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UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549
____________________FORM
10-Q

x
    
    QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934For the Quarterly Period Ended September 30, 2009o
    
    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
    (I.R.S. Employer Identification No.)Organization)2114 Central Street, Suite 600, Kansas City, MO
    64108(Address of Principal Executive Office)
    (Zip Code)


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

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

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

Indicate by check mark whether the
registrant is a large accelerated filer, an accelerated filer, a non-accelerated
filer or a smaller reporting company. See the definitions of large accelerated
filer, accelerated filer and smaller reporting company in Rule 12b-2 of the
Exchange Act.

|Large
      accelerated filero | Accelerated
      filero | Non-accelerated filero | Smaller
      reporting companyx
|------------------------------ | ------------------------ | ---------------------- | --------------------------------

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

The number of shares of the Registrants
Common Stock outstanding on November 12, 2009 was 9,368,053.

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|NOVASTAR FINANCIAL,
      INC.FORM 10-QFor the
      Quarterly Period Ended September 30, 2009
|----------------------------------------------------------------------------------------------
|                                                                                              

TABLE OF CONTENTS

|Part I   |  | Financial Information                                                                       |  |   
|-------- |  | ------------------------------------------------------------------------------------------- |  | --
|         |  |                                                                                             |  |   
|Item 1.  |  | Financial Statements (Unaudited)                                                            |  | 1 
|         |  | Condensed
      Consolidated Balance Sheets                                                 |  | 1 
|         |  | Condensed Consolidated Statements of Operations                                             |  | 2 
|         |  | Condensed
      Consolidated Statement of Shareholders Deficit                             |  | 3 
|         |  | Condensed Consolidated Statements of Cash Flows                                             |  | 4 
|         |  | Notes to
      Condensed Consolidated Financial Statements                                  |  | 6 
|         |  |                                                                                             |  |   
|Item 2.  |  | Managements Discussion and Analysis of Financial Condition and
      Results of Operations |  | 27
|         |  |                                                                                             |  |   
|Item 3.  |  | Quantitative and Qualitative Disclosures About Market
Risk                                  |  | 41
|         |  |                                                                                             |  |   
|Item 4.  |  | Controls and Procedures                                                                     |  | 41
|         |  |                                                                                             |  |   
|Part II  |  | Other Information                                                                           |  |   
|         |  |                                                                                             |  |   
|Item 1.  |  | Legal Proceedings                                                                           |  | 42
|         |  |                                                                                             |  |   
|Item 1A. |  | Risk Factors                                                                                |  | 43
|         |  |                                                                                             |  |   
|Item 2.  |  | Unregistered Sales of Equity Securities and Use of
    Proceeds                             |  | 43
|         |  |                                                                                             |  |   
|Item 3.  |  | Defaults Upon Senior Securities                                                             |  | 43
|         |  |                                                                                             |  |   
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                         |  | 44
|         |  |                                                                                             |  |   
|Item 5.  |  | Other Information                                                                           |  | 44
|         |  |                                                                                             |  |   
|Item 6.  |  | Exhibits                                                                                    |  | 44

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

|NOVASTAR FINANCIAL,
      INC.CONDENSED CONSOLIDATED
      BALANCE SHEETS(unaudited;
      dollars in thousands, except share
amounts)
|--------------------------------------------------------------------------------------------------------------------------------------

|                                                                                |  | September 30, |            | December 31,
|------------------------------------------------------------------------------- |  | ------------- | ---------- | ------------
|                                                                                |  | 2009          |            | 2008        
|Assets                                                                          |  |               |            |             
|Unrestricted cash and cash equivalents                                          |  | $             | 14,818     |             
|Restricted cash                                                                 |  |               | 4,294      |             
|Mortgage loans  held-in-portfolio, net of allowance of $746,702
      and      |  |               |            |             
|$776,001, respectively                                                          |  |               | 1,387,555  |             
|Mortgage securities − trading                                                   |  |               | 1,425      |             
|Mortgage securities − available-for-sale                                        |  |               | 6,669      |             
|Real estate owned                                                               |  |               | 83,573     |             
|Accrued interest receivable                                                     |  |               | 74,842     |             
|Other assets                                                                    |  |               | 8,693      |             
|Assets of discontinued operations                                               |  |               | -          |             
|Total assets                                                                    |  | $             | 1,581,869  |             
|                                                                               
|Liabilities and Shareholders Deficit                                           |  |               |            |             
|Liabilities:                                                                    |  |               |            |             
|Asset-backed bonds secured by mortgage loans                                    |  | $             | 2,361,588  |             
|Asset-backed bonds secured by mortgage
    securities                           |  |               | 1,063      |             
|Junior subordinated debentures                                                  |  |               | 77,692     |             
|Due to servicer                                                                 |  |               | 141,093    |             
|Dividends payable                                                               |  |               | 30,450     |             
|Accounts payable and other liabilities                                          |  |               | 18,294     |             
|Liabilities of discontinued operations                                          |  |               | -          |             
|Total
      liabilities                                                         |  |               | 2,630,180  |             
|                                                                               
|Commitments and contingencies (Note 7)                                          |  |               |            |             
|                                                                               
|Shareholders deficit :                                                         |  |               |            |             
|Capital stock, $0.01 par value, 50,000,000 shares
      authorized:             |  |               |            |             
|Redeemable preferred stock, $25 liquidating preference
      per share;         |  |               |            |             
|2,990,000 shares, issued and outstanding                                        |  |               | 30         |             
|Convertible participating preferred stock, $25
      liquidating preference per |  |               |            |             
|share; 2,100,000 shares, issued and
outstanding                                 |  |               | 21         |             
|Common stock, 9,368,053, issued and
outstanding                                 |  |               | 94         |             
|Additional paid-in capital                                                      |  |               | 786,811    |             
|Accumulated deficit                                                             |  |               | (1,840,393 | )           
|Accumulated other comprehensive income                                          |  |               | 4,662      |             
|Other                                                                           |  |               | (87        | )           
|Total NovaStar shareholders deficit                                            |  |               | (1,048,862 | )           
|Noncontrolling interests                                                        |  |               | 551        |             
|Total shareholders deficit                                                     |  |               | (1,048,311 | )           
|Total liabilities and shareholders deficit                                     |  | $             | 1,581,869  |             

See notes to condensed consolidated
financial statements.

1

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|NOVASTAR FINANCIAL,
      INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(unaudited;
      dollars in thousands, except share and per share
  amounts)
|----------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                              |  | For the Nine Months |           | For the Three Months
|------------------------------------------------------------- |  | ------------------- | --------- | --------------------
|                                                              |  | Ended September 30, |           | Ended September 30, 
|                                                              |  | 2009                |           | 2008                
|Interest income                                               |  | $                   | 114,269   |                     
|Interest
      expense                                        |  |                     | 18,803    |                     
|Net interest income before provision for credit losses        |  |                     | 95,466    |                     
|Provision for
      credit losses                             |  |                     | 211,050   |                     
|Net interest loss after provision for credit losses           |  |                     | (115,584  | )                   
|                                                             
|Other operating (expense) income:                             |  |                     |           |                     
|(Losses) gains on derivative instruments                      |  |                     | (4,817    | )                   
|Gains on debt extinguishment                                  |  |                     | -         |                     
|Fair value adjustments                                        |  |                     | (6,597    | )                   
|Impairment on mortgage securities  available-for-sale        |  |                     | (1,155    | )                   
|Appraisal fee income                                          |  |                     | 22,018    |                     
|Appraisal fee expense                                         |  |                     | (15,306   | )                   
|Premiums for mortgage loan insurance                          |  |                     | (4,908    | )                   
|Servicing fee expense                                         |  |                     | (8,343    | )                   
|Other income (expense), net                                   |  |                     | 433       |                     
|Total other operating (expense) income                        |  |                     | (18,675   | )                   
|                                                             
|General and administrative expenses:                          |  |                     |           |                     
|Compensation and benefits                                     |  |                     | 4,015     |                     
|Office administration                                         |  |                     | 4,023     |                     
|Professional and outside services                             |  |                     | 5,635     |                     
|Other appraisal management expenses                           |  |                     | 9,456     |                     
|Other                                                         |  |                     | 589       |                     
|Total general and administrative expenses                     |  |                     | 23,718    |                     
|                                                             
|Loss from continuing operations before income tax             |  |                     | (157,977  | )                   
|Income tax
      expense (benefit)                            |  |                     | 245       |                     
|Loss from continuing operations                               |  |                     | (158,222  | )                   
|Income from
      discontinued operations, net of income tax  |  |                     | -         |                     
|Net loss                                                      |  |                     | (158,222  | )                   
|Less: Net loss
      attributable to noncontrolling interests |  |                     | (1,174    | )                   
|Net loss available to common
      shareholders               |  | $                   | (157,048  | )                   
|Basic earnings
      per share:                               |  |                     |           |                     
|Loss from continuing operations available to common           |  |                     |           |                     
|shareholders                                                  |  | $                   | (17.98    | )                   
|Income from discontinued operations, net of income tax        |  |                     | -         |                     
|Net loss available to common shareholders                     |  | $                   | (17.98    | )                   
|Diluted earnings
      per share:                             |  |                     |           |                     
|Loss from continuing operations available to common           |  |                     |           |                     
|shareholders                                                  |  | $                   | (17.98    | )                   
|Income from discontinued operations, net of income tax        |  |                     | -         |                     
|Net loss available to common shareholders                     |  | $                   | (17.98    | )                   
|Weighted average basic shares
      outstanding               |  |                     | 9,368,053 |                     
|Weighted average diluted shares
      outstanding             |  |                     | 9,368,053 |                     

See notes to condensed consolidated
financial statements.

2

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|NOVASTAR FINANCIAL,
      INC.CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS
      DEFICIT(unaudited; dollars in
thousands)
|------------------------------------------------------------------------------------------------------------------------------

|                                  |  | RedeemablePreferredStock |    | ConvertibleParticipatingPreferredStock |   | CommonStock |  | AdditionalPaid-inCapital |    | AccumulatedDeficit |   | AccumulatedOtherComprehensiveIncome |  | NoncontrollingInterest |            | Other |  | TotalShareholdersDeficit
|--------------------------------- |  | ------------------------ | -- | -------------------------------------- | - | ----------- |  | ------------------------ | -- | ------------------ | - | ----------------------------------- |  | ---------------------- | ---------- | ----- |  | -------------------------
|Balance, January 1, 2009          |  | $                        | 30 |                                        | $ | 21          |  | $                        | 94 |                    | $ | 786,279                             |  | $                      | (1,671,984 | )     |  | $                        
|Forgiveness
      of              |  |                          |    |                                        |   |             |  |                          |    |                    |   |                                     |  |                        |            |       |  |                          
|founders
      notes             |  |                          |    |                                        |   |             |  |                          |    |                    |   |                                     |  |                        |            |       |  |                          
|receivable                        |  |                          | -  |                                        |   | -           |  |                          | -  |                    |   | -                                   |  |                        | -          |       |  |                          
|Compensation                      |  |                          |    |                                        |   |             |  |                          |    |                    |   |                                     |  |                        |            |       |  |                          
|recognized under                  |  |                          |    |                                        |   |             |  |                          |    |                    |   |                                     |  |                        |            |       |  |                          
|stock compensation                |  |                          |    |                                        |   |             |  |                          |    |                    |   |                                     |  |                        |            |       |  |                          
|plans                             |  |                          | -  |                                        |   | -           |  |                          | -  |                    |   | 532                                 |  |                        | -          |       |  |                          
|Accumulating                      |  |                          |    |                                        |   |             |  |                          |    |                    |   |                                     |  |                        |            |       |  |                          
|dividends
      on                |  |                          |    |                                        |   |             |  |                          |    |                    |   |                                     |  |                        |            |       |  |                          
|preferred
      stock             |  |                          | -  |                                        |   | -           |  |                          | -  |                    |   | -                                   |  |                        | (11,361    | )     |  |                          
|Contribution from                 |  |                          |    |                                        |   |             |  |                          |    |                    |   |                                     |  |                        |            |       |  |                          
|noncontrolling                    |  |                          |    |                                        |   |             |  |                          |    |                    |   |                                     |  |                        |            |       |  |                          
|interests                         |  |                          | -  |                                        |   | -           |  |                          | -  |                    |   | -                                   |  |                        | -          |       |  |                          
|Acquisition
      of              |  |                          |    |                                        |   |             |  |                          |    |                    |   |                                     |  |                        |            |       |  |                          
|noncontrolling                    |  |                          |    |                                        |   |             |  |                          |    |                    |   |                                     |  |                        |            |       |  |                          
|interests                         |  |                          | -  |                                        |   | -           |  |                          | -  |                    |   | -                                   |  |                        | -          |       |  |                          
|Comprehensive loss:               |  |                          |    |                                        |   |             |  |                          |    |                    |   |                                     |  |                        |            |       |  |                          
|Net loss                          |  |                          | -  |                                        |   | -           |  |                          | -  |                    |   | -                                   |  |                        | (157,048   | )     |  |                          
|Other                             |  |                          |    |                                        |   |             |  |                          |    |                    |   |                                     |  |                        |            |       |  |                          
|comprehensive loss                |  |                          | -  |                                        |   | -           |  |                          | -  |                    |   | -                                   |  |                        | -          |       |  |                          
|Total                             |  |                          |    |                                        |   |             |  |                          |    |                    |   |                                     |  |                        |            |       |  |                          
|comprehensive                     |  |                          |    |                                        |   |             |  |                          |    |                    |   |                                     |  |                        |            |       |  |                          
|loss                              |  |                          | -  |                                        |   | -           |  |                          | -  |                    |   | -                                   |  |                        | -          |       |  |                          
|Balance, September 30,
      2009 |  | $                        | 30 |                                        | $ | 21          |  | $                        | 94 |                    | $ | 786,811                             |  | $                      | (1,840,393 | )     |  | $                        

See notes tocondensedconsolidatedfinancialstatements.

3

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|NOVASTAR FINANCIAL,
      INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited;
      dollars in thousands)
|--------------------------------------------------------------------------------------------------------------------

|                                                                                   |  | For the Nine Months Ended
|---------------------------------------------------------------------------------- |  | -------------------------
|                                                                                   |  | September 30,            
|                                                                                   |  | 2009                     
|Cash flows from operating activities:                                              |  |                          
|Net
    loss                                                                       |  | $                        
|Income from discontinued operations                                                |  |                          
|Loss from
      continuing operations                                              |  |                          
|Adjustments to reconcile loss from continuing operations to net
      cash used in |  |                          
|operating
      activities:                                                        |  |                          
|Accretion of available-for-sale and trading securities                             |  |                          
|Interest capitalized on loans held-in-portfolio                                    |  |                          
|Amortization of premiums on mortgage loans                                         |  |                          
|Amortization of deferred debt issuance costs                                       |  |                          
|Provision for credit losses                                                        |  |                          
|Impairments on mortgage securities  available-for-sale                            |  |                          
|Fair value adjustments                                                             |  |                          
|Losses on derivative instruments                                                   |  |                          
|Compensation recognized under stock compensation plans                             |  |                          
|Forgiveness of founders promissory notes                                          |  |                          
|Depreciation expense                                                               |  |                          
|Gains on debt extinguishment                                                       |  |                          
|Changes in:                                                                        |  |                          
|Accrued interest receivable                                                        |  |                          
|Other assets                                                                       |  |                          
|Due to servicer                                                                    |  |                          
|Accounts payable and other liabilities                                             |  |                          
|Net cash provided by operating activities from
      continuing operations         |  |                          
|Net cash used in operating activities from discontinued
      operations           |  |                          
|Net cash provided by operating activities                                          |  |                          
|                                                                                  
|Cash flows from investing activities:                                              |  |                          
|Proceeds from
      paydowns on mortgage securities  available-for-sale           |  |                          
|Proceeds from paydowns of mortgage securities  trading                            |  |                          
|Proceeds from
      repayments of mortgage loans  held-in-portfolio               |  |                          
|Proceeds from sales of assets acquired through
foreclosure                         |  |                          
|Cash used to
      collateralize customer warranties                               |  |                          
|Purchases of property and equipment                                                |  |                          
|Restricted cash
      proceeds                                                     |  |                          
|Proceeds from disposal of property and equipment                                   |  |                          
|Acquisition of
      business, net of cash acquired                                |  |                          
|Net cash provided by investing activities from
      continuing operations         |  |                          
|Net cash provided by investing activities from
      discontinued operations       |  |                          
|Net cash provided by investing activities                                          |  |                          

Continued

4

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|                                                                         |  | For the Nine Months
    Ended
|------------------------------------------------------------------------ |  | -----------------------------
|                                                                         |  | September 30,                
|Cash flows from financing activities:                                    |  | 2009                         
|Payments on
      asset-backed bonds                                     |  |                              
|Net change in short-term borrowings                                      |  |                              
|Repurchases of
      trust preferred debt                                |  |                              
|Contributions from noncontrolling interests                              |  |                              
|Net cash used in financing activities from continuing
      operations   |  |                              
|Net cash used in financing activities from discontinued
      operations |  |                              
|Net cash used in financing activities                                    |  |                              
|Net decrease in cash and cash equivalents                                |  |                              
|Cash and cash
      equivalents, beginning of period                     |  |                              
|Cash and cash equivalents, end of
      period                           |  | $                            

|Supplemental Disclosure of Cash
      Flow Information(unaudited; dollars in
  thousands)
|-----------------------------------------------------------------------------------------

|                                                                                   |  | For the Nine Months Ended
|---------------------------------------------------------------------------------- |  | -------------------------
|                                                                                   |  | September 30,            
|                                                                                   |  | 2009                     
|Cash paid for interest                                                             |  | $                        
|Cash paid for
      income taxes                                                   |  |                          
|Cash received on mortgage securities  available-for-sale with no
      cost basis |  |                          
|Non-cash
      investing and financing activities:                                 |  |                          
|Assets acquired through foreclosure                                                |  |                          
|Preferred stock dividends accrued, not yet paid                                    |  |                          
|                                                                                   |  |                          

|See notes to condensed consolidated financial
      statements. | Concluded
|--------------------------------------------------------------- | ---------

5

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|NOVASTAR FINANCIAL, INC.NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSAs of and for the period
      ended September 30, 2009 (Unaudited)
|-----------------------------------------------------------------------------------------------------------------------------------------------------

Note 1. Financial Statement
Presentation

Description of
Operations- NovaStar Financial, Inc. and
its subsidiaries (NFI or the Company) hold certain nonconforming residential
mortgage securities. Prior to changes in its business in 2007, the Company
originated, purchased, securitized, sold, invested in and serviced residential
nonconforming mortgage loans and mortgage backed securities. The Company
retained, through its mortgage securities investment portfolio, significant
interests in the nonconforming loans it originated and purchased, and through
its servicing platform, serviced all of the loans in which it retained
interests.

Effective August 1, 2008, the Company
acquired a 75% interest in StreetLinks National Appraisal Services, LLC
(StreetLinks), a residential mortgage appraisal company, for an initial cash
purchase price of $750,000 plus future payments contingent upon StreetLinks
reaching certain earnings targets. Results of operations from August 1, 2008
forward are included in the consolidated statement of operations. Simultaneously
with the acquisition, the Company transferred ownership of 5% of StreetLinks to
the Chief Executive Officer of StreetLinks. Subsequent to September 30, 2009,
the Company contributed capital to StreetLinks and increased its ownership to
88%.

On April 26, 2009, the Company acquired a
70% interest in Advent Financial Services, LLC (Advent), a start up operation
which will provide access to tailored banking accounts, small dollar banking
products and related services to meet the needs of low and moderate income level
individuals, for an initial cash contribution into Advent of $2 million.
Management is continuing to evaluate opportunities to invest excess cash as it
is available.

Financial Statement
Presentation-The Companys condensed consolidated financial statements have
been prepared in conformity with accounting principles generally accepted in the
United States of America (GAAP) and prevailing practices within the financial
services industry. The preparation of financial statements requires management
to make estimates and assumptions that affect the reported amounts of assets and
liabilities at the date of the financial statements and the reported amounts of
income and expense during the period. The Company uses estimates and employs the
judgments of management in determining the amount of its allowance for credit
losses, amortizing premiums or accreting discounts on its mortgage assets,
establishing the fair value of its mortgage securities, derivative instruments,
CDO debt and estimating appropriate accrual rates on mortgage securities 
available-for-sale. While the condensed consolidated financial statements and
footnotes reflect the best estimates and judgments of management at the time,
actual results could differ significantly from those estimates. In accordance
with Subsequent Event guidance, the Company evaluated all events or transactions
that occurred after September 30, 2009 through November 12, 2009, the date the
Company issued these financial statements. During this period the Company did
not have any material recognizable or nonrecognizable subsequent
events.

The condensed consolidated financial
statements of the Company include the accounts of all wholly-owned and
majority-owned subsidiaries. Investments in entities for which the Company has
significant influence are accounted for under the equity method. Intercompany
accounts and transactions have been eliminated in consolidation. Interim results
are not necessarily indicative of results for a full year.

The Companys condensed consolidated
financial statements as of September 30, 2009 and for the nine and three months
ended September 30, 2009 and 2008 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.

The Companys condensed consolidated
financial statements should be read in conjunction with Managements Discussion
and Analysis of Financial Condition and Results of Operations and the
consolidated financial statements of the Company and the notes thereto, included
in the Companys Annual Report on Form 10-K for the fiscal year ended December
31, 2008.

Going Concern Considerations-As of September 30, 2009, the Companys
total liabilities exceeded its total assets under GAAP, resulting in a
shareholders deficit. The Companys losses, negative cash flows, shareholders
deficit, and lack of significant operations raise substantial doubt about the
Companys ability to continue as a going concern and, therefore, may not realize
its assets and discharge its liabilities in the normal course of business. There
is no assurance that cash flows will be sufficient to meet the Companys
obligations. The Companys condensed consolidated financial statements have been
prepared on a going concern basis of accounting which contemplates continuity of
operations, realization of assets, liabilities and commitments in the normal
course of business. The Companys condensed consolidated financial statements do
not reflect any adjustments relating to the recoverability and classification of
recorded asset amounts or to the amounts and classification of liabilities that
may be necessary should the Company be unable to continue as a going concern.

6

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Current Liquidity and Near-Term
Obligations- As of November 12, 2009,
the Company had approximately $18.6 million in available cash on hand (including
restricted cash of $4.3 million). In addition to the Companys operating
expenses, the Company has quarterly interest payments due on its trust preferred
securities and intends to make payments in legal/lease obligations related to
its discontinued lending and servicing operations. The Companys current
projections indicate sufficient available cash and cash flows from its mortgage
securities to meet these payment needs. However, the cash flow from the
Companys mortgage securities is volatile and uncertain in nature, and the
amounts the Company receives could vary materially from its projections.
Therefore, no assurances can be given that the Company will be able to meet its
cash flow needs, in which case it may seek protection under applicable
bankruptcy laws.

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

Business Plan-The Company continues to develop its operating entities,
StreetLinks and Advent, and to increase their production and revenue. The
Company will continue to focus on minimizing losses, preserving liquidity, and
exploring new operating company opportunities.

Note 2. New Accounting Pronouncements

Accounting Pronouncements Adopted in
2009

Accounting standards
codification- In June 2009, the Financial
Accounting Standards Board (FASB) issued an accounting pronouncement
establishing theFASB Accounting Standards
Codificationas the source of authoritative
accounting principles recognized by the FASB to be applied by nongovernmental
entities. This pronouncement was effective for financial statements issued for
interim and annual periods ending after September 15, 2009, for most entities.
On the effective date, all non-SEC accounting and reporting standards will be
superceded. The Company adopted this new accounting pronouncement for the
quarterly period ended September 30, 2009, as required, and adoption did not
have a material impact on the Companys financial statements taken as a whole.

Accounting Pronouncements Not Yet
Adopted

Consolidation of variable interest
entities- In June 2009, the FASB issued
variable interest entity guidance, which amends the consolidation guidance
applicable to variable interest entities (VIEs). The amendments to the
consolidation guidance affect all entities currently within the scope of the
previous guidance, as well as qualifying special-purpose entities (QSPEs) that
are currently excluded from the previous guidance. This guidance is effective as
of the beginning of the first fiscal year that begins after November 15, 2009.
The Company is continuing to evaluate the impact that this guidance will have on
its financial condition and results of operation upon adoption.

Accounting for transfers of financial
assets- In June 2009, the FASB issued
guidance relating to the transfers of financial assets. This guidance amends the
derecognition accounting and disclosure requirements of previous guidance. It
also eliminates the exemption from consolidation for QSPEs and also requires a
transferor to evaluate all existing QSPEs to determine whether it must be
consolidated. This guidance is effective for financial asset transfers occurring
after the beginning of an entitys first fiscal year that begins after November
15, 2009. The Company is continuing to evaluate the impact that this guidance
will have on its financial condition and results of operation upon adoption.

Note 3. Mortgage Loans 
Held-in-Portfolio

Mortgage loans  held-in-portfolio, all of
which are secured by residential properties, consisted of the following as of
September 30, 2009 and December 31, 2008 (dollars in thousands):

|                                           |  | September 30, |           | December 31,
|------------------------------------------ |  | ------------- | --------- | ------------
|                                           |  | 2009          |           | 2008        
|Mortgage loans  held-in-portfolio:        |  |               |           |             
|Outstanding principal                      |  | $             | 2,117,984 |             
|Net unamortized deferred origination costs |  |               | 16,273    |             
|Amortized cost                             |  |               | 2,134,257 |             
|Allowance for credit losses                |  |               | (746,702  | )           
|Mortgage loans  held-in-portfolio         |  | $             | 1,387,555 |             
|Weighted average coupon                    |  |               | 7.11      | %           
|                                           |  |               |           |             

7

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

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

Accordingly, the loans in these
securitizations remain on the balance sheet as Mortgage loans 
held-in-portfolio. Given this treatment, retained interests are not created,
and securitization bond financing is reflected on the balance sheet as a
liability. The Company records interest income on loans held-in-portfolio and
interest expense on the bonds issued in the securitizations over the life of the
securitizations. Deferred debt issuance costs and discounts related to the bonds
are amortized on a level yield basis over the estimated life of the
bonds.

Mortgage loans  held-in-portfolio are
serviced by a third party entity. During the nine months ended September 30,
2009, the servicer modified loans totaling $210.0 million in principal with
weighted-average interest rates of 8.41% and 4.75% before and after
modification, respectively. During the three months ended September 30, 2009,
the servicer modified loans totaling $24.9 million in principal with
weighted-average interest rates of 8.40% and 4.16% before and after
modification, respectively. Generally, the modifications are offered to
borrowers experiencing financial difficulties and serve to reduce monthly
payments and defer unpaid interest. The Companys estimates for the allowance
for loan losses and related provision include the projected impact of the
modified loans.

At September 30, 2009 all of the loans
classified as held-in-portfolio were pledged as collateral for financing
purposes.

Activity in the allowance for credit
losses on mortgage loans  held-in-portfolio is as follows for the nine and
three months ended September 30, 2009 and 2008, respectively (dollars in
thousands):

|                                  |  | For the Nine Months
    Ended |          | For the Three Months
    Ended
|--------------------------------- |  | ----------------------------- | -------- | ------------------------------
|                                  |  | September 30,                 |          | September 30,                 
|                                  |  | 2009                          |          | 2008                          
|Balance, beginning of period      |  | $                             | 776,001  |                               
|Provision for
      credit losses |  |                               | 211,050  |                               
|Charge-offs, net of recoveries    |  |                               | (240,349 | )                             
|Balance, end of period            |  | $                             | 746,702  |                               
|                                  |  |                               |          |                               

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

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

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

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

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

8

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

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

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

Variable Interest
Entities

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

There were no material reconsideration
events during the period.

9

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

|                            |  |              |           | **Assets After
Intercompany** |   |                   |  |             
|--------------------------- |  | ------------ | --------- | ----------------------------- | - | ----------------- |  | ------------
|                            |  |              |           | Eliminations                  |   | Liabilities After |  |             
|                            |  |              |           |                               |   |                   |  | Intercompany
|Consolidated VIEs           |  | Total Assets |           | Unrestricted                  |   | Restricted (A)    |  | Eliminations
|September 30, 2009          |  |              |           |                               |   |                   |  |             
|Mortgage Loan
      VIEs(C) |  | $            | 1,554,109 |                               | $ | -                 |  | $           
|CDO(D)                      |  |              | 1,517     |                               |   | -                 |  |             
|December 31, 2008           |  |              |           |                               |   |                   |  |             
|Mortgage Loan VIEs(C)       |  | $            | 1,930,063 |                               | $ | -                 |  | $           
|CDO(D)                      |  |              | 7,435     |                               |   | -                 |  |             
|                            |  |              |           |                               |   |                   |  |             

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

Securitizations

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

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

|                     |  | Size/Principal |           | Assets on |   | Liabilities      |  | Maximum     |   | Year to   |   | Year to  
|-------------------- |  | -------------- | --------- | --------- | - | ---------------- |  | ----------- | - | --------- | - | ---------
|                     |  | Outstanding    |           | Balance   |   | on
      Balance |  | Exposure to |   | Date Loss |   | Date Cash
|                     |  | (A)            |           | Sheet     |   | Sheet            |  | Loss(B)     |   | on Sale   |   | Flows    
|September 30, 2009   |  |                |           |           |   |                  |  |             |   |           |   |          
|Residential mortgage |  |                |           |           |   |                  |  |             |   |           |   |          
|loans(C)             |  | $              | 7,039,707 |           | $ | 7,096            |  | $           | - |           | $ | 7,096    
|December 31, 2008    |  |                |           |           |   |                  |  |             |   |           |   |          
|Residential mortgage |  |                |           |           |   |                  |  |             |   |           |   |          
|loans(C)             |  | $              | 8,121,668 |           | $ | 15,919           |  | $           | - |           | $ | 15,919   
|                    

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

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

Retained interests are recorded in the
Condensed Consolidated Balance Sheets at fair value. The Company estimates fair
value based on the present value of expected future cash flows using
managements best estimates of credit losses, prepayment rates, forward yield
curves, and discount rates, commensurate with the risks involved. Retained
interests are either held as mortgage securities  trading, with changes in fair
value recorded in the Condensed Consolidated Statements of Operations, or as
mortgage securities  available-for-sale, with changes in fair value included in
accumulated other comprehensive income.

Retained interests are reviewed
periodically for impairment. Retained interests in securitized assets held as
available-for-sale and trading were approximately $7.1 million and $13.5 million
at September 30, 2009 and December 31, 2008, respectively. The retained
interests consisted of $6.9 million of residual interests and $0.2 million of
retained subordinated interests as of September 30, 2009.

10

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The following table presents information
on retained interests excluding the offsetting benefit of financial instruments
used to hedge risks, held by the Company as of September 30, 2009 arising from
the Companys residential mortgage-related securitization transactions. The
pre-tax sensitivities of the current fair value of the retained interests to
immediate 10% and 25% adverse changes in assumptions and parameters are also
shown (dollars in thousands):

|Carrying amount/fair value of
      residual interests                                             | $ | 6,923
|-------------------------------------------------------------------------------------------------- | - | -----
|Weighted average
      life (in years)                                                             |   | 3.67 
|Weighted average prepayment speed assumption (CPR)
    (percent)                                   |   | 17.5 
|Fair value after a 10% increase in prepayment speed                                                | $ | 6,414
|Fair value after a 25% increase in prepayment speed                                                | $ | 5,722
|Weighted average
      expected annual credit losses (percent of current collateral
      balance) |   | 25.8 
|Fair value after a 10% increase in annual credit losses                                            | $ | 6,094
|Fair value after a 25% increase in annual credit losses                                            | $ | 5,644
|Weighted average residual cash flows discount rate
    (percent)                                   |   | 25.0 
|Fair value after a 500 basis
      point increase in discount rate                                 | $ | 6,676
|Fair value after a 1000 basis
      point increase in discount rate                                | $ | 6,447
|Market interest
      rates:                                                                       |   |      
|Fair value after a 100 basis
      point increase in market rates                                  | $ | 4,073
|Fair value after a 200 basis
      point increase in market rates                                  | $ | 2,583
|                                                                                                   |   |      

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

Note 4. Mortgage Securities 
Available-for-Sale

As of September 30, 2009, and December 31,
2008, mortgage securities  available-for-sale consisted entirely of the
Companys investment in the residual securities issued by securitization trusts
sponsored by the Company, but did not include the NMFT Series 2007-2 residual
security, which was designated as trading as a result of the Companys adoption
of Accounting for Certain Hybrid Financial Instruments an amendment of previous
FASB guidance on January 1, 2007. As a result, the NMFT Series 2007-2, residual
security qualifies for the scope exception concerning bifurcation provided by
the new guidance. Residual securities consist of interest-only, prepayment
penalty and overcollateralization bonds. Management estimates the fair value of
the residual securities by discounting the expected future cash flows of the
collateral and bonds.

The following table presents certain
information on the Companys portfolio of mortgage securities 
available-for-sale as of September 30, 2009 and December 31, 2008 (dollars in
thousands):

|                              |  |                  |       |            |   | Unrealized Losses |  |                |   |          
|----------------------------- |  | ---------------- | ----- | ---------- | - | ----------------- |  | -------------- | - | ---------
|                              |  |                  |       | Unrealized |   | Less Than Twelve  |  | Estimated Fair |   | Average  
|                              |  | Cost
      Basis |       | Gain       |   | Months            |  | Value          |   | Yield (A)
|As of September 30, 2009      |  | $                | 2,007 |            | $ | 4,662             |  | $              | - |          
|As of December
      31, 2008 |  | $                | 3,771 |            | $ | 9,017             |  | $              | - |          
|                             

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

During the nine and three months ended
September 30, 2009 and 2008, management concluded that the decline in value on
certain securities in the Companys mortgage securities  available-for-sale
portfolio were other-than-temporary. As a result, the Company recognized
impairments on mortgage securities  available-for-sale of $1.2 million and $0.7
million during the nine and three months ended September 30, 2009, respectively,
as compared to $22.9 million and $1.7 million during the same periods of
2008.

11

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

Note 5. Mortgage Securities  Trading

As of September 30, 2009 and December 31,
2008, mortgage securities  trading consisted of the NMFT Series 2007-2 residual
security and subordinated securities retained by the Company from securitization
transactions as well as subordinated securities purchased from other issuers in
the open market. Management estimates the fair value of the residual securities
by discounting the expected future cash flows of the collateral and bonds. The
fair value of the subordinated securities is estimated based on quoted broker
prices. Refer to Note 9 for a description of the valuation methods as of
September 30, 2009 and December 31, 2008.

The following table summarizes the
Companys mortgage securities  trading as of September 30, 2009 and December
31, 2008 (dollars in thousands):

|                                             |  |                     |         | Amortized Cost |   |            |  | Average  
|-------------------------------------------- |  | ------------------- | ------- | -------------- | - | ---------- |  | ---------
|                                             |  | Original
      Face |         | Basis          |   | Fair Value |  | Yield (A)
|As of September 30, 2009                     |  |                     |         |                |   |            |  |          
|Subordinated
      securities pledged to CDO |  | $                   | 332,489 |                | $ | 145,086    |  | $        
|Other subordinated securities                |  |                     | 102,625 |                |   | 28,358     |  |          
|Residual
      securities                    |  |                     | -       |                |   | 408        |  |          
|Total                                        |  | $                   | 435,114 |                | $ | 173,852    |  | $        
|                                            
|As of December 31, 2008                      |  | $                   | 435,114 |                | $ | 433,968    |  | $        
|                                            

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

The Company recognized net trading losses
of $11.3 million and $1.6 million for the nine and three months ended September
30, 2009, respectively as compared to net trading losses of $78.6 million and
$3.7 million for the same periods of 2008. These net trading losses are included
in the fair value adjustments line on the Companys condensed consolidated
statements of operations.

There were no trading securities pledged
as collateral as of September 30, 2009 and December 31, 2008.

Note 6. Borrowings

Junior Subordinated
Debentures

NFIs wholly owned subsidiary NovaStar
Mortgage, Inc. (NMI) has approximately $77.7 million in principal amount of
unsecured notes (collectively, the Notes) outstanding to NovaStar Capital
Trust I and NovaStar Capital Trust II (collectively, the Trusts) which secure
trust preferred securities issued by the Trusts. NFI has guaranteed NMI's
obligations under the Notes. NMI failed to make quarterly interest payments that
were due on all payment dates in 2008 and through April 24, 2009 on these Notes.

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

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

12

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Note 7. Commitments and
Contingencies

Litigation.

In May 2007, a lawsuit entitledNational Community Reinvestment Coalition v.
NovaStar Financial, Inc.,et al., was filed against
the Company in the United States District Court for the District of Columbia.
Plaintiff, a non-profit organization, alleges that the Company maintains
corporate policies of not making loans on Indian reservations, on dwellings used
for adult foster care or on rowhouses in Baltimore, Maryland in violation of the
federal Fair Housing Act. The lawsuit seeks injunctive relief and damages,
including punitive damages, in connection with the lawsuit. On May 30, 2007, the
Company responded to the lawsuit by filing a motion to dismiss certain of
plaintiffs claims. On March 31, 2008 that motion was denied by the Court. In
October 2009 the Company reached a settlement to this claim which did not
significantly impact the Companys financial statements.

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

In February 2007, a number of
substantially similar putative class actions were filed in the United States
District Court for the Western District of Missouri. The complaints name the
Company and three of the Companys former and current executive officers as
defendants and generally allege, among other things, that the defendants made
materially false and misleading statements regarding the Companys business and
financial results. The plaintiffs purport to have brought the actions on behalf
of all persons who purchased or otherwise acquired the Companys common stock
during the period May 4, 2006 through February 20, 2007. Following consolidation
of the actions, a consolidated amended complaint was filed on October 19, 2007.
On December 29, 2007, the defendants moved to dismiss all of plaintiffs claims.
On June 4, 2008, the District Court dismissed the plaintiffs complaints without
leave to amend. The plaintiffs filed an appeal of the District Courts ruling.
On September 1, 2009 the United States Court of Appeals for the Eight Circuit
affirmed the judgment of the District Court.

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

On January 31, 2008, two purported
shareholders filed separate derivative actions in the Circuit Court of Jackson
County, Missouri against various former and current officers and directors and
named the Company as a nominal defendant. The essentially identical petitions
seek monetary damages alleging that the individual defendants breached fiduciary
duties owed to the Company, alleging insider selling and misappropriation of
information, abuse of control, gross mismanagement, waste of corporate assets,
and unjust enrichment between May 2006 and December 2007. On June 24, 2008 a
third, similar case was filed in United States District Court for the Western
District of Missouri. On July 13, 2009 the Company filed a motion to dismiss the
plaintiffs claims. The Company believes that these claims are without merit and
will vigorously defend against them.

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

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

13

---

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

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

Note 8. Comprehensive
Income

The following is a rollforward of
accumulated other comprehensive income for the nine and three months ended
September 30, 2009 and 2008 (dollars in thousands):

|                                                                  | For the Nine Months |          | For the Three Months
|----------------------------------------------------------------- | ------------------- | -------- | --------------------
|                                                                  | Ended September 30, |          | Ended September 30, 
|                                                                  | 2009                |          | 2008                
|Net loss                                                          | $                   | (158,222 | )                   
|Other
      comprehensive (loss) income:                          |                     |          |                     
|Change in unrealized loss on mortgage securities                 |                     |          |                     
|available-for-sale                                                |                     | (5,511   | )                   
|Change in
      unrealized gain (loss) on derivative instruments  |                     |          |                     
|used in cash flow
    hedges                                      |                     | 8        |                     
|Impairment on mortgage securities - available-for-sale            |                     |          |                     
|reclassified to
    earnings                                      |                     | 1,155    |                     
|Net settlements
      of derivative instruments used in cash flow |                     |          |                     
|hedges reclassified to
      earnings                             |                     | 84       |                     
|Other comprehensive (loss) income                                 |                     | (4,264   | )                   
|Total
      comprehensive loss                                    |                     | (162,486 | )                   
|Comprehensive loss attributable to noncontrolling                 |                     |          |                     
|interests                                                         |                     | 1,174    |                     
|Total
      comprehensive loss attributable to NovaStar           |                     |          |                     
|Financial, Inc.                                                   | $                   | (161,312 | )                   
|                                                                 

Note 9. Fair Value Accounting

Fair Value
Measurements

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

14

---

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

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

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

The following tables present for each of
the fair value hierarchy levels, the Companys assets and liabilities related to
continuing operations which are measured at fair value on a recurring basis as
of September 30, 2009 and December 31, 2008 (dollars in thousands).

|                                             |  |               |       | Fair
      Value Measurements at Reporting Date Using
|-------------------------------------------- |  | ------------- | ----- | -----------------------------------------------------
|                                             |  |               |       | Quoted Prices                                        
|                                             |  |               |       | in
      Active                                      
|                                             |  | Fair Value at |       | Markets for                                          
|                                             |  | September 30, |       | Identical Assets                                     
|Description                                  |  | 2009          |       | (Level 1)                                            
|Assets:                                      |  |               |       |                                                      
|Mortgage
      securities -trading           |  | $             | 1,425 |                                                      
|Mortgage securities  available-for-sale     |  |               | 6,669 |                                                      
|Total
      assets                           |  | $             | 8,094 |                                                      
|                                            
|Liabilities:                                 |  |               |       |                                                      
|Asset-backed
      bonds secured by mortgage |  |               |       |                                                      
|securities                                   |  | $             | 1,063 |                                                      
|Derivative instruments, net                  |  |               | 2,394 |                                                      
|Total liabilities                            |  | $             | 3,457 |                                                      
|                                            

15

---

|                                             |  |               |        | Fair
      Value Measurements at Reporting Date Using
|-------------------------------------------- |  | ------------- | ------ | -----------------------------------------------------
|                                             |  |               |        | Quoted Prices                                        
|                                             |  |               |        | in
      Active                                      
|                                             |  | Fair Value at |        | Markets for                                          
|                                             |  | December 31,  |        | Identical Assets                                     
|Description                                  |  | 2008          |        | (Level 1)                                            
|Assets:                                      |  |               |        |                                                      
|Mortgage
      securities -trading           |  | $             | 7,085  |                                                      
|Mortgage securities  available-for-sale     |  |               | 12,788 |                                                      
|Total
      assets                           |  | $             | 19,873 |                                                      
|                                            
|Liabilities:                                 |  |               |        |                                                      
|Asset-backed
      bonds secured by mortgage |  |               |        |                                                      
|securities                                   |  | $             | 5,376  |                                                      
|Derivative instruments, net                  |  |               | 9,102  |                                                      
|Total liabilities                            |  | $             | 14,478 |                                                      
|                                            

The following tables provide a
reconciliation of the beginning and ending balances for the Companys mortgage
securities  trading which are measured at fair value on a recurring basis using
significant unobservable inputs (Level 3) for the nine and three months ended
September 30, 2009 and 2008 (dollars in thousands):

|                                                       |  |            |          |                 |  |            |          |   |  | Estimated Fair
|------------------------------------------------------ |  | ---------- | -------- | --------------- |  | ---------- | -------- | - |  | --------------
|                                                       |  |            |          |                 |  |            |          |   |  | Value of      
|                                                       |  |            |          |                 |  |            |          |   |  | Mortgage      
|                                                       |  | Cost Basis |          | Unrealized Gain |  | Securities
|As of December 31, 2008                                |  | $          | 433,968  |                 |  | $          | (426,883 | ) |  | $             
|Increases (decreases) to
      mortgage securities -   |  |            |          |                 |  |            |          |   |  |               
|trading                                                |  |            |          |                 |  |            |          |   |  |               
|Accretion of income                                    |  |            | 9,992    |                 |  |            | -        |   |  |               
|Proceeds from paydowns of
      securities             |  |            | (4,397   | )               |  |            | -        |   |  |               
|Other than temporary
      impairments                 |  |            | (265,711 | )               |  |            | 265,711  |   |  |               
|Mark-to-market value
      adjustment                  |  |            | -        |                 |  |            | (11,255  | ) |  |               
|Net (decrease) increase to
      mortgage securities - |  |            |          |                 |  |            |          |   |  |               
|trading                                                |  |            | (260,116 | )               |  |            | 254,456  |   |  |               
|As of September
      30, 2009                         |  | $          | 173,852  |                 |  | $          | (172,427 | ) |  | $             
|                                                      
|                                                      

|                                                      
|------------------------------------------------------
|                                                      
|                                                      
|                                                      
|                                                      
|As of December 31, 2007                               
|Increases (decreases) to
      mortgage securities -  
|trading                                               
|Securities transferred from
      Level 2 to Level 3  
|Accretion of income                                   
|Proceeds from paydowns of
      securities            
|Mark-to-market value
      adjustment                 
|Net (decrease) increase to
      mortgage securities -
|trading                                               
|As of September
      30, 2008                        
|                                                      

16

---

|                                                       |  |            |          |                 |  |            |          |   |  | Estimated Fair
|------------------------------------------------------ |  | ---------- | -------- | --------------- |  | ---------- | -------- | - |  | --------------
|                                                       |  |            |          |                 |  |            |          |   |  | Value of      
|                                                       |  |            |          |                 |  |            |          |   |  | Mortgage      
|                                                       |  | Cost Basis |          | Unrealized Gain |  | Securities
|As of June 30, 2009                                    |  | $          | 402,192  |                 |  | $          | (399,747 | ) |  | $             
|Increases (decreases) to
      mortgage securities -   |  |            |          |                 |  |            |          |   |  |               
|trading                                                |  |            |          |                 |  |            |          |   |  |               
|Accretion of income                                    |  |            | 1,292    |                 |  |            | -        |   |  |               
|Proceeds from paydowns of
      securities             |  |            | (762     | )               |  |            | -        |   |  |               
|Other than temporary
      impairments                 |  |            | (228,870 | )               |  |            | 228,870  |   |  |               
|Mark-to-market value
      adjustment                  |  |            | -        |                 |  |            | (1,550   | ) |  |               
|Net (decrease) increase to
      mortgage securities - |  |            |          |                 |  |            |          |   |  |               
|trading                                                |  |            | (228,340 | )               |  |            | 227,320  |   |  |               
|As of September
      30, 2009                         |  | $          | 173,852  |                 |  | $          | (172,427 | ) |  | $             
|                                                      

|                                                      
|------------------------------------------------------
|                                                      
|                                                      
|                                                      
|                                                      
|                                                      
|As of June 30, 2008                                   
|Increases (decreases) to
      mortgage securities -  
|trading                                               
|Securities transferred from
      Level 2 to Level 3  
|Accretion of income                                   
|Proceeds from paydowns of
      securities            
|Mark-to-market value
      adjustment                 
|Net (decrease) increase to
      mortgage securities -
|trading                                               
|As of September
      30, 2008                        
|                                                      

The following tables provide a
reconciliation of the beginning and ending balances for the Companys mortgage
securities  available-for-sale which are measured at fair value on a recurring
basis using significant unobservable inputs (Level 3) for the nine and three
months ended September 30, 2009 and 2008 (dollars in thousands):

|                                                       |  |            |         |                 |  | Estimated Fair
|------------------------------------------------------ |  | ---------- | ------- | --------------- |  | --------------
|                                                       |  |            |         |                 |  | Value of      
|                                                       |  |            |         |                 |  | Mortgage      
|                                                       |  | Cost Basis |         | Unrealized Gain |  | Securities    
|As of December 31, 2008                                |  | $          | 3,771   |                 |  | $             
|Increases (decreases) to
      mortgage securities    |  |            |         |                 |  |               
|available-for-sale                                     |  |            |         |                 |  |               
|Accretion of income
    (A)                            |  |            | 11,421  |                 |  |               
|Proceeds from paydowns of
      securities (A) (B)     |  |            | (12,030 | )               |  |               
|Impairment on mortgage
      securities  available-   |  |            |         |                 |  |               
|for-sale                                               |  |            | (1,155  | )               |  |               
|Mark-to-market value
      adjustment                  |  |            | -       |                 |  |               
|Net (decrease) increase to
      mortgage securities  |  |            |         |                 |  |               
|available-for-sale                                     |  |            | (1,764  | )               |  |               
|As of September
      30, 2009                         |  | $          | 2,007   |                 |  | $             
|                                                      

|(A) |  | Cash received on mortgage
      securities with no cost basis was $1.9 million for the nine months ended
      September 30, 2009.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|(B) |  | For mortgage securities with a remaining
      cost basis, the Company reduces the cost basis by the amount of cash that
      is contractually due from the securitization trusts. In contrast, for
      mortgage securities in which the cost basis has previously reached zero,
      the Company records in interest income the amount of cash that is
      contractually due from the securitization trusts. In both cases, there are
      instances where the Company may not receive a portion of this cash until
      after the balance sheet reporting date. Therefore, these amounts are
      recorded as receivables from the securitization trusts. As of September
      30, 2009, the Company had no receivables from securitization trusts
      related to mortgage securities available-for-sale with a remaining cost
      basis.

17

---

|                                                       |            |         |        |  |                 |       |          | Estimated Fair
|------------------------------------------------------ | ---------- | ------- | ------ |  | --------------- | ----- | -------- | --------------
|                                                       |            |         |        |  |                 |       |          | Value of      
|                                                       |            |         |        |  | Unrealized Gain |       | Mortgage
|                                                       | Cost Basis |         | (Loss) |  | Securities     
|As of December 31, 2007                                | $          | 33,302  |        |  | $               | 69    |          | $             
|Increases (decreases) to
      mortgage securities    |            |         |        |  |                 |       |          |               
|available-for-sale                                     |            |         |        |  |                 |       |          |               
|Accretion of income
    (A)                            |            | 5,976   |        |  |                 | -     |          |               
|Proceeds from paydowns of
      securities (A) (B)     |            | (10,992 | )      |  |                 | -     |          |               
|Impairment on mortgage
      securities  available-   |            |         |        |  |                 |       |          |               
|for-sale                                               |            | (22,897 | )      |  |                 | -     |          |               
|Mark-to-market value
      adjustment                  |            | -       |        |  |                 | 1,454 |          |               
|Net (decrease) increase to
      mortgage securities  |            |         |        |  |                 |       |          |               
|available-for-sale                                     |            | (27,913 | )      |  |                 | 1,454 |          |               
|As of September
      30, 2008                         | $          | 5,389   |        |  | $               | 1,523 |          | $             
|                                                      

|(A) |  | Cash received on mortgage
      securities with no cost basis was $2.0 million for the nine months ended
      September 30, 2008.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(B) |  | For mortgage securities with a
      remaining cost basis, the Company reduces the cost basis by the amount of
      cash that is contractually due from the securitization trusts. In
      contrast, for mortgage securities in which the cost basis has previously
      reached zero, the Company records in interest income the amount of cash
      that is contractually due from the securitization trusts. In both cases,
      there are instances where the Company may not receive a portion of this
      cash until after the balance sheet reporting date. Therefore, these
      amounts are recorded as receivables from the securitization trusts. As of
      September 30, 2008, the Company had no receivable due from securitization
      trusts. As of December 31, 2007 the Company had receivables from
      securitization trusts of $12.5 million related to mortgage securities
      available-for-sale with a remaining cost basis.
|   

|                                                       |            |        |                 |  |            |        |   |  | Estimated Fair
|------------------------------------------------------ | ---------- | ------ | --------------- |  | ---------- | ------ | - |  | --------------
|                                                       |            |        |                 |  |            |        |   |  | Value of      
|                                                       |            |        |                 |  |            |        |   |  | Mortgage      
|                                                       | Cost Basis |        | Unrealized Gain |  | Securities
|As of June 30, 2009                                    | $          | 2,314  |                 |  | $          | 7,405  |   |  | $             
|Increases (decreases) to
      mortgage securities    |            |        |                 |  |            |        |   |  |               
|available-for-sale                                     |            |        |                 |  |            |        |   |  |               
|Accretion of income
    (A)                            |            | 3,445  |                 |  |            | -      |   |  |               
|Proceeds from paydowns of
      securities (A)         |            | (3,049 | )               |  |            | -      |   |  |               
|Impairment on mortgage
      securities  available-   |            |        |                 |  |            |        |   |  |               
|for-sale                                               |            | (703   | )               |  |            |        |   |  |               
|Mark-to-market value
      adjustment                  |            | -      |                 |  |            | (2,743 | ) |  |               
|Net (decrease) increase to
      mortgage securities  |            |        |                 |  |            |        |   |  |               
|available-for-sale                                     |            | (307   | )               |  |            | (2,743 | ) |  |               
|As of September
      30, 2009                         | $          | 2,007  |                 |  | $          | 4,662  |   |  | $             
|                                                      

|(A) |  | Cash received on mortgage
      securities with no cost basis was $0.7 million for the three months ended
      September 30, 2009.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------
|   

18

---

|                                                       |            |        |        |  |                 |       |          | Estimated Fair
|------------------------------------------------------ | ---------- | ------ | ------ |  | --------------- | ----- | -------- | --------------
|                                                       |            |        |        |  |                 |       |          | Value of      
|                                                       |            |        |        |  | Unrealized Gain |       | Mortgage
|                                                       | Cost Basis |        | (Loss) |  | Securities     
|As of June 30, 2008                                    | $          | 8,434  |        |  | $               | 733   |          | $             
|Increases (decreases) to
      mortgage securities    |            |        |        |  |                 |       |          |               
|available-for-sale                                     |            |        |        |  |                 |       |          |               
|Accretion of
      income (A)                          |            | 2,617  |        |  |                 | -     |          |               
|Proceeds from
      paydowns of securities (A)         |            | (3,994 | )      |  |                 | -     |          |               
|Impairment on mortgage
      securities  available-   |            |        |        |  |                 |       |          |               
|for-sale                                               |            | (1,668 | )      |  |                 | -     |          |               
|Mark-to-market value
      adjustment                  |            | -      |        |  |                 | 790   |          |               
|Net (decrease) increase to
      mortgage securities  |            |        |        |  |                 |       |          |               
|available-for-sale                                     |            | (3,045 | )      |  |                 | 790   |          |               
|As of September
      30, 2008                         | $          | 5,389  |        |  | $               | 1,523 |          | $             
|                                                      

|(A) |  | Cash received on mortgage
      securities with no cost basis was $0.5 million for the three months ended
      September 30, 2008.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------

19

---

The following table provides quantitative
disclosures about the fair value measurements for the Companys assets which are
measured at fair value on a nonrecurring basis as of September 30, 2009 and
December 31, 2008 (dollars in thousands):

|                        |  |             |        | **Fair Value Measurements at Reporting Date
  Using**
|----------------------- |  | ----------- | ------ | -----------------------------------------------------
|                        |  |             |        |                                                      
|                        |  |             |        |                                                      
|                        |  | Real Estate |        | Identical Assets                                     
|Fair Value at           |  | Owned       |        | (Level 1)                                            
|September 30, 2009      |  | $           | 83,573 |                                                      
|December 31,
      2008 |  |             | 70,480 |                                                      
|                       

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

The following table provides a summary of
the impact to earnings for the nine and three months ended September 30, 2009
and 2008 from the Companys assets and liabilities related to continuing
operations which are measured at fair value on a recurring and nonrecurring
basis (dollars in thousands):

|                            |  |                  |  | Fair Value      |         | Fair Value       |  |     
|--------------------------- |  | ---------------- |  | --------------- | ------- | ---------------- |  | ----
|                            |  |                  |  | Adjustments For |         | Adjustments For  |  |     
|                            |  |                  |  | the Nine Months |         | the Three Months |  |     
|                            |  |                  |  | Ended September |         | Ended September  |  |     
|                            |  |                  |  | 30              |         | 30               |  |     
|                            |  | Fair
      Value |  |                 |         |                  |  |     
|Asset or
      Liability    |  | Measurement      |  |                 |         |                  |  |     
|Measured at Fair
Value      |  | Frequency        |  | 2009            |         | 2008             |  | 2009
|Mortgage securities -       |  |                  |  |                 |         |                  |  |     
|trading                     |  | Recurring        |  | $               | (11,255 | )                |  | $   
|Mortgage
      securities  |  |                  |  |                 |         |                  |  |     
|available-for-sale          |  | Recurring        |  |                 | (1,155  | )                |  |     
|Real estate
      owned     |  | Nonrecurring     |  |                 | (9,164  | )                |  |     
|Derivative instruments,     |  |                  |  |                 |         |                  |  |     
|net                         |  | Recurring        |  |                 | 5,124   |                  |  |     
|Asset-backed bonds          |  |                  |  |                 |         |                  |  |     
|secured by
      mortgage   |  |                  |  |                 |         |                  |  |     
|securities                  |  | Recurring        |  |                 | 4,658   |                  |  |     
|Total fair value losses     |  |                  |  | $               | (11,792 | )                |  | $   
|                           

Valuation Methods

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

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

20

---

Mortgage securities 
available-for-sale.Mortgage securities 
available-for-sale represent beneficial interests theCompany retains in securitization and
resecuritization transactions which include residual securities. The Company had
no subordinated securities included within the mortgage securities 
available-for-sale classification as of September 30, 2009 or December 31, 2008.
Mortgage securities classified as available-for-sale are reported at their
estimated fair value with unrealized gains and losses reported in accumulated
other comprehensive income. To the extent that the cost basis of mortgage
securities exceeds the fair value and the unrealized loss is considered to be
other-than-temporary, an impairment charge is recognized and the amount recorded
in accumulated other comprehensive income or loss is reclassified to earnings as
a realized loss. The specific identification method is used in computing
realized gains or losses.

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

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

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

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

Fair Value Option for Financial
Assets and Financial Liabilities

The Company elected the fair value option
for the asset-backed bonds issued from the CDO, which the Company closed in the
first quarter of 2007. The Company elected the fair value option for these
liabilities to help reduce earnings volatility which otherwise would arise if
the accounting method for this debt was not matched with the fair value
accounting for the related mortgage securities - trading. The asset-backed bonds
which are being carried at fair value are included in the Asset-backed bonds
secured by mortgage securities line item on the condensed consolidated balance
sheets. The Company recognized fair value adjustments of $4.7 million and $1.2
million for the nine and three months ended September 30, 2009, respectively,
and $58.3 million and $6.1 million for the same periods in 2008, respectively,
which is included in the Fair value adjustments line item on the condensed
consolidated statements of operations. A significant majority of the change in
the asset-backed bonds balance is due to the fair value adjustments since
adoption of the guidance.

The Company has not elected fair value
accounting for any other balance sheet items as allowed by the guidance from
Fair Value Option for Financial Assets and Financial
Liabilities.

The following table shows the difference
between the unpaid principal balance and the fair value of the asset-backed
bonds secured by mortgage securities for which the Company has elected fair
value accounting as of September 30, 2009 and December 31, 2008 (dollars in
thousands):

|                                     |  | Asset-Backed     |         |                   |   |            |     |  
|------------------------------------ |  | ---------------- | ------- | ----------------- | - | ---------- | --- | -
|                                     |  | Bonds Secured by |         |                   |   |            |     |  
|                                     |  | Mortgage         |         | Year to Date Gain |   |            |    
|Unpaid Principal Balance as
      of |  | Securities       |         | Recognized        |   | Fair Value
|September 30, 2009                   |  | $                | 323,869 |                   | $ | 4,658      |     | $
|December 31,
      2008              |  |                  | 324,243 |                   |   | 58,337     | (A) |  
|                                    

|(A) |  | For the nine months
      ended September 30, 2008.
|--- |  | ---------------------------------------------------

Substantially all of the $4.7 million
change in fair value of the asset-backed bonds during the nine months ended
September 30, 2009 is considered to be related to specific credit risk as all of
the bonds are floating rate. The change in credit risk was caused by spreads
widening in the asset-backed securities market during the nine months ended
September 30, 2009.

Note 10. Derivative Instruments and
Hedging Activities

The Companys objective and strategy for
using derivative instruments is to mitigate the risk of increased costs on its
variable rate liabilities during a period of rising rates, subject to cost and
liquidity risk constraints. The Companys primary goals for managing interest
rate risk are to maintain the net interest margin between its assets and
liabilities and diminish the effect of changes in general interest rate levels
on the market value of the Company.

21

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The derivative instruments used by the
Company to manage this risk are interest rate caps and interest rate swaps.
Interest rate caps are contracts in which the Company pays either an upfront
premium or monthly or quarterly premium to a counterparty. In return, the
Company receives payments from the counterparty when interest rates rise above a
certain rate specified in the contract. During the nine and three months ended
September 30, 2009, premiums paid pursuant to interest rate cap agreements
related to continuing operations aggregated approximately $54,000 and $16,000,
respectively, as compared to $0.3 and $0.1 million for the same periods in 2008.
When premiums are financed by the Company, a liability is recorded for the
premium obligation. Premiums due to counterparties as of September 30, 2009 and
December 31, 2008 were approximately $11,000 and $0.1 million, respectively, and
had a weighted average interest rate of 4.5% and 3.9%, respectively. The future
contractual maturities of premiums due to counterparties as ofSeptember 30, 2009 are all due during 2009. There are no
future contractual maturities premiums due in 2010 or thereafter. The interest
rate swap agreements to which the Company is party stipulate that the Company
pay a fixed rate of interest to the counterparty and the counterparty pays the
company a variable rate of interest based on the notional amount of the
contract. The liabilities that the Company hedges are asset-backed bonds as
discussed in Note 3.

The Company also has derivative
instruments that do not meet the requirements for hedge accounting. However,
these derivative instruments do contribute to the Companys overall risk
management strategy by serving to reduce interest rate risk on asset-backed
bonds collateralized by the Companys loans held-in-portfolio.

The following tables present derivative
instruments as of September 30, 2009 and December 31, 2008 (dollars in
thousands):

|                                             |                 |         |            |   |          |   |  | Maximum      
|-------------------------------------------- | --------------- | ------- | ---------- | - | -------- | - |  | -------------
|                                             |                 |         |            |   |          |   |  | Days
      to
|                                             | Notional Amount |         | Fair Value |   | Maturity
|As of September 30, 2009:                    |                 |         |            |   |          |   |  |              
|Non-hedge derivative
      instruments       | $               | 230,000 |            | $ | (2,394   | ) |  | 117          
|                                            
|As of December 31, 2008:                     |                 |         |            |   |          |   |  |              
|Non-hedge
      derivative instruments       | $               | 461,500 |            | $ | (9,034   | ) |  | 390          
|Cash flow
      hedge derivative instruments |                 | 40,000  |            |   | (68      | ) |  | 25           
|                                            

The Company recognized net expense of $2.0
and $0.6 million during the nine and three months ended September 30, 2008 on
derivative instruments qualifying as cash flow hedges, which is recorded as a
component of interest expense. There was no expense recorded relating to
derivative instruments qualifying as cash flow hedges during the nine and three
months ended September 30, 2009

During the three months ended September
30, 2009 and 2008, respectively, hedge ineffectiveness was
insignificant.

The Companys derivative instruments
involve, to varying degrees, elements of credit and market risk in addition to
the amount recognized in the consolidated financial statements.

Credit RiskThe
Companys exposure to credit risk on derivative instruments is equal to the
amount of deposits (margin) held by the counterparty, plus any net receivable
due from the counterparty, plus the cost of replacing the contracts should the
counterparty fail. The Company seeks to minimize credit risk through the use of
credit approval and review processes, the selection of only the most
creditworthy counterparties, continuing review and monitoring of all
counterparties, exposure reduction techniques and thorough legal scrutiny of
agreements. Before engaging in negotiated derivative transactions with any
counterparty, the Company has in place fully executed written agreements.
Agreements with counterparties also call for full two-way netting of payments.
Under these agreements, on each payment exchange date all gains and losses of
counterparties are netted into a single amount, limiting exposure to the
counterparty to any net receivable amount due.

Market RiskThe potential for financial loss due to adverse changes in market
interest rates is a function of the sensitivity of each position to changes in
interest rates, the degree to which each position can affect future earnings
under adverse market conditions, the source and nature of funding for the
position, and the net effect due to offsetting positions. The derivative
instruments utilized leave the Company in a market position that is designed to
be a better position than if the derivative instrument had not been used in
interest rate risk management.

Other Risk ConsiderationsThe Company is cognizant of the risks
involved with derivative instruments and has policies and procedures in place to
mitigate risk associated with the use of derivative instruments in ways
appropriate to its business activities, considering its risk profile as a
limited end-user.

22

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Note 11. Income Taxes

Based on the evidence available as of
September 30, 2009 and December 31, 2008, including the significant pre-tax
losses incurred by the Company in 2008 and the second quarter of 2009, the
liquidity issues facing the Company and the decision by the Company to close all
of its mortgage lending and loan servicing operations, the Company believes that
it is more likely than not that the Company will not realize its deferred tax
assets. Based on these conclusions, theCompany
recorded a valuation allowance against its entire net deferred tax assets as of
September 30, 2009 and December 31, 2008.

The Company recognizes tax benefits in
accordance with the FASB interpretation,Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement,Accounting for Income Taxes. This
interpretation establishes a more-likely-than-not recognition threshold that
must be met before a tax benefit can be recognized in the financial statements.
As of September 30, 2009 and December 31, 2008, the total gross amount of
unrecognized tax benefits was $1.1 million and $0.5 million, respectively. The
increase of $0.6 million is attributed to filing positions taken on recently
filed returns.

Note 12. Segment
Reporting

As of September 30, 2009, the Company
reviews, manages and operates its business in one segment: portfolio management.
Portfolio management operating results come from the income generated on the
mortgage assets and operating business the Company manages less associated
costs. The portfolio management segments operating results for the nine and
three months ended September 30, 2009 and 2008 are the same as the Companys
condensed consolidated statements of operations.

23

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Note 13. Earnings Per
Share

The computations of basic and diluted
earnings per share for the nine and three months ended September 30, 2009 and
2008 (dollars in thousands, except per share amounts):

|                                                             | For the Nine Months
    Ended |           | For the Three Months
|------------------------------------------------------------ | ----------------------------- | --------- | --------------------
|                                                             | September 30,                 |           | Ended September 30, 
|                                                             | 2009                          |           | 2008                
|Numerator:                                                   |                               |           |                     
|Loss from
      continuing operations                        | $                             | (158,222  | )                   
|Less loss attributable to noncontrolling interests           |                               | (1,174    | )                   
|Dividends on
      preferred shares                          |                               | (11,361   | )                   
|Loss from continuing operations available to                 |                               |           |                     
|common shareholders                                          |                               | (168,409  | )                   
|Income from
      discontinued operations, net of income tax |                               | -         |                     
|Net loss available to common shareholders                    | $                             | (168,409  | )                   
|                                                            
|Denominator:                                                 |                               |           |                     
|Weighted average
      common shares outstanding            |                               |           |                     
|basic and
      diluted                                      |                               | 9,368,053 |                     
|                                                            
|Basic earnings per share:                                    |                               |           |                     
|Loss from
      continuing operations                        | $                             | (16.89    | )                   
|Less loss attributable to noncontrolling interests           |                               | (0.12     | )                   
|Dividends on
      preferred shares                          |                               | (1.21     | )                   
|Loss from continuing operations available to                 |                               |           |                     
|common shareholders                                          |                               | (17.98    | )                   
|Income from
      discontinued operations, net of income tax |                               | -         |                     
|Net loss available to common shareholders                    | $                             | (17.98    | )                   
|                                                            
|Diluted earnings per share:                                  |                               |           |                     
|Loss from
      continuing operations                        | $                             | (16.89    | )                   
|Less loss attributable to noncontrolling interests           |                               | (0.12     | )                   
|Dividends on
      preferred shares                          |                               | (1.21     | )                   
|Loss from continuing operations available to                 |                               |           |                     
|common shareholders                                          |                               | (17.98    | )                   
|Income from
      discontinued operations, net of income     |                               |           |                     
|tax                                                          |                               | -         |                     
|Net loss available to common shareholders                    | $                             | (17.98    | )                   
|                                                            

The following stock options to purchase
shares of common stock were outstanding during each period presented, but were
not included in the computation of diluted earnings per share because the number
of shares assumed to be repurchased, as calculated was greater than the number
of shares to be obtained upon exercise, therefore, the effect would be
antidilutive (in thousands, except exercise prices):

|                                      | For the Nine Months
    Ended |       | For the Three Months
|------------------------------------- | ----------------------------- | ----- | --------------------
|                                      | September 30,                 |       | Ended September 30, 
|                                      | 2009                          |       | 2008                
|Number of stock options               |                               | 114   |                     
|Weighted average
      exercise price | $                             | 52.98 |                     
|                                     

24

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Note 14. Fair Value of Financial
Instruments

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

The estimated fair values of the Companys
financial instruments related to continuing operations are as follows as of
September 30, 2009 and December 31, 2008 (dollars in thousands):

|                                               | As of
      September 30, 2009 |           | As of
      December 31, 2008
|---------------------------------------------- | ------------------------------ | --------- | -----------------------------
|                                               |                                |           |                              
|                                               | Carrying Value                 |           | Fair Value                   
|Financial assets:                              |                                |           |                              
|Cash and cash
      equivalents                | $                              | 14,818    |                              
|Restricted
      cash                          |                                | 4,294     |                              
|Mortgage
      loans - held-in-portfolio       |                                | 1,387,555 |                              
|Mortgage
      securities - trading            |                                | 1,425     |                              
|Mortgage
      securities - available-for-sale |                                | 6,669     |                              
|Accrued
      interest receivable              |                                | 74,842    |                              
|Financial
      liabilities:                   |                                |           |                              
|Borrowings:                                    |                                |           |                              
|Asset-backed bonds secured by mortgage         |                                |           |                              
|loans                                          |                                | 2,361,588 |                              
|Asset-backed bonds secured by mortgage         |                                |           |                              
|securities                                     |                                | 1,063     |                              
|Junior subordinated debentures                 |                                | 77,692    |                              
|Accrued
      interest payable                 |                                | 1,007     |                              
|Derivative
      instruments:                  |                                |           |                              
|Interest rate
      swap agreements            |                                | 2,394     |                              
|                                              

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

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

Mortgage loans held-in-portfolio  The fair value of mortgage loans 
held-in-portfolio was estimated using the carrying value less a market discount
as of September 30, 2009. The internal rate of return is less than what an
outside investor would require due to the embedded credit risk, therefore a
market discount is required to get to the fair value. The fair value of mortgage
loans  held-in-portfolio approximated its carrying value at December 31,
2008.

Mortgage securities- trading
Mortgage securities  trading is made up of
residual securities and subordinated securities. The fair value of residual
securities is estimated by discounting future projected cash flows using a
discount rate commensurate with the risks involved. The fair value of the
subordinated securities is estimated using quoted broker prices and compared to
internal discounted cash flows.

Mortgage securities 
available-for-sale Mortgage securities 
available-for-sale is made up of residual securities. The fair value of residual
securities is estimated by discounting future projected cash flows using a
discount rate commensurate with the risks involved.

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

Asset-backed bonds secured by mortgage
loans The fair value of asset-backed bonds
secured by mortgage loans and the related accrued interest payable was estimated
using the fair value of mortgage loans  held-in-portfolio at September 30, 2009
as the trusts have no recourse to the Companys other, unsecuritized
assets.

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

25

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

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

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

26

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

The following discussion should be read in
conjunction with the preceding unaudited condensed consolidated financial
statements of NovaStar Financial, Inc. and its subsidiaries (the Company
,NovaStar Financial, NFI , we or us) and the notes thereto as well as
NovaStar Financials annual report to shareholders and Annual Report on Form
10-K for the fiscal year ended December 31, 2008.

Executive Overview

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

Because of severe declines in housing
prices and national and international economic crises, we have suffered
significant losses during 2008 and 2009 because of declining values of our
investments in mortgage loans and securities. Liquidity constraints forced us to
reduce operations and administrative staff and take other measures to conserve
cash.

Managements focus is building its newly
acquired operating businesses, reducing corporate operating cash needs, clearing
follow-on matters arising from our legacy lending and servicing operations and
evaluating investment opportunities.

Management made significant steps in the
rebuilding process by investing in StreetLinks National Appraisal Services, LLC
(StreetLinks) during the third quarter of 2008 and Advent Financial Services,
LLC (Advent) during the second quarter of 2009. StreetLinks is a national
residential appraisal management company. StreetLinks collects a fee for
appraisal services from lenders and borrowers and passes most of the fee through
to an independent residential appraiser. StreetLinks retains a portion of the
fee to cover its costs of managing the process of fulfilling the appraisal
order. Management believes that StreetLinks is situated to take advantage of
growth opportunities in the residential appraisal management business. We have
added significant new customers for StreetLinks during 2009, which have produced
significant increases in revenue for StreetLinks during 2009. Advent is in its
start-up phase and will provide access to tailored banking accounts, small
dollar banking products and related services to meet the needs of low and
moderate income level individuals. Advent is currently developing systems and a
network of business partners for the distribution of its services.

The Companys condensed consolidated
financial statements as of September 30, 2009 and for the nine and three months
ended September 30, 2009 and 2008 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.

The Companys condensed consolidated
financial statements should be read in conjunction with Managements Discussion
and Analysis of Financial Condition and Results of Operations and the
consolidated financial statements of the Company and the notes thereto, included
in the Companys Annual Report on Form 10-K for the fiscal year ended December
31, 2008.

Going Concern Considerations-As of September 30, 2009, the Companys total
liabilities exceeded its total assets under GAAP, resulting in a shareholders
deficit. The Companys losses, negative cash flows, shareholders deficit, and
lack of significant operations raise substantial doubt about the Companys
ability to continue as a going concern and, therefore, may not realize its
assets and discharge its liabilities in the normal course of business. There is
no assurance that cash flows will be sufficient to meet the Companys
obligations. The Companys consolidated financial statements have been prepared
on a going concern basis of accounting which contemplates continuity of
operations, realization of assets, liabilities and commitments in the normal
course of business. The Companys condensed consolidated financial statements do
not reflect any adjustments relating to the recoverability and classification of
recorded asset amounts or to the amounts and classification of liabilities that
may be necessary should the Company be unable to continue as a going concern.

Impact of Recently Issued Accounting
Pronouncements

Accounting Pronouncements Adopted in
2009

Accounting standards
codification- In June 2009, the Financial
Accounting Standards Board (FASB) issued an accounting pronouncement
establishing theFASB Accounting Standards
Codificationas the source of authoritative
accounting principles recognized by the FASB to be applied by nongovernmental
entities. This pronouncement was effective for financial statements issued for
interim and annual periods ending after September 15, 2009, for most entities.
On the effective date, all non-SEC accounting and reporting standards will be
superceded. The Company adopted this new accounting pronouncement for the
quarterly period ended September 30, 2009, as required, and adoption did not
have a material impact on the Companys financial statements taken as a whole.

27

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Accounting Pronouncements Not Yet
Adopted

Consolidation of variable interest
entities- In June 2009, the FASB issued
variable interest entity guidance, which amends the consolidation guidance
applicable to variable interest entities (VIEs). The amendments to the
consolidation guidance affect all entities currently within the scope of the
previous guidance, as well as qualifying special-purpose entities (QSPEs) that
are currently excluded from the previous guidance. This guidance is effective as
of the beginning of the first fiscal year that begins after November 15, 2009.
The Company is continuing to evaluate the impact that this guidance will have on
its financial condition and results of operation upon adoption.

Accounting for transfers of financial
assets- In June 2009, the FASB issued
guidance relating to the transfers of financial assets. This guidance amends the
derecognition accounting and disclosure requirements of previous guidance. It
also eliminates the exemption from consolidation for QSPEs and also requires a
transferor to evaluate all existing QSPEs to determine whether it must be
consolidated. This guidance is effective for financial asset transfers occurring
after the beginning of an entitys first fiscal year that begins after November
15, 2009. The Company is continuing to evaluate the impact that this guidance
will have on its financial condition and results of operation upon adoption.

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

The key performance measures for executive
management are:

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

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

|Table 1 Key
      Performance Metrics                           |                               |        |              |  |   |        |  
|---------------------------------------------------------------- | ----------------------------- | ------ | ------------ |  | - | ------ | -
|(dollars in thousands; except per
      share amounts)           |                               |        |              |  |   |        |  
|                                                                
|                                                                 | September 30,                 |        | December 31,
|                                                                 | 2009                          |        | 2008        
|Cash and cash equivalents, including restricted cash             | $                             | 19,112 |              |  | $ | 30,836 |  
|                                                                
|                                                                 | For the Nine Months
    Ended
|                                                                 | September 30,                
|                                                                 | 2009                          |        | 2008        
|Net loss available to common shareholders, per diluted
    share | $                             | (17.98 | )            |  | $ | (67.92 | )
|                                                                

Liquidity During the nine months ended September 30, 2009, we received $16.4
million in cash on our securities portfolio. We received $20.8 million in cash
relating to appraisal fee income. We used cash to repay interest on borrowings,
pay for current operating and administrative costs, invest in StreetLinks and
Advent and pay for costs related to our legacy mortgage lending and servicing
operations. As of September 30, 2009, we had $19.1 million in cash, cash
equivalents and restricted cash, a decrease of $11.7 million from December 31,
2008. As of November 12, 2009, we have $18.6 million in cash and cash
equivalents (including restricted cash of $4.3 million). See Liquidity and
Capital Resources for further discussion of our liquidity position and steps we
have taken to preserve liquidity levels.

As part of our near-term future strategy,
we are focused on building our operating businesses, minimizing losses,
preserving liquidity and, if and when cash is available, investing in
opportunities that can contribute positively to our liquidity position. Our
mortgage securities are a primary source of new cash flows. Based on the current
projections, the cash flows from our mortgage securities
will continue to decrease in the next several months as the underlying mortgage
loans are repaid and could be significantly less than the current projections if
future market conditions are not as projected. While StreetLinks is generating
significant revenues, it is using all cash generated in building its
infrastructure to sustain growth and is not profitable. We have significant
outstanding obligations under our subordinated debt agreements. Our liquidity
consists solely of cash and cash equivalents.

28

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Significant Recent
EventsAs discussed in Note 6 to our condensed consolidated financial
statement, we renegotiated the terms of our junior subordinated debentures in
April 2009. As discussed above, during the quarter ended June 30, 2009, we
acquired a 70% ownership in Advent for an initial cash contribution into Advent
of $2 million.

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

Financial Condition as of September 30,
2009 as Compared to December 31, 2008

The following provides explanations for
material changes in the components of our balance sheet when comparing amounts
from September 30, 2009 and December 31, 2008.

Cash and Cash
Equivalents.See Liquidity and Capital Resources
for discussion of our cash and cash equivalents.

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

The mortgage loans  held-in-portfolio
balance has declined as their value has decreased significantly. The value is
dependent largely in part on their credit quality and the borrowers repayment
performance. The credit quality of the portfolio continues to worsen and
borrowers repayment performance continues to be poor. Specifically, during
recent months, the loss severity rate on foreclosed and liquidated loans has
increased. Therefore, we continue to increase the allowance for losses as a
percentage of loan principal. The allowance has decreased from $776.0 as of
December 31, 2008 to $746.7 million as of September 30, 2009 due to the loan
principal balances declining by a greater amount which was mainly due to
borrower repayments and foreclosures. Additionally, the balance of mortgage
loans  held-in-portfolio has decreased due to regular borrower repayments.
During the nine months ended September 30, 2009 the trusts received repayments
of the mortgage loans totaling $74.4 million. These balances will continue to
decline either through normal borrower repayments or through continued
devaluation as delinquencies, foreclosures and losses occur.

Mortgage loans  held-in-portfolio are
serviced by a third party entity. During the nine months ended September 30,
2009, the servicer modified loans totaling $210.0 million in principal with
weighted-average interest rates of 8.41% and 4.75% before and after
modification, respectively. Generally, the modifications are offered to
borrowers experiencing financial difficulties and serve to reduce monthly
payments and/or defer unpaid interest. The Companys estimates for the allowance
for loan losses and related provision include the projected impact of the
modified loans.

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

Mortgage Securities  Trading and
Available-for-Sale.During the nine
months ended September 30, 2009, the value of the securities continued to
decline as the estimated future cash flow from the securities is decreasing. The
decrease is attributable largely to the continued poor credit quality and
repayment performance of the mortgage loans underlying these securities. In
general, the default rate on the underlying loans has increased dramatically
over the past two years. Defaults are the result of national economic conditions
that have led to job losses, severe declines in housing prices and the inability
for credit-challenged individuals to refinance mortgage loans. In many cases,
the securities we own have ceased to generate cash flow and, for the securities
generating cash, we expect cash flow to continue to decline. We have
consistently written the value of our securities down over the past two years
and will likely continue to write them down as their economic value declines.

29

---

The following tables provide details of
our mortgage securities.

|Table 2  Values of Individual Mortgage Securities 
      Available-for-Sale
|-----------------------------------------------------------------------------
|(dollars in
  thousands)                                                     
|                                                                             
|                                                                             
|Securitization                                                               
|Trust (A)                                                                    
|NMFT Series :                                                                
|2002-3                                                                       
|2003-1                                                                       
|2003-2                                                                       
|2003-3                                                                       
|2003-4                                                                       
|2004-1                                                                       
|2004-2                                                                       
|2004-3                                                                       
|2004-4                                                                       
|2005-1                                                                       
|2005-2                                                                       
|2005-3                                                                       
|2005-4                                                                       
|2006-2                                                                       
|2006-3                                                                       
|2006-4                                                                       
|2006-5                                                                       
|2006-6                                                                       
|Total                                                                        
|                                                                             

|(A) | We established the trust upon
      securitization of the underlying loans, which generally were originated by
      us.
|--- | ------------------------------------------------------------------------------------------------------------------------

|Table 3  Mortgage Securities - Trading
|---------------------------------------
|(dollars in thousands)                 
|As of September 30,
    2009           
|                                       
|S&P Rating                             
|Subordinated Securities:               
|Non-investment Grade (B)               
|Residual Securities:                   
|Unrated                                
|Total                                  
|                                       
|As of December 31,
  2008              
|Subordinated Securities:               
|Investment Grade
      (A)             
|Non-investment Grade
      (B)         
|Total
      Subordinated Securities    
|Residual Securities:                   
|Unrated                                
|Total                                  
|                                       

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

30

---

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

Real Estate Owned.Real estate owned includes the value of
properties for foreclosed loans owned by securitization trusts, as discussed
under Mortgage Loans  Held-in-Portfolio. We consolidate the assets and
liabilities as part of the securitization trust. A servicer that is independent
from us and the trusts services the mortgage loans and processes defaults for
liquidation. Proceeds from liquidation of this real estate will flow through the
trust and will generally be paid to third party bondholders. The amount of real
estate owned is dependent upon the number of the overall mortgage loans
outstanding, the rate of defaults, the timing of liquidations and the estimated
value of the real estate. The amount of real estate owned has fluctuated during
2008 and 2009, and will continue to fluctuate in the short term. Over the long
term, the amount of real estate owned will decrease as the mortgage loans owned
by the consolidated trusts decline.

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

Accrued Interest Receivable.Accrued interest receivable includes the
interest due from individual borrowers to the trusts who own the mortgage loans
 held-in-portfolio. For all mortgage loans that do not carry mortgage
insurance, the accrual of interest on loans is discontinued when, in
managements opinion, the interest is not collectible in the normal course of
business, but in no case beyond when a loan becomes 90 days delinquent. For
mortgage loans that do carry mortgage insurance, the accrual of interest is only
discontinued when in managements opinion, the interest is not collectible.
Management generally deems all of the accrued interest on loans with mortgage
interest to be collectible. The quantity of delinquent loans has significantly
increased, as a percent of total loans outstanding, from December 31, 2008 to
September 30, 2009. Therefore, the amount of accrued interest has also
increased. Over the long term, the amount of accrued interest receivable will
decrease as the mortgage loans owned by the consolidated trusts decline.

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

Asset-backed Bonds Secured by
Mortgage Assets.The balances of the
asset-backed bonds have decreased as the bonds have repaid. We record the value
of the bonds secured by loans at the value of the proceeds, less repayments. We
record the CDO (secured by mortgage securities) at its market value. These
balances will decrease going forward as the underlying assets repay or may be
charged off as the assets are deemed to be insufficient to fully repay the bond
obligations.

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

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

Stockholders
Deficit.As of September 30, 2009 our total liabilities exceeded our total assets
under GAAP by $1.0 billion.

The liabilities of the securitization
trusts exceed the assets of those trusts as of September 30, 2009 and December
31, 2008 by $1.0 billion and $932.1 million, respectively. These amounts do not
include any adjustments for intercompany eliminations, see Table 9 for further
detail. The severe devaluation of the mortgage assets, as discussed in the
respective categories above, has resulted in the significant deficit of these
trusts. The assets and liabilities of these trusts are consolidated under GAAP.
Due to the significant impact to our financial statements of these trusts, we
have also provided the assets and liabilities of the trusts on a separate and
combined basis under the heading Assets and Liabilities of Consolidated
Securitization Trusts.

The significant increase in our
shareholders deficit during the nine months ended September 30, 2009 results
from our large net loss, driven primarily by valuation allowances taken on our
mortgage loans.

31

---

Results of Operations  Comparisons
Consolidated Earnings

Net Interest (Expense) Income.As discussed above, in general, our
mortgage assets have been significantly impaired due to national and
international economic crises, housing price deterioration and mortgage loan
credit defaults. The trends and reasons for the changes in the components of
interest income and expense are generally the same when comparing the nine
months and three months ended September 30, 2009 with the same periods in 2008.
Interest income has declined as these assets have become impaired and due to
repayments and liquidations. Interest expense has declined as the related
principals balances have declined, as interest rates have declined and as we
repaid all short-term borrowings during 2008. Interest expense is adjustable,
generally based on a spread to LIBOR.

Provision for Credit Losses.The provision for credit losses relates
to mortgage loans which have been securitized. As discussed above, in general,
the credit quality of the securitized mortgage loans significantly deteriorated
beginning generally before 2008 due to national and international economic
crises, housing price deterioration and mortgage loan credit defaults. The
performance of the loans continues to deteriorate. A significant portion of the
securitized loans have become uncollectible or will only be partially collected.
Provisions for these losses have increased in connection with the declining
credit quality of the loans.

The total dollar amount of the provision
for credit losses is smaller when comparing the nine and three months ended
September 30, 2009 to the same periods in 2008. As the amount of securitized
loans decreases and as they age, the credit exposure is smaller, resulting in
decreasing provisions.

|Table 4  Net Interest
      Expense                        
|------------------------------------------------------------
|(dollars in thousands)                                      
|                                                            
|                                                            
|                                                            
|Interest
      income:                                      
|Mortgage
    securities                                     
|Mortgage loans
      held-in-portfolio                      
|Other interest
      income                                 
|Total
      interest income                                 
|                                                            
|Interest
      expense:                                     
|Short-term borrowings
      secured by mortgage securities  
|Asset-backed bonds
      secured by mortgage loans          
|Asset-backed bonds
      secured by mortgage securities     
|Junior subordinated
      debentures                        
|Total
      interest expense                                
|Net
      interest income before provision for credit losses
|Provision for credit
    losses                             
|Net interest
      loss                                     
|                                                            

(Losses) Gains on Derivative
Instruments. The derivative instruments
for which the value is on our balance sheet are owned by securitization trusts.
Derivative instruments transferred into a securitization trust are administered
by the trustee in accordance with the trust documents. These derivative
instruments are used to mitigate interest rate risk within the related
securitization trust.

Losses or gains on the derivative
instruments are dependent on short-term interest rates (generally declining
rates produce greater losses or lower gains) and the amount of the notional
balance outstanding during the reporting period. For the three month period
ended September 30, 2008, interest rates were generally flat and the gain on
derivative instruments was due to the reversal of previous losses as instruments
matured. For the three month period ended September 30, 2009, interest rates
were declining and instruments were maturing, resulting in a small net
loss. Significant declines in interest rates during the first three months of 2008 and 2009 generated significant losses on
derivatives for each of the nine month period ended September 30, 2009 and 2008.

32

---

Gains on Debt
Extinguishment. We recorded gains on debt
extinguish for the nine months ended September 30, 2008 of $6.4 million. There
were no gains recorded for the same period of 2009. On May 29, 2008, we
purchased trust preferred securities of NovaStar Capital Trust II having a par
value of $6.9 million for $0.6 million. As a result, $6.9 million of principal
and accrued interest of $0.2 million of the Notes was retired and the principal
amount, accrued interest, and related unamortized debt issuance costs related to
these Notes were removed from the balance sheet at September 30, 2008 resulting
in a gain of $6.4 million.

Fair Value Adjustments.Adjustment for changes in value on our
trading securities and the asset-backed bonds issued in our CDO are recorded as
Fair Value Adjustments. The significant value declines during the nine and three
month period ended September 30, 2008 are a result of significant spread
widening in the subprime mortgage market for these types of asset-backed
securities, along with the poor credit performance of the underlying mortgage
loans. By the end of 2008, the total value of the trading securities and the
asset-backed bonds had declined significantly, resulting in a lower overall
adjustment in the nine months ended September 30, 2009 when compared to the same
period in 2008. During the three months ended September 30, 2009, very low
short-term interest rates are driving higher expected cash flows from these
securities and, therefore, higher overall values.

Impairment on Mortgage Securities 
Available-for-Sale.To the extent that the cost basis of mortgage securities 
available-for-sale exceeds the fair value and the unrealized loss is considered
to be other than temporary, an impairment charge is recognized and the amount
recorded in accumulated other comprehensive income or loss is reclassified to
earnings as a realized loss. The large impairments during the nine and three
months ended September 30, 2008 were primarily driven by an increase in actual
and projected losses due to the deteriorating credit quality of the loans
underlying the securities. By September 30, 2008, the total value of the
available-for-sale securities had declined significantly, resulting in a lower
overall impairment in the nine and three months ended September 30, 2009 when
compared to the same periods in 2008.

Appraisal Fee Income and Expense.Fees are collected from customers
(borrowers or lenders), a portion of which is paid to independent mortgage loan
appraisers. Fee income and expense is recognized when the appraisal is completed
and delivered to the customer. During the nine months ended September 30, 2009,
the unit volume appraisal services increased significantly, resulting in high
revenue and expense when comparing to the first nine months of 2008. We acquired
a majority interest in StreetLinks on August 1, 2008, and therefore recognized
minimal revenue and incurred minimal expense for appraisal management services
during the nine and three month periods ended September 30, 2008. Following is a
summary of the unit count of completed orders:

|Table 5  Appraisals Completed
      2009 |       
|----------------------------------------- | ------
|First quarter                             | 4,809 
|Second
      quarter                      | 27,440
|Third quarter                             | 26,960
|                                         
|Nine months ended September 30, 2009      | 59,209

General and Administrative Expenses.During late 2007 and into early 2008, we
eliminated a significant portion of our administrative overhead. We terminated
officers and staff in our executive, information systems, legal, human resource
and finance/accounting departments. We also terminated numerous contracts for
professional services. One of managements key focuses during 2008 was to reduce
or eliminate all unnecessary general and administrative expenses. As a result,
excluding the impact on operating expenses for StreetLinks of $9.5 million and
$3.6 million for the nine and three months ended September 30, 2009,
respectively and $0.5 million for the nine and three months ended September 30,
2008, operating expenses have declined when comparing general and administrative
expenses for the nine and three month periods ended September 30, 2009 and
2008.

Contractual Obligations

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

The following table summarizes our
contractual obligations for both continuing and discontinued operations, as of
September 30, 2009, other than short-term borrowing arrangements.

33

---

|Table 6  Contractual
      Obligations 
|----------------------------------------
|**(dollars in
  thousands)**            
|                                        
|                                        
|Contractual
      Obligations           
|Estimated long-term debt payments (A)   
|Junior
      subordinated debentures (B)
|Operating leases (C)                    
|Total,
      consolidated obligations   
|Non-recourse obligations                
|                                        
|Recourse obligations                    
|                                        

|(A) | The asset-backed bonds will be
      repaid only to the extent there is sufficient cash receipts on the
      underlying mortgage loans, which collateralize the debt. The trusts that
      own these assets and asset-backed obligations have no recourse to us for
      any shortfall. The timing of the repayment of these mortgage loans is
      affected by prepayments. These amounts include expected interest payments
      on the obligations. Interest obligations on our variable-rate long-term
      debt are based on the prevailing interest rate as of September 30, 2009
      for each respective obligation. The trustee considers the remaining
      collateral to be insufficient to cover the bonds outstanding and therefore
      has reduced the obligations accordingly by $144.5 million.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(B) | The junior subordinated
      debentures are assumed to mature in 2035 and 2036 in computing the future
      payments. These amounts include expected interest payments on the
      obligations. Interest obligations on our junior subordinated debentures
      are based on the prevailing interest rate of 1.0% per annum as of
      September 30, 2009 for each respective obligation. See Note 6 to the
      condensed consolidated financial statements for additional
    details.                                                                                                                                                                                                                                                                                                                           
|   
|(C) | The operating lease obligations
      do not include rental income of $1.3 million to be received under sublease
      contracts.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        

Liquidity and Capital
Resources

We have taken numerous actions to reduce
our cash needs and liquidity risk. Our residual and subordinated mortgage
securities are a primary source of significant cash flows. Based on the current
projections, the cash flows from our mortgage securities will decrease in the
next several months as the underlying mortgage loans are repaid, and could be
significantly less than the current projections if losses on the underlying
mortgage loans exceed the current assumptions or if short-term interest rates
increase significantly. We have operating expenses associated with our
administration, as well as payment obligations with respect to unsecured debt,
including periodic interest payments with respect to junior subordinated
debentures. As discussed in Item 1. Legal Proceedings we are the subject of
various legal proceedings, the outcome of which is uncertain. We may also face
demands in the future that are unknown to us today related to our legacy lending
and servicing operations. If the cash flows from our mortgage securities are
less than currently anticipated and our operating businesses do not generate
positive cash flow, there can be no assurance that we will be able to continue
as a going concern.

As of November 12, 2009, we had
approximately $18.6 million in cash on hand (including restricted cash of $4.3
million). In addition to our corporate administrative expenses, which currently
range from approximately $650,000 to $1.25 million per month we have quarterly
interest payments due on our trust preferred securities. The Company made a
payment on the trust preferred securities on October 30, 2009 of $0.1 million.
The next payment on the trust preferred securities is due on December 30, 2009
and totals $0.1 million. Our current projections indicate sufficient available
cash and cash flows from our mortgage assets to meet these payment needs.
However, our mortgage asset cash flows are currently volatile and uncertain in
nature, and the amounts we receive could vary materially from our projections.
Therefore, no assurances can be given that we will be able to meet our cash flow
needs.

Overview of Cash Flow for the nine
months ended September 30, 2009

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

34

---

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

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

|Table 7  Primary Sources Cash Receipts and
    Disbursements              
|---------------------------------------------------------------------------
|(dollars in
  thousands)                                                   
|                                                                           
|                                                                           
|                                                                           
|****                                                                       
|**Primary sources:**                                                       
|Payments received on
      mortgage securities                             
|Receipts for appraisal
      management services                           
|                                                                           
|Primary uses:                                                              
|Payment of corporate
      general, administrative and capital expenditures
|Payments for appraisals
      and related administrative costs             
|                                                                           

Statement of Cash Flows - Operating,
Investing and Financing Activities

The following table provides a summary of
our operating, investing and financing cash flows as taken from our consolidated
statements of cash flows for the nine months ended September 30, 2009 and
2008.

|Table 8  Summary of Operating, Investing and Financing Cash
      Flows
|------------------------------------------------------------------------
|(dollars in
  thousands)                                                
|                                                                        
|                                                                        
|                                                                        
|Consolidated Statements of Cash Flows:                                  
|Cash provided by
      operating activities                             
|Cash flows provided by investing activities                             
|Cash flows used
      in financing activities                           
|                                                                        

Operating
Activities.The increase in cash provided by operating activities was substantially
related to the increase in the balance of the amounts due to servicer. Operating
activities, other than the cash flow of the securitized loan trusts, generated a
net use of cash during the nine months ended September 30, 2009. See a
discussion of the impact of the consolidated loan trusts under the heading
Assets and Liabilities of Consolidated Securitization Trusts.

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

Financing
Activities.All short term borrowings were paid off in 2008 and therefore we have no
repayments of short-term borrowings during 2009. The payments on asset-backed
bonds relates to bonds issued by securitization loan trusts, which have
decreased as the assets in the trusts used to pay those bonds have
declined.

35

---

Future Sources and Uses of Cash

Primary Sources of
Cash

Cash Received From Our Mortgage
Securities Portfolio.A major driver of
cash flows is the proceeds we receive from our mortgage securities. For the nine
months ended September 30, 2009 we received $16.4 million in proceeds from
repayments on mortgage securities. The cash flows we receive on our mortgage
securitiesavailable-for-sale are highly dependent on the interest rate spread
between the underlying collateral and the bonds issued by the securitization
trusts and default and prepayment experience of the underlying collateral. The
following factors have been the significant drivers in the overall fluctuations
in these cash flows:

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

Proceeds from Repayments of Mortgage
Loans. As we discussed above, significant
cash is collected by the securitization trusts from the payment of principal and
interest on securitized loans and securities. The cash is held by the trust and
is used to repay obligations (primarily to bondholders) of the trust. The cash
is not available to us and we are not responsible for the obligations of the
trust.

Primary Uses of Cash

Payments of General and
Administrative Expenses.We continue to
have significant general and administrative expenses associated with managing
and operating our business. These expenses include staff and management
compensation and related benefit payments, professional expenses for audit, tax
and related services, legal services, rent and general office operational costs.

Investment in Assets or Operating
Businesses.To the extent we have cash
available to invest in assets or operating businesses, management intends to do
so. During the second quarter of 2009, we invested $2 million to acquire Advent.

Repayments of Long-Term Borrowings.As of September 30, 2009, we had $78.1
million in outstanding principal of junior subordinated debentures relating to
the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital
Trust II We have unamortized debt issue costs of $500,000 and therefore a
carrying value for the debt of $77.6 million. During the second quarter of 2009,
we restructured our obligations under the junior subordinated debentures, which
we expect to reduce cash requirements for interest in the near term. As part of
the restructuring, we repaid all interest accrued through December 31, 2008,
totaling $5.3 million. Details of the restructuring are included in Note 6 to
the financial statements included in the Companys Annual Report on Form 10-K
for the fiscal year ended December 31, 2008. See Table 6 for an estimate of our
contractual obligations related to these junior subordinated debentures.

Assets and Liabilities of Consolidated
Securitization Trusts

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

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

During 2007, we also securitized certain
mortgage securities through a Collateralized Debt Obligation structure.

36

---

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

|1. | We sold a portion of the
      beneficial interests we owned,                                                                                                                                                                                                                                                  
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|2. | The credit losses on the
      securitized loans increased to the point where the remaining beneficial
      interests we own are not significant,                                                                                                                                                             
|3. | We sold the right to service all
      securitized loans,                                                                                                                                                                                                                                                      
|4. | We executed amendments to the
      securitization agreements for the 2006 loan pools whereby we relinquished
      all rights to place certain derivative instruments into the securitization
      trust and to repurchase a limited number of loans from the trust for any
      reason and at any time, and
|5. | For the 2007 securitized loan
      pool, a significant portion of the derivatives placed into the trust have
      expired and the remaining derivatives will expire by the first quarter of
      2010.                                                                                                      

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

Below is financial information for each of
the securitization trusts we consolidate and for the total of all consolidated
trust balance sheets. The discussion of the individual line items within this
financial information is included in the discussion of our consolidated
financial statements in the applicable forgoing sections of this report. The
following disclosure is considered non-GAAP financial information.

37

---

|Table 9  Non-GAAP Disclosure: Assets and Liabilities of
      Securitization Trusts (A)
|----------------------------------------------------------------------------------------
|(dollars in
      thousands)                                                            
|                                                                                        
|                                                                                        
|                                                                                        
|                                                                                        
|Assets                                                                                  
|Mortgage loans  held                                                                   
|in
      portfolio, net of                                                              
|allowance                                                                               
|Trading
      securities                                                                
|Real estate
      owned                                                                 
|Accrued
      interest                                                                  
|receivable                                                                              
|Other
    assets                                                                        
|Total assets                                                                            
|                                                                                        
|Liabilities and net deficiency in
      assets                                          
|Liabilities:                                                                            
|Asset-backed                                                                            
|bonds
      secured                                                                     
|by
      mortgage                                                                       
|loans
      (B)                                                                         
|Asset-backed                                                                            
|bonds
      secured                                                                     
|by
      mortgage                                                                       
|securities                                                                              
|Other
      liabilities                                                                 
|Total
      liabilities                                                                 
|Total net deficiency                                                                    
|**in
      assets**                                                                     
|                                                                                        
|Total liabilities and                                                                   
|net deficiency in                                                                       
|assets                                                                                  
|                                                                                        

|(A) | Stand-alone
      balances do not include impact of intercompany eliminations.                                                                                                                                                                   
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    |                                                                                                                                                                                                                                                  
|(B) | In
      accordance with its obligations under the related securitization
      agreements, the trustee for the respective securitization trusts has
      charged off asset-backed bonds totaling $144.5 million as of September 30,
      2009.

38

---

|Table 10  Non-GAAP Disclosure: Operating Results of Securitization
      Trusts (A)
|------------------------------------------------------------------------------------
|(dollars in
  thousands)                                                            
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|                                                                                    
|Interest Income                                                                     
|Interest
      expense                                                              
|Provision for credit                                                                
|losses                                                                              
|Servicing
      fee                                                                 
|expense                                                                             
|Mortgage insurance                                                                  
|Other
      income                                                                  
|(expense) (B)                                                                       
|General and                                                                         
|administrative                                                                      
|expenses                                                                            
|Net income
      (loss)                                                             
|before tax                                                                          
|expense                                                                             
|                                                                                    
|Tax expense                                                                         
|                                                                                    
|Net income (loss)                                                                   
|                                                                                    

|(A) |  | Stand-alone balances
      do not include impact of intercompany eliminations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|(B) |  | In accordance with its
      obligations under the related securitization agreements, the trustee for
      the respective securitization trusts has charged off asset-backed bonds
      totaling $126.9 million and $6.6 million for the nine months ended
      September 30, 2009 and 2008, respectively. In the opinion of the trustee,
      the securitized assets will not be sufficient to pay for these bonds. The
      gain recorded on this debt forgiveness is included in other income
      (expense). The debt forgiveness and related gain is not recorded under
      GAAP as the debt is not legally extinguished, even though in the opinion
      of the trustee the debt will not likely be
paid.

|                        | For
      the Three Months Ended September 30,
|----------------------- | ----------------------------------------------
|                        | 2009                                          
|                        |                                               
|                        |                                               
|                        | CDO                                           
|Interest Income         | $                                             
|Interest
      expense  |                                               
|Provision for credit    |                                               
|losses                  |                                               
|Servicing
      fee     |                                               
|expense                 |                                               
|Mortgage insurance      |                                               
|Other
      income      |                                               
|(expense) (B)           |                                               
|General and             |                                               
|administrative          |                                               
|expenses                |                                               
|Net income
      (loss) |                                               
|before tax              |                                               
|expense                 |                                               
|                        |                                               
|Tax expense             |                                               
|(benefit)               |                                               
|                        |                                               
|Net income (loss)       | $****                                         
|                       

|(A) |  | Stand-alone balances
      do not include impact of intercompany eliminations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|(B) |  | In accordance with its obligations under the
      related securitization agreements, the trustee for the respective
      securitization trusts has charged off asset-backed bonds owned by us
      totaling $66.3 million and $0.4 million for the three months ended
      September 30, 2009 and 2008, respectively. In the opinion of the trustee,
      the securitized assets will not be sufficient to pay for these bonds. The
      gain recorded on this debt forgiveness is included in other income
      (expense). The debt forgiveness and related gain is not recorded under
      GAAP as the debt is not legally extinguished, even though in the opinion
      of the trustee the debt will not likely be
paid.

39

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|Table 11  Non-GAAP Disclosure: Cash Flows of Securitization Trusts
      (A)
|-----------------------------------------------------------------------------
|(dollars in
  thousands)                                                     
|                                                                             
|                                                                             
|                                                                             
|                                                                             
|Net cash flow
      from:                                                    
|Operating activities                                                         
|Investing
      activities                                                   
|Financing activities                                                         
|                                                                             
|Net cash flow                                                                
|Cash, beginning
      of                                                     
|year                                                                         
|                                                                             
|Cash, end of year                                                            
|                                                                             

|(A) |  | Stand-alone balances do not include impact of intercompany
      eliminations.
|--- |  | ------------------------------------------------------------------------------

40

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Item 3. Quantitative and Qualitative
Disclosures About Market Risk

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

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(d)) as of the end of the period covered by this report and concluded that
the Companys controls and procedures were effective.

Internal Control over Financial
Reporting

Managements Report on Internal Control
over Financial Reporting

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

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

Management of the Company has assessed the
effectiveness of the Companys internal control over financial reporting as of
September 30, 2009. To make this assessment, management used the criteria for
effective internal control over financial reporting described inInternal ControlIntegrated Framework, issued by the Committee of Sponsoring Organizations of the
Treadway Commission. Based on our assessment under the framework inInternal ControlIntegrated
Framework,management concluded that the
Companys internal control over financial reporting was not effective as of
September 30, 2009 because of the existence of a material weakness in internal
controls over financial reporting related to the lack of segregation of duties
within our accounting department.

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

The Company identified a control
deficiency that was deemed a material weakness in internal controls over
financial reporting at September 30, 2008. The deficiency relates to the
inadequate segregation of duties amongst the Company's employees with respect to
accounting, financial reporting and disclosure. The material weakness was a
result of the reduction in our accounting staff which occurred during the third
quarter ended September 30, 2008. The material weakness identified above did not
result in the restatement of prior period financial statements or any other
related financial disclosure, nor did it disclose any errors or misstatements.

Management has taken steps to remedy the
material weakness by hiring additional accounting department staff, and
reallocating duties, including responsibilities for financial reporting, among
the Companys employees. However, based on the overall lack of accounting
department resources, this material weakness was not remediated as of September
30, 2009.

Changes in Internal Control over
Financial Reporting

There were no changes in our internal
controls over financial reporting during the three months ended September 30,
2009 that have materially affected, or are reasonably likely to materially
affect, our internal controls over financial reporting.

41

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PART II.
OTHER INFORMATION

Item 1. Legal Proceedings

Litigation.

In May 2007, a lawsuit entitledNational Community Reinvestment Coalition v.
NovaStar Financial, Inc.,et al., was filed against
the Company in the United States District Court for the District of Columbia.
Plaintiff, a non-profit organization, alleges that the Company maintains
corporate policies of not making loans on Indian reservations, on dwellings used
for adult foster care or on rowhouses in Baltimore, Maryland in violation of the
federal Fair Housing Act. The lawsuit seeks injunctive relief and damages,
including punitive damages, in connection with the lawsuit. On May 30, 2007, the
Company responded to the lawsuit by filing a motion to dismiss certain of
plaintiffs claims. On March 31, 2008 that motion was denied by the Court. In
October 2009 the Company reached a settlement to this claim which did not
significantly impact the Companys financial statements.

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

In February 2007, a number of
substantially similar putative class actions were filed in the United States
District Court for the Western District of Missouri. The complaints name the
Company and three of the Companys former and current executive officers as
defendants and generally allege, among other things, that the defendants made
materially false and misleading statements regarding the Companys business and
financial results. The plaintiffs purport to have brought the actions on behalf
of all persons who purchased or otherwise acquired the Companys common stock
during the period May 4, 2006 through February 20, 2007. Following consolidation
of the actions, a consolidated amended complaint was filed on October 19, 2007.
On December 29, 2007, the defendants moved to dismiss all of plaintiffs claims.
On June 4, 2008, the District Court dismissed the plaintiffs complaints without
leave to amend. The plaintiffs filed an appeal of the District Courts ruling.
On September 1, 2009 the United States Court of Appeals for the Eight Circuit
affirmed the judgment of the District Court.

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

On January 31, 2008, two purported
shareholders filed separate derivative actions in the Circuit Court of Jackson
County, Missouri against various former and current officers and directors and
named the Company as a nominal defendant. The essentially identical petitions
seek monetary damages alleging that the individual defendants breached fiduciary
duties owed to the Company, alleging insider selling and misappropriation of
information, abuse of control, gross mismanagement, waste of corporate assets,
and unjust enrichment between May 2006 and December 2007. On June 24, 2008 a
third, similar case was filed in United States District Court for the Western
District of Missouri. On July 13, 2009 the Company filed a motion to dismiss the
plaintiffs claims. The Company believes that these claims are without merit and
will vigorously defend against them.

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

42

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

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

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

Item 1A. Risk Factors

Risk Factors

There have been no material changes to
the risk factors previously disclosed in the Companys Annual Report on Form
10-K for the fiscal year ended December 31, 2008.

|Item 2. Unregistered Sales of Equity Securities and Use of
      Proceeds
|-------------------------------------------------------------------------
|(dollars in
      thousands)                                             
|Issuer Purchases of Equity Securities                                    
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|July 1, 2009  July 30, 2009                                             
|August 1, 2009  August 31,       2009                                   
|September 1, 2009  September 30, 2009                                   
|                                                                         

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

Item 3. Defaults Upon Senior Securities

NFIs wholly owned subsidiary NovaStar
Mortgage, Inc. (NMI) has approximately $77.6 million in principal amount of
unsecured notes (collectively, the Notes) outstanding to NovaStar Capital
Trust I and NovaStar Capital Trust II (collectively, the Trusts) which secure
trust preferred securities issued by the Trusts. NFI has guaranteed NMI's
obligations under the Notes. NMI failed to make quarterly interest payments that
were due on all payment dates in 2008 and through April 24, 2009 on these Notes.

43

---

On April 24, 2009 (the Exchange Date),
the parties executed the necessary documents to complete an exchange of the
Notes for new preferred obligations. On the Exchange Date, the Company paid
interest due through December 31, 2008, in the aggregate amount of $5.3 million.
In addition, the Company paid $0.3 million in legal and administrative costs on
behalf of the Trusts.

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

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

None.

Item 5. Other Information

At its meeting on November 10, 2009, the
Companys Board of Directors (the Board) appointed Gregory T. Barmore as Lead
Independent Director for a maximum tenure of three years. Mr. Barmore will
receive no additional compensation for serving as Lead Independent
Director.

The Lead Independent Director assists the
Chairman of the Board with board-related matters and acts, as necessary, as a
liaison between the independent directors and the Chairman of the Board. To that
end, the Lead Director will, among other things: (i) approve an appropriate
schedule of meetings of the Companys Board of Directors; (ii) review agendas
for the Board and Committee meetings; (iii) assess the quality, quantity and
timeliness of the flow of information from the Companys management to the
independent directors; (iv) whenever appropriate, direct the retention of
consultants who report directly to the Board; (v) assist the Board and the
Companys officers in assuring compliance with and implementation of the
Companys Corporate Governance Guidelines and be principally responsible for
recommending revisions to the Corporate Governance Guidelines; (vi) coordinate
an agenda for the Boards independent directors; (vii) evaluate, along with the
members of the Compensation Committee and the full Board, the Chief Executive
Officers performance and meet with the Chief Executive Officer to discuss the
Boards evaluation; and (vii) review the membership and performance of the
various Board committees and committee chairs.

Item 6. Exhibits

Exhibit Listing

|Exhibit No. |     | Description of
    Document
|----------- | --- | ---------------------------
|11.1        | (1) |                            
|            |     |                            
|31.1        |     |                            
|            |     |                            
|31.2        |     |                            
|            |     |                            
|32.1        |     |                            
|            |     |                            
|32.2        |     |                            

|(1) |  | See
      Note 13 to the condensed consolidated financial
  statements.
|--- |  | -----------------------------------------------------------------------

44

---

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 12,
      2009 |  | /s/ W. Lance Anderson                   
|----------------------------- |  | ----------------------------------------
|                              |  | W. Lance
      Anderson, Chairman of the
|                              |  | Board of
      Directors and Chief      
|                              |  | Executive
      Officer                 
|                              |  | (Principal
      Executive Officer)     
|                              |  |                                         
|DATE: November 12,
      2009 |  | /s/ Rodney E. Schwatken                 
|                              |  | Rodney E.
      Schwatken, Chief        
|                              |  | Financial
      Officer                 
|                              |  | (Principal
      Financial Officer)     

45

---