UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549





FORM
10-Q/A


(Amendment
No. 1)





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





For
the Quarterly Period Ended June 30, 2008





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





For
the Transition Period From ________ to ________








Commission
File Number 001-13533





NOVASTAR
FINANCIAL, INC.


(Exact
Name of Registrant as Specified in its Charter)





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





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





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








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





Indicate
by check mark whether the registrant 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 o
              Accelerated filer x
              Non-accelerated filer o
              Smaller reporting company o





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


Yes o  No x





The
number of shares of the Registrant’s Common Stock outstanding on July 31, 2008
was 9,391,341.










NOVASTAR
FINANCIAL, INC.


FORM
10-Q


For
the Quarterly Period Ended June 30, 2008







TABLE
OF CONTENTS





Part
      I
                Financial
      InformationExplanatory
      Note
                1Item
      1.
                Financial
      Statements (Unaudited)
                2Condensed
      Consolidated Balance Sheets
                2Condensed
      Consolidated Statements of Operations
                3Condensed
      Consolidated Statement of Shareholders’ Deficit
                4Condensed
      Consolidated Statements of Cash Flows
                5Notes
      to Condensed Consolidated Financial Statements
                8Item
      2.
                Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                30Item
      3.
                Quantitative
      and Qualitative Disclosures About Market Risk
                51Item
      4.
                Controls
      and Procedures
                53Part
      II
                Other
      InformationItem
      1.
                Legal
      Proceedings
                54Item
      1A.
                Risk
      Factors
                56Item
      2.
                Unregistered
      Sales of Equity Securities and Use of Proceeds
                64Item
      3.
                Defaults
      Upon Senior Securities
                64Item
      4.
                Submission
      of Matters to a Vote of Security Holders
                65Item
      5.
                Other
      Information
                65Item
      6.
                Exhibits
                65









Explanatory
Note




On
January 30, 2009, management of NovaStar Financial, Inc. (“NFI”) and its
subsidiaries (“the Company”), in consultation with the Company’s independent
auditors, concluded that the condensed consolidated financial statements as
of and for the six and three months ended June 30, 2008 presented in the
Company’s previously issued Quarterly Report on Form 10-Q for the quarterly
period ended June 30, 2008 (“Second Quarter Form 10-Q”), filed on August 18,
2008 should be restated.  This conclusion was reported in a Current
Report on Form 8-K filed on February 4, 2009.  Accordingly, the
Company is filing this Amendment No. 1 to the Second Quarter Form 10-Q
(“Amendment No. 1”) to restate the condensed consolidated financial statements
and make the related revisions to the Second Quarter Form 10-Q as described in
Note 17 to the condensed consolidated financial statements.




Except
with respect to the foregoing, this Amendment No. 1 does not modify or update
any of our prior disclosure from the Second Quarter Form 10-Q or exhibits
thereto and does not reflect events occurring after the filing of the Second
Quarter Form 10-Q.  Other events occurring after the filing of the
Second Quarter Form 10-Q have been addressed in our reports filed with the SEC
subsequent to the filing of the Second Quarter Form
10-Q.  Accordingly, this Amendment No. 1 should be read in conjunction
with such reports.


1


PART
I. FINANCIAL INFORMATION





Item
1. Financial Statements





NOVASTAR FINANCIAL,
INC.


CONDENSED
CONSOLIDATED BALANCE SHEETS


(unaudited;
dollars in thousands, except share amounts)


June
      30,
                  
                  
                  December
      31,2008
                  
                  
                  2007(Restated)AssetsUnrestricted
      cash and cash equivalents
                  
                  $
                  10,269
                  
                  
                  $
                  25,364Restricted
      cash
                  
                  
                  7,181
                  
                  
                  
                  8,998Mortgage
      loans – held-in-portfolio, net of allowance of $616,690 and $230,138,
      respectively
                  
                  
                  2,161,720
                  
                  
                  
                  2,870,013Mortgage
      securities -
      trading
                  
                  
                  25,275
                  
                  
                  
                  109,203Mortgage
      securities -
      available-for-sale
                  
                  
                  9,167
                  
                  
                  
                  33,371Real
      estate owned
                  
                  
                  66,539
                  
                  
                  
                  76,614Accrued
      interest receivable
                  
                  
                  66,039
                  
                  
                  
                  61,704Other
      assets
                  
                  
                  5,875
                  
                  
                  
                  37,244Assets
      of discontinued operations
                  
                  
                  2,477
                  
                  
                  
                  8,255Total
      assets
                  
                  $
                  2,354,542
                  
                  
                  $
                  3,230,766Liabilities
      and Shareholders’ DeficitLiabilities:Asset-backed
      bonds secured by mortgage loans
                  
                  $
                  2,784,301
                  
                  
                  $
                  3,065,746Asset-backed
      bonds secured by mortgage securities
                  
                  
                  18,630
                  
                  
                  
                  74,385Short-term
      borrowings secured by mortgage securities
                  
                  
                  -
                  
                  
                  
                  45,488Junior
      subordinated debentures
                  
                  
                  77,077
                  
                  
                  
                  83,561Due
      to servicer
                  
                  
                  77,165
                  
                  
                  
                  56,450Derivative
      instruments, net
                  
                  
                  10,574
                  
                  
                  
                  6,896Dividends
      payable
                  
                  
                  10,473
                  
                  
                  
                  3,816Accounts
      payable and other liabilities
                  
                  
                  25,411
                  
                  
                  
                  53,392Liabilities
      of discontinued operations
                  
                  
                  47,608
                  
                  
                  
                  59,416Total
      liabilities
                  
                  
                  3,051,239
                  
                  
                  
                  3,442,254Commitments
      and contingencies (Note 7)Shareholders’
      deficit:Capital stock, $0.01 par value, 50,000,000 shares
    authorized:Redeemable
      preferred stock, $25 liquidating preference per share; 2,990,000 shares,
      issued and outstanding
                  
                  
                  30
                  
                  
                  
                  30Convertible
      participating preferred stock, $25 liquidating preference per share;
      2,100,000 shares, issued and outstanding
                  
                  
                  21
                  
                  
                  
                  21Common
      stock, 9,391,341 and 9,439,273 shares, issued and outstanding,
      respectively
                  
                  
                  94
                  
                  
                  
                  94Additional
      paid-in capital
                  
                  
                  786,440
                  
                  
                  
                  786,342Accumulated
      deficit
                  
                  
                  (1,482,862
                  )
                  
                  
                  (996,649
                  )Accumulated
      other comprehensive loss
                  
                  
                  (246
                  )
                  
                  
                  (1,117
                  )Other
                  
                  
                  (174
                  )
                  
                  
                  (209
                  )Total
      shareholders’ deficit
                  
                  
                  (696,697
                  )
                  
                  
                  (211,488
                  )Total
      liabilities and shareholders’ deficit
                  
                  $
                  2,354,542
                  
                  
                  $
                  3,230,766





See notes
to condensed consolidated financial statements.


2


NOVASTAR
FINANCIAL, INC.


CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS


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


For
      the Six Months
                        Ended
      June 30,
                      
                      
                      For
      the Three Months
                        Ended
      June 30,2008
                      
                      
                      2007
                      
                      
                      2008
                      
                      
                      2007(Restated)
                      
                      
                      
                      
                      
                      (Restated)Interest
      income
                      
                      $
                      131,008
                      
                      
                      $
                      187,755
                      
                      
                      $
                      59,542
                      
                      
                      $
                      104,095Interest
      expense
                      
                      
                      65,283
                      
                      
                      
                      115,676
                      
                      
                      
                      29,001
                      
                      
                      
                      65,901Net
      interest income before provision for credit losses
                      
                      
                      65,725
                      
                      
                      
                      72,079
                      
                      
                      
                      30,541
                      
                      
                      
                      38,194Provision
      for credit losses
                      
                      
                      461,436
                      
                      
                      
                      93,167
                      
                      
                      
                      212,120
                      
                      
                      
                      73,254Net
      interest loss after provision for credit losses
                      
                      
                      (395,711
                      )
                      
                      
                      (21,088
                      )
                      
                      
                      (181,579
                      )
                      
                      
                      (35,060
                      )Other
      operating expense:(Losses)
      gains on derivative instruments
                      
                      
                      (10,613
                      )
                      
                      
                      6,506
                      
                      
                      
                      4,974
                      
                      
                      
                      6,128Gains
      on debt extinguishment
                      
                      
                      6,418
                      
                      
                      
                      -
                      
                      
                      
                      6,418
                      
                      
                      
                      -Fair
      value adjustments
                      
                      
                      (22,669
                      )
                      
                      
                      (26,233
                      )
                      
                      
                      (9,952
                      )
                      
                      
                      (16,741
                      )Impairment
      on mortgage securities – available-for-sale
                      
                      
                      (21,229
                      )
                      
                      
                      (25,993
                      )
                      
                      
                      (1,848
                      )
                      
                      
                      (22,569
                      )Premiums
      for mortgage loan insurance
                      
                      
                      (8,317
                      )
                      
                      
                      (7,606
                      )
                      
                      
                      (4,043
                      )
                      
                      
                      (4,798
                      )Servicing
      fee expense
                      
                      
                      (7,093
                      )
                      
                      
                      -
                      
                      
                      
                      (3,397
                      )
                      
                      
                      -Other
      income (expense), net
                      
                      
                      80
                      
                      
                      
                      (213
                      )
                      
                      
                      69
                      
                      
                      
                      (223
                      )Total
      other operating expense
                      
                      
                      (63,423
                      )
                      
                      
                      (53,539
                      )
                      
                      
                      (7,779
                      )
                      
                      
                      (38,203
                      )General
      and administrative expenses:Compensation
      and benefits
                      
                      
                      3,479
                      
                      
                      
                      16,900
                      
                      
                      
                      930
                      
                      
                      
                      8,151Office
      administration
                      
                      
                      4,553
                      
                      
                      
                      5,948
                      
                      
                      
                      2,284
                      
                      
                      
                      2,870Professional
      and outside services
                      
                      
                      3,887
                      
                      
                      
                      13,168
                      
                      
                      
                      1,976
                      
                      
                      
                      5,449Marketing
                      
                      
                      -
                      
                      
                      
                      57
                      
                      
                      
                      -
                      
                      
                      
                      57Travel
      and other
                      
                      
                      370
                      
                      
                      
                      4,040
                      
                      
                      
                      226
                      
                      
                      
                      1,174Total
      general and administrative expenses
                      
                      
                      12,289
                      
                      
                      
                      40,113
                      
                      
                      
                      5,416
                      
                      
                      
                      17,701Loss
      from continuing operations before income tax expense
    (benefit)
                      
                      
                      (471,423
                      )
                      
                      
                      (114,740
                      )
                      
                      
                      (194,774
                      )
                      
                      
                      (90,964
                      )Income
      tax expense (benefit)
                      
                      
                      1,084
                      
                      
                      
                      (186,582
                      )
                      
                      
                      433
                      
                      
                      
                      (71,206
                      )(Loss)
      income from continuing operations
                      
                      
                      (472,507
                      )
                      
                      
                      71,842
                      
                      
                      
                      (195,207
                      )
                      
                      
                      (19,758
                      )Loss
      from discontinued operations, net of income tax
                      
                      
                      (7,347
                      )
                      
                      
                      (78,706
                      )
                      
                      
                      (1,977
                      )
                      
                      
                      (33,120
                      )Net
      loss
                      
                      
                      (479,854
                      )
                      
                      
                      (6,864
                      )
                      
                      
                      (197,184
                      )
                      
                      
                      (52,878
                      )Basic
      earnings per share:Loss
      from continuing operations available to common
shareholders
                      
                      $
                      (51.31
                      )
                      
                      $
                      7.34
                      
                      
                      $
                      (21.27
                      )
                      
                      $
                      (2.29
                      )Loss
      from discontinued operations, net of income tax
                      
                      
                      (0.79
                      )
                      
                      
                      (8.43
                      )
                      
                      
                      (0.21
                      )
                      
                      
                      (3.55
                      )Net
      loss available to common shareholders
                      
                      $
                      (52.10
                      )
                      
                      $
                      (1.09
                      )
                      
                      $
                      (21.48
                      )
                      
                      $
                      (5.84
                      )Diluted
      earnings per share:Loss
      from continuing operations available to common
shareholders
                      
                      $
                      (51.31
                      )
                      
                      $
                      7.34
                      
                      
                      $
                      (21.27
                      )
                      
                      $
                      (2.29
                      )Loss
      from discontinued operations, net of income tax
                      
                      
                      (0.79
                      )
                      
                      
                      (8.43
                      )
                      
                      
                      (0.21
                      )
                      
                      
                      (3.55
                      )Net
      loss available to common shareholders
                      
                      $
                      (52.10
                      )
                      
                      $
                      (1.09
                      )
                      
                      $
                      (21.48
                      )
                      
                      $
                      (5.84
                      )Weighted
      average basic shares outstanding
                      
                      
                      9,337,427
                      
                      
                      
                      9,328,679
                      
                      
                      
                      9,337,695
                      
                      
                      
                      9,336,655Weighted
      average diluted shares outstanding
                      
                      
                      9,337,427
                      
                      
                      
                      9,328,679
                      
                      
                      
                      9,337,695
                      
                      
                      
                      9,336,655





See notes to condensed consolidated
financial statements.


3


NOVASTAR
FINANCIAL, INC.


CONDENSED
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ DEFICIT


(unaudited;
dollars in thousands)







Redeemable
                          Preferred
                          Stock
                        
                        
                        Convertible
                          Participating
                          Preferred
                          Stock
                        
                        
                        Common
                          Stock
                        
                        
                        Additional
                          Paid-in
                          Capital
                        
                        
                        Accumulated
                          Deficit
                        
                        
                        Accumulated
                          Other
                          Comprehensive
                          Loss
                        
                        
                        Other
                        
                        
                        Total
                          Shareholders’
                          DeficitBalance,
      January 1, 2008
                        
                        $
                        30
                        
                        
                        $
                        21
                        
                        
                        $
                        94
                        
                        
                        $
                        786,342
                        
                        
                        $
                        (996,649
                        )
                        
                        $
                        (1,117
                        )
                        
                        $
                        (209
                        )
                        
                        $
                        (211,488
                        )Forgiveness
      of founder’s notes receivable
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        35
                        
                        
                        
                        35Compensation
      recognized under stock compensation plans
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        97
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        97Accumulating
      dividends on preferred stock
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        (6,657
                        )
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        (6,657
                        )Other
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        1
                        
                        
                        
                        298
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        299Comprehensive
      loss:Net
      loss (as restated)
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (479,854
                        )
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (479,854
                        )Other
      comprehensive income
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        871
                        
                        
                        
                        
                        
                        
                        
                        871Total
      comprehensive loss (as restated)
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        (478,983
                        )Balance,
      June 30, 2008
                        
                        $
                        30
                        
                        
                        $
                        21
                        
                        
                        $
                        94
                        
                        
                        $
                        786,440
                        
                        
                        $
                        (1,482,862
                        )
                        
                        $
                        (246
                        )
                        
                        $
                        (174
                        )
                        
                        $
                        (696,697
                        )





See notes to condensed consolidated
financial statements.


4


NOVASTAR
FINANCIAL, INC.


CONDENSEDCONSOLIDATED
STATEMENTS OF CASH FLOWS


(unaudited;
dollars in thousands)


For
      the Six Months Ended June 30,2008
                    
                    
                    2007(Restated)Cash
      flows from operating activities:Net
      loss
                    
                    $
                    (479,854
                    )
                    
                    $
                    (6,864
                    )Loss
      from discontinued operations
                    
                    
                    (7,347
                    )
                    
                    
                    (78,706
                    )(Loss)
      income from continuing operations
                    
                    
                    (472,507
                    )
                    
                    
                    71,842Adjustments
      to reconcile (loss) income from continuing operations to net cash used in
      operating activities:Impairment
      on mortgage securities – available-for-sale
                    
                    
                    21,229
                    
                    
                    
                    25,993Gains
      (losses) on derivative instruments
                    
                    
                    10,613
                    
                    
                    
                    (6,505
                    )Depreciation
      expense
                    
                    
                    519
                    
                    
                    
                    1,316Amortization
      of deferred debt issuance costs
                    
                    
                    1,887
                    
                    
                    
                    4,210Compensation
      recognized under stock compensation plans
                    
                    
                    97
                    
                    
                    
                    686Provision
      for credit losses
                    
                    
                    461,436
                    
                    
                    
                    93,167Amortization
      of premiums on mortgage loans
                    
                    
                    10,153
                    
                    
                    
                    8,826Interest
      capitalized on loans held-in-portfolio
                    
                    
                    (14,355
                    )
                    
                    
                    (23,065
                    )Forgiveness
      of founders’ promissory notes
                    
                    
                    35
                    
                    
                    
                    70Provision
      for deferred income taxes
                    
                    
                    -
                    
                    
                    
                    (192,889
                    )Fair
      value adjustments
                    
                    
                    22,669
                    
                    
                    
                    26,238Accretion
      of available-for-sale and trading securities
                    
                    
                    (26,758
                    )
                    
                    
                    (57,630
                    )Losses
      on sales of mortgage assets
                    
                    
                    -
                    
                    
                    
                    212Gains
      on debt extinguishment
                    
                    
                    (6,418
                    )
                    
                    
                    -Changes
      in:Accrued
      interest receivable
                    
                    
                    (4,336
                    )
                    
                    
                    (9,849
                    )Derivative
      instruments, net
                    
                    
                    546
                    
                    
                    
                    1,787Other
      assets
                    
                    
                    5,903
                    
                    
                    
                    24,898Due
      to servicer
                    
                    
                    20,715
                    
                    
                    
                    -Accounts
      payable and other liabilities
                    
                    
                    (18,792
                    )
                    
                    
                    40,874Net
      cash provided by operating activities from continuing
      operations
                    
                    
                    12,636
                    
                    
                    
                    10,181Net
      cash used in operating activities from discontinued
    operations
                    
                    
                    (15,183
                    )
                    
                    
                    (755,891
                    )Net
      cash used in operating activities
                    
                    
                    (2,547
                    )
                    
                    
                    (745,710
                    )Continued




5





Cash
      flows from investing activities:Proceeds
      from paydowns on mortgage securities – available-for-sale
                      
                      
                      19,226
                      
                      
                      
                      108,299Proceeds
      from paydowns of mortgage securities - trading
                      
                      
                      36,127
                      
                      
                      
                      14,604Purchase
      of mortgage securities - trading
                      
                      
                      -
                      
                      
                      
                      (21,957
                      )Proceeds
      from sale of mortgage securities - trading
                      
                      
                      -
                      
                      
                      
                      7,413Proceeds
      from repayments of mortgage loans held-in-portfolio
                      
                      
                      194,022
                      
                      
                      
                      471,694Proceeds
      from sales of assets acquired through foreclosure
                      
                      
                      67,113
                      
                      
                      
                      2,079Restricted
      cash proceeds (payments)
                      
                      
                      1,817
                      
                      
                      
                      (8,844
                      )Purchases
      of property and equipment
                      
                      
                      -
                      
                      
                      
                      (2,929
                      )Net
      cash provided by investing activities
                      
                      
                      318,305
                      
                      
                      
                      570,359Net
      cash provided by investing activities from discontinued
      operations
                      
                      
                      1,826
                      
                      
                      
                      9,155Net
      cash provided by investing activities
                      
                      
                      320,131
                      
                      
                      
                      579,514Cash
      flows from financing activities:Proceeds
      from issuance of asset-backed bonds
                      
                      
                      -
                      
                      
                      
                      2,111,415Payments
      on asset-backed bonds
                      
                      
                      (286,622
                      )
                      
                      
                      (474,578
                      )Proceeds
      from issuance of capital stock and exercise of equity instruments, net of
      offering costs
                      
                      
                      -
                      
                      
                      
                      3,150Net
      change in short-term borrowings
                      
                      
                      (45,488
                      )
                      
                      
                      (236,608
                      )Repurchase
      of trust preferred debt
                      
                      
                      (550
                      )
                      
                      
                      -Dividends
      paid on vested options
                      
                      
                      -
                      
                      
                      
                      (499
                      )Dividends
      paid on preferred stock
                      
                      
                      -
                      
                      
                      
                      (3,326
                      )Net
      cash (used in) provided by financing activities from continuing
      operations
                      
                      
                      (332,660
                      )
                      
                      
                      1,399,554Net
      cash used in financing activities from discontinued
    operations
                      
                      
                      (19
                      )
                      
                      
                      (1,286,008
                      )Net
      cash (used in) provided by financing activities
                      
                      
                      (332,679
                      )
                      
                      
                      113,546Net
      decrease in cash and cash equivalents
                      
                      
                      (15,095
                      )
                      
                      
                      (52,650
                      )Cash
      and cash equivalents, beginning of period
                      
                      
                      25,364
                      
                      
                      
                      150,522Cash
      and cash equivalents, end of period
                      
                      $
                      10,269
                      
                      
                      $
                      97,872Continued




6


SUPPLEMENTAL
DISCLOSURE OF CASH FLOW INFORMATION


(unaudited;
dollars in thousands)


For
      the Six Months Ended June 30,2008
                  
                  
                  2007(Restated)Cash
      paid for interest
                  
                  $
                  64,906
                  
                  
                  $
                  160,508Cash
      paid for income taxes
                  
                  
                  2,871
                  
                  
                  
                  330Cash
      received on mortgage securities – available-for-sale with no cost
      basis
                  
                  
                  -
                  
                  
                  
                  3,296Non-cash
      operating, investing and financing activities:Transfer
      of loans to held-in-portfolio from held-for-sale
                  
                  
                  -
                  
                  
                  
                  1,880,340Transfer
      of mortgage securities from available-for-sale to trading
    (A)
                  
                  
                  
                  
                  
                  
                  46,383Assets
      acquired through foreclosure
                  
                  
                  67,113
                  
                  
                  
                  2,079Dividends
      payable
                  
                  
                  10,473
                  
                  
                  
                  1,663(A)  Transfer
      was made upon adoption of SFAS 159.
                    
                    See
      notes to condensed consolidated financial statements.




7


NOVASTAR
FINANCIAL, INC.


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


June
30, 2008 (Unaudited)





Note
1. Financial Statement Presentation





Description of
Operations - NovaStar Financial, Inc. and its subsidiaries operate as a
non-conforming residential mortgage portfolio manager and is exploring
opportunities in the residential housing and other markets.  Prior to
changes in its business in 2007 and early 2008, the Company originated,
purchased, securitized, sold, invested in and serviced residential nonconforming
mortgage loans and mortgage backed securities.  The Company retained,
through its mortgage securities investment portfolio, significant interests in
the nonconforming loans it originated and purchased, and through its servicing
platform, serviced all of the loans in which it retained
interests.  Historically, the Company had elected to be taxed as a
real estate investment trust (“REIT”) under the Internal Revenue Code of 1986,
as amended (the “Code”).  During the third quarter of 2007, the
Company announced that it would not be able to pay a dividend on its common
stock with respect to its 2006 taxable income, and as a result the Company's
status as a REIT terminated, retroactive to January 1, 2006.  This
retroactive revocation of the Company’s REIT status resulted in it becoming
taxable as a C corporation for 2006 and subsequent years.





Financial
Statement Presentation-The Company’s condensed consolidated financial statements have been
prepared in conformity with accounting principles generally accepted in the
United States of America and prevailing practices within the financial services
industry. These condensed consolidated financial statements should be read in
conjunction with the financial statements and notes thereto included in our
December 31, 2007 Form 10-K.  The preparation of financial statements
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities at the date of the financial statements and
the reported amounts of income and expense during the period. The Company uses
estimates and employs the judgments of management in determining the amount of
its allowance for credit losses, amortizing premiums or accreting discounts on
its mortgage assets, establishing the fair value of its mortgage securities,
reserve for losses on third party sales, derivative instruments, CDO debt and
estimating appropriate accrual rates on mortgage securities –
available-for-sale. While the condensed consolidated financial statements and
footnotes reflect the best estimates and judgments of management at the time,
actual results could differ significantly from those estimates.





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





As of
June 30, 2008, the Company’s total liabilities exceeded its total assets under
Generally Accepted Accounting Principles (“GAAP”), resulting in a shareholders’
deficit. The Company’s losses, negative cash flows from operations and its
shareholders’ deficit raise substantial doubt about the Company’s ability to
continue as a going concern, which is dependent upon, among other things, the
maintenance of sufficient operating cash flows.  There is no assurance
that cash flows will be sufficient to meet the Company’s
obligations.





The
Company’s condensed consolidated financial statements as of June 30, 2008 and
for the six and three months ended June 30, 2008 and 2007 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 its mortgage lending
      segment and loan servicing segment as discontinued operations in the
      condensed consolidated statements of operations for the six and three
      months ended June 30, 2007.





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


8


·
            The
      Company created a new line item on the condensed consolidated balance
      sheet named “Derivative instruments, net” to separate balances related to
      its derivative instruments which were previously reported in the “Accounts
      payable and other liabilities” line item as of December 31,
      2007.  The line item was created due to the materiality of the
      amounts recorded as of June 30,
2008.





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 condensed 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, 2007.





Liquidity,
Business Plan, Significant Events and Material Trends





Described
below are some of the marketplace conditions, significant events and known
material trends and uncertainties that may impact the Company’s future results
of operations.




Current
Liquidity - The Company used $4.9 million in cash to fully repay
outstanding indebtedness to Wachovia on May 9, 2008. In addition, $2.1
million of cash was used on May 8, 2008 to satisfy terms of the American
Interbanc Mortgage (“AIM”) Settlement Agreement as discussed in detail in Note 7
to these financial statements.




Short and Long
Term Obligations - A discussion of the Company’s borrowings is included
in Note 6 to these financial statements. NFI’s wholly owned subsidiary NovaStar
Mortgage, Inc. (“NMI”) has approximately $77.1 million in principal amount of
unsecured notes (collectively, the “Notes” and shown on our condensed
consolidated balance sheet as junior subordinated debentures) outstanding to
NovaStar Capital Trust I and NovaStar Capital Trust II (collectively, the
“Trusts”) which secure trust preferred securities issued by the Trusts. The
foregoing is net of amounts owed in respect of trust preferred securities of
NovaStar Capital Trust II having a par value of $6.9 million purchased by NMI on
May 29, 2008 for $0.6 million. NFI has guaranteed NMI’s obligations under
the Notes.




NMI
failed to make quarterly interest payments that were due on
March 30, April 30, June 30 and July 30, 2008
totaling, for all payment dates combined, approximately $2.8 million on the
Notes. As a result, NMI is in default under the related indentures and NFI is in
default under the related guarantees. An agreement by the trustees and trust
preferred security holders of the Trusts to forbear in the exercise of remedies
with respect to the initial payment defaults expired on May 30, 2008.
Consequently, the trustee and holders of 25% of the outstanding trust preferred
securities of each Trust have the right to accelerate all principal, accrued
interest, and other obligations of NMI under the related Notes and to demand
payment of all such amounts from NFI under the related guarantees. The total
principal and accrued interest owed under the Notes, net of amounts owed in
respect of the trust preferred securities held by NMI, was approximately $80.4
million as of August 18, 2008. In addition, the Company is obligated to
reimburse the trustees for all reasonable expenses, disbursements and advances
in connection with the exercise of rights under the indentures.




On
June 4, 2008 and August 14, 2008, the Company received written notices
of acceleration from the holders of the trust preferred securities of NovaStar
Capital Trust I and NovaStar Capital Trust II, respectively, which declared all
obligations of NMI under the related Notes and indenture to be immediately due
and payable, and stated the intention of the trust preferred security holders to
pursue all available rights and remedies, including but not limited to enforcing
their rights under the related guarantee. As of the date of filing, no suit has
been filed to enforce the holders’ rights under the indentures or the related
guarantees.




While NFI
is attempting to restructure the terms of the indentures, there can be no
assurance that it will be able to do so. Enforcement of remedies under the Notes
and related indentures and guarantees would have a material adverse effect on
NFI’s financial condition and liquidity and would likely cause NFI to seek the
protection of applicable bankruptcy laws.




The
Company also expects to have near-term payments for lease and other contract
terminations and normal operating expenses. Lease and other contract termination
payments will vary, depending on negotiations and available cash. The Company’s
current projections indicate sufficient cash and cash flows will be available
from its mortgage assets to meet short-term payment needs through 2008. However,
the Company’s mortgage asset cash flows are currently volatile and uncertain in
nature, and the amounts the Company receives could vary materially from its
projections. In addition, these cash flows are expected to continue to decrease
over the next several months. Therefore, no assurance can be given that the
Company will be able to meet its cash flow needs, in which case it would be
required to seek protection of applicable bankruptcy laws.




Certain
states required the Company to post surety bonds in connection with its former
mortgage lending operations. During 2007, the Company was required to post
letters of credit to support its reimbursement obligations to the sureties, and
was required to cash collateralize the letters of credit pursuant to its letter
of credit agreements with Wachovia Bank. The Company is in the process of
terminating these surety bonds and the associated letters of credit as a result
of the discontinuation of its mortgage lending operations and has received back
collateral associated with letters of credit terminated to date. Collateral
totaling $7.2 million remained outstanding as of June 30, 2008, $1.0
million of which the Company has received back subsequent to June 30, 2008.
Cancellation of the remaining surety bonds and related letters of credit is
subject to certain conditions and may take several months or longer to complete.
In addition, the Company is currently in default under the letter of credit
agreements as a result of, among other matters, the Company being in default
under debt agreements related to its trust preferred securities, discussed
further below. Although the Company has received a return of collateral
notwithstanding this default, Wachovia Bank is not obligated to return cash
collateral to the Company so long as a default exists. Consequently, no
assurances can be given as to the timing or amount of any additional return of
the remaining cash collateral.


9


Future Strategy,
Liquidity and Going Concern Considerations –The Company will continue to
focus on minimizing losses and preserving liquidity as it manages its existing
portfolio of mortgage securities. The Company’s residual and subordinated
mortgage securities are currently its only significant source of cash flows.
Based on current projections, the cash flows from its mortgage securities will
decrease in the next several months as the underlying mortgage loans are repaid,
and could be significantly less than the current projections if losses on the
underlying mortgage loans exceed, or prepayments are less than, the current
assumptions. In addition, the Company has significant operating expenses
associated with office leases and other obligations relating to its discontinued
operations. As noted above, the Company also has significant obligations with
respect to Notes relating to the trust preferred securities of NovaStar Capital
Trust I and NovaStar Capital Trust II.




If, as
the cash flows from its mortgage securities decrease, the Company is unable to
recommence or invest in profitable operations, restructure its unsecured debt,
capital structure and contractual obligations or if the cash flows from its
mortgage securities are less than currently anticipated, there can be no
assurance that the Company will be able to realize its assets and discharge its
liabilities in the normal course of business and continue as a going concern or
avoid seeking the protection of applicable bankruptcy laws. The financial
statements do not include any adjustments relating to the recoverability and
classification of recorded asset amounts or to the amounts and classification of
liabilities that may be necessary should the Company be unable to continue as a
going concern.




The
Company has initiated efforts to restructure its indebtedness and certain
contractual obligations and is assessing potential changes to elements of its
capital structure, with the goal of negotiating and implementing changes to
facilitate the achievement of long-term value. There can be no assurances that
any of these efforts will be successful.




Due to
the fact that the Company has a negative net worth, it does not currently have
ongoing significant business operations that are profitable and its common stock
and Series C preferred stock have been delisted from the New York Stock
Exchange, it is unlikely that the Company will be able to obtain additional
equity or debt financing on favorable terms, or at all, for the foreseeable
future. To the extent the Company requires additional liquidity and cannot
obtain it, the Company will be forced to file for bankruptcy.




To the
extent available, the Company may use excess cash to make certain investments if
it determines that such investments could provide attractive risk-adjusted
returns to shareholders, including, potentially investing in new or existing
operating companies. Because of certain state licensing requirements, it is
unlikely the Company will be able to directly recommence mortgage lending
activities so long as the Company continues to have a shareholders’ deficit. The
Company’s ability to start or acquire new businesses is significantly
constrained by its limited liquidity and its likely inability to obtain debt
financing or to issue equity securities as a result of its current financial
condition, including a shareholders’ deficit, as well as other uncertainties and
risks. As discussed in Note 16 to the condensed consolidated financial
statements, the Company acquired a majority interest in an appraisal management
company subsequent to June 30, 2008. There can be no assurances that the
Company will be able to establish or acquire additional new business
operations.




Recent Market
Developments - During 2008, global financial market conditions have
continued to deteriorate. Financial services, and the mortgage industry in
particular, have remained under continuous pressure due to numerous factors,
which include industry-wide deterioration of the value of mortgage assets held
by financial institutions, the deterioration of mortgage credit among mortgage
lenders, the downgrades of mortgage securities by the rating agencies, and a
reluctance on the part of banks and broker-dealers to finance mortgage
securities within the credit markets. Because of these factors, mortgage
security market valuations remain volatile, mortgage securities trading remains
limited and mortgage securities financing markets remain challenging as the
industry continues to report negative news. The global financial market
conditions have led to the failure of numerous financial lenders during 2007 and
2008. The factors described above continue to contribute to the decline in the
market values of the Company’s securities and loans.




The
market has also seen a significant drop in LIBOR rates since the end of 2007 as
the Federal Reserve made several cuts in short-term interest rates, which
decreases the variable interest rates paid on the bonds issued by the
securitization trusts. Because the Company largely holds residual and
subordinated securities issued by these trusts, absent any other changes, lower
LIBOR rates would have positive effects on the cash flows the Company receives
from its mortgage securities. However, the severe deterioration in credit and
prepayment performance of the underlying collateral will likely offset part or
all of any positive impact of decreased LIBOR rates.




Given the
current uncertainty regarding these market conditions, the Company is unable to
offer any additional factual information on the situation and how it will impact
it other than to disclose what the Company is currently seeing in the mortgage
market. As a result, the Company expects to continue to operate with no leverage
and to continue to take actions in an effort to preserve liquidity and available
cash.


10


Home
prices - Generally, housing values are experiencing broad-based declines
nationwide. Housing values are likely to continue to decrease during the near
term which could affect the Company’s credit loss experience, and will continue
to impact its earnings, cash flows, financial condition and ability to continue
as a going concern.




Loan
Repurchases - When the Company sold mortgage loans, whether as whole
loans or pursuant to a securitization, it made customary representations and
warranties to the purchaser about the mortgage loans and the manner in which
they were originated. The Company’s whole loan sale agreements require it to
repurchase or substitute mortgage loans in the event the Company breaches any of
these representations or warranties. In addition, the Company may be required to
repurchase mortgage loans as a result of borrower, broker, or employee fraud.
Likewise, the Company is required to repurchase or substitute mortgage loans if
it breaches a representation or warranty in connection with its securitizations.
Enforcement of repurchase obligations against the Company would further harm the
Company’s liquidity, cash flow, financial condition, and ability to continue as
a going concern.




Credit
Deterioration - The residential mortgage market has encountered
significant difficulties which have materially adversely affected the Company’s
performance. 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, over the last year residential property values in
most states have declined, in some areas severely, after extended periods during
which those values appreciated. To the extent residential property values
continue to decline, it is likely to result in additional increases in
delinquencies and losses on residential mortgage loans, 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 in monthly payments on adjustable rate
mortgage (“ARM”) loans. Any increase in prevailing market interest rates may
result in increased payments for borrowers who have adjustable rate mortgage
loans. Moreover, borrowers with option ARM mortgage loans with a negative
amortization may experience a substantial increase in their monthly payment even
without an increase in prevailing market interest rates when the loans reach
their negative amortization cap. Compounding this issue, the current lack of
appreciation in residential property values and the adoption of tighter
underwriting standards throughout the mortgage loan industry has adversely
affected 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, the value of the Company’s mortgage securities and the mortgage
loans held in its portfolio will be further reduced, which will adversely affect
the Company’s operating results, liquidity, cash flow, financial condition,
business prospects and ability to continue as a going concern.





Note
2. New Accounting Pronouncements





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





In
December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements” (“SFAS 160”), which requires
consolidated net income to be reported at amounts that include the amounts
attributable to both the parent and non-controlling interest.  SFAS
160 is effective for fiscal years beginning on or after December 15,
2008.  The adoption of this standard is not expected to have a
material effect on our consolidated financial statements.





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





In April
2008, the FASB issued FASB Staff Position (“FSP”) No. SFAS 142-3, “Determination
of the Useful Life of Intangible Assets” (“FSP SFAS 142-3”). FSP SFAS 142-3
amends paragraph 11(d) of FASB Statement No. 142 “Goodwill and Other Intangible
Assets” (“SFAS 142”) which amends the factors that should be considered in
developing renewal or extension assumptions used to determine the useful life of
a recognized intangible asset under SFAS 142. FSP SFAS 142-3 is intended to
improve the consistency between the useful life of a recognized intangible asset
under SFAS 142 and the period of expected cash flows used to measure the fair
value of the asset. FSP SFAS 142-3 is effective for financial statements issued
for fiscal years beginning after December 15, 2008 and must be applied
prospectively to intangible assets acquired after the effective date. The
Company is evaluating the impact that adoption of FSP SFAS 142-3 will have on
our consolidated financial statements.


11


In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles” (SFAS 162”).  SFAS 162 identifies the sources of
accounting principles and the framework for selecting principles to be used in
the preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles in the
United States.  This statement shall be effective 60 days following the
SEC’s approval of the Public Company Accounting Oversight Board’s amendments to
the PCAOB’s Interim Auditing Standards (AU) section 411, “The Meaning of Present
Fairly in Conformity with Generally Accepted Accounting Principles.” The Company
is in the process of evaluating the potential effect of adoption of
SFAS 162.





Note
3. Mortgage Loans – Held in Portfolio





Mortgage
loans, all of which are secured by residential properties, consisted of the
following as of June 30, 2008 and December 31, 2007 (dollars in
thousands):





June
      30, 2008
                                  
                                  
                                  December
      31,
                                    2007Mortgage
      loans – held-in-portfolio:Outstanding
      principal
                                  
                                  $
                                  2,756,149
                                  
                                  
                                  $
                                  3,067,737Net
      unamortized deferred origination costs
                                  
                                  
                                  22,261
                                  
                                  
                                  
                                  32,414Amortized
      cost
                                  
                                  
                                  2,778,410
                                  
                                  
                                  
                                  3,100,151Allowance
      for credit losses
                                  
                                  
                                  (616,690
                                  )
                                  
                                  
                                  (230,138
                                  )Mortgage
      loans – held-in-portfolio
                                  
                                  $
                                  2,161,720
                                  
                                  
                                  $
                                  2,870,013Weighted
      average coupon
                                  
                                  
                                  8.62
                                  %
                                  
                                  
                                  8.59
                                  %





Mortgage
loans held-in-portfolio consist of loans that the Company has securitized in
structures that are accounted for as financings. These securitizations are
structured legally as sales, but for accounting purposes are treated as
financings as defined by SFAS No. 140, “Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities (a replacement of FASB
Statement No. 125”).  The NHES 2006-1 and NHES 2006-MTA1
securitizations do not meet the qualifying special purpose entity criteria
necessary for sale treatment under SFAS 140 and related interpretations because
after the loans are securitized the securitization trusts may acquire
derivatives relating to beneficial interests retained by the Company and, the
Company, has discretion to call (other than a clean-up call) loans back from the
trust.  The NHES 2007-1 securitization does not meet the qualifying
special purpose entity criteria necessary for sale treatment under SFAS 140 and
related interpretations because of the excessive benefit the Company receives
from the derivative instruments delivered into the trust to counteract interest
rate risk.  Accordingly, the loans in these securitizations remain on
the balance sheet as “Mortgage loans held-in-portfolio”, retained interests were
not created, and securitization bond financing is reflected on the balance sheet
as a liability. The Company records interest income on loans held-in-portfolio
and interest expense on the bonds issued in the securitizations over the life of
the securitizations. Deferred debt issuance costs and discounts related to the
bonds are amortized on a level yield basis over the estimated life of the
bonds.





At June
30, 2008 all of the loans classified as held-in-portfolio were pledged as
collateral for the related securitization bond financing.





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, 2008 and 2007, respectively
(dollars in thousands):




For
      the Six Months Ended
                                      June
      30,
                                    
                                    
                                    For
      the Three Months Ended
                                      June
      30,2008
                                    
                                    
                                    2007
                                    
                                    
                                    2008
                                    
                                    
                                    2007Balance,
      beginning of period
                                    
                                    $
                                    230,138
                                    
                                    
                                    $
                                    22,452
                                    
                                    
                                    $
                                    445,120
                                    
                                    
                                    $
                                    34,911Provision
      for credit losses
                                    
                                    
                                    461,436
                                    
                                    
                                    
                                    93,167
                                    
                                    
                                    
                                    212,120
                                    
                                    
                                    
                                    73,254Charge-offs,
      net of recoveries
                                    
                                    
                                    (74,884
                                    )
                                    
                                    
                                    (15,523
                                    )
                                    
                                    
                                    (40,550
                                    )
                                    
                                    
                                    (8,069
                                    )Balance,
      end of period
                                    
                                    $
                                    616,690
                                    
                                    
                                    $
                                    100,096
                                    
                                    
                                    $
                                    616,690
                                    
                                    
                                    $
                                    100,096




12


Note
4. Mortgage Securities – Available-for-Sale





As of
June 30, 2008, and December 31, 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, but does not include the NMFT
Series 2007-2 residual security, which was designated as trading as a result of
the Company’s adoption of SFAS 155, “Accounting for Certain Hybrid Financial
Instruments”, an amendment of SFAS 133 and SFAS 140 (“SFAS 155”) on January
1, 2007 and the complexities and uncertainties surrounding the application of
this Statement.  As a result, the NMFT Series 2007-2 residual security
qualifies for the scope exception concerning bifurcation provided by SFAS
155.  Residual securities consist of interest-only, prepayment penalty
and overcollateralization bonds.  Management estimates the fair value
of the residual securities by discounting the expected future cash flows of the
collateral and bonds.





The
following table presents certain information on the Company’s portfolio of
mortgage securities – available-for-sale as of June 30, 2008 and December 31,
2007 (dollars in thousands):





Cost
      Basis
                                      
                                      
                                      Unrealized
                                        Gain
                                      
                                      
                                      Unrealized
      Losses
                                        Less
      Than Twelve
                                        Months
                                      
                                      
                                      Estimated
      Fair
                                        Value
                                      
                                      
                                      Average
                                        Yield
      (A)As
      of June 30, 2008
                                      
                                      $
                                      8,434
                                      
                                      
                                      $
                                      733
                                      
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      9,167
                                      
                                      
                                      
                                      33.36
                                      %As
      of December 31, 2007
                                      
                                      
                                      33,302
                                      
                                      
                                      
                                      69
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      33,371
                                      
                                      
                                      
                                      26.94
                                      %


(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 and three months ended June 30, 2008 and 2007, 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 impairments on mortgage securities – available-for-sale of $21.2
million and $1.8 million during the six and three months ended June 30, 2008,
respectively, as compared to $26.0 million and $22.6 million during the same
periods of 2007.





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, 2008 to mature in one to five
years.





Note
5. Mortgage Securities – Trading





As of
June 30, 2008 and December 31, 2007, mortgage securities – trading consisted of
the NMFT Series 2007-2 residual security and subordinated securities retained by
the Company from securitization transactions as well as subordinated securities
purchased from other issuers in the open market.  Management estimates
the fair value of the residual securities 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 to the condensed consolidated financial
statements for a description of the valuation methods as of June 30, 2008 and
December 31, 2007.





The
following table summarizes the Company’s mortgage securities – trading as of
June 30, 2008 and December 31, 2007 (dollars in thousands):





Original
      Face
                                
                                
                                Amortized
      Cost
                                  Basis
                                
                                
                                Fair
      Value
                                
                                
                                Average
                                  Yield
      (A)As
      of June 30, 2008Subordinated
      securities pledged to CDO
                                
                                $
                                332,489
                                
                                
                                $
                                318,907
                                
                                
                                $
                                15,827Other
      subordinated securities
                                
                                
                                102,625
                                
                                
                                
                                95,174
                                
                                
                                
                                2,895Residual
      securities
                                
                                
                                N/A
                                
                                
                                
                                24,227
                                
                                
                                
                                6,553Total
                                
                                $
                                435,114
                                
                                
                                $
                                438,308
                                
                                
                                $
                                25,275
                                
                                
                                
                                11.05
                                %As
      of December 31, 2007
                                
                                $
                                435,114
                                
                                
                                $
                                447,370
                                
                                
                                $
                                109,203
                                
                                
                                
                                13.85
                                %


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





The
Company recognized net trading losses of $(74.9) million and $(23.3) million for
the six and three months ended June 30, 2008, respectively as compared to net
trading losses of $(89.7) million and $(39.7) million for the same periods of
2007. These net trading losses are included in the fair value adjustments line
on the Company’s condensed consolidated statements of operations.





As of
December 31, 2007 the Company had pledged all of its trading securities as
collateral for financing purposes.  On May 9, 2008, the short-term
borrowings collateralized by the Company’s trading securities were repaid and
the collateral was released back to the Company.


13


Note
6. Borrowings




Short-term Borrowings





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





Asset-backed Bonds
(“ABB”)





On
January 30, 2008, an event of default occurred under the CDO bond indenture
agreement due to noncompliance with certain overcollateralization
tests.  As a result, the trustee, upon notice and at the direction of
a majority of the secured noteholders, may declare all of the secured notes to
be immediately due and payable including accrued and unpaid
interest.  No such notice has been given as of August 18,
2008.  The Company does not expect any significant impact to its
financial condition, cash flows or results of operation as a result of the event
of default.





Junior
Subordinated Debentures




Trust Preferred
Obligations.
NFI’s wholly owned subsidiary NovaStar Mortgage, Inc. (“NMI”) has approximately
$77.1 million in principal amount of unsecured notes (collectively, the “Notes”)
outstanding to NovaStar Capital Trust I and NovaStar Capital Trust II
(collectively, the “Trusts”) which secure trust preferred securities issued by
the Trusts. The foregoing is net of amounts owed in respect of trust preferred
securities of NovaStar Capital Trust II having a par value of $6.9 million
purchased by NMI on May 29, 2008 for $0.6 million. NFI has guaranteed NMI’s
obligations under the Notes.




NMI
failed to make quarterly interest payments on the Notes, that were due on
March 30, April 30, June 30 and July 30, 2008
totaling, approximately $2.8 million for all payment dates combined. As a
result, NMI is in default under the related indentures and NFI is in default
under the related guarantees. An agreement by the trustees and trust preferred
security holders of the Trusts to forbear in the exercise of remedies with
respect to the initial payment defaults expired on May 30, 2008.
Consequently, the trustee and holders of 25% of the outstanding trust preferred
securities of each Trust have the right to accelerate all principal, accrued
interest, and other obligations of NMI under the related Notes and to demand
payment of all such amounts from NFI under the related guarantees. The total
principal and accrued interest owed under the Notes, net of amounts owed in
respect of the trust preferred securities held by NMI, was approximately $80.4
million as of August 18, 2008. In addition, the Company is obligated to
reimburse the trustees for all reasonable expenses, disbursements and advances
in connection with the exercise of rights under the indentures.




On
May 29, 2008, NFI purchased trust preferred securities of NovaStar Capital
Trust II having a par value of $6.9 million for $0.6 million. As a result, $6.9
million of principal and accrued interest of $0.2 million of the Notes was
retired and the principal amount, accrued interest, and related unamortized debt
issuance costs related to these Notes were removed from the balance sheet at
June 30, 2008 resulting in a gain of $6.4 million, recorded to the “Gains
on debt extinguishment” line item of the condensed consolidated statements of
operations.





On
June 4, 2008 and August 14, 2008, the Company received written notices
of acceleration from the holders of the trust preferred securities of NovaStar
Capital Trust I and NovaStar Capital Trust II, respectively, which declared all
obligations of NMI under the related Notes and indenture to be immediately due
and payable, and stated the intention of the trust preferred security holders to
pursue all available rights and remedies, including but not limited to enforcing
their rights under the related guarantee. As of the date of filing, no suit has
been filed to enforce the holders’ rights under the indentures or the related
guarantees.




While NFI
is attempting to restructure the terms of the indentures, there can be no
assurance that it will be able to do so. Enforcement of remedies under the Notes
and related indentures and guarantees would have a material adverse effect on
NFI’s financial condition and liquidity and would likely cause NFI to seek the
protection of applicable bankruptcy laws.





Note
7. Commitments and Contingencies





Contingencies




American
Interbanc Mortgage Litigation. On March 17, 2008, the Company and
American Interbanc Mortgage, LLC (“Plaintiff”) entered into a Confidential
Settlement Term Sheet Agreement (the “Settlement Terms”) with respect to the
actions, judgments and claims described below.




In March
2002, Plaintiff filed an action against NovaStar Home Mortgage, Inc. (“NHMI”) in
Superior Court of Orange County, California entitled American Interbanc Mortgage
LLC v. NovaStar Home Mortgage, Inc. et. al. (the “California Action”). In the
California Action, Plaintiff alleged that NHMI and two other mortgage companies
(“Defendants”) engaged in false advertising and unfair competition under certain
California statutes 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 “Judgment”). The award is joint
and several against the Defendants, including NHMI.


14




NHMI’s
motion for the trial court to overturn or reduce the verdict was denied on
August 20, 2007, and NHMI appealed that decision (the “Appeal”). Pending
the Appeal, Plaintiff commenced enforcement actions in the states of Missouri
(the “Kansas City Action”) and Delaware, and obtained an enforcement judgment in
Delaware (the “Delaware Judgment”). On January 23, 2008, Plaintiff filed an
involuntary petition for bankruptcy against NHMI under 11 U.S.C. Sec. 303, in
the United States Bankruptcy Court for the Western District of Missouri (the
“Involuntary”).




On
March 17, 2008, the Company and Plaintiff entered into the Settlement Terms
with respect to the California Action, the Judgment, the Kansas City Action, the
Delaware Judgment, the Involuntary, and all related claims.




Pursuant
to the Settlement Terms, the Involuntary was dismissed on April 24, 2008.
As provided in the Settlement Terms, on May 8, 2008, the Company paid
Plaintiff $2.0 million plus the balance in an account established by order of
the Bankruptcy Court, and NHMI satisfied obligations totaling $48,000 to certain
identified creditors. The parties also agreed to extend the Appeal briefing
period pending finalization of the settlement of the other actions, judgments
and claims, as described below.




The
Settlement Terms provide that, following satisfaction of certain other
conditions, the parties will dismiss the California Action as to NHMI and the
Kansas City Action and Delaware Judgment, effect notice of satisfaction of the
Judgment, and effect a mutual release of all claims that were or could have been
raised in any of the foregoing or that are related to the subject matter
thereof. In the event that the conditions are not satisfied, as to which no
assurance can be given, the Judgment will remain in effect and the related
claims will not be released, which could result in NHMI and, if found liable for
the Judgment, the Company seeking the protection of applicable bankruptcy
laws.




In
addition to the initial payments made to the Plaintiff following dismissal of
the Involuntary, the Company will pay Plaintiff $5.5 million if, prior to
July 1, 2010, (i) NFI’s average common stock market capitalization is
at least $94.4 million over a period of five consecutive business days, or
(ii) the holders of NFI’s common stock are paid $94.4 million in net asset
value as a result of any sale of NFI or its assets. If NFI is sold prior to
July 1, 2010 for less than $94.4 million and ceases to be a public company,
then NFI will obligate the purchaser to pay Plaintiff $5.5 million in the event
the value of the company exceeds $94.4 million prior to July 1, 2010 as
determined by an independent valuation company.




In
accordance with generally accepted accounting principles, NHMI has recorded a
liability of $45.2 million as of June 30, 2008 with a corresponding charge
to earnings. The $45.2 million includes interest which is accruing on the
obligation. Because NHMI is a wholly owned indirect subsidiary of the Company,
the $45.2 million liability is included in the consolidated financial statements
of the Company. The liability is included in the “Liabilities of discontinued
operations” line of the consolidated balance sheets.





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




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




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


15




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 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 sought
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 defendants filed a motion to dismiss the
action. On December 19, 2007, the Court granted defendants’ motion to
dismiss the complaint, including the claims against NovaStar Financial, Inc.,
but the Court allowed the plaintiffs to file an amended complaint. On
January 9, 2008, the plaintiffs filed an amended complaint that did not
make any claim against NovaStar Financial, Inc., but did assert the above claims
against its subsidiaries, NovaStar Mortgage, Inc. and NovaStar Home Mortgage,
Inc. (the “Subsidiary Defendants”). In June 2008, the named plaintiffs and
Subsidiary Defendants agreed to settle the claims of the named plaintiffs and to
dismiss the lawsuit for a nominal amount.




On
January 10, 2008, the City of Cleveland, Ohio filed suit against the
Company and approximately 20 other mortgage, commercial and investment bankers
alleging a public nuisance had been created in the City of Cleveland by the
operation of the subprime mortgage industry. The case was filed in state court
and promptly removed to the United States District Court for the Northern
District of Ohio. The plaintiff seeks damages for loss of property values in the
City of Cleveland, and for increased costs of providing services and
infrastructure, as a result of foreclosures of subprime mortgages. The Company
believes that these claims are without merit and will vigorously defend against
them.




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





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




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




On
July 7, 2008, plaintiff Jennifer Jones filed a purported class action case
in the United States District Court for the Western District of Missouri against
the Company, certain former and current officers of the Company, and unnamed
members of the Company’s “Retirement Committee”. Plaintiff, a former
employee of the Company, seeks class action certification on behalf of all
persons who were participants in or beneficiaries of the Company’s 401(k) plan
from May 4, 2006 until November 15, 2007 and whose accounts included
investments in the Company’s common stock. Plaintiff alleges that the
Company’s common stock was an inappropriately risky investment option for
retirement savings, and that defendants breached their fiduciary duties by
allowing investment of some of the assets contained in the 401(k) plan to be
made in the Company’s common stock. The Company has not yet filed its
initial responsive pleading, and discovery is not yet underway. The Company
believes it has meritorious defenses to the case and expects to defend the case
vigorously.


16


In
addition to those matters listed above, the Company is currently a party to
various other legal proceedings and claims, including, but not limited to,
breach of contract claims, tort claims, and claims for violations of federal and
state consumer protection laws.
  In
addition, the Company has received requests or subpoenas for information from
various regulators or law enforcement officials, including, without limitation,
the United States Department of Justice, the Federal Bureau of Investigation,
the New York Attorney General and the Department of Labor. Management does not
expect any significant negative impact to the Company as a result  of these
requests and subpoenas.
   
 Note
8. Comprehensive Loss
 
 Comprehensive
income includes revenues, expenses, gains and losses that are not included in
net income. The following is a rollforward of accumulated other comprehensive
income for the six and three months ended June 30, 2008 and 2007 (dollars in
thousands):
 For the Six Months Ended
                                                                          June 30,
                                                                        
                                                                        
                                                                        For the Three Months Ended
                                                                          June 30,2008
                                                                        
                                                                        
                                                                        2007
                                                                        
                                                                        
                                                                        2008
                                                                        
                                                                        
                                                                        2007Net
      loss
                                                                        
                                                                        $
                                                                        (479,854
                                                                        )
                                                                        
                                                                        $
                                                                        (6,864
                                                                        )
                                                                        
                                                                        $
                                                                        (197,184
                                                                        )
                                                                        
                                                                        $
                                                                        (52,878
                                                                        )Other
      comprehensive income (loss):Change
      in unrealized loss on mortgage securities
      – available-for-sale
                                                                        
                                                                        
                                                                        (20,565
                                                                        )
                                                                        
                                                                        
                                                                        (59,638
                                                                        )
                                                                        
                                                                        
                                                                        (4,437
                                                                        )
                                                                        
                                                                        
                                                                        (50,052
                                                                        )Change
      in unrealized gain on derivative instruments used in cash flow
      hedges
                                                                        
                                                                        
                                                                        1,354
                                                                        
                                                                        
                                                                        
                                                                        715
                                                                        
                                                                        
                                                                        
                                                                        599
                                                                        
                                                                        
                                                                        
                                                                        800Impairment
      on mortgage securities - available-for-sale reclassified to
      earnings
                                                                        
                                                                        
                                                                        21,229
                                                                        
                                                                        
                                                                        
                                                                        25,993
                                                                        
                                                                        
                                                                        
                                                                        1,848
                                                                        
                                                                        
                                                                        
                                                                        22,569Valuation
      allowance for deferred taxes
                                                                        
                                                                        
                                                                        -
                                                                        
                                                                        
                                                                        
                                                                        6,560
                                                                        
                                                                        
                                                                        
                                                                        -
                                                                        
                                                                        
                                                                        
                                                                        5,861Net
      settlements of derivative instruments used in cash flow hedges
      reclassified to earnings
                                                                        
                                                                        
                                                                        (1,147
                                                                        )
                                                                        
                                                                        
                                                                        (339
                                                                        )
                                                                        
                                                                        
                                                                        272
                                                                        
                                                                        
                                                                        
                                                                        (209
                                                                        )Other
      comprehensive income (loss)
                                                                        
                                                                        
                                                                        871
                                                                        
                                                                        
                                                                        
                                                                        (26,709
                                                                        )
                                                                        
                                                                        
                                                                        (1,718
                                                                        )
                                                                        
                                                                        
                                                                        (21,031
                                                                        )Total
      comprehensive loss
                                                                        
                                                                        $
                                                                        (478,983
                                                                        )
                                                                        
                                                                        $
                                                                        (33,573
                                                                        )
                                                                        
                                                                        $
                                                                        (198,902
                                                                        )
                                                                        
                                                                        $
                                                                        (73,909
                                                                        )
 
 Note
9. Fair Value Accounting
 
 Effective
January 1, 2007, the Company adopted SFAS No. 157, “Fair Value
Measurements” (“SFAS 157”) and SFAS No. 159, “The Fair Value Option for
Financial Assets” (“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.
  17
  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, 2008 (dollars in thousands):
 Fair Value Measurements at Reporting Date UsingDescription
                                    
                                    Fair Value at
                                      6/30/2008
                                    
                                    
                                    Quoted Prices in
                                      Active Markets
                                      for Identical
                                      Assets
                                      (Level 1)
                                    
                                    
                                    Significant Other
                                      Observable Inputs
                                      (Level 2)
                                    
                                    
                                    Significant
                                      Unobservable
                                      Inputs (Level 3)Assets:Mortgage
      securities -trading
                                    
                                    $
                                    25,275
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    18,722
                                    
                                    
                                    $
                                    6,553Mortgage
      securities – available-for-sale
                                    
                                    
                                    9,167
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    9,167Derivative
      instruments
                                    
                                    
                                    891
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    891
                                    
                                    
                                    
                                    -Total
      assets
                                    
                                    $
                                    35,333
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    19,613
                                    
                                    
                                    $
                                    15,720Liabilities:Asset-backed
      bonds secured by mortgage securities
                                    
                                    $
                                    18,630
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    18,630
                                    
                                    
                                    $
                                    -Derivative
      instruments, net
                                    
                                    
                                    10,574
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    10,574
                                    
                                    
                                    
                                    -Total
      liabilities
                                    
                                    $
                                    29,204
                                    
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    29,204
                                    
                                    
                                    $
                                    -
 
 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) for the six
months ended June 30, 2008 and 2007 (dollars in thousands):
 Cost
                                                                  Basis
                                                                
                                                                
                                                                Unrealized
                                                                  Loss
                                                                
                                                                
                                                                Estimated
                                                                  Fair Value of
                                                                  Mortgage
                                                                  SecuritiesAs
      of December 31, 2007
                                                                
                                                                $
                                                                41,275
                                                                
                                                                
                                                                $
                                                                (16,534
                                                                )
                                                                
                                                                $
                                                                24,741Increases
      (decreases) to mortgage securities-trading:Accretion
      of income
                                                                
                                                                
                                                                4,640
                                                                
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                4,640Proceeds
      from paydowns of securities
                                                                
                                                                
                                                                (21,687
                                                                )
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                (21,687
                                                                )Mark-to-market
      value adjustment
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                (1,141
                                                                )
                                                                
                                                                
                                                                (1,141
                                                                )Net
      decrease to mortgage securities
                                                                
                                                                
                                                                (17,047
                                                                )
                                                                
                                                                
                                                                (1,141
                                                                )
                                                                
                                                                
                                                                (18,188
                                                                )As
      of  June 30, 2008
                                                                
                                                                $
                                                                24,228
                                                                
                                                                
                                                                $
                                                                (17,675
                                                                )
                                                                
                                                                $
                                                                6,553
 Cost
                                                                    Basis
                                                                  
                                                                  
                                                                  Unrealized
                                                                    Gain
                                                                    (Loss)
                                                                  
                                                                  
                                                                  Estimated
                                                                    Fair Value of
                                                                    Mortgage
                                                                    SecuritiesAs
      of December 31, 2006
                                                                  
                                                                  $
                                                                  -
                                                                  
                                                                  
                                                                  $
                                                                  -
                                                                  
                                                                  
                                                                  $
                                                                  -Increases
      (decreases) to mortgage securities-trading:New
      securities retained in securitizations
                                                                  
                                                                  
                                                                  56,387
                                                                  
                                                                  
                                                                  
                                                                  226
                                                                  
                                                                  
                                                                  
                                                                  56,613Accretion
      of income
                                                                  
                                                                  
                                                                  654
                                                                  
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  654Proceeds
      from paydowns of securities
                                                                  
                                                                  
                                                                  (2,303
                                                                  )
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  (2,303
                                                                  )Mark-to-market
      value adjustment
                                                                  
                                                                  
                                                                  -
                                                                  
                                                                  
                                                                  
                                                                  (48
                                                                  )
                                                                  
                                                                  
                                                                  (48
                                                                  )Net
      increase to mortgage securities
                                                                  
                                                                  
                                                                  54,738
                                                                  
                                                                  
                                                                  
                                                                  178
                                                                  
                                                                  
                                                                  
                                                                  54,916As
      of  June 30, 2007
                                                                  
                                                                  $
                                                                  54,738
                                                                  
                                                                  
                                                                  $
                                                                  178
                                                                  
                                                                  
                                                                  $
                                                                  54,916
  18
 
 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)
for the six months ended June 30, 2008 and 2007 (dollars in
thousands):
 Cost
                                                                      Basis
                                                                    
                                                                    
                                                                    Unrealized
                                                                      Gain
                                                                      (Loss)
                                                                    
                                                                    
                                                                    Estimated
                                                                      Fair Value of
                                                                      Mortgage
                                                                      SecuritiesAs
      of December 31, 2007
                                                                    
                                                                    $
                                                                    33,302
                                                                    
                                                                    
                                                                    $
                                                                    69
                                                                    
                                                                    
                                                                    $
                                                                    33,371Increases
      (decreases) to mortgage securities:Accretion
      of income (A)
                                                                    
                                                                    
                                                                    3,359
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    3,359Proceeds
      from paydowns of securities (A) (B)
                                                                    
                                                                    
                                                                    (6,998
                                                                    )
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    (6,998
                                                                    )Impairment
      on mortgage securities - available-for-sale
                                                                    
                                                                    
                                                                    (21,229
                                                                    )
                                                                    
                                                                    
                                                                    21,229
                                                                    
                                                                    
                                                                    
                                                                    -Mark-to-market
      value adjustment
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    (20,565
                                                                    )
                                                                    
                                                                    
                                                                    (20,565
                                                                    )Net
      (decrease) increase to mortgage securities
                                                                    
                                                                    
                                                                    (24,868
                                                                    )
                                                                    
                                                                    
                                                                    664
                                                                    
                                                                    
                                                                    
                                                                    (24,204
                                                                    )As
      of  June 30, 2008
                                                                    
                                                                    $
                                                                    8,434
                                                                    
                                                                    
                                                                    $
                                                                    733
                                                                    
                                                                    
                                                                    $
                                                                    9,167
 (A)
              Cash
      received on mortgage securities with no cost basis was $1.5 million for
      the six months ended June 30, 2008.
 (B)
              For
      mortgage securities with a remaining cost basis, the Company reduces the
      cost basis by the amount of cash that is contractually due from the
      securitization trusts. In contrast, for mortgage securities in which the
      cost basis has previously reached zero, the Company records in interest
      income the amount of cash that is contractually due from the
      securitization trusts. In both cases, there are instances where the
      Company may not receive a portion of this cash until after the balance
      sheet reporting date. Therefore, these amounts are recorded as receivables
      from the securitization trusts. As of June 30, 2008 and December 31, 2007
      the Company had receivables from securitization trusts of $0.3 million and
      $12.5 million, respectively, related to mortgage securities
      available-for-sale with a remaining cost
basis.
 Cost
                                                                  Basis
                                                                
                                                                
                                                                Unrealized
                                                                  Gain
                                                                  (Loss)
                                                                
                                                                
                                                                Estimated
                                                                  Fair Value of
                                                                  Mortgage
                                                                  SecuritiesAs
      of December 31, 2006
                                                                
                                                                $
                                                                310,760
                                                                
                                                                
                                                                $
                                                                38,552
                                                                
                                                                
                                                                $
                                                                349,312Increases
      (decreases) to mortgage securities:Transfer
      to mortgage securities – trading upon adoption of SFAS 159
                                                                
                                                                
                                                                (47,814
                                                                )
                                                                
                                                                
                                                                1,131
                                                                
                                                                
                                                                
                                                                (46,683
                                                                )Accretion
      of income (A)
                                                                
                                                                
                                                                34,689
                                                                
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                34,689Proceeds
      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)
                As
      of June 30, 2007 the Company had receivables from securitization trusts of
      $21.7 million, related to mortgage securities available-for-sale with a
      remaining cost basis. Also the Company had receivables from securitization
      trusts of $0.2 million related to mortgage securities with a zero cost
      basis as of June 30, 2007.
 
 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, 2008 (dollars in thousands):
 Fair Value Measurements at Reporting Date UsingDescription
                                                                
                                                                Fair Value at
                                                                  6/30/2008
                                                                
                                                                
                                                                Quoted Prices in
                                                                  Active Markets
                                                                  for Identical
                                                                  Assets
                                                                  (Level 1)
                                                                
                                                                
                                                                Significant
                                                                  Other
                                                                  Observable
                                                                  Inputs (Level 2)
                                                                
                                                                
                                                                Significant
                                                                  Unobservable
                                                                  Inputs (Level 3)Real
      estate owned
                                                                
                                                                
                                                                66,539
                                                                
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                66,539Total
                                                                
                                                                $
                                                                66,539
                                                                
                                                                
                                                                $
                                                                -
                                                                
                                                                
                                                                $
                                                                -
                                                                
                                                                
                                                                $
                                                                66,539
  19
 
 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.  Any valuation adjustments at the
time the loan becomes real estate owned are charged to the allowance for credit
losses.
 
 The
following table provides a summary of the impact to earnings for the six and
three months ended June 30, 2008 from the Company’s assets and liabilities which
are measured at fair value on a recurring and nonrecurring basis (dollars in
thousands):
 Fair Value
                                                                                                                      Adjustments For
                                                                                                                      the Six Months
                                                                                                                      Ended June 30
                                                                                                                    
                                                                                                                    
                                                                                                                    Fair Value
                                                                                                                      Adjustments For
                                                                                                                      the Three Months
                                                                                                                      Ended June 30Asset or Liability
                                                                                                                      Measured at Fair Value
                                                                                                                    
                                                                                                                    Fair Value
                                                                                                                      Measurement
                                                                                                                      Frequency
                                                                                                                    
                                                                                                                    2008
                                                                                                                    
                                                                                                                    
                                                                                                                    2007
                                                                                                                    
                                                                                                                    
                                                                                                                    2008
                                                                                                                    
                                                                                                                    
                                                                                                                    2007
                                                                                                                    
                                                                                                                    Statement of Operations Line
                                                                                                                      Item ImpactedMortgage
      securities - trading
                                                                                                                    
                                                                                                                    Recurring
                                                                                                                    
                                                                                                                    $
                                                                                                                    (74,866
                                                                                                                    )
                                                                                                                    
                                                                                                                    $
                                                                                                                    (89,740
                                                                                                                    )
                                                                                                                    
                                                                                                                    $
                                                                                                                    (23,261
                                                                                                                    )
                                                                                                                    
                                                                                                                    $
                                                                                                                    (39,681
                                                                                                                    )
                                                                                                                    Fair
      value adjustmentsMortgage
      securities – available-for-sale
                                                                                                                    
                                                                                                                    Recurring
                                                                                                                    
                                                                                                                    
                                                                                                                    (21,229
                                                                                                                    )
                                                                                                                    
                                                                                                                    
                                                                                                                    (25,993
                                                                                                                    )
                                                                                                                    
                                                                                                                    
                                                                                                                    (1,848
                                                                                                                    )
                                                                                                                    
                                                                                                                    
                                                                                                                    (22,569
                                                                                                                    )
                                                                                                                    Impairment
      on mortgage securities – available-for-saleDerivative
      instruments, net
                                                                                                                    
                                                                                                                    Recurring
                                                                                                                    
                                                                                                                    
                                                                                                                    (10,613
                                                                                                                    )
                                                                                                                    
                                                                                                                    
                                                                                                                    6,506
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    4,974
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    6,128
                                                                                                                    
                                                                                                                    (Losses)
      gains on derivative instrumentsAsset-backed
      bonds secured by mortgage securities
                                                                                                                    
                                                                                                                    Recurring
                                                                                                                    
                                                                                                                    
                                                                                                                    52,197
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    63,508
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    13,309
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    22,940
                                                                                                                    
                                                                                                                    Fair
      value adjustmentsTotal
      fair value losses
                                                                                                                    
                                                                                                                    
                                                                                                                    
                                                                                                                    $
                                                                                                                    (54,511
                                                                                                                    )
                                                                                                                    
                                                                                                                    $
                                                                                                                    (45,719
                                                                                                                    )
                                                                                                                    
                                                                                                                    $
                                                                                                                    (6,826
                                                                                                                    )
                                                                                                                    
                                                                                                                    $
                                                                                                                    (33,182
                                                                                                                    )
 
 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 limited activity and the illiquid nature of the market for these
securities.
  In
addition, upon the closings of its NMFT Series 2007-2 securitization, the
Company classified the residual securities it retained as trading. Management
estimates the fair value of its residual securities by discounting the expected
future cash flows of the collateral and bonds. Due to the unobservable inputs
used by the Company in determining the expected future cash flows, the Company
determined its valuation methodology for residual securities would qualify as
Level 3. See “Mortgage securities – available-for-sale” for further discussion
of the Company’s valuation policies relating to residual
securities.
  Mortgage securities –
available-for-sale.Mortgage securities – available-for-sale represent
beneficial interests the Company retained 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, 2008. Mortgage securities classified as
available-for-sale are reported at their estimated fair value with unrealized
gains and losses reported in accumulated other comprehensive income. To the
extent that the cost basis of mortgage securities exceeds the fair value and the
unrealized loss is considered to be other than temporary, an impairment charge
is recognized and the amount recorded in accumulated other comprehensive income
or loss is reclassified to earnings as a realized loss. The specific
identification method is used in computing realized gains or losses. The Company
uses two methodologies for determining the initial value of its residual
securities 1) the whole loan price methodology and 2) the discount rate
methodology. The Company believes the best estimate of the initial value of the
residual securities it retained 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.
  20
  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.See discussion under Fair Value Option for Financial
Assets and Financial Liabilities (SFAS 159).
  Real estate owned.Real estate
owned is carried at the lower of cost or fair value less estimated selling
costs. The Company estimates fair value at the asset’s liquidation value less
selling costs using management’s assumptions which are based on historical loss
severities for similar assets.
  Fair
Value Option for Financial Assets and Financial Liabilities
(SFAS 159)
  Under
SFAS 159, the Company may elect to report most financial instruments and
certain other items at fair value on an instrument-by-instrument basis with
changes in fair value reported in earnings. After the initial adoption, the
election is made at the acquisition of an eligible financial asset, financial
liability, or firm commitment or when certain specified reconsideration events
occur. The fair value election may not be revoked once an election is
made.
  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 $52.2 million and $13.2 million for the six and three months
ended June 30, 2008, respectively, and $63.5 million and $22.9 million for
the same periods in 2007. These adjustments are 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.
  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, 2008 (dollars in thousands):
 Description
                                                                      
                                                                      Unpaid Principal Balance
                                                                        as of June 30, 2008
                                                                      
                                                                      
                                                                      Gain
                                                                        Recognized
                                                                      
                                                                      
                                                                      Balance at Fair ValueAsset-backed
      bonds secured by mortgage securities
                                                                      
                                                                      $
                                                                      343,642
                                                                      
                                                                      
                                                                      $
                                                                      52,197
                                                                      
                                                                      
                                                                      $
                                                                      18,630
 
 Substantially
all of the $52.2 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 and second quarter of
2008.
  21
 
 Note
10. Interest Income
 
 The
following table presents the components of interest income for the six and three
months ended June 30, 2008 and 2007 (dollars in thousands):
 For the Six Months Ended
                                                                    June 30,
                                                                  
                                                                  
                                                                  For the Three Months Ended
                                                                    June 30,2008
                                                                  
                                                                  
                                                                  2007
                                                                  
                                                                  
                                                                  2008
                                                                  
                                                                  
                                                                  2007Interest
      Income:Mortgage
      securities
                                                                  
                                                                  $
                                                                  26,758
                                                                  
                                                                  
                                                                  $
                                                                  60,348
                                                                  
                                                                  
                                                                  $
                                                                  12,028
                                                                  
                                                                  
                                                                  $
                                                                  28,634Mortgage
      loans held-in-portfolio
                                                                  
                                                                  
                                                                  103,312
                                                                  
                                                                  
                                                                  
                                                                  123,740
                                                                  
                                                                  
                                                                  
                                                                  47,287
                                                                  
                                                                  
                                                                  
                                                                  73,760Other
      interest income (A)
                                                                  
                                                                  
                                                                  938
                                                                  
                                                                  
                                                                  
                                                                  3,667
                                                                  
                                                                  
                                                                  
                                                                  227
                                                                  
                                                                  
                                                                  
                                                                  1,701Total
      interest income
                                                                  
                                                                  $
                                                                  131,008
                                                                  
                                                                  
                                                                  $
                                                                  187,755
                                                                  
                                                                  
                                                                  $
                                                                  59,542
                                                                  
                                                                  
                                                                  $
                                                                  104,095
 (A)
              Other
      interest income includes interest from corporate operating cash. During
      the six and three months ended June 30, 2007 other interest income also
      included interest earned on funds the Company held as custodian and the
      Company’s warehouse notes
receivable.
 
 Note
11. Interest Expense
 
 The
following table presents the components of interest expense for the six and
three months ended June 30, 2008 and 2007 (dollars in
thousands):
 For the Six Months Ended
                                                                  June 30,
                                                                
                                                                
                                                                For the Three Months Ended
                                                                  June 30,2008
                                                                
                                                                
                                                                2007
                                                                
                                                                
                                                                2008
                                                                
                                                                
                                                                2007Interest
      Expense:Short-term
      borrowings secured by mortgage securities
                                                                
                                                                $
                                                                434
                                                                
                                                                
                                                                $
                                                                12,446
                                                                
                                                                
                                                                $
                                                                58
                                                                
                                                                
                                                                $
                                                                6,159Asset-backed
      bonds secured by mortgage loans
                                                                
                                                                
                                                                54,929
                                                                
                                                                
                                                                
                                                                91,306
                                                                
                                                                
                                                                
                                                                24,569
                                                                
                                                                
                                                                
                                                                52,555Asset-backed
      bonds secured by mortgage securities
                                                                
                                                                
                                                                6,606
                                                                
                                                                
                                                                
                                                                7,867
                                                                
                                                                
                                                                
                                                                2,921
                                                                
                                                                
                                                                
                                                                5,152Junior
      subordinated debentures
                                                                
                                                                
                                                                3,314
                                                                
                                                                
                                                                
                                                                4,057
                                                                
                                                                
                                                                
                                                                1,453
                                                                
                                                                
                                                                
                                                                2,035Total
      interest expense
                                                                
                                                                $
                                                                65,283
                                                                
                                                                
                                                                $
                                                                115,676
                                                                
                                                                
                                                                $
                                                                29,001
                                                                
                                                                
                                                                $
                                                                65,901
 
 Note
12. Discontinued Operations
 
 During
2007, the Company undertook workforce reductions pursuant to plans of
termination (“Exit Plans”) to align its organization and costs with its decision
to discontinue its mortgage lending and mortgage servicing
activities.   The Company considers an operating unit to be
discontinued upon its termination date, which is the point in time when the
operations substantially cease.  The provisions of SFAS 144 require
the results of operations associated with those operating units terminated to be
classified as discontinued operations and segregated from the Company’s
continuing results of operations for all periods presented.  In
accordance with SFAS 144, the Company has reclassified the operating results of
its mortgage lending segment and loan servicing operations segment as
discontinued operations in the condensed consolidated statements of operations
for the six months ended June 30, 2007.
 
 The major
classes of assets and liabilities reported as discontinued operations as of June
30, 2008 and December 31, 2007 are as follows (dollars in
thousands):
 June 30,
                                
                                
                                December 31,2008
                                
                                
                                2007AssetsMortgage
      loans -
      held-for-sale
                                
                                $
                                1,710
                                
                                
                                $
                                5,253Real
      estate owned
                                
                                
                                767
                                
                                
                                
                                2,574Other
      assets
                                
                                
                                -
                                
                                
                                
                                428Total
      assets
                                
                                $
                                2,477
                                
                                
                                $
                                8,255LiabilitiesShort-term
      borrowings secured by mortgage loans
                                
                                $
                                -
                                
                                
                                $
                                19Accounts
      payable and other liabilities (A)
                                
                                
                                47,608
                                
                                
                                
                                59,397Total
      liabilities
                                
                                $
                                47,608
                                
                                
                                $
                                59,416
 (A)
                                Includes
      a $45.2 million liability recorded in connection with the judgment
      rendered against NHMI in the California Action by AIM, the settlement of
      which is currently pending, subject to certain
    contingencies.
 
  22
 The
operating results of all discontinued operations for the six and three months
ended June 30, 2008 and 2007 are summarized as follows (dollars in
thousands):
 For the Six Months Ended
                                                                  June30,
                                                                
                                                                
                                                                For the Three Months Ended
                                                                  June30,2008
                                                                
                                                                
                                                                2007
                                                                
                                                                
                                                                2008
                                                                
                                                                
                                                                2007Interest
      income
                                                                
                                                                $
                                                                822
                                                                
                                                                
                                                                $
                                                                73,761
                                                                
                                                                
                                                                $
                                                                389
                                                                
                                                                
                                                                $
                                                                26,384Interest
      expense
                                                                
                                                                
                                                                (15
                                                                )
                                                                
                                                                
                                                                45,088
                                                                
                                                                
                                                                
                                                                2
                                                                
                                                                
                                                                
                                                                15,982Net
      interest income
                                                                
                                                                
                                                                837
                                                                
                                                                
                                                                
                                                                28,673
                                                                
                                                                
                                                                
                                                                387
                                                                
                                                                
                                                                
                                                                10,402Other
      operating expense:Gains
      (losses) on sales of mortgage assets
                                                                
                                                                
                                                                410
                                                                
                                                                
                                                                
                                                                (12,182
                                                                )
                                                                
                                                                
                                                                (36
                                                                )
                                                                
                                                                
                                                                (5,880
                                                                )Gains
      (losses) on derivative instruments
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                (781
                                                                )
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                2,269Valuation
      adjustment on mortgage loans – held-for-sale
                                                                
                                                                
                                                                (3,273
                                                                )
                                                                
                                                                
                                                                (24,560
                                                                )
                                                                
                                                                
                                                                2
                                                                
                                                                
                                                                
                                                                (4,363
                                                                )Fee
      income
                                                                
                                                                
                                                                902
                                                                
                                                                
                                                                
                                                                11,162
                                                                
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                5,131Premiums
      for mortgage loan insurance
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                (2,656
                                                                )
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                (342
                                                                )Other
      income
                                                                
                                                                
                                                                240
                                                                
                                                                
                                                                
                                                                1,623
                                                                
                                                                
                                                                
                                                                17
                                                                
                                                                
                                                                
                                                                (2,358
                                                                )Total
      other operating expense
                                                                
                                                                
                                                                (1,721
                                                                )
                                                                
                                                                
                                                                (27,394
                                                                )
                                                                
                                                                
                                                                (17
                                                                )
                                                                
                                                                
                                                                (5,543
                                                                )General
      and administrative expenses
                                                                
                                                                
                                                                6,463
                                                                
                                                                
                                                                
                                                                79,985
                                                                
                                                                
                                                                
                                                                2,347
                                                                
                                                                
                                                                
                                                                37,979Loss
      from discontinued operations
                                                                
                                                                $
                                                                (7,347
                                                                )
                                                                
                                                                $
                                                                (78,706
                                                                )
                                                                
                                                                $
                                                                (1,977
                                                                )
                                                                
                                                                $
                                                                (33,120
                                                                )
 
 Mortgage
Loans – Held-for-Sale
 
 Mortgage
loans – held-for-sale, relating to discontinued operations, all of which are
secured by residential properties, consisted of the following as of June 30,
2008 and December 31, 2007 (dollars in thousands):
 June 30,
                                                2008
                                              
                                              
                                              December 31,
                                                2007Mortgage
      loans – held-for-sale:Outstanding
      principal
                                              
                                              $
                                              16,205
                                              
                                              
                                              $
                                              17,545Allowance
      for the lower of cost or fair value
                                              
                                              
                                              (14,495
                                              )
                                              
                                              
                                              (12,292
                                              )Mortgage
      loans – held-for-sale
                                              
                                              $
                                              1,710
                                              
                                              
                                              $
                                              5,253Weighted
      average coupon
                                              
                                              
                                              10.17
                                              %
                                              
                                              
                                              10.23
                                              %
 
 Activity
in the allowance for the lower of cost or fair value on mortgage loans –
held-for-sale, relating to discontinued operations, is as follows for the six
and three months ended June 30, 2008 and 2007, respectively (dollars in
thousands):
 For the Six Months Ended
                                                                  June 30,
                                                                
                                                                
                                                                For the Three Months Ended
                                                                  June 30,2008
                                                                
                                                                
                                                                2007
                                                                
                                                                
                                                                2008
                                                                
                                                                
                                                                2007Balance,
      beginning of period
                                                                
                                                                $
                                                                12,292
                                                                
                                                                
                                                                $
                                                                5,006
                                                                
                                                                
                                                                $
                                                                14,646
                                                                
                                                                
                                                                $
                                                                25,872Valuation
      adjustment on mortgage loans held-for-sale
                                                                
                                                                
                                                                3,273
                                                                
                                                                
                                                                
                                                                24,560
                                                                
                                                                
                                                                
                                                                (2
                                                                )
                                                                
                                                                
                                                                4,363Transfer
      from the reserve for loan repurchases
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                22,329
                                                                
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                3,806Transfer
      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
                                                                
                                                                
                                                                569
                                                                
                                                                
                                                                
                                                                (10,075
                                                                )
                                                                
                                                                
                                                                1,305
                                                                
                                                                
                                                                
                                                                (7,064
                                                                )Charge-offs,
      net of recoveries
                                                                
                                                                
                                                                (1,639
                                                                )
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                (1,454
                                                                )
                                                                
                                                                
                                                                -Balance,
      end of period
                                                                
                                                                $
                                                                14,495
                                                                
                                                                
                                                                $
                                                                23,718
                                                                
                                                                
                                                                $
                                                                14,495
                                                                
                                                                
                                                                $
                                                                23,718
  23
  Commitments
and Contingencies
 
 See Note
7 regarding contingencies arising from discontinued operations.
 
 In the
ordinary course of the Company’s mortgage lending business, the Company sold
whole pools of loans with recourse for borrower defaults. When whole pools are
sold as opposed to securitized, the third party has recourse against the Company
for certain borrower defaults. Because the loans are no longer on the Company’s
balance sheet, the recourse component is considered a guarantee.  The
Company maintained a $1.2 million reserve related to these guarantees as of June
30, 2008 compared to a $2.2 million reserve as of December 31,
2007.
 
 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, 2008 and December 31, 2007, the
Company had loans sold with recourse with an outstanding principal balance of
$8.9 billion and $10.1 billion, respectively. Historically, repurchases of loans
where a defect has occurred have been insignificant; therefore, the Company has
recorded no reserves related to these guarantees.
 
 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.
 
 The
following table provides quantitative disclosures about the fair value
measurements for the Company’s assets related to discontinued operations which
are measured at fair value on a nonrecurring basis as of June 30, 2008 (dollars
in thousands):
 Fair Value Measurements at Reporting Date UsingDescription
                                                                    
                                                                    Fair Value at
                                                                      6/30/2008
                                                                    
                                                                    
                                                                    Quoted Prices in
                                                                      Active Markets
                                                                      for Identical
                                                                      Assets
                                                                      (Level 1)
                                                                    
                                                                    
                                                                    Significant
                                                                      Other
                                                                      Observable
                                                                      Inputs (Level 2)
                                                                    
                                                                    
                                                                    Significant
                                                                      Unobservable
                                                                      Inputs (Level 3)Mortgage
      loans-held-for-sale
                                                                    
                                                                    $
                                                                    1,710
                                                                    
                                                                    
                                                                    $
                                                                    -
                                                                    
                                                                    
                                                                    $
                                                                    -
                                                                    
                                                                    
                                                                    $
                                                                    1,710Real
      estate owned
                                                                    
                                                                    
                                                                    767
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    767Total
                                                                    
                                                                    $
                                                                    2,477
                                                                    
                                                                    
                                                                    $
                                                                    -
                                                                    
                                                                    
                                                                    $
                                                                    -
                                                                    
                                                                    
                                                                    $
                                                                    2,477
 
 The
Company’s mortgage loans held-for-sale have a fair value lower than their cost
basis by $14.5 million.  Therefore, all mortgage loans held-for-sale
have been written down to fair value. The Company recorded a valuation
adjustment of $3.3 million and $(2.0) thousand on mortgage loans – held-for-sale
for the six and three months ended June 30, 2008, as compared to $24.6 million
and $4.4 million for the same periods in 2007.  At the time a mortgage
loan held-for-sale becomes real estate owned, the Company records the property
at the lower of its carrying amount or fair value.  Upon
foreclosure and through liquidation, the Company evaluates the
property's fair value as compared to its carrying amount and records a
valuation adjustment when the carrying amount exceeds fair value.  For
mortgage loans held-for-sale, valuation adjustments for discontinued operations
are recorded in the “Loss from discontinued operations, net of income tax” line
item of the Company's condensed consolidated statements of
operations.
 
 The
following table provides a summary of the impact to earnings for the six and
three months ended June 30, 2008 and 2007 from the Company’s assets and
liabilities related to discontinued operations which are measured at fair value
on a recurring and nonrecurring basis as of June 30, 2008 (dollars in
thousands):
  24
 Fair Value
                                                                                              Adjustments For the
                                                                                              Six Months Ended
                                                                                              June 30
                                                                                            
                                                                                            
                                                                                            Fair Value
                                                                                              Adjustments For
                                                                                              the Three Months
                                                                                              Ended June 30Asset or Liability
                                                                                              Measured at Fair
                                                                                              Value
                                                                                            
                                                                                            Fair Value
                                                                                              Measurement
                                                                                              Frequency
                                                                                            
                                                                                            2008
                                                                                            
                                                                                            
                                                                                            2007
                                                                                            
                                                                                            
                                                                                            2008
                                                                                            
                                                                                            
                                                                                            2007
                                                                                            
                                                                                            Statement of Discontinued
                                                                                              Operations Line Item ImpactedMortgage
      loans – held-for-sale
                                                                                            
                                                                                            Nonrecurring
                                                                                            
                                                                                            $
                                                                                            (3,273
                                                                                            )
                                                                                            
                                                                                            $
                                                                                            (24,560
                                                                                            )
                                                                                            
                                                                                            $
                                                                                            2
                                                                                            
                                                                                            
                                                                                            $
                                                                                            (4,363
                                                                                            )
                                                                                            Valuation
      adjustment on mortgage loans – held-for-saleReal
      estate owned
                                                                                            
                                                                                            Nonrecurring
                                                                                            
                                                                                            
                                                                                            (165
                                                                                            )
                                                                                            
                                                                                            
                                                                                            (2,955
                                                                                            )
                                                                                            
                                                                                            
                                                                                            109
                                                                                            
                                                                                            
                                                                                            
                                                                                            (428
                                                                                            )
                                                                                            Gains
      (losses) on sales of mortgage assetsTotal
      fair value losses
                                                                                            
                                                                                            
                                                                                            
                                                                                            $
                                                                                            (3,438
                                                                                            )
                                                                                            
                                                                                            $
                                                                                            (27,515
                                                                                            )
                                                                                            
                                                                                            $
                                                                                            111
                                                                                            
                                                                                            
                                                                                            $
                                                                                            (4,791
                                                                                            )
 
 Valuation
Methods
 
 Mortgage loans - held-for-sale and
real estate owned.Both mortgage loans - held-for-sale and
real estate owned are carried at the lower of cost or fair value.  As
of June 30, 2008, the Company estimated the fair value of its mortgage loans –
held-for-sale and real estate owned based on two categories.  All
loans and real estate owned that had mortgage insurance were marked down to a
value which reflects the Company’s best estimate of net realizable
value.  All loans and real estate owned which did not have mortgage
insurance were valued at zero due to their nonperforming
characteristics.
 
 Note
13. Income Taxes
 
 Based on
the evidence available as of June 30, 2008 and December 31, 2007, including the
significant pre-tax losses incurred by the Company in 2007 and the first two
quarters of 2008, the ongoing disruption to the credit markets, the liquidity
issues facing the Company and the decision by the Company to close all of its
mortgage lending and loan servicing operations, the Company believes that it is
more likely than not that the Company will not realize its deferred tax
assets.  Based on these conclusions, the Company recorded a valuation
allowance against its entire net deferred tax assets as of June 30, 2008 and
December 31, 2007.
 
 As of
June 30, 2008, the Company had not yet filed its 2007 federal net operating loss
carryback to offset its 2006 taxable income.  Accordingly, the Company
has recorded additional interest of $0.8 million for the six months ended June
30, 2008 related to the balance due to the IRS, which is included in the
accounts payable and other liabilities line item of the Company’s condensed
consolidated balance sheet.  The Company intends to offset the 2006
tax liability with the receivable recorded for the projected 2007 federal net
operating loss to be carried back against its 2006 taxable income.
 
 The
Company recognizes tax benefits in accordance with the Financial Accounting
Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income
Taxes,” an interpretation of SFAS No. 109, “Accounting for Income Taxes”, (“FIN
48”).  FIN 48 establishes a “more-likely-than-not” recognition
threshold that must be met before a tax benefit can be recognized in the
financial statements.  As of June 30, 2008 and December 31, 2007, the
total gross amount of unrecognized tax benefits was $3.7 million and $6.3
million, respectively.  The Company believes that it is reasonably
possible the IRS will issue a closing agreement or determination letter in 2008
with respect to an uncertain tax position taken by the Company in
2007.  The unrecognized tax benefit related to such uncertain tax
position was approximately $2.8 million and $5.4 million at June 30, 2008 and
December 31, 2007, respectively.  The decrease of $2.6 million in the
unrecognized tax benefit for such uncertain tax position for the six months
ended June 30, 2008 was due to a change in measurement of the uncertain tax
position.
 
 Note
14. Segment Reporting
 
 The
Company reviews, manages and operates its business in one segment: mortgage
portfolio management. Mortgage portfolio management operating results come from
the income generated on the mortgage assets the Company manages less associated
costs. As discussed under Note 12, the Company discontinued its mortgage lending
and loan servicing segments during 2007 and had discontinued its branch
operations in 2006.  The mortgage portfolio management segment’s
operating results for the six and three months ended June 30, 2008 and 2007 are
the same as the Company’s condensed consolidated statements of
operations.
 
 Note
15. Earnings Per Share
 
 The
computations of basic and diluted earnings per share for the six and three
months ended June 30, 2008 and 2007 are as follows (in thousands, except share
and per share amounts):
  25
 
 For the Six Months Ended
                                                                              June 30,
                                                                            
                                                                            
                                                                            For the Three Months
                                                                              Ended June 30,2008
                                                                            
                                                                            
                                                                            2007
                                                                            
                                                                            
                                                                            2008
                                                                            
                                                                            
                                                                            2007Numerator:(Loss)
      income from continuing operations
                                                                            
                                                                            $
                                                                            (472,507
                                                                            )
                                                                            
                                                                            $
                                                                            71,842
                                                                            
                                                                            
                                                                            $
                                                                            (195,207
                                                                            )
                                                                            
                                                                            $
                                                                            (19,758
                                                                            )Dividends
      on preferred shares
                                                                            
                                                                            
                                                                            (6,657
                                                                            )
                                                                            
                                                                            
                                                                            (3,326
                                                                            )
                                                                            
                                                                            
                                                                            (3,369
                                                                            )
                                                                            
                                                                            
                                                                            (1,663
                                                                            )Loss
      from continuing operations available to common
shareholders
                                                                            
                                                                            
                                                                            (479,164
                                                                            )
                                                                            
                                                                            
                                                                            68,516
                                                                            
                                                                            
                                                                            
                                                                            (198,576
                                                                            )
                                                                            
                                                                            
                                                                            (21,421
                                                                            )Loss
      from discontinued operations, net of income tax
                                                                            
                                                                            
                                                                            (7,347
                                                                            )
                                                                            
                                                                            
                                                                            (78,706
                                                                            )
                                                                            
                                                                            
                                                                            (1,977
                                                                            )
                                                                            
                                                                            
                                                                            (33,120
                                                                            )Net
      loss available to common shareholders
                                                                            
                                                                            $
                                                                            (486,511
                                                                            )
                                                                            
                                                                            $
                                                                            (10,190
                                                                            )
                                                                            
                                                                            $
                                                                            (200,553
                                                                            )
                                                                            
                                                                            $
                                                                            (54,541
                                                                            )Denominator:Weighted
      average common shares outstanding – basic
                                                                            
                                                                            
                                                                            9,337,427
                                                                            
                                                                            
                                                                            
                                                                            9,328,679
                                                                            
                                                                            
                                                                            
                                                                            9,337,695
                                                                            
                                                                            
                                                                            
                                                                            9,336,655Weighted
      average common shares outstanding – dilutive:Weighted
      average common shares outstanding – basic
                                                                            
                                                                            
                                                                            9,337,427
                                                                            
                                                                            
                                                                            
                                                                            9,328,679
                                                                            
                                                                            
                                                                            
                                                                            9,337,695
                                                                            
                                                                            
                                                                            
                                                                            9,336,655Stock
      options
                                                                            
                                                                            
                                                                            -
                                                                            
                                                                            
                                                                            
                                                                            -
                                                                            
                                                                            
                                                                            
                                                                            -
                                                                            
                                                                            
                                                                            
                                                                            -Restricted
      stock
                                                                            
                                                                            
                                                                            -
                                                                            
                                                                            
                                                                            
                                                                            -
                                                                            
                                                                            
                                                                            
                                                                            -
                                                                            
                                                                            
                                                                            
                                                                            -Weighted
      average common shares outstanding – dilutive
                                                                            
                                                                            
                                                                            9,337,427
                                                                            
                                                                            
                                                                            
                                                                            9,328,679
                                                                            
                                                                            
                                                                            
                                                                            9,337,695
                                                                            
                                                                            
                                                                            
                                                                            9,336,655Basic
      earnings per share:(Loss)
      income from continuing operations
                                                                            
                                                                            $
                                                                            (50.60
                                                                            )
                                                                            
                                                                            $
                                                                            7.70
                                                                            
                                                                            
                                                                            $
                                                                            (20.91
                                                                            )
                                                                            
                                                                            $
                                                                            (2.11
                                                                            )Dividends
      on preferred shares
                                                                            
                                                                            
                                                                            (0.71
                                                                            )
                                                                            
                                                                            
                                                                            (0.36
                                                                            )
                                                                            
                                                                            
                                                                            (0.36
                                                                            )
                                                                            
                                                                            
                                                                            (0.18
                                                                            )(Loss)
      income from continuing operations available to common
      shareholders
                                                                            
                                                                            
                                                                            (51.31
                                                                            )
                                                                            
                                                                            
                                                                            7.34
                                                                            
                                                                            
                                                                            
                                                                            (21.27
                                                                            )
                                                                            
                                                                            
                                                                            (2.29
                                                                            )Loss
      from discontinued operations, net of income tax
                                                                            
                                                                            
                                                                            (0.79
                                                                            )
                                                                            
                                                                            
                                                                            (8.43
                                                                            )
                                                                            
                                                                            
                                                                            (0.21
                                                                            )
                                                                            
                                                                            
                                                                            (3.55
                                                                            )Net
      loss available to common shareholders
                                                                            
                                                                            $
                                                                            (52.10
                                                                            )
                                                                            
                                                                            $
                                                                            (1.09
                                                                            )
                                                                            
                                                                            $
                                                                            (21.48
                                                                            )
                                                                            
                                                                            $
                                                                            (5.84
                                                                            )Diluted
      earnings per share:(Loss)
      income from continuing operations
                                                                            
                                                                            $
                                                                            (50.60
                                                                            )
                                                                            
                                                                            $
                                                                            7.70
                                                                            
                                                                            
                                                                            $
                                                                            (20.91
                                                                            )
                                                                            
                                                                            $
                                                                            (2.11
                                                                            )Dividends
      on preferred shares
                                                                            
                                                                            
                                                                            (0.71
                                                                            )
                                                                            
                                                                            
                                                                            (0.36
                                                                            )
                                                                            
                                                                            
                                                                            (0.36
                                                                            )
                                                                            
                                                                            
                                                                            (0.18
                                                                            )(Loss)
      income from continuing operations available to common
      shareholders
                                                                            
                                                                            
                                                                            (51.31
                                                                            )
                                                                            
                                                                            
                                                                            7.34
                                                                            
                                                                            
                                                                            
                                                                            (21.27
                                                                            )
                                                                            
                                                                            
                                                                            (2.29
                                                                            )Loss
      from discontinued operations, net of income tax
                                                                            
                                                                            
                                                                            (0.79
                                                                            )
                                                                            
                                                                            
                                                                            (8.43
                                                                            )
                                                                            
                                                                            
                                                                            (0.21
                                                                            )
                                                                            
                                                                            
                                                                            (3.55
                                                                            )Net
      loss available to common shareholders
                                                                            
                                                                            $
                                                                            (52.10
                                                                            )
                                                                            
                                                                            $
                                                                            (1.09
                                                                            )
                                                                            
                                                                            $
                                                                            (21.48
                                                                            )
                                                                            
                                                                            $
                                                                            (5.84
                                                                            )
 
 The
following stock options to purchase shares of common stock were outstanding
during each period presented, but were not included in the computation of
diluted earnings per share because the effect would be antidilutive (in
thousands, except exercise prices):
 For the Six Months Ended
                                                                  June 30,
                                                                
                                                                For the Three Months
                                                                  Ended June 30,2008
                                                                
                                                                2007
                                                                
                                                                2008
                                                                
                                                                2007Number
      of stock options
                                                                
                                                                
                                                                250
                                                                
                                                                
                                                                
                                                                330
                                                                
                                                                
                                                                
                                                                266
                                                                
                                                                
                                                                
                                                                461Weighted
      average exercise price
                                                                
                                                                $
                                                                39.35
                                                                
                                                                
                                                                $
                                                                40.52
                                                                
                                                                
                                                                $
                                                                37.11
                                                                
                                                                
                                                                $
                                                                32.24
 
 For the
six and three months ended June 30, 2008, the Company had 2.1 million shares of
convertible participating preferred stock which were convertible into 1.9
million shares of common stock, but were not included in the computation of
diluted earnings per share because the effect would be
antidilutive.  The weighted average conversion price was
$28.00.
  26
  Note
16. Subsequent Events
 
 On August
8, 2008, the Company entered into a Membership Interest Purchase Agreement,
dated as of August 1, 2008, with PipeFire, LLC (“PipeFire”), the existing equity
holders of PipeFire, and certain beneficial owners of such equity interests,
pursuant to which the Company acquired 75% of the equity interests of PipeFire
from its existing equity holders.  The acquisition was deemed by the
Purchase Agreement to be effective as of August 1, 2008.  Following
the closing of the acquisition, PipeFire’s name was changed to StreetLinks
National Appraisal Services LLC (“StreetLinks”).
 
 The
initial purchase price paid by the Company for the acquired interest at closing
was $0.8 million.  Additional purchase price amounts, up to an
aggregate additional amount of $3.3 million, will be payable at such times as
StreetLinks achieves certain pre-tax income objectives.
  Note
17.  Restatement of previously issued condensed consolidated financial
statements
  Subsequent
to the filing of the Company’s Quarterly Report on Form 10-Q for the second
quarter of 2008 and as a result of the consideration of comments received from
the Staff of the SEC in connection with a review of the Company’s
aforementioned filing, management has determined that the Company’s condensed
consolidated financial statements for the six and three month periods ended
June 30, 2008 should be restated.
  Prior to
June 30, 2008, the Company’s 2007 securitized loan pool (“NHES 2007-1”) did
not meet the qualifying special purpose entity criteria necessary for
derecognition of the securitized assets and liabilities pursuant to SFAS 140 and
related authoritative accounting literature because of the excessive benefit
expected to be received from the derivative instruments delivered to the trust
to counteract interest rate risk. As a result, the assets and liabilities
relating to this securitization were included in the Company’s consolidated
financial statements.
  During
and prior to the quarter ended June 30, 2008, a series of events occurred
that led the Company to reassess the Qualifying Special Purpose Entity (“QSPE”)
criteria and conclude that it had relinquished control over the securitized
loans as of June 30, 2008. Consequently, the Company determined that the
assets and liabilities should be deconsolidated pursuant to SFAS 140. As of
June 30, 2008, the mortgage loans – held-in-portfolio, asset-backed bonds
secured by mortgage loans and all other assets and liabilities relating to this
securitization were removed from the balance sheet; interests retained by the
Company in this transaction were recorded in the “Mortgage securities – trading”
line of the Company’s balance sheet; and a gain was recorded through the “Gains
(losses) on sales of mortgage assets” line of the condensed consolidated
statement of operations.
  Although
management believed at the time that derecognition of the NHES 2007-1 was an
acceptable interpretation of SFAS 140, the accounting rules for asset transfers
are complicated and require interpretations to be made for specific transactions
and events.  After consideration of the comments received from and
discussions with the SEC, the Company has concluded to consolidate NHES 2007-1
and restate its consolidated financial statements for the six and three month
periods ended June 30, 2008.
 
 27
  Condensed
Consolidated Balance Sheet Impacts
  The
following table sets forth the effects of the adjustments on the June 30, 2008
consolidated balance sheet (in thousands, except share and per share
amounts):
 As Previously
                                          
                                          
                                          
                                          
                                          
                                          As RestatedReported
                                          
                                          
                                          AdjustmentsAssetsUnrestricted
      cash and cash equivalents
                                          
                                          $
                                          10,269
                                          
                                          
                                          $
                                          -
                                          
                                          
                                          $
                                          10,269Restricted
      cash
                                          
                                          
                                          7,181
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          7,181Mortgage
      loans – held-in-portfolio, net of allowance of $308,162 (previously
      reported) and $616,690 (as restated)
                                          
                                          
                                          1,014,747
                                          
                                          
                                          
                                          1,146,973
                                          
                                          
                                          
                                          2,161,720Mortgage
      securities -
      trading
                                          
                                          
                                          27,837
                                          
                                          
                                          
                                          (2,562
                                          )
                                          
                                          
                                          25,275Mortgage
      securities -
      available-for-sale
                                          
                                          
                                          9,167
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          9,167Real
      estate owned
                                          
                                          
                                          26,724
                                          
                                          
                                          
                                          39,815
                                          
                                          
                                          
                                          66,539Accrued
      interest receivable
                                          
                                          
                                          30,276
                                          
                                          
                                          
                                          35,763
                                          
                                          
                                          
                                          66,039Other
      assets
                                          
                                          
                                          5,875
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          5,875Assets
      of discontinued operations
                                          
                                          
                                          2,477
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          2,477Total
      assets
                                          
                                          $
                                          1,134,553
                                          
                                          
                                          $
                                          1,219,989
                                          
                                          
                                          $
                                          2,354,542Liabilities
      and Shareholders’ EquityLiabilities:Asset-backed
      bonds secured by mortgage loans
                                          
                                          $
                                          1,311,934
                                          
                                          
                                          $
                                          1,472,367
                                          
                                          
                                          $
                                          2,784,301Asset-backed
      bonds secured by mortgage securities
                                          
                                          
                                          18,630
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          18,630Short-term
      borrowings secured by mortgage securities
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -Junior
      subordinated debentures
                                          
                                          
                                          77,077
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          77,077Due
      to servicer
                                          
                                          
                                          29,308
                                          
                                          
                                          
                                          47,857
                                          
                                          
                                          
                                          77,165Derivative
      instruments, net
                                          
                                          
                                          -
                                          
                                          
                                          
                                          10,574
                                          
                                          
                                          
                                          10,574Dividends
      payable
                                          
                                          
                                          10,473
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          10,473Accounts
      payable and other liabilities
                                          
                                          
                                          23,911
                                          
                                          
                                          
                                          1,500
                                          
                                          
                                          
                                          25,411Liabilities
      of discontinued operations
                                          
                                          
                                          47,608
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          47,608Total
      liabilities
                                          
                                          
                                          1,518,941
                                          
                                          
                                          
                                          1,532,298
                                          
                                          
                                          
                                          3,051,239Commitments
      and contingencies (Note 7)Shareholders’
      deficit:Capital
      stock, $0.01 par value, 50,000,000 shares authorized:Redeemable
      preferred stock, $25 liquidating preference per share; 2,990,000 shares,
      issued and outstanding
                                          
                                          
                                          30
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          30Convertible
      participating preferred stock, $25 liquidating preference per share;
      2,100,000 shares, issued and outstanding
                                          
                                          
                                          21
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          21Common
      stock, 9,391,341 and 9,439,273 shares, issued and outstanding,
      respectively
                                          
                                          
                                          94
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          94Additional
      paid-in capital
                                          
                                          
                                          786,440
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          786,440Accumulated
      deficit
                                          
                                          
                                          (1,170,553
                                          )
                                          
                                          
                                          (312,309
                                          )
                                          
                                          
                                          (1,482,862
                                          )Accumulated
      other comprehensive loss
                                          
                                          
                                          (246
                                          )
                                          
                                          
                                          -
                                          
                                          
                                          
                                          (246
                                          )Other
                                          
                                          
                                          (174
                                          )
                                          
                                          
                                          -
                                          
                                          
                                          
                                          (174
                                          )Total
      shareholders’ deficit
                                          
                                          
                                          (384,388
                                          )
                                          
                                          
                                          (312,309
                                          )
                                          
                                          
                                          (696,697
                                          )Total
      liabilities and shareholders’ deficit
                                          
                                          $
                                          1,134,553
                                          
                                          
                                          $
                                          1,219,989
                                          
                                          
                                          $
                                          2,354,542
  28
  Condensed
Consolidated
Statements of Operations Impacts
  The following
      table sets forth the effects of the adjustments on the condensed
      consolidated statements of operations for the six and three months ended
      June 30, 2008 (in thousands, except share and per share
      amounts):ForTheSixMonthsEnded
                                                  June 30, 2008
                                                
                                                
                                                ForTheThreeMonthsEnded
                                                  June 30, 2008As
                                                  Previously
                                                  Reported
                                                
                                                
                                                Adjustments
                                                
                                                
                                                As
                                                  Restated
                                                
                                                
                                                As
                                                  Previously
                                                  Reported
                                                
                                                
                                                Adjustments
                                                
                                                
                                                As RestatedInterest
      income
                                                
                                                $
                                                131,008
                                                
                                                
                                                $
                                                -
                                                
                                                
                                                $
                                                131,008
                                                
                                                
                                                $
                                                59,542
                                                
                                                
                                                $
                                                -
                                                
                                                
                                                $
                                                59,542Interest
      expense
                                                
                                                
                                                65,283
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                65,283
                                                
                                                
                                                
                                                29,001
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                29,001Net
      interest income before provision for credit losses
                                                
                                                
                                                65,725
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                65,725
                                                
                                                
                                                
                                                30,541
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                30,541Provision
      for credit losses
                                                
                                                
                                                461,436
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                461,436
                                                
                                                
                                                
                                                212,120
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                212,120Net
      interest loss after provision for credit losses
                                                
                                                
                                                (395,711
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                (395,711
                                                )
                                                
                                                
                                                (181,579
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                (181,579
                                                )Other
      operating expense:Gains
      (losses) on sales of mortgage assets
                                                
                                                
                                                312,309
                                                
                                                
                                                
                                                (312,309
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                312,309
                                                
                                                
                                                
                                                (312,309
                                                )
                                                
                                                
                                                -(Losses)
      gains on derivative instruments
                                                
                                                
                                                (10,613
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                (10,613
                                                )
                                                
                                                
                                                4,974
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                4,974Gains
      on debt extinguishment
                                                
                                                
                                                6,418
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                6,418
                                                
                                                
                                                
                                                6,418
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                6,418Fair
      value adjustments
                                                
                                                
                                                (22,669
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                (22,669
                                                )
                                                
                                                
                                                (9,952
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                (9,952
                                                )Impairment
      on mortgage securities – available-for-sale
                                                
                                                
                                                (21,229
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                (21,229
                                                )
                                                
                                                
                                                (1,848
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                (1,848
                                                )Premiums
      for mortgage loan insurance
                                                
                                                
                                                (8,317
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                (8,317
                                                )
                                                
                                                
                                                (4,043
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                (4,043
                                                )Servicing
      fee expense
                                                
                                                
                                                (7,093
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                (7,093
                                                )
                                                
                                                
                                                (3,397
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                (3,397
                                                )Other
      income (expense), net
                                                
                                                
                                                80
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                80
                                                
                                                
                                                
                                                69
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                69Total
      other operating expense
                                                
                                                
                                                248,886
                                                
                                                
                                                
                                                (312,309
                                                )
                                                
                                                
                                                (63,423
                                                )
                                                
                                                
                                                304,530
                                                
                                                
                                                
                                                (312,309
                                                )
                                                
                                                
                                                (7,779
                                                )General
      and administrative expenses:Compensation
      and benefits
                                                
                                                
                                                3,479
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                3,479
                                                
                                                
                                                
                                                930
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                930Office
      administration
                                                
                                                
                                                4,553
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                4,553
                                                
                                                
                                                
                                                2,284
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                2,284Professional
      and outside services
                                                
                                                
                                                3,887
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                3,887
                                                
                                                
                                                
                                                1,976
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                1,976Travel
      and other
                                                
                                                
                                                370
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                370
                                                
                                                
                                                
                                                226
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                226Total
      general and administrative expenses
                                                
                                                
                                                12,289
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                12,289
                                                
                                                
                                                
                                                5,416
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                5,416Loss
      from continuing operations before income tax expense
    (benefit)
                                                
                                                
                                                (159,114
                                                )
                                                
                                                
                                                (312,309
                                                )
                                                
                                                
                                                (471,423
                                                )
                                                
                                                
                                                117,535
                                                
                                                
                                                
                                                (312,309
                                                )
                                                
                                                
                                                (194,774
                                                )Income
      tax expense (benefit)
                                                
                                                
                                                1,084
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                1,084
                                                
                                                
                                                
                                                433
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                433(Loss)
      income from continuing operations
                                                
                                                
                                                (160,198
                                                )
                                                
                                                
                                                (312,309
                                                )
                                                
                                                
                                                (472,507
                                                )
                                                
                                                
                                                117,102
                                                
                                                
                                                
                                                (312,309
                                                )
                                                
                                                
                                                (195,207
                                                )Loss
      from discontinued operations, net of income tax
                                                
                                                
                                                (7,347
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                (7,347
                                                )
                                                
                                                
                                                (1,977
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                (1,977
                                                )Net
      (loss) income
                                                
                                                
                                                (167,545
                                                )
                                                
                                                
                                                (312,309
                                                )
                                                
                                                
                                                (479,854
                                                )
                                                
                                                
                                                115,125
                                                
                                                
                                                
                                                (312,309
                                                )
                                                
                                                
                                                (197,184
                                                )Basic
      earnings per share:(Loss)
      income from continuing operations available to common
      shareholders
                                                
                                                $
                                                (17.87
                                                )
                                                
                                                $
                                                (33.44
                                                )
                                                
                                                $
                                                (51.31
                                                )
                                                
                                                $
                                                10.18
                                                
                                                
                                                
                                                (31.45
                                                )
                                                
                                                $
                                                (21.27
                                                )Loss
      from discontinued operations, net of income tax
                                                
                                                
                                                (0.79
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                (0.79
                                                )
                                                
                                                
                                                (0.21
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                (0.21
                                                )Net
      (loss) income available to common shareholders
                                                
                                                $
                                                (18.66
                                                )
                                                
                                                $
                                                (33.44
                                                )
                                                
                                                $
                                                (52.10
                                                )
                                                
                                                $
                                                9.97
                                                
                                                
                                                
                                                (31.45
                                                )
                                                
                                                $
                                                (21.48
                                                )Diluted
      earnings per share:(Loss)
      income from continuing operations available to common
      shareholders
                                                
                                                $
                                                (17.87
                                                )
                                                
                                                $
                                                (33.44
                                                )
                                                
                                                $
                                                (51.31
                                                )
                                                
                                                $
                                                10.18
                                                
                                                
                                                
                                                (31.45
                                                )
                                                
                                                $
                                                (21.27
                                                )Loss
      from discontinued operations, net of income tax
                                                
                                                
                                                (0.79
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                (0.79
                                                )
                                                
                                                
                                                (0.22
                                                )
                                                
                                                
                                                -
                                                
                                                
                                                
                                                (0.21
                                                )Net
      (loss) income available to common shareholders
                                                
                                                $
                                                (18.66
                                                )
                                                
                                                $
                                                (33.44
                                                )
                                                
                                                $
                                                (52.10
                                                )
                                                
                                                $
                                                9.96
                                                
                                                
                                                
                                                (31.45
                                                )
                                                
                                                $
                                                (21.48
                                                )Weighted
      average basic shares outstanding
                                                
                                                
                                                9,337,427
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                9,337,427
                                                
                                                
                                                
                                                9,337,695
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                9,337,695Weighted
      average diluted shares outstanding
                                                
                                                
                                                9,337,427
                                                
                                                
                                                
                                                -
                                                
                                                
                                                
                                                9,337,427
                                                
                                                
                                                
                                                9,340,694
                                                
                                                
                                                
                                                (2,999
                                                )
                                                
                                                
                                                9,337,695
  Condensed
Consolidated Statements of Cash Flows Impacts
  The
following table sets forth the effects of the adjustments on the condensed
consolidated statements of cash flows for the six months ended June 30, 2008 (in
thousands):
 PreviouslyReported
                                            
                                            
                                            Adjustments
                                            
                                            
                                            As
      RestatedNet
      loss
                                            
                                            $
                                            (167,545
                                            )
                                            
                                            $
                                            (312,309
                                            )
                                            
                                            $
                                            (479,854
                                            )Loss
      from continuing operations
                                            
                                            
                                            (160,198
                                            )
                                            
                                            
                                            (312,309
                                            )
                                            
                                            
                                            (472,507
                                            )Losses
      (gains) on sales of mortgage assets
                                            
                                            
                                            (312,309
                                            )
                                            
                                            
                                            312,309
                                            
                                            
                                            
                                            -Net
      cash used in operating activities
                                            
                                            
                                            (2,547
                                            )
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (2,547
                                            )Net
      cash provided by investing activities
                                            
                                            
                                            320,131
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            320,131Net
      cash (used in) provided by financing activities
                                            
                                            
                                            (332,679
                                            )
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (332,679
                                            )Net
      decrease in cash and cash equivalents
                                            
                                            
                                            (15,095
                                            )
                                            
                                            
                                            -
                                            
                                            
                                            
                                            (15,095
                                            )Cash
      and cash equivalents, beginning of period
                                            
                                            
                                            25,364
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            25,364Cash
      and cash equivalents, end of period
                                            
                                            $
                                            10,269
                                            
                                            
                                            $
                                            -
                                            
                                            
                                            $
                                            10,269
  29
  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,
2007.
 
 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, cash flows and cash needs, and future asset values,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 continue as a going concern; decreases in
cash flows from our mortgage securities; our ability to reduce expenses;
exercise of remedies with respect to existing defaults under, and our ability to
restructure the agreements governing, our indebtedness and other contractual
obligations; our ability to identify and establish or invest in, and
successfully manage and grow, businesses that may be outside of the businesses
in which we historically have operated; impairments on our mortgage assets;
decreases in prepayment rates or increases in default rates or losses on
mortgage loans underlying our mortgage assets; loan repurchase requests; changes
in assumptions regarding estimated loan losses and fair value amounts; the
extent and timing of the return of cash posted as collateral on letters of
credit; our ability to maintain effective internal control over financial
reporting and disclosure controls and procedures in the future; residential
property values; interest rate fluctuations on our assets that differ from our
liabilities; 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; compliance with new accounting pronouncements; the
impact of general economic conditions; and the risks that are from time to time
included in our filings with the Securities and Exchange Commission (“SEC”),
including this report on Form 10-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.
 
 Restatement
 
 Described
in Note17 to the accompanying unaudited condensed consolidated financial
statements, we have restated our condensed consolidated financial statements for
the six and three months ended June 30, 2008.
 
 Executive
Overview of Performance
 
 The
financial services sector continued to see widespread market turmoil during the
second quarter of 2008.  In particular, the mortgage industry
continued to experience extreme conditions.  Significant disruptions
continued in global capital markets.  Housing valuations continued
their steep decline.  Home foreclosures and mortgage delinquencies are
severely negatively impacting the performance and value of mortgage loans and
securities today.  The full impact of the events of 2007 and 2008 are
not expected to be fully understood in the near term.
 
 As
previously reported we ceased all lending and loan servicing operations in 2007
due to the extreme conditions surrounding the financial services
sector.  Management has undertaken severe and far-reaching measures in
an attempt to preserve liquidity and to continue to operate as a going
concern.  The market conditions and the resulting actions by
management have generated significant losses during 2007 and 2008 and we
currently have a significant stockholders’ deficit.
 
 The
following discussion outlines the major factors which drove our second quarter
2008 financial performance.
 
 Credit
performance – With repayment risks no longer offset by rising home values
and liquidity in the mortgage lending market, delinquencies in the industry
continued to rise in 2008.  These credit issues continue to negatively
affect the income generated by, and values of, our portfolio of mortgage loans
and securities.  We recorded provisions for credit losses totaling
$461.4 million in the six months ended June 30, 2008, to account for the
significant effect of the credit deterioration in our loan
portfolio.
  30
 
 Borrower
Prepayments–In
the past, we retained the prepayment securities from the securitizations we
executed.  These securities receive the prepayment penalty cash flows
paid by borrowers when they prepay their loan.  Due to the inability
of many borrowers to refinance their loan as a result of tighter market
underwriting standards and the decline in home values, we are experiencing
slower than expected prepayment speeds.
 
 We
recognized impairments of $21.2 million on our mortgage securities –
available-for-sale for the six months ended June 30, 2008 primarily as a result
of these slower prepayment speeds.
 
 Liquidity– Our cash balances declined by approximately $15.1 million during the
six months ended June 30, 2008 primarily due to repayment of short-term secured
borrowings, lease terminations, current income tax payments, litigation
settlements and normal business operations.  We no longer maintain any
short-term borrowing arrangements.  As a result, we face substantial
liquidity risk and uncertainty, near-term and otherwise, which threatens our
ability to continue as a going concern and avoid bankruptcy.  See
“Liquidity and Capital Resources” for further discussion of our liquidity
position and steps we have taken to preserve liquidity levels.
 
 See
discussion under heading “Industry Overview and Known Material Trends and
Uncertainties” below for more information about current conditions in our
industry and the steps we are taking or considering to manage our business in
this challenging environment.
 
 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
                                                                                              
                                                                                              
                                                                                              For the Three MonthsEnded
      June 30,
                                                                                              
                                                                                              
                                                                                              Ended
      June 30,2008
                                                                                              
                                                                                              
                                                                                              2007
                                                                                              
                                                                                              
                                                                                              2008
                                                                                              
                                                                                              
                                                                                              2007Net
      loss available to common shareholders
                                                                                              
                                                                                              $
                                                                                              (486,511
                                                                                              )
                                                                                              
                                                                                              $
                                                                                              (10,190
                                                                                              )
                                                                                              
                                                                                              $
                                                                                              (200,553
                                                                                              )
                                                                                              
                                                                                              $
                                                                                              (54,541
                                                                                              )Net
      loss available to common shareholders, per diluted share
                                                                                              
                                                                                              $
                                                                                              (52.10
                                                                                              )
                                                                                              
                                                                                              $
                                                                                              (1.09
                                                                                              )
                                                                                              
                                                                                              $
                                                                                              (21.48
                                                                                              )
                                                                                              
                                                                                              $
                                                                                              (5.84
                                                                                              )
  For
the six months ended June 30, 2008 as compared to the six months ended June 30,
2007.
  We had a
net loss available to common shareholders of $486.5 million during the six
months ended June 30, 2008 as compared to a net loss available to common
shareholders of $10.2 million for the same period in 2007.
 
 We
incurred a significant loss from continuing operations of $472.5 million during
the six months ended June 30, 2008 as compared to income from continuing
operations of $71.8 million for the same period in 2007.  The
following factors contributed to the current year loss as compared to the prior
period income:
 
 ·
              We
      incurred income tax expense of $1.1 million for the six months ended June
      30, 2008 as compared to earning a benefit of $186.6 million for the same
      period of 2007.  The tax benefit in 2007 was driven by the
      formal plan approved by the Board of Directors to revoke REIT status as of
      January 1, 2008.  This plan was subsequently superseded in the
      third quarter of 2007 by termination of our REIT status as of January 1,
      2006.
 
 ·
              An
      increase in our provision for credit losses for our mortgage loans
      held-in-portfolio to $461.4 million for the six months ended June 30, 2008
      from $93.2 million for the same period in 2007.  This increase
      of $368.2 million was primarily due to the continued credit deterioration
      in our mortgage loans
held-in-portfolio.
 
 ·
              A
      net loss due to fair value adjustments of $22.7 million related to our
      trading securities and the asset-backed bonds issued in our CDO
      transaction. The trading securities had a negative fair value adjustment
      of approximately $(74.9) million while the CDO asset-backed bonds had a
      positive fair value adjustment of $52.2 million.  These
      adjustments were a result of significant credit deterioration of
      underlying loans collateralizing these
  securities.
  31
 
 We
incurred a loss from discontinued operations of $7.3 million during the six
months ended June 30, 2008 as compared to $78.7 million for the same period in
2007.  The 2008 loss is much lower than 2007 because the shutdown of
our mortgage lending and loan servicing operations in 2007 was substantially
completed by the end of 2007.  The current period loss was primarily
driven by the additional lower of cost or market adjustment on our mortgage
loans – held-for-sale to their estimated fair value and residual operating
costs.
 
 For
the three months ended June 30, 2008 as compared to the three months ended June
30, 2007.
  We had a
net loss available to common shareholders of $200.6 million during the three
months ended June 30, 2008 as compared to a net loss available to common
shareholders of $54.5 million for the same period in 2007.
 
 We had a
loss from continuing operations of $195.2 million during the three months ended
June 30, 2008 as compared to a loss from continuing operations of $19.8 million
for the same period in 2007.  The following factors contributed to the
larger loss during the second quarter 2008 compared to the same period in
2007:
 
 ·
              We
      incurred income tax expense of $0.4 million for the three months ended
      June 30, 2008 as compared to earning a benefit of $71.2 million for the
      same period of 2007. The tax benefit in 2007 was driven by the formal plan
      approved by the Board of Directors to revoke status as a real estate
      investment trust (“REIT”) as of January 1, 2008. This plan was
      subsequently superseded in the third quarter of 2007 by termination of our
      REIT status as of January 1, 2006 as a result of our inability to pay a
      dividend on our common stock with respect to our 2006 taxable
      income.
  ·
              An
      increase in our provision for credit losses for our mortgage loans
      held-in-portfolio to $212.1 for the three months ended June 30, 2008 from
      $73.3 million for the same period in 2007.  This increase of
      $138.8 million was primarily due to the continued credit deterioration in
      our mortgage loans
held-in-portfolio.
 
 We
incurred a loss from discontinued operations of $2.0 million during the three
months ended June 30, 2008 as compared to $33.1 million for the same period in
2007.  The 2008 loss is much lower than 2007 because the shutdown of
our mortgage lending and loan servicing operations in 2007 was substantially
completed by the end of 2007.  The current quarter loss was primarily
driven by residual operating costs.
 
 Industry
Overview and Known Material Trends and Uncertainties
 
 Described
below are some of the marketplace conditions and known material trends and
uncertainties that have become evident in the first and second quarters of 2008
which may impact our future results of operations.
 
 Future Strategy,
Liquidity and Going Concern Considerations - We will continue to focus on
minimizing losses and preserving liquidity as we manage our existing
portfolio of mortgage securities.  Our residual and subordinated
mortgage securities are currently our only significant source of cash flows.
Based on current projections, the cash flows from our mortgage securities will
decrease in the next several months as the underlying mortgage loans are repaid,
and could be significantly less than the current projections if losses on the
underlying mortgage loans exceed, or prepayments are less than, the current
assumptions.  In addition, we have significant operating expenses
associated with office leases, and other obligations relating to our
discontinued operations.  We also have significant obligations with
respect to junior subordinated notes relating to the trust preferred securities
of NovaStar Capital Trust I and NovaStar Capital Trust II.  See
“Liquidity and Capital Resources” for additional discussion regarding the recent
defaults under the junior subordinated notes.
 
 If, as
the cash flows from our mortgage securities decrease, we are unable to
recommence or invest in profitable operations, restructure our unsecured debt,
capital structure and contractual obligations or if the cash flows from our
mortgage securities are less than currently anticipated, there can be no
assurance that we will be able to continue as a going concern and avoid seeking
the protection of applicable bankruptcy laws.
 
 We have
initiated efforts to restructure our indebtedness and certain contractual
obligations and are assessing potential changes to elements of our capital
structure, with the goal of negotiating and implementing changes to facilitate
the achievement of long-term value.  There can be no assurance that
any of these efforts will be successful.
 
 Due to
the fact that we have a negative net worth, we do not currently have ongoing
significant business operations that are profitable and our common stock and
Series C preferred stock have been delisted from the New York Stock Exchange, it
is unlikely that we will be able to obtain additional equity or debt financing
on favorable terms, or at all, for the foreseeable future.  To the
extent we require additional liquidity and cannot obtain it, we will be forced
to file for bankruptcy.
  32
  To the
extent available, we may use excess cash to make certain investments if we
determine that such investments could provide attractive risk-adjusted returns
to shareholders, including, potentially investing in new or existing operating
companies.  Because of certain state licensing requirements, it is
unlikely we will be able to directly recommence mortgage lending activities so
long as we continue to have a shareholders’ deficit.  Our ability to
start or acquire new businesses is significantly constrained by our limited
liquidity and our likely inability to obtain debt financing or to issue equity
securities as a result of our current financial condition, including a
shareholders’ deficit, as well as other uncertainties and risks.  As
discussed in Note 16 to the condensed consolidated financial statements, the
Company acquired a majority interest in an appraisal management company
subsequent to June 30, 2008.  There can be no assurances that we will
be able to establish or acquire additional new business operations.
 
 Recent Market
Developments - During 2008, global financial market conditions have
continued to deteriorate.  Financial services, and the mortgage
industry in particular, have remained under continuous pressure due to numerous
factors, which include industry-wide deterioration of the value of mortgage
assets held by financial institutions, the deterioration of mortgage credit
among mortgage lenders, the downgrades of mortgage securities by the rating
agencies, and a reluctance on the part of banks and broker-dealers to finance
mortgage securities within the credit markets.  Because of these
factors, mortgage security market valuations remain volatile, mortgage
securities trading remains limited and mortgage securities financing markets
remain challenging as the industry continues to report negative
news.  The global financial market conditions have led to the failure
of numerous financial lenders during 2007 and 2008.
 
 The
factors described above continue to contribute to the decline in the market
values of our securities and loans.
  The
market has also seen a significant drop in LIBOR rates since the end of 2007 as
the Federal Reserve made several cuts in short-term interest rates, which
decreases the variable interest rates paid on the bonds issued by the
securitization trusts.  Because we largely hold residual and
subordinated securities issued by these trusts, absent any other changes,
lower LIBOR rates would have positive effects on the cash flows we receive from
our mortgage securities.  However, the severe deterioration in credit
and prepayment performance of the underlying collateral will likely offset part
or all of any positive impact of decreased LIBOR rates.
  Given the
current uncertainty regarding these market conditions, we are unable to offer
any additional factual information on the situation and how it will impact us
other than to disclose what we are currently seeing in the mortgage market. As a
result, we expect to continue to operate with no leverage and to continue to
take actions in an effort to preserve liquidity and available cash.
 
 Home prices
- Generally, housing values are experiencing broad-based declines
nationwide. Housing values are likely to decrease during the near term which
could affect our credit loss experience, which will continue to impact our
earnings, cash flows, financial condition and ability to continue as a going
concern.
 
 Loan
Repurchases - When we sold mortgage loans, whether as whole loans or
pursuant to a securitization, we made customary representations and warranties
to the purchaser about the mortgage loans and the manner in which they were
originated. Our whole loan sale agreements require us to repurchase or
substitute mortgage loans in the event we breach any of these representations or
warranties. In addition, we may be required to repurchase mortgage loans as a
result of borrower, broker, or employee fraud. Likewise, we are required to
repurchase or substitute mortgage loans if we breach a representation or
warranty in connection with our securitizations.  Enforcement of
repurchase obligations against us would further harm our liquidity, cash flow,
financial condition and ability to continue as a going concern.
 
 Credit
Deterioration - The residential mortgage market has encountered
significant difficulties which have materially adversely affected our
performance. Delinquencies and losses with respect to residential mortgage loans
generally have increased and are likely to increase, particularly in the
sub-prime sector. In addition, over the last year residential property values in
most states have declined, in some areas severely, after extended periods during
which those values appreciated.  To the extent residential property
values continue to decline, it is likely to result in additional increases in
delinquencies and losses on residential mortgage loans, 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 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, borrowers with option ARM mortgage loans with a negative amortization
feature may experience a substantial increase in their monthly payment even
without an increase in prevailing market interest rates when the loans reach
their negative amortization cap. Compounding this issue, the current lack of
appreciation in residential property values and the adoption of tighter
underwriting standards throughout the mortgage loan industry has adversely
affected 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, the value of our mortgage securities and the mortgage loans held
in our portfolio will be further reduced, which will adversely affect our
operating results, liquidity, cash flow, financial condition, business prospects
and ability to continue as a going concern.
  33




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 our one
reportable segment, which is our mortgage portfolio management segment.
Management has discussed the development and selection of these critical
accounting estimates with the audit committee of our Board of Directors and the
audit committee has reviewed our disclosure.





Transfers of
Assets (Loan and Mortgage Security Securitizations) and Related Gains. In
a loan securitization, we combined the mortgage loans we originated and
purchased in pools to serve as collateral for asset-backed bonds. In a mortgage
security securitization (also known as a “resecuritization”), we combined
mortgage securities retained in previous loan securitization transactions to
serve as collateral for asset-backed bonds. The loans or mortgage securities
were transferred to a trust designed to serve only for the purpose of holding
the collateral. The trust is considered a qualifying special purpose entity as
defined by SFAS 140. The owners of the asset-backed bonds have no recourse to us
in the event the collateral does not perform as planned except where defects
have occurred in the loan documentation and underwriting process.





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




 ̈
              Have
      the transferred assets been isolated from the
  transferor?
  ̈
              Does
      the transferee have the right to pledge or exchange the transferred
      assets?
  ̈
              Is
      there a “call” agreement that requires the transfereeto return specific
      assets?
  ̈
              Is
      there an agreement that both obligates and entitles the transferee to
      return the transferred assets prior to
maturity?
  ̈
              Have
      any derivative instruments been
transferred?





When
these transfers were executed in a manner such that we surrendered control over
the collateral, the transfer was accounted for as a sale. In accordance with
SFAS 140, a gain or loss on the sale was recognized based on the carrying amount
of the financial assets involved in the transfer, allocated between the assets
transferred and the retained interests based on their relative fair value at the
date of transfer. In a securitization accounted for as a sale, we retained (but
have subsequently sold) the right to service the underlying mortgage loans and
we also retained 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 used
two methodologies for determining the initial value of our residual securities:
1) the whole loan price methodology and 2) the discount rate methodology. We
generally tried to use the whole loan price methodology when significant open
market sales pricing data was available. Under this method, the initial value of
the loans transferred in a securitization accounted for as a sale was estimated
based on the expected open market sales price of a similar pool. In open market
transactions, the purchaser has the right to reject loans at its discretion. In
a loan securitization, loans generally cannot be rejected. As a result, we
adjusted the market price for the loans to compensate for the estimated value of
rejected loans. The market price of the securities retained was derived by
deducting the percent of net proceeds received in the securitization (i.e. the
economic value of the loans transferred) from the estimated adjusted market
price for the entire pool of the loans.





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





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


34


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





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





When we
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
executed for loans we securitized include a removal of accounts provision which
gives the servicer the right, but not the obligation, to repurchase from the
trust loans that are 90 days to 119 days delinquent. While we retained these
servicing rights, we recorded the mortgage loans subject to the removal of
accounts provision in mortgage loans held-for-sale at fair value and the related
repurchase obligation as a liability. However, in November 2007 we sold all of
our mortgage servicing rights, including the removal of accounts rights, to a
third party, which resulted in the removal of the mortgage loans subject to the
removal of accounts provision from our balance sheet.  In addition, we
retained a “clean up” call option that 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.  However, we
subsequently sold these clean up call rights, in part, to the buyer of our
mortgage servicing rights, and we do not expect to exercise any of the call
rights that we retained.




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




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




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





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


35


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





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





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





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





Mortgage
Loans. Mortgage loans held-for-sale are recorded at the lower of cost or
market  based on two categories.  All loans that had
mortgage insurance were marked down to a value which reflects the Company’s best
estimate of net realizable value.  All loans which did not have
mortgage insurance were valued at zero due to their nonperforming
characteristics. 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-for-sale are recorded in the “Assets of
discontinued operations” line item of the condensed consolidated balance
sheets.  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
and current economic conditions, experience and trends. We pay mortgage
insurance premiums on a portion of the loans maintained on our balance sheet and
have included the cost of mortgage insurance in our statement of
operations.





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.





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


36


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





Derivative
instruments that 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 long-term borrowings collateralized by our loans
held-in-portfolio.





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





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





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





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





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





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


37


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





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





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





Impact
of Recently Issued Accounting Pronouncements





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





In
December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements” (SFAS 160), which
requires consolidated net income to be reported at amounts that include the
amounts attributable to both the parent and non-controlling
interest.  SFAS 160 is effective for fiscal years beginning on or
after December 15, 2008.  The adoption of this standard is not
expected to have a material effect on our consolidated financial
statements.





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





In April
2008, the FASB issued FASB Staff Position (“FSP”) No. SFAS 142-3, “Determination
of the Useful Life of Intangible Assets” (FSP SFAS 142-3). FSP SFAS 142-3 amends
paragraph 11(d) of FASB Statement No. 142 “Goodwill and Other Intangible Assets”
(SFAS 142) which amends the factors that should be considered in developing
renewal or extension assumptions used to determine the useful life of a
recognized intangible asset under SFAS 142. FSP SFAS 142-3 is intended to
improve the consistency between the useful life of a recognized intangible asset
under SFAS 142 and the period of expected cash flows used to measure the fair
value of the asset. FSP SFAS 142-3 is effective for financial statements issued
for fiscal years beginning after December 15, 2008 and must be applied
prospectively to intangible assets acquired after the effective date. We are
evaluating the impact that adoption of FSP SFAS 142-3 will have on our
consolidated financial statements.





In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles” (SFAS 162”).  SFAS 162 identifies the sources of
accounting principles and the framework for selecting principles to be used in
the preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles in the
United States.  This statement shall be effective 60 days following the
SEC’s approval of the Public Company Accounting Oversight Board’s amendments to
the PCAOB’s Interim Auditing Standards (AU) section 411, The Meaning of Present
Fairly in Conformity with Generally Accepted Accounting Principles. The Company
is in the process of evaluating the potential effect of adoption of
SFAS 162.


38


Results
of Operations – Consolidated Earnings Comparisons





Six
Months Ended June 30, 2008 as Compared to the Six Months Ended June 30,
2007





See the
“Executive Overview of Performance” for discussion of the results of operations
for the six months ended June 30, 2008 as compared to the six months ended June
30, 2007.





Three
Months Ended June 30, 2008 as Compared to the Three Months Ended June 30,
2007





See the
“Executive Overview of Performance” for discussion of the results of operations
for the three months ended June 30, 2008 as compared to the three months ended
June 30, 2007.





Net
Interest Loss





We earn
interest income primarily on our mortgage assets which include mortgage
securities available-for-sale, mortgage securities trading and mortgage loans
held-in-portfolio. In addition we earn interest income on available cash we hold
for general operating needs. Interest expense consists primarily of interest
paid on borrowings secured by mortgage assets, which includes asset backed bonds
and, to a lesser extent, warehouse repurchase agreements.





The
following table provides the components of net interest income for the six and
three months ended June 30, 2008 and 2007.





Table
2— Net Interest Loss


(dollars
in thousands)


For
      the Six Months
                                                              
                                                              
                                                              For
      the Three MonthsEnded
      June 30,
                                                              
                                                              
                                                              Ended
      June 30,2008
                                                              
                                                              
                                                              2007
                                                              
                                                              
                                                              2008
                                                              
                                                              
                                                              2007Interest
      income:Mortgage
      securities
                                                              
                                                              $
                                                              26,758
                                                              
                                                              
                                                              $
                                                              60,348
                                                              
                                                              
                                                              $
                                                              12,028
                                                              
                                                              
                                                              $
                                                              28,634Mortgage
      loans held-in-portfolio
                                                              
                                                              
                                                              103,312
                                                              
                                                              
                                                              
                                                              123,740
                                                              
                                                              
                                                              
                                                              47,287
                                                              
                                                              
                                                              
                                                              73,760Other
      interest income
                                                              
                                                              
                                                              938
                                                              
                                                              
                                                              
                                                              3,667
                                                              
                                                              
                                                              
                                                              227
                                                              
                                                              
                                                              
                                                              1,701Total
      interest income
                                                              
                                                              
                                                              131,008
                                                              
                                                              
                                                              
                                                              187,755
                                                              
                                                              
                                                              
                                                              59,542
                                                              
                                                              
                                                              
                                                              104,095Interest
      expense:Short-term
      borrowings secured by mortgage securities
                                                              
                                                              
                                                              434
                                                              
                                                              
                                                              
                                                              12,446
                                                              
                                                              
                                                              
                                                              58
                                                              
                                                              
                                                              
                                                              6,159Asset-backed
      bonds secured by mortgage loans
                                                              
                                                              
                                                              54,929
                                                              
                                                              
                                                              
                                                              91,306
                                                              
                                                              
                                                              
                                                              24,569
                                                              
                                                              
                                                              
                                                              52,555Asset-backed
      bonds secured by mortgage securities
                                                              
                                                              
                                                              6,606
                                                              
                                                              
                                                              
                                                              7,867
                                                              
                                                              
                                                              
                                                              2,921
                                                              
                                                              
                                                              
                                                              5,152Junior
      subordinated debentures
                                                              
                                                              
                                                              3,314
                                                              
                                                              
                                                              
                                                              4,057
                                                              
                                                              
                                                              
                                                              1,453
                                                              
                                                              
                                                              
                                                              2,035Total
      interest expense
                                                              
                                                              
                                                              65,283
                                                              
                                                              
                                                              
                                                              115,676
                                                              
                                                              
                                                              
                                                              29,001
                                                              
                                                              
                                                              
                                                              65,901Net
      interest income before provision for credit losses
                                                              
                                                              
                                                              65,725
                                                              
                                                              
                                                              
                                                              72,079
                                                              
                                                              
                                                              
                                                              30,541
                                                              
                                                              
                                                              
                                                              38,194Provision
      for credit losses
                                                              
                                                              
                                                              (461,436
                                                              )
                                                              
                                                              
                                                              (93,167
                                                              )
                                                              
                                                              
                                                              (212,120
                                                              )
                                                              
                                                              
                                                              (73,254
                                                              )Net
      interest loss
                                                              
                                                              $
                                                              (395,711
                                                              )
                                                              
                                                              $
                                                              (21,088
                                                              )
                                                              
                                                              $
                                                              (181,579
                                                              )
                                                              
                                                              $
                                                              (35,060
                                                              )





Our net
interest loss after provision for credit losses was $(395.7) million and
$(181.6) million for the six and three months ended June 30, 2008 as compared to
$(21.1) and $(35.1) million for the same periods in 2007.  The main
driver behind this significant decline was an increase in the provision for
credit losses as a result of the continued credit deterioration of our mortgage
loans – held-in-portfolio and an increase in the anticipated severity of the
credit losses.  The principal balance of loans delinquent greater than
60 days increased by 97%, or approximately $411.1 million from December 31,
2007.  See Table 7 for a breakdown of our mortgage loans –
held-in-portfolio by delinquency category as of June 30, 2008 and December 31,
2007.  Significant factors contributing to the increase in over 60-day
delinquencies were:





·
            Continued
      decline in home prices;


·
            Continued
      weakness in the economy;


·
            Tighter
      underwriting standards within the mortgage industry making it difficult
      for borrowers to refinance; and


·
            As
      a result of the sale of our mortgage servicing rights, we no longer
      possess the ability to identify and address potential or actual
      delinquencies and defaults.


39


The
following tables summarize the expected credit loss assumption for our mortgage
loans – held-in-portfolio as of June 30, 2008 and December 31, 2007 both
currently and at the time of securitization.  The credit loss
assumptions are derived from our internally developed credit models which are
also used in the valuation of our residual securities.  Table 3
demonstrates the significant increase in our expected credit loss assumption, as
well as, the increase in the respective allowance for credit losses balance for
each securitization from December 31, 2007 to June 30, 2008. These increases
were driven by the significant increase in over 60-day delinquencies as
discussed above and shown in Table 7. The increase in expected credit losses was
also driven by a change in our home price appreciation (“HPA”)
assumptions.   Prior to December 31, 2007, we consistently used
an HPA assumption of 3.5% which was our best estimate as to long-term
HPA.  As the housing market continued to severely decline in 2007, we
revised our assumption at December 31, 2007 to -5.0% for year 1 and zero
thereafter.  At March 31, 2008, as new data was received and analyzed
and as facts and circumstances in the housing market continued to change, we
revised our HPA assumption to -10.0% for year 1, -5.0% for year 2 and +3.5%
thereafter.  These assumptions remained the same at June 30,
2008.





Table
3 — Expected Credit Loss Assumptions for our Mortgage Loans –
Held-in-Portfolio


(dollars
in thousands)




As
      of June 30, 2008:Securitization
                                                  Trust
                                                
                                                Original
                                                  Principal
                                                  Balance
                                                
                                                
                                                Current
                                                  Principal
                                                  Balance
                                                
                                                
                                                Allowance
                                                  for Credit
                                                  Losses
                                                
                                                
                                                Remaining
                                                  Expected
                                                  Credit
                                                  Losses(A)
                                                
                                                
                                                Original
                                                  Expected
                                                  Credit
                                                  Losses2006-1
                                                
                                                $
                                                1,350,000
                                                
                                                
                                                $
                                                582,119
                                                
                                                
                                                $
                                                141,602
                                                
                                                
                                                
                                                11.2
                                                %
                                                
                                                
                                                2.9
                                                %2006-MTA1
                                                
                                                
                                                1,199,013
                                                
                                                
                                                
                                                718,529
                                                
                                                
                                                
                                                166,560
                                                
                                                
                                                
                                                16.3
                                                
                                                
                                                
                                                1.72007-1
                                                
                                                
                                                1,888,756
                                                
                                                
                                                
                                                1,455,501
                                                
                                                
                                                
                                                308,528
                                                
                                                
                                                
                                                27.5
                                                
                                                
                                                
                                                6.2


(A)   Represents
expected credit losses over the entire life of the loans, net of mortgage
insurance.  Includes actual losses, net of mortgage insurance, to date and
expected credit losses over the remaining life of the loans, net of mortgage
insurance.




As
      of December 31, 2007:Securitization
      Trust
                                                  
                                                  Original
                                                    Principal
                                                    Balance
                                                  
                                                  Current
                                                    Principal
                                                    Balance
                                                  
                                                  Allowance
                                                    forCredit
                                                    Losses
                                                  
                                                  
                                                  Remaining
                                                    Expected
                                                    Credit
                                                    Losses(A)
                                                  
                                                  
                                                  Original
                                                    Expected
                                                    Credit
                                                    Losses2006-1
                                                  
                                                  
                                                  $
                                                  1,350,000
                                                  
                                                  
                                                  $
                                                  694,101
                                                  
                                                  
                                                  $
                                                  40,031
                                                  
                                                  
                                                  
                                                  6.5
                                                  %
                                                  
                                                  
                                                  2.9
                                                  %2006-MTA1
                                                  
                                                  
                                                  
                                                  1,199,013
                                                  
                                                  
                                                  
                                                  753,787
                                                  
                                                  
                                                  
                                                  27,312
                                                  
                                                  
                                                  
                                                  5.7
                                                  
                                                  
                                                  
                                                  1.72007-1
                                                  
                                                  
                                                  
                                                  1,888,756
                                                  
                                                  
                                                  
                                                  1,619,849
                                                  
                                                  
                                                  
                                                  162,795
                                                  
                                                  
                                                  
                                                  13.5
                                                  
                                                  
                                                  
                                                  6.2
 (A)   Represents
expected credit losses over the entire life of the loans, net of mortgage
insurance.  Includes actual losses, net of mortgage insurance, to date and
expected credit losses over the remaining life of the loans, net of mortgage
insurance.
 
 Activity
in the allowance for credit losses on mortgage loans – held-in-portfolio was as
follows for the six and three months ended June 30, 2008 and 2007 (dollars in
thousands):
 
 Table
4— Allowance for Credit Losses on Mortgage Loans –
Held-in-Portfolio
 (dollars
in thousands)
 For
      the Six Months Ended
                        June30,
                      
                      
                      For
      the Three Months Ended
                        June
      30,2008
                      
                      
                      2007
                      
                      
                      2008
                      
                      
                      2007Balance,
      beginning of period
                      
                      $
                      230,138
                      
                      
                      $
                      22,452
                      
                      
                      $
                      445,120
                      
                      
                      $
                      34,911Provision
      for credit losses
                      
                      
                      461,436
                      
                      
                      
                      93,167
                      
                      
                      
                      212,120
                      
                      
                      
                      73,254Charge-offs,
      net of recoveries
                      
                      
                      (74,884
                      )
                      
                      
                      (15,523
                      )
                      
                      
                      (40,550
                      )
                      
                      
                      (8,069
                      )Balance,
      end of period
                      
                      $
                      616,690
                      
                      
                      $
                      100,096
                      
                      
                      $
                      616,690
                      
                      
                      $
                      100,096
 
 Based on
generally accepted accounting principles we must maintain an allowance for
credit losses for our mortgage loans held-in-portfolio at a level that estimates
the probable losses inherent in the loan portfolio.  Because these
loans have been legally sold into securitization trusts in securitizations
treated as financings, the credit loss reduces the amount of our equity in the
related trust, which is generally the difference between the cost basis of the
trust’s assets (adjusted for credit loss allowances) and the trust’s liabilities
arising from third-party investor bond financing.  Although recourse
on the bond financing is limited to the assets of the trust, our equity in the
trust under generally accepted accounting principles will be reflected as a
negative amount when, as a result of the charge to earnings through our
provision for credit losses, the trust’s liabilities exceed the trust’s assets
under generally accepted accounting principles.  The following table
presents the assets and liabilities of our securitization trusts accounted for
as financing transactions as of June 30, 2008 and December 31, 2007, with “net
assets (deficiency)” being a reasonable indication of what the equity position
of each trust was as of the end of the period presented.
  40
  Table
5— Condensed Balance Sheet of Securitizations Accounted for as Financing
Transactions
 (dollars
in thousands)
 
 As of June 30, 2008:NHES
                                    
                                    
                                    NHES
                                    
                                    
                                    NHES2006-MTA1
                                    
                                    
                                    2006-1
                                    
                                    
                                    2007-1
                                    
                                    
                                    TotalsAssets:Mortgage
      loans – held-in-portfolioOutstanding
      principal
                                    
                                    $
                                    718,529
                                    
                                    
                                    $
                                    582,119
                                    
                                    
                                    $
                                    1,455,501
                                    
                                    
                                    $
                                    2,756,149Net
      unamortized deferred origination costs
                                    
                                    
                                    17,811
                                    
                                    
                                    
                                    4,450
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    22,261Allowance
      for credit losses
                                    
                                    
                                    (166,560
                                    )
                                    
                                    
                                    (141,602
                                    )
                                    
                                    
                                    (308,528
                                    )
                                    
                                    
                                    (616,690
                                    )Mortgage
      loans – held-in-portfolio
                                    
                                    
                                    569,780
                                    
                                    
                                    
                                    444,967
                                    
                                    
                                    
                                    1,146,973
                                    
                                    
                                    
                                    2,161,720Accrued
      interest receivable
                                    
                                    
                                    12,374
                                    
                                    
                                    
                                    17,901
                                    
                                    
                                    
                                    35,764
                                    
                                    
                                    
                                    66,039Real
      estate owned
                                    
                                    
                                    4,979
                                    
                                    
                                    
                                    21,745
                                    
                                    
                                    
                                    39,815
                                    
                                    
                                    
                                    66,539Total
      assets
                                    
                                    $
                                    587,133
                                    
                                    
                                    $
                                    484,613
                                    
                                    
                                    $
                                    1,222,552
                                    
                                    
                                    $
                                    2,294,298Liabilities:Asset-backed
      bonds secured by mortgage loans
                                    
                                    $
                                    713,016
                                    
                                    
                                    $
                                    598,918
                                    
                                    
                                    $
                                    1,472,366
                                    
                                    
                                    $
                                    2,784,301Other
      liabilities
                                    
                                    
                                    6,521
                                    
                                    
                                    
                                    24,735
                                    
                                    
                                    
                                    59,931
                                    
                                    
                                    
                                    91,186Total
      liabilities
                                    
                                    
                                    719,537
                                    
                                    
                                    
                                    623,653
                                    
                                    
                                    
                                    1,532,297
                                    
                                    
                                    
                                    2,875,487Net
      deficiency
                                    
                                    
                                    (132,404
                                    )
                                    
                                    
                                    (139,040
                                    )
                                    
                                    
                                    (309,745
                                    )
                                    
                                    
                                    (581,189
                                    )Total
      liabilities and net deficiency
                                    
                                    $
                                    587,133
                                    
                                    
                                    $
                                    484,613
                                    
                                    
                                    $
                                    1,222,552
                                    
                                    
                                    $
                                    2,294,298
 
 As
      of December 31, 2007:NHES
                                
                                
                                NHES
                                
                                
                                NHES2006-MTA1
                                
                                
                                2006-1
                                
                                
                                2007-1
                                
                                
                                TotalsAssets:Mortgage
      loans – held-in-portfolioOutstanding
      principal
                                
                                $
                                753,787
                                
                                
                                $
                                694,101
                                
                                
                                $
                                1,619,849
                                
                                
                                $
                                3,067,737Net
      unamortized deferred origination costs
                                
                                
                                27,177
                                
                                
                                
                                5,237
                                
                                
                                
                                -
                                
                                
                                
                                32,414Allowance
      for credit losses
                                
                                
                                (27,312
                                )
                                
                                
                                (40,031
                                )
                                
                                
                                (162,795
                                )
                                
                                
                                (230,138
                                )Mortgage
      loans – held-in-portfolio
                                
                                
                                753,652
                                
                                
                                
                                659,307
                                
                                
                                
                                1,457,054
                                
                                
                                
                                2,870,013Accrued
      interest receivable
                                
                                
                                14,091
                                
                                
                                
                                14,238
                                
                                
                                
                                33,375
                                
                                
                                
                                61,704Real
      estate owned
                                
                                
                                4,851
                                
                                
                                
                                32,126
                                
                                
                                
                                39,637
                                
                                
                                
                                76,614Total
      assets
                                
                                $
                                772,594
                                
                                
                                $
                                705,671
                                
                                
                                $
                                1,530,066
                                
                                
                                $
                                3,008,331Liabilities:Asset-backed
      bonds secured by mortgage loans
                                
                                $
                                748,182
                                
                                
                                $
                                714,476
                                
                                
                                $
                                1,603,088
                                
                                
                                $
                                3,065,746Other
      liabilities
                                
                                
                                5,751
                                
                                
                                
                                19,927
                                
                                
                                
                                45,087
                                
                                
                                
                                70,765Total
      liabilities
                                
                                
                                753,933
                                
                                
                                
                                734,403
                                
                                
                                
                                1,648,175
                                
                                
                                
                                3,136,511Net
      assets (deficiency)
                                
                                
                                18,661
                                
                                
                                
                                (28,732
                                )
                                
                                
                                (118,109
                                )
                                
                                
                                (128,180
                                )Total
      liabilities and net assets (deficiency)
                                
                                $
                                772,594
                                
                                
                                $
                                705,671
                                
                                
                                $
                                1,530,066
                                
                                
                                $
                                3,008,331
 
 (Losses) Gains on
Derivative Instruments. The derivative instruments on our balance sheet
which are not included in discontinued operations represent derivative
instruments which have been transferred into our securitization trusts
structured as financings.  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. Derivative
instruments transferred into a securitization trust are administered by the
trustee in accordance with the trust documents.
  41
  We also
entered into three credit default swaps (“CDS”) during 2007 as part of our CDO
transaction previously discussed.  The CDS had a notional amount of
$16.5 million and a fair value of $6.1 million at the date of purchase and are
pledged as collateral against the CDO ABB.  At June 30, 2008 and
December 31, 2007 the fair value was $0.9 million and $2.5 million,
respectively, and we recorded losses related to fair value adjustments of $1.1
million and $0.4 million for the six and three months ended June 30,
2008.   The CDS are included in the “Other assets” line item of
the condensed consolidated balance sheets.
 
 As a
result of declining interest rates in the first quarter, modestly increasing
interest rates in the second quarter, and declining values of the CDS, the
(losses) gains on derivative instruments from continuing operations were $(10.6)
million and $5.0 million for the six and three months ended June 30, 2008 as
compared to gains of $6.5 million and 6.1 million for the same periods of
2007.
 
 Gains on Debt
Extinguishment. We recorded gains on debt extinguish for the six and
three months ended June 30, 2008 of $6.4 million and $6.4 million,
respectively.  There were no gains recorded for the same periods of
2007.  On May 29, 2008, we purchased trust preferred securities of
NovaStar Capital Trust II having a par value of $6.9 million for $0.6
million.  As a result, $6.9 million of principal and accrued interest
of $0.2 million of the Notes was retired and the principal amount, accrued
interest, and related unamortized debt issuance costs related to these Notes
were removed from the balance sheet at June 30, 2008 resulting in a gain of $6.4
million.
 
 Fair Value
Adjustments.  We recorded net losses due to fair value
adjustments of $22.7 million and $10.0 million related to our trading securities
and the asset-backed bonds issued in our CDO transaction for the six and three
months ended June 30, 2008 compared to losses of $26.2 and $16.7 million for the
same periods of 2007.  The trading securities had fair value losses of
approximately $74.9 million and $23.3 million for the six and three months ended
June 30, 2008 compared to $89.7 million and $39.7 million for the same periods
in 2007.  The CDO asset-backed bonds had fair value gains of $52.2
million and $13.2 million for the six and three months ended June 30, 2008
compared to $63.5 million and $22.9 million for the same periods in
2007.  These adjustments were a result of poor credit performance of
the underlying mortgage loans mainly due to significant declines in housing
prices.
 
 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, 2008 we recorded impairment losses of
$21.2 million and $1.8 million, respectively as compared to a $26.0 million and
$22.6 million impairment losses for the same periods of 2007.  The
impairments during the six and three months ended June 30, 2008 were driven by
slower prepayment speeds resulting in a decline in our prepayment penalty cash
flows.  During the six months ended June 30, 2007 impairments were
mainly driven by increasing credit losses.
 
 Servicing Fee
Expense.We
recorded servicing fee expense of $7.1 million and $3.4 million for the six and
three months ended June 30, 2008, respectively.  There was no
servicing fee expense for the same periods of 2007.  Servicing fee
expense consists of expenses paid for our mortgage loans – held-in-portfolio
serviced by a third party.  These amounts 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 by the
servicer.  As previously disclosed during 2007, we sold our mortgage
servicing rights which subsequently resulted in the abandonment of our servicing
operations, prior to this we did not incur any servicing fee expenses as we
serviced our own loans.
 
 General and
Administrative Expenses.
The main categories of our general and administrative expenses are: compensation
and benefits, office administration, professional and outside services and
travel 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. Travel and other
expense primarily includes miscellaneous banking fees, travel and entertainment
expenses. General and administrative expenses were $12.3 million and $5.4
million for the six and three months ended June 30, 2008, as compared to $40.1
million and $17.7 million for the same periods in 2007.  Generally,
the decrease in all of the general and administrative expense categories was the
result of the shutdown of our mortgage lending and loan servicing segments in
2007.  Also contributing to the decline from 2007 was the $4.7 million
charge for debt issuance costs related to the CDO transaction in the first
quarter of 2007.
 
 Income
Taxes
 
 Based on
the evidence available as of June 30, 2008 and December 31, 2007, including the
significant pre-tax losses incurred by us in 2007 and the first two quarters of
2008, the ongoing disruption to the credit markets, the liquidity issues facing
us and the decision by us to close all of our mortgage lending and loan
servicing operations, we believe that it is more likely than not that we will
not realize our deferred tax assets.  Based on these conclusions, we
recorded a valuation allowance against our entire net deferred tax assets as of
June 30, 2008 and December 31, 2007.
  42
  As of
June 30, 2008, we had not yet filed our 2007 federal net operating loss
carryback to offset our 2006 taxable income.  Accordingly, we recorded
additional interest of $0.8 million for the six and three months ended June 30,
2008 related to the balance due to the IRS, which is included in the “Accounts
payable and other liabilities” line item of our condensed consolidated balance
sheets.  We intend to offset the 2006 tax liability with the
receivable recorded for the projected 2007 federal net operating loss to be
carried back against our 2006 taxable income.
 
 The IRS
has completed their examination of the 2005 federal income tax return of NFI
Holding Corporation, a wholly-owned subsidiary.  There were no
adjustments as a result of this exam.
 
 Discontinued
Operations
 
 June
30, 2008 as Compared to June 30, 2007
 
 See the
“Executive Overview of Performance” for discussion of the results of operations
for the six and three months ended June 30, 2008 as compared to the six and
three months ended June 30, 2007.
 
 Financial
Condition
 
 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, 2008.
 
 Table
      6 — Rollforward of Mortgage Loans - Held-in-Portfolio
                            (dollars
      in thousands)June 30,
                            2008Beginning
      principal balance
                          
                          $
                          3,067,737Borrower
      repayments
                          
                          
                          (194,022
                          )Capitalization
      of interest
                          
                          
                          14,355Transfers
      to real estate owned
                          
                          
                          (131,922
                          )Ending
      principal balance
                          
                          
                          2,756,149Net
      unamortized deferred origination costs
                          
                          
                          22,261Amortized
      cost
                          
                          
                          2,778,410Allowance
      for credit losses
                          
                          
                          (616,690
                          )Mortgage
      loans held-in-portfolio
                          
                          $
                          2,161,720
 
 The
following table provides delinquency information for our loans classified as
held-in-portfolio as of June 30, 2008 and December 31, 2007.
  Table
      7 — Mortgage Loans – Held-in-Portfolio Delinquencies
                                    (dollars
      in thousands)As of June 30, 2008
                                  
                                  
                                  As of December 31, 2007Current Principal
                                  
                                  
                                  Percent
                                    of Total
                                  
                                  
                                  Current Principal
                                  
                                  
                                  Percent of
                                    TotalCurrent
                                  
                                  $
                                  1,781,508
                                  
                                  
                                  
                                  65
                                  %
                                  
                                  $
                                  2,484,386
                                  
                                  
                                  
                                  81
                                  %30-59
      days delinquent
                                  
                                  
                                  138,541
                                  
                                  
                                  
                                  5
                                  
                                  
                                  
                                  158,366
                                  
                                  
                                  
                                  560-89
      days delinquent
                                  
                                  
                                  116,919
                                  
                                  
                                  
                                  4
                                  
                                  
                                  
                                  98,039
                                  
                                  
                                  
                                  390
      + days delinquent
                                  
                                  
                                  381,636
                                  
                                  
                                  
                                  14
                                  
                                  
                                  
                                  150,811
                                  
                                  
                                  
                                  5In
      process of foreclosure
                                  
                                  
                                  337,545
                                  
                                  
                                  
                                  12
                                  
                                  
                                  
                                  176,135
                                  
                                  
                                  
                                  6Total
      principal
                                  
                                  $
                                  2,756,149
                                  
                                  
                                  
                                  100
                                  %
                                  
                                  $
                                  3,067,737
                                  
                                  
                                  
                                  100
                                  %
  43
  Mortgage
Securities Available-for-Sale and Trading.
 
 The
following tables summarize our mortgage securities – available-for-sale and
trading portfolios and the current assumptions as of June 30, 2008 and December
31, 2007.
 
 Table
8 — Valuation and Assumptions for Individual Mortgage Securities –
Available-for-Sale and Trading (dollars in thousands):
 
 As
      of June 30, 2008Current
      Assumptions
                                                  
                                                  
                                                  Current
      Valuation AssumptionsSecuritization
                                                    Trust
                                                  
                                                  Cost
      (A)
                                                  
                                                  
                                                  Unrealized
                                                    Gain
      (loss)
                                                    (A)
                                                  
                                                  
                                                  Estimated
                                                    Fair Value
                                                    of
                                                    Mortgage
      Securities
                                                    (A)
                                                  
                                                  
                                                  Discount
                                                    Rate
                                                  
                                                  
                                                  Constant
                                                    Prepayment
                                                    Rate
                                                  
                                                  
                                                  Expected
                                                    Credit
                                                    Losses
      (B)
                                                  
                                                  
                                                  Discount
                                                    Rate
                                                  
                                                  
                                                  Constant
                                                    Prepayment
                                                    Rate
                                                  
                                                  
                                                  Expected
                                                    Credit
                                                    Losses
                                                    (B)NMFT
      Series – Available-for-Sale:2002-3
                                                  
                                                  $
                                                  1,507
                                                  
                                                  
                                                  $
                                                  531
                                                  
                                                  
                                                  $
                                                  2,038
                                                  
                                                  
                                                  
                                                  25
                                                  %
                                                  
                                                  
                                                  13
                                                  %
                                                  
                                                  
                                                  0.7
                                                  %
                                                  
                                                  
                                                  20
                                                  %
                                                  
                                                  
                                                  30
                                                  %
                                                  
                                                  
                                                  1.0
                                                  %2003-1
                                                  
                                                  
                                                  2,151
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  2,151
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  10
                                                  
                                                  
                                                  
                                                  2.0
                                                  
                                                  
                                                  
                                                  20
                                                  
                                                  
                                                  
                                                  28
                                                  
                                                  
                                                  
                                                  3.32003-2
                                                  
                                                  
                                                  953
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  953
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  10
                                                  
                                                  
                                                  
                                                  1.7
                                                  
                                                  
                                                  
                                                  28
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  2.72003-3
                                                  
                                                  
                                                  249
                                                  
                                                  
                                                  
                                                  2
                                                  
                                                  
                                                  
                                                  251
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  9
                                                  
                                                  
                                                  
                                                  2.5
                                                  
                                                  
                                                  
                                                  20
                                                  
                                                  
                                                  
                                                  22
                                                  
                                                  
                                                  
                                                  3.62003-4
                                                  
                                                  
                                                  12
                                                  
                                                  
                                                  
                                                  20
                                                  
                                                  
                                                  
                                                  32
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  11
                                                  
                                                  
                                                  
                                                  2.8
                                                  
                                                  
                                                  
                                                  20
                                                  
                                                  
                                                  
                                                  30
                                                  
                                                  
                                                  
                                                  5.12004-1
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  15
                                                  
                                                  
                                                  
                                                  40
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  14
                                                  
                                                  
                                                  
                                                  2.9
                                                  
                                                  
                                                  
                                                  20
                                                  
                                                  
                                                  
                                                  33
                                                  
                                                  
                                                  
                                                  5.92004-2
                                                  
                                                  
                                                  40
                                                  
                                                  
                                                  
                                                  4
                                                  
                                                  
                                                  
                                                  44
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  13
                                                  
                                                  
                                                  
                                                  3.2
                                                  
                                                  
                                                  
                                                  26
                                                  
                                                  
                                                  
                                                  31
                                                  
                                                  
                                                  
                                                  5.12004-3
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  97
                                                  
                                                  
                                                  
                                                  97
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  14
                                                  
                                                  
                                                  
                                                  4.0
                                                  
                                                  
                                                  
                                                  19
                                                  
                                                  
                                                  
                                                  34
                                                  
                                                  
                                                  
                                                  4.52004-4
                                                  
                                                  
                                                  13
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  13
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  16
                                                  
                                                  
                                                  
                                                  3.7
                                                  
                                                  
                                                  
                                                  26
                                                  
                                                  
                                                  
                                                  35
                                                  
                                                  
                                                  
                                                  4.02005-1
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  17
                                                  
                                                  
                                                  
                                                  5.0
                                                  
                                                  
                                                  
                                                  15
                                                  
                                                  
                                                  
                                                  37
                                                  
                                                  
                                                  
                                                  3.62005-2
                                                  
                                                  
                                                  1
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  1
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  15
                                                  
                                                  
                                                  
                                                  6.2
                                                  
                                                  
                                                  
                                                  13
                                                  
                                                  
                                                  
                                                  39
                                                  
                                                  
                                                  
                                                  2.12005-3
                                                  
                                                  
                                                  105
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  105
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  16
                                                  
                                                  
                                                  
                                                  8.0
                                                  
                                                  
                                                  
                                                  15
                                                  
                                                  
                                                  
                                                  41
                                                  
                                                  
                                                  
                                                  2.02005-4
                                                  
                                                  
                                                  112
                                                  
                                                  
                                                  
                                                  64
                                                  
                                                  
                                                  
                                                  176
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  17
                                                  
                                                  
                                                  
                                                  9.1
                                                  
                                                  
                                                  
                                                  15
                                                  
                                                  
                                                  
                                                  43
                                                  
                                                  
                                                  
                                                  2.32006-2
                                                  
                                                  
                                                  322
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  322
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  20
                                                  
                                                  
                                                  
                                                  12.7
                                                  
                                                  
                                                  
                                                  15
                                                  
                                                  
                                                  
                                                  44
                                                  
                                                  
                                                  
                                                  2.42006-3
                                                  
                                                  
                                                  500
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  500
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  20
                                                  
                                                  
                                                  
                                                  14.4
                                                  
                                                  
                                                  
                                                  15
                                                  
                                                  
                                                  
                                                  43
                                                  
                                                  
                                                  
                                                  3.02006-4
                                                  
                                                  
                                                  561
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  561
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  21
                                                  
                                                  
                                                  
                                                  14.5
                                                  
                                                  
                                                  
                                                  15
                                                  
                                                  
                                                  
                                                  43
                                                  
                                                  
                                                  
                                                  2.92006-5
                                                  
                                                  
                                                  844
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  844
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  20
                                                  
                                                  
                                                  
                                                  17.8
                                                  
                                                  
                                                  
                                                  15
                                                  
                                                  
                                                  
                                                  43
                                                  
                                                  
                                                  
                                                  3.92006-6
                                                  
                                                  
                                                  1,039
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  1,039
                                                  
                                                  
                                                  
                                                  25
                                                  
                                                  
                                                  
                                                  19
                                                  
                                                  
                                                  
                                                  18.2
                                                  
                                                  
                                                  
                                                  15
                                                  
                                                  
                                                  
                                                  41
                                                  
                                                  
                                                  
                                                  3.7Total
                                                  
                                                  $
                                                  8,434
                                                  
                                                  
                                                  $
                                                  733
                                                  
                                                  
                                                  $
                                                  9,167NMFT
      Series – Trading Securities:2007-2
                                                  
                                                  $
                                                  28,422
                                                  
                                                  
                                                  $
                                                  (13,949
                                                  )
                                                  
                                                  $
                                                  14,473
                                                  
                                                  
                                                  
                                                  25
                                                  %
                                                  
                                                  
                                                  16
                                                  %
                                                  
                                                  
                                                  21.9
                                                  %
                                                  
                                                  
                                                  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.
  44
 
 As
      of December 31, 2007Current
      Assumptions
                                                    
                                                    
                                                    Current
      Valuation AssumptionsSecuritization
                                                      Trust
                                                    
                                                    Cost
      (A)
                                                    
                                                    
                                                    Unrealized
                                                      Gain
      (loss)
                                                      (A)
                                                    
                                                    
                                                    Estimated
                                                      Fair
      Value
                                                      of
                                                      Mortgage
      Securities
                                                      (A)
                                                    
                                                    
                                                    Discount
                                                      Rate
                                                    
                                                    
                                                    Constant
                                                      Prepayment
                                                      Rate
                                                    
                                                    
                                                    Expected
                                                      Credit
                                                      Losses
      (B)
                                                    
                                                    
                                                    Discount
                                                      Rate
                                                    
                                                    
                                                    Constant
                                                      Prepayment
                                                      Rate
                                                    
                                                    
                                                    Expected
                                                      Credit
                                                      Losses
                                                      (B)NMFT
      Series – Available-for-Sale:2002-3
                                                    
                                                    $
                                                    1,932
                                                    
                                                    
                                                    $
                                                    -
                                                    
                                                    
                                                    $
                                                    1,932
                                                    
                                                    
                                                    
                                                    25
                                                    %
                                                    
                                                    
                                                    24
                                                    %
                                                    
                                                    
                                                    0.6
                                                    %
                                                    
                                                    
                                                    20
                                                    %
                                                    
                                                    
                                                    30
                                                    %
                                                    
                                                    
                                                    1.0
                                                    %2003-1
                                                    
                                                    
                                                    3,260
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    3,260
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    20
                                                    
                                                    
                                                    
                                                    1.7
                                                    
                                                    
                                                    
                                                    20
                                                    
                                                    
                                                    
                                                    28
                                                    
                                                    
                                                    
                                                    3.32003-2
                                                    
                                                    
                                                    2,817
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    2,817
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    18
                                                    
                                                    
                                                    
                                                    1.2
                                                    
                                                    
                                                    
                                                    28
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    2.72003-3
                                                    
                                                    
                                                    1,233
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    1,233
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    16
                                                    
                                                    
                                                    
                                                    1.2
                                                    
                                                    
                                                    
                                                    20
                                                    
                                                    
                                                    
                                                    22
                                                    
                                                    
                                                    
                                                    3.62003-4
                                                    
                                                    
                                                    1,279
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    1,279
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    20
                                                    
                                                    
                                                    
                                                    1.6
                                                    
                                                    
                                                    
                                                    20
                                                    
                                                    
                                                    
                                                    30
                                                    
                                                    
                                                    
                                                    5.12004-1
                                                    
                                                    
                                                    180
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    180
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    24
                                                    
                                                    
                                                    
                                                    2.4
                                                    
                                                    
                                                    
                                                    20
                                                    
                                                    
                                                    
                                                    33
                                                    
                                                    
                                                    
                                                    5.92004-2
                                                    
                                                    
                                                    180
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    180
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    23
                                                    
                                                    
                                                    
                                                    2.4
                                                    
                                                    
                                                    
                                                    26
                                                    
                                                    
                                                    
                                                    31
                                                    
                                                    
                                                    
                                                    5.12004-3
                                                    
                                                    
                                                    986
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    986
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    24
                                                    
                                                    
                                                    
                                                    3.0
                                                    
                                                    
                                                    
                                                    19
                                                    
                                                    
                                                    
                                                    34
                                                    
                                                    
                                                    
                                                    4.52004-4
                                                    
                                                    
                                                    48
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    48
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    26
                                                    
                                                    
                                                    
                                                    2.6
                                                    
                                                    
                                                    
                                                    26
                                                    
                                                    
                                                    
                                                    35
                                                    
                                                    
                                                    
                                                    4.02005-1
                                                    
                                                    
                                                    512
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    512
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    27
                                                    
                                                    
                                                    
                                                    3.6
                                                    
                                                    
                                                    
                                                    15
                                                    
                                                    
                                                    
                                                    37
                                                    
                                                    
                                                    
                                                    3.62005-2
                                                    
                                                    
                                                    642
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    642
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    24
                                                    
                                                    
                                                    
                                                    3.3
                                                    
                                                    
                                                    
                                                    13
                                                    
                                                    
                                                    
                                                    39
                                                    
                                                    
                                                    
                                                    2.12005-3
                                                    
                                                    
                                                    1,335
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    1,335
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    24
                                                    
                                                    
                                                    
                                                    3.6
                                                    
                                                    
                                                    
                                                    15
                                                    
                                                    
                                                    
                                                    41
                                                    
                                                    
                                                    
                                                    2.02005-3
      (C)
                                                    
                                                    
                                                    158
                                                    
                                                    
                                                    
                                                    69
                                                    
                                                    
                                                    
                                                    227
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    N/A
                                                    
                                                    
                                                    
                                                    N/A
                                                    
                                                    
                                                    
                                                    N/A
                                                    
                                                    
                                                    
                                                    N/A
                                                    
                                                    
                                                    
                                                    N/A2005-4
                                                    
                                                    
                                                    1,344
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    1,344
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    27
                                                    
                                                    
                                                    
                                                    4.5
                                                    
                                                    
                                                    
                                                    15
                                                    
                                                    
                                                    
                                                    43
                                                    
                                                    
                                                    
                                                    2.32005-4
      (C)
                                                    
                                                    
                                                    212
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    212
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    N/A
                                                    
                                                    
                                                    
                                                    N/A
                                                    
                                                    
                                                    
                                                    N/A
                                                    
                                                    
                                                    
                                                    N/A
                                                    
                                                    
                                                    
                                                    N/A2006-2
                                                    
                                                    
                                                    2,301
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    2,301
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    32
                                                    
                                                    
                                                    
                                                    6.8
                                                    
                                                    
                                                    
                                                    15
                                                    
                                                    
                                                    
                                                    44
                                                    
                                                    
                                                    
                                                    2.42006-3
                                                    
                                                    
                                                    2,994
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    2,994
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    31
                                                    
                                                    
                                                    
                                                    8.4
                                                    
                                                    
                                                    
                                                    15
                                                    
                                                    
                                                    
                                                    43
                                                    
                                                    
                                                    
                                                    3.02006-4
                                                    
                                                    
                                                    2,960
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    2,960
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    32
                                                    
                                                    
                                                    
                                                    8.2
                                                    
                                                    
                                                    
                                                    15
                                                    
                                                    
                                                    
                                                    43
                                                    
                                                    
                                                    
                                                    2.92006-5
                                                    
                                                    
                                                    4,217
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    4,217
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    31
                                                    
                                                    
                                                    
                                                    11.0
                                                    
                                                    
                                                    
                                                    15
                                                    
                                                    
                                                    
                                                    43
                                                    
                                                    
                                                    
                                                    3.92006-6
                                                    
                                                    
                                                    4,712
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    4,712
                                                    
                                                    
                                                    
                                                    25
                                                    
                                                    
                                                    
                                                    30
                                                    
                                                    
                                                    
                                                    10.0
                                                    
                                                    
                                                    
                                                    15
                                                    
                                                    
                                                    
                                                    41
                                                    
                                                    
                                                    
                                                    3.7Total
                                                    
                                                    $
                                                    33,302
                                                    
                                                    
                                                    $
                                                    69
                                                    
                                                    
                                                    $
                                                    33,371NMFT
      Series – Trading Securities:2007-2
                                                    
                                                    $
                                                    41,275
                                                    
                                                    
                                                    $
                                                    (13,959
                                                    )
                                                    
                                                    $
                                                    27,316
                                                    
                                                    
                                                    
                                                    25
                                                    %
                                                    
                                                    
                                                    20
                                                    %
                                                    
                                                    
                                                    12.5
                                                    %
                                                    
                                                    
                                                    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)
              Represents
      derivative cash flow bonds (“CT
Bonds”).
 
 As of
June 30, 2008 and December 31, 2007 the fair value of our mortgage securities –
available-for-sale was $9.2 million and $33.4 million, respectively. The decline
is mostly due to slower prepayment speeds resulting in a decline in our
prepayment penalty cashflows and an increase in expected credit losses and
normal paydowns.  The value of our mortgage securities –
available-for-sale, as well as the cash flows we receive from them, are highly
dependent upon interest rate spreads, as well as credit losses and prepayment
experience of the borrowers of the underlying mortgage security
collateral.
 
 Mortgage
Securities – Trading.
 
 The
following tables provide a summary of our portfolio of trading securities at
June 30, 2008 and December 31, 2007:
 
 Table
9 — Mortgage Securities - Trading
 (dollars
in thousands)
 
 As
      of June 30, 2008S&P Rating
                          
                          Original Face
                          
                          
                          Amortized Cost
                            Basis
                          
                          
                          Fair Value
                          
                          
                          Number of
                            Securities
                          
                          
                          Weighted
                            Average YieldSubordinated
      Securities:Investment
      Grade (A)
                          
                          
                          25,305
                          
                          
                          
                          24,386
                          
                          
                          
                          1,959
                          
                          
                          
                          6
                          
                          
                          
                          4.96
                          %Non-investment
      Grade (B)
                          
                          
                          409,809
                          
                          
                          
                          389,694
                          
                          
                          
                          16,763
                          
                          
                          
                          102
                          
                          
                          
                          6.31Total
      Subordinated Securities
                          
                          
                          435,114
                          
                          
                          
                          414,080
                          
                          
                          
                          18,722
                          
                          
                          
                          108
                          
                          
                          
                          6.17Residual
      Securities:Unrated
                          
                          
                          N/A
                          
                          
                          
                          24,228
                          
                          
                          
                          6,553
                          
                          
                          
                          2
                          
                          
                          
                          25.00Total
                          
                          $
                          435,114
                          
                          
                          $
                          438,308
                          
                          
                          $
                          25,275
                          
                          
                          
                          110
                          
                          
                          
                          11.05
                          %
 (A)
              Investment
      grade includes all securities with ratings above
  BB+.
 (B)
              Non-investment
      grade includes all securities with ratings below
  BBB-.
  45
 
 As
      of December 31, 2007S&P Rating
                          
                          Original Face
                          
                          
                          Amortized Cost Basis
                          
                          
                          Fair Value
                          
                          
                          Number of
                            Securities
                          
                          
                          Weighted
                            Average YieldSubordinated
      Securities:Investment
      Grade (A)
                          
                          $
                          389,881
                          
                          
                          $
                          367,581
                          
                          
                          $
                          80,004
                          
                          
                          
                          91
                          
                          
                          
                          11.46
                          %Non-investment
      Grade (B)
                          
                          
                          45,233
                          
                          
                          
                          38,514
                          
                          
                          
                          4,458
                          
                          
                          
                          17
                          
                          
                          
                          17.05Total
      Subordinated Securities
                          
                          
                          435,114
                          
                          
                          
                          406,095
                          
                          
                          
                          84,462
                          
                          
                          
                          108
                          
                          
                          
                          11.76Residual
      Securities:Unrated
                          
                          
                          N/A
                          
                          
                          
                          41,275
                          
                          
                          
                          24,741
                          
                          
                          
                          1
                          
                          
                          
                          21.00Total
                          
                          $
                          435,114
                          
                          
                          $
                          447,370
                          
                          
                          $
                          109,203
                          
                          
                          
                          109
                          
                          
                          
                          13.85
                          %
 (A)
              Investment
      grade includes all securities with ratings above
  BB+.
 (B)
              Non-investment
      grade includes all securities with ratings below
  BBB-.
 
 As of
June 30, 2008 and December 31, 2007, mortgage securities – trading consisted of
the NMFT Series 2007-2 residual security and subordinated securities retained by
the Company from securitization transactions as well as subordinated securities
purchased from other issuers in the open market. The aggregate fair market value
of these securities as of June 30, 2008 and December 31, 2007 was $25.3 million
and $109.2 million, respectively. Management estimates their fair value based on
quoted market prices for subordinated securities and by discounting the expected
future cash flows of the collateral and bonds for the residual securities. The
market value of our mortgage securities - trading have declined due to the
continued credit deterioration and an increase in the anticipated severity of
the credit losses in the underlying collateral. We recognized net trading losses
of $(74.9) million and $(23.3) million for the six and three months ended June
30, 2008 and $(89.7) million and $(39.7) million for the same periods in
2007.
 
 Real
Estate Owned.
 
 Real
estate owned relating to continuing operations at June 30, 2008 and December 31,
2007 was $66.5 million and $76.6 million, respectively.   This
change is directly related to the timing of foreclosures and subsequent
liquidations of real estate owned arising out of our NHES 2006-1, 2006-MTA1 and
2007-1 securitizations.  The stated amount of real estate owned on our
condensed consolidated balance sheet is net of expected future losses on the
sale of the property.
 
 Short-term
Borrowings.
 
 On May 9,
2008, we fully repaid all outstanding borrowings with Wachovia and all
agreements were terminated effective the same day. We have no further borrowing
capacity currently available to us. See “Liquidity and Capital Resources” for
further discussion of our financing availability and liquidity.
 
 Shareholders’
Deficit.
 
 The
increase in our shareholders’ deficit as of June 30, 2008 compared to December
31, 2007 is a result of the following increases and decreases.
 
 Shareholders’
deficit decreased by:
 ·
              $21.2
      million due to impairment on mortgage securities – available for sale
      reclassified to earnings; and
 ·
                $0.4
      million due to changes in other miscellaneous activity.·
                $0.2
      million due to adjustments on derivative instruments used in cash flow
      hedges reclassified to
earnings.
 
 
 Shareholders’
deficit increased by:
 ·
                $479.9
      million due to a net loss recognized for the six months ended June 30,
      2008, which includes a $461.4 million dollar provision for credit
      losses;
 ·
                  $20.6
      million due to the decrease in unrealized gains on mortgage securities
      classified as available-for-sale; and·
                  $6.7
      million due to dividends accrued on preferred
  stock.
 
 
 
  46
  
 As of
June 30, 2008, our total liabilities exceeded our total assets under GAAP,
resulting in a shareholders’ deficit. Our losses, negative cash flows from
operations and our shareholders’ deficit raise substantial doubt about our
ability to continue as a going concern, which is dependent upon, among other
things, the maintenance of sufficient operating cash flows.  There is
no assurance that cash flows will be sufficient to meet our
obligations.
 
 Contractual
Obligations
 
 We have
entered into certain long-term debt, hedging and lease agreements, which
obligate us to make future payments to satisfy the related contractual
obligations.
 
 The
following table summarizes our contractual obligations as of June 30,
2008.
  Table
10 — Contractual Obligations
 (dollars
      in thousands)Payments
      Due by PeriodContractual
      Obligations
                                  Total
                                  
                                  Less
      than 1
                                    Year
                                  
                                  1-3
      Years
                                  
                                  3-5
      Years
                                  
                                  More
      Than 5
                                    YearsLong—term
      debt (A)
                                  
                                  $
                                  3,468,753
                                  
                                  
                                  $
                                  729,034
                                  
                                  
                                  $
                                  958,441
                                  
                                  
                                  $
                                  782,349
                                  
                                  
                                  $
                                  998,929Junior
      subordinated debentures (B)
                                  
                                  
                                  211,591
                                  
                                  
                                  
                                  4,909
                                  
                                  
                                  
                                  9,817
                                  
                                  
                                  
                                  9,817
                                  
                                  
                                  
                                  187,048Operating
      leases (C)
                                  
                                  
                                  15,253
                                  
                                  
                                  
                                  6,020
                                  
                                  
                                  
                                  8,773
                                  
                                  
                                  
                                  460
                                  
                                  
                                  
                                  -Total
                                  
                                  $
                                  3,705,597
                                  
                                  
                                  $
                                  739,963
                                  
                                  
                                  $
                                  977,031
                                  
                                  
                                  $
                                  792,626
                                  
                                  
                                  $
                                  1,016,977
 (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, 2008 for each respective
      obligation.
 (B)
              The
      junior subordinated debentures are assumed to mature in 2035 and 2036 in
      computing the future payments. These amounts include expected interest
      payments on the obligations. Interest obligations on our junior
      subordinated debentures are based on the prevailing interest rate at June
      30, 2008 for each respective
obligation.
 (C)
              Does
      not include rental income of $2.2 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. Deferred lease incentives as of June 30,
2008 and 2007 were $0.8 million and $2.6 million, respectively.
  47
  Liquidity
and Capital Resources
 
 We had
$10.3 million in unrestricted cash and cash equivalents at June 30, 2008, which
was a decrease of $15.1 million from December 31, 2007.  As of August
18, 2008, we had approximately $14.9 million of unrestricted cash and cash
equivalents.
 
 Current Liquidity
and Near-Term Obligations.  Our current projections indicate
sufficient available cash and cash flows from our mortgage assets to meet these
short-term payment needs through 2008.  However, our mortgage asset cash
flows are currently volatile and uncertain in nature, and the amounts we receive
could vary materially from our projections.  Therefore, no assurances can
be given that we will be able to meet our cash flow needs, in which case we
would be required to seek protection of applicable bankruptcy laws.
 
 Collateralization
of letters of credit supporting surety bonds.Certain states required
that we post surety bonds in connection with our former mortgage lending
operations.  During 2007, we were required to post letters of credit
to support our reimbursement obligations to the sureties, and were required to
cash collateralize the letters of credit pursuant to our letter of credit
agreements with Wachovia Bank.  We are in the process of terminating
these surety bonds and the associated letters of credit as a result of the
discontinuation of our mortgage lending operations and have received back
collateral associated with letters of credit terminated to
date.  Collateral totaling $7.2 million remained outstanding as of
June 30, 2008, $1.1 million of which we have received back subsequent to June
30, 2008. Cancellation of the remaining surety bonds and related letters of
credit is subject to certain conditions and may take several months or longer to
complete.  In addition, we are currently in default under the letter
of credit agreements as a result of, among other matters, our default under debt
agreements related to our trust preferred securities, discussed further
below.  Although we have received a return of collateral
notwithstanding this default, Wachovia Bank is not obligated to return cash
collateral to us so long as a default exists.  Consequently, no
assurances can be given as to the timing or amount of any additional return of
the remaining cash collateral.
 
 Trust Preferred
Obligations.  Our wholly owned subsidiary NovaStar Mortgage,
Inc. (“NMI”) has approximately $77.1 million in principal amount of unsecured
notes (collectively, the “Notes”) outstanding to NovaStar Capital Trust I and
NovaStar Capital Trust II (collectively, the “Trusts”) which secure trust
preferred securities issued by the Trusts.  The foregoing is net of
amounts owed in respect of trust preferred securities of NovaStar Capital Trust
II having a par value of $6.9 million purchased by NMI on May 29, 2008 for $0.6
million.  We have guaranteed NMI's obligations under the
Notes.
 
 NMI
failed to make quarterly interest payments that were due on March 30, April 30,
June 30 and July 30, September 30, October 30, December 30, 2008 and January 30,
2009 totaling, for all payment dates combined, approximately $5.5 million on the
Notes.  As a result, NMI is in default under the related indentures
and we are in default under the related guarantees.  An agreement by
the trustees and trust preferred security holders of the Trusts to forbear in
the exercise of remedies with respect to the initial payment defaults expired on
May 30, 2008.  Consequently, the trustee and holders of 25% of the
outstanding trust preferred securities of each Trust have the right to
accelerate all principal, accrued interest, and other obligations of NMI under
the related Notes and to demand payment of all such amounts from us under the
related guarantees.  The total principal and accrued interest owed
under the Notes, net of amounts owed in respect of the trust preferred
securities held by NMI, was approximately $80.4 million as of August 18,
2008.   In addition, we are obligated to reimburse the trustees
for all reasonable expenses, disbursements and advances in connection with the
exercise of rights under the indentures.
 
 On June
4, 2008 and August 14, 2008, we received written notices of acceleration from
the holders of the trust preferred securities of NovaStar Capital Trust I and
NovaStar Capital Trust II, respectively, which declared all obligations of NMI
under the related Notes and indenture  to be immediately due and
payable, and stated the intention of the trust preferred security holders to
pursue all available rights and remedies, including but not limited to enforcing
their rights under the related guarantee.  As of August 18, 2008, our
aggregate obligation under the related Notes and indenture Notes is $77.1
million.  As of the date of filing, no suit has been filed to enforce
the holders’ rights under the indentures or the related guarantees.
 
 While we
are attempting to restructure the terms of the indentures, there can be no
assurance that we will be able to do so.   Enforcement of
remedies under the Notes and related indentures and guarantees would have a
material adverse effect on our financial condition and liquidity and would
likely cause us to seek the protection of applicable bankruptcy
laws.
  48
  Table
11 — Summary of Operating, Investing and Financing Cash Flows
 (dollars
      in thousands)For
      the Six Months Ended June
                                    30,
                                  
                                  (Decrease)
      /2008
                                  
                                  2007
                                  
                                  IncreaseConsolidated
      Statements of Cash Flows:Cash
      used in operating activities
                                  
                                  $
                                  (2,547
                                  )
                                  
                                  $
                                  (745,710
                                  )
                                  
                                  $
                                  743,163Cash
      flows provided by investing activities
                                  
                                  
                                  320,131
                                  
                                  
                                  
                                  579,514
                                  
                                  
                                  
                                  (259,383
                                  )Cash
      flows (used in) provided by financing activities
                                  
                                  
                                  (332,679
                                  )
                                  
                                  
                                  113,546
                                  
                                  
                                  
                                  (446,225
                                  )
 
 Operating Activities. Net
cash used in operating activities decreased by $743.2 million for the six months
ended June 30, 2008 as compared to the six months ended June 30,
2007.  We discontinued all servicing and lending operations and
therefore, used significantly less cash in operations.
 
 Investing Activities. Net
cash provided by investing activities decreased by $259.4 million for the six
months ended June 30, 2008 as compared to the same period of
2007.  Our mortgage loan portfolio has declined significantly
and borrower defaults have increased, resulting in lower repayments of our
mortgage loans held-in-portfolio for the six months ended June 30, 2008 as
compared to the first six months of 2007, along with an increase of the sale of
loans through foreclosure.   We also experienced a decrease in
paydowns on our mortgage securities – available-for-sale during the first six
months of 2008 as compared to the same period of 2007 as a result of poor credit
performance of the underlying loans.  Cash proceeds from the sale
of of assets acquired through foreclosure have increased as our
foreclosed loan activity has increased significantly.
 
 Financing Activities. Net
cash (used in) provided by financing activities decreased to $(332.7) million
for the six months ended June 30, 2008 from $113.5 million for the six months
ended June 30, 2007. The decrease is due to the issuance of $2.1 billion of
asset-backed bonds during the first quarter of 2007 from a CDO and loan
securitization both structured as financing transactions for accounting
purposes.  This was partially offset by paydowns of short-term
borrowings.  We also experienced a decrease in paydowns of our
asset-backed bonds during the first six months of 2008 as compared to the same
period of 2007.
 
 Primary Uses of
Cash
 
 Investments in
New Mortgage Securities.During 2007 we altered our operations
substantially when we discontinued our origination business.  Prior to
that, we retained significant interests in the nonconforming loans we originated
and purchased through our mortgage securities investment portfolio. Our
securitization activities required capital to fund the primary bonds we
retained, overcollateralization, securitization expenses and our operating costs
to originate the mortgage loans.
 
 For the
six months ended June 30, 2008, we retained no residual or subordinated
securities.  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 completed during that period. 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.
 
 Repayments of
Long-Term Borrowings.Our payments on asset-backed bonds decreased from
$474.6 million for the six months ended June 30, 2007 to $286.6 million for the
same period of 2008, respectively.  Due to the fact that we do not
intend to engage in any additional on-balance sheet securitizations in the
foreseeable future, we expect our payments on asset-backed bonds to decrease as
our current asset-backed bonds mature.
 
 In
addition, as of June 30, 2008, our wholly owned subsidiary NovaStar Mortgage,
Inc. had $77.1 million in outstanding principal of junior subordinated
debentures relating to the trust preferred securities of NovaStar Capital Trust
I and NovaStar Capital Trust II.  We have guaranteed the obligations
of NovaStar Mortgage, Inc. under the junior subordinated
debentures.  We are obligated to make periodic interest payments based
on a variable interest rate of three-month LIBOR plus 3.5% which resets
quarterly.  See Table 10 for an estimate of our contractual
obligations related to these junior subordinated debentures, and the discussion
above regarding our default with respect to, and acceleration of, these
obligations.
 
 Repayments of
Short-Term Borrowings.During the six months ended June 30,
2008, we fully repaid the remaining $57.3 million of outstanding borrowings with
Wachovia and related fees.  We currently have no outstanding
short-term borrowings and no agreements providing for further
borrowings.
 
 Common and
Preferred Stock Dividend Payments. We did not declare any common stock
dividends for the six months ended June 30, 2008 or 2007.  Preferred
stock dividends declared per share were $1.12 for the six months ended June 30,
2008 and 2007.   Our Board of Directors has suspended dividend
payments on our Series C and Series D-1 Preferred Stock.  As a result,
dividends on our Series C and Series D-1 preferred stock continue to accrue and
the dividend rate on the Series D-1 Preferred Stock increased from 9.0% to
13.0%, compounded quarterly, effective January 16, 2008, with respect to all
unpaid dividends and subsequently accruing dividends.  Accrued and
unpaid dividends on our preferred stock must be paid prior to the payment of any
dividend on our common stock.  We do not expect to pay any dividends
for the foreseeable future.
  49
 
 Loan Sale and
Securitization Repurchases. We have sold 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 year
ended December 31, 2007, we sold $912.9 million of loans with recourse for
borrower defaults. We maintained a $1.2 million and $2.2 million recourse
reserve related to these guarantees as of June 30, 2008 and December 31, 2007,
respectively.  We did not repurchase any loans during the six months
ended June 30, 2008. We paid $100.3 million in cash to repurchase loans sold to
third parties during the six months ended June 30, 2007.  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.
 
 We also
have sold loans to securitization trusts and guaranteed losses suffered by the
trust resulting from defects in the loan origination process. Defects may have
occurred in the loan documentation and underwriting process, either through
processing errors made by us or through intentional or unintentional
misrepresentations made by the borrower or agents during those processes. If a
defect is identified, we are required to repurchase the loan. As of June 30,
2008 and December 31, 2007, we had loans sold with recourse to securitization
trusts with an outstanding principal balance of $8.9 billion and $10.1 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, 2008, we have not recorded any reserves related to these
guarantees.
 
 Expenses Related
to Discontinued Operations.  We have significant ongoing
expenses associated with our discontinued operations, including obligations
under multiple office leases, software agreements, and other contractual
obligations, that no longer contribute to our revenue producing
operations.  See “Other Liquidity Factors” for further
discussion.
 
 Primary
Sources of Cash
 
 Cash Received
From Our Mortgage Securities Portfolio.A major driver of cash flows from
investing activities is the proceeds we receive from our mortgage securities
portfolio. Proceeds on mortgage securities that are pledged to the CDO are
required to be used to pay principal and interest on the CDO asset-backed
bonds.  We were required to use the cash inflows from the remaining
securities to paydown Wachovia’s remaining debt until it was fully repaid on May
9, 2008.  For the six months ended June 30, 2008 we received $55.4
million in proceeds from repayments on mortgage securities as compared to $122.9
million for the same period of 2007. The cash flows we receive on our mortgage
securities are highly dependent on the 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
      decreased modestly.
 ·
              Higher
      credit losses have 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 a result of the underlying mortgages being repaid and us not
      purchasing additional mortgage securities—available for
    sale.
 
 Proceeds from
Repayments of Mortgage Loans – Held-in-portfolio. For the six months
ended June 30, 2008 we received $194.0 million in proceeds from the repayments
of our portfolio of mortgage loans held-in-portfolio compared to $471.7 million
for the same period of 2007.   All of these amounts are required
to be used to pay principal and interest on the related asset-backed bonds
secured by the mortgage loans.  The decrease in 2008 is primarily the
result of slower borrower prepayments and credit defaults.
 
 Other
Liquidity Factors
 
 Table 10
details our major contractual obligations due over the next 12 months and
beyond.  As previously discussed, for the near future, we will focus
on minimizing losses and preserving liquidityas we manage our
existing portfolio of mortgage securities.  Our residual and
subordinated mortgage securities are currently our only significant source of
cash flows.  Based on current projections, the cash flows from our
mortgage securities will decrease in the next several months as the underlying
mortgage loans are repaid, and could be significantly less than the current
projections if losses on the underlying mortgage loans exceed the current
assumptions.  In addition, we have significant operating expenses
associated with office leases, and other obligations relating to our
discontinued operations.  In addition, as discussed above NMI
defaulted on its junior subordinated debentures relating to the trust preferred
securities of NovaStar Capital Trust I and NovaStar Capital Trust
II.  If, as the cash flows from mortgage securities decrease, we are
unable to recommence or invest in profitable operations, and restructure our
unsecured debt, capital structure and contractual obligations or if the cash
flows from our mortgage securities are less than currently anticipated, there
can be no assurance that we will be able to continue as a going concern and
avoid seeking the protection of applicable bankruptcy laws.  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.
  50
 
 Off-Balance
Sheet Arrangements
 
 As
previously discussed, historically, we have pooled the loans we originated and
purchased and typically securitized them to obtain long-term financing for the
assets. The loans were transferred to a trust where they serve as collateral for
asset-backed bonds, which the trust issued to the public. We often retained the
residual and subordinated securities issued by the trust.  We also
securitized residual and subordinated securities that we retained from our
securitizations and that we purchased from third parties.  As
discussed elsewhere, our inability to access the securitization market has had a
material adverse effect on our results of operations, financial condition,
liquidity and ability to continue as a going concern.
 
 Information
about the revenues, expenses, liabilities and cash flows we have in connection
with our securitization transactions, as well as information about the
securities issued and interests retained in our securitizations, are detailed in
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations.”
 
 In the
ordinary course of business, we have sold whole pools of loans to investors with
recourse for certain borrower defaults. We also have sold loans to
securitization trusts and guaranteed to cover losses suffered by the trust
resulting from defects in the loan origination process. See “Liquidity and
Capital Resources – Primary Uses of Cash – Loan Sale and Securitization
Repurchases” for further discussion of these guarantees and recourse
obligations.
 
 Inflation
 
 Virtually
all of our assets and liabilities are financial in nature. As a result, interest
rates and other factors drive our performance far more than does inflation.
Changes in interest rates do not necessarily correlate with inflation rates or
changes in inflation rates. Our financial statements are prepared in accordance
with GAAP. As a result, financial activities and the balance sheet are measured
with reference to historical cost or fair market value without considering
inflation.
 
 Item
3. Quantitative and Qualitative Disclosures About Market Risk
 
 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.
 
 As of
June 30, 2008, all borrowings under our 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.
 
 Historically,
we have transferred 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 entered into these interest rate agreements as we
originated and purchased mortgage loans in our mortgage lending segment. At the
time of a securitization structured as a sale, we transferred interest rate
agreements into the securitization trusts and they were removed from our balance
sheet. The trust assumed the obligation to make payments and obtained 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 used either 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 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 deficit.
  51


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 asset-backed bonds (“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.




Table
12 - Interest Rate Sensitivity - Market Value


(dollars in
      thousands)Basis Point Increase (Decrease) in Interest Rates (A)(200)
                          
                          
                          
                          (100)
                          
                          
                          
                          100
                          
                          
                          
                          200As
      of June 30, 2008:Change
      in market values of:Assets
      – non trading (B)
                          
                          $
                          5,875
                          
                          
                          $
                          2,902
                          
                          
                          $
                          (2,803
                          )
                          
                          $
                          (5,383
                          )Assets
      – trading (C)
                          
                          
                          14,416
                          
                          
                          
                          6,531
                          
                          
                          
                          (4,204
                          )
                          
                          
                          (7,050
                          )Cumulative
      change in market value
                          
                          $
                          20,291
                          
                          
                          $
                          9,433
                          
                          
                          $
                          (7,007
                          )
                          
                          $
                          (12,433
                          )Percent
      change of market value portfolio equity (D)
                          
                          
                          10.7
                          %
                          
                          
                          5.0
                          %
                          
                          
                          (3.7
                          )%
                          
                          
                          (6.6
                          )%As
      of December 31, 2007:Change
      in market values of:Assets
      – non trading (B)
                          
                          $
                          42,484
                          
                          
                          $
                          19,234
                          
                          
                          $
                          (18,057
                          )
                          
                          $
                          (32,868
                          )Assets
      – trading (C)
                          
                          
                          33,448
                          
                          
                          
                          15,269
                          
                          
                          
                          (14,210
                          )
                          
                          
                          (26,053
                          )Cumulative
      change in market value
                          
                          $
                          75,932
                          
                          
                          $
                          34,503
                          
                          
                          $
                          (32,267
                          )
                          
                          $
                          (58,921
                          )Percent
      change of market value portfolio equity (D)
                          
                          
                          61.0
                          %
                          
                          
                          24.6
                          %
                          
                          
                          (17.5
                          )%
                          
                          
                          (30.5
                          )%


(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 and
      mortgage securities -
available-for-sale.


(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, 2008 and December 31,
  2007.





Hedging.We currently have no
intention of entering into new derivative instruments.  In the past,
we used derivative instruments, including interest rate swap and cap contracts,
to mitigate the risk of our cost of funding increasing at a faster rate than the
interest on assets.  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.





All
derivative instruments on our balance sheet as of June 30, 2008 are related to
securitizations structured as financings and are legally held by the trust. The
following table summarizes the key contractual terms associated with these
interest rate risk management contracts as of June 30, 2008.  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, 2008.


52


Table
13 - Interest Rate Risk Management Contracts


(dollars
      in thousands)Maturity RangeNet Fair
                                                                                                Value
                                                                                              
                                                                                              
                                                                                              Total
                                                                                                Notional
                                                                                                Amount
                                                                                              
                                                                                              
                                                                                              2008
                                                                                              
                                                                                              
                                                                                              2009
                                                                                              
                                                                                              
                                                                                              2010
                                                                                              
                                                                                              
                                                                                              2011
                                                                                              
                                                                                              
                                                                                              2012and
                                                                                                beyondPay-fixed
      swaps:Contractual
      maturity
                                                                                              
                                                                                              $
                                                                                              (10,602
                                                                                              )
                                                                                              
                                                                                              $
                                                                                              735,000
                                                                                              
                                                                                              
                                                                                              $
                                                                                              290,000
                                                                                              
                                                                                              
                                                                                              $
                                                                                              405,000
                                                                                              
                                                                                              
                                                                                              $
                                                                                              40,000
                                                                                              
                                                                                              
                                                                                              $
                                                                                              —
                                                                                              
                                                                                              
                                                                                              $
                                                                                              —Weighted
      average pay rate
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              4.9
                                                                                              %
                                                                                              
                                                                                              
                                                                                              4.9
                                                                                              %
                                                                                              
                                                                                              
                                                                                              4.9
                                                                                              %
                                                                                              
                                                                                              
                                                                                              5.0
                                                                                              %
                                                                                              
                                                                                              
                                                                                              —
                                                                                              
                                                                                              
                                                                                              
                                                                                              —Weighted
      average receive rate
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              2.5
                                                                                              %
                                                                                              
                                                                                              
                                                                                              (A)
                                                                                              
                                                                                              
                                                                                              (A)
                                                                                              
                                                                                              
                                                                                              (A)
                                                                                              
                                                                                              
                                                                                              —
                                                                                              
                                                                                              
                                                                                              
                                                                                              —Interest
      rate caps:Contractual
      maturity
                                                                                              
                                                                                              $
                                                                                              28
                                                                                              
                                                                                              
                                                                                              $
                                                                                              140,000
                                                                                              
                                                                                              
                                                                                              $
                                                                                              100,000
                                                                                              
                                                                                              
                                                                                              $
                                                                                              40,000
                                                                                              
                                                                                              
                                                                                              $
                                                                                              —
                                                                                              
                                                                                              
                                                                                              $
                                                                                              —
                                                                                              
                                                                                              
                                                                                              $
                                                                                              —Weighted
      average strike rate
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              
                                                                                              5.1
                                                                                              %
                                                                                              
                                                                                              
                                                                                              5.1
                                                                                              %
                                                                                              
                                                                                              
                                                                                              5.0
                                                                                              %
                                                                                              
                                                                                              
                                                                                              —
                                                                                              
                                                                                              
                                                                                              
                                                                                              —
                                                                                              
                                                                                              
                                                                                              
                                                                                              —


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





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.  Our principal
executive officer and principal financial officer evaluated as of June 30, 2008
and concluded that our controls and procedures were effective.  In
addition, we have considered the restatement of our condensed consolidated
financial statements to be consistent with the views of the Staff of the
Securities and Exchange Commission and have concluded that such restatement does
not represent a material weakness in our internal controls over financial
reporting.





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.


53


PART
II. OTHER INFORMATION





Item
1.  Legal Proceedings




American
Interbanc Mortgage Litigation. On March 17, 2008, the Company and
American Interbanc Mortgage, LLC (“Plaintiff”) entered into a Confidential
Settlement Term Sheet Agreement (the “Settlement Terms”) with respect to the
actions, judgments and claims described below.




In March
2002, Plaintiff filed an action against NovaStar Home Mortgage, Inc. (“NHMI”) in
Superior Court of Orange County, California entitled American Interbanc Mortgage
LLC v. NovaStar Home Mortgage, Inc. et. al. (the “California Action”). In the
California Action, Plaintiff alleged that NHMI and two other mortgage companies
(“Defendants”) engaged in false advertising and unfair competition under certain
California statutes 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 “Judgment”). The award is joint
and several against the Defendants, including NHMI.




NHMI’s
motion for the trial court to overturn or reduce the verdict was denied on
August 20, 2007, and NHMI appealed that decision (the “Appeal”). Pending
the Appeal, Plaintiff commenced enforcement actions in the states of Missouri
(the “Kansas City Action”) and Delaware, and obtained an enforcement judgment in
Delaware (the “Delaware Judgment”). On January 23, 2008, Plaintiff filed an
involuntary petition for bankruptcy against NHMI under 11 U.S.C. Sec. 303, in
the United States Bankruptcy Court for the Western District of Missouri (the
“Involuntary”).




On
March 17, 2008, the Company and Plaintiff entered into the Settlement Terms
with respect to the California Action, the Judgment, the Kansas City Action, the
Delaware Judgment, the Involuntary, and all related claims.




Pursuant
to the Settlement Terms, the Involuntary was dismissed on April 24, 2008.
As provided in the Settlement Terms, the Company paid Plaintiff $2.0 million
plus the balance in an account established by order of the Bankruptcy Court, and
NHMI satisfied obligations of $48,000 to certain identified creditors. The
parties also agreed to extend the Appeal briefing period pending finalization of
the settlement of the other actions, judgments and claims, as described
below.




The
Settlement Terms provide that, following satisfaction of certain other
conditions, the parties will dismiss the California Action as to NHMI and the
Kansas City Action and Delaware Judgment, effect notice of satisfaction of the
Judgment, and effect a mutual release of all claims that were or could have been
raised in any of the foregoing or that are related to the subject matter
thereof. In the event that the conditions are not satisfied, as to which no
assurance can be given, the Judgment will remain in effect and the related
claims will not be released, which could result in NHMI and, if found liable for
the Judgment, the Company seeking the protection of applicable bankruptcy
laws.




In
addition to the initial payments made to the Plaintiff following dismissal of
the Involuntary, the Company will pay Plaintiff $5.5 million if, prior to
July 1, 2010, (i) NFI’s average common stock market capitalization is
at least $94.4 million over a period of five consecutive business days, or
(ii) the holders of NFI’s common stock are paid $94.4 million in net asset
value as a result of any sale of NFI or its assets. If NFI is sold prior to
July 1, 2010 for less than $94.4 million and ceases to be a public company,
then NFI will obligate the purchaser to pay Plaintiff $5.5 million in the event
the value of the company exceeds $94.4 million prior to July 1, 2010 as
determined by an independent valuation company.




In
accordance with generally accepted accounting principles, NHMI has recorded a
liability of $45.2 million as of March 31, 2008 with a corresponding charge
to earnings. The $45.2 million includes interest which is accruing on the
obligation. Because NHMI is a wholly owned indirect subsidiary of the Company,
the $45.2 million liability is included in the consolidated financial statements
of the Company. The liability is included in the “Liabilities of discontinued
operations” line of the consolidated balance sheets. The Company paid the
Plaintiff $2.1 million on May 8, 2008 in accordance with the Settlement
Terms.





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


54




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




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




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 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 sought
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 defendants filed a motion to dismiss the
action. On December 19, 2007, the Court granted defendants’ motion to
dismiss the complaint, including the claims against NovaStar Financial, Inc.,
but the Court allowed the plaintiffs to file an amended complaint. On
January 9, 2008, the plaintiffs filed an amended complaint that did not
make any claim against NovaStar Financial, Inc., but did assert the above claims
against its subsidiaries, NovaStar Mortgage, Inc. and NovaStar Home Mortgage,
Inc. (the “Subsidiary Defendants”). In June 2008, the named plaintiffs and
Subsidiary Defendants agreed to settle the claims of the named plaintiffs and to
dismiss the lawsuit for a nominal amount.




On
January 10, 2008, the City of Cleveland, Ohio filed suit against the
Company and approximately 20 other mortgage, commercial and investment bankers
alleging a public nuisance had been created in the City of Cleveland by the
operation of the subprime mortgage industry. The case was filed in state court
and promptly removed to the United States District Court for the Northern
District of Ohio. The plaintiff seeks damages for loss of property values in the
City of Cleveland, and for increased costs of providing services and
infrastructure, as a result of foreclosures of subprime mortgages. The Company
believes that these claims are without merit and will vigorously defend against
them.




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




On
May 6, 2008, the Company received a letter written on behalf of J.P. Morgan
Mortgage Acceptance Corp. and certain affiliates (“Morgan”) demanding
indemnification of claims asserted against Morgan in a case entitled
Plumbers & Pipefitters Local #562 Supplemental Plan and Trust v. J.P.
Morgan Acceptance Corp. et al, filed in the Supreme Court of the State of New
York, County of Nassau. The case seeks class action certification for
alleged violations by Morgan of sections 11 and 15 of the Securities Act of
1933, on behalf of all persons who purchased certain categories of mortgage
backed securities issued by Morgan in 2006-7. Morgan’s indemnity demand
alleges that any liability it might have to plaintiffs would be based, in part,
upon alleged misrepresentations made by the Company with respect to certain
mortgages that make up a portion of the collateral for the securities at
issue. The Company believes it has meritorious defenses to this demand and
expects to defend vigorously any claims asserted.




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


55




On
July 7, 2008, plaintiff Jennifer Jones filed a purported class action case
in the United States District Court for the Western District of Missouri against
the Company, certain present and former officers of the Company, and unnamed
members of the Company’s “Retirement Committee”. Plaintiff, a former
employee of the Company, seeks class action certification on behalf of all
persons who were participants in or beneficiaries of the Company’s 401(k) plan
from May 4, 2006 until November 15, 2007 and whose accounts included
investments in NovaStar Financial, Inc.’s common stock. Plaintiff alleges
that the Company’s common stock was an inappropriately risky investment option
for retirement savings, and that defendants breached their fiduciary duties by
allowing investment of some of the assets contained in the 401(k) plan to be
made in the Company’s common stock. The Company has not yet filed its
initial responsive pleading, and discovery is not yet underway. The Company
believes it has meritorious defenses to the case and expects to defend the case
vigorously.




In
addition to those matters listed above, the Company is currently a party to
various other legal proceedings and claims, including, but not limited to,
breach of contract claims, tort claims, and claims for violations of federal and
state consumer protection laws.




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





Item
1A.  Risk Factors





Risk
Factors




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




Risks
Related to Recent Changes in Our Business





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





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





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





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





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


56





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





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





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





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





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





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





If
we are not able to successfully restructure our unsecured debt, other
significant contractual obligations and preferred stock, we are not likely to be
able to continue as a going concern.





Based on
current projections, the cash flows from our remaining mortgage securities will
continue to significantly decrease over the next several months to levels that
are below our current expenses and that are below levels necessary to commence
other operations.  In addition, we are in default with respect to
payments on our unsecured debt related to our trust preferred
securities.  Because our known obligations exceed our existing assets
and because of the liquidation rights and preferences of our preferred stock,
the issuance of additional equity for new capital is highly
unlikely.  Consequently, we have initiated efforts to restructure our
indebtedness and certain contractual obligations, and we are assessing potential
changes to our preferred stock.  Our ability to implement any
restructuring is dependent upon agreement of various third parties and security
holders.  We expect that these efforts and negotiations will be
complex, and there can be no assurances that any negotiations or other efforts
will be successful.  To the extent that they are not, we would be
unlikely to be able to continue as a going concern and would be likely to seek
the protection of applicable bankruptcy laws.


57





We
are in default with respect to payments due on our unsecured indebtedness, which
has resulted in the acceleration of indebtedness that greatly exceeds our
current ability to pay.  In the event that holders of our debt seek
enforcement of remedies against us, we will be required to seek the protection
of applicable bankruptcy laws.





Our
wholly owned subsidiary NovaStar Mortgage, Inc. has outstanding junior
subordinated debentures related to the outstanding trust preferred securities of
NovaStar Capital Trust I and NovaStar Capital Trust II.  We have
guaranteed NovaStar Mortgage’s obligations under these debentures, including
NovaStar Mortgage’s obligations to make periodic interest payments
thereon.   The total outstanding obligations under these
debentures exceed $80 million.  We are in default with respect to
interest payments under these debentures, and the prior agreement of the
affected trusts and securities holders to forbear in the exercise of their
remedies against us has expired.  On June 4, 2008 and August 14, 2008,
we received written notices of acceleration from the holders of the trust
preferred securities of NovaStar Capital Trust I and NovaStar Capital Trust II,
respectively, which declared all obligations of NMI under the related Notes and
indenture  to be immediately due and payable, and stated the intention
of the trust preferred security holders to pursue all available rights and
remedies, including but not limited to enforcing their rights under the related
guarantee.  As of the date of filing, no suit has been filed to
enforce the holders’ rights under the indentures or the related
guarantees.




While we
are negotiating with the applicable parties in an effort to restructure the
terms of the debentures, there can be no assurance that we will be able to do
so. Enforcement of remedies against us under the debentures and related
guarantees would have a material adverse effect on our financial condition and
liquidity and would likely cause us to seek the protection of applicable
bankruptcy laws.





Our
default under the trust preferred debentures constitutes a cross-default under
certain letter of credit agreements between us and Wachovia Bank, under which
letters of credit have been issued to support certain surety
bonds.  So long as a default exists under the letter of credit
agreements, no assurance can be given as to our ability to receive back any cash
collateral posted under these agreements upon termination of related surety
bonds and associated letters of credit.  A material delay or reduction
in our receipt of this cash collateral would have a material adverse effect on
our liquidity position and could force us to seek the protection of applicable
bankruptcy laws.





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





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





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





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





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





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





Our
common stock and our 8.90% Series C Preferred Stock were delisted by the New
York Stock Exchange (“NYSE”) in January 2008, as a result of failure to meet
applicable standards for continued listing on the NYSE.  Our common
stock and Series C Preferred Stock are currently quoted on the OTC Bulletin
Board and on the Pink Sheets.  However, there can be no assurance that
an active trading market will be maintained.  Trading of securities on
the OTC and Pink Sheets is generally limited and is effected on a less regular
basis than on exchanges, such as the NYSE, and accordingly investors who own or
purchase our stock will find that the liquidity or transferability of the stock
may be limited.


58





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





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





We are
not required to pay out our taxable income in the form of dividends, as we are
no longer subject to a REIT distribution requirement. Instead, payment of
dividends is at the discretion of our board of directors.  To preserve
liquidity, our board of directors has suspended dividend payments on our Series
C and Series D-1 Preferred Stock.  Dividends on our Series C and D-1
Preferred Stock continue to accrue and the dividend rate on our Series D-1
Preferred Stock increased from 9.0% to 13.0%, compounded quarterly, effective
January 16, 2008 with respect to all unpaid dividends and subsequently accruing
dividends.  No dividends can be paid on any of our common stock until
all accrued and unpaid dividends on our Series C and Series D-1 Preferred Stock
are paid in full.  Accumulating dividends with respect to our
preferred stock will negatively affect the ability of our common stockholders to
receive any distribution or other value upon liquidation.





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





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





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





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





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





Risks
Related to Interest Rates and Our Hedging Strategies





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





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





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


59




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


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


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





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





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





Risks
Related to Credit Losses





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





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





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





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





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





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





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


60





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





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





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





Mortgage
insurers may not pay claims resulting in increased credit losses.





Mortgage
insurance mitigates the risk of credit losses. We face the risk that the
mortgage insurers insuring loans serving as collateral for our mortgage
securities might not have the financial ability to pay all claims presented 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, financial condition, liquidity and cash flows, and ability to
continue as a going concern.





Geographic
concentration of mortgage loans increases our exposure to risks in those
areas.





Over-concentration
in any one geographic area of our loans held for sale or underlying our mortgage
securities increases our exposure to the economic risks associated with that
area. Declines in the residential real estate markets in which we are
concentrated, including California and Florida, have reduced the values of the
properties collateralizing our mortgages which in turn has increased 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, the value of, and cash flows from, our mortgage securities and loans held
for sale will further decrease which will adversely affect our operating
results, liquidity, cash flows, financial condition and ability to continue as a
going concern.





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
negatively affect the value of, and cash flows from, our mortgage assets, which
will adversely affect our operating results, liquidity, cash flows, financial
condition and ability to continue as a going concern.





As
a result of our sale of our mortgage servicing rights, we no longer possess the
ability to identify and address potential or actual delinquencies and defaults
on the mortgage loans underlying our residual and subordinated
securities.





We have
traditionally utilized our role as servicer of our securitized pools of mortgage
loans to attempt to identify and address potential and actual borrower
delinquencies and defaults.  On November 1, 2007, we sold to a third
party our servicing rights with respect to our securitized loans.  As
a result, we no longer control the lender-borrower relationship, which may
exacerbate the increase in delinquencies and defaults under such mortgage loans
and the negative impact on the value and cash flows of our residual and
subordinated securities resulting from such delinquencies and
defaults.





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





Failure
to qualify for an exemption from regulation as an investment company could
adversely affect our ability to continue in business.


61





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 SEC’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.  If we fail to qualify for an
applicable exemption from the Investment Company Act, we could be required to
restructure our activities which would materially adversely affect our financial
condition, results of operations, liquidity, and ability to continue as a going
concern.





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





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





Risks
Related to Our Capital Stock





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





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





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


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


·
              actual
      or anticipated changes in residential real estate
  values;


·
              actual
      or anticipated changes in market interest
rates;


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


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


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


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


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


·
              actual
      or anticipated changes in financial estimates by securities
      analysts;


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


·
              additions
      or departures of senior management and key personnel;
  and


·
              actions
      by institutional
shareholders.





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





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





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


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


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


62




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





Other
Risks Related to our Business





You
should exercise caution in reviewing our condensed consolidated financial
statements.





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





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





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





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





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


63





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


(dollars
      in thousands)Issuer Purchases of Equity SecuritiesTotal Number
                                          of Shares
                                          Purchased
                                        
                                        
                                        Average
                                          Price Paid
                                          per Share
                                        
                                        
                                        Total Number of
                                          Shares
                                          Purchased as
                                          Part of Publicly
                                          Announced
                                          Plans or
                                          Programs
                                        
                                        
                                        Approximate Dollar
                                          Value of Shares That
                                          May Yet Be
                                          Purchased Under
                                          the Plans or
                                          Programs (A)April
      1, 2008 – April 30, 2008
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        $
                                        1,020May
      1, 2008 – May 31, 2008
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        $
                                        1,020June
      1, 2008 – June 30, 2008
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        $
                                        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





The
Company’s wholly owned subsidiary NovaStar Mortgage, Inc. (“NMI”) has
approximately $77.1 million in principal amount of unsecured notes
(collectively, the “Notes”) outstanding to NovaStar Capital Trust I and NovaStar
Capital Trust II (collectively, the “Trusts”) which secure trust preferred
securities issued by the Trusts.  The foregoing is net of amounts owed
in respect of trust preferred securities of NovaStar Capital Trust II having a
par value of $6.9 million purchased by NMI on May 29, 2008 for
$0.6 million.  The Company has guaranteed NMI's obligations under
the Notes.





NMI
failed to make quarterly interest payments that were due on March 30, April
30, June 30 and July 30, 2008 totaling, for all payment dates
combined, approximately $2.8 million on the Notes.  As a result, NMI
is in default under the related indentures and the Company is in default under
the related guarantees.  An agreement by the trustees and trust
preferred security holders of the Trusts to forbear in the exercise of remedies
with respect to the initial payment defaults expired on May 30,
2008.  Consequently, the trustee and holders of 25% of the outstanding
trust preferred securities of each Trust have the right to accelerate all
principal, accrued interest, and other obligations of NMI under the related
Notes and to demand payment of all such amounts from the Company under the
related guarantees.  The total principal and accrued interest owed
under the Notes, net of amounts owed in respect of the trust preferred
securities held by NMI, was approximately $80.4 million as of August 18,
2008.  In addition, the Company is obligated to reimburse the trustees
for all reasonable expenses, disbursements and advances in connection with the
exercise of rights under the indentures.





On June
4, 2008 and August 14, 2008, the Company received written notices of
acceleration from the holders of the trust preferred securities of NovaStar
Capital Trust I and NovaStar Capital Trust II, respectively, which declared all
obligations of NMI under the related Notes and indenture  to be
immediately due and payable, and stated the intention of the trust preferred
security holders to pursue all available rights and remedies, including but not
limited to enforcing their rights under the related guarantee.  As of
August 18, 2008, the aggregate obligations of NMI under the related Notes and
indenture Notes is $77.1 million.  As of the date of filing, no suit
has been filed to enforce the holders’ rights under the indentures or the
related guarantees.





To preserve liquidity, the
Company’s Board of Directors has suspended the payment of dividends on its
Series C Cumulative Redeemable Perpetual Preferred Stock (“Series C”) and its
Series D1 Convertible Participating Preferred Stock (“Series
D1”).As a result, dividends continue to accrue on the Series
C and Series D1 Preferred Stock.  The Company has total
accrued dividends payable related to the Series C and Series D1 Preferred Stock
of $10.5 million as of June 30, 2008.  All accrued and unpaid
dividends on the Company’s preferred stock must be paid prior to any payments of
dividends or other distributions on the Company’s common stock.  In
addition, if at any time dividends on the Series C Preferred Stock are in
arrears for six or more quarterly periods (whether or not consecutive), the
holders of the Series C Preferred Stock, voting as a single class, have the
right to elect two additional directors to the Company’s Board of
Directors.  The Company does not expect to pay any dividends for the
foreseeable future.





Dividends
on the Series C Preferred Stock are payable in cash and accrue at a rate of
8.90% annually.  Accrued and unpaid dividends payable related to the
Series C Preferred Stock were approximately $5.0 million as of June 30, 2008 and
$5.9 million as of August 18, 2008.





Dividends
on the Series D1 Preferred Stock are payable in cash and accrue at a rate of
9.00% per annum, or 13.00% per annum if any such dividends are not declared and
paid when due.  The dividend rate on the Series D1 Preferred Stock
increased from 9.0% to 13.0%, compounded quarterly, effective January 16, 2008
with respect to all unpaid dividends and subsequently accruing
dividends.  Accrued and unpaid
dividends payable related to the Series D1 Preferred Stock were approximately
$5.5 million as of June 30, 2008 and $6.4 million as of August 18,
2008.


64





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





The 2008
annual meeting of shareholders of NovaStar Financial, Inc. was held on May 22,
2008. Donald M. Berman was elected as director.  W. Lance Anderson,
Gregory T. Barmore, Edward W. Mehrer, 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
      ResultsFor
                          Against
                          Abstain1.
                          Election
      of DirectorsDonald
      M. Berman (term expiring in 2011)
                          7,674,535
                          436,729
                          63,245For
                          Against
                          Abstain2.
                          Approval
      of the amendment to Article XI of the Company’s charter
                          6,182,075
                          956,261
                          1,036,1733.
                          Ratification
      of Deloitte & Touche LLP as NovaStar Financial, Inc.’s independent
      registered public accountants for 2007
                          7,858,379
                          278,241
                          37,889





Approval
of a majority of our outstanding shares of common stock and Series D-1 Preferred
Stock voting together as a single class, and the approval of two-thirds of our
outstanding shares of Series D-1 Preferred Stock voting as a separate class was
required for the passage of Proposal 2 – Approval of the amendment to Article XI
of the Company’s charter.  The holders of 50% of our Series D-1
Preferred Stock abstained on Proposal 2 and, consequently, it was not
approved.





Item
5. Other Information





None





Item
6. Exhibits





Exhibit
Listing





Exhibit No.
                
                Description
      of Document2.11*
                
                Servicing
      Rights Transfer Agreement, dated as of October 12, 2007, between Saxon
      Mortgage Services, Inc. and NovaStar Mortgage, Inc.10.20.1
                
                Second
      and Amended Restated Trust Agreement, dated September 20, 2005, between
      NovaStar Mortgage, Inc., JPMorgan Chase Bank, NA, Chase Bank USA, NA and
      certain administrative trustees10.21.1
                
                Amended
      and Restated Junior Subordinated Indenture, dated September 20, 2005,
      between NovaStar Mortgage, Inc. and JPMorgan Chase Bank,
    NA.10.552*
                
                Confidential
      Settlement Term Sheet Agreement, dated March 17, 2008, between American
      Interbanc Mortgage LLC, NovaStar Financial, Inc., NovaStar Mortgage, Inc.,
      NFI Holding Corp., and NovaStar Home Mortgage,
  Inc.




1
Incorporated by reference to Exhibit 2.1 to Form 10-Q filed by the Registrant
with the SEC on November 14, 2007.
 *PORTIONS OF THIS AGREEMENT
HAVE BEEN OMITTED PURSUANT TO A REQUEST FOR CONFIDENTIAL TREATMENT THAT HAS BEEN
FILED SEPARATELY WITH The SECURITIES AND EXCHANGE COMMISSION.


2
Incorporated by reference to Exhibit 10.55 to Form 10-Q filed by the Registrant
with the SEC on May 19, 2008.


65





10.563
                  
                  Summary
      of Oral Agreement, dated May 21, 2008, between NovaStar Mortgage, Inc. and
      Kodiak CDO II Ltd.10.574
                  
                  Membership
      Interest Purchase Agreement, dated as of August 1, 2008, by and among
      NovaStar Financial, Inc., PipeFire, LLC, the existing members of PipeFire,
      LLC, and certain beneficial owners of such membership
      interests11.15
                  
                  Statement
      Regarding Computation of Per Share Earnings31.1
                  
                  Chief
      Executive Officer Certification - Section 302 of the Sarbanes-Oxley Act of
      200231.2
                  
                  Principal
      Financial Officer Certification - Section 302 of the Sarbanes-Oxley Act of
      200232.1
                  
                  Chief
      Executive Officer Certification - Section 906 of the Sarbanes-Oxley Act of
      200232.2
                  
                  Principal
      Financial Officer Certification - Section 906 of the Sarbanes-Oxley Act of
      2002




3
Incorporated by reference to Form 8-K filed by the Registrant with the SEC on
June 5, 2008.


4
Incorporated by reference to Form 8-K filed by the Registrant with the SEC on
August 14, 2008.


5 See Note
15 to the condensed consolidated financial statements.


66





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:
      March 20, 2009
            
            /s/
      W. LANCE ANDERSONW.
      Lance Anderson, Chairman of the
              Board
      of Directors and Chief
              Executive
      Officer(Principal
      Executive Officer)DATE:
      March 20, 2009
            
            /s/
      RODNEY E. SCHWATKENRodney
      E. Schwatken, Chief
              Financial
      Officer(Principal
      Financial Officer)


67