UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549


3⁄43⁄43⁄43⁄43⁄43⁄43⁄43⁄43⁄43⁄4


FORM
10-Q





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





For
the Quarterly Period Ended September 30, 2008





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


For
the Transition Period From ___________ to ___________





3⁄43⁄43⁄43⁄43⁄43⁄43⁄43⁄43⁄43⁄4





Commission
File Number 001-13533





NOVASTAR
FINANCIAL, INC.


(Exact
Name of Registrant as Specified in its Charter)





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





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





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





3⁄43⁄43⁄43⁄43⁄43⁄43⁄43⁄43⁄43⁄4





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





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, 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. (Check one):





Large
      accelerated filer  ̈
            Accelerated
      filer x
            Non-accelerated
      filer  ̈
            Smaller
      reporting company  ̈





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


Yes  ̈  Nox





The
number of shares of the Registrant’s Common Stock outstanding on March 31, 2009
was 9,368,053.













NOVASTAR
FINANCIAL, INC.


FORM
10-Q


For
the Quarterly Period Ended September 30, 2008










TABLE
OF CONTENTS





Part
      I
                Financial
      InformationItem
      1.
                Financial
      Statements (Unaudited)
                1Condensed
      Consolidated Balance Sheets
                1Condensed
      Consolidated Statements of Operations
                2Condensed
      Consolidated Statement of Shareholders’ Deficit
                3Condensed
      Consolidated Statements of Cash Flows
                4Notes
      to Condensed Consolidated Financial Statements
                7Item
      2.
                Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                28Item
      3.
                Quantitative
      and Qualitative Disclosures About Market Risk
                51Item
      4.
                Controls
      and Procedures
                53Part
      II
                Other
      InformationItem
      1.
                Legal
      Proceedings
                54Item
      1A.
                Risk
      Factors
                56Item
      2.
                Unregistered
      Sales of Equity Securities and Use of Proceeds
                63Item
      3.
                Defaults
      Upon Senior Securities
                64Item
      4.
                Submission
      of Matters to a Vote of Security Holders
                65Item
      5.
                Other
      Information
                65Item
      6.
                Exhibits
                65





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
      31,2008
                
                
                2007AssetsUnrestricted
      cash and cash equivalents
                
                $
                18,754
                
                
                $
                25,364Restricted
      cash
                
                
                5,788
                
                
                
                8,998Mortgage
      loans – held-in-portfolio, net of allowance of $791,906 and $230,138,
      respectively
                
                
                1,881,000
                
                
                
                2,870,013Mortgage
      securities -
      trading
                
                
                14,981
                
                
                
                109,203Mortgage
      securities -
      available-for-sale
                
                
                6,912
                
                
                
                33,371Real
      estate owned
                
                
                53,763
                
                
                
                76,614Accrued
      interest receivable
                
                
                72,223
                
                
                
                61,704Other
      assets
                
                
                6,815
                
                
                
                37,244Assets
      of discontinued operations
                
                
                1,743
                
                
                
                8,255Total
      assets
                
                $
                2,061,979
                
                
                $
                3,230,766Liabilities
      and Shareholders’ DeficitLiabilities:Asset-backed
      bonds secured by mortgage loans
                
                $
                2,673,254
                
                
                $
                3,065,746Asset-backed
      bonds secured by mortgage securities
                
                
                11,114
                
                
                
                74,385Short-term
      borrowings secured by mortgage securities
                
                
                -
                
                
                
                45,488Junior
      subordinated debentures
                
                
                77,200
                
                
                
                83,561Due
      to servicer
                
                
                95,934
                
                
                
                56,450Dividends
      payable
                
                
                15,351
                
                
                
                3,816Accounts
      payable and other liabilities
                
                
                28,343
                
                
                
                53,392Liabilities
      of discontinued operations
                
                
                3,677
                
                
                
                59,416Total
      liabilities
                
                
                2,904,873
                
                
                
                3,442,254Commitments
      and contingencies (Note 7)Shareholders’
      deficit:Capital stock, $0.01 par value, 50,000,000 shares
    authorized:Redeemable
      preferred stock, $25 liquidating preference per share; 2,990,000 shares,
      issued and outstanding
                
                
                30
                
                
                
                30Convertible
      participating preferred stock, $25 liquidating preference per share;
      2,100,000 shares, issued and outstanding
                
                
                21
                
                
                
                21Common
      stock, 9,390,016 and 9,439,273 shares, issued and outstanding,
      respectively
                
                
                94
                
                
                
                94Additional
      paid-in capital
                
                
                786,303
                
                
                
                786,342Accumulated
      deficit
                
                
                (1,630,451
                )
                
                
                (996,649
                )Accumulated
      other comprehensive income (loss)
                
                
                1,266
                
                
                
                (1,117
                )Other
                
                
                (157
                )
                
                
                (209
                )Total
      shareholders’ deficit
                
                
                (842,894
                )
                
                
                (211,488
                )Total
      liabilities and shareholders’ deficit
                
                $
                2,061,979
                
                
                $
                3,230,766





See notes
to condensed consolidated financial statements.


1


NOVASTAR
FINANCIAL, INC.


CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS


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


For
      the Nine Months
                      Ended
      September 30,
                    
                    
                    For
      the Three Months
                      Ended
      September 30,2008
                    
                    
                    2007
                    
                    
                    2008
                    
                    
                    2007Interest
      income
                    
                    $
                    183,277
                    
                    
                    $
                    279,737
                    
                    
                    $
                    52,269
                    
                    
                    $
                    91,981Interest
      expense
                    
                    
                    91,157
                    
                    
                    
                    182,289
                    
                    
                    
                    25,874
                    
                    
                    
                    66,613Net
      interest income before provision for credit losses
                    
                    
                    92,120
                    
                    
                    
                    97,448
                    
                    
                    
                    26,395
                    
                    
                    
                    25,368Provision
      for credit losses
                    
                    
                    667,638
                    
                    
                    
                    192,326
                    
                    
                    
                    206,202
                    
                    
                    
                    99,159Net
      interest expense after provision for credit losses
                    
                    
                    (575,518
                    )
                    
                    
                    (94,878
                    )
                    
                    
                    (179,807
                    )
                    
                    
                    (73,791
                    )Other
      operating expense:(Losses)
      gains on derivative instruments
                    
                    
                    (9,480
                    )
                    
                    
                    (2,888
                    )
                    
                    
                    1,133
                    
                    
                    
                    (9,394
                    )Gains
      on debt extinguishment
                    
                    
                    6,418
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Fair
      value adjustments
                    
                    
                    (20,269
                    )
                    
                    
                    (58,224
                    )
                    
                    
                    2,400
                    
                    
                    
                    (31,993
                    )Impairments
      on mortgage securities – available-for-sale
                    
                    
                    (22,897
                    )
                    
                    
                    (72,209
                    )
                    
                    
                    (1,668
                    )
                    
                    
                    (46,216
                    )Appraisal
      fee income
                    
                    
                    1,522
                    
                    
                    
                    -
                    
                    
                    
                    1,522
                    
                    
                    
                    -Appraisal
      fee expense
                    
                    
                    (1,195
                    )
                    
                    
                    -
                    
                    
                    
                    (1,195
                    )
                    
                    
                    -Servicing
      fee expense
                    
                    
                    (10,365
                    )
                    
                    
                    -
                    
                    
                    
                    (3,272
                    )
                    
                    
                    -Premiums
      for mortgage loan insurance
                    
                    
                    (12,126
                    )
                    
                    
                    (12,059
                    )
                    
                    
                    (3,809
                    )
                    
                    
                    (4,453
                    )Other
      (expense) income, net
                    
                    
                    (37
                    )
                    
                    
                    (202
                    )
                    
                    
                    (117
                    )
                    
                    
                    12Total
      other operating expense
                    
                    
                    (68,429
                    )
                    
                    
                    (145,582
                    )
                    
                    
                    (5,006
                    )
                    
                    
                    (92,044
                    )General
      and administrative expenses:Compensation
      and benefits
                    
                    
                    4,583
                    
                    
                    
                    23,361
                    
                    
                    
                    1,104
                    
                    
                    
                    6,460Office
      administration
                    
                    
                    6,734
                    
                    
                    
                    10,487
                    
                    
                    
                    2,181
                    
                    
                    
                    4,539Professional
      and outside services
                    
                    
                    5,686
                    
                    
                    
                    17,483
                    
                    
                    
                    1,799
                    
                    
                    
                    4,315Other
      appraisal management expenses
                    
                    
                    509
                    
                    
                    
                    -
                    
                    
                    
                    509
                    
                    
                    
                    -Marketing
      and other
                    
                    
                    390
                    
                    
                    
                    (1,619
                    )
                    
                    
                    20
                    
                    
                    
                    (5,718
                    )Total
      general and administrative expenses
                    
                    
                    17,902
                    
                    
                    
                    49,712
                    
                    
                    
                    5,613
                    
                    
                    
                    9,596Loss
      from continuing operations before income tax (benefit)
    expense
                    
                    
                    (661,849
                    )
                    
                    
                    (290,172
                    )
                    
                    
                    (190,426
                    )
                    
                    
                    (175,431
                    )Income
      tax (benefit) expense
                    
                    
                    (16,753
                    )
                    
                    
                    59,200
                    
                    
                    
                    (17,837
                    )
                    
                    
                    245,783Loss
      from continuing operations
                    
                    
                    (645,096
                    )
                    
                    
                    (349,372
                    )
                    
                    
                    (172,589
                    )
                    
                    
                    (421,214
                    )Income
      (loss) from discontinued operations, net of income tax
                    
                    
                    22,471
                    
                    
                    
                    (252,863
                    )
                    
                    
                    29,818
                    
                    
                    
                    (174,157
                    )Net
      loss
                    
                    $
                    (622,625
                    )
                    
                    $
                    (602,235
                    )
                    
                    $
                    (142,771
                    )
                    
                    $
                    (595,371
                    )Basic
      earnings per share:Loss
      from continuing operations available to common
shareholders
                    
                    $
                    (70.33
                    )
                    
                    $
                    (38.08
                    )
                    
                    $
                    (19.00
                    )
                    
                    $
                    (45.40
                    )Income
      (loss) from discontinued operations, net of income tax
                    
                    
                    2.41
                    
                    
                    
                    (27.10
                    )
                    
                    
                    3.19
                    
                    
                    
                    (18.65
                    )Net
      loss available to common shareholders
                    
                    $
                    (67.92
                    )
                    
                    $
                    (65.18
                    )
                    
                    $
                    (15.81
                    )
                    
                    $
                    (64.05
                    )Diluted
      earnings per share:Loss
      from continuing operations available to common
shareholders
                    
                    $
                    (70.33
                    )
                    
                    $
                    (38.08
                    )
                    
                    $
                    (19.00
                    )
                    
                    $
                    (45.40
                    )Income
      (loss) from discontinued operations, net of income tax
                    
                    
                    2.41
                    
                    
                    
                    (27.10
                    )
                    
                    
                    3.19
                    
                    
                    
                    (18.65
                    )Net
      loss available to common shareholders
                    
                    $
                    (67.92
                    )
                    
                    $
                    (65.18
                    )
                    
                    $
                    (15.81
                    )
                    
                    $
                    (64.05
                    )Weighted
      average basic shares outstanding
                    
                    
                    9,337,517
                    
                    
                    
                    9,331,206
                    
                    
                    
                    9,337,695
                    
                    
                    
                    9,336,175Weighted
      average diluted shares outstanding
                    
                    
                    9,337,517
                    
                    
                    
                    9,331,206
                    
                    
                    
                    9,337,695
                    
                    
                    
                    9,336,175





See notes
to condensed consolidated financial statements.


2





NOVASTAR FINANCIAL,
INC.


CONDENSED CONSOLIDATED STATEMENT OF
SHAREHOLDERS’ DEFICIT(unaudited; dollars in thousands, except share
amounts)


Redeemable
                  Preferred
                  Stock
                
                
                Convertible
                  Participating
                  Preferred
                  Stock
                
                
                Common
                  Stock
                
                
                Additional
                  Paid-in
                  Capital
                
                
                Accumulated
                  Deficit
                
                
                Accumulated
                  Other
                  Comprehensive
                  (Loss)
      Income
                
                
                Other
                
                
                Total
                  Shareholders’
                  DeficitBalance,
      January 1, 2008
                
                $
                30
                
                
                $
                21
                
                
                $
                94
                
                
                $
                786,342
                
                
                $
                (996,649
                )
                
                $
                (1,117
                )
                
                $
                (209
                )
                
                $
                (211,488
                )Forgiveness
      of founders’ notes receivable
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                52
                
                
                
                52Compensation
      recognized under stock compensation plans
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (39
                )
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (39
                )Accumulating
      dividends on preferred stock
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (11,536
                )
                
                
                -
                
                
                
                -
                
                
                
                (11,536
                )Other
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                359
                
                
                
                -
                
                
                
                -
                
                
                
                359Comprehensive
      income:Net
      income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (622,625
                )
                
                
                
                
                
                
                
                
                
                
                (622,625
                )Other
      comprehensive income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                2,383
                
                
                
                
                
                
                
                2,383Total
      comprehensive income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (620,242
                )Balance,
      September 30, 2008
                
                $
                30
                
                
                $
                21
                
                
                $
                94
                
                
                $
                786,303
                
                
                $
                (1,630,451
                )
                
                $
                1,266
                
                
                $
                (157
                )
                
                $
                (842,894
                )





See notes
to condensed consolidated financial statements.


3


NOVASTAR FINANCIAL,
INC.


CONDENSEDCONSOLIDATED STATEMENTS OF CASH
FLOWS


(unaudited;
in thousands)


For the Nine Months Ended September
      30,2008
                
                
                2007Cash
      flows from operating activities:Net
      loss
                
                $
                (622,625
                )
                
                $
                (602,235
                )Income
      (loss) from discontinued operations
                
                
                22,471
                
                
                
                (252,863
                )Loss
      from continuing operations
                
                
                (645,096
                )
                
                
                (349,372
                )Adjustments
      to reconcile loss from continuing operations to net cash used in operating
      activities:Impairment
      on mortgage securities – available-for-sale
                
                
                22,897
                
                
                
                72,209Losses
      on derivative instruments
                
                
                9,480
                
                
                
                2,888Depreciation
      expense
                
                
                844
                
                
                
                1,952Amortization
      of deferred debt issuance costs
                
                
                3,325
                
                
                
                8,297Compensation
      recognized under stock compensation plans
                
                
                (39
                )
                
                
                843Provision
      for credit losses
                
                
                667,638
                
                
                
                192,326Amortization
      of premiums on mortgage loans
                
                
                12,671
                
                
                
                10,360Interest
      capitalized on loans held-in-portfolio
                
                
                (17,957
                )
                
                
                (33,900
                )Forgiveness
      of founders’ promissory notes
                
                
                52
                
                
                
                104Provision
      for deferred income taxes
                
                
                -
                
                
                
                41,620Fair
      value adjustments
                
                
                20,269
                
                
                
                58,224Accretion
      of available-for-sale and trading securities
                
                
                (35,301
                )
                
                
                (81,139
                )Losses
      on sales of mortgage assets
                
                
                -
                
                
                
                200Gains
      on debt extinguishment
                
                
                (6,418
                )
                
                
                -Changes
      in:Accrued
      interest receivable
                
                
                (10,519
                )
                
                
                (15,665
                )Derivative
      instruments, net
                
                
                615
                
                
                
                2,680Other
      assets
                
                
                5,205
                
                
                
                31,779Due
      to servicer
                
                
                39,483
                
                
                
                -Accounts
      payable and other liabilities
                
                
                (24,692
                )
                
                
                39,367Net
      cash provided by (used in) operating activities from continuing
      operations
                
                
                42,457
                
                
                
                (17,227
                )Net
      cash used in operating activities from discontinued
    operations
                
                
                (28,837
                )
                
                
                (1,180,940
                )Net
      cash provided by (used in) operating activities
                
                
                13,620
                
                
                
                (1,198,167
                )Continued


4





Cash
      flows from investing activities:Proceeds
      from paydowns on mortgage securities – available-for-sale
                      
                      
                      23,475
                      
                      
                      
                      156,984Proceeds
      from paydowns of mortgage securities - trading
                      
                      
                      48,605
                      
                      
                      
                      30,662Purchase
      of mortgage securities - trading
                      
                      
                      -
                      
                      
                      
                      (21,957
                      )Proceeds
      from sale of mortgage securities - trading
                      
                      
                      -
                      
                      
                      
                      7,420Proceeds
      from repayments of mortgage loans held-in-portfolio
                      
                      
                      254,793
                      
                      
                      
                      679,365Proceeds
      from sales of assets acquired through foreclosure
                      
                      
                      94,719
                      
                      
                      
                      5,009Restricted
      cash proceeds (payments)
                      
                      
                      3,210
                      
                      
                      
                      (8,960
                      )Purchases
      of property and equipment
                      
                      
                      -
                      
                      
                      
                      (3,132
                      )Acquisition
      of businesses, net of cash acquired
                      
                      
                      (709
                      )
                      
                      
                      -Net
      cash provided by investing activities
                      
                      
                      424,093
                      
                      
                      
                      845,391Net
      cash provided by investing activities from discontinued
      operations
                      
                      
                      2,092
                      
                      
                      
                      16,719Net
      cash provided by investing activities
                      
                      
                      426,185
                      
                      
                      
                      862,110Cash
      flows from financing activities:Proceeds
      from issuance of asset-backed bonds
                      
                      
                      -
                      
                      
                      
                      2,111,415Payments
      on asset-backed bonds
                      
                      
                      (400,358
                      )
                      
                      
                      (679,080
                      )Proceeds
      from issuance of capital stock and exercise of equity instruments, net of
      offering costs
                      
                      
                      -
                      
                      
                      
                      49,378Net
      change in short-term borrowings
                      
                      
                      (45,488
                      )
                      
                      
                      (353,792
                      )Repurchase
      of trust preferred debt
                      
                      
                      (550
                      )
                      
                      
                      -Dividends
      paid on vested options
                      
                      
                      -
                      
                      
                      
                      (498
                      )Dividends
      paid on preferred stock
                      
                      
                      -
                      
                      
                      
                      (4,990
                      )Net
      cash (used in) provided by financing activities from continuing
      operations
                      
                      
                      (446,396
                      )
                      
                      
                      1,122,433Net
      cash used in financing activities from discontinued
    operations
                      
                      
                      (19
                      )
                      
                      
                      (885,368
                      )Net
      cash (used in) provided by financing activities
                      
                      
                      (446,415
                      )
                      
                      
                      237,065Net
      decrease in cash and cash equivalents
                      
                      
                      (6,610
                      )
                      
                      
                      (98,992
                      )Cash
      and cash equivalents, beginning of period
                      
                      
                      25,364
                      
                      
                      
                      150,522Cash
      and cash equivalents, end of period
                      
                      $
                      18,754
                      
                      
                      $
                      51,530Continued


5


SUPPLEMENTAL DISCLOSURE OF CASH FLOW
INFORMATION


(unaudited;
in thousands)


For the Nine Months Ended September
      30,2008
                        
                        
                        2007Cash
      paid for interest
                        
                        $
                        89,058
                        
                        
                        $
                        250,156Cash
      paid for income taxes
                        
                        
                        3,456
                        
                        
                        
                        5,996Cash
      received on mortgage securities – available-for-sale with no cost
      basis
                        
                        
                        1,982
                        
                        
                        
                        3,426Non-cash
      operating, investing and financing activities:Transfer
      of loans to held-in-portfolio from held-for-sale
                        
                        
                        -
                        
                        
                        
                        1,880,340Transfer
      of mortgage securities from available-for-sale to trading
    (A)
                        
                        
                        -
                        
                        
                        
                        46,683Assets
      acquired through foreclosure
                        
                        
                        71,653
                        
                        
                        
                        97,976Cost
      basis of securities retained in securitizations
                        
                        
                        -
                        
                        
                        
                        56,387Tax
      benefit derived from capitalization of affiliate
                        
                        
                        
                        
                        
                        
                        (7,195
                        )Preferred
      stock dividends accrued, not yet paid
                        
                        
                        11,536
                        
                        
                        
                        2,634







(A)   
      Transfer was made upon adoption of SFAS 159.
                
                See
      notes to condensed consolidated financial statements.
              Concluded


6


NOVASTAR
FINANCIAL, INC.


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


September
30, 2008 (Unaudited)





Note
1. Financial Statement Presentation




Description of
Operations - NovaStar Financial, Inc. (“NFI”) and its subsidiaries (the
“Company”) hold certain non-conforming residential mortgage securities and is
exploring opportunities in the residential housing and other markets. A
majority-owned subsidiary of the Company, StreetLinks National Appraisal
Services LLC, is a residential mortgage appraisal management company. 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. Historically, the Company had
elected to be taxed as a real estate investment trust (“REIT”) under the
Internal Revenue Code of 1986, as amended (the “Code”). During the third quarter
of 2007, the Company announced that it would not be able to pay a dividend on
its common stock with respect to its 2006 taxable income, and as a result the
Company's status as a REIT terminated, retroactive to January 1, 2006. This
retroactive revocation of the Company’s REIT status resulted in it becoming
taxable as a C corporation for 2006 and subsequent years.




Effective
August 1, 2008, the Company acquired a 75 percent 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 condensed
consolidated statement of operations. Simultaneously with the acquisition, the
Company transferred ownership of 5 percent of StreetLinks to the Chief Executive
Officer of StreetLinks.





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




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





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




The
Company’s condensed consolidated financial statements as of September 30, 2008
and for the three and nine months ended September 30, 2008 and 2007 are
unaudited. In the opinion of management, all necessary adjustments have been
made, which were of a normal and recurring nature, for a fair presentation of
the condensed consolidated financial statements. Reclassifications to prior year
amounts have been made to conform to current year presentation, as
follows.


7





·
              In
      accordance with Statement of Financial Accounting Standards (“SFAS”) No.
      144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, the
      Company has reclassified the operating results of its mortgage lending
      segment and loan servicing segment as discontinued operations in the
      condensed consolidated statements of operations for the nine and three
      months ended September 30, 2007.


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





The
Company’s condensed consolidated financial statements should be read in
conjunction with Management’s Discussion and Analysis of Financial Condition and
Results of Operations and the condensed consolidated financial statements of the
Company and the notes thereto, included in the Company’s Annual Report on Form
10-K for the fiscal year ended December 31, 2007.




Liquidity,
Business Plan, Significant Events and Material Trends





Short and Long
Term Obligations - A discussion of the Company’s borrowings is included
in Note 6 to these financial statements. NFI’s wholly owned subsidiary NovaStar
Mortgage, Inc. (“NMI”) has approximately $77.2 million in principal amount of
unsecured notes (collectively, the “Notes”) outstanding to NovaStar Capital
Trust I and NovaStar Capital Trust II (collectively, the “Trusts”) which secure
trust preferred securities issued by the Trusts. The foregoing is net of amounts
owed in respect of trust preferred securities of NovaStar Capital Trust II
having a par value of $6.9 million purchased by NMI on May 29, 2008 for $0.6
million. NFI has guaranteed NMI's obligations under the Notes.




NMI
failed to make quarterly interest payments that were due on March 30, April 30,
June 30, July 30, September 30, October 30 and December 30, 2008, and January 30
and March 30, 2009 totaling, for all payment dates combined, approximately $6.1
million on the Notes. As a result, NMI is in default under the related
indentures and NFI is in default under the related guarantees. On June 4, 2008
and August 14, 2008, the Company received written notices of acceleration from
the holders of the trust preferred securities of NovaStar Capital Trust I and
NovaStar Capital Trust II, respectively, which declared all obligations of NMI
under the related Notes and indenture to be immediately due and payable, and
stated the intention of the trust preferred security holders to pursue all
available rights and remedies, including but not limited to enforcing their
rights under the related guarantee. The total principal and accrued interest
owed under the Notes, net of amounts owed in respect of the trust preferred
securities held by NMI, was approximately $84.0 million as of April 27, 2009. In
addition, the Company is obligated to reimburse the trustees for all reasonable
expenses, disbursements and advances in connection with the exercise of rights
under the indentures.





On
September 12, 2008, a petition for involuntary Chapter 7 bankruptcy entitled In
re NovaStar Mortgage, Inc. (Case No. 08-12125-CSS) was filed against NMI by the
holders of the trust preferred securities in U.S. Bankruptcy Court for the
District of Delaware in Wilmington, Delaware.  The filing did not include
NFI or any other subsidiary or affiliate of NFI.




On
February 18, 2009, the Company, NMI, the Trusts and the trust preferred security
holders entered into agreements to settle the claims of the trust preferred
security holders arising from NMI’s failure to make the scheduled quarterly
interest payments on the Notes. As part of the settlement, the existing
preferred obligations would be exchanged for new preferred obligations. The
settlement and exchange were contingent upon, among other things, the dismissal
of the involuntary Chapter 7 bankruptcy. On March 9, 2009, the Bankruptcy
Court entered an order dismissing the involuntary proceeding. On April 27,
2009 (the “Exchange Date”), the parties executed the necessary documents to
complete the Exchange. 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.


8





The
Company’s current projections indicate sufficient cash and cash flows will be
available from its mortgage assets to meet operating expenses through 2009.
However, the Company’s mortgage asset cash flows are currently volatile and
uncertain in nature, and the amounts the Company receives could vary materially
from its projections. In addition, these cash flows are expected to continue to
decrease over the next several months. Therefore, no assurance can be given that
the Company will be able to meet its cash flow needs, in which case it would be
required to seek protection of applicable bankruptcy laws.





Certain
states required the Company to post surety bonds in connection with its former
mortgage lending operations. During 2007, the Company was required to post
letters of credit to support its reimbursement obligations to the sureties, and
was required to cash collateralize the letters of credit pursuant to its letter
of credit agreements with Wachovia Bank. The Company is in the process of
terminating these surety bonds and the associated letters of credit as a result
of the discontinuation of its mortgage lending operations and has received back
collateral associated with letters of credit terminated to date. Collateral
totaling $5.8 million remained outstanding as of September 30, 2008.
Cancellation of the remaining surety bonds and related letters of credit is
subject to certain conditions and may take several months or longer to complete.
In addition, the Company is currently in default under the letter of credit
agreements as a result of, among other matters, the Company being in default
under debt agreements related to its trust preferred securities. Although the
Company has received a return of collateral notwithstanding this default,
Wachovia Bank is not obligated to return cash collateral to the Company so long
as a default exists. Consequently, no assurances can be given as to the timing
or amount of any additional return of the remaining cash
collateral.





Future Strategy,
Liquidity and Going Concern Considerations – The Company will continue to
focus on minimizing losses, preserving liquidity, and exploring operating
company opportunities. The Company’s residual and subordinated mortgage
securities are currently its only significant source of cash flows. Based on
current projections, the cash flows from the mortgage securities will decrease
in the next several months as the underlying mortgage loans are repaid, and
could be significantly less than the current projections if losses on the
underlying mortgage loans exceed, or prepayments are less than, the current
assumptions. In addition, the Company has significant operating expenses
associated with office leases, and other obligations relating to its
discontinued operations. The Company also has significant obligations with
respect to junior subordinated notes relating to the trust preferred securities
of NovaStar Capital Trust I and NovaStar Capital Trust II. See “Liquidity and
Capital Resources” for additional discussion regarding the recent defaults under
the junior subordinated notes.




If, as
the cash flows from its mortgage securities decrease, the Company is unable to
recommence or acquire profitable operations, restructure its unsecured debt,
capital structure and contractual obligations or if the cash flows from its
mortgage securities are less than currently anticipated, there can be no
assurance that the Company will be able to continue as a going concern and avoid
seeking the protection of applicable bankruptcy laws.





The
Company has initiated efforts to restructure its indebtedness and certain
contractual obligations and is assessing potential changes to elements of its
capital structure, with the goal of negotiating and implementing changes to
facilitate its ability to continue as a going concern. There can be no
assurance that any of these efforts will be successful.





Due to
the fact that the Company has a negative net worth, does not currently
have significant ongoing business operations that are profitable, its
common stock and its 8.90% Series C Cumulative Redeemable Preferred Stock (the
“Series C Preferred Stock”) have been delisted from the New York Stock
Exchange, and due to the illiquidity in the capital markets it is unlikely that
the Company will be able to obtain additional equity or debt financing on
favorable terms, or at all, for the foreseeable future. To the extent the
Company requires additional liquidity and cannot obtain it, the Company will be
forced to file for bankruptcy.





As
discussed in the Description of Operations section above, the Company acquired a
majority interest in an appraisal management company during the third quarter of
2008, and the Company intends to seek out other operating business
opportunities. It is unlikely, however, that the Company will be able to
directly recommence mortgage lending activities so long as it continues to have
a shareholders’ deficit because certain state licensing requirements prohibit
companies from lending when they have a shareholders’ deficit. Further, the
Company’s ability to start or acquire new businesses is significantly
constrained by its limited liquidity and its likely inability to obtain debt
financing or to issue equity securities as a result of its current financial
condition, including a shareholders’ deficit, as well as other uncertainties and
risks.





Recent Market
Developments - During 2008 and 2009, global financial market conditions
have continued to deteriorate. Financial services, and the mortgage industry in
particular, have remained under continuous pressure due to numerous factors,
which include industry-wide deterioration of the value of mortgage assets held
by financial institutions, the deterioration of mortgage credit among mortgage
lenders, the downgrades of mortgage securities by the rating agencies, and a
reluctance on the part of banks and broker-dealers to finance mortgage
securities within the credit markets. Because of these factors, mortgage
security market valuations remain volatile, mortgage securities trading remains
limited and mortgage securities financing markets remain challenging as the
industry continues to report negative news. The factors described above continue
to contribute to the decline in the market values of the Company’s
securities.


9




The
market has also seen significant fluctuations in LIBOR rates since the end of
2007 as the credit crisis has severely disrupted international liquidity and
capital markets and as various regulatory bodies have attempted to moderate the
lending and liquidity marketplace. This volatility in interest rates and the
severe deterioration in credit and prepayment performance of the collateral
underlying the securities the Company owns has made it extremely difficult to
predict, with any certainty, the cash flows from the Company’s securities
portfolio.





Given the
current uncertainty regarding these market conditions, the Company is unable to
offer any additional information on the situation. As a result, the Company
expects to continue to operate without any additional leverage and to continue
to take actions in an effort to preserve liquidity and available
cash.




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





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





Credit
Deterioration - The residential mortgage market has encountered
significant difficulties which have materially adversely affected the Company’s
performance. Delinquencies and losses with respect to residential mortgage loans
generally have increased and may continue to increase, particularly in the
sub-prime sector. In addition, over the last year residential property values in
most states have declined, in some areas severely, after extended periods during
which those values appreciated. To the extent residential property values
continue to decline, it is likely to result in additional increases in
delinquencies and losses on residential mortgage loans, especially with respect
to any residential mortgage loans where the aggregate loan amounts (including
any subordinate loans) are close to or greater than the related property values.
Another factor that may have contributed to, and may in the future result in,
higher delinquency rates is the increase in monthly payments on adjustable rate
mortgage (“ARM”) loans. Any increase in prevailing market interest rates may
result in increased payments for borrowers who have adjustable rate mortgage
loans. Moreover, borrowers with option ARM mortgage loans with a negative
amortization may experience a substantial increase in their monthly payment even
without an increase in prevailing market interest rates when the loans reach
their negative amortization cap. Compounding this issue, the current lack of
appreciation in residential property values and the adoption of tighter
underwriting standards throughout the mortgage loan industry has adversely
affected the ability of borrowers to refinance these loans and avoid default,
particularly borrowers facing a reset of the monthly payment to a higher amount.
To the extent that delinquencies or losses continue to increase for these or
other reasons, the value of the Company’s mortgage securities will be further
reduced, which will adversely affect the Company’s operating results, liquidity,
cash flow, financial condition, business prospects and ability to continue as a
going concern.





Note
2. New Accounting Pronouncements





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





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





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


10





In April
2008, the FASB issued FASB Staff Position (“FSP”) No. SFAS 142-3, “Determination
of the Useful Life of Intangible Assets” (“FSP SFAS 142-3”). FSP SFAS 142-3
amends paragraph 11(d) of FASB Statement No. 142 “Goodwill and Other Intangible
Assets” (“SFAS 142”) which amends the factors that should be considered in
developing renewal or extension assumptions used to determine the useful life of
a recognized intangible asset under SFAS 142. FSP SFAS 142-3 is intended to
improve the consistency between the useful life of a recognized intangible asset
under SFAS 142 and the period of expected cash flows used to measure the fair
value of the asset. FSP SFAS 142-3 is effective for financial statements issued
for fiscal years beginning after December 15, 2008 and must be applied
prospectively to intangible assets acquired after the effective date. The
Company does not expect that adoption of FSP SFAS 142-3 will have a significant
impact on the Company’s consolidated financial statements.





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





On
September 15, 2008, the FASB issued two exposure drafts proposing amendments to
SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities”, and FASB Interpretation No. 46R, “Consolidation
of Variable Interest Entities” (“FIN 46R”). Currently, the transfers of the
Company’s mortgage loans in securitization transactions qualify for sale
accounting treatment. The trusts used in the Company’s securitizations are not
consolidated for financial reporting purposed because the trusts are qualifying
special purpose entities (“QSPE”). Because the transfers qualify as sales and
the trusts are not subject to consolidation, the assets and liabilities of the
trusts are not reported on the balance sheet under GAAP. Under the proposed
amendments, the concept of a QSPE would be eliminated and would modify the
consolidation conclusions. As proposed, these amendments would be effective for
the Company at the beginning of 2010. The proposed amendments, if adopted, could
require the Company to consolidate the assets and liabilities of the Company’s
securitization trusts. This could have a significant effect on our financial
condition as affected off-balance sheet loans and related liabilities would be
recorded on the balance sheet.





On
October 10, 2008, the FASB issued FSP No. 157-3, “Determining the Fair Value of
a Financial Asset When the Market for That Asset Is Not Active” (“FSP
157-3”).  FSP 157-3 clarifies the application of FAS 157 in a market
that is not active and provides an example to illustrate key consideration in
determining the fair value of a financial asset when the market for that
financial asset is not active.  The issuance of FSP 157-3 did not have
a material impact on the Company’s determination of fair value for its financial
assets.





In
December 2008, the FASB issued FSP FAS 140-4 and FIN 46(R)-8,
Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets
and Interests in Variable Interest Entities (“FSP FAS 140-4 and
FIN 46(R)-8”), which requires expanded disclosures for transfers of
financial assets and involvement with variable interest entities (“VIEs”). Under
this guidance, the disclosure objectives related to transfers of financial
assets now include providing information on (i) the Company’s continued
involvement with financial assets transferred in a securitization or asset
backed financing arrangement, (ii) the nature of restrictions on assets
held by the Company that relate to transferred financial assets, and
(iii) the impact on financial results of continued involvement with assets
sold and assets transferred in secured borrowing arrangements. VIE disclosure
objectives now include providing information on (i) significant judgments
and assumptions used by the Company to determine the consolidation or disclosure
of a VIE, (ii) the nature of restrictions related to the assets of a
consolidated VIE, (iii) the nature of risks related to the Company’s
involvement with the VIE and (iv) the impact on financial results related
to the Company’s involvement with the VIE. Certain disclosures are also required
where the Company is a non-transferor sponsor or servicer of a QSPE. FSP
FAS 140-4 and FIN 46(R)-8 is effective for the first reporting period
ending after December 15, 2008. Since the FSP only requires certain
additional disclosures, the Company does not expect the adoption will have a
material impact on its condensed consolidated financial statements.




In
January 2009, the FASB issued FSP EITF 99-20-1, Amendments to the
Impairment Guidance of EITF Issue No. 99-20 (“FSP EITF 99-20-1”),
which eliminates the requirement that the holder’s best estimate of cash flows
be based upon those that a “market participant” would use. FSP EITF 99-20-1
was amended to require recognition of other-than-temporary impairment when it is
“probable” that there has been an adverse change in the holder’s best estimate
of cash flows from the cash flows previously projected. This amendment aligns
the impairment guidance under EITF 99-20, Recognition of Interest Income
and Impairment on Purchased Beneficial Interests and Beneficial Interests That
Continue to Be Held by a Transferor in Securitized Financial Assets, with the
guidance in SFAS No. 115. FSP EITF 99-20-1 retains and
re-emphasizes the other-than-temporary impairment guidance and disclosures in
pre-existing GAAP and SEC requirements. FSP EITF 99-20-1 is effective for
interim and annual reporting periods ending after December 15, 2008. The
Company does not expect the adoption of FSP EITF 99-20-1 will have a
material impact on its condensed consolidated financial
statements.


11





Note
3. Mortgage Loans – Held in Portfolio




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





September 30,
                  2008
                
                
                December 31,
                  2007Mortgage
      loans – held-in-portfolio:Outstanding
      principal
                
                $
                2,653,163
                
                
                $
                3,067,737Net
      unamortized deferred origination costs
                
                
                19,743
                
                
                
                32,414Amortized
      cost
                
                
                2,672,906
                
                
                
                3,100,151Allowance
      for credit losses
                
                
                (791,906
                )
                
                
                (230,138
                )Mortgage
      loans – held-in-portfolio
                
                $
                1,881,000
                
                
                $
                2,870,013Weighted
      average coupon
                
                
                8.17
                %
                
                
                8.59
                %





Mortgage
loans held-in-portfolio consist of loans that the Company has securitized in
structures that are accounted for as financings. These securitizations are
structured legally as sales, but for accounting purposes are treated as
financings as defined by SFAS No. 140, “Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities (a replacement of FASB
Statement No. 125”). The NHES 2006-1 and NHES 2006-MTA1 securitizations at
inception did not meet the criteria necessary for derecognition under SFAS 140
and related interpretations because after the loans were securitized the
securitization trusts may 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 SFAS 140 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. Accordingly, the loans in the NHES
2006-1, NHES 2006-MTA1, and NHES 2007-1 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.





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




Activity
in the allowance for credit losses on mortgage loans – held-in-portfolio is as
follows for the nine and three months ended September 30, 2008 and 2007,
respectively (dollars in thousands):




For the Nine Months Ended
                  September 30,
                
                
                For the Three Months Ended
                  September 30,2008
                
                
                2007
                
                
                2008
                
                
                2007Balance,
      beginning of period
                
                $
                230,138
                
                
                $
                22,452
                
                
                $
                616,690
                
                
                $
                100,096Provision
      for credit losses
                
                
                667,638
                
                
                
                192,326
                
                
                
                206,202
                
                
                
                99,159Charge-offs,
      net of recoveries
                
                
                (105,870
                )
                
                
                (39,570
                )
                
                
                (30,986
                )
                
                
                (24,047
                )Balance,
      end of period
                
                $
                791,906
                
                
                $
                175,208
                
                
                $
                791,906
                
                
                $
                175,208





12




Note
4. Mortgage Securities – Available-for-Sale


As of
September 30, 2008, and December 31, 2007, 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 SFAS 155,
“Accounting for Certain Hybrid Financial Instruments”, an amendment of SFAS 133
and SFAS 140 (“SFAS 155”) on January 1, 2007 and the complexities and
uncertainties surrounding the application of this Statement. As a result, the
NMFT Series 2007-2, residual security qualifies for the scope exception
concerning bifurcation provided by SFAS 155. Residual securities consist of
interest-only, prepayment penalty and overcollateralization bonds. Management
estimates the fair value of the residual securities by discounting the expected
future cash flows of the collateral and bonds.




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





Cost Basis
                  
                  
                  Unrealized
                    Gain
                  
                  
                  Unrealized Losses
                    Less Than Twelve
                    Months
                  
                  
                  Estimated Fair
                    Value
                  
                  
                  Average
                    Yield (A)As
      of September 30, 2008
                  
                  $
                  5,389
                  
                  
                  $
                  1,523
                  
                  
                  $
                  -
                  
                  
                  $
                  6,912
                  
                  
                  
                  24.51
                  %As
      of December 31, 2007
                  
                  
                  33,302
                  
                  
                  
                  69
                  
                  
                  
                  -
                  
                  
                  
                  33,371
                  
                  
                  
                  26.94
                  %


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





During
the nine and three months ended September 30, 2008 and 2007, management
concluded that the decline in value on certain securities in the Company’s
mortgage securities portfolio were other-than-temporary. As a result, the
Company recognized impairments on mortgage securities – available-for-sale of
$22.9 million and $1.7 million during the nine and three months ended September
30, 2008, respectively, as compared to $72.2 million and $46.2 million during
the same periods of 2007.




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




Note
5. Mortgage Securities – Trading





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




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





Original Face
                  
                  
                  Amortized Cost
                    Basis
                  
                  
                  Fair Value
                  
                  
                  Average
                    Yield (A)As
      of September 30, 2008Subordinated
      securities pledged to CDO
                  
                  $
                  332,489
                  
                  
                  $
                  318,907
                  
                  
                  $
                  9,807Other
      subordinated securities
                  
                  
                  102,625
                  
                  
                  
                  95,173
                  
                  
                  
                  3,451Residual
      securities
                  
                  
                  N/A
                  
                  
                  
                  17,675
                  
                  
                  
                  1,723Total
                  
                  $
                  435,114
                  
                  
                  $
                  431,755
                  
                  
                  $
                  14,981
                  
                  
                  
                  8.66
                  %As
      of December 31, 2007
                  
                  $
                  435,114
                  
                  
                  $
                  447,370
                  
                  
                  $
                  109,203
                  
                  
                  
                  13.85
                  %





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





The
Company recognized net trading losses of $78.6 million and $3.7 million for the
nine and three months ended September 30, 2008, respectively, as compared to net
trading losses of $237.9 million and $148.2 million for the same periods of
2007. These net trading losses are included in the fair value adjustments line
on the Company’s condensed consolidated statements of operations.





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


13





Note
6. Borrowings




Short-term
Borrowings




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





Asset-backed
Bonds (“ABB”)




On
January 30, 2008, an event of default occurred under the CDO bond indenture
agreement due to noncompliance with certain overcollateralization tests. As a
result, the trustee, upon notice and at the direction of a majority of the
secured noteholders, may declare all of the secured notes to be immediately due
and payable including accrued and unpaid interest. No such notice has been given
as of April 27, 2009. The Company does not expect any significant impact to its
financial condition, cash flows or results of operation as a result of the event
of default.





Junior
Subordinated Debentures




Trust Preferred
Obligations. NFI’s wholly owned subsidiary NovaStar Mortgage, Inc.
(“NMI”) has approximately $77.2 million in principal amount of unsecured notes
(collectively, the “Notes”) outstanding to NovaStar Capital Trust I and NovaStar
Capital Trust II (collectively, the “Trusts”) which secure trust preferred
securities issued by the Trusts. The foregoing is net of amounts owed in respect
of trust preferred securities of NovaStar Capital Trust II having a par value of
$6.9 million purchased by NMI on May 29, 2008 for $0.6 million. NFI has
guaranteed NMI's obligations under the Notes.




NMI
failed to make quarterly interest payments that were due on March 30, April 30,
June 30, July 30, September 30, October 30 and December 30, 2008, and January 30
and March 30, 2009 totaling, for all payment dates combined, approximately $6.1
million on the Notes. As a result, NMI is in default under the related
indentures and NFI is in default under the related guarantees.




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





On June
4, 2008 and August 14, 2008, the Company received written notices of
acceleration from the holders of the trust preferred securities of NovaStar
Capital Trust I and NovaStar Capital Trust II, respectively, which declared all
obligations of NMI under the related Notes and indenture to be immediately due
and payable, and stated the intention of the trust preferred security holders to
pursue all available rights and remedies, including but not limited to enforcing
their rights under the related guarantee. The total principal and accrued
interest owed under the Notes, net of amounts owed in respect of the trust
preferred securities held by NMI, was approximately $84.0 million as of April
27, 2009. In addition, the Company is obligated to reimburse the trustees for
all reasonable expenses, disbursements and advances in connection with the
exercise of rights under the indentures.




On
September 12, 2008, a petition for involuntary Chapter 7 bankruptcy entitled In
re NovaStar Mortgage, Inc. (Case No. 08-12125-CSS) was filed against NMI by the
holders of the trust preferred securities in U.S. Bankruptcy Court for the
District of Delaware in Wilmington, Delaware.  The filing did not include
NFI or any other subsidiary or affiliate of NFI.




On
February 18, 2009, the Company, NMI, the Trusts and the trust preferred security
holders entered into agreements to settle the claims of the trust preferred
security holders arising from NMI’s failure to make the scheduled quarterly
interest payments on the Notes. As part of the settlement, the existing
preferred obligations would be exchanged for new preferred obligations. The
settlement and exchange were contingent upon, among other things, the dismissal
of the involuntary Chapter 7 bankruptcy. On March 9, 2009, the Bankruptcy
Court entered an order dismissing the involuntary proceeding. On April 27,
2009 (the “Exchange Date”), the parties executed the necessary documents to
complete the Exchange. 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.


14


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.





Note
7. Commitments and Contingencies




Contingencies





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




In March
2002, Plaintiff filed an action against NovaStar Home Mortgage, Inc. (“NHMI”) in
Superior Court of Orange County, California entitled American Interbanc Mortgage
LLC v. NovaStar Home Mortgage, Inc. et. al. (the “California Action”). In the
California Action, Plaintiff alleged that NHMI and two other mortgage companies
(“Defendants”) engaged in false advertising and unfair competition under certain
California statutes and interfered intentionally with Plaintiff’s prospective
economic relations. On May 4, 2007, a jury returned a verdict by a 9-3 vote
awarding Plaintiff $15.9 million. The court trebled the award, made adjustments
for amounts paid by settling Defendants, and entered a $46.1 million judgment
against Defendants on June 27, 2007 (the “Judgment”). The award is joint and
several against the Defendants, including NHMI.




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




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




Pursuant
to the Settlement Terms, the Involuntary Bankruptcy was dismissed on April 24,
2008 and on May 8, 2008, the Company paid Plaintiff $2.0 million plus the
balance in an account established by order of the Bankruptcy Court, and NHMI
satisfied obligations totaling $48,000 to certain identified creditors. In
addition to the initial payments made to the Plaintiff following dismissal of
the Involuntary Bankruptcy, the Company agreed to pay Plaintiff $5.5 million if,
prior to July 1, 2010, (i) NFI’s average common stock market capitalization is
at least $94.4 million over a period of five consecutive business days, or (ii)
the holders of NFI’s common stock are paid $94.4 million in net asset value as a
result of any sale of NFI or its assets. If NFI is sold prior to July 1, 2010
for less than $94.4 million and ceases to be a public company, then NFI will
obligate the purchaser to pay Plaintiff $5.5 million in the event the value of
the company exceeds $94.4 million prior to July 1, 2010 as determined by an
independent valuation company.




Pursuant
to the Settlement Terms, the releases of NHMI and its affiliate became
effective on September 11, 2008.     As a result,
NHMI has reversed a previously recorded liability of $45.2 million that was
included in the consolidated financial statements of the Company.




Trust Preferred
Settlement.On
September 12, 2008, a petition for involuntary Chapter 7 bankruptcy entitled In
re NovaStar Mortgage, Inc. (Case No. 08-12125-CSS) was filed against NMI by the
holders of the trust preferred securities in U.S. Bankruptcy Court for the
District of Delaware in Wilmington, Delaware. The filing did not include NFI or
any other subsidiary or affiliate of NFI. On February 18, 2009, the Company,
NMI, NovaStar Capital Trust I, NovaStar Capital Trust II and the trust preferred
securities holders entered into agreements to settle the claims of the trust
preferred securities holders arising from NMI’s failure to make the scheduled
quarterly interest payments on certain unsecured notes issued by NMI to the
trusts. The settlement was contingent upon, among other things, the dismissal of
the involuntary Chapter 7 bankruptcy. On March 9, 2009, the Bankruptcy Court
entered an order dismissing the involuntary proceeding.See
Note 6—Trust Preferred Obligations above for additional discussion of the claims
of the petitioners and the settlement.





Other
Litigation. Since
April 2004, a number of substantially similar class action lawsuits have been
filed and consolidated into a single action in the United States District Court
for the Western District of Missouri. The consolidated complaint names the
Company and three of the Company’s current and former executive officers as
defendants and generally alleges that the defendants made public statements
that were misleading for failing to disclose certain regulatory and licensing
matters. The plaintiffs purport to have brought this consolidated action on
behalf of all persons who purchased the Company’s common stock (and sellers of
put options on the Company’s common stock) during the period October 29, 2003
through April 8, 2004. On January 14, 2005, the Company filed a motion to
dismiss this action, and on May 12, 2005, the court denied such motion. On
February 8, 2007, the court certified the case as a class action. The Company
has entered into a settlement agreement to resolve these pending class action
lawsuits. The total amount of the settlement, which is subject to the approval
of the United States District Court for the Western District of Missouri, is
$7.25 million, and it will be paid by the Company’s insurance carriers. The
settlement agreement contains no admission of fault or wrongdoing by the Company
or other defendants.





15





At this
time, the Company cannot predict the probable outcome of the following claims
and as such no amounts have been accrued in the condensed 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 Court dismissed the plaintiffs’
complaints without leave to amend. The plaintiffs have filed an appeal of the
Court’s ruling.





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





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. 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 in
connection with seek monetary damages, 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. 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, and plaintiff has filed a motion to remand the case to state court. 
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. Pursuant to a stipulation, the
Company has not yet filed its initial responsive pleading, and discovery is not
yet underway.   The Company believes it has meritorious defenses to
the case and expects to defend the case vigorously.


16





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 believes it has meritorious defenses to the
case and expects to defend the case vigorously.





On
October 21, 2008, EHD Holdings, LLC, the purported owner of the building which
leases the Company its former principal office space in Kansas City, filed an
action for unpaid rent in the Circuit Court of Jackson County,
Missouri. The action seeks the immediate possession of the office space,
unpaid rent though October 20, 2008 of approximately $1.1 million, plus any
accruing rent thereafter, plus attorney fees.





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





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





Note
8. Comprehensive Income




Other
comprehensive income includes revenues, expenses, gains and losses that are not
included in net income. The following is the detail of comprehensive income for
the nine and three months ended September 30, 2008 and 2007 (dollars in
thousands):





For the Nine Months
                  Ended September 30,
                
                
                For the Three Months Ended
                  September 30,2008
                
                
                2007
                
                
                2008
                
                
                2007Net
      loss
                
                $
                (622,625
                )
                
                $
                (602,235
                )
                
                $
                (142,771
                )
                
                $
                (595,371
                )Other
      comprehensive income (loss):Change
      in unrealized loss on mortgage securities –
    available-for-sale
                
                
                (21,443
                )
                
                
                (108,376
                )
                
                
                (879
                )
                
                
                (48,738
                )Change
      in unrealized gain on derivative instruments used in cash flow
      hedges
                
                
                (1,059
                )
                
                
                231
                
                
                
                88
                
                
                
                (479
                )Impairment
      on mortgage securities - available-for-sale reclassified to
      earnings
                
                
                22,897
                
                
                
                72,209
                
                
                
                1,669
                
                
                
                46,216Valuation
      allowance for deferred taxes
                
                
                -
                
                
                
                1,855
                
                
                
                -
                
                
                
                (4,705
                )Net
      settlements of derivative instruments used in cash flow hedges
      reclassified to earnings
                
                
                1,988
                
                
                
                (740
                )
                
                
                633
                
                
                
                (401
                )Other
      comprehensive income (loss)
                
                
                2,383
                
                
                
                (34,821
                )
                
                
                1,511
                
                
                
                (8,107
                )Total
      comprehensive loss
                
                $
                (620,242
                )
                
                $
                (637,056
                )
                
                $
                (141,260
                )
                
                $
                (603,478
                )







Note
9. Fair Value Accounting





Effective
January 1, 2007, the Company adopted SFAS No. 157, “Fair Value
Measurements” (“SFAS 157”) and SFAS No. 159, “The Fair Value Option for
Financial Assets” (“SFAS 159”). Both standards address aspects of the expanding
application of fair value accounting.




17




Fair
Value Measurements (SFAS 157)





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





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




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





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





The
following table presents for each of the fair value hierarchy levels, the
Company’s assets and liabilities which are measured at fair value on a recurring
basis as of September 30, 2008 (dollars in thousands):




Fair Value Measurements at Reporting Date
      UsingDescription
                
                Fair Value at
                  September
                  30, 2008
                
                
                Quoted Prices in
                  Active Markets
                  for Identical
                  Assets
                  (Level 1)
                
                
                Significant Other
                  Observable Inputs
                  (Level 2)
                
                
                Significant
                  Unobservable
                  Inputs (Level 3)Assets:Mortgage
      securities -trading
                
                $
                14,981
                
                
                $
                -
                
                
                $
                -
                
                
                $
                14,981Mortgage
      securities – available-for-sale
                
                
                6,912
                
                
                
                -
                
                
                
                -
                
                
                
                6,912Derivative
      instruments
                
                
                509
                
                
                
                -
                
                
                
                -
                
                
                
                509Total
      assets
                
                $
                22,402
                
                
                $
                -
                
                
                $
                -
                
                
                $
                22,402Liabilities:Asset-backed
      bonds secured by mortgage securities
                
                $
                11,114
                
                
                $
                -
                
                
                $
                -
                
                
                $
                11,114Total
      liabilities
                
                $
                11,114
                
                
                $
                -
                
                
                $
                -
                
                
                $
                11,114





The
following table provides a reconciliation of the beginning and ending balances
for the Company’s mortgage securities – trading which are measured at fair value
on a recurring basis using significant unobservable inputs (Level 3) for the
nine months ended September 30, 2008 and 2007 (dollars in
thousands):




Cost Basis
                
                
                Unrealized
                  Loss
                
                
                Estimated
                  Fair Value of
                  Mortgage
                  SecuritiesAs
      of December 31, 2007
                
                $
                41,275
                
                
                $
                (16,534
                )
                
                $
                24,741Increases
      (decreases) to mortgage securities-trading:Securities
      transferred from Level 2 to Level 3
                
                
                414,080
                
                
                
                (395,359
                )
                
                
                18,721Accretion
      of income
                
                
                11,259
                
                
                
                -
                
                
                
                11,259Proceeds
      from paydowns of securities
                
                
                (34,859
                )
                
                
                -
                
                
                
                (34,859
                )Mark-to-market
      value adjustment
                
                
                -
                
                
                
                (4,881
                )
                
                
                (4,881
                )Net
      increase (decrease) to mortgage securities
                
                
                390,480
                
                
                
                (400,240
                )
                
                
                (9,760
                )As
      of September 30, 2008
                
                $
                431,755
                
                
                $
                (416,774
                )
                
                $
                14,981









18





Cost
                  Basis
                
                
                Unrealized
                  Gain
                  (Loss)
                
                
                Estimated
                  Fair Value of
                  Mortgage
                  SecuritiesAs
      of December 31, 2006
                
                $
                -
                
                
                $
                -
                
                
                $
                -Increases
      (decreases) to mortgage securities-trading:New
      securities retained in securitizations
                
                
                56,387
                
                
                
                226
                
                
                
                56,613Accretion
      of income
                
                
                3,102
                
                
                
                -
                
                
                
                3,102Proceeds
      from paydowns of securities
                
                
                (11,836
                )
                
                
                -
                
                
                
                (11,836
                )Mark-to-market
      value adjustment
                
                
                -
                
                
                
                (6,132
                )
                
                
                (6,132
                )Net
      increase (decrease) to mortgage securities
                
                
                47,653
                
                
                
                (5,906
                )
                
                
                41,747As
      of September 30, 2007
                
                $
                47,653
                
                
                $
                (5,906
                )
                
                $
                41,747







The
following table provides a reconciliation of the beginning and ending balances
for the Company’s mortgage securities – available-for-sale which are measured at
fair value on a recurring basis using significant unobservable inputs (Level 3)
for the nine months ended September 30, 2008 and 2007 (dollars in
thousands):





Cost
                  Basis
                
                
                Unrealized
                  Gain
                
                
                Estimated
                  Fair Value of
                  Mortgage
                  SecuritiesAs
      of December 31, 2007
                
                $
                33,302
                
                
                $
                69
                
                
                $
                33,371Increases
      (decreases) to mortgage securities:Accretion
      of income (A)
                
                
                5,976
                
                
                
                -
                
                
                
                5,976Proceeds
      from paydowns of securities (A) (B)
                
                
                (10,992
                )
                
                
                -
                
                
                
                (10,992
                )Impairment
      on mortgage securities - available-for-sale
                
                
                (22,897
                )
                
                
                -
                
                
                
                (22,897
                )Mark-to-market
      value adjustment
                
                
                -
                
                
                
                1,454
                
                
                
                1,454Net
      (decrease) increase to mortgage securities
                
                
                (27,913
                )
                
                
                1,454
                
                
                
                (26,459
                )As
      of September 30, 2008
                
                $
                5,389
                
                
                $
                1,523
                
                
                $
                6,912





(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.




Cost
                  Basis
                
                
                Unrealized
                  Gain
                
                
                Estimated
                  Fair Value of
                  Mortgage
                  SecuritiesAs
      of December 31, 2006
                
                $
                310,760
                
                
                $
                38,552
                
                
                $
                349,312Increases
      (decreases) to mortgage securities:Transfer
      to mortgage securities – trading upon adoption of SFAS 159
                
                
                (47,814
                )
                
                
                1,131
                
                
                
                (46,683
                )Accretion
      of income (A)
                
                
                44,133
                
                
                
                -
                
                
                
                44,133Proceeds
      from paydowns of securities (A) (B)
                
                
                (152,102
                )
                
                
                -
                
                
                
                (152,102
                )Impairment
      on mortgage securities - available-for-sale
                
                
                (72,209
                )
                
                
                72,209
                
                
                
                -Mark-to-market
      value adjustment
                
                
                -
                
                
                
                (108,376
                )
                
                
                (108,376
                )Net
      decrease to mortgage securities
                
                
                (227,992
                )
                
                
                (35,036
                )
                
                
                (263,028
                )As
      of September 30, 2007
                
                $
                82,768
                
                
                $
                3,516
                
                
                $
                86,284








19




(A)
              Cash
      received on mortgage securities with no cost basis was $3.4 million for
      the nine months ended September 30,
2007.
 (B)
              As
      of September 30, 2007 and December 31, 2006 the Company had receivables
      from securitization trusts of $16.3 million and $21.2 million,
      respectively, related to mortgage securities available-for-sale with a
      remaining cost basis. Also the Company had receivables from securitization
      trusts of $49,000 and $0.7 million related to mortgage securities with a
      zero cost basis as of September 30, 2007 and December 31, 2006,
      respectively.




The
following table provides quantitative disclosures about the fair value
measurements for the Company’s assets which are measured at fair value on a
nonrecurring basis as of September 30, 2008 (dollars in thousands):
  Fair
      Value Measurements at Reporting Date UsingDescription
                                          
                                          Fair
      Value at
                                            September
      30, 2008
                                          
                                          
                                          Quoted
      Prices in
                                            Active
      Markets
                                            for
      Identical Assets
                                            (Level
      1)
                                          
                                          
                                          Significant
      Other
                                            Observable
                                            Inputs
      (Level 2)
                                          
                                          
                                          Significant
                                            Unobservable
                                            Inputs
      (Level 3)Real
      estate owned
                                          
                                          $
                                          53,763
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -
                                          
                                          
                                          $
                                          53,763
 
 At the
time a mortgage loan held-for-sale or held-in-portfolio becomes real estate
owned, the Company records the property at the lower of its carrying
amount or fair value.  Upon foreclosure and
through liquidation, the Company evaluates the property's fair value
as compared to its carrying amount and records a valuation adjustment when
the carrying amount exceeds fair value.  Any valuation adjustments at the
time the loan becomes real estate owned are charged to the allowance for credit
losses.


The
following table provides a summary of the impact to earnings for the nine and
three months ended September 30, 2008 and 2007 from the Company’s assets and
liabilities which are measured at fair value on a recurring and nonrecurring
basis (dollars in thousands):





Fair Value Adjustments
                For the Nine months
                ended September 30
              
              
              Fair Value
                Adjustments For the
                Three Months Ended
                September 30Asset or Liability
                Measured at Fair
                Value
              
              Fair Value
                Measurement
                Frequency
              
              2008
              
              
              2007
              
              
              2008
              
              
              2007
              
              Statement of
                Operations Line Item
                ImpactedMortgage
      securities - trading
              
              Recurring
              
              $
              (78,607
              )
              
              $
              (237,919
              )
              
              $
              (3,741
              )
              
              $
              (148,179
              )
              Fair
      value adjustmentsMortgage
      securities – available-for-sale
              
              Recurring
              
              
              (22,897
              )
              
              
              (72,209
              )
              
              
              (1,668
              )
              
              
              (46,216
              )
              Impairment
      on mortgage securities – available-for-saleAsset-backed
      bonds secured by mortgage securities
              
              Recurring
              
              
              58,338
              
              
              
              179,695
              
              
              
              6,141
              
              
              
              116,187
              
              Fair
      value adjustmentsDerivative
      instruments, net
              
              Recurring
              
              
              2,343
              
              
              
              (5,775
              )
              
              
              4,793
              
              
              
              (10,778
              )
              Losses
      on derivative instrumentsTotal
      fair value losses
              
              
              
              $
              (40,823
              )
              
              $
              (136,208
              )
              
              $
              5,525
              
              
              $
              (88,986
              )









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. As of September 30, 2008, the Company
estimated fair value for its subordinated securities based on quoted market
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 retained in
securitization and resecuritization transactions which include residual
securities. The Company had no subordinated securities included within the
mortgage securities – available-for-sale classification as of September 30,
2008. Mortgage securities classified as available-for-sale are reported at their
estimated fair value with unrealized gains and losses reported in accumulated
other comprehensive income. To the extent that the cost basis of mortgage
securities exceeds the fair value and the unrealized loss is considered to be
other than temporary, an impairment charge is recognized and the amount recorded
in accumulated other comprehensive income or loss is reclassified to earnings as
a realized loss. The specific identification method is used in computing
realized gains or losses. The Company used two methodologies for determining the
initial value of its residual securities: 1) the whole loan price methodology
and 2) the discount rate methodology. The Company believes the best estimate of
the initial value of the residual securities it retained in its securitizations
accounted for as sales is derived from the market value of the pooled loans. As
such, the Company generally used the whole loan price methodology when
significant open market sales pricing data was available. Under this method, the
initial value of the loans transferred in a securitization accounted for as a
sale was estimated based on the expected open market sales price of a similar
pool. In open market transactions, the purchaser has the right to reject loans
at its discretion. In a loan securitization, loans generally cannot be rejected.
As a result, the Company adjusted the market price for the loans to compensate
for the estimated value of rejected loans. The market price of the securities
retained was derived by deducting the net proceeds received in the
securitization (i.e. the economic value of the loans transferred) from the
estimated adjusted market price for the entire pool of the loans.




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




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




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




Derivative instruments.The
fair value of interest rate agreements are estimated by discounting the
projected future cash flows using appropriate market rates.





Asset-backed bonds secured by
mortgage securities.See discussion under Fair Value Option for Financial
Assets and Financial Liabilities (SFAS 159).





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





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




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




On
January 1, 2007, the Company adopted the provisions of SFAS 159. The Company
elected the fair value option for the asset-backed bonds issued from NovaStar
ABS CDO I, which closed in the first quarter of 2007. The Company elected the
fair value option for these liabilities to help reduce earnings volatility which
otherwise would arise if the accounting method for this debt was not matched
with the fair value accounting for the related mortgage securities - trading.
The asset-backed bonds which are being carried at fair value are included in the
“Asset-backed bonds secured by mortgage securities“ line item on the condensed
consolidated balance sheets. The Company recognized fair value adjustments of
$58.3 million and $6.1 million for the nine and three months ended September 30,
2008, respectively, and $179.7 million and $116.2 million for the same periods
in 2007. These adjustments are included in the “Fair value adjustments” line
item on the condensed consolidated statements of operations. Prior to September
30, 2008, the Company estimated fair value for its subordinated securities
underlying the asset-backed bonds solely from quoted market prices. As of
September 30, 2008, the Company estimated fair value for its underlying
subordinated securities based on quoted market 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 of the underlying
securities caused a change from Level 2 to Level 3 for the asset-backed bonds
due to the unobservable inputs used by the Company in determining the expected
future cash flows. The Company calculates interest expense for these
asset-backed bonds based on the prevailing coupon rates of the specific classes
of debt and records interest expense in the period incurred. Interest expense
amounts are included in the “Interest expense” line item of the condensed
consolidated statements of operations.




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


21





The
following table shows the impact of electing the fair value option for the nine
months ended September 30, 2008 (dollars in thousands):





Description
                
                Unpaid
      Principal Balance
                  as
      of September 30, 2008
                
                
                Gain
                  Recognized
                
                
                Balance
      at Fair ValueAsset-backed
      bonds secured by mortgage securities
                
                $
                325,641
                
                
                $
                58,337
                
                
                $
                11,114









Substantially
all of the $58.3 million change in fair value of the asset-backed bonds is
considered to be related to specific credit risk as all of the bonds are
floating rate. The change in credit risk was caused by spreads widening in the
asset-backed securities market during the first three quarters of
2008.





Note
10. Interest Income




The
following table presents the components of interest income for the nine and
three months ended September 30, 2008 and 2007 (dollars in
thousands):





For the Nine Months
                  Ended September 30,
                
                
                For the Three Months Ended
                  September 30,2008
                
                
                2007
                
                
                2008
                
                
                2007Interest
      Income:Mortgage
      securities
                
                $
                33,319
                
                
                $
                83,866
                
                
                $
                6,561
                
                
                $
                23,517Mortgage
      loans held-in-portfolio
                
                
                148,829
                
                
                
                191,191
                
                
                
                45,517
                
                
                
                67,451Other
      interest income (A)
                
                
                1,129
                
                
                
                4,680
                
                
                
                191
                
                
                
                1,013Total
      interest income
                
                $
                183,277
                
                
                $
                279,737
                
                
                $
                52,269
                
                
                $
                91,981


(A)
              Other
      interest income includes interest from corporate operating cash. During
      the nine and three months ended September 30, 2007 other interest income
      also included interest earned on funds the Company held as custodian and
      the Company’s warehouse notes
receivable.





Note
11. Interest Expense





The
following table presents the components of interest expense for the nine and
three months ended September 30, 2008 and 2007 (dollars in
thousands):





For the Nine Months
                  Ended September 30,
                
                
                For the Three Months Ended
                  September 30,2008
                
                
                2007
                
                
                2008
                
                
                2007Interest
      Expense:Short-term
      borrowings secured by mortgage securities
                
                $
                434
                
                
                $
                22,220
                
                
                $
                -
                
                
                $
                9,774Asset-backed
      bonds secured by mortgage loans
                
                
                75,445
                
                
                
                141,086
                
                
                
                20,516
                
                
                
                49,780Asset-backed
      bonds secured by mortgage securities
                
                
                10,699
                
                
                
                12,868
                
                
                
                4,093
                
                
                
                5,001Junior
      subordinated debentures
                
                
                4,579
                
                
                
                6,115
                
                
                
                1,265
                
                
                
                2,058Total
      interest expense
                
                $
                91,157
                
                
                $
                182,289
                
                
                $
                25,874
                
                
                $
                66,613







Note
12. Discontinued Operations





During
2007, the Company undertook workforce reductions pursuant to plans of
termination (“Exit Plans”) to align its organization and costs with its decision
to discontinue its mortgage lending and mortgage servicing activities. The
Company considers an operating unit to be discontinued upon its termination
date, which is the point in time when the operations substantially cease. The
provisions of SFAS 144 require the results of operations associated with those
operating units terminated to be classified as discontinued operations and
segregated from the Company’s continuing results of operations for all periods
presented. In accordance with SFAS 144, the Company has reclassified the
operating results of its mortgage lending segment and loan servicing operations
segment as discontinued operations in the condensed consolidated statements of
operations for the nine months ended September 30, 2007.




22




The major
classes of assets and liabilities reported as discontinued operations as of
September 30, 2008 and December 31, 2007 are as follows (dollars in
thousands):





September
      30,
                
                
                December
      31,2008
                
                
                
                2007(A)AssetsMortgage
      loans -
      held-for-sale
                
                $
                1,297
                
                
                $
                5,253Real
      estate owned
                
                
                446
                
                
                
                2,574Other
      assets
                
                
                -
                
                
                
                428Total
      assets
                
                $
                1,743
                
                
                $
                8,255LiabilitiesShort-term
      borrowings secured by mortgage loans
                
                $
                -
                
                
                $
                19Accounts
      payable and other liabilities (A)
                
                
                3,677
                
                
                
                59,397Total
      liabilities
                
                $
                3,677
                
                
                $
                59,416


(A)
              The
      accounts payable and other liabilities line includes a $45.2 million
      liability as of December 31, 2007 recorded in connection with the judgment
      rendered against NHMI in the California Action by AIM, the settlement of
      which became final as of September 11,
2008.









The
operating results of all discontinued operations for the nine and three months
ended September 30, 2008 and 2007 are summarized as follows (dollars in
thousands):





For the Nine Months Ended
                    September 30,
                  
                  
                  For the Three Months Ended
                    September 30,2008
                  
                  
                  2007
                  
                  
                  2008
                  
                  
                  2007Interest
      income
                  
                  $
                  964
                  
                  
                  $
                  92,757
                  
                  
                  $
                  143
                  
                  
                  $
                  18,996Interest
      expense
                  
                  
                  (13
                  )
                  
                  
                  71,102
                  
                  
                  
                  2
                  
                  
                  
                  26,015Net
      interest income
                  
                  
                  977
                  
                  
                  
                  21,655
                  
                  
                  
                  141
                  
                  
                  
                  (7,019
                  )Other
      operating expense:Gains
      (losses) on sales of mortgage assets
                  
                  
                  573
                  
                  
                  
                  (15,679
                  )
                  
                  
                  163
                  
                  
                  
                  (3,497
                  )Gains
      (losses) on derivative instruments
                  
                  
                  -
                  
                  
                  
                  (4,261
                  )
                  
                  
                  -
                  
                  
                  
                  (3,479
                  )Valuation
      adjustment on mortgage loans – held-for-sale
                  
                  
                  (3,733
                  )
                  
                  
                  (98,935
                  )
                  
                  
                  (460
                  )
                  
                  
                  (74,375
                  )Fee
      income
                  
                  
                  903
                  
                  
                  
                  17,901
                  
                  
                  
                  1
                  
                  
                  
                  6,739Premiums
      for mortgage loan insurance
                  
                  
                  -
                  
                  
                  
                  (2,668
                  )
                  
                  
                  -
                  
                  
                  
                  (12
                  )Other
      income
                  
                  
                  241
                  
                  
                  
                  (6,267
                  )
                  
                  
                  -
                  
                  
                  
                  (7,890
                  )Total
      other operating expense
                  
                  
                  (2,016
                  )
                  
                  
                  (109,909
                  )
                  
                  
                  (296
                  )
                  
                  
                  (82,514
                  )General
      and administrative expenses (A)
                  
                  
                  (37,097
                  )
                  
                  
                  164,609
                  
                  
                  
                  (43,560
                  )
                  
                  
                  84,624Gain
      (loss) from discontinued operations before income tax
    expense
                  
                  
                  36,058
                  
                  
                  
                  (252,863
                  )
                  
                  
                  43,405
                  
                  
                  
                  (174,157
                  )Income
      tax expense
                  
                  
                  13,587
                  
                  
                  
                  -
                  
                  
                  
                  13,587
                  
                  
                  
                  -Gain
      (loss) from discontinued operations
                  
                  $
                  22,471
                  
                  
                  $
                  (252,863
                  )
                  
                  $
                  29,818
                  
                  
                  $
                  (174,157
                  )







(A)
            The
      general and administrative expenses line includes the reversal of a $45.2
      million liability during the nine and three months ended September 30,
      2008 which was recorded in connection with the judgment rendered against
      NHMI in the California Action by AIM, the settlement of which became final
      as of September 11, 2008.







Mortgage
Loans – Held-for-Sale




Mortgage
loans – held-for-sale, relating to discontinued operations, all of which are
secured by residential properties, consisted of the following as of September
30, 2008 and December 31, 2007 (dollars in thousands):


23





September 30,
                  2008
                
                
                December 31,
                  2007Mortgage
      loans – held-for-sale:Outstanding
      principal
                
                $
                16,353
                
                
                $
                17,545Allowance
      for the lower of cost or fair value
                
                
                (15,056
                )
                
                
                (12,292
                )Mortgage
      loans – held-for-sale
                
                $
                1,297
                
                
                $
                5,253Weighted
      average coupon
                
                
                10.18
                %
                
                
                10.23
                %









Activity
in the allowance for the lower of cost or fair value on mortgage loans –
held-for-sale, relating to discontinued operations, is as follows for the nine
and three months ended September 30, 2008 and 2007, respectively (dollars in
thousands):





For the Nine Months Ended
                  September 30,
                
                
                For the Three Months Ended
                  September 30,2008
                
                
                2007
                
                
                2008
                
                
                2007Balance,
      beginning of period
                
                $
                12,292
                
                
                $
                5,006
                
                
                $
                14,495
                
                
                $
                23,718Valuation
      adjustment on mortgage loans held-for-sale
                
                
                3,733
                
                
                
                98,935
                
                
                
                460
                
                
                
                74,375Transfer
      from the reserve for loan repurchases
                
                
                -
                
                
                
                23,206
                
                
                
                -
                
                
                
                877Transfer
      to cost basis of mortgage loans – held-in-portfolio
                
                
                -
                
                
                
                (14,843
                )
                
                
                -
                
                
                
                -Reduction
      due to loans securitized or sold to third parties
                
                
                -
                
                
                
                (3,323
                )
                
                
                -
                
                
                
                (64
                )Transfers
      to real estate owned
                
                
                567
                
                
                
                (15,859
                )
                
                
                (2
                )
                
                
                (5,784
                )Charge-offs,
      net of recoveries
                
                
                (1,536
                )
                
                
                -
                
                
                
                103
                
                
                
                -Balance,
      end of period
                
                $
                15,056
                
                
                $
                93,122
                
                
                $
                15,056
                
                
                $
                93,122









Commitments
and Contingencies




See Note
7 regarding contingencies arising from discontinued operations.





In the
ordinary course of the Company’s mortgage lending business, the Company sold
whole pools of loans with recourse for borrower defaults. When whole pools are
sold as opposed to securitized, the third party has recourse against the Company
for certain borrower defaults. Because the loans are no longer on the Company’s
balance sheet, the recourse component is considered a guarantee. The Company
maintained a $1.1 million reserve related to these guarantees as of September
30, 2008 compared to a $2.2 million reserve as of December 31,
2007.




Prior to
2008, in the ordinary course of the Company’s mortgage lending business, the
Company sold loans to securitization trusts and guaranteed losses suffered by
the trusts resulting from defects in the loan origination process. Defects may
occur in the loan documentation and underwriting process, either through
processing errors made by the Company or through intentional or unintentional
misrepresentations made by the borrower or agents during those processes. If a
defect is identified, the Company is required to repurchase the loan. As of
September 30, 2008 and December 31, 2007, the Company had loans sold with
recourse with an outstanding principal balance of $8.5 billion and $10.1
billion, respectively. Historically, repurchases of loans where a defect has
occurred have been insignificant; therefore, the Company has recorded no
reserves related to these guarantees.




Fair
Value Accounting





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




Fair
Value Measurements (SFAS 157)




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


24





The
following table provides quantitative disclosures about the fair value
measurements for the Company’s assets related to discontinued operations which
are measured at fair value on a nonrecurring basis as of September 30, 2008
(dollars in thousands):




Fair Value Measurements at Reporting Date
      UsingDescription
                
                Fair Value at
                  September 30,
                  2008
                
                
                Quoted Prices in
                  Active Markets
                  for Identical
                  Assets
                  (Level 1)
                
                
                Significant
                  Other
                  Observable
                  Inputs (Level 2)
                
                
                Significant
                  Unobservable
                  Inputs (Level 3)Mortgage
      loans-held-for-sale
                
                $
                1,297
                
                
                $
                -
                
                
                $
                -
                
                
                $
                1,297Real
      estate owned
                
                
                446
                
                
                
                -
                
                
                
                -
                
                
                
                446Total
                
                $
                1,743
                
                
                $
                -
                
                
                $
                -
                
                
                $
                1,743







The
Company’s mortgage loans held-for-sale have a fair value lower than their cost
basis by $15.1 million. Therefore, all mortgage loans held-for-sale have been
written down to fair value. The Company recorded a valuation adjustment of $3.7
million and $0.5 million on mortgage loans – held-for-sale for the nine and
three months ended September 30, 2008, as compared to $98.9 million and $74.4
million for the same periods in 2007. At the time a mortgage loan held-for-sale
becomes real estate owned, the Company records the property at the lower
of its carrying amount or fair value.  Upon foreclosure and
through liquidation, the Company evaluates the property's fair value
as compared to its carrying amount and records a valuation adjustment when
the carrying amount exceeds fair value.  For mortgage loans held-for-sale,
valuation adjustments for discontinued operations are recorded in the “Loss from
discontinued operations, net of income tax” line item of the Company's condensed
consolidated statements of operations.




The
following table provides a summary of the impact to earnings for the nine and
three months ended September 30, 2008 and 2007 from the Company’s assets and
liabilities related to discontinued operations which are measured at fair value
on a recurring and nonrecurring basis as of September 30, 2008 (dollars in
thousands):





Fair Value
                        Adjustments For the
                        Nine months ended
                        September 30
                      
                      
                      Fair Value
                        Adjustments For the
                        Three Months Ended
                        September 30Asset or Liability
                        Measured at Fair
                        Value
                      
                      Fair Value
                        Measurement
                        Frequency
                      
                      2008
                      
                      2007
                      
                      
                      2008
                      
                      2007
                      
                      Statement of Discontinued
                        Operations Line Item
                        ImpactedMortgage loans – held-for-sale
                      
                      Nonrecurring
                      
                      $
                      (3,733
                      )
                      
                      $
                      (98,935
                      )
                      
                      $
                      (460
                      )
                      
                      $
                      (74,375
                      )
                      Valuation
      adjustment on mortgage loans – held-for-saleReal
      estate owned
                      
                      Nonrecurring
                      
                      
                      (62
                      )
                      
                      
                      (8,133
                      )
                      
                      
                      103
                      
                      
                      
                      (3,290
                      )
                      Gains
      (losses) on sales of mortgage assetsTotal
      fair value losses
                      
                      
                      
                      $
                      (3,795
                      )
                      
                      $
                      (107,068
                      )
                      
                      $
                      (357
                      )
                      
                      $
                      (77,665
                      )









Valuation
Methods





Mortgage loans - held-for-sale and
real estate owned.Both mortgage loans - held-for-sale and real estate
owned are carried at the lower of cost or fair value. As of September 30, 2008,
the Company estimated the fair value of its mortgage loans – held-for-sale and
real estate owned based on two categories. All loans and real estate owned that
had mortgage insurance were marked down to a value which reflects the Company’s
best estimate of net realizable value. All loans and real estate owned which did
not have mortgage insurance were valued at zero due to their nonperforming
characteristics.





Note
13. Income Taxes





Based on
the evidence available as of September 30, 2008 and December 31, 2007, including
the significant tax losses incurred by the Company in 2007 and the first three
quarters of 2008, the ongoing disruption to the credit markets, the liquidity
issues facing the Company and the termination of all of the Company’s mortgage
lending and loan servicing operations, the Company believes that it is more
likely than not that the Company will not realize its deferred tax assets. Based
on these conclusions, the Company recorded a valuation allowance against its
entire net deferred tax assets as of September 30, 2008 and December 31,
2007.





25





Prior to
September 30, 2008, the Company used its 2007 federal net operating loss
carryback to offset its 2006 taxable income. Accordingly, the Company has
recorded additional interest of $0.8 million for the nine months ended September
30, 2008 related to the balance due to the IRS, which is included in the
accounts payable and other liabilities line item of the Company’s condensed
consolidated balance sheet. The Company also offset the 2006 tax liability with
the receivable recorded for the 2007 federal net operating loss carried back
against its 2006 taxable income.





The
Company recognizes tax benefits in accordance with the Financial Accounting
Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income
Taxes,” an interpretation of SFAS No. 109, “Accounting for Income Taxes”, (“FIN
48”).  FIN 48 establishes a “more-likely-than-not” recognition
threshold that must be met before a tax benefit can be recognized in the
financial statements.  As of September 30, 2008 and December 31, 2007,
the total gross amount of unrecognized tax benefits was $1.0 million and $6.3
million, respectively. With respect to an uncertain tax position, the Company
requested the IRS to issue a closing agreement or determination letter for 2006
and 2007. The IRS has verbally provided guidance to the Company and the Company
has filed tax returns consistent with that guidance. The uncertain tax position
balance has been adjusted to reflect these filings.




Note
14. Segment Reporting




The
Company reviews, manages and operates its business in one segment: mortgage
portfolio management. Mortgage portfolio management operating results come from
the income generated on the mortgage assets the Company manages less associated
costs. As discussed in Note 12, the Company discontinued its mortgage lending
and loan servicing segments during 2007 and had discontinued its branch
operations in 2006. The mortgage portfolio management segment’s operating
results for the nine and three months ended September 30, 2008 and 2007 are the
same as the Company’s condensed consolidated statements of
operations.




Note
15. Earnings Per Share





The
computations of basic and diluted earnings per share for the nine and three
months ended September 30, 2008 and 2007 are as follows (in thousands, except
share and per share amounts):





For the Nine Months Ended
                  September 30,
                
                
                For the Three Months
                  Ended September 30,2008
                
                
                2007
                
                
                2008
                
                
                2007Numerator:Loss
      from continuing operations
                
                $
                (645,096
                )
                
                $
                (349,372
                )
                
                $
                (172,589
                )
                
                $
                (421,214
                )Dividends
      on preferred shares
                
                
                (11,536
                )
                
                
                (5,960
                )
                
                
                (4,879
                )
                
                
                (2,634
                )Loss
      from continuing operations available to common
shareholders
                
                
                (656,632
                )
                
                
                (355,332
                )
                
                
                (177,468
                )
                
                
                (423,848
                )Income
      (loss) from discontinued operations, net of income tax
                
                
                22,471
                
                
                
                (252,863
                )
                
                
                29,818
                
                
                
                (174,157
                )Loss
      available to common shareholders
                
                $
                (634,161
                )
                
                $
                (608,195
                )
                
                $
                (147,650
                )
                
                $
                (598,005
                )Denominator:Weighted
      average common shares outstanding – basic
                
                
                9,337,517
                
                
                
                9,331,206
                
                
                
                9,337,695
                
                
                
                9,336,175Weighted
      average common shares outstanding – dilutive:Weighted
      average common shares outstanding – basic
                
                
                9,337,517
                
                
                
                9,331,206
                
                
                
                9,337,695
                
                
                
                9,336,175Stock
      options
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Restricted
      stock
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Weighted
      average common shares outstanding – dilutive
                
                
                9,337,517
                
                
                
                9,331,206
                
                
                
                9,337,695
                
                
                
                9,336,175Basic
      earnings per share:Loss
      from continuing operations
                
                $
                (69.09
                )
                
                $
                (37.44
                )
                
                $
                (18.48
                )
                
                $
                (45.12
                )Dividends
      on preferred shares
                
                
                (1.24
                )
                
                
                (0.64
                )
                
                
                (0.52
                )
                
                
                (0.28
                )Loss
      from continuing operations available to common
shareholders
                
                
                (70.33
                )
                
                
                (38.08
                )
                
                
                (19.00
                )
                
                
                (45.40
                )Income
      (loss) from discontinued operations, net of income tax
                
                
                2.41
                
                
                
                (27.10
                )
                
                
                3.19
                
                
                
                (18.65
                )Net
      loss available to common shareholders
                
                $
                (67.92
                )
                
                $
                (65.18
                )
                
                $
                (15.81
                )
                
                $
                (64.05
                )Diluted
      earnings per share:Loss
      from continuing operations
                
                $
                (69.09
                )
                
                $
                (37.44
                )
                
                $
                (18.48
                )
                
                $
                (45.12
                )Dividends
      on preferred shares
                
                
                (1.24
                )
                
                
                (0.64
                )
                
                
                (0.52
                )
                
                
                (0.28
                )Loss
      from continuing operations available to common
shareholders
                
                
                (70.33
                )
                
                
                (38.08
                )
                
                
                (19.00
                )
                
                
                (45.40
                )Income
      (loss) from discontinued operations, net of income tax
                
                
                2.41
                
                
                
                (27.10
                )
                
                
                3.19
                
                
                
                (18.65
                )Net
      loss available to common shareholders
                
                $
                (67.92
                )
                
                $
                (65.18
                )
                
                $
                (15.81
                )
                
                $
                (64.05
                )







26




The
following restricted stock and stock options to purchase shares of common stock
were outstanding during each period presented, but were not included in the
computation of diluted earnings per share because the 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
                    September 30,
                  
                  For the Three Months
                    Ended September 30,2008
                  
                  2007
                  
                  2008
                  
                  2007Number
      of stock options
                  
                  
                  185
                  
                  
                  
                  369
                  
                  
                  
                  185
                  
                  
                  
                  454Weighted
      average exercise price
                  
                  $
                  53.26
                  
                  
                  $
                  36.79
                  
                  
                  $
                  53.26
                  
                  
                  $
                  32.08









Note
16. Subsequent Events





On
February 18, 2009, the Company, NMI, the Trusts and the trust preferred security
holders entered into agreements to settle the claims of the trust preferred
security holders arising from NMI’s failure to make the scheduled quarterly
interest payments on the Notes. As part of the settlement, the existing
preferred obligations would be exchanged for new preferred obligations. The
settlement and exchange were contingent upon, among other things, the dismissal
of the involuntary Chapter 7 bankruptcy. On March 9, 2009, the Bankruptcy
Court entered an order dismissing the involuntary proceeding. On April 27,
2009 (the “Exchange Date”), the parties executed the necessary documents to
complete the Exchange. 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.


27


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





The
following discussion should be read in conjunction with the preceding unaudited
condensed consolidated financial statements of NovaStar Financial, Inc. and its
subsidiaries (the “Company” ,”NovaStar Financial”, “NFI” , “we” or “us”) and the
notes thereto as well as NovaStar Financial’s annual report to shareholders and
annual report on Form 10-K for the fiscal year ended December 31,
2007.





Safe
Harbor Statement




Statements
in this report regarding NovaStar Financial, Inc. and its business, which are
not historical facts, are “forward-looking statements” within the meaning of
Section 21E of the Securities Exchange Act of 1934, as amended. Forward looking
statements are those that predict or describe future events and that do not
relate solely to historical matters and include statements regarding
management's beliefs, estimates, projections, and assumptions with respect to,
among other things, our future operations, business plans and strategies, cash
flows and cash needs, and future asset values, as well as industry and market
conditions, all of which are subject to change at any time without notice. Words
such as "believe," "expect," "anticipate," "promise," "plan," and other
expressions or words of similar meanings, as well as future or conditional verbs
such as "will," "would," "should," "could," or "may" are generally intended to
identify forward-looking statements. Actual results and operations for any
future period may vary materially from those discussed herein. Some important
factors that could cause actual results to differ materially from those
anticipated include: our ability to continue as a going concern; decreases in
cash flows from our mortgage securities; our ability to reduce expenses;
exercise of remedies with respect to existing defaults under, and our ability to
restructure the agreements governing, our indebtedness and other contractual
obligations; our ability to maintain an exemption from regulation under the
Investment Company Act of 1940, our ability to identify and establish or invest
in, and successfully manage and grow, operating businesses that may be outside
of the businesses in which we historically have operated; impairments on our
mortgage assets; decreases in prepayment rates or increases in default rates or
losses on mortgage loans underlying our mortgage assets; loan repurchase
requests; changes in assumptions regarding estimated loan losses and fair value
amounts; the extent and timing of the return of cash posted as collateral on
letters of credit; our ability to maintain effective internal control over
financial reporting and disclosure controls and procedures in the future;
residential property values; interest rate fluctuations on our assets that
differ from our liabilities; the outcome of litigation or regulatory actions
pending against us or other legal contingencies; our compliance with applicable
local, state and federal laws and regulations; compliance with new accounting
pronouncements; the impact of general economic conditions; and the risks that
are from time to time included in our filings with the Securities and Exchange
Commission (“SEC”), including this report on Form 10-Q. Other factors not
presently identified may also cause actual results to differ. This report
on Form 10-Q speaks only as of its date and we expressly disclaim any duty to
update the information herein except as required by federal securities
laws.





Executive
Overview of Performance





The
financial services sector continued to experience widespread market turmoil. In
particular, the mortgage industry continued to experience extreme conditions.
Significant disruptions continued in global capital markets. Housing valuations
continued their steep decline. Home foreclosures and mortgage delinquencies are
severely negatively impacting the performance and value of mortgage loans and
securities today. The full impact of the events of 2007 and 2008 are not
expected to be fully understood in the near term.





As
previously reported we ceased all lending and loan servicing operations in 2007
due to the extreme conditions surrounding the financial services sector.
Management has undertaken severe and far-reaching measures in an attempt to
preserve liquidity and to continue to operate as a going concern. The market
conditions and the resulting actions by management have generated significant
losses during 2007 and 2008 and we currently have a significant stockholders’
deficit.





The
following discussion outlines the major factors which drove our third quarter
2008 financial performance.





Credit
Performance – With repayment risks no longer offset by rising home values
and liquidity in the mortgage lending market, delinquencies in the industry
continued to rise in 2008. These credit issues continue to negatively affect the
income generated by, and values of, our portfolio of mortgage loans and
securities. We recorded provisions for credit losses totaling $667.6 million for
the nine months ended September 30, 2008, to account for the significant effect
of the credit deterioration in our loan portfolio.





Borrower
Prepayments–In
the past, we retained the prepayment securities from the securitizations we
executed. These securities receive the prepayment penalty cash flows paid by
borrowers when they prepay their loan. Due to the inability of many borrowers to
refinance their loan as a result of tighter market underwriting standards and
the decline in home values, we are experiencing slower than expected prepayment
speeds.





28





We
recognized impairments of $22.9 million on our mortgage securities –
available-for-sale for the nine months ended September 30, 2008 as a result of
slower prepayment speeds and poor credit performance.




Liquidity– Our cash balances declined by approximately $6.6 million during the
nine months ended September 30, 2008 primarily due to repayment of short-term
secured borrowings, lease terminations, current income tax payments, litigation
settlements, normal business operations and costs associated with discontinued
operations. We no longer maintain any short-term borrowing arrangements. As a
result, we face substantial liquidity risk and uncertainty, near-term and
otherwise, which threatens our ability to continue as a going concern and avoid
bankruptcy. See “Liquidity and Capital Resources” for further discussion of our
liquidity position and steps we have taken to preserve liquidity
levels.





See
discussion under heading “Industry Overview and Known Material Trends and
Uncertainties” below for more information about current conditions in our
industry and the steps we are taking or considering to manage our business in
this challenging environment.





The
following selected key performance metrics are derived from our condensed
consolidated financial statements for the periods presented and should be read
in conjunction with the more detailed information therein and with the
disclosure included elsewhere in “Management’s Discussion and Analysis of
Financial Condition and Results of Operations.”




Table 1 — Summary of Financial
Highlights and Key Performance Metrics


(dollars
in thousands; except per share amounts)





For
      the Nine Months
                
                
                For
      the Three MonthsEnded September 30,
                
                
                Ended September 30,2008
                
                
                2007
                
                
                2008
                
                
                2007Net
      loss available to common shareholders
                
                $
                (634,161
                )
                
                $
                (608,195
                )
                
                $
                (147,650
                )
                
                $
                (598,005
                )Net
      loss available to common shareholders, per diluted share
                
                $
                (67.92
                )
                
                $
                (65.18
                )
                
                $
                (15.81
                )
                
                $
                (64.05
                )










For the nine months ended September
30, 2008 as compared to the nine months ended September 30, 2007.We had a
net loss available to common shareholders of $634.2 million during the nine
months ended September 30, 2008 as compared to a net loss available to common
shareholders of $608.2 million for the same period in 2007.




We had a
net loss from continuing operations of $645.1 million during the nine months
ended September 30, 2008 as compared to a net loss from continuing operations of
$349.4 million for the same period in 2007. The following factors contributed to
the current year loss as compared to the prior period income:





·
            We
      had an income tax benefit of $16.8 million for the nine months ended
      September 30, 2008 as compared to incurring an income tax expense of $59.2
      million for the same period of 2007. The income tax expense in 2007 was
      driven by the formal plan approved by the Board of Directors to revoke our
      status as a real estate investment trust (“REIT”) as of January 1, 2008.
      This plan was subsequently superseded in the third quarter of 2007 by
      termination of our REIT status as of January 1,
  2006.





·
              An
      increase in our provision for credit losses for our mortgage loans
      held-in-portfolio to $667.6 million for the nine months ended September
      30, 2008 from $192.3 million for the same period in 2007. This increase of
      $475.3 million was primarily due to the continued credit deterioration in
      our mortgage loans held-in-portfolio.


·
            A
      net loss due to fair value adjustments of $20.3 million related to our
      trading securities and the asset-backed bonds issued in our CDO
      transaction. The trading securities had a negative fair value adjustment
      of approximately $(78.6) million while the CDO asset-backed bonds had a
      positive fair value adjustment of $58.3 million. These adjustments were a
      result of significant credit deterioration of underlying loans
      collateralizing these
securities.


29





We had
net income from discontinued operations of $22.5 million during the nine months
ended September 30, 2008 as compared to a loss of $252.9 million for the same
period in 2007.  We had net income in 2008 primarily due to the
reversal of the AIM litigation accrual.  The loss in 2007 was mainly
due to the shutdown of our mortgage lending and loan servicing operations being
substantially completed by the end of 2007.
 
 For
the three months ended September 30, 2008 as compared to the three months ended
September 30, 2007.
  We had a
net loss available to common shareholders of $147.7 million during the three
months ended September 30, 2008 as compared to a net loss available to common
shareholders of $598.0 million for the same period in 2007.
 
 We had a
loss from continuing operations of $172.6 million during the three months ended
September 30, 2008 as compared to a loss from continuing operations of $421.2
million for the same period in 2007.  The following items were also
significant factors during the quarter:
 
 ·
              We
      had an income tax benefit of $17.8 million for the three months ended
      September 30, 2008 as compared to incurring an income tax expense of
      $245.8 million for the same period of 2007. The tax expense in 2007 was
      driven by the formal plan approved by the Board of Directors to revoke
      status as a REIT as of January 1, 2008. This plan was subsequently
      superseded in the third quarter of 2007 by termination of our REIT status
      as of January 1, 2006 as a result of our inability to pay a dividend on
      our common stock with respect to our 2006 taxable
  income.
  ·
              An
      increase in our provision for credit losses for our mortgage loans
      held-in-portfolio to $206.2 million for the three months ended September
      30, 2008 from $99.2 million for the same period in 2007.  This
      increase of $107.0 million was primarily due to the continued credit
      deterioration in our mortgage loans
  held-in-portfolio.
 
 ·
              We
      had net income from discontinued operations of $29.8 million during the
      three months ended September 30, 2008 as compared to incurring a loss of
      $174.2 million for the same period in 2007.  This change from
      2007 to 2008 is primarily due to the shutdown of our mortgage lending and
      loan servicing operations which was substantially completed by the end of
      2007.  The current quarter income was primarily driven by the
      reversal of the AIM litigation accrual offset in part by residual
      operating costs.
 
 Industry
Overview and Known Material Trends and Uncertainties
 
 Future Strategy,
Liquidity and Going Concern Considerations - We will continue to focus on
minimizing losses and preserving liquidity and exploring operating company
opportunities.  Our residual and subordinated mortgage securities are
currently our only significant source of cash flows. Based on current
projections, the cash flows from our mortgage securities will decrease in the
next several months as the underlying mortgage loans are repaid, and could be
significantly less than the current projections if losses on the underlying
mortgage loans exceed, or prepayments are less than, the current
assumptions.  In addition, we have significant operating expenses
associated with office leases and other obligations relating to our discontinued
operations.  We also have significant obligations with respect to
junior subordinated notes relating to the trust preferred securities of NovaStar
Capital Trust I and NovaStar Capital Trust II.  See “Liquidity and
Capital Resources” for additional discussion regarding the recent defaults under
the junior subordinated notes.
 
 If, as
the cash flows from our mortgage securities decrease, we are unable to
recommence or acquire profitable operations, restructure our unsecured debt,
capital structure and contractual obligations or if the cash flows from our
mortgage securities are less than currently anticipated, there can be no
assurance that we will be able to continue as a going concern and avoid seeking
the protection of applicable bankruptcy laws.
 
 We have
initiated efforts to restructure our indebtedness and certain contractual
obligations and are assessing potential changes to elements of our capital
structure, with the goal of negotiating and implementing changes to facilitate
the achievement of long-term value.  There can be no assurance that
any of these efforts will be successful.
 
 Due to
the fact that we have a negative net worth, we do not currently have significant
ongoing business operations that are profitable and our common stock and Series
C Preferred Stock have been delisted from the New York Stock Exchange, and due
to the illiquidity in the capital markets it is unlikely that we will be able to
obtain additional equity or debt financing on favorable terms, or at all, for
the foreseeable future.  To the extent we require additional liquidity
and cannot obtain it, we will be forced to file for
bankruptcy.


30


As
discussed in Note 1 to the condensed consolidated financial statements, we
acquired a majority interest in an appraisal management company during the third
quarter of 2008, and we intend to seek out other operating business
opportunities. It is unlikely, however, that we will be able to directly
recommence mortgage lending activities so long as we continue to have a
shareholders’ deficit because certain state licensing requirements prohibit
companies from lending when they have a shareholders’ deficit. Further, our
ability to start or acquire new businesses is significantly constrained by our
limited liquidity and our likely inability to obtain debt financing or to issue
equity securities as a result of our current financial condition, including a
shareholders’ deficit, as well as other uncertainties and risks.





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





The
factors described above continue to contribute to the decline in the market
values of our securities. The market has also seen significant fluctuations in
LIBOR rates since the end of 2007 as the credit crisis has severely disrupted
international liquidity and capital markets and as various regulatory bodies
have attempted to moderate the lending and liquidity marketplace. This
volatility in interest rates and the severe deterioration in credit and
prepayment performance of the collateral underlying the securities the Company
owns has made it extremely difficult to predict, with any certainty, the cash
flow from our securities portfolio.




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




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





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





Credit
Deterioration - The residential mortgage market has encountered
significant difficulties which have materially adversely affected our
performance. Delinquencies and losses with respect to residential mortgage loans
generally have increased and are likely to increase, particularly in the
sub-prime sector. In addition, over the last year residential property values in
most states have declined, in some areas severely, after extended periods during
which those values appreciated. To the extent residential property values
continue to decline, it is likely to result in additional increases in
delinquencies and losses on residential mortgage loans, especially with respect
to any residential mortgage loans where the aggregate loan amounts (including
any subordinate loans) are close to or greater than the related property values.
Another factor that may have contributed to, and may in the future result in,
higher delinquency rates is the increase in monthly payments on adjustable rate
mortgage loans. Any increase in prevailing market interest rates may result in
increased payments for borrowers who have adjustable rate mortgage loans.
Moreover, borrowers with option ARM mortgage loans with a negative amortization
feature may experience a substantial increase in their monthly payment even
without an increase in prevailing market interest rates when the loans reach
their negative amortization cap. Compounding this issue, the current lack of
appreciation in residential property values and the adoption of tighter
underwriting standards throughout the mortgage loan industry has adversely
affected the ability of borrowers to refinance these loans and avoid default,
particularly borrowers facing a reset of the monthly payment to a higher amount.
To the extent that delinquencies or losses continue to increase for these or
other reasons, the value of our mortgage securities will be further reduced,
which will adversely affect our operating results, liquidity, cash flow,
financial condition, business prospects and ability to continue as a going
concern.





31




Critical
Accounting Estimates


We
prepare our condensed consolidated financial statements in conformity with GAAP
and, therefore, are required to make estimates regarding the values of our
assets and liabilities and in recording income and expenses. These estimates are
based, in part, on our judgment and assumptions regarding various economic
conditions that we believe are reasonable based on facts and circumstances
existing at the time of reporting. These estimates affect reported amounts of
assets, liabilities and accumulated other comprehensive income at the date of
the condensed consolidated financial statements and the reported amounts of
income, expenses and other comprehensive income during the periods presented.
The following summarizes the components of our condensed consolidated financial
statements where understanding accounting policies is critical to understanding
and evaluating our reported financial results, especially given the significant
estimates used in applying the policies. The discussion is intended to
demonstrate the significance of estimates to our financial statements and the
related accounting policies. Management has discussed the development and
selection of these critical accounting estimates with the Audit Committee of our
Board of Directors and the Audit Committee has reviewed our
disclosure.





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




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





·
            Have
      the transferred assets been isolated from the
  transferor?


·
            Does
      the transferee have the right to pledge or exchange the transferred
      assets?


·
            Is
      there a “call” agreement that requires the transfereeto return specific
      assets?


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


·
            Have
      any derivative instruments been
transferred?





When we
are deemed to have surrendered control over the collateral, the transfer is
accounted for as a sale. In accordance with SFAS 140, a gain or loss on the sale
was recognized based on the carrying amount of the financial assets involved in
the transfer, allocated between the assets transferred and the retained
interests based on their relative fair value as of the date we are no longer
deemed to control the collateral. In a securitization accounted for as a sale,
we retain certain mortgage securities issued by the trust. The gain recognized
upon a securitization structured as a sale depends on, among other things, the
estimated fair value of the components of the securitization – the loans or
mortgage securities and derivative instruments transferred, the securities
retained and the mortgage servicing rights. The estimated fair value of the
securitization components is considered a “critical accounting estimate” as 1)
these gains or losses have historically represented a significant portion of our
operating results and 2) the valuation assumptions used regarding economic
conditions and the make-up of the collateral, including interest rates,
principal payments, prepayments and loan defaults are highly uncertain and
require a large degree of judgment.




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




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




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





32




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





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




When we
had the ability to exert control over the transferred collateral in a
securitization, the assets remained on our financial statements and a liability
was recorded for the related asset-backed bonds. The servicing agreements that
we executed for loans we securitized include a removal of accounts provision
which gives the servicer the right, but not the obligation, to repurchase from
the trust loans that are 90 days to 119 days delinquent. While we retained these
servicing rights, we recorded the mortgage loans subject to the removal of
accounts provision in mortgage loans held-for-sale at fair value and the related
repurchase obligation as a liability. However, in November 2007 we sold all of
our mortgage servicing rights, including the removal of accounts rights, to a
third party, which resulted in the removal of the mortgage loans subject to the
removal of accounts provision from our balance sheet. In addition, we retained a
“clean up” call option that could be exercised when the aggregate principal
balance of the mortgage loans declined to ten percent or less of the original
aggregated mortgage loan principal balance. However, we subsequently sold these
clean up call rights, in part, to the buyer of our mortgage servicing rights,
and we do not expect to exercise any of the call rights that we
retained.





We are
required to periodically re-evaluate the accounting treatment for loan
securitizations. In certain circumstances, if the reasons and conditions
affecting the accounting treatment for a securitization have changed, we may be
required to adjust our financial statements accordingly at the time of the
re-evaluation. Securitizations previously treated as sales may need to be
brought back on to our financial statements as assets, along with the related
liabilities. Transfers where the assets and liabilities have been retained on
our financial statements may need to be removed. These transactions may result
in significant gains or losses and may cause significant changes in our
financial statements that may make period comparisons difficult.




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




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





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


·
            Prepayment
      penalties received from borrowers who payoff their loans early in their
      life.


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





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


33





The cash
flows we receive are highly dependent upon the interest rate environment. The
interest rates on the bonds issued by the securitization trust are indexed to
short-term interest rates, while the coupons on the pool of loans held by the
securitization trust are less interest rate sensitive. As a result, as rates
rise and fall, our cash flows will fall and rise, because the cash we receive on
our residual securities is dependent on this interest rate spread. As our cash
flows fall and rise, the value of our residual securities will decrease or
increase. Additionally, the cash flows we receive are dependent on the default
and prepayment experience of the borrowers of the underlying mortgage security
collateral. Increasing or decreasing cash flows will increase or decrease the
yield on our securities.




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





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




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





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




Allowance for
Credit Losses. An allowance for credit losses is maintained for
mortgage loans held-in-portfolio. The amount of the allowance is based on
the assessment by management of probable losses incurred based on various
factors affecting our mortgage loan portfolio, including current economic
conditions, the makeup of the portfolio based on credit grade, loan-to-value
ratios, delinquency status, mortgage insurance we purchase and other relevant
factors. The allowance is maintained through ongoing adjustments to
operating income. The assumptions used by management in estimating the amount of
the allowance for credit losses are highly uncertain and involve a great deal of
judgment.





An
internally developed migration analysis is the primary tool used in analyzing
our allowance for credit losses. This tool takes into consideration historical
information regarding foreclosure and loss severity experience and applies that
information to the portfolio at the reporting date. We also take into
consideration our use of mortgage insurance as a method of managing credit risk
and current economic conditions, experience and trends. We pay mortgage
insurance premiums on a portion of the loans maintained on our balance sheet and
have included the cost of mortgage insurance in our statement of
operations.





Our
estimate of expected losses could increase if our actual loss experience is
different than originally estimated. In addition, our estimate of expected
losses could increase if economic factors change the value we could reasonably
expect to obtain from the sale of the property.




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





34





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




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




Derivative
instruments that met the hedge accounting criteria of SFAS 133 were considered
cash flow hedges. We also had derivative instruments that do not meet the
requirements for hedge accounting. However, these derivative instruments
contributed to our overall risk management strategy by serving to reduce
interest rate risk on long-term borrowings collateralized by our loans
held-in-portfolio.




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





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




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




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





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





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





35




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





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




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





Impact
of Recently Issued Accounting Pronouncements




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





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





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





In April
2008, the FASB issued FASB Staff Position (“FSP”) No. SFAS 142-3, “Determination
of the Useful Life of Intangible Assets” (“FSP SFAS 142-3”). FSP SFAS 142-3
amends paragraph 11(d) of FASB Statement No. 142 “Goodwill and Other Intangible
Assets” (“SFAS 142”) which amends the factors that should be considered in
developing renewal or extension assumptions used to determine the useful life of
a recognized intangible asset under SFAS 142. FSP SFAS 142-3 is intended to
improve the consistency between the useful life of a recognized intangible asset
under SFAS 142 and the period of expected cash flows used to measure the fair
value of the asset. FSP SFAS 142-3 is effective for financial statements issued
for fiscal years beginning after December 15, 2008 and must be applied
prospectively to intangible assets acquired after the effective date. The
Company does not expect that adoption of FSP SFAS 142-3 will have a significant
impact on the Company’s consolidated financial statements.





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


36




On
September 15, 2008, the FASB issued two exposure drafts proposing amendments to
SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities”, and FASB Interpretation No. 46R, “Consolidation
of Variable Interest Entities” (“FIN 46R”).  Currently, the transfers
of the Company’s mortgage loans in securitization transactions qualify for sale
accounting treatment.  The trusts used in the Company’s
securitizations are not consolidated for financial reporting purposed because
the trusts are qualifying special purpose entities (“QSPE”).  Because
the transfers qualify as sales and the trusts are not subject to consolidation,
the assets and liabilities of the trusts are not reported on the balance sheet
under GAAP.  Under the proposed amendments, the concept of a QSPE
would be eliminated and would modify the consolidation
conclusions.  As proposed, these amendments would be effective for the
Company at the beginning of 2010.  The proposed amendments, if
adopted, could require the Company to consolidate the assets and liabilities of
the Company’s securitization trusts.  This could have a significant
effect on our financial condition as affected off-balance sheet loans and
related liabilities would be recorded on the balance sheet.





On
October 10, 2008, the FASB issued FSP No. 157-3, “Determining the Fair Value of
a Financial Asset When the Market for That Asset Is Not Active” (“FSP
157-3”).  FSP 157-3 clarifies the application of FAS 157 in a market
that is not active and provides an example to illustrate key consideration in
determining the fair value of a financial asset when the market for that
financial asset is not active.  The issuance of FSP 157-3 did not have
a material impact on the Company’s determination of fair value for its financial
assets.





In
December 2008, the FASB issued FSP FAS 140-4 and FIN 46(R)-8,
Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets
and Interests in Variable Interest Entities (“FSP FAS 140-4 and
FIN 46(R)-8”), which requires expanded disclosures for transfers of
financial assets and involvement with variable interest entities (“VIEs”). Under
this guidance, the disclosure objectives related to transfers of financial
assets now include providing information on (i) the Company’s continued
involvement with financial assets transferred in a securitization or asset
backed financing arrangement, (ii) the nature of restrictions on assets
held by the Company that relate to transferred financial assets, and
(iii) the impact on financial results of continued involvement with assets
sold and assets transferred in secured borrowing arrangements. VIE disclosure
objectives now include providing information on (i) significant judgments
and assumptions used by the Company to determine the consolidation or disclosure
of a VIE, (ii) the nature of restrictions related to the assets of a
consolidated VIE, (iii) the nature of risks related to the Company’s
involvement with the VIE and (iv) the impact on financial results related
to the Company’s involvement with the VIE. Certain disclosures are also required
where the Company is a non-transferor sponsor or servicer of a QSPE. FSP
FAS 140-4 and FIN 46(R)-8 is effective for the first reporting period
ending after December 15, 2008. Since the FSP only requires certain
additional disclosures, the Company does not expect the adoption will have a
material impact on its condensed consolidated financial
statements.





In
January 2009, the FASB issued FSP EITF 99-20-1, Amendments to the
Impairment Guidance of EITF Issue No. 99-20 (“FSP EITF 99-20-1”),
which eliminates the requirement that the holder’s best estimate of cash flows
be based upon those that a “market participant” would use. FSP EITF 99-20-1
was amended to require recognition of other-than-temporary impairment when it is
“probable” that there has been an adverse change in the holder’s best estimate
of cash flows from the cash flows previously projected. This amendment aligns
the impairment guidance under EITF 99-20, Recognition of Interest Income
and Impairment on Purchased Beneficial Interests and Beneficial Interests That
Continue to Be Held by a Transferor in Securitized Financial Assets, with the
guidance in SFAS No. 115. FSP EITF 99-20-1 retains and
re-emphasizes the other-than-temporary impairment guidance and disclosures in
pre-existing GAAP and SEC requirements. FSP EITF 99-20-1 is effective for
interim and annual reporting periods ending after December 15, 2008. The
Company does not expect the adoption of FSP EITF 99-20-1 will have a
material impact on its condensed consolidated financial statements.





Results
of Operations – Consolidated Earnings Comparisons





Nine
months ended September 30, 2008 as Compared to the Nine months ended September
30, 2007





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





Three
months ended September 30, 2008 as Compared to the Three months ended September
30, 2007





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





Net
Interest (Expense) Income





We earn
interest income primarily on our mortgage assets which include mortgage
securities available-for-sale, mortgage securities trading and mortgage loans
held-in-portfolio. In addition we earn interest income on available cash we hold
for general operating needs. Interest expense consists primarily of interest
paid on borrowings secured by mortgage assets, which includes asset backed bonds
and, to a lesser extent, warehouse repurchase agreements.  Going
forward, we anticipate that our interest income and expenses will be
significantly lower as we have removed all mortgage loans held-in-portfolio and
asset backed bonds secured by mortgage loans from our balance sheet as described
in Note 3 to our condensed consolidated financial statements and have repaid all
indebtedness due under our warehouse repurchase agreements.





37




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





Table
2— Net Interest (Expense) Income


(dollars
in thousands)







For the Nine Months
                                
                                
                                For the Three MonthsEnded September 30,
                                
                                
                                Ended September 30,2008
                                
                                
                                2007
                                
                                
                                2008
                                
                                
                                2007Interest
      income:Mortgage
      securities
                                
                                $
                                33,319
                                
                                
                                $
                                83,866
                                
                                
                                $
                                6,561
                                
                                
                                $
                                23,517Mortgage
      loans held-in-portfolio
                                
                                
                                148,829
                                
                                
                                
                                191,191
                                
                                
                                
                                45,517
                                
                                
                                
                                67,451Other
      interest income
                                
                                
                                1,129
                                
                                
                                
                                4,680
                                
                                
                                
                                191
                                
                                
                                
                                1,013Total
      interest income
                                
                                
                                183,277
                                
                                
                                
                                279,737
                                
                                
                                
                                52,269
                                
                                
                                
                                91,981Interest
      expense:Short-term
      borrowings secured by mortgage securities
                                
                                
                                434
                                
                                
                                
                                22,220
                                
                                
                                
                                -
                                
                                
                                
                                9,774Asset-backed
      bonds secured by mortgage loans
                                
                                
                                75,445
                                
                                
                                
                                141,086
                                
                                
                                
                                20,516
                                
                                
                                
                                49,780Asset-backed
      bonds secured by mortgage securities
                                
                                
                                10,699
                                
                                
                                
                                12,868
                                
                                
                                
                                4,093
                                
                                
                                
                                5,001Junior
      subordinated debentures
                                
                                
                                4,579
                                
                                
                                
                                6,115
                                
                                
                                
                                1,265
                                
                                
                                
                                2,058Total
      interest expense
                                
                                
                                91,157
                                
                                
                                
                                182,289
                                
                                
                                
                                25,874
                                
                                
                                
                                66,613Net
      interest income before provision for credit losses
                                
                                
                                92,120
                                
                                
                                
                                97,448
                                
                                
                                
                                26,395
                                
                                
                                
                                25,368Provision
      for credit losses
                                
                                
                                667,638
                                
                                
                                
                                192,326
                                
                                
                                
                                206,202
                                
                                
                                
                                99,159Net
      interest (expense) income
                                
                                $
                                (575,518
                                )
                                
                                $
                                (94,878
                                )
                                
                                $
                                (179,807
                                )
                                
                                $
                                (73,791
                                )









Our net
interest expense after provision for credit losses was $(575.5) million and
$(179.8) million for the nine and three months ended September 30, 2008 as
compared to $(94.9) and $(73.8) million for the same periods in
2007.  The main driver behind this significant decline for the nine
months ended September 30, 2008 compared to the same period in 2007 was an
increase in the provision for credit losses as a result of the continued credit
deterioration of our mortgage loans – held-in-portfolio and an increase in the
anticipated severity of the credit losses.





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




38





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


(dollars
in thousands)





As
of September 30, 2008:





Securitization
                                                        Trust
                                                      
                                                      Original
                                                        Principal
                                                        Balance
                                                      
                                                      
                                                      Current
                                                        Principal
                                                        Balance
                                                      
                                                      
                                                      Allowance
                                                        for Credit
                                                        Losses
                                                      
                                                      
                                                      Remaining
                                                        Expected
                                                        Credit
                                                        Losses(A)
                                                      
                                                      
                                                      Original
                                                        Expected
                                                        Credit
                                                        Losses2006-1
                                                      
                                                      $
                                                      1,350,000
                                                      
                                                      
                                                      $
                                                      557,255
                                                      
                                                      
                                                      $
                                                      134,216
                                                      
                                                      
                                                      
                                                      12.1
                                                      %
                                                      
                                                      
                                                      2.9
                                                      %2006-MTA1
                                                      
                                                      
                                                      1,199,013
                                                      
                                                      
                                                      
                                                      692,477
                                                      
                                                      
                                                      
                                                      165,498
                                                      
                                                      
                                                      
                                                      16.4
                                                      
                                                      
                                                      
                                                      1.72007-1
                                                      
                                                      
                                                      1,888,756
                                                      
                                                      
                                                      
                                                      1,403,431
                                                      
                                                      
                                                      
                                                      492,193
                                                      
                                                      
                                                      
                                                      27.7
                                                      
                                                      
                                                      
                                                      6.2





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





As
of December 31, 2007:





Securitization
                            Trust
                          
                          Original
                            Principal
                            Balance
                          
                          
                          Current
                            Principal
                            Balance
                          
                          
                          Allowance forCredit Losses
                          
                          
                          Remaining
                            Expected
                            Credit
                            Losses(A)
                          
                          
                          Original
                            Expected
                            Credit
                            Losses2006-1
                          
                          $
                          1,350,000
                          
                          
                          $
                          694,101
                          
                          
                          $
                          40,031
                          
                          
                          
                          6.5
                          %
                          
                          
                          2.9
                          %2006-MTA1
                          
                          
                          1,199,013
                          
                          
                          
                          753,787
                          
                          
                          
                          27,312
                          
                          
                          
                          5.7
                          
                          
                          
                          1.72007-1
                          
                          
                          1,888,756
                          
                          
                          
                          1,619,849
                          
                          
                          
                          162,795
                          
                          
                          
                          13.5
                          
                          
                          
                          6.2





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





Activity
in the allowance for credit losses on mortgage loans – held-in-portfolio was as
follows for the nine and three months ended September 30, 2008 and 2007 (dollars
in thousands):





Table
4 — Allowance for Credit Losses on Mortgage Loans –
Held-in-Portfolio


(dollars
in thousands)







For the Nine Months Ended
                  September 30,
                
                
                For the Three Months Ended
                  September 30,2008
                
                
                2007
                
                
                2008
                
                
                2007Balance,
      beginning of period
                
                $
                230,138
                
                
                $
                22,452
                
                
                $
                616,690
                
                
                $
                100,096Provision
      for credit losses
                
                
                667,638
                
                
                
                192,326
                
                
                
                206,202
                
                
                
                99,159Charge-offs,
      net of recoveries
                
                
                (105,870
                )
                
                
                (39,570
                )
                
                
                (30,986
                )
                
                
                (24,047
                )Balance,
      end of period
                
                $
                791,906
                
                
                $
                175,208
                
                
                $
                791,906
                
                
                $
                175,208







Based on
generally accepted accounting principles we must maintain an allowance for
credit losses for our mortgage loans held-in-portfolio at a level that estimates
the probable losses inherent in the loan portfolio.  Because these
loans have been legally sold into securitization trusts in securitizations
treated as financings, the credit loss reduces the amount of our equity in the
related trust, which is generally the difference between the cost basis of the
trust’s assets (adjusted for credit loss allowances) and the trust’s liabilities
arising from third-party investor bond financing.  Although recourse
on the bond financing is limited to the assets of the trust, our equity in the
trust under generally accepted accounting principles will be reflected as a
negative amount when, as a result of the charge to earnings through our
provision for credit losses, the trust’s liabilities exceed the trust’s assets
under generally accepted accounting principles.  The following table
presents the assets and liabilities of our securitization trusts accounted for
as financing transactions as of September 30, 2008 and December 31, 2007, with
“net assets (deficiency)” being a reasonable indication of what the equity
position of each trust was as of the end of the period presented.




39





Table
5 — Condensed Balance Sheet of Securitizations Accounted for as Financing
Transactions


(dollars
in thousands)





As
of September 30, 2008:





NHES
                    
                    
                    NHES
                    
                    
                    NHES2006-MTA1
                    
                    
                    
                    2006-1
                    
                    
                    
                    2007-1
                    
                    
                    TotalsAssets:Mortgage
      loans – held-in-portfolioOutstanding
      principal
                    
                    $
                    692,477
                    
                    
                    $
                    557,255
                    
                    
                    $
                    1,403,431
                    
                    
                    $
                    2,653,163Net
      unamortized deferred origination costs
                    
                    
                    15,876
                    
                    
                    
                    3,867
                    
                    
                    
                    -
                    
                    
                    
                    19,743Allowance
      for credit losses
                    
                    
                    (165,498
                    )
                    
                    
                    (134,216
                    )
                    
                    
                    (492,192
                    )
                    
                    
                    (791,906
                    )Mortgage
      loans – held-in-portfolio
                    
                    
                    542,855
                    
                    
                    
                    426,906
                    
                    
                    
                    911,239
                    
                    
                    
                    1,881,000Accrued
      interest receivable
                    
                    
                    10,099
                    
                    
                    
                    20,460
                    
                    
                    
                    41,664
                    
                    
                    
                    72,223Real
      estate owned
                    
                    
                    9,035
                    
                    
                    
                    17,477
                    
                    
                    
                    27,251
                    
                    
                    
                    53,763Total
      assets
                    
                    $
                    561,989
                    
                    
                    $
                    464,843
                    
                    
                    $
                    980,154
                    
                    
                    $
                    2,006,986Liabilities:Asset-backed
      bonds secured by mortgage loans
                    
                    $
                    692,404
                    
                    
                    $
                    569,158
                    
                    
                    $
                    1,411,692
                    
                    
                    $
                    2,673,254Other
      liabilities
                    
                    
                    12,727
                    
                    
                    
                    28,712
                    
                    
                    
                    64,122
                    
                    
                    
                    105,561Total
      liabilities
                    
                    
                    705,131
                    
                    
                    
                    597,870
                    
                    
                    
                    1,475,814
                    
                    
                    
                    2,778,815Net
      deficiency
                    
                    
                    (143,142
                    )
                    
                    
                    (133,027
                    )
                    
                    
                    (495,660
                    )
                    
                    
                    (771,829
                    )Total
      liabilities and net deficiency
                    
                    $
                    561,989
                    
                    
                    $
                    464,843
                    
                    
                    $
                    980,154
                    
                    
                    $
                    2,006,986









As
of December 31, 2007:





NHES
                    
                    
                    NHES
                    
                    
                    NHES2006-MTA1
                    
                    
                    
                    2006-1
                    
                    
                    
                    2007-1
                    
                    
                    TotalsAssets:Mortgage
      loans – held-in-portfolioOutstanding
      principal
                    
                    $
                    753,787
                    
                    
                    $
                    694,101
                    
                    
                    $
                    1,619,849
                    
                    
                    $
                    3,067,737Net
      unamortized deferred origination costs
                    
                    
                    27,177
                    
                    
                    
                    5,237
                    
                    
                    
                    -
                    
                    
                    
                    32,414Allowance
      for credit losses
                    
                    
                    (27,312
                    )
                    
                    
                    (40,031
                    )
                    
                    
                    (162,795
                    )
                    
                    
                    (230,138
                    )Mortgage
      loans – held-in-portfolio
                    
                    
                    753,652
                    
                    
                    
                    659,307
                    
                    
                    
                    1,457,054
                    
                    
                    
                    2,870,013Accrued
      interest receivable
                    
                    
                    14,091
                    
                    
                    
                    14,238
                    
                    
                    
                    33,375
                    
                    
                    
                    61,704Real
      estate owned
                    
                    
                    4,851
                    
                    
                    
                    32,126
                    
                    
                    
                    39,637
                    
                    
                    
                    76,614Total
      assets
                    
                    $
                    772,594
                    
                    
                    $
                    705,671
                    
                    
                    $
                    1,530,066
                    
                    
                    $
                    3,008,331Liabilities:Asset-backed
      bonds secured by mortgage loans
                    
                    $
                    748,182
                    
                    
                    $
                    714,476
                    
                    
                    $
                    1,603,088
                    
                    
                    $
                    3,065,746Other
      liabilities
                    
                    
                    5,751
                    
                    
                    
                    19,927
                    
                    
                    
                    45,087
                    
                    
                    
                    70,765Total
      liabilities
                    
                    
                    753,933
                    
                    
                    
                    734,403
                    
                    
                    
                    1,648,175
                    
                    
                    
                    3,136,511Net
      assets (deficiency)
                    
                    
                    18,661
                    
                    
                    
                    (28,732
                    )
                    
                    
                    (118,109
                    )
                    
                    
                    (128,180
                    )Total
      liabilities and net assets (deficiency)
                    
                    $
                    772,594
                    
                    
                    $
                    705,671
                    
                    
                    $
                    1,530,066
                    
                    
                    $
                    3,008,331









Losses on
Derivative Instruments. The derivative instruments on our balance sheet
as of December 31, 2007 included interest rate swap and interest rate cap
agreements which have been transferred into our securitization trusts structured
as financings.





We also
entered into three credit default swaps (“CDS”) during 2007 as part of our CDO
transaction.  The CDS had a notional amount of $16.5 million and a
fair value of $6.1 million at the date of purchase and are pledged as collateral
against the CDO ABB.  At September 30, 2008 and December 31, 2007 the
fair value was $0.5 million and $2.5 million, respectively, and we recorded
losses related to fair value adjustments of $2.0 million and $0.4 million for
the nine and three months ended September 30, 2008.   The CDS are
included in the “Other assets” line item of the condensed consolidated balance
sheets.





As a
result of declining interest rates in the first quarter, modestly increasing
interest rates in the second and third quarters, and declining values of the
CDS, the (losses) gains on derivative instruments from continuing operations
were $(9.5) million and $1.1 million for the nine and three months ended
September 30, 2008 as compared to $2.9 million and $9.4 million for the same
periods of 2007.





Gains on Debt
Extinguishment. We recorded gains on debt extinguishment for the nine
months ended September 30, 2008 of $6.4 million.  There were no gains
recorded for the three months ended September 30, 2008 or the same periods of
2007.  On May 29, 2008, we purchased trust preferred securities of
NovaStar Capital Trust II having a par value of $6.9 million for $0.6
million.  As a result, $6.9 million of principal and accrued interest
of $0.2 million of the Notes was retired and the principal amount, accrued
interest, and related unamortized debt issuance costs related to these Notes
were removed from the balance sheet resulting in a gain of $6.4
million.




40





Fair Value
Adjustments.  We recorded net (losses) gains due to fair value
adjustments of $(20.3) million and $2.4 million related to our trading
securities and the asset-backed bonds issued in our CDO transaction for the nine
and three months ended September 30, 2008 compared to losses of $(58.2) and
$(32.0) million for the same periods of 2007.  The trading securities
had fair value losses of approximately $78.6 million and $3.7 million for the
nine and three months ended September 30, 2008 compared to $237.9 million and
$148.2 million for the same periods in 2007.  The CDO asset-backed
bonds had fair value gains of $58.3 million and $6.1 million for the nine and
three months ended September 30, 2008 compared to $179.7 million and $116.2
million for the same periods in 2007.  These adjustments were a result
of poor credit performance of the underlying mortgage loans.





Impairment on
Mortgage Securities – Available-for-Sale.To the extent that the
cost basis of mortgage securities – available-for-sale exceeds the fair value
and the unrealized loss is considered to be other than temporary, an impairment
charge is recognized and the amount recorded in accumulated other comprehensive
income or loss is reclassified to earnings as a realized loss.  During
the nine and three months ended September 30, 2008 we recorded impairment losses
of $22.9 million and $1.7 million, respectively as compared to a $72.2 million
and $46.2 million impairment losses for the same periods of 2007.  The
impairments during the nine and three months ended September 30, 2008 were
driven by slower prepayment speeds resulting in a decline in our prepayment
penalty cash flows.  During the nine and three months ended September
30, 2007 impairments were mainly driven by increasing credit
losses.





Premiums for
Mortgage Loans Insurance.We obtained mortgage
loan insurance for mortgage loans related to mortgage loans held-in-portfolio in
order to mitigate the risk of loss due to foreclosures on these
loans.  Mortgage loan insurance significantly reduces the risk of
credit losses born by the owner of the loans.  We recorded expense
related to premiums for mortgage loan insurance of $12.1 million and $3.8
million the nine and three months ended September 30, 2008, respectively as
compared to $12.1 million and $4.5 million for the same periods in
2007.





Servicing Fee
Expense.We
recorded servicing fee expense of $10.4 million and $3.3 million for the nine
and three months ended September 30, 2008, respectively.  There was no
servicing fee expense for the same periods of 2007.  Servicing fee
expense consists of expenses paid for our mortgage loans – held-in-portfolio
serviced by a third party.  These amounts are determined as a
percentage of the principal collected for the loans serviced and are recognized
in the period in which payments on the loans are received by the
servicer.  As previously disclosed during 2007, we sold our mortgage
servicing rights which subsequently resulted in the abandonment of our servicing
operations, prior to this we did not incur any servicing fee expenses as we
serviced our own loans.





Appraisal Fee Income, Appraisal Fee Expense, and
Other Appraisal Management Expenses.We recorded appraisal fee
income of $1.5 million, appraisal fee expense of $1.2 million, and other
appraisal management expenses of $0.5 million for the nine and three months
ended September 30, 2008.  These income statement items relate to the
operations of our StreetLinks subsidiary, as discussed in Note 1 to the
condensed consolidated financial statements.  Appraisal fee income
consists of fees received for home appraisals completed by third-party
appraisers.  Appraisal fee expense consists of amounts paid to the
third-party appraisers for the completion of the appraisals.  Other
appraisal management expenses are the general and administrative expenses for
StreetLinks.





General and
Administrative Expenses.
The main categories of our general and administrative expenses are: compensation
and benefits, office administration, professional and outside services and
marketing and other expense. Compensation and benefits includes employee base
salaries, benefit costs and incentive compensation awards. Office administration
includes items such as rent, depreciation, telephone, office supplies, postage,
delivery, maintenance and repairs. Professional and outside services include
fees for legal, accounting and other consulting services. Marketing and other
expense primarily includes miscellaneous banking fees, travel and entertainment
expenses. General and administrative expenses were $17.9 million and $5.6
million for the nine and three months ended September 30, 2008, as compared to
$49.7 million and $9.6 million for the same periods in
2007.  Generally, the decrease in all of the general and
administrative expense categories was the result of the shutdown of our mortgage
lending and loan servicing segments in 2007.





Income
Taxes





Based on
the evidence available as of September 30, 2008 and December 31, 2007, including
the significant tax losses incurred by us in 2007 and the first three quarters
of 2008, the ongoing disruption to the credit markets, the liquidity issues
facing us and the termination of all of our mortgage lending and loan servicing
operations, we believe that it is more likely than not that we will not realize
our deferred tax assets.  Based on these conclusions, we recorded a
valuation allowance against our entire net deferred tax assets as of September
30, 2008 and December 31, 2007.




41





Prior to
September 30, 2008, we used our 2007 federal net operating loss carryback to
offset our 2006 taxable income.  Accordingly, we recorded additional
interest of $0.8 million for the nine months ended September 30, 2008 related to
the balance due to the IRS, which is included in the “Accounts payable and other
liabilities” line item of our condensed consolidated balance
sheets.  We also offset the 2006 tax liability with the receivable
recorded for the 2007 federal net operating loss carried back against our 2006
taxable income.





We had an
income tax benefit of $16.8 million and $17.8 million for the nine and three
months ended September 30, 2008 as compared to incurring an income tax expense
of $59.2 million and $245.8 million for the same periods of 2007. The tax
expense in 2007 was driven by the formal plan approved by the Board of Directors
to revoke status as a REIT as of January 1, 2008. This plan was subsequently
superseded in the third quarter of 2007 by termination of our REIT status as of
January 1, 2006 as a result of our inability to pay a dividend on our common
stock with respect to our 2006 taxable income.





Discontinued
Operations





September
30, 2008 as Compared to September 30, 2007





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





Financial
Condition





Mortgage Loans -
Held-in-Portfolio.





The
following table summarizes the activity of our mortgage loans classified as
held-in-portfolio for the nine months ended September 30, 2008.





Table
6 — Rollforward of Mortgage Loans - Held-in-Portfolio


(dollars
in thousands)





Beginning
      principal balance
                      
                      $
                      3,067,737Borrower
      repayments
                      
                      
                      (254,793
                      )Capitalization
      of interest
                      
                      
                      17,957Transfers
      to real estate owned
                      
                      
                      (177,738)Ending
      principal balance
                      
                      
                      2,653,163Net
      unamortized deferred origination costs
                      
                      
                      19,743Amortized
      cost
                      
                      
                      2,672,906Allowance
      for credit losses
                      
                      
                      (791,906
                      )Mortgage
      loans held-in-portfolio
                      
                      $
                      1,881,000







The
following table provides delinquency information for our loans classified as
held-in-portfolio as of September 30, 2008 and December 31, 2007.





Table
7 — Mortgage Loans – Held-in-Portfolio Delinquencies


(dollars
in thousands)





As of September 30, 2008
                      
                      
                      As of December 31, 2007Current Principal
                      
                      
                      Percent
                        ofTotal
                      
                      
                      Current Principal
                      
                      
                      Percent
                        ofTotalCurrent
                      
                      $
                      1,555,160
                      
                      
                      
                      59
                      %
                      
                      $
                      2,484,386
                      
                      
                      
                      81
                      %30-59
      days delinquent
                      
                      
                      119,175
                      
                      
                      
                      4
                      
                      
                      
                      158,366
                      
                      
                      
                      560-89
      days delinquent
                      
                      
                      99.932
                      
                      
                      
                      4
                      
                      
                      
                      98,039
                      
                      
                      
                      390
      + days delinquent
                      
                      
                      503,565
                      
                      
                      
                      19
                      
                      
                      
                      150,811
                      
                      
                      
                      5In
      process of foreclosure
                      
                      
                      375,331
                      
                      
                      
                      14
                      
                      
                      
                      176,135
                      
                      
                      
                      6Total
      principal
                      
                      $
                      2,653,163
                      
                      
                      
                      100
                      %
                      
                      $
                      3,067,737
                      
                      
                      
                      100
                      %










42





Mortgage
Securities Available-for-Sale and Trading (Residual Securities).





The
following tables summarize our mortgage securities – available-for-sale
portfolio and the residual securities in our trading portfolio and the current
assumptions as of September 30, 2008 and December 31, 2007.





Table
8 — Valuation and Assumptions for Individual Mortgage Securities –
Available-for-Sale and Trading (Residual Securities)(dollars in thousands):





As
of September 30, 2008





Current Valuation AssumptionsSecuritization
                              Trust
                            
                            Cost (A)
                            
                            
                            Unrealized Gain
                              (Loss) (A)
                            
                            
                            Estimated Fair Value
                              of Mortgage
                              Securities (A)
                            
                            
                            Discount Rate
                            
                            
                            Constant
                              Prepayment
                              Rate
                            
                            
                            Expected Credit
                              Losses (B)Mortgage
      Securities – Available-for-Sale:2002-3
                            
                            $
                            1,241
                            
                            
                            $
                            395
                            
                            
                            $
                            1,636
                            
                            
                            
                            25
                            %
                            
                            
                            13
                            %
                            
                            
                            0.7
                            %2003-1
                            
                            
                            1,568
                            
                            
                            
                            266
                            
                            
                            
                            1,834
                            
                            
                            
                            25
                            
                            
                            
                            11
                            
                            
                            
                            2.02003-2
                            
                            
                            1,015
                            
                            
                            
                            553
                            
                            
                            
                            1,568
                            
                            
                            
                            25
                            
                            
                            
                            10
                            
                            
                            
                            1.72003-3
                            
                            
                            250
                            
                            
                            
                            172
                            
                            
                            
                            422
                            
                            
                            
                            25
                            
                            
                            
                            9
                            
                            
                            
                            2.42003-4
                            
                            
                            -
                            
                            
                            
                            11
                            
                            
                            
                            11
                            
                            
                            
                            25
                            
                            
                            
                            11
                            
                            
                            
                            2.72004-1
                            
                            
                            4
                            
                            
                            
                            23
                            
                            
                            
                            27
                            
                            
                            
                            25
                            
                            
                            
                            14
                            
                            
                            
                            3.12004-2
                            
                            
                            8
                            
                            
                            
                            24
                            
                            
                            
                            32
                            
                            
                            
                            25
                            
                            
                            
                            13
                            
                            
                            
                            3.22004-3
                            
                            
                            -
                            
                            
                            
                            79
                            
                            
                            
                            79
                            
                            
                            
                            25
                            
                            
                            
                            14
                            
                            
                            
                            4.12004-4
                            
                            
                            11
                            
                            
                            
                            -
                            
                            
                            
                            11
                            
                            
                            
                            25
                            
                            
                            
                            15
                            
                            
                            
                            3.82005-1
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            25
                            
                            
                            
                            17
                            
                            
                            
                            5.32005-2
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            25
                            
                            
                            
                            15
                            
                            
                            
                            6.32005-3
                            
                            
                            5
                            
                            
                            
                            -
                            
                            
                            
                            5
                            
                            
                            
                            25
                            
                            
                            
                            16
                            
                            
                            
                            8.12005-4
                            
                            
                            73
                            
                            
                            
                            -
                            
                            
                            
                            73
                            
                            
                            
                            25
                            
                            
                            
                            17
                            
                            
                            
                            9.72006-2
                            
                            
                            126
                            
                            
                            
                            -
                            
                            
                            
                            126
                            
                            
                            
                            25
                            
                            
                            
                            20
                            
                            
                            
                            13.72006-3
                            
                            
                            183
                            
                            
                            
                            -
                            
                            
                            
                            183
                            
                            
                            
                            25
                            
                            
                            
                            20
                            
                            
                            
                            16.02006-4
                            
                            
                            195
                            
                            
                            
                            -
                            
                            
                            
                            195
                            
                            
                            
                            25
                            
                            
                            
                            20
                            
                            
                            
                            15.92006-5
                            
                            
                            300
                            
                            
                            
                            -
                            
                            
                            
                            300
                            
                            
                            
                            25
                            
                            
                            
                            20
                            
                            
                            
                            19.42006-6
                            
                            
                            410
                            
                            
                            
                            -
                            
                            
                            
                            410
                            
                            
                            
                            25
                            
                            
                            
                            19
                            
                            
                            
                            20.0Total
                            
                            $
                            5,389
                            
                            
                            $
                            1,523
                            
                            
                            $
                            6,912Mortgage
      Securities – Trading (Residual Securities):2007-2
                            
                            
                            17,675
                            
                            
                            
                            (15,952
                            )
                            
                            
                            1,723
                            
                            
                            
                            25
                            
                            
                            
                            17
                            
                            
                            
                            23.7Total
                            
                            $
                            23,064
                            
                            
                            $
                            (14,429
                            )
                            
                            $
                            8,635













(A)
              The
      interest-only, prepayment penalty and overcollateralization securities are
      presented on a combined basis.
 (B)
              For
      securities that have not reached their call date - represents expected
      credit losses for the life of the securitization up to the expected date
      in which the related asset-backed bonds will be called, net of mortgage
      insurance recoveries.




43








As
of December 31, 2007





Current Valuation AssumptionsSecuritization
                      Trust
                    
                    Cost (A)
                    
                    
                    Unrealized Gain
                      (Loss) (A)
                    
                    
                    Estimated Fair Value
                      of Mortgage
                      Securities (A)
                    
                    
                    Discount Rate
                    
                    
                    Constant
                      Prepayment
                      Rate
                    
                    
                    Expected Credit
                      Losses (B)Mortgage
      Securities – Available-for-Sale:2002-3
                    
                    $
                    1,932
                    
                    
                    $
                    -
                    
                    
                    $
                    1,932
                    
                    
                    
                    25
                    %
                    
                    
                    24
                    %
                    
                    
                    0.6
                    %2003-1
                    
                    
                    3,260
                    
                    
                    
                    -
                    
                    
                    
                    3,260
                    
                    
                    
                    25
                    
                    
                    
                    20
                    
                    
                    
                    1.72003-2
                    
                    
                    2,817
                    
                    
                    
                    -
                    
                    
                    
                    2,817
                    
                    
                    
                    25
                    
                    
                    
                    18
                    
                    
                    
                    1.22003-3
                    
                    
                    1,233
                    
                    
                    
                    -
                    
                    
                    
                    1,233
                    
                    
                    
                    25
                    
                    
                    
                    16
                    
                    
                    
                    1.22003-4
                    
                    
                    1,279
                    
                    
                    
                    -
                    
                    
                    
                    1,279
                    
                    
                    
                    25
                    
                    
                    
                    20
                    
                    
                    
                    1.62004-1
                    
                    
                    180
                    
                    
                    
                    -
                    
                    
                    
                    180
                    
                    
                    
                    25
                    
                    
                    
                    24
                    
                    
                    
                    2.42004-2
                    
                    
                    180
                    
                    
                    
                    -
                    
                    
                    
                    180
                    
                    
                    
                    25
                    
                    
                    
                    23
                    
                    
                    
                    2.42004-3
                    
                    
                    986
                    
                    
                    
                    -
                    
                    
                    
                    986
                    
                    
                    
                    25
                    
                    
                    
                    24
                    
                    
                    
                    3.02004-4
                    
                    
                    48
                    
                    
                    
                    -
                    
                    
                    
                    48
                    
                    
                    
                    25
                    
                    
                    
                    26
                    
                    
                    
                    2.62005-1
                    
                    
                    512
                    
                    
                    
                    -
                    
                    
                    
                    512
                    
                    
                    
                    25
                    
                    
                    
                    27
                    
                    
                    
                    3.62005-2
                    
                    
                    642
                    
                    
                    
                    -
                    
                    
                    
                    642
                    
                    
                    
                    25
                    
                    
                    
                    24
                    
                    
                    
                    3.32005-3
                    
                    
                    1,335
                    
                    
                    
                    -
                    
                    
                    
                    1,335
                    
                    
                    
                    25
                    
                    
                    
                    24
                    
                    
                    
                    3.62005-3
      (C)
                    
                    
                    158
                    
                    
                    
                    69
                    
                    
                    
                    227
                    
                    
                    
                    25
                    
                    
                    
                    N/A
                    
                    
                    
                    N/A2005-4
                    
                    
                    1,344
                    
                    
                    
                    -
                    
                    
                    
                    1,344
                    
                    
                    
                    25
                    
                    
                    
                    27
                    
                    
                    
                    4.52005-4
      (C)
                    
                    
                    212
                    
                    
                    
                    -
                    
                    
                    
                    212
                    
                    
                    
                    25
                    
                    
                    
                    N/A
                    
                    
                    
                    N/A2006-2
                    
                    
                    2,301
                    
                    
                    
                    -
                    
                    
                    
                    2,301
                    
                    
                    
                    25
                    
                    
                    
                    32
                    
                    
                    
                    6.82006-3
                    
                    
                    2,994
                    
                    
                    
                    -
                    
                    
                    
                    2,994
                    
                    
                    
                    25
                    
                    
                    
                    31
                    
                    
                    
                    8.42006-4
                    
                    
                    2,960
                    
                    
                    
                    -
                    
                    
                    
                    2,960
                    
                    
                    
                    25
                    
                    
                    
                    32
                    
                    
                    
                    8.22006-5
                    
                    
                    4,217
                    
                    
                    
                    -
                    
                    
                    
                    4,217
                    
                    
                    
                    25
                    
                    
                    
                    31
                    
                    
                    
                    11.02006-6
                    
                    
                    4,712
                    
                    
                    
                    -
                    
                    
                    
                    4,712
                    
                    
                    
                    25
                    
                    
                    
                    30
                    
                    
                    
                    10.0Total
                    
                    $
                    33,302
                    
                    
                    $
                    69
                    
                    
                    $
                    33,371Mortgage
      Securities – Trading (Residual Securities):2007-2
                    
                    $
                    41,275
                    
                    
                    $
                    (13,959
                    )
                    
                    $
                    27,316
                    
                    
                    
                    25
                    %
                    
                    
                    20
                    %
                    
                    
                    12.5
                    %







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


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


(C)
            Represents
      derivative cash flow bonds (“CT
Bonds”).





As of
September 30, 2008 and December 31, 2007 the fair value of our mortgage
securities – available-for-sale was $6.9 million and $33.4 million,
respectively. The decline is mostly due to slower prepayment speeds resulting in
a decline in our prepayment penalty cashflows and an increase in expected credit
losses and normal paydowns.  The value of our mortgage securities –
available-for-sale, as well as the cash flows we receive from them, are highly
dependent upon interest rate spreads, as well as credit losses and prepayment
experience of the borrowers of the underlying mortgage security
collateral.





Mortgage
Securities – Trading.





The
following tables provide a summary of our portfolio of trading securities at
September 30, 2008 and December 31, 2007:





Table
9 — Mortgage Securities - Trading


(dollars
in thousands)





As
of September 30, 2008





S&P Rating
                  
                  Original Face
                  
                  
                  Amortized Cost
                    Basis
                  
                  
                  Fair Value
                  
                  
                  Number of
                    Securities
                  
                  
                  Weighted
                    Average YieldSubordinated
      Securities:Investment
      Grade (A)
                  
                  $
                  12,505
                  
                  
                  $
                  11,770
                  
                  
                  $
                  860
                  
                  
                  
                  3
                  
                  
                  
                  4.20
                  %Non-investment
      Grade (B)
                  
                  
                  422,609
                  
                  
                  
                  402,310
                  
                  
                  
                  12,398
                  
                  
                  
                  87
                  
                  
                  
                  6.70Total
      Subordinated Securities
                  
                  
                  435,114
                  
                  
                  
                  414,080
                  
                  
                  
                  13,258
                  
                  
                  
                  90
                  
                  
                  
                  6.53Residual
      Securities:Unrated
                  
                  
                  N/A
                  
                  
                  
                  17,674
                  
                  
                  
                  1,723
                  
                  
                  
                  1
                  
                  
                  
                  25.00Total
                  
                  $
                  435,114
                  
                  
                  $
                  431,754
                  
                  
                  $
                  14,981
                  
                  
                  
                  91
                  
                  
                  
                  8.66
                  %







(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-.





44




As
of December 31, 2007





S&P Rating
                  
                  Original Face
                  
                  
                  Amortized Cost
                    Basis
                  
                  
                  Fair Value
                  
                  
                  Number of
                    Securities
                  
                  
                  Weighted
                    Average YieldSubordinated
      Securities:Investment
      Grade (A)
                  
                  $
                  389,881
                  
                  
                  $
                  367,581
                  
                  
                  $
                  80,004
                  
                  
                  
                  91
                  
                  
                  
                  11.46
                  %Non-investment
      Grade (B)
                  
                  
                  45,233
                  
                  
                  
                  38,514
                  
                  
                  
                  4,458
                  
                  
                  
                  17
                  
                  
                  
                  17.05Total
      Subordinated Securities
                  
                  
                  435,114
                  
                  
                  
                  406,095
                  
                  
                  
                  84,462
                  
                  
                  
                  108
                  
                  
                  
                  11.76Residual
      Securities:Unrated
                  
                  
                  N/A
                  
                  
                  
                  41,275
                  
                  
                  
                  24,741
                  
                  
                  
                  1
                  
                  
                  
                  21.00Total
                  
                  $
                  435,114
                  
                  
                  $
                  447,370
                  
                  
                  $
                  109,203
                  
                  
                  
                  109
                  
                  
                  
                  13.85
                  %







(A)
            Investment
      grade includes all securities with ratings above
  BB+.


(B)
            Non-investment
      grade includes all securities with ratings below
  BBB-.





As of
September 30, 2008 and December 31, 2007, mortgage securities – trading
consisted of the NMFT Series 2007-2 residual security and subordinated
securities retained by the Company from securitization transactions as well as
subordinated securities purchased from other issuers in the open
market.  The aggregate fair market value of these securities as of
September 30, 2008 and December 31, 2007 was $15.0 million and $109.2 million,
respectively. Management estimates their fair value based on quoted market
prices for subordinated securities and by discounting the expected future cash
flows of the collateral and bonds for the residual securities. The market value
of our mortgage securities - trading have declined due to the continued credit
deterioration and an increase in the anticipated severity of the credit losses
in the underlying collateral. We recognized net trading losses of $78.6 million
and $3.7 million for the nine and three months ended September 30, 2008 and
$237.9 million and $148.2 million for the same periods in 2007.





Real
Estate Owned.





Real
estate owned relating to continuing operations at September 30, 2008 and
December 31, 2007 was $53.8 and $76.6 million,
respectively.   This change is directly related to the timing of
foreclosures and subsequent liquidations of real estate owned arising out of our
NHES 2006-1, 2006-MTA1 and 2007-1 securitizations. The stated amount of real
estate owned on our condensed consolidated balance sheet is net of expected
future losses on the sale of the property.





Asset-backed
bonds.





We issued
asset-backed bonds secured by mortgage loans and securities as a means for
long-term financing. As of September 30, 2008 we had $2.7 billion in
asset-backed bonds compared to $3.1 billion at December 31, 2007. The decrease
was mainly due to bond payments during the year.





Due
to Servicer.





Due to
servicer represents the principal and interest advances that we owe our
third-party servicer relating to our mortgage loans
held-in-portfolio.  The due to servicer increased by $39.4 million
from December 31, 2007 compared to September 30, 2008 due to the timing of the
receipts and payments related to the mortgage loans
held-in-portfolio.





Short-term
Borrowings.





On May 9,
2008, we fully repaid all outstanding borrowings with Wachovia and all
agreements were terminated effective the same day. We have no further borrowing
capacity currently available to us. See “Liquidity and Capital Resources” for
further discussion of our financing availability and liquidity.





Shareholders’
Deficit.





The
decrease in our shareholders’ deficit as of September 30, 2008 compared to
December 31, 2007 is mainly due to the following increases and
decreases.





Shareholders’
deficit decreased by:


·
              $22.9
      million due to impairment on mortgage securities – available for sale
      reclassified to earnings; and


·
              $45.2
      million due to the reversal of the AIM litigation
  accrual





Shareholders’
deficit increased by:


·
              $622.6
      million due to net loss recognized for the nine months ended September 30,
      2008;


·
              $1.5
      million due to the decrease in unrealized gains on mortgage securities
      classified as available-for-sale;
and


·
              $11.5
      million due to the increase in dividends accrued on preferred
      stock.





As of
September 30, 2008, our total liabilities exceeded our total assets under GAAP,
resulting in a shareholders’ deficit. Our historical losses, negative cash flows
from operations and our shareholders’ deficit raise substantial doubt about our
ability to continue as a going concern, which is dependent upon, among other
things, the maintenance of sufficient operating cash flows.  There is
no assurance that cash flows will be sufficient to meet our
obligations.




45





Contractual
Obligations





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





The
following table summarizes our contractual obligations as of September 30,
2008.




Table
10 — Contractual Obligations


(dollars
in thousands)





Payments Due by PeriodContractual Obligations
                
                Total
                
                
                Less than 1
                  Year
                
                
                1-3 Years
                
                
                3-5 Years
                
                
                More Than 5
                  YearsLong—term
      debt (A)
                
                $
                3,511,729
                
                
                $
                737,026
                
                
                $
                878,047
                
                
                $
                841,011
                
                
                $
                1,055,645Junior
      subordinated debentures (B)
                
                
                240,706
                
                
                
                9,538
                
                
                
                11,801
                
                
                
                11,801
                
                
                
                207,566Operating
      leases (C)
                
                
                15,387
                
                
                
                6,338
                
                
                
                8,244
                
                
                
                805
                
                
                
                -Total
                
                $
                3,767,822
                
                
                $
                752,902
                
                
                $
                898,092
                
                
                $
                853,617
                
                
                $
                1,263,211







(A)
            Our
      asset-backed bonds are non-recourse as repayment is dependent upon payment
      of the underlying mortgage securities, which collateralize the debt. The
      timing of the repayment of these mortgage securities is affected by
      prepayments of the underlying mortgage loans. These amounts include
      expected interest payments on the obligations. Interest obligations on our
      variable-rate long-term debt are based on the prevailing interest rate at
      September 30, 2008 for each respective
  obligation.


(B)
            The
      junior subordinated debentures are assumed to mature in 2035 and 2036 in
      computing the future payments. These amounts include expected interest
      payments on the obligations. Interest obligations on our junior
      subordinated debentures are based on the prevailing interest rate at
      September 30, 2008 for each respective obligation.  Past-due
      interest of approximately $3.6 million is also included in the less than 1
      year period.


(C)
            Does
      not include rental income of $2.0 million to be received under sublease
      contracts.





We
recorded deferred lease incentives, which will be amortized into rent expense
over the life of the respective lease. Deferred lease incentives as of September
30, 2008 and 2007 were $0.7 million and $0.8 million, respectively.





Liquidity
and Capital Resources





We had
$18.8 million in unrestricted cash and cash equivalents at September 30, 2008,
which was a decrease of $6.6 million from December 31, 2007.  As ofApril 27, 2009, we had approximately $18.4
million of unrestricted cash and cash
equivalents.





Current Liquidity
and Near-Term Obligations.  Our current projections indicate
sufficient available cash and cash flows from our mortgage assets to meet
our operating expenses through 2008 and 2009.  However, our mortgage
asset cash flows are currently volatile and uncertain in nature, and the amounts
we receive could vary materially from our projections.  In addition, these
cash flows are expected to decrease over the next several
months.  Therefore, no assurances can be given that we will be able to
meet our cash flow needs, in which case we would be required to seek protection
of applicable bankruptcy laws.





Collateralization
of letters of credit supporting surety bonds.Certain states required
that we post surety bonds in connection with our former mortgage lending
operations.  During 2007, we were required to post letters of credit
to support our reimbursement obligations to the sureties, and were required to
cash collateralize the letters of credit pursuant to our letter of credit
agreements with Wachovia Bank.  We are in the process of terminating
these surety bonds and the associated letters of credit as a result of the
discontinuation of our mortgage lending operations and have received back
collateral associated with letters of credit terminated to
date.  Collateral totaling $5.8 million remained outstanding as of
September 30, 2008. Cancellation of the remaining surety bonds and related
letters of credit is subject to certain conditions and may take several months
or longer to complete.  In addition, we are currently in default under
the letter of credit agreements as a result of, among other matters, our default
under debt agreements related to our trust preferred securities, discussed
further below.  Although we have received a return of collateral
notwithstanding this default, Wachovia Bank is not obligated to return cash
collateral to us so long as a default exists.  Consequently, no
assurances can be given as to the timing or amount of any additional return of
the remaining cash collateral.





Trust Preferred
Obligations.  Our wholly owned subsidiary NovaStar Mortgage,
Inc. (“NMI”) has approximately $77.2 million in principal amount of unsecured
notes (collectively, the “Notes”) outstanding to NovaStar Capital Trust I and
NovaStar Capital Trust II (collectively, the “Trusts”) which secure trust
preferred securities issued by the Trusts.  The foregoing is net of
amounts owed in respect of trust preferred securities of NovaStar Capital Trust
II having a par value of $6.9 million purchased by NMI on May 29, 2008 for $0.6
million.  We have guaranteed NMI's obligations under the
Notes.




46





NMI
failed to make quarterly interest payments that were due on March 30, April 30,
June 30, July 30, September 30, October 30 and December 30, 2008, and January 30
and March 30, 2009 totaling, for all payment dates combined, approximately $6.1
million on the Notes.  As a result, NMI is in default under the
related indentures and we are in default under the related
guarantees.





On June
4, 2008 and August 14, 2008, we received written notices of acceleration from
the holders of the trust preferred securities of NovaStar Capital Trust I and
NovaStar Capital Trust II, respectively, which declared all obligations of NMI
under the related Notes and indenture  to be immediately due and
payable, and stated the intention of the trust preferred security holders to
pursue all available rights and remedies, including but not limited to enforcing
their rights under the related guarantee.  The total principal and
accrued interest owed under the Notes, net of amounts owed in respect of the
trust preferred securities held by NMI, was approximately $84.0 million as of
April 27, 2009.   In addition, we are obligated to reimburse the
trustees for all reasonable expenses, disbursements and advances in connection
with the exercise of rights under the indentures.





On
September 12, 2008, a petition for involuntary Chapter 7 bankruptcy entitled In
re NovaStar Mortgage, Inc. (Case No. 08-12125-CSS) was filed against NMI by the
holders of the trust preferred securities in U.S. Bankruptcy Court for the
District of Delaware in Wilmington, Delaware.  The filing did not include
NFI or any other subsidiary or affiliate of NFI.





On
February 18, 2009, the Company, NMI, the Trusts and the trust preferred security
holders entered into agreements to settle the claims of the trust preferred
security holders arising from NMI’s failure to make the scheduled quarterly
interest payments on the Notes.  As part of the settlement, the
existing preferred obligations would be exchanged for new preferred
obligations.  The settlement and exchange were contingent upon, among
other things, the dismissal of the involuntary Chapter 7
bankruptcy.  On March 9, 2009, the Bankruptcy Court entered an order
dismissing the involuntary proceeding.  On April 27, 2009 (the
“Exchange Date”), the parties executed the necessary documents to complete the
Exchange.  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.





Table
11 — Summary of Operating, Investing and Financing Cash Flows


(dollars
in thousands)





For the Nine Months Ended
                  September 30,
                
                Increase /2008
                
                2007
                
                (Decrease)Consolidated
      Statements of Cash Flows:Cash
      provided by (used in) operating activities
                
                $
                13,620
                
                
                $
                (1,198,167
                )
                
                $
                1,211,787Cash
      flows provided by investing activities
                
                
                426,185
                
                
                
                862,110
                
                
                
                (435,925
                )Cash
      flows (used in) provided by financing activities
                
                
                (446,415
                )
                
                
                237,065
                
                
                
                (683,480
                )









Operating Activities. Net
cash provided by (used in) operating activities increased by $1.2 billion for
the nine months ended September 30, 2008 as compared to the nine months ended
September 30, 2007.  We discontinued all servicing and lending
operations and therefore, used significantly less cash in
operations.




47





Investing Activities. Net
cash provided by investing activities decreased by $435.9 million for the nine
months ended September 30, 2008 as compared to the same period of
2007.  Our mortgage loan portfolio declined significantly
and borrower defaults increased, resulting in lower repayments of our
mortgage loans held-in-portfolio for the nine months ended September 30, 2008 as
compared to the first nine months of 2007, along with an increase of the sale of
loans through foreclosure.   We also experienced a decrease in
paydowns on our mortgage securities – available-for-sale during the first nine
months of 2008 as compared to the same period of 2007 as a result of poor credit
performance of the underlying loans.  Cash proceeds from the sale
of  assets acquired through foreclosure have increased as our
foreclosed loan activity has increased significantly.





Financing Activities. Net
cash (used in) provided by financing activities decreased by $683.5 million for
the nine months ended September 30, 2008 as compared to the nine months ended
September 30, 2007. The decrease is primarily due to the issuance of $2.1
billion of asset-backed bonds during the first quarter of 2007 from a CDO and a
loan securitization both structured as financing transactions for accounting
purposes.  This was partially offset by paydowns of short-term
borrowings.  We also experienced a decrease in paydowns of our
asset-backed bonds during the first nine months of 2008 as compared to the same
period of 2007.





Primary Uses of
Cash





Investments in
New Mortgage Securities.During 2007 we altered our operations
substantially when we discontinued our origination business.  Prior to
that, we retained significant interests in the nonconforming loans we originated
and purchased through our mortgage securities investment portfolio. Our
securitization activities required capital to fund the primary bonds we
retained, overcollateralization, securitization expenses and our operating costs
to originate the mortgage loans.





For the
nine months ended September 30, 2007, we retained residual securities with a
cost basis of $56.4 million and no subordinated securities from our
securitization transactions completed during that period.  In
addition, we purchased subordinated securities during the first quarter of 2007
with a cost basis of $22.0 million from other issuers which settled in the
second quarter of 2007.





Repayments of
Long-Term Borrowings.Our payments on asset-backed bonds decreased from
$679.1 million for the nine months ended September 30, 2007 to $400.4 million
for the same period of 2008.  Due to the fact that we do not intend to
engage in any additional on-balance sheet securitizations in the foreseeable
future, we expect our payments on asset-backed bonds to decrease as our current
asset-backed bonds mature.





In
addition, as of September 30, 2008, our wholly owned subsidiary NovaStar
Mortgage, Inc. had $77.2 million in outstanding principal of junior subordinated
debentures relating to the trust preferred securities of NovaStar Capital Trust
I and NovaStar Capital Trust II.  We have guaranteed the obligations
of NovaStar Mortgage, Inc. under the junior subordinated
debentures.  We are obligated to make periodic interest payments based
on a variable interest rate of three-month LIBOR plus 3.5% which resets
quarterly.  See Table 10 for an estimate of our contractual
obligations related to these junior subordinated debentures, and the discussion
above regarding our default with respect to, and acceleration of, these
obligations.





Repayments of
Short-term Borrowings.During the nine months ended September
30, 2008, we fully repaid the remaining $57.3 million of outstanding borrowings
with Wachovia and related fees.  We currently have no outstanding
short-term borrowings and no agreements providing for further
borrowings.





Common and
Preferred Stock Dividend Payments. We did not declare any common stock
dividends for the nine months ended September 30, 2008 or
2007.  Preferred stock dividends declared per share were $1.24 for the
nine months ended September 30, 2007.   Our Board of Directors
has suspended dividend payments on our 8.90% Series C and Cumulative Preferred
Stock (the “Series C Preferred Stock”) and our 9.00% Series D1 Mandatory
Convertible Preferred Stock (the “Series D1 Preferred Stock”).  As a
result, dividends on our Series C Preferred Stock and Series D1 Preferred Stock
continue to accrue and the dividend rate on the Series D1 Preferred Stock
increased from 9.0% to 13.0%, compounded quarterly, effective January 16, 2008,
with respect to all unpaid dividends and subsequently accruing
dividends.  Accrued and unpaid dividends on our preferred stock must
be paid prior to the payment of any dividend on our common stock.  We
do not expect to pay any dividends for the foreseeable future.





Loan Sale and
Securitization Repurchases. We have sold whole pools of loans with
recourse for certain borrower defaults. Because the loans are no longer on our
balance sheet, the recourse component is considered a guarantee. During the year
ended December 31, 2007, we sold $912.9 million of loans with recourse for
borrower defaults. We maintained a $1.1 million and $2.2 million recourse
reserve related to these guarantees as of September 30, 2008 and December 31,
2007, respectively.  We did not repurchase any loans during the nine
months ended September 30, 2008. We paid $104.3 million in cash to repurchase
loans sold to third parties during the nine months ended September 30,
2007.  The recourse reserve is our estimate of the loss we expect to
incur in repurchasing the loan and then either liquidating or reselling the
loan. The cash we must have on hand to repurchase these loans is much higher
than the estimated loss, and is higher than the principal amount of the loans as
we generally must reimburse the investor for the remaining unpaid principal
balance, any premium recapture, any unpaid accrued interest and any other
out-of-pocket advances in accordance with the loan sale agreement.




48





We also
have sold loans to securitization trusts and guaranteed losses suffered by the
trust resulting from defects in the loan origination process. Defects may have
occurred in the loan documentation and underwriting process, either through
processing errors made by us or through intentional or unintentional
misrepresentations made by the borrower or agents during those processes. If a
defect is identified, we are required to repurchase the loan. As of September
30, 2008 and December 31, 2007, we had loans sold with recourse to
securitization trusts with an outstanding principal balance of $11.2 billion and
$10.1 billion, respectively. Historically, repurchases of loans from
securitization trusts where a defect has occurred have been insignificant.
Because we have received no significant requests to repurchase loans from our
securitization trusts as of September 30, 2008, we have not recorded any
reserves related to these guarantees.





Expenses Related
to Discontinued Operations.  We have significant ongoing
expenses associated with our discontinued operations, including obligations
under multiple office leases, software agreements, and other contractual
obligations, that no longer contribute to our revenue producing
operations.  See “Other Liquidity Factors” for further
discussion.





Primary
Sources of Cash





Cash Received
From Our Mortgage Securities Portfolio.A major driver of cash flows from
investing activities is the proceeds we receive from our mortgage securities
portfolio. Proceeds on mortgage securities that are pledged to the CDO are
required to be used to pay principal and interest on the CDO asset-backed
bonds.  We were required to use the cash inflows from the remaining
securities to paydown Wachovia’s remaining debt until it was fully repaid on May
9, 2008.  For the nine months ended September 30, 2008 we received
$72.1 million in proceeds from repayments on mortgage securities as compared to
$187.6 million for the same period of 2007. The cash flows we receive on our
mortgage securities are highly dependent on the default and prepayment
experience of the underlying collateral. The following factors have been the
significant drivers in the overall fluctuations in these cash
flows:





·
            The
      coupons on the underlying collateral of our mortgage securities have
      decreased modestly.


·
            Higher
      credit losses have decreased cash available to distribute with respect to
      our residual securities.


·
            We
      have lower average balances of our mortgage securities—available-for-sale
      portfolio as a result of the underlying mortgages being repaid and us not
      purchasing additional mortgage securities—available for
    sale.





Proceeds from
Repayments of Mortgage Loans – Held-in-portfolio. For the nine months
ended September 30, 2008 we received $254.8 million in proceeds from the
repayments of our portfolio of mortgage loans held-in-portfolio compared to
$679.3 million for the same period of 2007.   All of these
amounts are required to be used to pay principal and interest on the related
asset-backed bonds secured by the mortgage loans.  The decrease in
2008 is primarily the result of decreased principal balances, slower borrower
prepayments and credit defaults.





Other
Liquidity Factors





Table 10
details our major contractual obligations due over the next 12 months and
beyond.  As previously discussed, for the near future, we will focus
on minimizing losses and preserving liquidity as we explore operating company
opportunities.  Our residual and subordinated mortgage securities are
currently our only significant source of cash flows.  Based on current
projections, the cash flows from our mortgage securities will decrease in the
next several months as the underlying mortgage loans are repaid, and could be
significantly less than the current projections if losses on the underlying
mortgage loans exceed the current assumptions.  In addition, we have
significant operating expenses associated with office leases and other
obligations relating to our discontinued operations.  In addition, as
discussed above, NMI defaulted on its junior subordinated debentures relating to
the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital
Trust II.  If, as the cash flows from mortgage securities decrease, we
are unable to recommence or acquire profitable business operations, and
restructure our unsecured debt, capital structure and contractual obligations or
if the cash flows from our mortgage securities are less than currently
anticipated, there can be no assurance that we will be able to continue as a
going concern and avoid seeking the protection of applicable bankruptcy
laws.  Factors that can affect our liquidity are discussed in the
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations” and “Risk Factors” sections of this document.





Off-Balance
Sheet Arrangements





As
previously discussed, historically, we pooled the loans we originated and
purchased and typically securitized them to obtain long-term financing for the
assets. The loans were transferred to a trust where they serve as collateral for
asset-backed bonds, which the trust issued to the public. We often retained the
residual and subordinated securities issued by the trust.  We also
securitized residual and subordinated securities that we retained from our
securitizations and that we purchased from third parties.  As
discussed elsewhere, our inability to access the securitization market has had a
material adverse effect on our results of operations, financial condition,
liquidity and ability to continue as a going concern.




49





Information
about the revenues, expenses, liabilities and cash flows we have in connection
with our securitization transactions, as well as information about the
securities issued and interests retained in our securitizations, are detailed in
“Management’s Discussion and Analysis of Financial Condition and Results of
Operations.”





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





Inflation





Virtually
all of our assets and liabilities are financial in nature. As a result, interest
rates and other factors drive our performance far more than does inflation.
Changes in interest rates do not necessarily correlate with inflation rates or
changes in inflation rates. Our financial statements are prepared in accordance
with GAAP. As a result, financial activities and the balance sheet are measured
with reference to historical cost or fair market value without considering
inflation.




50





Item
3. Quantitative and Qualitative Disclosures About Market Risk





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





As of
September 30, 2008, all borrowings under our financing arrangements adjust
quarterly off LIBOR.  On the other hand, very few of the mortgage
assets we own adjust on a monthly or daily basis.  Most of the
mortgage loans contain rates that are fixed for some period of time and then
adjust frequently thereafter.





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





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





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





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




Table
12 — Interest Rate Sensitivity - Market Value


(dollars
in thousands)


Basis Point Increase (Decrease) in Interest Rates (A)(200)
                
                
                
                (100)
                
                
                
                100
                
                
                
                200As
      of September 30, 2008:Change
      in market values of:Assets
      – non trading (B)
                
                $
                13,563
                
                
                $
                5,768
                
                
                $
                (2,798
                )
                
                $
                (4,823
                )Assets
      – trading (C)
                
                
                13,877
                
                
                
                5,899
                
                
                
                (2,643
                )
                
                
                (4,229
                )Cumulative
      change in market value
                
                $
                27,440
                
                
                $
                11,667
                
                
                $
                (5,441
                )
                
                $
                (9,052
                )Percent
      change of market value portfolio equity (D)
                
                
                7.0
                %
                
                
                3.0
                %
                
                
                (1.5
                )%
                
                
                (2.5
                )%As
      of December 31, 2007:Change
      in market values of:Assets
      – non trading (B)
                
                $
                42,484
                
                
                $
                19,234
                
                
                $
                (18,057
                )
                
                $
                (32,868
                )Assets
      – trading (C)
                
                
                33,448
                
                
                
                15,269
                
                
                
                (14,210
                )
                
                
                (26,053
                )Cumulative
      change in market value
                
                $
                75,932
                
                
                $
                34,503
                
                
                $
                (32,267
                )
                
                $
                (58,921
                )Percent
      change of market value portfolio equity (D)
                
                
                61.0
                %
                
                
                24.6
                %
                
                
                (17.5
                )%
                
                
                (30.5
                )%




51





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


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


(C)
            Consists
      of mortgage securities – trading.


(D)
            Total
      change in estimated market value as a percent of market value portfolio
      equity as of September 30, 2008 and December 31,
  2007.





Hedging.We currently have no
intention of entering into new derivative instruments.  In the past,
we used derivative instruments, including interest rate swap and cap contracts,
to mitigate the risk of our cost of funding increasing at a faster rate than the
interest on assets.  Interest rate cap and swap agreements are legal
contracts between us and a third-party firm or “counterparty”. Under an interest
rate cap agreement the counterparty agrees to make payments to us in the future
should the one-month LIBOR interest rate rise above the strike rate specified in
the contract. We make either quarterly or monthly premium payments or have
chosen to pay the premiums at the beginning to the counterparties under
contract. Each contract has either a fixed or amortizing notional face amount on
which the interest is computed and a set term to maturity. When the referenced
LIBOR interest rate rises above the contractual strike rate, we earn cap income.
Under interest rate swap agreements we pay a fixed rate of interest while
receiving a rate that adjusts with one-month LIBOR.





All
derivative instruments on our balance sheet as of September 30, 2008 are related
to securitizations structured as financings and are legally held by the trust.
The following table summarizes the key contractual terms associated with these
interest rate risk management contracts as of September 30, 2008.  All
of our pay-fixed swap contracts and interest rate cap contracts are indexed to
one-month LIBOR.   We have determined the following estimated net
fair value amounts by using available market information and valuation
methodologies we deem appropriate as of September 30, 2008.





Table
13 - Interest Rate Risk Management Contracts


(dollars
in thousands)


Maturity RangeNet Fair
                    Value
                  
                  
                  Total
                    Notional
                    Amount
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2011
                  
                  
                  2012 and
                    beyondPay-fixed
      swaps:Contractual
      maturity
                  
                  $
                  (4,797
                  )
                  
                  $
                  735,000
                  
                  
                  $
                  290,000
                  
                  
                  $
                  405,000
                  
                  
                  $
                  40,000
                  
                  
                  $
                  —
                  
                  
                  $
                  —Weighted
      average pay rate
                  
                  
                  
                  
                  
                  
                  4.9
                  %
                  
                  
                  4.9
                  %
                  
                  
                  4.9
                  %
                  
                  
                  5.0
                  %
                  
                  
                  —
                  
                  
                  
                  —Weighted
      average receive rate
                  
                  
                  
                  
                  
                  
                  3.9
                  %
                  
                  (A)
                  
                  
                  (A)
                  
                  
                  (A)
                  
                  
                  
                  —
                  
                  
                  
                  —Interest
      rate caps:Contractual
      maturity
                  
                  $
                  49
                  
                  
                  $
                  140,000
                  
                  
                  $
                  100,000
                  
                  
                  $
                  40,000
                  
                  
                  $
                  —
                  
                  
                  $
                  —
                  
                  
                  $
                  —Weighted
      average strike rate
                  
                  
                  
                  
                  
                  
                  5.1
                  %
                  
                  
                  5.1
                  %
                  
                  
                  5.0
                  %
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —







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




52





Item
4. Controls and Procedures





Disclosure
Controls and Procedures. We maintain a system of
disclosure controls and procedures (as defined in Rules 13a-15(e) under the
Securities Exchange Act of 1934) which are designed to ensure that information
required to be disclosed by us in reports we file or submit under the federal
securities laws, including this report, is recorded, processed, summarized and
reported on a timely basis. These disclosure controls and procedures include
controls and procedures designed to ensure that information required to be
disclosed in reports we file or submit under the federal securities laws is
accumulated and communicated to management, including our principal executive
officer (“CEO”) and principal financial officer (“CFO”), on a timely basis to
allow decisions regarding required disclosure. Management, with the
participation of our CEO and CFO, evaluated the effectiveness of our disclosure
controls and procedures as of September 30, 2008.  Based on this
evaluation, management has concluded that our disclosure controls and procedures
were not effective as of September 30, 2008 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.




During
the period covered by this quarterly report, we identified a control deficiency
that was deemed a material weakness in internal controls over financial
reporting at 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.





Management
intends to remedy the material weakness by hiring additional accounting
department staff, and reallocating duties, including responsibilities for
financial reporting, among the Company’s employees.   Based on
the lack of resources available to hire and train employees, management does not
expect this to be remediated by the end of the year.





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.




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




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





53





PART
II. OTHER INFORMATION





Item
1.  Legal Proceedings





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





In March
2002, Plaintiff filed an action against NovaStar Home Mortgage, Inc. (“NHMI”) in
Superior Court of Orange County, California entitled American Interbanc Mortgage
LLC v. NovaStar Home Mortgage, Inc. et. al. (the “California
Action”).  In the California Action, Plaintiff alleged that NHMI and
two other mortgage companies (“Defendants”) engaged in false advertising and
unfair competition under certain California statutes and interfered
intentionally with Plaintiff’s prospective economic relations. On May 4, 2007, a
jury returned a verdict by a 9-3 vote awarding Plaintiff $15.9 million. The
court trebled the award, made adjustments for amounts paid by settling
Defendants, and entered a $46.1 million judgment against Defendants on June 27,
2007 (the “Judgment”).  The award is joint and several against the
Defendants, including NHMI.





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





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





Pursuant
to the Settlement Terms, the Involuntary Bankruptcy was dismissed on April 24,
2008 and on May 8, 2008, the Company paid Plaintiff $2.0 million plus the
balance in an account established by order of the Bankruptcy Court, and NHMI
satisfied obligations totaling $48,000 to certain identified
creditors.  In addition to the initial payments made to the Plaintiff
following dismissal of the Involuntary Bankruptcy, the Company agreed to pay
Plaintiff $5.5 million if, prior to July 1, 2010, (i) NFI’s average common stock
market capitalization is at least $94.4 million over a period of five
consecutive business days, or (ii) the holders of NFI’s common stock are paid
$94.4 million in net asset value as a result of any sale of NFI or its
assets.  If NFI is sold prior to July 1, 2010 for less than $94.4
million and ceases to be a public company, then NFI will obligate the purchaser
to pay Plaintiff $5.5 million in the event the value of the company exceeds
$94.4 million prior to July 1, 2010 as determined by an independent valuation
company.





Pursuant
to the Settlement Terms, the releases of NHMI and its affiliate became
effective on September 11, 2008.     As a result,
NHMI  has reversed a previously recorded liability of $45.2 million
that was included in the consolidated financial statements of the
Company.





Trust Preferred
Settlement.On September 12,
2008, a petition for involuntary Chapter 7 bankruptcy entitled In re NovaStar
Mortgage, Inc. (Case No. 08-12125-CSS) was filed against NMI by the holders of
the trust preferred securities in U.S. Bankruptcy Court for the District of
Delaware in Wilmington, Delaware.  The filing did not include NFI or
any other subsidiary or affiliate of NFI.  On February 18, 2009, the
Company, NMI, NovaStar Capital Trust I, NovaStar Capital Trust II and the trust
preferred securities holders entered into agreements to settle the claims of the
trust preferred securities holders arising from NMI’s failure to make the
scheduled quarterly interest payments on certain unsecured notes issued by NMI
to the trusts.  The settlement was contingent upon, among other
things, the dismissal of the involuntary Chapter 7 bankruptcy.  On
March 9, 2009, the Bankruptcy Court entered an order dismissing the involuntary
proceeding.See
Note 6—Trust Preferred Obligations above for additional discussion of the claims
of the petitioners and the settlement.





Other
Litigation.  Since April 2004,
a number of substantially similar class action lawsuits have been filed and
consolidated into a single action in the United States District Court for the
Western District of Missouri. The consolidated complaint names the Company and
three of the Company’s current and former executive officers as defendants and
generally alleges that the defendants made public statements that were
misleading for failing to disclose certain regulatory and licensing matters. The
plaintiffs purport to have brought this consolidated action on behalf of all
persons who purchased the Company’s common stock (and sellers of put options on
the Company’s common stock) during the period October 29, 2003 through April 8,
2004. On January 14, 2005, the Company filed a motion to dismiss
this action, and on May 12, 2005, the court denied such motion. On February
8, 2007, the court certified the case as a class action. The Company has entered
into a settlement agreement to resolve these pending class action lawsuits. The
total amount of the settlement, which is subject to the approval of the United
States District Court for the Western District of Missouri, is $7.25 million,
and it will be paid by the Company’s insurance carriers. The settlement
agreement contains no admission of fault or wrongdoing by the Company or other
defendants.




54





At this
time, the Company cannot predict the probable outcome of the following claims
and as such no amounts have been accrued in the condensed 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 Court
dismissed the plaintiffs’ complaints without leave to amend.  The
plaintiffs have filed an appeal of the Court’s ruling.




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





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.
 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 in connection with seek monetary damages, 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.  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, and plaintiff has filed a motion to remand the case to state court. 
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.  Pursuant to a stipulation, the
Company has not yet filed its initial responsive pleading, and discovery is not
yet underway.   The Company believes it has meritorious defenses to
the case and expects to defend the case vigorously.




55





On July
7, 2008, plaintiff Jennifer Jones filed a purported class action case in the
United States District Court for the Western District of Missouri against the
Company, certain 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 believes it has meritorious defenses to the
case and expects to defend the case vigorously.





On
September 12, 2008, a petition for involuntary Chapter 7 bankruptcy entitled In
re NovaStar Mortgage, Inc. (Case No. 08-12125-CSS) was filed against NMI by the
holders of the trust preferred securities in U.S. Bankruptcy Court for the
District of Delaware in Wilmington, Delaware.  The filing did not include
NFI or any other subsidiary or affiliate of NFI.  On February 18, 2009, the
Company, NMI, NovaStar Capital Trust I, NovaStar Capital Trust II and the trust
preferred securities holders entered into agreements to settle the claims of the
trust preferred securities holders arising from NMI’s failure to make the
scheduled quarterly interest payments on certain unsecured notes issued by NMI
to the trusts.  The settlement was contingent upon, among other
things, the dismissal of the involuntary Chapter 7 bankruptcy.  On
March 9, 2009, the Bankruptcy Court entered an order dismissing the involuntary
proceeding.See
Note 6—Borrowings above for additional discussion of the claims of the
petitioners and the settlement.





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.





On
October 21, 2008, EHD Holdings, LLC, the purported owner of the building which
leases the Company its former principal office space in Kansas City, filed an
action for unpaid rent in the Circuit Court of Jackson County,
Missouri.  The action seeks the immediate possession of the office
space, unpaid rent though October 20, 2008 of approximately $1.1 million, plus
any accruing rent thereafter, plus attorney fees.





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





In
addition, the Company has received requests or subpoenas for information from
various regulators or law enforcement officials, including, without limitation,
the United States Department of Justice, the Federal Bureau of Investigation,
the New York Attorney General and the Department of Labor.





Item
1A.  Risk Factors





Risk
Factors




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




Risks
Related to Recent Changes in Our Business





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




56





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





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





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





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





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





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





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





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





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




57





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





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





Based on
current projections, the cash flows from our remaining mortgage securities will
continue to significantly decrease to levels that are below our current expenses
and that are below levels necessary to commence other operations. Because our
known obligations exceed our existing assets, because of the liquidation rights
and preferences of our preferred stock and because of the current conditions in
the capital markets, the issuance of additional equity for new capital is highly
unlikely.  Consequently, we are attempting to restructure our
indebtedness and certain contractual obligations, and we are assessing potential
changes to our preferred stock.  Our ability to implement any
restructuring is dependent upon and agreement of various third parties and
security holders.  We can provide no assurance that any negotiations
or other efforts to restructure our debt will be successful.  To the
extent that they are not, we would be unlikely to be able to continue as a going
concern and would be likely to seek the protection of applicable bankruptcy
laws.





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





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





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





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





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





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





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




58





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





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





We are
not required to pay out our taxable income in the form of dividends, as we are
no longer subject to a REIT distribution requirement. Instead, payment of
dividends is at the discretion of our board of directors.  To preserve
liquidity, our board of directors has suspended dividend payments on our Series
C Preferred Stock and Series D1 Preferred Stock.  Dividends on our
Series C Preferred Stock and D1 Preferred Stock continue to accrue and the
dividend rate on our Series D1 Preferred Stock increased from 9.0% to 13.0%,
compounded quarterly, effective January 16, 2008 with respect to all unpaid
dividends and subsequently accruing dividends.  No dividends can be
paid on any of our common stock until all accrued and unpaid dividends on our
Series C Preferred Stock and Series D1 Preferred Stock are paid in
full.  Accumulating dividends with respect to our preferred stock will
negatively affect the ability of our common stockholders to receive any
distribution or other value upon liquidation.





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





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





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





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





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





Risks
Related to Interest Rates and Our Hedging Strategies





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





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





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





59





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


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


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





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





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





Risks
Related to Credit Losses





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





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





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





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





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





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





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




60





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





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





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





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





Mortgage
insurance mitigates the risk of credit losses. We face the risk that the
mortgage insurers insuring loans serving as collateral for our mortgage
securities might not have the financial ability to pay all claims presented or
may deny a claim if the loan is not properly serviced, has been improperly
originated, is the subject of fraud, or for other reasons. Any of those events
could increase our credit losses and thus adversely affect our results of
operations, financial condition, liquidity and cash flows, and ability to
continue as a going concern.





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





Over-concentration
in any one geographic area of our loans held for sale or underlying our mortgage
securities increases our exposure to the economic risks associated with that
area. Declines in the residential real estate markets in which we are
concentrated, including California and Florida, have reduced the values of the
properties collateralizing our mortgages which in turn has increased the risk of
delinquency, foreclosure, or losses from those loans. In addition, increases in
the unemployment rate in markets in which we are concentrated increases the
likelihood that borrowers in those areas may become delinquent on their loans.
To the extent that borrowers in a geographic area in which we have made a
significant number of loans become delinquent or otherwise default on such
loans, the value of, and cash flows from, our mortgage securities and loans held
for sale will further decrease which will adversely affect our operating
results, liquidity, cash flows, financial condition and ability to continue as a
going concern.





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





Standard
homeowner insurance policies generally do not provide coverage for natural
disasters, such as hurricanes and floods. Furthermore, nonconforming borrowers
are not likely to have special hazard insurance. To the extent that borrowers do
not have insurance coverage for natural disasters, they may not be able to
repair the property or may stop paying their mortgages if the property is
damaged. A natural disaster that results in a significant number of
delinquencies could cause increased foreclosures and decrease our ability to
recover losses on properties affected by such disasters, and that in turn could
negatively affect the value of, and cash flows from, our mortgage assets, which
will adversely affect our operating results, liquidity, cash flows, financial
condition and ability to continue as a going concern.





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





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




61





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





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





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





Risks
Related to Our Capital Stock





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





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





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


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


·
              actual
      or anticipated changes in residential real estate
  values;


·
              actual
      or anticipated changes in market interest
rates;


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


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


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


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


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


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


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


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


·
              actions
      by institutional
shareholders.





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





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





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


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


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





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




62





Other
Risks Related to our Business





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





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





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





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





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





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





The
accounting for our mortgage assets may result volatility of our results of
operations and our financial statements.





The
accounting treatment applicable to our mortgage assets is dependent on various
factors outside of our control and may significantly affect our results of
operations and financial statements. As current turmoil in the subprime industry
continues to affect the characteristics of our mortgage assets we may be
required to adjust the accounting treatment of our assets.  As a
result of this, stockholders must undertake a complex analysis to understand our
earnings (losses), cash flows and financial condition.




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


(dollars
in thousands)


Issuer Purchases of Equity SecuritiesTotal NumberofShares
                  Purchased
                
                
                Average
                  Price Paid
                  per Share
                
                
                Total Number of
                  SharesPurchasedasPart of PubliclyAnnouncedPlansorPrograms
                
                
                Approximate Dollar
                  Value of Shares That
                  May Yet BePurchasedUnderthe Plans orPrograms (A)July
      1, 2008 – July 31, 2008
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                $
                1,020August
      1, 2008 – August 31, 2008
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                $
                1,020September
      1, 2008 – September 30, 2008
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                $
                1,020





(A)
            Current
      report on Form 8-K was filed on October 2, 2000 announcing that the Board
      of Directors authorized the Company to repurchase its common shares, in an
      amount not to exceed $9 million.




63





Item
3. Defaults Upon Senior Securities





The
Company’s wholly owned subsidiary NovaStar Mortgage, Inc. (“NMI”) has
approximately $77.2 million in principal amount of unsecured notes
(collectively, the “Notes”) outstanding to NovaStar Capital Trust I and NovaStar
Capital Trust II (collectively, the “Trusts”) which secure trust preferred
securities issued by the Trusts.    The Company has
guaranteed NMI's obligations under the Notes.





NMI
failed to make quarterly interest payments that were due on March 30, April 30,
June 30, July 30, September 30, October 30 and December 30, 2008, and January 30
and March 30, 2009 totaling, for all payment dates combined, approximately $6.1
million on the Notes.  As a result, NMI is in default under the
related indentures and the Company is in default under the related
guarantees.  An agreement by the trustees and trust preferred security
holders of the Trusts to forbear in the exercise of remedies with respect to the
initial payment defaults expired on May 30, 2008.  Consequently, the
trustee and holders of 25% of the outstanding trust preferred securities of each
Trust have the right to accelerate all principal, accrued interest, and other
obligations of NMI under the related Notes and to demand payment of all such
amounts from the Company under the related guarantees.  The total
principal and accrued interest owed under the Notes, net of amounts owed in
respect of the trust preferred securities held by NMI, was approximately $84.0
million as of April 27, 2009.  In addition, the Company is obligated
to reimburse the trustees for all reasonable expenses, disbursements and
advances in connection with the exercise of rights under the
indentures.





On
September 12, 2008, a petition for involuntary Chapter 7 bankruptcy entitled In
re NovaStar Mortgage, Inc. (Case No. 08-12125-CSS) was filed against NMI by the
holders of the trust preferred securities in U.S. Bankruptcy Court for the
District of Delaware in Wilmington, Delaware.  The filing did not include
NFI or any other subsidiary or affiliate of NFI.  On March 9, 2009, the
Bankruptcy Court entered an order dismissing the involuntary
proceeding.





On
February 18, 2009, the Company, NMI, the Trusts and the trust preferred security
holders entered into agreements to settle the claims of the trust preferred
security holders arising from NMI’s failure to make the scheduled quarterly
interest payments on the Notes.  As part of the settlement, the
existing preferred obligations would be exchanged for new preferred
obligations.  The settlement and exchange were contingent upon, among
other things, the dismissal of the involuntary Chapter 7
bankruptcy.  On March 9, 2009, the Bankruptcy Court entered an order
dismissing the involuntary proceeding.  On April 27, 2009 (the
“Exchange Date”), the parties executed the necessary documents to complete the
Exchange.  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.





To preserve liquidity, the
Company’s Board of Directors has suspended the payment of dividends on its 8.9%
Series C Cumulative Redeemable Preferred Stock (the “Series C Preferred Stock”)
and its Series D1 Mandatory Convertible Preferred Stock (the “Series D1
Preferred Stock”).As a result, dividends continue to accrue
on the Series C Preferred Stock and Series D1 Preferred Stock.  The Company has total
accrued dividends payable related to the Series C Preferred Stock and Series D1
Preferred Stock of $23.9 million as of April 27, 2009.  All
accrued and unpaid dividends on the Company’s preferred stock must be paid prior
to any payments of dividends or other distributions on the Company’s common
stock.  In addition, if at any time dividends on the Series C
Preferred Stock are in arrears for six or more quarterly periods (whether or not
consecutive), the holders of the Series C Preferred Stock, voting as a single
class, have the right to elect two additional directors to the Company’s Board
of Directors.  The Company does not expect to pay any dividends for
the foreseeable future.




64





Dividends
on the Series C Preferred Stock are payable in cash and accrue at a rate of
8.90% annually.  Accrued and unpaid dividends payable related to the
Series C Preferred Stock were approximately $6.7 million as of September 30,
2008 and $10.5 million as of April 27, 2009.




On March
17, 2009, the Company notified the holders of the Series C Preferred Stock that
the Company would not make the dividend payment on the Series C Preferred Stock
due on March 31, 2009.  Because dividends on the Series C Preferred
Stock are presently in arrears for five quarters, under the terms of the
Articles Supplementary to the Company’s Charter that established the Series C
Preferred Stock, the holders of the Series C Preferred Stock had the right, as
of March 31, 2009, to elect two additional directors to the Company’s board of
directors.  The notice also allowed the holders of the Series C
Preferred Stock to make nominations for the election of the two additional
directors to occur by vote of the holders of the Series C Preferred Stock at the
Company’s next annual meeting of stockholders.





Dividends
on the Series D1 Preferred Stock are payable in cash and accrue at a rate of
9.00% per annum, or 13.00% per annum if any such dividends are not declared and
paid when due.  The dividend rate on the Series D1 Preferred Stock
increased from 9.0% to 13.0%, compounded quarterly, effective October 16, 2007
with respect to all unpaid dividends and subsequently accruing
dividends.  Accrued and unpaid
dividends payable related to the Series D1 Preferred Stock were approximately
$8.7 million as of September 30, 2008 and $13.4 million as of April 27,
2009.





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





None.





Item
5. Other Information





None.





Item
6. Exhibits





Exhibit
Listing





Exhibit No.
                    
                    Description
      of Document10.55
                    
                    Confidential
      Settlement Term Sheet Agreement, dated March 17, 2008, between American
      Interbanc Mortgage LLC, NovaStar Financial, Inc., NovaStar Mortgage, Inc.,
      NFI Holding Corp., and NovaStar Home Mortgage, Inc. (Complete Agreement
      Filed Due to Expiration of Confidential Treatment
  Request)11.11
                    
                    Statement
      Regarding Computation of Per Share Earnings31.1
                    
                    Chief
      Executive Officer Certification - Section 302 of the Sarbanes-Oxley Act of
      200231.2
                    
                    Principal
      Financial Officer Certification - Section 302 of the Sarbanes-Oxley Act of
      200232.1
                    
                    Chief
      Executive Officer Certification - Section 906 of the Sarbanes-Oxley Act of
      200232.2
                    
                    Principal
      Financial Officer Certification - Section 906 of the Sarbanes-Oxley Act of
      2002




1  See
Note 15 to the condensed consolidated financial statements.




65





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:
      April 27, 2009
              
              /s/ W. LANCE
  ANDERSONW. Lance Anderson, Chairman of the
                Board of Directors and Chief
                Executive Officer(Principal Executive Officer)DATE:
      April 27, 2009
              
              /s/ RODNEY E.
    SCHWATKENRodney E. Schwatken, Chief
                Financial Officer(Principal Financial Officer)




66