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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q



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



For the Quarterly Period Ended March 31, 2005



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



For the Transition Period From
 to



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Commission File Number 001-13533



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NOVASTAR FINANCIAL, INC.

(Exact Name
of Registrant as Specified in its Charter)



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



|                                              |  |           
|--------------------------------------------- |  | ----------
|8140 Ward Parkway, Suite 300, Kansas City, MO |  | 64114     
|(Address of Principal Executive Office)       |  | (Zip Code)



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



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



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



The number of shares of the Registrants Common Stock outstanding on May 3, 2005 was
27,926,011.



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NOVASTAR FINANCIAL, INC.



FORM 10-Q

For the Quarterly Period Ended March 31, 2005



TABLE OF CONTENTS



|        |  |                                                                                           |  |   
|------- |  | ----------------------------------------------------------------------------------------- |  | --
|Part I  |  | Financial Information                                                                     |  |   
|        |  |                                                                                          
|Item 1. |  | Financial Statements                                                                      |  | 1 
|        |  | Condensed Consolidated Balance Sheets                                                     |  | 1 
|        |  | Condensed Consolidated Statements of Income                                               |  | 2 
|        |  | Condensed Consolidated Statement of Stockholders Equity                                  |  | 4 
|        |  | Condensed Consolidated Statements of Cash Flows                                           |  | 5 
|        |  | Notes to Condensed Consolidated Financial Statements                                      |  | 7 
|        |  |                                                                                          
|Item 2. |  | Managements Discussion and Analysis of Financial Condition and Results of Operations     |  | 16
|        |  | Table 1, Nonconforming Loan Originations and Purchases                                    |  | 27
|        |  | Table 2, Carrying Value of Mortgage Loans                                                 |  | 27
|        |  | Table 3, Valuation of Individual Mortgage Securities  Available-for-Sale and Assumptions |  | 29
|        |  | Table 4, Summary of Mortgage Securities  Available-for-Sale Retained by Year of Issue    |  | 35
|        |  | Table 5, Short-term Financing Resources                                                   |  | 37
|        |  | Table 6, Mortgage Securities Interest Analysis                                            |  | 39
|        |  | Table 7, Mortgage Portfolio Management Net Interest Income Analysis                       |  | 40
|        |  | Table 8, Gains on Sales of Mortgage Assets and Gains (Losses) on Derivative Instruments   |  | 42
|        |  | Table 9, Mortgage Loan Securitizations                                                    |  | 43
|        |  | Table 10, Wholesale Loan Costs of Production, as a Percent of Principal                   |  | 44
|        |  | Table 11, Reconciliation of Overhead Costs                                                |  | 45
|        |  | Table 12, Taxable Net Income                                                              |  | 45
|        |  | Table 13, Summary of Servicing Operations                                                 |  | 46
|        |  | Table 14, Contractual Obligations                                                         |  | 49
|        |  |                                                                                          
|Item 3. |  | Quantitative and Qualitative Disclosures About Market Risk                                |  | 50
|        |  | Table 15, Interest Rate Sensitivity  Market Value                                        |  | 51
|        |  | Table 16, Interest Rate Risk Management Contracts                                         |  | 53
|        |  |                                                                                          
|Item 4. |  | Controls and Procedures                                                                   |  | 53
|        |  |                                                                                          
|Part II |  | Other Information                                                                         |  |   
|        |  |                                                                                          
|Item 1. |  | Legal Proceedings                                                                         |  | 54
|        |  |                                                                                          
|Item 2. |  | Unregistered Sales of Equity Securities and Use of Proceeds                               |  | 54
|        |  |                                                                                          
|Item 3. |  | Defaults Upon Senior Securities                                                           |  | 54
|        |  |                                                                                          
|Item 4. |  | Submission of Matters to a Vote of Security Holders                                       |  | 54
|        |  |                                                                                          
|Item 5. |  | Other Information                                                                         |  | 54
|        |  |                                                                                          
|Item 6. |  | Exhibits                                                                                  |  | 55





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PART I. FINANCIAL INFORMATION



Item 1. Financial Statements



NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited; dollars in thousands, except share amounts)



|                                                                                                                      |  |                |           |   |                   |   |           |  
|--------------------------------------------------------------------------------------------------------------------- |  | -------------- | --------- | - | ----------------- | - | --------- | -
|                                                                                                                      |  | March 31, 2005 |           |   | December 31, 2004 |  
|Assets                                                                                                                |  |                |           |   |                   |   |           |  
|Cash and cash equivalents                                                                                             |  | $              | 237,910   |   |                   | $ | 268,563   |  
|Mortgage loans  held-for-sale                                                                                        |  |                | 585,021   |   |                   |   | 747,594   |  
|Mortgage loans  held-in-portfolio                                                                                    |  |                | 54,285    |   |                   |   | 59,527    |  
|Mortgage securities  available-for-sale                                                                              |  |                | 530,578   |   |                   |   | 489,175   |  
|Mortgage securities  trading                                                                                         |  |                |          |   |                   |   | 143,153   |  
|Mortgage servicing rights                                                                                             |  |                | 47,712    |   |                   |   | 42,010    |  
|Derivative instruments, net                                                                                           |  |                | 22,595    |   |                   |   | 18,841    |  
|Servicing related advances                                                                                            |  |                | 19,594    |   |                   |   | 20,190    |  
|Property and equipment, net                                                                                           |  |                | 15,900    |   |                   |   | 15,476    |  
|Other assets                                                                                                          |  |                | 54,487    |   |                   |   | 56,782    |  
|                                                                                                                      |  |                |           |   |                   |   |           |  
|Total assets                                                                                                          |  | $              | 1,568,082 |   |                   | $ | 1,861,311 |  
|                                                                                                                      |  |                |           |   |                   |   |           |  
|Liabilities and Stockholders Equity                                                                                  |  |                |           |   |                   |   |           |  
|Liabilities:                                                                                                          |  |                |           |   |                   |   |           |  
|Short-term borrowings secured by mortgage loans                                                                       |  | $              | 561,596   |   |                   | $ | 720,791   |  
|Short-term borrowings secured by mortgage securities                                                                  |  |                | 100,007   |   |                   |   | 184,737   |  
|Asset-backed bonds secured by mortgage loans                                                                          |  |                | 48,695    |   |                   |   | 53,453    |  
|Asset-backed bonds secured by mortgage securities                                                                     |  |                | 242,388   |   |                   |   | 336,441   |  
|Junior subordinated debentures                                                                                        |  |                | 48,428    |   |                   |   |          |  
|Dividends payable                                                                                                     |  |                | 40,720    |   |                   |   | 73,431    |  
|Due to securitizations trusts                                                                                         |  |                | 20,102    |   |                   |   | 20,930    |  
|Accounts payable and other liabilities                                                                                |  |                | 47,524    |   |                   |   | 45,184    |  
|                                                                                                                      |  |                |           |   |                   |   |           |  
|Total liabilities                                                                                                     |  |                | 1,109,460 |   |                   |   | 1,434,967 |  
|Commitments and contingencies (Note 7)                                                                                |  |                |           |   |                   |   |           |  
|Stockholders equity:                                                                                                 |  |                |           |   |                   |   |           |  
|Capital stock, $0.01 par value, 50,000,000 shares authorized:                                                         |  |                |           |   |                   |   |           |  
|Redeemable preferred stock, $25 liquidating preference per share; 2,990,000 shares authorized, issued and outstanding |  |                | 30        |   |                   |   | 30        |  
|Common stock, 27,897,946 and 27,709,984 shares authorized, issued and outstanding, respectively                       |  |                | 279       |   |                   |   | 277       |  
|Additional paid-in capital                                                                                            |  |                | 439,308   |   |                   |   | 433,107   |  
|Accumulated deficit                                                                                                   |  |                | (91,451   | ) |                   |   | (85,354   | )
|Accumulated other comprehensive income                                                                                |  |                | 111,257   |   |                   |   | 79,120    |  
|Other                                                                                                                 |  |                | (801      | ) |                   |   | (836      | )
|                                                                                                                      |  |                |           |   |                   |   |           |  
|Total stockholders equity                                                                                            |  |                | 458,622   |   |                   |   | 426,344   |  
|                                                                                                                      |  |                |           |   |                   |   |           |  
|Total liabilities and stockholders equity                                                                            |  | $              | 1,568,082 |   |                   | $ | 1,861,311 |  
|                                                                                                                      |  |                |           |   |                   |   |           |  



See
notes to condensed consolidated financial statements.



1



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NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

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



|                                                                   |  |                                     |        |   |      |   |         |  
|------------------------------------------------------------------ |  | ----------------------------------- | ------ | - | ---- | - | ------- | -
|                                                                   |  | For the Three MonthsEnded March 31, |       
|                                                                   |  | 2005                                |        |   | 2004 |  
|Interest income:                                                   |  |                                     |        |   |      |   |         |  
|Mortgage securities                                                |  | $                                   | 40,463 |   |      | $ | 33,196  |  
|Mortgage loans held-for-sale                                       |  |                                     | 20,279 |   |      |   | 15,116  |  
|Mortgage loans held-in-portfolio                                   |  |                                     | 1,313  |   |      |   | 2,047   |  
|                                                                   |  |                                     |        |   |      |   |         |  
|Total interest income                                              |  |                                     | 62,055 |   |      |   | 50,359  |  
|Interest expense:                                                  |  |                                     |        |   |      |   |         |  
|Short-term borrowings secured by mortgage loans                    |  |                                     | 10,263 |   |      |   | 4,755   |  
|Short-term borrowings secured by mortgage securities               |  |                                     | 800    |   |      |   | 1,192   |  
|Asset-backed bonds secured by mortgage loans                       |  |                                     | 417    |   |      |   | 364     |  
|Asset-backed bonds secured by mortgage securities                  |  |                                     | 4,807  |   |      |   | 2,348   |  
|Net settlements of derivative instruments used in cash flow hedges |  |                                     | 180    |   |      |   | 2,062   |  
|Junior subordinated debentures                                     |  |                                     | 140    |   |      |   |        |  
|                                                                   |  |                                     |        |   |      |   |         |  
|Total interest expense                                             |  |                                     | 16,607 |   |      |   | 10,721  |  
|                                                                   |  |                                     |        |   |      |   |         |  
|Net interest income before provision for credit losses             |  |                                     | 45,448 |   |      |   | 39,638  |  
|Provision for credit losses                                        |  |                                     | (619   | ) |      |   | (146    | )
|                                                                   |  |                                     |        |   |      |   |         |  
|Net interest income                                                |  |                                     | 44,829 |   |      |   | 39,492  |  
|Fee income                                                         |  |                                     | 18,583 |   |      |   | 17,987  |  
|Gains on sales of mortgage assets                                  |  |                                     | 18,246 |   |      |   | 51,780  |  
|Gains (losses) on derivative instruments                           |  |                                     | 14,601 |   |      |   | (25,398 | )
|Premiums for mortgage loan insurance                               |  |                                     | (942   | ) |      |   | (626    | )
|Impairment on mortgage securities  available-for-sale             |  |                                     | (1,612 | ) |      |   |        |  
|Other income, net                                                  |  |                                     | 3,587  |   |      |   | 1,108   |  
|General and administrative expenses:                               |  |                                     |        |   |      |   |         |  
|Compensation and benefits                                          |  |                                     | 33,427 |   |      |   | 26,675  |  
|Office administration                                              |  |                                     | 8,890  |   |      |   | 7,163   |  
|Marketing                                                          |  |                                     | 5,088  |   |      |   | 7,398   |  
|Professional and outside services                                  |  |                                     | 4,379  |   |      |   | 2,356   |  
|Loan expense                                                       |  |                                     | 3,692  |   |      |   | 2,610   |  
|Other                                                              |  |                                     | 4,810  |   |      |   | 3,972   |  
|                                                                   |  |                                     |        |   |      |   |         |  
|Total general and administrative expenses                          |  |                                     | 60,286 |   |      |   | 50,174  |  
|                                                                   |  |                                     |        |   |      |   |         |  
|Income from continuing operations before income tax expense        |  |                                     | 37,006 |   |      |   | 34,169  |  
|Income tax expense                                                 |  |                                     | 819    |   |      |   | 1,523   |  
|                                                                   |  |                                     |        |   |      |   |         |  
|Income from continuing operations                                  |  |                                     | 36,187 |   |      |   | 32,646  |  
|Loss from discontinued operations, net of income tax               |  |                                     | (984   | ) |      |   | (1,721  | )
|                                                                   |  |                                     |        |   |      |   |         |  
|Net income                                                         |  |                                     | 35,203 |   |      |   | 30,925  |  
|Dividends on preferred shares                                      |  |                                     | (1,663 | ) |      |   | (1,275  | )
|                                                                   |  |                                     |        |   |      |   |         |  
|Net income available to common shareholders                        |  | $                                   | 33,540 |   |      | $ | 29,650  |  
|                                                                   |  |                                     |        |   |      |   |         |  



Continued



2



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|                                                                   |  |                                     |        |   |      |   |        |  
|------------------------------------------------------------------ |  | ----------------------------------- | ------ | - | ---- | - | ------ | -
|                                                                   |  | For the Three MonthsEnded March 31, |       
|                                                                   |  | 2005                                |        |   | 2004 |  
|Basic earnings per share:                                          |  |                                     |        |   |      |   |        |  
|Income from continuing operations available to common shareholders |  | $                                   | 1.24   |   |      | $ | 1.27   |  
|Loss from discontinued operations, net of income tax               |  |                                     | (0.03  | ) |      |   | (0.07  | )
|                                                                   |  |                                     |        |   |      |   |        |  
|Net income available to common shareholders                        |  | $                                   | 1.21   |   |      | $ | 1.20   |  
|                                                                   |  |                                     |        |   |      |   |        |  
|Diluted earnings per share:                                        |  |                                     |        |   |      |   |        |  
|Income from continuing operations available to common shareholders |  | $                                   | 1.23   |   |      | $ | 1.24   |  
|Loss from discontinued operations, net of income tax               |  |                                     | (0.04  | ) |      |   | (0.07  | )
|                                                                   |  |                                     |        |   |      |   |        |  
|Net income available to common shareholders                        |  | $                                   | 1.19   |   |      | $ | 1.17   |  
|                                                                   |  |                                     |        |   |      |   |        |  
|Weighted average basic shares outstanding                          |  |                                     | 27,766 |   |      |   | 24,655 |  
|                                                                   |  |                                     |        |   |      |   |        |  
|Weighted average diluted shares outstanding                        |  |                                     | 28,111 |   |      |   | 25,274 |  
|                                                                   |  |                                     |        |   |      |   |        |  
|Dividends declared per common share                                |  | $                                   | 1.40   |   |      | $ | 1.35   |  
|                                                                   |  |                                     |        |   |      |   |        |  



See
notes to condensed consolidated financial statements.

Concluded



3



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NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS EQUITY

(unaudited; dollars in thousands, except share amounts)



|                                                                |  |                 |    |              |   |                          |  |   |                    |   |  |                                     |         |       |  |   |                            |  |   |      |   |  |   |         |  
|--------------------------------------------------------------- |  | --------------- | -- | ------------ | - | ------------------------ |  | - | ------------------ | - |  | ----------------------------------- | ------- | ----- |  | - | -------------------------- |  | - | ---- | - |  | - | ------- | -
|                                                                |  | Preferred Stock |    | Common Stock |   | AdditionalPaid-inCapital |  |   | AccumulatedDeficit |   |  | AccumulatedOtherComprehensiveIncome |         | Other |  |   | Total Stockholders Equity | 
|Balance, January 1, 2005                                        |  | $               | 30 |              | $ | 277                      |  | $ | 433,107            |   |  | $                                   | (85,354 | )     |  | $ | 79,120                     |  | $ | (836 | ) |  | $ | 426,344 |  
|                                                                |  |                 |    |              |   |                          |  |   |                    |   |  |                                     |         |       |  |   |                            |  |   |      |   |  |   |         |  
|Forgiveness of founders notes receivable                       |  |                 |   |              |   |                         |  |   |                   |   |  |                                     |        |       |  |   |                           |  |   | 35   |   |  |   | 35      |  
|                                                                |  |                 |    |              |   |                          |  |   |                    |   |  |                                     |         |       |  |   |                            |  |   |      |   |  |   |         |  
|Issuance of common stock, 116,735 shares                        |  |                 |   |              |   | 1                        |  |   | 4,632              |   |  |                                     |        |       |  |   |                           |  |   |     |   |  |   | 4,633   |  
|                                                                |  |                 |    |              |   |                          |  |   |                    |   |  |                                     |         |       |  |   |                            |  |   |      |   |  |   |         |  
|Issuance of stock under stock compensation plans, 71,227 shares |  |                 |   |              |   | 1                        |  |   | 533                |   |  |                                     |        |       |  |   |                           |  |   |     |   |  |   | 534     |  
|Compensation recognized under stock compensation plans          |  |                 |   |              |   |                         |  |   | 458                |   |  |                                     |        |       |  |   |                           |  |   |     |   |  |   | 458     |  
|Dividend equivalent rights (DERs) on vested options             |  |                 |   |              |   |                         |  |   | 581                |   |  |                                     | (581    | )     |  |   |                           |  |   |     |   |  |   |        |  
|Dividends on common stock ($1.40 per share)                     |  |                 |   |              |   |                         |  |   |                   |   |  |                                     | (39,056 | )     |  |   |                           |  |   |     |   |  |   | (39,056 | )
|Dividends on preferred stock ($0.56 per share)                  |  |                 |   |              |   |                         |  |   |                   |   |  |                                     | (1,663  | )     |  |   |                           |  |   |     |   |  |   | (1,663  | )
|Tax benefit derived from stock compensation plans               |  |                 |   |              |   |                         |  |   | (3                 | ) |  |                                     |        |       |  |   |                           |  |   |     |   |  |   | (3      | )
|                                                                |  |                 |    |              |   |                          |  |   |                    |   |  |                                     |         |       |  |   |                            |  |   |      |   |  |   |         |  
|Comprehensive income:                                           |  |                 |    |              |   |                          |  |   |                    |   |  |                                     |         |       |  |   |                            |  |   |      |   |  |   |         |  
|Net income                                                      |  |                 |    |              |   |                          |  |   |                    |   |  |                                     | 35,203  |       |  |   |                           |  |   |      |   |  |   | 35,203  |  
|                                                                |  |                 |    |              |   |                          |  |   |                    |   |  |                                     |         |       |  |   |                            |  |   |      |   |  |   |         |  
|Other comprehensive income                                      |  |                 |    |              |   |                          |  |   |                    |   |  |                                     |        |       |  |   | 32,137                     |  |   |      |   |  |   | 32,137  |  
|                                                                |  |                 |    |              |   |                          |  |   |                    |   |  |                                     |         |       |  |   |                            |  |   |      |   |  |   |         |  
|Total comprehensive income                                      |  |                 |    |              |   |                          |  |   |                    |   |  |                                     |         |       |  |   |                            |  |   |      |   |  |   | 67,340  |  
|                                                                |  |                 |    |              |   |                          |  |   |                    |   |  |                                     |         |       |  |   |                            |  |   |      |   |  |   |         |  
|Balance, March 31, 2005                                         |  | $               | 30 |              | $ | 279                      |  | $ | 439,308            |   |  | $                                   | (91,451 | )     |  | $ | 111,257                    |  | $ | (801 | ) |  | $ | 458,622 |  
|                                                                |  |                 |    |              |   |                          |  |   |                    |   |  |                                     |         |       |  |   |                            |  |   |      |   |  |   |         |  



See
notes to condensed consolidated financial statements.



4



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NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited; in thousands)



|                                                                                                                   |  |                                     |            |   |      |   |            |  
|------------------------------------------------------------------------------------------------------------------ |  | ----------------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                                                                                   |  | For the Three MonthsEnded March 31, |           
|                                                                                                                   |  | 2005                                |            |   | 2004 |  
|Cash flows from operating activities:                                                                              |  |                                     |            |   |      |   |            |  
|Income from continuing operations                                                                                  |  | $                                   | 36,187     |   |      | $ | 32,646     |  
|Adjustments to reconcile income from continuing operations to net cash provided by (used in) operating activities: |  |                                     |            |   |      |   |            |  
|Amortization of mortgage servicing rights                                                                          |  |                                     | 5,746      |   |      |   | 3,283      |  
|Impairment on mortgage securities  available-for-sale                                                             |  |                                     | 1,612      |   |      |   |           |  
|(Gains) losses on derivative instruments                                                                           |  |                                     | (14,601    | ) |      |   | 25,398     |  
|Depreciation expense                                                                                               |  |                                     | 1,808      |   |      |   | 1,325      |  
|Amortization of deferred debt issuance costs                                                                       |  |                                     | 1,622      |   |      |   | 873        |  
|Compensation recognized under stock compensation plans                                                             |  |                                     | 458        |   |      |   | 414        |  
|Provision for credit losses                                                                                        |  |                                     | 619        |   |      |   | 146        |  
|Amortization of premiums on mortgage loans                                                                         |  |                                     | 85         |   |      |   | 214        |  
|Forgiveness of founders promissory notes                                                                          |  |                                     | 35         |   |      |   | 35         |  
|Accretion of available-for-sale securities                                                                         |  |                                     | (36,761    | ) |      |   | (22,843    | )
|Originations and purchases of mortgage loans held-for-sale                                                         |  |                                     | (1,975,147 | ) |      |   | (1,830,844 | )
|Repayments of mortgage loans held-for-sale                                                                         |  |                                     | 1,174      |   |      |   | 2,477      |  
|Proceeds from sale of mortgage loans held-for-sale to third parties                                                |  |                                     | 12,057     |   |      |   | 17,782     |  
|Proceeds from sale of mortgage loans held-for-sale in securitizations                                              |  |                                     | 2,066,840  |   |      |   | 1,680,565  |  
|Gains on sales of mortgage assets                                                                                  |  |                                     | (18,246    | ) |      |   | (51,780    | )
|Repayments of mortgage securities - trading                                                                        |  |                                     | 143,153    |   |      |   |           |  
|Changes in:                                                                                                        |  |                                     |            |   |      |   |            |  
|Servicing related advances                                                                                         |  |                                     | 563        |   |      |   | 107        |  
|Derivative instruments, net                                                                                        |  |                                     | 1,754      |   |      |   | (1,478     | )
|Other assets                                                                                                       |  |                                     | (9,537     | ) |      |   | (5,363     | )
|Accounts payable and other liabilities                                                                             |  |                                     | (439       | ) |      |   | (13,020    | )
|                                                                                                                   |  |                                     |            |   |      |   |            |  
|Net cash provided by (used in) operating activities from continuing operations                                     |  |                                     | 218,982    |   |      |   | (160,063   | )
|Net cash used in operating activities from discontinued operations                                                 |  |                                     | (1,561     | ) |      |   | (218       | )
|                                                                                                                   |  |                                     |            |   |      |   |            |  
|Net cash provided by (used in) operating activities                                                                |  |                                     | 217,421    |   |      |   | (160,281   | )
|Cash flows from investing activities:                                                                              |  |                                     |            |   |      |   |            |  
|Proceeds from paydowns on available-for-sale securities                                                            |  |                                     | 113,782    |   |      |   | 61,507     |  
|Mortgage loan repaymentsheld-in-portfolio                                                                         |  |                                     | 4,127      |   |      |   | 9,442      |  
|Proceeds from sales of assets acquired through foreclosure                                                         |  |                                     | 709        |   |      |   | 1,476      |  
|Purchases of property and equipment                                                                                |  |                                     | (2,232     | ) |      |   | (767       | )
|                                                                                                                   |  |                                     |            |   |      |   |            |  
|Net cash provided by investing activities                                                                          |  |                                     | 116,386    |   |      |   | 71,658     |  
|Cash flows from financing activities:                                                                              |  |                                     |            |   |      |   |            |  
|Proceeds from issuance of asset-backed bonds, net of debt issuance costs                                           |  |                                     |           |   |      |   | 154,025    |  
|Payments on asset-backed bonds                                                                                     |  |                                     | (100,433   | ) |      |   | (47,560    | )
|Proceeds from issuance of capital stock and exercise of equity instruments, net of offering costs                  |  |                                     | 216        |   |      |   | 83,224     |  
|Tax benefit derived from stock compensation plans                                                                  |  |                                     | (3         | ) |      |   |           |  
|Change in short-term borrowings                                                                                    |  |                                     | (243,925   | ) |      |   | 9,434      |  
|Issuance of junior subordinated debentures                                                                         |  |                                     | 48,428     |   |      |   |           |  
|Dividends paid on capital stock                                                                                    |  |                                     | (68,743    | ) |      |   | (30,819    | )
|                                                                                                                   |  |                                     |            |   |      |   |            |  
|Net cash (used in) provided by financing activities                                                                |  |                                     | (364,460   | ) |      |   | 168,304    |  
|                                                                                                                   |  |                                     |            |   |      |   |            |  
|Net (decrease) increase in cash and cash equivalents                                                               |  |                                     | (30,653    | ) |      |   | 79,681     |  
|Cash and cash equivalents, beginning of period                                                                     |  |                                     | 268,563    |   |      |   | 118,180    |  
|                                                                                                                   |  |                                     |            |   |      |   |            |  
|Cash and cash equivalents, end of period                                                                           |  | $                                   | 237,910    |   |      | $ | 197,861    |  
|                                                                                                                   |  |                                     |            |   |      |   |            |  



Continued



5



---

|                                                                             |  |                                    |        |   |      |   |        |  
|---------------------------------------------------------------------------- |  | ---------------------------------- | ------ | - | ---- | - | ------ | -
|                                                                             |  | For the ThreeMonths EndedMarch 31, |       
|                                                                             |  | 2005                               |        |   | 2004 |  
|Supplemental disclosure of cash flow information:                            |  |                                    |        |   |      |   |        |  
|Cash paid for interest                                                       |  | $                                  | 16,289 |   |      | $ | 10,290 |  
|                                                                             |  |                                    |        |   |      |   |        |  
|Cash paid for income taxes                                                   |  | $                                  | 48     |   |      | $ | 5,897  |  
|                                                                             |  |                                    |        |   |      |   |        |  
|Cash received on mortgage securities  available-for-sale with no cost basis |  | $                                  | 3,812  |   |      | $ | 10,352 |  
|                                                                             |  |                                    |        |   |      |   |        |  
|Non-cash operating, investing and financing activities:                      |  |                                    |        |   |      |   |        |  
|Cost basis of securities retained in securitizations                         |  | $                                  | 88,433 |   |      | $ | 82,785 |  
|                                                                             |  |                                    |        |   |      |   |        |  
|Retention of mortgage servicing rights                                       |  | $                                  | 11,448 |   |      | $ | 7,461  |  
|                                                                             |  |                                    |        |   |      |   |        |  
|Change in loans under removal of accounts provision                          |  | $                                  | (828   | ) |      | $ | (2,141 | )
|                                                                             |  |                                    |        |   |      |   |        |  
|Change in due to securitization trusts                                       |  | $                                  | (828   | ) |      | $ | (2,141 | )
|                                                                             |  |                                    |        |   |      |   |        |  
|Assets acquired through foreclosure                                          |  | $                                  | 666    |   |      | $ | 1,323  |  
|                                                                             |  |                                    |        |   |      |   |        |  
|Dividends payable                                                            |  | $                                  | 40,720 |   |      | $ | 33,480 |  
|                                                                             |  |                                    |        |   |      |   |        |  
|Dividend reinvestment plan program                                           |  | $                                  | 4,689  |   |      | $ | 1,016  |  
|                                                                             |  |                                    |        |   |      |   |        |  
|Restricted stock issued in satisfaction of prior year accrued bonus          |  | $                                  | 262    |   |      | $ | 1,816  |  
|                                                                             |  |                                    |        |   |      |   |        |  



See
notes to condensed consolidated financial statements.

Concluded



6



---



NOVASTAR FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2005 (Unaudited)



Note 1. Financial Statement Presentation



NovaStar Financial, Inc. and subsidiaries (the Company) operates as a specialty finance company that originates, purchases, invests in and
services residential nonconforming loans. The Company offers a wide range of mortgage loan products to borrowers, commonly referred to as nonconforming borrowers, who generally do not satisfy the credit, collateral, documentation or
other underwriting standards prescribed by conventional mortgage lenders and loan buyers, including United States of America government-sponsored entities such as Fannie Mae or Freddie Mac. The Company retains significant interests in the
nonconforming loans originated and purchased through their mortgage securities investment portfolio. The Company services all of the loans they retain interests in through their servicing platform, in order to better manage the credit performance of
those loans.



The Companys condensed consolidated
financial statements as of March 31, 2005 and for the three months ended March 31, 2005 and 2004 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. Certain reclassifications to prior year amounts have been made to conform to current year presentation.



The Companys condensed consolidated financial statements should be read in conjunction with Managements
Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements of the Company and the notes thereto, included in the Companys annual report to shareholders and annual report on Form 10-K for
the fiscal year ended December 31, 2004.



The condensed
consolidated financial statements of NovaStar Financial, Inc. (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.



Note 2. New Accounting
Pronouncements



In December 2004, the Financial Accounting
Standards Board (FASB) issued a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. This Statement establishes standards for the accounting for transactions in which an entity exchanges its equity
instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entitys equity instruments or that may be settled by the issuance
of those equity instruments. This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions and does not change the accounting guidance for share-based payment
transactions with parties other than employees provided in SFAS No. 123 and Emerging Issues Task Force of the FASB (EITF) Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction
with Selling, Goods or Services. Entities no longer have the option to use the intrinsic value method of APB 25 that was provided in SFAS No. 123 as originally issued, which generally resulted in the recognition of no compensation cost. Under
SFAS No. 123(R), the cost of employee services received in exchange for an equity award must be based on the grant-date fair value of the award. The cost of the awards under SFAS No. 123(R) will be recognized over the period an employee provides
service, typically the vesting period. No compensation cost is recognized for equity instruments in which the requisite service is not provided. For employee awards that are treated as liabilities, initial cost of the awards will be measured at fair
value. The fair value of the liability awards will be remeasured subsequently at each reporting date through the settlement date with changes in fair value during the period an employee provides service recognized as compensation cost over that
period. Under SFAS No. 123(R), all companies must use the modified prospective approach to all equity awards granted, issued, modified or cash settled prior to the date of adoption. Under the modified prospective approach, compensation expense
recognized from the point of adoption going forward is the same as if the fair value method as disclosed under the pro forma disclosure requirements of the original SFAS No. 123 had been applied from its effective date. Restatement of prior periods
(interim or annual) is not required. However, companies may elect to restate prior periods to mirror compensation expense recognized under the pro forma disclosures of the original SFAS No. 123 using the modified retrospective



7



---

approach. Under this approach, compensation expense can either be adjusted to 1) all prior periods presented with an adjustment to the beginning of the
earliest periods additional paid-in capital, deferred taxes and retained earnings for the remaining compensation expense that would have been recognized had the company applied the provisions of the original SFAS No. 123 since its effective
date (annual periods beginning after December 15, 1994) or 2) only to interim prior periods of the initial adoption year with no adjustment to beginning of year additional paid-in capital, deferred taxes and retained earnings, if adoption does not
coincide with the beginning of the companys fiscal year. We plan to adopt this standard using the required modified prospective approach. This Statement was originally effective as of the first interim or annual reporting period that begins
after June 15, 2005. In April of 2005, the SEC amended the compliance dates for SFAS No. 123(R). This Statement is now effective at the beginning of the next fiscal year that begins after June 15, 2005. As discussed in Note 1 to the 2004 annual
report on Form 10-K, the Company implemented the fair value provisions of SFAS No. 123 during 2003. As such, the adoption of this Statement is not anticipated to have a significant impact on the Companys condensed consolidated financial
statements.



In March 2005, SEC Staff Accounting Bulletin (SAB)
No. 107, Application of FASB No. 123 (revised 2004), Accounting for Stock-Based Compensationwas released. This release summarizes the SEC staff position regarding the interaction between FASB No. 123 (revised 2004), Share-Based
Payment and certain SEC rules and regulations and provides the SECs views regarding the valuation of share-based payment arrangements for public companies. As discussed in Note 1 to the 2004 annual report on Form 10-K, the Company
implemented the fair value provisions of the original SFAS No. 123 during 2003. As such, the adoption of this release is not anticipated to have a significant impact on the Companys condensed consolidated financial statements.



On March 3, 2005, the FASB issued FASP Staff Position (FSP) FIN 46(R)-5,
Implicit Variable Interests Under FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities. This FSP addresses whether a reporting enterprise has an implicit variable interest in a variable interest entity (VIE) or potential
VIE when specific conditions exist. This FSP is applicable to both nonpublic and public reporting enterprises. It covers issues that commonly arise in leasing arrangements among related parties, as well as other types of arrangements involving both
related and unrelated parties. Although implicit variable interests are mentioned in Interpretation 46(R), the term is not defined and only one example is provided. This FSP offers additional guidance, stating that implicit variable interests are
implied financial interests in an entity that change with changes in the fair value of the entitys net assets exclusive of variable interests. An implicit variable interest acts the same as an explicit variable interest except it involves the
absorbing and/or receiving of variability indirectly from the entity (rather than directly). The identification of an implicit variable interest is a matter of judgment that depends on the relevant facts and circumstances. As the Company has already
adopted Interpretation 46(R), this FSP will be effective in the first reporting period beginning after March 3, 2005. Restatement to the date of initial application of Interpretation 46(R) is permitted but not required. The adoption of this FSP is
not anticipated to have a significant impact on the Companys condensed consolidated financial statements.



Note 3. Loan Securitizations



On February 22, 2005, the Company executed a securitization transaction accounted for as a sale of loans (NMFT Series 2005-1). In this transaction,
derivative instruments were transferred into the trust. These instruments serve to reduce interest rate risk to the bondholders. Details of this transaction are as follows (dollars in thousands):



|                   |  |                  |           |                                      |   |                          |  |                              |        |                                               |   |                |  |   |        |  |   |       
|------------------ |  | ---------------- | --------- | ------------------------------------ | - | ------------------------ |  | ---------------------------- | ------ | --------------------------------------------- | - | -------------- |  | - | ------ |  | - | ------
|                   |  |                  |           | Allocated Value ofRetained Interests |   |                          |  |                              |        |                                              
|                   |  | Net BondProceeds |           | MortgageServicingRights              |   | SubordinatedBond Classes |  | PrincipalBalanceof LoansSold |        | Fair Valueof DerivativeInstrumentsTransferred |   | GainRecognized
|NMFT Series 2005-1 |  | $                | 2,066,840 |                                      | $ | 11,448                   |  | $                            | 88,433 |                                               | $ | 2,100,000      |  | $ | 13,669 |  | $ | 18,136



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



8



---

Note 4. Mortgage Securities  Available-for-Sale



Available-for-sale mortgage securities consisted of the Companys
investment in the interest-only, prepayment penalty and other subordinated securities that the securitization trust issued. The primary bonds were sold to parties independent of the Company. Management estimates their fair value of the mortgage
securities by discounting the expected future cash flow of the collateral and bonds. The average annualized yield on mortgage securities is the interest income for the period as a percentage of the average fair market value of the mortgage
securities. The cost basis, unrealized gains, estimated fair value and average yield of mortgage securities as of March 31, 2005 and December 31, 2004 were as follows (dollars in thousands):



|                        |  |            |         |                |   |                     |  |              |         |  |      |  
|----------------------- |  | ---------- | ------- | -------------- | - | ------------------- |  | ------------ | ------- |  | ---- | -
|                        |  | Cost Basis |         | UnrealizedGain |   | EstimatedFair Value |  | AverageYield |        
|As of March 31, 2005    |  | $          | 419,321 |                | $ | 111,257             |  | $            | 530,578 |  | 31.7 | %
|As of December 31, 2004 |  |            | 409,946 |                |   | 79,229              |  |              | 489,175 |  | 31.4 |  



The following table is
a rollforward of mortgage securities  available-for-sale from January 1, 2004 to March 31, 2005 (in thousands):



|                                                       |  |            |          |   |                 |   |         |                                          |  |   |          |  
|------------------------------------------------------ |  | ---------- | -------- | - | --------------- | - | ------- | ---------------------------------------- |  | - | -------- | -
|                                                       |  | Cost Basis |          |   | Unrealized Gain |   |         | EstimatedFair Value ofMortgageSecurities | 
|As of January 1, 2004                                  |  | $          | 294,562  |   |                 | $ | 87,725  |                                          |  | $ | 382,287  |  
|                                                       |  |            |          |   |                 |   |         |                                          |  |   |          |  
|Increases (decreases) to mortgage securities:          |  |            |          |   |                 |   |         |                                          |  |   |          |  
|New securities retained in securitizations             |  |            | 381,833  |   |                 |   | 6,637   |                                          |  |   | 388,470  |  
|Accretion of income (A)                                |  |            | 100,666  |   |                 |   |        |                                          |  |   | 100,666  |  
|Proceeds from paydowns of securities (A) (B)           |  |            | (351,213 | ) |                 |   |        |                                          |  |   | (351,213 | )
|Impairment on mortgage securities - available-for-sale |  |            | (15,902  | ) |                 |   |        |                                          |  |   | (15,902  | )
|Mark-to-market value adjustment                        |  |            |         |   |                 |   | (15,133 | )                                        |  |   | (15,133  | )
|                                                       |  |            |          |   |                 |   |         |                                          |  |   |          |  
|Net increase (decrease) to mortgage securities         |  |            | 115,384  |   |                 |   | (8,496  | )                                        |  |   | 106,888  |  
|                                                       |  |            |          |   |                 |   |         |                                          |  |   |          |  
|As of December 31, 2004                                |  |            | 409,946  |   |                 |   | 79,229  |                                          |  |   | 489,175  |  
|                                                       |  |            |          |   |                 |   |         |                                          |  |   |          |  
|Increases (decreases) to mortgage securities:          |  |            |          |   |                 |   |         |                                          |  |   |          |  
|New securities retained in securitizations             |  |            | 88,433   |   |                 |   | 798     |                                          |  |   | 89,231   |  
|Accretion of income (A)                                |  |            | 36,761   |   |                 |   |        |                                          |  |   | 36,761   |  
|Proceeds from paydowns of securities (A) (B)           |  |            | (114,207 | ) |                 |   |        |                                          |  |   | (114,207 | )
|Impairment on mortgage securities - available-for-sale |  |            | (1,612   | ) |                 |   |        |                                          |  |   | (1,612   | )
|Mark-to-market value adjustment                        |  |            |         |   |                 |   | 31,230  |                                          |  |   | 31,230   |  
|                                                       |  |            |          |   |                 |   |         |                                          |  |   |          |  
|Net increase to mortgage securities                    |  |            | 9,375    |   |                 |   | 32,028  |                                          |  |   | 41,403   |  
|                                                       |  |            |          |   |                 |   |         |                                          |  |   |          |  
|As of March 31, 2005                                   |  | $          | 419,321  |   |                 | $ | 111,257 |                                          |  | $ | 530,578  |  
|                                                       |  |            |          |   |                 |   |         |                                          |  |   |          |  

---

|(A) | Cash received on mortgage securities with no cost basis was $3.8 million for the three months ended March 31, 2005 and $32.2 million for the year ended December 31, 2004.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(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 and included in other assets. As of March 31, 2005 and December 31, 2004, the
Company had receivables from securitization trusts of $4.4 million and $4.1 million, respectively, related to mortgage securities with a remaining cost basis. Also, the Company had receivables from securitization trusts of $0.6 million and $0.7
million related to mortgage securities with a zero cost basis as of March 31, 2005 and December 31, 2004, respectively.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



9



---

Note 5. Junior Subordinated Debentures



On March 15, 2005, the Company completed the issuance of $50.0 million in unsecured floating rate trust preferred securities
through a newly formed statutory trust, NovaStar Capital Trust I (NCTI), organized under Delaware law. The trust preferred securities require quarterly interest distributions. The interest rate is floating at the three-month LIBOR rate plus 3.5% and
resets quarterly. The notes are redeemable, at the Companys option, in whole or in part, anytime without penalty on or after March 15, 2010, but are mandatorily redeemable when they mature on March 15, 2035. If they are redeemed on or after
March 15, 2010, but prior to maturity, the redemption price will be 100% of the principal amount plus accrued and unpaid interest.



NCTI was formed for the sole purpose of issuing these trust preferred securities. The proceeds from the issuance of the trust preferred securities and
from the sale of 100% of the voting common stock of NCTI to the Company were loaned to the Company in exchange for junior subordinated debentures of $51.6 million, which are the sole assets of NCTI. The terms of the junior subordinated debentures
match the terms of the trust preferred securities. The debentures are subordinate and junior in right of payment to all present and future senior indebtedness and certain other financial obligations of the Company. The Company also entered into a
guarantee, which together with its obligations under the junior subordinated debentures, provides full and unconditional guarantees of the trust preferred securities. Following payment by the Company of offering costs, the Companys net
proceeds from the offering aggregated $48.4 million.



The
assets and liabilities of NCTI are not consolidated into the condensed consolidated financial statements of the Company. Accordingly, the Companys equity interest in NCTI is accounted for using the equity method. Interest on the junior
subordinated debt is included in the Companys condensed consolidated statements of income as interest expensesubordinated debt and the junior subordinated debentures are presented as a separate category on the condensed consolidated
balance sheets.



Note 6. UBS Borrowings



In connection with the lending agreement with UBS Warburg Real Estate
Securities, Inc. (UBS), NovaStar Mortgage SPV I (NovaStar Trust), a Delaware statutory trust, has been established by NovaStar Mortgage, Inc. (NMI) as a wholly-owned special-purpose warehouse finance subsidiary
whose assets and liabilities are included in the Companys condensed consolidated financial statements.



NovaStar Trust has agreed to issue and sell to UBS mortgage notes (the Notes). Under the legal agreements which document the issuance and sale
of the Notes:



| |  |  | all assets which are from time to time owned by NovaStar Trust are legally owned by NovaStar Trust and not by NMI.
| | - |  | ------------------------------------------------------------------------------------------------------------------



| |  |  | NovaStar Trust is a legal entity separate and distinct from NMI and all other affiliates of NMI.
| | - |  | ------------------------------------------------------------------------------------------------



| |  |  | the assets of NovaStar Trust are legally assets only of NovaStar Trust, and are not legally available to NMI and all other affiliates of NMI or their respective creditors, for
pledge to other creditors or to satisfy the claims of other creditors.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | none of NMI or any other affiliate of NMI is legally liable on the debts of NovaStar Trust, except for an amount limited to 10% of the maximum dollar amount of the Notes permitted
to be issued.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the only assets of NMI which result from the issuance and sale of the Notes are:
| | - |  | --------------------------------------------------------------------------------



| | 1) | any cash portion of the purchase price paid from time to time by NovaStar Trust in consideration of Mortgage Loans sold to NovaStar Trust by NMI; and
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------



| | 2) | the value of NMIs net equity investment in NovaStar Trust.
| | -- | -----------------------------------------------------------



As of March 31, 2005, NovaStar Trust had the following assets:



| | 1) | whole loans: $341.4 million
| | -- | ---------------------------



| | 2) | real estate owned properties: $0, and
| | -- | -------------------------------------



| | 3) | cash and cash equivalents: $0.8 million.
| | -- | ----------------------------------------



As of March 31, 2005, NovaStar Trust had the following liabilities and equity:



| | 1) | short-term debt due to UBS: $340.6 million, and
| | -- | -----------------------------------------------



| | 2) | $1.6 million in members equity investment.
| | -- | -------------------------------------------



10



---

Note 7. Commitments and Contingencies



Commitments.The Company has commitments to borrowers to fund residential mortgage loans as well as
commitments to purchase and sell mortgage loans to third parties. At March 31, 2005, the Company had outstanding commitments to originate, purchase and sell loans of $422.9 million, $3.5 million and $11.6 million, respectively. At December 31, 2004,
the Company had outstanding commitments to originate loans of $361.2 million. The Company had no commitments to purchase or sell loans at December 31, 2004. The commitments to originate and purchase loans do not necessarily represent future cash
requirements, as some portion of the commitments are likely to expire without being drawn upon.



In the ordinary course of business, the Company sells loans with recourse for borrower defaults. For loans that have been sold with recourse and are no
longer on the Companys balance sheet, the recourse component is considered a guarantee. The Company sold no loans with recourse for borrower defaults during 2004 and none were sold during the first three months of 2005. The Company did not
maintain a reserve related to these guarantees as of March 31, 2005 compared with a reserve of $45,000 as of December 31, 2004.



In the ordinary course of business, the Company sells loans with recourse where a defect occurred in the loan origination process and guarantees to cover
investor losses should origination defects occur. 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 March 31, 2005 and December 31, 2004, the Company had loans sold with recourse with an outstanding principal balance of $12.2
billion and $11.4 billion, respectively. Repurchases of loans where a defect has occurred have been insignificant.



Contingencies. The Company is currently party to various legal proceedings and claims. While management, including internal counsel,
currently believes that the ultimate outcome of these proceedings and claims, individually and in the aggregate, will not have a material adverse effect on the Companys financial condition or results of operations, litigation is subject to
inherent uncertainties. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on the results of operations for the period in which the ruling occurs.



As of March 31, 2005, there have been no material changes to the legal
proceedings disclosed in the Companys annual report to shareholders and annual report on Form 10-K for the fiscal year ended December 31, 2004.



Note 8. Issuance of Capital Stock



The Company sold 116,735 shares of its common stock during the three months ended March 31, 2005 under its Direct Purchase and Dividend Reinvestment Plan.
Net proceeds of $4.8 million were raised under these sales of common stock.



During the three months ended March 31, 2005, 71,227 shares of common stock were issued under the Companys stock-based compensation plan. Proceeds of $0.5 million were received under these issuances.



11



---

Note 9. Comprehensive Income



Comprehensive income includes net income and revenues, expenses, gains and losses that are not included in net income.
Following is a summary of comprehensive income for the three months ended March 31, 2005 and 2004 (in thousands).



|                                                                                                         |  |                                     |        |      |   |         |  
|-------------------------------------------------------------------------------------------------------- |  | ----------------------------------- | ------ | ---- | - | ------- | -
|                                                                                                         |  | For the Three MonthsEnded March 31, |       
|                                                                                                         |  | 2005                                |        | 2004 |  
|Net income                                                                                               |  | $                                   | 35,203 |      | $ | 30,925  |  
|Other comprehensive income (loss):                                                                       |  |                                     |        |      |   |         |  
|Change in unrealized gain on available-for-sale securities                                               |  |                                     | 30,416 |      |   | (15,444 | )
|Change in unrealized loss on derivative instruments used in cash flow hedges, net of related tax effects |  |                                     |       |      |   | (103    | )
|Impairment on available-for-sale securities reclassified to earnings                                     |  |                                     | 1,612  |      |   |        |  
|Net settlements of derivative instruments used in cash flow hedges reclassified to earnings              |  |                                     | 109    |      |   | 1,798   |  
|Other amortization                                                                                       |  |                                     |       |      |   | (26     | )
|                                                                                                         |  |                                     |        |      |   |         |  
|Other comprehensive income (loss)                                                                        |  |                                     | 32,137 |      |   | (13,775 | )
|                                                                                                         |  |                                     |        |      |   |         |  
|Total comprehensive income                                                                               |  | $                                   | 67,340 |      | $ | 17,150  |  
|                                                                                                         |  |                                     |        |      |   |         |  



Note 10. Branch Operations



As the demand for conforming loans declined significantly
during 2004 and into 2005, many branches have not been able to generate sufficient mortgage loan volume to, in turn, produce sufficient fees to meet operating expense demands. As a result of these conditions, a significant number of branch managers
have voluntarily terminated employment with the Company. The Company has also terminated branches when loan production results were substandard. The Company considers a branch to be discontinued upon its termination date, which is the point in time
when the operations cease. The discontinued operations apply to the branch operations segment presented in Note 11. The operating results for these discontinued operations have been segregated from the on-going operating results of the Company. The
operating results of all discontinued operations are summarized as follows (in thousands):



|                                    |  |                                     |        |   |      |   |         |  
|----------------------------------- |  | ----------------------------------- | ------ | - | ---- | - | ------- | -
|                                    |  | For the Three MonthsEnded March 31, |       
|                                    |  | 2005                                |        |   | 2004 |  
|Fee income                          |  | $                                   | 4,668  |   |      | $ | 27,411  |  
|General and administrative expenses |  |                                     | (6,268 | ) |      |   | (30,209 | )
|                                    |  |                                     |        |   |      |   |         |  
|Loss before income tax benefit      |  |                                     | (1,600 | ) |      |   | (2,798  | )
|Income tax benefit                  |  |                                     | 616    |   |      |   | 1,077   |  
|                                    |  |                                     |        |   |      |   |         |  
|Loss from discontinued operations   |  | $                                   | (984   | ) |      | $ | (1,721  | )
|                                    |  |                                     |        |   |      |   |         |  



As of March 31, 2005,
the Company has $1.2 million in cash, $0.1 million in receivables included in other assets and $1.3 million in payables included in accounts payable and other liabilities pertaining to discontinued operations, which are included in the condensed
consolidated balance sheets. As of December 31, 2004, the Company had $1.8 million in cash, $1.1 million in receivables included in other assets and $2.9 million in payables included in accounts payable and other liabilities pertaining to
discontinued operations.



12



---

Note 11. Segment Reporting



The Company reviews, manages and operates its business in three segments. These business segments are: mortgage portfolio
management, mortgage lending and loan servicing and branch operations. Mortgage portfolio management operating results are driven from the income generated on the assets the Company manages less associated management costs. Mortgage lending and loan
servicing operations include the marketing, underwriting and funding of loan production. Servicing operations represent the income and costs to service the Companys on and off-balance sheet loans. Branch operations include the collective
income generated by the Companys wholly-owned subsidiary, NovaStar Home Mortgage, Inc. (NHMI), brokers and the associated operating costs. Also, the corporate-level income and costs to support the NHMI branches are represented in
the branch operations segment. Branches that have terminated in 2004 and in the first quarter of 2005 have been segregated from the results of the ongoing operations of the Company for the three months ended March 31, 2005 and 2004. Following is a
summary of the operating results of the Companys primary operating units for the three months ended March 31, 2005 and 2004 (in thousands):



For the Three Months Ended March 31, 2005



|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |         |  
|------------------------------------------------------ |  | --------------------------- | ------ | - | --------------------------------- | - | ------- | ---------------- |  | - | ------------ | - |  | ----- | ------ | - |  | - | ------- | -
|                                                       |  | MortgagePortfolioManagement |        |   | Mortgage Lendingand LoanServicing |   |         | BranchOperations |  |   | Eliminations |   |  | Total |       
|Interest income                                        |  | $                           | 41,776 |   |                                   | $ | 20,202  |                  |  | $ | 79           |   |  | $     | (2     | ) |  | $ | 62,055  |  
|Interest expense                                       |  |                             | 6,024  |   |                                   |   | 12,311  |                  |  |   | 40           |   |  |       | (1,768 | ) |  |   | 16,607  |  
|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |         |  
|Net interest income before provision for credit losses |  |                             | 35,752 |   |                                   |   | 7,891   |                  |  |   | 39           |   |  |       | 1,766  |   |  |   | 45,448  |  
|Provision for credit losses                            |  |                             | (619   | ) |                                   |   |        |                  |  |   |             |   |  |       |       |   |  |   | (619    | )
|Fee income                                             |  |                             |       |   |                                   |   | 8,643   |                  |  |   | 18,913       |   |  |       | (8,973 | ) |  |   | 18,583  |  
|Gains on sales of mortgage assets                      |  |                             | 114    |   |                                   |   | 13,746  |                  |  |   |             |   |  |       | 4,386  |   |  |   | 18,246  |  
|Gains (losses) on derivative instruments               |  |                             | (52    | ) |                                   |   | 14,653  |                  |  |   |             |   |  |       |       |   |  |   | 14,601  |  
|Impairment on mortgage securities  available-for-sale |  |                             | (1,612 | ) |                                   |   |        |                  |  |   |             |   |  |       |       |   |  |   | (1,612  | )
|Other income (expense)                                 |  |                             | 5,252  |   |                                   |   | (933    | )                |  |   | 16           |   |  |       | (1,690 | ) |  |   | 2,645   |  
|General and administrative expenses                    |  |                             | (3,173 | ) |                                   |   | (41,325 | )                |  |   | (19,886      | ) |  |       | 4,098  |   |  |   | (60,286 | )
|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |         |  
|Income (loss) before income tax                        |  |                             | 35,662 |   |                                   |   | 2,675   |                  |  |   | (918         | ) |  |       | (413   | ) |  |   | 37,006  |  
|Income tax expense (benefit)                           |  |                             |       |   |                                   |   | 1,033   |                  |  |   | (358         | ) |  |       | 144    |   |  |   | 819     |  
|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |         |  
|Income (loss) from continuing operations               |  |                             | 35,662 |   |                                   |   | 1,642   |                  |  |   | (560         | ) |  |       | (557   | ) |  |   | 36,187  |  
|Loss from discontinued operations, net of income tax   |  |                             |       |   |                                   |   |        |                  |  |   | (879         | ) |  |       | (105   | ) |  |   | (984    | )
|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |         |  
|Net income (loss)                                      |  | $                           | 35,662 |   |                                   | $ | 1,642   |                  |  | $ | (1,439       | ) |  | $     | (662   | ) |  | $ | 35,203  |  
|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |         |  



For the Three Months Ended March
31, 2004



|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |         |  
|------------------------------------------------------ |  | --------------------------- | ------ | - | --------------------------------- | - | ------- | ---------------- |  | - | ------------ | - |  | ----- | ------ | - |  | - | ------- | -
|                                                       |  | MortgagePortfolioManagement |        |   | Mortgage Lendingand LoanServicing |   |         | BranchOperations |  |   | Eliminations |   |  | Total |       
|Interest income                                        |  | $                           | 35,243 |   |                                   | $ | 15,126  |                  |  | $ |             |   |  | $     | (10    | ) |  | $ | 50,359  |  
|Interest expense                                       |  |                             | 5,246  |   |                                   |   | 7,711   |                  |  |   | 19           |   |  |       | (2,255 | ) |  |   | 10,721  |  
|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |         |  
|Net interest income before provision for credit losses |  |                             | 29,997 |   |                                   |   | 7,415   |                  |  |   | (19          | ) |  |       | 2,245  |   |  |   | 39,638  |  
|Provision for credit losses                            |  |                             | (146   | ) |                                   |   |        |                  |  |   |             |   |  |       |       |   |  |   | (146    | )
|Fee income                                             |  |                             |       |   |                                   |   | 7,771   |                  |  |   | 19,116       |   |  |       | (8,900 | ) |  |   | 17,987  |  
|Gains on sales of mortgage assets                      |  |                             | 385    |   |                                   |   | 46,932  |                  |  |   |             |   |  |       | 4,463  |   |  |   | 51,780  |  
|Losses on derivative instruments                       |  |                             | (1,190 | ) |                                   |   | (24,208 | )                |  |   |             |   |  |       |       |   |  |   | (25,398 | )
|Other income (expense)                                 |  |                             | 4,181  |   |                                   |   | (1,624  | )                |  |   | 10           |   |  |       | (2,085 | ) |  |   | 482     |  
|General and administrative expenses                    |  |                             | (1,949 | ) |                                   |   | (32,650 | )                |  |   | (19,511      | ) |  |       | 3,936  |   |  |   | (50,174 | )
|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |         |  
|Income (loss) before income tax                        |  |                             | 31,278 |   |                                   |   | 3,636   |                  |  |   | (404         | ) |  |       | (341   | ) |  |   | 34,169  |  
|Income tax expense (benefit)                           |  |                             |       |   |                                   |   | 1,887   |                  |  |   | (158         | ) |  |       | (206   | ) |  |   | 1,523   |  
|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |         |  
|Income (loss) from continuing operations               |  |                             | 31,278 |   |                                   |   | 1,749   |                  |  |   | (246         | ) |  |       | (135   | ) |  |   | 32,646  |  
|Loss from discontinued operations, net of income tax   |  |                             |       |   |                                   |   |        |                  |  |   | (630         | ) |  |       | (1,091 | ) |  |   | (1,721  | )
|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |         |  
|Net income (loss)                                      |  | $                           | 31,278 |   |                                   | $ | 1,749   |                  |  | $ | (876         | ) |  | $     | (1,226 | ) |  | $ | 30,925  |  
|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |         |  



13



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Intersegment revenues and expenses that were eliminated in consolidation were as follows for the three months ended March
31, 2005 and 2004 (in thousands):



|                                                                                                  |  |                                    |       |   |      |   |       |  
|------------------------------------------------------------------------------------------------- |  | ---------------------------------- | ----- | - | ---- | - | ----- | -
|                                                                                                  |  | For the ThreeMonths EndedMarch 31, |      
|                                                                                                  |  | 2005                               |       |   | 2004 |  
|Amounts paid to (received from) mortgage portfolio from (to) mortgage lending and loan servicing: |  |                                    |       |   |      |   |       |  
|Loan servicing fees                                                                               |  | $                                  | (75   | ) |      | $ | (130  | )
|Interest income on intercompany debt                                                              |  |                                    | 1,745 |   |      |   | 2,236 |  
|Guaranty, commitment, loan sale and securitization fees                                           |  |                                    | 2,434 |   |      |   | 2,012 |  
|Interest income on warehouse borrowings                                                           |  |                                    | 20    |   |      |   |      |  
|Gain on sale of mortgage securities  available-for-sale retained in securitizations              |  |                                    | (799  | ) |      |   |      |  
|Amounts paid to (received from) branch operations from (to) mortgage lending and loan servicing:  |  |                                    |       |   |      |   |       |  
|Lender premium                                                                                    |  |                                    | 4,083 |   |      |   | 6,577 |  
|Subsidized fees                                                                                   |  |                                    |      |   |      |   | 21    |  
|Interest income on warehouse line                                                                 |  |                                    | (2    | ) |      |   | (10   | )
|Fee income on warehouse line                                                                      |  |                                    | (1    | ) |      |   | (9    | )



Based on SFAS No. 91,
Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, the Company defers certain nonrefundable fees and direct costs associated with the origination of loans in the
branch operations segment which are subsequently brokered to the mortgage lending and servicing segment. The mortgage lending and servicing segment ultimately funds the loans and then sells the loans either through securitizations or outright sales
to third parties. The net deferred cost (income) becomes part of the cost basis of the loans and serves to either increase (net deferred income) or decrease (net deferred cost) the gain or loss recognized by the mortgage lending and servicing
segment. These transactions are accounted for in the eliminations column of the Companys segment reporting. The following table summarizes these amounts for the three months ended March 31, 2005 and 2004 (in thousands):



|                                  |  |                                     |        |   |      |   |        |  
|--------------------------------- |  | ----------------------------------- | ------ | - | ---- | - | ------ | -
|                                  |  | For the Three MonthsEnded March 31, |       
|                                  |  | 2005                                |        |   | 2004 |  
|Gains on sales of mortgage assets |  | $                                   | 572    |   |      | $ |       |  
|Fee income                        |  |                                     | (5,587 | ) |      |   | (7,260 | )
|General & administrative expenses |  |                                     | 4,701  |   |      |   | 7,260  |  



14



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Note 12. Earnings Per Share



The computations of basic and diluted earnings per share for the three months ended March 31, 2005 and 2004 are as follows
(in thousands, except per share amounts):



|                                                                   |  |                                    |        |   |      |   |        |  
|------------------------------------------------------------------ |  | ---------------------------------- | ------ | - | ---- | - | ------ | -
|                                                                   |  | For the ThreeMonths EndedMarch 31, |       
|                                                                   |  | 2005                               |        |   | 2004 |  
|Numerator:                                                         |  |                                    |        |   |      |   |        |  
|Income from continuing operations                                  |  | $                                  | 36,187 |   |      | $ | 32,646 |  
|Dividends on preferred shares                                      |  |                                    | (1,663 | ) |      |   | (1,275 | )
|                                                                   |  |                                    |        |   |      |   |        |  
|Income from continuing operations available to common shareholders |  |                                    | 34,524 |   |      |   | 31,371 |  
|Loss from discontinued operations, net of income tax               |  |                                    | (984   | ) |      |   | (1,721 | )
|                                                                   |  |                                    |        |   |      |   |        |  
|Net income available to common shareholders                        |  | $                                  | 33,540 |   |      | $ | 29,650 |  
|                                                                   |  |                                    |        |   |      |   |        |  
|                                                                   |  |                                   
|Denominator:                                                       |  |                                    |        |   |      |   |        |  
|Weighted average common shares outstanding  basic                 |  |                                    | 27,766 |   |      |   | 24,655 |  
|                                                                   |  |                                    |        |   |      |   |        |  
|Weighted average common shares outstanding  dilutive:             |  |                                    |        |   |      |   |        |  
|Weighted average common shares outstanding  basic                 |  |                                    | 27,766 |   |      |   | 24,655 |  
|Stock options                                                      |  |                                    | 339    |   |      |   | 608    |  
|Restricted stock                                                   |  |                                    | 6      |   |      |   | 11     |  
|                                                                   |  |                                    |        |   |      |   |        |  
|Weighted average common shares outstanding  dilutive              |  |                                    | 28,111 |   |      |   | 25,274 |  
|                                                                   |  |                                    |        |   |      |   |        |  
|                                                                   |  |                                   
|Basic earnings per share:                                          |  |                                    |        |   |      |   |        |  
|Income from continuing operations                                  |  | $                                  | 1.30   |   |      | $ | 1.32   |  
|Dividends on preferred shares                                      |  |                                    | (0.06  | ) |      |   | (0.05  | )
|                                                                   |  |                                    |        |   |      |   |        |  
|Income from continuing operations available to common shareholders |  |                                    | 1.24   |   |      |   | 1.27   |  
|Loss from discontinued operations, net of income tax               |  |                                    | (0.03  | ) |      |   | (0.07  | )
|                                                                   |  |                                    |        |   |      |   |        |  
|Net income available to common shareholders                        |  | $                                  | 1.21   |   |      | $ | 1.20   |  
|                                                                   |  |                                    |        |   |      |   |        |  
|                                                                   |  |                                   
|Diluted earnings per share:                                        |  |                                    |        |   |      |   |        |  
|Income from continuing operations                                  |  | $                                  | 1.29   |   |      | $ | 1.29   |  
|Dividends on preferred shares                                      |  |                                    | (0.06  | ) |      |   | (0.05  | )
|                                                                   |  |                                    |        |   |      |   |        |  
|Income from continuing operations available to common shareholders |  |                                    | 1.23   |   |      |   | 1.24   |  
|Loss from discontinued operations, net of income tax               |  |                                    | (0.04  | ) |      |   | (0.07  | )
|                                                                   |  |                                    |        |   |      |   |        |  
|Net income available to common shareholders                        |  | $                                  | 1.19   |   |      | $ | 1.17   |  
|                                                                   |  |                                    |        |   |      |   |        |  



15



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



The following discussion should be read in conjunction with the preceding condensed consolidated financial statements of NovaStar Financial, Inc. and
its subsidiaries (the Company or NovaStar Financial) 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, 2004.



Safe Harbor Statement



Safe Harbor statement under the Private Securities Litigation
Reform Act of 1995: Statements in this discussion regarding NovaStar Financial, Inc. (NovaStar Financial or NFI) and its business, which are not historical facts, are forward-looking statements that involve risks
and uncertainties. Certain matters discussed in this quarterly report may constitute forward-looking statements within the meaning of the federal securities laws that inherently include certain risks and uncertainties. Actual results and the time of
certain events could differ materially from those projected in or contemplated by the forward-looking statements due to a number of factors, including general economic conditions, fluctuations in interest rates, fluctuations in prepayment speeds,
fluctuations in losses due to defaults on mortgage loans, the availability of non-conforming residential mortgage loans, the availability and access to financing and liquidity resources, and other risk factors outlined in the annual report on Form
10-K for the fiscal year ended December 31, 2004. Other factors not presently identified may also cause actual results to differ. Management continuously updates and revises these estimates and assumptions based on actual conditions experienced. It
is not practicable to publish all revisions and, as a result, no one should assume that results projected in or contemplated by the forward-looking statements will continue to be accurate in the future. Risks and uncertainties, which could cause
results to differ from those discussed in the forward-looking statements herein, are listed in the Risk Management section of the annual report on Form 10-K for the fiscal year ended December 31, 2004.



Overview of Performance



During the three months ended March 31, 2005, we reported income from continuing operations available to common shareholders
of $34.5 million, or $1.23 per diluted share, as compared to $31.4 million, or $1.24 per diluted share, for the same period in 2004. We also reported a loss from discontinued operations, net of income tax, of $1.0 million, or $0.04 per diluted share
and $1.7 million, or $0.07 per diluted share for the three months ended March 31, 2005 and 2004, respectively. See further discussion of discontinued operations under the heading Results of Operations.



Our income from continuing operations available to common shareholders was
driven largely by the income generated by our mortgage securities available-for-sale portfolio, which increased from $404.0 million as of March 31, 2004 to $530.6 million as of March 31, 2005. These securities are retained in the securitization of
the mortgage loans we originate and purchase. We securitized $2.1 billion of mortgage loans for the three months ended March 31, 2005 as compared to $1.7 billion for the same period in 2004. The increased volume of mortgage loans we securitized is
directly attributable to the increase in our loan origination and purchase volume. During the three months ended March 31, 2005 and 2004, we originated and purchased $1.9 billion and $1.8 billion, respectively, in nonconforming, residential mortgage
loans. Although we securitized approximately $400 million more of nonconforming, residential mortgage loans for the three months ended March 31, 2005 as compared to the same period in 2004, our income from continuing operations available to common
shareholders increased only slightly by $3.1 million as a result of the decline in profit margins in our mortgage lending segment.



Profit margins within our mortgage lending segment continued to tighten in the first quarter of 2005 as short-term rates continued to rise while the
coupons on the mortgage loans we originated and purchased increased only slightly from 2004. One-month LIBOR and the two-year swap rate increased from 1.09% and 1.88%, respectively, at March 31, 2004 to 2.87% and 4.19%, respectively, at March 31,
2005 while the weighted average coupon on our nonconforming originations and purchases for the three months ended March 31, 2005 was 7.6% as compared to 7.4% for the same period in 2004. These factors contributed to the whole loan price used in
valuing our mortgage securities at the time of securitization to significantly decrease throughout 2004 and into the first quarter of 2005, which is directly correlated to the decrease in gains on sales of



16



---

mortgage loans as a percentage of the loans securitized. For the three months ended March 31, 2005 and 2004, the weighted average net whole loan price used
in the initial valuation of our retained securities was 102.54 and 104.71, respectively, and the weighted average gain on securitization as a percentage of the collateral securitized was 0.9% and 3.0%, respectively.



Additionally, as a result of our interest rate risk management strategies, we
recognized gains (losses) on derivative instruments which did not qualify for hedge accounting of $14.6 million and ($25.4) million for the three months ended March 31, 2005 and 2004, respectively. During periods of rising rates, these derivative
instruments help maintain the net interest margin between our assets and liabilities as well as diminish the effect of changes in general interest rate levels on the market value of our mortgage assets. Of the $14.6 million in gains on derivative
instruments for the three months ended March 31, 2005, $9.9 million was related to mark-to-market gains on derivatives transferred into the NMFT Series 2005-1 securitization while $5.3 million was related to mark-to-market gains on derivatives that
were still owned by us at March 31, 2005. The remaining difference is attributable to net settlements paid to counterparties.



Summary of Operations and Key Performance Measurements



Our net income is highly dependent upon our mortgage securities - available-for-sale portfolio, which is generated from the securitization of
nonconforming loans we have originated and purchased. These mortgage securities represent the right to receive the net future cash flows from a pool of nonconforming loans. Generally speaking, the more nonconforming loans we originate and purchase,
the larger our securities portfolio and, therefore, the greater earnings potential. As a result, earnings are related to the volume of nonconforming loans and related performance factors for those loans, including their average coupon, borrower
default rate and borrower prepayment rate. Information regarding our lending volume is presented under the heading Financial Condition as of March 31, 2005 and December 31, 2004 - Mortgage Loans.



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



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



The key performance measures for management are:



| |  |  | net income available to common shareholders
| | - |  | -------------------------------------------



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



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



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



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



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



Known Material Trends



Over the last ten years, the nonconforming lending market has grown from less than $50 billion to approximately $530 billion in 2004 as estimated by the National Mortgage News. A significant portion of these loans are made to borrowers who
are using equity in their primary residence to consolidate low-balance, installment or consumer debt. The nonconforming market has grown through a variety of interest rate environments. One of the main drivers of growth in this market has been the
rise in housing prices which gives borrowers the opportunity to use the equity in their home to consolidate their high interest rate, short-term, non-tax deductible consumer or installment debt into lower interest rate, long-term, often tax
deductible mortgage debt. Management estimates that NovaStar Financial has a 1-2% market share. While management cannot predict consumer spending and borrowing habits, historical trends indicate that the market in which we operate is relatively
stable and should continue to experience long-term growth.



17



---

We depend on the capital markets to finance the mortgage loans we originate and purchase. The primary
bonds we issue in our loan securitizations are sold to large, institutional investors and United States of America government-sponsored enterprises. The capital markets also provide us with capital to operate our business. The trend has been
favorable in the capital markets for the types of securitization transactions we execute. Investor appetite for the bonds created by securitizations has been strong. Additionally, commercial and investment banks have provided significant liquidity
to finance our mortgage lending operations through warehouse repurchase facilities. While management cannot predict the future liquidity environment, we are unaware of any material trend that would disrupt continued liquidity support in the capital
markets for our business. See the Liquidity and Capital Resources section of Managements Discussion and Analysis of Financial Condition and Results of Operations for further discussion of liquidity risks and resources
available to us.



Another trend, which could continue to impact
our profitability, is that profit margins in the mortgage banking industry continue to tighten. Competitive pressures are holding mortgage loan coupons generally flat while short-term interest rates continue to increase. See the Overview of
Performance section for discussion regarding the impact this trend has had on recent performance.



Within the past two years, the mortgage Real Estate Investments Trust (REIT) industry has seen a significant increase in the desire for
raising public capital. Additionally, there have been several new entrants to the mortgage REIT business and other mortgage lenders that have converted to (or that are considering conversion to) REIT status. This increased reliance on the capital
markets and increase in number of mortgage REITs may decrease the pricing and increase the underwriting costs of raising equity in the mortgage REIT industry.



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



Description of Businesses



Mortgage Portfolio Management



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



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



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



| |  | Earnings are generated from the return on our mortgage securities  available-for-sale and mortgage loan portfolio.
|- |  | -------------------------------------------------------------------------------------------------------------------



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



Earnings from our portfolio of mortgage loans
and securities generate a substantial portion of our earnings. Gross interest income was $62.1 million and $50.4 million for the three months ended March 31, 2005 and 2004, respectively. Net interest income before provision for credit losses from
the portfolio was $45.4 million and $39.6 million for the three months ended March 31, 2005 and 2004, respectively. See our discussion of interest income under the heading Results of Operations - Net Interest Income. See Note 11 to our
condensed consolidated financial statements for a summary of operating results for mortgage portfolio management.



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



18



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In certain circumstances, because we enter into interest rate agreements that do not meet the hedging
criteria set forth in accounting principles generally accepted in the United States of America, we are required to record the change in the value of derivatives as a component of earnings even though they may reduce our interest rate risk. In times
where short-term rates rise or drop significantly, the value of our agreements will increase or decrease, respectively. As a result, we recognized gains on these derivatives of $14.6 million in the three months ended March 31, 2005 compared with
losses of $25.4 million for the same period in 2004.



Mortgage Lending and
Loan Servicing



The mortgage lending operation is
significant to our financial results as it produces the loans that ultimately collateralize the mortgage securities  available-for-sale that we hold in our portfolio. During the first three months of 2005, we originated and purchased $1.9
billion in nonconforming mortgage loans compared with $1.8 billion during the same period of 2004. The majority of these loans were retained in our servicing portfolio and serve as collateral for our securities. The loans we originate and purchase
are sold, either in securitization transactions or in outright sales to third parties. During the first three months of 2005 we securitized $2.1 billion in loans compared with $1.7 billion during the same period of 2004. We recognized gains on sales
of mortgage assets totaling $18.2 million and $51.8 million during the three months ended March 31, 2005 and 2004, respectively. In securitization transactions accounted for as sales, we retain interest-only, prepayment penalty,
overcollateralization and other subordinated securities, along with the right to service the loans. See Note 11 to our condensed consolidated financial statements for a summary of operating results for mortgage lending and loan servicing.



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



Our nationwide loan origination network includes wholesale loan brokers, correspondent institutions and direct to consumer operations. We have developed a nationwide network of wholesale loan brokers and mortgage lenders who submit mortgage
loans to us. Except for NovaStar Home Mortgage brokers described below, these brokers and mortgage lenders are independent from any of the NovaStar Financial entities. Our sales force, which includes account executives in 39 states, develops and
maintains relationships with this network of independent retail brokers. Our correspondent origination channel consists of a network of institutions from which we purchase nonconforming mortgage loans on a bulk or flow basis. Our direct to consumer
origination channel consists of call centers, which use telemarketing and internet loan lead sources to originate mortgage loans.



We underwrite, process, fund and service the nonconforming mortgage loans sourced through our broker network in centralized facilities. Further details
regarding the loan originations are discussed under the Financial Condition as of March 31, 2005 and December 31, 2004 - Mortgage Loans.



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



For long-term funding, we pool our mortgage loans and issue asset-backed bonds (ABB). Primary bonds  AAA through BBB rated  are
issued to the public. We retain the interest-only, prepayment penalty, overcollateralization and other subordinated bonds. We also retain the right to service the loans. Prior to 1999, our ABB transactions were executed and designed to meet
accounting rules that resulted in securitizations being treated as financing transactions. The mortgage loans and related debt continue to be presented on our condensed consolidated balance sheets, and no gain was recorded. Beginning in



19



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1999, our securitization transactions have been structured to qualify as sales for accounting and income tax purposes. The loans and related bond liability
are not recorded in our condensed consolidated financial statements. We do, however, record the value of the securities and servicing rights we retain. Details regarding ABBs we issued can be found in Managements Discussion and Analysis
of Financial Condition and Results of Operations.



Loan
servicing remains a critical part of our business operation. In the opinion of management, maintaining contact with our borrowers is critical in managing credit risk and in borrower retention. Nonconforming borrowers are more prone to late payments
and are more likely to default on their obligations than conventional borrowers. By servicing our loans, we strive to identify problems with borrowers early and take quick action to address problems. Borrowers may be motivated to refinance their
mortgage loans either by improving their personal credit or due to a decrease in interest rates. By keeping in close touch with borrowers, we can provide them with information about NovaStar Financial products to encourage them to refinance with us.
Mortgage servicing yields fee income for us in the form of fees paid by the borrowers for normal customer service and processing fees. In addition we receive contractual fees approximating 0.50% of the outstanding balance and rights to future cash
flows arising after the investors in the securitization trusts have received the return for which they contracted. We recognized $14.5 million and $8.5 million in loan servicing fee income from the securitization trusts during the three months ended
March 31, 2005 and 2004, respectively. Also, see Results of Operations - Mortgage Loan Servicing for further discussion and analysis of the servicing operations.



Branch Operations



In 1999, we opened our retail mortgage broker business operating under the name NovaStar Home Mortgage, Inc. (NHMI). Prior to 2004, many of
these NHMI branches were operated as limited liability companies (LLC) in which we owned a minority interest in the LLC and the branch manager was the majority interest holder. In December 2003, we decided to terminate the LLCs
effective January 1, 2004. As of January 1, 2004, continuing branches that formerly operated as LLCs became wholly-owned operating units of NHMI and their financial results are included in the condensed consolidated financial statements.
Branch offices offer conforming and nonconforming loans to potential borrowers. Loans are brokered for approved investors, including NovaStar Mortgage. The NHMI branches are considered departmental functions of NHMI under which the branch manager
(department head) is an employee of NHMI and receives compensation based on the profitability of the branch (department) as bonus compensation. See Note 11 to our condensed consolidated financial statements for a summary of operating results for our
branches.



We routinely close branches and branch managers
voluntarily terminate their employment with us, which generally results in the branchs closure. As the demand for conforming loans declined significantly during 2004 and into 2005, many branches were not able to produce sufficient fees to meet
operating expense demands. As a result of these conditions, a significant number of branch managers voluntarily terminated employment with us. We have also terminated many branches when loan production results were substandard. In these
terminations, the branch and all operations are eliminated. Note 10 to our condensed consolidated financial statements provides detail regarding the impact of the discontinued operations and modifications to our branch program.



The branch business provides an additional source for mortgage loan
originations that, in most cases, we will eventually sell, either in securitizations or in outright sales to third parties. During the first three months of 2005 and 2004, our branches brokered $481.3 million and $849.0 million, respectively, in
nonconforming loans, of which we funded $198.5 million and $411.8 million, respectively.



20



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Following is a diagram of the industry in which we operate and our loan production including nonconforming and conforming
during the first three months of 2005 (in thousands).



LOGO



---

|(A) | A portion of the loans securitized or sold to unrelated parties as of March 31, 2005 were originated prior to 2005, but due to timing were not yet securitized or sold at the end of
2004. Loans originated and purchased during the first three months of 2005 that we have not securitized or sold to unrelated parties as of March 31, 2005 are included in our mortgage loans held-for-sale
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(B) | The AAA-BBB rated securities from the NMFT Series 2005-1 securitization were purchased by bond investors during the first three months of 2005.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------



|(C) | The excess cash flow and subordinated bonds retained by NovaStar Financial are from the NMFT Series 2005-1 securitization transaction, which occurred during the first three months
of 2005.
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Critical Accounting Estimates



We prepare our condensed consolidated financial statements in conformity with accounting principles generally accepted in
the United States of America and, therefore, are required to make estimates regarding the values of our assets and liabilities and in recording income and expenses. These estimates are based, in part, on our judgment and assumptions regarding
various economic conditions that we believe are reasonable based on facts and circumstances existing at the time of reporting. The results of these estimates affect reported amounts of assets, liabilities and accumulated other comprehensive income
at the date of the 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. Detailed accounting policies are provided in Note 1 to our 2004 consolidated financial statements contained in our annual report on Form 10-K for the fiscal
year ended December 31, 2004. Our critical accounting estimates impact only two of our three reportable segments; our mortgage portfolio management and mortgage lending and loan servicing segments. Management has discussed the development and
selection of these critical accounting estimates with the audit committee of our board of directors and the audit committee has reviewed our disclosure.



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



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



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



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



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



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



| |  |  | Have any derivative instruments been transferred?
| | - |  | -------------------------------------------------



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



When these transfers are executed in a manner such that we have surrendered control over the collateral, the transfer is accounted for as a sale. In
accordance with SFAS No. 140, a gain or loss on the sale is recognized based on the carrying amount of the financial assets involved in the transfer, allocated between the assets transferred and the retained interests based on their relative fair
value at the date of transfer. In a loan securitization, we do retain the right to service the underlying mortgage loans and we also retain certain mortgage securities - available-for-sale issued by the trust (see Mortgage Securities 
Available-for-Sale below). As previously discussed, the gain recognized upon securitization depends on, among other things, the estimated fair value of the components of the securitization  the loans or mortgage securities - available-for-sale
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 represent a significant portion of
our operating results and 2) the



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valuation assumptions used regarding economic conditions and the make-up of the collateral, including interest rates, principal payments, prepayments and
loan defaults are highly uncertain and require a large degree of judgment.



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



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



For purposes of valuing our mortgage securities - available-for-sale, it is
important to know that in recent securitization transactions we not only have transferred loans to the trust, but we have also transferred interest rate agreements to the trust with the objective of reducing interest rate risk within the trust.
During the period before loans are transferred in a securitization transaction we enter into interest rate swap or cap agreements. Certain of these interest rate agreements are then transferred into the trust at the time of securitization.
Therefore, the trust assumes the obligation to make payments and obtains the right to receive payments under these agreements.



In valuing our mortgage securities - available-for-sale it is also important to understand what portion of the underlying mortgage loan collateral is
covered by mortgage insurance. The trust legally assumes the responsibility to pay the mortgage insurance premiums and the rights to receive claims for credit losses. Therefore, we have no obligation to pay these insurance premiums. 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 mortgage securities - available-for-sale consider this risk. We discuss mortgage
insurance premiums under the heading Results of Operations - Premiums for Mortgage Loan Insurance.



The weighted average net whole loan market price used in the initial valuation of our retained securities was 102.54 and 104.71 during the three months
ended March 31, 2005 and 2004, respectively. The weighted average implied discount rate for the three months ended March 31, 2005 and 2004 was 15% and 20%, respectively. If the whole loan market price used in the initial valuation of our mortgage
securities - available-for-sale for the three months ended March 31, 2005 had been increased or decreased by 50 basis points, the initial value of our mortgage securities - available-for-sale and the gain we recognized would have increased or
decreased by $10.4 million.



Information regarding the
assumptions we used is discussed under Mortgage Securities  Available-for-Sale below.



When we do have the ability to exert control over the transferred collateral in a securitization, the assets remain on our financial records and a
liability is recorded for the related asset-backed bonds. The servicing agreements that we execute for loans we have securitized includes a removal of accounts provision which gives us the right, not the obligation, to repurchase mortgage loans from
the trust. The removal of accounts provision can be exercised for loans that are 90 days to 119 days delinquent. We record the mortgage loans subject to the removal of accounts provision in mortgage loans held-for-sale at fair value and the related
repurchase obligation as a liability. The clean up call option 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.



23



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



| |  |  | The interest spread between the coupon on the underlying loans and the cost of financing.
| | - |  | -----------------------------------------------------------------------------------------



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



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



The cash flows we receive are highly dependent upon the interest rate
environment. The cost of financing for the securitized loans is indexed to short-term interest rates, while the loan coupons are less interest sensitive. As a result, as rates rise and fall, our cash flows will fall and rise, which in turn will
decrease or increase the value of our mortgage securities. Additionally, the cash flows we receive are dependent on the default and prepayment experience of the borrowers of the underlying mortgage security collateral. Increasing or decreasing cash
flows will increase or decrease the yield on our securities.



We believe the accounting estimates related to the valuation of our mortgage securities - available-for-sale and establishing the rate of income recognition on mortgage securities - available-for-sale are critical accounting
estimates because they can materially affect net income and stockholders equity and require us to forecast interest rates, mortgage principal payments, prepayments and loan default assumptions which are highly uncertain and require a
large degree of judgment. The rate used to discount the projected cash flows is also critical in the valuation of our mortgage securities - available-for-sale. 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 - available-for-sale. We believe the value of our mortgage securities - available-for-sale is fair, but can provide no assurance
that future prepayment and loss experience or changes in their required market discount rate will not require write-downs of the residual assets. Impairments would reduce income in future periods when deemed other-than-temporary.



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



At each reporting period subsequent to the initial valuation
of the retained securities, the fair value of mortgage securities - available-for-sale is estimated based on the present value of future expected cash flows to be received. Managements best estimate of key assumptions, including credit losses,
prepayment speeds, the market discount rates and forward yield curves commensurate with the risks involved, are used in estimating future cash flows. To the extent that the cost basis of mortgage securities - 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 three
months ended March 31, 2005, we recorded an impairment loss of $1.6 million on NMFT Series 1999-1 and 2004-4. The impairments were a result of the increase in short-term interest rates during the first three months of 2005. While we do use forward
yield curves in valuing our securities, the increase in two-year and three-year swap rates in the first three months of 2005 was greater than the forward yield curve had anticipated, thus causing a greater than expected decline in value. See Table 3
for a quarterly summary of the cost basis, unrealized gain and fair value of our mortgage securities - available-for-sale.



Our average security yield has decreased to 31.7% for the three months ended March 31, 2005 from 33.8% for the same period of 2004. This decrease is a
result of the significant rise in short-term interest rates in 2004 and in the first three months of 2005. Mortgage securities  available-for-sale income has increased from $33.2 million for the three months ended March 31, 2004 to $40.5
million for the same period of 2005 due to the increase in the average balance of our securities portfolio. If the rates used to accrue income on our mortgage securities during 2005 had increased or decreased by 10%, net income during the three
months ended March 31, 2005 would have increased by $9.6 million and decreased by $10.6 million, respectively.



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As of March 31, 2005, the weighted average discount rate used in valuing our mortgage securities -
available-for-sale was 21% as compared to 22% as of December 31, 2004. The weighted-average constant prepayment rate used in valuing our mortgage securities as of March 31, 2005 was 40 versus 39 as of December 31, 2004. If the discount rate used in
valuing our mortgage securities - available-for-sale as of March 31, 2005 had been increased by 5%, the value of our mortgage securities - available-for-sale would have decreased by $28.4 million. If we had decreased the discount rate used in
valuing our mortgage securities - available-for-sale by 5%, the value of our mortgage securities - available-for-sale would have increased by $32.0 million.



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



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



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



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



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



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



Mortgage Servicing Rights (MSR). MSR are recorded at allocated cost based upon the relative fair values
of the transferred loans and the servicing rights. MSR are amortized in proportion to and over the projected net servicing revenues. Periodically, we evaluate the carrying value of originated MSR based on their



25



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



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



Financial Condition as of March 31, 2005 and December 31, 2004



Mortgage Loans. We classify our mortgage loans into two categories:
held-for-sale and held-in-portfolio. Loans we have originated and purchased, but have not yet sold or securitized, are classified as held-for-sale. We expect to sell these loans outright in third-party
transactions or in securitization transactions that will be, for tax and accounting purposes, recorded as sales. We use warehouse mortgage repurchase agreements to finance our held-for-sale loans. As such, the fluctuations in mortgage loans
held-for-sale and short-term borrowings between March 31, 2005 and December 31, 2004 are dependent on loans we have originated and purchased during the period as well as loans we have sold outright or through securitization transactions.



The volume and cost of our loan production is critical to our financial
results. The loans we produce serve as collateral for our mortgage securities - available-for-sale and generate gains as they are sold or securitized. The cost of our production is also critical to our financial results as it is a significant factor
in the gains we recognize. The following table summarizes our loan production for the first quarter of 2005 and all of 2004. We discuss our cost of production under Results of Operations - General and Administrative Expenses. Also,
detail regarding mortgage loans sold or securitized and the gains recognized during the first quarter of 2005 and all of 2004 can be found in the Results of Operations - Gains on Sales of Mortgage Assets and Gains (Losses) on Derivative
Instruments.



26



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Table 1  Nonconforming Loan Originations and Purchases

(dollars in thousands, except for average loan balance)



|               |  |        |  |           |           |                      |   |                     |            |       |                  |  |    |                              |  |     |  |     |   |  |    |  
|-------------- |  | ------ |  | --------- | --------- | -------------------- | - | ------------------- | ---------- | ----- | ---------------- |  | -- | ---------------------------- |  | --- |  | --- | - |  | -- | -
|               |  | Number |  | Principal |           | Average Loan Balance |   | PricePaid to Broker |            |       | Weighted Average |  |    | PercentwithPrepaymentPenalty | 
|               |  |        |  |           |           | Loan to Value        |   |                     | FICO Score |       | Coupon           |  |   
|2005:          |  |        |  |           |           |                      |   |                     |            |       |                  |  |    |                              |  |     |  |     |   |  |    |  
|First quarter  |  | 13,100 |  | $         | 1,947,851 |                      | $ | 148,691             |            | 101.2 | %                |  | 82 | %                            |  | 629 |  | 7.6 | % |  | 66 | %
|               |  |        |  |           |           |                      |   |                     |            |       |                  |  |    |                              |  |     |  |     |   |  |    |  
|2004:          |  |        |  |           |           |                      |   |                     |            |       |                  |  |    |                              |  |     |  |     |   |  |    |  
|First Quarter  |  | 12,137 |  | $         | 1,783,119 |                      | $ | 146,916             |            | 101.3 | %                |  | 82 | %                            |  | 622 |  | 7.4 | % |  | 74 | %
|Second Quarter |  | 13,400 |  |           | 1,978,801 |                      |   | 147,672             |            | 101.2 |                  |  | 83 |                              |  | 621 |  | 7.7 |   |  | 74 |  
|Third Quarter  |  | 15,825 |  |           | 2,427,412 |                      |   | 153,391             |            | 101.4 |                  |  | 82 |                              |  | 621 |  | 7.7 |   |  | 74 |  
|Fourth Quarter |  | 14,612 |  |           | 2,235,029 |                      |   | 152,711             |            | 101.3 |                  |  | 82 |                              |  | 625 |  | 7.7 |   |  | 68 |  
|               |  |        |  |           |           |                      |   |                     |            |       |                  |  |    |                              |  |     |  |     |   |  |    |  
|Total          |  | 55,974 |  | $         | 8,424,361 |                      | $ | 150,505             |            | 101.3 | %                |  | 82 | %                            |  | 622 |  | 7.6 | % |  | 72 | %
|               |  |        |  |           |           |                      |   |                     |            |       |                  |  |    |                              |  |     |  |     |   |  |    |  



A portion of the
mortgage loans on our balance sheet serve as collateral for asset-backed bonds we have issued and are classified as held-in-portfolio. The carrying value of held-in-portfolio mortgage loans as of March 31, 2005 was $54.3
million compared to $59.5 million as of December 31, 2004.



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



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



The operating performance of our mortgage loan portfolio, including net interest income, allowance for credit losses and effects of hedging, are discussed
under Results of Operations. Gains on the sales of mortgage loans, including impact of securitizations treated as sales, is also discussed under Results of Operations.



Table 2  Carrying Value of Mortgage Loans

(dollars in thousands)



|                                |  |               |         |   |                  |   |         |  
|------------------------------- |  | ------------- | ------- | - | ---------------- | - | ------- | -
|                                |  | March 31,2005 |         |   | December 31,2004 |  
|Held-in-portfolio:              |  |               |         |   |                  |   |         |  
|Current principal               |  | $             | 54,127  |   |                  | $ | 58,859  |  
|                                |  |               |         |   |                  |   |         |  
|Premium                         |  | $             | 1,090   |   |                  | $ | 1,175   |  
|                                |  |               |         |   |                  |   |         |  
|Coupon                          |  |               | 10.0    | % |                  |   | 10.0    | %
|                                |  |               |         |   |                  |   |         |  
|Held-for-sale:                  |  |               |         |   |                  |   |         |  
|Current principal               |  | $             | 559,545 |   |                  | $ | 719,904 |  
|                                |  |               |         |   |                  |   |         |  
|Premium                         |  | $             | 5,374   |   |                  | $ | 6,760   |  
|                                |  |               |         |   |                  |   |         |  
|Coupon                          |  |               | 7.6     | % |                  |   | 7.7     | %
|                                |  |               |         |   |                  |   |         |  
|Percent with prepayment penalty |  |               | 64      | % |                  |   | 65      | %
|                                |  |               |         |   |                  |   |         |  



27



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Mortgage Securities Available-for-Sale.Since 1998, we have pooled the
majority of the loans we have originated or purchased to serve as collateral for asset-backed bonds in securitizations that are treated as sales for accounting and tax purposes. In these transactions, the loans are removed from our balance sheet.
However, we retain excess interest, prepayment penalty and subordinated principal securities. Additionally, we service the loans sold in these securitizations (see Financial Condition as of March 31, 2005 and December 31, 2004 - Mortgage
Servicing Rights). As of March 31, 2005 and December 31, 2004, the fair value of our mortgage securities  available-for-sale was $530.6 million and $489.2 million, respectively. During the first three months of 2005 and 2004 we executed
securitizations totaling $2.1 billion and $1.7 billion in mortgage loans and retained mortgage securities with a cost basis of $88.4 million and $82.8 million, respectively. See Note 4 to the condensed consolidated financial statements for a summary
of the activity in our mortgage securities portfolio.



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



In estimating the fair value of our mortgage securities, management must make
assumptions regarding the future performance and cash flow of the mortgage loans collateralizing the securities. These estimates are based on managements judgments about the nature of the loans. The cash flows we receive on our mortgage
securities will be the net of the gross coupon and the bond cost less administrative costs (servicing and trustee fees) and the cost of mortgage insurance. Additionally, the trust is a party to interest rate agreements. Our cash flow will include
(exclude) payments from (to) the interest rate agreement counterparty. Table 3 provides a summary of the critical assumptions used in estimating the cash flows of the collateral and the resulting estimated fair value of the mortgage securities.



In 2002 and 2003, interest expense on asset-backed bonds was
unexpectedly low. As a result, the spread between the coupon interest and the bond cost was unusually high and our cost basis in many of our older mortgage securities was significantly reduced. For example, our cost basis in NMFT Series 2000-2,
2001-1 and 2001-2 has been reduced to zero (see Table 3). When our cost basis in the retained securities (interest-only, prepayment penalty and subordinated securities) reaches zero, the remaining future cash flows received on the securities are
recognized entirely as income.



The operating performance of
our mortgage securities portfolio, including net interest income and effects of hedging are discussed under Results of Operations.



28



---

Table 3  Valuation of Individual Mortgage Securities  Available-for-Sale and Assumptions

(dollars in thousands)



|                        |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|----------------------- |  | ---- | ----- | -------------- | ------------ | --------------------------------------- |  | ---------------------- | ------ |  | ----------------------------------- | - |  | ------------ | - |  | ---------------------- | - |  | ----------------------- | - |  | -- | - |  | --- | -
|                        |  | Cost |       | UnrealizedGain |              | EstimatedFair ValueofMortgageSecurities |  | Current Assumptions    |        |  | Assumptions at Trust Securitization |  
|                        |  |      |       |                | DiscountRate |                                         |  | ConstantPrepaymentRate |        |  | (A)ExpectedCreditLosses             |   |  | DiscountRate |   |  | ConstantPrepaymentRate |   |  | (A)ExpectedCreditLosses |  
|March 31, 2005:         |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|NMFT 1999-1             |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Subordinated securities |  | $    | 7,150 |                | $            | 32                                      |  | $                      | 7,182  |  | 17                                  | % |  | 40           | % |  | 4.8                    | % |  | 17                      | % |  | 30 | % |  | 2.5 | %
|NMFT 2000-1             |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Interest-only           |  |      | 632   |                |              | 668                                     |  |                        | 1,300  |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Prepayment penalty      |  |      |      |                |              | 6                                       |  |                        | 6      |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Subordinated securities |  |      | 168   |                |              |                                        |  |                        | 168    |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      | 800   |                |              | 674                                     |  |                        | 1,474  |  | 15                                  |   |  | 35           |   |  | 1.4                    |   |  | 15                      |   |  | 27 |   |  | 1.0 |  
|NMFT 2000-2             |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Interest-only           |  |      |      |                |              | 1,468                                   |  |                        | 1,468  |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Prepayment penalty      |  |      |      |                |              | 90                                      |  |                        | 90     |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Subordinated securities |  |      |      |                |              | 75                                      |  |                        | 75     |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |      |                |              | 1,633                                   |  |                        | 1,633  |  | 15                                  |   |  | 34           |   |  | 1.0                    |   |  | 15                      |   |  | 28 |   |  | 1.0 |  
|NMFT 2001-1             |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Interest-only           |  |      |      |                |              | 1,562                                   |  |                        | 1,562  |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Prepayment penalty      |  |      |      |                |              | 126                                     |  |                        | 126    |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Subordinated securities |  |      |      |                |              | 620                                     |  |                        | 620    |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |      |                |              | 2,308                                   |  |                        | 2,308  |  | 20                                  |   |  | 33           |   |  | 1.2                    |   |  | 20                      |   |  | 28 |   |  | 1.2 |  
|NMFT 2001-2             |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Interest-only           |  |      |      |                |              | 4,323                                   |  |                        | 4,323  |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Prepayment penalty      |  |      |      |                |              | 366                                     |  |                        | 366    |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Subordinated securities |  |      |      |                |              | 2,132                                   |  |                        | 2,132  |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |      |                |              | 6,821                                   |  |                        | 6,821  |  | 25                                  |   |  | 32           |   |  | 0.8                    |   |  | 25                      |   |  | 28 |   |  | 1.2 |  
|NMFT 2002-1             |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Interest-only           |  |      | 3,049 |                |              |                                        |  |                        | 3,049  |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Prepayment penalty      |  |      | 1     |                |              | 410                                     |  |                        | 411    |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Subordinated securities |  |      | 1,658 |                |              | 6,232                                   |  |                        | 7,890  |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      | 4,708 |                |              | 6,642                                   |  |                        | 11,350 |  | 20                                  |   |  | 40           |   |  | 0.7                    |   |  | 20                      |   |  | 32 |   |  | 1.7 |  
|NMFT 2002-2             |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Interest-only           |  |      | 1,903 |                |              |                                        |  |                        | 1,903  |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Prepayment penalty      |  |      | 42    |                |              | 260                                     |  |                        | 302    |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Subordinated securities |  |      | 2,616 |                |              | 949                                     |  |                        | 3,565  |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      | 4,561 |                |              | 1,209                                   |  |                        | 5,770  |  | 25                                  |   |  | 42           |   |  | 1.5                    |   |  | 25                      |   |  | 27 |   |  | 1.6 |  



29



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|                        |  |        |  |                |              |                                         |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|----------------------- |  | ------ |  | -------------- | ------------ | --------------------------------------- | ---------------------- | ------------------- | ------------------------ | ----------------------------------- | ------------ | --- | ---------------------- | -- | ------------------------ | -- |  | ---
|                        |  | Cost   |  | UnrealizedGain |              | EstimatedFair ValueofMortgageSecurities |                        | Current Assumptions |                          | Assumptions at Trust Securitization
|                        |  |        |  |                | DiscountRate |                                         | ConstantPrepaymentRate |                     | (A) ExpectedCreditLosses |                                     | DiscountRate |     | ConstantPrepaymentRate |    | (A) ExpectedCreditLosses
|NMFT 2002-3             |  |        |  |                |              |                                         |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Interest-only           |  | 6,094  |  |               |              | 6,094                                   |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Prepayment penalty      |  | 213    |  | 740            |              | 953                                     |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Subordinated securities |  | 3,536  |  | 3,692          |              | 7,228                                   |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|                        |  |        |  |                |              |                                         |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|                        |  | 9,843  |  | 4,432          |              | 14,275                                  |                        | 20                  |                          | 39                                  |              | 0.5 |                        | 20 |                          | 30 |  | 1.0
|NMFT 2003-1             |  |        |  |                |              |                                         |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Interest-only           |  | 13,472 |  |               |              | 13,472                                  |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Prepayment penalty      |  | 1,989  |  | 655            |              | 2,644                                   |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Subordinated securities |  | 13,181 |  | 7,908          |              | 21,089                                  |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|                        |  |        |  |                |              |                                         |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|                        |  | 28,642 |  | 8,563          |              | 37,205                                  |                        | 20                  |                          | 38                                  |              | 1.2 |                        | 20 |                          | 28 |  | 3.3
|NMFT 2003-2             |  |        |  |                |              |                                         |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Interest-only           |  | 10,937 |  | 4,259          |              | 15,196                                  |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Prepayment penalty      |  | 2,691  |  | 1,693          |              | 4,384                                   |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Subordinated securities |  | 2,890  |  | 4,116          |              | 7,006                                   |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|                        |  |        |  |                |              |                                         |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|                        |  | 16,518 |  | 10,068         |              | 26,586                                  |                        | 28                  |                          | 38                                  |              | 1.0 |                        | 28 |                          | 25 |  | 2.7
|NMFT 2003-3             |  |        |  |                |              |                                         |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Interest-only           |  | 15,061 |  | 7,697          |              | 22,758                                  |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Prepayment penalty      |  | 3,434  |  | 3,123          |              | 6,557                                   |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Subordinated securities |  | 7,612  |  | 6,543          |              | 14,155                                  |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|                        |  |        |  |                |              |                                         |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|                        |  | 26,107 |  | 17,363         |              | 43,470                                  |                        | 20                  |                          | 36                                  |              | 1.0 |                        | 20 |                          | 22 |  | 3.6
|NMFT 2003-4             |  |        |  |                |              |                                         |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Interest-only           |  | 16,670 |  | 5,467          |              | 22,137                                  |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Prepayment penalty      |  | 3,175  |  | 4,985          |              | 8,160                                   |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Subordinated securities |  |       |  | 7,763          |              | 7,763                                   |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|                        |  |        |  |                |              |                                         |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|                        |  | 19,845 |  | 18,215         |              | 38,060                                  |                        | 20                  |                          | 44                                  |              | 1.4 |                        | 20 |                          | 30 |  | 5.1
|NMFT 2004-1             |  |        |  |                |              |                                         |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Interest-only           |  | 28,054 |  | 4,238          |              | 32,292                                  |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Prepayment penalty      |  | 4,987  |  | 6,121          |              | 11,108                                  |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Subordinated securities |  |       |  | 8,179          |              | 8,179                                   |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|                        |  |        |  |                |              |                                         |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|                        |  | 33,041 |  | 18,538         |              | 51,579                                  |                        | 20                  |                          | 44                                  |              | 2.2 |                        | 20 |                          | 33 |  | 5.9
|NMFT 2004-2             |  |        |  |                |              |                                         |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Interest-only           |  | 23,901 |  | 3,804          |              | 27,705                                  |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Prepayment penalty      |  | 4,022  |  | 5,255          |              | 9,277                                   |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|Subordinated securities |  | 3,965  |  | 2,837          |              | 6,802                                   |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|                        |  |        |  |                |              |                                         |                        |                     |                          |                                     |              |     |                        |    |                          |    |  |    
|                        |  | 31,888 |  | 11,896         |              | 43,784                                  |                        | 26                  |                          | 42                                  |              | 2.7 |                        | 26 |                          | 31 |  | 5.1



30



---

|                |  |      |         |                |              |                                         |                        |                     |                          |                                     |              |  |                        |  |                          |  |    |  |    |  |    
|--------------- |  | ---- | ------- | -------------- | ------------ | --------------------------------------- | ---------------------- | ------------------- | ------------------------ | ----------------------------------- | ------------ |  | ---------------------- |  | ------------------------ |  | -- |  | -- |  | ---
|                |  | Cost |         | UnrealizedGain |              | EstimatedFair ValueofMortgageSecurities |                        | Current Assumptions |                          | Assumptions at Trust Securitization
|                |  |      |         |                | DiscountRate |                                         | ConstantPrepaymentRate |                     | (A) ExpectedCreditLosses |                                     | DiscountRate |  | ConstantPrepaymentRate |  | (A) ExpectedCreditLosses
|NMFT 2004-3 (B) |  |      | 72,182  |                |              | 2,863                                   |                        |                     | 75,045                   |                                     | 19           |  | 42                     |  | 3.3                      |  | 19 |  | 34 |  | 4.5
|NMFT 2004-4 (B) |  |      | 76,583  |                |              |                                        |                        |                     | 76,583                   |                                     | 26           |  | 39                     |  | 3.1                      |  | 26 |  | 35 |  | 4.0
|NMFT 2005-1 (B) |  |      | 87,453  |                |              |                                        |                        |                     | 87,453                   |                                     | 15           |  | 37                     |  | 3.6                      |  | 15 |  | 37 |  | 3.6
|                |  |      |         |                |              |                                         |                        |                     |                          |                                     |              |  |                        |  |                          |  |    |  |    |  |    
|Total           |  | $    | 419,321 |                | $            | 111,257                                 |                        | $                   | 530,578                  |                                     |              |  |                        |  |                          |  |    |  |    |  |    
|                |  |      |         |                |              |                                         |                        |                     |                          |                                     |              |  |                        |  |                          |  |    |  |    |  |    

---

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



|(B) | The interest-only, prepayment penalty and subordinated securities are packaged in one bond.
|--- | -------------------------------------------------------------------------------------------



31



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|                        |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|----------------------- |  | ---- | ----- | -------------- | ------------ | --------------------------------------- |  | ---------------------- | ------ |  | ----------------------------------- | - |  | ------------ | - |  | ---------------------- | - |  | ----------------------- | - |  | -- | - |  | --- | -
|                        |  | Cost |       | UnrealizedGain |              | EstimatedFair ValueofMortgageSecurities |  | Current Assumptions    |        |  | Assumptions at Trust Securitization |  
|                        |  |      |       |                | DiscountRate |                                         |  | ConstantPrepaymentRate |        |  | (A)ExpectedCreditLosses             |   |  | DiscountRate |   |  | ConstantPrepaymentRate |   |  | (A)ExpectedCreditLosses |  
|December 31, 2004:      |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|NMFT 1999-1             |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Subordinated securities |  | $    | 7,001 |                | $            |                                        |  | $                      | 7,001  |  | 17                                  | % |  | 33           | % |  | 4.8                    | % |  | 17                      | % |  | 30 | % |  | 2.5 | %
|NMFT 2000-1             |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Interest-only           |  |      |      |                |              | 352                                     |  |                        | 352    |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Prepayment penalty      |  |      |      |                |              | 28                                      |  |                        | 28     |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Subordinated securities |  |      | 681   |                |              | 158                                     |  |                        | 839    |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      | 681   |                |              | 538                                     |  |                        | 1,219  |  | 15                                  |   |  | 46           |   |  | 1.2                    |   |  | 15                      |   |  | 27 |   |  | 1.0 |  
|NMFT 2000-2             |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Interest-only           |  |      |      |                |              | 2,019                                   |  |                        | 2,019  |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Prepayment penalty      |  |      |      |                |              | 105                                     |  |                        | 105    |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Subordinated securities |  |      |      |                |              | 166                                     |  |                        | 166    |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |      |                |              | 2,290                                   |  |                        | 2,290  |  | 15                                  |   |  | 34           |   |  | 1.0                    |   |  | 15                      |   |  | 28 |   |  | 1.0 |  
|NMFT 2001-1             |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Interest-only           |  |      |      |                |              | 2,262                                   |  |                        | 2,262  |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Prepayment penalty      |  |      |      |                |              | 161                                     |  |                        | 161    |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Subordinated securities |  |      |      |                |              | 688                                     |  |                        | 688    |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |      |                |              | 3,111                                   |  |                        | 3,111  |  | 20                                  |   |  | 37           |   |  | 1.1                    |   |  | 20                      |   |  | 28 |   |  | 1.2 |  
|NMFT 2001-2             |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Interest-only           |  |      |      |                |              | 6,182                                   |  |                        | 6,182  |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Prepayment penalty      |  |      |      |                |              | 458                                     |  |                        | 458    |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Subordinated securities |  |      |      |                |              | 1,961                                   |  |                        | 1,961  |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |      |                |              | 8,601                                   |  |                        | 8,601  |  | 25                                  |   |  | 33           |   |  | 0.8                    |   |  | 25                      |   |  | 28 |   |  | 1.2 |  
|NMFT 2002-1             |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Interest-only           |  |      | 3,553 |                |              | 242                                     |  |                        | 3,795  |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Prepayment penalty      |  |      | 111   |                |              | 457                                     |  |                        | 568    |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Subordinated securities |  |      | 1,314 |                |              | 5,413                                   |  |                        | 6,727  |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      | 4,978 |                |              | 6,112                                   |  |                        | 11,090 |  | 20                                  |   |  | 42           |   |  | 0.9                    |   |  | 20                      |   |  | 32 |   |  | 1.7 |  
|NMFT 2002-2             |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Interest-only           |  |      | 2,713 |                |              |                                        |  |                        | 2,713  |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Prepayment penalty      |  |      | 151   |                |              | 251                                     |  |                        | 402    |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|Subordinated securities |  |      | 2,184 |                |              | 1,391                                   |  |                        | 3,575  |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      |       |                |              |                                         |  |                        |        |  |                                     |   |  |              |   |  |                        |   |  |                         |   |  |    |   |  |     |  
|                        |  |      | 5,048 |                |              | 1,642                                   |  |                        | 6,690  |  | 25                                  |   |  | 40           |   |  | 1.4                    |   |  | 25                      |   |  | 27 |   |  | 1.6 |  



32



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|                        |  |        |  |                |  |                                         |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|----------------------- |  | ------ |  | -------------- |  | --------------------------------------- |  | ------------------- |  | ----------------------------------- |  | ------------------------ |  | ------------ |  | ---------------------- |  | ------------------------
|                        |  |        |  |                |  |                                         |  | Current Assumptions |  | Assumptions at Trust Securitization
|                        |  | Cost   |  | UnrealizedGain |  | EstimatedFair ValueofMortgageSecurities |  | DiscountRate        |  | ConstantPrepaymentRate              |  | (A) ExpectedCreditLosses |  | DiscountRate |  | ConstantPrepaymentRate |  | (A) ExpectedCreditLosses
|NMFT 2002-3             |  |        |  |                |  |                                         |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Interest-only           |  | 8,148  |  |               |  | 8,148                                   |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Prepayment penalty      |  | 509    |  | 686            |  | 1,195                                   |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Subordinated securities |  | 2,387  |  | 3,131          |  | 5,518                                   |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|                        |  |        |  |                |  |                                         |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|                        |  | 11,044 |  | 3,817          |  | 14,861                                  |  | 20                  |  | 41                                  |  | 0.7                      |  | 20           |  | 30                     |  | 1.0                     
|NMFT 2003-1             |  |        |  |                |  |                                         |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Interest-only           |  | 17,963 |  | 363            |  | 18,326                                  |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Prepayment penalty      |  | 2,316  |  | 956            |  | 3,272                                   |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Subordinated securities |  | 11,783 |  | 3,912          |  | 15,695                                  |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|                        |  |        |  |                |  |                                         |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|                        |  | 32,062 |  | 5,231          |  | 37,293                                  |  | 20                  |  | 39                                  |  | 1.8                      |  | 20           |  | 28                     |  | 3.3                     
|NMFT 2003-2             |  |        |  |                |  |                                         |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Interest-only           |  | 15,404 |  | 2,422          |  | 17,826                                  |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Prepayment penalty      |  | 4,089  |  | 2,133          |  | 6,222                                   |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Subordinated securities |  | 2,487  |  | 3,368          |  | 5,855                                   |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|                        |  |        |  |                |  |                                         |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|                        |  | 21,980 |  | 7,923          |  | 29,903                                  |  | 28                  |  | 38                                  |  | 1.5                      |  | 28           |  | 25                     |  | 2.7                     
|NMFT 2003-3             |  |        |  |                |  |                                         |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Interest-only           |  | 20,825 |  | 3,449          |  | 24,274                                  |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Prepayment penalty      |  | 5,108  |  | 3,427          |  | 8,535                                   |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Subordinated securities |  | 6,842  |  | 2,363          |  | 9,205                                   |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|                        |  |        |  |                |  |                                         |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|                        |  | 32,775 |  | 9,239          |  | 42,014                                  |  | 20                  |  | 37                                  |  | 1.6                      |  | 20           |  | 22                     |  | 3.6                     
|NMFT 2003-4             |  |        |  |                |  |                                         |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Interest-only           |  | 21,466 |  | 5,480          |  | 26,946                                  |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Prepayment penalty      |  | 4,994  |  | 5,408          |  | 10,402                                  |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Subordinated securities |  |       |  | 6,839          |  | 6,839                                   |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|                        |  |        |  |                |  |                                         |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|                        |  | 26,460 |  | 17,727         |  | 44,187                                  |  | 20                  |  | 44                                  |  | 1.7                      |  | 20           |  | 30                     |  | 5.1                     
|NMFT 2004-1             |  |        |  |                |  |                                         |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Interest-only           |  | 35,731 |  |               |  | 35,731                                  |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Prepayment penalty      |  | 6,816  |  | 5,968          |  | 12,784                                  |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Subordinated securities |  |       |  | 1,335          |  | 1,335                                   |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|                        |  |        |  |                |  |                                         |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|                        |  | 42,547 |  | 7,303          |  | 49,850                                  |  | 20                  |  | 43                                  |  | 3.5                      |  | 20           |  | 33                     |  | 5.9                     
|NMFT 2004-2             |  |        |  |                |  |                                         |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Interest-only           |  | 31,062 |  |               |  | 31,062                                  |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Prepayment penalty      |  | 5,313  |  | 4,814          |  | 10,127                                  |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|Subordinated securities |  | 3,481  |  | 881            |  | 4,362                                   |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|                        |  |        |  |                |  |                                         |  |                     |  |                                     |  |                          |  |              |  |                        |  |                         
|                        |  | 39,856 |  | 5,695          |  | 45,551                                  |  | 26                  |  | 41                                  |  | 3.8                      |  | 26           |  | 31                     |  | 5.1                     



33



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|                |  |      |         |                |   |                                         |  |                     |         |                                     |    |                          |    |              |     |                        |    |                          |    |  |    
|--------------- |  | ---- | ------- | -------------- | - | --------------------------------------- |  | ------------------- | ------- | ----------------------------------- | -- | ------------------------ | -- | ------------ | --- | ---------------------- | -- | ------------------------ | -- |  | ---
|                |  |      |         |                |   |                                         |  | Current Assumptions |         | Assumptions at Trust Securitization
|                |  | Cost |         | UnrealizedGain |   | EstimatedFair ValueofMortgageSecurities |  | DiscountRate        |         | ConstantPrepaymentRate              |    | (A) ExpectedCreditLosses |    | DiscountRate |     | ConstantPrepaymentRate |    | (A) ExpectedCreditLosses
|NMFT 2004-3 (B) |  |      | 89,442  |                |   |                                        |  |                     | 89,442  |                                     | 19 |                          | 39 |              | 3.9 |                        | 19 |                          | 34 |  | 4.5
|NMFT 2004-4 (B) |  |      | 96,072  |                |   |                                        |  |                     | 96,072  |                                     | 26 |                          | 36 |              | 3.7 |                        | 26 |                          | 35 |  | 4.0
|                |  |      |         |                |   |                                         |  |                     |         |                                     |    |                          |    |              |     |                        |    |                          |    |  |    
|Total           |  | $    | 409,946 |                | $ | 79,229                                  |  | $                   | 489,175 |                                     |    |                          |    |              |     |                        |    |                          |    |  |    
|                |  |      |         |                |   |                                         |  |                     |         |                                     |    |                          |    |              |     |                        |    |                          |    |  |    

---

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



|(B) | The interest-only, prepayment penalty and subordinated securities are packaged in one bond.
|--- | -------------------------------------------------------------------------------------------



34



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The following table summarizes the cost basis, unrealized gain and fair value of our mortgage securities
- available-for-sale grouped by year of issue. For example, under the Year of Issue for Mortgage Securities Retained column, the year 2003 is a combination of NMFT Series 2003-1, NMFT Series 2003-2, NMFT Series 2003-3 and NMFT
Series 2003-4.



Table 4  Summary of Mortgage Securities  Available-for-Sale Retained by Year of Issue



(in thousands)



|                                               |      |                |                |  |            |         |  |   |        
|---------------------------------------------- | ---- | -------------- | -------------- |  | ---------- | ------- |  | - | -------
|                                               |      | 2005          
|Year of Issue
for Mortgage Securities Retained |      | As of March 31
|                                               | Cost |                | UnrealizedGain |  | Fair Value
|1999                                           |      | $              | 7,150          |  | $          | 32      |  | $ | 7,182  
|2000                                           |      |                | 800            |  |            | 2,307   |  |   | 3,107  
|2001                                           |      |                |               |  |            | 9,129   |  |   | 9,129  
|2002                                           |      |                | 19,112         |  |            | 12,283  |  |   | 31,395 
|2003                                           |      |                | 91,112         |  |            | 54,209  |  |   | 145,321
|2004                                           |      |                | 213,694        |  |            | 33,297  |  |   | 246,991
|2005                                           |      |                | 87,453         |  |            |        |  |   | 87,453 
|                                               |      |                |                |  |            |         |  |   |        
|Total                                          |      | $              | 419,321        |  | $          | 111,257 |  | $ | 530,578
|                                               |      |                |                |  |            |         |  |   |        



|                                           |      |                   |                |                    |            |               |      |                |                |  |            |         |      |   |                |  |            |         |      |   |                |  |            |        |  |   |         |  |   |         |  |   |        |  |   |        
|------------------------------------------ | ---- | ----------------- | -------------- | ------------------ | ---------- | ------------- | ---- | -------------- | -------------- |  | ---------- | ------- | ---- | - | -------------- |  | ---------- | ------- | ---- | - | -------------- |  | ---------- | ------ |  | - | ------- |  | - | ------- |  | - | ------ |  | - | -------
|                                           |      | 2004             
|Year ofIssue forMortgageSecuritiesRetained |      | As of December 31 |                | As of September 30 |            | As of June 30 |      | As of March 31
|                                           | Cost |                   | UnrealizedGain |                    | Fair Value |               | Cost |                | UnrealizedGain |  | Fair Value |         | Cost |   | UnrealizedGain |  | Fair Value |         | Cost |   | UnrealizedGain |  | Fair Value
|1999                                       |      | $                 | 7,001          |                    | $          |              |      | $              | 7,001          |  | $          | 6,818   |      | $ |               |  | $          | 6,818   |      | $ | 6,597          |  | $          |       |  | $ | 6,597   |  | $ | 6,353   |  | $ | 185    |  | $ | 6,538  
|2000                                       |      |                   | 681            |                    |            | 2,828         |      |                | 3,509          |  |            | 539     |      |   | 3,046          |  |            | 3,585   |      |   | 412            |  |            | 5,161  |  |   | 5,573   |  |   | 1,298   |  |   | 8,194  |  |   | 9,492  
|2001                                       |      |                   |               |                    |            | 11,712        |      |                | 11,712         |  |            |        |      |   | 16,064         |  |            | 16,064  |      |   | 321            |  |            | 20,910 |  |   | 21,231  |  |   | 233     |  |   | 27,579 |  |   | 27,812 
|2002                                       |      |                   | 21,070         |                    |            | 11,571        |      |                | 32,641         |  |            | 23,978  |      |   | 14,181         |  |            | 38,159  |      |   | 29,202         |  |            | 14,067 |  |   | 43,269  |  |   | 36,201  |  |   | 18,899 |  |   | 55,100 
|2003                                       |      |                   | 113,277        |                    |            | 40,120        |      |                | 153,397        |  |            | 142,796 |      |   | 28,458         |  |            | 171,254 |      |   | 184,097        |  |            | 8,841  |  |   | 192,938 |  |   | 226,676 |  |   | 16,090 |  |   | 242,766
|2004                                       |      |                   | 267,917        |                    |            | 12,998        |      |                | 280,915        |  |            | 218,898 |      |   | 7,709          |  |            | 226,607 |      |   | 118,684        |  |            | 758    |  |   | 119,442 |  |   | 60,961  |  |   | 1,334  |  |   | 62,295 
|                                           |      |                   |                |                    |            |               |      |                |                |  |            |         |      |   |                |  |            |         |      |   |                |  |            |        |  |   |         |  |   |         |  |   |        |  |   |        
|Total                                      |      | $                 | 409,946        |                    | $          | 79,229        |      | $              | 489,175        |  | $          | 393,029 |      | $ | 69,458         |  | $          | 462,487 |      | $ | 339,313        |  | $          | 49,737 |  | $ | 389,050 |  | $ | 331,722 |  | $ | 72,281 |  | $ | 404,003
|                                           |      |                   |                |                    |            |               |      |                |                |  |            |         |      |   |                |  |            |         |      |   |                |  |            |        |  |   |         |  |   |         |  |   |        |  |   |        



Mortgage
Securities  Trading. Mortgage securities  trading consist of mortgage securities purchased by us that we intend to sell in the near term. These securities are recorded at fair value with gains and losses, realized and
unrealized, included in earnings. As of December 31, 2004, mortgage securities - trading consisted of an adjustable-rate mortgage-backed security with a fair market value of $143.2 million. For the year ended December 31, 2004, we recorded no gains
or losses related to the security. As of December 31, 2004, we had pledged the security as collateral for financing purposes. During the first quarter of 2005, we sold this security. No gain or loss was recognized on this security during the three
months ended March 31, 2005.



Mortgage Servicing Rights.
As discussed under Mortgage Securities  Available for Sale, we retain the right to service mortgage loans we originate, purchase and have securitized. Servicing rights for loans we sell to third parties are not retained and we have not
purchased the right to service loans. As of March 31, 2005, we have $47.7 million in capitalized mortgage servicing rights compared with $42.0 million as of December 31, 2004. The carrying value of the mortgage servicing rights we retained in our
securitizations during the first three months of 2005 and 2004 was $11.4 million and $7.5 million, respectively. Amortization



35



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of mortgage servicing rights was $5.7 million and $3.3 million for the three months ended March 31, 2005 and 2004, respectively.



Servicing Related Advances. Advances on behalf of borrowers for taxes,
insurance and other customer service functions are made by NovaStar Mortgage and aggregated $19.6 million as of March 31, 2005 compared with $20.2 million as of December 31, 2004.



Derivative Instruments, net. Derivative instruments, net increased from $18.8 million at December 31, 2004 to $22.6
million at March 31, 2005. These amounts include the collateral (margin deposits) required under the terms of our derivative instrument contracts, net of the derivative instrument market values. Due to the nature of derivative instruments we use,
the margin deposits required will generally increase as interest rates decline and decrease as interest rates rise. On the other hand, the market value of our derivative instruments will decline as interest rates decline and increase as interest
rates rise.



36



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Other Assets. Included in other assets are receivables from securitizations, warehouse loans
receivable, tax assets and other miscellaneous assets. Our receivables from securitizations were $5.0 million and $4.8 million at March 31, 2005 and December 31, 2004, respectively. These receivables represent cash due to us on our mortgage
securities - available-for-sale. As of March 31, 2005 we had warehouse loans receivable of $6.2 million, compared to $5.9 as of December 31, 2004. In 2004, we began lending to independent mortgage loan brokers in an effort to strengthen our
relationships with these brokers and, in turn, increase our nonconforming loan production. As of March 31, 2005, we had a deferred tax asset of $6.7 million compared to $11.2 million as of December 31, 2004. As of March 31, 2005, we had a current
tax receivable of $21.3 million compared to $17.2 million as of December 31, 2004.



Short-term Borrowings. Mortgage loan originations and purchases are funded with various financing facilities prior to securitization. Repurchase agreements are used as interim, short-term financing before loans
are transferred in our securitization transactions. The balances outstanding under our short-term arrangements fluctuate based on lending volume, equity transactions, financing activities and cash flows from other operating and investing activities.
As shown in Table 5, we have $237.9 million in immediately available funds as of March 31, 2005. We have borrowed approximately $656.5 million of the $3.7 billion in committed mortgage securities and mortgage loans repurchase facilities, leaving
approximately $3.0 billion available to support the mortgage lending and mortgage portfolio operations. See the Liquidity and Capital Resources section of Managements Discussion and Analysis of Financial Condition and Results
of Operations for a further discussion of liquidity risks and resources available to us.



Table 5  Short-term Financing Resources



(in thousands)



|                                                             |  |              |           |                             |   |            |  |              |         |  |   |        
|------------------------------------------------------------ |  | ------------ | --------- | --------------------------- | - | ---------- |  | ------------ | ------- |  | - | -------
|                                                             |  | Credit Limit |           | Lending Value of Collateral |   | Borrowings |  | Availability
|Unrestricted cash                                            |  |              |           |                             |   |            |  |              |         |  | $ | 237,910
|Mortgage securities and mortgage loans repurchase facilities |  | $            | 3,650,000 |                             | $ | 656,529    |  | $            | 656,529 |  |   |       
|Other                                                        |  |              | 100,000   |                             |   | 5,074      |  |              | 5,074   |  |   |       
|                                                             |  |              |           |                             |   |            |  |              |         |  |   |        
|Total                                                        |  | $            | 3,750,000 |                             | $ | 661,603    |  | $            | 661,603 |  | $ | 237,910
|                                                             |  |              |           |                             |   |            |  |              |         |  |   |        



Asset-backed
Bonds. During 1997 and 1998, we completed the securitization of loans in transactions that were structured as financing arrangements for accounting purposes. These non-recourse financing arrangements match the loans with the financing
arrangement for long periods of time, as compared to repurchase agreements that mature frequently with interest rates that reset frequently and have liquidity risk in the form of margin calls. Under the terms of our asset-backed bonds we are
entitled to repurchase the mortgage loan collateral and repay the remaining bond obligations when the aggregate collateral principal balance falls below 35% of their original balance for the loans in NHES 97-01 and 25% for the loans in NHES 97-02,
98-01 and 98-02. While the principal balances have fallen below the required thresholds, we have not exercised our right to repurchase any loans and repay bond obligations. As of March 31, 2005 and December 31, 2004 we had asset-backed bonds secured
by mortgage loans outstanding of $48.7 million and $53.5 million, respectively.



Our asset-backed bonds, Net Interest Margin Securities (NIMs), are secured by the interest-only, prepayment penalty and subordinated mortgage securities of our mortgage securities  available-for-sale
and are a form of long-term financing. The resecuritizations were structured as secured borrowings for financial reporting and income tax purposes. In accordance with SFAS No. 140, control over the transferred assets was not surrendered and thus the
transaction was considered a financing for the mortgage securities - available-for-sale. Therefore, the mortgage securities are recorded as assets and the asset-backed bonds are recorded as debt. As of March 31, 2005 and December 31, 2004 we had
asset-backed bonds secured by mortgage securities outstanding of $242.4 million and $336.4 million, respectively.



Due to securitization trusts. Due to securitization trusts represents the fair value of the loans we have the right to repurchase from the
securitization trusts. The servicing agreements we execute for loans we have securitized include a removal of accounts provision which gives us the right, not the obligation, to repurchase mortgage loans from the trust. The removal of accounts
provision can be exercised for loans that are 90 days to 119 days delinquent. As of March 31, 2005 and December 31, 2004, our liability related to this provision was $20.1 million and $20.9 million, respectively.



Accounts Payable and Other Liabilities. Included in accounts payable
and other liabilities is accrued payroll and other liabilities. Our accrued payroll decreased from $24.9 million at December 31, 2004 to $17.1 million at March 31, 2005.



37



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Stockholders Equity.The increase in our stockholders equity as of March 31,
2005 compared to December 31, 2004 is a result of the following increases and decreases.



Stockholders equity increased by:



| |  |  | $35.2 million due to net income recognized for the three months ended March 31, 2005
| | - |  | ------------------------------------------------------------------------------------



| |  |  | $30.4 million due to increase in unrealized gains on mortgage securities classified as available-for-sale
| | - |  | ---------------------------------------------------------------------------------------------------------



| |  |  | $4.6 million due to issuance of common stock
| | - |  | --------------------------------------------



| |  |  | $1.6 million due to impairment on mortgage securities  available for sale reclassified to earnings
| | - |  | ---------------------------------------------------------------------------------------------------



| |  |  | $0.1 million due to net settlements on cash flow hedges reclassified to earnings
| | - |  | --------------------------------------------------------------------------------



| |  |  | $0.5 million due to compensation recognized under stock option plan, and
| | - |  | ------------------------------------------------------------------------



| |  |  | $0.5 million due to issuance of stock under stock compensation plans.
| | - |  | ---------------------------------------------------------------------



Stockholders equity decreased by:



| |  |  | $39.1 million due to dividends accrued or paid on common stock, and
| | - |  | -------------------------------------------------------------------



| |  |  | $1.7 million due to dividends accrued or paid on preferred stock.
| | - |  | -----------------------------------------------------------------



Results of Operations



Continuing Operations.During the three months ended March 31, 2005, we earned income from continuing operations available to common
shareholders of $34.5 million, or $1.23 per diluted share, compared with income from continuing operations available to common shareholders of $31.4 million, or $1.24 per diluted share, for the same period of 2004.



Our primary sources of revenue are interest earned on our mortgage loan and
securities portfolios, fee income and gains on sales and securitizations of mortgage loans. As discussed under Overview of Performance, income from continuing operations available to common shareholders increased during the first three
months of 2005 as compared to same period of 2004 due primarily to higher volumes of average mortgage securities - available-for-sale held and mortgage loan originations and purchases securitized. The effects of the higher mortgage security volume
are displayed in Table 6. Details regarding higher mortgage loan origination and purchase volumes and gains on securitization of these assets are shown in Tables 1, 8 and 9.



Discontinued Operations.As the demand for conforming loans declined significantly during 2004 and into 2005, many
branches have not been able to produce sufficient fees to meet operating expense demands. As a result of these conditions, a significant number of branch managers voluntarily terminated employment with us. We also terminated branches when loan
production results were substandard. In these terminations, the branch and all operations are eliminated. The operating results for these discontinued operations have been segregated from our on-going operating results. Our loss from discontinued
operations net of income tax for the three months ended March 31, 2005 was $1.0 million, compared with $1.7 million for the same period in 2004. Note 10 to our condensed consolidated financial statements provides detail regarding the impact of the
discontinued operations.



Net Interest Income.Our
mortgage securities available-for-sale primarily represent our ownership in the net cash flows of the underlying mortgage loan collateral in excess of bond expenses and cost of funding. The cost of funding is indexed to one-month LIBOR and resets
monthly while the coupon on the mortgage loan collateral adjusts more slowly depending on the contractual terms of the loan. In 2002, we began transferring interest rate agreements at the time of securitization into the securitization trusts to help
provide protection to the third-party bondholders from interest rate risk. These agreements reduce interest rate risk within the trust and, as a result, the cash flows we receive on our interest-only securities are less volatile as interest rates
change. The significant increase in one month LIBOR during 2004 and the first three months of 2005, as discussed in Overview of Performance, has caused a decrease in our average net yield on our securities from 30.2% for the three months
ended March 31, 2004 to 27.3% for the same period of 2005, as shown in Table 6.



While the spreads on our securities have decreased, the overall interest income continues to be high due to the sizeable increase in our mortgage securities - available-for-sale retained. As shown in Tables 6 and 7,
the average value of our mortgage securities - available-for-sale increased from $393.1 million during the three months ended March 31, 2004 to $509.9 million during the three months ended March 31, 2005. The average balance of mortgage loans
collateralizing our securities increased from $6.8 billion for the three months ended March 31, 2004 to $11.6 billion for the same period in 2005. We expect to increase the amount of mortgage securities - available-for-sale we own as we securitize
the mortgage loans we originate and purchase.



Table 6 is a
summary of the interest income and expense related to our mortgage securities  available-for-sale and the related yields as a percentage of the fair market value of these securities for the three months ended March 31, 2005 and 2004.



38



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Table 6  Mortgage Securities Interest Analysis

(dollars in thousands)



|                                                                      |  |                                     |         |   |      |   |         |  
|--------------------------------------------------------------------- |  | ----------------------------------- | ------- | - | ---- | - | ------- | -
|                                                                      |  | For the Three MonthsEnded March 31, |        
|                                                                      |  | 2005                                |         |   | 2004 |  
|Average fair market value of mortgage securities  available-for-sale |  | $                                   | 509,877 |   |      | $ | 393,145 |  
|Average borrowings                                                    |  |                                     | 355,881 |   |      |   | 284,550 |  
|                                                                      |  |                                    
|Interest income                                                       |  |                                     | 40,463  |   |      |   | 33,196  |  
|Interest expense                                                      |  |                                     | 5,607   |   |      |   | 3,540   |  
|                                                                      |  |                                     |         |   |      |   |         |  
|Net interest income                                                   |  | $                                   | 34,856  |   |      | $ | 29,656  |  
|                                                                      |  |                                     |         |   |      |   |         |  
|Yields:                                                               |  |                                     |         |   |      |   |         |  
|Interest income                                                       |  |                                     | 31.7    | % |      |   | 33.8    | %
|Interest expense                                                      |  |                                     | 6.3     |   |      |   | 5.0     |  
|                                                                      |  |                                     |         |   |      |   |         |  
|Net interest spread                                                   |  |                                     | 25.4    | % |      |   | 28.8    | %
|                                                                      |  |                                     |         |   |      |   |         |  
|Net Yield                                                             |  |                                     | 27.3    | % |      |   | 30.2    | %
|                                                                      |  |                                     |         |   |      |   |         |  



Net interest income on
mortgage loans represents income on loans held-for-sale during their warehouse period as well as loans held-in-portfolio, which are maintained on our balance sheet as a result of the four securitization transactions we executed in 1997 and 1998. Net
interest income on mortgage loans before other expense increased from $10.0 million for the three months ended March 31, 2004 to $10.7 million for the same period in 2005. The net interest income from mortgage loans is primarily driven by loan
volume and the amount of time held-for-sale loans are in the warehouse.



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



Our portfolio income comes from mortgage loans either directly (mortgage loans held-in-portfolio) or indirectly (mortgage
securities). Table 7 attempts to look through the balance sheet presentation of our portfolio income and present income as a percentage of average assets under management. The net interest income for mortgage securities, mortgage loans held-for-sale
and mortgage loans held-in-portfolio reflects the income after interest expense, hedging, prepayment penalty income and credit expense (mortgage insurance and credit losses). This metric allows us to be more easily compared to other finance
companies or financial institutions that use on balance sheet portfolio accounting, where return on assets is a common performance calculation.



Our portfolio net interest yield on assets was 1.36% for the three months ended March 31, 2005 as compared to 1.74% for the same period of 2004. As
previously discussed, the decrease in our net interest yield on assets primarily resulted from the decrease in the interest spreads on our mortgage securities. Table 7 shows the net interest yield in assets under management and the return on assets
during the three months ended March 31, 2005 and 2004.



39



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Table 7  Mortgage Portfolio Management Net Interest Income Analysis

(dollars in thousands)



|                                                            |  |                    |            |   |                             |   |           |                                |  |   |        |   |  |   |            |  
|----------------------------------------------------------- |  | ------------------ | ---------- | - | --------------------------- | - | --------- | ------------------------------ |  | - | ------ | - |  | - | ---------- | -
|For the Three Months Ended:                                 |  | MortgageSecurities |            |   | MortgageLoans Held-for-Sale |   |           | MortgageLoansHeld-in-Portfolio |  |   | Total  |  
|March 31, 2005                                              |  |                    |            |   |                             |   |           |                                |  |   |        |   |  |   |            |  
|Interest income                                             |  | $                  | 40,463     |   |                             | $ | 20,279    |                                |  | $ | 1,313  |   |  | $ | 62,055     |  
|Interest expense:                                           |  |                    |            |   |                             |   |           |                                |  |   |        |   |  |   |            |  
|Short-term borrowings (A)                                   |  |                    | 800        |   |                             |   | 10,263    |                                |  |   |       |   |  |   | 11,063     |  
|Asset-backed bonds                                          |  |                    | 4,807      |   |                             |   |          |                                |  |   | 417    |   |  |   | 5,224      |  
|Cash flow hedging net settlements                           |  |                    |           |   |                             |   | 180       |                                |  |   |       |   |  |   | 180        |  
|                                                            |  |                    |            |   |                             |   |           |                                |  |   |        |   |  |   |            |  
|Total interest expense (B)                                  |  |                    | 5,607      |   |                             |   | 10,443    |                                |  |   | 417    |   |  |   | 16,467     |  
|                                                            |  |                    |            |   |                             |   |           |                                |  |   |        |   |  |   |            |  
|Mortgage portfolio net interest income before other expense |  |                    | 34,856     |   |                             |   | 9,836     |                                |  |   | 896    |   |  |   | 45,588     |  
|Other income (expense) (C)                                  |  |                    | 716        |   |                             |   | (2,168    | )                              |  |   | (718   | ) |  |   | (2,170     | )
|                                                            |  |                    |            |   |                             |   |           |                                |  |   |        |   |  |   |            |  
|Mortgage portfolio net interest income                      |  | $                  | 35,572     |   |                             | $ | 7,668     |                                |  | $ | 178    |   |  | $ | 43,418     |  
|                                                            |  |                    |            |   |                             |   |           |                                |  |   |        |   |  |   |            |  
|Average balance of the underlying loans                     |  | $                  | 11,635,845 |   |                             | $ | 1,051,892 |                                |  | $ | 54,456 |   |  | $ | 12,742,193 |  
|Net interest yield on assets                                |  |                    | 1.22       | % |                             |   | 2.92      | %                              |  |   | 1.30   | % |  |   | 1.36       | %
|                                                            |  |                    |            |   |                             |   |           |                                |  |   |        |   |  |   |            |  
|March 31, 2004                                              |  |                    |            |   |                             |   |           |                                |  |   |        |   |  |   |            |  
|Interest income                                             |  | $                  | 33,196     |   |                             | $ | 15,116    |                                |  | $ | 2,047  |   |  | $ | 50,359     |  
|Interest expense:                                           |  |                    |            |   |                             |   |           |                                |  |   |        |   |  |   |            |  
|Short-term borrowings (A)                                   |  |                    | 1,192      |   |                             |   | 4,755     |                                |  |   |       |   |  |   | 5,947      |  
|Asset-backed bonds                                          |  |                    | 2,348      |   |                             |   |          |                                |  |   | 364    |   |  |   | 2,712      |  
|Cash flow hedging net settlements                           |  |                    |           |   |                             |   | 719       |                                |  |   | 1,343  |   |  |   | 2,062      |  
|                                                            |  |                    |            |   |                             |   |           |                                |  |   |        |   |  |   |            |  
|Total interest expense                                      |  |                    | 3,540      |   |                             |   | 5,474     |                                |  |   | 1,707  |   |  |   | 10,721     |  
|                                                            |  |                    |            |   |                             |   |           |                                |  |   |        |   |  |   |            |  
|Mortgage portfolio net interest income before other expense |  |                    | 29,656     |   |                             |   | 9,642     |                                |  |   | 340    |   |  |   | 39,638     |  
|Other expense (C)                                           |  |                    |           |   |                             |   | (5,855    | )                              |  |   | (290   | ) |  |   | (6,145     | )
|                                                            |  |                    |            |   |                             |   |           |                                |  |   |        |   |  |   |            |  
|Mortgage portfolio net interest income                      |  | $                  | 29,656     |   |                             | $ | 3,787     |                                |  | $ | 50     |   |  | $ | 33,493     |  
|                                                            |  |                    |            |   |                             |   |           |                                |  |   |        |   |  |   |            |  
|Average balance of the underlying loans                     |  | $                  | 6,843,651  |   |                             | $ | 779,278   |                                |  | $ | 84,025 |   |  | $ | 7,706,954  |  
|Net interest yield on assets                                |  |                    | 1.73       | % |                             |   | 1.94      | %                              |  |   | 0.24   | % |  |   | 1.74       | %
|                                                            |  |                    |            |   |                             |   |           |                                |  |   |        |   |  |   |            |  

---

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



|(B) | Does not include interest expense related to the junior subordinated debentures.
|--- | --------------------------------------------------------------------------------



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



Impact of Interest Rate Agreements.We have executed interest rate
agreements designed to mitigate exposure to interest rate risk on short-term borrowings. Interest rate cap agreements require us to pay either a one-time up front premium or a monthly or quarterly premium, while allowing us to receive a
rate that adjusts with LIBOR when rates rise above a certain agreed-upon rate. Interest rate swap agreements allow us to pay a fixed rate of interest while receiving a rate that adjusts with one-month LIBOR. These agreements are used to alter, in
effect, the interest rates on funding costs to more closely match the yield on interest-earning assets. We incurred expenses of $0.2 million and $2.1 million related to net settlements of our interest rate agreements classified as cash flow hedges
for the three months ended March 31, 2005 and 2004, respectively. We incurred expenses of $0.6 million and $5.4 million related to net settlements of our interest rate agreements classified as non-cash flow hedges for the three months ended March
31, 2005 and 2004, respectively. Fluctuations in these expenses are solely dependent upon the movement in LIBOR as well as our average notional amount outstanding.



Provision forCredit Losses.We originate, purchase and own loans in which the borrower possesses
credit risk higher than that of conforming borrowers. Delinquent loans and losses are expected to occur. We



40



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maintain an allowance for credit losses for our mortgage loans  held-in-portfolio. Provisions for credit losses are made in amounts considered
necessary to maintain an allowance at a level sufficient to cover probable losses inherent in the loan portfolio. Charge-offs are recognized at the time of foreclosure by recording the value of real estate owned property at its estimated realizable
value. One of the principal methods used to determine probable losses is a delinquency migration analysis. This analysis takes into consideration historical information regarding foreclosure and loss severity experience and applies that information
to the portfolio at the reporting date.



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



During the three months ended March 31, 2005 we recognized net credit losses of $0.6 million compared with net credit losses of $0.1 million for the
three months ended March 31, 2004. We incurred net charge-offs of $0.2 million and $0.3 million for the three months ended March 31, 2005 and 2004, respectively.



Fee Income.Fee income primarily consists of broker fees and service fee income. Due to the elimination of the
LLCs and their subsequent inclusion in the condensed consolidated financial statements, branch management fees are eliminated in consolidation.



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



Service fees are paid to us by either the investor or the borrower on mortgage loans serviced. Fees paid by investors on loans serviced are determined as a percentage of the principal collected for the loans serviced
and are recognized in the period in which payments on the loans are received. Fees paid by borrowers on loans serviced are considered ancillary fees related to loan servicing and include late fees, processing fees and, for loans held-in-portfolio,
prepayment penalties. Revenue is recognized on fees received from borrowers when an event occurs that generates the fee and they are considered to be collectible.



Overall, fee income increased from $18.0 million for the three months ended March 31, 2004 to $18.6 million for the same
period of 2005 primarily due to the increase in our servicing portfolio from $8.4 billion as of March 31, 2004 to $12.9 billion as of March 31, 2005. The increase in fee income as a result of the increase in our servicing portfolio was offset by the
decline in broker fees, which resulted from lower retail origination volume placed with third-party investors.



Gains on Sales of Mortgage Assets and Gains (Losses) on Derivative Instruments. We execute securitization transactions in which we transfer
mortgage loan collateral to an independent trust. The trust holds the mortgage loans as collateral for the securities it issues to finance the sale of the mortgage loans. In those transactions, certain securities are issued to entities unrelated to
us, and we retain the interest-only, prepayment penalty and non-investment grade subordinated securities. In addition, we continue to service the loan collateral. These transactions were structured as sales for accounting and income tax reporting
during the three months ended March 31, 2005 and 2004. Whole loan sales have also been executed whereby we sell loans to third parties. In the outright sales of mortgage loans, we retain no assets or servicing rights. Table 9 provides a summary of
mortgage loans transferred in securitizations.



We have entered
into derivative instrument contracts that do not meet the requirements for hedge accounting treatment, but contribute to our overall risk management strategy by serving to reduce interest rate risk related to short-term borrowing rates. Changes in
the fair value of these derivative instruments are credited or charged to current earnings. We recognized gains of $14.6 million during the three months ended March 31, 2005, compared with losses of $25.4 million for the same period of 2004.



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



41



---

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

(in thousands)



|                                                                 |  |                                     |        |   |      |   |         |  
|---------------------------------------------------------------- |  | ----------------------------------- | ------ | - | ---- | - | ------- | -
|                                                                 |  | For the Three MonthsEnded March 31, |       
|                                                                 |  | 2005                                |        |   | 2004 |  
|Gains on sales of mortgage loans transferred in securitizations  |  | $                                   | 18,136 |   |      | $ | 51,092  |  
|Gains on sales of mortgage loans to third parties  conforming   |  |                                     | 147    |   |      |   | 486     |  
|(Losses) gains on sales of real estate owned                     |  |                                     | (37    | ) |      |   | 202     |  
|                                                                 |  |                                     |        |   |      |   |         |  
|Gains on sales of mortgage assets                                |  |                                     | 18,246 |   |      |   | 51,780  |  
|Gains (losses) on derivatives                                    |  |                                     | 14,601 |   |      |   | (25,398 | )
|                                                                 |  |                                     |        |   |      |   |         |  
|Net gains on sales of mortgage assets and derivative instruments |  | $                                   | 32,847 |   |      | $ | 26,382  |  
|                                                                 |  |                                     |        |   |      |   |         |  



42



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Table 9  Mortgage Loan Securitizations

(dollars in thousands)



|                                |  |                                               |           |                     |   |                                       |  |                                                                                                 |         |  |              |   |  |                                                     |   |  |      |  
|------------------------------- |  | --------------------------------------------- | --------- | ------------------- | - | ------------------------------------- |  | ----------------------------------------------------------------------------------------------- | ------- |  | ------------ | - |  | --------------------------------------------------- | - |  | ---- | -
|                                |  | Mortgage Loans Transferred in Securitizations |          
|                                |  |                                               |           |                     |   |                                       |  | Weighted Average AssumptionsUnderlying Initial Value of MortgageSecurities  Available-for-Sale |        
|For the Year Ended December
31, |  | Principal Amount                              |           | Net Gain Recognized |   | InitialCost BasisofMortgageSecurities |  | ConstantPrepaymentRate                                                                          |         |  | DiscountRate |   |  | Expected TotalCredit Losses,Net ofMortgageInsurance |  
|2005:                           |  |                                               |           |                     |   |                                       |  |                                                                                                 |         |  |              |   |  |                                                     |   |  |      |  
|First quarter                   |  | $                                             | 2,100,000 |                     | $ | 18,136                                |  | $                                                                                               | 88,433  |  | 37           | % |  | 15                                                  | % |  | 3.63 | %
|                                |  |                                               |           |                     |   |                                       |  |                                                                                                 |         |  |              |   |  |                                                     |   |  |      |  
|2004:                           |  |                                               |           |                     |   |                                       |  |                                                                                                 |         |  |              |   |  |                                                     |   |  |      |  
|Fourth quarter                  |  | $                                             | 2,500,000 |                     | $ | 21,721                                |  | $                                                                                               | 94,911  |  | 35           | % |  | 26                                                  | % |  | 3.98 | %
|Third quarter                   |  |                                               | 2,759,716 |                     |   | 46,551                                |  |                                                                                                 | 127,572 |  | 33           |   |  | 21                                                  |   |  | 4.61 |  
|Second quarter                  |  |                                               | 1,367,430 |                     |   | 24,888                                |  |                                                                                                 | 76,565  |  | 32           |   |  | 24                                                  |   |  | 5.42 |  
|First quarter                   |  |                                               | 1,702,658 |                     |   | 51,092                                |  |                                                                                                 | 82,785  |  | 32           |   |  | 20                                                  |   |  | 5.69 |  
|                                |  |                                               |           |                     |   |                                       |  |                                                                                                 |         |  |              |   |  |                                                     |   |  |      |  
|Total                           |  | $                                             | 8,329,804 |                     | $ | 144,252                               |  | $                                                                                               | 381,833 |  | 33           | % |  | 22                                                  | % |  | 4.77 | %
|                                |  |                                               |           |                     |   |                                       |  |                                                                                                 |         |  |              |   |  |                                                     |   |  |      |  



Premiums for
Mortgage Loan Insurance.The use of mortgage insurance is one method of managing the credit risk in the mortgage asset portfolio. Premiums for mortgage insurance on loans maintained on our balance sheet are paid by us and are recorded as a
portfolio cost and included in the income statement under the caption Premiums for Mortgage Loan Insurance. These premiums totaled $0.9 and $0.6 million for the three months ended March 31, 2005 and 2004, respectively. We received
mortgage insurance proceeds on claims filed of $0.2 million and $1.1 million for the three months ended March 31, 2005 and 2004, respectively.



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



We intend to continue to use mortgage insurance coverage as a credit
management tool as we continue to originate, purchase and securitize mortgage loans. Mortgage insurance claims on loans where a defect occurred in the loan origination process will not be paid by the mortgage insurer. The assumptions we use to value
our mortgage securities - available-for-sale consider this risk. The percentage of loans with mortgage insurance generally should be lower than 50%. For the 2005-1 securitization, the mortgage loans that were transferred into the trust had mortgage
insurance coverage at the time of transfer of 44% of total principal. As of March 31, 2005 and December 31, 2004, 45% of our securitized loans total principal had mortgage insurance coverage.



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



Other Income, net.Included in other income, net is primarily interest income on our cash accounts and deposits with derivative instrument
counterparties (swap margin). Other income, net increased from $1.1 million for the three months ended March 31, 2004 to $3.6 million for the same period of 2005. This increase



43



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is a result of higher average cash balances in bank accounts where we earn income on the average collected balances. In addition we are earning higher rates
on these balances due to the increase in short-term interest rates.



General and Administrative Expenses.The main categories of our general and administrative expenses are compensation and benefits, loan expense, marketing, office administration and professional and outside services. Compensation and
benefits includes employee base salaries, benefit costs and incentive compensation awards. Loan expense primarily includes expenses relating to the underwriting of mortgage loans that do not fund successfully and servicing costs. Marketing primarily
includes costs of purchased loan leads, advertising and business promotion. 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.



The increase in general and administrative expenses from $50.2 million for the three months ended March 31, 2004 to $60.3 million for the same period in 2005 is primarily attributable to growth in our wholesale, correspondent and servicing
operations. We employed 2,479 people as of March 31, 2005 compared with 2,158 as of March 31, 2004.



Note 11 to the condensed consolidated financial statements presents an income statement for our three segments, setting forth our expenses by segment.



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



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



|               |  |               |   |  |                                           |   |  |                       |  
|-------------- |  | ------------- | - |  | ----------------------------------------- | - |  | --------------------- | -
|               |  | OverheadCosts |   |  | PremiumPaid toBroker,Net of FeesCollected |   |  | Total AcquisitionCost |  
|2005:          |  |               |   |  |                                           |   |  |                       |  
|First quarter  |  | 2.11          | % |  | 0.67                                      | % |  | 2.78                  | %
|2004:          |  |               |   |  |                                           |   |  |                       |  
|Fourth quarter |  | 1.95          | % |  | 0.71                                      | % |  | 2.66                  | %
|Third quarter  |  | 1.68          | % |  | 0.73                                      | % |  | 2.41                  | %
|Second quarter |  | 1.71          | % |  | 0.72                                      | % |  | 2.43                  | %
|First quarter  |  | 1.84          | % |  | 0.82                                      | % |  | 2.66                  | %



The following table is
a reconciliation of our overhead costs to the general and administrative expenses of the mortgage lending and loan servicing segment as shown in Note 11 to the condensed consolidated financial statements, presented in accordance with accounting
principles generally accepted in the United States of America (GAAP). The reconciliation does not address premiums paid to brokers since they are deferred at origination under GAAP and recognized when the related loans are sold or securitized. We
believe this presentation of overhead costs provides useful information regarding our financial performance because it more accurately reflects the direct costs of loan production and allows us to monitor the performance of our core operations,
which is more difficult to do when looking at GAAP financial statements, and provides useful information regarding our financial performance. Management uses this measure for the same purpose. However, this presentation is not intended to be used as
a substitute for financial results prepared in accordance with GAAP.



44



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Table 11  Reconciliation of Overhead Costs

(dollars in thousands, except overhead as a percentage)



|                                                                            |  |                                     |           |   |      |   |           |  
|--------------------------------------------------------------------------- |  | ----------------------------------- | --------- | - | ---- | - | --------- | -
|                                                                            |  | For the Three Months EndedMarch 31, |          
|                                                                            |  | 2005                                |           |   | 2004 |  
|Mortgage lending and loan servicing general and administrative expenses (A) |  | $                                   | 41,325    |   |      | $ | 32,650    |  
|Direct origination costs classified as a reduction in gain-on-sale          |  |                                     | 10,221    |   |      |   | 9,658     |  
|Costs of servicing                                                          |  |                                     | (6,888    | ) |      |   | (5,107    | )
|Other lending expenses                                                      |  |                                     | (9,344    | ) |      |   | (8,643    | )
|                                                                            |  |                                     |           |   |      |   |           |  
|Overhead costs                                                              |  | $                                   | 35,314    |   |      | $ | 28,558    |  
|                                                                            |  |                                     |           |   |      |   |           |  
|Wholesale production, principal                                             |  | $                                   | 1,669,930 |   |      | $ | 1,551,971 |  
|Overhead, as a percentage                                                   |  |                                     | 2.11      | % |      |   | 1.84      | %

---

|(A) | Mortgage lending and loan servicing general and administrative expenses are presented in Note 11 to the condensed consolidated financial statements.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------



Income Taxes.Since our inception, NFI has elected to be
treated as a REIT for federal income tax purposes. As a REIT, NFI is not required to pay any corporate level income taxes as long as we distribute 100 percent of our taxable income in the form of dividend distributions to our shareholders. To
maintain our REIT status, NFI must meet certain requirements prescribed by the Internal Revenue Code. We intend to operate NFI in a manner that allows us to meet these requirements.



Below is a summary of the taxable net income available to common shareholders for the three months ended March 31, 2005 and
2004.



Table 12  Taxable Net Income

(dollars in thousands)



|                                                    |  |                                     |        |   |               |   |        |  
|--------------------------------------------------- |  | ----------------------------------- | ------ | - | ------------- | - | ------ | -
|                                                    |  | For the Three MonthsEnded March 31, |       
|                                                    |  | 2005Estimated                       |        |   | 2004Estimated |  
|Consolidated net income                             |  | $                                   | 35,203 |   |               | $ | 30,925 |  
|Equity in net income of NFI Holding Corp.           |  |                                     | (341   | ) |               |   | 353    |  
|Consolidation eliminations between the REIT and TRS |  |                                     | 799    |   |               |   |       |  
|                                                    |  |                                     |        |   |               |   |        |  
|REIT net income                                     |  |                                     | 35,661 |   |               |   | 31,278 |  
|Adjustments to net income to compute taxable income |  |                                     | 33,887 |   |               |   | 12,702 |  
|                                                    |  |                                     |        |   |               |   |        |  
|Taxable income before preferred dividends           |  |                                     | 69,548 |   |               |   | 43,980 |  
|Preferred dividends                                 |  |                                     | (1,663 | ) |               |   | (1,275 | )
|                                                    |  |                                     |        |   |               |   |        |  
|Taxable income available to common shareholders     |  | $                                   | 67,885 |   |               | $ | 42,705 |  
|                                                    |  |                                     |        |   |               |   |        |  
|Taxable income per common share (A)                 |  | $                                   | 2.43   |   |               | $ | 1.72   |  
|                                                    |  |                                     |        |   |               |   |        |  

---

|(A) | The common shares outstanding as of the end of each period presented is used in calculating the taxable income per common share.
|--- | --------------------------------------------------------------------------------------------------------------------------------



The primary difference between consolidated net income and taxable income is
due to differences in the recognition of income on our portfolio of interest-only mortgage securities  available-for-sale. Generally, the accrual of interest on interest-only securities is accelerated for income tax purposes. This is the
result of the current original issue discount rules as promulgated under Internal Revenue Code Sections 1271 through 1275. On September 30, 2004, the IRS released Announcement 2004-75. This Announcement describes rules that may be included in
proposed regulations regarding the timing of income and/or deductions attributable to interest-only securities. No proposed regulations that would impact income for 2005 have been issued. Based on the Announcement, we believe that if the IRS does
propose and adopt new regulations on this issue, the change will have the effect of narrowing the spread between book income and taxable income on interest-only mortgage securities, and thus, will have a similar impact to NFI in years following the
effective date of the rules.



To maintain its qualification as
a REIT, NFI is required to declare dividend distributions of at least 90 percent of our taxable income by the filing date of our federal tax return, including extensions. Any taxable income that has not been declared to be distributed by this date
is subject to corporate income taxes. At this time, NFI intends to declare dividends equal to 100 percent of our taxable income for 2004 and 2005 by the required distribution date.



45



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Accordingly, we have not accrued any corporate income tax for NFI for the three months ended March 31, 2005.



As a REIT, NFI may be subject to a federal excise tax. An excise tax is
incurred if NFI distributes less than 85 percent of its taxable income by the end of the calendar year. As part of the amount distributed by the end of the calendar year, NFI may include dividends that were declared in October, November or December
and paid on or before January 31 of the following year. To the extent that 85 percent of our taxable income exceeds our dividend distributions in any given year, an excise tax of 4 percent is due and payable on the shortfall. For the three months
ended March 31, 2005 and 2004, we have provided for excise tax of $1.6 million and $0.6 million, respectively. Excise taxes are reflected as a component of general and administrative expenses on our condensed consolidated statements of income. As of
March 31, 2005 and December 31, 2004, accrued excise tax payable was $0.6 million and $1.8 million, respectively. The excise tax payable is reflected as a component of accounts payable and other liabilities on our condensed consolidated balance
sheets.



NFI Holding Corporation, a wholly-owned subsidiary of
NFI, and its subsidiaries (collectively known as the TRS) are treated as taxable REIT subsidiaries. The TRS is subject to corporate income taxes and files a consolidated federal income tax return. The TRS reported net income
from continuing operations before income taxes of $2.1 million for the three months ended March 31, 2005 compared with $2.9 million for the same period of 2004. As shown in our statement of income, this resulted in an income tax expense of $0.8
million and $1.5 million for the three months ended March 31, 2005 and 2004, respectively. Additionally, the TRS reported a net loss from discontinued operations before income taxes of $1.6 million and $2.8 million for the three months ended March
31, 2005 and 2004, respectively, resulting in an income tax benefit of $0.6 million and $1.1 million, respectively.



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



Mortgage Loan Servicing. Loan servicing is a critical part of our business. In the opinion of management, maintaining contact with borrowers is vital in managing credit risk and in borrower retention. Nonconforming borrowers are
prone to late payments and are more likely to default on their obligations than conventional borrowers. We strive to identify issues and trends with borrowers early and take quick action to address such matters. Our annualized costs of servicing per
unit decreased from $326 at March 31, 2004 to $297 at March 31, 2005.



Table 13  Summary of Servicing Operations

(in thousands, except per unit cost)



|                                                                       |  |                |            |   |         |   |      |  
|---------------------------------------------------------------------- |  | -------------- | ---------- | - | ------- | - | ---- | -
|                                                                       |  | 2005           |           
|                                                                       |  | March 31Amount |            |   | PerUnit |  
|Unpaid principal                                                       |  | $              | 12,860,740 |   |         |   |      |  
|                                                                       |  |                |            |   |         |   |      |  
|Number of loans                                                        |  |                | 92,827     |   |         |   |      |  
|                                                                       |  |                |            |   |         |   |      |  
|Servicing income, before amortization of mortgage servicing rights     |  | $              | 11,968     |   |         | $ | 516  |  
|Costs of servicing                                                     |  |                | (6,888     | ) |         |   | (297 | )
|                                                                       |  |                |            |   |         |   |      |  
|Net servicing income, before amortization of mortgage servicing rights |  |                | 5,080      |   |         |   | 219  |  
|Amortization of mortgage servicing rights                              |  |                | (5,746     | ) |         |   | (248 | )
|                                                                       |  |                |            |   |         |   |      |  
|Net servicing loss                                                     |  | $              | (666       | ) |         | $ | (29  | )
|                                                                       |  |                |            |   |         |   |      |  



46



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|                                                                       |  |                   |            |   |         |   |      |                    |  |   |            |   |  |               |      |   |         |   |           |                |  |   |         |   |  |   |           |   |  |   |      |  
|---------------------------------------------------------------------- |  | ----------------- | ---------- | - | ------- | - | ---- | ------------------ |  | - | ---------- | - |  | ------------- | ---- | - | ------- | - | --------- | -------------- |  | - | ------- | - |  | - | --------- | - |  | - | ---- | -
|                                                                       |  | 2004              |           
|                                                                       |  | December 31Amount |            |   | PerUnit |   |      | September 30Amount |  |   | PerUnit    |   |  | June 30Amount |      |   | PerUnit |   |           | March 31Amount |  |   | PerUnit |  
|Unpaid principal                                                       |  | $                 | 12,151,196 |   |         |   |      |                    |  | $ | 11,073,505 |   |  |               |      |   |         | $ | 9,604,342 |                |  |   |         |   |  | $ | 8,428,852 |   |  |   |      |  
|                                                                       |  |                   |            |   |         |   |      |                    |  |   |            |   |  |               |      |   |         |   |           |                |  |   |         |   |  |   |           |   |  |   |      |  
|Number of loans                                                        |  |                   | 87,543     |   |         |   |      |                    |  |   | 80,324     |   |  |               |      |   |         |   | 70,942    |                |  |   |         |   |  |   | 62,600    |   |  |   |      |  
|                                                                       |  |                   |            |   |         |   |      |                    |  |   |            |   |  |               |      |   |         |   |           |                |  |   |         |   |  |   |           |   |  |   |      |  
|Servicing income, before amortization of mortgage servicing rights     |  | $                 | 10,619     |   |         | $ | 485  |                    |  | $ | 8,846      |   |  | $             | 441  |   |         | $ | 8,277     |                |  | $ | 467     |   |  | $ | 8,031     |   |  | $ | 513  |  
|Costs of servicing                                                     |  |                   | (6,768     | ) |         |   | (309 | )                  |  |   | (5,810     | ) |  |               | (289 | ) |         |   | (5,160    | )              |  |   | (291    | ) |  |   | (5,107    | ) |  |   | (326 | )
|                                                                       |  |                   |            |   |         |   |      |                    |  |   |            |   |  |               |      |   |         |   |           |                |  |   |         |   |  |   |           |   |  |   |      |  
|Net servicing income, before amortization of mortgage servicing rights |  |                   | 3,851      |   |         |   | 176  |                    |  |   | 3,036      |   |  |               | 152  |   |         |   | 3,117     |                |  |   | 176     |   |  |   | 2,924     |   |  |   | 187  |  
|Amortization of mortgage servicing rights                              |  |                   | (5,321     | ) |         |   | (243 | )                  |  |   | (4,476     | ) |  |               | (223 | ) |         |   | (3,854    | )              |  |   | (217    | ) |  |   | (3,283    | ) |  |   | (210 | )
|                                                                       |  |                   |            |   |         |   |      |                    |  |   |            |   |  |               |      |   |         |   |           |                |  |   |         |   |  |   |           |   |  |   |      |  
|Net servicing loss                                                     |  | $                 | (1,470     | ) |         | $ | (67  | )                  |  | $ | (1,440     | ) |  | $             | (71  | ) |         | $ | (737      | )              |  | $ | (41     | ) |  | $ | (359      | ) |  | $ | (23  | )
|                                                                       |  |                   |            |   |         |   |      |                    |  |   |            |   |  |               |      |   |         |   |           |                |  |   |         |   |  |   |           |   |  |   |      |  



Liquidity and Capital Resources



Liquidity means the need for, access to and uses of cash.
Our primary needs for cash include the origination and acquisition of mortgage loans, principal repayment and interest on borrowings, operating expenses and dividend payments. Substantial cash is required to support the operating activities of the
business, especially the mortgage origination operation. Mortgage asset sales, principal, interest and fees collected on mortgage assets support cash needs. Drawing upon various borrowing arrangements typically satisfies major cash requirements. As
shown in Table 5, we have $237.9 million in immediately available funds.



Mortgage lending requires significant cash to fund loan originations and purchases. Our warehouse lending arrangements, which include repurchase agreements, support the mortgage lending operation. Our warehouse
mortgage lenders allow us to borrow between 98% and 100% of the outstanding principal. Funding for the difference  generally 2% of the principal - must come from cash on hand.



Loans financed with warehouse repurchase credit facilities are subject to changing market valuation and margin calls. The
market value of our loans is dependent on a variety of economic conditions, including interest rates (and borrower demand) and end investor desire and capacity. Market values have declined over the past year, but have remained well in excess of par.
However, there is no certainty that the prices will remain in excess of par. To the extent the value of the loans declines significantly, we would be required to repay portions of the amounts we have borrowed. The value of our loans held-for-sale,
excluding the loans under removal of accounts provision, as of March 31, 2005 would need to decline by approximately 42% before we would use all immediately available funds, assuming no other constraints on our immediately available funds.



In the ordinary course of business, we sell loans with
recourse where a defect occurred in the loan origination process and guarantee to cover investor losses should origination defects occur. Defects may occur in the loan documentation and underwriting process, either through processing errors made by
us or through intentional or unintentional misrepresentations made by the borrower or agents during those processes. If a defect is identified, we are required to repurchase the loan. As of March 31, 2005 and December 31, 2004, we had loans sold
with recourse with an outstanding principal balance of $12.2 billion and $11.4 billion, respectively. Historically, repurchases of loans where a defect has occurred have been insignificant, as such, there is minimal liquidity risk.



The derivative financial instruments we use also subject us to margin
call risk. Under our interest rate swaps, we pay a fixed rate to the counterparties while they pay us a floating rate. While floating rates are low, on a net basis we are paying the counterparty. In order to mitigate credit exposure to us, the
counterparty requires us to post margin deposits with them. As of March 31, 2005, we have approximately $5.1 million on deposit. A decline in interest rates would subject us to additional exposure for cash margin calls. However, when short-term
interest rates (the basis for our funding costs) are low and the coupon rates on our loans are high, our net interest margin (and therefore incoming cash flow) is high which should offset any requirement to post additional collateral. Severe and
immediate changes in interest rates will impact the volume of our incoming cash flow. To the extent rates increase dramatically, our funding costs will increase quickly. While many of our loans are adjustable, they typically will not reset as
quickly as our funding costs. This circumstance would temporarily reduce incoming cash flow. As noted above, derivative financial instruments are used to mitigate the effect of interest rate volatility. In this rising rate situation, our interest
rate swaps and caps would provide additional cash flows to mitigate the lower cash flows on loans and securities.



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



47



---

Cash activity during the three months ended March 31, 2005 and 2004 is presented in the condensed
consolidated statement of cash flows.



As noted above, proceeds
from equity offerings have provided the equity capital to support our operations. Since inception, we have raised $362 million in net proceeds through private and public equity offerings. Equity offerings provide another future liquidity source.



Off Balance Sheet Arrangements



As discussed previously, we pool the loans we originate and purchase and
securitize them to obtain long-term financing for the assets. The loans are transferred to a trust where they serve as collateral for asset-backed bonds, which the trust issues to the public. Our ability to use the securitization capital market is
critical to the operations of our business. Table 3 summarizes our off balance sheet securitizations.



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



Specific items that may affect our ability to use the securitizations to finance our loans relate primarily to the
performance of the loans that have been securitized. Extremely poor loan performance may lead to poor bond performance and investor unwillingness to buy bonds supported by our collateral. Historically, our financial performance and condition has
little impact on our ability to securitize, as evidenced by our ability to securitize in 1998, 1999 and 2000 when our financial trend was weak. There, however, are no assurances that we will be able to securitize loans in the future when we have
poor loan performance.



We have commitments to borrowers to
fund residential mortgage loans as well as commitments to purchase and sell mortgage loans to third parties. At March 31, 2005, the Company had outstanding commitments to originate, purchase and sell loans of $422.9 million, $3.5 million and $11.6
million, respectively. As of December 31, 2004, we had outstanding commitments to originate loans of $361.2 million. We had no commitments to purchase or sell loans at December 31, 2004. The commitments to originate and purchase loans do not
necessarily represent future cash requirements, as some portion of the commitments are likely to expire without being drawn upon or may be subsequently declined for credit or other reasons.



48



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Contractual Obligations



We have entered into certain long-term debt and lease agreements, which obligate us to make future payments to satisfy the related contractual
obligations. Notes 5, 6 and 7 of the condensed consolidated financial statements discuss these obligations in further detail.



Since December 31, 2004, we have issued junior subordinated debentures as discussed in Note 5. The following table summarizes our contractual obligations
with regard to our long-term debt and lease agreements as of March 31, 2005.



Table 14  Contractual Obligations

(in thousands)



|                                                                       |  |                        |         |                 |   |          |  |          |        |              |   |        |  |   |        
|---------------------------------------------------------------------- |  | ---------------------- | ------- | --------------- | - | -------- |  | -------- | ------ | ------------ | - | ------ |  | - | -------
|                                                                       |  | Payments Due by Period
|Contractual Obligations                                                |  | Total                  |         | Less than 1Year |   | 1-3Years |  | 4-5Years |        | After 5Years
|Short-term borrowings                                                  |  | $                      | 661,603 |                 | $ | 661,603  |  |          |       |              |   |       |  |   |       
|Long-term debt (A)                                                     |  | $                      | 303,780 |                 | $ | 226,214  |  | $        | 64,061 |              | $ | 10,294 |  | $ | 3,211  
|Junior subordinated debentures (B)                                     |  | $                      | 147,650 |                 | $ | 3,255    |  | $        | 6,510  |              | $ | 6,510  |  | $ | 131,375
|Operating leases                                                       |  | $                      | 49,956  |                 | $ | 9,027    |  | $        | 17,526 |              | $ | 16,295 |  | $ | 7,108  
|Premiums due to counterparties related to interest rate cap agreements |  | $                      | 4,629   |                 | $ | 2,653    |  | $        | 1,643  |              |   | 333    |  |   |       

---

|(A) | Repayment of the asset-backed bonds is dependent upon payment of the underlying mortgage loans, which collateralize the debt. The repayment of these mortgage loans is affected by
prepayments. Interest obligations on our variable-rate long-term debt are based on the prevailing interest rate at March 31, 2005 for each respective obligation.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(B) | The junior subordinated debentures are assumed to mature in 2035 in computing the future payments. Interest obligations on our junior subordinated debentures are based on the
prevailing interest rate at March 31, 2005 for each respective obligation.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Inflation



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



Impact of Recently Issued Accounting Pronouncements



In December 2004, the Financial Accounting Standards Board (FASB) issued a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. This Statement establishes standards for the
accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the
entitys equity instruments or that may be settled by the issuance of those equity instruments. This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions and
does not change the accounting guidance for share-based payment transactions with parties other than employees provided in SFAS No. 123 and Emerging Issues Task Force of the FASB (EITF) Issue No. 96-18, Accounting for Equity Instruments That Are
Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. Entities no longer have the option to use the intrinsic value method of APB 25 that was provided in SFAS No. 123 as originally issued, which
generally resulted in the recognition of no compensation cost. Under SFAS No. 123(R), the cost of employee services received in exchange for an equity award must be based on the grant-date fair value of the award. The cost of the awards under SFAS
No. 123(R) will be recognized over the period an employee provides service, typically the vesting period. No compensation cost is recognized for equity instruments in which the requisite service is not provided. For employee awards that are treated
as liabilities, initial cost of the awards will be measured at fair value. The fair value of the liability awards will be remeasured subsequently at each reporting date through the settlement date with changes



49



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in fair value during the period an employee provides service recognized as compensation cost over that period. Under SFAS No. 123(R), all companies must use
the modified prospective approach to all equity awards granted, issued, modified or cash settled prior to the date of adoption. Under the modified prospective approach, compensation expense recognized from the point of adoption going forward is the
same as if the fair value method as disclosed under the pro forma disclosure requirements of the original SFAS No. 123 had been applied from its effective date. Restatement of prior periods (interim or annual) is not required. However, companies may
elect to restate prior periods to mirror compensation expense recognized under the pro forma disclosures of the original SFAS No. 123 using the modified retrospective approach. Under this approach, compensation expense can either be adjusted to 1)
all prior periods presented with an adjustment to the beginning of the earliest periods additional paid-in capital, deferred taxes and retained earnings for the remaining compensation expense that would have been recognized had the company
applied the provisions of the original SFAS No. 123 since its effective date (annual periods beginning after December 15, 1994) or 2) only to interim prior periods of the initial adoption year with no adjustment to beginning of year additional
paid-in capital, deferred taxes and retained earnings, if adoption does not coincide with the beginning of the companys fiscal year. We plan to adopt this standard using the required modified prospective approach. This Statement was originally
effective as of the first interim or annual reporting period that begins after June 15, 2005. In April of 2005, the SEC amended the compliance dates for SFAS No. 123(R). This Statement is now effective at the beginning of the next fiscal year that
begins after June 15, 2005. As discussed in Note 1 to the 2004 annual report on Form 10-K, the Company implemented the fair value provisions of SFAS No. 123 during 2003. As such, the adoption of this Statement is not anticipated to have a
significant impact on the Companys condensed consolidated financial statements.



In March 2005, SEC Staff Accounting Bulletin (SAB) No. 107, Application of FASB No. 123 (revised 2004), Accounting for Stock-Based Compensationwas released. This release summarizes the SEC staff position
regarding the interaction between FASB No. 123 (revised 2004), Share-Based Payment and certain SEC rules and regulations and provides the SECs views regarding the valuation of share-based payment arrangements for public companies. As
discussed in Note 1 to the 2004 annual report on Form 10-K, the Company implemented the fair value provisions of the original SFAS No. 123 during 2003. As such, the adoption of this release is not anticipated to have a significant impact on the
condensed Companys consolidated financial statements.



On
March 3, 2005, the FASB issued FASP Staff Position (FSP) FIN 46(R)-5, Implicit Variable Interests Under FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities. This FSP addresses whether a reporting enterprise has an
implicit variable interest in a variable interest entity (VIE) or potential VIE when specific conditions exist. This FSP is applicable to both nonpublic and public reporting enterprises. It covers issues that commonly arise in leasing arrangements
among related parties, as well as other types of arrangements involving both related and unrelated parties. Although implicit variable interests are mentioned in Interpretation 46(R), the term is not defined and only one example is provided. This
FSP offers additional guidance, stating that implicit variable interests are implied financial interests in an entity that change with changes in the fair value of the entitys net assets exclusive of variable interests. An implicit variable
interest acts the same as an explicit variable interest except it involves the absorbing and/or receiving of variability indirectly from the entity (rather than directly). The identification of an implicit variable interest is a matter of judgment
that depends on the relevant facts and circumstances. As the Company has already adopted Interpretation 46(R), this FSP will be effective in the first reporting period beginning after March 3, 2005. Restatement to the date of initial application of
Interpretation 46(R) is permitted but not required. The adoption of this FSP is not anticipated to have a significant impact on the Companys condensed consolidated financial statements.



Item 3. Quantitative and Qualitative Disclosures About Market Risk



Our investment policy sets the following general goals:



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



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



Interest Rate Risk. When interest rates on our assets do not adjust at the same rates as our liabilities or when the assets have fixed rates and
the liabilities have adjustable rates, future earnings potential is affected. We express this interest rate risk as the risk that the market value of assets will increase or decrease at different rates than that of the liabilities. Expressed another
way, this is the risk that net asset value will experience an



50



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adverse change when interest rates change. We assess the risk based on the change in market values given increases and decreases in interest rates. We also
assess the risk based on the impact to net income in changing interest rate environments.



Management primarily uses financing sources where the interest rate resets frequently. As of March 31, 2005, borrowings under all financing arrangements adjust daily or monthly. On the other hand, very few of the
mortgage assets we own adjust on a monthly or daily basis. Most of the mortgage loans contain features where their rates are fixed for some period of time and then adjust frequently thereafter. For example, one of our loan products is the
2/28 loan. This loan is fixed for its first two years and then adjusts every six months thereafter.



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



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



Table 15 - Interest Rate Sensitivity - Market Value

(dollars in thousands)



|                                                    |  |                                                     |         |   |       |   |         |     |  |   |         |    |  |   |         |   
|--------------------------------------------------- |  | --------------------------------------------------- | ------- | - | ----- | - | ------- | --- |  | - | ------- | -- |  | - | ------- | --
|                                                    |  | Basis Point Increase (Decrease) in Interest Rate(A) |        
|                                                    |  | (200)                                               |         |   | (100) |   |         | 100 |  |   | 200     |   
|As of March 31, 2005:                               |  |                                                     |         |   |       |   |         |     |  |   |         |    |  |   |         |   
|Change in market values of:                         |  |                                                     |         |   |       |   |         |     |  |   |         |    |  |   |         |   
|Assets                                              |  | $                                                   | 65,440  |   |       | $ | 30,379  |     |  | $ | (36,257 | )  |  | $ | (78,428 | ) 
|Interest rate agreements                            |  |                                                     | (46,475 | ) |       |   | (24,499 | )   |  |   | 27,061  |    |  |   | 55,125  |   
|                                                    |  |                                                     |         |   |       |   |         |     |  |   |         |    |  |   |         |   
|Cumulative change in market value                   |  | $                                                   | 18,965  |   |       | $ | 5,880   |     |  | $ | (9,196  | )  |  | $ | (23,303 | ) 
|                                                    |  |                                                     |         |   |       |   |         |     |  |   |         |    |  |   |         |   
|Percent change of market value portfolio equity (B) |  |                                                     | 3.9     | % |       |   | 1.2     | %   |  |   | (1.9    | )% |  |   | (4.8    | )%
|                                                    |  |                                                     |         |   |       |   |         |     |  |   |         |    |  |   |         |   
|As of December 31, 2004:                            |  |                                                     |         |   |       |   |         |     |  |   |         |    |  |   |         |   
|Change in market values of:                         |  |                                                     |         |   |       |   |         |     |  |   |         |    |  |   |         |   
|Assets                                              |  | $                                                   | 70,438  |   |       | $ | 33,198  |     |  | $ | (34,045 | )  |  | $ | (72,840 | ) 
|Interest rate agreements                            |  |                                                     | (54,085 | ) |       |   | (28,046 | )   |  |   | 27,832  |    |  |   | 55,113  |   
|                                                    |  |                                                     |         |   |       |   |         |     |  |   |         |    |  |   |         |   
|Cumulative change in market value                   |  | $                                                   | 16,353  |   |       | $ | 5,152   |     |  | $ | (6,213  | )  |  | $ | (17,727 | ) 
|                                                    |  |                                                     |         |   |       |   |         |     |  |   |         |    |  |   |         |   
|Percent change of market value portfolio equity (B) |  |                                                     | 3.3     | % |       |   | 1.0     | %   |  |   | (1.3    | )% |  |   | (3.6    | )%
|                                                    |  |                                                     |         |   |       |   |         |     |  |   |         |    |  |   |         |   

---

|(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) | Total change in estimated market value as a percent of market value portfolio equity as of March 31, 2005 and December 31, 2004.
|--- | --------------------------------------------------------------------------------------------------------------------------------



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



51



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



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



Interest rate cap agreements are legal contracts between us and a third-party firm or counterparty. The
counterparty agrees to make payments to us in the future should the one-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. Payments on an annualized basis equal the contractual notional face amount times the difference between actual LIBOR and the strike rate. Interest rate swaps have similar characteristics. However, interest rate swap
agreements allow us to pay a fixed rate of interest while receiving a rate that adjusts with one-month LIBOR.



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



52



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We have determined the following estimated net fair value amounts by using available market information
and valuation methodologies we deem appropriate as of March 31, 2005.



Table 16  Interest Rate Risk Management Contracts

(dollars in thousands)



|                              |  |                |        |                     |   |           |      |  |   |         |   |  |      |         |   |      |   |         |   |  |   |         |  
|----------------------------- |  | -------------- | ------ | ------------------- | - | --------- | ---- |  | - | ------- | - |  | ---- | ------- | - | ---- | - | ------- | - |  | - | ------- | -
|                              |  | Maturity Range |       
|                              |  | Net FairValue  |        | TotalNotionalAmount |   |           | 2005 |  |   | 2006    |   |  | 2007 |         |   | 2008 |  
|Pay-fixed swaps:              |  |                |        |                     |   |           |      |  |   |         |   |  |      |         |   |      |   |         |   |  |   |         |  
|Contractual maturity          |  | $              | 7,347  |                     | $ | 1,125,000 |      |  | $ | 250,000 |   |  | $    | 150,000 |   |      | $ | 585,000 |   |  | $ | 140,000 |  
|Weighted average pay rate     |  |                |        |                     |   | 3.4       | %    |  |   | 2.1     | % |  |      | 2.8     | % |      |   | 3.9     | % |  |   | 4.1     | %
|Weighted average receive rate |  |                |        |                     |   | 2.9       | %    |  |   | (A      | ) |  |      | (A      | ) |      |   | (A      | ) |  |   | (A      | )
|Interest rate caps:           |  |                |        |                     |   |           |      |  |   |         |   |  |      |         |   |      |   |         |   |  |   |         |  
|Contractual maturity          |  | $              | 10,123 |                     | $ | 1,070,000 |      |  | $ | 450,000 |   |  | $    | 200,000 |   |      | $ | 340,000 |   |  | $ | 80,000  |  
|Weighted average strike rate  |  |                |        |                     |   | 2.5       | %    |  |   | 1.6     | % |  |      | 2.0     | % |      |   | 3.8     | % |  |   | 4.0     | %

---

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



Item 4. Controls and Procedures



Disclosure Controls and Procedures. The Company maintains a system of disclosure controls and procedures which are designed to ensure that information required to be disclosed by the Company in reports that it files or submits under
the federal securities laws, including this report, is recorded, processed, summarized and reported on a timely basis. These disclosure controls and procedures include controls and procedures designed to ensure that information required to be
disclosed under the federal securities laws is accumulated and communicated to the Companys management on a timely basis to allow decisions regarding required disclosure. The Companys principal executive officer and principal financial
officer evaluated the Companys disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report and concluded that the Companys controls and procedures were
effective.



Changes in Internal Controls over Financial
Reporting.There were no changes in our internal controls over financial reporting during the quarter ended March 31, 2005 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial
reporting.



53



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PART II. OTHER INFORMATION



Item 1. Legal Proceedings



Since April 2004, a number of substantially similar class action lawsuits have been filed and consolidated into a single action in United States District Court for the Western District of Missouri. The consolidated complaint names as
defendants the Company and three of its executive officers 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 stock) during the period October 29, 2003 through April 8, 2004. The Company believes that these claims
are without merit and intends to vigorously defend against them.



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



In addition to those matters listed above, the Company is currently party to
various other legal proceedings and claims. While management, including internal counsel, currently believes that the ultimate outcome of these proceedings and claims, individually and in the aggregate, will not have a material adverse effect on the
Companys financial condition or results of operations, litigation is subject to inherent uncertainties. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on the results of operations for the
period in which the ruling occurs.



In April 2004, the Company
also received notice of an informal inquiry from the Securities & Exchange Commission requesting that it provide various documents relating to its business. The Company has been cooperating fully with the Commissions inquiry.



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



Issuer Purchases of Equity Securities



|                                     |  |                               |  |                             |  |                                                                              |  |                                                                                       |          
|------------------------------------ |  | ----------------------------- |  | --------------------------- |  | ---------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------- | ---------
|                                     |  | TotalNumberof SharesPurchased |  | Average PricePaid per Share |  | Total Number ofShares Purchasedas Part of PubliclyAnnounced Plansor Programs |  | ApproximateDollar valueof Sharesthat May YetBe PurchasedUnder thePlans orPrograms (A)
|January 1, 2005  January 31, 2005   |  |                              |  |                            |  |                                                                             |  | $                                                                                     | 1,020,082
|February 1, 2005  February 28, 2005 |  |                              |  |                            |  |                                                                             |  | $                                                                                     | 1,020,082
|March 1, 2005  March 31, 2005       |  |                              |  |                            |  |                                                                             |  | $                                                                                     | 1,020,082

---

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



Item 3. Defaults Upon Senior Securities



None



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



None



Item 5. Other Information



None



54



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Item 6. Exhibits



Exhibit Listing



|            |  |                                                                                                                                
|----------- |  | -------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Document                                                                                                        
|            | 
|4.4         |  | Amended and Restated Trust Agreement, including the forms of Common Securities Certificate and Preferred Securities Certificate
|            | 
|4.5         |  | Junior Subordinated Indenture, including the form of Junior Subordinated Note                                                  
|            | 
|4.6         |  | Parent Guarantee Agreement                                                                                                     
|            | 
|10.34       |  | Purchase Agreement                                                                                                             
|            | 
|11.1(1)     |  | Statement Regarding Computation of Per Share Earnings                                                                          
|            | 
|31.1        |  | Chief Executive Officer Certification - Section 302 of the Sarbanes-Oxley Act of 2002                                          
|            | 
|31.2        |  | Principal Financial Officer Certification - Section 302 of the Sarbanes-Oxley Act of 2002                                      
|            | 
|32.1        |  | Chief Executive Officer Certification - Section 906 of the Sarbanes-Oxley Act of 2002                                          
|            | 
|32.2        |  | Principal Financial Officer Certification - Section 906 of the Sarbanes-Oxley Act of 2002                                      

---

|(1) | See Note 12 to the condensed consolidated financial statements.
|--- | ---------------------------------------------------------------



55



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NOVASTAR FINANCIAL, INC.



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: May 5, 2005        |  |  |  | /s/ Scott F. Hartman                                                         
|                         |  |  |  | Scott F. Hartman Chairman of the Board, Secretary and Chief Executive Officer
|                         |  | 
|DATE: May 5, 2005        |  |  |  | /s/ Gregory S. Metz                                                          
|                         |  |  |  | Gregory S. Metz Chief Financial Officer                                      



56