##### Table of Contents

---

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549



---



FORM 10-Q



---



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



For the quarterly period ended September 30, 2004.



OR



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



For the Transition Period From  to



Commission File Number 001-13533



---



NOVASTAR FINANCIAL, INC.

(Exact name of registrant as specified in its charter)



---



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Maryland                                                       |  | 74-2830661                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|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



---



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 November 3, 2004
was 25,493,915.



---



---

##### Table of Contents

NOVASTAR FINANCIAL, INC.



FORM 10-Q

Quarter Ended September 30, 2004



|        |  |                                                                                       |  |   
|------- |  | ------------------------------------------------------------------------------------- |  | --
|Part I  |  | Financial Information                                                                 |  |   
|        |  |                                                                                      
|Item 1. |  | Condensed Consolidated Financial Statements (unaudited):                              |  |   
|        |  | Balance Sheets                                                                        |  | 1 
|        |  | Statements of Income                                                                  |  | 2 
|        |  | Statements of Cash Flows                                                              |  | 3 
|        |  | Notes to Condensed Consolidated Financial Statements                                  |  | 4 
|        |  |                                                                                      
|Item 2. |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 15
|        |  | Table 1, Nonconforming Loan Originations                                              |  | 23
|        |  | Table 2, Carrying Value of Mortgage Loans                                             |  | 24
|        |  | Table 3, Valuation of Individual Mortgage Securities and Assumptions                  |  | 25
|        |  | Table 4, Summary of Mortgage Securities Retained by Year of Issue                     |  | 29
|        |  | Table 5, Short-term Financing Resources                                               |  | 30
|        |  | Table 6, Mortgage Securities Interest Analysis                                        |  | 32
|        |  | Table 7, Mortgage Portfolio Management Net Interest Income Analysis                   |  | 33
|        |  | Table 8, Gains on Sales of Mortgage Assets and Losses on Derivative Instruments       |  | 36
|        |  | Table 9, Mortgage Loan Sales and Securitizations                                      |  | 37
|        |  | Table 10, General and Administrative Expenses                                         |  | 38
|        |  | Table 11, Wholesale Loan Costs of Production, as a Percent of Principal               |  | 39
|        |  | Table 12, Summary of Servicing Operations                                             |  | 39
|        |  | Table 13, Taxable Net Income                                                          |  | 40
|        |  | Table 14, Contractual Obligations                                                     |  | 42
|        |  |                                                                                      
|Item 3. |  | Quantitative and Qualitative Disclosures about Market Risk                            |  | 43
|        |  | Table 15, Interest Rate Sensitivity  Income                                          |  | 43
|        |  | Table 16, Interest Rate Sensitivity  Market Value                                    |  | 44
|        |  | Table 17, Interest Rate Risk Management Contracts                                     |  | 45
|        |  |                                                                                      
|Item 4. |  | Controls and Procedures                                                               |  | 45
|        |  |                                                                                      
|Part II |  | Other Information                                                                     |  |   
|        |  |                                                                                      
|Item 1. |  | Legal Proceedings                                                                     |  | 46
|        |  |                                                                                      
|Item 2. |  | Changes in Securities and Use of Proceeds and Issuer Purchases of Equity Securities   |  | 46
|        |  |                                                                                      
|Item 3. |  | Defaults Upon Senior Securities                                                       |  | 46
|        |  |                                                                                      
|Item 4. |  | Submission of Matters to a Vote of Security Holders                                   |  | 46
|        |  |                                                                                      
|Item 5. |  | Other Information                                                                     |  | 46
|        |  |                                                                                      
|Item 6. |  | Exhibits and Reports on Form 8-K                                                      |  | 47
|        |  |                                                                                      
|        |  | Signatures                                                                            |  | 48



---

##### Table of Contents

PART I. FINANCIAL INFORMATION



NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited; dollars in thousands, except share amounts)



|                                                                                    |  |                    |           |   |                   |   |           |  
|----------------------------------------------------------------------------------- |  | ------------------ | --------- | - | ----------------- | - | --------- | -
|                                                                                    |  | September 30, 2004 |           |   | December 31, 2003 |  
|Assets                                                                              |  |                    |           |   |                   |   |           |  
|Cash and cash equivalents                                                           |  | $                  | 190,890   |   |                   | $ | 118,180   |  
|Mortgage loans  held-for-sale                                                      |  |                    | 1,026,776 |   |                   |   | 697,992   |  
|Mortgage loans  held-in-portfolio                                                  |  |                    | 65,833    |   |                   |   | 94,717    |  
|Mortgage securities  available-for-sale                                            |  |                    | 462,487   |   |                   |   | 382,287   |  
|Mortgage servicing rights                                                           |  |                    | 33,702    |   |                   |   | 19,685    |  
|Servicing related advances                                                          |  |                    | 20,936    |   |                   |   | 19,281    |  
|Deposits with derivative instrument counterparties, net                             |  |                    | 18,493    |   |                   |   | 19,492    |  
|Property and equipment, net                                                         |  |                    | 14,356    |   |                   |   | 14,537    |  
|Other assets                                                                        |  |                    | 61,384    |   |                   |   | 33,786    |  
|                                                                                    |  |                    |           |   |                   |   |           |  
|Total assets                                                                        |  | $                  | 1,894,857 |   |                   | $ | 1,399,957 |  
|                                                                                    |  |                    |           |   |                   |   |           |  
|Liabilities and Stockholders Equity                                                |  |                    |           |   |                   |   |           |  
|Liabilities:                                                                        |  |                    |           |   |                   |   |           |  
|Short-term borrowings secured by mortgage loans                                     |  | $                  | 989,454   |   |                   | $ | 639,852   |  
|Short-term borrowings secured by mortgage securities                                |  |                    | 157,287   |   |                   |   | 232,684   |  
|Asset-backed bonds secured by mortgage loans                                        |  |                    | 60,011    |   |                   |   | 89,384    |  
|Asset-backed bonds secured by mortgage securities                                   |  |                    | 207,432   |   |                   |   | 43,596    |  
|Accounts payable and other liabilities                                              |  |                    | 68,948    |   |                   |   | 63,658    |  
|Dividends payable                                                                   |  |                    | 35,600    |   |                   |   | 30,559    |  
|                                                                                    |  |                    |           |   |                   |   |           |  
|Total liabilities                                                                   |  |                    | 1,518,732 |   |                   |   | 1,099,733 |  
|                                                                                    |  |                   
|Commitments and contingencies                                                       |  |                    |           |   |                   |   |           |  
|                                                                                    |  |                   
|Stockholders equity:                                                               |  |                    |           |   |                   |   |           |  
|Capital stock, $0.01 par value, 50,000,000 shares authorized:                       |  |                    |           |   |                   |   |           |  
|Common stock, 25,428,223 and 24,447,315 shares issued and outstanding, respectively |  |                    | 254       |   |                   |   | 245       |  
|Preferred stock, 2,990,000 issued and outstanding                                   |  |                    | 30        |   |                   |   |          |  
|Additional paid-in capital                                                          |  |                    | 341,051   |   |                   |   | 231,294   |  
|Accumulated deficit                                                                 |  |                    | (33,541   | ) |                   |   | (15,522   | )
|Accumulated other comprehensive income                                              |  |                    | 69,202    |   |                   |   | 85,183    |  
|Other                                                                               |  |                    | (871      | ) |                   |   | (976      | )
|                                                                                    |  |                    |           |   |                   |   |           |  
|Total stockholders equity                                                          |  |                    | 376,125   |   |                   |   | 300,224   |  
|                                                                                    |  |                    |           |   |                   |   |           |  
|Total liabilities and stockholders equity                                          |  | $                  | 1,894,857 |   |                   | $ | 1,399,957 |  
|                                                                                    |  |                    |           |   |                   |   |           |  



See accompanying notes to condensed
consolidated financial statements.



1



---

##### Table of Contents

NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

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



|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|--------------------------------------------------------------------- |  | --------------------------------------- | ------- | - | ---------------------------------------- | - | ------- | ---- |  | - | ------- | - |  | - | ------ | -
|                                                                      |  | For the Nine Months Ended September 30, |         |   | For the Three Months Ended September 30, |  
|                                                                      |  | 2004                                    |         |   | 2003                                     |   |         | 2004 |  |   | 2003    |  
|Interest income:                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Mortgage securities                                                   |  | $                                       | 97,220  |   |                                          | $ | 68,286  |      |  | $ | 31,887  |   |  | $ | 26,611 |  
|Mortgage loans held-for-sale                                          |  |                                         | 61,288  |   |                                          |   | 47,172  |      |  |   | 26,378  |   |  |   | 14,551 |  
|Mortgage loans held-in-portfolio                                      |  |                                         | 5,316   |   |                                          |   | 8,644   |      |  |   | 1,524   |   |  |   | 2,628  |  
|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Total interest income                                                 |  |                                         | 163,824 |   |                                          |   | 124,102 |      |  |   | 59,789  |   |  |   | 43,790 |  
|Interest expense:                                                     |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Short-term borrowings secured by mortgage loans                       |  |                                         | 20,223  |   |                                          |   | 15,524  |      |  |   | 9,231   |   |  |   | 5,002  |  
|Short-term borrowings secured by mortgage securities                  |  |                                         | 3,285   |   |                                          |   | 2,163   |      |  |   | 942     |   |  |   | 793    |  
|Asset-backed bonds secured by mortgage loans                          |  |                                         | 1,041   |   |                                          |   | 1,848   |      |  |   | 350     |   |  |   | 477    |  
|Asset-backed bonds secured by mortgage securities                     |  |                                         | 8,401   |   |                                          |   | 3,779   |      |  |   | 3,558   |   |  |   | 1,782  |  
|Net settlements of derivative instruments used in cash flow hedges    |  |                                         | 2,850   |   |                                          |   | 7,085   |      |  |   | 269     |   |  |   | 2,267  |  
|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Total interest expense                                                |  |                                         | 35,800  |   |                                          |   | 30,399  |      |  |   | 14,350  |   |  |   | 10,321 |  
|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Net interest income before credit (losses) recoveries                 |  |                                         | 128,024 |   |                                          |   | 93,703  |      |  |   | 45,439  |   |  |   | 33,469 |  
|Credit (losses) recoveries                                            |  |                                         | (843    | ) |                                          |   | 1,138   |      |  |   | (182    | ) |  |   | 875    |  
|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Net interest income                                                   |  |                                         | 127,181 |   |                                          |   | 94,841  |      |  |   | 45,257  |   |  |   | 34,344 |  
|Fee income                                                            |  |                                         | 100,344 |   |                                          |   | 52,721  |      |  |   | 34,265  |   |  |   | 18,526 |  
|Gains on sales of mortgage assets                                     |  |                                         | 123,369 |   |                                          |   | 107,662 |      |  |   | 46,415  |   |  |   | 34,188 |  
|Premiums for mortgage loan insurance                                  |  |                                         | (2,875  | ) |                                          |   | (2,656  | )    |  |   | (1,294  | ) |  |   | (653   | )
|Impairment on mortgage securities  available-for-sale                |  |                                         | (8,692  | ) |                                          |   |        |      |  |   | (2,575  | ) |  |   |       |  
|Losses on derivative instruments                                      |  |                                         | (17,819 | ) |                                          |   | (32,330 | )    |  |   | (19,536 | ) |  |   | (8,144 | )
|Other income, net                                                     |  |                                         | 3,881   |   |                                          |   | 1,067   |      |  |   | 1,267   |   |  |   | 124    |  
|General and administrative expenses:                                  |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Compensation and benefits                                             |  |                                         | 116,164 |   |                                          |   | 69,074  |      |  |   | 40,524  |   |  |   | 25,452 |  
|Marketing                                                             |  |                                         | 38,723  |   |                                          |   | 18,199  |      |  |   | 13,294  |   |  |   | 6,540  |  
|Office administration                                                 |  |                                         | 30,992  |   |                                          |   | 16,261  |      |  |   | 10,773  |   |  |   | 6,136  |  
|Loan expense                                                          |  |                                         | 15,689  |   |                                          |   | 14,820  |      |  |   | 5,415   |   |  |   | 5,258  |  
|Professional and outside services                                     |  |                                         | 10,946  |   |                                          |   | 4,825   |      |  |   | 4,911   |   |  |   | 1,847  |  
|Other                                                                 |  |                                         | 12,602  |   |                                          |   | 7,170   |      |  |   | 4,816   |   |  |   | 2,200  |  
|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Total general and administrative expenses                             |  |                                         | 225,116 |   |                                          |   | 130,349 |      |  |   | 79,733  |   |  |   | 47,433 |  
|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Income from continuing operations before income tax expense (benefit) |  |                                         | 100,273 |   |                                          |   | 90,956  |      |  |   | 24,066  |   |  |   | 30,952 |  
|Income tax expense (benefit)                                          |  |                                         | 7,267   |   |                                          |   | 14,168  |      |  |   | (1,385  | ) |  |   | 5,844  |  
|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Income from continuing operations                                     |  |                                         | 93,006  |   |                                          |   | 76,788  |      |  |   | 25,451  |   |  |   | 25,108 |  
|Loss from discontinued operations, net of income tax                  |  |                                         | (2,067  | ) |                                          |   |        |      |  |   | (1,063  | ) |  |   |       |  
|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Net income                                                            |  |                                         | 90,939  |   |                                          |   | 76,788  |      |  |   | 24,388  |   |  |   | 25,108 |  
|Dividends on preferred shares                                         |  |                                         | (4,601  | ) |                                          |   |        |      |  |   | (1,663  | ) |  |   |       |  
|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Net income available to common shareholders                           |  | $                                       | 86,338  |   |                                          | $ | 76,788  |      |  | $ | 22,725  |   |  | $ | 25,108 |  
|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Basic earnings per share:                                             |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Income from continuing operations available to common shareholders    |  | $                                       | 3.55    |   |                                          | $ | 3.53    |      |  | $ | 0.95    |   |  | $ | 1.12   |  
|Loss from discontinued operations, net of income tax                  |  |                                         | (0.08   | ) |                                          |   |        |      |  |   | (0.04   | ) |  |   |       |  
|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Net income available to common shareholders                           |  | $                                       | 3.47    |   |                                          | $ | 3.53    |      |  | $ | 0.91    |   |  | $ | 1.12   |  
|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Weighted average basic shares outstanding                             |  |                                         | 24,889  |   |                                          |   | 21,734  |      |  |   | 25,034  |   |  |   | 22,386 |  
|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Diluted earnings per share:                                           |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Income from continuing operations available to common shareholders    |  | $                                       | 3.48    |   |                                          | $ | 3.43    |      |  | $ | 0.93    |   |  | $ | 1.09   |  
|Loss from discontinued operations, net of income tax                  |  |                                         | (0.08   | ) |                                          |   |        |      |  |   | (0.04   | ) |  |   |       |  
|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Net income available to common shareholders                           |  | $                                       | 3.40    |   |                                          | $ | 3.43    |      |  | $ | 0.89    |   |  | $ | 1.09   |  
|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Weighted average diluted shares outstanding                           |  |                                         | 25,383  |   |                                          |   | 22,364  |      |  |   | 25,455  |   |  |   | 23,048 |  
|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Dividends declared per common share                                   |  | $                                       | 4.10    |   |                                          | $ | 3.79    |      |  | $ | 1.40    |   |  | $ | 1.25   |  
|                                                                      |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  



See accompanying notes to condensed
consolidated financial statements.



2



---

##### Table of Contents

NOVASTAR FINANCIAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited; in thousands)



|                                                                                                      |  |                                         |            |   |      |   |            |  
|----------------------------------------------------------------------------------------------------- |  | --------------------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                                                                      |  | For the Nine Months Ended September 30, |           
|                                                                                                      |  | 2004                                    |            |   | 2003 |  
|Cash flows from operating activities:                                                                 |  |                                         |            |   |      |   |            |  
|Income from continuing operations                                                                     |  | $                                       | 93,006     |   |      | $ | 76,788     |  
|Adjustments to reconcile net income to net cash used in operating activities:                         |  |                                         |            |   |      |   |            |  
|Amortization of premiums on mortgage assets                                                           |  |                                         | 586        |   |      |   | 868        |  
|Amortization of mortgage servicing rights                                                             |  |                                         | 11,614     |   |      |   | 6,206      |  
|Accretion of available-for-sale securities                                                            |  |                                         | (69,260    | ) |      |   | (58,534    | )
|Impairment on mortgage securities  available-for-sale                                                |  |                                         | 8,692      |   |      |   |           |  
|Amortization of deferred debt issuance costs                                                          |  |                                         | 2,546      |   |      |   | 688        |  
|Forgiveness of founders promissory notes                                                             |  |                                         | 104        |   |      |   | 104        |  
|Credit losses (recoveries)                                                                            |  |                                         | 843        |   |      |   | (1,138     | )
|Proceeds from sale of mortgage loans held-for-sale in securitizations                                 |  |                                         | 5,712,996  |   |      |   | 3,572,553  |  
|Proceeds from sale of mortgage loans held-for-sale to third parties                                   |  |                                         | 52,588     |   |      |   | 886,854    |  
|Originations and purchases of mortgage loans held-for-sale                                            |  |                                         | (6,292,520 | ) |      |   | (4,427,602 | )
|Repayments of mortgage loans held-for-sale                                                            |  |                                         | 18,911     |   |      |   | 17,440     |  
|Gains on sales of mortgage assets                                                                     |  |                                         | (123,369   | ) |      |   | (107,662   | )
|Losses on derivative instruments                                                                      |  |                                         | 17,819     |   |      |   | 32,330     |  
|Compensation recognized under stock option plan                                                       |  |                                         | 1,335      |   |      |   | 1,010      |  
|Depreciation expense                                                                                  |  |                                         | 4,368      |   |      |   | 2,494      |  
|Changes in:                                                                                           |  |                                         |            |   |      |   |            |  
|Servicing related advances                                                                            |  |                                         | (1,483     | ) |      |   | (4,067     | )
|Other assets                                                                                          |  |                                         | (46,844    | ) |      |   | (56,488    | )
|Other liabilities                                                                                     |  |                                         | 1,970      |   |      |   | 18,871     |  
|                                                                                                      |  |                                         |            |   |      |   |            |  
|Net cash used in operating activities from continuing operations                                      |  |                                         | (606,098   | ) |      |   | (39,285    | )
|Net cash used in operating activities from discontinued operations                                    |  |                                         | (869       | ) |      |   |           |  
|                                                                                                      |  |                                         |            |   |      |   |            |  
|Net cash used in operating activities                                                                 |  |                                         | (606,967   | ) |      |   | (39,285    | )
|Cash flows from investing activities:                                                                 |  |                                         |            |   |      |   |            |  
|Mortgage loan repaymentsheld-in-portfolio                                                            |  |                                         | 25,802     |   |      |   | 37,649     |  
|Proceeds from paydowns on available-for-sale securities                                               |  |                                         | 240,385    |   |      |   | 120,600    |  
|Proceeds from sales of assets acquired through foreclosure                                            |  |                                         | 4,639      |   |      |   | 5,286      |  
|                                                                                                      |  |                                         |            |   |      |   |            |  
|Net cash provided by investing activities                                                             |  |                                         | 270,826    |   |      |   | 163,535    |  
|Cash flows from financing activities:                                                                 |  |                                         |            |   |      |   |            |  
|Payments on asset-backed bonds                                                                        |  |                                         | (177,045   | ) |      |   | (89,045    | )
|Proceeds from issuance of asset-backed bonds                                                          |  |                                         | 308,962    |   |      |   | 52,271     |  
|Change in short-term borrowings                                                                       |  |                                         | 274,205    |   |      |   | (64,552    | )
|Net proceeds from issuance of capital stock and exercise of equity instruments, net of offering costs |  |                                         | 104,467    |   |      |   | 39,045     |  
|Dividends paid on preferred stock                                                                     |  |                                         | (4,601     | ) |      |   |           |  
|Dividends paid on common stock                                                                        |  |                                         | (97,137    | ) |      |   | (71,563    | )
|                                                                                                      |  |                                         |            |   |      |   |            |  
|Net cash provided by (used in) financing activities                                                   |  |                                         | 408,851    |   |      |   | (133,844   | )
|                                                                                                      |  |                                         |            |   |      |   |            |  
|Net increase (decrease) in cash and cash equivalents                                                  |  |                                         | 72,710     |   |      |   | (9,594     | )
|Cash and cash equivalents, beginning of period                                                        |  |                                         | 118,180    |   |      |   | 79,742     |  
|                                                                                                      |  |                                         |            |   |      |   |            |  
|Cash and cash equivalents, end of period                                                              |  | $                                       | 190,890    |   |      | $ | 70,148     |  
|                                                                                                      |  |                                         |            |   |      |   |            |  
|Supplemental disclosure of cash flow information:                                                     |  |                                         |            |   |      |   |            |  
|Cash paid for interest                                                                                |  | $                                       | 34,816     |   |      | $ | 30,467     |  
|                                                                                                      |  |                                         |            |   |      |   |            |  
|Cash paid for income taxes                                                                            |  | $                                       | 28,261     |   |      | $ | 5,222      |  
|                                                                                                      |  |                                         |            |   |      |   |            |  
|Cash received on mortgage securities with no cost basis                                               |  | $                                       | 24,678     |   |      | $ | 9,752      |  
|                                                                                                      |  |                                         |            |   |      |   |            |  
|Non-cash operating and investing activities:                                                          |  |                                         |            |   |      |   |            |  
|Retention of mortgage servicing rights                                                                |  | $                                       | 25,631     |   |      | $ | 14,255     |  
|                                                                                                      |  |                                         |            |   |      |   |            |  
|Assets acquired through foreclosure                                                                   |  | $                                       | 3,015      |   |      | $ | 6,794      |  
|                                                                                                      |  |                                         |            |   |      |   |            |  
|Cost basis of securities retained in securitizations                                                  |  | $                                       | 286,922    |   |      | $ | 211,708    |  
|                                                                                                      |  |                                         |            |   |      |   |            |  
|Dividend reinvestment plan program                                                                    |  | $                                       | 1,016      |   |      | $ | 383        |  
|                                                                                                      |  |                                         |            |   |      |   |            |  
|Restricted stock issued in satisfaction of prior year accrued bonus                                   |  | $                                       | 1,816      |   |      | $ |           |  
|                                                                                                      |  |                                         |            |   |      |   |            |  

Concluded



See accompanying notes to condensed consolidated financial statements.



3



---

##### Table of Contents

NOVASTAR FINANCIAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2004 (Unaudited)



Note 1. Financial Statement Presentation



The condensed consolidated financial statements as of September 30, 2004 and for the periods ended September 30, 2004 and 2003 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 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 NovaStar Financial and the notes thereto,
included in NovaStar Financials annual report to shareholders and annual report on Form 10-K for the fiscal year ended December 31, 2003.



The condensed consolidated financial statements of NovaStar Financial, Inc. (Company) include the accounts of all wholly owned subsidiaries.
Intercompany accounts and transactions have been eliminated in consolidation. Interim results are not necessarily indicative of results for a full year.



The Company was party to limited liability company agreements (LLCs), formed to facilitate the operation of retail mortgage broker businesses
as branch affiliates. The LLC agreements provided for initial capitalization and membership interests of 99.9% to each branch manager and 0.1% to the Company. Prior to 2004, the Company accounted for its interest in the LLC agreements using the
equity method of accounting. In December 2003, the Company determined it would terminate the LLCs effective January 1, 2004. During February 2004, the Company notified the branch managers of the limited liability companies that the Company was
terminating these agreements effective January 1, 2004. Continuing branches that formerly operated under these agreements became operating units of the Company and their financial results are included in the condensed consolidated financial
statements. The inclusion resulted in expected increases in general and administrative expenses, which were substantially offset by increases in related fee income. See Note 11 for consolidated pro forma statements of income. Certain of the branches
have discontinued during 2004 and the results of their operations are included in discontinued operations. Refer to Note 10.



Additionally, 2003 results were restated related to the Companys adoption of the preferable fair value recognition provisions of Statement of
Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation under the modified prospective transition method selected by the Company as described in SFAS No. 148, Accounting for Stock-Based Compensation
 Transition and Disclosure. Refer to Note 3.



Note 2. New
Accounting Pronouncement



In March 2004, SEC Staff
Accounting Bulletin (SAB) No. 105, Application of Accounting Principles to Loan Commitments was released. This release summarizes the SEC staff position regarding the application of accounting principles generally accepted in the United
States of America to loan commitments accounted for as derivative instruments. The Company accounts for interest rate lock commitments issued on mortgage loans that will be held for sale as derivative instruments. Consistent with SAB No. 105, the
Company considers the fair value of these commitments to be zero at the commitment date, with subsequent changes in fair value determined solely on changes in market interest rates. As of September 30, 2004, the Company had interest rate lock
commitments on mortgage loans with principal balances of $457 million, the fair value of which was $(118,000).



At the March 17-18, 2004 Emerging Issues Task Force (EITF) meeting, the Task Force reached a consensus on Issue No. 03-1, The Meaning of
Other-Than-Temporary Impairment and its Application to Certain Investments. Issue 03-1 provides guidance for determining when an investment is other-than-temporarily impaired and disclosure requirements regarding impairments that have not been
recognized as other-than-temporary. In September 2004, the FASB delayed the effective date of paragraphs 10-20 of this issue. These paragraphs give guidance on how to evaluate and recognize an impairment loss that is other than temporary. The
disclosure requirements have not been deferred. Issue 03-1 is not expected to have a material impact on the condensed consolidated financial statements.



4



---

##### Table of Contents

Note 3. Stock Based Compensation



The Companys 1996 Stock Option Plan provides for the grant of qualified incentive stock options (ISOs), non-qualified
stock options (NQSOs), deferred stock, restricted stock, performance shares, stock appreciation rights, limited stock awards and dividend equivalent rights (DERs). Prior to 2003, the Company accounted for those plans under the recognition and
measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees (APB No. 25) and related interpretations. Effective January 1, 2003, the Company adopted the preferable fair value recognition provisions of SFAS No.
123. Under the modified prospective transition method selected by the Company as described in SFAS No. 148, compensation cost recognized for the nine and three months ended September 30, 2003 is the same as that which would have been recognized had
the fair value method of SFAS No. 123 been applied from its original effective date.



As a result of adopting SFAS No. 123 and SFAS No. 148, 2003 results were restated to reflect the impact of the adoption of the fair value method under SFAS 123. For the nine and three months ended September 30, 2003,
the impact of this restatement on compensation and benefits, within general and administrative expenses, was a decrease of approximately $7.1 million and $0.8 million, respectively, resulting in a positive impact to net income in the same amount.
The net income per diluted share impact of this restatement was an increase of $0.32 and $0.04 per share for the nine and three months ended September 30, 2003.



Note 4. Loan Securitizations



On January 14, 2004, NovaStar Mortgage delivered the remaining $479.8 million in loans collateralizing NMFT Series 2003-4. On March 11, 2004, June 16,
2004 and September 9, 2004, NovaStar Mortgage executed securitization transactions accounted for as sales of loans. In each of these transactions, derivative instruments were transferred into the trusts. These instruments serve to reduce interest
rate risk to the bondholders. Details of these transactions are as follows (dollars in thousands):



|                       |  |                                   |           |                                                  |   |                                      |  |   |                                      |   |                     |   |           |  |   |       
|---------------------- |  | --------------------------------- | --------- | ------------------------------------------------ | - | ------------------------------------ |  | - | ------------------------------------ | - | ------------------- | - | --------- |  | - | ------
|                       |  | Value of Asset-BackedBonds Issued |           | Economic Residual Value as of September 30, 2004 |   | Fair Value of Derivative Instruments |  |   | Principal Balance of Collateral Sold |   | Net Gain Recognized
|NMFT Series 2003-4 (A) |  | $                                 | 1,482,000 |                                                  | $ | 44,144                               |  | $ |                                     |   |                     | $ | 479,810   |  | $ | 9,015 
|NMFT Series 2004-1     |  | $                                 | 1,727,250 |                                                  | $ | 61,121                               |  | $ | (13,848                              | ) |                     | $ | 1,750,000 |  | $ | 64,112
|NMFT Series 2004-2     |  | $                                 | 1,374,800 |                                                  | $ | 58,631                               |  | $ | 15,665                               |   |                     | $ | 1,399,999 |  | $ | 8,961 
|NMFT Series 2004-3     |  | $                                 | 2,156,000 |                                                  | $ | 106,855                              |  | $ | (6,705                               | ) |                     | $ | 2,199,995 |  | $ | 40,443

---

|(A) | On November 20, 2003, $1.0 billion in loans collateralizing NMFT Series 2003-4 and derivative instruments with a fair value of $(192,000) were delivered with a gain of $22.0 million
recognized.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Note 5. Mortgage Securities 
Available-for-Sale



Available-for-sale mortgage securities
consisted of the Companys investment in the interest-only, prepayment penalty and other subordinated securities that the trust issued. The primary bonds were sold to parties independent of the Company. Management estimates their fair value by
discounting the expected future cash flow of the collateral and bonds. The average yield on mortgage securities is the interest income for the year as a percentage of the average fair market value on mortgage securities. The cost basis, unrealized
gains and losses and estimated fair value and average yield of mortgage securities as of September 30, 2004 and December 31, 2003 were as follows (dollars in thousands):



|                         |  |            |         |                  |   |                      |  |               |     |  |   |         |  |      |  
|------------------------ |  | ---------- | ------- | ---------------- | - | -------------------- |  | ------------- | --- |  | - | ------- |  | ---- | -
|                         |  | Cost Basis |         | Gross Unrealized |   | Estimated Fair Value |  | Average Yield |    
|                         |  | Gains      |         | Losses           |   |                     
|As of September 30, 2004 |  | $          | 393,029 |                  | $ | 69,458               |  | $             |    |  | $ | 462,487 |  | 31.7 | %
|As of December 31, 2003  |  |            | 294,562 |                  |   | 87,826               |  |               | 101 |  |   | 382,287 |  | 34.3 |  



5



---

##### Table of Contents

The Company recorded an impairment loss of $8.7 million and $2.6 million on its mortgage securities
 available-for-sale for the nine and three months ended September 30, 2004, respectively. The following table is a rollforward of mortgage securities from January 1, 2003 to September 30, 2004 (in thousands).



|                                                       |  |      |          |   |                     |   |         |                                             |  |   |          |  
|------------------------------------------------------ |  | ---- | -------- | - | ------------------- | - | ------- | ------------------------------------------- |  | - | -------- | -
|                                                       |  | Cost |          |   | Net Unrealized Gain |   |         | Estimated Fair Value of Mortgage Securities | 
|As of January 1, 2003                                  |  | $    | 102,665  |   |                     | $ | 76,214  |                                             |  | $ | 178,879  |  
|                                                       |  |      |          |   |                     |   |         |                                             |  |   |          |  
|Increases (decreases) to mortgage securities:          |  |      |          |   |                     |   |         |                                             |  |   |          |  
|New securities retained in securitizations             |  |      | 292,675  |   |                     |   | 7,077   |                                             |  |   | 299,752  |  
|Accretion of income (B)                                |  |      | 78,097   |   |                     |   |        |                                             |  |   | 78,097   |  
|Proceeds from paydowns of securities (B) (C)           |  |      | (178,875 | ) |                     |   |        |                                             |  |   | (178,875 | )
|Mark-to-market value adjustment                        |  |      |         |   |                     |   | 4,434   |                                             |  |   | 4,434    |  
|                                                       |  |      |          |   |                     |   |         |                                             |  |   |          |  
|Net increase to mortgage securities                    |  |      | 191,897  |   |                     |   | 11,511  |                                             |  |   | 203,408  |  
|                                                       |  |      |          |   |                     |   |         |                                             |  |   |          |  
|As of December 31, 2003                                |  |      | 294,562  |   |                     |   | 87,725  |                                             |  |   | 382,287  |  
|                                                       |  |      |          |   |                     |   |         |                                             |  |   |          |  
|Increases (decreases) to mortgage securities:          |  |      |          |   |                     |   |         |                                             |  |   |          |  
|New securities retained in securitizations (A)         |  |      | 286,922  |   |                     |   | 5,791   |                                             |  |   | 292,713  |  
|Accretion of income (B)                                |  |      | 69,260   |   |                     |   |        |                                             |  |   | 69,260   |  
|Proceeds from paydowns of securities (B)(C)            |  |      | (249,023 | ) |                     |   |        |                                             |  |   | (249,023 | )
|Impairment on mortgage securities - available-for-sale |  |      | (8,692   | ) |                     |   |        |                                             |  |   | (8,692   | )
|Mark-to-market value adjustment                        |  |      |         |   |                     |   | (24,058 | )                                           |  |   | (24,058  | )
|                                                       |  |      |          |   |                     |   |         |                                             |  |   |          |  
|Net increase (decrease) to mortgage securities         |  |      | 98,467   |   |                     |   | (18,267 | )                                           |  |   | 80,200   |  
|                                                       |  |      |          |   |                     |   |         |                                             |  |   |          |  
|As of September 30, 2004                               |  | $    | 393,029  |   |                     | $ | 69,458  |                                             |  | $ | 462,487  |  
|                                                       |  |      |          |   |                     |   |         |                                             |  |   |          |  

---

|(A) | See Note 4 for further discussion.
|--- | ----------------------------------

|(B) | Cash received on mortgage securities with no cost basis was $24.7 million for the nine months ended September 30, 2004 and $20.7 million for the year ended December 31, 2003.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(C) | 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 September 30, 2004 and December 31, 2003, the
Company had receivables from securitization trusts of $5.5 million and $0.1 million, respectively, related to mortgage securities with a remaining cost basis. Also, the Company had receivables from securitization trusts of $3.3 million related to
mortgage securities with a zero cost basis as of September 30, 2004.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Note 6. NovaStar NIMS 2004-N1 and NIMS 2004-N2



On February 19, 2004, the Company issued asset-backed bonds, NIMS 2004-N1, in the amount of $156.6 million secured by the interest only, prepayment penalty and subordinated mortgage securities of NMFT 2003-3 and NMFT 2003-4 as a means for
long-term financing. On July 23, 2004, the Company issued asset-backed bonds, NIMS 2004-N2, in the amount of $157.5 million secured by the interest only, prepayment penalty and subordinated mortgage securities of NMFT 2004-1 and NMFT 2004-2 as a
means for long-term financing. The mortgage securities are recorded as assets of the Company and the asset-backed bonds are recorded as debt. The performance of the mortgage loan collateral underlying these securities is the sole source of repayment
of these asset-backed bonds. The interest rate on both issuances of the asset-backed bonds is fixed at 4.458% and the estimated weighted average months to maturity is based on estimates and assumptions made by management. The actual maturity may
differ from expectations.



6



---

##### Table of Contents

Note 7. 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 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 September 30, 2004, NovaStar Trust had the following assets:
| | - | ------------------------------------------------------------------



| | 1) | whole loans: $451.5 million
| | -- | ---------------------------



| | 2) | REO Properties: $0, and
| | -- | -----------------------



| | 3) | cash and cash equivalents: $0.6 million.
| | -- | ----------------------------------------



| |  | As of September 30, 2004, NovaStar Trust had the following liabilities and equity:
| | - | ----------------------------------------------------------------------------------



| | 1) | short-term debt due to UBS: $449.7 million, and
| | -- | -----------------------------------------------



| | 2) | $2.4 million in members equity investment.
| | -- | -------------------------------------------



Note 8. Issuance of Capital Stock



The Company sold 668,778 shares of its common stock during the nine months ended September 30, 2004 under the Direct Purchase and Dividend Reinvestment
Plan. Net proceeds of $31.6 million were raised under these sales of common stock.



During the nine months ended September 30, 2004, 312,130 shares of common stock were issued under the Companys stock based compensation plan. Proceeds of $1.7 million were received under these issuances.



On January 16, 2004, the Company sold 2.6 million shares of
Series C Cumulative Redeemable Perpetual Preferred Stock, raising $62.9 million in net proceeds. The shares have a liquidation value of $25.00 per share and pay an annual coupon of 8.90%. On February 6, 2004, the underwriters exercised their options
for 390,000 shares in over-allotments resulting in net proceeds of $9.2 million.



7



---

##### Table of Contents

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 nine and three months ended September 30, 2004 and 2003 (in thousands).



|                                                                                            |  |                                        |         |   |                                          |   |        |      |  |   |        |   |  |   |        |  
|------------------------------------------------------------------------------------------- |  | -------------------------------------- | ------- | - | ---------------------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                                            |  | For the Nine Months EndedSeptember 30, |         |   | For the Three Months Ended September 30, |  
|                                                                                            |  | 2004                                   |         |   | 2003                                     |   |        | 2004 |  |   | 2003   |  
|Net income.                                                                                 |  | $                                      | 90,939  |   |                                          | $ | 76,788 |      |  | $ | 24,388 |   |  | $ | 25,108 |  
|Other comprehensive income                                                                  |  |                                        |         |   |                                          |   |        |      |  |   |        |   |  |   |        |  
|Change in unrealized gain on available-for-sale securities, net of income taxes             |  |                                        | (18,267 | ) |                                          |   | 14,093 |      |  |   | 19,721 |   |  |   | (6,261 | )
|Change in unrealized loss on derivative instruments used in cash flow hedges                |  |                                        | (564    | ) |                                          |   | (1,824 | )    |  |   | (152   | ) |  |   | (233   | )
|Net settlements of derivative instruments used in cash flow hedges reclassified to earnings |  |                                        | 2,876   |   |                                          |   | 7,161  |      |  |   | 269    |   |  |   | 2,292  |  
|Other amortization                                                                          |  |                                        | (26     | ) |                                          |   | (77    | )    |  |   |       |   |  |   | (26    | )
|                                                                                            |  |                                        |         |   |                                          |   |        |      |  |   |        |   |  |   |        |  
|Comprehensive income                                                                        |  | $                                      | 74,958  |   |                                          | $ | 96,141 |      |  | $ | 44,226 |   |  | $ | 20,880 |  
|                                                                                            |  |                                        |         |   |                                          |   |        |      |  |   |        |   |  |   |        |  



Note 10. Discontinued Operations



During 2004, the Company has changed policies governing
its broker branches. As the demand for conforming loans has declined significantly during 2004, 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 have voluntarily terminated employment with the Company. The Company has also terminated branches for non-compliance with policy or when loan production results were substandard. The discontinued operations apply to the branch
operations segment presented in Note 12. 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 Nine Months Ended September 30,2004 |         |   | For the Three Months Ended September 30,2004 |  
|Fee income                          |  | $                                           | 26,934  |   |                                              | $ | 4,644  |  
|General and administrative expenses |  |                                             | (31,329 | ) |                                              |   | (6,823 | )
|                                    |  |                                             |         |   |                                              |   |        |  
|Loss before income tax benefit      |  |                                             | (4,395  | ) |                                              |   | (2,179 | )
|Income tax benefit                  |  |                                             | (2,328  | ) |                                              |   | (1,116 | )
|                                    |  |                                             |         |   |                                              |   |        |  
|Loss from discontinued operations   |  | $                                           | (2,067  | ) |                                              | $ | (1,063 | )
|                                    |  |                                             |         |   |                                              |   |        |  



As of September
30, 2004, the Company has $1.2 million in cash, $0.3 million in receivables included in other assets and $1.5 million in payables included in accounts payable and other liabilities pertaining to discontinued operations, which are included in the
condensed consolidated financial statements.



8



---

##### Table of Contents

Note 11. Pro Forma 2003 Statements of Income



As discussed in Note 1, the LLC agreements were terminated effective January 1, 2004. Continuing branches that formerly
operated under these agreements became operating units of the Company and their financial results are included in the condensed consolidated financial statements. The inclusion resulted in expected increases in general and administrative expenses,
which were substantially offset by increases in related fee income. The Company did not purchase any assets or liabilities as a result of these branches becoming operating units. The following table compares the nine and three months ended September
30, 2003 as reported Pro Forma as if the LLCs had been operating units of the Company (in thousands). The Pro Forma only includes LLCs which are still in existence as of September 30, 2004. See Note 10 and Note 12 for discussion of
discontinued operations related to the branches.



|                                                     |  |                                              |          |   |                                               |   |          |        |  |   |           |   |  |   |         |  
|---------------------------------------------------- |  | -------------------------------------------- | -------- | - | --------------------------------------------- | - | -------- | ------ |  | - | --------- | - |  | - | ------- | -
|                                                     |  | For the Nine Months Ended September 30, 2003 |          |   | For the Three Months Ended September 30, 2003 |  
|                                                     |  | Actual                                       |          |   | Pro Forma                                     |   |          | Actual |  |   | Pro Forma |  
|Net interest income                                  |  | $                                            | 94,841   |   |                                               | $ | 94,841   |        |  | $ | 34,344    |   |  | $ | 34,344  |  
|Gains on sales of mortgage assets                    |  |                                              | 107,662  |   |                                               |   | 121,312  |        |  |   | 34,188    |   |  |   | 40,260  |  
|Fee income                                           |  |                                              | 52,721   |   |                                               |   | 88,779   |        |  |   | 18,526    |   |  |   | 33,978  |  
|Other expense, net                                   |  |                                              | (33,919  | ) |                                               |   | (33,919  | )      |  |   | (8,673    | ) |  |   | (8,673  | )
|General and administrative expenses                  |  |                                              | (130,349 | ) |                                               |   | (177,608 | )      |  |   | (47,433   | ) |  |   | (66,955 | )
|                                                     |  |                                              |          |   |                                               |   |          |        |  |   |           |   |  |   |         |  
|Income before income tax expense                     |  |                                              | 90,956   |   |                                               |   | 93,405   |        |  |   | 30,952    |   |  |   | 32,954  |  
|Income tax expense                                   |  |                                              | 14,168   |   |                                               |   | 15,283   |        |  |   | 5,844     |   |  |   | 6,765   |  
|                                                     |  |                                              |          |   |                                               |   |          |        |  |   |           |   |  |   |         |  
|Income from continuing operations                    |  |                                              | 76,788   |   |                                               |   | 78,122   |        |  |   | 25,108    |   |  |   | 26,189  |  
|Loss from discontinued operations, net of income tax |  |                                              |         |   |                                               |   | (2,487   | )      |  |   |          |   |  |   | (1,187  | )
|                                                     |  |                                              |          |   |                                               |   |          |        |  |   |           |   |  |   |         |  
|Net income                                           |  | $                                            | 76,788   |   |                                               | $ | 75,635   |        |  | $ | 25,108    |   |  | $ | 25,002  |  
|                                                     |  |                                              |          |   |                                               |   |          |        |  |   |           |   |  |   |         |  
|Basic earnings per share:                            |  |                                              |          |   |                                               |   |          |        |  |   |           |   |  |   |         |  
|Income from continuing operations                    |  | $                                            | 3.53     |   |                                               | $ | 3.59     |        |  | $ | 1.12      |   |  | $ | 1.17    |  
|Loss from discontinued operations, net of income tax |  |                                              |         |   |                                               |   | (0.11    | )      |  |   |          |   |  |   | (0.05   | )
|                                                     |  |                                              |          |   |                                               |   |          |        |  |   |           |   |  |   |         |  
|Net income available to common shareholders          |  | $                                            | 3.53     |   |                                               | $ | 3.48     |        |  | $ | 1.12      |   |  | $ | 1.12    |  
|                                                     |  |                                              |          |   |                                               |   |          |        |  |   |           |   |  |   |         |  
|Diluted earnings per share:                          |  |                                              |          |   |                                               |   |          |        |  |   |           |   |  |   |         |  
|Income from continuing operations                    |  | $                                            | 3.43     |   |                                               | $ | 3.49     |        |  | $ | 1.09      |   |  | $ | 1.14    |  
|Loss from discontinued operations, net of income tax |  |                                              |         |   |                                               |   | (0.11    | )      |  |   |          |   |  |   | (0.05   | )
|                                                     |  |                                              |          |   |                                               |   |          |        |  |   |           |   |  |   |         |  
|Net income available to common shareholders          |  | $                                            | 3.43     |   |                                               | $ | 3.38     |        |  | $ | 1.09      |   |  | $ | 1.09    |  
|                                                     |  |                                              |          |   |                                               |   |          |        |  |   |           |   |  |   |         |  



Note 12. Segment Reporting



The Company reviews, manages and operates its business in
three segments. These business segments are: mortgage portfolio management, mortgage lending and loan servicing and 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 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. As discussed in Note 1 and Note 11, the LLC agreements were terminated effective January 1, 2004. Continuing branch operations that formerly operated under these agreements became operating units of the
Company and their financial results are included in the condensed consolidated financial statements. As discussed in Note 10, branches that have terminated in 2004 have been segregated from the results of the ongoing operations of the Company for
the three and nine months ended September 30, 2004. Following is a summary of the operating results of the Companys primary operating units for the nine and three months ended September 30, 2004 and 2003 (in thousands).



9



---

##### Table of Contents

Nine Months Ended September 30, 2004



|                                                       |  |                             |         |   |                                   |   |          |                  |  |   |              |   |  |       |         |   |  |   |          |  
|------------------------------------------------------ |  | --------------------------- | ------- | - | --------------------------------- | - | -------- | ---------------- |  | - | ------------ | - |  | ----- | ------- | - |  | - | -------- | -
|                                                       |  | MortgagePortfolioManagement |         |   | Mortgage Lendingand LoanServicing |   |          | BranchOperations |  |   | Eliminations |   |  | Total |        
|Interest income                                        |  | $                           | 102,534 |   |                                   | $ | 61,316   |                  |  | $ |             |   |  | $     | (26     | ) |  | $ | 163,824  |  
|Interest expense                                       |  |                             | 14,285  |   |                                   |   | 28,087   |                  |  |   | 50           |   |  |       | (6,622  | ) |  |   | 35,800   |  
|                                                       |  |                             |         |   |                                   |   |          |                  |  |   |              |   |  |       |         |   |  |   |          |  
|Net interest income (expense) before credit losses     |  |                             | 88,249  |   |                                   |   | 33,229   |                  |  |   | (50          | ) |  |       | 6,596   |   |  |   | 128,024  |  
|Credit losses                                          |  |                             | (843    | ) |                                   |   |         |                  |  |   |             |   |  |       |        |   |  |   | (843     | )
|Fee income                                             |  |                             |        |   |                                   |   | 21,453   |                  |  |   | 125,785      |   |  |       | (46,894 | ) |  |   | 100,344  |  
|Gains on sales of mortgage assets                      |  |                             | 388     |   |                                   |   | 98,764   |                  |  |   |             |   |  |       | 24,217  |   |  |   | 123,369  |  
|Impairment on mortgage securities  available for sale |  |                             | (8,692  | ) |                                   |   |         |                  |  |   |             |   |  |       |        |   |  |   | (8,692   | )
|Losses on derivative instruments                       |  |                             | (318    | ) |                                   |   | (17,501  | )                |  |   |             |   |  |       |        |   |  |   | (17,819  | )
|Other income (expense)                                 |  |                             | 14,831  |   |                                   |   | (7,645   | )                |  |   | 29           |   |  |       | (6,209  | ) |  |   | 1,006    |  
|General and administrative expenses                    |  |                             | (5,424  | ) |                                   |   | (108,464 | )                |  |   | (132,925     | ) |  |       | 21,697  |   |  |   | (225,116 | )
|                                                       |  |                             |         |   |                                   |   |          |                  |  |   |              |   |  |       |         |   |  |   |          |  
|Income (loss) before income tax                        |  |                             | 88,191  |   |                                   |   | 19,836   |                  |  |   | (7,161       | ) |  |       | (593    | ) |  |   | 100,273  |  
|Income tax expense (benefit)                           |  |                             |        |   |                                   |   | 9,394    |                  |  |   | (2,793       | ) |  |       | 666     |   |  |   | 7,267    |  
|                                                       |  |                             |         |   |                                   |   |          |                  |  |   |              |   |  |       |         |   |  |   |          |  
|Income (loss) from continuing operations               |  |                             | 88,191  |   |                                   |   | 10,442   |                  |  |   | (4,368       | ) |  |       | (1,259  | ) |  |   | 93,006   |  
|Loss from discontinued operations, net of income tax   |  |                             |        |   |                                   |   |         |                  |  |   | (23          | ) |  |       | (2,044  | ) |  |   | (2,067   | )
|                                                       |  |                             |         |   |                                   |   |          |                  |  |   |              |   |  |       |         |   |  |   |          |  
|Net income (loss)                                      |  | $                           | 88,191  |   |                                   | $ | 10,442   |                  |  | $ | (4,391       | ) |  | $     | (3,303  | ) |  | $ | 90,939   |  
|                                                       |  |                             |         |   |                                   |   |          |                  |  |   |              |   |  |       |         |   |  |   |          |  



Nine Months Ended September 30,
2003



|                                             |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |          |  
|-------------------------------------------- |  | --------------------------- | ------ | - | --------------------------------- | - | ------- | ---------------- |  | - | ------------ | - |  | ----- | ------ | - |  | - | -------- | -
|                                             |  | MortgagePortfolioManagement |        |   | Mortgage Lendingand LoanServicing |   |         | BranchOperations |  |   | Eliminations |   |  | Total |       
|Interest income                              |  | $                           | 76,930 |   |                                   | $ | 47,172  |                  |  | $ |             |   |  | $     |       |   |  | $ | 124,102  |  
|Interest expense                             |  |                             | 12,751 |   |                                   |   | 23,762  |                  |  |   |             |   |  |       | (6,114 | ) |  |   | 30,399   |  
|                                             |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |          |  
|Net interest income before credit recoveries |  |                             | 64,179 |   |                                   |   | 23,410  |                  |  |   |             |   |  |       | 6,114  |   |  |   | 93,703   |  
|Credit recoveries                            |  |                             | 1,138  |   |                                   |   |        |                  |  |   |             |   |  |       |       |   |  |   | 1,138    |  
|Fee income                                   |  |                             | 289    |   |                                   |   | 29,345  |                  |  |   | 30,159       |   |  |       | (7,072 | ) |  |   | 52,721   |  
|Gains (losses) on sales of mortgage assets   |  |                             | (1,353 | ) |                                   |   | 108,289 |                  |  |   |             |   |  |       | 726    |   |  |   | 107,662  |  
|Losses on derivative instruments             |  |                             | (962   | ) |                                   |   | (31,368 | )                |  |   |             |   |  |       |       |   |  |   | (32,330  | )
|Other income (expense)                       |  |                             | 12,389 |   |                                   |   | (10,647 | )                |  |   | 43           |   |  |       | (3,374 | ) |  |   | (1,589   | )
|General and administrative expenses          |  |                             | (5,230 | ) |                                   |   | (99,283 | )                |  |   | (25,836      | ) |  |       |       |   |  |   | (130,349 | )
|                                             |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |          |  
|Income before income tax                     |  |                             | 70,450 |   |                                   |   | 19,746  |                  |  |   | 4,366        |   |  |       | (3,606 | ) |  |   | 90,956   |  
|Income tax expense                           |  |                             |       |   |                                   |   | 12,509  |                  |  |   | 1,659        |   |  |       |       |   |  |   | 14,168   |  
|                                             |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |          |  
|Net income                                   |  | $                           | 70,450 |   |                                   | $ | 7,237   |                  |  | $ | 2,707        |   |  | $     | (3,606 | ) |  | $ | 76,788   |  
|                                             |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |          |  



10



---

##### Table of Contents

Three Months Ended September 30, 2004



|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |         |   |  |   |         |  
|------------------------------------------------------ |  | --------------------------- | ------ | - | --------------------------------- | - | ------- | ---------------- |  | - | ------------ | - |  | ----- | ------- | - |  | - | ------- | -
|                                                       |  | MortgagePortfolioManagement |        |   | Mortgage Lendingand LoanServicing |   |         | BranchOperations |  |   | Eliminations |   |  | Total |        
|Interest income                                        |  | $                           | 33,411 |   |                                   | $ | 26,386  |                  |  | $ |             |   |  | $     | (8      | ) |  | $ | 59,789  |  
|Interest expense                                       |  |                             | 4,851  |   |                                   |   | 11,729  |                  |  |   | 14           |   |  |       | (2,244  | ) |  |   | 14,350  |  
|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |         |   |  |   |         |  
|Net interest income (expense) before credit losses     |  |                             | 28,560 |   |                                   |   | 14,657  |                  |  |   | (14          | ) |  |       | 2,236   |   |  |   | 45,439  |  
|Credit losses                                          |  |                             | (182   | ) |                                   |   |        |                  |  |   |             |   |  |       |        |   |  |   | (182    | )
|Fee income                                             |  |                             |       |   |                                   |   | 6,750   |                  |  |   | 44,961       |   |  |       | (17,446 | ) |  |   | 34,265  |  
|Gains (losses) on sales of mortgage assets             |  |                             | (21    | ) |                                   |   | 38,873  |                  |  |   |             |   |  |       | 7,563   |   |  |   | 46,415  |  
|Impairment on mortgage securities - available for sale |  |                             | (2,575 | ) |                                   |   |        |                  |  |   |             |   |  |       |        |   |  |   | (2,575  | )
|Losses on derivative instruments                       |  |                             | (900   | ) |                                   |   | (18,636 | )                |  |   |             |   |  |       |        |   |  |   | (19,536 | )
|Other income (expense)                                 |  |                             | 5,912  |   |                                   |   | (3,814  | )                |  |   | 9            |   |  |       | (2,134  | ) |  |   | (27     | )
|General and administrative expenses                    |  |                             | (1,820 | ) |                                   |   | (38,758 | )                |  |   | (47,744      | ) |  |       | 8,589   |   |  |   | (79,733 | )
|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |         |   |  |   |         |  
|Income (loss) before income tax                        |  |                             | 28,974 |   |                                   |   | (928    | )                |  |   | (2,788       | ) |  |       | (1,192  | ) |  |   | 24,066  |  
|Income tax expense (benefit)                           |  |                             |       |   |                                   |   | (688    | )                |  |   | (1,087       | ) |  |       | 390     |   |  |   | (1,385  | )
|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |         |   |  |   |         |  
|Income (loss) from continuing operations               |  |                             | 28,974 |   |                                   |   | (240    | )                |  |   | (1,701       | ) |  |       | (1,582  | ) |  |   | 25,451  |  
|Loss from discontinued operations, net of income tax   |  |                             |       |   |                                   |   |        |                  |  |   | (542         | ) |  |       | (521    | ) |  |   | (1,063  | )
|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |         |   |  |   |         |  
|Net income (loss)                                      |  | $                           | 28,974 |   |                                   | $ | (240    | )                |  | $ | (2,243       | ) |  | $     | (2,103  | ) |  | $ | 24,388  |  
|                                                       |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |         |   |  |   |         |  



Three Months Ended September 30,
2003



|                                             |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |         |  
|-------------------------------------------- |  | --------------------------- | ------ | - | --------------------------------- | - | ------- | ---------------- |  | - | ------------ | - |  | ----- | ------ | - |  | - | ------- | -
|                                             |  | MortgagePortfolioManagement |        |   | Mortgage Lendingand LoanServicing |   |         | BranchOperations |  |   | Eliminations |   |  | Total |       
|Interest income                              |  | $                           | 29,239 |   |                                   | $ | 14,551  |                  |  | $ |             |   |  | $     |       |   |  | $ | 43,790  |  
|Interest expense                             |  |                             | 4,573  |   |                                   |   | 4,035   |                  |  |   |             |   |  |       | 1,713  |   |  |   | 10,321  |  
|                                             |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |         |  
|Net interest income before credit recoveries |  |                             | 24,666 |   |                                   |   | 10,516  |                  |  |   |             |   |  |       | (1,713 | ) |  |   | 33,469  |  
|Credit recoveries                            |  |                             | 875    |   |                                   |   |        |                  |  |   |             |   |  |       |       |   |  |   | 875     |  
|Fee income                                   |  |                             | 34     |   |                                   |   | 9,882   |                  |  |   | 10,959       |   |  |       | (2,349 | ) |  |   | 18,526  |  
|Gains (losses) on sales of mortgage assets   |  |                             | (360   | ) |                                   |   | 36,796  |                  |  |   |             |   |  |       | (2,248 | ) |  |   | 34,188  |  
|Gains (losses) on derivative instruments     |  |                             | 156    |   |                                   |   | (8,300  | )                |  |   |             |   |  |       |       |   |  |   | (8,144  | )
|Other income (expense)                       |  |                             | 13     |   |                                   |   | (3,422  | )                |  |   | 11           |   |  |       | 2,869  |   |  |   | (529    | )
|General and administrative expenses          |  |                             | (1,621 | ) |                                   |   | (36,620 | )                |  |   | (9,192       | ) |  |       |       |   |  |   | (47,433 | )
|                                             |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |         |  
|Income before income tax                     |  |                             | 23,763 |   |                                   |   | 8,852   |                  |  |   | 1,778        |   |  |       | (3,441 | ) |  |   | 30,952  |  
|Income tax expense                           |  |                             |       |   |                                   |   | 5,180   |                  |  |   | 664          |   |  |       |       |   |  |   | 5,844   |  
|                                             |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |         |  
|Net income                                   |  | $                           | 23,763 |   |                                   | $ | 3,672   |                  |  | $ | 1,114        |   |  | $     | (3,441 | ) |  | $ | 25,108  |  
|                                             |  |                             |        |   |                                   |   |         |                  |  |   |              |   |  |       |        |   |  |   |         |  



11



---

##### Table of Contents

Intersegment revenues and expenses that were eliminated in consolidation were as follows for the nine and three months
ended September 30, 2004 and 2003 (in thousands):



|                                                                                                  |  |                                         |        |   |                                          |   |       |      |  |   |        |   |  |   |        |  
|------------------------------------------------------------------------------------------------- |  | --------------------------------------- | ------ | - | ---------------------------------------- | - | ----- | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                                                  |  | For the Nine Months Ended September 30, |        |   | For the Three Months Ended September 30, |  
|                                                                                                  |  | 2004                                    |        |   | 2003                                     |   |       | 2004 |  |   | 2003   |  
|Amounts paid to (received from) mortgage portfolio from (to) mortgage lending and loan servicing: |  |                                         |        |   |                                          |   |       |      |  |   |        |   |  |   |        |  
|Loan servicing fees                                                                               |  | $                                       | (341   | ) |                                          | $ | (536  | )    |  | $ | (95    | ) |  | $ | (164   | )
|Intercompany interest income                                                                      |  |                                         | 6,565  |   |                                          |   | 6,114 |      |  |   | 2,223  |   |  |   | (1,713 | )
|Guaranty, commitment, loan sale and securitization fees                                           |  |                                         | 7,933  |   |                                          |   | 7,430 |      |  |   | 3,470  |   |  |   | 2,077  |  
|Interest income on warehouse borrowings                                                           |  |                                         | 7      |   |                                          |   |      |      |  |   | 7      |   |  |   |       |  
|Gain on sale of mortgage securities retained in securitizations                                   |  |                                         | (1,954 | ) |                                          |   |      |      |  |   | (1,954 | ) |  |   |       |  
|Amounts paid to (received from) branch operations from (to) mortgage lending and loan servicing:  |  |                                         |        |   |                                          |   |       |      |  |   |        |   |  |   |        |  
|Lender premium                                                                                    |  |                                         | 21,566 |   |                                          |   | 4,167 |      |  |   | 7,941  |   |  |   | 1,193  |  
|Subsidized fees                                                                                   |  |                                         | 21     |   |                                          |   | 2,204 |      |  |   |       |   |  |   | 992    |  
|Interest income and fees on warehouse line                                                        |  |                                         | (50    | ) |                                          |   |      |      |  |   | (14    | ) |  |   |       |  



Additionally, as
previously discussed, the LLC agreements were terminated effective January 1, 2004 and all continuing branches that formerly operated under these agreements became operating units of the Company. As a result, during consolidation, the Company is
applying the provisions of SFAS No. 91 Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases to its branch operations segment. Based on SFAS No. 91, 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 nine and three months ended September 30, 2004 (in thousands):



|                                  |  |                                     |         |   |                                      |   |         |  
|--------------------------------- |  | ----------------------------------- | ------- | - | ------------------------------------ | - | ------- | -
|                                  |  | Nine Months Ended September 30,2004 |         |   | Three Months Ended September 30,2004 |  
|Gains on sales of mortgage assets |  | $                                   | 6,648   |   |                                      | $ | 1,650   |  
|Fee income                        |  |                                     | (29,462 | ) |                                      |   | (10,473 | )
|General & administrative expenses |  |                                     | 21,697  |   |                                      |   | 8,589   |  



12



---

##### Table of Contents

Note 13. Commitments, Guarantees and Contingencies



In the ordinary course of business, the Company sells loans with recourse for borrower defaults. For loans that have been
sold with recourse that 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 for the nine and three months ended September 30, 2004
compared to $151.2 million and $27.1 million, respectively for the nine and three months ended September 30, 2003. The Companys reserve related to these guarantees totaled $45,000 and $41,000 as of September 30, 2004 and December 31, 2003,
respectively.



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 September 30,
2004, the Company had loans sold with recourse for origination defects with an outstanding principal balance of $10.0 billion. Repurchases of loans where a defect has occurred have been immaterial.



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 September 30, 2004 and December 31, 2003, the Company had commitments to fund mortgage loans with agreed-upon rates of approximately $457 million and $228 million,
respectively. Outstanding commitments to purchase loans from third parties at September 30, 2004 and December 31, 2003, were $83 million and $60 million, respectively. There were no commitments to sell loans to third parties at September 30, 2004
and December 31, 2003. 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.



In the normal course of its business, the
Company is subject to various legal proceedings and claims. The resolution of these legal proceedings and claims, in the opinion of management, will not have a material adverse effect on the Companys financial condition or results of
operations. Since April 2004, a number of substantially similar class action lawsuits and three derivative lawsuits (now consolidated into a single case) have been filed in the United States District Court in Kansas City and in Missouri and Maryland
state courts against the Company and/or several of its executive officers and/or directors. The complaints generally claim that the defendants are liable for making or failing to prevent alleged misstatements or omissions in the Companys
public disclosures. The Company believes that these claims are without merit and intends to vigorously defend against them. In addition, the Company in April 2004 received notice of an informal inquiry from the Securities and Exchange Commission
requesting that it provide various documents relating to its business. The Company is cooperating fully with the Commissions inquiry.



13



---

##### Table of Contents

Note 14. Earnings Per Share



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



The computations of basic and diluted EPS for the nine and three months ended September 30, 2004 and 2003 are as follows (in thousands except per share amounts):



|                                                                   |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       
|------------------------------------------------------------------ |  | --------------------------------------- | ------ | ---------------------------------------- | ---- | - | ------ |  | - | ------ | - |  | - | ------
|                                                                   |  | For the Nine Months Ended September 30, |        | For the Three Months Ended September 30,
|                                                                   |  | 2004                                    |        |                                          | 2003 |   | 2004   |  |   | 2003  
|Numerator:                                                         |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       
|Income from continuing operations                                  |  | $                                       | 93,006 |                                          |      | $ | 76,788 |  | $ | 25,451 |   |  | $ | 25,108
|Dividends on preferred shares                                      |  |                                         | (4,601 | )                                        |      |   |       |  |   | (1,663 | ) |  |   |      
|                                                                   |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       
|Income from continuing operations available to common shareholders |  |                                         | 88,405 |                                          |      |   | 76,788 |  |   | 23,788 |   |  |   | 25,108
|Loss from discontinued operations, net of income tax               |  |                                         | (2,067 | )                                        |      |   |       |  |   | (1,063 | ) |  |   |      
|                                                                   |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       
|Net income available to common shareholders                        |  | $                                       | 86,338 |                                          |      | $ | 76,788 |  | $ | 22,725 |   |  | $ | 25,108
|                                                                   |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       
|Denominator:                                                       |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       
|Weighted average common shares outstanding  basic                 |  |                                         | 24,889 |                                          |      |   | 21,734 |  |   | 25,034 |   |  |   | 22,386
|                                                                   |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       
|Weighted average common shares outstanding  dilutive:             |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       
|Weighted average common shares outstanding - basic                 |  |                                         | 24,889 |                                          |      |   | 21,734 |  |   | 25,034 |   |  |   | 22,386
|Stock options                                                      |  |                                         | 475    |                                          |      |   | 630    |  |   | 420    |   |  |   | 662   
|Restricted stock                                                   |  |                                         | 19     |                                          |      |   |       |  |   | 1      |   |  |   |      
|                                                                   |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       
|Weighted average common shares outstanding  dilutive              |  |                                         | 25,383 |                                          |      |   | 22,364 |  |   | 25,455 |   |  |   | 23,048
|                                                                   |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       
|Basic earnings per share:                                          |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       
|Income from continuing operations                                  |  | $                                       | 3.74   |                                          |      | $ | 3.53   |  | $ | 1.02   |   |  | $ | 1.12  
|Dividends on preferred shares                                      |  |                                         | (0.19  | )                                        |      |   |       |  |   | (0.07  | ) |  |   |      
|                                                                   |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       
|Income from continuing operations available to common shareholders |  |                                         | 3.55   |                                          |      |   | 3.53   |  |   | 0.95   |   |  |   | 1.12  
|Loss from discontinued operations, net of income tax               |  |                                         | (0.08  | )                                        |      |   |       |  |   | (0.04  | ) |  |   |      
|                                                                   |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       
|Net income available to common shareholders                        |  | $                                       | 3.47   |                                          |      | $ | 3.53   |  | $ | 0.91   |   |  | $ | 1.12  
|                                                                   |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       
|Diluted earnings per share:                                        |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       
|Income from continuing operations                                  |  | $                                       | 3.66   |                                          |      | $ | 3.43   |  | $ | 1.00   |   |  | $ | 1.09  
|Dividends on preferred shares                                      |  |                                         | (0.18  | )                                        |      |   |       |  |   | (0.07  | ) |  |   |      
|                                                                   |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       
|Income from continuing operations available to common shareholders |  |                                         | 3.48   |                                          |      |   | 3.43   |  |   | 0.93   |   |  |   | 1.09  
|Net loss from discontinued operations                              |  |                                         | (0.08  | )                                        |      |   |       |  |   | (0.04  | ) |  |   |      
|                                                                   |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       
|Net income available to common shareholders                        |  | $                                       | 3.40   |                                          |      | $ | 3.43   |  | $ | 0.89   |   |  | $ | 1.09  
|                                                                   |  |                                         |        |                                          |      |   |        |  |   |        |   |  |   |       



Note 15. Subsequent Events



On October 28, 2004, the Company announced additional
branch program modifications allowing it to concentrate on branches originating substantially nonconforming loan volume to its portfolio. The Company anticipates that some branches will choose to leave the program after reviewing the modifications.
To provide a transition opportunity, the Company has an agreement in principle with a leading brokerage firm, which enables branches to transfer affiliation. The agreement also designates the Company as a preferred outlet for selling nonconforming
mortgages within the brokerage firms branch network.



14



---

##### Table of Contents

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 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, 2003.



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, 2003. Other factors
not presently identified may also cause actual results to differ. Management continuously updates and revises these estimates and assumptions based on actual conditions experienced. It is not practicable to publish all revisions and, as a result, no
one should assume that results projected in or contemplated by the forward-looking statements will continue to be accurate in the future. 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, 2003.



Overview of Performance



During the nine and three months ended September 30, 2004, we reported net income of $90.9 million and $24.4 million, or $3.40 and $0.89 per diluted
share, respectively as compared to $76.8 million and $25.1 million, or $3.43 and $1.09 per diluted share for the same periods of 2003. Our earnings were driven largely by the income generated by our mortgage securities portfolio, which increased
from $337.6 million as of September 30, 2003 to $462.5 million as of September 30, 2004. These securities are retained in securitizations of the mortgage loans we originate. We securitized $5.8 billion of mortgage loans during the first nine months
of 2004 as compared to $3.7 billion during the same period of 2003. The increased volume of mortgage loans we securitized is directly attributable to the increase in our loan origination volume. During the first nine months of 2004 and 2003, we
originated $6.2 billion and $3.7 billion, respectively, in nonconforming, residential mortgage loans. We increased our loan production for the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2003 through
adding sales personnel primarily in new and underserved markets.



Summary of
Operations and Key Performance Measurements



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



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



We
also service the mortgage loans we originate and that serve as collateral for our mortgage securities. The servicing function is critical to the management of credit risk (risk of borrower default and the related economic loss) within 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
| | - | -------------------------------------------



| |  | estimated REIT taxable net income per common share
| | - | --------------------------------------------------



15



---

##### Table of Contents

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



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



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



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



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



State and local governing bodies are focused on the nonconforming lending
business and any excessive fees borrowers incur in obtaining a mortgage loan  generally termed predatory lending within the mortgage industry. In several instances, states or local governing bodies have imposed strict laws on
lenders to curb predatory lending. To date, these laws have 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.



As
discussed in Note 15 to our condensed consolidated financial statements, during 2004, we changed policies governing our broker branches. Additionally, as the demand for conforming loans has declined significantly during 2004, many branches have not
been able to produce sufficient fees to meet operating demands. As a result of these conditions, a significant number of branch managers have voluntarily terminated employment with us. We have also terminated branches for non-compliance with policy
or when loan production results were substandard. Furthermore, on October 28, 2004, we announced additional branch program modifications allowing us to concentrate on branches originating substantial nonconforming loan volume to our portfolio. We
anticipate that some branches will choose to leave the program after reviewing the modifications. To provide a transition opportunity, we have entered into an agreement in principle with a leading brokerage firm, which enables branches to transfer
affiliation. The agreement also designates us as a preferred outlet for nonconforming mortgages within the brokerage firms branch network.



Description of Businesses



Mortgage Portfolio Management



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



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



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



16



---

##### Table of Contents

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



| | Our mortgage securities include 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 $163.8 million and $59.8 million for the nine and three months ended September 30, 2004, respectively, compared with $124.1 million and $43.8 million for the same period of 2003. Net
interest income before credit losses/recoveries from the portfolio was $128.0 million and $45.4 million for the nine and three months ended September 30, 2004, respectively, compared to $93.7 million and $33.5 million during the same period of 2003.
See our discussion of interest income under the heading Results of Operations and Net Interest Income.



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



In certain circumstances, because we enter into interest rate agreements that
do not meet the hedging criteria set forth in accounting principles generally accepted in the United States of America, we are required to record the change in the value of derivatives as a component of earnings even though they may reduce our
interest rate risk. In times where short-term rates rise or drop significantly, the value of our agreements will increase or decrease, respectively. As a result, we recognized losses on these derivatives of $17.8 million and $19.5 million for the
nine and three months ended September 30, 2004, respectively, compared with $32.3 million and $8.1 million for the same period of 2003.



Mortgage Lending and Loan Servicing



The mortgage lending operation is significant to our financial results as it produces the loans that ultimately collateralize the mortgage securities that
we hold in our portfolio. During the first nine months of 2004, we originated $6.2 billion in nonconforming mortgage loans, the majority of which were retained in our servicing portfolio and serve as collateral for our securities. The loans we
originate are sold, either in securitization transactions or in outright sales to third parties. We recognized gains on sales of mortgage assets totaling $123.4 million and $46.4 million during the nine and three months ended September 30, 2004,
respectively, compared with $107.7 million and $34.2 million during the nine and three months ended September 30, 2003. In securitization transactions accounted for as sales, we retain interest-only, prepayment penalty, overcollateralization and
other subordinated securities, along with the right to service the loans.



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



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 entities. Our
sales force, which includes account executives in 40 states, develops and maintains relationships with this network of independent retail brokers. Our correspondent origination channel consists of a network of institutions in 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 Mortgage Loans section of Managements Discussion and Analysis of Financial Condition and
Results of Operations.



A significant risk to our
mortgage lending operations is liquidity risk  the risk that we will not have financing facilities and cash available to fund and hold loans prior to their sale or securitization. We maintain committed lending facilities with large banking and
investment institutions to reduce this risk. On a short-term basis, we



17



---

##### Table of Contents

finance mortgage loans using warehouse lines of credit and repurchase agreements. In addition, we have access to
facilities secured by our mortgage securities. Details regarding available financing arrangements and amounts outstanding under those arrangements are included in Managements Discussion and Analysis of Financial Condition and Results of
Operations.



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



Loan servicing remains a critical part of our business operation. In the opinion of management, maintaining contact with our borrowers is critical in
managing credit risk and in borrower retention. Nonconforming borrowers are more prone to late payments and are more likely to default on their obligations than conventional borrowers. By servicing our loans, we strive to identify problems with
borrowers early and take quick action to address problems. Borrowers may be motivated to refinance their mortgage loans either by improving their personal credit or due to a decrease in interest rates. By keeping in close touch with borrowers, we
can provide them with information about company products to encourage them to refinance with us. Mortgage servicing yields fee income for us in the form of normal customer service and processing fees. We recognized $28.6 million and $10.5 million in
loan servicing fee income from the securitization trusts during the nine and three months ended September 30, 2004, respectively, compared with $13.9 million and $5.8 million for the same periods of 2003. See also Mortgage Loan Servicing
under Managements Discussion and Analysis of Financial Condition and Results of Operations for further discussion and analysis of the servicing operations.



Branch Operations



In 1999, we opened our retail mortgage broker business operating under the name NovaStar Home Mortgage, Inc. Prior to 2004, many of these broker branches
operating under LLC agreements where we owned a minority interest in the LLC and the branch manager was the majority shareholder. In December 2003, we decided to terminate the LLCs effective January 1, 2004. As of January 1, 2004, continuing
branches that formerly operated under LLC agreements became operating units of us and their financial results are included in the condensed consolidated financial statements. See Notes 1 and 11 of the Notes to Condensed Consolidated Financial
Statements for further discussion. 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.



We routinely close branches or branch managers voluntarily terminate their employment with us, which generally results in
the branchs closure. During 2004, we changed policies governing our broker branches. Additionally, as the demand for conforming loans has declined significantly during 2004, 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 have voluntarily terminated employment with us. We have also terminated many branches for non-compliance with policy or when loan production results
were substandard. In these terminations, the branch and all operations are eliminated. As of September 30, 2004 we had 239 active branches as compared to 420 active branches reported as of September 30, 2003. Note 10 to our condensed consolidated
financial statements provides details regarding the impact of the discontinued operations. Additionally, Note 15 to our condensed consolidated financial statements discusses 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 nine months of 2004 and 2003, our branches brokered $2.9 billion and $1.4 billion, respectively, in
nonconforming loans, of which we funded $1.3 billion and $811.3 million, respectively.



18



---

##### Table of Contents

Following is a diagram of the industry in which we operate and our loan production during 2004 (in
thousands).



LOGO



---

| | (A) | A portion of the loans securitized or sold to unrelated parties as of September 30, 2004 originated prior to 2004, but due to timing were not yet securitized or sold at the end of
2003. Loans originated in 2004 that we have not securitized or sold to unrelated parties as of September 30, 2004 are included in our mortgage loans held-for-sale
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (B) | The AAA-BBB rated securities related to NMFT Series 2004-1, 2004-2 and 2004-3 were purchased by bond investors during the first nine months of 2004.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------

| | (C) | The excess cash flow and subordinated bonds retained by NovaStar includes the securitization transactions that occurred during the first nine months of 2004 for NMFT Series 2003-4,
2004-1, 2004-2 and 2004-3.
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Significance of Estimates and
Critical Accounting Policies



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
2003 consolidated financial statements. Our critical accounting estimates impact only two of our three reportable segments; our mortgage portfolio management and mortgage lending and loan servicing segments. Management has discussed the development
and selection of these critical accounting estimates with the audit committee of our board of directors and the audit committee has reviewed our disclosure.



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



In order for us to determine proper accounting treatment for each securitization or resecuritization, we evaluate whether or not we have retained or
surrendered control over the transferred assets by reference to the conditions set



19



---

##### Table of Contents

forth in SFAS No. 140. All terms of these transactions are evaluated against the conditions set forth in these
statements. Some of the questions that must be considered include:



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



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



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



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



| |  | 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 issued by the trust (see Mortgage Securities below). In a resecuritization, we
retain an interest in a subordinated security that represents the right to receive the cash flows on the underlying mortgage security collateral after the senior bonds have been satisfied. As previously discussed, the gain recognized upon
securitization (or resecuritization) depends on, among other things, the estimated fair value of the components of the securitization (or resecuritization)  the loans or mortgage securities transferred, the securities retained and the mortgage
servicing rights. The estimated fair value of the securitization (or resecuritization) components is considered a critical accounting estimate as 1) these gains or losses represent a significant portion of our operating results and 2)
the valuation assumptions used regarding economic conditions and the make-up of the collateral, including interest rates, principal payments, prepayments and loan defaults are highly uncertain and require a large degree of judgment.



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



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



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



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



The weighted
average whole loan market price used in the initial valuation of our retained securities was 103.42 and 103.59 during the nine months ended September 30, 2004 and 2003, respectively. The weighted average implied discount rate for the nine months
ended September 30, 2004 and 2003 was 21% and 23%, respectively. If the whole loan market price used in the initial valuation of our mortgage securities in 2004 had been increased or decreased by 50 basis points, the initial value of our mortgage
securities and the gain we recognized would have increased or decreased by approximately $29.1 million.



20



---

##### Table of Contents

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



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



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



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



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



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



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



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



We believe the accounting estimates related to the valuation of our mortgage
securities and establishing the rate of income recognition on mortgage securities are critical accounting estimates because they can materially affect net income and stockholders equity and require us to forecast interest rates,
mortgage principal payments, prepayments and loan default assumptions which are highly uncertain and require a large degree of judgment. The rate used to discount the projected cash flows is also critical in the valuation of our mortgage securities.
We use internal, historical collateral performance data and published forward yield curves when modeling future expected cash flows and establishing the rate of income recognized on mortgage securities. We believe the value of our mortgage
securities is fair, but can provide no assurance that future prepayment and loss experience or changes in their required market discount rate will not require write-downs of the residual assets. Write-downs would reduce income of future periods.



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



At each reporting period subsequent to the initial
valuation of the retained securities, the fair value of mortgage securities is estimated based on the present value of future expected cash flows to be received. Managements best estimate of key assumptions, including credit losses, prepayment
speeds, the market discount rates and forward yield curves commensurate with the risks involved, are used in estimating future cash flows. To the extent that the cost basis of mortgage securities exceeds the fair value and the unrealized loss is
considered to be other than temporary, an impairment charge is recognized and the amount recorded in accumulated other comprehensive income or loss is reclassified to earnings as a realized loss. During the nine and three months ended September 30,
2004, we recorded an impairment loss of $8.7 million and $2.6 million on NMFT Series 2004-1 and 2004-2. The impairment on NMFT Series 2004-1 was a result of the significant increase in short-term rates in the second quarter, while the impairment on
NMFT Series 2004-2 resulted from being higher than anticipated prepayment performance. Also contributing to the impairments is the fact that NMFT Series 2004-1 and 2004-2 are new securities and they did not have sizable unrealized gains to help
absorb the decline in fair value, which was the case with our older securities. See Table 4 for a quarterly summary of the cost basis, unrealized gain (loss) and fair value of our mortgage securities.



During 2004, our average security yield has decreased to 31.7% and 29.9% for
the nine and three months ended September 30, 2004, respectively, from 34.4% and 33.3% for the same period of 2003. This decrease is a result of the significant rise in short-term interest rates in 2004. Mortgage securities income has increased from
$68.3 million for the nine months ended September 30, 2003 to $97.2 million for the same period of 2004 due to the increase in the average balance of our securities portfolio. If the rates used to accrue income on our mortgage securities during 2004
had increased or decreased by 10%, net income during the nine months ended September 30, 2004 would have increased by $23.7 million and decreased by $26.7 million, respectively.



21



---

##### Table of Contents

As of September 30, 2004, the weighted average discount rate used in valuing our mortgage securities was
21% as compared to 22% as of December 31, 2003. The weighted-average constant prepayment rate used in valuing our mortgage securities as of September 30, 2004 and December 31, 2003 was 36 and 33, respectively. If the discount rate used in valuing
our mortgage securities as of September 30, 2004 had been increased by 500 basis points, the value of our mortgage securities would have decreased by $22.8 million. If we had decreased the discount rate used in valuing our mortgage securities by 500
basis points, the value of our mortgage securities would have increased $25.7 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 objective and strategy for using derivative instruments is to mitigate the risk of increased
costs on our variable rate liabilities during a period of rising rates (i.e. interest rate risk). Our primary goals for managing interest rate risk are to maintain the net interest margin between our assets and liabilities and diminish the effect of
changes in general interest rate levels on 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.



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



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



Mortgage Servicing Rights (MSR). Originated MSR are recorded at allocated cost based upon the relative fair values of the transferred loans and the
servicing rights. MSR are amortized in proportion to the projected net servicing revenue over the expected life of the related mortgage loans. Periodically, we evaluate the carrying value of originated MSR based on their estimated fair value. If the
estimated fair value, using a discounted cash flow methodology, is less than the carrying amount of the mortgage servicing rights, the mortgage servicing rights are written down to the amount of the estimated fair value. For purposes of evaluating
and measuring impairment of MSR we stratify the mortgage servicing rights based on their predominant risk characteristics. The 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,



22



---

##### Table of Contents

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 September 30, 2004 and December 31, 2003



Mortgage Loans. We classify our mortgage loans
into two categories: held-for-sale and held-in-portfolio. Loans we have originated, but have not yet sold or securitized, are classified as held-for-sale. We expect to sell these loans outright in third party
transactions or in securitization transactions that will be, for tax and accounting purposes, recorded as sales. We use warehouse lines of credit and mortgage repurchase agreements to finance our held-for-sale loans. As such, the fluctuations in
mortgage loans held-for-sale and short-term borrowings between September 30, 2004 and December 31, 2003 is dependent on loans we have originated during the period as well as loans we have sold outright or through securitization transactions.



The volume and cost of our loan production is critical to our
financial results. The loans we produce serve as collateral for our mortgage securities and generate gains as they are sold or securitized. The cost of our production is also critical to our financial results as it is a significant factor in the
gains we recognize. The following table summarizes our loan production for 2004 and 2003. We discuss our cost of production under General and Administrative Expenses under Results of Operations. Also, details regarding
mortgage loans sold or securitized and the gains recognized during 2004 can be found in the Gains on Sales of Mortgage Assets and Gains (Losses) on Derivative Instruments section of this document.



Table 1  Nonconforming Loan Originations

(dollars in thousands, except for average loan balance)



|               |  |        |  |           |           |                      |   |                      |            |       |                  |  |    |                                 |  |     |  |     |   |  |    |  
|-------------- |  | ------ |  | --------- | --------- | -------------------- | - | -------------------- | ---------- | ----- | ---------------- |  | -- | ------------------------------- |  | --- |  | --- | - |  | -- | -
|               |  | Number |  | Principal |           | Average Loan Balance |   | Price Paid to Broker |            |       | Weighted Average |  |    | Percent with Prepayment Penalty | 
|               |  |        |  |           |           | Loan to Value        |   |                      | FICO Score |       | Coupon           |  |   
|2004:          |  |        |  |           |           |                      |   |                      |            |       |                  |  |    |                                 |  |     |  |     |   |  |    |  
|Third quarter  |  | 15,825 |  | $         | 2,427,412 |                      | $ | 153,391              |            | 101.4 | %                |  | 82 | %                               |  | 621 |  | 7.7 | % |  | 74 | %
|Second quarter |  | 13,400 |  |           | 1,978,801 |                      |   | 147,672              |            | 101.2 |                  |  | 83 |                                 |  | 621 |  | 7.7 |   |  | 74 |  
|First quarter  |  | 12,137 |  |           | 1,783,119 |                      |   | 146,916              |            | 101.3 |                  |  | 82 |                                 |  | 622 |  | 7.4 |   |  | 74 |  
|               |  |        |  |           |           |                      |   |                      |            |       |                  |  |    |                                 |  |     |  |     |   |  |    |  
|Total          |  | 41,362 |  | $         | 6,189,332 |                      | $ | 149,638              |            | 101.3 | %                |  | 82 | %                               |  | 621 |  | 7.6 | % |  | 74 | %
|               |  |        |  |           |           |                      |   |                      |            |       |                  |  |    |                                 |  |     |  |     |   |  |    |  
|2003:          |  |        |  |           |           |                      |   |                      |            |       |                  |  |    |                                 |  |     |  |     |   |  |    |  
|Fourth quarter |  | 11,145 |  | $         | 1,587,357 |                      | $ | 142,428              |            | 101.2 | %                |  | 80 | %                               |  | 626 |  | 7.6 | % |  | 75 | %
|Third quarter  |  | 10,415 |  |           | 1,491,476 |                      |   | 143,205              |            | 101.1 |                  |  | 77 |                                 |  | 648 |  | 7.1 |   |  | 75 |  
|Second quarter |  | 8,925  |  |           | 1,259,546 |                      |   | 141,126              |            | 101.3 |                  |  | 78 |                                 |  | 642 |  | 7.2 |   |  | 78 |  
|First quarter  |  | 6,426  |  |           | 912,599   |                      |   | 142,017              |            | 101.3 |                  |  | 78 |                                 |  | 638 |  | 7.5 |   |  | 80 |  
|               |  |        |  |           |           |                      |   |                      |            |       |                  |  |    |                                 |  |     |  |     |   |  |    |  
|Total          |  | 36,911 |  | $         | 5,250,978 |                      | $ | 142,261              |            | 101.2 | %                |  | 78 | %                               |  | 638 |  | 7.3 | % |  | 77 | %
|               |  |        |  |           |           |                      |   |                      |            |       |                  |  |    |                                 |  |     |  |     |   |  |    |  



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 September 30, 2004 was $65.8
million compared to $94.7 million as of December 31, 2003.



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



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



The operating performance of our mortgage loan portfolio, including net interest income, allowance for credit losses and effects of hedging, are discussed
under Results of Operations and Interest Rate/Market Risk. Gains on the sales of mortgage loans, including impact of securitizations treated as sales, is also discussed under Results of Operations. Additional
information relating to our loans held-in-portfolio and loans held-for-sale can be



23



---

##### Table of Contents

accessed via our website at www.novastarmortgage.com. Such information includes a summary of our loans held-in-portfolio
and loans held-for-sale by FICO score and geographic concentration. For held-in-portfolio loans, loan performance characteristics such as credit quality and prepayment experience are also available.



Table 2  Carrying Value of Mortgage Loans

(dollars in thousands)



|                                |  |                    |           |   |                   |   |         |  
|------------------------------- |  | ------------------ | --------- | - | ----------------- | - | ------- | -
|                                |  | September 30, 2004 |           |   | December 31, 2003 |  
|Held-in-portfolio:              |  |                    |           |   |                   |   |         |  
|Current principal               |  | $                  | 65,266    |   |                   | $ | 94,162  |  
|                                |  |                    |           |   |                   |   |         |  
|Premium                         |  | $                  | 1,288     |   |                   | $ | 1,874   |  
|                                |  |                    |           |   |                   |   |         |  
|Coupon                          |  |                    | 10.0      | % |                   |   | 10.0    | %
|                                |  |                    |           |   |                   |   |         |  
|Percent with prepayment penalty |  |                    |          | % |                   |   |        | %
|                                |  |                    |           |   |                   |   |         |  
|Held-for-sale:                  |  |                    |           |   |                   |   |         |  
|Current principal               |  | $                  | 1,015,131 |   |                   | $ | 687,880 |  
|                                |  |                    |           |   |                   |   |         |  
|Premium                         |  | $                  | 11,645    |   |                   | $ | 10,112  |  
|                                |  |                    |           |   |                   |   |         |  
|Coupon                          |  |                    | 7.6       | % |                   |   | 7.7     | %
|                                |  |                    |           |   |                   |   |         |  
|Percent with prepayment penalty |  |                    | 73        | % |                   |   | 74      | %
|                                |  |                    |           |   |                   |   |         |  



Mortgage Securities Available-for-Sale.Since 1998, we have pooled the majority of the loans we have originated to serve as collateral for asset-backed bonds in securitizations that are treated as sales for accounting and tax purposes.
In these transactions, the loans are removed from our balance sheet. However, we retain excess interest, prepayment penalty and subordinated principal securities. Additionally, we service the loans sold in these securitizations (see Mortgage
Servicing Rights under the header Financial Condition as of September 30, 2004 and December 31, 2003). As of September 30, 2004 and December 31, 2003, the fair value of our mortgage securities was $462.5 million and $382.3 million,
respectively. During the first nine months of 2004, we executed securitizations totaling $5.8 billion in mortgage loans and retained mortgage securities with a fair value of $292.7 million. See Note 5 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.



During the past two years, interest expense on asset-backed bonds has been unexpectedly low. As a result, the spread between
the coupon interest and the bond cost has been unusually high and our cost basis in many of our mortgage securities has been significantly reduced. For example, our cost basis in NMFT Series 2000-1, 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 and Interest Rate/Market Risk. Additional information relating to our loans collateralizing our mortgage securities can be accessed via our
website at www.novastarmortgage.com. Such information includes a summary of our loans collateralizing our mortgage securities by FICO score and geographic concentration, as well as, loan performance characteristics such as credit quality and
prepayment experience.



24



---

##### Table of Contents

Table 3  Valuation of Individual Mortgage Securities and Assumptions (dollars in thousands)



|                        |  |      |       |                            |               |                                            |  |                          |        |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|----------------------- |  | ---- | ----- | -------------------------- | ------------- | ------------------------------------------ |  | ------------------------ | ------ |  | ----------------------------------- | - |  | ------------- | - |  | ------------------------ | - |  | -------------------------- | - |  | -- | - |  | --- | -
|                        |  | Cost |       | Net Unrealized Gain (Loss) |               | EstimatedFair Value of Mortgage Securities |  | Current Assumptions      |        |  | Assumptions at Trust Securitization |  
|                        |  |      |       |                            | Discount Rate |                                            |  | Constant Prepayment Rate |        |  | Expected Credit Losses (A)          |   |  | Discount Rate |   |  | Constant Prepayment Rate |   |  | Expected Credit Losses (A) |  
|September 30, 2004:     |  |      |       |                            |               |                                            |  |                          |        |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|NMFT 1999-1             |  |      |       |                            |               |                                            |  |                          |        |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Subordinated securities |  | $    | 6,818 |                            | $             |                                           |  | $                        | 6,818  |  | 17                                  | % |  | 39            | % |  | 4.7                      | % |  | 17                         | % |  | 30 | % |  | 2.5 | %
|NMFT 2000-1             |  |      |       |                            |               |                                            |  |                          |        |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Interest only           |  |      |      |                            |               | 779                                        |  |                          | 779    |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Prepayment penalty      |  |      |      |                            |               | 81                                         |  |                          | 81     |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Subordinated securities |  |      | 539   |                            |               | 261                                        |  |                          | 800    |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|                        |  |      |       |                            |               |                                            |  |                          |        |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|                        |  |      | 539   |                            |               | 1,121                                      |  |                          | 1,660  |  | 15                                  |   |  | 40            |   |  | 1.2                      |   |  | 15                         |   |  | 27 |   |  | 1.0 |  
|NMFT 2000-2             |  |      |       |                            |               |                                            |  |                          |        |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Interest only           |  |      |      |                            |               | 722                                        |  |                          | 722    |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Prepayment penalty      |  |      |      |                            |               | 57                                         |  |                          | 57     |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Subordinated securities |  |      |      |                            |               | 1,146                                      |  |                          | 1,146  |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|                        |  |      |       |                            |               |                                            |  |                          |        |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|                        |  |      |      |                            |               | 1,925                                      |  |                          | 1,925  |  | 15                                  |   |  | 44            |   |  | 0.7                      |   |  | 15                         |   |  | 28 |   |  | 1.0 |  
|NMFT 2001-1             |  |      |       |                            |               |                                            |  |                          |        |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Interest only           |  |      |      |                            |               | 3,496                                      |  |                          | 3,496  |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Prepayment penalty      |  |      |      |                            |               | 217                                        |  |                          | 217    |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Subordinated securities |  |      |      |                            |               | 646                                        |  |                          | 646    |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|                        |  |      |       |                            |               |                                            |  |                          |        |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|                        |  |      |      |                            |               | 4,359                                      |  |                          | 4,359  |  | 20                                  |   |  | 35            |   |  | 1.1                      |   |  | 20                         |   |  | 28 |   |  | 1.2 |  
|NMFT 2001-2             |  |      |       |                            |               |                                            |  |                          |        |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Interest only           |  |      |      |                            |               | 8,871                                      |  |                          | 8,871  |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Prepayment penalty      |  |      |      |                            |               | 616                                        |  |                          | 616    |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Subordinated securities |  |      |      |                            |               | 2,218                                      |  |                          | 2,218  |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|                        |  |      |       |                            |               |                                            |  |                          |        |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|                        |  |      |      |                            |               | 11,705                                     |  |                          | 11,705 |  | 25                                  |   |  | 34            |   |  | 0.8                      |   |  | 25                         |   |  | 28 |   |  | 1.2 |  
|NMFT 2002-1             |  |      |       |                            |               |                                            |  |                          |        |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Interest only           |  |      | 4,006 |                            |               | 1,631                                      |  |                          | 5,637  |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Prepayment penalty      |  |      | 248   |                            |               | 504                                        |  |                          | 752    |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Subordinated securities |  |      | 1,112 |                            |               | 4,680                                      |  |                          | 5,792  |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|                        |  |      |       |                            |               |                                            |  |                          |        |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|                        |  |      | 5,366 |                            |               | 6,815                                      |  |                          | 12,181 |  | 20                                  |   |  | 38            |   |  | 1.0                      |   |  | 20                         |   |  | 32 |   |  | 1.7 |  
|NMFT 2002-2             |  |      |       |                            |               |                                            |  |                          |        |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Interest only           |  |      | 3,578 |                            |               |                                           |  |                          | 3,578  |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Prepayment penalty      |  |      | 258   |                            |               | 234                                        |  |                          | 492    |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|Subordinated securities |  |      | 1,645 |                            |               | 1,677                                      |  |                          | 3,322  |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|                        |  |      |       |                            |               |                                            |  |                          |        |  |                                     |   |  |               |   |  |                          |   |  |                            |   |  |    |   |  |     |  
|                        |  |      | 5,481 |                            |               | 1,911                                      |  |                          | 7,392  |  | 25                                  |   |  | 39            |   |  | 1.6                      |   |  | 25                         |   |  | 27 |   |  | 1.6 |  



25



---

##### Table of Contents

|                        |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|----------------------- |  | ---- | ------- | -------------------------- | - | ------------------------------------------ |  | -------------------------- | ------- | ----------------------------------- | -- | ------------------------ | -- | -------------------------- | --- |  | -- |  | -- |  | ---
|                        |  | Cost |         | Net Unrealized Gain (Loss) |   | EstimatedFair Value of Mortgage Securities |  | Current Assumptions        |         | Assumptions at Trust Securitization
|                        |  |      |         | Discount Rate              |   | Constant Prepayment Rate                   |  | Expected Credit Losses (A) |         | Discount Rate                       |    | Constant Prepayment Rate |    | Expected Credit Losses (A)
|September 30, 2004:     |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|NMFT 2002-3             |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Interest only           |  |      | 10,610  |                            |   | 1,624                                      |  |                            | 12,234  |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Prepayment penalty      |  |      | 1,055   |                            |   | 496                                        |  |                            | 1,551   |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Subordinated securities |  |      | 1,466   |                            |   | 3,335                                      |  |                            | 4,801   |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|                        |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|                        |  |      | 13,131  |                            |   | 5,455                                      |  |                            | 18,586  |                                     | 20 |                          | 39 |                            | 0.8 |  | 20 |  | 30 |  | 1.0
|NMFT 2003-1             |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Interest only           |  |      | 21,846  |                            |   | 370                                        |  |                            | 22,216  |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Prepayment penalty      |  |      | 3,618   |                            |   | 1,348                                      |  |                            | 4,966   |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Subordinated securities |  |      | 11,061  |                            |   | 2,253                                      |  |                            | 13,314  |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|                        |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|                        |  |      | 36,525  |                            |   | 3,971                                      |  |                            | 40,496  |                                     | 20 |                          | 38 |                            | 2.0 |  | 20 |  | 28 |  | 3.3
|NMFT 2003-2             |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Interest only           |  |      | 21,131  |                            |   | 2,835                                      |  |                            | 23,966  |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Prepayment penalty      |  |      | 6,022   |                            |   | 1,395                                      |  |                            | 7,417   |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Subordinated securities |  |      | 2,194   |                            |   | 2,735                                      |  |                            | 4,929   |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|                        |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|                        |  |      | 29,347  |                            |   | 6,965                                      |  |                            | 36,312  |                                     | 28 |                          | 34 |                            | 1.8 |  | 28 |  | 25 |  | 2.7
|NMFT 2003-3             |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Interest only           |  |      | 28,595  |                            |   | 3,783                                      |  |                            | 32,378  |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Prepayment penalty      |  |      | 6,990   |                            |   | 2,165                                      |  |                            | 9,155   |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Subordinated securities |  |      | 6,265   |                            |   | 2,504                                      |  |                            | 8,769   |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|                        |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|                        |  |      | 41,850  |                            |   | 8,452                                      |  |                            | 50,302  |                                     | 20 |                          | 33 |                            | 2.1 |  | 20 |  | 22 |  | 3.6
|NMFT 2003-4             |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Interest only           |  |      | 28,409  |                            |   | 3,505                                      |  |                            | 31,914  |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Prepayment penalty      |  |      | 6,665   |                            |   | 4,838                                      |  |                            | 11,503  |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Subordinated securities |  |      |        |                            |   | 727                                        |  |                            | 727     |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|                        |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|                        |  |      | 35,074  |                            |   | 9,070                                      |  |                            | 44,144  |                                     | 20 |                          | 42 |                            | 2.9 |  | 20 |  | 30 |  | 5.1
|NMFT 2004-1 (B)         |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Interest only           |  |      | 48,524  |                            |   | 562                                        |  |                            | 49,086  |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Prepayment penalty      |  |      | 8,846   |                            |   | 3,189                                      |  |                            | 12,035  |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|                        |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|                        |  |      | 57,370  |                            |   | 3,751                                      |  |                            | 61,121  |                                     | 20 |                          | 36 |                            | 5.0 |  | 20 |  | 33 |  | 5.9
|NMFT 2004-2             |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Interest only           |  |      | 46,091  |                            |   |                                           |  |                            | 46,091  |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Prepayment penalty      |  |      | 6,132   |                            |   | 2,293                                      |  |                            | 8,425   |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Subordinated securities |  |      | 3,268   |                            |   | 847                                        |  |                            | 4,115   |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|                        |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|                        |  |      | 55,491  |                            |   | 3,140                                      |  |                            | 58,631  |                                     | 26 |                          | 34 |                            | 4.6 |  | 26 |  | 31 |  | 5.1
|NMFT 2004-3 (C)         |  |      | 106,037 |                            |   | 818                                        |  |                            | 106,855 |                                     | 19 |                          | 34 |                            | 4.5 |  | 19 |  | 34 |  | 4.5
|                        |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|Total                   |  | $    | 393,029 |                            | $ | 69,458                                     |  | $                          | 462,487 |                                     |    |                          |    |                            |     |  |    |  |    |  |    
|                        |  |      |         |                            |   |                                            |  |                            |         |                                     |    |                          |    |                            |     |  |    |  |    |  |    

---

|(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) | Due to the expected credit losses and mortgage insurance coverage on NMFT Series 2004-1, the value of the subordinated securities is zero.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------

|(C) | The interest only, prepayment penalty and subordinated securities are packaged in one bond for the Series NMFT 2004-3.
|--- | ----------------------------------------------------------------------------------------------------------------------



26



---

##### Table of Contents

|                        |  |      |        |                            |               |        |                                             |                          |                     |        |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|----------------------- |  | ---- | ------ | -------------------------- | ------------- | ------ | ------------------------------------------- | ------------------------ | ------------------- | ------ | -------------------------- | ----------------------------------- | - | ------------- | -- | --- | ----------------------- | --- | - | -------------------------- | -- | - |  | -- | - |  | --- | -
|                        |  | Cost |        | Net Unrealized Gain (Loss) |               |        | Estimated Fair Value of Mortgage Securities |                          | Current Assumptions |        |                            | Assumptions at Trust Securitization |  
|                        |  |      |        |                            | Discount Rate |        |                                             | Constant Prepayment Rate |                     |        | Expected Credit Losses (A) |                                     |   | Discount Rate |    |     | Constant PrepaymentRate |     |   | Expected Credit Losses (A) |   
|December 31, 2003:      |  |      |        |                            |               |        |                                             |                          |                     |        |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|NMFT 1999-1             |  |      |        |                            |               |        |                                             |                          |                     |        |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|Subordinated securities |  | $    | 6,119  |                            | $             | (101   | )                                           |                          | $                   | 6,018  |                            | 17                                  | % |               | 39 | %   |                         | 5.2 | % |                            | 17 | % |  | 30 | % |  | 2.5 | %
|                        |  |      |        |                            |               |        |                                             |                          |                    
|NMFT 2000-1             |  |      |        |                            |               |        |                                             |                          |                     |        |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|Interest only           |  |      |       |                            |               | 1,942  |                                             |                          |                     | 1,942  |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|Prepayment penalty      |  |      |       |                            |               | 244    |                                             |                          |                     | 244    |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|Subordinated securities |  |      | 299    |                            |               | 708    |                                             |                          |                     | 1,007  |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|                        |  |      |        |                            |               |        |                                             |                          |                     |        |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|                        |  |      | 299    |                            |               | 2,894  |                                             |                          |                     | 3,193  |                            | 15                                  |   |               | 57 |     |                         | 1.3 |   |                            | 15 |   |  | 27 |   |  | 1.0 |  
|NMFT 2000-2             |  |      |        |                            |               |        |                                             |                          |                     |        |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|Interest only           |  |      |       |                            |               | 3,074  |                                             |                          |                     | 3,074  |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|Prepayment penalty      |  |      |       |                            |               | 274    |                                             |                          |                     | 274    |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|Subordinated securities |  |      | 754    |                            |               | 1,993  |                                             |                          |                     | 2,747  |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|                        |  |      |        |                            |               |        |                                             |                          |                     |        |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|                        |  |      | 754    |                            |               | 5,341  |                                             |                          |                     | 6,095  |                            | 15                                  |   |               | 63 |     |                         | 1.0 |   |                            | 15 |   |  | 28 |   |  | 1.0 |  
|NMFT 2001-1             |  |      |        |                            |               |        |                                             |                          |                     |        |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|Interest only           |  |      |       |                            |               | 6,386  |                                             |                          |                     | 6,386  |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|Prepayment penalty      |  |      |       |                            |               | 518    |                                             |                          |                     | 518    |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|Subordinated securities |  |      |       |                            |               | 1,629  |                                             |                          |                     | 1,629  |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|                        |  |      |        |                            |               |        |                                             |                          |                     |        |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|                        |  |      |       |                            |               | 8,533  |                                             |                          |                     | 8,533  |                            | 20                                  |   |               | 53 |     |                         | 1.1 |   |                            | 20 |   |  | 28 |   |  | 1.2 |  
|NMFT 2001-2             |  |      |        |                            |               |        |                                             |                          |                     |        |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|Interest only           |  |      |       |                            |               | 16,343 |                                             |                          |                     | 16,343 |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|Prepayment penalty      |  |      |       |                            |               | 1,469  |                                             |                          |                     | 1,469  |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|Subordinated securities |  |      | 185    |                            |               | 3,164  |                                             |                          |                     | 3,349  |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|                        |  |      |        |                            |               |        |                                             |                          |                     |        |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|                        |  |      | 185    |                            |               | 20,976 |                                             |                          |                     | 21,161 |                            | 25                                  |   |               | 41 |     |                         | 0.9 |   |                            | 25 |   |  | 28 |   |  | 1.2 |  
|NMFT 2002-1             |  |      |        |                            |               |        |                                             |                          |                     |        |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|Interest only           |  |      | 8,437  |                            |               | 5,285  |                                             |                          |                     | 13,722 |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|Prepayment penalty      |  |      | 550    |                            |               | 937    |                                             |                          |                     | 1,487  |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|Subordinated securities |  |      | 1,183  |                            |               | 3,444  |                                             |                          |                     | 4,627  |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|                        |  |      |        |                            |               |        |                                             |                          |                     |        |                            |                                     |   |               |    |     |                         |     |   |                            |    |   |  |    |   |  |     |  
|                        |  |      | 10,170 |                            |               | 9,666  |                                             |                          |                     | 19,836 |                            | 20                                  |   |               | 45 | (B) |                         | 1.3 |   |                            | 20 |   |  | 32 |   |  | 1.7 |  



27



---

##### Table of Contents

|                        |  |      |         |                            |   |                                             |  |                     |                            |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|----------------------- |  | ---- | ------- | -------------------------- | - | ------------------------------------------- |  | ------------------- | -------------------------- | ----------------------------------- | ------------- |  | ----------------------- | --- | -------------------------- | --- |  | -- |  | -- |  | ---
|                        |  | Cost |         | Net Unrealized Gain (Loss) |   | Estimated Fair Value of Mortgage Securities |  | Current Assumptions |                            | Assumptions at Trust Securitization
|                        |  |      |         | Discount Rate              |   | Constant Prepayment Rate                    |  |                     | Expected Credit Losses (A) |                                     | Discount Rate |  | Constant PrepaymentRate |     | Expected Credit Losses (A)
|December 31, 2003:      |  |      |         |                            |   |                                             |  |                     |                            |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|NMFT 2002-2             |  |      |         |                            |   |                                             |  |                     |                            |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Interest only           |  |      | 7,093   |                            |   | 1,489                                       |  |                     | 8,582                      |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Prepayment penalty      |  |      | 582     |                            |   | 678                                         |  |                     | 1,260                      |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Subordinated securities |  |      | 1,750   |                            |   | 1,315                                       |  |                     | 3,065                      |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|                        |  |      |         |                            |   |                                             |  |                     |                            |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|                        |  |      | 9,425   |                            |   | 3,482                                       |  |                     | 12,907                     |                                     | 25            |  | 44                      | (B) |                            | 1.8 |  | 25 |  | 27 |  | 1.6
|NMFT 2002-3             |  |      |         |                            |   |                                             |  |                     |                            |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Interest only           |  |      | 20,801  |                            |   | 5,362                                       |  |                     | 26,163                     |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Prepayment penalty      |  |      | 1,348   |                            |   | 1,662                                       |  |                     | 3,010                      |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Subordinated securities |  |      | 2,225   |                            |   | 1,847                                       |  |                     | 4,072                      |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|                        |  |      |         |                            |   |                                             |  |                     |                            |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|                        |  |      | 24,374  |                            |   | 8,871                                       |  |                     | 33,245                     |                                     | 20            |  | 39                      | (B) |                            | 0.9 |  | 20 |  | 30 |  | 1.0
|NMFT 2003-1             |  |      |         |                            |   |                                             |  |                     |                            |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Interest only           |  |      | 47,352  |                            |   | 2,280                                       |  |                     | 49,632                     |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Prepayment penalty      |  |      | 3,949   |                            |   | 1,814                                       |  |                     | 5,763                      |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Subordinated securities |  |      | 6,698   |                            |   | 2,877                                       |  |                     | 9,575                      |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|                        |  |      |         |                            |   |                                             |  |                     |                            |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|                        |  |      | 57,999  |                            |   | 6,971                                       |  |                     | 64,970                     |                                     | 20            |  | 28                      | (B) |                            | 2.8 |  | 20 |  | 28 |  | 3.3
|NMFT 2003-2             |  |      |         |                            |   |                                             |  |                     |                            |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Interest only           |  |      | 58,709  |                            |   | 4,863                                       |  |                     | 63,572                     |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Prepayment penalty      |  |      | 3,042   |                            |   | 2,513                                       |  |                     | 5,555                      |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Subordinated securities |  |      | 25      |                            |   | 265                                         |  |                     | 290                        |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|                        |  |      |         |                            |   |                                             |  |                     |                            |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|                        |  |      | 61,776  |                            |   | 7,641                                       |  |                     | 69,417                     |                                     | 28            |  | 30                      | (B) |                            | 2.6 |  | 28 |  | 25 |  | 2.7
|NMFT 2003-3             |  |      |         |                            |   |                                             |  |                     |                            |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Interest only           |  |      | 72,637  |                            |   | 3,128                                       |  |                     | 75,765                     |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Prepayment penalty      |  |      | 3,098   |                            |   | 1,830                                       |  |                     | 4,928                      |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Subordinated securities |  |      | 1,628   |                            |   | 3,535                                       |  |                     | 5,163                      |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|                        |  |      |         |                            |   |                                             |  |                     |                            |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|                        |  |      | 77,363  |                            |   | 8,493                                       |  |                     | 85,856                     |                                     | 20            |  | 26                      | (B) |                            | 3.4 |  | 20 |  | 22 |  | 3.6
|NMFT 2003-4             |  |      |         |                            |   |                                             |  |                     |                            |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Interest only           |  |      | 41,668  |                            |   | 4,107                                       |  |                     | 45,775                     |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Prepayment penalty      |  |      | 4,430   |                            |   | 61                                          |  |                     | 4,491                      |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Subordinated securities |  |      |        |                            |   | 790                                         |  |                     | 790                        |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|                        |  |      |         |                            |   |                                             |  |                     |                            |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|                        |  |      | 46,098  |                            |   | 4,958                                       |  |                     | 51,056                     |                                     | 20            |  | 33                      | (B) |                            | 5.3 |  | 20 |  | 30 |  | 5.1
|                        |  |      |         |                            |   |                                             |  |                     |                            |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|Total                   |  | $    | 294,562 |                            | $ | 87,725                                      |  | $                   | 382,287                    |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    
|                        |  |      |         |                            |   |                                             |  |                     |                            |                                     |               |  |                         |     |                            |     |  |    |  |    |  |    

---

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

|(B) | Amounts have been corrected to properly reflect the constant prepayment rates used in the valuation of our mortgage securities as of December 31, 2003 based on the expected date in
which the related asset-backed bonds can be called.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



28



---

##### Table of Contents

The following table summarizes the cost basis, unrealized gain (loss) and fair value of our mortgage
securities with the mortgage securities 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 Retained by Year of Issue

(in thousands)



|                                               |      |                    |                        |               |            |                |      |   |                        |  |            |         |      |   |                        |  |            |         |  |   |         |  |   |        |  |   |        
|---------------------------------------------- | ---- | ------------------ | ---------------------- | ------------- | ---------- | -------------- | ---- | - | ---------------------- |  | ---------- | ------- | ---- | - | ---------------------- |  | ---------- | ------- |  | - | ------- |  | - | ------ |  | - | -------
|                                               |      | 2004              
|Year of Issue
for Mortgage Securities Retained |      | As of September 30 |                        | As of June 30 |            | As of March 31
|                                               | Cost |                    | Unrealized Gain (Loss) |               | Fair Value |                | Cost |   | Unrealized Gain (Loss) |  | Fair Value |         | Cost |   | Unrealized Gain (Loss) |  | Fair Value
|1999                                           |      | $                  | 6,818                  |               |            |               |      | $ | 6,818                  |  | $          | 6,597   |      |   |                       |  | $          | 6,597   |  | $ | 6,353   |  | $ | 185    |  | $ | 6,538  
|2000                                           |      |                    | 539                    |               |            | 3,046          |      |   | 3,585                  |  |            | 412     |      |   | 5,161                  |  |            | 5,573   |  |   | 1,298   |  |   | 8,194  |  |   | 9,492  
|2001                                           |      |                    |                       |               |            | 16,064         |      |   | 16,064                 |  |            | 321     |      |   | 20,910                 |  |            | 21,231  |  |   | 233     |  |   | 27,579 |  |   | 27,812 
|2002                                           |      |                    | 23,978                 |               |            | 14,181         |      |   | 38,159                 |  |            | 29,202  |      |   | 14,067                 |  |            | 43,269  |  |   | 36,201  |  |   | 18,899 |  |   | 55,100 
|2003                                           |      |                    | 142,796                |               |            | 28,458         |      |   | 171,254                |  |            | 184,097 |      |   | 8,841                  |  |            | 192,938 |  |   | 226,676 |  |   | 16,090 |  |   | 242,766
|2004                                           |      |                    | 218,898                |               |            | 7,709          |      |   | 226,607                |  |            | 118,684 |      |   | 758                    |  |            | 119,442 |  |   | 60,961  |  |   | 1,334  |  |   | 62,295 
|                                               |      |                    |                        |               |            |                |      |   |                        |  |            |         |      |   |                        |  |            |         |  |   |         |  |   |        |  |   |        
|Total                                          |      | $                  | 393,029                |               | $          | 69,458         |      | $ | 462,487                |  | $          | 339,313 |      | $ | 49,737                 |  | $          | 389,050 |  | $ | 331,722 |  | $ | 72,281 |  | $ | 404,003
|                                               |      |                    |                        |               |            |                |      |   |                        |  |            |         |      |   |                        |  |            |         |  |   |         |  |   |        |  |   |        



|                                             |      |                   |                        |                    |   |               |   |                |   |                        |  |   |            |  |      |        |                        |  |   |            |  |      |         |                        |   |        |            |  |   |         |  |   |         |  |   |        |   |  |   |        
|-------------------------------------------- | ---- | ----------------- | ---------------------- | ------------------ | - | ------------- | - | -------------- | - | ---------------------- |  | - | ---------- |  | ---- | ------ | ---------------------- |  | - | ---------- |  | ---- | ------- | ---------------------- | - | ------ | ---------- |  | - | ------- |  | - | ------- |  | - | ------ | - |  | - | -------
|                                             |      | 2003             
|Year of Issue for MortgageSecuritiesRetained |      | As of December 31 |                        | As of September 30 |   | As of June 30 |   | As of March 31
|                                             | Cost |                   | Unrealized Gain (Loss) |                    |   | Fair Value    |   | Cost           |   | Unrealized Gain (Loss) |  |   | Fair Value |  | Cost |        | Unrealized Gain (Loss) |  |   | Fair Value |  | Cost |         | Unrealized Gain (Loss) |   |        | Fair Value
|1999                                         |      | $                 | 6,119                  |                    | $ | (101          | ) |                | $ | 6,018                  |  | $ | 6,014      |  | $    | (423   | )                      |  | $ | 5,591      |  | $    | 5,938   |                        | $ | (363   | )          |  | $ | 5,575   |  | $ | 5,864   |  | $ | (655   | ) |  | $ | 5,209  
|2000                                         |      |                   | 1,053                  |                    |   | 8,235         |   |                |   | 9,288                  |  |   | 1,040      |  |      | 10,154 |                        |  |   | 11,194     |  |      | 1,289   |                        |   | 11,929 |            |  |   | 13,218  |  |   | 2,327   |  |   | 12,352 |   |  |   | 14,679 
|2001                                         |      |                   | 185                    |                    |   | 29,509        |   |                |   | 29,694                 |  |   | 1,419      |  |      | 35,459 |                        |  |   | 36,878     |  |      | 5,426   |                        |   | 41,359 |            |  |   | 46,785  |  |   | 10,310  |  |   | 43,527 |   |  |   | 53,837 
|2002                                         |      |                   | 43,969                 |                    |   | 22,019        |   |                |   | 65,988                 |  |   | 50,848     |  |      | 25,869 |                        |  |   | 76,717     |  |      | 58,883  |                        |   | 27,345 |            |  |   | 86,228  |  |   | 66,928  |  |   | 26,775 |   |  |   | 93,703 
|2003                                         |      |                   | 243,236                |                    |   | 28,063        |   |                |   | 271,299                |  |   | 189,710    |  |      | 17,542 |                        |  |   | 207,252    |  |      | 132,959 |                        |   | 16,167 |            |  |   | 149,126 |  |   | 67,134  |  |   | 7,515  |   |  |   | 74,649 
|                                             |      |                   |                        |                    |   |               |   |                |   |                        |  |   |            |  |      |        |                        |  |   |            |  |      |         |                        |   |        |            |  |   |         |  |   |         |  |   |        |   |  |   |        
|Total                                        |      | $                 | 294,562                |                    | $ | 87,725        |   |                | $ | 382,287                |  | $ | 249,031    |  | $    | 88,601 |                        |  | $ | 337,632    |  | $    | 204,495 |                        | $ | 96,437 |            |  | $ | 300,932 |  | $ | 152,563 |  | $ | 89,514 |   |  | $ | 242,077
|                                             |      |                   |                        |                    |   |               |   |                |   |                        |  |   |            |  |      |        |                        |  |   |            |  |      |         |                        |   |        |            |  |   |         |  |   |         |  |   |        |   |  |   |        



Mortgage Servicing
Rights. As discussed under Mortgage Securities  Available for Sale, we retain the right to service mortgage loans we originate and have securitized. Servicing rights for loans we sell to third parties are not retained and we
have not purchased the right to service loans. As of September 30, 2004, we have $33.7 million in capitalized mortgage servicing rights compared with $19.7 million as of December 31, 2003. The value of the mortgage servicing rights we retained in
our securitizations during the first nine months of 2004 and 2003 was $25.6 million and $14.3 million, respectively. Amortization of mortgage servicing rights was $11.6 million and $4.5 million for the nine and three months ended September 30, 2004,
respectively, compared to $6.2 million and $2.6 million for the same period of 2003.



Servicing Related Advances.Advances on behalf of borrowers for taxes, insurance and other customer service functions are made by NovaStar Mortgage and aggregated $20.9 million as of September 30, 2004 compared
with $19.3 million as of December 31, 2003. These balances will generally increase as our assets and loan servicing balances increase.



Deposits with derivative instrument counterparties, net.Deposits with derivative instrument counterparties, net decreased from $19.5 million at
December 31, 2003 to $18.5 million at September 30, 2004. Derivative instruments 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.



Other
Assets. Included in other assets are receivables from securitizations, warehouse loans receivable, tax assets and other miscellaneous assets. Our receivables from securitizations were $8.8 million and $6.2 million at September 30, 2004 and
December 31, 2003, respectively. These receivables represent cash due to us on our mortgage securities. As of September 30, 2004 we had warehouse loans receivable of $8.5 million. 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 September 30, 2004, we had a tax asset of $25.8 million that includes deferred and current portions of income tax compared to
$10.5 million as of December 31, 2003.



29



---

##### Table of Contents

Short-term Financing Arrangements. Mortgage loan originations are funded with various financing
facilities prior to securitization. Repurchase agreements are used as interim, short-term financing before loans are transferred in our securitization transactions. The balances outstanding under our short-term arrangements fluctuate based on
lending volume, cash flows from operating, investing and other financing activities and equity transactions. As shown in Table 5, we have $190.9 million in immediately available funds as of September 30, 2004. We have borrowed approximately $1.1
billion of the $2.9 billion in committed lines of credit and mortgage securities repurchase facilities, leaving approximately $1.8 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                                                 |  |              |           |                             |   |            |  |              |           |  | $ | 190,890
|Lines of credit and mortgage and securities repurchase facilities |  | $            | 2,925,000 |                             | $ | 1,146,742  |  | $            | 1,146,742 |  | $ |       
|                                                                  |  |              |           |                             |   |            |  |              |           |  |   |        
|Total.                                                            |  | $            | 2,925,000 |                             | $ | 1,146,742  |  | $            | 1,146,742 |  | $ | 190,890
|                                                                  |  |              |           |                             |   |            |  |              |           |  |   |        



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



On February 19, 2004, we issued asset-backed bonds, NIMS 2004-N1, in the amount of $156.6 million secured by the interest only, prepayment penalty and
subordinated mortgage securities of NMFT 2003-3 and NMFT 2003-4 as a means for long-term financing. On July 23, 2004, we issued asset-backed bonds, NIMS 2004-N2, in the amount of $157.5 million secured by the interest only, prepayment penalty and
subordinated mortgage securities of NMFT 2004-1 and NMFT 2004-2 as a means for long-term financing. The mortgage securities are recorded as assets and the asset-backed bonds are recorded as debt. 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.



Accounts Payable and Other Liabilities. Included in accounts payable
and other liabilities is the provision for removal of loans from securitization trusts, accrued payroll and other liabilities. A provision within the trust for each of our securitization transactions gives us the right, not the obligation, to
repurchase loans from the trust that are between 90 and 119 days delinquent. In accordance with SFAS No. 140, we are required to record the loans that meet this definition and a corresponding liability to the trust on our balance sheet at fair
value. As of September 30, 2004 and December 31, 2003, our liability related to this provision was $19.2 million and $14.5 million, respectively. This liability should generally increase as we continue to securitize the loans we originate. Our
accrued payroll increased from $18.1 million at December 31, 2003 to $31.6 million at September 30, 2004. The increase in accrued payroll is due to our change from a semi-monthly payroll to a bi-weekly payroll.



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



The increase in our stockholders equity as of September 30, 2004 compared to December 31, 2003 is a result of the
following increases and decreases.



30



---

##### Table of Contents

Stockholders equity increased by:



| |  | $90.9 million increase due to net income recognized for the nine months ended September 30, 2004
| | - | ------------------------------------------------------------------------------------------------



| |  | $72.1 million increase due to issuance of preferred stock
| | - | ---------------------------------------------------------



| |  | $31.6 million increase due to issuance of common stock
| | - | ------------------------------------------------------



| |  | $2.9 million increase due to net settlements on cash flow hedges reclassified to earnings
| | - | -----------------------------------------------------------------------------------------



| |  | $3.2 million increase due to compensation recognized under stock option plan
| | - | ----------------------------------------------------------------------------



| |  | $1.7 million increase due to exercise of stock options, and
| | - | -----------------------------------------------------------



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



Stockholders equity decreased by:



| |  | $103.2 million decrease due to dividends accrued or paid on common stock
| | - | ------------------------------------------------------------------------



| |  | $18.3 million decrease due to decrease in unrealized gains on mortgage securities classified as available-for-sale
| | - | ------------------------------------------------------------------------------------------------------------------



| |  | $4.6 million decrease due to dividends accrued or paid on preferred stock, and
| | - | ------------------------------------------------------------------------------



| |  | $0.5 million decrease due to increase in unrealized losses on derivative instruments used in cash flow hedges.
| | - | --------------------------------------------------------------------------------------------------------------



Results of Operations



During the nine and three months ended September 30, 2004, we earned net income of $90.9 million and $24.4 million, or $3.40
and $0.89 per diluted share, respectively, compared with net income of $76.8 million and $25.1 million, or $3.43 and $1.09 per diluted share for the same period of 2003.



Our primary sources of revenue are interest earned on our mortgage loan and securities portfolios, fees from borrowers and
gains on sales and securitizations of mortgage loans. Earnings increased during 2004 as compared to 2003 due primarily to higher volumes of average mortgage securities held and mortgage loan originations securitized. The effects of the higher
mortgage security volume is displayed in Table 6. Details regarding higher mortgage loan origination volumes and gains on securitization of these assets are shown in Tables 1, 8 and 9.



Net Interest Income



Our securities 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 securitization trusts to help reduce this interest rate risk and to decrease the volatility of future cash flows related to the securitized mortgage loans. As a result, future interest income on our
mortgage securities is expected to be less volatile. The spreads on our newer mortgage securities have returned to expected or normal levels as a result of this interest rate risk management strategy and also as a result of the coupon on the
mortgage loans adjusting downward. Since we did not transfer interest rate agreements into the trusts prior to 2002, our older securities continue to experience high yields as a result of the dramatic decrease in one-month LIBOR in 2002 and the
first half of 2003. However, the increase in one-month LIBOR in 2004 has caused our overall securities yields to decrease from the yields we experienced in 2003.



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 retained. Based on these factors, as shown in Table 6, we experienced a decrease in the average net yield on our securities from 31.4% and 30.1% for the nine and three months ended September 30, 2003,
respectively, compared to 27.9% and 25.7% for the same period of 2004.



The overall dollar volume of interest income has increased primarily because the size of our mortgage securities portfolio has increased significantly during the past year. As shown in Tables 6 and 7, the average value of our mortgage
securities increased from $264.9 million and $319.3 million during the nine and three months ended September 30, 2003, respectively to $409.5 million and $425.8 million during the same period of 2004. The average balance of mortgage loans
collateralizing our securities increased from $3.7 billion and $4.8 billion during the nine and three months ended September 30, 2003 to $7.8 billion and $8.7 billion during the nine and three months ended September 30, 2004. We expect to increase
the amount of mortgage securities we own as we securitize the mortgage loans we originate.



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



31



---

##### Table of Contents

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 $31.4
million and $9.4 million for the nine and three months ended September 30, 2003 to $42.5 million and $18.1 million for the same period of 2004. The net interest income from mortgage loans is primarily driven by loan volume and the amount of time
held-for-sale loans are in the warehouse.



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



Table 6 is a summary of the interest income and expense related to our mortgage securities and the related yields as a percentage of the fair market value
of these securities for the nine and three months ended September 30, 2004 and 2003.



Table 6  Mortgage Securities Interest Analysis

(dollars in thousands)



|                                                 |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |         |  
|------------------------------------------------ |  | --------------------------------------- | ------- | - | ---------------------------------------- | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                                                 |  | For the Nine Months Ended September 30, |         |   | For the Three Months Ended September 30, |  
|                                                 |  | 2004                                    |         |   | 2003                                     |   |         | 2004 |  |   | 2003    |  
|Average fair market value of mortgage securities |  | $                                       | 409,457 |   |                                          | $ | 264,880 |      |  | $ | 425,769 |   |  | $ | 319,282 |  
|Average borrowings                               |  |                                         | 323,741 |   |                                          |   | 204,934 |      |  |   | 351,780 |   |  |   | 248,838 |  
|                                                 |  |                                         |         |  
|Interest income                                  |  | $                                       | 97,220  |   |                                          | $ | 68,286  |      |  | $ | 31,887  |   |  | $ | 26,611  |  
|Interest expense                                 |  |                                         | 11,686  |   |                                          |   | 5,942   |      |  |   | 4,500   |   |  |   | 2,575   |  
|                                                 |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |         |  
|Net interest income                              |  | $                                       | 85,534  |   |                                          | $ | 62,344  |      |  | $ | 27,387  |   |  | $ | 24,036  |  
|                                                 |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |         |  
|Yields:                                          |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |         |  
|Interest income                                  |  |                                         | 31.7    | % |                                          |   | 34.4    | %    |  |   | 29.9    | % |  |   | 33.3    | %
|Interest expense                                 |  |                                         | 4.8     |   |                                          |   | 3.9     |      |  |   | 5.1     |   |  |   | 4.1     |  
|                                                 |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |         |  
|Net interest spread                              |  |                                         | 26.9    | % |                                          |   | 30.5    | %    |  |   | 24.8    | % |  |   | 29.2    | %
|                                                 |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |         |  
|Net Yield                                        |  |                                         | 27.9    | % |                                          |   | 31.4    | %    |  |   | 25.7    | % |  |   | 30.1    | %
|                                                 |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |         |  



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. 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.



The net interest income for mortgage securities, mortgage loans held-for-sale
and mortgage loans held-in-portfolio reflect the income after interest expense, hedging, prepayment penalty income and credit expense (mortgage insurance and provision to loss reserve). Table 7 shows the net yield in both assets under management and
the return on assets during the nine and three months ended September 30, 2004 and 2003.



32



---

##### Table of Contents

Table 7  Mortgage Portfolio Management Net Interest Income Analysis

(dollars in thousands)



|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |           |  
|----------------------------------------------------------- |  | ------------------- | --------- | - | ----------------------------- | - | --------- | --------------------------------- |  | - | ------- | - |  | - | --------- | -
|For the Nine Months Ended:                                  |  | Mortgage Securities |           |   | Mortgage Loans Held-for- Sale |   |           | Mortgage Loans Held-in- Portfolio |  |   | Total   |  
|September 30, 2004                                          |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |           |  
|Interest income                                             |  | $                   | 97,220    |   |                               | $ | 61,288    |                                   |  | $ | 5,316   |   |  | $ | 163,824   |  
|Interest expense:                                           |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |           |  
|Short-term borrowings (A)                                   |  |                     | 3,285     |   |                               |   | 20,223    |                                   |  |   |        |   |  |   | 23,508    |  
|Asset-backed bonds                                          |  |                     | 8,401     |   |                               |   |          |                                   |  |   | 1,041   |   |  |   | 9,442     |  
|Cash flow hedging net settlements                           |  |                     |          |   |                               |   | 1,292     |                                   |  |   | 1,558   |   |  |   | 2,850     |  
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |           |  
|Total interest expense                                      |  |                     | 11,686    |   |                               |   | 21,515    |                                   |  |   | 2,599   |   |  |   | 35,800    |  
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |           |  
|Mortgage portfolio net interest income before other expense |  |                     | 85,534    |   |                               |   | 39,773    |                                   |  |   | 2,717   |   |  |   | 128,024   |  
|Other expense (B)                                           |  |                     |          |   |                               |   | (18,977   | )                                 |  |   | (1,261  | ) |  |   | (20,238   | )
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |           |  
|Mortgage portfolio net interest income                      |  | $                   | 85,534    |   |                               | $ | 20,796    |                                   |  | $ | 1,456   |   |  | $ | 107,786   |  
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |           |  
|Average balance of the underlying loans                     |  | $                   | 7,763,688 |   |                               | $ | 1,090,414 |                                   |  | $ | 75,849  |   |  | $ | 8,929,951 |  
|Net interest yield on assets                                |  |                     | 1.47      | % |                               |   | 2.54      | %                                 |  |   | 2.56    | % |  |   | 1.61      | %
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |           |  
|September 30, 2003                                          |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |           |  
|Interest income                                             |  | $                   | 68,286    |   |                               | $ | 47,172    |                                   |  | $ | 8,644   |   |  | $ | 124,102   |  
|Interest expense:                                           |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |           |  
|Short-term borrowings (A)                                   |  |                     | 2,163     |   |                               |   | 15,524    |                                   |  |   |        |   |  |   | 17,687    |  
|Asset-backed bonds                                          |  |                     | 3,779     |   |                               |   |          |                                   |  |   | 1,848   |   |  |   | 5,627     |  
|Cash flow hedging net settlements                           |  |                     |          |   |                               |   | 2,124     |                                   |  |   | 4,961   |   |  |   | 7,085     |  
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |           |  
|Total interest expense                                      |  |                     | 5,942     |   |                               |   | 17,648    |                                   |  |   | 6,809   |   |  |   | 30,399    |  
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |           |  
|Mortgage portfolio net interest income before other expense |  |                     | 62,344    |   |                               |   | 29,524    |                                   |  |   | 1,835   |   |  |   | 93,703    |  
|Other expense (B)                                           |  |                     |          |   |                               |   | (7,391    | )                                 |  |   | 363     |   |  |   | (7,028    | )
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |           |  
|Mortgage portfolio net interest income                      |  | $                   | 62,344    |   |                               | $ | 22,133    |                                   |  | $ | 2,198   |   |  | $ | 86,675    |  
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |           |  
|Average balance of the underlying loans                     |  | $                   | 3,717,057 |   |                               | $ | 825,177   |                                   |  | $ | 123,245 |   |  | $ | 4,665,479 |  
|Net interest yield on assets                                |  |                     | 2.24      | % |                               |   | 3.58      | %                                 |  |   | 2.38    | % |  |   | 2.48      | %
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |           |  



33



---

##### Table of Contents

|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |            |  
|----------------------------------------------------------- |  | ------------------- | --------- | - | ----------------------------- | - | --------- | --------------------------------- |  | - | ------- | - |  | - | ---------- | -
|For the Three Months Ended:                                 |  | Mortgage Securities |           |   | Mortgage Loans Held-for- Sale |   |           | Mortgage Loans Held-in- Portfolio |  |   | Total   |  
|September 30, 2004                                          |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |            |  
|Interest income                                             |  | $                   | 31,887    |   |                               | $ | 26,378    |                                   |  | $ | 1,524   |   |  | $ | 59,789     |  
|Interest expense:                                           |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |            |  
|Short-term borrowings (A)                                   |  |                     | 942       |   |                               |   | 9,231     |                                   |  |   |        |   |  |   | 10,173     |  
|Asset-backed bonds                                          |  |                     | 3,558     |   |                               |   |          |                                   |  |   | 350     |   |  |   | 3,908      |  
|Cash flow hedging net settlements                           |  |                     |          |   |                               |   | 269       |                                   |  |   |        |   |  |   | 269        |  
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |            |  
|Total interest expense                                      |  |                     | 4,500     |   |                               |   | 9,500     |                                   |  |   | 350     |   |  |   | 14,350     |  
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |            |  
|Mortgage portfolio net interest income before other expense |  |                     | 27,387    |   |                               |   | 16,878    |                                   |  |   | 1,174   |   |  |   | 45,439     |  
|Other expense (B)                                           |  |                     |          |   |                               |   | (7,517    | )                                 |  |   | (308    | ) |  |   | (7,825     | )
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |            |  
|Mortgage portfolio net interest income                      |  | $                   | 27,387    |   |                               | $ | 9,361     |                                   |  | $ | 866     |   |  | $ | 37,614     |  
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |            |  
|Average balance of the underlying loans                     |  | $                   | 8,690,208 |   |                               | $ | 1,430,323 |                                   |  | $ | 67,008  |   |  | $ | 10,187,539 |  
|Net interest yield on assets                                |  |                     | 1.26      | % |                               |   | 2.62      | %                                 |  |   | 5.17    | % |  |   | 1.48       | %
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |            |  
|September 30, 2003                                          |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |            |  
|Interest income                                             |  | $                   | 26,611    |   |                               | $ | 14,551    |                                   |  | $ | 2,628   |   |  | $ | 43,790     |  
|Interest expense:                                           |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |            |  
|Short-term borrowings (A)                                   |  |                     | 793       |   |                               |   | 5,002     |                                   |  |   |        |   |  |   | 5,795      |  
|Asset-backed bonds                                          |  |                     | 1,782     |   |                               |   |          |                                   |  |   | 477     |   |  |   | 2,259      |  
|Cash flow hedging net settlements                           |  |                     |          |   |                               |   | 747       |                                   |  |   | 1,520   |   |  |   | 2,267      |  
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |            |  
|Total interest expense                                      |  |                     | 2,575     |   |                               |   | 5,749     |                                   |  |   | 1,997   |   |  |   | 10,321     |  
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |            |  
|Mortgage portfolio net interest income before other expense |  |                     | 24,036    |   |                               |   | 8,802     |                                   |  |   | 631     |   |  |   | 33,469     |  
|Other expense (B)                                           |  |                     |          |   |                               |   | (2,496    | )                                 |  |   | 534     |   |  |   | (1,962     | )
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |            |  
|Mortgage portfolio net interest income                      |  | $                   | 24,036    |   |                               | $ | 6,306     |                                   |  | $ | 1,165   |   |  | $ | 31,507     |  
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |            |  
|Average balance of the underlying loans                     |  | $                   | 4,751,484 |   |                               | $ | 770,687   |                                   |  | $ | 109,118 |   |  | $ | 5,631,289  |  
|Net interest yield on assets                                |  |                     | 2.02      | % |                               |   | 3.27      | %                                 |  |   | 4.27    | % |  |   | 2.24       | %
|                                                            |  |                     |           |   |                               |   |           |                                   |  |   |         |   |  |   |            |  

---

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

|(B) | Other expense includes prepayment penalty income, 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 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 $19.4 million and $6.6 million related to the net settlements of our interest rate agreements for the nine
and three months ended September 30, 2004, respectively, compared with $12.5 million and $4.3 million for the same period of 2003. Fluctuations in these expenses are solely dependent upon the movement in LIBOR as well as our average notional amount
outstanding.



Credit (Losses) Recoveries



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



34



---

##### Table of Contents

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 nine and three months ended September 30, 2004 we recognized net credit losses of $843,000 and $182,000, respectively, compared with net credit recoveries of $1.1 million and $0.9 million for the same period of 2003. We incurred
net charge-offs of $1.4 million and $363,000 for the nine and three months ended September 30, 2004, respectively, compared with $478,000 and $149,000 for the same period of 2003.



Fee Income



Fee income in 2004 primarily consists of broker fees and service fee income. During 2003, affiliated branch management fees were also a component of 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 in 2004.



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



Affiliated branch management fees, a source of fee income in
2003, were charged to affiliated mortgage brokers to manage their administrative operations, which included providing accounting, payroll, human resources, loan investor management and license management services. The amount of the fees was agreed
upon when entering a contractual agreement with affiliated mortgage brokers and were recognized as services were rendered. Affiliated branch management fees were $9.5 million and $3.9 million for the nine and three months ended September 30, 2003.



Overall, fee income increased from $52.7 million and $18.5
million for the nine and three months ended September 30, 2003 to $100.3 million and $34.3 million for the same period of 2004 due primarily to the termination of the LLCs and the inclusion of those branches in our consolidated financial
statements. This had a significant impact on fee income due to the volume of broker fee income that these branches generate. For comparative purposes, if the LLCs had been operating units during 2003 fee income would have been $88.8 million
and $34.0 million for the nine and three months ended September 30, 2003, respectively.



Additionally, fee income increased due to the increase in our servicing portfolio from $6.2 billion as of September 30, 2003 to $11.1 billion as of September 30, 2004.



35



---

##### Table of Contents

Gains on Sales of Mortgage Assets and Losses on Derivative Instruments



We execute securitization transactions in which we transfer mortgage loan
collateral to an independent trust. The trust holds the mortgage loans as collateral for the securities it issues to finance the sale of the mortgage loans. In those transactions, certain securities are issued to entities unrelated to us, and we
retain the interest-only and non-investment grade subordinated securities. In addition, we continue to service the loan collateral. These transactions were structured as sales for accounting and income tax reporting during the nine months ended
September 30, 2004 and 2003. Whole loan sales have also been executed whereby we sell loans to third parties. In the outright sales of mortgage loans, we retain no assets or servicing rights. Table 9 provides a summary of mortgage loans sold
outright and transferred in securitizations.



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 losses of $17.8 million and $19.5 million during the nine and three months ended September 30, 2004, respectively, compared with $32.3 million
and $8.1 million for the same period of 2003, reflective of the corresponding decrease in fair value of these non-hedge derivative instruments.



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



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

(in thousands)



|                                                                  |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|----------------------------------------------------------------- |  | --------------------------------------- | ------- | - | ---------------------------------------- | - | ------- | ---- |  | - | ------- | - |  | - | ------ | -
|                                                                  |  | For the Nine Months Ended September 30, |         |   | For the Three Months Ended September 30, |  
|                                                                  |  | 2004                                    |         |   | 2003                                     |   |         | 2004 |  |   | 2003    |  
|Gains on sales of mortgage loans transferred in securitizations   |  | $                                       | 122,531 |   |                                          | $ | 99,198  |      |  | $ | 46,551  |   |  | $ | 32,853 |  
|Gains on sales of mortgage loans to third parties  nonconforming |  |                                         |        |   |                                          |   | 3,404   |      |  |   |        |   |  |   | 428    |  
|Gains on sales of mortgage loans to third parties  conforming    |  |                                         | 1,133   |   |                                          |   | 6,743   |      |  |   | 282     |   |  |   | 1,591  |  
|Losses on sales of real estate owned                              |  |                                         | (295    | ) |                                          |   | (1,683  | )    |  |   | (418    | ) |  |   | (684   | )
|                                                                  |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Gains on sales of mortgage assets                                 |  |                                         | 123,369 |   |                                          |   | 107,662 |      |  |   | 46,415  |   |  |   | 34,188 |  
|Losses on derivatives                                             |  |                                         | (17,819 | ) |                                          |   | (32,330 | )    |  |   | (19,536 | ) |  |   | (8,144 | )
|                                                                  |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  
|Net gains on sales of mortgage assets and derivative instruments  |  | $                                       | 105,550 |   |                                          | $ | 75,332  |      |  | $ | 26,879  |   |  | $ | 26,044 |  
|                                                                  |  |                                         |         |   |                                          |   |         |      |  |   |         |   |  |   |        |  



36



---

##### Table of Contents

Table 9  Mortgage Loan Sales and Securitizations

(dollars in thousands)



|                                                    |  |                                  |         |                        |     |   |                     |   |                               |  |      
|--------------------------------------------------- |  | -------------------------------- | ------- | ---------------------- | --- | - | ------------------- | - | ----------------------------- |  | -----
|                                                    |  | Outright Mortgage Loan Sales (A)
|For the Year Ended December
31,                     |  | Principal Amount                 |         | Percent of Total Sales |     |   | Net Gain Recognized |   | Weighted Average Price To Par
|2004:                                               |  |                                  |         |                        |     |   |                     |   |                               |  |      
|There were no outright mortgage loan sales in 2004. |  |                                 
|                                                    |  |                                  |         |                       
|2003:                                               |  |                                  |         |                        |     |   |                     |   |                               |  |      
|Fourth quarter                                      |  | $                                |        |                        |    | % |                     | $ |                              |  |     
|Third quarter                                       |  |                                  | 27,085  |                        | 2.1 |   |                     |   | 428                           |  | 102.7
|Second quarter                                      |  |                                  | 12,057  |                        | 0.9 |   |                     |   | 101                           |  | 105.3
|First quarter                                       |  |                                  | 112,068 |                        | 9.4 |   |                     |   | 2,875                         |  | 104.3
|                                                    |  |                                  |         |                        |     |   |                     |   |                               |  |      
|Total                                               |  | $                                | 151,210 |                        | 2.8 | % |                     | $ | 3,404                         |  | 104.1
|                                                    |  |                                  |         |                        |     |   |                     |   |                               |  |      



|                                |  |                                               |           |                        |       |   |                     |   |                                      |  |                                                                              |         |               |    |  |                                                         |   |  |      |  
|------------------------------- |  | --------------------------------------------- | --------- | ---------------------- | ----- | - | ------------------- | - | ------------------------------------ |  | ---------------------------------------------------------------------------- | ------- | ------------- | -- |  | ------------------------------------------------------- | - |  | ---- | -
|                                |  | Mortgage Loans Transferred in Securitizations |          
|                                |  |                                               |           |                        |       |   |                     |   |                                      |  | Weighted Average Assumptions Underlying Initial Value of Mortgage Securities |        
|For the Year Ended December
31, |  | Principal Amount                              |           | Percent of Total Sales |       |   | Net Gain Recognized |   | Initial Value of Mortgage Securities |  | Constant Prepayment Rate                                                     |         | Discount Rate |    |  | Expected Total Credit Losses, Net of Mortgage Insurance |  
|2004:                           |  |                                               |           |                        |       |   |                     |   |                                      |  |                                                                              |         |               |    |  |                                                         |   |  |      |  
|Third quarter                   |  | $                                             | 2,759,716 |                        | 100.0 | % |                     | $ | 46,551                               |  | $                                                                            | 129,748 |               | 33 |  | 21                                                      | % |  | 4.61 | %
|Second quarter                  |  |                                               | 1,367,430 |                        | 100.0 |   |                     |   | 24,888                               |  |                                                                              | 77,695  |               | 32 |  | 23                                                      |   |  | 5.42 |  
|First quarter                   |  |                                               | 1,702,658 |                        | 100.0 |   |                     |   | 51,092                               |  |                                                                              | 85,270  |               | 32 |  | 20                                                      |   |  | 5.69 |  
|                                |  |                                               |           |                        |       |   |                     |   |                                      |  |                                                                              |         |               |    |  |                                                         |   |  |      |  
|Total                           |  | $                                             | 5,829,804 |                        | 100.0 | % |                     | $ | 122,531                              |  | $                                                                            | 292,713 |               | 33 |  | 21                                                      | % |  | 5.12 | %
|                                |  |                                               |           |                        |       |   |                     |   |                                      |  |                                                                              |         |               |    |  |                                                         |   |  |      |  
|2003:                           |  |                                               |           |                        |       |   |                     |   |                                      |  |                                                                              |         |               |    |  |                                                         |   |  |      |  
|Fourth quarter                  |  | $                                             | 1,668,780 |                        | 100.0 | % |                     | $ | 37,104                               |  | $                                                                            | 86,166  |               | 28 |  | 20                                                      | % |  | 4.45 | %
|Third quarter                   |  |                                               | 1,251,016 |                        | 97.9  |   |                     |   | 32,853                               |  |                                                                              | 70,793  |               | 23 |  | 22                                                      |   |  | 3.33 |  
|Second quarter                  |  |                                               | 1,314,733 |                        | 99.1  |   |                     |   | 41,389                               |  |                                                                              | 73,053  |               | 26 |  | 26                                                      |   |  | 2.81 |  
|First quarter                   |  |                                               | 1,084,906 |                        | 90.6  |   |                     |   | 24,956                               |  |                                                                              | 69,740  |               | 28 |  | 20                                                      |   |  | 3.30 |  
|                                |  |                                               |           |                        |       |   |                     |   |                                      |  |                                                                              |         |               |    |  |                                                         |   |  |      |  
|Total                           |  | $                                             | 5,319,435 |                        | 97.2  | % |                     | $ | 136,302                              |  | $                                                                            | 299,752 |               | 26 |  | 22                                                      | % |  | 3.55 | %
|                                |  |                                               |           |                        |       |   |                     |   |                                      |  |                                                                              |         |               |    |  |                                                         |   |  |      |  

---

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



Premiums for Mortgage Loan Insurance



The use of mortgage insurance is one method of managing the credit risk in the mortgage asset portfolio. Premiums for mortgage insurance on loans
maintained on our balance sheet are paid by us and are recorded as a portfolio cost and included in the income statement under the caption Premiums for Mortgage Loan Insurance. These premiums totaled $2.9 million and $1.3 million for the
nine and three months ended September 30, 2004, respectively, compared with $2.7 million and $0.7 million for the same period of 2003. We received mortgage insurance proceeds on claims filed of $2.1 million and $0.5 million during the nine and three
months ended September 30, 2004, respectively, compared with $1.4 million and $0.5 million for the same period of 2003.



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



We intend to continue to use mortgage insurance coverage as a credit
management tool as we continue to originate and securitize mortgage loans. 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



37



---

##### Table of Contents

securities consider this risk. The percentage of loans with mortgage insurance has decreased in 2004 and 2003 and
generally should be lower than 50% in the future. For the 2004-1, 2004-2 and 2004-3 securitizations, the mortgage loans that were transferred into the trusts had mortgage insurance coverage at the time of transfer of 26%, 38% and 35%, respectively.
We have the risk that mortgage insurance providers will revise their guidelines to an extent where we will no longer be able to acquire coverage on all of our new production. Similarly, the providers may also increase insurance premiums to a point
where the cost of coverage outweighs its benefit. We monitor the mortgage insurance market and currently anticipate being able to obtain affordable coverage to the extent we deem it is warranted.



General and Administrative Expenses



The main categories of our general and administrative expenses are
compensation and benefits, loan expense, marketing, office administration and professional and outside services. Compensation and benefits includes employee base salaries, benefit costs and incentive compensation awards. Discussion on stock-based
compensation expense included in compensation and benefits is in Note 3. Loan expense primarily includes expenses relating to the underwriting of mortgage loans that do not fund successfully. 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 $130.3 million and $47.4 million during the nine and three months ended September 30, 2003 to $225.1 million and $79.7 million for the same period in 2004 is primarily attributable to the termination of the LLCs
and the inclusion of those branches in our condensed consolidated financial statements. Our new retail lines of business, growth in our wholesale business and our expanding servicing operations also contributed to the increase in general and
administrative expenses. We employed 1,653 people as of September 30, 2004 compared with 1,351 as of September 30, 2003 in our mortgage portfolio management and mortgage lending and loan servicing operations.



Note 12 to the condensed consolidated financial statements presents a
condensed income statement for our three segments, detailing our expenses by segment. For comparative purposes, Table 10 presents the general and administrative expenses assuming the LLCs had been included in our condensed consolidated
financial statements during 2003.



Table 10  General and Administrative Expenses

(dollars in thousands)



|                                          |  |                                         |         |                                          |   |         |  |           |        |  |   |       
|----------------------------------------- |  | --------------------------------------- | ------- | ---------------------------------------- | - | ------- |  | --------- | ------ |  | - | ------
|                                          |  | For the Nine Months Ended September 30, |         | For the Three Months Ended September 30,
|                                          |  | 2004                                    |         | 2003                                     |   | 2004    |  | 2003     
|                                          |  |                                         |         | Pro Forma                                |   |         |  | Pro Forma
|Compensation and benefits                 |  | $                                       | 116,164 |                                          | $ | 90,284  |  | $         | 40,524 |  | $ | 34,385
|Marketing                                 |  |                                         | 38,723  |                                          |   | 38,360  |  |           | 13,294 |  |   | 14,712
|Office administration                     |  |                                         | 30,992  |                                          |   | 20,620  |  |           | 10,773 |  |   | 7,907 
|Loan expense                              |  |                                         | 15,689  |                                          |   | 15,911  |  |           | 5,415  |  |   | 5,733 
|Professional and outside services         |  |                                         | 10,946  |                                          |   | 4,840   |  |           | 4,911  |  |   | 1,855 
|Other                                     |  |                                         | 12,602  |                                          |   | 7,593   |  |           | 4,816  |  |   | 2,363 
|                                          |  |                                         |         |                                          |   |         |  |           |        |  |   |       
|Total general and administrative expenses |  | $                                       | 225,116 |                                          | $ | 177,608 |  | $         | 79,733 |  | $ | 66,955
|                                          |  |                                         |         |                                          |   |         |  |           |        |  |   |       
|Employees                                 |  |                                         | 4,042   |                                          |   | 3,080   |  |           | 4,042  |  |   | 3,080 



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



38



---

##### Table of Contents

Table 11  Wholesale Loan Costs of Production, as a Percent of Principal



|               |  |                       |  |                                               |  |                       
|-------------- |  | --------------------- |  | --------------------------------------------- |  | ----------------------
|               |  | Gross Loan Production |  | Premium Paid to Broker, Net of Fees Collected |  | Total Acquisition Cost
|2004:          |  |                       |  |                                               |  |                       
|Third quarter  |  | 1.68                  |  | 0.73                                          |  | 2.41                  
|Second quarter |  | 1.71                  |  | 0.72                                          |  | 2.43                  
|First quarter  |  | 1.84                  |  | 0.82                                          |  | 2.66                  
|               |  |                       | 
|2003:          |  |                       |  |                                               |  |                       
|Fourth quarter |  | 1.66                  |  | 0.77                                          |  | 2.43                  
|Third quarter  |  | 1.59                  |  | 0.61                                          |  | 2.20                  
|Second quarter |  | 1.71                  |  | 0.72                                          |  | 2.43                  
|First quarter. |  | 1.85                  |  | 0.75                                          |  | 2.60                  



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 $282 and $308 for the nine and three months ended September 30, 2003 to $267 and
$289 for the nine and three months ended September 30, 2004.



Table 12  Summary of Servicing Operations

(dollars in thousands, except per loan cost and number of loans)



|                                                                       |  |                    |            |   |         |   |      |               |  |   |           |   |  |                |      |   |         |   |           |   |  |   |      |  
|---------------------------------------------------------------------- |  | ------------------ | ---------- | - | ------- | - | ---- | ------------- |  | - | --------- | - |  | -------------- | ---- | - | ------- | - | --------- | - |  | - | ---- | -
|                                                                       |  | 2004               |           
|                                                                       |  | September 30Amount |            |   | PerUnit |   |      | June 30Amount |  |   | PerUnit   |   |  | March 31Amount |      |   | PerUnit |  
|Unpaid principal                                                       |  | $                  | 11,073,505 |   |         |   |      |               |  | $ | 9,604,342 |   |  |                |      |   |         | $ | 8,428,852 |   |  |   |      |  
|                                                                       |  |                    |            |   |         |   |      |               |  |   |           |   |  |                |      |   |         |   |           |   |  |   |      |  
|Number of loans                                                        |  |                    | 80,324     |   |         |   |      |               |  |   | 70,942    |   |  |                |      |   |         |   | 62,600    |   |  |   |      |  
|                                                                       |  |                    |            |   |         |   |      |               |  |   |           |   |  |                |      |   |         |   |           |   |  |   |      |  
|Servicing income, before amortization of mortgage servicing rights     |  | $                  | 8,846      |   |         | $ | 441  |               |  | $ | 8,277     |   |  | $              | 467  |   |         | $ | 7,985     |   |  | $ | 510  |  
|Costs of servicing                                                     |  |                    | (5,810     | ) |         |   | (289 | )             |  |   | (5,160    | ) |  |                | (291 | ) |         |   | (5,107    | ) |  |   | (326 | )
|                                                                       |  |                    |            |   |         |   |      |               |  |   |           |   |  |                |      |   |         |   |           |   |  |   |      |  
|Net servicing income, before amortization of mortgage servicing rights |  |                    | 3,036      |   |         |   | 152  |               |  |   | 3,117     |   |  |                | 176  |   |         |   | 2,878     |   |  |   | 184  |  
|Amortization of mortgage servicing rights                              |  |                    | (4,476     | ) |         |   | (223 | )             |  |   | (3,854    | ) |  |                | (217 | ) |         |   | (3,283    | ) |  |   | (210 | )
|                                                                       |  |                    |            |   |         |   |      |               |  |   |           |   |  |                |      |   |         |   |           |   |  |   |      |  
|Net servicing loss                                                     |  | $                  | (1,440     | ) |         | $ | (71  | )             |  | $ | (737      | ) |  | $              | (41  | ) |         | $ | (405      | ) |  | $ | (26  | )
|                                                                       |  |                    |            |   |         |   |      |               |  |   |           |   |  |                |      |   |         |   |           |   |  |   |      |  



|                                                                       |  |                   |           |   |         |   |      |                     |  |   |           |   |  |               |      |   |         |   |           |                |  |   |         |   |  |   |           |   |  |   |      |  
|---------------------------------------------------------------------- |  | ----------------- | --------- | - | ------- | - | ---- | ------------------- |  | - | --------- | - |  | ------------- | ---- | - | ------- | - | --------- | -------------- |  | - | ------- | - |  | - | --------- | - |  | - | ---- | -
|                                                                       |  | 2003              |          
|                                                                       |  | December 31Amount |           |   | PerUnit |   |      | September 30 Amount |  |   | PerUnit   |   |  | June 30Amount |      |   | PerUnit |   |           | March 31Amount |  |   | PerUnit |  
|Unpaid principal                                                       |  | $                 | 7,206,113 |   |         |   |      |                     |  | $ | 6,161,345 |   |  |               |      |   |         | $ | 5,145,005 |                |  |   |         |   |  | $ | 4,212,986 |   |  |   |      |  
|                                                                       |  |                   |           |   |         |   |      |                     |  |   |           |   |  |               |      |   |         |   |           |                |  |   |         |   |  |   |           |   |  |   |      |  
|Number of loans                                                        |  |                   | 54,196    |   |         |   |      |                     |  |   | 46,692    |   |  |               |      |   |         |   | 39,452    |                |  |   |         |   |  |   | 32,835    |   |  |   |      |  
|                                                                       |  |                   |           |   |         |   |      |                     |  |   |           |   |  |               |      |   |         |   |           |                |  |   |         |   |  |   |           |   |  |   |      |  
|Servicing income, before amortization of mortgage servicing rights     |  | $                 | 6,359     |   |         | $ | 469  |                     |  | $ | 5,265     |   |  | $             | 451  |   |         | $ | 4,600     |                |  | $ | 466     |   |  | $ | 4,262     |   |  | $ | 519  |  
|Costs of servicing                                                     |  |                   | (4,384    | ) |         |   | (323 | )                   |  |   | (3,591    | ) |  |               | (308 | ) |         |   | (3,108    | )              |  |   | (315    | ) |  |   | (3,178    | ) |  |   | (387 | )
|                                                                       |  |                   |           |   |         |   |      |                     |  |   |           |   |  |               |      |   |         |   |           |                |  |   |         |   |  |   |           |   |  |   |      |  
|Net servicing income, before amortization of mortgage servicing rights |  |                   | 1,975     |   |         |   | 146  |                     |  |   | 1,674     |   |  |               | 143  |   |         |   | 1,492     |                |  |   | 151     |   |  |   | 1,084     |   |  |   | 132  |  
|Amortization of mortgage servicing rights                              |  |                   | (2,790    | ) |         |   | (206 | )                   |  |   | (2,554    | ) |  |               | (219 | ) |         |   | (1,925    | )              |  |   | (195    | ) |  |   | (1,726    | ) |  |   | (210 | )
|                                                                       |  |                   |           |   |         |   |      |                     |  |   |           |   |  |               |      |   |         |   |           |                |  |   |         |   |  |   |           |   |  |   |      |  
|Net servicing loss                                                     |  | $                 | (815      | ) |         | $ | (60  | )                   |  | $ | (880      | ) |  | $             | (76  | ) |         | $ | (433      | )              |  | $ | (44     | ) |  | $ | (642      | ) |  | $ | (78  | )
|                                                                       |  |                   |           |   |         |   |      |                     |  |   |           |   |  |               |      |   |         |   |           |                |  |   |         |   |  |   |           |   |  |   |      |  



39



---

##### Table of Contents

Income Taxes



Since our inception, NFI has elected to be treated as a REIT for 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 nine and three months ended September 30, 2004 and 2003.



Table 13  Taxable Net Income

(dollars in thousands)



|                                                          |  |                                         |         |   |                                          |   |         |      |  |   |              |   |  |   |        |  
|--------------------------------------------------------- |  | --------------------------------------- | ------- | - | ---------------------------------------- | - | ------- | ---- |  | - | ------------ | - |  | - | ------ | -
|                                                          |  | For the Nine Months Ended September 30, |         |   | For the Three Months Ended September 30, |  
|                                                          |  | 2004                                    |         |   | 2003 (A) (B)                             |   |         | 2004 |  |   | 2003 (A) (B) |  
|Consolidated net income                                   |  | $                                       | 90,939  |   |                                          | $ | 76,788  |      |  | $ | 24,388       |   |  | $ | 25,108 |  
|Equity in net income of NFI Holding Corp.                 |  |                                         | (4,701  | ) |                                          |   | (16,639 | )    |  |   | 2,633        |   |  |   | (6,575 | )
|Consolidation eliminations between the REIT and TRS       |  |                                         | 1,954   |   |                                          |   | 3,221   |      |  |   | 1,954        |   |  |   | 3,221  |  
|                                                          |  |                                         |         |   |                                          |   |         |      |  |   |              |   |  |   |        |  
|REIT net income                                           |  |                                         | 88,192  |   |                                          |   | 63,370  |      |  |   | 28,975       |   |  |   | 21,754 |  
|Adjustments to net income to compute taxable income       |  |                                         | 81,544  |   |                                          |   | 38,021  |      |  |   | 40,555       |   |  |   | 13,133 |  
|                                                          |  |                                         |         |   |                                          |   |         |      |  |   |              |   |  |   |        |  
|Taxable income before preferred dividends                 |  |                                         | 169,736 |   |                                          |   | 101,391 |      |  |   | 69,530       |   |  |   | 34,887 |  
|Preferred dividends                                       |  |                                         | (4,601  | ) |                                          |   |        |      |  |   | (1,663       | ) |  |   |       |  
|                                                          |  |                                         |         |   |                                          |   |         |      |  |   |              |   |  |   |        |  
|Estimated taxable income available to common shareholders |  | $                                       | 165,135 |   |                                          | $ | 101,391 |      |  | $ | 67,867       |   |  | $ | 34,887 |  
|                                                          |  |                                         |         |   |                                          |   |         |      |  |   |              |   |  |   |        |  
|Estimated taxable income per common shareholder           |  | $                                       | 6.63    |   |                                          | $ | 4.44    |      |  | $ | 2.67         |   |  | $ | 1.53   |  
|                                                          |  |                                         |         |   |                                          |   |         |      |  |   |              |   |  |   |        |  

---

|(A) | The estimated taxable income in 2003 has been adjusted for our adoption of SFAS No. 123, Accounting for Stock-Based Compensation discussed in Note 3.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------

|(B) | During the third quarter of 2004, NovaStar Financial filed its required federal REIT income tax return for the tax year ended December 31, 2003. The actual amount of 2003 REIT
federal taxable income, before the deduction for dividends paid, was $137.9 million. This differs from the estimated amount provided in the 2003 annual report on Form 10-K of $136.5 million for the year ended December 31, 2003.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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 by the required distribution date. Accordingly, we have not accrued any corporate income tax for NFI for the nine or three
months ended September 30, 2004.



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 nine and three months ended September 30, 2004, we have provided for excise tax of $1.6 million and $0.5 million, respectively. Excise taxes are reflected as a component of general and administrative expenses on our
Condensed Consolidated Statements of Income. As of September 30, 2004, and December 31, 2003, accrued excise tax payable was $1.3 million and $0.2 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 file a
consolidated federal income tax return. The TRS reported net income (loss) from continuing operations before income taxes of $14.0 million and $(2.9) million for the nine and three months ended September 30, 2004, respectively, compared with $30.8
million and $12.4 million for the same period of 2003. As shown in our statement of income, this resulted in an income tax expense (benefit) of $7.3 million and $(1.4) million for the nine and three months ended September 30, 2004, respectively,
compared with $14.2 million and $5.8 million for the same period of 2003. Additionally, the TRS reported a net loss from discontinued operations before income taxes of $(4.4) million and $(2.2) million for the nine and three months ended September
30, 2004, respectively. This resulted in an income tax benefit of $2.3 million and $1.1 million for the nine and three months ended September 30, 2004, respectively.



40



---

##### Table of Contents

Discontinued Operations



During 2004, we changed policies governing our broker branches. As the demand for conforming loans has declined significantly during 2004, 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 have voluntarily terminated employment with us. We also terminated branches for
non-compliance with policy or 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. Note 10 to our condensed consolidated financial statements provides details regarding the impact of the discontinued operations.



Liquidity and Capital Resources



Liquidity means the need for, access to and uses of cash. Our primary needs for cash include the acquisition of mortgage loans, principal repayment and
interest on borrowings, operating expenses and dividend payments. Substantial cash is required to support the operating activities of the business, especially the mortgage origination operation. Mortgage asset sales, principal, interest and fees
collected on mortgage assets support cash needs. Drawing upon various borrowing arrangements typically satisfies major cash requirements. As shown in Table 5, we have $190.9 million in immediately available funds.



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



Loans
financed with warehouse and repurchase credit facilities are subject to changing market valuation and margin calls. The market value of our loans is dependent on a variety of economic conditions, including interest rates (and borrower demand) and
end investor desire and capacity. Market values have been consistent over the past three years. However, there is no certainty that the prices will remain constant. To the extent the value of the loans declines significantly, we would be required to
repay portions of the amounts we have borrowed. The value of our recourse loans (classified as held-for-sale) as of September 30, 2004 would need to decline by approximately 19% before we would use all immediately available funds,
assuming no other constraints on our immediately available funds.



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



The derivative financial instruments we use also subject us to margin call risk. Under our interest rate swaps, we pay a fixed rate to the
counterparties while they pay us a floating rate. While floating rates are low, on a net basis we are paying the counterparty. In order to mitigate credit exposure to us, the counterparty requires us to post margin deposits with them. As of
September 30, 2004, we have approximately $12.3 million on deposit. Further declining interest rates would subject us to additional exposure for cash margin calls. However, the asset side of the balance sheet should increase in value in a further
declining interest rate scenario. Incoming cash on our mortgage loans and securities is a principal source of cash. The volume of cash depends on, among other things, interest rates. While short-term interest rates (the basis for our funding costs)
are low and the coupon rates on our loans are high, our net interest margin (and therefore incoming cash flow) is high. Severe and immediate changes in interest rates will impact the volume of our incoming cash flow. To the extent rates increase
dramatically, our funding costs will increase quickly. While many of our loans are adjustable, they typically will not reset as quickly as our funding costs. This circumstance would temporarily reduce incoming cash flow. As noted above, derivative
financial instruments are used to mitigate the effect of interest rate volatility. In this rising rate situation, our interest rate swaps and caps would provide additional cash flows to mitigate the lower cash flows on loans and securities.



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



Cash activity during the nine and three months ended September
30, 2004 and 2003 is presented in the condensed consolidated statements of cash flows.



As noted above, proceeds from equity offerings have supported our operations. Since inception, we have raised $292 million in net proceeds through private and public equity offerings. Equity offerings provide another
future liquidity source.



41



---

##### Table of Contents

Off Balance Sheet Arrangements



As discussed previously, we pool the loans we originate and securitize them to obtain long-term financing for the assets.
The loans are transferred to a trust where they serve as collateral for asset-backed bonds, which the trust issues to the public. Our ability to use the securitization capital market is critical to the operations of our business. Table 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. Our financial performance and condition has little impact on our ability to securitize, as evidenced by our ability to securitize in 1998, 1999 and 2000 when our financial trend was weak.



We have commitments to borrowers to fund residential mortgage
loans as well as commitments to purchase and sell mortgage loans to third parties. At September 30, 2004 and December 31, 2003, we had commitments to fund mortgage loans with agreed-upon rates of approximately $457 million and $228 million,
respectively. We had outstanding commitments to purchase loans of $83 million and no commitments to sell loans to third parties at September 30, 2004. As of December 31, 2003, we had outstanding commitments to purchase loans of $60 million and no
commitments to sell loans to third parties. 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.



Contractual Obligations



We have entered into certain long-term agreements, which
obligate us to make future payments to satisfy the related contractual obligations. The following table summarizes our contractual obligations with regard to our long-term debt and lease agreements as of September 30, 2004.



Table 14  Contractual Obligations

(in thousands)



|                                                                       |  |                        |           |                  |   |           |  |           |        |               |   |        |  |   |      
|---------------------------------------------------------------------- |  | ---------------------- | --------- | ---------------- | - | --------- |  | --------- | ------ | ------------- | - | ------ |  | - | -----
|                                                                       |  | Payments Due by Period
|Contractual Obligations                                                |  | Total                  |           | Less than 1 Year |   | 1-3 Years |  | 4-5 Years |        | After 5 Years
|Short-term borrowings(B)                                               |  | $                      | 1,146,741 |                  | $ | 1,146,741 |  |           |       |               |   |       |  |   |     
|Long-term debt (A)(B)                                                  |  | $                      | 267,443   |                  | $ | 227,272   |  | $         | 23,816 |               | $ | 12,137 |  | $ | 4,218
|Mortgage loan purchase commitments                                     |  | $                      | 83,436    |                  | $ | 83,436    |  |           |       |               |   |       |  |   |     
|Operating leases                                                       |  | $                      | 32,790    |                  | $ | 6,579     |  | $         | 10,957 |               | $ | 10,117 |  | $ | 5,137
|Premiums due to counterparties related to interest rate cap agreements |  | $                      | 2,279     |                  | $ | 1,508     |  | $         | 771    |               |   |       |  |   |     

---

|(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.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(B) | Due to the variable-rate nature of our short-term and long-term debt and the uncertainty as to interest rate movements, we have not included our expected interest obligations.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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.



42



---

##### Table of Contents

Impact of Recently Issued Accounting Pronouncements



Note 1 of the consolidated financial statements contained in the Annual Report on Form 10-K for the fiscal year ended
December 31, 2003 describes certain recently issued accounting pronouncements. Also, refer to Note 2 of the condensed consolidated financial statements contained in this document for additional discussion. Management believes the implementation of
these pronouncements and others that have gone into effect since the date of these reports will not have a material impact on the condensed consolidated financial statements.



Item 3. Quantitative and Qualitative Disclosures About Market Risk



Interest Rate/Market Risk



Our
investment policy sets the following general goals:



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



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



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



Management primarily uses financing sources where the interest rate resets frequently. As of September 30, 2004, borrowings under all financing arrangements adjust daily or monthly. On the other hand, very few of the mortgage assets we own
adjust on a monthly or daily basis. Most of the mortgage loans contain features where their rates are fixed for some period of time and then adjust frequently thereafter. For example, one of our loan products is the 2/28 loan. This loan
is fixed for its first two years and then adjusts every six months thereafter.



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



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



Table 15 - Interest Rate Sensitivity - Income

(dollars in thousands)



|                                                |  |                                                      |  |       |        |   |     |   |         |     |  |   |         |   
|----------------------------------------------- |  | ---------------------------------------------------- |  | ----- | ------ | - | --- | - | ------- | --- |  | - | ------- | --
|                                                |  | Basis Point Increase (Decrease) in Interest Rate (A) | 
|                                                |  | (200) (C)                                            |  | (100) |        |   | 100 |   |         | 200 | 
|As of September 30, 2004:                       |  |                                                      |  |       |        |   |     |   |         |     |  |   |         |   
|Change in net interest income                   |  | N/A                                                  |  | $     | 7,525  |   |     | $ | (6,619  | )   |  | $ | (15,897 | ) 
|                                                |  |                                                      |  |       |        |   |     |   |         |     |  |   |         |   
|Percent change in net interest income from base |  | N/A                                                  |  |       | 2.3    | % |     |   | (2.0    | )%  |  |   | (4.8    | )%
|                                                |  |                                                      |  |       |        |   |     |   |         |     |  |   |         |   
|Percent change of capital (B)                   |  | N/A                                                  |  |       | 2.0    | % |     |   | (1.8    | )%  |  |   | (4.2    | )%
|                                                |  |                                                      |  |       |        |   |     |   |         |     |  |   |         |   
|As of December 31, 2003:                        |  |                                                      |  |       |        |   |     |   |         |     |  |   |         |   
|Change in net interest income                   |  | N/A                                                  |  | $     | 15,546 |   |     | $ | (11,393 | )   |  | $ | (20,777 | ) 
|                                                |  |                                                      |  |       |        |   |     |   |         |     |  |   |         |   
|Percent change in net interest income from base |  | N/A                                                  |  |       | 5.6    | % |     |   | (4.1    | )%  |  |   | (7.5    | )%
|                                                |  |                                                      |  |       |        |   |     |   |         |     |  |   |         |   
|Percent change of capital (B)                   |  | N/A                                                  |  |       | 5.2    | % |     |   | (3.8    | )%  |  |   | (6.9    | )%
|                                                |  |                                                      |  |       |        |   |     |   |         |     |  |   |         |   

---

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

|(B) | Total change in estimated spread income as a percent of total stockholders equity as of September 30, 2004 and December 31, 2003.
|--- | ----------------------------------------------------------------------------------------------------------------------------------

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



43



---

##### Table of Contents

Table 16 - Interest Rate Sensitivity - Market Value

(dollars in thousands)



|                                                    |  |                                                      |  |       |         |   |     |   |         |     |  |   |          |   
|--------------------------------------------------- |  | ---------------------------------------------------- |  | ----- | ------- | - | --- | - | ------- | --- |  | - | -------- | --
|                                                    |  | Basis Point Increase (Decrease) in Interest Rate (A) | 
|                                                    |  | (200) (C)                                            |  | (100) |         |   | 100 |   |         | 200 | 
|As of September 30, 2004:                           |  |                                                      |  |       |         |   |     |   |         |     |  |   |          |   
|Change in market values of:                         |  |                                                      |  |       |         |   |     |   |         |     |  |   |          |   
|Assets                                              |  | N/A                                                  |  | $     | 51,081  |   |     | $ | (50,848 | )   |  | $ | (105,776 | ) 
|Interest rate agreements                            |  | N/A                                                  |  |       | (32,279 | ) |     |   | 33,373  |     |  |   | 66,216   |   
|                                                    |  |                                                      |  |       |         |   |     |   |         |     |  |   |          |   
|Cumulative change in market value                   |  | N/A                                                  |  | $     | 18,802  |   |     | $ | (17,475 | )   |  | $ | (39,560  | ) 
|                                                    |  |                                                      |  |       |         |   |     |   |         |     |  |   |          |   
|Percent change of market value portfolio equity (B) |  | N/A                                                  |  |       | 4.0     | % |     |   | (3.8    | )%  |  |   | (8.5     | )%
|                                                    |  |                                                      |  |       |         |   |     |   |         |     |  |   |          |   
|As of December 31, 2003:                            |  |                                                      |  |       |         |   |     |   |         |     |  |   |          |   
|Change in market values of:                         |  |                                                      |  |       |         |   |     |   |         |     |  |   |          |   
|Assets                                              |  | N/A                                                  |  | $     | 34,499  |   |     | $ | (65,216 | )   |  | $ | (144,343 | ) 
|Interest rate agreements                            |  | N/A                                                  |  |       | (31,250 | ) |     |   | 34,073  |     |  |   | 69,497   |   
|                                                    |  |                                                      |  |       |         |   |     |   |         |     |  |   |          |   
|Cumulative change in market value                   |  | N/A                                                  |  | $     | 3,249   |   |     | $ | (31,143 | )   |  | $ | (74,846  | ) 
|                                                    |  |                                                      |  |       |         |   |     |   |         |     |  |   |          |   
|Percent change of market value portfolio equity (B) |  | N/A                                                  |  |       | 1.0     | % |     |   | (9.1    | )%  |  |   | (21.9    | )%
|                                                    |  |                                                      |  |       |         |   |     |   |         |     |  |   |          |   

---

|(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 September 30, 2004 and December 31, 2003.
|--- | ------------------------------------------------------------------------------------------------------------------------------------

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



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



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



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



44



---

##### Table of Contents

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.



We have determined the following estimated net fair value amounts by using available market information and appropriate valuation methodologies as of
September 30, 2004.



Table 17Interest Rate Risk Management Contracts

(dollars in thousands)



|                              |  |                |       |                     |   |           |      |  |   |         |   |  |      |         |   |      |   |         |   |  |   |         |  
|----------------------------- |  | -------------- | ----- | ------------------- | - | --------- | ---- |  | - | ------- | - |  | ---- | ------- | - | ---- | - | ------- | - |  | - | ------- | -
|                              |  | Maturity Range |      
|                              |  | Net FairValue  |       | TotalNotionalAmount |   |           | 2004 |  |   | 2005    |   |  | 2006 |         |   | 2007 |  
|Pay-fixed swaps:              |  |                |       |                     |   |           |      |  |   |         |   |  |      |         |   |      |   |         |   |  |   |         |  
|Contractual maturity          |  | $              | 468   |                     | $ | 1,515,000 |      |  | $ |        |   |  | $    | 285,000 |   |      | $ | 980,000 |   |  | $ | 250,000 |  
|Weighted average pay rate     |  |                |       |                     |   | 2.9       | %    |  |   |        |   |  |      | 2.4     | % |      |   | 2.9     | % |  |   | 3.3     | %
|Weighted average receive rate |  |                |       |                     |   | 1.8       | %    |  |   | (A      | ) |  |      | (A      | ) |      |   | (A      | ) |  |   | (A      | )
|                              |  |                |       |                     |   |          
|Interest rate caps:           |  |                |       |                     |   |           |      |  |   |         |   |  |      |         |   |      |   |         |   |  |   |         |  
|Contractual maturity          |  | $              | 5,300 |                     | $ | 751,910   |      |  | $ | 101,910 |   |  | $    | 450,000 |   |      | $ | 200,000 |   |  | $ |        |  
|Weighted average strike rate  |  |                |       |                     |   | 1.7       | %    |  |   | 1.8     | % |  |      | 1.6     | % |      |   | 2.0     | % |  |   |        |  



---

|(A) | The pay-fixed swaps receive rate is indexed to one-month 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 Control over Financial Reporting.There has been no change in NovaStar Financials internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange
Act Rule 13a-15 that occurred during the quarter ended September 30, 2004 that has materially affected, or is reasonably likely to materially affect, NovaStar Financials internal control over financial reporting.



Evaluation of Internal Controls. The Company is currently undertaking
an analysis and documentation of its internal control framework over financial reporting, which is required by Section 404 of the Sarbanes Oxley Act of 2002. In the course of this review, the Company has identified deficiencies in segregation of
duties and information system controls. In aggregate or isolation, these deficiencies do not materially impact the accuracy or quality of the Companys financial statements. Remediation plans are in place to address these deficiencies prior to
December 31, 2004. The Company expects to complete its internal control review and remediation process prior to December 31, 2004.



45



---

##### Table of Contents

PART II. OTHER INFORMATION



Item 1. Legal Proceedings



In
the normal course of its business, the Company is subject to various legal proceedings and claims. The resolution of these legal proceedings and claims, in the opinion of management, will not have a material adverse effect on the Companys
financial condition or results of operations. Since April 2004, a number of substantially similar class action lawsuits and three derivative lawsuits (now consolidated into a single case) have been filed in the United States District Court in Kansas
City and in Missouri and Maryland state courts against the Company and/or several of its executive officers and/or directors. The complaints generally claim that the defendants are liable for making or failing to prevent alleged misstatements or
omissions in the Companys public disclosures. The Company believes that these claims are without merit and intends to vigorously defend against them. In addition, the Company in April 2004 received notice of an informal inquiry from the
Securities and Exchange Commission requesting that it provide various documents relating to its business. The Company is cooperating fully with the Commissions inquiry.



Item 2. Changes in Securities and Use of Proceeds and Issuer Purchases of Equity Securities



Issuer Purchases of Equity Securities



|                                       |  |                                |  |                             |  |                                                                            |  |                                                                                        |          
|-------------------------------------- |  | ------------------------------ |  | --------------------------- |  | -------------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------- | ---------
|                                       |  | Total Number ofSharesPurchased |  | Average PricePaid per Share |  | Total Number ofSharesPurchased asPart of PubliclyAnnouncedPlans orPrograms |  | ApproximateDollar value ofShares that MayYet BePurchasedUnder the Plansor Programs (A)
|July 1, 2004  July 31, 2004           |  |                               |  |                            |  |                                                                           |  | $                                                                                      | 1,020,082
|August 1, 2004  August 31, 2004       |  |                               |  |                            |  |                                                                           |  | $                                                                                      | 1,020,082
|September 1, 2004  September 30, 2004 |  |                               |  |                            |  |                                                                           |  | $                                                                                      | 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



Not applicable



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



Not applicable



Item 5. Other Information



None



46



---

##### Table of Contents

Item 6. Exhibits and Reports on Form 8-K



|(a) | Exhibit Listing
|--- | ---------------



|            |  |                                                                                          
|----------- |  | -----------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Document                                                                  
|3.1*        |  | Articles of Amendment and Restatement of the Registrant                                  
|            | 
|3.3*        |  | Bylaws of the Registrant                                                                 
|            | 
|3.3a***     |  | Amendment to Bylaws of the Registrant, adopted February 2, 2000                          
|            | 
|3.4**       |  | Articles Supplementary of the Registrant, adopted January 15, 2004                       
|            | 
|31.1        |  | Chief Executive Officer Certification - Section 302 of the Sarbanes-Oxley Act of 2002    
|            | 
|31.2        |  | Principal Financial Officer Certification - Section 302 of the Sarbanes-Oxley Act of 2002
|            | 
|32.1        |  | Chief Executive Officer Certification - Section 906 of the Sarbanes-Oxley Act of 2002    
|            | 
|32.2        |  | Principal Financial Officer Certification - Section 906 of the Sarbanes-Oxley Act of 2002

---

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

|** | Incorporated by reference to the correspondingly numbered exhibit to Form 8-A/A filed by the Registrant with the SEC on January 20, 2004.
|-- | -----------------------------------------------------------------------------------------------------------------------------------------

|*** | Incorporated by reference to the correspondingly numbered exhibit to Annual Report on Form 10-K filed by the Registrant with the SEC on March 20, 2000.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------



|(b) | NovaStar Financial filed the following Form 8-Ks during the three months ended September 30, 2004.
|--- | ---------------------------------------------------------------------------------------------------



| | 1. | Press Release, dated July 19, 2004 NovaStar Financial Appoints Greg Metz as Senior Vice President and Chief Financial Officer. Current report on Form 8-K was filed on
July 20, 2004.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 2. | Press Release, dated July 29, 2004 NovaStar Financial Reports Second-Quarter Earnings Up 18% as Record $2 Billion in Loan Production Fuels Mortgage Loan Portfolio
Growth. Current report on Form 8-K was filed on July 29, 2004.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 3. | Press Release, dated September 13,2004 NovaStar Closes $2.2 billion Asset Backed Securitization. Current report on Form 8-K was filed on September 13, 2004.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 4. | Monthly Loan Origination Data from January 2004 to August 2004. Current report on Form 8-K was filed on September 14, 2004.
| | -- | ---------------------------------------------------------------------------------------------------------------------------



47



---

##### Table of Contents

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: November 4, 2004   |  | /s/ Scott F. Hartman                
|                         |  | Scott F. Hartman                    
|                         |  | Chairman of the Board, Secretary and
|                         |  | Chief Executive Officer             
|                         | 
|DATE: November 4, 2004   |  | /s/ Gregory S. Metz                 
|                         |  | Gregory S. Metz                     
|                         |  | Chief Financial Officer             



48