detected on a timely basis. The following material weakness has
been identified and included in management's assessment: internal control over
financial reporting was not effective because there was a lack of segregation of
duties within the Company’s accounting department. This material weakness was
considered in determining the nature, timing, and extent of audit tests applied
in our audit of the consolidated financial statements as of and for the year
ended December 31, 2009, of the Company and this report does not affect our
report on such financial statements.




In our opinion,
because of the effect of the material weakness identified above on the
achievement of the objectives of the control criteria, the Company has not
maintained effective internal control over financial reporting as of December
31, 2009, based on the criteria established in Internal Control — Integrated
Framework issued by
the Committee of Sponsoring Organizations of the Treadway Commission.




We have also
audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the consolidated financial statements as of and
for the year ended December 31, 2009, of the Company and our report dated March
31, 2010 expressed an unqualified opinion on those financial statements.




/s/ DELOITTE &
TOUCHE LLP




Kansas City,
MissouriMarch 31, 2010




66




---



Item 9B. Other
Information




None




PART III




Item 10. Directors, Executive Officers
and Corporate Governance




Information with
respect to Items 401,405 and 407(d)(4) and (d)(5) of Regulation S-K is
incorporated by reference to the information included in our Proxy Statement,
for the 2010 Annual Meeting of Shareholders.




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




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




Our investor
relations contact information follows:




Investor Relations2114 Central StreetSuite 600Kansas City, MO 64108816.237.7000Email: ir@novastar1.com


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




Item 11. Executive
Compensation




Information with
respect to Items 402 and 407(e)(4) and (e)(5) of Regulation S-K is incorporated
by reference to the information included in our Proxy Statement for the 2010
Annual Meeting of Shareholders.




67




---



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




Information with
respect to Items 403 of Regulation S-K is incorporated by reference to the
information included in our Proxy Statement for the 2010 Annual Meeting of
Shareholders.




The following table
sets forth information as of December 31, 2009 with respect to compensation
plans under which our common stock may be issued.




Equity Compensation Plan
      InformationNumber of SecuritiesRemaining Availablefor Future IssuanceNumber of Securities
      to
            
            
            
            
            
            Under Equitybe Issued Upon
            
            
            Weighted Average
            
            Compensation PlansExercise of
      Outstanding
            
            
            Exercise Price of
            
            (Excluding SharesOptions, Warrants and
            
            
            Outstanding
    Options,
            
            Reflected in the
      FirstPlan Category
            
            Rights
            
            
            Warrants and Rights
            
            Column)Equity compensation plans approved
      bystockholders
            
            277,487
            (A)
            
            $
            22.22
            
            392,595
            (B)Equity compensation plans not approvedby stockholders
            
            -
            
            
            
            -
            
            -Total
            
            277,487
            
            
            $
            22.22
            
            392,595


(A)
            
            Certain of
      the options have dividend equivalent rights (DERs) attached to them when
      issued. As of December 31, 2009, these options have 15,199 DERs
      attached.(B)
            
            Represents
      shares that may be issued pursuant to the Company’s 2004 Incentive Stock
      Plan, which provides for the grant of qualified incentive stock options,
      non-qualified stock options, deferred stock, restricted stock, restricted
      stock units, performance share awards, dividend equivalent rights and
      stock appreciation awards.





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




Information with
respect to Item 404 and 407(a) of Regulation S-K is incorporated by reference to
the information included in our Proxy Statement for the 2010 Annual Meeting of
Shareholders.




Item 14. Principal Accountant Fees and
Services.




Information with
respect to Item 9(e) of Schedule 14A is incorporated by reference to the
information included in our Proxy Statement for the 2010 Annual Meeting of
Shareholders.




68




---



PART IV




Item 15. Exhibits and Financial
Statements Schedules




Financial Statements and Schedules




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




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




Exhibit Listing




Exhibit No.
            
            Description of
      Document3.11
            
            Articles of Amendment and
      Restatement of NovaStar Financial, Inc. (including all amendments and
      applicable Articles Supplementary)3.1.12
            
            Certificate of Amendment of the
      Registrant3.23
            
            Amended and Restated Bylaws of the
      Registrant, adopted July 27, 20053.2.14
            
            Amendment to the Amended and
      Restated Bylaws of the Registrant4.15
            
            Specimen Common Stock
      Certificate4.26
            
            Specimen Preferred Stock
      Certificate10.17
            
            Employment Agreement, dated as of
      January 7, 2008, by and between NovaStar Financial, Inc. and Rodney E.
      Schwatken.10.28
            
            Form of Indemnification Agreement
      for Officers and Directors of NovaStar Financial, Inc. and its
      Subsidiaries10.49
            
            NovaStar Financial Inc. 2004
      Incentive Stock Plan10.510
            
            Amendment One to the NovaStar
      Financial, Inc. 2004 Incentive Stock Option Plan10.6
            
            Stock Option Agreement under
      NovaStar Financial, Inc. 2004 Incentive Stock Plan10.711
            
            Restricted Stock Agreement under
      NovaStar Financial, Inc. 2004 Incentive Stock Plan10.812
            
            Performance Contingent Deferred
      Stock Award Agreement under NovaStar Financial, Inc. 2004 Incentive Stock
      Plan10.913
            
            NovaStar Financial, Inc. Executive
      Bonus Plan10.1014
            
            2005 Compensation Plan for
      Independent Directors10.1115
            
            NovaStar Financial, Inc. Long Term
      Incentive Plan10.1216
            
            Securities Purchase Agreement,
      dated July 16, 2007, by and among NovaStar Financial, Inc., Massachusetts
      Mutual Life Insurance Company, Jefferies Capital Partners IV L.P.,
      Jefferies Employee Partners IV LLC and JCP Partners IV
  LLC


1 Incorporated by reference to Exhibit 3.1
to Form 10-Q filed by the Registrant on August 9, 2007. 2 Incorporated by reference to Exhibit 3.1
to Form 8-K filed by the Registrant with the SEC on May 26, 2005. 3 Incorporated by reference to Exhibit
3.3.1 to Form 10-Q filed by the Registrant with the SEC on August 5,
2005. 4  Incorporated by reference to Exhibit 3.2.1 to Form 8-K filed by the
Registrant with the SEC on March 16, 2009. 5 Incorporated by reference to Exhibit 4.1
to Form 10-Q filed by the Registrant with the SEC on August 5, 2005. 6 Incorporated by reference to Exhibit 4.3
to Form 8-A/A filed by the Registrant with the SEC on January 20, 2004. 7 Incorporated by reference to Exhibit
10.1 to Form 8-K/A filed by the Registrant with the SEC on January 10, 2008. 8 Incorporated by reference to Exhibit
10.10 to Form 8-K filed by the Registrant with the SEC on November 16, 2005. 9 Incorporated by reference to Exhibit
10.15 to Form S-8 filed by the Registrant with the SEC on June 30, 2004. 10 Incorporated by reference to Exhibit
10.46 to Form 10-Q filed by the Registrant with the SEC on May 10, 2007. 11 Incorporated by reference to Exhibit
10.25.2 to Form 8-K filed by the Registrant with the SEC on February 4, 2005. 12 Incorporated by reference to Exhibit
10.25.3 to Form 8-K filed by the Registrant with the SEC on February 4, 2005. 13 Incorporated by reference to Exhibit
10.26 to Form 8-K filed by the Registrant with the SEC on March 15, 2007. 14  Incorporated by reference to Exhibit 10.30 to Form 8-K filed by the
Registrant with the SEC on February 11, 2005.  15  Incorporated by reference to Exhibit
10.34 to Form 8-K filed by the Registrant with the SEC on February 14,
2006.  16 Incorporated by reference to Exhibit
10.1 to Form 8-K filed by the Registrant with the SEC on July 20, 2007.




69




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10.1317
            
            Standby Purchase Agreement, dated
      July 16, 2007, by and among NovaStar Financial, Inc., Massachusetts Mutual
      Life Insurance Company, Jefferies Capital Partners IV L.P., Jefferies
      Employee Partners IV LLC and JCP Partners IV LLC10.1418
            
            Registration Rights and
      Shareholders Agreement, dated July 16, 2007, by and among NovaStar
      Financial, Inc., Massachusetts Mutual Life Insurance Company, Jefferies
      Capital Partners IV L.P., Jefferies Employee Partners IV LLC and JCP
      Partners IV LLC10.1519
            
            Letter Agreement, dated July 16,
      2007, by and among NovaStar Financial, Inc.,Massachusetts Mutual Life
      Insurance Company, Jefferies Capital Partners IV L.P., Jefferies Employee
      Partners IV LLC and JCP Partners IV LLC, and Scott Hartman10.1620
            
            Letter Agreement, dated July 16,
      2007, by and among NovaStar Financial, Inc., Massachusetts Mutual Life
      Insurance Company, Jefferies Capital Partners IV L.P., Jefferies Employee
      Partners IV LLC and JCP Partners IV LLC, and Lance Anderson10.1721
            
            Letter Agreement, dated July 16,
      2007, by and among NovaStar Financial, Inc., Massachusetts Mutual Life
      Insurance Company, Jefferies Capital Partners IV L.P., Jefferies Employee
      Partners IV LLC and JCP Partners IV LLC, and Mike Bamburg10.1922
            
            Confidential Settlement Term Sheet
      Agreement, dated March 17, 2008, between American Interbanc Mortgage LLC,
      NovaStar Financial, Inc., NovaStar Mortgage, Inc., NFI Holding Corp., and
      NovaStar Home Mortgage, Inc. (Complete Agreement Filed Due to Expiration
      of Confidential Treatment Request)10.2123
            
            Settlement Agreement, dated as of
      February 18, 2009, among NovaStar Mortgage, Inc., NovaStar Financial,
      Inc., Taberna Preferred Funding I, Ltd., Taberna Preferred Funding II,
      Ltd. and Kodiak CDI I, Ltd.10.2024
            
            Escrow Agreement, dated as of
      February 18, 2009, by an among NovaStar Mortgage, Inc., NovaStar
      Financial, Inc., Taberna Preferred Funding I, Ltd., Taberna Preferred
      Funding II, Ltd., Kodiak CDI I, Ltd. and WolfBlock LLP10.2225
            
            Exchange Agreement, dated as of
      February 18, 2009, by and among NovaStar Mortgage, Inc., NovaStar
      Financial, Inc., NovaStar Capital Trust I/B, NovaStar Capital Trust II/B,
      Taberna Preferred Funding I, Ltd., Taberna Preferred Funding II, Ltd. and
      Kodiak CDI I, Ltd.10.2326
            
            Amended and Restated Trust
      Agreement, dated as of February 18, 2009, by and among, NovaStar Mortgage,
      Inc., The Bank of New York Mellon Trust Company, National Association, BNY
      Mellon Trust of Delaware and certain administrative trustees (including
      the form of Preferred Securities Certificate) (I/B)10.2427
            
            Junior Subordinated Indenture,
      dated as of February 18, 2009, between NovaStar Mortgage, Inc. and The
      Bank of New York Mellon Trust Company, National Association
  (I/B)10.2528
            
            Parent Guarantee Agreement, dated
      as of February 18, 2009, between NovaStar Financial, Inc. and The Bank of
      New York Mellon Trust Company, National Association (I/B)10.2629
            
            Amended and Restated Trust
      Agreement, dated as of February 18, 2009, by and among, NovaStar Mortgage,
      Inc., The Bank of New York Mellon Trust Company, National Association, BNY
      Mellon Trust of Delaware and certain administrative trustees (including
      the form of Preferred Securities Certificate) (II/B)10.2727
            
            Junior Subordinated Indenture,
      dated as of February 18, 2009, between NovaStar Mortgage, Inc. and The
      Bank of New York Mellon Trust Company, National Association
    (II/B)10.2828
            
            Parent Guarantee Agreement, dated
      as of February 18, 2009, between NovaStar Financial, Inc. and The Bank of
      New York Mellon Trust Company, National Association (II/B)10.2932
            
            Securities Purchase Agreement, dated as of April 26, 2009, by and
      among NovaStar Financial, Inc., Advent Financial Services, LLC and Mark A.
      Ernst.


17 Incorporated by
reference to Exhibit 10.2 to Form 8-K filed by the Registrant with the SEC on
July 20, 2007. 18 Incorporated by
reference to Exhibit 10.3 to Form 8-K filed by the Registrant with the SEC on
July 20, 2007. 19 Incorporated by
reference to Exhibit 10.4 to Form 8-K filed by the Registrant with the SEC on
July 20, 2007. 20 Incorporated by
reference to Exhibit 10.5 to Form 8-K filed by the Registrant with the SEC on
July 20, 2007. 21 Incorporated by
reference to Exhibit 10.6 to Form 8-K filed by the Registrant with the SEC on
July 20, 2007. 22 Incorporated by
reference to Exhibit 10.55 to Form 10-Q filed by the Registrant with the SEC on
April 27, 2009. 23 Incorporated by
reference to Exhibit 10.53 to Form 8-K filed by the Registrant with the SEC on
February 24, 2009. 24 Incorporated by
reference to Exhibit 10.54 to Form 8-K filed by the Registrant with the SEC on
February 24, 2009. 25 Incorporated by
reference to Exhibit 10.55 to Form 8-K filed by the Registrant with the SEC on
February 24, 2009. 26 Incorporated by
reference to Exhibit 10.56 to Form 8-K filed by the Registrant with the SEC on
February 24, 2009. 27 Incorporated by
reference to Exhibit 10.57 to Form 8-K filed by the Registrant with the SEC on
February 24, 2009. 28 Incorporated by
reference to Exhibit 10.58 to Form 8-K filed by the Registrant with the SEC on
February 24, 2009. 29 Incorporated by
reference to Exhibit 10.59 to Form 8-K filed by the Registrant with the SEC on
February 24, 2009. 30 Incorporated by
reference to Exhibit 10.60 to Form 8-K filed by the Registrant with the SEC on
February 24, 2009. 31 Incorporated by
reference to Exhibit 10.61 to Form 8-K filed by the Registrant with the SEC on
February 24, 2009. 32 Incorporated by
reference to Exhibit 10.62 to Form 8-K filed by the Registrant with the SEC on
February 24, 2009.




70




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10.3033
            
            Release and Settlement Agreement
      dated as of June 30, 2009 by and between NovaStar Financial, Inc. and
      EHMD, LLC, EHD Holdings, LLC and EHD Properties, LLC.11.134
            
            Statement Regarding Computation of
      Per Share Earnings14.135
            
            NovaStar Financial, Inc. Code of
      Conduct21.1
            
            Subsidiaries of the
      Registrant23.1
            
            Consents of Deloitte & Touche
      LLP31.1
            
            Chief Executive Officer
      Certification - Section 302 of the Sarbanes-Oxley Act of 200231.2
            
            Principal Financial Officer
      Certification - Section 302 of the Sarbanes-Oxley Act of 200232.1
            
            Chief Executive Officer
      Certification - Section 906 of the Sarbanes-Oxley Act of 200232.2
            
            Principal Financial Officer
      Certification - Section 906 of the Sarbanes-Oxley Act of
  2002


33 Incorporated by reference to Exhibit
10.1 to Form 8-K filed by the Registrant with the SEC on July 1,
2009. 34 See Note 16 to the consolidated
financial statements. 35 Incorporated by reference to Exhibit
14.1 to Form 8-K filed by the Registrant with the SEC on February 14, 2006.




71




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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 31, 2010
            /s/ W. LANCE
      ANDERSONW. Lance Anderson, Chairman of the
      Boardof Directors and Chief Executive
      Officer


Pursuant to the
requirements of the Securities Exchange Act of 1934, this report has been signed
below by the following persons on behalf of the registrant and in the capacities
and dates indicated.




DATE: March 31, 2010
            /s/ W. LANCE
      ANDERSONW. Lance Anderson, Chairman of the
      Boardof Directors and Chief Executive
      Officer(Principal Executive
    Officer)DATE: March 31, 2010
            /s/ RODNEY E.
      SCHWATKENRodney E. Schwatken, Chief
      Financial Officerand Chief Accounting
    Officer(Principal Financial
    Officer)DATE: March 31, 2010
            /s/ EDWARD W.
      MEHREREdward W. Mehrer,
  DirectorDATE: March 31, 2010
            /s/ GREGORY T.
      BARMOREGregory T. Barmore,
    DirectorDATE: March 31, 2010
            /s/ ART N.
      BURTSCHERArt N. Burtscher,
  DirectorDATE: March 31, 2010
            /s/ DONALD M.
      BERMANDonald M. Berman,
  DirectorDATE: March 31, 2010
            /s/ HOWARD
      M. AMSTERHoward M. Amster,
  DirectorDATE: March 31, 2010
            /s/ BARRY A.
      IGDALOFFBarry A. Igdaloff,
    Director


72




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