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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



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

For the Quarterly Period Ended June 30, 2007



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

For the Transition Period From  to

Commission File Number 001-13533



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NOVASTAR FINANCIAL, INC.

(Exact Name of Registrant as Specified in its Charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Maryland                                                       |  | 74-2830661                          
|(State or Other Jurisdiction of Incorporation or Organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|8140 Ward Parkway, Suite 300, Kansas City, MO                  |  | 64114                               
|(Address of Principal Executive Office)                        |  | (Zip Code)                          

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



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

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

Large accelerated filer   x                    Accelerated
filer ̈Non-accelerated filer ̈

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

The number of shares of the Registrants Common Stock outstanding on July 31, 2007 was to 9,469,031.



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##### Table of Contents

NOVASTAR FINANCIAL, INC.

FORM 10-Q

For the Quarterly Period Ended June 30, 2007

TABLE OF CONTENTS



|         |  |                                                                                       |  |    
|-------- |  | ------------------------------------------------------------------------------------- |  | ---
|Part I   |  | Financial Information                                                                 |  |    
|         |  |                                                                                      
|Item 1.  |  | Financial Statements (unaudited)                                                      |  |    
|         |  | Condensed Consolidated Balance Sheets                                                 |  | 1  
|         |  | Condensed Consolidated Statements of Operations                                       |  | 2  
|         |  | Condensed Consolidated Statement of Shareholders Equity                              |  | 3  
|         |  | Condensed Consolidated Statements of Cash Flows                                       |  | 4  
|         |  | Notes to Condensed Consolidated Financial Statements                                  |  | 7  
|         |  |                                                                                      
|Item 2.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 42 
|         |  |                                                                                      
|Item 3.  |  | Quantitative and Qualitative Disclosures About Market Risk                            |  | 97 
|         |  |                                                                                      
|Item 4.  |  | Controls and Procedures                                                               |  | 100
|         |  |                                                                                      
|Part II  |  | Other Information                                                                     |  |    
|         |  |                                                                                      
|Item 1.  |  | Legal Proceedings                                                                     |  | 100
|         |  |                                                                                      
|Item 1A. |  | Risk Factors                                                                          |  | 102
|         |  |                                                                                      
|Item 2.  |  | Unregistered Sales of Equity Securities and Use of Proceeds                           |  | 128
|         |  |                                                                                      
|Item 3.  |  | Defaults Upon Senior Securities                                                       |  | 128
|         |  |                                                                                      
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                   |  | 128
|         |  |                                                                                      
|Item 5.  |  | Other Information                                                                     |  | 129
|         |  |                                                                                      
|Item 6.  |  | Exhibits                                                                              |  | 130



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##### Table of Contents

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited; dollars in
thousands, except share amounts)



|                                                                                                           |  |               |           |   |                   |   |           |  
|---------------------------------------------------------------------------------------------------------- |  | ------------- | --------- | - | ----------------- | - | --------- | -
|                                                                                                           |  | June 30, 2007 |           |   | December 31, 2006 |  
|                                                                                                           | 
|Assets                                                                                                     |  |               |           |   |                   |   |           |  
|Cash and cash equivalents                                                                                  |  | $             | 97,872    |   |                   | $ | 150,522   |  
|Restricted cash                                                                                            |  |               | 8,844     |   |                   |   |          |  
|Mortgage loans  held-for-sale                                                                             |  |               | 448,150   |   |                   |   | 1,741,819 |  
|Mortgage loans  held-in-portfolio, net of allowance of $100,096 and $22,452, respectively                 |  |               | 3,415,303 |   |                   |   | 2,116,535 |  
|Mortgage securities  available-for-sale                                                                   |  |               | 168,915   |   |                   |   | 349,312   |  
|Mortgage securities  trading                                                                              |  |               | 368,022   |   |                   |   | 329,361   |  
|Mortgage servicing rights                                                                                  |  |               | 55,099    |   |                   |   | 62,830    |  
|Deferred income tax asset, net                                                                             |  |               | 246,280   |   |                   |   | 47,188    |  
|Servicing related advances                                                                                 |  |               | 52,243    |   |                   |   | 40,923    |  
|Warehouse notes receivable                                                                                 |  |               | 3,114     |   |                   |   | 39,462    |  
|Accrued interest receivable                                                                                |  |               | 39,698    |   |                   |   | 37,692    |  
|Real estate owned                                                                                          |  |               | 50,026    |   |                   |   | 21,534    |  
|Derivative instruments, net                                                                                |  |               | 20,902    |   |                   |   | 16,816    |  
|Other assets                                                                                               |  |               | 75,211    |   |                   |   | 74,269    |  
|                                                                                                           |  |               |           |   |                   |   |           |  
|Total assets                                                                                               |  | $             | 5,049,679 |   |                   | $ | 5,028,263 |  
|                                                                                                           |  |               |           |   |                   |   |           |  
|Liabilities and Shareholders Equity                                                                       |  |               |           |   |                   |   |           |  
|Liabilities:                                                                                               |  |               |           |   |                   |   |           |  
|Short-term borrowings secured by mortgage loans                                                            |  | $             | 313,968   |   |                   | $ | 1,631,773 |  
|Short-term borrowings secured by mortgage securities                                                       |  |               | 267,072   |   |                   |   | 503,680   |  
|Other short-term borrowings                                                                                |  |               | 48,552    |   |                   |   | 16,755    |  
|Asset-backed bonds secured by mortgage loans                                                               |  |               | 3,391,037 |   |                   |   | 2,067,490 |  
|Asset-backed bonds secured by mortgage securities                                                          |  |               | 267,992   |   |                   |   | 9,519     |  
|Junior subordinated debentures                                                                             |  |               | 83,307    |   |                   |   | 83,041    |  
|Due to securitization trusts                                                                               |  |               | 120,138   |   |                   |   | 107,043   |  
|Accounts payable and other liabilities                                                                     |  |               | 71,007    |   |                   |   | 94,392    |  
|                                                                                                           |  |               |           |   |                   |   |           |  
|Total liabilities                                                                                          |  |               | 4,563,073 |   |                   |   | 4,513,693 |  
|                                                                                                           |  |              
|Commitments and contingencies (Note 10)                                                                    |  |               |           |   |                   |   |           |  
|                                                                                                           |  |              
|Shareholders equity:                                                                                      |  |               |           |   |                   |   |           |  
|Capital stock, $0.01 par value, 50,000,000 shares authorized:                                              |  |               |           |   |                   |   |           |  
|Redeemable preferred stock, $25 liquidating preference per share; 2,990,000 shares, issued and outstanding |  |               | 30        |   |                   |   | 30        |  
|Common stock, 9,469,910 and 9,315,313 shares, issued and outstanding, respectively                         |  |               | 95        |   |                   |   | 93        |  
|Additional paid-in capital                                                                                 |  |               | 746,502   |   |                   |   | 742,028   |  
|Accumulated deficit                                                                                        |  |               | (270,496  | ) |                   |   | (263,572  | )
|Accumulated other comprehensive income                                                                     |  |               | 10,963    |   |                   |   | 36,548    |  
|Other                                                                                                      |  |               | (488      | ) |                   |   | (557      | )
|                                                                                                           |  |               |           |   |                   |   |           |  
|Total shareholders equity                                                                                 |  |               | 486,606   |   |                   |   | 514,570   |  
|                                                                                                           |  |               |           |   |                   |   |           |  
|Total liabilities and shareholders equity                                                                 |  | $             | 5,049,679 |   |                   | $ | 5,028,263 |  
|                                                                                                           |  |               |           |   |                   |   |           |  

See notes to condensed consolidated financial statements.



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##### Table of Contents

NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited; dollars in thousands, except share amounts)



|                                                                             |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|---------------------------------------------------------------------------- |  | -------------------------------- | -------- | - | ---------------------------------- | - | ------- | ---- |  | - | -------- | - |  | - | ------- | -
|                                                                             |  | For the Six MonthsEnded June 30, |          |   | For the Three MonthsEnded June 30, |  
|                                                                             |  | 2007                             |          |   | 2006                               |   |         | 2007 |  |   | 2006     |  
|Interest income                                                              |  | $                                | 261,516  |   |                                    | $ | 217,463 |      |  | $ | 130,479  |   |  | $ | 132,791 |  
|Interest expense                                                             |  |                                  | 160,764  |   |                                    |   | 92,191  |      |  |   | 81,884   |   |  |   | 65,262  |  
|                                                                             |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|Net interest income before provision for credit losses                       |  |                                  | 100,752  |   |                                    |   | 125,272 |      |  |   | 48,595   |   |  |   | 67,529  |  
|Provision for credit losses                                                  |  |                                  | 93,167   |   |                                    |   | 9,590   |      |  |   | 73,254   |   |  |   | 6,045   |  
|                                                                             |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|Net interest income (expense)                                                |  |                                  | 7,585    |   |                                    |   | 115,682 |      |  |   | (24,659  | ) |  |   | 61,484  |  
|                                                                             |  |                                  |          |  
|Other operating (expense) income:                                            |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|(Losses) gains on sales of mortgage assets                                   |  |                                  | (12,394  | ) |                                    |   | 23,318  |      |  |   | (9,103   | ) |  |   | 23,285  |  
|Gains on derivative instruments                                              |  |                                  | 5,725    |   |                                    |   | 14,731  |      |  |   | 8,396    |   |  |   | 6,140   |  
|Fair value adjustments                                                       |  |                                  | (26,232  | ) |                                    |   | 4,236   |      |  |   | (16,741  | ) |  |   | 1,866   |  
|Valuation adjustment on mortgage loans  held-for-sale                       |  |                                  | (24,560  | ) |                                    |   | (137    | )    |  |   | (4,363   | ) |  |   | 1,812   |  
|Impairments on mortgage securities  available-for-sale                      |  |                                  | (25,993  | ) |                                    |   | (6,453  | )    |  |   | (22,569  | ) |  |   | (4,488  | )
|Fee income                                                                   |  |                                  | 11,162   |   |                                    |   | 14,458  |      |  |   | 5,131    |   |  |   | 6,888   |  
|Premiums for mortgage loan insurance                                         |  |                                  | (10,262  | ) |                                    |   | (6,150  | )    |  |   | (5,141   | ) |  |   | (3,802  | )
|Other income, net                                                            |  |                                  | 1,623    |   |                                    |   | 372     |      |  |   | 643      |   |  |   | 218     |  
|                                                                             |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|Total other operating (expense) income                                       |  |                                  | (80,931  | ) |                                    |   | 44,375  |      |  |   | (43,747  | ) |  |   | 31,919  |  
|                                                                             |  |                                  |          |  
|General and administrative expenses:                                         |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|Compensation and benefits                                                    |  |                                  | 56,666   |   |                                    |   | 61,153  |      |  |   | 25,846   |   |  |   | 32,786  |  
|Office administration                                                        |  |                                  | 17,026   |   |                                    |   | 13,378  |      |  |   | 7,614    |   |  |   | 6,565   |  
|Professional and outside services                                            |  |                                  | 21,998   |   |                                    |   | 10,278  |      |  |   | 12,762   |   |  |   | 6,600   |  
|Loan expense                                                                 |  |                                  | 6,038    |   |                                    |   | 3,184   |      |  |   | 2,492    |   |  |   | 1,590   |  
|Marketing                                                                    |  |                                  | 10,161   |   |                                    |   | 1,385   |      |  |   | 4,128    |   |  |   | 732     |  
|Other                                                                        |  |                                  | 8,211    |   |                                    |   | 9,241   |      |  |   | 2,836    |   |  |   | 4,366   |  
|                                                                             |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|Total general and administrative expenses                                    |  |                                  | 120,100  |   |                                    |   | 98,619  |      |  |   | 55,678   |   |  |   | 52,639  |  
|                                                                             |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|(Loss) income from continuing operations before income tax (benefit) expense |  |                                  | (193,446 | ) |                                    |   | 61,438  |      |  |   | (124,084 | ) |  |   | 40,764  |  
|Income tax (benefit) expense                                                 |  |                                  | (186,582 | ) |                                    |   | 864     |      |  |   | (71,206  | ) |  |   | 5,443   |  
|                                                                             |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|(Loss) income from continuing operations                                     |  |                                  | (6,864   | ) |                                    |   | 60,574  |      |  |   | (52,878  | ) |  |   | 35,321  |  
|Loss from discontinued operations, net of income tax                         |  |                                  |         |   |                                    |   | (1,811  | )    |  |   |         |   |  |   | (586    | )
|                                                                             |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|Net (loss) income                                                            |  |                                  | (6,864   | ) |                                    |   | 58,763  |      |  |   | (52,878  | ) |  |   | 34,735  |  
|Dividends on preferred shares                                                |  |                                  | (3,326   | ) |                                    |   | (3,326  | )    |  |   | (1,663   | ) |  |   | (1,663  | )
|                                                                             |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|Net (loss) income available to common shareholders                           |  | $                                | (10,190  | ) |                                    | $ | 55,437  |      |  | $ | (54,541  | ) |  | $ | 33,072  |  
|                                                                             |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|Basic earnings per share:                                                    |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|(Loss) income from continuing operations available to common shareholders    |  | $                                | (1.09    | ) |                                    | $ | 6.99    |      |  | $ | (5.84    | ) |  | $ | 4.07    |  
|Loss from discontinued operations, net of income tax                         |  |                                  |         |   |                                    |   | (0.22   | )    |  |   |         |   |  |   | (0.07   | )
|                                                                             |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|Net (loss) income available to common shareholders                           |  | $                                | (1.09    | ) |                                    | $ | 6.77    |      |  | $ | (5.84    | ) |  | $ | 4.00    |  
|                                                                             |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|Diluted earnings per share:                                                  |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|(Loss) income from continuing operations available to common shareholders    |  | $                                | (1.09    | ) |                                    | $ | 6.94    |      |  | $ | (5.84    | ) |  | $ | 4.04    |  
|Loss from discontinued operations, net of income tax                         |  |                                  |         |   |                                    |   | (0.22   | )    |  |   |         |   |  |   | (0.07   | )
|                                                                             |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|Net (loss) income available to common shareholders                           |  | $                                | (1.09    | ) |                                    | $ | 6.72    |      |  | $ | (5.84    | ) |  | $ | 3.97    |  
|                                                                             |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|Weighted average basic shares outstanding                                    |  |                                  | 9,329    |   |                                    |   | 8,183   |      |  |   | 9,337    |   |  |   | 8,266   |  
|                                                                             |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|Weighted average diluted shares outstanding                                  |  |                                  | 9,329    |   |                                    |   | 8,246   |      |  |   | 9,337    |   |  |   | 8,330   |  
|                                                                             |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  
|Dividends declared per common share                                          |  | $                                |         |   |                                    | $ | 11.20   |      |  | $ |         |   |  | $ | 5.60    |  
|                                                                             |  |                                  |          |   |                                    |   |         |      |  |   |          |   |  |   |         |  

See notes to condensed consolidated financial statements.



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##### Table of Contents

NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS EQUITY

(unaudited; dollars in thousands, except share amounts)



|                                                                 |  |                |    |             |   |                          |  |                    |         |  |                                     |          |   |       |   |         |                          |  |   |      |   |  |   |         |  
|---------------------------------------------------------------- |  | -------------- | -- | ----------- | - | ------------------------ |  | ------------------ | ------- |  | ----------------------------------- | -------- | - | ----- | - | ------- | ------------------------ |  | - | ---- | - |  | - | ------- | -
|                                                                 |  | PreferredStock |    | CommonStock |   | AdditionalPaid-inCapital |  | AccumulatedDeficit |         |  | AccumulatedOtherComprehensiveIncome |          |   | Other |   |         | TotalShareholdersEquity | 
|Balance, January 1, 2007                                         |  | $              | 30 |             | $ | 93                       |  | $                  | 742,028 |  | $                                   | (263,572 | ) |       | $ | 36,548  |                          |  | $ | (557 | ) |  | $ | 514,570 |  
|Cumulative effect adjustment from adoption of SFAS 157           |  |                |   |             |   |                         |  |                    |        |  |                                     | 5,430    |   |       |   |        |                          |  |   |     |   |  |   | 5,430   |  
|Cumulative effect adjustment from adoption of SFAS 159           |  |                |   |             |   |                         |  |                    |        |  |                                     | (1,131   | ) |       |   | 1,131   |                          |  |   |     |   |  |   |        |  
|Cumulative effect adjustment from adoption of FIN 48             |  |                |   |             |   |                         |  |                    |        |  |                                     | (1,072   | ) |       |   |        |                          |  |   |     |   |  |   | (1,072  | )
|Forgiveness of founders notes receivable                        |  |                |   |             |   |                         |  |                    |        |  |                                     |         |   |       |   |        |                          |  |   | 69   |   |  |   | 69      |  
|Issuance of common stock, 35,094 shares                          |  |                |   |             |   | 1                        |  |                    | 3,189   |  |                                     |         |   |       |   |        |                          |  |   |     |   |  |   | 3,190   |  
|Issuance of stock under stock compensation plans, 119,504 shares |  |                |   |             |   | 1                        |  |                    | 209     |  |                                     |         |   |       |   |        |                          |  |   |     |   |  |   | 210     |  
|Compensation recognized under stock compensation plans           |  |                |   |             |   |                         |  |                    | 685     |  |                                     | 31       |   |       |   |        |                          |  |   |     |   |  |   | 716     |  
|Dividends on preferred stock ($1.12 per share)                   |  |                |   |             |   |                         |  |                    |        |  |                                     | (3,326   | ) |       |   |        |                          |  |   |     |   |  |   | (3,326  | )
|Other                                                            |  |                |   |             |   |                         |  |                    | 391     |  |                                     | 8        |   |       |   |        |                          |  |   |     |   |  |   | 399     |  
|                                                                 |  |                |    |             |   |                          |  |                    |         |  |                                     |          |   |       |   |         |                          |  |   |      |   |  |   |         |  
|Comprehensive income:                                            |  |                |    |             |   |                          |  |                    |         |  |                                     |          |   |       |   |         |                          |  |   |      |   |  |   |         |  
|Net loss                                                         |  |                |    |             |   |                          |  |                    |         |  |                                     | (6,864   | ) |       |   |         |                          |  |   |      |   |  |   | (6,864  | )
|Other comprehensive loss                                         |  |                |    |             |   |                          |  |                    |         |  |                                     |          |   |       |   | (26,716 | )                        |  |   |      |   |  |   | (26,716 | )
|                                                                 |  |                |    |             |   |                          |  |                    |         |  |                                     |          |   |       |   |         |                          |  |   |      |   |  |   |         |  
|Total comprehensive loss                                         |  |                |    |             |   |                          |  |                    |         |  |                                     |          |   |       |   |         |                          |  |   |      |   |  |   | (33,580 | )
|                                                                 |  |                |    |             |   |                          |  |                    |         |  |                                     |          |   |       |   |         |                          |  |   |      |   |  |   |         |  
|Balance, June 30, 2007                                           |  | $              | 30 |             | $ | 95                       |  | $                  | 746,502 |  | $                                   | (270,496 | ) |       | $ | 10,963  |                          |  | $ | (488 | ) |  | $ | 486,606 |  
|                                                                 |  |                |    |             |   |                          |  |                    |         |  |                                     |          |   |       |   |         |                          |  |   |      |   |  |   |         |  

See notes to condensed consolidated financial statements.



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NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited; in thousands)



|                                                                                                            |  |                                   |            |   |      |   |            |  
|----------------------------------------------------------------------------------------------------------- |  | --------------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                                                                            |  | For the Six Months Ended June 30, |           
|                                                                                                            |  | 2007                              |            |   | 2006 |  
|Cash flows from operating activities:                                                                       |  |                                   |            |   |      |   |            |  
|Net (loss) Income                                                                                           |  | $                                 | (6,864     | ) |      | $ | 58,763     |  
|Loss from discontinued operations                                                                           |  |                                   |           |   |      |   | 1,811      |  
|                                                                                                            |  |                                   |            |   |      |   |            |  
|(Loss) income from continuing operations                                                                    |  |                                   | (6,864     | ) |      |   | 60,574     |  
|Adjustments to reconcile (loss) income from continuing operations to net cash used in operating activities: |  |                                   |            |   |      |   |            |  
|Amortization of mortgage servicing rights                                                                   |  |                                   | 17,275     |   |      |   | 15,421     |  
|Impairment of mortgage servicing rights                                                                     |  |                                   | 222        |   |      |   |           |  
|Retention of mortgage servicing rights                                                                      |  |                                   | (9,766     | ) |      |   | (12,396    | )
|Impairment on mortgage securities  available-for-sale                                                      |  |                                   | 25,993     |   |      |   | 6,453      |  
|Gains on derivative instruments                                                                             |  |                                   | (5,725     | ) |      |   | (14,731    | )
|Depreciation expense                                                                                        |  |                                   | 2,915      |   |      |   | 3,866      |  
|Losses on disposals of property and equipment                                                               |  |                                   |           |   |      |   | 39         |  
|Amortization of deferred debt issuance costs                                                                |  |                                   | 5,584      |   |      |   | 2,008      |  
|Compensation recognized under stock compensation plans                                                      |  |                                   | 716        |   |      |   | 1,379      |  
|Provision for credit losses                                                                                 |  |                                   | 93,167     |   |      |   | 9,590      |  
|Amortization of premiums on mortgage loans                                                                  |  |                                   | 8,826      |   |      |   | 3,147      |  
|Interest capitalized on loans held-in-portfolio                                                             |  |                                   | (23,065    | ) |      |   | (8,628     | )
|Forgiveness of founders promissory notes                                                                   |  |                                   | 69         |   |      |   | 69         |  
|Provision for deferred income taxes                                                                         |  |                                   | (192,078   | ) |      |   | (6,580     | )
|Fair value adjustments                                                                                      |  |                                   | 26,232     |   |      |   | (4,236     | )
|Valuation adjustment on mortgage loans  held-for-sale                                                      |  |                                   | 24,560     |   |      |   | 137        |  
|Accretion of available-for-sale and trading securities                                                      |  |                                   | (57,630    | ) |      |   | (81,065    | )
|Losses (gains) on sales of mortgage assets                                                                  |  |                                   | 22,160     |   |      |   | (10,922    | )
|Originations and purchases of mortgage loans held-for-sale                                                  |  |                                   | (2,301,713 | ) |      |   | (5,728,713 | )
|Proceeds from repayments of mortgage loans held-for-sale                                                    |  |                                   | 30,532     |   |      |   | 54,907     |  
|Proceeds from sales of mortgage loans held-for-sale to third parties                                        |  |                                   | 247,032    |   |      |   | 823,768    |  
|Proceeds from sales of mortgage loans held-for-sale in securitizations                                      |  |                                   | 1,331,299  |   |      |   | 2,041,732  |  
|Changes in:                                                                                                 |  |                                   |            |   |      |   |            |  
|Servicing related advances                                                                                  |  |                                   | (11,320    | ) |      |   | (4,389     | )
|Accrued interest receivable                                                                                 |  |                                   | (9,849     | ) |      |   | (43,682    | )
|Derivative instruments, net                                                                                 |  |                                   | 1,842      |   |      |   | 2,020      |  
|Other assets                                                                                                |  |                                   | 23,479     |   |      |   | (59,260    | )
|Accounts payable and other liabilities                                                                      |  |                                   | 9,658      |   |      |   | 1,826      |  
|                                                                                                            |  |                                   |            |   |      |   |            |  
|Net cash used in operating activities from continuing operations                                            |  |                                   | (746,449   | ) |      |   | (2,947,666 | )
|Net cash provided by operating activities from discontinued operations                                      |  |                                   |           |   |      |   | 3,369      |  
|                                                                                                            |  |                                   |            |   |      |   |            |  
|Net cash used in operating activities                                                                       |  |                                   | (746,449   | ) |      |   | (2,944,297 | )
|                                                                                                            |  |                                   |            |   |      |   |            |  

Continued



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##### Table of Contents

|                                                                                                  |  |                                   |            |   |      |   |           |  
|------------------------------------------------------------------------------------------------- |  | --------------------------------- | ---------- | - | ---- | - | --------- | -
|                                                                                                  |  | For the Six Months Ended June 30, |           
|                                                                                                  |  | 2007                              |            |   | 2006 |  
|Cash flows from investing activities:                                                             |  |                                   |            |   |      |   |           |  
|Proceeds from paydowns on mortgage securities - available-for-sale                                |  |                                   | 108,293    |   |      |   | 183,614   |  
|Proceeds from paydowns of mortgage securities - trading                                           |  |                                   | 14,604     |   |      |   | 2,953     |  
|Purchase of mortgage securities - trading                                                         |  |                                   | (17,748    | ) |      |   | (52,325   | )
|Proceeds from sale of mortgage securities - trading                                               |  |                                   | 7,422      |   |      |   | 11,223    |  
|Purchase of mortgage securities - available-for-sale                                              |  |                                   |           |   |      |   | (1,922    | )
|Proceeds from repayments of mortgage loans held-in-portfolio                                      |  |                                   | 471,694    |   |      |   | 117,832   |  
|Proceeds from sales of assets acquired through foreclosure                                        |  |                                   | 9,166      |   |      |   | 718       |  
|Cash used to collateralize letter of credit                                                       |  |                                   | (8,844     | ) |      |   |          |  
|Purchases of property and equipment                                                               |  |                                   | (2,929     | ) |      |   | (824      | )
|                                                                                                  |  |                                   |            |   |      |   |           |  
|Net cash provided by investing activities                                                         |  |                                   | 581,658    |   |      |   | 261,269   |  
|                                                                                                  |  |                                   |            |   |      |   |           |  
|Cash flows from financing activities:                                                             |  |                                   |            |   |      |   |           |  
|Proceeds from issuance of asset-backed bonds                                                      |  |                                   | 2,111,415  |   |      |   | 2,366,796 |  
|Payments on asset-backed bonds                                                                    |  |                                   | (475,952   | ) |      |   | (117,843  | )
|Proceeds from issuance of capital stock and exercise of equity instruments, net of offering costs |  |                                   | 3,150      |   |      |   | 53,077    |  
|Net change in short-term borrowings                                                               |  |                                   | (1,522,616 | ) |      |   | 304,306   |  
|Proceeds from issuance of junior subordinated debentures                                          |  |                                   |           |   |      |   | 33,918    |  
|Repurchase of common stock                                                                        |  |                                   |           |   |      |   | (17       | )
|Dividends paid on vested options                                                                  |  |                                   | (530       | ) |      |   | (763      | )
|Dividends paid on preferred stock                                                                 |  |                                   | (3,326     | ) |      |   | (3,326    | )
|Dividends paid on common stock                                                                    |  |                                   |           |   |      |   | (88,941   | )
|                                                                                                  |  |                                   |            |   |      |   |           |  
|Net cash provided by financing activities from continuing operations                              |  |                                   | 112,141    |   |      |   | 2,547,207 |  
|Net cash used in financing activities from discontinued operations                                |  |                                   |           |   |      |   | (2,935    | )
|                                                                                                  |  |                                   |            |   |      |   |           |  
|Net cash provided by financing activities                                                         |  |                                   | 112,141    |   |      |   | 2,544,272 |  
|                                                                                                  |  |                                   |            |   |      |   |           |  
|Net decrease in cash and cash equivalents                                                         |  |                                   | (52,650    | ) |      |   | (138,756  | )
|Cash and cash equivalents, beginning of period                                                    |  |                                   | 150,522    |   |      |   | 264,694   |  
|                                                                                                  |  |                                   |            |   |      |   |           |  
|Cash and cash equivalents, end of period                                                          |  | $                                 | 97,872     |   |      | $ | 125,938   |  
|                                                                                                  |  |                                   |            |   |      |   |           |  

Continued



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SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

(unaudited; in thousands)



|                                                                                            |  |                                   |           |      |   |          
|------------------------------------------------------------------------------------------- |  | --------------------------------- | --------- | ---- | - | ---------
|                                                                                            |  | For the Six Months Ended June 30,
|                                                                                            |  | 2007                              |           | 2006
|Cash paid for interest                                                                      |  | $                                 | 160,508   |      | $ | 86,403   
|                                                                                            |  |                                   |           |      |   |          
|Cash paid for income taxes                                                                  |  |                                   | 330       |      |   | 6,235    
|                                                                                            |  |                                   |           |      |   |          
|Cash received on mortgage securities  available-for-sale with no cost basis                |  |                                   | 3,296     |      |   | 2,923    
|                                                                                            |  |                                   |           |      |   |          
|Cash received for dividend reinvestment plan                                                |  |                                   |          |      |   | 2,097    
|                                                                                            |  |                                   |           |      |   |          
|Non-cash operating, investing and financing activities:                                     |  |                                   |           |      |   |          
|                                                                                            |  |                                   |           |      |   |          
|Cost basis of securities retained in securitizations                                        |  |                                   | 56,387    |      |   | 87,648   
|                                                                                            |  |                                   |           |      |   |          
|Transfer of loans to held-in-portfolio from held-for-sale                                   |  |                                   | 1,880,340 |      |   | 2,548,984
|                                                                                            |  |                                   |           |      |   |          
|Transfer of mortgage securities  trading from mortgage securities  available-for-sale (A) |  |                                   | 46,383    |      |   |         
|                                                                                            |  |                                   |           |      |   |          
|Assets acquired through foreclosure                                                         |  |                                   | 52,787    |      |   | 3,832    
|                                                                                            |  |                                   |           |      |   |          
|Dividends payable                                                                           |  |                                   | 1,663     |      |   | 47,713   
|                                                                                            |  |                                   |           |      |   |          

---

|(A) | Transfer was made upon adoption of SFAS 159.
|--- | --------------------------------------------

See notes to condensed
consolidated financial statements.



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NOVASTAR FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2007 (Unaudited)

Note 1. Financial Statement
Presentation

NovaStar Financial, Inc. and its subsidiaries (the Company) operate as a specialty finance company that originates, purchases,
securitizes, sells, invests in and services residential nonconforming loans and mortgage backed securities. The Company offers a wide range of mortgage loan products to nonconforming borrowers, who generally do not satisfy the credit,
collateral, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers, including U.S. government-sponsored entities such as Fannie Mae or Freddie Mac. The Company retains significant interests in the
nonconforming loans originated and purchased through their mortgage securities investment portfolio. Historically, the Company has serviced all of the loans in which it retains interests through its servicing platform. The Company has elected to be
taxed as a real estate investment trust (REIT) under the Internal Revenue Code of 1986, as amended (the Code), but has authorized termination of its status as a REIT effective January 1, 2008.

The Companys condensed consolidated financial statements as of June 30, 2007 and for the six and three months ended June 30, 2007 and 2006 are unaudited.
In the opinion of management, all necessary adjustments have been made, which were of a normal and recurring nature, for a fair presentation of the condensed consolidated financial statements. Reclassifications to prior year amounts have been made
to conform to current year presentation, as follows.

In accordance with Statement of Financial Accounting Standards (SFAS) No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets, the Company has reclassified the operating results of NovaStar Home Mortgage, Inc. and its branches (NHMI) through December 31, 2006, as discontinued
operations in the condensed consolidated statements of operations for the six and three months ended June 30, 2006.

The Company created two new line
items on the condensed consolidated statements of operations named Fair value adjustments and Valuation adjustment on mortgage loans - held-for-sale to separate activity which was previously reported in the Other
income, net line item in the prior year period. These line items were created due to the materiality of the amounts recorded in the first and second quarters of 2007.

The Companys condensed consolidated financial statements should be read in conjunction with Managements Discussion and Analysis of Financial Condition and Results of Operations and the consolidated
financial statements of the Company and the notes thereto, included in the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2006.

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

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

Significant Liquidity
Factors During the First Six Months of 2007

Cash and Availability Activities. The Company had $97.9 million in unrestricted cash and cash
equivalents at June 30, 2007, which was a decrease of $52.7 million from December 31, 2006. The Company also had availability of $59.2 million as of June 30, 2007. Subsequent to June 30, 2007, the Company has been subject to
additional margin calls and has total unrestricted cash and availability of approximately $103.6 million as of August 8, 2007. The following factors contributed to the Companys change in cash position:

As a result of the 2007 subprime environment, the Company used up significant cash reserves during the six months ended June 30, 2007. The Companys cash
balances declined by approximately $52.7 million during the six months ended June 30, 2007 primarily due to margin calls, mortgage loan repurchases and normal business operations. As a result of the decrease in liquidity, the Company completed
several strategic initiatives to attempt to ensure adequate liquidity levels for its business operations. One of those initiatives was the closing of a $100 million lending facility to provide financing for certain residual securities and mortgage
servicing rights. The Companys cash availability increased $56.2 million from December 31, 2006 due to the pledging of collateral under the $100 million facility.



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Additionally, the Company closed a $1.9 billion comprehensive financing facility for the financing of substantially all
of its mortgage assets. The Companys intent for the near future is to solely use the $1.9 billion facility for its daily mortgage loan and security financing needs. Based on this intent, upon the closing of the comprehensive facility, the
Company transferred all borrowings with its other lenders to Wachovia during the second quarter of 2007 except for its servicing advance facility. While the Company still maintains lending facilities with other financial institutions which have not
expired, they currently are not being used with the exception of the servicing advance facility. Another transaction the Company entered into on July 16, 2007 as part of its strategic initiatives was the issuance of $48.8 million of convertible
preferred stock to certain private investors to enhance its liquidity position. Subject to the terms of applicable agreements, the Company has the right to issue another $101.2 million of preferred stock in the last half of 2007. See Note 11 and
Note 22 to the condensed consolidated financial statements for further discussion of the Companys liquidity position and steps taken to help ensure the Company maintains adequate liquidity levels to help navigate through the current
challenging environment.

During the first half of 2007, bond spreads on mortgage-backed securities widened as a result of investor concerns over
deteriorating credit quality in the subprime mortgage market. This widening caused a significant decline in the fair value of the Companys mortgage securities as well as its mortgage loans held-for-sale. Consequently, during the first half of
2007 the Company was subject to cash margin calls of approximately $86.6 million and $33.8 million on the Companys mortgage securities and mortgage loans held-for-sale, respectively. The Company could continue to be subject to additional
margin calls if the value of its mortgage assets declines further. From June 30, 2007 through August 8, 2007, the Company was subjected to margin calls of approximately $76.5 million due to the extremely volatile and less liquid secondary
market which has adversely affected the values of the Companys mortgage assets.

As the values of mortgage loans decreased in the first half of 2007,
not only was the Company subject to cash margin calls but the cash the Company was required to invest in new originations increased at the time of funding. The Company had invested approximately $41.0 million and $40.4 million of cash in its
mortgage loans held-for-sale on its balance sheet as of June 30, 2007 and December 31, 2006, respectively, which consists of the difference between the current principal on the loans and the lending value assigned to the loans by the
Companys lenders. Also contributing to this investment of cash is the fact that the Company is financing a larger balance of delinquent mortgage loans which have a lower lending value and consequently require a larger cash investment by the
Company because the amount the Company can borrow against these assets is very low.

The Company also had significant cash outlays in 2007 to repurchase
loans sold to third parties during 2006. When whole pools of mortgage loans are sold as opposed to securitized, the third party has recourse against the Company for certain borrower defaults. The cash the Company must have on hand to repurchase
these loans is much higher than the principal amount of the loan as the Company generally must reimburse the investor for the remaining unpaid principal balance, any premium recapture, any unpaid accrued interest and any other out-of-pocket advances
in accordance with the loan sale agreement. Typically, repurchased loans will subsequently be financed on the Companys warehouse repurchase agreements if eligible and then liquidated or sold. The Company paid $100.3 million in cash in the
first half of 2007 to repurchase loans sold to third parties. Significant capital is tied up in these assets as the lending values assigned to these assets is usually much lower than newly originated loans and some may not be eligible for financing.

The Company closed a collateralized debt obligation (CDO) structured as a financing transaction in the first quarter of 2007. 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. The Company received net proceeds from the issuance of the
asset-backed bonds and from the proceeds of its financing of the BBB bond aggregating $64.3 million.

During the first six months of 2007, the Company also
closed two loan securitizations. The net cash inflow from these transactions was $24.4 million. Generally, the Companys securitizations are a net positive cash flow event due to the financing it receives on the residual security it retains.

Industry Overview and Known Material Trends

Described
below are some of the marketplace conditions, known material trends and uncertainties that may impact the Companys future results of operations as the Company moves into the third quarter of 2007.

Conditions in the secondary markets, which had stabilized throughout the second quarter, have worsened early in the third quarter as investor concerns increase over
subprime asset quality and a weakening of the United States housing market. As a result of the many uncertainties in the subprime mortgage market (i.e. home price appreciation, home sales, credit quality, interest rates), bond investors continue to
drive bond spreads dramatically wider in the first part of the third quarter. As a result, the capital markets remain very volatile and less liquid and, at times have been and may in the future be effectively unavailable to the Company. The Company
believes the existing conditions in the secondary markets are unprecedented since the Companys inception and, as such, inherently involve significant risks and uncertainty. These conditions could continue to adversely impact investors
willingness to purchase bonds backed by subprime loans and whole pools of mortgage loans, the profit margins of mortgage originations, and the amounts lenders are willing to finance on mortgage loans pending their sale or securitization. Until bond
spreads return to more rational levels, it will be difficult for the Company to execute securitizations and loan sales at favorable prices. As a result, subsequent to the end of the second quarter the Company has been



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forced to further alter its business strategies and operations in response to market conditions. For example, due to the fact that the Company cannot sell or
securitize the loans it originates at favorable prices, or at times at all, the Company has drastically reduced, and recently temporarily suspended for a few days, its mortgage origination volumes and has made adjustments to its pricing and
underwriting guidelines. In addition, until the secondary market returns to more rational levels, the Company may elect or be required to further alter the scope or nature of its origination operations, further tighten its origination guidelines,
further raise interest rates, further reduce workforce or take other actions to align its operations with the current market environment, including the sale of certain assets or businesses. The Company cannot currently predict the impact that any of
those actions, if taken, would have on its financial condition, results of operations, liquidity or business prospects. In addition, the Company may experience additional mark-to-market losses on its mortgage securities  trading and mortgage
loans  held-for-sale which would likely result in further margin calls under its financing facilities.

The Companys liquidity position was
also severely impacted because of the 2007 market disruptions. Recently, the Companys principal lender effectively reduced the amount it can borrow against its mortgage loans to 94% of the principal of the loan. To the extent that the
Companys lenders further reduce the value of its mortgage assets securing its warehouse repurchase agreements or otherwise reduce the amount the Company can borrow against its assets, the Company could be subject to additional margin calls and
the amounts it can borrow could be reduced, which could materially adversely affect the Companys liquidity.

The Company initiated and completed a
formal process to explore a range of strategic alternatives during the second quarter of 2007. Note 22 to the Condensed Consolidated Financial Statements contain a description of the agreements that resulted from this process. The transactions
resulting from these agreements could also result in a change in control within the meaning of Section 382 of the Code, which may impact our ability to realize our deferred tax assets. To the extent that the Company is unable to
consummate the transactions on the terms described in Note 22 and does not result in a change in control, its liquidity and financial condition will be materially adversely affected. In addition, current industry conditions may cause the
Company to consider other additional alternatives.

As a result of the implementation of tighter origination guidelines, the Companys origination
volumes have substantially decreased in the first and second quarter of 2007. Loan originations were $2.2 billion and $0.8 billion during the six and three months ended June 30, 2007, respectively, as compared to $4.6 billion and $2.8 billion
during the six and three months ended June 30, 2006, respectively. The Company expects that the changes it has made to its pricing and underwriting guidelines will restrict further the number of borrowers who qualify for its loans. As a result,
it expects that its third quarter origination volume will be lower than in the second quarter and that its cost to fund loans will increase in the third quarter. Those changes may also expose the Company to further competition which could further
adversely affect the Companys origination business. By having lower originations, the Company necessarily will have fewer loans to securitize. Because the Company depends on its securitizations to increase the size of its mortgage securities
portfolio, the Company expects that the size of its mortgage portfolio will decline in future periods as its older mortgage securities mature and the Company is unable to replace them with additional mortgage securities.

Industry-wide tightening of underwriting guidelines and increases in interest rates may decrease refinancing opportunities for existing borrowers, which may result in
fewer loans and increased defaults by borrowers, particularly those facing a resetting of their existing loan to a higher monthly payment. If borrower defaults continue or increase, the Companys financial condition, liquidity and business
prospects will be further adversely affected.

The Companys Board of Directors approved a formal plan to voluntarily revoke the Companys REIT
status effective January 1, 2008. In order to voluntarily revoke REIT status, the Company must file such revocation with the Internal Revenue Service within 90 days of the beginning of the first tax year for which the revocation is to be
effective. The Company will continue to be subject to the REIT dividend distribution requirements for 2007 which require it to distribute at least 90 percent of its 2007 taxable income by the end of 2008 in order to retain its REIT status for 2007.
The Company expects little or no taxable income in 2007. Once the Company is a C corporation, payment of future dividends will be at the discretion of its board of directors. As a result, shareholders should not expect to receive dividends, other
than dividends with respect to the Companys 2006 taxable income, at any time in the near future.

The Company has stated its intention to declare a
dividend payable in preferred stock, the Company has not yet declared such a dividend with respect to its 2006 REIT taxable income. To timely meet the REIT dividend requirement, the Company must declare the dividend prior to the date it files its
2006 tax return and pay the dividend before the end of 2007. Because of recent volatility in the market price of our common stock and general stock market volatility, the Company may have difficulty valuing the preferred stock and determining
definitive terms. If for any reason the Company is unable to timely declare or pay its 2006 REIT dividend, the IRS may revoke its status as a REIT. Such revocation would be retroactive to the beginning of 2006. Retroactive revocation of the
Companys REIT status would result in it becoming taxable as a C corporation for 2006 and subsequent years. Tax treatment of a C corporation is materially different from tax treatment as a REIT and thus the tax characterization of the
Companys transactions and calculations of its taxable income would be different than how it has reported them to you and the IRS. These differences could result, among other things, in the Company owing a tax liability (including penalties and
interest) to the IRS, which could have a material adverse effect on the Companys financial condition, results of operations and liquidity. In addition, if the Company is unable to declare this dividend for any reason, the Investors may not be
obligated to purchase any shares of the Series D-2 Preferred Stock pursuant to the Standby Purchase Agreement, and the Companys status as a REIT will be jeopardized. These events will further undermine the Companys financial condition
and business prospects.

Along with several other industry competitors, the Company terminated its 2/28 product in July 2007 due to investor, regulatory
and rating agency concerns. The 2/28 product carries a fixed rate for the first two years of its life and then adjusts after two years based on an index rate. The Company intends to convert all of the 2/28 product existing in the Companys
mortgage loans - held-for-sale to a 3 year fixed product. The 2 year fixed product represents approximately 67% of the total principal of its mortgage loans  held-for-sale as of June 30, 2007. The Company does not expect this decision to
have a material impact on its financial condition or results of operations. However, there can be no assurance that the Company will not have to further alter its existing products as a result of investor, regulatory or rating agency concerns and
that such an alteration will not negatively affect its results of operations, liquidity or financial condition.



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To the extent the Company is unable to consummate the transactions on the terms described in Note 22, or in the event of
further deterioration in the mortgage-sector capital markets, the Companys financial and operational viability may become increasingly uncertain. The Company may be required to further reduce or eliminate some of its operations or sell assets.
The accompanying consolidated financial statements do not include any adjustments related to the effects of these uncertainties described above.

Note
2. New Accounting Pronouncements

In February 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting
Standards (SFAS) No. 155, Accounting for Certain Hybrid Financial Instruments, an amendment of SFAS No. 133 and SFAS No. 140 (SFAS 155). This statement permits fair value remeasurement for any
hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. It also clarifies which interest-only strips and principal-only strips are not subject to FASB Statement No. 133, Accounting for
Derivative Instruments and Hedging Activities (SFAS 133). The statement also establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or hybrid
financial instruments that contain an embedded derivative requiring bifurcation. The statement also clarifies that concentration of credit risks in the form of subordination are not embedded derivatives, and it also amends SFAS No. 140
(SFAS 140), Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities  a replacement of FASB Statement No. 125 to eliminate the prohibition on a Qualifying Special Purpose Entity
(QSPE) from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument.

In January 2007, the FASB provided a scope exception under SFAS 155 for securitized interests that only contain an embedded derivative that is tied to the prepayment risk of the underlying prepayable financial assets, and for which the
investor does not control the right to accelerate the settlement. If a securitized interest contains any other embedded derivative (for example, an inverse floater), then it would be subject to the bifurcation tests in SFAS 133, as would
securities purchased at a significant premium. The adoption of this standard on January 1, 2007 did not have a significant impact on the Companys financial position, results of operations or cash flows. However, to the extent that certain
of the Companys future investments in securitized financial assets do not meet the scope exception adopted by the FASB, the Companys future results of operations may exhibit volatility if such investments are required to be bifurcated or
marked to market value in their entirety through the income statement, depending on the election made by the Company.

In March 2006, the FASB issued SFAS
No. 156, Accounting for Servicing of Financial Assets, an amendment of SFAS No. 140 (SFAS 156). This statement requires that an entity separately recognize a servicing asset or a servicing liability when it
undertakes an obligation to service a financial asset under a servicing contract in certain situations. Such servicing assets or servicing liabilities are required to be initially measured at fair value, if practicable. SFAS 156 also allows an
entity to choose one of two methods when subsequently measuring its servicing assets and servicing liabilities: (1) the amortization methodor (2) the fair value measurement method. The amortization method existed under SFAS
140 and remains unchanged in (1) allowing entities to amortize their servicing assets or servicing liabilities in proportion to and over the period of estimated net servicing income or net servicing loss and (2) requiring the assessment of
those servicing assets or servicing liabilities for impairment or increased obligation based on fair value at each reporting date. The fair value measurement method allows entities to measure their servicing assets or servicing liabilities at fair
value at each reporting date and report changes in fair value in earnings in the period the change occurs. SFAS 156 introduces the notion of classesand allows companies to make a separate subsequent measurement election for each class of its
servicing rights. In addition, SFAS 156 requires certain comprehensive roll-forward disclosures that must be presented for each class. The Statement is effective as of the beginning of an entitys first fiscal year that begins after
September 15, 2006. The Company adopted SFAS 156 on January 1, 2007 and elected to continue using the amortization method for measuring its servicing assets.

In June 2006, the FASB issued FASB Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes  an Interpretation of FASB Statement No. 109. FIN 48 prescribes a
recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or to be taken on a tax return. This interpretation also provides additional guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation is effective for fiscal years beginning after December 15, 2006. The Company adopted the provisions of FIN 48 on January 1, 2007. The
cumulative effect of applying the provisions of FIN 48 is reported as an adjustment to the opening balance of accumulated deficit on January 1, 2007 and resulted in an increase to the Companys accumulated deficit of $1.1 million.



10



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##### Table of Contents

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157).
SFAS 157 establishes a framework for measuring fair value and requires expanded disclosures regarding fair value measurements. This accounting standard is effective for financial statements issued for fiscal years beginning after November 15,
2007, however early adoption is permitted. The Company adopted the provisions of SFAS 157 on January 1, 2007. See Note 9 which describes the impact of the adoption of SFAS 157 on the Companys condensed consolidated financial statements.

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108, Considering the Effects
of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB No. 108). SAB No. 108 provides guidance regarding the consideration of the effects of prior year misstatements in
quantifying current year misstatements for the purpose of materiality assessments. The method established by SAB No. 108 requires each of the Companys financial statements and the related financial statement disclosures to be considered
when quantifying and assessing the materiality of the misstatement. The provisions of SAB No. 108 are effective for financial statements issued for fiscal years beginning after December 31, 2006. The Company adopted SAB No. 108 on
January 1, 2007 and has deemed the impact immaterial on its condensed consolidated financial statements.

In February 2007, the FASB issued SFAS
No. 159, The Fair Value Option for Financial Assets and Financial Liabilitiesincluding an amendment of FASB Statement No. 115 (SFAS 159). SFAS 159 permits entities to choose to measure many financial
instruments and certain other items at fair value. Unrealized gains and losses on items for which the fair value option has been elected will be recognized in earnings at each subsequent reporting date. This accounting standard is effective for
financial statements issued for fiscal years beginning after November 15, 2007, however early adoption is permitted. The Company adopted the provisions of SFAS 159 on January 1, 2007. See Note 9 which describes the impact of the adoption
of SFAS 159 on the Companys condensed consolidated financial statements.

On July 24, 2007, the FASB released proposed Staff Position (FSP) FAS
140-d, Accounting for Transfers of Financial Assets and Repurchase Financing Transactions. The FSP focuses on the circumstances that would permit a transferor and a transferee to separately evaluate the accounting for a transfer of a
financial asset and a repurchase financing under FASB Statement No. 140, Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.The proposed FSP states that a transfer of a financial asset and a
repurchase agreement involving the transferred financial asset should be considered part of the same arrangement when the counterparties to the two transactions are the same unless certain criteria are met. The criteria in the proposed FSP are
intended to identify whether (1) there is a valid and distinct business or economic purpose for entering separately into the two transactions and (2) the repurchase financing does not result in the initial transferor regaining control over
the previously transferred financial assets. Its purpose is to limit diversity of practice in accounting for these situations, resulting in more consistent financial reporting. Consequently, it is the FASBs desire to have the proposed FSP
effective as soon as practicable. This FSP would be effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. Early application is not permitted.

During the first quarter of 2006, the Company purchased approximately $1.0 billion of mortgage loans from counterparties which were subsequently financed through
repurchase agreements with that same counterparty. As of June 30, 2007, the entire $1.0 billion of mortgage loans purchased during 2006 remained on the Companys condensed consolidated balance sheet but they were no longer financed with
repurchase agreements as they had been securitized in transactions structured as financings and the short-term repurchase agreements were replaced with asset-backed bond financing. Additionally, the Company is still evaluating FSP 140-d but believes
there would be no material change to its financial statements based on this current proposal issued by the FASB.



11



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Note 3. Mortgage Loans

Mortgage loans, all of which are secured by residential properties, consisted of the following as of June 30, 2007 and December 31, 2006 (dollars in thousands):



|                                              |  |              |           |   |                  |   |           |  
|--------------------------------------------- |  | ------------ | --------- | - | ---------------- | - | --------- | -
|                                              |  | June 30,2007 |           |   | December 31,2006 |  
|Mortgage loans  held-for-sale:               |  |              |           |   |                  |   |           |  
|Outstanding principal                         |  | $            | 352,675   |   |                  | $ | 1,631,891 |  
|Loans under removal of accounts provision     |  |              | 120,138   |   |                  |   | 107,043   |  
|Net deferred origination costs (fees)         |  |              | (945      | ) |                  |   | 7,891     |  
|Allowance for the lower of cost or fair value |  |              | (23,718   | ) |                  |   | (5,006    | )
|                                              |  |              |           |   |                  |   |           |  
|Mortgage loans  held-for-sale                |  | $            | 448,150   |   |                  | $ | 1,741,819 |  
|                                              |  |              |           |   |                  |   |           |  
|Weighted average coupon                       |  |              | 9.35%     |   |                  |   | 8.69%     |  
|                                              |  |              |           |   |                  |   |           |  
|Percent of loans with prepayment penalties    |  |              | 60%       |   |                  |   | 58%       |  
|                                              |  |              |           |   |                  |   |           |  
|Mortgage loans  held-in-portfolio:           |  |              |           |   |                  |   |           |  
|Outstanding principal                         |  | $            | 3,489,521 |   |                  | $ | 2,101,768 |  
|Net unamortized deferred origination costs    |  |              | 28,094    |   |                  |   | 37,219    |  
|Carrying value adjustment                     |  |              | (2,216    | ) |                  |   |          |  
|                                              |  |              |           |   |                  |   |           |  
|Amortized cost                                |  |              | 3,515,399 |   |                  |   | 2,138,987 |  
|Allowance for credit losses                   |  |              | (100,096  | ) |                  |   | (22,452   | )
|                                              |  |              |           |   |                  |   |           |  
|Mortgage loans  held-in-portfolio            |  | $            | 3,415,303 |   |                  | $ | 2,116,535 |  
|                                              |  |              |           |   |                  |   |           |  
|Weighted average coupon                       |  |              | 8.64%     |   |                  |   | 8.35%     |  
|                                              |  |              |           |   |                  |   |           |  
|Percent of loans with prepayment penalties    |  |              | 62%       |   |                  |   | 61%       |  
|                                              |  |              |           |   |                  |   |           |  

Activity in the allowance for the lower of cost or fair value on mortgage loans  held-for-sale is as follows
for the six and three months ended June 30, 2007 and 2006, respectively (dollars in thousands):



|                                                             |  |                                  |         |   |                                    |   |        |      |  |   |        |   |  |   |        |  
|------------------------------------------------------------ |  | -------------------------------- | ------- | - | ---------------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                             |  | For the Six MonthsEnded June 30, |         |   | For the Three MonthsEnded June 30, |  
|                                                             |  | 2007                             |         |   | 2006                               |   |        | 2007 |  |   | 2006   |  
|Balance, beginning of period                                 |  | $                                | 5,006   |   |                                    | $ | 3,530  |      |  | $ | 25,872 |   |  | $ | 5,549  |  
|Valuation adjustment on mortgage loans held-for-sale         |  |                                  | 24,560  |   |                                    |   | 137    |      |  |   | 4,363  |   |  |   | (1,812 | )
|Transfer from the reserve for loan repurchases               |  |                                  | 22,329  |   |                                    |   | 1,532  |      |  |   | 3,806  |   |  |   |       |  
|Transfer to cost basis of mortgage loans  held-in-portfolio |  |                                  | (14,843 | ) |                                    |   |       |      |  |   |       |   |  |   |       |  
|Reduction due to loans securitized or sold to third parties  |  |                                  | (3,259  | ) |                                    |   |       |      |  |   | (3,259 | ) |  |   |       |  
|Transfers to real estate owned                               |  |                                  | (10,075 | ) |                                    |   |       |      |  |   | (7,064 | ) |  |   |       |  
|Charge-offs, net of recoveries                               |  |                                  |        |   |                                    |   | (1,462 | )    |  |   |       |   |  |   |       |  
|                                                             |  |                                  |         |   |                                    |   |        |      |  |   |        |   |  |   |        |  
|Balance, end of period                                       |  | $                                | 23,718  |   |                                    | $ | 3,737  |      |  | $ | 23,718 |   |  | $ | 3,737  |  
|                                                             |  |                                  |         |   |                                    |   |        |      |  |   |        |   |  |   |        |  



12



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##### Table of Contents

Activity in the allowance for credit losses on mortgage loans  held-in-portfolio is as follows for the six and
three months ended June 30, 2007 and 2006, respectively (dollars in thousands):



|                             |  |                                  |         |   |                                    |   |       |      |  |   |         |   |  |   |       |  
|---------------------------- |  | -------------------------------- | ------- | - | ---------------------------------- | - | ----- | ---- |  | - | ------- | - |  | - | ----- | -
|                             |  | For the Six MonthsEnded June 30, |         |   | For the Three MonthsEnded June 30, |  
|                             |  | 2007                             |         |   | 2006                               |   |       | 2007 |  |   | 2006    |  
|Balance, beginning of period |  | $                                | 22,452  |   |                                    | $ | 699   |      |  | $ | 34,911  |   |  | $ | 4,137 |  
|Provision for credit losses  |  |                                  | 93,167  |   |                                    |   | 9,590 |      |  |   | 73,254  |   |  |   | 6,045 |  
|Charge-offs                  |  |                                  | (16,524 | ) |                                    |   | (503  | )    |  |   | (8,941  | ) |  |   | (390  | )
|Recoveries                   |  |                                  | 1,001   |   |                                    |   | 113   |      |  |   | 872     |   |  |   | 107   |  
|                             |  |                                  |         |   |                                    |   |       |      |  |   |         |   |  |   |       |  
|Balance, end of period       |  | $                                | 100,096 |   |                                    | $ | 9,899 |      |  | $ | 100,096 |   |  | $ | 9,899 |  
|                             |  |                                  |         |   |                                    |   |       |      |  |   |         |   |  |   |       |  

Note 4. Loan Securitizations and Loan Sales

The Company closed two mortgage loan securitizations during the six months ended June 30, 2007. NovaStar Mortgage Funding Trust (NMFT) Series 2007-2 was structured legally and for accounting purposes
as a sale under SFAS No. 140. NovaStar Home Equity Series (NHES) Series 2007-1 was structured legally as a sale, but for accounting purposes was treated as a financing under SFAS No. 140. This securitization did not meet the
qualifying special purpose entity criteria under SFAS No. 140 at the time of the securitization, but may meet the criteria at a future date which then would be accounted for as a sale. Accordingly, the loans remain on the Companys balance
sheet as mortgage loans - held-in-portfolio, retained interests are not created, and securitization bond financing replaces the short-term debt used to finance the loans. The Company records interest income on loans held-in-portfolio and
interest expense on the bonds issued in the securitizations over the life of the securitizations. Deferred debt issuance costs and discounts related to the bonds are amortized on a level yield basis over the estimated life of the bonds.

Details of the Companys loan securitization transaction structured for accounting purposes as a sale which closed during the six months ended June 30, 2007
are as follows (dollars in thousands):



|                   |  |                  |           |                         |   |                          |  |                               |        |                                               |   |                |  |   |       |  |   |      
|------------------ |  | ---------------- | --------- | ----------------------- | - | ------------------------ |  | ----------------------------- | ------ | --------------------------------------------- | - | -------------- |  | - | ----- |  | - | -----
|                   |  | Net BondProceeds |           | MortgageServicingRights |   | SubordinatedBond Classes |  | PrincipalBalance ofLoans Sold |        | Fair Value ofDerivativeInstrumentsTransferred |   | LossRecognized
|NMFT Series 2007-2 |  | $                | 1,331,299 |                         | $ | 9,766                    |  | $                             | 56,387 |                                               | $ | 1,400,000      |  | $ | 4,161 |  | $ | 4,981

The Company retained interest-only, prepayment penalty and other subordinated interests in the underlying cash
flows and servicing responsibilities from the financial assets transferred as part of the NMFT 2007-2 securitization. The value of the Companys retained interests is subject to credit, prepayment, and interest rate risks on the transferred
financial assets.

Details of the Companys loan securitization transaction structured for accounting purposes as a financing which closed during the
six months ended June 30, 2007 is as follows (dollars in thousands):



|                    |  |                   |  |                                 |           |                 |   |                  |  |                                               |           |  |            
|------------------- |  | ----------------- |  | ------------------------------- | --------- | --------------- | - | ---------------- |  | --------------------------------------------- | --------- |  | -----------
|Securitization Name |  | Date Issued       |  | PrincipalBalance ofLoansPledged |           | BondsIssued (A) |   | Net BondProceeds |  | Interest RateSpread OverOne MonthLIBOR (A)(B)
|NHES 2007-1         |  | February 28, 2007 |  | $                               | 1,888,756 |                 | $ | 1,794,386        |  | $                                             | 1,784,662 |  | 0.10%-1.75%

---

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

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



13



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##### Table of Contents

Loan Sales.The Company executes sales of loans to third parties with the related servicing on those loans
released. Gains and losses on whole loan sales are recognized in the period the sale occurs. The Company generally has an obligation to repurchase whole loans sold in circumstances in which the borrower fails to make the first payment or, in some
cases, any of the first three payments. Additionally, the Company is also required to repay all or a portion of the premium it receives on the sale of whole loans in the event that the loan is prepaid in its entirety in the first year. The Company
records a reserve for losses on repurchased loans upon the sale of the mortgage loans which is included in the accounts payable and other liabilities line on the companys condensed consolidated balance sheets.

Activity in the reserve for repurchases is as follows for the six and three months ended June 30, 2007 and 2006 (dollars in thousands):



|                                                                                                |  |                                  |         |   |                                   |   |        |      |  |   |        |   |  |   |       |  
|----------------------------------------------------------------------------------------------- |  | -------------------------------- | ------- | - | --------------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ----- | -
|                                                                                                |  | For the Six MonthsEnded June 30, |         |   | For the ThreeMonths EndedJune 30, |  
|                                                                                                |  | 2007                             |         |   | 2006                              |   |        | 2007 |  |   | 2006   |  
|Balance, beginning of period                                                                    |  | $                                | 24,773  |   |                                   | $ | 2,345  |      |  | $ | 7,336  |   |  | $ | 1,802 |  
|Provision for repurchased loans                                                                 |  |                                  | 3,611   |   |                                   |   | 1,152  |      |  |   | 523    |   |  |   | 51    |  
|Transfer to the allowance for the lower of cost or fair value on mortgage loans  held-for-sale |  |                                  | (22,329 | ) |                                   |   | (1,532 | )    |  |   | (3,806 | ) |  |   |      |  
|Charge-offs, net                                                                                |  |                                  | (2,543  | ) |                                   |   | (205   | )    |  |   | (541   | ) |  |   | (93   | )
|                                                                                                |  |                                  |         |   |                                   |   |        |      |  |   |        |   |  |   |       |  
|Balance, end of period                                                                          |  | $                                | 3,512   |   |                                   | $ | 1,760  |      |  | $ | 3,512  |   |  | $ | 1,760 |  
|                                                                                                |  |                                  |         |   |                                   |   |        |      |  |   |        |   |  |   |       |  

Note 5. Mortgage Securities  Available-for-Sale

As of June 30, 2007, mortgage securities  available-for-sale consist entirely of the Companys investment in the residual securities issued by
securitization trusts sponsored by the Company. As of December 31, 2006 mortgage securities  available for sale contained residual securities as well as subordinated securities issued by securitization trusts sponsored by the Company. In
previous years, the Companys policy was to designate its residual securities as available-for-sale but as a result of the Companys adoption of SFAS 155 on January 1, 2007 and the complexities and uncertainties surrounding the
application of this Statement, the Company has designated the NMFT Series 2007-2 residual security as trading. As a result, the NMFT Series 2007-2 residual security qualifies for the scope exception provided by SFAS 155. Residual securities consist
of interest-only, prepayment penalty and overcollateralization bonds. Subordinated securities consist of rated bonds which are lower than other rated bonds on the capital structure. Management estimates the fair value of the residual securities by
discounting the expected future cash flows of the collateral and bonds. Fair value of the subordinated securities is based on quoted market prices. The following table presents certain information on the Companys portfolio of mortgage
securities  available-for-sale as of June 30, 2007 and December 31, 2006 (dollars in thousands):



|                        |  |            |         |                |   |                                         |  |   |                     |   |                   |   |         |  |       |  
|----------------------- |  | ---------- | ------- | -------------- | - | --------------------------------------- |  | - | ------------------- | - | ----------------- | - | ------- |  | ----- | -
|                        |  | Cost Basis |         | UnrealizedGain |   | Unrealized LossesLess ThanTwelve Months |  |   | EstimatedFair Value |   | Average Yield (A) |  
|As of June 30, 2007     |  | $          | 162,877 |                | $ | 6,038                                   |  | $ |                    |   |                   | $ | 168,915 |  | 32.77 | %
|As of December 31, 2006 |  |            | 310,760 |                |   | 39,683                                  |  |   | (1,131              | ) |                   |   | 349,312 |  | 41.84 |  

---

|(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 six months ended June 30, 2007 and 2006, management concluded that the decline in value on
certain securities in the Companys mortgage securities portfolio were other-than-temporary. As a result, the Company recognized an impairment on mortgage securities  available-for-sale of $26.0 million and $22.6 million during the six
and three months ended June 30, 2007, respectively, as compared to $6.5 million and $4.5 million during the same periods of 2006.

As of
December 31, 2006, the Company had two subordinated available-for-sale securities with unrealized losses and fair values aggregating $46.7 million that were not deemed to be other-than-temporarily impaired. In accordance with the Companys
adoption of SFAS 159, these securities were transferred from available-for-sale to the trading classification on January 1, 2007 and the related unrealized losses of $1.1 million representing the cumulative effect
adjustment were reclassified from accumulated other comprehensive income to accumulated deficit. As of June 30, 2007, the Company had no available-for-sale securities with unrealized losses and had no subordinated securities within its mortgage
securities  available-for-sale.



14



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##### Table of Contents

Maturities of mortgage securities owned by the Company depend on repayment characteristics and experience of the
underlying financial instruments. The Company expects the securities it owns as of June 30, 2007 to mature in one to five years.

Note 6. Mortgage
Securities  Trading

As of June 30, 2007, mortgage securities  trading consisted of residual securities and subordinated securities
retained by the Company from securitization transactions as well as subordinated securities purchased from other issuers in the open market. On December 31, 2006, mortgage securities  trading consisted only of subordinated securities that
were 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. Refer to Note 9 for a description of the valuation methods as of December 31, 2006 and June 30, 2007. The following table summarizes the Companys mortgage securities  trading as of
June 30, 2007 and December 31, 2006 (dollars in thousands):



|                                       |  |               |         |                     |   |            |  |                  |         |  |       |  
|-------------------------------------- |  | ------------- | ------- | ------------------- | - | ---------- |  | ---------------- | ------- |  | ----- | -
|                                       |  | Original Face |         | Amortized CostBasis |   | Fair Value |  | AverageYield (A) |        
|As of June 30, 2007                    |  |               |         |                     |   |            |  |                  |         |  |       |  
|Subordinated securities pledged to CDO |  | $             | 332,489 |                     | $ | 309,624    |  | $                | 245,479 |  |       |  
|Other subordinated securities          |  |               | 102,625 |                     |   | 88,648     |  |                  | 67,627  |  |       |  
|Residual securities                    |  |               | N/A     |                     |   | 54,738     |  |                  | 54,916  |  |       |  
|                                       |  |               |         |                     |   |            |  |                  |         |  |       |  
|Total                                  |  | $             | 435,114 |                     | $ | 453,010    |  | $                | 368,022 |  | 13.89 | %
|                                       |  |               |         |                     |   |            |  |                  |         |  |       |  
|As of December 31, 2006                |  | $             | 365,898 |                     | $ | 332,045    |  | $                | 329,361 |  | 13.12 | %
|                                       |  |               |         |                     |   |            |  |                  |         |  |       |  

---

|(A) | Calculated from the average fair value of the securities.
|--- | ---------------------------------------------------------

The Company
recognized net trading losses of $89.7 million and $39.7 million for the six and three months ended June 30, 2007, respectively as compared to net trading gains of $4.2 million and $1.8 million for the same periods of 2006. These net trading
(losses) gains are included in the fair value adjustments line on the Companys condensed consolidated statements of operations.

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

During the six months ended June 30, 2007 the Company purchased four subordinated bonds with a fair value at the date of purchase of $22.0 million to include in
NovaStar ABS CDO I.

In the second quarter of 2007 the Company sold three subordinated bonds with a fair value of $7.2 million to a third party. The
Company realized losses on the sales of these securities of $3.1 million during the six and three months ended June 30, 2007.

As of June 30,
2007 and December 31, 2006 the Company had pledged all of its trading securities as collateral for financing purposes.

Note 7. Collateralized Debt
Obligation Issuance

In the first quarter of 2007 the Company closed a CDO. The collateral for this securitization consisted of subordinated securities
which the Company retained from its loan securitizations as well as subordinated securities purchased from other issuers. This securitization was structured legally as a sale, but for accounting purposes was accounted for as a financing under SFAS
No. 140. This securitization did not meet the qualifying special purpose entity criteria under SFAS No. 140. Accordingly, the securities remain on the Companys balance sheet, retained interests were not created, and securitization
bond financing replaced the short-term debt used to finance the securities. The Company records interest income on the securities and interest expense on the bonds issued in the securitization over the life of the related securities and bonds.



15



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##### Table of Contents

Details of the CDO transaction are as follows (dollars in thousands):



|                    |  |                  |  |                                   |         |                 |   |                      |  |                                               |         |  |            
|------------------- |  | ---------------- |  | --------------------------------- | ------- | --------------- | - | -------------------- |  | --------------------------------------------- | ------- |  | -----------
|Securitization Name |  | Date Issued      |  | ParAmount ofSecuritiesPledged (A) |         | BondsIssued (B) |   | Net BondProceeds (B) |  | Interest Rate SpreadOver Three MonthLIBOR (B)
|NovaStar ABS CDO I  |  | February 8, 2007 |  | $                                 | 374,862 |                 | $ | 331,500              |  | $                                             | 326,753 |  | 0.32%-2.25%

---

|(A) | The amount shown includes subordinated bonds retained by the Company.
|--- | ---------------------------------------------------------------------

|(B) | The amounts shown do not include the Class D and subordinated bonds retained by the Company.
|--- | --------------------------------------------------------------------------------------------

Note 8. Mortgage Servicing Rights

The Company records mortgage servicing rights (MSRs) arising
from the transfer of loans to the securitization trusts.

The following table summarizes the carrying value of mortgage servicing rights and the activity
during the six and three months ended June 30, 2007 and 2006 (dollars in thousands):



|                                                                                 |  |                                  |         |   |                                   |   |         |      |  |   |        |   |  |   |        |  
|-------------------------------------------------------------------------------- |  | -------------------------------- | ------- | - | --------------------------------- | - | ------- | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                                 |  | For the Six MonthsEnded June 30, |         |   | For the ThreeMonths EndedJune 30, |  
|                                                                                 |  | 2007                             |         |   | 2006                              |   |         | 2007 |  |   | 2006   |  
|Balance, beginning of period                                                     |  | $                                | 62,830  |   |                                   | $ | 57,122  |      |  | $ | 52,499 |   |  | $ | 50,983 |  
|Amount capitalized in connection with transfer of loans to securitization trusts |  |                                  | 9,766   |   |                                   |   | 12,396  |      |  |   | 9,766  |   |  |   | 10,138 |  
|Amortization                                                                     |  |                                  | (17,275 | ) |                                   |   | (15,421 | )    |  |   | (7,965 | ) |  |   | (7,024 | )
|(Additions) reductions to the valuation allowance                                |  |                                  | (222    | ) |                                   |   |        |      |  |   | 799    |   |  |   |       |  
|                                                                                 |  |                                  |         |   |                                   |   |         |      |  |   |        |   |  |   |        |  
|Balance, end of period                                                           |  | $                                | 55,099  |   |                                   | $ | 54,097  |      |  | $ | 55,099 |   |  | $ | 54,097 |  
|                                                                                 |  |                                  |         |   |                                   |   |         |      |  |   |        |   |  |   |        |  

The following table summarizes the activity to the valuation allowance for impairment of MSRs for the six
and three months ended June 30, 2007 (dollars in thousands):



|                                  |  |                                      |       |   |                                        |   |       |  
|--------------------------------- |  | ------------------------------------ | ----- | - | -------------------------------------- | - | ----- | -
|                                  |  | For the SixMonths EndedJune 30, 2007 |       |   | For the ThreeMonths EndedJune 30, 2007 |  
|Balance, beginning of period      |  | $                                    |      |   |                                        | $ | 1,021 |  
|Provision for impairments         |  |                                      | 1,021 |   |                                        |   |      |  
|Reversal of temporary impairments |  |                                      | (799  | ) |                                        |   | (799  | )
|                                  |  |                                      |       |   |                                        |   |       |  
|Balance, end of period            |  | $                                    | 222   |   |                                        | $ | 222   |  
|                                  |  |                                      |       |   |                                        |   |       |  

The estimated fair value of the MSRs aggregated $66.6 million and $60.0 million at June 30, 2007 and
June 30, 2006, respectively. The fair value is estimated by discounting estimated future cash flows from the servicing assets using discount rates that approximate current market rates. The fair value as of June 30, 2007 was determined
utilizing a 12% discount rate, credit losses net of mortgage insurance (as a percent of current principal balance) of 4.3% and an annual prepayment rate of 43%. The fair value as of June 30, 2006 was determined utilizing a 12% discount rate,
credit losses net of mortgage insurance (as a percent of current principal balance) of 2.0% and an annual prepayment rate of 49%.

At June 30, 2007
the amortized cost basis on certain stratifications of the Companys MSRs exceeded their fair value. The Company recognized a net impairment of $0.2 million for the six months ended June 30, 2007 after recording a reversal of
temporary impairments of $(0.8) million during the three months ended June 30, 2007. These amounts are included in the fee income line item on the condensed consolidated statements of operations. The Company did not recognize an impairment on
MSRs during the six and three months ended June 30, 2006.

The Company receives annual servicing fees approximating 0.50% of the outstanding
balance. Servicing fees received from the securitization trusts were $29.7 million and $13.4 million for the six and three months ended June 30, 2007, respectively, as compared to $29.8 million and $14.1 million for the same periods of 2006.
These amounts are included in the fee income line item on the condensed consolidated statements of operations.



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The Company holds, as custodian, principal and interest collected from borrowers on behalf of the securitization trusts,
as well as funds collected from borrowers to ensure timely payment of hazard and primary mortgage insurance and property taxes related to the properties securing the loans. These funds are not owned by the Company and are held in trust. The Company
held, as custodian, $382.7 million and $658.0 million at June 30, 2007 and 2006, respectively.

Note 9. Fair Value Accounting

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

Fair Value Measurements (SFAS 157)

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

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



| |  |  | Level 1Quoted prices for identical instruments in active markets
| | - |  | -----------------------------------------------------------------



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



| |  |  | Level 3Instruments whose significant value drivers are unobservable.
| | - |  | ---------------------------------------------------------------------

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

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

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



|                              |  |                                                    |         |                                                                  |   |                                               |  |   |        
|----------------------------- |  | -------------------------------------------------- | ------- | ---------------------------------------------------------------- | - | --------------------------------------------- |  | - | -------
|Description                   |  | December 31, 2006(Carrying valueprior to adoption) |         | Cumulative-effectAdjustment toJanuary 1, 2007Accumulated Deficit |   | January 1, 2007(Carrying valueafter adoption)
|Mortgage securities  trading |  | $                                                  | 329,361 |                                                                  | $ | 5,430                                         |  | $ | 334,791



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##### Table of Contents

The following table presents for each of the fair value hierarchy levels, the Companys assets and liabilities which
are measured at fair value on a recurring basis as of June 30, 2007 (dollars in thousands):



|                                                  |  |                        |         |                                                             |   |                                             |  |                                         |         |  |   |        
|------------------------------------------------- |  | ---------------------- | ------- | ----------------------------------------------------------- | - | ------------------------------------------- |  | --------------------------------------- | ------- |  | - | -------
|                                                  |  |                        |         | Fair Value Measurements at Reporting Date Using            
|Description                                       |  | Fair Value at6/30/2007 |         | Quoted Prices inActive Marketsfor
IdenticalAssets (Level 1) |   | Significant OtherObservableInputs (Level 2) |  | SignificantUnobservableInputs (Level 3)
|Assets                                            |  |                        |         |                                                             |   |                                             |  |                                         |         |  |   |        
|Mortgage securities - trading                     |  | $                      | 368,022 |                                                             | $ |                                            |  | $                                       | 313,106 |  | $ | 54,916 
|Mortgage securities  available-for-sale          |  |                        | 168,915 |                                                             |   |                                            |  |                                         |        |  |   | 168,915
|Derivative instruments, net                       |  |                        | 20,902  |                                                             |   |                                            |  |                                         | 20,902  |  |   |       
|                                                  |  |                        |         |                                                             |   |                                             |  |                                         |         |  |   |        
|Total Assets                                      |  | $                      | 557,839 |                                                             | $ |                                            |  | $                                       | 334,008 |  | $ | 223,831
|                                                  |  |                        |         |                                                             |   |                                             |  |                                         |         |  |   |        
|Liabilities                                       |  |                        |         |                                                             |   |                                             |  |                                         |         |  |   |        
|Asset-backed bonds secured by mortgage securities |  | $                      | 267,992 |                                                             | $ |                                            |  | $                                       | 267,992 |  | $ |       
|                                                  |  |                        |         |                                                             |   |                                             |  |                                         |         |  |   |        

The following table provides a reconciliation of the beginning and ending balances for the Companys mortgage
securities  trading which are measured at fair value on a recurring basis using significant unobservable inputs (Level 3) from December 31, 2006 to June 30, 2007 (dollars in thousands):



|                                                      |  |            |        |   |                |   |     |                                          |  |   |        |  
|----------------------------------------------------- |  | ---------- | ------ | - | -------------- | - | --- | ---------------------------------------- |  | - | ------ | -
|                                                      |  | Cost Basis |        |   | UnrealizedGain |   |     | Estimated FairValue ofMortgageSecurities | 
|As of December 31, 2006                               |  | $          |       |   |                | $ |    |                                          |  | $ |       |  
|Increases (decreases) to mortgage securities-trading: |  |            |        |   |                |   |     |                                          |  |   |        |  
|New securities retained in securitizations            |  |            | 56,387 |   |                |   | 226 |                                          |  |   | 56,613 |  
|Accretion of income                                   |  |            | 654    |   |                |   |    |                                          |  |   | 654    |  
|Proceeds from paydowns of securities                  |  |            | (2,303 | ) |                |   |    |                                          |  |   | (2,303 | )
|Mark-to-market value adjustment                       |  |            |       |   |                |   | (48 | )                                        |  |   | (48    | )
|                                                      |  |            |        |   |                |   |     |                                          |  |   |        |  
|Net increase to mortgage securities                   |  |            | 54,738 |   |                |   | 178 |                                          |  |   | 54,916 |  
|                                                      |  |            |        |   |                |   |     |                                          |  |   |        |  
|As of June 30, 2007                                   |  | $          | 54,738 |   |                | $ | 178 |                                          |  | $ | 54,916 |  
|                                                      |  |            |        |   |                |   |     |                                          |  |   |        |  



18



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##### Table of Contents

The following table provides 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, 2006 to June 30, 2007 (dollars in thousands):



|                                                                    |  |            |          |   |                |   |         |                                          |  |   |          |  
|------------------------------------------------------------------- |  | ---------- | -------- | - | -------------- | - | ------- | ---------------------------------------- |  | - | -------- | -
|                                                                    |  | Cost Basis |          |   | UnrealizedGain |   |         | Estimated FairValue ofMortgageSecurities | 
|As of December 31, 2006                                             |  | $          | 310,760  |   |                | $ | 38,552  |                                          |  | $ | 349,312  |  
|Increases (decreases) to mortgage securities:                       |  |            |          |   |                |   |         |                                          |  |   |          |  
|Transfer to mortgage securities  trading upon adoption of SFAS 159 |  |            | (47,814  | ) |                |   | 1,131   |                                          |  |   | (46,683  | )
|Accretion of income (A)                                             |  |            | 34,689   |   |                |   |        |                                          |  |   | 34,689   |  
|Proceeds from paydowns of securities (A) (B)                        |  |            | (108,765 | ) |                |   |        |                                          |  |   | (108,765 | )
|Impairment on mortgage securities - available-for-sale              |  |            | (25,993  | ) |                |   | 25,993  |                                          |  |   |         |  
|Mark-to-market value adjustment                                     |  |            |         |   |                |   | (59,638 | )                                        |  |   | (59,638  | )
|                                                                    |  |            |          |   |                |   |         |                                          |  |   |          |  
|Net decrease to mortgage securities                                 |  |            | (147,883 | ) |                |   | (32,514 | )                                        |  |   | (180,397 | )
|                                                                    |  |            |          |   |                |   |         |                                          |  |   |          |  
|As of June 30, 2007                                                 |  | $          | 162,877  |   |                | $ | 6,038   |                                          |  | $ | 168,915  |  
|                                                                    |  |            |          |   |                |   |         |                                          |  |   |          |  

---

|(A) | Cash received on mortgage securities with no cost basis was $3.3 million for the six months ended June 30, 2007.
|--- | ----------------------------------------------------------------------------------------------------------------

|(B) | For mortgage securities with a remaining cost basis, the Company reduces the cost basis by the amount of cash that is contractually due from the securitization trusts. In contrast,
for mortgage securities in which the cost basis has previously reached zero, the Company records in interest income the amount of cash that is contractually due from the securitization trusts. In both cases, there are instances where the Company may
not receive a portion of this cash until after the balance sheet reporting date. Therefore, these amounts are recorded as receivables from the securitization trusts. As of June 30, 2007 and December 31, 2006 the Company had receivables
from securitization trusts of $21.7 million and $21.2 million, respectively, related to mortgage securities available-for-sale with a remaining cost basis. Also the Company had receivables from securitization trusts of $0.2 million and $0.7 million
related to mortgage securities with a zero cost basis as of June 30, 2007 and December 31, 2006, respectively.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The following table
provides quantitative disclosures about the fair value measurements for the Companys assets which are measured at fair value on a nonrecurring basis as of June 30, 2007 (dollars in thousands):



|                             |  |                        |         |                                                             |   |                                              |  |                                         |   |  |   |        
|---------------------------- |  | ---------------------- | ------- | ----------------------------------------------------------- | - | -------------------------------------------- |  | --------------------------------------- | - |  | - | -------
|                             |  |                        |         | Fair Value Measurements at Reporting Date Using            
|Description                  |  | Fair Value at6/30/2007 |         | Quoted Prices inActive Marketsfor IdenticalAssets (Level 1) |   | Significant OtherObservable Inputs (Level 2) |  | SignificantUnobservableInputs (Level 3)
|Mortgage loans-held-for-sale |  | $                      | 45,399  |                                                             | $ |                                             |  | $                                       |  |  | $ | 45,399 
|Real estate owned            |  |                        | 50,026  |                                                             |   |                                             |  |                                         |  |  |   | 50,026 
|Mortgage servicing rights    |  |                        | 9,434   |                                                             |   |                                             |  |                                         |  |  |   | 9,434  
|                             |  |                        |         |                                                             |   |                                              |  |                                         |   |  |   |        
|Total                        |  | $                      | 104,859 |                                                             | $ |                                             |  | $                                       |  |  | $ | 104,859
|                             |  |                        |         |                                                             |   |                                              |  |                                         |   |  |   |        

Mortgage loans held-for-sale have a carrying value of $448.2 million as of June 30, 2007 of which $45.4
million were written down to fair value with the remaining balance recorded at cost. The loans which are carried at fair value had a cost basis of $69.1 million. The Company recorded a valuation adjustment of $24.6 million and $4.4 million for
the six and three months ended June 30, 2007.

At the time a mortgage loan held-for-sale or 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. For mortgage loans held-for-sale, any valuation adjustments are recorded to earnings in the (losses) gains on sales of mortgage assets line item of the
Companys condensed consolidated statements of operations. For mortgage loans held-in-portfolio, any valuation adjustments at the time the loan becomes real estate owned is charged to the allowance for credit losses. Any subsequent
valuation adjustments are recorded to earnings in the (losses) gains on sales of mortgage assets line item of the Companys condensed consolidated income statements. During the six and three months ended June 30, 2007, the
Company recorded $5.1 million and $3.7 million, respectively, of losses due to valuation adjustments in its condensed consolidated statements of operations.



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##### Table of Contents

MSRs have a carrying value of $55.1 million as of June 30, 2007 of which $9.4 million were written down
to fair value with the remaining balance recorded at amortized cost. Periodically, the Company evaluates the carrying value of originated MSRs based on their estimated fair value. If the estimated fair value, using a discounted cash flow
methodology, is less than the carrying amount of the mortgage servicing rights, the mortgage servicing rights are written down to the amount of the estimated fair value. For purposes of evaluating and measuring impairment of MSRs the Company
stratifies the mortgage servicing rights based on their predominant risk characteristics. The most predominant risk characteristic considered is period of origination. The Company recorded a net impairment of $0.2 million for the six months ended
June 30, 2007 related to the stratums which had a fair value lower than amortized cost.

The following table provides a summary of the impact to
earnings for the six and three months ended June 30, 2007 from the Companys assets and liabilities which are measured at fair value on a recurring and nonrecurring basis as of June 30, 2007 (dollars in thousands):



|                                                            |  |                                |  |                                                        |  |                                                          |         |   |                                       |   |         |  
|----------------------------------------------------------- |  | ------------------------------ |  | ------------------------------------------------------ |  | -------------------------------------------------------- | ------- | - | ------------------------------------- | - | ------- | -
|                                                            |  |                                |  |                                                        |  | Fair Value AdjustmentsIncluded In Current PeriodEarnings |        
|Asset or Liability Measured at Fair Value                   |  | Fair ValueMeasurementFrequency |  | Income Statement Line Item Impacted                    |  | For the SixMonthsEndedJune 30,2007                       |         |   | For the ThreeMonthsEndedJune 30, 2007 |  
|Mortgage securities - trading                               |  | Recurring                      |  | Fair value adjustments                                 |  | $                                                        | (89,740 | ) |                                       | $ | (39,681 | )
|Mortgage securities  available-for-sale                    |  | Recurring                      |  | Impairment on mortgage securities  available-for-sale |  |                                                          | (25,993 | ) |                                       |   | (22,569 | )
|Derivative instruments, net                                 |  | Recurring                      |  | Gains on derivative instruments                        |  |                                                          | 3,442   |   |                                       |   | 7,405   |  
|Asset-backed bonds secured by mortgage securities           |  | Recurring                      |  | Fair value adjustments                                 |  |                                                          | 63,508  |   |                                       |   | 22,940  |  
|Mortgage loans-held-for-sale                                |  | Nonrecurring                   |  | Valuation adjustment on mortgage loans  held-for-sale |  |                                                          | (24,560 | ) |                                       |   | (4,363  | )
|Real estate owned                                           |  | Nonrecurring                   |  | (Losses) gains on sales of mortgage assets             |  |                                                          | (5,055  | ) |                                       |   | (3,651  | )
|Mortgage servicing rights                                   |  | Nonrecurring                   |  | Fee income                                             |  |                                                          | (222    | ) |                                       |   | 799     |  
|                                                            |  |                                |  |                                                        |  |                                                          |         |   |                                       |   |         |  
|Total Fair Value Losses Included in Current Period Earnings |  |                                |  |                                                        |  | $                                                        | (78,620 | ) |                                       | $ | (39,120 | )
|                                                            |  |                                |  |                                                        |  |                                                          |         |   |                                       |   |         |  

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. Fair value for the subordinated securities classified as trading is estimated using quoted market prices. The Company determined these quoted market prices would qualify as Level 2 due to the inactive and illiquid
nature of the market for these securities. The Company recorded a cumulative-effect adjustment to its accumulated deficit of $5.4 million which represented a gain on its mortgage securities - trading as part of the adoption of FAS 157 on
January 1, 2007. This cumulative-effect adjustment resulted from the Companys change in policies to use quoted market prices which constitute the Companys highest and best execution as compared to the midpoint of mid-market pricing
at December 31, 2006.

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



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##### Table of Contents

Mortgage securities  available-for-sale.Mortgage securities  available-for-sale represent beneficial
interests the Company retains in securitization and resecuritization transactions which include residual securities. The Company had no subordinated securities included within the mortgage securities  available-for-sale classification as of
June 30, 2007. Mortgage securities classified as available-for-sale are reported at their estimated fair value with unrealized gains and losses reported in accumulated other comprehensive income. To the extent that the cost basis of mortgage
securities exceeds the fair value and the unrealized loss is considered to be other than temporary, an impairment charge is recognized and the amount recorded in accumulated other comprehensive income or loss is reclassified to earnings as a
realized loss. The specific identification method is used in computing realized gains or losses. The Company uses two methodologies for determining the initial value of its residual securities 1) the whole loan price methodology and 2) the discount
rate methodology. The Company believes the best estimate of the initial value of the residual securities it retains in its securitizations accounted for as sales is derived from the market value of the pooled loans. As such, the Company generally
will try to use the whole loan price methodology when significant open market sales pricing data is available. Under this method, the initial value of the loans transferred in a securitization accounted for as a sale is estimated based on the
expected open market sales price of a similar pool. In open market transactions, the purchaser has the right to reject loans at its discretion. In a loan securitization, loans generally cannot be rejected. As a result, the Company adjusts the market
price for the loans to compensate for the estimated value of rejected loans. The market price of the securities retained is derived by deducting the net proceeds received in the securitization (i.e. the economic value of the loans transferred) from
the estimated adjusted market price for the entire pool of the loans.

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

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

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

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

Asset-backed bonds secured by
mortgage securities.The Company elected the fair value option for the asset-backed bonds issued from NovaStar ABS CDO I, which closed in the first quarter of 2007. The 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 determined these
quoted market prices would qualify as Level 2 due to the inactive and illiquid nature of the market.

Mortgage loans - held-for-sale.Mortgage loans
- held-for-sale are carried at the lower of cost or fair value. For current performing loans and loans less than 90 days delinquent, the Company estimates fair value by discounting projected cash flows using market discount rates at which similar
pools of loans would be discounted in the market. The cash flows are based on managements assumptions including credit losses and prepayment speeds. For loans which are delinquent greater than 90 days, the Company estimates fair value at their
liquidation value less selling costs using managements assumptions which include the frequency and severity of losses. The frequency and severities are based on historical performance data for similar assets. For any pool of loans within the
two categories described above which have been sold and have yet to settle, the Company uses the sales price of the transaction as its estimate of fair value.

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.

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



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Removal of accounts provision/Due to trusts. The removal of accounts provision and due to trusts line items are
carried at fair value and consist of loans in securitization trusts which are between 90 and 119 days past due. As of June 30, 2007 the removal of accounts provision had a fair value of $120.1 million, which was included in the mortgage
loans  held for sale line on the condensed consolidated balance sheet. The offsetting liability of $120.1 million is reflected by the due to securitization trusts line on the condensed consolidated balance sheet as of
June 30, 2007. The Company estimates fair value of the mortgage loans at their liquidation value less selling costs using managements assumptions which include frequencies and severities. The frequencies and severities are based on
historical performance data for similar assets. The carrying amount of the removal of accounts provision asset and the due to trusts liability will always be equal and offsetting. Therefore, there is never a net income effect on
the Companys condensed consolidated income statements for these line items.

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

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

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

On January 1, 2007, the Company adopted the provisions of SFAS 159. The Company elected the fair value option for the asset-backed bonds issued from NovaStar ABS
CDO I, which closed in the first quarter of 2007. The Company elected the fair value option for these liabilities to help reduce earnings volatility which otherwise would arise if the accounting method for this debt was not matched with the fair
value accounting for the related mortgage securities - trading. The asset-backed bonds which are being carried at fair value are included in the Asset-backed bonds secured by mortgage securities line item on the condensed consolidated
balance sheets. The Company recognized a fair value adjustment of $63.5 million and $22.9 million for the six and three months ended June 30, 2007, respectively, which is included in the Fair value adjustments line item on the
condensed consolidated statements of operations. The Company calculates interest expense for these asset-backed bonds based on the prevailing coupon rates of the specific classes of debt and records interest expense in the period incurred. Interest
expense amounts are included in the Interest expense line item of the condensed consolidated statements of operations.

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

The Company also reclassified its cash flows from purchases and sales of mortgage securities  trading from the operating activities section to the investing
activities section of the condensed consolidated statements of cash flows as a result of the adoption of SFAS 159.

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

The following table shows the impact of electing the fair value option for the six
months ended June 30, 2007 (dollars in thousands):



|                                                  |  |                                             |         |                |   |                      |  |   |        
|------------------------------------------------- |  | ------------------------------------------- | ------- | -------------- | - | -------------------- |  | - | -------
|Description                                       |  | Unpaid Principal Balanceas of June 30, 2007 |         | GainRecognized |   | Balance atFair Value
|Asset-backed bonds secured by mortgage securities |  | $                                           | 331,500 |                | $ | 63,508               |  | $ | 267,992

The $63.5 million gain was recorded directly to the Fair value adjustments line item within the
condensed consolidated statements of operations as this CDO closed in the first quarter of 2007. Therefore, there was no cumulative-effect adjustment to retained earnings related to this transaction. Substantially all of the $63.5 million change in
fair value of the asset-backed bonds is considered to be related to specific credit risk as all of the bonds are floating rate. The change in credit risk was caused by spreads widening in the asset-backed securities market during the first six
months of 2007.



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##### Table of Contents

In accordance with SFAS 159, debt issuance costs are current period expenses and are not amortized over the life of the
debt on a level-yield basis. The $4.7 million in expenses the Company incurred as part of the issuance of NovaStar ABS CDO I were included in the professional and outside services line item on the condensed consolidated statements of operations for
the six months ended, June 30, 2007.

Note 10. Commitments and Contingencies

Commitments. The Company has commitments to borrowers to fund residential mortgage loans as well as commitments to purchase and sell mortgage loans to third parties. At June 30, 2007, the Company had
outstanding commitments to originate loans of $232.7 million. The Company had no commitments to sell or purchase loans at June 30, 2007. At December 31, 2006, the Company had outstanding commitments to originate and purchase loans of
$774.0 million and $11.8 million, respectively. The Company had no outstanding commitments to sell loans at December 31, 2006. The commitments to originate and purchase loans do not necessarily represent future cash requirements, as some
portion of the commitments are likely to expire without being drawn upon.

In the ordinary course of business, the Company sells whole pools of loans with
recourse for certain borrower defaults. Because the loans are no longer on the Companys balance sheet, the recourse component is considered a guarantee. The Company maintained a $3.5 million reserve related to these guarantees as of
June 30, 2007 compared to a $24.8 million reserve as of December 31, 2006. During the first six months of 2007, the Company sold $244.1 million of loans at par with recourse for borrower defaults compared to $793.1 million for the same
period of 2006. During the first six months of 2007 the Company paid $100.3 million in cash to repurchase loans sold to third parties compared to $8.8 million for the same period of 2006.

In the ordinary course of business, the Company sells loans to securitization trusts and guarantees losses suffered by the trusts resulting from defects in the loan
origination process. Defects may occur in the loan documentation and underwriting process, either through processing errors made by the Company or through intentional or unintentional misrepresentations made by the borrower or agents during those
processes. If a defect is identified, the Company is required to repurchase the loan. As of June 30, 2007 and December 31, 2006, the Company had loans sold with recourse with an outstanding principal balance of $11.6 billion and $12.6
billion, respectively. Historically, repurchases of loans where a defect has occurred have been insignificant; therefore, the Company has recorded no reserves related to these guarantees.

Contingencies. In March 2002, an action was filed against NHMI in Superior Court of Orange County, California entitled American Interbanc Mortgage, LLC v.
NovaStar Home Mortgage, Inc. et. al. In the action, the plaintiff alleged that NHMI and two other mortgage companies (Defendants) engaged in false advertising under a California statute permitting lawsuits by a competitor. Plaintiff
amended its complaint subsequently to allege also that Defendants engaged in unfair competition under a different California statute and interfered intentionally with Plaintiffs prospective economic relations. On May 4, 2007, a jury
returned a verdict by a 9-3 vote awarding plaintiff $15.9 million. The court trebled the award, made adjustments for amounts paid by settling Defendants, and entered a $46.1 million judgment against Defendants on June 27, 2007. The award is
joint and several against the three defendants including NHMI. It is unknown if the other two defendants have the financial ability to pay any of the award. NHMI is currently reviewing its alternatives and will first ask the trial court to overturn
the verdict because NHMI does not believe the verdict is supported by the evidence. Absent such a decision NHMI is currently reviewing its various options for appeal. There can be no assurances that these efforts will be successful. NHMI has a
variety of alternative legal steps that can be taken. As such, it is too early in the process to determine that a liability is probable or estimatable and it is not reasonably possible to determine the outcome, therefore, the Company has not
recorded any liability or corresponding charge to earnings related to this case.

Since April 2004, a number of substantially similar class action lawsuits
have been filed and consolidated into a single action in the United States District Court for the Western District of Missouri. The consolidated complaint names the Company and three of the Companys executive officers as defendants and
generally alleges that the defendants made public statements that were misleading for failing to disclose certain regulatory and licensing matters. The plaintiffs purport to have brought this consolidated action on behalf of all persons who
purchased the Companys common stock (and sellers of put options on the Companys common stock) during the period October 29, 2003 through April 8, 2004. On January 14, 2005, the Company filed a motion to dismiss
this action, and on May 12, 2005, the court denied such motion. On February 8, 2007, the court certified the case as a class action, and the Companys petition for permission to appeal the class certification decision has been
denied but is the subject of a pending petition for rehearing. The Company believes that these claims are without merit and continues to vigorously defend against them.

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



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state licensing and regulatory requirements. The parties have reached a settlement of the derivative actions under which the Company agrees to adopt certain
corporate governance measures and the Companys insurance carrier will pay attorneys fees to plaintiffs counsel. The settlement agreement is subject to court approval. Notice of the settlement terms has been provided to
shareholders, and a hearing for final court approval of the settlement is scheduled for September 19, 2007.

In April 2005, three putative class
actions filed against NHMI and certain of its affiliates were consolidated for pre-trial proceedings in the United States District Court for the Southern District of Georgia entitled In Re NovaStar Home Mortgage, Inc. Mortgage Lending Practices
Litigation. These cases contend that NHMI improperly shared settlement service fees with limited liability companies in which NHMI had an interest (the LLCs), in violation of the fee splitting and anti-referral provisions of the
federal Real Estate Settlement Procedures Act (RESPA), and also allege certain violations of state law and civil conspiracy. Plaintiffs seek treble damages with respect to the RESPA claims, disgorgement of fees with respect to the state
law claims as well as other damages, injunctive relief, and attorneys fees. In addition, two other related class actions have been filed in state courts. Miller v. NovaStar Financial, Inc., et al., was filed in October 2004 in the
Circuit Court of Madison County, Illinois and Jones et al. v. NovaStar Home Mortgage, Inc., et al., was filed in December 2004 in the Circuit Court for Baltimore City, Maryland. In the Miller case, plaintiffs allege a violation of the
Illinois Consumer Fraud and Deceptive Practices Act and civil conspiracy and contend certain LLCs provided settlement services without the borrowers knowledge. The plaintiffs in the Miller case seek a disgorgement of fees, other
damages, injunctive relief and attorneys fees on behalf of the class of plaintiffs. In the Jones case, the plaintiffs allege the LLCs violated the Maryland Mortgage Lender Law by acting as lenders and/or brokers in Maryland without
proper licenses and contend this arrangement amounted to a civil conspiracy. The plaintiffs in the Jones case seek a disgorgement of fees and attorneys fees. In January 2007, all of the plaintiffs and NHMI agreed upon a nationwide
settlement. On June 22, 2007, the parties signed a settlement agreement that provides for a claims-made settlement class. The settlement agreement must be approved by the U.S. District Court for the Southern District of Georgia in Savannah,
Georgia. On July 11, 2007, the district court tentatively approved the agreement and set a fairness hearing to consider final approval of the proposed settlement on September 14, 2007. Since not all class members will elect to be part of
the settlement, the Company estimated the probable obligation related to the settlement to be in a range of $3.9 million to $4.7 million. In accordance with SFAS No. 5, Accounting for Contingencies, the Company recorded a charge to
earnings of $3.9 million in December of 2006. This amount is included in Accounts payable and other liabilities on the Companys consolidated balance sheet.

In December 2005, a putative class action was filed against NovaStar Mortgage, Inc. (NMI) in the United States District Court for the Western District of Washington entitled Pierce et al. v. NovaStar
Mortgage, Inc. Plaintiffs contend that NMI failed to disclose prior to closing that a broker payment would be made on their loans, which was an unfair and deceptive practice in violation of the Washington Consumer Protection Act. Plaintiffs seek
excess interest charged, and treble damages as provided in the Washington Consumer Protection Act and attorneys fees. On October 31, 2006, the district court granted plaintiffs motion to certify a Washington state class. For
business reasons, NMI entered into a settlement agreement with the plaintiffs on June 21, 2007. The agreement, which must be approved by the district court, calls for NMI to pay class members $3.3 million and to pay $1.8 million in
attorneys fees. On June 27, 2007, the district court tentatively approved the settlement agreement and scheduled a hearing for September 28, 2007 to consider final approval of the settlement.

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

Since February 2007, a number of substantially similar putative class actions have been filed in the United States District Court for the Western District of Missouri.
The complaints name the Company and three of the Companys executive officers as defendants and generally allege, among other things, that the defendants made materially false and misleading statements regarding the Companys business and
financial results. The plaintiffs purport to have brought the actions on behalf of all persons who purchased or otherwise acquired the Companys common stock during the period May 4, 2006 through February 20, 2007. The Company
believes that these claims are without merit and will vigorously defend against them.

In June 2007, two borrowers filed a putative class action entitled
Kubiak v. NovaStar Mortgage, Inc., against the Company and two of its subsidiaries in the United States District Court for the Northern District of California, alleging that payments of premiums to



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brokers by one of the subsidiaries were not properly disclosed to borrowers in the manner allegedly required by federal or state law, thus constituting
unfair competition and false advertising under California law and violation of the California Consumer Legal Remedies Act. Plaintiffs seek statutory and punitive damages, restitution, injunctive relief and attorneys fees on behalf of
California borrowers who allegedly failed to receive adequate disclosure of such premiums. The Company believes that these claims are without merit and will vigorously defend against them.

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, class action or individual claims for violations of the RESPA, FLSA, federal and state laws prohibiting employment discrimination, federal and state laws prohibiting discrimination in lending and federal and state licensing and
consumer protection laws.

While management, including internal counsel, currently believes that the ultimate outcome of all these proceedings and claims
will not have a material adverse effect on the Companys financial condition or results of operations, litigation is subject to inherent uncertainties. If an unfavorable ruling were to occur, there exists the possibility of a material adverse
impact on the Companys financial condition, results of operations and cash flows.

Note 11. Short-term Borrowings,

As of June 30, 2007, the Company continues to fail to satisfy the profitability covenant under one of its warehouse financing facilities. The Companys GAAP net
income, determined on a pre-tax basis, was not greater than $1 for the six months ended June 30, 2007 and it has been unable to obtain a modification or waiver of this requirement. Therefore, the $1 billion of borrowing capacity under this
facility is not available to the Company so long as the Company remains out of compliance. The Company had no borrowings outstanding under this facility as of June 30, 2007 and, thus, the breach has not triggered any cross-default provisions
with its other warehouse facilities, and thus did not permit those lenders to accelerate all amounts then outstanding under those facilities. On May 1, 2007, the lender under this facility delivered a notice of default to the Company demanding
payment of $2.9 million representing fees owed under the agreement and notifying the Company that it was applying $2.9 million in cash that it held as collateral towards this amount.

As a result of the significant decline in the Companys liquidity position, in April 2007, the Company executed a Master Repurchase Agreement (2007 Residual Securities) (the Residual Securities
Facility) with Wachovia Investment Holdings, LLC and Wachovia Capital Markets, LLC ( Wachovia Capital), providing for the financing of certain of the Companys existing residual securities and the Company also executed a
Master Repurchase Agreement (2007 Servicing Rights) (the Servicing Rights Facility) with Wachovia Bank, NA and Wachovia Capital (collectively, with Wachovia Investment Holdings, LLC and their respective affiliates, Wachovia),
providing for the financing of certain mortgage servicing rights.

The maximum amount that may be outstanding at any time under the Residual Securities
Facility and the Servicing Rights Facility is $40 million and $70 million, respectively, which amounts will be reduced if and to the extent necessary so that the aggregate amount outstanding from time to time under both the Residual Securities
Facility and Servicing Rights Facility does not exceed $100 million. The advance rate under each facility is up to 60% of the fair value of the assets securing the facility, as determined from time to time by Wachovia. The interest rate under the
Residual Securities Facility is LIBOR plus 3.5% and the interest rate under the Servicing Rights Facility is LIBOR plus 3.75%. Loan proceeds from these facilities will be used for general corporate purposes. Each of these facilities has a term of
364 days, subject to automatic renewal for another 364 days unless Wachovia gives at least 120 days notice of its intention to terminate the facility on the maturity date. The Company is required to notify Wachovia of any margin calls under any
repurchase facilities the Company has with any third parties in excess of $5 million in the aggregate, in which event Wachovia will have the option to increase the aggregate amount available under other financing facilities between the Company and
Wachovia and cause the Company to place the assets subject to the margin call on such facilities. Upon a change of control, Wachovia has the right to terminate the facilities and require the payment of a termination fee.

Mortgage servicing rights eligible for financing under the Servicing Rights Facility include rights of NovaStar Mortgage, Inc. (NMI) under existing servicing
agreements relating to certain of the Companys securitizations and, subject to certain approvals of the related securitization trustees, other existing mortgage servicing rights of the Company. Servicing rights arising in connection with
future securitizations may also be financed under the Servicing Rights Facility if mutually agreed by the parties. In each case, the related servicing agreement must be acceptable to Wachovia.

Under the Servicing Rights Facility, the Company will remain the servicer of the pledged servicing rights, provided Wachovia will have the right to replace the Company
as the servicer if (1) the tangible net worth of the Company falls below a certain amount, (2) the Companys servicing rating is downgraded below a certain level by Moodys, S&P or Fitch or (3) an event of default under
either facility occurs.



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In May 2007, the Company executed a $1.9 billion comprehensive financing facility arranged by Wachovia Capital. The
facility expands and replaces the whole-loan and securities repurchase agreements previously existing between Wachovia and the Company, other than the Servicing Rights Facility and the Residual Securities Facility. The intent of the comprehensive
facility was to put in place a financing facility that enables the Company to primarily use Wachovia for its borrowing needs. Based on this intent, upon the closing of the comprehensive facility, the Company transferred all borrowings with its other
lenders to Wachovia during the second quarter of 2007 except for its servicing advance facility. As the Companys lending facilities held with other lenders besides Wachovia expire throughout 2007, the aggregate credit limit available to the
Company would decrease from $4.0 billion to $2.0 billion assuming the Company does not renew the facilities. The $2.0 billion credit limit with Wachovia could be increased in the event the Company needs additional borrowing capacity but only upon
Wachovias approval.

The $1.9 billion facility consists of the following separate agreements (collectively, the Agreements): (1) a
Whole Loan Master Repurchase Agreement; (2) a Securities Master Repurchase Agreement (Investment Grade); and (3) a Securities Master Repurchase Agreement (Non Investment Grade). The aggregate purchase price under each individual Agreement
will reduce availability under the other Agreements such that the maximum aggregate purchase price under all Agreements at any point in time will not exceed $1.9 billion. Financing capacity under the Agreements is in addition to the aggregate $100
million financing capacity under the Servicing Rights Facility and the Residual Securities Facility.

The Agreements are cross-collateralized with each
other and all other repurchase and similar financing facilities between the Company and Wachovia, including the Servicing Rights Facility and the Residual Securities Facility. The Company was required to pay Wachovia a structuring fee in connection
with the Agreements and certain additional fees and expenses, including but not limited to reimbursement of due diligence expenses and payment of certain fees in the event of voluntary prepayment or termination by the Company or the occurrence of an
event of default. In addition, upon a change of control, Wachovia has the right to terminate the Agreements and require the payment of a termination fee.

Under the Whole Loan Master Repurchase Agreement, the specific advance rate applicable to a particular asset depends on, among other matters, the type, age and performance of such asset and, in some cases, the Companys level of
liquidity. For recently originated mortgage loans under which there has been no delinquency in any of the first three monthly payments following origination, the advance rate under this Agreement is generally between 95% and 98% of the market value
of such loan and such advances will bear interest at one-month LIBOR plus 0.65%. For other mortgage loans and real estate owned, the advance rate is generally between 65% to 95% of market value, but may be lower pending Wachovias review of a
particular asset, and such advances bear interest at a rate ranging between one-month LIBOR plus 0.65% to one-month LIBOR plus 2%. In addition, advance rates for mortgage loans and real estate owned are subject to additional but similar limitations
based upon the outstanding principal balance of the mortgage loan or the appraised value of the real estate owned and, in some cases, additional but similar limitations based upon the Companys valuation of the asset, cost, or committed sale
price.

The advance rate under the Non-Investment Grade Securities Facility is up to 65% of the market value of the mortgage securities securing the
advance. The interest rate applicable to such advances will range from one-month LIBOR plus 1% to one-month LIBOR plus 2.5%, depending on the type of mortgage securities securing the advance.

The advance rate under the Investment Grade Securities Facility ranges from 70% to 97% of the market value of the securities securing the advance. The interest rate
applicable to such advances will range from one-month LIBOR to one-month LIBOR plus 0.65%, depending on the type of securities securing the advance.

All
of the Companys credit facilities include numerous representations, warranties and covenants, including requirements to maintain a certain minimum net worth, minimum equity ratios and other customary debt covenants. Events of default under
these facilities include material breaches of representations or warranties, failure to comply with covenants, material adverse effects upon or changes in the Companys business, assets, or financial condition, and other customary matters.
Events of default under certain of the Companys facilities also include termination of its status as servicer with respect to certain securitized loan pools, certain downgrades in its servicer ratings and failure to maintain profitability over
consecutive quarters. If the Company was unable to make the necessary representations and warranties at the time the Company need financing, the Company would not be able to obtain needed funds. In addition, if the Company breaches any covenant or
an event of default otherwise occurs under any credit facility under which borrowings are outstanding, the lenders under all existing credit facilities could demand immediate repayment of all outstanding amounts because all of the Companys
credit facilities contain cross-default provisions. As discussed previously, as of June 30, 2007, the Company continued to fail to satisfy the profitability covenant under one of the Companys warehouse financing facilities which requires
GAAP net income, determined on a pre-tax basis, to be greater than $1 for the six months ended June 30, 2007. The Company has been unable to obtain a modification or waiver of this requirement; therefore, the borrowing capacity under this
facility is not available to the Company so long as it remains out of compliance. The Company currently has no borrowings outstanding under this facility. On May 1, 2007, the lender under this facility delivered a notice of default to the
Company demanding payment of $2.9 million representing fees owed under the agreement and notifying the Company that it was applying $2.9 million in cash that it held as collateral towards this amount.



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While management believes the Company is in compliance with all other covenants as of June 30, 2007, any future breach or non-compliance could have a
material adverse effect on the Companys financial condition.

Note 12. Issuance of Capital Stock and Reverse Stock Split

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

The Company sold 35,094 shares of its common stock during the six
months ended June 30, 2007 under its Direct Stock Purchase and Dividend Reinvestment Plan (DRIP). Net proceeds of $3.2 million were raised under these sales of common stock. The Company suspended the DRIP during the first quarter of
2007.

During the first six months of 2007, 119,504 shares of common stock were issued under the Companys stock-based compensation plan. Proceeds of
$0.2 million were received under these issuances.

Note 13. Comprehensive Income

Comprehensive income includes net income and revenues, expenses, gains and losses that are not included in net income. Following is a summary of comprehensive income for the six and three months ended June 30,
2007 and 2006 (in thousands):



|                                                                                                        |  |                                  |         |   |                                    |   |         |      |  |   |         |   |  |   |         |  
|------------------------------------------------------------------------------------------------------- |  | -------------------------------- | ------- | - | ---------------------------------- | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                                                        |  | For the Six MonthsEnded June 30, |         |   | For the Three MonthsEnded June 30, |  
|                                                                                                        |  | 2007                             |         |   | 2006                               |   |         | 2007 |  |   | 2006    |  
|Net (loss) income                                                                                       |  | $                                | (6,864  | ) |                                    | $ | 58,763  |      |  | $ | (52,878 | ) |  | $ | 34,735  |  
|Other comprehensive loss:                                                                               |  |                                  |         |   |                                    |   |         |      |  |   |         |   |  |   |         |  
|Change in unrealized loss on mortgage securities  available-for-sale, net of tax                       |  |                                  | (44,658 | ) |                                    |   | (34,966 | )    |  |   | (35,799 | ) |  |   | (24,651 | )
|Change in unrealized gain on derivative instruments used in cash flow hedges, net of tax                |  |                                  | 631     |   |                                    |   | 3,595   |      |  |   | 723     |   |  |   | 3,595   |  
|Impairment on mortgage securities - available-for-sale reclassified to earnings, net of tax             |  |                                  | 17,572  |   |                                    |   | 6,453   |      |  |   | 14,176  |   |  |   | 4,488   |  
|Net settlements of derivative instruments used in cash flow hedges reclassified to earnings, net of tax |  |                                  | (261    | ) |                                    |   | (258    | )    |  |   | (131    | ) |  |   | (258    | )
|                                                                                                        |  |                                  |         |   |                                    |   |         |      |  |   |         |   |  |   |         |  
|Other comprehensive loss                                                                                |  |                                  | (26,716 | ) |                                    |   | (25,176 | )    |  |   | (21,031 | ) |  |   | (16,826 | )
|                                                                                                        |  |                                  |         |   |                                    |   |         |      |  |   |         |   |  |   |         |  
|Total comprehensive (loss) income                                                                       |  | $                                | (33,580 | ) |                                    | $ | 33,587  |      |  | $ | (73,909 | ) |  | $ | 17,909  |  
|                                                                                                        |  |                                  |         |   |                                    |   |         |      |  |   |         |   |  |   |         |  



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Note 14. Interest Income

The following table presents the components of interest income for the six and three months ended June 30, 2007 and 2006 (dollars in thousands):



|                                 |  |                                  |         |                                    |   |         |  |      |         |  |   |        
|-------------------------------- |  | -------------------------------- | ------- | ---------------------------------- | - | ------- |  | ---- | ------- |  | - | -------
|                                 |  | For the Six MonthsEnded June 30, |         | For the Three MonthsEnded June 30,
|                                 |  | 2007                             |         | 2006                               |   | 2007    |  | 2006
|Interest Income:                 |  |                                  |         |                                    |   |         |  |      |         |  |   |        
|Mortgage securities              |  | $                                | 60,348  |                                    | $ | 83,988  |  | $    | 28,634  |  | $ | 41,413 
|Mortgage loans held-for-sale     |  |                                  | 59,288  |                                    |   | 69,144  |  |      | 19,623  |  |   | 35,960 
|Mortgage loans held-in-portfolio |  |                                  | 123,740 |                                    |   | 48,409  |  |      | 73,760  |  |   | 46,607 
|Other interest income (A)        |  |                                  | 18,140  |                                    |   | 15,922  |  |      | 8,462   |  |   | 8,811  
|                                 |  |                                  |         |                                    |   |         |  |      |         |  |   |        
|Total interest income            |  | $                                | 261,516 |                                    | $ | 217,463 |  | $    | 130,479 |  | $ | 132,791
|                                 |  |                                  |         |                                    |   |         |  |      |         |  |   |        

---

|(A) | Other interest income includes interest earned on funds the Company holds as custodian, interest from corporate operating cash and interest earned on the Companys warehouse
notes receivable.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Note 15. Interest Expense

The following table presents the components of interest expense for the six and three months ended June 30, 2007 and 2006 (dollars in thousands):



|                                                     |  |                                  |         |                                    |   |        |  |      |        |  |   |       
|---------------------------------------------------- |  | -------------------------------- | ------- | ---------------------------------- | - | ------ |  | ---- | ------ |  | - | ------
|                                                     |  | For the Six MonthsEnded June 30, |         | For the Three MonthsEnded June 30,
|                                                     |  | 2007                             |         | 2006                               |   | 2007   |  | 2006
|Interest expense:                                    |  |                                  |         |                                    |   |        |  |      |        |  |   |       
|Short-term borrowings secured by mortgage loans      |  | $                                | 44,231  |                                    | $ | 65,801 |  | $    | 15,371 |  | $ | 43,034
|Short-term borrowings secured by mortgage securities |  |                                  | 12,446  |                                    |   | 2,802  |  |      | 6,159  |  |   | 1,856 
|Other short-term borrowings                          |  |                                  | 857     |                                    |   | 21     |  |      | 612    |  |   | 21    
|Asset-backed bonds secured by mortgage loans         |  |                                  | 91,306  |                                    |   | 17,672 |  |      | 52,555 |  |   | 17,344
|Asset-backed bonds secured by mortgage securities    |  |                                  | 7,867   |                                    |   | 3,023  |  |      | 5,152  |  |   | 1,206 
|Junior subordinated debentures                       |  |                                  | 4,057   |                                    |   | 2,872  |  |      | 2,035  |  |   | 1,801 
|                                                     |  |                                  |         |                                    |   |        |  |      |        |  |   |       
|Total interest expense                               |  | $                                | 160,764 |                                    | $ | 92,191 |  | $    | 81,884 |  | $ | 65,262
|                                                     |  |                                  |         |                                    |   |        |  |      |        |  |   |       

Note 16. Exit or Disposal Activities

On March 14, 2007 and June 1, 2007, management of the Company committed the Company to a workforce reduction pursuant to plans of termination (the Plans). The Company undertook these Plans to
align its organization with changing conditions in the mortgage market. The Plans resulted in the elimination of approximately 437 positions in the first half of 2007. The Plans will conclude during the third quarter of 2007.

The Company recorded a $3.7 million and $0.7 million pre-tax charge to earnings for these Plans during the six and three months ended June 30, 2007, respectively.
These amounts are included in the compensation and benefits line item of the Companys condensed consolidated statements of operations and it impacts the Companys mortgage lending segment. The total pre-tax charge to earnings consists
primarily of one-time employment termination benefits. The Companys liability balance at June 30, 2007 related to these Plans was $0.3 million which is included in the accounts payable and other liabilities line item on the condensed
consolidated balance sheets.



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The following is a reconciliation of the liability balance for the six months ended June 30, 2007 (dollars in
thousands):



|                                                                                    |  |   |        |  
|----------------------------------------------------------------------------------- |  | - | ------ | -
|Beginning liability balance                                                         |  | $ |       |  
|Recognition of the liability and charge to expense upon commencement of the Plan    |  |   | 3,696  |  
|Benefits paid during the period                                                     |  |   | (3,364 | )
|                                                                                    |  |   |        |  
|Ending liability balance for amounts that will be paid in the third quarter of 2007 |  | $ | 332    |  
|                                                                                    |  |   |        |  

Note 17. Income Taxes

The components of income tax expense (benefit) attributable to continuing operations for the six and three months ended June 30, 2007 and 2006 were as follows (dollars in thousands):



|                                   |  |                                  |          |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|---------------------------------- |  | -------------------------------- | -------- | - | ---------------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                   |  | For the Six MonthsEnded June 30, |          |   | For the Three MonthsEnded June 30, |  
|                                   |  | 2007                             |          |   | 2006                               |   |        | 2007 |  |   | 2006    |  
|Current:                           |  |                                  |          |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|Federal                            |  | $                                | 4,897    |   |                                    | $ | 6,781  |      |  | $ | 4,037   |   |  | $ | 11,820 |  
|State and local                    |  |                                  | 599      |   |                                    |   | 663    |      |  |   | 493     |   |  |   | 1,170  |  
|                                   |  |                                  |          |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|Total current                      |  |                                  | 5,496    |   |                                    |   | 7,444  |      |  |   | 4,530   |   |  |   | 12,990 |  
|                                   |  |                                  |          |  
|Deferred: (A)                      |  |                                  |          |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|Federal                            |  |                                  | (170,911 | ) |                                    |   | (6,004 | )    |  |   | (67,522 | ) |  |   | (6,880 | )
|State and local                    |  |                                  | (21,167  | ) |                                    |   | (576   | )    |  |   | (8,214  | ) |  |   | (667   | )
|                                   |  |                                  |          |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|Total deferred                     |  |                                  | (192,078 | ) |                                    |   | (6,580 | )    |  |   | (75,736 | ) |  |   | (7,547 | )
|                                   |  |                                  |          |  
|Total income tax (benefit) expense |  | $                                | (186,582 | ) |                                    | $ | 864    |      |  | $ | (71,206 | ) |  | $ | 5,443  |  
|                                   |  |                                  |          |   |                                    |   |        |      |  |   |         |   |  |   |        |  

---

|(A) | Does not reflect the deferred tax effects of unrealized gains and losses on mortgage securities-available-for-sale and derivative financial instruments that are included in
shareholders equity except for amounts recognized by the REIT of $6.8 million and $(4.4) million for the six and three months ended June 30, 2007, respectively. As a result of these tax effects, shareholders equity (increased)
decreased by $(6.2) million and $5.1 million in the six months ended June 30, 2007 and 2006, respectively. Includes $117.0 million and $32.8 million of net deferred tax benefit (federal and state) recognized by the REIT for the six and three
months ended June 30, 2007, respectively, as a result of the Companys decision to revoke its REIT election effective January 1, 2008.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

A reconciliation of the expected federal income tax expense (benefit) using the federal statutory tax rate of 35 percent to the Companys actual income tax expense (benefit) and resulting effective tax rate from continuing operations
for the six and three months ended June 30, 2007 and 2006 were as follows (dollars in thousands):



|                                                        |  |                                  |          |   |                                    |   |         |      |  |   |         |   |  |   |        |  
|------------------------------------------------------- |  | -------------------------------- | -------- | - | ---------------------------------- | - | ------- | ---- |  | - | ------- | - |  | - | ------ | -
|                                                        |  | For the Six MonthsEnded June 30, |          |   | For the Three MonthsEnded June 30, |  
|                                                        |  | 2007                             |          |   | 2006                               |   |         | 2007 |  |   | 2006    |  
|Income tax at statutory rate                            |  | $                                | (67,706  | ) |                                    | $ | 21,504  |      |  | $ | (43,429 | ) |  | $ | 14,268 |  
|Benefit of REIT election                                |  |                                  | 3,118    |   |                                    |   | (20,698 | )    |  |   | 7,837   |   |  |   | (9,120 | )
|State income taxes, net of federal tax benefit (A)      |  |                                  | (13,369  | ) |                                    |   | 57      |      |  |   | (5,018  | ) |  |   | 327    |  
|Tax effect of REIT revocation effective January 1, 2008 |  |                                  | (108,592 | ) |                                    |   |        |      |  |   | (30,496 | ) |  |   |       |  
|Other                                                   |  |                                  | (33      | ) |                                    |   | 1       |      |  |   | (100    | ) |  |   | (32    | )
|                                                        |  |                                  |          |   |                                    |   |         |      |  |   |         |   |  |   |        |  
|Total income tax (benefit) expense                      |  | $                                | (186,582 | ) |                                    | $ | 864     |      |  | $ | (71,206 | ) |  | $ | 5,443  |  
|                                                        |  |                                  |          |   |                                    |   |         |      |  |   |         |   |  |   |        |  

---

|(A) | The six and three months ended June 30, 2007 includes a $8.4 million and a $2.3 million, respectively, state deferred tax benefit, (net of federal benefit) recognized by the
REIT as a result of the Companys decision to revoke its REIT election effective January 1, 2008.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Significant components of the Companys deferred tax assets and liabilities at June 30, 2007 and
December 31, 2006 were as follows (dollars in thousands):



|                                                 |  |                  |         |   |                  |   |        |  
|------------------------------------------------ |  | ---------------- | ------- | - | ---------------- | - | ------ | -
|                                                 |  | June 30,2007 (A) |         |   | December 31,2006 |  
|Deferred tax assets:                             |  |                  |         |   |                  |   |        |  
|Basis difference  investments                   |  | $                | 122,801 |   |                  | $ | 10,639 |  
|Federal net operating loss carryforwards         |  |                  | 106,665 |   |                  |   | 19,055 |  
|State net operating loss carryforwards           |  |                  | 11,844  |   |                  |   | 2,474  |  
|Allowance for loan losses                        |  |                  | 9,247   |   |                  |   |       |  
|Deferred compensation                            |  |                  | 9,227   |   |                  |   | 8,158  |  
|Other                                            |  |                  | 8,191   |   |                  |   | 6,630  |  
|Excess inclusion income                          |  |                  | 4,260   |   |                  |   | 10,884 |  
|Loan sale recourse obligations                   |  |                  | 1,261   |   |                  |   | 9,272  |  
|Mark-to-market adjustment on loans               |  |                  |        |   |                  |   | 7,866  |  
|                                                 |  |                  |         |   |                  |   |        |  
|Gross deferred tax asset                         |  |                  | 273,496 |   |                  |   | 74,978 |  
|Valuation allowance                              |  |                  | (3,345  | ) |                  |   | (685   | )
|                                                 |  |                  |         |   |                  |   |        |  
|Deferred tax asset                               |  |                  | 270,151 |   |                  |   | 74,293 |  
|                                                 |  |                  |         |   |                  |   |        |  
|Deferred tax liabilities:                        |  |                  |         |   |                  |   |        |  
|Mortgage servicing rights                        |  |                  | 20,762  |   |                  |   | 23,675 |  
|Unrealized gain on available-for-sale securities |  |                  | 2,458   |   |                  |   | 1,855  |  
|Other                                            |  |                  | 651     |   |                  |   | 1,575  |  
|                                                 |  |                  |         |   |                  |   |        |  
|Deferred tax liability                           |  |                  | 23,871  |   |                  |   | 27,105 |  
|                                                 |  |                  |         |   |                  |   |        |  
|Net deferred tax asset                           |  | $                | 246,280 |   |                  | $ | 47,188 |  
|                                                 |  |                  |         |   |                  |   |        |  

---

|(A) | Includes $117.0 million of net deferred tax assets (federal and state) recognized by the REIT, as a result of the Companys decision to revoke its REIT election effective
January 1, 2008.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

NovaStar Financial, Inc. (NFI) has elected to be treated as a REIT for federal income tax purposes and, as
such, is not required to pay any corporate level income taxes as long as NFI remains a REIT and distributes 100 percent of its taxable income in the form of dividend distributions to its shareholders.

Deferred taxes are required to be determined for each tax-paying component of a consolidated entity. The REIT and the taxable REIT subsidiary (the TRS) have
previously been viewed as two separate components for this purpose. Historically, the Company has recorded deferred taxes only at the TRS. Conversely, prior to 2007, the Company has not recorded deferred taxes at the REIT because of its intent to
operate NFI as a REIT.

On May 3, 2007, the Companys Board of Directors approved a resolution enabling management to take the necessary steps to
revoke NFIs REIT election effective January 1, 2008. Management intends to carry out this plan.

The decision to revoke NFIs REIT status
was based on several significant factors. First, operating as a REIT restricts the Companys ability to operate its business. The REIT source of income tests and diversification of assets tests not only limits the Companys ability to
hedge its interest rate risk, but also unduly restricts the Companys ability to efficiently manage its portfolio management business. Second, since the Company is required to distribute most of its earnings in the form of dividends to
shareholders to comply with REIT distribution requirements, the Companys ability to retain capital to grow its business is significantly reduced. Third, the Companys projections demonstrate that it will not generate taxable income at the
REIT from 2007 through 2011. This is due primarily to the expected reversal of deductible temporary differences that have accumulated over the past several years. In years prior to 2007, the Company experienced significantly higher taxable income
compared to financial statement income. This was due primarily to timing differences between financial statement and income tax recognition of income and losses on the Companys portfolio of interest-only mortgage securities. Without taxable
income, the Company will not have a requirement to distribute dividends to shareholders.



30



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Because of the Companys decision to revoke NFIs REIT status effective January 1, 2008, the Company
scheduled the reversal of deductible and taxable temporary differences as of December 31, 2006 (as well as new temporary differences originating during 2007) for amounts to be realized during the Companys final calendar year as a REIT and
for amounts to be realized in subsequent taxable years. NFI will be taxable as a C corporation in the tax year the revocation of its REIT election is effective (2008) and for subsequent taxable years. Accordingly, NFI recorded deferred taxes as
of June 30, 2007 based on estimated cumulative temporary differences at January 1, 2008 that are expected to reverse in a subsequent taxable year.

All differences between financial statement carrying amounts and tax bases (i.e. cumulative temporary differences or CTDs) accumulated as of December 31, 2006 were based on actual financial statement balances and the
Companys best estimate of income tax balances, as the Company has yet to file its 2006 REIT income tax return. These CTDs were then rolled forward through January 1, 2008 for what the Company estimates to be realized on NFIs
final REIT return for 2007. In rolling forward the projected CTDs, the Company used estimates based on calendar year 2007 projections of financial statement income, securitization activity, interest income, bad debt expenses, and other
estimates. Such estimates were derived from information best available through June 30, 2007 as well as assumptions on information that is not yet available and are likely to change. It is reasonable to expect changes to the Companys
estimate of the deferred tax assets and liabilities in the remaining 2007 interim periods, as actual information becomes available. Such changes will affect the Companys income tax expense and will increase the volatility of the effective tax
rate during 2007.

Based on the estimate of temporary differences as of June 30, 2007, NFI will have approximately $328.6 million of net future
deductible timing differences remaining at January 1, 2008. Accordingly NFI recorded a net deferred tax asset of $123.8 million (excluding the deferred tax liability on unrealized gains from available for sale securities of $6.8 million) using
an effective tax rate of approximately 37.7%. The effective tax rate of 37.7% was calculated by including the REIT in consolidated/combined tax returns with the TRS beginning in 2008. The change in the projected temporary difference for the REIT
from $253.2 as of March 31, 2007 to $328.6 as of June 30, 2007 was a result of changes in REIT pre-tax book income for 2007 and basis differences in the Companys mortgage securities. The primary differences for the changes were due
to (1) GAAP impairments; (2) changes to projected cash flows; and (3) changes in accrual rates on securities.

In determining the amount of
deferred tax assets to recognize in the financial statements, the Company evaluates the likelihood of realizing such benefits in future periods. FASB Statement No. 109 Accounting for Income Taxes (FAS 109) requires the
recognition of a valuation allowance if it is more likely than not that all or some portion of the deferred tax asset will not be realized. FAS 109 indicates the more likely than not threshold is a level of likelihood that is more than 50 percent.

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

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

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. 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 FAS 109 in determining the amount of valuation allowance to be recorded. Alternative sources of taxable income identified in FAS 109 include the
following: 1) taxable income in prior carryback year, 2) future reversals of existing taxable temporary differences, 3) future taxable income exclusive of reversing temporary differences and carryforwards, and 4) tax planning strategies.



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As a result of the decision to revoke its REIT election effective January 1, 2008, the Company evaluated the
positive and negative evidence as of June 30, 2007 on a combined enterprise basis (i.e. the REIT and the TRS) to form its conclusion. The Company has not generated a cumulative loss in recent years. In addition, the Company has never
experienced the expiration of a net operating loss in a significant taxing jurisdiction. The fact the Company has not experienced a cumulative loss in recent years is significant objective evidence in evaluating the need for a valuation allowance.

In determining the amount of valuation allowance to record as of June 30, 2007, if any, the Company concluded the weight given to the positive
evidence supports a conclusion that it is more likely than not that $248.7 million of the net deferred tax asset (excluding the deferred tax liability on unrealized gains from available for sale securities of $2.5 million) of $252.0 million as of
June 30, 2007 will be realized. Based on these conclusions, the Company recorded a valuation allowance for deferred tax assets as of June 30, 2007 and December 31, 2006 of $3.3 million and $0.7 million, respectively. The valuation
allowance recorded by the Company relates to various separate company state net operating losses for which it determined it was more likely than not that such state net operating losses would not be realized.

In all future interim periods, the Company will continue to monitor all factors that impact positive and negative evidence relating to its deferred tax assets. If
management concludes at any point in the future that negative evidence outweighs positive evidence, the Company may need to record a valuation allowance on some or all of its entire deferred tax asset. Factors that may lead to a change from positive
to negative evidence include, but are not limited to: cumulative losses in recent years, losses expected in future years, a brief carryforward period, and significant differences from projected GAAP income or loss.

As of June 30, 2007, NFI Holding Corporation, the taxable REIT subsidiary, had an estimated federal net operating loss carryforward of $304.8 million, which will be
available to offset future taxable income. If not used, this net operating loss will begin to expire in 2025.

FIN 48

Effective January 1, 2007, the Company adopted FIN 48. FIN 48 requires a company to evaluate whether a tax position taken by the company will more likely
than not be sustained upon examination by the appropriate taxing authority. It also provides guidance on how a company should measure the amount of benefit that the company is to recognize in its financial statements. As a result of
the implementation of FIN 48, the Company recorded a $1.1 million net liability as an increase to the opening balance of accumulated deficit. As of January 1, 2007, the total gross amount of unrecognized tax benefits was $1.6 million. The
total amount of unrecognized tax benefits that would impact the effective tax rate, if recognized, was $1.1 million. While it is expected that the amount of unrecognized tax benefits will change in the next twelve months, the Company does not
expect this change to have a significant impact on the results of operations or the financial position of the Company.

It is the Companys policy to
recognize interest and penalties related to income tax matters in income tax expense. Interest and penalties related to income tax matters classified as a component of income tax expense was insignificant for the six months ended June 30,
2007. Accrued interest and penalties was $0.6 million and $0.7 million as of January 1, 2007 and June 30, 2007, respectively.

The Company and
its subsidiaries are subject to U.S. federal income tax as well as income tax of multiple state jurisdictions. Tax years 2003 to 2007 remain subject to examination for U.S. federal income tax and tax years 2002 to 2007 remain subject to examination
by major state tax jurisdictions.

The activity in the accrued liability for unrecognized tax benefits for the six and three months ended June 30,
2007 was as follows (dollars in thousands):



|                                                |  |                                      |       |                                        |   |      
|----------------------------------------------- |  | ------------------------------------ | ----- | -------------------------------------- | - | -----
|                                                |  | For the SixMonths EndedJune 30, 2007 |       | For the ThreeMonths EndedJune 30, 2007
|Beginning balance                               |  | $                                    | 1,554 |                                        | $ | 1,584
|Gross increases  tax positions in prior period |  |                                      | 60    |                                        |   | 30   
|                                                |  |                                      |       |                                        |   |      
|Ending balance                                  |  | $                                    | 1,614 |                                        | $ | 1,614
|                                                |  |                                      |       |                                        |   |      



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Note 18. Segment Reporting

The Company reviews, manages and operates its business in three segments: mortgage portfolio management, mortgage lending and loan servicing. The Companys branch operations segment was discontinued as of June 30, 2006, therefore
the Company no longer considers it a segment. The branch operations are now included as part of the mortgage lending segment and are presented as discontinued operations. The prior period results have been reclassified to reflect this change.
Mortgage portfolio management operating results are driven from the income generated on the assets the Company manages less associated costs. Mortgage lending operations include the marketing, underwriting and funding of loan production as well as
the results of NHMI, a wholly owned subsidiary of the Company, which has been presented as a discontinued operation. Loan servicing operations represent the income and costs to service the Companys portfolio of loans.

Following is a summary of the operating results of the Companys segments for the six and three months ended June 30, 2007 and 2006, as reclassified to reflect
the change in segment structure and the results of the discontinued operations for the six and three months ended June 30, 2007 and 2006 (dollars in thousands):

For the Six Months Ended June 30, 2007



|                                                                   |  |                             |          |   |                 |   |          |               |  |   |              |   |  |       |         |   |  |   |          |  
|------------------------------------------------------------------ |  | --------------------------- | -------- | - | --------------- | - | -------- | ------------- |  | - | ------------ | - |  | ----- | ------- | - |  | - | -------- | -
|                                                                   |  | MortgagePortfolioManagement |          |   | MortgageLending |   |          | LoanServicing |  |   | Eliminations |   |  | Total |        
|Interest income                                                    |  | $                           | 186,849  |   |                 | $ | 61,241   |               |  | $ | 13,426       |   |  | $     |        |   |  | $ | 261,516  |  
|Interest expense                                                   |  |                             | 111,620  |   |                 |   | 61,193   |               |  |   |             |   |  |       | (12,049 | ) |  |   | 160,764  |  
|                                                                   |  |                             |          |   |                 |   |          |               |  |   |              |   |  |       |         |   |  |   |          |  
|Net interest income before provision for credit losses             |  |                             | 75,229   |   |                 |   | 48       |               |  |   | 13,426       |   |  |       | 12,049  |   |  |   | 100,752  |  
|Provision for credit losses                                        |  |                             | (93,167  | ) |                 |   |         |               |  |   |             |   |  |       |        |   |  |   | (93,167  | )
|Losses on sales of mortgage assets                                 |  |                             | (212     | ) |                 |   | (12,182  | )             |  |   |             |   |  |       |        |   |  |   | (12,394  | )
|Fair value adjustments                                             |  |                             | (26,232  | ) |                 |   |         |               |  |   |             |   |  |       |        |   |  |   | (26,232  | )
|Valuation adjustment on mortgage loans  held-for-sale             |  |                             |         |   |                 |   | (24,560  | )             |  |   |             |   |  |       |        |   |  |   | (24,560  | )
|Premiums for mortgage loan insurance                               |  |                             | (7,606   | ) |                 |   | (2,656   | )             |  |   |             |   |  |       |        |   |  |   | (10,262  | )
|Fee income                                                         |  |                             |         |   |                 |   | 1,296    |               |  |   | 15,891       |   |  |       | (6,025  | ) |  |   | 11,162   |  
|Gains (losses) on derivative instruments                           |  |                             | 6,506    |   |                 |   | (781     | )             |  |   |             |   |  |       |        |   |  |   | 5,725    |  
|Impairment on mortgage securities  available- for-sale            |  |                             | (25,993  | ) |                 |   |         |               |  |   |             |   |  |       |        |   |  |   | (25,993  | )
|Other income, net                                                  |  |                             | 7,627    |   |                 |   | 20       |               |  |   |             |   |  |       | (6,024  | ) |  |   | 1,623    |  
|General and administrative expenses                                |  |                             | (11,230  | ) |                 |   | (88,449  | )             |  |   | (20,421      | ) |  |       |        |   |  |   | (120,100 | )
|                                                                   |  |                             |          |   |                 |   |          |               |  |   |              |   |  |       |         |   |  |   |          |  
|(Loss) income from continuing operations before income tax expense |  |                             | (75,078  | ) |                 |   | (127,264 | )             |  |   | 8,896        |   |  |       |        |   |  |   | (193,446 | )
|Income tax (benefit) expense                                       |  |                             | (146,896 | ) |                 |   | (42,694  | )             |  |   | 3,008        |   |  |       |        |   |  |   | (186,582 | )
|                                                                   |  |                             |          |   |                 |   |          |               |  |   |              |   |  |       |         |   |  |   |          |  
|Net income (loss)                                                  |  | $                           | 71,818   |   |                 | $ | (84,570  | )             |  | $ | 5,888        |   |  | $     |        |   |  | $ | (6,864   | )
|                                                                   |  |                             |          |   |                 |   |          |               |  |   |              |   |  |       |         |   |  |   |          |  



33



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For the Six Months Ended June 30, 2006



|                                                                   |  |                             |         |   |                 |   |         |               |  |   |              |   |  |       |         |   |  |   |         |  
|------------------------------------------------------------------ |  | --------------------------- | ------- | - | --------------- | - | ------- | ------------- |  | - | ------------ | - |  | ----- | ------- | - |  | - | ------- | -
|                                                                   |  | MortgagePortfolioManagement |         |   | MortgageLending |   |         | LoanServicing |  |   | Eliminations |   |  | Total |        
|Interest income                                                    |  | $                           | 133,430 |   |                 | $ | 71,028  |               |  | $ | 13,005       |   |  | $     |        |   |  | $ | 217,463 |  
|Interest expense                                                   |  |                             | 41,460  |   |                 |   | 56,512  |               |  |   |             |   |  |       | (5,781  | ) |  |   | 92,191  |  
|                                                                   |  |                             |         |   |                 |   |         |               |  |   |              |   |  |       |         |   |  |   |         |  
|Net interest income before provision for credit losses             |  |                             | 91,970  |   |                 |   | 14,516  |               |  |   | 13,005       |   |  |       | 5,781   |   |  |   | 125,272 |  
|Provision for credit losses                                        |  |                             | (9,590  | ) |                 |   |        |               |  |   |             |   |  |       |        |   |  |   | (9,590  | )
|Gains on sales of mortgage assets                                  |  |                             | 360     |   |                 |   | 43,386  |               |  |   |             |   |  |       | (20,428 | ) |  |   | 23,318  |  
|Fair value adjustments                                             |  |                             | 4,236   |   |                 |   |        |               |  |   |             |   |  |       |        |   |  |   | 4,236   |  
|Valuation adjustment on mortgage loans  held-for-sale             |  |                             |        |   |                 |   | (137    | )             |  |   |             |   |  |       |        |   |  |   | (137    | )
|Premiums for mortgage loan insurance                               |  |                             | (2,277  | ) |                 |   | (3,873  | )             |  |   |             |   |  |       |        |   |  |   | (6,150  | )
|Fee income                                                         |  |                             | 236     |   |                 |   | 3,083   |               |  |   | 12,547       |   |  |       | (1,408  | ) |  |   | 14,458  |  
|Gains on derivative instruments                                    |  |                             | 109     |   |                 |   | 14,622  |               |  |   |             |   |  |       |        |   |  |   | 14,731  |  
|Impairment on mortgage securities  available- for-sale            |  |                             | (6,453  | ) |                 |   |        |               |  |   |             |   |  |       |        |   |  |   | (6,453  | )
|Other income (expense), net                                        |  |                             | 6,750   |   |                 |   | (2,006  | )             |  |   |             |   |  |       | (4,372  | ) |  |   | 372     |  
|General and administrative expenses                                |  |                             | (9,026  | ) |                 |   | (71,398 | )             |  |   | (18,195      | ) |  |       |        |   |  |   | (98,619 | )
|                                                                   |  |                             |         |   |                 |   |         |               |  |   |              |   |  |       |         |   |  |   |         |  
|Income (loss) from continuing operations before income tax expense |  |                             | 76,315  |   |                 |   | (1,807  | )             |  |   | 7,357        |   |  |       | (20,427 | ) |  |   | 61,438  |  
|Income tax expense (benefit)                                       |  |                             | 6,425   |   |                 |   | (670    | )             |  |   | 2,706        |   |  |       | (7,597  | ) |  |   | 864     |  
|                                                                   |  |                             |         |   |                 |   |         |               |  |   |              |   |  |       |         |   |  |   |         |  
|Income (loss) from continuing operations                           |  |                             | 69,890  |   |                 |   | (1,137  | )             |  |   | 4,651        |   |  |       | (12,830 | ) |  |   | 60,574  |  
|Loss from discontinued operations, net of income tax               |  |                             |        |   |                 |   | (1,811  | )             |  |   |             |   |  |       |        |   |  |   | (1,811  | )
|                                                                   |  |                             |         |   |                 |   |         |               |  |   |              |   |  |       |         |   |  |   |         |  
|Net income (loss)                                                  |  | $                           | 69,890  |   |                 | $ | (2,948  | )             |  | $ | 4,651        |   |  | $     | (12,830 | ) |  | $ | 58,763  |  
|                                                                   |  |                             |         |   |                 |   |         |               |  |   |              |   |  |       |         |   |  |   |         |  



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For the Three Months Ended June 30, 2007



|                                                                   |  |                             |         |   |                 |   |         |               |  |   |              |   |  |       |        |   |  |   |          |  
|------------------------------------------------------------------ |  | --------------------------- | ------- | - | --------------- | - | ------- | ------------- |  | - | ------------ | - |  | ----- | ------ | - |  | - | -------- | -
|                                                                   |  | MortgagePortfolioManagement |         |   | MortgageLending |   |         | LoanServicing |  |   | Eliminations |   |  | Total |       
|Interest income                                                    |  | $                           | 103,293 |   |                 | $ | 20,726  |               |  | $ | 6,460        |   |  | $     |       |   |  | $ | 130,479  |  
|Interest expense                                                   |  |                             | 63,867  |   |                 |   | 24,815  |               |  |   |             |   |  |       | (6,798 | ) |  |   | 81,884   |  
|                                                                   |  |                             |         |   |                 |   |         |               |  |   |              |   |  |       |        |   |  |   |          |  
|Net interest income (loss) before provision for credit losses      |  |                             | 39,426  |   |                 |   | (4,089  | )             |  |   | 6,460        |   |  |       | 6,798  |   |  |   | 48,595   |  
|Provision for credit losses                                        |  |                             | (73,254 | ) |                 |   |        |               |  |   |             |   |  |       |       |   |  |   | (73,254  | )
|Losses on sales of mortgage assets                                 |  |                             | (212    | ) |                 |   | (8,891  | )             |  |   |             |   |  |       |       |   |  |   | (9,103   | )
|Fair value adjustments                                             |  |                             | (16,741 | ) |                 |   |        |               |  |   |             |   |  |       |       |   |  |   | (16,741  | )
|Valuation adjustment on mortgage loans  held-for-sale             |  |                             |        |   |                 |   | (4,363  | )             |  |   |             |   |  |       |       |   |  |   | (4,363   | )
|Premiums for mortgage loan insurance                               |  |                             | (4,798  | ) |                 |   | (343    | )             |  |   |             |   |  |       |       |   |  |   | (5,141   | )
|Fee income                                                         |  |                             |        |   |                 |   | 489     |               |  |   | 8,468        |   |  |       | (3,826 | ) |  |   | 5,131    |  
|Gains on derivative instruments                                    |  |                             | 6,128   |   |                 |   | 2,268   |               |  |   |             |   |  |       |       |   |  |   | 8,396    |  
|Impairment on mortgage securities  available- for-sale            |  |                             | (22,569 | ) |                 |   |        |               |  |   |             |   |  |       |       |   |  |   | (22,569  | )
|Other income, net                                                  |  |                             | 3,589   |   |                 |   | 26      |               |  |   |             |   |  |       | (2,972 | ) |  |   | 643      |  
|General and administrative expenses                                |  |                             | (4,511  | ) |                 |   | (40,341 | )             |  |   | (10,826      | ) |  |       |       |   |  |   | (55,678  | )
|                                                                   |  |                             |         |   |                 |   |         |               |  |   |              |   |  |       |        |   |  |   |          |  
|(Loss) income from continuing operations before income tax expense |  |                             | (72,942 | ) |                 |   | (55,244 | )             |  |   | 4,102        |   |  |       |       |   |  |   | (124,084 | )
|Income tax (benefit) expense                                       |  |                             | (55,680 | ) |                 |   | (16,786 | )             |  |   | 1,260        |   |  |       |       |   |  |   | (71,206  | )
|                                                                   |  |                             |         |   |                 |   |         |               |  |   |              |   |  |       |        |   |  |   |          |  
|Net (loss) income                                                  |  | $                           | (17,262 | ) |                 | $ | (38,458 | )             |  | $ | 2,842        |   |  | $     |       |   |  | $ | (52,878  | )
|                                                                   |  |                             |         |   |                 |   |         |               |  |   |              |   |  |       |        |   |  |   |          |  



35



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##### Table of Contents

For the Three Months Ended June 30, 2006



|                                                                   |  |                             |        |   |                 |   |         |               |  |   |              |   |  |       |        |   |  |   |         |  
|------------------------------------------------------------------ |  | --------------------------- | ------ | - | --------------- | - | ------- | ------------- |  | - | ------------ | - |  | ----- | ------ | - |  | - | ------- | -
|                                                                   |  | MortgagePortfolioManagement |        |   | MortgageLending |   |         | LoanServicing |  |   | Eliminations |   |  | Total |       
|Interest income                                                    |  | $                           | 88,476 |   |                 | $ | 37,130  |               |  | $ | 7,185        |   |  | $     |       |   |  | $ | 132,791 |  
|Interest expense                                                   |  |                             | 37,693 |   |                 |   | 29,822  |               |  |   |             |   |  |       | (2,253 | ) |  |   | 65,262  |  
|                                                                   |  |                             |        |   |                 |   |         |               |  |   |              |   |  |       |        |   |  |   |         |  
|Net interest income before provision for credit losses             |  |                             | 50,783 |   |                 |   | 7,308   |               |  |   | 7,185        |   |  |       | 2,253  |   |  |   | 67,529  |  
|Provision for credit losses                                        |  |                             | (6,045 | ) |                 |   |        |               |  |   |             |   |  |       |       |   |  |   | (6,045  | )
|Gains on sales of mortgage assets                                  |  |                             | 34     |   |                 |   | 24,466  |               |  |   |             |   |  |       | (1,215 | ) |  |   | 23,285  |  
|Fair value adjustments                                             |  |                             | 1,866  |   |                 |   |        |               |  |   |             |   |  |       |       |   |  |   | 1,866   |  
|Valuation adjustment on mortgage loans  held-for-sale             |  |                             |       |   |                 |   | 1,812   |               |  |   |             |   |  |       |       |   |  |   | 1,812   |  
|Premiums for mortgage loan insurance                               |  |                             | (2,221 | ) |                 |   | (1,581  | )             |  |   |             |   |  |       |       |   |  |   | (3,802  | )
|Fee income                                                         |  |                             | 236    |   |                 |   | 1,483   |               |  |   | 6,535        |   |  |       | (1,366 | ) |  |   | 6,888   |  
|Gains on derivative instruments                                    |  |                             | 109    |   |                 |   | 6,031   |               |  |   |             |   |  |       |       |   |  |   | 6,140   |  
|Impairment on mortgage securities  available- for-sale            |  |                             | (4,488 | ) |                 |   |        |               |  |   |             |   |  |       |       |   |  |   | (4,488  | )
|Other income (expense), net                                        |  |                             | 2,267  |   |                 |   | (1,162  | )             |  |   |             |   |  |       | (887   | ) |  |   | 218     |  
|General and administrative expenses                                |  |                             | (4,700 | ) |                 |   | (39,345 | )             |  |   | (8,594       | ) |  |       |       |   |  |   | (52,639 | )
|                                                                   |  |                             |        |   |                 |   |         |               |  |   |              |   |  |       |        |   |  |   |         |  
|Income (loss) from continuing operations before income tax expense |  |                             | 37,841 |   |                 |   | (988    | )             |  |   | 5,126        |   |  |       | (1,215 | ) |  |   | 40,764  |  
|Income tax expense (benefit)                                       |  |                             | 4,398  |   |                 |   | (358    | )             |  |   | 1,855        |   |  |       | (452   | ) |  |   | 5,443   |  
|                                                                   |  |                             |        |   |                 |   |         |               |  |   |              |   |  |       |        |   |  |   |         |  
|Income (loss) from continuing operations                           |  |                             | 33,443 |   |                 |   | (630    | )             |  |   | 3,271        |   |  |       | (763   | ) |  |   | 35,321  |  
|Loss from discontinued operations, net of income tax               |  |                             |       |   |                 |   | (586    | )             |  |   |             |   |  |       |       |   |  |   | (586    | )
|                                                                   |  |                             |        |   |                 |   |         |               |  |   |              |   |  |       |        |   |  |   |         |  
|Net income (loss)                                                  |  | $                           | 33,443 |   |                 | $ | (1,216  | )             |  | $ | 3,271        |   |  | $     | (763   | ) |  | $ | 34,735  |  
|                                                                   |  |                             |        |   |                 |   |         |               |  |   |              |   |  |       |        |   |  |   |         |  

Intersegment revenues and expenses that were eliminated in consolidation were as follows for the six and three
months ended June 30, 2007 and 2006 (in thousands):



|                                                                                          |  |                    |        |      |                      |         |      |  |      |       |  |   |       |  
|----------------------------------------------------------------------------------------- |  | ------------------ | ------ | ---- | -------------------- | ------- | ---- |  | ---- | ----- |  | - | ----- | -
|                                                                                          |  | For the Six Months |        |      | For the Three Months |        
|                                                                                          |  | Ended June 30,     |        |      | Ended June 30,       |        
|                                                                                          |  | 2007               |        | 2006 |                      |         | 2007 |  | 2006 |      
|Amounts paid to (received from) mortgage portfolio management from (to) mortgage lending: |  |                    |        |      |                      |         |      |  |      |       |  |   |       |  
|Interest income on intercompany debt                                                      |  | $                  | 12,049 |      | $                    | 5,781   |      |  | $    | 6,798 |  | $ | 2,253 |  
|Guaranty, commitment, loan sale and securitization fees                                   |  |                    | 1,511  |      |                      | 2,217   |      |  |      | 577   |  |   | 1,226 |  
|Gains on sales of mortgage loans                                                          |  |                    |       |      |                      | (19,713 | )    |  |      |      |  |   | (565  | )
|Gains on sales of mortgage securities  available-for-sale retained in securitizations    |  |                    |       |      |                      | (715    | )    |  |      |      |  |   | (650  | )
|                                                                                          |  |                    |        |     
|Amounts paid to loan servicing from mortgage portfolio management:                        |  |                    |        |      |                      |         |      |  |      |       |  |   |       |  
|Loan servicing fees                                                                       |  | $                  | 5,934  |      | $                    | 1,397   |      |  | $    | 3,788 |  | $ | 1,360 |  
|                                                                                          |  |                    |        |     
|Amounts paid to loan servicing from mortgage lending:                                     |  |                    |        |      |                      |         |      |  |      |       |  |   |       |  
|Loan servicing fees                                                                       |  | $                  | 91     |      | $                    | 11      |      |  | $    | 38    |  | $ | 6     |  



36



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Note 19. Earnings Per Share

The computations of basic and diluted earnings per share for the six and three months ended June 30, 2007 and 2006 are as follows (in thousands, except per share amounts):



|                                                                          |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|------------------------------------------------------------------------- |  | -------------------------------- | ------- | - | ---------------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------ | -
|                                                                          |  | For the Six MonthsEnded June 30, |         |   | For the Three MonthsEnded June 30, |  
|                                                                          |  | 2007                             |         |   | 2006                               |   |        | 2007 |  |   | 2006    |  
|Numerator:                                                                |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|(Loss) income from continuing operations                                  |  | $                                | (6,864  | ) |                                    | $ | 60,574 |      |  | $ | (52,878 | ) |  | $ | 35,321 |  
|Dividends on preferred shares                                             |  |                                  | (3,326  | ) |                                    |   | (3,326 | )    |  |   | (1,663  | ) |  |   | (1,663 | )
|                                                                          |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|(Loss) income from continuing operations available to common shareholders |  |                                  | (10,190 | ) |                                    |   | 57,248 |      |  |   | (54,541 | ) |  |   | 33,658 |  
|Loss from discontinued operations, net of income tax                      |  |                                  |        |   |                                    |   | (1,811 | )    |  |   |        |   |  |   | (586   | )
|                                                                          |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|Net (loss) income available to common shareholders                        |  | $                                | (10,190 | ) |                                    | $ | 55,437 |      |  | $ | (54,541 | ) |  | $ | 33,072 |  
|                                                                          |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|Denominator:                                                              |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|Weighted average common shares outstanding  basic                        |  |                                  | 9,329   |   |                                    |   | 8,183  |      |  |   | 9,337   |   |  |   | 8,266  |  
|                                                                          |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|Weighted average common shares outstanding  dilutive:                    |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|Weighted average common shares outstanding  basic                        |  |                                  | 9,329   |   |                                    |   | 8,183  |      |  |   | 9,337   |   |  |   | 8,266  |  
|Stock options                                                             |  |                                  |        |   |                                    |   | 58     |      |  |   |        |   |  |   | 58     |  
|Restricted stock                                                          |  |                                  |        |   |                                    |   | 5      |      |  |   |        |   |  |   | 6      |  
|                                                                          |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|Weighted average common shares outstanding  dilutive                     |  |                                  | 9,329   |   |                                    |   | 8,246  |      |  |   | 9,337   |   |  |   | 8,330  |  
|                                                                          |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|Basic earnings per share:                                                 |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|(Loss) income from continuing operations                                  |  | $                                | (0.73   | ) |                                    | $ | 7.40   |      |  | $ | (5.66   | ) |  | $ | 4.27   |  
|Dividends on preferred shares                                             |  |                                  | (0.36   | ) |                                    |   | (0.41  | )    |  |   | (0.18   | ) |  |   | (0.20  | )
|                                                                          |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|(Loss) income from continuing operations available to common shareholders |  |                                  | (1.09   | ) |                                    |   | 6.99   |      |  |   | (5.84   | ) |  |   | 4.07   |  
|Loss from discontinued operations, net of income tax                      |  |                                  |        |   |                                    |   | (0.22  | )    |  |   |        |   |  |   | (0.07  | )
|                                                                          |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|Net (loss) income available to common shareholders                        |  | $                                | (1.09   | ) |                                    | $ | 6.77   |      |  | $ | (5.84   | ) |  | $ | 4.00   |  
|                                                                          |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|Diluted earnings per share:                                               |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|(Loss) income from continuing operations                                  |  | $                                | (0.73   | ) |                                    | $ | 7.34   |      |  | $ | (5.66   | ) |  | $ | 4.24   |  
|Dividends on preferred shares                                             |  |                                  | (0.36   | ) |                                    |   | (0.40  | )    |  |   | (0.18   | ) |  |   | (0.20  | )
|                                                                          |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|(Loss) income from continuing operations available to common shareholders |  |                                  | (1.09   | ) |                                    |   | 6.94   |      |  |   | (5.84   | ) |  |   | 4.04   |  
|Loss from discontinued operations, net of income tax                      |  |                                  |        |   |                                    |   | (0.22  | )    |  |   |        |   |  |   | (0.07  | )
|                                                                          |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  
|Net (loss) income available to common shareholders                        |  | $                                | (1.09   | ) |                                    | $ | 6.72   |      |  | $ | (5.84   | ) |  | $ | 3.97   |  
|                                                                          |  |                                  |         |   |                                    |   |        |      |  |   |         |   |  |   |        |  

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



|                                                            |  |                                  |       |                                    |   |        |  |      |       |  |   |       
|----------------------------------------------------------- |  | -------------------------------- | ----- | ---------------------------------- | - | ------ |  | ---- | ----- |  | - | ------
|                                                            |  | For the Six MonthsEnded June 30, |       | For the Three MonthsEnded June 30,
|                                                            |  | 2007                             |       | 2006                               |   | 2007   |  | 2006
|Number of stock options and restricted stock (in thousands) |  |                                  | 330   |                                    |   | 56     |  |      | 461   |  |   | 67    
|Weighted average exercise price                             |  | $                                | 40.52 |                                    | $ | 141.87 |  | $    | 32.24 |  | $ | 140.00



37



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##### Table of Contents

See Note 22 for a description of the mandatory convertible preferred stock transactions the Company has either completed,
or intends to complete, subsequent to June 30, 2007 which could materially change the Companys future number of common shares or potential common shares outstanding.

Note 20. Stock Compensation Plans

The Company adopted an
Equity Award Policy on February 12, 2007 governing the grant of equity awards. In general, equity awards may be granted only at a meeting of the Compensation Committee or the entire Board during the Trading Window, as defined in the
Companys Insider Trading and Disclosure Policy for Designated Insiders. The Trading Window for a particular quarter is open beginning on the second business day following an earnings release with respect to the prior quarter until the 15thday 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 NYSE on the date of grant.

Grants of long-term equity awards for 2007 were made on March 14, 2007, in accordance
with the Companys Equity Award Policy. On that date 206,096 stock options were granted to employees with an exercise price of $16.72, which was the closing market price on the NYSE of the Companys common stock on that date. The options
granted are subject to a four year vesting period.

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

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

The following table summarized the weighted average fair value
of options granted for the six months ended June 30, 2007 determined using the Black-Scholes option pricing model and the assumptions used in the determination. The volatility assumption was calculated from the historical realized volatility on
the Companys common stock for a period approximating the expected life.



|                               |  |   |       |  
|------------------------------ |  | - | ----- | -
|Fair value, at date of grant   |  | $ | 10.06 |  
|Expected life in years         |  |   | 5     |  
|Annual risk-free interest rate |  |   | 4.46  | %
|Volatility                     |  |   | 65.03 | %
|Dividend yield                 |  |   | 0.0   | %

The Company also granted and issued 115,463 shares of restricted stock on March 14, 2007. These restricted
stock awards will vest at the end of 5 years and they had a fair value of $16.72 per share.



38



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##### Table of Contents

Note 21. Discontinued Operations

By June 30, 2006, the Company had terminated all of the remaining NHMI branches and related operations. The Company considers a branch to be discontinued upon its termination date, which is the point in time when
the operations cease. The Company has presented the operating results of NHMI as discontinued operations in the condensed consolidated statements of operations for the six and three months ended June 30, 2006. NHMI had no material assets at
June 30, 2006. The operating results of all discontinued operations are summarized as follows (dollars in thousands):



|                                    |  |                                  |        |   |                                    |   |        |  
|----------------------------------- |  | -------------------------------- | ------ | - | ---------------------------------- | - | ------ | -
|                                    |  | For the Six MonthsEnded June 30, |        |   | For the Three MonthsEnded June 30, |  
|                                    |  | 2006                             |        |   | 2006                               |  
|Interest income                     |  | $                                | 174    |   |                                    | $ | 95     |  
|Interest expense                    |  |                                  | (196   | ) |                                    |   | (7     | )
|Gains on sales of mortgage assets   |  |                                  | 1,192  |   |                                    |   | 462    |  
|Fee income                          |  |                                  | 5,594  |   |                                    |   | 2,403  |  
|Other income                        |  |                                  | 154    |   |                                    |   |       |  
|General and administrative expenses |  |                                  | (9,802 | ) |                                    |   | (3,886 | )
|                                    |  |                                  |        |   |                                    |   |        |  
|Loss before income tax benefit      |  |                                  | (2,884 | ) |                                    |   | (933   | )
|Income tax benefit                  |  |                                  | (1,073 | ) |                                    |   | (347   | )
|                                    |  |                                  |        |   |                                    |   |        |  
|Loss from discontinued operations   |  | $                                | (1,811 | ) |                                    | $ | (586   | )
|                                    |  |                                  |        |   |                                    |   |        |  

Note 22. Subsequent Events

Securities Purchase Agreement. On July 16, 2007, the Company entered into a Securities Purchase Agreement (the Securities Purchase Agreement) pursuant to which Massachusetts Mutual Life
Insurance Company (MassMutual), Jefferies Capital Partners IV L.P., Jefferies Employee Partners IV LLC, and JCP Partners IV LLC (collectively, Jefferies Capital Partners, and together with MassMutual, the
Investors), purchased for $48.8 million in cash 2,100,000 shares of the Companys 9.00% Series D-1 Mandatory Convertible Preferred Stock, par value $0.01 per share and initial liquidation preference of $25.00 per share (Series
D-1 Preferred Stock), in a private placement not registered under the Securities Act of 1933, as amended (the Securities Act). The Company intends to use the proceeds from the sale of the Series D-1 Preferred Stock under the
Securities Purchase Agreement for general working capital. Prior to the execution of the Securities Purchase Agreement, MassMutual, through certain of its affiliates, and certain affiliates of Jefferies Capital Partners, owned 771,800 shares and
224 shares of common stock of the Company, par value $0.01 per share (the Common Stock), respectively.

Dividends on the Series D-1
Preferred Stock accrue at a rate of 9.00% per annum, and are payable in cash. In addition, holders of the Series D-1 Preferred Stock are entitled to participate in any common stock dividends on an as converted basis.

The Series D-1 Preferred Stock is convertible into the Companys common stock at any time at the option of the holders. The Series D-1 Preferred Stock was initially
convertible into 1,875,000 shares (post-split) of common stock based upon the initial conversion price of $28.00 per share (post-split), subject to adjustment. If the Company has not obtained stockholder approval for certain adjustments to the
conversion price of the Series D-1 Preferred Stock designed to provide certain anti-dilution protection to the holders of such stock upon certain issuances of capital stock by the Company (the Shareholder Approval) on or prior to
July 16, 2010, the Company may elect to convert all of the Series D-1 Preferred Stock 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. If the Company has not obtained Shareholder Approval on or prior to the ninth anniversary of the issuance of the Series D-1 Preferred Stock,
the Series D-1 Preferred Stock will automatically convert into shares of Common Stock. In addition, if NFI has obtained Shareholder Approval, the shares of Series D-1 Preferred Stock will automatically convert into shares of Series D-2 Preferred
Stock on the later of July 16, 2009 or the date the Company obtains such Shareholder Approval.

In connection with the purchase of the Series D-1
Preferred Stock pursuant to the Securities Purchase Agreement, the Investors also committed to purchase up to $101.2 million of a new series of the Companys convertible preferred securities which were designated as 9.00% Series D-2 Mandatory
Convertible Preferred Stock, par value $0.01 per share and to have an initial liquidation preference of $25.00 per share (the Series D-2 Preferred Stock), to the extent any such shares are not subscribed for in a planned rights offering
of such shares by the Company by entering into a Standby Purchase Agreement with the Company dated July 16, 2007 (the Standby Purchase Agreement). Also in connection with the Securities Purchase Agreement, the Company entered into a
Registration Rights and Shareholders Agreement dated July 16, 2007 (the Registration Rights Agreement) with the Investors that provides the Investors with (i) customary registration rights with respect to certain shares
owned by the Investors as described below;



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and (ii) certain other rights, including the right to designate Directors to the Companys Board of Directors, the right to approve certain
transactions, including a change in control, and certain preemptive rights to subscribe for the Companys securities.

In addition, upon a Change of
Control (as defined in the Registration Rights Agreement), the Investors have the right to require the Company to redeem all or a portion of their Series D-1 Preferred Stock purchased pursuant to the Securities Purchase Agreement, the Series D-2
Preferred Stock purchased by the Investors in connection with the Rights Offering or the Standby Purchase Agreement or, if and when issued, any Series E Preferred Stock.

Standby Purchase and Rights Offering. In connection with the Securities Purchase Agreement, the Companys Board of Directors approved a rights offering (the Rights Offering) pursuant to
which holders of the Companys Common Stock and Series D-1 Preferred Stock will receive non-transferable rights (the Rights) to purchase shares of the Series D-2 Preferred Stock at a price of $25.00 per share.The Series D-2
Preferred Stock will be convertible into the Companys Common Stock as contemplated in the Securities Purchase Agreement. Pursuant to the Standby Purchase Agreement, and subject to certain conditions, each of MassMutual and Jefferies Capital
Partners has agreed severally to purchase 50% of the shares of Series D-2 Preferred Stock that remain unsold in the Rights Offering.

As contemplated in
the Securities Purchase Agreement, the Series D-2 Preferred Stock will rank pari passu with the shares of Series D-1 Preferred Stock, and will be convertible into the Companys Common Stock at any time, at the option of the holders,
based on the initial conversion price of $28.00 per share (post-split), subject to adjustment in the same manner as the Series D-1 Preferred Stock. After three years, the Series D-2 Preferred Stock also would be convertible into Common Stock at
NovaStars option, under specified circumstances. At the end of nine years, if not already converted, the Series D-2 Preferred Stock would mandatorily be converted into shares of Common Stock at the then current conversion ratio. The Series D-2
Preferred Stock will accrue cumulative dividends at the rate of 9.0% per annum, payable in kind, by adding accrued dividends to the stated value of the Series D-2 Preferred Stock, or in cash, at the Companys election. The Series D-2
Preferred Stock would initially be non-voting, but upon receipt of certain state regulatory agency approvals relating to the acquisition by the Investors of the Series D-1 Preferred Stock and the Series D-2 Preferred Stock, would have the same
voting rights, on an as-converted basis, as holders of the Companys Common Stock.

The Standby Purchase Agreement contains customary
representations and covenants of the Company including that the Company operate in the ordinary course of business until the closing of the purchase of shares by the Investors pursuant to the Standby Purchase Agreement.

The Investors obligation to purchase the Series D-2 Preferred Stock under the Standby Purchase Agreement is subject to customary closing conditions, including,
among other things, the Companys Board of Directors having declared the REIT Dividend and having set the record date for determination of the stockholders of the Company entitled to receive payment of the REIT Dividend (which date will be on
or prior to December 31, 2007 but not earlier than the first business day after the closing under the Standby Purchase Agreement); the Company having taken all actions necessary to increase the size of its Board of Directors so that the
Investors are able to designate a number of directors as contemplated by the Registration Rights Agreement and having filled such vacancies with individuals designated by the Investors in accordance with the Registration Rights Agreement; and since
the date of the Standby Purchase Agreement, there not having been an NFI Material Adverse Effect (as defined below).

An NFI Material
Adverse Effect under the Standby Purchase Agreement means any event, change, circumstance or effect that individually or in the aggregate (with other events, changes, circumstances or effects) is or is reasonably likely to (A) be
materially adverse to the Companys ability to perform its obligations under the Standby Purchase Agreement or the other transaction documents, or (B) be materially adverse on the financial condition, assets, liabilities, business or
results of operations of the Company and its subsidiaries, taken as a whole (subject to certain exclusions only in the case of clause (B) for (i) events, changes, circumstances or effects relating to general economic or market conditions,
so long as such conditions do not have a disproportionate effect on the Company and its subsidiaries, compared to other companies in the industries in which the Company and its subsidiaries conduct their business, (ii) certain extraordinary
events such as acts of war, hostilities or natural disasters, (iii) decreases in the market value or trading volume of the Companys Common Stock on the New York Stock Exchange or failure by the Company or its subsidiaries to meet any
projections, or budgets so long as, in the case of (iii), no underlying event or circumstance that itself constitutes such a material adverse effect has resulted in or contributed to such decrease in the market value or trading volume or such
failure of any projections or budgets, and (iv) certain other exceptions).

The Standby Purchase Agreement may be terminated and the transactions
contemplated thereby abandoned (1) by the mutual consent of the Company and the Investors; (2) by either Investor or the Company if the other breaches any covenant, representation or warranty, which breach would cause the failure of
certain conditions precedent to the closing of the transactions under the Standby Purchase Agreement, if such breach is not capable of cure on or prior to December 31, 2007; (3) by either Investor if the Company



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fails to satisfy any other conditions to the closing under the Standby Purchase Agreement and such failure cannot be cured on or prior to December 10,
2007; (4) by either Investor if any updates to the Companys disclosure schedules disclose any matter that has, or would be reasonably likely to have, an NFI Material Adverse Effect, (5) by either Investor if the Rights Offering has
not commenced by October 25, 2007; (6) by either Investor if the record date for the REIT Dividend has occurred and/or the REIT Dividend has been paid; or (7) by the Company or either Investor after January 31, 2008 provided,
that the right to terminate the Standby Purchase Agreement under clauses (3) and (7) will not be available to a party if that party has failed to fulfill any obligation under the Standby Purchase Agreement and such failure has materially
contributed to the failure of any condition precedent or the closing of the standby commitment.

REIT Dividend Payment. The Company currently
intends, in the third quarter of 2007, to declare a dividend (the REIT Dividend) in order to satisfy certain requirements to distribute 2006 taxable income relating to its status as a REIT under the Code. Timing of the declaration and
distribution of the REIT Dividend will be determined by the Board of Directors, but federal tax rules for REITs require that the Company declare dividends based on 2006 taxable income by the deadline for its tax return, which is September 17,
2007, and distribute those dividends by year-end.

In the Securities Purchase Agreement, the Company has agreed (1) to declare the REIT Dividend on or
before September 17, 2007, (2) that the record date for the REIT Dividend will not be before the earlier of (A) the date all of the shares of the Series D-2 Preferred Stock are purchased in the Rights Offering as described above or
the first business day after the closing of the transactions contemplated by the Standby Purchase Agreement and (B) December 10, 2007 and (3) that the REIT Dividend will be distributed in the form of shares of 9.00% Series E
Convertible Preferred Stock, (the Series E Preferred Stock), ranking pari passu with the Series D-1 Preferred Stock and the Series D-2 Preferred Stock. Definitive terms of the Series E Preferred Stock will be determined by the
Companys Board of Directors.

In order to facilitate the transactions contemplated by the Securities Purchase Agreement, on July 12, 2007, the
Companys Board of Directors approved a one for four reverse stock split of the Companys issued and outstanding shares of common stock, which was effective on July 27, 2007. Current and prior year share amounts and earnings per share
disclosures have been restated to reflect the reverse stock split. After the reverse stock split, the Company was authorized to issue 50,000,000 shares of capital stock consisting of 38,763,000 shares of common stock, 2,990,000 shares of 8.90%
Series C Cumulative Redeemable Preferred Stock, par value of $0.01 per share (Series C Preferred Stock), 2,100,000 shares of 9.00% Series D-1 Preferred Stock (initially convertible into 1,875,000 shares of common stock, subject to
certain adjustments), and 6,147,000 shares of 9.00% Series D-2 Preferred Stock (initially convertible into 5,488,393 shares of common stock, subject to certain adjustments). After the reverse stock split, the Company had the following shares issued
and outstanding: 9,469,910 shares of common stock, 2,990,000 shares of Series C Preferred Stock, and 2,100,000 shares of Series D-1 Preferred Stock. At this time, none of the Series D-2 Preferred Stock is outstanding.



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

The following
discussion should be read in conjunction with the preceding unaudited condensed consolidated financial statements of NovaStar Financial, Inc. and its subsidiaries (the Company ,NovaStar Financial, NFI ,
we or us) and the notes thereto as well as NovaStar Financials annual report to shareholders and annual report on Form 10-K for the fiscal year ended December 31, 2006.

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 will, 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 and
operate our business during this difficult period for the subprime industry; our ability to consummate our recently announced transactions, including the rights offering and the transactions contemplated by the Standby Purchase Agreement, on their
current terms; our ability to generate and maintain sufficient liquidity on favorable terms; the size, frequency and structure of our securitizations; our ability to originate and sell loans at a profit; impairments on our mortgage assets; increases
in prepayment or default rates on our mortgage assets; increases in loan repurchase requests; changes in the types of products we offer; inability of potential borrowers to meet our underwriting guidelines; changes in assumptions regarding estimated
loan losses and fair value amounts; our ability to improve and maintain effective internal control over financial reporting and disclosure controls and procedures in the future; finalization of the amount and terms of any severance provided to
terminated employees; finalization of the accounting impact of our previously-announced reduction in workforce; events impacting the subprime mortgage industry in general, including events impacting our competitors and liquidity available to the
industry; the initiation of margin calls under our credit facilities; the ability of our servicing operations to maintain high performance standards and maintain appropriate ratings from rating agencies; our ability to generate acceptable
origination volume while maintaining an acceptable level of overhead; residential property values; our continued status as a REIT and our compliance with laws and regulations applicable to REITs; interest rate fluctuations on our assets that
differ from our liabilities; our ability to acquire mortgage insurance at favorable prices or at all; the outcome of litigation or regulatory actions pending against us or other legal contingencies; our compliance with applicable local, state and
federal laws and regulations or opinions of counsel relating thereto and the impact of new local, state or federal legislation or regulations or opinions of counsel relating thereto or court decisions on our operations; our ability to adapt to and
implement technological changes; compliance with new accounting pronouncements; our ability to successfully integrate acquired businesses or assets with our existing business; the impact of general economic conditions; and the risks that are from
time to time included in our filings with the SEC, including this report on Form 10-Q. Other factors not presently identified may also cause actual results to differ. This report on Form 10-Q speaks only as of its date and we expressly disclaim
any duty to update the information herein except as required by federal securities laws.



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Executive Overview of Performance

The second quarter of 2007 continued to be a very challenging environment in the mortgage industry. The following economic and financial factors were significant drivers in our financial results for the six and three
months ended June 30, 2007:



| |  |  | REIT status revocation  On May 3, 2007, our Board of Directors approved a formal plan to voluntarily revoke our REIT status effective January 1,
2008. We will continue to be subject to the REIT dividend distribution requirements for 2007 which require us to distribute at least 90 percent of our 2007 taxable income by the end of 2008 in order to retain our REIT status for 2007.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The decision to revoke NFIs REIT status was based on several significant factors. First, operating as a REIT
restricts our ability to operate our business. The REIT source of income tests and diversification of assets tests not only limits our ability to hedge our interest rate risk, but also unduly restricts our ability to efficiently manage our portfolio
management business. Second, since we are required to distribute most of our earnings in the form of dividends to shareholders to comply with REIT distribution requirements, our ability to retain capital to grow our business is significantly
reduced. Third, our projections demonstrate that we will not generate taxable income at the REIT from 2007 through 2011. This is due primarily to the expected reversal of deductible temporary differences that have accumulated over the past several
years. As we have disclosed in previous filings, we had experienced significantly higher taxable income compared to financial statement income in years prior to 2007. This was due primarily to timing differences between financial statement and
income tax recognition of income and losses on our portfolio of interest-only mortgage securities. Without taxable income, we will not have a requirement to distribute dividends to shareholders.

With the Board of Directors decision to authorize management to revoke NFIs REIT election effective January 1, 2008, the REIT scheduled
the reversal of deductible and taxable temporary differences as of December 31, 2006 (as well as new temporary differences originating during 2007) for amounts to be realized during our final calendar year as a REIT and for amounts to be
realized in subsequent taxable years. As previously stated, NFI will be taxable as a C corporation in the tax year the revocation of its REIT election is effective (2008) and for subsequent taxable years. Accordingly, NFI initially recorded
deferred taxes as of March 31, 2007 based on estimated cumulative temporary differences at January 1, 2008 that are expected to reverse in a subsequent taxable year. We recorded an income tax benefit of $84.2 million during the three
months ended March 31, 2007 related to this initial recording of deferred taxes. For the three months ended June 30, 2007 we recorded an additional tax benefit of $32.8 million for a total income tax benefit of $117.0 million for the six
months ended June 30, 2007 as a result of this decision to de-REIT.



| |  |  | Bond spread widening  Generally, the market value of our mortgage assets (i.e. mortgage loans and mortgage securities) fluctuates inversely with bond spreads
in the market. As bond spreads widen (i.e. investors demand more return), the value of our mortgage assets will decline, alternatively, as they tighten, the market value will increase. While bond spreads stabilized during the second quarter of 2007
and even improved, they worsened towards the end of the second quarter and early in the third quarter as investor concerns over deterioration of subprime asset quality grew. Overall, bond spreads have dramatically widened in 2007 from 2006, as such,
we have experienced significant mark-to-market losses on our mortgage securities  trading and mortgage loans  held-for-sale. We recognized losses on our mortgage securities - trading due to fair value adjustments of $89.7 million and
$39.7 million for the six and three months ended June 30, 2007, respectively. We recorded $24.6 million and $4.4 million of losses from valuation adjustments on our mortgage loans  held-for-sale for the six and three months ended
June 30, 2007, respectively.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Credit performance  With repayment risks no longer offset by rapidly rising home values, delinquencies in the industry began to rise in 2006 and continued to
rise in the first half of 2007. These credit issues have caused whole loans to lose significant value, affecting the value of and income generated by our portfolio of mortgage loans and securities. We recorded an impairment on our mortgage
securities  available-for-sale as a result of credit deterioration of $26.0 million and $22.6 during the six and three months ended June 30, 2007, respectively. We also experienced significant mark-to-market losses on our trading
securities for the six and three months ended June 30, 2007 as discussed in the preceding paragraph. Another significant effect of the credit deterioration in our portfolio was our recording of provision for credit losses of $93.2 million and
$73.3 million for the six and three months ended June 30, 2007, respectively.
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| |  |  | Adoption of SFAS 159  As a result of the adoption of SFAS 159, we elected fair value treatment for the asset-backed bonds we issued in our CDO transaction
executed in the first quarter of 2007. The adoption resulted in gains due to fair value adjustments of $63.5 million and $22.9 million for the six and three months ended June 30, 2007, respectively, which have substantially offset the
mark-to-market losses on the trading securities which were a part of our CDO transaction. These mark-to-market gains are netted with the mark-to-market losses on our trading securities in the Fair value adjustments line item of our
condensed consolidated statements of operations.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Declining origination volumes  The key area of focus for our mortgage lending segment is to ensure that the 2007 vintage performs better than 2006 and in line
with our expectations. In this regard, we have significantly altered our proprietary model and underwriting guidelines and processes in an attempt to minimize losses and enhance asset quality in loan originations going forward. This has negatively
impacted our origination volumes as fewer borrowers qualify under these new guidelines. As a result of this decline in volume, we committed to certain workforce reductions pursuant to plans of termination (the Plans) during the first and
second quarters of 2007. We recorded a pre-tax charge to earnings of $3.7 million and $0.7 million for the six and three months ended June 30, 2007, respectively, which consisted primarily of one-time employment termination benefits. These
Plans resulted in the elimination of approximately 437 positions. In addition, we have limited origination volumes due to uncertainty regarding our ability to sell or securitize loans due to uncertainty in the secondary market.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Liquidity  As a result of the 2007 subprime environment, we used up significant cash reserves during the six months ended June 30, 2007. Our cash
balances declined by approximately $43.8 million during the six months ended June 30, 2007 primarily due to margin calls, mortgage loan repurchases and normal business operations. As a result of the decrease in liquidity, we have completed
several strategic initiatives in an attempt to provide adequate liquidity levels for our business operations. One of those initiatives was the closing of a $100 million lending facility to provide financing for certain residual securities and
mortgage servicing rights. Additionally, we closed a $1.9 billion comprehensive financing facility for the financing of all of our mortgage assets. Our intent for the near future is to solely use the $1.9 billion facility for our daily mortgage loan
and security financing needs. While we still maintain approximately $2.0 billion of lending facilities with other financial institutions which have not expired (but are scheduled to expire in 2007), they currently are not being used with the
exception of our servicing advance facility. Another transaction we entered into on July 16, 2007 as part of our strategic initiatives, we issued $48.8 million of convertible preferred stock to certain private investors to facilitate the
enhancement of our liquidity position. Additionally, our intent is to issue another $101.2 million of preferred stock in the last half of 2007. See Note 22 to the Condensed Consolidated Financial Statements as well as Liquidity and Capital
Resources for further discussion of our liquidity position and steps we have taken to ensure we maintain adequate liquidity levels to position ourselves to navigate through these challenging times.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | See discussion under heading Industry Overview and Known Material Trends below for more information about current conditions in our industry and the
steps we are taking or considering to manage and operate our business in this challenging environment.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

The following selected key performance metrics are derived from our condensed 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.

Table 1  Summary of Financial Highlights and Key Performance Metrics

(dollars in thousands; except per share amounts)



|                                                                                      |  |                                   |           |    |                                     |   |           |      |  |   |           |    |  |   |           |  
|------------------------------------------------------------------------------------- |  | --------------------------------- | --------- | -- | ----------------------------------- | - | --------- | ---- |  | - | --------- | -- |  | - | --------- | -
|                                                                                      |  | For the Six Months Ended June 30, |           |    | For the Three Months Ended June 30, |  
|                                                                                      |  | 2007                              |           |    | 2006                                |   |           | 2007 |  |   | 2006      |   
|(Loss) income from continuing operations before income tax (benefit) expense          |  | $                                 | (193,446  | )  |                                     | $ | 61,438    |      |  | $ | (124,084  | )  |  | $ | 40,764    |  
|Net (loss) income available to common shareholders                                    |  | $                                 | (10,190   | )  |                                     | $ | 55,437    |      |  | $ | (54,541   | )  |  | $ | 33,072    |  
|Net (loss) income available to common shareholders, per diluted share                 |  | $                                 | (1.09     | )  |                                     | $ | 6.72      |      |  | $ | (5.84     | )  |  | $ | 3.97      |  
|Nonconforming originations and purchases (A)                                          |  | $                                 | 2,215,408 |    |                                     | $ | 4,651,411 |      |  | $ | 773,733   |    |  | $ | 2,816,586 |  
|Weighted average coupon of nonconforming originations and purchases                   |  |                                   | 8.95      | %  |                                     |   | 8.61      | %    |  |   | 9.32      | %  |  |   | 8.66      | %
|Nonconforming loans securitized in transactions structured as sales, principal        |  | $                                 | 1,400,000 |    |                                     | $ | 2,090,788 |      |  | $ | 1,400,000 |    |  | $ | 1,711,844 |  
|Nonconforming loans securitized in transactions structured as financings, principal   |  | $                                 | 1,888,756 |    |                                     | $ | 2,425,370 |      |  | $ |          |    |  | $ | 2,425,370 |  
|Nonconforming loans sold to third parties, principal                                  |  | $                                 | 244,125   |    |                                     | $ | 793,056   |      |  | $ | 170,439   |    |  | $ | 434,065   |  
|Loss (gains) on sales of mortgage assets                                              |  | $                                 | (12,394   | )  |                                     | $ | 23,318    |      |  | $ | (9,103    | )  |  | $ | 23,285    |  
|Weighted average whole loan price used in the initial valuation of residual interests |  |                                   | 99.33     |    |                                     |   | 101.94    |      |  |   | 99.33     |    |  |   | 102.03    |  
|Net interest yield on assets (B)                                                      |  |                                   | (0.19     | )% |                                     |   | 1.36      | %    |  |   | (0.88     | )% |  |   | 1.36      | %
|Net yield on mortgage securities (C)                                                  |  |                                   | 13.55     | %  |                                     |   | 38.03     | %    |  |   | 12.29     | %  |  |   | 38.78     | %
|Costs of production, as a percent of principal (D)                                    |  |                                   | 2.91      | %  |                                     |   | 2.23      | %    |  |   | 3.20      | %  |  |   | 1.82      | %

---

|(A) | Excludes the MTA bulk purchased loans in the first quarter of 2006.
|--- | -------------------------------------------------------------------

|(B) | This metric is defined in Table 4.
|--- | ----------------------------------

|(C) | This metric is defined in Table 3.
|--- | ----------------------------------

|(D) | This metric is defined in Table 11.
|--- | -----------------------------------

For the Six Months Ended
June 30, 2007 as Compared to the Six Months Ended June 30, 2006.

Net loss available to common shareholders increased by $65.6 million during
the six months ended June 30, 2007 as compared to the same period in 2006.

We incurred a significant pre-tax loss of $193.4 million during the six
months ended June 30, 2007 as compared to pre-tax income of $61.4 million for the same period in 2006. The following factors contributed to the current year loss and the decrease in pre-tax net income from the six months ended June 30,
2006:



| |  |  | An increase in our provision for credit losses for our mortgage loans held-in-portfolio of $83.6 million which was primarily due to the continued credit
deterioration in our mortgage loans held-in-portfolio.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | A net loss due to fair value adjustments of $26.2 million related to our trading securities and the asset-backed bonds issued in our CDO transaction executed during
the first six months of 2007. The trading securities had a negative fair value adjustment of approximately $89.7 million while the CDO asset-backed bonds had a positive fair value adjustment of $63.5 million. These adjustments were a result of
significant spread widening in the subprime mortgage market for these types of asset-backed securities.
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| |  |  | We incurred (losses) gains on sales of mortgage assets of ($12.4) million and $23.3 million for the first six months of 2007 and 2006, respectively. The loss in
2007 was primarily due to $5.1 million of losses on sales of real estate owned and a loss on our NMFT Series 2007-2 securitization of approximately $5.0 million. As default rates have increased so have the assets we have acquired through foreclosure
(real estate owned). The loss on the 2007-2 securitization resulted from the volatile and less liquid secondary market which adversely impacts secondary market execution and mortgage banking profit margins.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Higher delinquencies and thus higher expected credit losses as a result of the weakening housing market contributed to an increase in impairments in our mortgage
securities available-for-sale portfolio of $19.5 million from 2006.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | An increase in the charge to earnings from the lower of cost or market valuation adjustment on our mortgage loans held-for-sale of $24.4 million. The increase in
this adjustment was primarily the result of the significant decline in whole loan values in the first quarter of 2007 caused by investor concerns over deteriorating credit quality in the subprime whole loan secondary market.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | A decrease in gains recognized on derivative instruments which did not qualify for hedge accounting of $9.0 million from 2006. This change is solely driven by
short-term interest rate fluctuations on our inventory of derivative instruments.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

We recorded a significant tax benefit in the first six
months of 2007 of $186.6 million which includes a $117.0 million tax benefit related to our decision to de-REIT effective January 1, 2008 as previously discussed.

For the Three Months Ended June 30, 2007 as Compared to the Three Months Ended June 30, 2006.

Net loss
available to common shareholders increased by $87.6 million during the three months ended June 30, 2007 as compared to the same period in 2006.

We
incurred a significant pre-tax loss of $124.1 million during the three months ended June 30, 2007 as compared to pre-tax income of $40.8 million for the same period in 2006. The following factors contributed to the current year loss and the
decrease in pre-tax net income from the three months ended June 30, 2006:



| |  |  | An increase in our provision for credit losses for our mortgage loans held-in-portfolio of $67.2 million which was primarily due to the continued credit
deterioration in our mortgage loans held-in-portfolio.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | A net loss due to fair value adjustments of $16.7 million related to our trading securities and the asset-backed bonds issued in our CDO transaction executed during
the first six months of 2007. The trading securities had a negative fair value adjustment of approximately $39.7 million while the CDO asset-backed bonds had a positive fair value adjustment of $22.9 million. These adjustments were a result of
significant spread widening in the subprime mortgage market for these types of asset-backed securities.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We incurred (losses) gains on sales of mortgage assets of ($9.1) million and $23.3 million for the three months ended June 30, 2007 and 2006, respectively. The
loss in 2007 was primarily due to $3.7 million of losses on sales of real estate owned and a loss on our NMFT Series 2007-2 securitization of approximately $5.0 million. As default rates have increased so have the assets we have acquired through
foreclosure (real estate owned). The loss on the 2007-2 securitization resulted from the volatile and less liquid secondary market which adversely impacts secondary market execution and mortgage banking profit margins.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Higher delinquencies and thus higher expected credit losses as a result of the weakening housing market contributed to an increase in impairments in our mortgage
securities available-for-sale portfolio of $18.1 million from 2006.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | An increase in the charge to earnings from the lower of cost or market valuation adjustment on our mortgage loans held-for-sale of $6.2 million. The increase in
this adjustment was primarily the result of the significant decline in whole loan values caused by investor concerns over deteriorating credit quality in the subprime whole loan secondary market.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

We recorded a significant tax benefit in the three months ended June 30, 2007 of $71.2 million which includes a $32.8 million tax benefit related to our decision to
de-REIT effective January 1, 2008 as previously discussed.



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##### Table of Contents

Industry Overview and Known Material Trends

Described below are some of the marketplace conditions, known material trends and uncertainties that may impact our future results of operations as we move into the third quarter of 2007.



| |  |  | Conditions in the secondary markets, which had stabilized throughout the second quarter, have worsened early in the third quarter as investor concerns increase over
subprime asset quality and a weakening of the United States housing market. As a result of the many uncertainties in the subprime mortgage market (i.e. home price appreciation, home sales, credit quality, interest rates), bond investors continue to
drive bond spreads dramatically wider in the first part of the third quarter. As a result, the capital markets remain very volatile and less liquid and, at times have been and may in the future be effectively unavailable to us. We believe the
existing conditions in the secondary markets are unprecedented since our inception and, as such, inherently involve significant risks and uncertainty. These conditions could continue to adversely impact investors willingness to purchase bonds
backed by subprime loans and whole pools of mortgage loans, the profit margins of mortgage originations, and the amounts lenders are willing to finance on mortgage loans pending their sale or securitization. Until bond spreads return to more
rational levels, it will be difficult for us to execute securitizations and loan sales at favorable prices. As a result, subsequent to the end of the second quarter we have been forced to further alter our business strategies and operations in
response to market conditions. For example, due to the fact that we cannot sell or securitize the loans we originate at favorable prices, or at times at all, we have drastically reduced, and recently temporarily suspended for a few days, our
mortgage origination volumes and have made adjustments to our pricing and underwriting guidelines. In addition, until the secondary market returns to more rational levels, we may elect or be required to further alter the scope or nature of our
origination operations (including changes to our loan products), further tighten our origination guidelines, further raise our interest rates, further reduce our workforce or take other actions to align our operations with the current market
environment, including the sale of certain assets or businesses. We cannot currently predict the impact that any of those actions, if taken, would have on our financial condition, results of operations, liquidity or business prospects. In addition,
we may experience additional mark-to-market losses on our mortgage securities  trading and mortgage loans  held-for-sale which would likely result in further margin calls under our financing facilities.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | As discussed under Executive Overview of Performance, our liquidity position was also severely impacted because of the 2007 market disruptions. Recently
our principal lender has effectively reduced the amount we can borrow against our mortgage loans to 94% of the principal of the loan. To the extent that our lenders further reduce the value of our mortgage assets securing our warehouse repurchase
agreements or otherwise reduce the amount we can borrow against our assets, we could be subject to additional margin calls and the amounts we can borrow could be reduced, which could materially adversely affect our liquidity. See Liquidity and
Capital Resources.
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| |  |  | We initiated and completed a formal process to explore a range of strategic alternatives during the second quarter of 2007. Note 22 to the condensed consolidated
financial statements contains a description of the agreements that resulted from this process. To the extent that we are unable to consummate the transactions on the terms described in Note 22 our liquidity and financial condition will be
materially adversely affected. In addition, current industry conditions may cause us to consider other additional alternatives.
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| |  |  | As discussed under Executive Overview of Performance, as a result of the implementation of tighter origination guidelines, our origination volumes have
substantially decreased in the first and second quarter of 2007. Loan originations were $2.2 billion and $0.8 billion during the six and three months ended June 30, 2007, respectively, as compared to $4.7 billion and $2.8 billion during the six
and three months ended June 30, 2006, respectively. We expect that the changes we have made to our pricing and underwriting guidelines will restrict further the number of borrowers who qualify for our loans. As a result we expect our third
quarter origination volume will be lower than in the second quarter and that our cost to fund loans will increase in the third quarter. Those changes may also expose us to further competition which could further adversely affect our origination
business. By having lower originations, we necessarily will have fewer loans to securitize. Because we depend on our securitizations to increase the size of our mortgage securities portfolio, we expect that the size of our mortgage portfolio will
decline in future periods as our older mortgage securities mature and we are unable to replace them with additional mortgage securities.
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| |  |  | Industry-wide tightening of underwriting guidelines and increases in interest rates may decrease refinancing opportunities for existing borrowers, which may result
in fewer loans and increased defaults by borrowers, particularly those facing a resetting of their existing loan to a higher monthly payment. If borrower defaults continue or increase, our financial condition, liquidity and business prospects will
be further adversely affected.
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| |  |  | As discussed under Executive Overview of Performance, our Board of Directors approved a formal plan to voluntarily revoke our REIT status effective
January 1, 2008. In order to voluntarily revoke REIT status, we must file such revocation with the Internal Revenue Service within 90 days of the beginning of the first tax year for which the revocation is to be effective. We will continue to
be subject to the REIT dividend distribution requirements for 2007 which require us to distribute at least 90 percent of our 2007 taxable income by the end of 2008 in order to retain our REIT status for 2007. We expect little or no taxable income in
2007. Once we are a C corporation, payment of future dividends will be at the discretion of our board of directors. As a result shareholders should not expect to receive dividends with respect to these future periods.
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| |  |  | Along with several other industry competitors, we terminated our 2/28 product in July 2007 due to investor, regulatory and rating agency concerns. The 2/28 product
carries a fixed rate for the first two years of its life and then adjusts after two years based on an index rate. We intend to convert all of the 2/28 product existing in our mortgage loansheld-for-sale to a 3 year fixed product. The 2 year
fixed product represents approximately 67% of the total principal of our mortgage loans  held-for-sale as of June 30, 2007. We do not expect this decision to have a material impact on our financial condition or results of operations.
However, there can be no assurance that we will not have to further alter our existing products as a result of investor, regulatory or rating agency concerns and that such an alteration will not negatively affect our results of operations, liquidity
or financial condition.
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| |  |  | We have previously announced our intent to pay the required dividend with respect to our 2006 REIT taxable income by issuing preferred stock. If we are unable to
declare this dividend for any reason, the Investors may not be obligated to purchase any shares of our Series D-2 Preferred Stock pursuant to the Standby Purchase Agreement, and our status as a REIT will be jeopardized. These events will further
undermine our financial condition and business prospects.
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Company Overview

We operate as a specialty finance company that originates, purchases, securitizes, sells, invests in and services residential nonconforming loans. We offer a wide range
of mortgage loan products to borrowers, commonly referred to as nonconforming borrowers, who generally do not satisfy the credit, collateral, documentation or other underwriting standards prescribed by conventional mortgage lenders and
loan buyers, including United States of America government-sponsored entities such as Fannie Mae or Freddie Mac.

We operate three core businesses:



| |  | Mortgage portfolio management
|- |  | -----------------------------



| |  | Mortgage lending
|- |  | ----------------



| |  | Loan servicing
|- |  | --------------

Segment information regarding these
businesses for the three months and six months ended June 30, 2007 and 2006 is included in Note 18 to our condensed consolidated financial statements.

Mortgage Portfolio Management

We operate as a long-term mortgage securities and mortgage loan portfolio investor. 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). We have historically financed our investment in these mortgage securities by issuing asset-backed bonds (ABB), debt and capital
stock and by entering into repurchase agreements. Our mortgage portfolio management operations generate earnings primarily from the interest income generated from our mortgage securities and mortgage loan portfolios.

In 2005 we began retaining various subordinated securities from our securitization transactions. In 2006, we began purchasing subordinated ABS of other ABS issuers. We
will continue to acquire, retain, and aggregate ABS with the intention of securing non-recourse long-term financing through collateralized debt obligation (CDO) securitizations. In the future, we may enter into derivative transactions
referencing third party ABS, commonly referred to as synthetic assets. We also intend to retain the risk of the underlying securities by investing in the equity and subordinated debt of CDO securitizations. CDO equity securities bear the
first-loss and second-loss credit risk with respect to the securities owned by the securitization entity. Our goal is to leverage our extensive



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portfolio management experience by purchasing securities that are higher in the capital structure than our residual securities and executing CDOs for
long-term non-recourse financing, thereby generating good risk-adjusted returns. We closed our first CDO securitization which was structured as a financing transaction on February 8, 2007.

The long-term mortgage loan portfolio on our balance sheet consists of mortgage loans classified as held-in-portfolio resulting from securitization transactions treated
as financings completed in the second quarter of 2006 and the first quarter of 2007 (NHES Series 2006-1, NHES Series 2006-MTA1, NHES Series 2007-1). We have financed our investment in these loans by issuing ABB.

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

Mortgage
Lending

The mortgage lending operation is significant to our financial results as it produces loans that ultimately collateralize the mortgage
securities that we hold in our portfolio. The loans we originate and purchase are sold, either in securitization transactions structured as sales or financing transactions, or are sold outright to third parties. We finance the loans we originate and
purchase by using warehouse repurchase agreements on a short-term basis. For long-term financing, we securitize our mortgage loans and issue ABB.

Our
mortgage lending operations generate earnings primarily from securitizing and selling loans for a premium. We also earn revenue from fees from loan originations and interest income on mortgage loans held-for-sale. The timing, size and structure of
our securitization transactions have a significant impact on the gain on sale recognized and ultimately the profitability of this segment. In addition the market prices for whole loans and short-term interest rates have a significant impact on this
segments profitability.

Our mortgage lending segment originates and purchases primarily nonconforming, single-family residential mortgage loans. Our
mortgage lending operation continues to innovate in loan origination. Our lending decisions are driven by three primary objectives:



| |  |  | Originating loans that perform in line with expectations,
| | - |  | ---------------------------------------------------------



| |  |  | Maintaining economically sound pricing (profitable coupons), and
| | - |  | ----------------------------------------------------------------



| |  |  | Controlling costs of origination.
| | - |  | ---------------------------------

In our
nonconforming lending operations, we lend to individuals who generally do not qualify for agency/conventional lending programs because of a lack of available documentation, previous credit difficulties or higher loan-to-value (LTV)
ratios. These types of borrowers are generally willing to pay higher mortgage loan origination fees and interest rates than those charged by conventional lenders. Because these borrowers typically use the proceeds of the mortgage loans to
consolidate debt and to finance home improvements, education and other consumer needs, loan volume is generally less dependent on general levels of interest rates or home sales and therefore less cyclical than conventional mortgage lending. However,
loan volume is dependent, in a large part, on the value of the home securing the loan and the creditworthiness of the borrower. To the extent that home values do not rise, or actually decline, or borrowers do not satisfy our underwriting guidelines,
the volume and value of loans originated will decline.

Our nationwide loan origination network includes wholesale loan brokers, mortgage lenders, and
correspondent institutions, all of which are independent of any of the NovaStar Financial entities, as well as our own direct to consumer operations. Our sales force, which includes account executives in 35 states, develops and maintains
relationships with this network of independent retail brokers. Our correspondent origination channel consists of a network of institutions from which we purchase nonconforming mortgage loans on a bulk or flow basis. Our direct to consumer operations
channel consists of call centers where we contact potential borrowers as well as a network of branch operations which we acquired in the fourth quarter of 2006 in order to expand this origination channel.

We underwrite, process, fund and service the nonconforming mortgage loans sourced through our network of wholesale loan brokers and mortgage lenders and our direct to
consumer operations in centralized facilities.

See Industry Overview and Known Material Trends for discussion of significant current events
relating to the mortgage lending segment.



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Loan Servicing

Management believes loan servicing remains a critical part of our business operation because maintaining contact with our borrowers is critical in managing credit risk and for borrower retention. Nonconforming borrowers are more prone to
late payments and are more likely to default on their obligations than conventional borrowers. By servicing our loans, we strive to identify problems with borrowers early and take quick action to address problems. In addition, borrowers may be
motivated to refinance their mortgage loans either by improving their personal credit or due to a decrease in interest rates. By keeping in close touch with borrowers, we can provide them with information about NovaStar Financial products to
encourage them to refinance with us.

We retain the servicing rights with respect to the loans we securitize. Mortgage servicing yields fee income for us
in the form of contractual fees approximating 0.50% of the outstanding balance of loans we service that have been securitized. In addition we receive fees paid by borrowers for normal customer service and processing fees. We also earn interest
income on funds we hold as custodian as part of the servicing process.

Critical Accounting Estimates

We prepare our condensed 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 condensed consolidated financial statements and the reported amounts of income, expenses and other comprehensive
income during the periods presented. The following summarizes the components of our condensed consolidated financial statements where understanding accounting policies is critical to understanding and evaluating our reported financial results,
especially given the significant estimates used in applying the policies. The discussion is intended to demonstrate the significance of estimates to our financial statements and the related accounting policies. Our critical accounting estimates
impact each of our three reportable segments; our mortgage portfolio management, mortgage lending and loan servicing segments. Management has discussed the development and selection of these critical accounting estimates with the audit committee of
our Board of Directors and the audit committee has reviewed our disclosure.

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

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



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



| |  | Does the transferee have the right to pledge or exchange the transferred assets?
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| |  | Is there a call agreement that requires the transferor to return specific assets?
|- |  | -----------------------------------------------------------------------------------



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



| |  | Have any derivative instruments been transferred?
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When these transfers are executed in a manner such that we have surrendered control over the collateral, the transfer is
accounted for as a sale. In accordance with SFAS 140, a gain or loss on the sale is recognized based on the carrying amount of the financial assets involved in the transfer, allocated between the assets transferred and the retained interests based
on their relative fair value at the date of transfer. In a securitization accounted for as a sale, we retain the right to service the underlying mortgage loans and we also retain certain mortgage securities issued by the trust. As previously
discussed, the gain recognized upon a securitization structured as a sale depends on, among other things, the estimated fair value of the components of the securitization  the loans or mortgage securities and derivative instruments
transferred, the securities retained and the mortgage servicing rights. The estimated fair value of the securitization components is considered a critical accounting estimate as 1) these gains or losses can represent a significant
portion of our operating results and 2) the valuation assumptions used regarding economic conditions and the make-up of the collateral, including interest rates, principal payments, prepayments and loan defaults are highly uncertain and require a
large degree of judgment.

We use two methodologies for determining the initial value of our residual securities 1) the whole loan price methodology and 2)
the discount rate methodology. We believe the best estimate of the initial value of the residual securities we retain in our securitizations accounted for as a sale is derived from the market value of the pooled loans. As such, we generally will try
to use the whole loan price methodology when significant open market sales pricing data is available. Under this method, the initial value of the loans transferred in a securitization accounted for as a sale is estimated based on the expected open
market sales price of a similar pool. In open market transactions, the purchaser has the right to reject loans at its discretion. In a loan securitization, loans generally cannot be rejected. As a result, we adjust the market price for the loans to
compensate for the estimated value of rejected loans. The market price of the securities retained is derived by deducting the percent of net proceeds received in the securitization (i.e. the economic value of the loans transferred) from the
estimated adjusted market price for the entire pool of the loans.

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

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

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

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

The weighted average net whole loan market price used in the initial valuation of our retained securities was 99.33 for the six and three months ended June 30, 2007 compared to 101.94 and 102.03 for the same
periods of 2006. The weighted average initial implied discount rate for the six and three months ended June 30, 2007 was 20% as compared to 15% for the same periods of 2006. The decrease in the whole loan price used in the initial valuation of
our retained securities is partially due to the increase in short-term interest rates. If the whole loan market price used in the initial valuation of our residual securities for the three months ended June 30, 2007 had been increased or
decreased by 50 basis points, the initial value of our residual securities and the gain we recognized would have increased or decreased by approximately $7.0 million.



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

Mortgage Securities  Available-for-Sale and Trading. Our mortgage
securities  available-for-sale and trading represent beneficial interests we retain 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 retain in securitization transactions structured as sales primarily consist of the right to receive the future cash flows from a pool of securitized mortgage loans which include:



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



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



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

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

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 fair, but can provide no assurance that future changes in interest rates, prepayment and loss experience or changes in the market discount rate will not require
write-downs of the residual assets. For mortgage securities classified as available-for-sale, impairments would reduce income in future periods when deemed other-than-temporary.



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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, the 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.

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. When we retain new residual securities during a period when short-term interest
rate increases are greater than anticipated by the forward yield curve, we generally are more susceptible to impairments on our newer mortgage securities as they do not have sizable unrealized gains to help offset the decline in value.

As of June 30, 2007 and 2006 the weighted average discount rate used in valuing our residual securities was 19% and 17%, respectively. The weighted-average
constant prepayment rate used in valuing our residual securities as of June 30, 2007 was 43% versus 49% as of June 30, 2006. If the discount rate used in valuing our residual securities as of June 30, 2007 had been increased by 5%,
the value of our mortgage securities- available-for-sale would have decreased by approximately $11.9 million. If we had decreased the discount rate used in valuing our residual securities by 5%, the value of our residual securities would have
increased by approximately $13.7 million.

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

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. We pay mortgage insurance premiums on a portion of the loans maintained on our balance sheet and have included the
cost of mortgage insurance in our income statement.

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. If actual losses increase or if values reasonably expected to
be obtained from property sales decrease, the provision for losses would increase. Any increase in the provision for losses would adversely affect our results of operations.



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

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

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

Derivative instruments that meet the hedge accounting criteria of SFAS 133 are considered cash flow hedges. We also have derivative instruments
that do not meet the requirements for hedge accounting. However, these derivative instruments do contribute to our overall risk management strategy by serving to reduce interest rate risk on average short-term borrowings collateralized by our loans
held-for-sale.

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

Mortgage Servicing Rights (MSRs).Beginning in 2007, due to the
adoption of SFAS 156, MSRs are initially recorded at fair value. Prior to 2007, MSRs were initially recorded at allocated cost based upon the relative fair values of the transferred loans, derivative instruments and the servicing rights.
Additionally, we elected to continue to amortize our MSRs in proportion to and over the projected net servicing revenues as opposed to the fair value method as allowed under SFAS 156. Periodically, we evaluate the carrying value of originated
MSRs based on their estimated fair value. If the estimated fair value, using a discounted cash flow methodology, is less than the carrying amount of the mortgage servicing rights, the mortgage servicing rights are written down to the amount of
the estimated fair value. For purposes of evaluating and measuring impairment of MSRs we stratify the mortgage servicing rights based on their predominant risk characteristics. The most predominant risk characteristic considered is period of
origination. The mortgage loans underlying the MSRs are pools of homogeneous, nonconforming residential loans.

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

Deferred Tax Asset, net. NFI has elected to be
treated as a REIT for federal income tax purposes. NFI is not required to pay any corporate level income taxes as long as we remain a REIT and distribute 100 percent of our taxable income in the form of dividend distributions to our shareholders.

We record 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 is recognized for all future taxable temporary differences, while a deferred tax asset is recognized for all future deductible temporary differences, operating loss carryforwards and tax credit



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carryforwards. In accordance with FAS 109, we record 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.

As of June 30, 2007 and December 31, 2006, our
net deferred tax asset (excluding valuation allowance and deferred taxes related to unrealized gains on available for sale securities) was $252.0 million and $49.7 million, respectively.

Deferred taxes are required to be determined for each tax-paying component of a consolidated entity. The REIT and the taxable REIT subsidiary have previously been viewed as two separate components for this purpose.
Historically, we have recorded deferred taxes only at the TRS. Conversely, prior to 2007, we have not recorded deferred taxes at the REIT because of our intent to operate NFI as a REIT.

On May 3, 2007, our Board of Directors approved a resolution enabling management to take the necessary steps to revoke NFIs REIT election effective January 1, 2008. Management intends to carry out this
plan.

The decision to revoke NFIs REIT status was based on several significant factors. First, operating as a REIT restricts our ability to operate
the business. The REIT source of income tests and diversification of assets tests not only limits our ability to hedge our interest rate risk, but also unduly restricts our ability to efficiently manage our portfolio management business. Second,
since we are required to distribute most of our earnings in the form of dividends to shareholders to comply with REIT distribution requirements, our ability to retain capital to grow our business is significantly reduced. Third, our projections
demonstrate that we will not generate taxable income at the REIT from 2007 through 2011. This is due primarily to the expected reversal of deductible temporary differences that have accumulated over the past several years. In years prior to 2007, we
experienced significantly higher taxable income compared to financial statement income. This was due primarily to timing differences between financial statement and income tax recognition of income and losses on our portfolio of interest-only
mortgage securities. Without taxable income, we will not have a requirement to distribute dividends to shareholders.

Because of our decision to revoke
NFIs REIT status effective January 1, 2008, we scheduled the reversal of deductible and taxable temporary differences as of December 31, 2006 (as well as new temporary differences originating during 2007) for amounts to be realized
during our final calendar year as a REIT and for amounts to be realized in subsequent taxable years. NFI will be taxable as a C corporation in the tax year the revocation of its REIT election is effective (2008) and for subsequent taxable
years. Accordingly, NFI recorded deferred taxes as of June 30, 2007 based on estimated cumulative temporary differences at January 1, 2008 that are expected to reverse in a subsequent taxable year.

All differences between financial statement carrying amounts and tax bases (i.e. cumulative temporary differences or CTDs) accumulated as of
December 31, 2006 were based on actual financial statement balances and our best estimate of income tax balances, as we have yet to file our 2006 REIT income tax return. These CTDs were then rolled forward through January 1, 2008 for
what we estimate to be realized on NFIs final REIT return for 2007. In rolling forward the projected CTDs, we used estimates based on calendar year 2007 projections of financial statement income, securitization activity, interest income,
bad debt expenses, and other estimates. Such estimates were derived from information best available through June 30, 2007 as well as assumptions on information that is not yet available and are likely to change. It is reasonable to expect
changes to our estimate of the deferred tax assets and liabilities in the remaining 2007 interim periods, as actual information becomes available. Such changes will affect our income tax expense and will increase the volatility of the effective tax
rate during 2007.

Based on our estimate of temporary differences as of June 30, 2007, NFI will have approximately $328.6 million of net future
deductible timing differences remaining at January 1, 2008. Accordingly NFI recorded a net deferred tax asset of $123.8 million (excluding the deferred tax liability on unrealized gains from available for sale securities of $6.8 million) using
an effective tax rate of approximately 37.7%. The effective tax rate of 37.7% was calculated by including the REIT in consolidated/combined tax returns with the TRS beginning in 2008. The change in the projected temporary difference for the REIT
from $253.2 as of March 31, 2007 to $328.6 as of June 30, 2007 was a result of changes in REIT pre-tax book income for 2007 and basis differences in our mortgage securities. The primary differences for the changes were due to (1) GAAP
impairments; (2) changes to projected cash flows; and (3) changes in accrual rates on securities.

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. FASB Statement No. 109 Accounting for Income Taxes (FAS 109) requires the recognition of a
valuation allowance if it is more likely than not that all or some portion of the deferred tax asset will not be realized. FAS 109 indicates the more likely than not threshold is a level of likelihood that is more than 50 percent.

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



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

We examine and weigh all available evidence (both positive and negative and both historical and forecasted) in the process of determining whether it is more likely than
not that a deferred tax asset will be realized. 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 FAS 109 in determining the
amount of valuation allowance to be recorded. Alternative sources of taxable income identified in FAS 109 include the following: 1) taxable income in prior carryback year, 2) future reversals of existing taxable temporary differences, 3) future
taxable income exclusive of reversing temporary differences and carryforwards, and 4) tax planning strategies.

As a result of the decision to revoke our
REIT election effective January 1, 2008, we evaluated the positive and negative evidence as of June 30, 2007 on a combined enterprise basis (i.e. the REIT and the TRS) to form its conclusion. We have not generated a cumulative loss in
recent years. In addition, we have never experienced the expiration of a net operating loss in a significant taxing jurisdiction. The fact that we have not experienced a cumulative loss in recent years is significant objective evidence in evaluating
the need for a valuation allowance.

In determining the amount of valuation allowance to record as of June 30, 2007, if any, we concluded the weight
given to the positive evidence supports a conclusion that it is more likely than not that $248.7 million of the net deferred tax asset (excluding the deferred tax liability on unrealized gains from available for sale securities of $2.5 million) of
$252.0 million as of June 30, 2007 will be realized. Based on these conclusions, we recorded a valuation allowance for deferred tax assets as of June 30, 2007 and December 31, 2006 of $3.3 million and $0.7 million, respectively. The
valuation allowance recorded by us relates to various separate company state net operating losses for which it determined it was more likely than not that such state net operating losses would not be realized.

In all future interim periods, we will continue to monitor all factors that impact positive and negative evidence relating to our deferred tax assets. If management
concludes at any point in the future that negative evidence outweighs positive evidence, we may need to record a valuation allowance on some or our entire entire deferred tax asset. Factors that may lead to a change from positive to negative
evidence include, but are not limited to: cumulative losses in recent years, losses expected in future years, a brief carryforward period, and significant differences from projected GAAP income or loss.

Impact of Recently Issued Accounting Pronouncements

In February
2006, the FASB issued SFAS 155, an amendment of SFAS No. 133 and SFAS No. 140. This statement permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require
bifurcation. It also clarifies which interest-only strips and principal-only strips are not subject to SFAS 133. The statement also establishes a requirement to evaluate interests in securitized financial assets to identify interests that are
freestanding derivatives or hybrid financial instruments that contain an embedded derivative requiring bifurcation. The statement also clarifies that concentration of credit risks in the form of subordination are not embedded derivatives, and it
also amends SFAS 140, to eliminate the prohibition on a QSPE from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument.



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In January 2007, the FASB provided a scope exception under SFAS 155 for securitized interests that only contain an
embedded derivative that is tied to the prepayment risk of the underlying prepayable financial assets, and for which the investor does not control the right to accelerate the settlement. If a securitized interest contains any other embedded
derivative (for example, an inverse floater), then it would be subject to the bifurcation tests in SFAS 133, as would securities purchased at a significant premium. The adoption of this standard on January 1, 2007 did not have a
significant impact on our financial position, results of operations or cash flows. However, to the extent that certain of our future investments in securitized financial assets do not meet the scope exception adopted by the FASB, our future results
of operations may exhibit volatility if such investments are required to be bifurcated or marked to market value in their entirety through the income statement, depending on the election made by us.

In March 2006, the FASB issued SFAS 156. This statement requires that an entity separately recognize a servicing asset or a servicing liability when it undertakes an
obligation to service a financial asset under a servicing contract in certain situations. Such servicing assets or servicing liabilities are required to be initially measured at fair value, if practicable. SFAS 156 also allows an entity to choose
one of two methods when subsequently measuring its servicing assets and servicing liabilities: (1) the amortization methodor (2) the fair value measurement method. The amortization method existed under SFAS 140 and remains
unchanged in (1) allowing entities to amortize their servicing assets or servicing liabilities in proportion to and over the period of estimated net servicing income or net servicing loss and (2) requiring the assessment of those servicing
assets or servicing liabilities for impairment or increased obligation based on fair value at each reporting date. The fair value measurement method allows entities to measure their servicing assets or servicing liabilities at fair value at each
reporting date and report changes in fair value in earnings in the period the change occurs. SFAS 156 introduces the notion of classesand allows companies to make a separate subsequent measurement election for each class of its servicing
rights. In addition, SFAS 156 requires certain comprehensive roll-forward disclosures that must be presented for each class. The Statement is effective as of the beginning of an entitys first fiscal year that begins after September 15,
2006. We adopted SFAS 156 on January 1, 2007 and elected to continue using the amortization method for measuring its servicing assets.

In June 2006,
the FASB issued FIN 48. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or to be taken on a tax return. This interpretation also provides additional
guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation is effective for fiscal years beginning after December 15, 2006. We adopted the provisions of FIN
48 on January 1, 2007. The cumulative effect of applying the provisions of FIN 48 is reported as an adjustment to the opening balance of accumulated deficit on January 1, 2007 and resulted in an increase to our accumulated deficit of $1.1
million.

In September 2006, the FASB issued SFAS 157. SFAS 157 establishes a framework for measuring fair value and requires expanded disclosures
regarding fair value measurements. This accounting standard is effective for financial statements issued for fiscal years beginning after November 15, 2007, however early adoption is permitted. We adopted the provisions of SFAS 157 on
January 1, 2007. See Note 9 which describes the impact of the adoption of SFAS 157 on our condensed consolidated financial statements.

In September
2006, the SEC issued SAB No. 108. SAB No. 108 provides guidance regarding the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of materiality assessments. The method
established by SAB No. 108 requires each of our financial statements and the related financial statement disclosures to be considered when quantifying and assessing the materiality of the misstatement. The provisions of SAB No. 108 are
effective for financial statements issued for fiscal years beginning after December 31, 2006. We adopted SAB No. 108 on January 1, 2007 and have deemed the impact immaterial on our condensed consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilitiesincluding an
amendment of FASB Statement No. 115 (SFAS 159). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. Unrealized gains and losses on items for which the fair value
option has been elected will be recognized in earnings at each subsequent reporting date. This accounting standard is effective for financial statements issued for fiscal years beginning after November 15, 2007, however early adoption is
permitted. We adopted the provisions of SFAS 159 on January 1, 2007. See Note 9 which describes the impact of the adoption of SFAS 159 on our condensed consolidated financial statements.



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On July 24, 2007, the FASB released FSP 140-d. The FSP focuses on the circumstances that would permit a transferor
and a transferee to separately evaluate the accounting for a transfer of a financial asset and a repurchase financing under SFAS 140.The proposed FSP states that a transfer of a financial asset and a repurchase agreement involving the
transferred financial asset should be considered part of the same arrangement when the counterparties to the two transactions are the same unless certain criteria are met. The criteria in the proposed FSP are intended to identify whether
(1) there is a valid and distinct business or economic purpose for entering separately into the two transactions and (2) the repurchase financing does not result in the initial transferor regaining control over the previously transferred
financial assets. Its purpose is to limit diversity of practice in accounting for these situations, resulting in more consistent financial reporting. Consequently, it is the FASBs desire to have the proposed FSP effective as soon as
practicable. This FSP would be effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. Early application is not permitted.

During the first quarter of 2006, we purchased approximately $1.0 billion of mortgage loans from counterparties which were subsequently financed through repurchase
agreements with that same counterparty. As of June 30, 2007, the entire $1.0 billion of mortgage loans purchased during 2006 remained on our condensed consolidated balance sheet but they were no longer financed with repurchase agreements as
they had been securitized in transactions structured as financings and the short-term repurchase agreements were replaced with asset-backed bond financing. Additionally, we are still evaluating FSP 140-d but believe there would be no material change
to our financial statements based on this current proposal issued by the FASB.

Results of Operations  Consolidated Earnings Comparisons

Six Months Ended June 30, 2007 as Compared to the Six Months Ended June 30, 2006

See the Executive Overview of Performance for discussion of the results of operations for the six months ended June 30, 2007 as compared to the six
months ended June 30, 2006.

Three Months Ended June 30, 2007 as Compared to the Three Months Ended June 30, 2006

See the Executive Overview of Performance for discussion of the results of operations for the three months ended June 30, 2007 as compared to the three
months ended June 30, 2006.

Net Interest Income (Expense).

We earn interest income primarily on our mortgage assets which include mortgage securities available-for-sale, mortgage securities trading, mortgage loans held-in-portfolio and mortgage loans held-for-sale. In
addition we earn interest income on servicing funds we hold as custodian along with general operating funds. Interest expense consists primarily of interest paid on borrowings secured by mortgage assets, which includes warehouse repurchase
agreements and asset backed bonds.



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The following table provides the components of net interest income for the six and three months ended June 30, 2007
and 2006.

Table 2 Net Interest Income

(dollars in thousands)



|                                                       |  |                                   |         |   |                                     |   |         |      |  |   |         |   |  |   |         |  
|------------------------------------------------------ |  | --------------------------------- | ------- | - | ----------------------------------- | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                       |  | For the Six Months Ended June 30, |         |   | For the Three Months Ended June 30, |  
|                                                       |  | 2007                              |         |   | 2006                                |   |         | 2007 |  |   | 2006    |  
|Interest income:                                       |  |                                   |         |   |                                     |   |         |      |  |   |         |   |  |   |         |  
|Mortgage securities                                    |  | $                                 | 60,348  |   |                                     | $ | 83,988  |      |  | $ | 28,634  |   |  | $ | 41,413  |  
|Mortgage loans held-for-sale                           |  |                                   | 59,288  |   |                                     |   | 69,144  |      |  |   | 19,623  |   |  |   | 35,960  |  
|Mortgage loans held-in-portfolio                       |  |                                   | 123,740 |   |                                     |   | 48,409  |      |  |   | 73,760  |   |  |   | 46,607  |  
|Other interest income                                  |  |                                   | 18,140  |   |                                     |   | 15,922  |      |  |   | 8,462   |   |  |   | 8,811   |  
|                                                       |  |                                   |         |   |                                     |   |         |      |  |   |         |   |  |   |         |  
|Total interest income                                  |  |                                   | 261,516 |   |                                     |   | 217,463 |      |  |   | 130,479 |   |  |   | 132,791 |  
|                                                       |  |                                   |         |   |                                     |   |         |      |  |   |         |   |  |   |         |  
|Interest expense:                                      |  |                                   |         |   |                                     |   |         |      |  |   |         |   |  |   |         |  
|Short-term borrowings secured by mortgage loans        |  |                                   | 44,231  |   |                                     |   | 65,801  |      |  |   | 15,371  |   |  |   | 43,034  |  
|Short-term borrowings secured by mortgage securities   |  |                                   | 12,446  |   |                                     |   | 2,802   |      |  |   | 6,159   |   |  |   | 1,856   |  
|Other short-term borrowings                            |  |                                   | 857     |   |                                     |   | 21      |      |  |   | 612     |   |  |   | 21      |  
|Asset-backed bonds secured by mortgage loans           |  |                                   | 91,306  |   |                                     |   | 17,672  |      |  |   | 52,555  |   |  |   | 17,344  |  
|Asset-backed bonds secured by mortgage securities      |  |                                   | 7,867   |   |                                     |   | 3,023   |      |  |   | 5,152   |   |  |   | 1,206   |  
|Junior subordinated debentures                         |  |                                   | 4,057   |   |                                     |   | 2,872   |      |  |   | 2,035   |   |  |   | 1,801   |  
|                                                       |  |                                   |         |   |                                     |   |         |      |  |   |         |   |  |   |         |  
|Total interest expense                                 |  |                                   | 160,764 |   |                                     |   | 92,191  |      |  |   | 81,884  |   |  |   | 65,262  |  
|                                                       |  |                                   |         |   |                                     |   |         |      |  |   |         |   |  |   |         |  
|Net interest income before provision for credit losses |  |                                   | 100,752 |   |                                     |   | 125,272 |      |  |   | 48,595  |   |  |   | 67,529  |  
|Provision for credit losses                            |  |                                   | (93,167 | ) |                                     |   | (9,590  | )    |  |   | (73,254 | ) |  |   | (6,045  | )
|                                                       |  |                                   |         |   |                                     |   |         |      |  |   |         |   |  |   |         |  
|Net interest income (expense)                          |  | $                                 | 7,585   |   |                                     | $ | 115,682 |      |  | $ | (24,659 | ) |  | $ | 61,484  |  
|                                                       |  |                                   |         |   |                                     |   |         |      |  |   |         |   |  |   |         |  

Our net interest income (expense) decreased to $7.6 million and ($24.7) million for the six and three months ended
June 30, 2007, respectively, from $115.7 million and $61.5 million for the same periods in 2006. Interest income on mortgage loans held-in-portfolio increased for the six and three months ended June 30, 2007 from the same periods of 2006
as a result of higher average mortgage loan balances due to the on balance sheet securitizations we executed in 2006 and 2007. This increase was offset by lower interest income from our mortgage securities due to the addition of lower-yielding
securities and credit deterioration and lower interest from our mortgage loans  held-for-sale due to lower originations. This increase in interest income was further offset by an increase in interest expense as a result of higher average
outstanding debt balances as well as an increased cost of financing. Another major driver in the decline in net interest income (expense) from 2006 was the fact that we experienced a significant increase in our provision for credit losses, which was
a result of the NHEL 2007-1 securitization being structured as a financing transaction as well as overall credit deterioration in the mortgage loan portfolio.



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Activity in the allowance for credit losses on mortgage loans  held-in-portfolio is as follows for the six and
three months ended June 30, 2007 and 2006, respectively (dollars in thousands):



|                             |  |                                  |         |   |                                    |   |       |      |  |   |         |   |  |   |       |  
|---------------------------- |  | -------------------------------- | ------- | - | ---------------------------------- | - | ----- | ---- |  | - | ------- | - |  | - | ----- | -
|                             |  | For the Six MonthsEnded June 30, |         |   | For the Three MonthsEnded June 30, |  
|                             |  | 2007                             |         |   | 2006                               |   |       | 2007 |  |   | 2006    |  
|Balance, beginning of period |  | $                                | 22,452  |   |                                    | $ | 699   |      |  | $ | 34,911  |   |  | $ | 4,137 |  
|Provision for credit losses  |  |                                  | 93,167  |   |                                    |   | 9,590 |      |  |   | 73,254  |   |  |   | 6,045 |  
|Charge-offs                  |  |                                  | (16,524 | ) |                                    |   | (503  | )    |  |   | (8,941  | ) |  |   | (390  | )
|Recoveries                   |  |                                  | 1,001   |   |                                    |   | 113   |      |  |   | 872     |   |  |   | 107   |  
|                             |  |                                  |         |   |                                    |   |       |      |  |   |         |   |  |   |       |  
|Balance, end of period       |  | $                                | 100,096 |   |                                    | $ | 9,899 |      |  | $ | 100,096 |   |  | $ | 9,899 |  
|                             |  |                                  |         |   |                                    |   |       |      |  |   |         |   |  |   |       |  

As shown in table 3, below, our average net security yield decreased to 13.58% and 12.35% for the six and three
months ended June 30, 2007 from 38.03% and 38.78% for the same periods of 2006. The decrease in our average security yield for the six and three months ended June 30, 2007 compared to the same periods in 2006 is primarily a result of
margin compression caused by credit deterioration as well as our retention and purchase of lower-yielding residual and subordinated securities.

The
following table presents the average balances for our mortgage securities, mortgage loans held-for-sale, mortgage loans held-in-portfolio and our repurchase agreement and securitization financings for those assets with the corresponding yields for
the six and three months ended June 30, 2007 and 2006. The interest income and expense used in the calculations includes the effects of premium amortization, discount accretion, debt issuance cost amortization and commitment fees on warehouse
lines of credit.



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Table 3 Net Interest Income Analysis

(dollars in thousands)



|                                                                 |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|---------------------------------------------------------------- |  | --------------------------------- | --------- | - | ----------------------------------- | - | --------- | ---- |  | - | --------- | - |  | - | --------- | -
|                                                                 |  | For the Six Months Ended June 30, |           |   | For the Three Months Ended June 30, |  
|                                                                 |  | 2007                              |           |   | 2006                                |   |           | 2007 |  |   | 2006      |  
|Mortgage securities interest analysis                            |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Average balances:                                                |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Mortgage securities (A)                                          |  | $                                 | 589,508   |   |                                     | $ | 411,061   |      |  | $ | 560,895   |   |  | $ | 395,528   |  
|Short-term borrowing secured by mortgage securities              |  |                                   | 307,480   |   |                                     |   | 95,946    |      |  |   | 238,393   |   |  |   | 119,242   |  
|Asset-backed bonds secured by mortgage securities                |  |                                   | 274,154   |   |                                     |   | 85,823    |      |  |   | 331,999   |   |  |   | 65,948    |  
|Yield analysis:                                                  |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Interest income (A)                                              |  |                                   | 20.47     | % |                                     |   | 40.86     | %    |  |   | 20.42     | % |  |   | 41.88     | %
|                                                                 |  |                                   |           |  
|Interest expense short-term borrowings                           |  |                                   | 8.10      | % |                                     |   | 5.84      | %    |  |   | 10.33     | % |  |   | 6.23      | %
|Interest expense asset-backed bonds                              |  |                                   | 5.74      | % |                                     |   | 7.04      | %    |  |   | 6.21      | % |  |   | 7.31      | %
|                                                                 |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Total financing expense                                          |  |                                   | 6.98      | % |                                     |   | 6.41      | %    |  |   | 7.93      | % |  |   | 6.61      | %
|                                                                 |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Net interest spread                                              |  |                                   | 13.49     | % |                                     |   | 37.66     | %    |  |   | 12.49     | % |  |   | 35.27     | %
|                                                                 |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Net yield (B)                                                    |  |                                   | 13.58     | % |                                     |   | 38.03     | %    |  |   | 12.35     | % |  |   | 38.78     | %
|                                                                 |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Mortgage loans held-for-sale interest analysis                   |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Average balances:                                                |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Mortgage loans held-for-sale                                     |  | $                                 | 1,385,387 |   |                                     | $ | 1,679,192 |      |  | $ | 1,000,493 |   |  | $ | 1,706,865 |  
|Short-term borrowings secured by mortgage loans held-for-sale    |  |                                   | 1,310,294 |   |                                     |   | 1,627,527 |      |  |   | 920,257   |   |  |   | 1,675,804 |  
|                                                                 |  |                                   |           |  
|Yield analysis:                                                  |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Interest income                                                  |  |                                   | 8.56      | % |                                     |   | 8.23      | %    |  |   | 7.84      | % |  |   | 8.43      | %
|Interest expense short-term borrowings                           |  |                                   | 6.65      | % |                                     |   | 5.67      | %    |  |   | 6.60      | % |  |   | 6.00      | %
|                                                                 |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Net interest spread                                              |  |                                   | 1.91      | % |                                     |   | 2.56      | %    |  |   | 1.24      | % |  |   | 2.43      | %
|                                                                 |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Net yield (B)                                                    |  |                                   | 2.27      | % |                                     |   | 2.74      | %    |  |   | 1.77      | % |  |   | 2.54      | %
|                                                                 |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Mortgage loans held-in-portfolio interest analysis               |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Average balances:                                                |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Mortgage loans held-in-portfolio                                 |  | $                                 | 3,118,527 |   |                                     | $ | 1,282,494 |      |  | $ | 3,603,865 |   |  | $ | 2,465,621 |  
|Asset-backed bonds secured by mortgage loans held-in-portfolio   |  |                                   | 3,139,907 |   |                                     |   | 636,399   |      |  |   | 3,610,951 |   |  |   | 1,240,249 |  
|Short-term borrowing secured by mortgage loans held-in-portfolio |  |                                   |          |   |                                     |   | 655,547   |      |  |   |          |   |  |   | 1,246,801 |  
|                                                                 |  |                                   |           |  
|Yield analysis:                                                  |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Interest income                                                  |  |                                   | 7.94      | % |                                     |   | 7.55      | %    |  |   | 8.19      | % |  |   | 7.56      | %
|                                                                 |  |                                   |           |  
|Interest expense asset-backed bonds                              |  |                                   | 5.82      | % |                                     |   | 5.55      | %    |  |   | 5.82      | % |  |   | 5.59      | %
|Interest expense short-term borrowings                           |  |                                   |          |   |                                     |   | 5.53      | %    |  |   |          |   |  |   | 5.55      | %
|                                                                 |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Total financing expense                                          |  |                                   | 5.82      | % |                                     |   | 5.54      | %    |  |   | 5.82      | % |  |   | 5.57      | %
|                                                                 |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Net interest spread                                              |  |                                   | 2.12      | % |                                     |   | 2.01      | %    |  |   | 2.37      | % |  |   | 1.99      | %
|                                                                 |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  
|Net yield (B)                                                    |  |                                   | 2.08      | % |                                     |   | 1.97      | %    |  |   | 2.35      | % |  |   | 1.94      | %
|                                                                 |  |                                   |           |   |                                     |   |           |      |  |   |           |   |  |   |           |  

---

|(A) | Consists of the average cost basis of our mortgage securities-available-for-sale portfolio as well as the average fair value of our mortgage securities trading portfolio. The yield
information does not give effect to the changes in fair value of our mortgage securities-available-for-sale portfolio which are reflected as a component of shareholders equity.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(B) | Net yield is calculated as the net interest income divided by the average daily balance of the asset. The net yield will not equal the net interest spread due to the difference in
denominators of the two calculations.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



61



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##### Table of Contents

Mortgage Portfolio Net Interest Income. Our portfolio income comes from mortgage loans either directly
(mortgage loans held-in-portfolio and mortgage loans held-for-sale) or indirectly (mortgage securities). Table 4 attempts to look through the balance sheet presentation of our portfolio income and present income as a percentage of average assets
under management. The net interest income for mortgage securities  available-for-sale, mortgage loans held-in-portfolio and mortgage loans held-for-sale reflects the income after interest expense, hedging and credit expense (mortgage insurance
and provision for credit losses). This metric allows us to be more easily compared to other finance companies or financial institutions that use on balance sheet portfolio accounting, where return on assets is a common performance calculation.

Our portfolio net interest yield on assets was (0.19%) and (0.88%) for the six and three months ended June 30, 2007, respectively, as compared to
1.36% for the six and three months ended June 30, 2006. The decrease in yield from the six and three months ended June 30, 2006 to 2007 can be attributed primarily to the credit deterioration in our portfolio which resulted in the
recording of a significantly higher provision for credit losses as well as the continued decline in yield on our mortgage securities due to credit deterioration and the addition of lower-yielding securities.

We generally expect our net interest yield on portfolio assets to be in the range of 1% to 1.25% over the long-term.

Table 4 shows the net interest yield on assets under management during the six and three months ended June 30, 2007 and 2006.

Table 4  Mortgage Portfolio Management Net Interest Income Analysis

(dollars in thousands)



|                                                            |  |                                         |            |   |                                  |   |           |                             |  |   |           |   |  |   |            |   
|----------------------------------------------------------- |  | --------------------------------------- | ---------- | - | -------------------------------- | - | --------- | --------------------------- |  | - | --------- | - |  | - | ---------- | --
|                                                            |  | MortgageSecurities
Available-for- Sale |            |   | MortgageLoans Held- in-Portfolio |   |           | MortgageLoansHeld-for- Sale |  |   | Total     |  
|For the Six Months Ended:                                   |  |                                         |            |   |                                  |   |           |                             |  |   |           |   |  |   |            |   
|June 30, 2007                                               |  |                                         |            |   |                                  |   |           |                             |  |   |           |   |  |   |            |   
|Interest income (A)                                         |  | $                                       | 37,215     |   |                                  | $ | 123,740   |                             |  | $ | 59,288    |   |  | $ | 220,243    |   
|Interest expense:                                           |  |                                         |            |   |                                  |   |           |                             |  |   |           |   |  |   |            |   
|Short-term borrowings                                       |  |                                         |           |   |                                  |   |          |                             |  |   | 44,231    |   |  |   | 44,231     |   
|Asset-backed bonds                                          |  |                                         |           |   |                                  |   | 91,306    |                             |  |   |          |   |  |   | 91,306     |   
|                                                            |  |                                         |            |   |                                  |   |           |                             |  |   |           |   |  |   |            |   
|Total interest expense (B)                                  |  |                                         |           |   |                                  |   | 91,306    |                             |  |   | 44,231    |   |  |   | 135,537    |   
|                                                            |  |                                         |            |   |                                  |   |           |                             |  |   |           |   |  |   |            |   
|Mortgage portfolio net interest income before other expense |  |                                         | 37,215     |   |                                  |   | 32,434    |                             |  |   | 15,057    |   |  |   | 84,706     |   
|Other expense (C)                                           |  |                                         |           |   |                                  |   | (99,270   | )                           |  |   | (1,224    | ) |  |   | (100,494   | ) 
|                                                            |  |                                         |            |   |                                  |   |           |                             |  |   |           |   |  |   |            |   
|Mortgage portfolio net interest income (expense)            |  | $                                       | 37,215     |   |                                  | $ | (66,836   | )                           |  | $ | 13,833    |   |  | $ | (15,788    | ) 
|                                                            |  |                                         |            |   |                                  |   |           |                             |  |   |           |   |  |   |            |   
|Average balance of the underlying loans                     |  | $                                       | 11,723,729 |   |                                  | $ | 3,118,527 |                             |  | $ | 1,385,387 |   |  | $ | 16,227,643 |   
|Net interest yield on assets                                |  |                                         | 0.63       | % |                                  |   | (4.29     | )%                          |  |   | 2.00      | % |  |   | (0.19      | )%
|                                                            |  |                                         |            |   |                                  |   |           |                             |  |   |           |   |  |   |            |   
|June 30, 2006                                               |  |                                         |            |   |                                  |   |           |                             |  |   |           |   |  |   |            |   
|Interest income (A)                                         |  | $                                       | 76,057     |   |                                  | $ | 48,409    |                             |  | $ | 69,144    |   |  | $ | 193,610    |   
|Interest expense:                                           |  |                                         |            |   |                                  |   |           |                             |  |   |           |   |  |   |            |   
|Short-term borrowings                                       |  |                                         |           |   |                                  |   | 17,964    |                             |  |   | 47,837    |   |  |   | 65,801     |   
|Asset-backed bonds                                          |  |                                         |           |   |                                  |   | 17,672    |                             |  |   |          |   |  |   | 17,672     |   
|                                                            |  |                                         |            |   |                                  |   |           |                             |  |   |           |   |  |   |            |   
|Total interest expense (B)                                  |  |                                         |           |   |                                  |   | 35,636    |                             |  |   | 47,837    |   |  |   | 83,473     |   
|                                                            |  |                                         |            |   |                                  |   |           |                             |  |   |           |   |  |   |            |   
|Mortgage portfolio net interest income before other expense |  |                                         | 76,057     |   |                                  |   | 12,773    |                             |  |   | 21,307    |   |  |   | 110,137    |   
|Other (expense) income (C)                                  |  |                                         |           |   |                                  |   | (11,868   | )                           |  |   | 2,371     |   |  |   | (9,497     | ) 
|                                                            |  |                                         |            |   |                                  |   |           |                             |  |   |           |   |  |   |            |   
|Mortgage portfolio net interest income                      |  | $                                       | 76,057     |   |                                  | $ | 905       |                             |  | $ | 23,678    |   |  | $ | 100,640    |   
|                                                            |  |                                         |            |   |                                  |   |           |                             |  |   |           |   |  |   |            |   
|Average balance of the underlying loans                     |  | $                                       | 11,848,826 |   |                                  | $ | 1,282,494 |                             |  | $ | 1,679,191 |   |  | $ | 14,810,511 |   
|Net interest yield on assets                                |  |                                         | 1.28       | % |                                  |   | 0.14      | %                           |  |   | 2.82      | % |  |   | 1.36       | % 
|                                                            |  |                                         |            |   |                                  |   |           |                             |  |   |           |   |  |   |            |   

---

|(A) | Does not include interest income from securities classified as trading and subordinated securities classified as available-for-sale.
|--- | ------------------------------------------------------------------------------------------------------------------------------------

|(B) | Does not include interest expense related to the junior subordinated debentures and interest expense on other short-term borrowings.
|--- | ------------------------------------------------------------------------------------------------------------------------------------

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



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|                                                                     |  |                                         |            |   |                                   |   |           |                             |  |   |           |   |  |   |            |   
|-------------------------------------------------------------------- |  | --------------------------------------- | ---------- | - | --------------------------------- | - | --------- | --------------------------- |  | - | --------- | - |  | - | ---------- | --
|                                                                     |  | MortgageSecurities
Available-for- Sale |            |   | Mortgage Loans Held- in-Portfolio |   |           | MortgageLoansHeld-for- Sale |  |   | Total     |  
|For the Three Months Ended:                                          |  |                                         |            |   |                                   |   |           |                             |  |   |           |   |  |   |            |   
|June 30, 2007                                                        |  |                                         |            |   |                                   |   |           |                             |  |   |           |   |  |   |            |   
|Interest income (A)                                                  |  | $                                       | 16,409     |   |                                   | $ | 73,760    |                             |  | $ | 19,623    |   |  | $ | 109,792    |   
|Interest expense:                                                    |  |                                         |            |   |                                   |   |           |                             |  |   |           |   |  |   |            |   
|Short-term borrowings                                                |  |                                         |           |   |                                   |   |          |                             |  |   | 15,371    |   |  |   | 15,371     |   
|Asset-backed bonds                                                   |  |                                         |           |   |                                   |   | 52,555    |                             |  |   |          |   |  |   | 52,555     |   
|                                                                     |  |                                         |            |   |                                   |   |           |                             |  |   |           |   |  |   |            |   
|Total interest expense (B)                                           |  |                                         |           |   |                                   |   | 52,555    |                             |  |   | 15,371    |   |  |   | 67,926     |   
|                                                                     |  |                                         |            |   |                                   |   |           |                             |  |   |           |   |  |   |            |   
|Mortgage portfolio net interest income before other (expense) income |  |                                         | 16,409     |   |                                   |   | 21,205    |                             |  |   | 4,252     |   |  |   | 41,866     |   
|Other (expense) income (C)                                           |  |                                         |           |   |                                   |   | (76,999   | )                           |  |   | 143       |   |  |   | (76,856    | ) 
|                                                                     |  |                                         |            |   |                                   |   |           |                             |  |   |           |   |  |   |            |   
|Mortgage portfolio net interest income                               |  | $                                       | 16,409     |   |                                   | $ | (55,794   | )                           |  | $ | 4,395     |   |  | $ | (34,990    | ) 
|                                                                     |  |                                         |            |   |                                   |   |           |                             |  |   |           |   |  |   |            |   
|Average balance of the underlying loans                              |  | $                                       | 11,385,161 |   |                                   | $ | 3,603,865 |                             |  | $ | 1,000,493 |   |  | $ | 15,989,520 |   
|Net interest yield on assets                                         |  |                                         | 0.58       | % |                                   |   | (6.20     | )%                          |  |   | 1.76      | % |  |   | (0.88      | )%
|                                                                     |  |                                         |            |   |                                   |   |           |                             |  |   |           |   |  |   |            |   
|June 30, 2006                                                        |  |                                         |            |   |                                   |   |           |                             |  |   |           |   |  |   |            |   
|Interest income (A)                                                  |  | $                                       | 36,722     |   |                                   | $ | 46,607    |                             |  | $ | 35,960    |   |  | $ | 119,289    |   
|Interest expense:                                                    |  |                                         |            |   |                                   |   |           |                             |  |   |           |   |  |   |            |   
|Short-term borrowings                                                |  |                                         |           |   |                                   |   | 17,288    |                             |  |   | 25,746    |   |  |   | 43,034     |   
|Asset-backed bonds                                                   |  |                                         |           |   |                                   |   | 17,344    |                             |  |   |          |   |  |   | 17,344     |   
|                                                                     |  |                                         |            |   |                                   |   |           |                             |  |   |           |   |  |   |            |   
|Total interest expense (B)                                           |  |                                         |           |   |                                   |   | 34,632    |                             |  |   | 25,746    |   |  |   | 60,378     |   
|                                                                     |  |                                         |            |   |                                   |   |           |                             |  |   |           |   |  |   |            |   
|Mortgage portfolio net interest income before other (expense) income |  |                                         | 36,722     |   |                                   |   | 11,975    |                             |  |   | 10,214    |   |  |   | 58,911     |   
|Other (expense) income (C)                                           |  |                                         |           |   |                                   |   | (8,266    | )                           |  |   | 1,896     |   |  |   | (6,370     | ) 
|                                                                     |  |                                         |            |   |                                   |   |           |                             |  |   |           |   |  |   |            |   
|Mortgage portfolio net interest income                               |  | $                                       | 36,722     |   |                                   | $ | 3,709     |                             |  | $ | 12,110    |   |  | $ | 52,541     |   
|                                                                     |  |                                         |            |   |                                   |   |           |                             |  |   |           |   |  |   |            |   
|Average balance of the underlying loans                              |  | $                                       | 11,334,835 |   |                                   | $ | 2,465,621 |                             |  | $ | 1,706,865 |   |  | $ | 15,507,321 |   
|Net interest yield on assets                                         |  |                                         | 1.30       | % |                                   |   | 0.59      | %                           |  |   | 2.84      | % |  |   | 1.36       | % 
|                                                                     |  |                                         |            |   |                                   |   |           |                             |  |   |           |   |  |   |            |   

---

|(A) | Does not include interest income from securities classified as trading and subordinated securities classified as available-for-sale.
|--- | ------------------------------------------------------------------------------------------------------------------------------------

|(B) | Does not include interest expense related to the junior subordinated debentures and interest expense on other short-term borrowings.
|--- | ------------------------------------------------------------------------------------------------------------------------------------

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



63



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Gains (Losses) on Sales of Mortgage Assets.The following table shows the changes and makeup of our
(losses) gains on sales of mortgage assets for the six and three months ended June 30, 2007 and June 30, 2006:

Table 5  (Losses)
Gains on Sales of Mortgage Assets

(dollars in thousands)



|                                                                         |  |                                  |         |   |                                    |   |        |      |  |   |        |   |  |   |        |  
|------------------------------------------------------------------------ |  | -------------------------------- | ------- | - | ---------------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                         |  | For the Six MonthsEnded June 30, |         |   | For the Three MonthsEnded June 30, |  
|                                                                         |  | 2007                             |         |   | 2006                               |   |        | 2007 |  |   | 2006   |  
|Gains on sales of mortgage loans to third parties                        |  | $                                | 1,253   |   |                                    | $ | 7,327  |      |  | $ | 52     |   |  | $ | 6,048  |  
|Provision for repurchased loans                                          |  |                                  | (3,611  | ) |                                    |   | (1,152 | )    |  |   | (523   | ) |  |   | (51    | )
|(Losses) gains on sales of mortgage loans transferred in securitizations |  |                                  | (4,981  | ) |                                    |   | 19,528 |      |  |   | (4,981 | ) |  |   | 18,325 |  
|Losses on sales of real estate owned                                     |  |                                  | (5,055  | ) |                                    |   | (1,192 | )    |  |   | (3,651 | ) |  |   | (575   | )
|Elimination of gains from discontinued operations                        |  |                                  |        |   |                                    |   | (1,193 | )    |  |   |       |   |  |   | (462   | )
|                                                                         |  |                                  |         |   |                                    |   |        |      |  |   |        |   |  |   |        |  
|(Losses) gains on sales of mortgage assets                               |  | $                                | (12,394 | ) |                                    | $ | 23,318 |      |  | $ | (9,103 | ) |  | $ | 23,285 |  
|                                                                         |  |                                  |         |   |                                    |   |        |      |  |   |        |   |  |   |        |  

We recorded losses on sales of mortgage assets for the six and three months ended June 30, 2007 of $(12.4)
million and $(9.1) million respectively, as compared to gains on sales of mortgage assets of $23.3 million and $23.3 million for the same periods of 2006. The losses recorded in 2007 are due primarily to losses on sales of real estate owned and a
decrease in gains on sales of mortgage loans transferred in securitizations. Our losses on sales of real estate owned increased due to credit deterioration in the subprime market particularly as it relates to our mortgage loans-held-for-sale. The
decrease in gains on sales of mortgage loans transferred in securitizations was a result of lower profit margins in the securitization market as well as a lower volume of loans securitized in transactions structured as sales. We securitized $1.4
billion of mortgage loans in the first six months of 2007 as compared to $2.1 billion for the same period of 2006.

Activity in the reserve for repurchases
is as follows for the six and three months ended June 30, 2007 and 2006 (dollars in thousands):



|                                                                                                |  |                                  |         |   |                                    |   |        |      |  |   |        |   |  |   |       |  
|----------------------------------------------------------------------------------------------- |  | -------------------------------- | ------- | - | ---------------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ----- | -
|                                                                                                |  | For the Six MonthsEnded June 30, |         |   | For the Three MonthsEnded June 30, |  
|                                                                                                |  | 2007                             |         |   | 2006                               |   |        | 2007 |  |   | 2006   |  
|Balance, beginning of period                                                                    |  | $                                | 24,773  |   |                                    | $ | 2,345  |      |  | $ | 7,336  |   |  | $ | 1,802 |  
|Provision for repurchased loans                                                                 |  |                                  | 3,611   |   |                                    |   | 1,152  |      |  |   | 523    |   |  |   | 51    |  
|Transfer to the allowance for the lower of cost or fair value on mortgage loans  held-for-sale |  |                                  | (22,329 | ) |                                    |   | (1,532 | )    |  |   | (3,806 | ) |  |   |      |  
|Charge-offs, net                                                                                |  |                                  | (2,543  | ) |                                    |   | (205   | )    |  |   | (541   | ) |  |   | (93   | )
|                                                                                                |  |                                  |         |   |                                    |   |        |      |  |   |        |   |  |   |       |  
|Balance, end of period                                                                          |  | $                                | 3,512   |   |                                    | $ | 1,760  |      |  | $ | 3,512  |   |  | $ | 1,760 |  
|                                                                                                |  |                                  |         |   |                                    |   |        |      |  |   |        |   |  |   |       |  



64



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Table 6  Mortgage Loans Transferred in Securitizations Structured as Sales

(dollars in thousands)



|               |  |                 |           |                                                                 |        |   |                          |   |        |                                        |  |                                                                                                 |        |  |              |   |  |                                                   |   |  |      |  
|-------------- |  | --------------- | --------- | --------------------------------------------------------------- | ------ | - | ------------------------ | - | ------ | -------------------------------------- |  | ----------------------------------------------------------------------------------------------- | ------ |  | ------------ | - |  | ------------------------------------------------- | - |  | ---- | -
|               |  |                 |           |                                                                 |        |   |                          |   |        |                                        |  | Weighted Average AssumptionsUnderlying Initial Value of MortgageSecurities 
Available-for-Sale |       
|               |  | PrincipalAmount |           | Whole LoanPrice Usedin the InitialValuation ofRetainedInterests |        |   | Net (Loss)GainRecognized |   |        | Initial CostBasis ofResidualSecurities |  | ConstantPrepaymentRate                                                                          |        |  | DiscountRate |   |  | ExpectedTotalCreditLosses,Net ofMortgageInsurance |  
|2007:          |  |                 |           |                                                                 |        |   |                          |   |        |                                        |  |                                                                                                 |        |  |              |   |  |                                                   |   |  |      |  
|First quarter  |  | $               |          |                                                                 |       |   |                          | $ |       |                                        |  | $                                                                                               |       |  |             |   |  |                                                  |   |  |     |  
|Second quarter |  |                 | 1,400,000 |                                                                 | 99.33  | % |                          |   | (4,981 | )                                      |  |                                                                                                 | 56,387 |  | 34           | % |  | 20                                                | % |  | 5.70 | %
|               |  |                 |           |                                                                 |        |   |                          |   |        |                                        |  |                                                                                                 |        |  |              |   |  |                                                   |   |  |      |  
|Total          |  | $               | 1,400,000 |                                                                 | 99.33  | % |                          | $ | (4,981 | )                                      |  | $                                                                                               | 56,387 |  | 34           | % |  | 20                                                | % |  | 5.70 | %
|               |  |                 |           |                                                                 |        |   |                          |   |        |                                        |  |                                                                                                 |        |  |              |   |  |                                                   |   |  |      |  
|2006:          |  |                 |           |                                                                 |        |   |                          |   |        |                                        |  |                                                                                                 |        |  |              |   |  |                                                   |   |  |      |  
|First quarter  |  | $               | 378,944   |                                                                 | 101.49 | % |                          | $ | 1,203  |                                        |  | $                                                                                               | 9,485  |  | 43           | % |  | 15                                                | % |  | 2.36 | %
|Second quarter |  |                 | 1,711,844 |                                                                 | 102.03 | % |                          |   | 18,325 |                                        |  |                                                                                                 | 49,905 |  | 44           | % |  | 15                                                | % |  | 2.53 | %
|               |  |                 |           |                                                                 |        |   |                          |   |        |                                        |  |                                                                                                 |        |  |              |   |  |                                                   |   |  |      |  
|Total          |  | $               | 2,090,788 |                                                                 | 101.94 | % |                          | $ | 19,528 |                                        |  | $                                                                                               | 59,390 |  | 44           | % |  | 15                                                | % |  | 2.50 | %
|               |  |                 |           |                                                                 |        |   |                          |   |        |                                        |  |                                                                                                 |        |  |              |   |  |                                                   |   |  |      |  

Table 6 demonstrates the credit deterioration in the subprime market by the increase in expected credit losses
from 2006 to 2007.

The following table summarizes our sales of nonconforming loans to third parties during the six and three months ended June 30,
2007 as compared to the same periods in 2006. This table illustrates the weak subprime mortgage market in 2007 through lower whole loan values and even tighter mortgage banking profit margins in 2007 as compared to 2006.

Table 7  Mortgage Loan Sales to Third Parties  Nonconforming

(dollars in thousands)



|               |  |                  |         |                           |   |        |                                                |  |        |  
|-------------- |  | ---------------- | ------- | ------------------------- | - | ------ | ---------------------------------------------- |  | ------ | -
|               |  | Principal Amount |         | Net (Loss) GainRecognized |   |        | Weighted Average Price to Parof the Loans Sold | 
|2007:          |  |                  |         |                           |   |        |                                                |  |        |  
|First Quarter  |  | $                | 73,686  |                           | $ | (1,887 | )                                              |  | 101.82 | %
|Second Quarter |  |                  | 170,439 |                           |   | (471   | )                                              |  | 100.77 | %
|               |  |                  |         |                           |   |        |                                                |  |        |  
|Total          |  | $                | 244,125 |                           | $ | (2,358 | )                                              |  | 101.09 | %
|               |  |                  |         |                           |   |        |                                                |  |        |  
|2006:          |  |                  |         |                           |   |        |                                                |  |        |  
|First Quarter  |  | $                | 358,991 |                           | $ | (173   | )                                              |  | 101.16 | %
|Second Quarter |  |                  | 434,065 |                           |   | 5,997  |                                                |  | 101.63 | %
|               |  |                  |         |                           |   |        |                                                |  |        |  
|Total          |  | $                | 793,056 |                           | $ | 5,824  |                                                |  | 101.42 | %
|               |  |                  |         |                           |   |        |                                                |  |        |  

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. Additionally, we transfer certain of these derivative
instruments into our securitization trusts when the securitizations are structured as sales to provide interest rate protection to the third-party bondholders. Prior to the date when we transfer these derivatives, changes in the fair value of these
derivative instruments and net settlements with counterparties are credited or charged to current earnings. The derivative instruments we use to mitigate interest rate risk will generally increase in value as short-term interest rates increase and
decrease in value as rates decrease. Fair value, at the date of securitization, of the derivative instruments transferred into securitizations structured as sales is included as part of the cost basis of the mortgage loans securitized. Derivative
instruments transferred into a securitization trust are administered by the trustee in accordance with the trust documents.



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Any cash flows from these derivatives projected to flow to our residual securities are included in the valuation. The gains on derivative instruments can be
summarized for the six and three months ended June 30, 2007 and 2006 as follows:

Table 8Gains on Derivative Instruments

(dollars in thousands)



|                                                  |  |                                  |       |   |                                   |   |        |      |  |   |       |   |  |   |        |  
|------------------------------------------------- |  | -------------------------------- | ----- | - | --------------------------------- | - | ------ | ---- |  | - | ----- | - |  | - | ------ | -
|                                                  |  | For the Six MonthsEnded June 30, |       |   | For the Three MonthsEnded June 30 |  
|                                                  |  | 2007                             |       |   | 2006                              |   |        | 2007 |  |   | 2006  |  
|Increase in fair value                            |  | $                                | 3,442 |   |                                   | $ | 9,897  |      |  | $ | 7,405 |   |  | $ | 3,835  |  
|Net settlements                                   |  |                                  | 2,934 |   |                                   |   | 6,244  |      |  |   | 1,538 |   |  |   | 3,477  |  
|Losses on commitments to originate mortgage loans |  |                                  | (651  | ) |                                   |   | (1,410 | )    |  |   | (547  | ) |  |   | (1,172 | )
|                                                  |  |                                  |       |   |                                   |   |        |      |  |   |       |   |  |   |        |  
|Gains on derivative instruments                   |  | $                                | 5,725 |   |                                   | $ | 14,731 |      |  | $ | 8,396 |   |  | $ | 6,140  |  
|                                                  |  |                                  |       |   |                                   |   |        |      |  |   |       |   |  |   |        |  

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. During the six and three months ended June 30, 2007, we recorded an
impairment loss of $26.0 million and $22.6 million, respectively, compared to $6.5 million and $4.5 during the same periods of 2006. The increase in impairments in 2007 was primarily driven by an increase in projected losses due to the deteriorating
credit quality of the loans underlying the securities declining. The following table summarizes the impairment on our mortgage securities  available-for-sale by mortgage security for the six and three months ended June 30, 2007 and
June 30, 2006.

Table 9  Impairment on Mortgage Securities  Available-for-Sale by Mortgage Security

(dollars in thousands)



|                                                       |  |                                  |        |                                    |   |       |  |      |        |  |   |      
|------------------------------------------------------ |  | -------------------------------- | ------ | ---------------------------------- | - | ----- |  | ---- | ------ |  | - | -----
|                                                       |  | For the Six MonthsEnded June 30, |        | For the Three MonthsEnded June 30,
|                                                       |  | 2007                             |        | 2006                               |   | 2007  |  | 2006
|Mortgage Securities  Available-for-Sale:              |  |                                  |        |                                    |   |       |  |      |        |  |   |      
|NMFT Series 2002-3                                     |  | $                                | 545    |                                    | $ |      |  | $    | 425    |  | $ |     
|NMFT Series 2003-1                                     |  |                                  | 789    |                                    |   |      |  |      | 789    |  |   |     
|NMFT Series 2003-3                                     |  |                                  | 1,651  |                                    |   |      |  |      | 1,651  |  |   |     
|NMFT Series 2003-4                                     |  |                                  | 607    |                                    |   |      |  |      | 607    |  |   |     
|NMFT Series 2004-1                                     |  |                                  | 1,325  |                                    |   |      |  |      | 1,325  |  |   |     
|NMFT Series 2004-2 CT Bond                             |  |                                  | 74     |                                    |   |      |  |      |       |  |   |     
|NMFT Series 2005-1                                     |  |                                  | 1,699  |                                    |   |      |  |      | 1,699  |  |   |     
|NMFT Series 2005-2                                     |  |                                  | 4,764  |                                    |   |      |  |      | 4,764  |  |   |     
|NMFT Series 2005-3                                     |  |                                  | 2,606  |                                    |   |      |  |      | 2,606  |  |   |     
|NMFT Series 2005-4                                     |  |                                  | 464    |                                    |   | 6,453 |  |      | 464    |  |   | 4,488
|NMFT Series 2006-2                                     |  |                                  | 1,000  |                                    |   |      |  |      | 1,000  |  |   |     
|NMFT Series 2006-4                                     |  |                                  | 2,603  |                                    |   |      |  |      | 1,390  |  |   |     
|NMFT Series 2006-5                                     |  |                                  | 2,252  |                                    |   |      |  |      | 2,076  |  |   |     
|NMFT Series 2006-6                                     |  |                                  | 5,614  |                                    |   |      |  |      | 3,773  |  |   |     
|                                                       |  |                                  |        |                                    |   |       |  |      |        |  |   |      
|Impairment on mortgage securities  available-for-sale |  | $                                | 25,993 |                                    | $ | 6,453 |  | $    | 22,569 |  | $ | 4,488
|                                                       |  |                                  |        |                                    |   |       |  |      |        |  |   |      



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Fee Income.Our fee income declined to $11.2 million and $5.1 million for the six and three months ended
June 30, 2007 respectively, from $14.5 million and $6.9 million for the same periods of 2006. Fee income primarily consists of service fee income. Service fees are paid to us by either the investor or the borrower on mortgage loans serviced.
Fees paid by investors on loans serviced are determined as a percentage of the principal collected for the loans serviced and are recognized in the period in which payments on the loans are received. These fees are approximately 0.50% of the
outstanding balance of the loans being serviced. Fees paid by borrowers on loans serviced are considered ancillary fees related to loan servicing and include late fees and processing fees. Revenue is recognized on fees received from borrowers when
an event occurs that generates the fee and they are considered to be collectible. Servicing fees received from the securitization trusts were $29.7 million and $13.4 million for the six and three months ended June 30, 2007, respectively,
compared with $29.8 million and $14.1 million for the same periods of 2006. Servicing fees have declined due to the increase in securitizations structured as financings. Servicing fees paid by the trusts structured as financings are eliminated upon
consolidation.

The amortization of mortgage servicing rights is also included in fee income. Mortgage servicing rights are amortized in proportion to and
over the estimated period of net servicing income. Generally, as the size of our servicing portfolio increases the amortization expense will increase. In addition the amortization of mortgage servicing rights is impacted by our assumptions regarding
prepayment speeds for the loans being serviced for investors. During periods of increasing loan prepayments, the amortization on our mortgage servicing rights generally will increase. See Table 24 for a summary of our expected prepayment rate
assumptions by securitization trust. Amortization of mortgage servicing rights increased to $17.3 million and $8.0 million for the six and three months ended June 30, 2007, respectively, from $15.4 million and $7.0 million for the same periods
in 2006.

Origination fees are received from borrowers at the time of loan closing and deferred until the related loans are sold or securitized in
transactions structured as sales. For securitizations structured as financings this fee income is deferred and amortized into interest income over the life of the loans using a level yield method.

Premiums for Mortgage Loan Insurance.The use of mortgage insurance is one method of managing the credit risk in the mortgage asset portfolio. Premiums for
mortgage insurance on loans maintained on our balance sheet are paid by us and are recorded as a portfolio cost and included in the income statement under the caption Premiums for Mortgage Loan Insurance. These premiums totaled $10.3
million and $5.1 million for the six and three months ended June 30, 2007, respectively, compared to $6.2 million and $3.8 million for the same periods of 2006. The increase in premiums on mortgage loan insurance for the six and three months
ended June 30, 2007 as compared to prior year is due to the large increase of loans-held-in-portfolio on our condensed consolidated balance sheet.

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

We intend to continue to
use mortgage insurance coverage as a credit management tool as we continue to originate, purchase and securitize mortgage loans. Mortgage insurance claims on loans where a defect occurred in the loan origination process will not be paid by the
mortgage insurer. The assumptions we use to value our mortgage securities  available-for-sale consider this risk. For the NHES Series 2007-1 the mortgage loans that were transferred into the trust had mortgage insurance coverage at the time of
transfer of 44% of total principal. As of June 30, 2007, 51% of the total principal of our securitized loans, excluding NHES 2006-MTA1, had mortgage insurance coverage compared to 55% as of June 30, 2006. We have excluded our NHES
2006-MTA1 deal from our analysis of securitized loans with mortgage insurance due to the low percentage of mortgage insurance purchased on those loans due to their higher credit quality.

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

General and Administrative Expenses.The main categories of our general and administrative expenses are: compensation and benefits, office administration,
professional and outside services, loan expense, marketing expense and other expense. Compensation and benefits includes employee base salaries, benefit costs and incentive compensation awards. Office administration includes items such as rent,
depreciation, telephone, office supplies, postage, delivery, maintenance and repairs. Professional and outside services include fees for legal, accounting and other consulting services. Loan expense primarily consists of expenses relating to the
underwriting of mortgage loans that do not fund successfully and servicing costs. Marketing expenses primarily consists of costs for purchased loan leads, advertising and business promotion. Other expense primarily includes miscellaneous banking
fees and travel and entertainment expenses. General and administrative expenses increased to $120.1 million and $55.7 million for the six and three months ended June 30, 2007, respectively as compared to $98.6 million and $52.6 million for the
same periods of 2006. The increase



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for the six months ended June 30, 2007 as compared to 2006 is due in large part to increased expenses related to the operation of retail branches
acquired during the fourth quarter of 2006. Other factors contributing to the increase were:



| |  |  | $4.7 million charge for debt issuance costs, included in professional and outside services, related to the issuance of asset-backed bonds in our CDO transaction
during the first quarter of 2007. In accordance with SFAS 159, debt issuance costs are current period expenses and are not amortized over the life of the debt on a level-yield basis.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | $3.7 million of compensation and benefits expense during the six months ended June 30, 2007 related to the reduction in force and in accordance with SFAS 146,
Accounting for Costs Associated with Exit or Disposal Activities.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | $5.1 million charge for the litigation settlement, included in professional and outside services, related to the Pierce et al. v. NovaStar Mortgage,
Inc. as discussed in Item 1. Legal Proceedings under Part II. Other Information.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Other Operational Data

Loan Fundings.

The following table
summarizes our loan production for the six and three months ended June 30, 2007 and 2006. We have separated MTA (option ARM) bulk loan purchased in the first quarter of 2006 from our normal originations and purchases because of the unique
nature of these purchases. These purchases were executed solely for the purpose of adding qualified assets to the REIT.

Table 10 Nonconforming
Loan Originations and Purchases

(dollars in thousands, except for average loan balance and number of loans)



|                                 |  |        |  |           |           |                    |   |                    |  |        |                  |  |    |           |  |        |  |      |                              |  |    |  
|-------------------------------- |  | ------ |  | --------- | --------- | ------------------ | - | ------------------ |  | ------ | ---------------- |  | -- | --------- |  | ------ |  | ---- | ---------------------------- |  | -- | -
|                                 |  |        |  |           |           |                    |   |                    |  |        | Weighted Average |  |    |           | 
|                                 |  | Number |  | Principal |           | AverageLoanBalance |   | PricePaid toBroker |  |        | LoantoValue      |  |    | FICOScore |  | Coupon |  |      | PercentwithPrepaymentPenalty | 
|2007:                            |  |        |  |           |           |                    |   |                    |  |        |                  |  |    |           |  |        |  |      |                              |  |    |  
|First quarter                    |  | 8,708  |  | $         | 1,441,675 |                    | $ | 165,558            |  | 100.3  | %                |  | 82 | %         |  | 621    |  | 8.75 | %                            |  | 63 | %
|Second quarter                   |  | 4,498  |  |           | 773,733   |                    |   | 172,017            |  | 101.19 |                  |  | 79 |           |  | 615    |  | 9.32 |                              |  | 63 |  
|                                 |  |        |  |           |           |                    |   |                    |  |        |                  |  |    |           |  |        |  |      |                              |  |    |  
|Total                            |  | 13,206 |  | $         | 2,215,408 |                    | $ | 167,758            |  | 100.61 | %                |  | 81 | %         |  | 619    |  | 8.95 | %                            |  | 63 | %
|                                 |  |        |  |           |           |                    |   |                    |  |        |                  |  |    |           |  |        |  |      |                              |  |    |  
|2006:                            |  |        |  |           |           |                    |   |                    |  |        |                  |  |    |           |  |        |  |      |                              |  |    |  
|First quarter                    |  | 11,373 |  | $         | 1,834,825 |                    | $ | 161,332            |  | 100.8  | %                |  | 81 | %         |  | 628    |  | 8.53 | %                            |  | 62 | %
|First quarter MTA bulk purchases |  | 2,415  |  |           | 991,407   |                    |   | 410,520            |  | 103.4  |                  |  | 74 |           |  | 713    |  | 6.89 |                              |  | 68 |  
|                                 |  |        |  |           |           |                    |   |                    |  |        |                  |  |    |           |  |        |  |      |                              |  |    |  
|Total first quarter              |  | 13,788 |  |           | 2,826,232 |                    |   | 204,978            |  | 101.8  |                  |  | 79 |           |  | 658    |  | 7.96 |                              |  | 64 |  
|Second quarter                   |  | 17,000 |  |           | 2,816,586 |                    |   | 165,682            |  | 100.9  |                  |  | 82 |           |  | 625    |  | 8.66 |                              |  | 61 |  
|                                 |  |        |  |           |           |                    |   |                    |  |        |                  |  |    |           |  |        |  |      |                              |  |    |  
|Total                            |  | 30,788 |  | $         | 5,642,818 |                    | $ | 183,280            |  | 101.3  | %                |  | 81 | %         |  | 641    |  | 8.31 | %                            |  | 63 | %
|                                 |  |        |  |           |           |                    |   |                    |  |        |                  |  |    |           |  |        |  |      |                              |  |    |  

We originated and purchased $2.2 billion in nonconforming loans during the six months ended June 30, 2007 as
compared to $5.6 billion for the same period of 2006. The 61% decrease in origination volume from 2006 was caused by the steps we have taken to tighten our underwriting guidelines to address the deteriorating credit environment and the fact that we
have curtailed our origination business due to the instability in the secondary market. Wholesale production in the six and three months ended June 30, 2007 represented 69% and 61%, respectively, compared to 82% and 84% for the same periods of 2006.
Retail production in the six and three months ended June 30, 2007 represented 29% and 39%, respectively, compared to 11% and 9% for the same periods of 2006.



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Cost of Production.

The cost of production table below includes all costs paid and fees collected during the loan origination cycle, including loans that do not fund. This distinction is important as we can only capitalize as deferred broker premium and costs,
those costs (net of fees) directly associated with a funded loan. Costs associated with loans that do not fund are recognized immediately as a component of general and administrative expenses. For loans held-for-sale, deferred net costs
are recognized when the related loans are sold outright or transferred in securitizations. For loans held-in-portfolio, deferred net costs are recognized over the life of the loan as a reduction to interest income. The cost of our production is also
critical to our financial results as it is a significant factor in the gains we recognize. Increased efficiencies in the nonconforming lending operation correlate to lower general and administrative costs and higher gains on sales of mortgage
assets. Overhead costs increased from the first six months of 2006 to 2007 primarily due to lower origination volumes. Premium paid to broker, net of fees collected decreased as a percentage of volume from 2006 to 2007 due primarily to higher retail
origination volume as a percentage of total volume as well as lower premiums paid to brokers on our wholesale production. We do not pay broker premiums for retail loans as they are direct to consumer loans. Additionally, retail originations earn
higher origination fees per loan.

Table 11  Cost of Production, as a Percent of Principal



|               |  |               |   |  |                                              |    |  |                       |  
|-------------- |  | ------------- | - |  | -------------------------------------------- | -- |  | --------------------- | -
|               |  | OverheadCosts |   |  | Premium Paidto Broker, Net of Fees Collected |    |  | TotalAcquisition Cost |  
|2007:          |  |               |   |  |                                              |    |  |                       |  
|First quarter  |  | 3.41          | % |  | (0.66                                        | )% |  | 2.75                  | %
|Second quarter |  | 4.84          | % |  | (1.64                                        | )% |  | 3.20                  | %
|Year to Date   |  | 3.91          | % |  | (1.00                                        | )% |  | 2.91                  | %
|               |  |               |  
|2006:          |  |               |   |  |                                              |    |  |                       |  
|First quarter  |  | 1.31          | % |  | 1.32                                         | %  |  | 2.63                  | %
|Second quarter |  | 1.50          | % |  | 0.32                                         | %  |  | 1.82                  | %
|Year to Date   |  | 1.41          | % |  | 0.82                                         | %  |  | 2.23                  | %

The following table is a reconciliation of our lending divisions overhead costs included in our cost of
production to general and administrative expenses of the mortgage lending segment as shown in Note 18 to the condensed consolidated financial statements, presented in accordance with GAAP. We believe this presentation of our cost of production
provides useful information to investors regarding our financial performance because it reflects the direct costs of loan production and allows us to monitor the performance of our core operations and provides useful information regarding our
financial performance. Management uses this measure for the same purpose. However, this presentation is not intended to be used as a substitute for financial results prepared in accordance with GAAP.



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Table 12  Reconciliation of Overhead Costs, Non-GAAP Financial Measure

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



|                                                                     |  |                                   |           |   |                                    |   |           |      |  |   |         |   |  |   |           |  
|-------------------------------------------------------------------- |  | --------------------------------- | --------- | - | ---------------------------------- | - | --------- | ---- |  | - | ------- | - |  | - | --------- | -
|                                                                     |  | For the Six Months Ended June 30, |           |   | For the Three MonthsEnded June 30, |  
|                                                                     |  | 2007                              |           |   | 2006                               |   |           | 2007 |  |   | 2006    |  
|Mortgage lending general and administrative expenses (A)             |  | $                                 | 88,449    |   |                                    | $ | 71,398    |      |  | $ | 40,341  |   |  | $ | 39,345    |  
|Direct origination costs classified as a reduction in gain-on-sale   |  |                                   | 14,818    |   |                                    |   | 15,261    |      |  |   | 5,828   |   |  |   | 7,465     |  
|Exit or disposal costs not included in lending overhead expenses (B) |  |                                   | (2,398    | ) |                                    |   |          |      |  |   | (492    | ) |  |   |          |  
|Other non-lending overhead expenses                                  |  |                                   | (14,177   | ) |                                    |   | (7,213    | )    |  |   | (8,194  | ) |  |   | (4,478    | )
|                                                                     |  |                                   |           |   |                                    |   |           |      |  |   |         |   |  |   |           |  
|Lending overhead costs                                               |  |                                   | 86,692    |   |                                    |   | 79,446    |      |  |   | 37,483  |   |  |   | 42,332    |  
|Premium paid to broker, net of fees collected                        |  |                                   | (22,315   | ) |                                    |   | 46,148    |      |  |   | (12,700 | ) |  |   | 8,956     |  
|                                                                     |  |                                   |           |   |                                    |   |           |      |  |   |         |   |  |   |           |  
|Total cost of loan production                                        |  | $                                 | 64,377    |   |                                    | $ | 125,594   |      |  | $ | 24,783  |   |  | $ | 51,288    |  
|                                                                     |  |                                   |           |   |                                    |   |           |      |  |   |         |   |  |   |           |  
|                                                                     |  |                                   |           |  
|Loan production, principal                                           |  | $                                 | 2,215,408 |   |                                    | $ | 5,642,818 |      |  | $ | 773,733 |   |  | $ | 2,816,586 |  
|Total cost of production, as a percentage of loan production (B)     |  |                                   | 2.91      | % |                                    |   | 2.23      | %    |  |   | 3.20    | % |  |   | 1.82      | %

---

|(A) | Mortgage lending general and administrative expenses are presented in Note 18 to the condensed consolidated financial statements.
|--- | ---------------------------------------------------------------------------------------------------------------------------------

|(B) | We have excluded the exit and disposal costs our lending division incurred from our analysis above. Our cost of loan production for the six and three months ended June 30, 2007
would have been 3.01% and 3.27%, respectively had we included these costs in this analysis.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Mortgage Loan Servicing

Servicing income, before amortization of mortgage servicing rights includes fee income and interest income, which is earned on custodial bank
accounts. The costs of servicing include the general and administrative expenses incurred by our servicing operation as well as allocated corporate expenses.

Our servicing income per loan before tax per unit increased to $171 for the six months ended June 30, 2007 from $145 for the six months ended June 30, 2006 due to a higher ratio of loans earning fee income within securitization
trusts to those loans in our warehouse which do not earn fee income. For the three months ended June 30, 2007, servicing income per loan before tax per unit decreased to $161 from $199 for three months ended June 30, 2006. This decrease is
due largely to higher servicing costs which resulted from the increase in delinquencies.



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Table 13  Summary of Servicing Operations

(dollars in thousands, except per loan cost)



|                                                                                      |  |                                   |            |   |             |   |      |        |  |   |             |   |  |   |      |  
|------------------------------------------------------------------------------------- |  | --------------------------------- | ---------- | - | ----------- | - | ---- | ------ |  | - | ----------- | - |  | - | ---- | -
|                                                                                      |  | For the Six Months Ended June 30, |           
|                                                                                      |  | 2007                              |            |   | 2006        |  
|                                                                                      |  | Amount                            |            |   | Per Loan(B) |   |      | Amount |  |   | Per Loan(B) |  
|Unpaid principal at period end (A)                                                    |  | $                                 | 15,450,030 |   |             |   |      |        |  | $ | 15,887,948  |   |  |   |      |  
|                                                                                      |  |                                   |            |   |             |   |      |        |  |   |             |   |  |   |      |  
|Number of loans at period end (A)                                                     |  |                                   | 100,231    |   |             |   |      |        |  |   | 104,499     |   |  |   |      |  
|                                                                                      |  |                                   |            |   |             |   |      |        |  |   |             |   |  |   |      |  
|Average unpaid principal during the period (A)                                        |  | $                                 | 16,140,842 |   |             |   |      |        |  | $ | 15,045,425  |   |  |   |      |  
|                                                                                      |  |                                   |            |   |             |   |      |        |  |   |             |   |  |   |      |  
|Average number of loans during the period (A)                                         |  |                                   | 104,305    |   |             |   |      |        |  |   | 101,366     |   |  |   |      |  
|                                                                                      |  |                                   |            |   |             |   |      |        |  |   |             |   |  |   |      |  
|Servicing income, before amortization of mortgage servicing rights                    |  | $                                 | 46,814     |   |             | $ | 898  |        |  | $ | 40,973      |   |  | $ | 808  |  
|Costs of servicing                                                                    |  |                                   | (20,421    | ) |             |   | (392 | )      |  |   | (18,195     | ) |  |   | (359 | )
|                                                                                      |  |                                   |            |   |             |   |      |        |  |   |             |   |  |   |      |  
|Net servicing income, before impairment and amortization of mortgage servicing rights |  |                                   | 26,393     |   |             |   | 506  |        |  |   | 22,778      |   |  |   | 449  |  
|Impairments of mortgage servicing rights, net of reversals                            |  |                                   | (222       | ) |             |   | (4   | )      |  |   |            |   |  |   |     |  
|Amortization of mortgage servicing rights                                             |  |                                   | (17,275    | ) |             |   | (331 | )      |  |   | (15,421     | ) |  |   | (304 | )
|                                                                                      |  |                                   |            |   |             |   |      |        |  |   |             |   |  |   |      |  
|Servicing income before income tax                                                    |  | $                                 | 8,896      |   |             | $ | 171  |        |  | $ | 7,357       |   |  | $ | 145  |  
|                                                                                      |  |                                   |            |   |             |   |      |        |  |   |             |   |  |   |      |  

---

|(A) | Includes loans we have sold and are still servicing on an interim basis.
|--- | ------------------------------------------------------------------------

|(B) | Per unit amounts are calculated using the average number of loans during the period presented.
|--- | ----------------------------------------------------------------------------------------------



|                                                                                      |  |                                     |            |   |             |   |      |        |  |   |             |   |  |   |      |  
|------------------------------------------------------------------------------------- |  | ----------------------------------- | ---------- | - | ----------- | - | ---- | ------ |  | - | ----------- | - |  | - | ---- | -
|                                                                                      |  | For the Three Months Ended June 30, |           
|                                                                                      |  | 2007                                |            |   | 2006        |  
|                                                                                      |  | Amount                              |            |   | Per Loan(B) |   |      | Amount |  |   | Per Loan(B) |  
|Unpaid principal at period end (A)                                                    |  | $                                   | 15,450,030 |   |             |   |      |        |  | $ | 15,887,948  |   |  |   |      |  
|                                                                                      |  |                                     |            |   |             |   |      |        |  |   |             |   |  |   |      |  
|Number of loans at period end (A)                                                     |  |                                     | 100,231    |   |             |   |      |        |  |   | 104,499     |   |  |   |      |  
|                                                                                      |  |                                     |            |   |             |   |      |        |  |   |             |   |  |   |      |  
|Average unpaid principal during the period (A)                                        |  | $                                   | 15,766,765 |   |             |   |      |        |  | $ | 15,615,447  |   |  |   |      |  
|                                                                                      |  |                                     |            |   |             |   |      |        |  |   |             |   |  |   |      |  
|Average number of loans during the period (A)                                         |  |                                     | 102,012    |   |             |   |      |        |  |   | 103,281     |   |  |   |      |  
|                                                                                      |  |                                     |            |   |             |   |      |        |  |   |             |   |  |   |      |  
|Servicing income, before amortization of mortgage servicing rights                    |  | $                                   | 22,094     |   |             | $ | 867  |        |  | $ | 20,744      |   |  | $ | 804  |  
|Costs of servicing                                                                    |  |                                     | (10,826    | ) |             |   | (425 | )      |  |   | (8,594      | ) |  |   | (333 | )
|                                                                                      |  |                                     |            |   |             |   |      |        |  |   |             |   |  |   |      |  
|Net servicing income, before impairment and amortization of mortgage servicing rights |  |                                     | 11,268     |   |             |   | 442  |        |  |   | 12,150      |   |  |   | 471  |  
|Reversal of temporary impairments                                                     |  |                                     | 799        |   |             |   | 31   |        |  |   |             |   |  |   |      |  
|Amortization of mortgage servicing rights                                             |  |                                     | (7,965     | ) |             |   | (312 | )      |  |   | (7,024      | ) |  |   | (272 | )
|                                                                                      |  |                                     |            |   |             |   |      |        |  |   |             |   |  |   |      |  
|Servicing income before income tax                                                    |  | $                                   | 4,102      |   |             | $ | 161  |        |  | $ | 5,126       |   |  | $ | 199  |  
|                                                                                      |  |                                     |            |   |             |   |      |        |  |   |             |   |  |   |      |  

---

|(A) | Includes loans we have sold and are still servicing on an interim basis.
|--- | ------------------------------------------------------------------------

|(B) | Per unit amounts are calculated using the average number of loans during the period presented.
|--- | ----------------------------------------------------------------------------------------------



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Income and Excise Taxes & REIT Status

NFI has elected to be treated as a REIT for federal income tax purposes. NFI is not required to pay any corporate level income taxes as long as we remain a REIT and
distribute 100 percent of our taxable income in the form of dividend distributions to our shareholders.

As a REIT, NFI may be subject to a federal excise
tax. An excise tax is incurred if NFI distributes less than 85 percent of its taxable income by the end of the calendar year. As part of the amount distributed by the end of the calendar year, NFI may include dividends that were declared in October,
November or December and paid on or before January 31 of the following year. To the extent that 85 percent of our taxable income exceeds our dividend distributions in any given year, an excise tax of 4 percent is due and payable on the
shortfall. For the six months ended June 30, 2007 and 2006, we accrued excise tax (benefit) expense of approximately $(340,000) and $3.4 million, respectively. Excise tax (benefit) expense is recorded in the other component of general and
administrative expenses on our condensed consolidated statements of operations. As of June 30, 2007 and December 31, 2006, accrued excise tax (receivable) payable was approximately $(463,000) and $4.7 million, respectively. The excise tax
receivable is reflected as a component of other assets on our condensed consolidated balance sheets. The excise tax payable is reflected as a component of accounts payable and other liabilities on our condensed consolidated balance sheets.

We record deferred tax assets and liabilities for the future tax consequences attributable to differences between the financial statement carrying amounts
and their respective income tax bases. A deferred tax liability is recognized for all future taxable temporary differences, while a deferred tax asset is recognized for all future deductible temporary differences, operating loss carryforwards and
tax credit carryforwards. In accordance with FAS 109, we record 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.

As of June 30, 2007 and December 31, 2006, our net deferred tax asset (excluding valuation allowance and deferred taxes related to
unrealized gains on available for sale securities) was $252.0 million and $49.7 million, respectively.

Deferred taxes are required to be determined for
each tax-paying component of a consolidated entity. The REIT and the taxable REIT subsidiary have previously been viewed as two separate components for this purpose. Historically, we have recorded deferred taxes only at the TRS. Conversely, prior to
2007, we have not recorded deferred taxes at the REIT because of our intent to operate NFI as a REIT.

On May 3, 2007, our Board of Directors approved
a resolution enabling management to take the necessary steps to revoke NFIs REIT election effective January 1, 2008. Management intends to carry out this plan.

The decision to revoke NFIs REIT status was based on several significant factors. First, operating as a REIT restricts our ability to operate our business. The REIT source of income tests and diversification of
assets tests not only limits our ability to hedge our interest rate risk, but also unduly restricts our ability to efficiently manage our portfolio management business. Second, since we are required to distribute most of our earnings in the form of
dividends to shareholders to comply with REIT distribution requirements, our ability to retain capital to grow our business is significantly reduced. Third, our projections demonstrate that we will not generate taxable income at the REIT from 2007
through 2011. This is due primarily to the expected reversal of deductible temporary differences that have accumulated over the past several years. As we have disclosed in previous filings, we had experienced significantly higher taxable income
compared to financial statement income in years prior to 2007. This was due primarily to timing differences between financial statement and income tax recognition of income and losses on our portfolio of interest-only mortgage securities. Without
taxable income, we will not have a requirement to distribute dividends to shareholders.

As a result of the factors identified above, management believes
it is in the best interest of the shareholders to release NFI from its REIT restrictions and operate as a C corporation.

With the Board of Directors
decision to authorize management to revoke NFIs REIT election effective January 1, 2008, NFI scheduled the reversal of deductible and taxable temporary differences as of December 31, 2006 (as well as new temporary differences
originating during 2007) for amounts to be realized during our final calendar year as a REIT and for amounts to be realized in subsequent taxable years. As previously stated, NFI will be taxable as a C corporation in the tax year the revocation of
its REIT election is effective (2008) and for subsequent taxable years. Accordingly, NFI recorded deferred taxes as of June 30, 2007 based on estimated cumulative temporary differences at January 1, 2008 that are expected to reverse
in a subsequent taxable year.

All differences between financial statement carrying amounts and tax bases (i.e. cumulative temporary differences or
CTDs) accumulated as of December 31, 2006 were based on actual financial statement balances and NFIs best estimate of income tax balances, as NFI has yet to file its 2006 REIT income tax return. These CTDs were
then rolled forward through January 1, 2008 for what NFI estimates to be realized on NFIs final REIT return for 2007. In rolling forward the projected CTDs, NFI used estimates



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based on calendar year 2007 projections of financial statement income, securitization activity, interest income, bad debt expenses, and other estimates. Such
estimates were derived from information best available through June 30, 2007 as well as assumptions on information that is not yet available and are likely to change. It is reasonable to expect changes to our estimate of the deferred tax assets
and liabilities in the remaining 2007 interim periods, as actual information becomes available. Such changes will affect our income tax expense and will increase the volatility of the effective tax rate during 2007.

Based on our estimate of temporary differences as of June 30, 2007, NFI will have approximately $328.6 million of net future deductible timing differences remaining
at January 1, 2008. Accordingly NFI recorded a net deferred tax asset of $123.8 million (excluding the deferred tax liability on unrealized gains from available for sale securities of $6.8 million) using an effective tax rate of approximately
37.7%. The effective tax rate of 37.7% was calculated by including the REIT in consolidated/combined tax returns with the TRS beginning in 2008. The change in the projected temporary difference for the REIT from $253.2 (as of March 31) to
$328.6 (as of June 30) was a result of changes in REIT pre-tax book income for 2007 and basis differences in securities. The primary differences for the changes were due to (1) GAAP impairments; (2) changes to projected cash flows;
and (3) changes in accrual rates on securities.

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

Under FAS 109, companies are required to identify and consider all
available evidence, both positive and negative, in determining whether it is more likely than not that all or some portion of their deferred tax asset 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.

Pursuant to FAS 109, 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 asset. A cumulative loss in recent years is significant negative evidence that is difficult to overcome when
determining the need for a valuation allowance. Similarly, cumulative earnings in recent years represents significant positive objective evidence. If the weight of the positive evidence is sufficient to support a conclusion that it is more likely
than not that a deferred tax asset will be realized, a valuation allowance should not be recorded.

It is our policy to 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. 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 will consider all alternative sources of taxable income identified in FAS 109 in determining the amount of valuation allowance to be recorded. Alternative sources of taxable income identified in FAS 109
include the following: 1) taxable income in prior carryback year, 2) future reversals of existing taxable temporary differences, 3) future taxable income exclusive of reversing temporary differences and carryforwards, and 4) tax planning strategies.

We recorded a valuation allowance for deferred tax assets as of June 30, 2007 and December 31, 2006 of $3.3 million and $0.7 million,
respectively. The net change in the valuation allowance for the six months ended June 30, 2007 was an increase of $2.6 million. The valuation allowance relates to various separate company state net operating losses for which we determined it
was more likely than not that such state net operating losses would not be realized.

In determining the amount of valuation allowance to record as of
June 30, 2007, if any, we evaluated all of our deferred tax assets and whether it was more likely than not such deferred tax assets would be realized. We concluded the weight given to the positive evidence supports a conclusion that it is more
likely than not that $248.7 million of the net deferred tax asset (excluding the deferred tax liability on unrealized gains from available for sale securities of $2.5 million) of $252.0 million as of June 30, 2007 will be realized.

As a result of our decision to revoke NFIs REIT election effective January 1, 2008, we evaluated the positive and negative evidence as of June 30,
2007 on a combined enterprise basis (i.e. the REIT and the TRS) to form our conclusion. On a combined enterprise



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basis, we have not generated a cumulative loss in recent years. In addition, we have never experienced the expiration of a net operating loss in a
significant taxing jurisdiction. The fact we have not experienced a cumulative loss in recent years is significant objective evidence in evaluating the need for a valuation allowance.

In all future interim periods, we will continue to monitor all factors that impact positive and negative evidence relating to our deferred tax assets. If management concludes at any point in the future that negative
evidence outweighs positive evidence, we may need to record a valuation allowance on some or all of the entire deferred tax asset. Factors that may lead to a change from positive to negative evidence include, but are not limited to: cumulative
losses in recent years, losses expected in future years, a brief carryforward period, and significant differences from projected financial statement income or loss.

As previously stated, it is expected that there will be little or no taxable income at the REIT for the year ended December 31, 2007. The primary reasons for this expectation are: 1) lower financial statement
income, 2) lower derivative income, 3) less frequent and smaller securitizations during 2007, and 4) the timing of bad debt expenses on our securitizations.

During the past five years, we believe that a minority of our shareholders have been non-United States holders. Accordingly, we anticipate that NFI will qualify as a domestically-controlled REIT for United States federal income
tax purposes for 2007. Investors who are non-United States holders should contact their tax advisor regarding the United States federal income tax consequences of dispositions of shares of a domestically-controlled REIT.

Financial Condition as of June 30, 2007 and December 31, 2006

The following table summarizes the activity of our mortgage loans classified as held-for-sale for the six months ended June 30, 2007.

Table 14  Rollforward of Mortgage LoansHeld-for-Sale

(dollars in thousands)



|                                                        |  |   |            |  
|------------------------------------------------------- |  | - | ---------- | -
|Beginning principal balance                             |  | $ | 1,631,891  |  
|Originations and purchases                              |  |   | 2,308,139  |  
|Borrower repayments                                     |  |   | (30,352    | )
|Sales to third parties                                  |  |   | (244,125   | )
|Sales in securitizations                                |  |   | (1,400,000 | )
|Transfers to real estate owned                          |  |   | (24,102    | )
|Repurchase of mortgage loans from securitization trusts |  |   |           |  
|Transfers of mortgage loans to held-in-portfolio        |  |   | (1,888,776 | )
|                                                        |  |   |            |  
|Ending principal balance                                |  |   | 352,675    |  
|Loans under removal of accounts provision               |  |   | 120,138    |  
|Net deferred origination costs                          |  |   | (945       | )
|Allowance for the lower of cost or fair value           |  |   | (23,718    | )
|                                                        |  |   |            |  
|Mortgage loans held-for-sale                            |  | $ | 448,150    |  
|                                                        |  |   |            |  

Our portfolio of mortgage loans held-for-sale decreased to $448.2 million at June 30, 2007 from $1.7 billion
at December 31, 2006. This decrease is a result of a lower volume of originations and purchases during the first six months of 2007 due to tightening of underwriting guidelines and our decision to limit origination volumes due to uncertainty in
the secondary market as well as the timing of our securitizations and loan sales.



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The following table provides information on the FICO scores, weighted average coupons and original weighted average
loan-to-values for our loans classified as held-for-sale as of June 30, 2007 and December 31, 2006.

Table 15  Mortgage Loans 
Held-for-Sale by FICO Score

(dollars in thousands)



|                         |  |                     |         |                       |                         |   |                                       |      |   |                  |   |                       |  |       |                                       |  |      |  
|------------------------ |  | ------------------- | ------- | --------------------- | ----------------------- | - | ------------------------------------- | ---- | - | ---------------- | - | --------------------- |  | ----- | ------------------------------------- |  | ---- | -
|                         |  | As of June 30, 2007 |         |                       | As of December 31, 2006 |  
|FICO Score               |  | CurrentPrincipal    |         | WeightedAverageCoupon |                         |   | OriginalWeightedAverage Loan-to-Value |      |   | CurrentPrincipal |   | WeightedAverageCoupon |  |       | OriginalWeightedAverage Loan-to-Value | 
|FICO score not available |  | $                   | 925     |                       | 8.83                    | % |                                       | 66.2 | % |                  | $ | 577                   |  | 10.89 | %                                     |  | 63.0 | %
|540 and below            |  |                     | 34,827  |                       | 10.44                   |   |                                       | 74.1 |   |                  |   | 134,147               |  | 9.68  |                                       |  | 79.7 |  
|540 to 579               |  |                     | 64,427  |                       | 9.72                    |   |                                       | 77.9 |   |                  |   | 248,559               |  | 9.21  |                                       |  | 81.4 |  
|580 to 619               |  |                     | 83,997  |                       | 9.59                    |   |                                       | 82.3 |   |                  |   | 336,457               |  | 8.90  |                                       |  | 84.6 |  
|620 to 659               |  |                     | 83,808  |                       | 9.09                    |   |                                       | 85.2 |   |                  |   | 392,316               |  | 8.60  |                                       |  | 84.7 |  
|660 and above            |  |                     | 84,691  |                       | 8.65                    |   |                                       | 84.1 |   |                  |   | 519,835               |  | 8.11  |                                       |  | 83.1 |  
|                         |  |                     |         |                       |                         |   |                                       |      |   |                  |   |                       |  |       |                                       |  |      |  
|Total                    |  | $                   | 352,675 |                       | 9.35                    | % |                                       | 81.8 | % |                  | $ | 1,631,891             |  | 8.69  | %                                     |  | 83.2 | %
|                         |  |                     |         |                       |                         |   |                                       |      |   |                  |   |                       |  |       |                                       |  |      |  

The following table provides information on the collateral location for our loans classified as held-for-sale as
of June 30, 2007 and December 31, 2006.

Table 16  Mortgage Loans  Held-for-Sale by Collateral Location



|                                              |  |                 |                         |  |                                               |  |                 |  
|--------------------------------------------- |  | --------------- | ----------------------- |  | --------------------------------------------- |  | --------------- | -
|As of June 30,
2007                           |  |                 | As of December 31, 2006 | 
|Collateral Location                           |  | Percent ofTotal |                         |  | Collateral Location                           |  | Percent ofTotal |  
|Florida                                       |  | 17              | %                       |  | Florida                                       |  | 19              | %
|California                                    |  | 16              |                         |  | California                                    |  | 12              |  
|Michigan                                      |  | 6               |                         |  | Virginia                                      |  | 5               |  
|Texas                                         |  | 5               |                         |  | Maryland                                      |  | 4               |  
|All other states (each less than 5% of total) |  | 56              |                         |  | All other states (each less than 4% of total) |  | 60              |  
|                                              |  |                 |                         |  |                                               |  |                 |  
|Total                                         |  | 100             | %                       |  | Total                                         |  | 100             | %
|                                              |  |                 |                         |  |                                               |  |                 |  

The following table provides information on the product type for our loans classified as held-for-sale as of
June 30, 2007 and December 31, 2006.

Table 17  Mortgage Loans  Held-for-Sale by Product Type

(dollars in thousands)



|                           |  |                    |         |                        |   |          
|-------------------------- |  | ------------------ | ------- | ---------------------- | - | ---------
|Product Type               |  | As ofJune 30, 2007 |         | As ofDecember 31, 2006
|2-Year Fixed               |  | $                  | 141,772 |                        | $ | 621,108  
|2-Year Fixed 40/30         |  |                    | 71,610  |                        |   | 301,488  
|30-Year Fixed              |  |                    | 52,099  |                        |   | 220,473  
|2-Year Fixed Interest-only |  |                    | 23,529  |                        |   | 140,899  
|MTA (Option ARM)           |  |                    | 17,372  |                        |   | 177,032  
|40/30-Year Fixed           |  |                    | 13,046  |                        |   | 33,937   
|Other Products             |  |                    | 33,247  |                        |   | 136,954  
|                           |  |                    |         |                        |   |          
|Total                      |  | $                  | 352,675 |                        | $ | 1,631,891
|                           |  |                    |         |                        |   |          



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The following table provides delinquency information for our loans classified as held-for-sale as of June 30, 2007
and December 31, 2006.

Table 18  Mortgage Loans  Held-for-Sale Delinquencies

(dollars in thousands)



|                          |  |                     |         |                 |                         |   |                   |   |                  |  |     |  
|------------------------- |  | ------------------- | ------- | --------------- | ----------------------- | - | ----------------- | - | ---------------- |  | --- | -
|                          |  | As of June 30, 2007 |         |                 | As of December 31, 2006 |  
|                          |  | Current Principal   |         | Percentof Total |                         |   | Current Principal |   | Percent of Total | 
|Current                   |  | $                   | 292,851 |                 | 83                      | % |                   | $ | 1,613,112        |  | 99  | %
|30-59 days delinquent     |  |                     | 419     |                 |                        |   |                   |   | 5,777            |  |    |  
|60-89 days delinquent     |  |                     | 751     |                 |                        |   |                   |   | 1,351            |  |    |  
|90 + days delinquent      |  |                     | 40,986  |                 | 12                      |   |                   |   | 1,349            |  |    |  
|In process of foreclosure |  |                     | 17,668  |                 | 5                       |   |                   |   | 10,302           |  | 1   |  
|                          |  |                     |         |                 |                         |   |                   |   |                  |  |     |  
|Total principal           |  | $                   | 352,675 |                 | 100                     | % |                   | $ | 1,631,891        |  | 100 | %
|                          |  |                     |         |                 |                         |   |                   |   |                  |  |     |  

Mortgage Loans - Held-in-Portfolio.

The following table summarizes the activity of our mortgage loans classified as held-in-portfolio for the six months ended June 30, 2007 and the year ended December 31, 2006.

Table 19  Rollforward of Mortgage Loans - Held-in-Portfolio

(dollars in thousands)



|                                               |  |   |           |  
|---------------------------------------------- |  | - | --------- | -
|Beginning principal balance                    |  | $ | 2,101,768 |  
|Borrower repayments                            |  |   | (471,694  | )
|Capitalization of interest                     |  |   | 23,065    |  
|Transfers of mortgage loans from held-for-sale |  |   | 1,888,776 |  
|Transfers to real estate owned                 |  |   | (52,394   | )
|                                               |  |   |           |  
|Ending principal balance                       |  |   | 3,489,521 |  
|Net unamortized deferred origination costs     |  |   | 28,094    |  
|Carrying value adjustment                      |  |   | (2,216    | )
|                                               |  |   |           |  
|Amortized cost                                 |  |   | 3,515,399 |  
|Allowance for credit losses                    |  |   | (100,096  | )
|                                               |  |   |           |  
|Mortgage loans held-in-portfolio               |  | $ | 3,415,303 |  
|                                               |  |   |           |  

Our portfolio of mortgage loans held-in-portfolio increased to $3.4 billion at June 30, 2007 from $2.1
billion at December 31, 2006. During the first quarter of 2007 we transferred mortgage loans with a principal balance of $1.9 billion from the held-for-sale classification to the held-in-portfolio classification which were used as the
underlying collateral for our NHEL 2007-1 securitization, which was structured as a financing and completed in the first quarter.



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The following table provides information on the FICO scores, weighted average coupons and original weighted average
loan-to-values for our loans classified as held-in-portfolio as of June 30, 2007 and December 31, 2006.

Table 20  Mortgage Loans 
Held-in-Portfolio by FICO Score

(dollars in thousands)



|                         |  |                     |           |                       |                         |   |                                       |       |   |                  |   |                       |  |      |                                       |  |      |  
|------------------------ |  | ------------------- | --------- | --------------------- | ----------------------- | - | ------------------------------------- | ----- | - | ---------------- | - | --------------------- |  | ---- | ------------------------------------- |  | ---- | -
|                         |  | As of June 30, 2007 |           |                       | As of December 31, 2006 |  
|FICO Score               |  | CurrentPrincipal    |           | WeightedAverageCoupon |                         |   | OriginalWeightedAverage Loan-to-Value |       |   | CurrentPrincipal |   | WeightedAverageCoupon |  |      | OriginalWeightedAverage Loan-to-Value | 
|FICO score not available |  | $                   | 12,763    |                       | 8.00                    | % |                                       | 75.02 | % |                  | $ | 14,605                |  | 7.85 | %                                     |  | 73.6 | %
|540 and below            |  |                     | 215,277   |                       | 9.72                    |   |                                       | 78.13 |   |                  |   | 79,552                |  | 9.66 |                                       |  | 75.6 |  
|540 to 579               |  |                     | 439,941   |                       | 9.27                    |   |                                       | 80.30 |   |                  |   | 163,578               |  | 9.25 |                                       |  | 78.3 |  
|580 to 619               |  |                     | 613,277   |                       | 8.85                    |   |                                       | 83.27 |   |                  |   | 255,777               |  | 8.81 |                                       |  | 81.0 |  
|620 to 659               |  |                     | 758,602   |                       | 8.50                    |   |                                       | 82.67 |   |                  |   | 368,232               |  | 8.24 |                                       |  | 79.5 |  
|660 and above            |  |                     | 1,449,661 |                       | 8.28                    |   |                                       | 79.89 |   |                  |   | 1,220,024             |  | 8.09 |                                       |  | 77.4 |  
|                         |  |                     |           |                       |                         |   |                                       |       |   |                  |   |                       |  |      |                                       |  |      |  
|Total                    |  | $                   | 3,489,521 |                       | 8.64                    | % |                                       | 81.01 | % |                  | $ | 2,101,768             |  | 8.35 | %                                     |  | 78.2 | %
|                         |  |                     |           |                       |                         |   |                                       |       |   |                  |   |                       |  |      |                                       |  |      |  

The following table provides information on the collateral location for our loans classified as held-in-portfolio
as of June 30, 2007 and December 31, 2006.

Table 21  Mortgage Loans  Held-in-Portfolio by Collateral Location



|                                              |  |                 |                         |  |                                               |  |                 |  
|--------------------------------------------- |  | --------------- | ----------------------- |  | --------------------------------------------- |  | --------------- | -
|As of June 30,
2007                           |  |                 | As of December 31, 2006 | 
|Collateral Location                           |  | Percentof Total |                         |  | Collateral Location                           |  | Percentof Total |  
|California                                    |  | 26              | %                       |  | California                                    |  | 42              | %
|Florida                                       |  | 19              |                         |  | Florida                                       |  | 19              |  
|All other states (each less than 4% of total) |  | 55              |                         |  | All other states (each less than 5% of total) |  | 39              |  
|                                              |  |                 |                         |  |                                               |  |                 |  
|Total                                         |  | 100             | %                       |  | Total                                         |  | 100             | %
|                                              |  |                 |                         |  |                                               |  |                 |  

The following table provides information on the product type for our loans classified as held-in-portfolio as of
June 30, 2007 and December 31, 2006.

Table 22  Mortgage Loans  Held-in-Portfolio by Product Type

(dollars in thousands)



|                   |  |                    |           |                        |   |          
|------------------ |  | ------------------ | --------- | ---------------------- | - | ---------
|Product Type       |  | As ofJune 30, 2007 |           | As ofDecember 31, 2006
|2-Year Fixed       |  | $                  | 1,220,679 |                        | $ | 608,188  
|MTA (Option ARM)   |  |                    | 848,446   |                        |   | 1,042,415
|2-Year Fixed 40/30 |  |                    | 425,183   |                        |   | 44,115   
|30-Year Fixed      |  |                    | 382,593   |                        |   | 135,576  
|Other Products     |  |                    | 612,620   |                        |   | 271,474  
|                   |  |                    |           |                        |   |          
|Total              |  | $                  | 3,489,521 |                        | $ | 2,101,768
|                   |  |                    |           |                        |   |          



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The following table provides delinquency information for our loans classified as held-in-portfolio as of June 30,
2007 and December 31, 2006.

Table 23  Mortgage Loans  Held-in-Portfolio Delinquencies

(dollars in thousands)



|                          |  |                     |           |                 |                         |   |                   |   |                 |  |     |  
|------------------------- |  | ------------------- | --------- | --------------- | ----------------------- | - | ----------------- | - | --------------- |  | --- | -
|                          |  | As of June 30, 2007 |           |                 | As of December 31, 2006 |  
|                          |  | Current Principal   |           | Percentof Total |                         |   | Current Principal |   | Percentof Total | 
|Current                   |  | $                   | 3,255,008 |                 | 93                      | % |                   | $ | 2,013,541       |  | 96  | %
|30-59 days delinquent     |  |                     | 77,326    |                 | 2                       |   |                   |   | 29,316          |  | 1   |  
|60-89 days delinquent     |  |                     | 48,828    |                 | 1                       |   |                   |   | 15,593          |  | 1   |  
|90 + days delinquent      |  |                     | 13,965    |                 | 1                       |   |                   |   | 5,080           |  |    |  
|In process of foreclosure |  |                     | 94,394    |                 | 3                       |   |                   |   | 38,238          |  | 2   |  
|                          |  |                     |           |                 |                         |   |                   |   |                 |  |     |  
|Total principal           |  | $                   | 3,489,521 |                 | 100                     | % |                   | $ | 2,101,768       |  | 100 | %
|                          |  |                     |           |                 |                         |   |                   |   |                 |  |     |  



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##### Table of Contents

Mortgage Securities Available-for-Sale and Trading.The following tables summarize our mortgage securities
 available for sale portfolio and the current assumptions and assumptions at the time of securitization as of June 30, 2007 and December 31, 2006.

Table 24  Valuation and Assumptions for Individual Mortgage Securities  Available-for-Sale and Trading

(dollars in
thousands)

As of June 30, 2007



|                                  |  |          |         |                    |   |                                            |  |                     |         |  |                                     |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|--------------------------------- |  | -------- | ------- | ------------------ | - | ------------------------------------------ |  | ------------------- | ------- |  | ----------------------------------- | - |  | ----------------------- | - |  | ------------ | - |  | ---------------------- | - |  | ----------------------- | - |  | --- | -
|                                  |  |          |         |                    |   |                                            |  | Current Assumptions |         |  | Assumptions at Trust Securitization |  
|Securitization Trust              |  | Cost (A) |         | UnrealizedGain (A) |   | EstimatedFair ValueofMortgageSecurities(A) |  | DiscountRate        |         |  | ConstantPrepaymentRate              |   |  | ExpectedCreditLosses(B) |   |  | DiscountRate |   |  | ConstantPrepaymentRate |   |  | ExpectedCreditLosses(B) |  
|NMFT Series  Available-for-Sale: |  |          |         |                    |   |                                            |  |                     |         |  |                                     |   |  |                         |   |  |              |  
|2002-3                            |  | $        | 2,528   |                    | $ |                                           |  | $                   | 2,528   |  | 15                                  | % |  | 32                      | % |  | 0.5          | % |  | 20                     | % |  | 30                      | % |  | 1.0 | %
|2003-1                            |  |          | 8,278   |                    |   |                                           |  |                     | 8,278   |  | 15                                  |   |  | 25                      |   |  | 1.3          |   |  | 20                     |   |  | 28                      |   |  | 3.3 |  
|2003-2                            |  |          | 6,158   |                    |   | 624                                        |  |                     | 6,782   |  | 15                                  |   |  | 26                      |   |  | 0.8          |   |  | 28                     |   |  | 25                      |   |  | 2.7 |  
|2003-3                            |  |          | 3,760   |                    |   |                                           |  |                     | 3,760   |  | 15                                  |   |  | 25                      |   |  | 0.9          |   |  | 20                     |   |  | 22                      |   |  | 3.6 |  
|2003-4                            |  |          | 3,303   |                    |   |                                           |  |                     | 3,303   |  | 15                                  |   |  | 31                      |   |  | 1.1          |   |  | 20                     |   |  | 30                      |   |  | 5.1 |  
|2004-1                            |  |          | 3,115   |                    |   |                                           |  |                     | 3,115   |  | 15                                  |   |  | 42                      |   |  | 1.5          |   |  | 20                     |   |  | 33                      |   |  | 5.9 |  
|2004-2                            |  |          | 17,787  |                    |   | 578                                        |  |                     | 18,365  |  | 15                                  |   |  | 44                      |   |  | 1.5          |   |  | 26                     |   |  | 31                      |   |  | 5.1 |  
|2004-3                            |  |          | 26,128  |                    |   | 870                                        |  |                     | 26,998  |  | 15                                  |   |  | 45                      |   |  | 1.8          |   |  | 19                     |   |  | 34                      |   |  | 4.5 |  
|2004-4                            |  |          | 15,898  |                    |   | 212                                        |  |                     | 16,110  |  | 15                                  |   |  | 50                      |   |  | 1.5          |   |  | 26                     |   |  | 35                      |   |  | 4.0 |  
|2005-1                            |  |          | 15,446  |                    |   |                                           |  |                     | 15,446  |  | 20                                  |   |  | 54                      |   |  | 1.9          |   |  | 15                     |   |  | 37                      |   |  | 3.6 |  
|2005-2                            |  |          | 3,950   |                    |   |                                           |  |                     | 3,950   |  | 20                                  |   |  | 50                      |   |  | 1.7          |   |  | 13                     |   |  | 39                      |   |  | 2.1 |  
|2005-3                            |  |          | 8,406   |                    |   |                                           |  |                     | 8,406   |  | 20                                  |   |  | 46                      |   |  | 1.7          |   |  | 15                     |   |  | 41                      |   |  | 2.0 |  
|2005-3 (C)                        |  |          | 977     |                    |   | 1,741                                      |  |                     | 2,718   |  | 20                                  |   |  | N/A                     |   |  | N/A          |   |  | N/A                    |   |  | N/A                     |   |  | N/A |  
|2005-4                            |  |          | 7,263   |                    |   |                                           |  |                     | 7,263   |  | 20                                  |   |  | 44                      |   |  | 2.3          |   |  | 15                     |   |  | 43                      |   |  | 2.3 |  
|2005-4 (C)                        |  |          | 2,761   |                    |   | 1,358                                      |  |                     | 4,119   |  | 20                                  |   |  | N/A                     |   |  | N/A          |   |  | N/A                    |   |  | N/A                     |   |  | N/A |  
|2006-2                            |  |          | 5,723   |                    |   |                                           |  |                     | 5,723   |  | 20                                  |   |  | 45                      |   |  | 3.8          |   |  | 15                     |   |  | 44                      |   |  | 2.4 |  
|2006-3                            |  |          | 5,532   |                    |   | 655                                        |  |                     | 6,187   |  | 20                                  |   |  | 45                      |   |  | 5.0          |   |  | 15                     |   |  | 43                      |   |  | 3.0 |  
|2006-4                            |  |          | 6,666   |                    |   |                                           |  |                     | 6,666   |  | 20                                  |   |  | 45                      |   |  | 4.5          |   |  | 15                     |   |  | 43                      |   |  | 2.9 |  
|2006-5                            |  |          | 8,540   |                    |   |                                           |  |                     | 8,540   |  | 20                                  |   |  | 44                      |   |  | 6.5          |   |  | 15                     |   |  | 43                      |   |  | 3.9 |  
|2006-6                            |  |          | 10,658  |                    |   |                                           |  |                     | 10,658  |  | 20                                  |   |  | 41                      |   |  | 5.7          |   |  | 15                     |   |  | 41                      |   |  | 3.7 |  
|                                  |  |          |         |                    |   |                                            |  |                     |         |  |                                     |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Total                             |  | $        | 162,877 |                    | $ | 6,038                                      |  | $                   | 168,915 |  |                                     |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                                  |  |          |         |                    |   |                                            |  |                     |         |  |                                     |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                                  |  |          |         |                    |   |                                           
|NMFT Series  Trading Securities: |  |          |         |                    |   |                                            |  |                     |         |  |                                     |   |  |                         |   |  |              |  
|2007-2                            |  | $        | 54,738  |                    | $ | 178                                        |  | $                   | 54,916  |  | 20                                  |   |  | 34                      |   |  | 5.8          |   |  | 20                     |   |  | 34                      |   |  | 5.7 |  
|                                  |  |          |         |                    |   |                                            |  |                     |         |  |                                     |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  

---

|(A) | The interest-only, prepayment penalty and overcollateralization securities are presented on a combined basis.
|--- | -------------------------------------------------------------------------------------------------------------

|(B) | For securities that have not reached their call date - represents expected credit losses for the life of the securitization up to the expected date in which the related asset-backed
bonds can be called, net of mortgage insurance recoveries.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(C) | Represent derivative cash flow bonds (CT Bonds).
|--- | --------------------------------------------------



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As of December 31, 2006



|                     |  |          |         |                          |   |        |                                             |  |                     |         |  |                                     |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|-------------------- |  | -------- | ------- | ------------------------ | - | ------ | ------------------------------------------- |  | ------------------- | ------- |  | ----------------------------------- | - |  | ----------------------- | - |  | ------------ | - |  | ---------------------- | - |  | ----------------------- | - |  | --- | -
|                     |  |          |         |                          |   |        |                                             |  | Current Assumptions |         |  | Assumptions at Trust Securitization |  
|Securitization Trust |  | Cost (A) |         | UnrealizedGain(Loss) (A) |   |        | EstimatedFair Value ofMortgageSecurities(A) |  | DiscountRate        |         |  | ConstantPrepaymentRate              |   |  | ExpectedCreditLosses(B) |   |  | DiscountRate |   |  | ConstantPrepaymentRate |   |  | ExpectedCreditLosses(B) |  
|NMFT Series:         |  |          |         |                          |   |        |                                             |  |                     |         |  |                                     |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|2002-3               |  | $        | 3,384   |                          | $ | 56     |                                             |  | $                   | 3,440   |  | 20                                  | % |  | 35                      | % |  | 0.4          | % |  | 20                     | % |  | 30                      | % |  | 1.0 | %
|2003-1               |  |          | 9,398   |                          |   | 418    |                                             |  |                     | 9,816   |  | 20                                  |   |  | 32                      |   |  | 1.3          |   |  | 20                     |   |  | 28                      |   |  | 3.3 |  
|2003-2               |  |          | 5,458   |                          |   | 2,450  |                                             |  |                     | 7,908   |  | 20                                  |   |  | 31                      |   |  | 0.8          |   |  | 28                     |   |  | 25                      |   |  | 2.7 |  
|2003-3               |  |          | 5,255   |                          |   | 254    |                                             |  |                     | 5,509   |  | 20                                  |   |  | 29                      |   |  | 0.8          |   |  | 20                     |   |  | 22                      |   |  | 3.6 |  
|2003-4               |  |          | 3,509   |                          |   | 1,513  |                                             |  |                     | 5,022   |  | 20                                  |   |  | 38                      |   |  | 1.0          |   |  | 20                     |   |  | 30                      |   |  | 5.1 |  
|2004-1               |  |          | 13,511  |                          |   | 3,170  |                                             |  |                     | 16,681  |  | 20                                  |   |  | 47                      |   |  | 1.3          |   |  | 20                     |   |  | 33                      |   |  | 5.9 |  
|2004-1 (D)           |  |          | 132     |                          |   |       |                                             |  |                     | 132     |  | 20                                  |   |  | N/A                     |   |  | N/A          |   |  | N/A                    |   |  | N/A                     |   |  | N/A |  
|2004-2               |  |          | 14,321  |                          |   | 4,492  |                                             |  |                     | 18,813  |  | 20                                  |   |  | 47                      |   |  | 1.3          |   |  | 26                     |   |  | 31                      |   |  | 5.1 |  
|2004-2 (D)           |  |          | 1,322   |                          |   | 60     |                                             |  |                     | 1,382   |  | 20                                  |   |  | N/A                     |   |  | N/A          |   |  | N/A                    |   |  | N/A                     |   |  | N/A |  
|2004-3               |  |          | 24,939  |                          |   | 8,982  |                                             |  |                     | 33,921  |  | 19                                  |   |  | 48                      |   |  | 1.5          |   |  | 19                     |   |  | 34                      |   |  | 4.5 |  
|2004-4               |  |          | 16,237  |                          |   | 8,684  |                                             |  |                     | 24,921  |  | 20                                  |   |  | 56                      |   |  | 1.3          |   |  | 26                     |   |  | 35                      |   |  | 4.0 |  
|2005-1               |  |          | 20,525  |                          |   | 4,558  |                                             |  |                     | 25,083  |  | 15                                  |   |  | 60                      |   |  | 1.7          |   |  | 15                     |   |  | 37                      |   |  | 3.6 |  
|2005-2               |  |          | 13,831  |                          |   | 67     |                                             |  |                     | 13,898  |  | 13                                  |   |  | 54                      |   |  | 1.5          |   |  | 13                     |   |  | 39                      |   |  | 2.1 |  
|2005-3               |  |          | 13,047  |                          |   | 1,169  |                                             |  |                     | 14,216  |  | 15                                  |   |  | 51                      |   |  | 1.5          |   |  | 15                     |   |  | 41                      |   |  | 2.0 |  
|2005-3 (C)           |  |          | 47,814  |                          |   | (1,131 | )                                           |  |                     | 46,683  |  | N/A                                 |   |  | N/A                     |   |  | N/A          |   |  | N/A                    |   |  | N/A                     |   |  | N/A |  
|2005-3 (D)           |  |          | 6,423   |                          |   | 1,473  |                                             |  |                     | 7,896   |  | 15                                  |   |  | N/A                     |   |  | N/A          |   |  | N/A                    |   |  | N/A                     |   |  | N/A |  
|2005-4               |  |          | 11,087  |                          |   | 1,194  |                                             |  |                     | 12,281  |  | 15                                  |   |  | 49                      |   |  | 2.0          |   |  | 15                     |   |  | 43                      |   |  | 2.3 |  
|2005-4 (D)           |  |          | 5,278   |                          |   | 1,143  |                                             |  |                     | 6,421   |  | 15                                  |   |  | N/A                     |   |  | N/A          |   |  | N/A                    |   |  | N/A                     |   |  | N/A |  
|2006-2               |  |          | 13,835  |                          |   |       |                                             |  |                     | 13,835  |  | 15                                  |   |  | 46                      |   |  | 3.2          |   |  | 15                     |   |  | 44                      |   |  | 2.4 |  
|2006-3               |  |          | 13,746  |                          |   |       |                                             |  |                     | 13,746  |  | 15                                  |   |  | 45                      |   |  | 4.3          |   |  | 15                     |   |  | 43                      |   |  | 3.0 |  
|2006-4               |  |          | 19,019  |                          |   |       |                                             |  |                     | 19,019  |  | 15                                  |   |  | 45                      |   |  | 3.5          |   |  | 15                     |   |  | 43                      |   |  | 2.9 |  
|2006-5               |  |          | 22,181  |                          |   |       |                                             |  |                     | 22,181  |  | 15                                  |   |  | 44                      |   |  | 4.8          |   |  | 15                     |   |  | 43                      |   |  | 3.9 |  
|2006-6               |  |          | 26,508  |                          |   |       |                                             |  |                     | 26,508  |  | 15                                  |   |  | 42                      |   |  | 3.9          |   |  | 15                     |   |  | 41                      |   |  | 3.7 |  
|                     |  |          |         |                          |   |        |                                             |  |                     |         |  |                                     |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|Total                |  | $        | 310,760 |                          | $ | 38,552 |                                             |  | $                   | 349,312 |  |                                     |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  
|                     |  |          |         |                          |   |        |                                             |  |                     |         |  |                                     |   |  |                         |   |  |              |   |  |                        |   |  |                         |   |  |     |  

---

|(A) | The interest-only, prepayment penalty and overcollateralization securities are presented on a combined basis.
|--- | -------------------------------------------------------------------------------------------------------------

|(B) | For securities that have not reached their call date - represents expected credit losses for the life of the securitization up to the expected date in which the related asset-backed
bonds can be called, net of mortgage insurance recoveries.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(C) | Consists of the Class M-11 and M-12 certificates of NMFT Series 2005-3. The M-11 is rated BBB/BBB- by Standard & Poors and Fitch, respectively. The M-12 is rated BBB-
by Standard and Poors. The fair value for these securities is based upon market prices.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(D) | Represent derivative cash flow bonds (CT Bonds).
|--- | --------------------------------------------------

As of
June 30, 2007 and December 31, 2006 the fair value of our mortgage securities  available-for-sale was $168.9 million and $349.3 million, respectively. The decline is mostly due to compressed margins, an increase in expected credit
losses and normal paydowns.



80



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##### Table of Contents

Summary of Securitizations.

The following tables provide a summary of the loans collateralizing our securitizations structured as sales as well as the outstanding asset backed bonds which were outstanding at June 30, 2007 and
December 31, 2006.

Table 25  Summary of Securitizations

(dollars in thousands)

As of June 30, 2007



|                     |  |            |  |                   |            |                    |   |                       |  |      |                                         |  |    |                                                   |  |                    |  |                             |            |  |                        |   |  |   
|-------------------- |  | ---------- |  | ----------------- | ---------- | ------------------ | - | --------------------- |  | ---- | --------------------------------------- |  | -- | ------------------------------------------------- |  | ------------------ |  | --------------------------- | ---------- |  | ---------------------- | - |  | --
|                     |  |            |  | Loan Collateral   |            | Asset Backed Bonds
|Securitization Trust |  | Issue Date |  | OriginalPrincipal |            | CurrentPrincipal   |   | WeightedAverageCoupon |  |      | Percent ofLoans WithPrepaymentPenalties |  |    | PrepaymentPenaltyPeriod forLoans w/Penalty (Yrs.) |  | RemainingPrincipal |  | WeightedAverageInterestRate |            |  | EstimatedMonthsto Call
|NMFT Series:         |  |            |  |                   |            |                    |   |                       |  |      |                                         |  |    |                                                   |  |                    |  |                             |            |  |                        |   |  |   
|2002-3               |  | 9/27/2002  |  | $                 | 750,003    |                    | $ | 62,631                |  | 8.64 | %                                       |  | 32 | %                                                 |  | 0.06               |  | $                           | 59,837     |  | 6.01                   | % |  | 7 
|2003-1               |  | 2/27/2003  |  |                   | 1,300,141  |                    |   | 147,858               |  | 7.88 |                                         |  | 39 |                                                   |  | 0.16               |  |                             | 137,862    |  | 6.09                   |   |  | 6 
|2003-2               |  | 6/12/2003  |  |                   | 1,499,998  |                    |   | 183,415               |  | 7.73 |                                         |  | 42 |                                                   |  | 0.32               |  |                             | 175,161    |  | 5.98                   |   |  | 9 
|2003-3               |  | 9/16/2003  |  |                   | 1,499,374  |                    |   | 241,429               |  | 7.38 |                                         |  | 43 |                                                   |  | 0.46               |  |                             | 234,692    |  | 5.92                   |   |  | 20
|2003-4               |  | 11/20/2003 |  |                   | 1,499,732  |                    |   | 214,307               |  | 8.01 |                                         |  | 39 |                                                   |  | 0.48               |  |                             | 209,081    |  | 6.17                   |   |  | 13
|2004-1               |  | 3/11/2004  |  |                   | 1,750,000  |                    |   | 223,991               |  | 9.00 |                                         |  | 27 |                                                   |  | 0.42               |  |                             | 217,643    |  | 6.14                   |   |  | 7 
|2004-2               |  | 6/16/2004  |  |                   | 1,399,999  |                    |   | 206,773               |  | 8.92 |                                         |  | 28 |                                                   |  | 0.50               |  |                             | 196,412    |  | 6.47                   |   |  | 10
|2004-3               |  | 9/9/2004   |  |                   | 2,199,995  |                    |   | 380,367               |  | 9.05 |                                         |  | 32 |                                                   |  | 0.48               |  |                             | 343,006    |  | 6.51                   |   |  | 12
|2004-4               |  | 11/18/2004 |  |                   | 2,500,000  |                    |   | 455,447               |  | 9.14 |                                         |  | 43 |                                                   |  | 0.15               |  |                             | 431,779    |  | 6.40                   |   |  | 11
|2005-1               |  | 2/22/2005  |  |                   | 2,100,000  |                    |   | 503,347               |  | 9.25 |                                         |  | 38 |                                                   |  | 0.19               |  |                             | 482,797    |  | 6.03                   |   |  | 15
|2005-2               |  | 5/27/2005  |  |                   | 1,799,992  |                    |   | 651,970               |  | 9.0  |                                         |  | 35 |                                                   |  | 0.27               |  |                             | 646,975    |  | 5.88                   |   |  | 25
|2005-3               |  | 9/22/2005  |  |                   | 2,499,983  |                    |   | 1,305,016             |  | 7.53 |                                         |  | 48 |                                                   |  | 0.33               |  |                             | 1,243,261  |  | 5.72                   |   |  | 33
|2005-4               |  | 12/15/2005 |  |                   | 1,599,999  |                    |   | 916,734               |  | 7.86 |                                         |  | 72 |                                                   |  | 0.50               |  |                             | 865,661    |  | 5.69                   |   |  | 37
|2006-2               |  | 6/19/2006  |  |                   | 1,021,102  |                    |   | 734,987               |  | 8.74 |                                         |  | 70 |                                                   |  | 0.80               |  |                             | 716,606    |  | 5.53                   |   |  | 41
|2006-3               |  | 6/29/2006  |  |                   | 1,100,000  |                    |   | 854,161               |  | 8.97 |                                         |  | 69 |                                                   |  | 0.91               |  |                             | 829,411    |  | 5.53                   |   |  | 42
|2006-4               |  | 8/29/2006  |  |                   | 1,025,359  |                    |   | 830,095               |  | 9.23 |                                         |  | 63 |                                                   |  | 0.89               |  |                             | 801,384    |  | 5.50                   |   |  | 44
|2006-5               |  | 9/28/2006  |  |                   | 1,300,000  |                    |   | 1,105,749             |  | 9.35 |                                         |  | 64 |                                                   |  | 0.98               |  |                             | 1,073,899  |  | 5.53                   |   |  | 45
|2006-6               |  | 11/30/2006 |  |                   | 1,250,000  |                    |   | 1,148,041             |  | 9.04 |                                         |  | 64 |                                                   |  | 1.11               |  |                             | 1,114,916  |  | 5.52                   |   |  | 52
|2007-2               |  | 6/1/2007   |  |                   | 1,400,000  |                    |   | 1,392,060             |  | 9.05 |                                         |  | 65 |                                                   |  | 1.41               |  |                             | 1,332,560  |  | 5.65                   |   |  | 69
|                     |  |            |  |                   |            |                    |   |                       |  |      |                                         |  |    |                                                   |  |                    |  |                             |            |  |                        |   |  |   
|Total                |  |            |  | $                 | 29,495,677 |                    | $ | 11,558,378            |  | 8.71 | %                                       |  | 56 | %                                                 |  | 0.72               |  | $                           | 11,112,943 |  | 5.75                   | % |  |   
|                     |  |            |  |                   |            |                    |   |                       |  |      |                                         |  |    |                                                   |  |                    |  |                             |            |  |                        |   |  |   



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As of December 31, 2006



|                     |  |            |  |                   |            |                    |   |                       |  |      |                                         |  |    |                                                   |  |                    |  |                             |            |  |                        |   |  |   
|-------------------- |  | ---------- |  | ----------------- | ---------- | ------------------ | - | --------------------- |  | ---- | --------------------------------------- |  | -- | ------------------------------------------------- |  | ------------------ |  | --------------------------- | ---------- |  | ---------------------- | - |  | --
|                     |  |            |  | Loan Collateral   |            | Asset Backed Bonds
|Securitization Trust |  | Issue Date |  | OriginalPrincipal |            | CurrentPrincipal   |   | WeightedAverageCoupon |  |      | Percent ofLoans WithPrepaymentPenalties |  |    | PrepaymentPenaltyPeriod forLoans w/Penalty (Yrs.) |  | RemainingPrincipal |  | WeightedAverageInterestRate |            |  | EstimatedMonthsto Call
|NMFT Series:         |  |            |  |                   |            |                    |   |                       |  |      |                                         |  |    |                                                   |  |                    |  |                             |            |  |                        |   |  |   
|2002-3               |  | 9/27/2002  |  | $                 | 750,003    |                    | $ | 73,038                |  | 8.92 | %                                       |  | 39 | %                                                 |  | 0.25               |  | $                           | 69,709     |  | 6.05                   | % |  | 3 
|2003-1               |  | 2/27/2003  |  |                   | 1,300,141  |                    |   | 173,155               |  | 8.09 |                                         |  | 38 |                                                   |  | 0.34               |  |                             | 161,034    |  | 6.17                   |   |  | 10
|2003-2               |  | 6/12/2003  |  |                   | 1,499,998  |                    |   | 214,894               |  | 7.92 |                                         |  | 41 |                                                   |  | 0.52               |  |                             | 205,224    |  | 6.14                   |   |  | 13
|2003-3               |  | 9/16/2003  |  |                   | 1,499,374  |                    |   | 282,333               |  | 7.62 |                                         |  | 41 |                                                   |  | 0.64               |  |                             | 273,863    |  | 6.23                   |   |  | 23
|2003-4               |  | 11/20/2003 |  |                   | 1,499,732  |                    |   | 260,628               |  | 8.27 |                                         |  | 36 |                                                   |  | 0.62               |  |                             | 253,505    |  | 6.37                   |   |  | 15
|2004-1               |  | 3/11/2004  |  |                   | 1,750,000  |                    |   | 309,992               |  | 9.01 |                                         |  | 41 |                                                   |  | 0.49               |  |                             | 287,573    |  | 6.39                   |   |  | 12
|2004-2               |  | 6/16/2004  |  |                   | 1,399,999  |                    |   | 274,380               |  | 9.06 |                                         |  | 54 |                                                   |  | 0.63               |  |                             | 249,761    |  | 6.33                   |   |  | 14
|2004-3               |  | 9/9/2004   |  |                   | 2,199,995  |                    |   | 496,297               |  | 9.31 |                                         |  | 50 |                                                   |  | 0.65               |  |                             | 452,297    |  | 6.38                   |   |  | 16
|2004-4               |  | 11/18/2004 |  |                   | 2,500,000  |                    |   | 642,881               |  | 9.43 |                                         |  | 38 |                                                   |  | 0.31               |  |                             | 613,188    |  | 6.22                   |   |  | 16
|2005-1               |  | 2/22/2005  |  |                   | 2,100,000  |                    |   | 903,930               |  | 7.75 |                                         |  | 42 |                                                   |  | 0.29               |  |                             | 879,083    |  | 5.83                   |   |  | 20
|2005-2               |  | 5/27/2005  |  |                   | 1,799,992  |                    |   | 972,061               |  | 7.65 |                                         |  | 73 |                                                   |  | 0.49               |  |                             | 963,061    |  | 5.80                   |   |  | 27
|2005-3               |  | 9/22/2005  |  |                   | 2,499,983  |                    |   | 1,566,120             |  | 7.45 |                                         |  | 71 |                                                   |  | 0.67               |  |                             | 1,499,111  |  | 5.72                   |   |  | 32
|2005-4               |  | 12/15/2005 |  |                   | 1,599,999  |                    |   | 1,109,493             |  | 7.89 |                                         |  | 70 |                                                   |  | 0.84               |  |                             | 1,056,693  |  | 5.69                   |   |  | 36
|2006-2               |  | 6/19/2006  |  |                   | 1,021,102  |                    |   | 870,831               |  | 8.76 |                                         |  | 68 |                                                   |  | 1.11               |  |                             | 852,451    |  | 5.54                   |   |  | 42
|2006-3               |  | 6/29/2006  |  |                   | 1,100,000  |                    |   | 992,739               |  | 8.97 |                                         |  | 67 |                                                   |  | 1.21               |  |                             | 967,989    |  | 5.55                   |   |  | 45
|2006-4               |  | 8/29/2006  |  |                   | 1,025,359  |                    |   | 951,206               |  | 9.25 |                                         |  | 60 |                                                   |  | 1.15               |  |                             | 922,495    |  | 5.52                   |   |  | 45
|2006-5               |  | 9/28/2006  |  |                   | 1,300,000  |                    |   | 1,250,254             |  | 9.37 |                                         |  | 61 |                                                   |  | 1.24               |  |                             | 1,218,404  |  | 5.55                   |   |  | 48
|2006-6               |  | 11/30/2006 |  |                   | 1,250,000  |                    |   | 1,242,134             |  | 9.06 |                                         |  | 63 |                                                   |  | 1.38               |  |                             | 1,209,009  |  | 5.55                   |   |  | 52
|                     |  |            |  |                   |            |                    |   |                       |  |      |                                         |  |    |                                                   |  |                    |  |                             |            |  |                        |   |  |   
|Total                |  |            |  | $                 | 28,095,677 |                    | $ | 12,586,366            |  | 8.52 | %                                       |  | 60 | %                                                 |  | 0.84               |  | $                           | 12,134,450 |  | 5.77                   | % |  |   
|                     |  |            |  |                   |            |                    |   |                       |  |      |                                         |  |    |                                                   |  |                    |  |                             |            |  |                        |   |  |   



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The following table provides information on the FICO scores, weighted average coupons and original weighted average
loan-to-values for our loans collateralizing our securitizations structured as sales as of June 30, 2007 and December 31, 2006.

Table 26
 Mortgage Loans Collateralizing Mortgage Securities by FICO Score

(dollars in thousands)



|                         |  |                     |            |                       |                         |   |                                      |      |   |                  |   |                       |  |       |                                      |  |      |  
|------------------------ |  | ------------------- | ---------- | --------------------- | ----------------------- | - | ------------------------------------ | ---- | - | ---------------- | - | --------------------- |  | ----- | ------------------------------------ |  | ---- | -
|                         |  | As of June 30, 2007 |            |                       | As of December 31, 2006 |  
|FICO Score               |  | CurrentPrincipal    |            | WeightedAverageCoupon |                         |   | OriginalWeightedAverageLoan-to-Value |      |   | CurrentPrincipal |   | WeightedAverageCoupon |  |       | OriginalWeightedAverageLoan-to-Value | 
|FICO score not available |  | $                   | 7,062      |                       | 9.82                    | % |                                      | 68.6 | % |                  | $ | 7,733                 |  | 10.08 | %                                    |  | 69.4 | %
|540 and below            |  |                     | 841,208    |                       | 10.04                   |   |                                      | 76.9 |   |                  |   | 922,909               |  | 9.85  |                                      |  | 77.1 |  
|540 to 579               |  |                     | 1,821,883  |                       | 9.50                    |   |                                      | 79.7 |   |                  |   | 1,942,624             |  | 9.28  |                                      |  | 79.6 |  
|580 to 619               |  |                     | 2,565,421  |                       | 8.96                    |   |                                      | 82.6 |   |                  |   | 2,728,305             |  | 8.79  |                                      |  | 82.5 |  
|620 to 659               |  |                     | 2,728,734  |                       | 8.48                    |   |                                      | 82.7 |   |                  |   | 2,923,022             |  | 8.27  |                                      |  | 82.6 |  
|660 and above            |  |                     | 3,594,070  |                       | 8.04                    |   |                                      | 82.8 |   |                  |   | 4,061,773             |  | 7.85  |                                      |  | 83.0 |  
|                         |  |                     |            |                       |                         |   |                                      |      |   |                  |   |                       |  |       |                                      |  |      |  
|Total                    |  | $                   | 11,558,378 |                       | 8.72                    | % |                                      | 81.8 | % |                  | $ | 12,586,366            |  | 8.52  | %                                    |  | 81.9 | %
|                         |  |                     |            |                       |                         |   |                                      |      |   |                  |   |                       |  |       |                                      |  |      |  

The following table provides information on the collateral location for our loans collateralizing our
securitizations structured as sales as of June 30, 2007 and December 31, 2006.

Table 27  Mortgage Loans Collateralizing Mortgage
Securities by Collateral Location



|                                              |  |                 |                         |  |                                               |  |                 |  
|--------------------------------------------- |  | --------------- | ----------------------- |  | --------------------------------------------- |  | --------------- | -
|As of June 30,
2007                           |  |                 | As of December 31, 2006 | 
|Collateral Location                           |  | Percentof Total |                         |  | Collateral Location                           |  | Percentof Total |  
|Florida                                       |  | 21              | %                       |  | Florida                                       |  | 20              | %
|California                                    |  | 14              |                         |  | California                                    |  | 15              |  
|Texas                                         |  | 5               |                         |  | Texas                                         |  | 5               |  
|All other states (each less than 5% of total) |  | 60              |                         |  | All other states (each less than 5% of total) |  | 60              |  
|                                              |  |                 |                         |  |                                               |  |                 |  
|Total                                         |  | 100             | %                       |  | Total                                         |  | 100             | %
|                                              |  |                 |                         |  |                                               |  |                 |  

The following table provides information on the product type for our loans collateralizing our securitizations
structured as sales as of June 30, 2007 and December 31, 2006.

Table 28  Mortgage Loans Collateralizing Mortgage Securities by Product
Type

(dollars in thousands)



|                           |  |                     |            |                         |   |           
|-------------------------- |  | ------------------- | ---------- | ----------------------- | - | ----------
|Product Type               |  | As of June 30, 2007 |            | As of December 31, 2006
|2-Year Fixed               |  | $                   | 5,086,359  |                         | $ | 6,078,256 
|30-Year Fixed              |  |                     | 2,435,949  |                         |   | 2,353,660 
|2-Year Fixed Interest-only |  |                     | 1,388,981  |                         |   | 1,655,605 
|2-Year Fixed 40/30         |  |                     | 1,093,545  |                         |   | 899,385   
|30/15-Year Fixed           |  |                     | 435,203    |                         |   | 484,363   
|15-Year Fixed              |  |                     | 341,620    |                         |   | 356,506   
|3-Year Fixed               |  |                     | 228,754    |                         |   | 278,350   
|Other Products             |  |                     | 547,967    |                         |   | 480,241   
|                           |  |                     |            |                         |   |           
|Outstanding principal      |  | $                   | 11,558,378 |                         | $ | 12,586,366
|                           |  |                     |            |                         |   |           



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The following table provides delinquency information for our loans collateralizing our securitizations structured as
sales as of June 30, 2007 and December 31, 2006.

Table 29  Mortgage Loans Collateralizing Mortgage Securities Delinquencies and Real
Estate Owned

(dollars in thousands)



|                                      |  |                     |            |                 |                         |   |                  |   |                 |  |     |  
|------------------------------------- |  | ------------------- | ---------- | --------------- | ----------------------- | - | ---------------- | - | --------------- |  | --- | -
|                                      |  | As of June 30, 2007 |            |                 | As of December 31, 2006 |  
|                                      |  | CurrentPrincipal    |            | Percentof Total |                         |   | CurrentPrincipal |   | Percentof Total | 
|Current                               |  | $                   | 10,232,381 |                 | 89                      | % |                  | $ | 11,488,283      |  | 91  | %
|30-59 days delinquent                 |  |                     | 267,104    |                 | 2                       |   |                  |   | 288,209         |  | 2   |  
|60-89 days delinquent                 |  |                     | 157,614    |                 | 1                       |   |                  |   | 148,986         |  | 1   |  
|90 + days delinquent                  |  |                     | 85,280     |                 | 1                       |   |                  |   | 67,622          |  | 1   |  
|In process of foreclosure             |  |                     | 470,580    |                 | 4                       |   |                  |   | 347,285         |  | 3   |  
|Real estate owned                     |  |                     | 345,419    |                 | 3                       |   |                  |   | 245,981         |  | 2   |  
|                                      |  |                     |            |                 |                         |   |                  |   |                 |  |     |  
|Total principal and real estate owned |  | $                   | 11,558,378 |                 | 100                     | % |                  | $ | 12,586,366      |  | 100 | %
|                                      |  |                     |            |                 |                         |   |                  |   |                 |  |     |  

The following tables provide a summary of our portfolio of trading securities at June 30, 2007 and
December 31, 2006:

Table 30  Mortgage Securities - Trading

(dollars in thousands)

As of June 30, 2007



|           |  |              |         |                     |   |            |  |                     |         |                      |     |  |       |  
|---------- |  | ------------ | ------- | ------------------- | - | ---------- |  | ------------------- | ------- | -------------------- | --- |  | ----- | -
|S&P Rating |  | OriginalFace |         | AmortizedCost Basis |   | Fair Value |  | Number ofSecurities |         | WeightedAverageYield |    
|A+         |  | $            | 2,199   |                     | $ | 2,202      |  | $                   | 2,085   |                      | 1   |  | 6.32  | %
|A          |  |              | 21,263  |                     |   | 20,655     |  |                     | 18,843  |                      | 5   |  | 7.65  |  
|A-         |  |              | 17,932  |                     |   | 16,209     |  |                     | 14,437  |                      | 4   |  | 11.45 |  
|BBB+       |  |              | 52,802  |                     |   | 50,443     |  |                     | 44,711  |                      | 15  |  | 8.77  |  
|BBB        |  |              | 129,795 |                     |   | 120,705    |  |                     | 99,362  |                      | 31  |  | 9.98  |  
|BBB-       |  |              | 165,890 |                     |   | 151,081    |  |                     | 111,548 |                      | 35  |  | 12.63 |  
|BB+        |  |              | 31,733  |                     |   | 26,465     |  |                     | 15,175  |                      | 12  |  | 16.32 |  
|BB         |  |              | 13,500  |                     |   | 10,512     |  |                     | 6,945   |                      | 5   |  | 19.65 |  
|Unrated    |  |              | N/A     |                     |   | 54,738     |  |                     | 54,916  |                      | 1   |  | 20.0  |  
|           |  |              |         |                     |   |            |  |                     |         |                      |     |  |       |  
|Total      |  | $            | 435,114 |                     | $ | 453,010    |  | $                   | 368,022 |                      | 109 |  | 12.49 | %
|           |  |              |         |                     |   |            |  |                     |         |                      |     |  |       |  

As of December 31, 2006



|           |  |              |         |                     |   |            |  |                     |         |                      |    |  |       |  
|---------- |  | ------------ | ------- | ------------------- | - | ---------- |  | ------------------- | ------- | -------------------- | -- |  | ----- | -
|S&P Rating |  | OriginalFace |         | AmortizedCost Basis |   | Fair Value |  | Number ofSecurities |         | WeightedAverageYield |   
|A+         |  | $            | 2,199   |                     | $ | 2,202      |  | $                   | 2,195   |                      | 1  |  | 6.40  | %
|A          |  |              | 15,692  |                     |   | 15,444     |  |                     | 15,466  |                      | 3  |  | 6.96  |  
|A-         |  |              | 13,432  |                     |   | 12,338     |  |                     | 12,227  |                      | 4  |  | 10.52 |  
|BBB+       |  |              | 53,657  |                     |   | 51,442     |  |                     | 51,367  |                      | 14 |  | 8.56  |  
|BBB        |  |              | 99,795  |                     |   | 93,035     |  |                     | 92,750  |                      | 24 |  | 9.71  |  
|BBB-       |  |              | 135,890 |                     |   | 121,971    |  |                     | 120,003 |                      | 28 |  | 11.94 |  
|BB+        |  |              | 31,733  |                     |   | 25,584     |  |                     | 25,181  |                      | 8  |  | 16.25 |  
|BB         |  |              | 13,500  |                     |   | 10,029     |  |                     | 10,172  |                      | 3  |  | 19.50 |  
|           |  |              |         |                     |   |            |  |                     |         |                      |    |  |       |  
|Total      |  | $            | 365,898 |                     | $ | 332,045    |  | $                   | 329,361 |                      | 85 |  | 11.03 | %
|           |  |              |         |                     |   |            |  |                     |         |                      |    |  |       |  



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As of June 30, 2007 and December 31, 2006, mortgage securities  trading consisted of residual securities,
subordinated securities which were retained from our securitization transactions and subordinated securities purchased from other issuers. The aggregate fair market value of these securities as of June 30, 2007 and December 31, 2006 was
$368.0 million and $329.4 million, respectively. Management estimates the fair value of the residual securities by discounting the expected future cash flows of the collateral and bonds and estimates the fair value of the subordinated securities
based on quoted market prices. The market value of our mortgage securities - trading fluctuates inversely with bond spreads in the market. Generally, as bond spreads widen (i.e. investors demand more return), the value of our mortgage securities -
trading will decline, alternatively, as they tighten, the market value of our mortgage securities  trading will increase. We recognized net trading losses of $89.7 million and $39.7 million for the six and three months ended June 30,
2007, respectively. We recognized net trading gains of $4.2 million and $1.9 million for the same periods of 2006. As bond spreads have continued to widen into 2007, we could experience additional mark-to-market losses on our mortgage securities -
trading if this trend does not reverse.

Mortgage Servicing Rights. We retain the right to service mortgage loans we originate, purchase and
have securitized. Servicing rights for loans we sell to third parties are not retained and we have not purchased the right to service those loans. As of June 30, 2007, we had $55.1 million in capitalized mortgage servicing rights compared with
$62.8 million as of December 31, 2006. The decrease is due to normal amortization which was offset by the retention of mortgage servicing rights of $9.8 million related to the NMFT Series 2007-2 securitization.

Accrued Interest Receivable.Accrued interest receivable increased to $39.7 million at June 30, 2007 from $37.7 million at December 31, 2006. The
increase is primarily attributable to the increase in our mortgage loans  held-in-portfolio balances at June 30, 2007 from December 31, 2006 as a result of structuring our NHEL 2007-1 securitization as a financing for GAAP purposes
rather than a sale during the first quarter of 2007.

Real Estate Owned.Real estate owned increased to $50.0 million at June 30, 2007
from $21.5 million at December 31, 2006. This increase is directly related to credit deterioration in our NHEL 2006-1 and 2007-1 securitizations, delinquent loans repurchased from third parties, and delinquent loans called out of our
off-balance sheet securitizations in 2006 through the exercise of the clean-up call. The stated amount of real estate owned on our consolidated balance sheet is net of expected future losses on the sale of the property.

Derivative Instruments, net.Derivative instruments, net increased to $20.9 million at June 30, 2007 from $16.8 million at December 31,
2006. These amounts include the collateral (margin deposits) required under the terms of our derivative instrument contracts, net of the derivative instrument market values. Due to the nature of derivative instruments we use, the margin deposits
required will generally increase as interest rates decline and decrease as interest rates rise. On the other hand, the market value of our derivative instruments will decline as interest rates decline and increase as interest rates rise.

Short-term Borrowings.Mortgage loan originations and purchases are funded with various financing facilities prior to securitization or sales to
third parties. Repurchase agreements are used as interim, short-term financing before loans are sold or transferred in our securitization transactions. In addition we finance certain of our mortgage securities by using repurchase agreements. As of
June 30, 2007 we had $0.6 billion in short-term borrowings compared to $2.2 billion at December 31, 2006 due to decreased volumes as a result of the tightening of our guidelines and our decision to limit origination volumes due to
uncertainty in the secondary market. The balances outstanding under our short-term repurchase agreements fluctuate based on lending volume, equity and debt issuances, financing activities and cash flows from other operating and investing activities.
See Table 33 for further discussion of our financing availability and liquidity.

Asset-backed bonds.We have issued asset-backed
bonds secured by mortgage loans and mortgage securities as a means for long-term financing. As of June 30, 2007 we had $3.7 billion in asset-backed bonds compared to $2.1 billion at December 31, 2006. We executed one loan securitization
which was treated as a financing during the first six months of 2007 which increased our asset-backed bonds by $1.9 billion. This increase was partially offset by bond payments during the period.



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Shareholders Equity.

The decrease in our shareholders equity as of June 30, 2007 compared to December 31, 2006 is a result of the following increases and decreases.

Shareholders equity increased by:



| |  |  | $5.4 million due to cumulative effect adjustment from adoption of SFAS 157;
| | - |  | ---------------------------------------------------------------------------



| |  |  | $3.2 million due to the issuance of common stock;
| | - |  | -------------------------------------------------



| |  |  | $17.6 million due to impairment on mortgage securities  available for sale reclassified to earnings;
| | - |  | -----------------------------------------------------------------------------------------------------



| |  |  | $0.2 million due to issuance of stock under incentive stock plans;
| | - |  | ------------------------------------------------------------------



| |  |  | $0.6 million due to changes in unrealized gains on derivative instruments used in cash flow hedges;
| | - |  | ---------------------------------------------------------------------------------------------------



| |  |  | $0.7 million due to compensation recognized under the stock compensation plan; and
| | - |  | ----------------------------------------------------------------------------------



| |  |  | $0.3 million due to changes in other miscellaneous activity.
| | - |  | ------------------------------------------------------------

Shareholders equity decreased by:



| |  |  | $6.9 million due to a net loss recognized for the six months ended June 30, 2007;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | $0.3 million due to adjustments on derivative instruments used in cash flow hedges reclassified to earnings;
| | - |  | ------------------------------------------------------------------------------------------------------------



| |  |  | $44.6 million due to the decrease in unrealized gains on mortgage securities classified as available-for-sale;
| | - |  | --------------------------------------------------------------------------------------------------------------



| |  |  | $3.3 million due to dividends accrued or paid on preferred stock; and
| | - |  | ---------------------------------------------------------------------



| |  |  | $1.1 million due to cumulative effect adjustment from the adoption of FIN 48.
| | - |  | -----------------------------------------------------------------------------

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

The following table summarizes our contractual obligations as of June 30, 2007, with the exception of short-term borrowing arrangements.

Table 31  Contractual Obligations

(dollars in
thousands)



|                                                                       |  |                        |           |                 |   |           |  |           |           |               |   |         |  |   |        
|---------------------------------------------------------------------- |  | ---------------------- | --------- | --------------- | - | --------- |  | --------- | --------- | ------------- | - | ------- |  | - | -------
|                                                                       |  | Payments Due by Period
|Contractual Obligations                                                |  | Total                  |           | Less than 1Year |   | 1-3 Years |  | 4-5 Years |           | After 5 Years
|Longterm debt (A)                                                     |  | $                      | 4,120,784 |                 | $ | 1,889,914 |  | $         | 1,384,621 |               | $ | 619,268 |  | $ | 226,981
|Junior subordinated debentures (B)                                     |  |                        | 297,823   |                 |   | 7,531     |  |           | 15,062    |               |   | 15,062  |  |   | 260,168
|Operating leases (C)                                                   |  |                        | 40,615    |                 |   | 11,699    |  |           | 21,038    |               |   | 7,374   |  |   | 504    
|Premiums due to counterparties related to interest rate cap agreements |  |                        | 8,456     |                 |   | 3,988     |  |           | 4,320     |               |   | 148     |  |   |       
|                                                                       |  |                        |           |                 |   |           |  |           |           |               |   |         |  |   |        
|Total                                                                  |  | $                      | 4,467,678 |                 | $ | 1,913,132 |  | $         | 1,425,041 |               | $ | 641,852 |  | $ | 487,653
|                                                                       |  |                        |           |                 |   |           |  |           |           |               |   |         |  |   |        

---

|(A) | Our asset-backed bonds are non-recourse as repayment is dependent upon payment of the underlying mortgage loans, which collateralize the debt. 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 June 30, 2007 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 June 30, 2007 for each respective obligation.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(C) | Does not include rental income of $10.9 million to be received under sublease contracts.
|--- | ----------------------------------------------------------------------------------------

We recorded deferred lease incentives, which will be amortized into rent expense over the life of the respective lease as of June 30, 2007 and 2006 were $2.6 million and $3.2 million, respectively.

Liquidity and Capital Resources

Substantial cash is required to
support our business operations. We strive to maintain adequate liquidity at all times to cover normal cyclical swings in funding availability and mortgage demand and to allow us to meet abnormal and unexpected funding requirements.



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Factors management considers important in determining whether to finance our operations via warehouse and repurchase
facilities, resecuritization or other asset-backed bond issuances or equity or debt offerings are as follows:



| |  |  | The financing costs involved.
| | - |  | -----------------------------



| |  |  | The dilutive effect to our common shareholders.
| | - |  | -----------------------------------------------



| |  |  | The market price of our common stock.
| | - |  | -------------------------------------



| |  |  | Subordination rights of lenders and shareholders.
| | - |  | -------------------------------------------------



| |  |  | Collateral and other covenant requirements.
| | - |  | -------------------------------------------

Overview of Significant Factors Affecting Liquidity During the Six Months Ended June 30, 2007

Significant Cash Inflows/
(Outflows). We had $97.9 million in cash and cash equivalents at June 30, 2007, which was a decrease of $52.7 million from December 31, 2006. The following factors contributed to our change in liquidity position:

During the first half of 2007, bond spreads on mortgage-backed securities widened as a result of investor concerns over deteriorating credit quality in the subprime
mortgage market. This widening caused a significant decline in the fair value of our mortgage securities as well as our mortgage loans held-for-sale. Consequently, during the first half of 2007 we were subject to cash margin calls of approximately
$86.6 million and $33.8 million on our mortgage securities and mortgage loans held-for-sale, respectively. From June 30, 2007 through August 8, 2007, we were subjected to margin calls of approximately $76.5 million due to the extremely volatile
and less liquid secondary market which has adversely affected the values of our mortgage securities. We could continue to be subject to additional margin calls if the value of our mortgage assets decline further. To the extent we are subject to
additional margin calls our liquidity could be adversely affected.

As the values of mortgage loans decreased in the first half of 2007, not only were we
subject to cash margin calls but the cash we were required to invest in new originations increased at the time of funding. We have invested approximately $41.0 million and $40.4 million of cash in our mortgage loans held-for-sale on our balance
sheet as of June 30, 2007 and December 31, 2007, respectively. The absolute amount of invested cash decreased due to the fact that we have originated fewer mortgage loans. However, the relative amount of cash that we must currently invest
has increased due to the fact that the difference between the current principal on the loans and the lending value assigned to the loans by our lenders has increased. Also contributing to this investment of cash is the fact that we are financing a
larger balance of delinquent mortgage loans have lower lending value, and consequently require a larger cash investment by us. In addition, our principal lender has recently reduced the amount we can borrow against our mortgage loans to 94% of the
principal of the loan. To the extent that the amount we can borrow against our mortgage loans is further reduced or the amount of delinquent loans we are required to finance increases our liquidity could be adversely affected.

We also had significant cash outlays to repurchase loans sold to third parties. When whole pools are sold as opposed to securitized, the third party has recourse against
us for certain borrower defaults. The cash we must have on hand to repurchase these loans is much higher than the principal amount of the loan as we generally must reimburse the investor for the remaining unpaid principal balance, any premium
recapture, any unpaid accrued interest and any other out-of-pocket advances in accordance with the loan sale agreement. Typically, repurchased loans will subsequently be financed on our warehouse repurchase agreements if eligible and then liquidated
or sold. We paid $100.3 million in cash in the first half of 2007 to repurchase loans sold to third parties in 2006. Significant capital is tied up in these assets as the amount we can borrow against these assets is much lower than performing loans
and some may not be eligible for financing. To the extent that we are required to purchase additional loans our liquidity could be adversely affected.

We
closed a CDO structured as a financing transaction in the first quarter of 2007. The collateral for this securitization consisted of subordinated securities which we retained from our loan securitizations as well as subordinated securities purchased
from other issuers. We received net proceeds from the issuance of the asset-backed bonds and from the proceeds of our financing of the BBB bond aggregating $64.3 million.

During the first six months of 2007, we also closed two loan securitizations. The net cash inflow from these transactions was $24.4 million. Generally, our securitizations are a net positive cash flow event due to the
financing we receive on the residual security we retain.

We rely on access to the secondary market for long-term financing of our mortgage loans. Due to
volatility in the secondary market due to concerns about the deteriorating credit quality of subprime loans, we have not been able to access the securitization market or sell loans to third parties during the first part of the third quarter. To the
extent we are unable to access this market in the near future, our liquidity could be adversely affected.



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Short-term Borrowings. As of June 30, 2007, we continued to fail to satisfy the profitability covenant
under one of our warehouse financing facilities. Our GAAP net income, determined on a pre-tax basis, was not greater than $1 for the six months ended June 30, 2007 and we have been unable to obtain a modification or waiver of this
requirement. Therefore, the $1 billion of borrowing capacity under this facility is not available to us so long as we remain out of compliance. We had no borrowings outstanding under this facility as of June 30, 2007 and, thus, the breach has
not triggered any cross-default provisions with our other warehouse facilities. On May 1, 2007, the lender under this facility delivered a notice of default to us demanding payment of $2.9 million representing fees owed under the agreement and
notifying us that it was applying $2.9 million in cash that it held as collateral towards this amount.

As a result of the significant decline in our
liquidity position, in April 2007, we executed the Residual Securities Facility with Wachovia, providing for the financing of certain of our existing residual securities and we also executed the Servicing Rights Facility with Wachovia, providing for
the financing of certain mortgage servicing rights.

The maximum amount that may be outstanding at any time under the Residual Securities Facility and the
Servicing Rights Facility is $40 million and $70 million, respectively, which amounts will be reduced if and to the extent necessary so that the aggregate amount outstanding from time to time under both the Residual Securities Facility and Servicing
Rights Facility does not exceed $100 million. The advance rate under each facility is up to 60% of the fair value of the assets securing the facility, as determined from time to time by Wachovia. The interest rate under the Residual Securities
Facility is LIBOR plus 3.5% and the interest rate under the Servicing Rights Facility is LIBOR plus 3.75%. Loan proceeds from these facilities will be used for general corporate purposes. Each of these facilities has a term of 364 days, subject to
automatic renewal for another 364 days unless Wachovia gives at least 120 days notice of its intention to terminate the facility on the maturity date. We are required to notify Wachovia of any margin calls under any repurchase facilities we have
with any third parties in excess of $5 million in the aggregate, in which event Wachovia will have the option to increase the aggregate amount available under other financing facilities between us and Wachovia and cause us to place the assets
subject to the margin call on such facilities. Upon a change of control, Wachovia has the right to terminate the facilities and require the payment of a termination fee.

Mortgage servicing rights eligible for financing under the Servicing Rights Facility include rights of NMI under existing servicing agreements relating to certain of our securitizations and, subject to certain
approvals of the related securitization trustees and other existing mortgage servicing rights. Servicing rights arising in connection with future securitizations may also be financed under the Servicing Rights Facility if mutually agreed by the
parties. In each case, the related servicing agreement must be acceptable to Wachovia.

Under the Servicing Rights Facility, we will remain the servicer of
the pledged servicing rights, provided Wachovia will have the right to replace us as the servicer if (1) the tangible net worth of NFI falls below a certain amount, (2) our servicing rating is downgraded below a certain level by
Moodys, S&P or Fitch or (3) an event of default under either facility occurs. To the extent we are replaced as a servicer, our balance sheet will be adversely affected due to a reduction in our mortgage servicing rights and our
condensed consolidated statements of operations could be adversely affected by a reduction in net servicing income.

In May 2007, we executed a $1.9
billion comprehensive financing facility arranged with Wachovia. The facility expands and replaces the whole-loan and securities repurchase agreements previously existing between Wachovia and us, other than the Servicing Rights Facility and the
Residual Securities Facility. The intent of the comprehensive facility was to put in place a financing facility that enables us to primarily use Wachovia for our borrowing needs. Based on this intent, when our lending facilities held with
institutions other than Wachovia expire throughout 2007, our available credit limit could decrease from $4.0 billion to $2.0 billion. In the event we need additional borrowing capacity, Wachovia may approve an increase but there can be no assurances
that Wachovia will grant such approval. Upon the close of the comprehensive facility, we transferred all borrowings with our other lenders to Wachovia.

The $1.9 billion facility consists of the following separate agreements (collectively, the Agreements), having the following sublimits: (1) a Whole Loan Master Repurchase Agreement ($1.9 billion); (2) a Securities
Master Repurchase Agreement (Investment Grade)($400 million); and (3) a Securities Master Repurchase Agreement (Non Investment Grade)($400 million). The aggregate purchase price under each individual Agreement will reduce availability under the
other Agreements such that the maximum aggregate purchase price under all Agreements at any point in time will not exceed $1.9 billion. Financing capacity under the Agreements is in addition to the aggregate $100 million financing capacity under the
Servicing Rights Facility and the Residual Securities Facility. Availability under the Whole Loan Master Repurchase Agreement includes approximately $152 million of availability for delinquent, non-performing loans and real estate owned. We
previously announced that the comprehensive Wachovia facility would include a Servicing Advance Master Repurchase Agreement. The parties at this time have decided not to enter into this facility but may do so in the future. We currently plan to
maintain our servicing advance facility with another financial institution.

The Agreements are cross-collateralized with each other and all other
repurchase and similar financing facilities between us and Wachovia, including the Servicing Rights Facility and the Residual Securities Facility. We were required to pay Wachovia a structuring fee in connection with the facility and certain
additional fees and expenses, including but not limited to reimbursement of due diligence expenses and payment of certain fees in the event of voluntary prepayment or termination by us or the occurrence of an event of default. In addition, upon a
change of control, Wachovia has the right to terminate the Agreements and require the payment of a termination fee.



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Under the Whole Loan Master Repurchase Agreement, the specific advance rate applicable to a particular asset depends on,
among other matters, the type, age and performance of such asset and, in some cases, our level of liquidity. For recently originated mortgage loans under which there has been no delinquency in any of the first three monthly payments following
origination, the advance rate under this Agreement is generally between 95% and 98% of the market value of such loan and such advances bear interest at one-month LIBOR plus 0.65%. For other mortgage loans and real estate owned, the advance rate is
generally between 65% to 95% of market value, but may be lower pending Wachovias review of a particular asset, and such advances bear interest at a rate ranging from one-month LIBOR plus 0.65% to one-month LIBOR plus 2%. In addition, advance
rates for mortgage loans and real estate owned are subject to additional but similar limitations based upon the outstanding principal balance of the mortgage loan or the appraised value of the real estate owned and, in some cases, additional but
similar limitations based upon our valuation of the asset, cost, or committed sale price.

The advance rate under the Investment Grade Securities Facility
ranges from 70% to 97% of the market value of the securities securing the advance. The interest rate applicable to such advances range from one-month LIBOR to one-month LIBOR plus 0.65%, depending on the type of securities securing the advance.

The advance rate under the Non-Investment Grade Securities Facility is up to 65% of the market value of the mortgage securities securing the advance. The
interest rate applicable to such advances range from one-month LIBOR plus 1% to one-month LIBOR plus 2.5%, depending on the type of mortgage securities securing the advance.

Securities Purchase Agreement. On July 16, 2007, NFI entered into a Securities Purchase Agreement pursuant to which the Investors purchased for $48.8 million in cash 2,100,000 shares
of NFIs Series D-1 Preferred Stock, in a private placement not registered under the Securities Act of 1933, as amended. NFI intends to use the proceeds from the sale of the Series D-1 Preferred Stock under the Securities Purchase Agreement for
general working capital. Prior to the execution of the Securities Purchase Agreement, MassMutual, through certain of its affiliates, and certain affiliates of Jefferies Capital Partners, owned 771,800 shares and 224 shares of common stock, par
value $0.01 per share (the Common Stock), respectively.

Dividends on the Series D-1 Preferred Stock accrue at a rate of 9.00% per
annum, and are payable in cash. In addition, holders of the Series D-1 Preferred Stock are entitled to participate in any common stock dividends on an as converted basis.

The Series D-1 Preferred Stock is convertible into NFIs common stock at any time at the option of the holders. The Series D-1 Preferred Stock was initially convertible into 1,875,000 shares (post-split) of
common stock based upon the initial conversion price of $28.00 per share (post-split), subject to adjustment. If NFI has not obtained stockholder approval for certain adjustments to the conversion price of the Series D-1 Preferred Stock designed to
provide certain anti-dilution protection to the holders of such stock upon certain issuances of capital stock by NFI (the Shareholder Approval) on or prior to July 16, 2010, NFI may elect to convert all of the Series D-1 Preferred
Stock into Common Stock, if at such time NFI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. If NFI has not obtained Shareholder Approval on or prior to the ninth anniversary of the issuance of the Series D-1 Preferred Stock, the Series D-1 Preferred Stock will automatically convert into shares of Common Stock. In
addition, if NFI has obtained Shareholder Approval, the shares of Series D-1 Preferred Stock will automatically convert into shares of Series D-2 Preferred Stock on the later of July 16, 2009 or the date NFI obtains such Shareholder Approval.

In connection with the purchase of the Series D-1 Preferred Stock pursuant to the Securities Purchase Agreement, the Investors also committed to purchase
up to $101.2 million of Series D-2 Preferred Stock, to the extent any such shares are not subscribed for in a planned rights offering of such shares by NFI by entering into the Standby Purchase Agreement. Also in connection with the Securities
Purchase Agreement, NFI entered into the Registration Rights Agreement with the Investors that provides the Investors with (i) customary registration rights with respect to certain shares owned by the Investors as described below; and
(ii) certain other rights, including the right to designate Directors to NFIs Board of Directors, the right to approve certain transactions, including a change in control, and certain preemptive rights to subscribe for our securities.

In addition, upon a Change of Control (as defined in the Registration Rights Agreement), the Investors have the right to require NFI to redeem all or a
portion of their Series D-1 Preferred Stock purchased pursuant to the Securities Purchase Agreement, the Series D-2 Preferred Stock purchased by the Investors in connection with the Rights Offering or the Standby Purchase Agreement or, if and when
issued, any Series E Preferred Stock.



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Standby Purchase and Rights Offering. In connection with the Securities Purchase Agreement, NFIs
Board of Directors approved the Rights Offering pursuant to which holders of NFIs Common Stock and Series D-1 Preferred Stock will receive the Rights to purchase shares of the Series D-2 Preferred Stock at a price of $25.00 per share.The Series D-2 Preferred Stock will be convertible into NFIs Common Stock as contemplated in the Securities Purchase Agreement. Pursuant to the Standby Purchase Agreement, and subject to certain conditions, each of MassMutual and Jefferies
Capital Partners has agreed severally to purchase 50% of the shares of Series D-2 Preferred Stock that remain unsold in the Rights Offering.

As
contemplated in the Securities Purchase Agreement, the Series D-2 Preferred Stock will rank pari passu with the shares of Series D-1 Preferred Stock, and will be convertible into NFIs Common Stock at any time, at the option of the
holders, based on the initial conversion price of $28.00 per share (post-split), subject to adjustment in the same manner as the Series D-1 Preferred Stock. After three years, the Series D-2 Preferred Stock also would be convertible into Common
Stock at NovaStars option, under specified circumstances. At the end of nine years, if not already converted, the Series D-2 Preferred Stock would mandatorily be converted into shares of Common Stock at the then current conversion ratio. The
Series D-2 Preferred Stock will accrue cumulative dividends at the rate of 9.00% per annum, payable in kind, by adding accrued dividends to the stated value of the Series D-2 Preferred Stock, or in cash, at NFIs election. The Series D-2
Preferred Stock would initially be non-voting, but upon receipt of certain state regulatory agency approvals relating to the acquisition by the Investors of the Series D-1 Preferred Stock and the Series D-2 Preferred Stock, would have the same
voting rights, on an as-converted basis, as holders of NFIs Common Stock.

The Standby Purchase Agreement contains customary
representations and covenants of NFI including that NFI operate in the ordinary course of business until the closing of the purchase of shares by the Investors pursuant to the Standby Purchase Agreement.

The Investors obligation to purchase the Series D-2 Preferred Stock under the Standby Purchase Agreement is subject to customary closing conditions, including,
among other things, NFIs Board of Directors having declared the REIT Dividend and having set the record date for determination of the stockholders of NFI entitled to receive payment of the REIT Dividend (which date will be on or prior to
December 31, 2007 but not earlier than the first business day after the closing under the Standby Purchase Agreement); NFI having taken all actions necessary to increase the size of its Board of Directors so that the Investors are able to
designate a number of directors as contemplated by the Registration Rights Agreement and having filled such vacancies with individuals designated by the Investors in accordance with the Registration Rights Agreement; and since the date of the
Standby Purchase Agreement, there not having been an NFI Material Adverse Effect (as defined below).

An NFI Material Adverse
Effect under the Standby Purchase Agreement means any event, change, circumstance or effect that individually or in the aggregate (with other events, changes, circumstances or effects) is or is reasonably likely to (A) be materially
adverse to NFIs ability to perform its obligations under the Standby Purchase Agreement or the other transaction documents, or (B) be materially adverse on the financial condition, assets, liabilities, business or results of operations of
NFI and its subsidiaries, taken as a whole (subject to certain exclusions only in the case of clause (B) for (i) events, changes, circumstances or effects relating to general economic or market conditions, so long as such conditions do not
have a disproportionate effect on NFI and its subsidiaries, compared to other companies in the industries in which NFI and its subsidiaries conduct their business, (ii) certain extraordinary events such as acts of war, hostilities or natural
disasters, (iii) decreases in the market value or trading volume of NFIs Common Stock on the New York Stock Exchange or failure by NFI or its subsidiaries to meet any projections, or budgets so long as, in the case of (iii), no underlying
event or circumstance that itself constitutes such a material adverse effect has resulted in or contributed to such decrease in the market value or trading volume or such failure of any projections or budgets, and (iv) certain other
exceptions).

The Standby Purchase Agreement may be terminated and the transactions contemplated thereby abandoned (1) by the mutual consent of NFI
and the Investors; (2) by either Investor or NFI if the other breaches any covenant, representation or warranty, which breach would cause the failure of certain conditions precedent to the closing of the transactions under the Standby Purchase
Agreement, if such breach is not capable of cure on or prior to December 31, 2007; (3) by either Investor if NFI fails to satisfy any other conditions to the closing under the Standby Purchase Agreement and such failure cannot be cured on or
prior to December 10, 2007; (4) by either Investor if any updates to NFIs disclosure schedules disclose any matter that has, or would be reasonably likely to have, an NFI Material Adverse Effect, (5) by either Investor if the
Rights Offering has not commenced by October 25, 2007; (6) by either Investor if the record date for the REIT Dividend has occurred and/or the REIT Dividend has been paid; or (7) by NFI or either Investor after January 31, 2008
provided, that the right to terminate the Standby Purchase Agreement under clauses (3) and (7) will not be available to a party if that party has failed to fulfill any obligation under the Standby Purchase Agreement and such failure has
materially contributed to the failure of any condition precedent or the closing of the standby commitment.

To the extent that the transaction contemplated
by the Rights Offering and the Standby Purchase Agreement are not consummated or are consummated on materially different terms, our liquidity could be adversely affected.



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REIT Dividend Payment. NFI currently intends, in the third quarter of 2007, to declare a dividend (the
REIT Dividend) in order to satisfy certain requirements to distribute 2006 taxable income relating to its status as a REIT under the Code. Timing of the declaration and distribution of the REIT Dividend will be determined by the Board of
Directors, but federal tax rules for REITs require that we declare dividends based on 2006 taxable income by the deadline for our tax return, which is September 17, 2007, and distribute those dividends by year-end.

In the Securities Purchase Agreement, we have agreed (1) to declare the REIT Dividend on or before September 17, 2007, (2) that the record
date for the REIT Dividend will not be before the earlier of (A) the date all of the shares of the Series D-2 Preferred Stock are purchased in the Rights Offering as described above or the first business day after the closing of the
transactions contemplated by the Standby Purchase Agreement and (B) December 10, 2007 and (3) that the REIT Dividend will be distributed in the form of shares of 9.00% Series E Convertible Preferred Stock, (the Series E
Preferred Stock), ranking pari passu with the Series D-1 Preferred Stock and the Series D-2 Preferred Stock. Definitive terms of the Series E Preferred Stock will be determined by NFIs Board of
Directors.

The following table provides a summary of our operating, investing and financing cash flows as taken from our consolidated
statements of cash flows for the six months ended June 30, 2007 and 2006.

Table 32  Summary of Operating, Investing and Financing Cash Flows

(dollars in thousands)



|                                            |  |                                   |          |   |      |   |            |                       |  |   |            |  
|------------------------------------------- |  | --------------------------------- | -------- | - | ---- | - | ---------- | --------------------- |  | - | ---------- | -
|                                            |  | For the Six Months Ended June 30, |          |   |      |  
|                                            |  | 2007                              |          |   | 2006 |   |            | (Decrease) / Increase | 
|Consolidated Statements of Cash Flows:      |  |                                   |          |   |      |   |            |                       |  |   |            |  
|Cash used in operating activities           |  | $                                 | (746,449 | ) |      | $ | (2,944,297 | )                     |  | $ | (2,197,848 | )
|Cash flows provided by investing activities |  |                                   | 581,658  |   |      |   | 261,269    |                       |  |   | 320,389    |  
|Cash flows provided by financing activities |  |                                   | 112,141  |   |      |   | 2,544,272  |                       |  |   | (2,432,131 | )

Operating Activities. Net cash used in operating activities decreased to $(746.4) million for the six
months ended June 30, 2007 from $(2.9) billion for the six months ended June 30, 2006. This decrease is due primarily to a decrease in our cash used for originations and purchases of mortgage loans held-for-sale of $3.4 billion during the
six months ended June 30, 2007 compared to the same period of 2006.

Investing Activities. Net cash provided by investing activities increased
to $581.7 million for the six months ended June 30, 2007 from $261.6 million for the same period of 2006. This increase is due primarily to higher repayments of our mortgage loans held-in-portfolio during the six months ended June 30, 2007
compared to the same period of 2006 which was driven by the on-balance sheet securitizations we executed in 2006 and 2007. This increase is offset somewhat by a decrease in paydowns on our mortgage securities  available-for-sale during the
first six months of 2007 as compared to the same period of 2006.

Financing Activities. Net cash provided by financing activities decreased to
$112.1 million for the six months ended June 30, 2007 from $2.5 billion for the six months ended June 30, 2006. This decrease is due primarily to a net decrease in short-term borrowings of $1.5 billion during the first six months of 2007
compared to a net increase in short-term borrowings of $0.3 billion for the same period of 2006. This change was the result of lower originations in the first six months of 2007.

Primary Uses of Cash

Investments in New Mortgage Securities.We retain significant interests in the
nonconforming loans we originate and purchase through our mortgage securities investment portfolio. We require capital in our securitizations to fund the primary bonds we retain, overcollateralization, securitization expenses and our operating costs
to originate the mortgage loans.

Our investments in new mortgage securities should generally increase or decrease in conjunction with our mortgage loan
production. In 2005, because we began retaining certain subordinated primary bonds, the amount of capital needed for our securitizations increased. For the six months ended June 30, 2007, we retained residual securities with a cost basis of
$56.4 million and no subordinated securities from our securitization transactions. In addition, we purchased subordinated securities during the first quarter of 2007 with a cost basis of $22.0 million from other issuers which settled in the second
quarter of 2007. For the six months ended June 30, 2006 we retained residual securities with a cost basis of $59.4 million and subordinated securities with a cost basis of $28.3 million from our securitization transactions. In addition in 2006
we began purchasing subordinated bonds from other issuers, which also requires capital. We purchased subordinated securities with a cost basis of $52.3 million from other issuers during the second quarter of 2006.



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Originations and Purchases of Mortgage Loans.Mortgage lending requires significant cash to fund loan
originations and purchases. The capital invested in our mortgage loans is outstanding until we sell or securitize the loans. For the six months ended June 30, 2007 and 2006 we used $2.3 billion and $5.7 billion in cash for the origination and
purchase of mortgage loans held-for-sale, respectively. As the values of mortgage loans decreased in the first quarter of 2007, not only were we subject to cash margin calls but the capital required to invest in new originations increased. We have
invested approximately $38.7 million of capital in our mortgage loans held-for-sale on our balance sheet as of June 30, 2007 which consists of the difference between the current principal on the loans and the amount we can borrow against these
loans. Due to uncertainty in the current market as discussed in Managements Discussion and Analysis of Financial Condition and Results of Operations  Industry Overview and Known Material Trends, we could be faced with additional
margin calls and the amount we can borrow against our mortgage assets may be further reduced, which would further affect our liquidity and we may be forced to alter our business strategies to preserve liquidity in this environment.

Repayments of Long-Term Borrowings.Our payments on asset-backed bonds increased to $476.0 million for the six months ended June 30, 2007 from $117.8
million for the same period of 2006 due to an increase in our mortgage loans  held-in-portfolio as a result of on-balance sheet securitizations completed in 2006 and 2007. Long-term borrowing repayments will fluctuate with the timing of new
issuances of long-term debt and their respective maturities. See Primary Sources of CashNet Proceeds From Issuances of Long-Term Debt.

Common and Preferred Stock Dividend Payments. In May 2007, the Board of Directors approved a formal plan to revoke our REIT status effective January 1, 2008. Because we currently intend to remain a
REIT through December 31, 2007, we must distribute at least 90% of our REIT taxable income for 2006 and 2007 to our shareholders in the form of dividend payments to maintain our qualification as a REIT through December 31, 2007.
Historically, we have generally declared cash dividends equal to 100% of our REIT taxable income but our ability to pay dividends is now restricted by covenants in our new financing facilities. As discussed previously under Overview of
Significant Factors Affecting Liquidity in the Six Months Ended June 30, 2007 within Liquidity and Capital Resources, we currently intend, in the third quarter of 2007, to declare the REIT dividend in order to satisfy certain
requirements to distribute 2006 taxable income relating to our status as a REIT under the Internal Revenue Code of 1986, as amended. Timing of the declaration and distribution of the REIT Dividend will be determined by the Board of Directors, but
federal tax rules for REITs require that we declare dividends based on 2006 taxable income by the deadline for our tax return, which is September 17, 2007, and distribute those dividends by year-end. Our estimate of undistributed taxable income
for 2006 is approximately $160 million.

We currently intend to pay our dividend with respect to our 2006 taxable income in securities as permitted by REIT
tax laws. For 2007, we expect to have little or no taxable income primarily due to the reversal of temporary taxable differences related to our residual securities.

We did not declare any common stock dividends for the six months ended June 30, 2007. We declared common stock dividends per share of $11.20 for the six months ended June 30, 2006. Preferred stock dividends
declared per share were $1.12 for the six months ended June 30, 2007 and 2006.

Loan Sale and Securitization Repurchases. In the
ordinary course of business, we sell whole pools of loans with recourse for certain borrower defaults. Because the loans are no longer on our balance sheet, the recourse component is considered a guarantee. During the six months ended June 30,
2007, we sold $244.1 million of loans with recourse for borrower defaults compared to $793.1 million for the same period of 2006. We maintained a $3.5 million recourse reserve related to these guarantees as of June 30, 2007 compared with a
reserve of $24.8 million as of December 31, 2006. We paid $100.3 million in cash to repurchase loans sold to third parties during the six months ended June 30, 2007 compared to $8.8 million during the same period of 2006. The recourse
reserve is our estimate of the loss we expect to incur in repurchasing the loan and then either liquidating or reselling the loan. The cash we must have on hand to repurchase these loans is much higher as we generally must reimburse the investor for
the remaining unpaid principal balance, any premium recapture, any unpaid accrued interest and any other out-of-pocket advances in accordance with the loan sale agreement. Repurchased loans will subsequently be financed on our warehouse repurchase
agreements if eligible and then liquidated or sold. The recourse reserve as of June 30, 2007 declined by $21.3 million from December 31, 2006 due to the fact that we only sold $244.1 million of loans to third parties during the six months
ended June 30, 2007 and we had repurchased the majority of loans reserved for at December 31, 2006. See discussion of haircuts on these loans below in Primary Sources of Cash  Change in Short-Term Borrowings, net (Warehouse
Lending Arrangements).

We also sell loans to securitization trusts and make a guarantee to cover losses suffered by the trust resulting from defects
in the loan origination process. Defects may occur in the loan documentation and underwriting process, either through processing errors made by us or through intentional or unintentional misrepresentations made by the borrower or agents during those
processes. If a defect is identified, we are required to repurchase the loan. As of December 31, 2006 and June 30, 2007, we had loans sold with recourse with an outstanding principal balance of $12.6 billion and $11.6 billion,
respectively. Historically, repurchases of loans from securitization trusts where a defect has occurred have been insignificant. Because we have received no significant requests to repurchase loans from our securitization trusts as of June 30,
2007, we have not recorded any reserves related to these guarantees.



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Primary Sources of Cash

Change in Short-Term Borrowings, net (Warehouse Lending Arrangements). Mortgage lending requires significant cash to fund loan originations and purchases. As of June 30, 2007, our current $1.9
billion warehouse lending arrangements with Wachovia, which include repurchase agreements generally having one-year terms, support our mortgage lending operation. We continue to have unexpired lending facilities with other financial institutions but
do not intend to use those facilities for the near future except for our servicing advance facility. As of June 30, 2007, our current warehouse repurchase agreements have various collateral advance rates depending on the collateral type or
delinquency status. Generally, for performing mortgage loans our lending agreements provide for advances at the lesser of 95% of market value or 100% of par. Funding for the difference, or haircut, must come from cash on hand. Advance
rates on nonperforming assets are generally tiered down depending on the delinquency severity and can range as low as 65% of the lesser of market value or principal balance. For our mortgage securities financings, our lending agreements have advance
rates ranging from 65% to 97% of the market value, depending on the type, age and rating of the security. Most of our subordinated securities have an advance rate ranging from 65% to 97% while our residual securities generally have an advance rate
ranging from 60% to 65% and our servicing rights have an advance rate of 60%. See Overview of Significant Factors Affecting Liquidity in the Six Months Ended June 30, 2007 for a discussion of the terms and conditions of our
repurchase agreements executed in the second quarter of 2007. Our short-term borrowings decreased by $1.5 billion for the six months ended June 30, 2007 compared to an increase of $0.3 million for the same period of 2006 due to a decrease in
the volume of loan originations during the first half of 2007 and the timing of securitizations executed between periods. At June 30, 2007 we pledged sufficient collateral under these agreements to provide us with $59.2 million of available
additional borrowing capacity. However, we have not utilized all borrowing capacity. Therefore, upon the pledge of additional collateral additional borrowing capacity should be available.

Loans and securities financed with warehouse repurchase agreements are subject to changing market valuation and margin calls. The market value of our loans is dependent
on a variety of economic conditions, including interest rates, borrower demand, borrower creditworthiness, and end investor desire and capacity. The market value of our securities is also dependent on a variety of economic conditions, including
interest rates, default rates on the underlying loans and market demand for the types of securities we retain from our securitizations and purchase from other issuers. To the extent the value of the loans or securities declines below the required
market value margin set forth in the lending agreements, we would be required to repay portions of the amounts we have borrowed.

During the first half of
2007, bond spreads widened on mortgage-backed securities to uncommon levels as a result of investor concerns over deteriorating credit quality in the subprime mortgage market. This widening caused a significant decline in the value of our mortgage
securities as well as our mortgage loans held-for-sale. Consequently, we were subject to cash margin calls of approximately $86.6 million and $33.8 million on our mortgage securities and mortgage loans held-for-sale, respectively. From June 30,
2007 to August 8, 2007, we were subjected to margin calls of approximately $76.5 million due to the extremely volatile and less liquid secondary market, which has adversely affected the values of our mortgage securities and our mortgage loans -
held-for-sale. We could continue to be subject to additional margin calls if the value of our mortgage assets further declines.

All of our warehouse
repurchase credit facilities include numerous representations, warranties and covenants, including requirements to maintain a certain minimum net worth, minimum equity ratios and other customary debt covenants. Events of default under these
facilities include material breaches of representations or warranties, failure to comply with covenants, material adverse effects upon or changes in our business, assets, or financial condition, and other customary matters. Events of default under
certain of our facilities also include termination of our status as servicer with respect to certain securitized loan pools, certain downgrades in our servicer ratings and failure to maintain profitability over consecutive quarters. If we were
unable to make the necessary representations and warranties at the time we need financing, we would not be able to obtain needed funds. In addition, if we breach any covenant or an event of default otherwise occurs under any warehouse repurchase
credit facility under which borrowings are outstanding, the lenders under all existing warehouse repurchase credit facilities could demand immediate repayment of all outstanding amounts because all of our warehouse repurchase credit facilities
contain cross-default provisions. As discussed previously, as of June 30, 2007, we continued to fail to satisfy the profitability covenant under one of our warehouse financing facilities which requires our GAAP net income, determined on a
pre-tax basis, to be greater than $1 for the six months ended June 30, 2007. We have been unable to obtain a modification or waiver of this requirement; therefore, the borrowing capacity under this facility is not available to us so long
as we remain out of compliance. We currently have no borrowings outstanding under this facility. On May 1, 2007, the lender under this facility delivered a notice of default to us demanding payment of $2.9 million representing fees owed under
the agreement and notifying us that it was applying $2.9 million in cash that it held as collateral towards this amount. While management believes at June 30, 2007 we were, and currently we are, in compliance with all other covenants, any future
breach or non-compliance could have a material adverse effect on our financial condition.

As shown in the table below, we had $97.9 million in cash as of
June 30, 2007 to support our mortgage lending and mortgage portfolio operations. We have borrowed approximately $629.6 million of the $4.0 billion in mortgage securities, mortgage loans and servicing advance financing facilities, leaving
approximately $3.3 billion available upon the pledge of eligible mortgage loans, securities or other collateral to support the mortgage lending and mortgage portfolio operations.



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As previously discussed under Overview of Significant Factors Affecting Liquidity in the Six Months Ended June 30, 2007, we are not in
compliance with the covenant requirements of one of our warehouse lending facilities as of June 30, 2007. The borrowing capacity under this facility is $1 billion and we have excluded it from our total credit limit as of June 30, 2007.
Additionally, included in the credit limit in Table 33 is $2.0 billion of credit provided by lending agreements with institutions other than Wachovia for which we have no intent to use in the near future and will expire in the last half of 2007.

Table 33  Short-term Financing Resources

(dollars in thousands)



|                                                                                |  |              |           |                           |   |            |  |                           |         |  |   |        
|------------------------------------------------------------------------------- |  | ------------ | --------- | ------------------------- | - | ---------- |  | ------------------------- | ------- |  | - | -------
|                                                                                |  | Credit Limit |           | LendingValue ofCollateral |   | Borrowings |  | ImmediatelyAvailableFunds
|Unrestricted cash                                                               |  |              |           |                           |   |            |  |                           |         |  | $ | 97,872 
|Mortgage securities, mortgage loans and servicing advance repurchase facilities |  | $            | 3,950,000 |                           | $ | 688,806    |  | $                         | 629,592 |  |   | 59,214 
|                                                                                |  |              |           |                           |   |            |  |                           |         |  |   |        
|Total                                                                           |  | $            | 3,950,000 |                           | $ | 688,806    |  | $                         | 629,592 |  | $ | 157,086
|                                                                                |  |              |           |                           |   |            |  |                           |         |  |   |        

Additionally, from June 30, 2007 through August 8, 2007, we were subjected to margin calls of approximately
$76.5 million due to the extremely volatile and less liquid secondary market which has adversely affected the values of our mortgage securities. As of August 8, 2007, our unrestricted cash and availability totaled approximately $103.6 million.

Cash Received From Our Mortgage Securities Portfolio.A major driver of cash flows from investing activities are the proceeds we receive
from our mortgage securitiesavailable-for-sale portfolio. For the six months ended June 30, 2007 we received $108.3 million in proceeds from repayments on mortgage securitiesavailable-for-sale as compared to $183.6 million for the
same period of 2006. 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:



| |  |  | The coupons on the underlying collateral of our mortgage securities have increased modestly while the interest rates paid on the bonds issued by the securitization
trusts have dramatically risen over the last couple of years.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The higher credit losses due to the substantial decline in housing price appreciation of the underlying collateral during 2006 and into 2007 has decreased cash
available to distribute with respect to our residual securities.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We have lower average balances of our mortgage securitiesavailable-for-sale portfolio as our paydowns have increased faster than our addition of new bonds
from our securitization transactions.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Proceeds from Repayments of Mortgage Loans. For the six months ended June 30,
2007 we received $502.2 million in proceeds from the repayments of our portfolio of mortgage loans held-for-sale and mortgage loans held-in-portfolio compared to $172.7 million for the same period of 2006. The significant increase in repayments is
due to a larger portfolio of mortgage loans held-in-portfolio in the first and second quarter of 2007 as compared to the same period of 2006.

Net
Proceeds from Securitizations of Mortgage Loans. We depend on the capital markets to finance the mortgage loans we originate and purchase. The primary bonds we issue in our loan securitizations structured as sales are sold to large,
institutional investors and U.S. government-sponsored enterprises. If the non-conforming loan industry continues to experience credit difficulties, our ability to access the securitization market on favorable terms, or at all, may be negatively
affected. The net proceeds from sales of mortgage loans held-for-sale in securitizations decreased to $1.3 billion for the six months ended June 30, 2007 from $2.0 billion for the same period of 2006. Until the secondary market stabilizes, we
expect that our volume of loans securitized will continue at current levels or decrease.

Net Proceeds from Sales of Mortgage Loans to Third Parties.We also depend on third party investors to provide liquidity for our mortgage loans. We generally will sell loans to third party investors that do not possess the economic characteristics meeting our long-term portfolio management
objectives. For the six months ended June 30, 2007 and 2006 we received net proceeds from the sales of mortgage loans held-for-sale to third parties of $247.0 million and $823.8 million, respectively. Due to the depressed mortgage banking
environment in the first half of 2007, we significantly decreased the volume of loans sold to third parties. Until the secondary market stabilizes, we expect that our volume of loans sold to third parties will continue at current levels or decrease.

Net Proceeds from Issuances of Long-Term Debt.The resecuritization of our mortgage securitiesavailable-for-sale, on balance sheet
securitizations, collateralized debt obligations as well as private debt offerings provide long-term sources of liquidity.

We received net proceeds of
$1.8 billion through the issuance of NHES Series 2007-1, an on-balance sheet securitization during the six months ended June 30, 2007. These asset-backed bonds are collateralized by mortgage loans  held-in-portfolio on our



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consolidated balance sheet. The $1.8 billion is prior to the netting of the repayment of short-term borrowings secured by the underlying mortgage loans and
prior to any new short-term borrowings secured by retained mortgage securities. The net cash outflow for this securitization was approximately $2.2 million.

In 2005 we began retaining various subordinated investment-grade securities from our securitization transactions that were previously held in the form of overcollateralization bonds. We also purchase subordinated securities from other ABS
issuers. We executed our first CDO in February 2007 and received net proceeds of $326.8 million through the issuance of asset-backed bonds. The $326.8 million is prior to the netting of the repayment of short-term borrowings secured by the
underlying mortgage securities and prior to any new short-term borrowings secured by the retained mortgage securities. The net cash inflow for the CDO was approximately $64.3 million.

We periodically issue asset-backed bonds (NIMs) secured by our mortgage securities  available-for-sale as a means for long-term non-recourse financing for these assets. We did not issue any NIMs in the first six
months of 2006 or 2007.

Net Proceeds from Issuances Equity or Debt or the Retention of Cash Flow. If our board of directors determines that
additional financing is required, we may raise the funds through additional equity offerings, debt financings, retention of cash flow (subject to provisions in the Code concerning distribution requirements and taxability of undistributed REIT
taxable income, so long as we remain a REIT) or a combination of these methods. In the event that our board of directors determines to raise additional equity capital, it has the authority, without stockholder approval, subject to applicable law and
NYSE regulations, to issue additional common stock or preferred stock in any manner and on terms and for consideration it deems appropriate up to the amount of authorized stock set forth in our charter. Since inception, we have raised $566.9 million
in net proceeds through private and public equity offerings. We had no significant equity issuances during the six and three months ended June 30, 2007. Subsequent to June 30, 2007, as discussed previously under Overview of
Significant Factors Affecting Liquidity in the Six Months Ended June 30, 2007 within Liquidity and Capital Resources, we issued $48.8 million of preferred stock and intend, subject to the satisfaction of certain conditions, to
issue $101.2 million of additional preferred stock in the last half of 2007.

Other Liquidity Factors

The derivative financial instruments we use also subject us to margin call risk. Under our interest rate swaps, we pay a fixed rate to the counterparties
while they pay us a floating rate. When floating rates are lower than the fixed rate on the interest rate swap, we are paying the counterparty. In order to mitigate credit exposure to us, the counterparty requires us to post margin deposits with
them. As of June 30, 2007 we had approximately $1.9 million on deposit with counterparties. A decline in interest rates would subject us to additional exposure for cash margin calls. However, when short-term interest rates (the basis for our
funding costs) are low and the coupon rates on our loans are high, our net interest margin (and therefore incoming cash flow) is high which should offset any requirement to post additional collateral. Severe and immediate changes in interest rates
will impact the volume of our incoming cash flow. To the extent rates increase dramatically, our funding costs will increase quickly. While many of our loans are adjustable, they typically will not reset as quickly as our funding costs. This
circumstance would reduce incoming cash flow. As noted above, derivative financial instruments are used to mitigate the effect of interest rate volatility. In this rising rate situation, our interest rate swaps and caps would provide additional cash
flows to mitigate the lower cash flow on loans and securities.

Table 30 details our major contractual obligations due over the next 12 months and beyond.
As previously discussed, the secondary markets upon which we rely for the financing and sale of our mortgage assets are currently extremely volatile and less liquid and our borrowing capacity under our warehouse repurchase facilities has been
reduced due to the reduction in the value of our mortgage assets and the amounts lenders are willing to lend against those assets, which has impacted and continues to impact the availability and terms of short-term and long-term financing available
to us. Management has taken steps, and anticipates that further steps will be necessary, to align our operations with these changed and changing market conditions. In particular, the scope and nature of our origination and securitization activities
are likely to be significantly reduced to decrease further investment of capital in these assets until we see a return of the secondary markets to more rational terms. Management believes these measures, together with cash and cash equivalents on
hand and other available liquidity sources including: 1) proceeds from mortgage loan sales and securitizations, 2) cash received on our mortgage securities available-for-sale, 3) draw downs on mortgage loan and securities repurchase agreements, 4)
proceeds from private and public debt and equity offerings and 5) proceeds from resecuritizations will be adequate to meet our liquidity needs for the next twelve months. However, our liquidity needs are less predictable, and our liquidity resources
are significantly more limited, than they have been in the past. We can provide no assurance, that, if needed, the liquidity resources we utilize will be available or will be available on terms we consider favorable. Factors that can affect our
liquidity are discussed in the Managements Discussion and Analysis of Financial Condition and Results of Operations and Risk Factors sections of this document.



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Off-Balance Sheet Arrangements

As discussed previously, we pool the loans we originate and purchase and typically securitize them to obtain long-term financing for the assets. The loans are transferred to a trust where they serve as collateral for
asset-backed bonds, which the trust issues to the public. We often retain our residual and subordinated securities issued by the trust. We also securitize residual and subordinated securities that we retain from our securitizations and we purchase
from third parties. Our ability to access the securitization capital market is critical to the operations of our business.

Information about the revenues,
expenses, liabilities and cash flows we have in connection with our securitization transactions are detailed in Managements Discussion and Analysis of Financial Condition and Results of Operations.

External factors that are reasonably likely to affect our ability to continue to use this arrangement would be those factors that could disrupt the securitization
capital market. A disruption in the market could prevent us from being able to sell the securities at a favorable price, or at all. Recently, there has been a significant disruption in the securitization market for residential mortgage loans and
securities caused by, among other things, an increased default rate on residential mortgage loans, and an increase in the number of rating downgrades with respect to bonds issued in connection with securitizations of subprime loans, including
downgrades from investment grade to junk bond status. To the extent that the current residential mortgage loan default rate continues to increase or fails to abate, the credit quality of mortgage-backed bonds continues to erode, or other events
occur, such as an international liquidity crisis such as occurred in the fall of 1998, sudden changes in interest rates, further changes in the nonconforming loan market, or other significant event risk, or a default under a comparable type of
securitization, our access to the securitization market could be further limited. Further, poor performance of our previously securitized loans could further harm our access to the securitization market.

If we were unable to access the securitization market, we may still be able to finance our mortgage operations by selling our loans to investors in the whole loan
market. However, recent pricing in the whole loan market has been unfavorable, and any significant sales of whole pools of loans at this time would likely be at a significant loss. In an attempt to offset the impact on our liquidity caused by the
disruption in the secondary market for loans, we have undertaken the steps set forth under Liquidity and Capital Resources  Overview of Significant Factors Affecting Liquidity during the Six Months Ended June 30, 2007. There,
however, can be no assurance that these steps will be sufficient to support our liquidity.

We have commitments to borrowers to fund residential mortgage
loans as well as commitments to purchase and sell mortgage loans to third parties. As of June 30, 2007, we had outstanding commitments to originate loans of $232.7 million. We had no commitments to sell or purchase loans at June 30, 2007.
As of December 31, 2006, we had outstanding commitments to originate and purchase loans of $774.0 million and $11.8 million, respectively. We had no outstanding commitments to sell loans at December 31, 2006. The commitments to originate
and purchase loans do not necessarily represent future cash requirements, as some portion of the commitments are likely to expire without being drawn upon.

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

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 and so long as we are a REIT, common stock dividends are based on taxable income. In each case, financial activities and the balance sheet are measured with reference to historical cost or fair market value without
considering inflation.



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Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our investment policy sets the following general
goals:



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



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

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

Management primarily uses financing sources under which the interest rate resets frequently. As of
June 30, 2007, borrowings under all financing arrangements adjust daily or monthly off LIBOR. On the other hand, very few of the mortgage assets we own adjust on a monthly or daily basis. Most of the mortgage loans contain rates that are fixed
for some period of time and then adjust frequently thereafter.

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

We transfer interest rate agreements at the time of securitization into the securitization trusts to protect the third-party bondholders from interest rate risk and to
decrease the volatility of future cash flows related to the securitized mortgage loans. We enter into these interest rate agreements as we originate and purchase mortgage loans in our mortgage lending segment. At the time of a securitization
structured as a sale, we transfer interest rate agreements into the securitization trusts and they are removed from our balance sheet. The trust assumes the obligation to make payments and obtains the right to receive payments under these
agreements. Generally, net settlement obligations paid by the trust for these interest rate agreements reduce the excess interest cash flows to our residual securities. Net settlement receipts from these interest rate agreements are either used to
cover interest shortfalls on the third-party primary bonds or to provide credit enhancement with any remaining funds then flowing to our residual securities. For securitizations structured as financings the derivatives will remain on our balance
sheet. Generally, these interest rate agreements do not meet the hedging criteria set forth in GAAP while they are on our balance sheet; therefore, we are required to record their change in value as a component of earnings even though they may
reduce our interest rate risk. In times when short-term rates rise or drop significantly, the value of our agreements will increase or decrease, respectively. Occasionally, we enter into interest rate agreements that do meet the hedging criteria set
forth in GAAP. In these instances, we record their change in value, if effective, directly to other comprehensive income on our statement of shareholders equity.

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

The following table summarizes managements estimates of the changes in market
value of our mortgage assets and interest rate agreements assuming interest rates were 100 and 200 basis points, or 1 and 2 percent higher or lower. The cumulative change in market value represents the change in market value of mortgage assets, net
of the change in market value of interest rate agreements. The change in market value of the liabilities on our balance sheet due to a change in interest rates is insignificant since a majority of our short-term borrowings and ABB are adjustable
rate; however, as noted above, rapid increases in short-term interest rates would negatively impact the interest-rate spread between our liabilities and assets and, consequently, our earnings.



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Table 34Interest Rate Sensitivity - Market Value

(dollars in thousands)



|                                                    |  |                                                       |         |   |       |   |         |     |  |   |         |    |  |   |          |   
|--------------------------------------------------- |  | ----------------------------------------------------- | ------- | - | ----- | - | ------- | --- |  | - | ------- | -- |  | - | -------- | --
|                                                    |  | Basis Point Increase (Decrease) in Interest Rates (A) |        
|                                                    |  | (200)                                                 |         |   | (100) |   |         | 100 |  |   | 200     |   
|As of June 30, 2007:                                |  |                                                       |         |   |       |   |         |     |  |   |         |    |  |   |          |   
|Change in market values of:                         |  |                                                       |         |   |       |   |         |     |  |   |         |    |  |   |          |   
|Assets  non trading (B)                            |  | $                                                     | 126,949 |   |       | $ | 51,241  |     |  | $ | (26,114 | )  |  | $ | (47,973  | ) 
|Assets  trading (C)                                |  |                                                       | 35,507  |   |       |   | 20,613  |     |  |   | (27,223 | )  |  |   | (52,596  | ) 
|Interest rate agreements                            |  |                                                       | (5,638  | ) |       |   | (4,806  | )   |  |   | 11,845  |    |  |   | 26,597   |   
|                                                    |  |                                                       |         |   |       |   |         |     |  |   |         |    |  |   |          |   
|Cumulative change in market value                   |  | $                                                     | 156,818 |   |       | $ | 67,048  |     |  | $ | (41,492 | )  |  | $ | (73,972  | ) 
|                                                    |  |                                                       |         |   |       |   |         |     |  |   |         |    |  |   |          |   
|Percent change of market value portfolio equity (D) |  |                                                       | 28.6    | % |       |   | 12.2    | %   |  |   | (7.6    | )% |  |   | (13.5    | )%
|                                                    |  |                                                       |         |   |       |   |         |     |  |   |         |    |  |   |          |   
|                                                    |  |                                                       |         |  
|As of December 31, 2006:                            |  |                                                       |         |   |       |   |         |     |  |   |         |    |  |   |          |   
|Change in market values of:                         |  |                                                       |         |   |       |   |         |     |  |   |         |    |  |   |          |   
|Assets  non trading (B)                            |  | $                                                     | 226,262 |   |       | $ | 105,038 |     |  | $ | (78,698 | )  |  | $ | (150,481 | ) 
|Assets  trading (C)                                |  |                                                       | 9,999   |   |       |   | 7,080   |     |  |   | (14,120 | )  |  |   | (30,707  | ) 
|Interest rate agreements                            |  |                                                       | (40,018 | ) |       |   | (20,946 | )   |  |   | 23,998  |    |  |   | 49,264   |   
|                                                    |  |                                                       |         |   |       |   |         |     |  |   |         |    |  |   |          |   
|Cumulative change in market value                   |  | $                                                     | 196,243 |   |       | $ | 91,172  |     |  | $ | (68,820 | )  |  | $ | (131,924 | ) 
|                                                    |  |                                                       |         |   |       |   |         |     |  |   |         |    |  |   |          |   
|Percent change of market value portfolio equity (D) |  |                                                       | 34.0    | % |       |   | 15.8    | %   |  |   | (11.9   | )% |  |   | (22.9    | )%
|                                                    |  |                                                       |         |   |       |   |         |     |  |   |         |    |  |   |          |   

---

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

|(B) | Includes mortgage loans held-for-sale, mortgage loans held-in-portfolio, mortgage securities - available-for-sale and mortgage servicing rights.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------

|(C) | Consists of mortgage securities  trading.
|--- | ------------------------------------------

|(D) | Total change in estimated market value as a percent of market value portfolio equity as of June 30, 2007 and December 31, 2006.
|--- | -------------------------------------------------------------------------------------------------------------------------------

Hedging.We use derivative instruments to mitigate the risk of our cost of funding increasing at a faster rate than the interest on the loans. We adhere to
an interest rate risk management program that is approved by our Board. This program is formulated with the intent to offset the potential adverse effects resulting from rate adjustment limitations on mortgage assets and the differences between
interest rate adjustment indices and interest rate adjustment periods of adjustable-rate mortgage loans and related borrowings.

We use interest rate cap
and swap contracts to mitigate the risk of the financing expense of variable rate liabilities increasing at a faster rate than the income produced on assets during a period of rising rates. Management intends generally to hedge as much of the
interest rate risk as determined to be in our best interest, given the cost and risk of hedging transactions and the limitations on our ability to hedge imposed on us by REIT tax requirements.

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

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

The following table summarizes the key contractual terms associated with our interest rate risk management contracts as of June 30, 2007. All of our pay-fixed swap contracts and interest rate cap contracts are
indexed to one-month LIBOR.

We have determined the following estimated net fair value amounts by using available market information and valuation
methodologies we deem appropriate as of June 30, 2007.



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Table 35  Interest Rate Risk Management Contracts

(dollars in thousands)



|                              |  |               |       |                     |   |           |                |  |   |         |     |  |      |         |     |      |   |         |                |  |   |         |     |  |   |        |  
|----------------------------- |  | ------------- | ----- | ------------------- | - | --------- | -------------- |  | - | ------- | --- |  | ---- | ------- | --- | ---- | - | ------- | -------------- |  | - | ------- | --- |  | - | ------ | -
|                              |  |               |       |                     |   |           | Maturity Range | 
|                              |  | Net FairValue |       | TotalNotionalAmount |   |           | 2007           |  |   | 2008    |     |  | 2009 |         |     | 2010 |   |         | 2011 andbeyond | 
|Pay-fixed swaps:              |  |               |       |                     |   |           |                |  |   |         |     |  |      |         |     |      |   |         |                |  |   |         |     |  |   |        |  
|Contractual maturity          |  | $             | 8,399 |                     | $ | 1,595,000 |                |  | $ | 430,000 |     |  | $    | 720,000 |     |      | $ | 405,000 |                |  | $ | 40,000  |     |  | $ |       |  
|Weighted average pay rate     |  |               |       |                     |   | 4.9       | %              |  |   | 4.8     | %   |  |      | 5.0     | %   |      |   | 4.9     | %              |  |   | 5.0     | %   |  |   |       |  
|Weighted average receive rate |  |               |       |                     |   | 5.3       | %              |  |   |         | (A) |  |      |         | (A) |      |   |         | (A)            |  |   |         | (A) |  |   |       |  
|                              |  |               |       |                     |   |           |               
|Interest rate caps:           |  |               |       |                     |   |           |                |  |   |         |     |  |      |         |     |      |   |         |                |  |   |         |     |  |   |        |  
|Contractual maturity          |  | $             | 6,903 |                     | $ | 1,070,000 |                |  | $ | 80,000  |     |  | $    | 365,000 |     |      | $ | 275,000 |                |  | $ | 310,000 |     |  | $ | 40,000 |  
|Weighted average strike rate  |  |               |       |                     |   | 5.1       | %              |  |   | 4.9     | %   |  |      | 5.0     | %   |      |   | 5.1     | %              |  |   | 5.3     | %   |  |   | 5.3    | %

---

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



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Item 4. Controls and Procedures

Disclosure Controls and Procedures. We maintain a system of disclosure
controls and procedures (as defined in Rules 13a-15(e) under the Securities Exchange Act of 1934) which are designed to ensure that information required to be disclosed by us in reports we file or submit under the federal securities laws, including
this report, is recorded, processed, summarized and reported on a timely basis. These disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in reports we file or submit under
the federal securities laws is accumulated and communicated to management, including our principal executive officer (CEO) and principal financial officer (CFO), on a timely basis to allow decisions regarding required
disclosure. Management, with the participation of our CEO and CFO, evaluated the effectiveness of our disclosure controls and procedures as of June 30, 2007. Based on this evaluation and solely because of the material weakness in internal control
over financial reporting related to our process to record fair value adjustments on our CDO debt described below, our CEO and CFO concluded that our disclosure controls and procedures were not effective as of June 30, 2007.

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

During the period
covered by this quarterly report, we identified a control deficiency that was deemed a material weakness in internal controls over financial reporting at June 30, 2007. The deficiency relates to the operating effectiveness of our process to
calculate and record fair value adjustments related to our CDO debt. Specifically, effective controls were not designed and in place to ensure the accuracy of spreadsheets used to prepare and calculate the fair value of our CDO debt. Management is
in the process of designing and implementing a remediation plan to improve the operating effectiveness of our process for calculating and recording fair value adjustments related to our CDO debt. The remediation plan includes:



| |  |  | Identifying all material schedules that require manual input and calculations which are a part of the process to record fair value adjustments on our CDO debt,
including appropriate supporting documents;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Requiring the accounting department to receive all schedules and supporting documentation related to amounts prepared and calculated by our portfolio management
department relating to the process to record fair value adjustments on our CDO debt;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Requiring the accounting department to reconcile all schedules to the appropriate supporting documentation relating to the process to record fair value adjustments
on our CDO debt; and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Requiring communication between the accounting department and portfolio management department when any subsequent revisions are made to the schedules relating to
the process to record fair value adjustments on our CDO debt.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

We will monitor, evaluate and test the operating effectiveness of these
enhanced controls during the third quarter of 2007.

The deficiency was identified and adjustments were made during the preparation of our Form 10-Q for
the quarterly period ended June 30, 2007. The deficiency did not require a restatement of prior period financial statements.

Changes in Internal
Controls over Financial Reporting.There were no changes in our internal controls over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) that occurred during our most recent fiscal quarter that have materially
affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

Our management, including our CEO and CFO, does
not expect that our disclosure controls and procedures or our internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that
the control systems objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent
limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our Company have been detected. These inherent limitations include the realities that
judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of
the controls. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future
conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with associated policies or procedures. Because of the inherent limitations in a cost-effective control system,
misstatements due to error or fraud may occur and not be detected.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

In March 2002, an action was filed against NHMI in Superior Court of Orange County, California
entitled American Interbanc Mortgage, LLC v. NovaStar Home Mortgage, Inc. et. al. In the action, the plaintiff alleged that NHMI and two other mortgage companies (Defendants) engaged in false advertising under a California statute
permitting lawsuits by a competitor. Plaintiff amended its complaint subsequently to allege also that Defendants engaged in unfair competition under a different California statute and interfered intentionally with Plaintiffs prospective
economic relations. On May 4, 2007, a jury returned a verdict by a 9-3 vote awarding plaintiff $15.9 million. The court trebled the award, made adjustments for amounts paid by settling Defendants, and entered a $46.1 million judgment against
Defendants on June 27, 2007. The award is joint and several against the three defendants including NHMI. It is unknown if the other two defendants have the financial ability to pay any of the award. NHMI is currently reviewing its alternatives
and will first ask the trial court to overturn the verdict because NHMI does not believe the verdict is supported by the evidence. Absent such a decision NHMI is currently reviewing its various options for appeal. There can be no assurances that
these efforts will be successful. NHMI has a variety of alternative legal steps that can be taken. As such, it is too early in the process to determine that a liability is probable or estimatable and it is not reasonably possible to determine the
outcome, therefore, we have not recorded any liability or corresponding charge to earnings related to this case.

Since April 2004, a number of
substantially similar class action lawsuits have been filed and consolidated into a single action in the United States District Court for the Western District of Missouri. The consolidated complaint names us and three of our executive officers as
defendants and generally alleges that the defendants made public statements that were misleading for failing to disclose certain regulatory and licensing matters. The plaintiffs purport to have brought this consolidated action on behalf of all
persons who purchased our common stock (and sellers of put options on our common stock) during the period October 29, 2003 through April 8, 2004. On January 14, 2005, we filed a motion to dismiss this action, and on May 12,
2005, the court denied such motion. On February 8, 2007, the court certified the case as a class action, and our petition for permission to appeal the class certification decision has been denied but is the subject of a pending petition for
rehearing. We believe that these claims are without merit and will continue to vigorously defend against them.

In the wake of the securities class action,
we have also been named as a nominal defendant in several derivative actions brought against certain of our officers and directors in Missouri and Maryland. The complaints in these actions generally claim that the defendants are liable us for
failing to monitor corporate affairs so as to ensure compliance with applicable state licensing and regulatory requirements. The parties have reached a settlement of the derivative actions under which we agree to adopt certain corporate governance
measures and our insurance carrier will pay attorneys fees to plaintiffs counsel. The settlement agreement is subject to court approval. Notice of the settlement terms has been provided to shareholders, and a hearing for final court
approval of the settlement is scheduled for September 19, 2007.

In April 2005, three putative class actions filed against NHMI and certain of its
affiliates were consolidated for pre-trial proceedings in the United States District Court for the Southern District of Georgia entitled In Re NovaStar Home Mortgage, Inc. Mortgage Lending Practices Litigation. These cases contend that NHMI
improperly shared settlement service fees with limited liability companies in which NHMI had an interest (the LLCs), in violation of the fee splitting and anti-referral provisions of the federal Real Estate Settlement Procedures Act
(RESPA), and also allege certain violations of state law and civil conspiracy. Plaintiffs seek treble damages with respect to the RESPA claims, disgorgement of fees with respect to the state law claims as well as other damages,
injunctive relief, and attorneys fees. In addition, two other related class actions have been filed in state courts. Miller v. NovaStar Financial, Inc., et al., was filed in October 2004 in the Circuit Court of Madison County, Illinois
and Jones et al. v. NovaStar Home Mortgage, Inc., et al., was filed in December 2004 in the Circuit Court for Baltimore City, Maryland. In the Miller case, plaintiffs



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allege a violation of the Illinois Consumer Fraud and Deceptive Practices Act and civil conspiracy and contend certain LLCs provided settlement services
without the borrowers knowledge. The plaintiffs in the Miller case seek a disgorgement of fees, other damages, injunctive relief and attorneys fees on behalf of the class of plaintiffs. In the Jones case, the plaintiffs
allege the LLCs violated the Maryland Mortgage Lender Law by acting as lenders and/or brokers in Maryland without proper licenses and contend this arrangement amounted to a civil conspiracy. The plaintiffs in the Jones case seek a
disgorgement of fees and attorneys fees. In January 2007, all of the plaintiffs and NHMI agreed upon a nationwide settlement. On June 22, 2007, the parties signed a settlement agreement that provides for a claims-made settlement class.
The settlement agreement must be approved by the U.S. District Court for the Southern District of Georgia in Savannah, Georgia. On July 11, 2007, the district court tentatively approved the agreement and set a fairness hearing to consider final
approval of the proposed settlement on September 14, 2007. Since not all class members will elect to be part of the settlement, we estimated the probable obligation related to the settlement to be in a range of $3.9 million to $4.7 million. In
accordance with SFAS No. 5, Accounting for Contingencies, we recorded a charge to earnings of $3.9 million in December of 2006. This amount is included in Accounts payable and other liabilities on our consolidated
balance sheet.

In December 2005, a putative class action was filed against NMI in the United States District Court for the Western District of Washington
entitled Pierce et al. v. NovaStar Mortgage, Inc. Plaintiffs contend that NMI failed to disclose prior to closing that a broker payment would be made on their loans, which was an unfair and deceptive practice in violation of the Washington
Consumer Protection Act. Plaintiffs seek excess interest charged, and treble damages as provided in the Washington Consumer Protection Act and attorneys fees. On October 31, 2006, the district court granted plaintiffs motion to
certify a Washington state class. NMI entered into a settlement agreement with the plaintiffs on June 21, 2007. The agreement, which must be approved by the district court, calls for NMI to pay class members $3.3 million and to pay $1.8 million
in attorneys fees. On June 27, 2007, the district court tentatively approved the settlement agreement and scheduled a hearing for September 28, 2007 to consider final approval of the settlement.

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

Since February 2007, a number of substantially similar putative class actions have been filed in the United States District Court for the Western District of Missouri. The complaints name us and three of our executive officers as defendants
and generally allege, among other things, that the defendants made materially false and misleading statements regarding our business and financial results. The plaintiffs purport to have brought the actions on behalf of all persons who purchased or
otherwise acquired our common stock during the period May 4, 2006 through February 20, 2007. We believe that these claims are without merit and will vigorously defend against them.

In June 2007, two borrowers filed a putative class action entitled Kubiak v. NovaStar Mortgage, Inc., against us and two of its subsidiaries in the United States
District Court for the Northern District of California, alleging that payments of premiums to brokers by one of the subsidiaries were not properly disclosed to borrowers in the manner allegedly required by federal or state law, thus constituting
unfair competition and false advertising under California law and violation of the California Consumer Legal Remedies Act. Plaintiffs seek statutory and punitive damages, restitution, injunctive relief and attorneys fees on behalf of
California borrowers who allegedly failed to receive adequate disclosure of such premiums. We believe that these claims are without merit and will vigorously defend against them.

In addition to those matters listed above, we are currently a party to various other legal proceedings and claims, including, but not limited to, breach of contract claims, class action or individual claims for
violations of the RESPA, FLSA, federal and state laws prohibiting employment discrimination, federal and state laws prohibiting discrimination in lending and federal and state licensing and consumer protection laws.

While management, including internal counsel, currently believes that the ultimate outcome of all these proceedings and claims will not have a material adverse effect on
our financial condition or results of operations, litigation is subject to inherent uncertainties. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on our financial condition and results of
operations.



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Item 1A. Risk Factors

Risk Factors

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

Risks Related to Securitization, Loan Sale, and Borrowing Activities

The subprime loan market is currently experiencing significant
disruption which has adversely affected our business.

Recently due to a number of market factors, including increased delinquencies on mortgage
loans and the failure of certain subprime mortgage companies and hedge funds, there has been extreme uncertainty and disruption in the subprime mortgage industry as a whole.As a result, our business has been materially and adversely affected
in a number of ways, including our ability to sell or securitize the loans we originate at favorable prices or at all. As a result of this uncertainty and disruption, we have been forced to alter our business strategies and operations in response to
market conditions. For example, due to the fact that we cannot sell or securitize the loans we originate at favorable prices, or at times at all, we have drastically reduced, and recently temporarily suspended, our wholesale mortgage origination
volumes. We have also recently tightened our underwriting guidelines, raised the interest rates on loans we originate, and changed the types of products we offer. We also may make further changes in these and other business practices including
further reducing our work force in response to market conditions. We are watching developments in our business and the subprime industry closely and we will consider all necessary or appropriate changes and strategies. There can be no assurances
that if this disruption continues that we will be able to operate our business as we have historically.

Our success is dependent on leverage, which
may create other risks.

Our success is dependent, in part, upon our ability to maintain and grow our assets through the use of leverage. Leverage
creates an opportunity for increased net income, but at the same time creates risks. For example, leveraging magnifies both positive and negative changes in our net worth. If we are unable to borrow funds, we will not be able to execute our business
strategy and our results of operations, financial condition and liquidity will be adversely affected. In addition, there can be no assurance that we will be able to meet our debt service obligations and, to the extent that we cannot, our financial
condition will be materially and adversely affected. Furthermore, if we were to liquidate, our debt holders and lenders will receive a distribution of our available assets before any distributions are made to our preferred or common shareholders.

The continued interruption in the securitization market or in our ability to access this market would harm our financial position.

We are dependent on the securitization market for long-term financing of our origination and purchase of mortgage loans and mortgage securities,
which we initially finance with our short-term financing. In addition, many of the buyers of our whole loans purchase the loans with the intention of securitizing them. Recently, there has been a significant disruption in the securitization market
for residential mortgage loans and mortgage securities caused by, among other things, an increased default rate on residential mortgage loans, and an increase in the number of ratings downgrades with respect to bonds issued in connection with
securitization of sub-prime loans, including downgrades from investment grade to junk bond status in addition to the financial condition of many companies that participate in this market. These developments have negatively affected our ability to
access the securitization market for our mortgage loans and mortgage securities, and at times the securitization markets have effectively been unavailable to us. To the extent that the current residential mortgage loan default rate continues to
increase or fails to abate, the credit quality of mortgage-backed bonds continues to erode, or other events occur, such as an international liquidity crisis such as occurred in the fall of 1998, sudden changes in interest rates, further changes in
the non-conforming loan market, or other significant event risk or a default under a comparable type of securitization, our access to the securitization market could be further limited. Further, poor performance of our previously securitized loans
could further harm our access to the securitization market.



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In addition, a court recently found a lender and securitization underwriter liable for consumer fraud committed by a
company to whom they provided financing and underwriting services. In the event other courts or regulators adopted the same liability theory, lenders and underwriters could be named as defendants in more litigation and as a result they may exit the
business or charge more for their services, all of which could have a negative impact on our ability to securitize our mortgage loans and mortgage securities and on the securitization market in general.

An inability to obtain long-term funding for our mortgage loans or mortgage securities in the securitization market in general or on attractive terms or a continued
weakness in the markets demand for our mortgage loans or mortgage securities would harm our results of operations, financial condition, liquidity and business prospects, and could result in defaults under our short term financing arrangements
for these assets. Alignment of our operations with these changes in the market may require or result in substantial decreases in our loan origination and securitization activities or other operations. Furthermore, we could be forced to sell assets
on unfavorable terms or to seek additional means to reduce losses or raise funds, including without limitation, reducing, eliminating or disposing of our mortgage origination, mortgage purchasing, loan servicing or other operations.

We may not be able to sell our mortgage loans on terms and conditions that are profitable to us or at all.

Historically, a portion of our revenues has come from the gains on sale generated by sales of pools of our mortgage loans as whole loans. We make whole loan sales to a
limited number of institutional purchasers, some of which may be frequent, repeat purchasers, and others of which may make only one or a few purchases from us. Recently, demand by purchasers of whole loans has decreased and prices have eroded. We
cannot assure you that we will have purchasers for our loans on terms and conditions that will be profitable to us or at all. Also, even though our mortgage loans have generally been marketable to multiple purchasers, certain loans may be marketable
to only one or a few purchasers, thereby increasing the risk that we may be unable to sell such loans at a profit.

Market factors may limit our
ability to originate and acquire mortgage assets at yields that are favorable relative to costs.

We face the risk that we might not be able to
originate or acquire mortgage assets that earn interest rates greater than our cost of funds under our short-term borrowings and securitizations, or that otherwise can be sold for prices in excess of our cost of origination. Recently, our mortgage
origination business has declined and suffered losses due to a change in market conditions, including a decrease in the spread between our cost of funds and the interest rate we earn on our mortgage loan portfolio and a decrease in the volume of
loans originated as a result of tighter underwriting guidelines. We may further tighten our underwriting guidelines or otherwise reduce our origination volumes in response to market demand dynamics. To the extent our mortgage origination business
continues to decline or experience losses, our results of operations, financial condition and business prospects would be materially adversely affected.

Failure to renew or obtain adequate funding under warehouse repurchase agreements may harm our business.

We utilize warehouse
repurchase agreements to provide short term financing for our origination and purchase of mortgage loans pending their sale or securitization, and to provide short-term financing for our purchase and retention of mortgage securities. Although we
currently maintain warehouse financing facilities with three lenders, we are currently dependent upon multiple facilities with a single lender.

Under a
warehouse repurchase agreement, we sell an asset and agree to repurchase the same asset at some point in time in the future. Generally, the repurchase agreements we enter into have one-year terms and require monthly roll-over repurchase
transactions, with a six- to nine-month maximum financing period for mortgage loans. Mortgage securities are eligible for financing for the entire term of the repurchase agreement. For financial accounting purposes, these arrangements are treated as
secured financings. We retain the assets on our balance sheet and record an obligation to repurchase the assets. The amount we may borrow under these arrangements is generally 95% to 100% of the asset market value with respect to performing mortgage
loans and 65% to 85% of the asset market value with respect to nonperforming mortgage loans and REO. Additionally, the amount we may borrow under these arrangements is generally 60% to 97% of the asset market value with respect to mortgage
securities depending on the investment rating. Recently, our principal lender has reduced the value of our loans in warehouse to 96% which reduces the amount we can borrow against our mortgage loans to 94% of the principal of the loan. There can be
no assurance that it will not further reduce the amount that we can borrow against our mortgage loans or other mortgage assets which will further negatively affect our liquidity. Generally our warehouse repurchase agreements give the lender the
exclusive authority to determine the market value of our assets. Recently, due to increased concerns about the performance of sub-prime loans our lenders have reduced the fair market value of the loans and mortgage securities, thus reducing the
amount we can borrow and requiring greater cash investment by us, both at the time a loan is first financed and through subsequent margin calls. To the extent that the market value of our assets does not improve or experiences a greater decline, our
liquidity, financial condition and results of operations would be materially adversely affected. In addition, an increase in the cost of warehouse financing in excess of any change in the income derived from our mortgage assets would have a material
adverse effect on our results of operations, financial condition, liquidity and business prospects.



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These warehouse repurchase agreements contain numerous representations, warranties and covenants, including requirements
to maintain a certain minimum net worth, to maintain minimum equity ratios, to maintain certain minimum amount of liquidity, to refrain from paying dividends without the consent of the lender unless we meet certain minimum liquidity requirements,
and other customary debt covenants. Events of default under these facilities include material breaches of representations and warranties, failure to comply with covenants, material adverse effects upon or changes in our business, assets, or
financial condition, and other customary matters. Events of default under certain of our facilities also include termination of our status as servicer with respect to certain securitized loan pools and certain downgrades in our servicer rating. If
we were unable to make the necessary representations and warranties at the time we need financing, we would not be able to obtain needed funds. In addition, if we default under any warehouse repurchase agreement under which borrowings are then
outstanding, the lenders under substantially all of our existing warehouse repurchase agreements could demand immediate payment of all outstanding amounts pursuant to cross-default provisions. Any failure to renew or obtain adequate funding under
these financing arrangements for any reason, or any demand by warehouse lenders for immediate payment of outstanding balances, could threaten our solvency and ability to continue operations if we were unable to replace such financing arrangements.
There is no assurance that we will continue to have access to short-term financing at levels necessary for operations or other liquidity needs.

A
decline in the market value of mortgage assets financed under our warehouse finance arrangements may result in margin calls or similar obligations, which may harm our liquidity, our status as a REIT, and our ability to rely on certain exemptions
under the Investment Company Act.

When, in a lenders opinion, the market value of assets subject to a warehouse repurchase agreement
decreases for any reason, including a rise in interest rates or general concern about the value or liquidity of the assets, we are required to repay the margin or difference in market value, or post additional collateral. If cash or additional
collateral is unavailable to meet margin calls, we may default on our obligations under the applicable repurchase agreement, which would cross-default substantially all of our warehouse repurchase agreements. In that event, our lenders would have
the right to liquidate the collateral we provided them to settle the amount due from us and, in general, the right to recover any deficiency from us.

We
have recently experienced an increase in margin calls which has negatively affected our cash position. If we continue to experience margin calls, we may be required to liquidate assets at a disadvantageous time, which could cause us to incur further
losses and adversely affect our results of operations and financial condition. In addition, an unplanned liquidation of assets could change our mix of investments, which in turn could jeopardize our current status as a REIT or our ability to rely on
certain exemptions under the Investment Company Act of 1940, as amended (the Investment Company Act).

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 harm our liquidity, results of operations and financial condition.

When we sell mortgage loans, whether as whole loans or pursuant to a securitization, we are required to make 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 fraud or in the event of early payment default on a mortgage loan. Likewise, we are required to repurchase or substitute mortgage loans if we breach a representation or warranty
in connection with our securitizations. The remedies available to us against the originating broker or correspondent, if any, may not be as broad as the remedies available to a purchaser of mortgage loans against us, and we face the further risk
that the originating broker or correspondent may not have the financial capacity to perform remedies that otherwise may be available to us. Therefore, if a purchaser enforces its remedies against us, we may not be able to recover losses from the
originating broker or correspondent. Repurchased loans are typically sold at a significant discount to the unpaid principal balance and, prior to sale, can be financed by us, if at all, only at a steep discount to our cost. As a result, significant
repurchase activity would harm our liquidity, cash flow, results of operations, financial condition and business prospects.

Recently, we have received an
increased number of repurchase and indemnity demands from purchasers of whole loans as a result of borrower fraud and early borrower payment defaults, which has had a negative impact on our liquidity and results of operations. During the first six
months of 2007, we paid $100.3 million in cash to repurchase loans sold to third parties. The cash we must have on hand to repurchase these loans is much higher than the principal amount of the loan as we generally must reimburse the investor for
the remaining unpaid principal balance, any premium recapture, any unpaid accrued interest and any out-of-pocket advances in accordance with the loan sale agreement. While we have taken steps to enhance our underwriting policies and procedures,
these enhancements do not affect previously originated loans, and there can be no assurance that these steps will be effective. To the extent that repurchase and indemnity demands continue at this rate or increase, our liquidity, results of
operations and financial condition will be adversely affected.



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Our investments in mortgage securities and loans are subject to changes in credit spreads which could adversely
affect our ability to realize gains on the sale of such investments and may subject us to margin calls or similar liquidity requirements.

The value
of mortgage securities is dependent on the yield demanded on these securities by the market based on their credit relative LIBOR. Excessive supply of these securities combined with reduced demand will generally cause the market to require a higher
yield on these securities, resulting in the use of a higher, or wider, spread over the benchmark rate (usually the applicable LIBOR security yield) to value such securities. Under such conditions, the value of our mortgage securities
portfolio would tend to decline.

Our loan portfolio is also subject to changes in credit spreads. The value of these loans is dependent on the yield
demanded by the market based on their credit relative to LIBOR. The value of our loans would tend to decline should the market require a higher yield on such loans, resulting in the use of a higher spread over the benchmark rate (usually the
applicable LIBOR yield).

As the default rate on subprime mortgage loans has continued to increase and residential home prices have continued to decline or
are no longer appreciating, the value of our loans and mortgage securities has decreased which has reduced our ability to realize gains, if any, upon the sale or securitization of these assets and, with respect to mortgage securities (which are
marked to market quarterly), has resulted in impairments for securities classified as available-for-sale and mark-to-market losses for securities classified as trading. In addition, decreases in the value of our mortgage loans and securities have
reduced the funds available to us in respect of these assets under our warehouse repurchase agreements and have resulted in margin calls. Further decreases in value would have similar effects. Further, a decrease in the value of third party mortgage
securities that we have accumulated for the purpose of a CDO offering may reduce the availability or attractiveness of the CDO offering, in which case we may be required to seek other forms of potentially less attractive longer-term financing or to
liquidate the assets on unfavorable terms.

We retain and assume credit risk under a variety of mortgage securities and similar assets in connection
with and as a result of our securitization activities. Significant losses on these assets reduce our earnings, negatively affect our liquidity, and otherwise negatively affect our business.

We retain certain residual securities resulting from our securitizations of mortgage loans, which typically consist of interest-only, prepayment penalty, and
overcollateralization bonds. We also retain from our securitizations, as well as purchase from third party ABS issuers, certain investment grade and non-investment grade rated subordinated mortgage securities. These residual and subordinated
securities are typically 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 retain
the first loss risk associated with the underlying pool of mortgage loans. As a result, the credit performance and prepayment rates of the sub-prime loans underlying these mortgage securities directly affect our returns on these mortgage
securities. Significant realized losses from our residual and subordinated mortgage securities would harm our results of operations and financial condition. In addition, because we finance these securities under short-term warehouse repurchase
agreements, decreases in the value of these retained securities may result in margin calls and adversely affect our liquidity. We have recently experienced losses on our residual and subordinated securities which have negatively affected our
financial condition and resulted in margin calls which have negatively affected our liquidity. If we experience any increased or sustained losses on these securities or additional margin calls, our liquidity, results of operations and financial
condition will be materially adversely affected.

We invest in or assume financial risk associated with mortgage securities issued by third party
residential real estate loan securitization entities, most of which are backed by sub-prime loans. In addition, following a CDO offering, we retain equity or unsecured debt securities of the CDO issuer. A significant portion of these third party
mortgage securities consists of securities that are subordinate to other securities secured by the same pool of assets and, as such, have significant investment risk. Generally, we do not control or influence the underwriting, servicing, management,
or loss mitigation efforts with respect to the assets underlying securities issued by securitizations we do not sponsor. If the asset pools underlying any of these securities were to experience poor credit results, the market value of the third
party securities that we hold directly and of our equity interest in or unsecured debt of a CDO issuer could decrease. Significant realized losses from third party mortgage securities, directly or indirectly through our interest in a CDO issuer,
could harm our results from operations, liquidity, and financial condition.

Further, we may enter into or assume financial risk associated with ABS credit
default swaps or similar derivatives, referred to a synthetic securities, in contemplation of the transfer of such synthetic securities to a CDO issuer in connection with our CDO offerings. Under these synthetic securities, we may
assume, in exchange for a premium, payment and credit risk associated with third party mortgage securities. In addition to the risks associated with the third party securities to which the synthetic security relates, synthetic securities are
unsecured and would expose us to the risk of payment default by the swap counterparty and to risks associated



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with the determination of settlement payments upon a credit event relating to the referenced mortgage securities or other settlement event. In addition, the
market for synthetic securities of this type is not highly liquid and, as such, we may not be able to realize the full value of a synthetic security in the event we need to liquidate or dispose of the synthetic security, which could negatively
impact our results of operations and financial condition.

Credit results with respect to mortgage assets underlying our securitizations may
negatively affect our access to the securitization market on favorable terms, or at all, which in turn would harm our financial condition and prospects.

If the non-conforming loan industry continues to experience credit difficulties, our ability to access the securitization market on favorable terms, or at all, may continue to be negatively affected. In addition, if the pools of mortgage
loans underlying our securitizations of mortgage loans or indirectly underlying our securitizations of mortgage securities were to experience poor credit results, the securities issued in these securitizations could have their credit ratings
down-graded, could suffer losses in market value, and could experience principal losses. In addition to reducing the long-term returns and near-term cash flows from the securities we have retained or acquired in these transactions, any of the
foregoing may reduce our ability to sponsor securitization transactions, including CDO offerings, in the future.

Competition in the securitization
market and excess supply of mortgage loans available for securitization may erode our securitization margins, which in turn may adversely affect or harm our financial condition and prospects.

Competition in the business of sponsoring securitizations of the type we focus on is increasing as Wall Street broker-dealers, hedge funds, mortgage REITs, investment
management companies, and other financial institutions expand their activities or enter this field. In addition, significant pools of sub-prime mortgage loans have accumulated across the industry during the current disruption in the mortgage
securitization markets, resulting in a significant backlog of sub-prime mortgage loans available for securitization. Increased competition and increased supply of unsecuritized mortgage loans could reduce our securitization margins. To the extent
that our securitization margins erode, our results of operations, financial condition and business prospects will be negatively impacted.

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

Our securitizations of mortgage loans that are structured as sales for financial reporting purposes result in gain recognition at closing as well as the recording of the
residual mortgage securities we retain at fair value.

Delinquency, loss, prepayment and discount rate assumptions have a material impact on the amount of
gain recognized. It is extremely difficult to validate the assumptions we use in determining the amount of gain on sale. If our actual experience differs materially from the assumptions that we use to determine our gain on sale, our future cash
flows, our financial condition and our results of operations could be negatively affected.

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. Such assumptions are complex as we must make judgments about the effect of
matters that are inherently uncertain. If our actual experience differs from our assumptions, we would be required to reduce the value of these securities which may lead to impairments. Furthermore, if our actual experience differs materially from
these assumptions, our cash flow, financial condition, results of operations and business prospects will be harmed.

Changes in accounting standards
might cause us to alter the way we structure or account for securitizations.

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



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The rate at which we are able to acquire eligible mortgage loans or mortgage securities and changes in market
conditions during asset accumulation may adversely affect our anticipated returns from the securitization of these assets.

We use short term
warehouse financing arrangements to finance the acquisition of mortgage loans and mortgage securities until a sufficient quantity of assets is accumulated, at which time we may refinance these lines through a securitization, CDO or other long term
financing. As a result, we are subject to the risk that we will not be able to acquire, during the period in which the relevant warehouse facility is available for the funding of such assets, a sufficient amount of eligible loans or securities to
maximize the efficiency of a securitization or CDO. In addition, changes in conditions in the capital markets may make a securitization or CDO less attractive to us by the time we do have a sufficient pool of collateral. If we are unable to
securitize these assets, we may be required to seek other forms of potentially less attractive financing or otherwise to liquidate the assets on unfavorable terms which would have an adverse affect on our liquidity, financial condition and results
of operations.

Risks Related to Interest Rates and Our Hedging Strategies

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

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



| |  |  | a substantial or sustained increase in interest rates could harm our ability to originate, acquire or sell mortgage loans and mortgage securities in expected
volumes, which could result in a decrease in our cash flow and in our ability to support our fixed overhead expenses;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | interest rate fluctuations may harm our earnings and access to capital 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;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | if prevailing interest rates increase after we fund a loan, the value that we receive upon the sale or securitization of the loan decreases;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | when we securitize loans, the value of the residual and subordinated securities we retain and the income we receive from them are based primarily on LIBOR, and an
increase in LIBOR increases our funding costs which reduces the net income 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 earnings 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 anticipated prepayment rates may harm our
earnings and the value of our mortgage securities.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

In addition, interest rate changes may also 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 decrease which decreases the book value of our equity.

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

Hedging against interest rate exposure may adversely affect our earnings, which could adversely affect cash available for operations.

There are limits on the ability of our hedging strategy to protect us completely against interest rate risks. When interest rates change, we expect the gain or loss on
derivatives to be offset by a related but inverse change in the value of the hedged items, generally our liabilities. We cannot assure you, however, that our use of derivatives will offset the risks related to changes in interest rates. We cannot
assure you that our hedging strategy and the derivatives that we use will adequately offset the risk of interest rate volatility or that our hedging transactions will not result in losses. We may enter into interest rate cap or swap agreements or
pursue other interest



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rate hedging strategies. Our hedging activity will vary in scope based on interest rates, the type of mortgage assets held, other changing market conditions
and, so long as we remain a REIT, compliance with REIT requirements. If we revoke our REIT status as announced effective January 1, 2008, we will not be subject to income limitations on hedging. Interest rate hedging may fail to protect or
could adversely affect us because, among other things:



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



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



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



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



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



| |  |  | the party owing money in the hedging transaction may default on its obligation to pay, which may result in the loss of unrealized profits; and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------



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

Any hedging activity we engage in may adversely affect our earnings, which could adversely affect
cash available for operations. Unanticipated changes in interest rates may result in poorer overall investment performance than if we had not engaged in any such hedging transactions.

Complying with REIT requirements may limit our ability to hedge effectively.

We attempt to minimize exposure
to interest rate fluctuations by hedging. For as long as we remain a REIT, the REIT provisions of the Code limit our ability to hedge mortgage assets and related borrowings by requiring us to limit our income in each year from any qualified hedges,
together with any other income not generated from qualified real estate assets, to no more than 25% of our gross income. The interest rate hedges that we generally enter into will not be counted as a qualified asset for the purposes of satisfying
this requirement. In addition, under the Code, for as long as we remain a REIT, we must limit our aggregate income from non-qualified hedging transactions and from other non-qualifying sources to no more than 5% of our annual gross income. As a
result, we may have to limit our use of advantageous hedging techniques. This could result in greater risks associated with changes in interest rates than we would otherwise want to incur. In addition, if it is ultimately determined that some of our
interest rate hedging transactions are non-qualified under the Code, we may have more than 5% of our annual gross income from non-qualified sources. If we violate the 5% or 25% limitations, we may have to pay a penalty tax equal to the amount of
income in excess of those limitations, multiplied by a fraction intended to reflect our profitability. In addition, if we fail to observe these limitations, we could lose our REIT status unless our failure was due to reasonable cause and not due to
willful neglect. If we revoke our REIT status as announced effective January 1, 2008, we will not be subject to income limitations on hedging.

Risks Related to Credit Losses, Prepayment Rates and Our Origination Volume

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

The residential mortgage market has recently encountered difficulties which have adversely affected our performance. In recent months, delinquencies and losses with
respect to residential mortgage loans generally have increased and may continue to increase, particularly in the sub-prime sector. In addition, in recent months residential property values in many states have declined or remained stable, after
extended periods during which those values appreciated. A continued decline or a lack of increase in those values may result in additional increases in delinquencies and losses on residential mortgage loans generally, especially with respect to any
residential mortgage loans where the aggregate loan amounts (including any subordinate loans) are close to or greater than the related property values. Another factor that may have contributed to, and may in the future result in, higher delinquency
rates is the increase



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in monthly payments on adjustable rate mortgage loans. Any increase in prevailing market interest rates may result in increased payments for borrowers who
have adjustable rate mortgage loans. Moreover, with respect to option ARM mortgage loans with a negative amortization feature which reach their negative amortization cap, borrowers may experience a substantial increase in their monthly payment even
without an increase in prevailing market interest rates. Compounding this issue, the current lack of appreciation in residential property values, increased interest rates, and the adoption of tighter underwriting standards throughout the sub-prime
mortgage loan industry may adversely affect the ability of borrowers to refinance these loans and avoid default, particularly borrowers facing a reset of the monthly payment to a higher amount. To the extent that delinquencies or losses continue to
increase for these or other reasons, our operating results, liquidity and financial condition would be adversely affected.

Loans made to
nonconforming mortgage borrowers entail relatively higher delinquency and default rates which will result in higher loan losses.

Lenders in the
nonconforming mortgage banking industry make loans to borrowers who have impaired or limited credit histories, limited documentation of income and higher debt-to-income ratios than traditional mortgage lenders allow. Mortgage loans made to
nonconforming mortgage loan borrowers generally entail a relatively higher risk of delinquency and foreclosure than mortgage loans made to borrowers with better credit and, therefore, will result in higher levels of realized losses than conventional
loans. 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. Loans that become delinquent prior to sale or securitization may become unsaleable or saleable only at a discount, and the longer we hold loans prior to sale or securitization, the greater the chance we will bear all
costs associated with the loans delinquency. Also, our cost of financing and servicing a delinquent or defaulted loan is generally higher than for a performing loan.

We bear the risk of delinquency and default on loans beginning when we originate them. In whole loan sales, our risk arising from delinquency and default typically extends only until the borrower makes the first or
the first several (typically no more than three) payments. When we securitize any of our loans, we continue to be exposed to delinquencies and losses, either through our residual interests for securitizations structured as sales or through the loans
that remain on our balance sheet for securitizations structured as financings. We also re-acquire the risks of delinquency and default for loans that we are obligated to repurchase.

We attempt to manage these risks with risk based mortgage loan pricing, mortgage insurance and appropriate underwriting criteria and policies and loan collection methods. However, as with the broader nonconforming
mortgage loan industry, we have recently experienced an increase in borrower delinquencies and defaults, which has adversely affected our cash flows, results of operations and financial condition. While we have taken steps to tighten our
underwriting guidelines and procedures, there can be no assurance that these steps will be effective. To the extent that we cannot successfully address these issues, or the increase in delinquencies and defaults becomes more severe, our results of
operations, liquidity and financial condition may be further adversely affected.

We face loss exposure due to fraudulent and negligent acts on the
part of loan applicants, employees, mortgage brokers and other third parties.

When we originate or purchase mortgage loans, we rely heavily upon
information provided to us by third parties, including information relating to the loan application, property appraisal, title information and employment and income documentation. If any of this information is fraudulently or negligently
misrepresented to us and such misrepresentation is not detected by us prior to loan funding, the value of the loan may be significantly lower than we expected. Whether a misrepresentation is made by the loan applicant, the loan broker, one of our
employees, or any other third party, we generally bear the risk of loss associated with it. A loan subject to misrepresentation typically cannot be sold and, if sold prior to our detection of the misrepresentation, generally must be repurchased by
us. We may not be able to recover losses incurred as a result of the misrepresentation.

As with the broader nonconforming mortgage loan industry, we have
recently experienced an increase in exposure due to fraud, which has resulted in an increase in our repurchase and indemnity obligations and has adversely affected our cash flow, results of operations and financial condition. To the extent that we
cannot successfully address these issues or the increase in fraud becomes more severe, our results of operations, liquidity and financial condition may be further adversely affected.



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Our efforts to manage credit risk may not be successful in limiting delinquencies and defaults in underlying loans
and may reduce origination volumes and increase cost and, as a result, our results of operations may be affected.

There are many aspects of credit
that we cannot control and our quality control and loss mitigation operations may not be successful in limiting future delinquencies, defaults and losses. 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, and a borrowers ability to repay a loan 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. Interest-only loans, negative amortization loans, adjustable-rate loans, reduced documentation loans, sub-prime loans, home equity lines of credit and second lien loans may involve
higher than expected delinquencies and defaults. Changes in consumer behavior, bankruptcy laws, and other laws may exacerbate loan losses.

Our
underwriting process may not be effective in mitigating these risks and our risk of loss on the underlying loans. In response to increasing default rates recently experienced by us and the nonconforming mortgage loan industry generally, we have
enhanced our underwriting policies and procedures and our loss mitigation efforts, which have contributed to a decrease in our origination volumes and have increased our operating costs. We may further tighten our underwriting guidelines in response
to the markets demand for higher quality loans. To the extent that these efforts continue to impede our origination of mortgage loans, are ineffective to reduce the current level of loan delinquencies and defaults or significantly increase our
operating costs, our results of operations may be adversely affected.

Mortgage insurers may in the future change their pricing or underwriting
guidelines or may not pay claims resulting in increased credit losses.

We use mortgage insurance to mitigate our risk of credit losses. Our
decision to obtain mortgage insurance coverage is dependent, in part, on pricing trends. Mortgage insurance coverage on our new mortgage loan production may not be available at rates that we believe are economically viable for us or at all. We also
face the risk that our mortgage insurers might not have the financial ability to pay all claims presented by us or may deny a claim if the loan is not properly serviced, has been improperly originated, is the subject of fraud, or for other reasons.
Any of those events could increase our credit losses and thus adversely affect our results of operations and financial condition.

Investments in
diverse types of assets and businesses could expose us to new, different, or increased risks.

We have invested in and intend to invest in a variety
of assets that are related to our current core business, including loans, securities, and related derivatives. We may make investments in debt and equity securities issued by our own and third party CDOs that own various types of assets. These CDOs
may invest in manufactured housing loans, sub-prime residential mortgage loans, and other residential mortgage loans backed by lower-quality borrowers, in other loans and receivables, in securities backed by the foregoing, and in credit default
derivatives referencing these or other securities. The higher credit and/or prepayment risks associated with these types of investments may increase our exposure to losses. In addition, certain of these assets may be relatively new or unique
products, which may increase contractual and liquidity risks.

Our reliance on cash-out refinancings as a significant source of our origination
volume increases the risk that our earnings will be harmed if the demand for this type of refinancing declines.

Approximately 71% of our loan
production volume during the six months ended June 30, 2007 consisted of cash-out refinancings. Our continued reliance on cash-out refinancings as a significant source of our origination volume increases the risk that our earnings will continue
to be adversely affected if interest rates rise and the prices of homes continues to decline, both of which reduce the demand and production volume for this type of refinancing. To the extent interest rates continue to rise, the number of borrowers
who would qualify or elect to pursue a cash-out refinancing could be significantly reduced further, which will result in a decline in that origination source. Similarly, a continued decrease in home prices would reduce the amount of equity available
to be borrowed against in cash-out refinancings and result in a continued decrease in our loan production volume from that origination source. Therefore, our reliance on cash-out refinancings as a significant source of our origination volume could
harm our results of operations, financial condition and business prospects.



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We have recently imposed stricter mortgage loan and borrower requirements, which has resulted in a decrease in our
mortgage loan origination and purchase volumes.

As a result of less favorable economic conditions and an increase in the number of fraudulently
obtained loans and borrower defaults, we have tightened our mortgage loan lending and purchase requirements and the processes we undergo to document loans. Consequently, there are fewer borrowers and loans that qualify under these revised standards.
As a result, our loan origination and purchase volumes have declined which has negatively affected our loan sale and securitization volumes. We may further tighten our underwriting guidelines in response to the markets demand for higher
quality loans, which may further decrease our origination volumes. A continued decline in our loan origination or purchase volumes resulting in a decrease in the volume of assets available to us for sale or securitization, could materially adversely
affect our results of operations and financial condition.

We recently discontinued offering our 2-28 loans and may be forced to further change our
product offerings, which may adversely affect our results of operation, financial condition and liquidity.

During the six months ended
June 30, 2007, our most popular loan was the 2/28 loan, under which the interest rate is a relatively low fixed rate for the first two years and then readjusts to a floating rate for the remaining 28 years. During the six months ended
June 30, 2007, originations of 2/28 loans totaled $1.5 billion of our total originations. We recently discontinued offering these types of loans due to investor, regulatory and rating agency concerns. While we intend to convert all of our 2/28
loans existing in our mortgage loans-held-for sale to three year loans, there can be no assurance that we will be able to make such conversions. Further, there can be no assurance that investors, regulatory agencies and rating agencies will continue
to view three year loans favorably and we may be further required to change our product offerings. To the extent that we cannot sell or securitize loans due to investor, regulatory or rating agency concerns our results of operations, financial
condition and liquidity will be adversely affected.

Our interest-only loans may have a higher risk of default and loss than our fully-amortizing
loans.

For the quarter ended June 30, 2007, originations of interest-only loans totaled $195.8 million, or 9%, of our total originations.
These interest-only loans require the borrowers to make monthly payments only of accrued interest for the first 24, 36 or 120 months following origination. After such interest-only period, the borrowers monthly payment is recalculated to cover
both interest and principal so that the mortgage loan will amortize fully prior to its final payment date. The interest-only feature may reduce the likelihood of prepayment during the interest-only period due to the smaller monthly payments relative
to a fully-amortizing mortgage loan. If the monthly payment increases, the related borrower may not be able to pay the increased amount and may default or may refinance the related mortgage loan to avoid the higher payment. Because no principal
payments may be made on such mortgage loans for an extended period following origination, if the borrower ultimately defaults, the unpaid principal balance of the related loans would be greater than otherwise would be the case for a fully-amortizing
loan. As a result, the likelihood that we would incur a loss on these loans will increase, especially in a declining real estate market.

A prolonged
economic slowdown or a decline in the real estate market could harm our results of operations.

A substantial portion of our mortgage assets consist
of single-family mortgage loans or mortgage securities evidencing interests in single-family mortgage loans. Because we make a substantial number of loans to credit-impaired borrowers, the actual rates of delinquencies, foreclosures and losses on
these loans tend to be higher during economic slowdowns. Recently, we have experienced an increase in delinquencies and foreclosures. Any sustained period of increased delinquencies or defaults or any sharp increase in the number of delinquencies
and defaults could harm our ability to sell or securitize loans, the prices we receive for our loans, the values of our mortgage loans held for sale, our ability to finance loan originations and our residual interests in securitizations, which would
harm our financial condition and results of operations. In addition, material declines in real estate values weaken our collateral loan-to-value ratios, increase the risk of default by decreasing the ability of borrowers to refinance loans they are
unable to sustain or to sell the mortgage property to repay the loan, and increase the possibility of loss if a borrower defaults. In such event, we will be subject to the risk of loss on such mortgage asset arising from borrower defaults to the
extent not covered by third-party credit enhancement.

Current loan performance data may not be indicative of future results.

When making capital budgeting and other decisions, we use projections, estimates and assumptions based on our experience in the mortgage lending industry. Actual results
and the timing of certain events could differ materially in adverse ways from those projected, due to factors including changes in general economic conditions, real estate values, interest rates, mortgage loan prepayment rates and in losses due to
defaults on mortgage loans. These differences and fluctuations could rise to levels that may adversely affect our profitability and financial condition.



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Changes in prepayment rates of mortgage loans could adversely affect the return that we are able to achieve on our
assets.

The value of our assets may be affected by prepayment rates on our residential mortgage loans and other floating rate assets. Prepayment
rates are influenced by changes in current interest rates and a variety of economic, geographic and other factors beyond our control, and consequently, such prepayment rates cannot be predicted with certainty. In periods of declining mortgage
interest rates, prepayments on loans generally increase. If general interest rates decline as well, the proceeds of such prepayments received during such periods are likely to be reinvested by us in assets yielding less than the yields on the assets
that were prepaid. In addition, the market value of floating rate assets may, because of the risk of prepayment, benefit less than fixed rate assets from declining interest rates. Conversely, in periods of rising interest rates, prepayments on loans
generally decrease, in which case we would not have the prepayment proceeds available to invest in assets with higher yields. Under certain interest rate and prepayment scenarios we may fail to recoup fully our cost of acquisition of certain
investments. As a result of all of these factors, changes in prepayment rates could adversely affect our return on our assets.

Geographic
concentration of mortgage loans we originate or purchase increases our exposure to risks in those areas.

Over-concentration of loans we originate
or purchase in any one geographic area increases our exposure to the economic risks associated with that area. Declines in the residential real estate markets in which we are concentrated have reduced the values of the properties collateralizing our
mortgages which in turn may increase the risk of delinquency, foreclosure, or losses from those loans. In addition, increases in the unemployment rate in markets in which we are concentrated increases the likelihood that borrowers in those areas may
become delinquent on their loans. To the extent that borrowers in a geographic area in which we have made a significant number of loans become delinquent or otherwise default on such loans, our financial condition and results of operations may be
adversely affected.

To the extent that we have a large number of loans in an area hit by a natural disaster, we may suffer losses.

Standard homeowner insurance policies generally do not provide coverage for natural disasters, such as hurricanes and floods. Furthermore,
nonconforming borrowers are not likely to have special hazard insurance. To the extent that borrowers do not have insurance coverage for natural disasters, they may not be able to repair the property or may stop paying their mortgages if the
property is damaged. A natural disaster that results in a significant number of delinquencies could cause increased foreclosures and decrease our ability to recover losses on properties affected by such disasters, and that in turn could harm our
financial condition and results of operations.

The federal banking agencies final guidance on nontraditional mortgage products may impact our
ability to originate, buy, or sell certain nontraditional mortgage loans.

On October 4, 2006, the Office of the Comptroller of the Currency,
the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and the National Credit Union Administration issued their final Interagency Guidance on Nontraditional Mortgage
Product Risks (the Guidance). Nontraditional mortgage products are those which allow borrowers to defer payment of principal and sometimes interest. They include what are commonly referred to as option ARM loans and
interest-only loans.

The Guidance addresses the portfolio risks and consumer protection issues that the federal agencies believe investors and lenders
face when making or investing in nontraditional mortgage loans. As a matter of portfolio risk management, the Guidance warns applicable financial institutions that loan terms should be analyzed to ensure a manageable risk level, utilizing sound
underwriting standards including an evaluation of factors that may compound the risk, such as reduced documentation programs and the use of second lien mortgages. The analysis of repayment ability should avoid over-reliance on credit scores as
a substitute for income verification in the underwriting process and should include an analysis of the borrowers ability to make the payment when it increases to include amortization of the loan.

As a matter of consumer protection, financial institutions subject to the Guidance, when promoting or describing nontraditional mortgage products, are directed to ensure
that they provide consumers with marketing materials and at application with information that is designed to help them make informed decisions when selecting and using these products. Lenders subject to the Guidance are instructed that the
information they are to provide should apprise consumers of the risk that the monthly payment amounts could increase in the future, and explain the possibility of negative amortization.

While not directly applicable to us, the Guidance may affect our ability to make, buy or sell the nontraditional loans covered by the Guidance. Further, the Guidance is instructive of the regulatory climate concerning
those loans and may be adopted in whole or part by other agencies that regulate us. The Guidance reports that the Conference of State Bank Supervisors and the State Financial Regulators Roundtable are committed to preparing a model guidance document
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as us, which would be similar in nature and scope to the Guidance. It is also possible that the Guidance, or certain provisions within it, may be
adopted as laws or used as guidance by federal, state or local agencies and that those laws or guidance may be applied to us.

If we are required (either
by a regulatory agency or by third-party originators or investors) to make changes to our business practices to comply with the Guidance, it might affect the business activities in which we may engage and the profitability of those activities. Our
business could be adversely affected if, as a result of the Guidance, investors from which we purchase loans, or to whom we sell loans, change their business practices and policies relative to nontraditional mortgage products. For example, if
entities from which we purchase loans are required to change their origination guidelines thereby affecting the volume, diversity, and quality of loans available for purchase by us, or if purchasers of mortgage loans are required to make changes to
the purchasing policies, then our loan volume, ability to sell mortgage loans and profitability could be adversely affected.

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

Various legal proceedings could adversely affect our financial condition or results of operations.

In the course of our business, we are subject to various legal proceedings and claims. See Item 1Legal Proceedings. The
resolution of these legal matters or other legal matters could result in a material adverse impact on our results of operations, financial condition and business prospects. Recently, a $46.1 million judgment was entered in a California state court
against our subsidiary, NovaStar Home Mortgage, Inc. (NHMI) in a case alleging false advertising and unfair competition. NHMI is currently reviewing its various legal options, including options for appeal. There can be no assurances that
any efforts will be successful. Because it is too early to determine that a liability is probable or estimable, we have not recorded any liability or corresponding charge to earnings related to this case. However, in the event that NovaStar
Financial, Inc. or any of its other subsidiaries becomes obligated on this judgment, our financial condition, liquidity and business prospects will be adversely affected.

We are subject to the risk that provisions of our loan agreements may be unenforceable.

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

Regulation as an investment company
could harm our business; efforts to avoid regulation as an investment company could limit our operations.

If we were required to comply with the
Investment Company Act, we would be prevented from conducting our business as described in this document by, among other things, substantially limiting our ability to use leverage. The Investment Company Act does not regulate entities that are
primarily engaged, directly or indirectly, in a business other than that of investing, reinvesting, owning, holding or trading in securities, or that are primarily engaged in the business of purchasing or otherwise acquiring
mortgages and other liens on and interests in real estate. Under the Commissions current interpretation, in order to qualify for the latter exemption we must maintain at least 55% of our assets directly in qualifying real estate
interests and at least an additional 25% of our assets in other real estate-related assets or additional qualifying real estate interests. Mortgage-backed securities that do not represent all the certificates issued with respect to an
underlying pool of mortgages may be treated as securities separate from the underlying mortgage loans and thus may not qualify as a qualifying real estate interest for the purposes of the 55% requirement. Therefore, to insure that we continue to
qualify for the exemption, we may be required to adopt less efficient methods of financing certain of our mortgage assets, we may be required to sell certain mortgage securities at disadvantageous terms, and we may be precluded from acquiring
certain types of higher yielding mortgage assets. If we fail to qualify for an applicable exemption from the Investment Company Act, we could not operate our business efficiently under the regulatory scheme imposed by the Investment Company Act.
Accordingly, we could be required to restructure our activities which could materially adversely affect our financial condition, results of operations, liquidity and business prospects.



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Our failure to comply with federal, state or local regulation of, or licensing requirements with respect to,
mortgage lending, loan servicing, broker compensation programs, or other aspects of our business could harm our operations and profitability.

As a
mortgage lender, loan servicer and broker, we are subject to an extensive body of both state and federal law. The volume of new or modified laws and regulations has increased in recent years and, in addition, some individual municipalities and
cities have begun to enact laws that restrict loan origination and servicing activities. As a result, it may be more difficult to comprehensively identify and accurately interpret all of these laws and regulations, to properly program our technology
systems and to effectively train our personnel with respect to all of these laws and regulations, thereby potentially increasing our exposure to the risks of noncompliance with these laws and regulations. Furthermore, some of the new regulations
require lenders to make subjective judgments, such as whether a loan will provide a net tangible benefit to the borrower. These restrictions impact the way in which a loans is underwritten and expose a lender to risks of litigation and
regulatory sanction regardless of the care with which a loan is underwritten. Our failure to comply with these laws and regulations can lead to civil and criminal liability; loss of licensure; damage to our reputation in the industry; borrowers
rescinding loans; inability to sell or securitize our loans; demands for indemnification or loan repurchases from purchasers of our loans; fines and penalties and litigation, including class action lawsuits; or administrative enforcement actions.
The remedies for violations of these laws are often not based solely on actual harm to the consumer and can result in damages and penalties that could extend not only to us, but to our secured warehouse lenders, institutional loan purchasers,
securitization trusts that hold our loans and other assignees, regardless of whether such assignee knew of or participated in the violation, which, in turn, could have an adverse affect on the availability of financing to us and our access to
securitization and other secondary markets. Any of these results could harm our results of operations, financial condition and business prospects.

New legislation could restrict our ability to make, finance and sell mortgage loans, could increase our compliance and origination costs, and could expose us to lawsuits and compliance actions, any of which could harm our earnings and
business prospects.

The regulatory environments in which we operate have an impact on the activities in which we may engage, how these activities
may be carried out, and the profitability of these activities. Therefore, changes to laws, regulations or regulatory policies can affect whether and to what extent we are able to operate profitably.

Recently, the Federal Reserve Chairman announced that the Federal Reserve plans this year to propose new regulations to address mortgage lending abuses, including
restrictions on stated income loans (loans requiring little or no evidence of income by the borrower), limitations on pre-payment penalties and requirements that lenders set-aside payments for subprime borrowers property taxes and homeowners
insurance. In addition, the Federal Reserve and other federal and state regulators have announced a pilot program to examine approximately 12 lenders not subject to federal regulation to ensure compliance with consumer protection laws. The
promulgation of any such regulations or increased enforcement efforts could adversely affect our results of operations, liquidity, financial condition and business prospects.

Furthermore, several states, cities or other government entities are considering or have passed laws, regulations or ordinances aimed at curbing lending practices perceived as predatory. The federal government is also
considering legislative and regulatory proposals in this regard. In general, these proposals involve lowering the existing thresholds for defining a high-cost loan and establish enhanced protections and remedies for borrowers who receive
such loans. For example, certain of these new or proposed laws and regulations prohibit inclusion of some provisions in mortgage loans that have mortgage rates or origination costs in excess of prescribed levels, and require that borrowers be given
certain disclosures or obtain advice, at the expense of the lender, prior to the consummation of such mortgage loans. Passage of these laws and rules could reduce our loan origination and purchase volumes and could increase our costs. The
institutions that provide short-term financing to us generally refuse to finance any loan labeled as a high cost loan under any local, state or federal law or regulation. In addition, many whole loan buyers may elect not to purchase
these loans, and rating agencies likewise may refuse to rate securities backed by such loans. Accordingly, these laws and rules could severely restrict short-term financing and the secondary market for a significant portion of our loan production.
This would effectively preclude us from continuing to originate loans either in jurisdictions unacceptable to our lenders or the rating agencies or that exceed the newly defined thresholds, which in either case could harm our results of operations,
liquidity and business prospects.

We cannot provide any assurance that these proposed laws, rules and regulations, or other similar laws, rules or
regulations, will not be adopted in the future. Adoption of these laws and regulations could have a material adverse impact on our business by substantially increasing the costs of compliance with a variety of inconsistent federal, state and local
rules, or by restricting our ability to charge rates and fees adequate to compensate us for the risk associated with certain loans.

Similarly, recently
enacted and proposed local, state and federal laws prohibiting or limiting marketing by telephone, facsimile, email and the Internet may limit our ability to market and our ability to access potential loan applicants.



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We are subject to significant legal and reputational risks and expenses under federal and state laws concerning
privacy, use, and security of customer information.

The scope of business activity affected by privacy concerns is likely to expand and
will affect our non-prime mortgage loan origination business. The federal Gramm-Leach-Bliley financial reform legislation imposes significant privacy obligations on us in connection with the collection, use and security of financial and other
non-public information provided to us by applicants and borrowers. We adopted a privacy policy and adopted controls and procedures to comply with the law after it took effect on July 1, 2001. Privacy rules also require us to protect the
security and integrity of the customer information we use and hold. Although we have systems and procedures designed to help us with these privacy requirements, we cannot assure you that more restrictive laws and regulations will not be adopted in
the future, or that governmental bodies will not interpret existing laws or regulations in a more restrictive manner, making compliance more difficult or expensive. These requirements also increase the risk that we may be subject to liability for
non-compliance.

A number of states are considering privacy amendments that may be more demanding than federal law, and California recently has enacted two
statutes  the California Financial Information Privacy Act (also know as SB-1) and the California Online Privacy Protection Act, both of which took effect on July 1, 2004. Under SB-1, a financial company must allow its customers to opt
out of the sharing of their information with affiliates in separately regulated lines of business and must receive a customer opt-in before confidential customer data may be shared with unaffiliated companies (subject to certain exceptions). Under
the new California Online Privacy Act, all operators of commercial websites and online services that allow interaction with California consumers (even if no transactions may be effected online) must post privacy policies meeting statutory
requirements. The FTC, which administers the federal privacy rules for mortgage lenders, has determined that privacy laws in several states are not preempted by Gramm-Leach-Bliley, most recently new privacy laws enacted by Vermont and Illinois. In
view of the public concern with privacy, we cannot assure you that additional rules that restrict or make more costly our activities and the activities of our vendors will not be adopted and will not restrict the marketing of our products and
services to new customers. Furthermore, despite our efforts, we will be subject to legal and reputational risks in connection with our collection and use of customer information, and we cannot assure you that we will not be subject to lawsuits or
compliance actions under such state or federal privacy requirements.

New regulatory actions affecting the mortgage industry may increase our costs
and decrease our mortgage acquisition.

In addition to changes to legal requirements contained in statutes, regulations, case law, and other sources
of law, changes in the investigation or enforcement policies of federal and state regulatory agencies could impact the activities in which we may engage, how the activities may be carried out, and the profitability of those activities. Several state
and federal agencies have initiated regulatory enforcement proceedings against mortgage companies for engaging in business practices that were not specifically or clearly proscribed by law, but which in the judgment of the regulatory agencies were
unfair or deceptive to consumers. For example, state attorneys general and other state officials representing various states entered into a settlement agreement with a large subprime mortgage company. The subject company agreed to pay a substantial
amount in restitution to consumers and reimbursement to the states and also agreed to make changes to certain business practices, including our underwriting criteria and pricing policies. Many of the practices and policies are not specifically
prohibited by any federal or state laws but were alleged to be deceptive or unfair to consumers. The terms of this settlement agreement do not apply directly to us; however, federal and state regulatory agencies and private parties might
nevertheless expect mortgage companies, including us, to make our business practices consistent with the provisions of the settlement agreement. If this happens, it could impact the activities in which we may engage, how we carry out those
activities, our acquisition practices and our profitability. We might also be required to pay fines, make reimbursements, and make other payments to third parties for our business practices. Additionally, if an administrative enforcement proceeding
were to result in us having to discontinue or alter certain business practices, then we might be placed at a competitive disadvantage vis-à-vis competitors who are not required to make comparable changes to their business practices.

Our failure to obtain and maintain licenses in the various jurisdictions in which we do business could have a material adverse effect on our results
of operations, financial condition and business.

We operate a highly regulated industry and we are subject to various licensing requirements. In
addition, some states in which we operate may impose regulatory requirements for financial disclosure regarding our officers and directors and persons or groups holding 10%, or in some case 5%, of our outstanding shares of stock. If any officer,
director, person or group holding 10%, or in applicable cases 5%, or more of our outstanding shares of stock (including the Investors) fails to meet or refuses to comply with a states applicable regulatory requirements for mortgage lending, we
could lose our authority to conduct business in the state, which could have a material adverse effect on our results of operations, financial condition, liquidity and business prospects.



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We are exposed to the risk of environmental liabilities with respect to properties to which we take title.

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

We conduct a
substantial portion of our business through our taxable REIT subsidiaries, which creates additional compliance requirements.

Currently, we conduct
a substantial portion of our business through taxable REIT subsidiaries, such as NovaStar Mortgage. Despite our current qualifications as a REIT, our taxable REIT subsidiaries must pay federal income tax on their taxable income. Our income from, and
investments in, our taxable REIT subsidiaries do not constitute permissible income or investments for some of the REIT qualification tests. So long as we remain a REIT, we may be subject to a 100% penalty tax, or our taxable REIT subsidiaries may be
denied deductions, to the extent that our dealings with our taxable REIT subsidiaries are deemed not to be arms length in nature.

Our cash
balances and cash flows have become limited , as a result we have announced our intent to pay our dividend with respect to our 2006 REIT taxable income in the form of taxable preferred stock.

We use cash among other things, to originate mortgage loans, to satisfy loan repurchase requests, to satisfy margin calls, to pay interest on our outstanding indebtedness
and for other operating needs. In addition, we may be required to pay down indebtedness in the event of any default under our credit facilities. As our taxable income from fiscal 2006 significantly exceeds our cash flows from operations, our minimum
REIT dividend distribution requirements could exceed the amount of our available cash. As a result, we have announced our intent to distribute a taxable preferred stock dividend to satisfy our REIT distribution requirement and eliminate our taxable
income for 2006. There can be no assurance that we will pay the dividends with respect to our 2007 REIT taxable income, if any, in cash.

Failure to
pay our 2006 REIT dividend would cause us to lose REIT status retroactively to the beginning of 2006.

To maintain our status as a REIT under the
Code, the tax laws require us to declare and pay a dividend equal to at least 90% of each years REIT taxable income. Although we have stated our intention to declare a dividend payable in preferred stock, we have not yet declared such a
dividend with respect to our 2006 REIT taxable income. To timely meet the REIT dividend requirement, we must declare the dividend prior to the date we file our 2006 tax return and pay the dividend before the end of 2007. Because of recent volatility
in the market price of our common stock and general stock market volatility, we may have difficulty valuing the preferred stock and determining definitive terms. If for any reason we are unable to timely declare or pay our 2006 REIT dividend, the
IRS may revoke our status as a REIT. Such revocation would be retroactive to the beginning of 2006. Retroactive revocation of our REIT status would result in our becoming taxable as a C corporation for 2006 and subsequent years. Tax treatment of a C
corporation is materially different from tax treatment as a REIT and thus the tax characterization of our transactions and calculations of our taxable income would be different than how we have reported them to you and the IRS. These differences
could result, among other things, in our owing a tax liability (including penalties and interest) to the IRS, which could have a material adverse effect on our financial condition, results of operations and liquidity.

So long as we remain a REIT, the tax imposed on REITs engaging in prohibited transactions will limit our ability to engage in transactions, including
certain methods of securitizing loans, which would be treated as sales for federal income tax purposes.

A REITs net income from prohibited
transactions is subject to a 100% tax. In general, prohibited transactions are sales or other dispositions of property, other than foreclosure property but including any mortgage loans held in inventory primarily for sale to customers in the
ordinary course of business. So long as we remain a REIT, we might be subject to this tax if we were to sell a loan or securitize the loans in a manner that was treated as a sale of such inventory for federal income tax purposes. Therefore, in order
to avoid the prohibited transactions tax, so long as we remain a REIT, we may choose not to engage in certain sales of loans other than through our taxable REIT subsidiaries and may limit the structures we utilize for our securitization transactions
even though such sales or structures might otherwise be beneficial for us. In addition, this prohibition may limit our ability to restructure our portfolio of mortgage loans from time to time even if we believe it would be in our best interest to do
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The income earned by our taxable REIT subsidiaries will be subject to federal income tax and, so long as we remain
a REIT, we could be subject to an excise tax on non-arms-length transactions with our taxable REIT subsidiaries.

Our taxable REIT
subsidiaries, including NovaStar Mortgage, engage in activities that are prohibited for REITs, and will owe income taxes on the taxable income, if any, from these activities. For example, income earned by NovaStar Mortgage from our loan origination
and sales activities, as well as from other origination and servicing functions, would generally not be qualifying income for purposes of the gross income tests applicable to REITs or might otherwise be subject to adverse tax liability if the income
were generated by a REIT. Even while we remain a REIT, our taxable REIT subsidiaries will be taxable as C corporations and are subject to federal, state and local income tax at the applicable corporate rates on their net taxable income, if any.

So long as we remain a REIT, in the event that any transactions between us and any of our taxable REIT subsidiaries are not conducted on an
arms-length basis, we could be subject to a 100% excise tax on certain amounts from such transactions. Any such tax could affect our overall profitability and the amounts of cash available for operations or to make distributions. At such time
as we no longer have REIT status, we would be eligible to consolidate the operations of all of our taxable and qualified REIT subsidiaries with our income and deductions.

We may, at some point in the future, borrow funds from one or more of our corporate subsidiaries. The IRS may recharacterize the indebtedness as a dividend distribution to us by our subsidiary. Any such
recharacterization may cause us to fail one or more of the REIT requirements.

As long as we remain a REIT, we may be harmed by changes in tax laws
applicable to REITs or the reduced 15% tax rate on certain corporate dividends may harm us.

Changes to the laws and regulations affecting us,
including changes to securities laws and changes to the Code applicable to the taxation of REITs may harm our business. New legislation may be enacted into law or new interpretations, rulings or regulations could be adopted, any of which could harm
us and our shareholders, potentially with retroactive effect.

Generally, dividends paid by REITs are not eligible for the 15% U.S. federal income tax rate
on certain corporate dividends, with certain exceptions. The more favorable treatment of regular corporate dividends could cause domestic non-corporate investors to consider stocks of other corporations that pay dividends as more attractive relative
to stocks of REITs. At such time as we are no longer a REIT, any dividend distributions that we make would be subject to that 15% maximum tax rate. There can be no assurance that we will make any dividend distributions if we are no longer a REIT.

Prior to the termination of our REIT status, we may be unable to comply with the REIT requirements or compliance with such requirements could harm
our financial condition.

The requirements to qualify as a REIT under the Code are highly technical and complex. We routinely rely on legal opinions
to support our tax positions. A technical or inadvertent failure to comply with the Code prior to the termination of our REIT status as a result of an incorrect interpretation of the Code or otherwise could subject us to excise taxes and penalties.
The determination that we qualify as a REIT requires an analysis of various factual matters and circumstances that may not be totally within our control. For example, to qualify as a REIT, at least 75% of our gross income must come from real estate
sources and 95% of our gross income must come from real estate sources and certain other sources that are itemized in the REIT tax laws, mainly interest and dividends. We are subject to various limitations on our ownership of securities, including a
limitation that the value of our investment in taxable REIT subsidiaries, including NovaStar Mortgage, cannot exceed 20% of our total assets at the end of any calendar quarter. In addition, at the end of each calendar quarter, at least 75% of our
assets must be qualifying real estate assets, government securities and cash and cash items. The need to comply with these asset ownership requirements prior to the termination of our REIT status may cause us to acquire other assets that are
qualifying real estate assets for purposes of the REIT requirements (for example, interests in other mortgage loan portfolios or mortgage-related assets) but are not part of our overall business strategy and might not otherwise be the best
investment alternative for us. Moreover, we may be unable to acquire sufficient qualifying REIT assets, due to our inability to obtain adequate financing or otherwise, in which case we may fail to qualify as a REIT or may incur a penalty tax at the
REIT level.

Also, we must distribute to our shareholders with respect to each year that we are a REIT at least 90% of our REIT taxable income (determined
without regard to the dividends paid deduction and by excluding any net capital gain). To the extent that we satisfy the 90% distribution requirement, but distribute less than 100% of our taxable income, we will be subject to federal corporate
income tax on our undistributed taxable income. In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our shareholders in a calendar year is less than a minimum amount specified under federal tax
laws. We expect in some years, including for the 2006 year, that we will be subject to the 4% excise tax, which would result in the payment of a portion of our available cash to the IRS without reducing the amount that still must be distributed to
shareholders to meet the REIT qualification tests. We have announced our intent to distribute a taxable preferred stock dividend to satisfy our REIT distribution requirement for 2006. If we are unable to pay dividends with respect to our 2006 REIT
taxable income in securities, for any reason, including insufficient authorized shares of capital stock, our REIT status would be terminated which would subject us to taxes, penalties and interest which could have a material adverse effect on our
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For all periods during which we are not a REIT, our distributions will not be deductible by us, and we will be subject to
federal income tax on our net taxable income, if any. This would reduce our earnings and cash. The tax liability resulting from our failure to qualify as a REIT, might cause us to borrow funds, liquidate some of our investments or take other steps
that could negatively affect our operating results, liquidity and financial condition.



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We could lose our REIT status if more than 20% of the value of our total assets are represented by the securities
of one or more taxable REIT subsidiaries at the close of any calendar quarter.

So long as we are a REIT, not more than 20% of the value of our
total assets may be represented by the securities of one or more taxable REIT subsidiaries at the close of any calendar quarter, subject to a 30-day cure period following the close of the quarter and, for taxable years beginning on or
after January 1, 2005, subject to certain relief provisions even after the 30-day cure period. Our taxable REIT subsidiaries, including NovaStar Mortgage, conduct a substantial portion of our business activities, including a majority of our
loan origination and servicing activities. If the IRS determines that the value of our investment in our taxable REIT subsidiaries was more than 20% of the value of our total assets at the close of any calendar quarter, we could lose our REIT status
or be subject to an excise tax. In certain cases, we may need to borrow from third parties to acquire additional qualifying REIT assets in order to comply with the 20% of assets test, although there is no assurance that we would be able to take such
steps.

Risks Related to Our Capital Stock

Investors in our common stock may experience losses, volatility and poor liquidity.

Our earnings, cash flow, taxable income, GAAP
income, book value and dividends can be volatile and difficult to predict. Investors should not rely on past performance, predictions or management beliefs. Fluctuations in our current and prospective earnings, cash flow and dividends, as well as
many other factors such as perceptions, economic conditions, stock market conditions, and the like, can affect the price of our common stock. Investors may experience volatile returns and material losses. In addition, liquidity in the trading of our
common stock may be insufficient to allow investors to sell their stock in a timely manner or at a reasonable price.

Although we historically paid a
regular common stock dividend in cash, we have announced our intent to pay the dividend with respect to our 2006 REIT taxable income by distributing capital stock. As mentioned elsewhere, we do not expect to have any taxable income in 2007.
Furthermore, for periods following the anticipated termination of our REIT status, we will not be required to pay out our taxable income in the form of dividends. Instead, payment of dividends will be at the discretion of our board of directors.

Our boards decision to authorize our officers to initiate efforts to terminate our status as a REIT may materially adversely affect our
business, financial condition, results of operations and the price of our securities.

On May 3, 2007, our board of directors authorized our
officers to initiate efforts to terminate our status as a REIT effective January 1, 2008. There can be no assurance that when we ultimately terminate our status as a REIT, we will be able to operate competitively or profitably in the future.

Accordingly, we face a number of risks, including, without limitation, the following:



| |  |  | our management and Board are heavily engaged in the process of reviewing and considering changes in our strategic plan and corporate model, and the diversion of
their attention from our day-to-day business and operations may detract from their business productivity;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | we are incurring, and will continue to incur, significant expenses related to this process, including expenses related to our outside legal counsel and other
professional advisors;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | we may incur significant costs in connection with obtaining third party consents and waivers necessary to terminate our status as a REIT, including consents from
the holders of trust preferred securities issued by an affiliate and waivers from lenders under certain warehouse repurchase agreements, or to eliminate such requirements;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our stock price has been, and may continue to be, negatively affected by the uncertainty in the market , including uncertainty about the subprime industry and the
uncertainty regarding the future of our company;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | we may be unable to complete any changes to our corporate structure on the timeline or terms that we anticipate, or on any timeline or terms that otherwise are
attractive to us;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | current relationships with third parties may limit our ability to pursue certain alternatives and may result in additional expenses to us; and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | we may be unable to realize the anticipated benefits of any such alternatives that we determine to pursue.
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If any of the foregoing risks were to occur, then our business, results of operations, liquidity, financial condition and
the price of our securities would be negatively affected.

We may not be successful in obtaining consents or waivers from certain third parties
necessary to permit us to terminate our status as a REIT, or to complete transactions to eliminate such requirements, which may prevent us from realizing the anticipated benefits of such termination.

In order to terminate our status as a REIT, we must obtain consents or waivers from third parties under certain agreements, including agreements relating to our trust
preferred securities and certain of our existing warehouse financing agreements. There can be no assurance that any such consents and waivers will be obtained or that any transactions necessary to eliminate such requirements will be completed.
Should we fail to obtain the necessary consents or waivers, or to complete any transactions necessary to eliminate such requirements, we will be unable to realize the anticipated benefits of terminating our status as a REIT.

We may not pay common stock dividends to stockholders in the future.

We currently intend to maintain our status as a REIT through December 31, 2007. So long as we maintain our status as a REIT, REIT provisions of the Code generally require that we annually distribute to our stockholders at least 90% of
all of our REIT taxable income. If in any year, however, we do not generate REIT taxable income, we are not required under the Code to declare and pay dividends. We do not expect, and there can be no assurance that we will generate REIT taxable
income for the year ending December 31, 2007. As a result, we may not be required to pay a dividend with respect to 2007. In addition, we have entered into agreements that may limit our ability to make a discretionary dividend distribution for
2007.

We expect to terminate our REIT status on January 1, 2008, at which time, we will be subject to tax as a regular corporation and will
otherwise operate as a regular corporation.

If our REIT status is terminated, we will be a C corporation, will be taxed at the corporate level and
will not be required to pay out our taxable income in the form of dividends. Instead, the payment of dividends will be at the discretion of our board. To the extent that the market views our decision to terminate our REIT status unfavorably, the
value of our capital stock could be adversely affected.

As a C corporation, our dividends will be taxed as dividends to the extent of our current and
accumulated earnings and profits. Distributions in excess of our current and accumulated profits will be taxed to a shareholder as a return of capital to the extent of the shareholders tax basis in his stock, and the amount of a distribution
in excess of the shareholders tax basis will be taxed as a capital gain (a long-term capital gain if the shareholder has held our stock for more than one year). Under the Code, the maximum federal income tax rate applicable to individuals on
dividends and long term capital gains derived from a stock investment in a C corporation is currently 15%.

Restrictions on ownership of capital
stock may inhibit market activity and the resulting opportunity for holders of our capital stock to receive a premium for their securities.

In
order for us to meet the requirements for qualification as a REIT, our charter generally prohibits, so long as we remain a REIT, any person from acquiring or holding, directly or indirectly, (i) shares of our common stock in excess of 9.8% (in
value or number of shares, whichever is more restrictive) of the aggregate outstanding shares of our common stock or (ii) shares of our capital stock in excess of 9.8% in value of the aggregate outstanding shares of our capital stock. These
restrictions may inhibit market activity or the opportunity for the holders of our capital stock to receive a premium for their stock that might otherwise exist in the absence of such restrictions. These restrictions will not apply when we revoke
our REIT status.



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

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



| |  |  | general market and economic conditions;
| | - |  | ---------------------------------------



| |  |  | actual or anticipated changes in residential real estate value;
| | - |  | ---------------------------------------------------------------



| |  |  | actual or anticipated changes in the delinquency and default rates on mortgage loans, in general, and specifically on the loans we originate or invest in through
our mortgage securities;
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| |  |  | actual or anticipated changes in our future financial performance;
| | - |  | ------------------------------------------------------------------



| |  |  | actual or anticipated changes in market interest rates;
| | - |  | -------------------------------------------------------



| |  |  | actual or anticipated changes in our access to capital, including access to the securitization markets;
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| |  |  | our decision to terminate our REIT status;
| | - |  | ------------------------------------------



| |  |  | actual or anticipated changes in the amount of our dividend, any delay in the payment of a dividend, the failure to make a dividend payment or the form of any
dividend payment;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  |  | the operations and stock performance of our competitors;
| | - |  | --------------------------------------------------------



| |  |  | developments in the subprime mortgage lending industry or the financial services sector generally;
| | - |  | --------------------------------------------------------------------------------------------------



| |  |  | the impact of new state or federal legislation or adverse court decisions;
| | - |  | --------------------------------------------------------------------------



| |  |  | fluctuations in our quarterly operating results;
| | - |  | ------------------------------------------------



| |  |  | the activities of investors who engage in short sales of our common stock;
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| |  |  | actual or anticipated changes in financial estimates by securities analysts;
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| |  |  | 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
common stock may become illiquid if an active public trading market cannot be sustained, which could adversely affect the trading price and your ability to transfer our common stock.

Our common stocks trading volume is relatively low compared to the securities of many other companies listed on the New York Stock Exchange. If an active public
trading market cannot be sustained, the trading price of our common stock could be adversely affected and your ability to transfer your shares of our common stock may be limited.



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

Our charter permits our board of directors, without 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; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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

In the future, we expect to access the capital markets from time to time by making additional offerings of securities, including
debt instruments, preferred stock or common stock, including our announced rights offering to purchase our Series D2 Preferred Stock. Additional equity offerings by us may dilute your interest in us or reduce the market price of our common stock, or
both. Our outstanding shares of preferred stock have, and any additional series of preferred stock may also have, a preference on distribution payments that could limit our ability to make a distribution to common shareholders. Because our decision
to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Further, market conditions could require us to
accept less favorable terms for the issuance of our securities in the future. Thus, our common shareholders will bear the risk of our future offerings reducing the market price of our common stock and diluting their interest in us.

Risks Related to Our Recently Announced Transactions

Certain
covenants in the Stock Purchase Agreement we recently executed may adversely affect the value of your common stock.

We recently executed a
Stock Purchase Agreement (the Stock Purchase Agreement) with Massachusetts Mutual Life Insurance Company (MassMutual), Jefferies Capital Partners IV L.P., Jefferies Employee Partners IV LLC, and JCP Partners IV LLC
(collectively, Jefferies Capital Partners, and together with MassMutual, the Investors) pursuant to which they purchased $48,825,000.00 of our 9.00% Series D-1 Mandatory Convertible Preferred Stock, which is convertible into
common stock (Series D-1 Preferred Stock). The Series D-1 Preferred Stock contains customary antidilution provisions, and the Stock Purchase Agreement further requires us to seek stockholder approval for certain adjustments to the
conversion price of the Series D-1 Preferred Stock and the Series D-2 Preferred Stock (defined below) in the event of certain issuances of our common stock below the then current conversion price. To the extent that our shareholders approve these
adjustments and we issue stock below such prices, your proportionate voting interest will be reduced, and the percentage that your shares represent of our expanded equity after the adjustments will be diluted.

If we are not able to sell all of the Series D-2 Preferred Stock offered pursuant to the Rights Offering or we are unable to close the transactions contemplated by
the Standby Purchase Agreement, our financial condition and liquidity will be adversely affected

As previously announced, our Board of Directors
has approved a rights offering (the Rights Offering) pursuant to which holders of our common stock and Series D-1 Preferred Stock will receive non-transferable rights (the Rights) to purchase shares of a new series of our
convertible preferred securities designated as the 9.00% Series D-2 Mandatory Convertible Preferred Stock, which is convertible into our common stock (the Series D-2 Preferred Stock). We have also entered into a Standby Purchase
Agreement with the Investors pursuant to which the Investors have agreed to purchase up to $101,175,000 of our Series D-2 Preferred Stock to the extent any such shares are not subscribed for in our Rights Offering. The Investors obligations
under the Standby Purchase Agreement are subject to several closing conditions, including, among other things, there not having been an NFI Material Adverse Effect (as defined in the Standby Purchase Agreement), us having operated our
business in the ordinary course since the date of the Standby Purchase Agreement, our Board having declared the REIT dividend in accordance with the terms of the Standby Purchase Agreement, all governmental filings and approvals having been made or
received and completion of certain steps within the time periods specified in the agreement. To the extent that we are not able to sell all of the Series D-2 Preferred Stock pursuant to the Rights Offering and the transactions contemplated by the
Standby Purchase Agreement are not consummated due to the failure of any condition or otherwise, our liquidity and financial condition will be materially adversely affected.



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Furthermore, if the Standby Purchase Agreement or other related documents are materially amended or modified, due to a
reevaluation of the economics of, or the parties ability to complete, the transactions contemplated thereby or otherwise, our liquidity and financial condition could be materially adversely affected. Further, an amendment to the terms of our
recently announced transactions or further changes to market conditions could require us to reinitiate or reevaluate our exploration of strategic alternatives, which could further affect the volatility of our stock price.

If the Rights Offering and the sale of shares to the Investors pursuant to the Standby Purchase Agreement are consummated, your relative ownership interest may
experience significant dilution.

Pursuant to the Standby Purchase Agreement, the Investors are obligated, subject to certain conditions, to
purchase all of the shares of Series D-2 Preferred Stock not subscribed for in the Rights Offering.

To the extent that you do not exercise your rights and
shares are purchased by other stockholders in the Rights Offering or by the Investors pursuant to the Standby Purchase Agreement, your proportionate voting interest will be reduced, and the percentage that your original shares represent of our
expanded equity after exercise of the rights will be diluted.

After the consummation of the Rights Offering and the sale of shares to the Investors,
beneficial ownership of a significant amount of our common stock, or common stock issuable upon conversion of our preferred stock, could be concentrated in the hands of a few of our stockholders and their interests may not coincide with yours.

As a result of the Standby Purchase Agreement and the Rights Offering, the Investors could have the ability to exercise substantial control over
matters generally requiring stockholder approval, including election of directors. Furthermore pursuant to the Registration Rights and Shareholders Agreement executed with the Investors (the Registration Rights Agreement), the Investors
are entitled to nominate a number of directors to fill newly established seats on our board of directors, depending upon their ownership of our capital stock and to approve certain transactions, including change of control transactions, so long as
they own a minimum number of shares of Series D-1 Preferred Stock Your interests as a holder of our common stock may differ from the interests of the Investors.

Pursuant to the Registration Rights Agreement the Investors are entitled to certain approval rights and other privileges.

Pursuant
to the Registration Rights Agreement, so long as the Investors own a specified number of shares of our Series D-1 Preferred Stock, they have the right to approve any change of control (as defined in the Registration Rights Agreement) transaction.
Furthermore, in any change of control transaction, the Investors have certain redemption rights and rights to receive certain consideration. As a result, the Investors may be able to block or otherwise interfere with a change of control transaction
that is beneficial to the other holders of our capital stock.

The Investors investment in us will reduce the amount of any REIT Dividend
otherwise payable to you.

As previously announced, in the third quarter of 2007, we intend to declare a dividend (which we sometimes refer to as
the REIT Dividend) (a) in order to satisfy the income tax requirements to make a distribution equal to our 2006 REIT taxable income to maintain our status as a REIT, under the Code and (b) to eliminate any corporate level tax
burden. We currently intend to make the distribution in the form of Series E Convertible Preferred Stock to record holders as of a date to be determined by our board of directors. We would expect the dividend to be taxable to recipients. Timing of
the declaration and distribution of the Series E Preferred Stock will be determined by our board of directors, but federal tax rules for REITs require that we declare dividends based on 2006 taxable income by the deadline for our 2006 tax return,
which is September 17, 2007, and distribute those dividends by December 31, 2007. We currently intend to distribute the dividend to holders of our common stock, our Series D-1 Preferred Stock and our Series D-2 Preferred Stock, if any. As
a result, the purchase of Series D-1 Preferred Stock by the Investors reduced the amount of the dividend that will be paid to our common stockholders. Furthermore, to the extent that you do not exercise your right to purchase your proportionate
share of our Series D-2 Preferred Stock in the Rights Offering, your right to the dividend with respect to our 2006 REIT taxable income will be further reduced.

There is no assurance that you will be able to sell any securities that we distribute as a dividend at a price that exceeds our valuation of the dividend at the time we declare it.

If we distribute our dividend with respect to our 2006 REIT taxable income in capital stock, recipients will be getting additional equity in us, not cash. As a result,
the value of the capital stock will depend on our results of operation, financial condition, business prospects and other factors. We will have no obligation to list the capital stock on any exchange. As a result, you may have limited liquidity with
respect to the capital stock. Furthermore, final terms of the Series E Preferred Stock determined by our board may



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further adversely affect the value of the Series E Preferred Stock. As a result, there is no assurance that you will ultimately receive the cash value of our
2006 REIT Dividend as we determine it upon distribution.

If we are unable to declare the REIT Dividend for any reason, the Investors may not be
obligated to purchase any shares of the Series D-2 Preferred Stock pursuant to the Standby Purchase Agreement.

Our dividend policy is subject to
revision at the discretion of our board of directors. Any distributions will be made at the discretion of our board of directors and will depend on our taxable income, our financial condition, maintenance of REIT status for 2007 and other factors as
our board of directors deems relevant. Recent volatility in the market price of our common stock and general stock market volatility, will affect the value of the Series E Preferred Stock and its definitive terms. Declaration of the REIT Dividend is
a condition to the Investors obligations to purchase Series D-2 Preferred Stock under the Standby Purchase Agreement. If we are unable to declare the REIT Dividend for any reason, including having insufficient authorized shares of capital
stock, the Investors may not be obligated to purchase any shares of Series D-2 Preferred Stock pursuant to the Standby Purchase Agreement.

Other Risks
Related to our Business

Intense competition in our industry may harm our financial condition.

Our loan origination business faces intense competition, primarily from consumer finance companies, conventional mortgage bankers, commercial banks, credit unions, thrift
institutions, and other independent wholesale mortgage lenders, including internet-based lending companies and other mortgage REITs. Competitors with lower costs of capital have a competitive advantage over us. In addition, establishing a mortgage
lending operation such as ours requires a relatively small commitment of capital and human resources, which permits new competitors to enter our markets quickly and to effectively compete with us. Furthermore, national banks, thrifts and their
operating subsidiaries are generally exempt from complying with many of the state and local laws that affect our operations, such as the prohibition on prepayment penalties. Thus, they may be able to provide more competitive pricing and terms than
we can offer. Any increase in the competition among lenders to originate nonconforming mortgage loans may result in either reduced income on mortgage loans compared to present levels, or revised underwriting standards permitting higher loan-to-value
ratios on properties securing nonconforming mortgage loans, either of which could adversely affect our results of operations, financial condition or business prospects.

If we are unable to maintain and expand our network of independent brokers, our loan origination business will decrease.

Our brokers are not contractually obligated to do business with us. Further, our competitors also have relationships with our brokers and actively compete with us in our efforts to expand our broker networks. If we
further reduce our mortgage originations, change our underwriting guidelines or our current product mix, or reduce amounts paid to brokers, brokers may cease doing business with us. Our failure to maintain existing relationships or expand our broker
networks could harm our business, financial condition, liquidity and results of operations.

Our reported GAAP financial results will differ from the
taxable income results that drive our common stock dividends so long as we remain a REIT, and our consolidated balance sheet, income statement, and statement of cash flows as reported for GAAP purposes may be difficult to interpret.

We manage our business based on long-term opportunities to earn cash flows. For so long as we remain a REIT, our common stock dividends will be
driven by the REIT tax laws and our taxable income will be calculated pursuant to the Code. Our reported results for GAAP purposes differ materially, however, from both our cash flows and our taxable income. We transfer mortgage loans or mortgage
securities into securitization trusts to obtain long-term non-recourse funding for these assets. When we surrender control over the transferred mortgage loans or mortgage securities, the transaction is accounted for as a sale. When we retain control
over the transferred mortgage loans or mortgage securities, the transaction is accounted for as a secured borrowing. These securitization transactions do not differ materially in their structure or cash flow generation characteristics, yet under
GAAP accounting these transactions are recorded differently. In a securitization transaction accounted for as a sale, we record a gain or loss on the assets transferred in our income statement and we record the retained interests at fair value on
our balance sheet. In a securitization transaction accounted for as a secured borrowing, we consolidate all the assets and liabilities of the trust on our financial statements (and thus do not show the retained interest we own as an asset). As a
result of this and other accounting issues, shareholders and



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analysts must undertake a complex analysis to understand, among other things, our economic cash flows and actual financial leverage. This complexity may
cause trading in our stock to be relatively illiquid or may lead observers to misinterpret our results.

Market values for our mortgage assets and hedges
can be volatile. For GAAP purposes, we mark-to-market our non-hedging derivative instruments through our GAAP consolidated income statement and we mark-to-market our mortgage securitiesavailable-for-sale through our GAAP consolidated balance
sheet through other comprehensive income unless the mortgage securities are in an unrealized loss position which has been deemed as an other-than-temporary impairment. An other-than-temporary impairment is recorded through the income statement in
the period incurred. Additionally, we do not mark-to-market our loans held for sale as they are carried at lower of cost or market, as such, any change in market value would not be recorded through our income statement until the related loans are
sold. If we sell an asset that has not been marked-to-market through our income statement at a reduced market price relative to its basis, our reported earnings will be reduced. A decrease in market value of our mortgage assets may or may not result
in deterioration in future cash flows. As a result, changes in our GAAP consolidated income statement and balance sheet due to market value adjustments should be interpreted with care.

The value of the net operating loss carryforwards and net unrealized built-in losses is subject to challenge by the IRS and our ability to use such losses may be significantly limited.

We currently have recorded a gross deferred tax asset, net of a valuation allowance, of $270.2 million, almost all of which relates to certain loss carryforwards and net
unrealized built-in-losses. We expect to be able to utilize such losses over time subject to the below. 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 by a number of factors including, but not limited to:



| |  |  | our ability to generate sufficient net income to utilize the net operating loss carryforwards and net unrealized built-in-losses;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------



| |  |  | the absence of a future ownership change of us within the meaning of Section 382 of the Code;
| | - |  | ---------------------------------------------------------------------------------------------



| |  |  | the acceptance by the IRS of the positions taken on our prior tax returns as to the amount and timing of its income and expenses; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------



| |  |  | future changes in laws or regulations relating, which changes may have retroactive effect, to the use of net operating loss carryforwards and net unrealized
built-in losses.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

To the extent that we are unable to utilize these net operating loss carryforwards and net unrealized built in losses,
our results of operations, liquidity and financial condition could be adversely affected in a significant manner.

Our ability to use our net
operating loss carryforwards and net unrealized built-in losses could be severely limited if the transfer restrictions are not effective in preventing an ownership change from occurring.

Pursuant to Section 382 of the Code, a corporation is limited in its ability to use existing net operating loss carryforwards and net unrealized built in losses once that
corporation experiences an ownership change (as that term is defined in the Code and IRS Regulations). More specifically, corporations are limited in their ability to use net operating loss carryforwards and net unrealized built in
losses that are in existence prior to an ownership change to offset taxable income they receive after an ownership change. We have imposed certain transfer restrictions on our Series D-1 Preferred Stock, and intend to impose
similar restrictions on our Series D-2 Preferred Stock, and have also agreed to take action necessary to amend our charter, including submitting the amendment to our stockholders for approval, to limit the transferability of our common stock in
order to attempt to preserve certain of our net operating loss carryforwards and net unrealized built-In losses. Although transfer restrictions are valid under the Maryland General Corporation Law, we are not aware of any published court decisions
enforcing similar transfer restrictions. Thus, a transfer could occur that would violate the transfer restrictions, and we may be unable to enforce such transfer restrictions. Even if a court were to enforce the transfer restrictions, the Internal
Revenue Service might not agree that the transfer restrictions provided a sufficient remedy with respect to an ownership change resulting from a prohibited transfer. In either of these cases despite the implementation of the transfer restrictions,
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 the company (and a
significantly higher tax cost to the company as compared to the situation where these tax benefits are preserved).

If the transfer restrictions on
our capital stock are not effective in preventing an ownership change from occurring, then our ability to use our net operating loss carryforwards and net unrealized built-in losses could be severely limited.

We have imposed certain transfer restrictions on our Series D-1 Preferred Stock, intend to impose similar restrictions on our Series D-2 Preferred Stock, and have also
agreed to take action necessary to amend our charter, including submitting the amendment to our stockholders for approval, to limit the transferability of our common stock in order to preserve certain net operating loss carryforwards and net
unrealized built-in losses. Although the transfer restrictions are valid under the Maryland General Corporation Law, we are not aware of any published court decisions enforcing similar transfer restrictions. Thus, a transfer could occur that would
violate the transfer restrictions, and we may be unable to enforce the transfer restrictions. Even if a court were to enforce the transfer restrictions, the IRS might not agree that the transfer restrictions provided a sufficient remedy with respect
to an ownership change resulting from a prohibited transfer. In either of those cases, despite the implementation of the transfer restrictions, an ownership change could occur that would limit our ability to use the tax benefits associated with the
net operating loss carryforwards and net unrealized built-in losses.

The transfer restrictions on our capital stock may delay or prevent takeover
bids by third parties and may delay or frustrate attempts by a stockholder to replace management.

The transfer restrictions on our capital stock
are complex and are designed to preserve the value of our net operating loss carryforwards and net unrealized built-in losses for the benefit of our stockholders and our status as a REIT. Any person who seeks to acquire a significant interest in us
will be required to negotiate with our board of directors. The transfer restrictions may also make it more difficult to effect a business combination transaction that stockholders may perceive to be favorable because of the need to negotiate with
our board of directors. The transfer restrictions could also make it more difficult for a stockholder to replace current management because a stockholders ability to increase its voting power is limited.



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The inability to attract and retain qualified employees could significantly harm our business.

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



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The success and growth of our business will depend upon our ability to adapt to and implement technological
changes.

Our mortgage loan origination business is currently dependent upon our ability to effectively interface with our brokers, borrowers and
other third parties and to efficiently process loan applications and closings. The origination process is becoming more dependent upon technological advancement, such as the ability to process applications over the Internet, accept electronic
signatures and provide process status updates instantly and other customer-expected conveniences that are cost-efficient to our process. Becoming proficient with new technology will require significant financial and personnel resources. If we become
reliant on any particular technology or technological solution, we may be harmed to the extent that such technology or technological solution (i) becomes non-compliant with existing industry standards, (ii) fails to meet or exceed the
capabilities of our competitors equivalent technologies or technological solutions, (iii) becomes increasingly expensive to service, retain and update, or (iv) becomes subject to third-party claims of copyright or patent
infringement. Any failure to acquire technologies or technological solutions when necessary could limit our ability to remain competitive in our industry and could also limit our ability to increase the cost-efficiencies of our operating model,
which would harm our results of operations, financial condition and business prospects.

Our business could be adversely affected if we experienced
an interruption in or breach of our communication or information systems or if we were unable to safeguard the security and privacy of the personal financial information we receive.

We rely heavily upon communications and information systems to conduct our business. Any material interruption, or breach in security, of our communication or information
systems or the third-party systems on which we rely could cause underwriting or other delays and could result in fewer loan applications being received, slower processing of applications and reduced efficiency in loan servicing. Additionally, in
connection with our loan file due diligence reviews, we have access to the personal financial information of the borrowers which is highly sensitive and confidential, and subject to significant federal and state regulation. If a third party were to
misappropriate this information or if we inadvertently disclosed this information, we potentially could be subject to both private and public legal actions. Our policies and safeguards may not be sufficient to prevent the misappropriation or
inadvertent disclosure of confidential information, may become noncompliant with existing federal or state laws or regulations governing privacy, or with those laws or regulations that may be adopted in the future.

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 by providing them with the opportunity to sell their shares possibly at a premium over the
then market price. 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. These provisions, as well as others, could discourage potential acquisition proposals, or delay or prevent a change in control and prevent changes in our
management, even if such actions would be in the best interests of our shareholders.



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

(dollars in thousands)



|                                      |  |                                |  |                            |  |                                                                           |  |                                                                                        |      
|------------------------------------- |  | ------------------------------ |  | -------------------------- |  | ------------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------- | -----
|Issuer Purchases of Equity
Securities
|                                      |  | Total Numberof SharesPurchased |  | AveragePrice Paidper Share |  | Total Numberof SharesPurchased asPart ofPubliclyAnnouncedPlans orPrograms |  | ApproximateDollar Value ofShares ThatMay Yet BePurchased Underthe Plans
orPrograms (A)
|April 1, 2007  April 30, 2007        |  |                               |  |                           |  |                                                                          |  | $                                                                                      | 1,020
|May 1, 2007  May 31, 2007            |  |                               |  |                           |  |                                                                          |  | $                                                                                      | 1,020
|June 1, 2007  June 31, 2007          |  |                               |  |                           |  |                                                                          |  | $                                                                                      | 1,020

---

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

Item 3. Defaults Upon Senior Securities

Not Applicable

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

The 2007 annual meeting of shareholders of NovaStar
Financial, Inc. was held on May 4, 2007, and was adjourned until June 8, 2007 in order to solicit additional votes in support of Proposal 2 regarding approval of a charter amendment to increase our authorized shares of capital stock.
Gregory T. Barmore and W. Lance Anderson were elected as directors. Scott F. Hartman, Edward W. Mehrer, Donald M. Berman and Art N. Burtscher s terms of office as directors continued after the meeting.

The following matters were voted on at the annual meeting:



|                                                                                                                               |  |              |  |           |  |        
|------------------------------------------------------------------------------------------------------------------------------ |  | ------------ |  | --------- |  | -------
|                                                                                                                               |  | Vote Results
|                                                                                                                               |  | For          |  | Withheld  |  |        
|1.      Election of Directors                                                                                                  |  |              |  |           |  |        
|W. Lance Anderson (term expiring in 2010)                                                                                      |  | 32,480,504   |  | 2,486,584 |  |        
|Gregory T. Barmore (term expiring in 2010)                                                                                     |  | 32,037,553   |  | 2,929,536 |  |        
|                                                                                                                               |  |              | 
|                                                                                                                               |  | For          |  | Against   |  | Abstain
|2.      Approval of the charter amendment to increase the authorized shares of capital stock                                   |  | 17,260,160   |  | 5,693,690 |  | 443,770
|                                                                                                                               |  |              | 
|3.      Ratification of Deloitte & Touche LLP as NovaStar Financial, Inc.s independent registered
public accountants for 2007 |  | 33,909,290   |  | 896,732   |  | 161,065

Due to the fact that we were required to obtain approval of a majority of our outstanding shares of common stock,
Proposal 2  Approval of the Charter Amendment to increase authorized shares of capital stock did not pass.



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##### Table of Contents

Item 5. Other Information

As previously disclosed in our Form 8-K filed with the Securities and Exchange Commission (the
SEC) on July 20, 2007, we entered into a Registration Rights and Shareholders Agreement, dated July 16, 2007, with the Investors (the Registration Rights Agreement). Pursuant to the Registration Rights Agreement,
the Investors have the right to designate up to four individuals for election to our Board of Directors depending on the percentage of shares owned by the Investors. For so long as the Investors have the right to designate one or more individuals
for election to our Board of Directors, the Registration Rights Agreement provides that the total number of members of the Board shall be fixed at eight, subject to adjustment as is necessary to ensure that the Investors can designate the number of
directors that they are entitled to designate under the Registration Rights Agreement. The foregoing is a summary of the terms of the Registration Rights Agreement relating to the Investors right to nominate individuals for election to our
Board of Directors and is qualified in its entirety by reference to the Registration Rights Agreement, which has been filed with the SEC. Other than the rights of the Investors to designate directors pursuant to the Registration Rights Agreement,
the procedures by which security holders may recommend nominees to our Board of Directors set forth in our proxy statement for our 2007 Annual Stockholders Meeting filed with the SEC on March 30, 2007 have not been modified.



129



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##### Table of Contents

Item 6. Exhibits

Exhibit Listing



|            |  |                                                                                                                                                                                                                                                                                                                                                                       
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Document                                                                                                                                                                                                                                                                                                                                               
|            | 
|3.1         |  | Articles of Amendment and Restatement of NovaStar Financial, Inc. (including all amendments and applicable Articles Supplementary)                                                                                                                                                                                                                                    
|            | 
|4.1         |  | See Item 3.1                                                                                                                                                                                                                                                                                                                                                          
|            | 
|10.49.1     |  | Amendment Number One to Master Repurchase Agreement (Residual Securities), dated as of May 10, 2007, among Wachovia Investment Holdings, LLC, Wachovia Capital Markets, LLC, NovaStar Mortgage,
Inc., NovaStar Certificates Financing, LLC, NovaStar Certificates Financing Corporation, NovaStar Financial, Inc., NFI Holding Corporation and HomeView Lending, Inc.1
|            | 
|10.52.1     |  | Amendment Number One to Master Repurchase Agreement (2007 Servicing Rights), dated as of May 10, 2007, among Wachovia Bank, N.A., Wachovia Capital Markets, LLC, NovaStar Mortgage, Inc., NovaStar
Financial, Inc., NovaStar Holding Corporation and HomeView Lending, Inc.2                                                                                          
|            | 
|10.67       |  | Master Repurchase Agreement (2007 Whole Loan), dated as of May 9, 2007, among Wachovia Bank, N.A., NFI Repurchase Corporation, NMI Repurchase Corporation, HomeView Lending, Inc., NMI Property
Financing, Inc., NovaStar Financial, Inc., NFI Holding Corporation and NovaStar Mortgage, Inc.3                                                                       
|            | 
|10.67.1     |  | Guaranty, dated as of May 9, 2007, among NovaStar Financial, Inc., NFI Holding Corporation, NovaStar Mortgage, Inc., HomeView Lending, Inc. and Wachovia Bank, NA4                                                                                                                                                                                                    
|            | 
|10.68       |  | Master Repurchase Agreement (2007 Non-Investment Grade Securities), dated as of May 31, 2007, among Wachovia Investment Holdings, LLC, Wachovia Capital Markets, LLC, NovaStar Mortgage, Inc.,
NovaStar Certificates Financing, LLC, NovaStar Certificates Financing Corporation, NFI Holding Corporation and NovaStar Financial, Inc.5                               
|            | 
|10.68.1     |  | Guaranty, dated as of May 31, 2007, among NovaStar Financial, Inc., NFI Holding Corporation and Wachovia Investment Holdings, LLC6                                                                                                                                                                                                                                    
|            | 
|10.69       |  | Master Repurchase Agreement (2007 Investment Grade Securities), dated as of May 31, 2007, among Wachovia Bank, N.A., Wachovia Capital Markets, LLC, NovaStar Mortgage, Inc., NovaStar Certificates
Financing, LLC, NovaStar Certificates Financing Corporation, NFI Holding Corporation and NovaStar Financial, Inc.7                                                 
|            | 
|10.69.1     |  | Guaranty, dated as of May 31, 2007, among NovaStar Financial, Inc., NFI Holding Corporation and Wachovia Bank, N.A.8                                                                                                                                                                                                                                                  
|            | 
|10.70       |  | 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 LLC9                                                                                                                               



---

|1 | Incorporated by reference to Exhibit 10.4 to Form 8-K filed by the Registrant with
the SEC on May 15, 2007
|- | ----------------------------------------------------------------------------------------------------------

|2 | Incorporated by reference to Exhibit 10.3 to Form 8-K filed by the Registrant with
the SEC on May 15, 2007
|- | ----------------------------------------------------------------------------------------------------------

|3 | Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with
the SEC on May 15, 2007
|- | ----------------------------------------------------------------------------------------------------------

|4 | Incorporated by reference to Exhibit 10.2 to Form 8-K filed by the Registrant with
the SEC on May 15, 2007
|- | ----------------------------------------------------------------------------------------------------------

|5 | Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with
the SEC on June 6, 2007
|- | ----------------------------------------------------------------------------------------------------------

|6 | Incorporated by reference to Exhibit 10.2 to Form 8-K filed by the Registrant with
the SEC on June 6, 2007
|- | ----------------------------------------------------------------------------------------------------------

|7 | Incorporated by reference to Exhibit 10.3 to Form 8-K filed by the Registrant with
the SEC on June 6, 2007
|- | ----------------------------------------------------------------------------------------------------------

|8 | Incorporated by reference to Exhibit 10.4 to Form 8-K filed by the Registrant with
the SEC on June 6, 2007
|- | ----------------------------------------------------------------------------------------------------------

|9 | Incorporated by reference to Exhibit 10.1 to Form 8-K filed by the Registrant with
the SEC on July 20, 2007
|- | -----------------------------------------------------------------------------------------------------------



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|      |  |                                                                                                                                                                                                                                                          
|----- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|      | 
|10.71 |  | 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                    
|      | 
|10.72 |  | 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 LLC11
|      | 
|10.73 |  | 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 Hartman12           
|      | 
|10.74 |  | 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 Anderson13          
|      | 
|10.75 |  | 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 Bamburg14            
|      | 
|11.1  |  | Statement Regarding Computation of Per Share Earnings15                                                                                                                                                                                                  
|      | 
|31.1  |  | Chief Executive Officer Certification - Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                    
|      | 
|31.2  |  | Principal Financial Officer Certification - Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                
|      | 
|32.1  |  | Chief Executive Officer Certification - Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                    
|      | 
|32.2  |  | Principal Financial Officer Certification - Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                



---

|10 | Incorporated by reference
to Exhibit 10.2 to Form 8-K filed by the Registrant with the SEC on July 20, 2007
|-- | -----------------------------------------------------------------------------------------------------------

|11 | Incorporated by reference to Exhibit 10.3 to Form 8-K filed by the Registrant with
the SEC on July 20, 2007
|-- | -----------------------------------------------------------------------------------------------------------

|12 | Incorporated by reference
to Exhibit 10.4 to Form 8-K filed by the Registrant with the SEC on July 20, 2007
|-- | -----------------------------------------------------------------------------------------------------------

|13 | Incorporated by reference
to Exhibit 10.5 to Form 8-K filed by the Registrant with the SEC on July 20, 2007
|-- | -----------------------------------------------------------------------------------------------------------

|14 | Incorporated by reference to Exhibit 10.6 to Form 8-K filed by the Registrant with
the SEC on July 20, 2007
|-- | -----------------------------------------------------------------------------------------------------------

|15 | See Note 19 to the condensed consolidated financial statements
|-- | --------------------------------------------------------------



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SIGNATURES

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

NOVASTAR FINANCIAL, INC.



|                     |  |                                                                                 
|-------------------- |  | --------------------------------------------------------------------------------
|DATE: August 9, 2007 |  | /s/ SCOTT F. HARTMAN                                                            
|                     |  | Scott F. Hartman, Chairman of the Board of Directors
and Chief Executive Officer
|                     |  | (Principal Executive Officer)                                                   
|                     | 
|DATE: August 9, 2007 |  | /s/ GREGORY S. METZ                                                             
|                     |  | Gregory S. Metz, Chief Financial Officer                                        
|                     |  | (Principal Financial Officer)                                                   



132