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

x
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
      SECURITIESEXCHANGE ACT OF 1934For the
      Quarterly Period Ended March 31, 2009o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
      SECURITIESEXCHANGE ACT OF 1934


For the Transition Period From
to___________ to ________________________________

Commission File Number
001-13533

NOVASTAR FINANCIAL,
INC.(Exact Name of Registrant as
Specified in its Charter)

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

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

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

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

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

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

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

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

The number of shares of the Registrants
Common Stock outstanding on July 10, 2009 was 9,368,053.

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---

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|NOVASTAR FINANCIAL, INC.
      FORM 10-QFor the Quarterly
      Period Ended March 31, 2009
|-------------------------------------------------------------------------------------------
|                                                                                           
|                                                                                           
|**TABLE OF
      CONTENTS**                                                                

|Part
      I |  | Financial
      Information                                                                 |   
|------------ |  | ------------------------------------------------------------------------------------------- | --
|             |  |                                                                                             |   
|Item 1.      |  | Financial Statements (Unaudited)                                                            | 1 
|             |  | Condensed
      Consolidated Balance Sheets                                                 | 1 
|             |  | Condensed Consolidated Statements of Operations                                             | 2 
|             |  | Condensed Consolidated Statement of Shareholders
      Deficit                             | 3 
|             |  | Condensed Consolidated Statements of Cash Flows                                             | 4 
|             |  | Notes to Condensed Consolidated Financial Statements                                        | 6 
|             |  |                                                                                             |   
|Item 2.      |  | Managements Discussion and Analysis of Financial Condition and
      Results of Operations | 23
|             |  |                                                                                             |   
|Item 3.      |  | Quantitative and Qualitative Disclosures About Market
      Risk                            | 36
|             |  |                                                                                             |   
|Item 4.      |  | Controls and Procedures                                                                     | 36
|             |  |                                                                                             |   
|Part II      |  | Other Information                                                                           | 37
|             |  |                                                                                             |   
|Item 1.      |  | Legal Proceedings                                                                           | 37
|             |  |                                                                                             |   
|Item 1A.     |  | Risk Factors                                                                                | 38
|             |  |                                                                                             |   
|Item 2.      |  | Unregistered Sales of Equity Securities and Use of
      Proceeds                           | 39
|             |  |                                                                                             |   
|Item 3.      |  | Defaults Upon Senior Securities                                                             | 39
|             |  |                                                                                             |   
|Item 4.      |  | Submission of Matters to a Vote of Security Holders                                         | 39
|             |  |                                                                                             |   
|Item 5.      |  | Other Information                                                                           | 40
|             |  |                                                                                             |   
|Item 6.      |  | Exhibits                                                                                    | 40

---

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

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

|                                                                                     | March 31, |            | December 31,
|------------------------------------------------------------------------------------ | --------- | ---------- | ------------
|                                                                                     | 2009      |            | 2008        
|Assets                                                                               |           |            |             
|Unrestricted cash and cash
      equivalents                                         | $         | 20,008     |             
|Restricted cash                                                                      |           | 6,059      |             
|Mortgage loans  held-in-portfolio, net of allowance of $793,679
      and $776,001, |           |            |             
|respectively                                                                         |           | 1,603,659  |             
|Mortgage securities  trading                                                        |           | 3,767      |             
|Mortgage securities  available-for-sale                                             |           | 11,091     |             
|Real estate owned                                                                    |           | 91,279     |             
|Accrued interest receivable                                                          |           | 76,053     |             
|Other assets                                                                         |           | 5,942      |             
|Assets of discontinued operations                                                    |           | -          |             
|Total assets                                                                         | $         | 1,817,858  |             
|                                                                                    
|Liabilities
      and Shareholders Deficit                                          |           |            |             
|Liabilities:                                                                         |           |            |             
|Asset-backed bonds secured by mortgage
    loans                                     | $         | 2,521,280  |             
|Asset-backed bonds secured by mortgage
      securities                              |           | 3,073      |             
|Junior subordinated debentures                                                       |           | 77,446     |             
|Due to servicer                                                                      |           | 135,145    |             
|Dividends payable                                                                    |           | 22,785     |             
|Accounts payable and other liabilities                                               |           | 31,858     |             
|Liabilities of discontinued operations                                               |           | -          |             
|Total liabilities                                                                    |           | 2,791,587  |             
|                                                                                    
|Commitments and contingencies (Note 7)                                               |           |            |             
|                                                                                    
|Shareholders deficit :                                                              |           |            |             
|Capital stock, $0.01 par value, 50,000,000 shares
      authorized:                  |           |            |             
|Redeemable preferred stock, $25 liquidating preference
      per share; 2,990,000    |           |            |             
|shares, issued and outstanding                                                       |           | 30         |             
|Convertible participating preferred stock, $25
      liquidating preference per      |           |            |             
|share; 2,100,000 shares, issued and
      outstanding                                |           | 21         |             
|Common stock, 9,368,053, issued and
      outstanding                                |           | 94         |             
|Additional paid-in capital                                                           |           | 786,253    |             
|Accumulated deficit                                                                  |           | (1,767,044 | )           
|Accumulated other comprehensive income                                               |           | 6,898      |             
|Other                                                                                |           | (122       | )           
|Total NovaStar Financial Inc.s shareholders
      deficit                          |           | (973,870   | )           
|Noncontrolling interests                                                             |           | 141        |             
|Total shareholders deficit                                                          |           | (973,729   | )           
|Total liabilities and shareholders
    deficit                                      | $         | 1,817,858  |             

See notes to condensed consolidated
financial statements.

1

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

|                                                                          | For the Three Months Ended
|------------------------------------------------------------------------- | --------------------------
|                                                                          | March 31,                 
|                                                                          | 2009                      
|Interest income                                                           | $                         
|Interest
      expense                                                    |                           
|Net interest income before provision for credit losses                    |                           
|Provision for
      credit losses                                         |                           
|Net interest expense after provision for credit losses                    |                           
|                                                                         
|Other operating
      expense:                                            |                           
|Losses on derivative
      instruments                                    |                           
|Fair value adjustments                                                    |                           
|Impairment on mortgage securities  available-for-sale                    |                           
|Appraisal fee income                                                      |                           
|Appraisal fee expense                                                     |                           
|Premiums for mortgage loan insurance                                      |                           
|Servicing fee expense                                                     |                           
|Other income, net                                                         |                           
|Total other operating expense                                             |                           
|                                                                         
|General and
      administrative expenses:                                |                           
|Compensation and benefits                                                 |                           
|Office administration                                                     |                           
|Professional and outside services                                         |                           
|Other appraisal management expenses                                       |                           
|Other                                                                     |                           
|Total general
      and administrative expenses                           |                           
|                                                                         
|Loss from
      continuing operations before income tax                   |                           
|Income tax expense                                                        |                           
|Loss from
      continuing operations                                     |                           
|Loss from discontinued operations, net of income tax                      |                           
|Net
    loss                                                              |                           
|Less: Net loss attributable to noncontrolling interests                   |                           
|Net loss
      available to common shareholders                           | $                         
|Basic earnings per share:                                                 |                           
|Loss from continuing operations available to
      common shareholders    | $                         
|Loss from discontinued operations, net of income tax                      |                           
|Net loss attributable to common
    shareholders                          | $                         
|Diluted earnings per share:                                               |                           
|Loss from continuing operations attributable to
      common shareholders | $                         
|Loss from discontinued operations, net of income tax                      |                           
|Net loss attributable to common
    shareholders                          | $                         
|Weighted average basic shares outstanding                                 |                           
|Weighted average
      diluted shares outstanding                         |                           

See notes to condensed consolidated
financial statements.

2

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

|                                                |               |    | Convertible   |   |            |  |                |    |                 |   |                   |   |                 | **Accumulated** |            |   |                   |   |           |   |  |  
|----------------------------------------------- | ------------- | -- | ------------- | - | ---------- |  | -------------- | -- | --------------- | - | ----------------- | - | --------------- | --------------- | ---------- | - | ----------------- | - | --------- | - |  | -
|                                                | Redeemable    |    | Participating |   |            |  | **Additional** |    |                 |   | **Other**         |   | Non             |                 |            |   |                   |   | **Total**
|                                                | **Preferred** |    | **Preferred** |   | **Common** |  | **Paid-in**    |    | **Accumulated** |   | **Comprehensive** |   | **controlling** |                 |            |   | **Shareholders'**
|                                                | Stock         |    | Stock         |   | Stock      |  | Capital        |    | Deficit         |   | Income            |   | Interest        |                 | Other      |   | **Deficit**      
|Balance,
      January 1, 2009                  | $             | 30 |               | $ | 21         |  | $              | 94 |                 | $ | 786,279           |   |                 | $               | (1,671,984 | ) |                   | $ | 8,926     |   |  | $
|Other                                           |               | -  |               |   | -          |  |                | -  |                 |   | (26               | ) |                 |                 | -          |   |                   |   | -         |   |  |  
|Accumulating
      dividends on preferred stock |               | -  |               |   | -          |  |                | -  |                 |   | -                 |   |                 |                 | (3,696     | ) |                   |   | -         |   |  |  
|Contribution from noncontrolling interests      |               | -  |               |   | -          |  |                | -  |                 |   | -                 |   |                 |                 | -          |   |                   |   | -         |   |  |  
|Comprehensive
      loss:                       |               |    |               |   |            |  |                |    |                 |   |                   |   |                 |                 |            |   |                   |   |           |   |  |  
|Net loss                                        |               | -  |               |   | -          |  |                | -  |                 |   | -                 |   |                 |                 | (91,364    | ) |                   |   | -         |   |  |  
|Other
      comprehensive loss                  |               | -  |               |   | -          |  |                | -  |                 |   | -                 |   |                 |                 | -          |   |                   |   | (2,028    | ) |  |  
|Total comprehensive loss                        |               | -  |               |   | -          |  |                | -  |                 |   | -                 |   |                 |                 | -          |   |                   |   | -         |   |  |  
|Balance,
      March 31, 2009                   | $             | 30 |               | $ | 21         |  | $              | 94 |                 | $ | 786,253           |   |                 | $               | (1,767,044 | ) |                   | $ | 6,898     |   |  | $

3

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

|                                                                                   | For the
      Three Months Ended
|---------------------------------------------------------------------------------- | --------------------------------
|                                                                                   | March 31,                       
|                                                                                   | 2009                            
|Cash flows from
      operating activities:                                        |                                 
|Net
      loss                                                                     | $                               
|Loss from discontinued
      operations                                            |                                 
|Loss
      from continuing operations                                              |                                 
|Adjustments to
      reconcile loss from continuing operations to net cash used in |                                 
|operating activities:                                                              |                                 
|Accretion of
      available-for-sale and trading securities                       |                                 
|Interest capitalized on loans held-in-portfolio                                    |                                 
|Amortization of premiums on mortgage loans                                         |                                 
|Amortization of deferred debt issuance costs                                       |                                 
|Provision for credit losses                                                        |                                 
|Impairments on mortgage securities 
      available-for-sale                      |                                 
|Fair
      value adjustments                                                       |                                 
|Losses on derivative instruments                                                   |                                 
|Other                                                                              |                                 
|Depreciation expense                                                               |                                 
|Changes in:                                                                        |                                 
|Accrued interest receivable                                                        |                                 
|Derivative instruments, net                                                        |                                 
|Other assets                                                                       |                                 
|Due to servicer                                                                    |                                 
|Accounts payable and other liabilities                                             |                                 
|Net cash provided by operating activities from continuing
      operations         |                                 
|Net cash used in operating activities from discontinued
      operations           |                                 
|Net cash provided by (used in) operating
    activities                            |                                 
|                                                                                  
|Cash flows from
      investing activities:                                        |                                 
|Proceeds from paydowns on mortgage securities -
      available-for-sale           |                                 
|Proceeds from paydowns
      of mortgage securities - trading                      |                                 
|Proceeds from repayments of mortgage loans
      held-in-portfolio                 |                                 
|Proceeds from sales of
      assets acquired through foreclosure                   |                                 
|Cash
      used to collateralize letter of credit                                  |                                 
|Purchases of property
      and equipment                                          |                                 
|Net cash provided by investing activities                                          |                                 
|Net cash provided by investing activities from
      discontinued operations       |                                 
|Net cash provided by investing activities                                          |                                 
|                                                                                   |                                 

4

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|                                                                         | For the Three Months Ended
|------------------------------------------------------------------------ | --------------------------
|                                                                         | March 31,                 
|Cash flows
      from financing activities:                              | 2009                      
|Payments on
      asset-backed bonds                                     |                           
|Net change in short-term borrowings                                      |                           
|Contributions
      from noncontrolling interests                        |                           
|Dividends paid on vested stock options                                   |                           
|Net cash used in financing activities from continuing operations         |                           
|Net cash used in financing activities from
      discontinued operations |                           
|Net cash used in financing activities                                    |                           
|Net decrease in cash and cash equivalents                                |                           
|Cash and cash
      equivalents, beginning of period                     |                           
|Cash and cash equivalents, end of period                                 | $                         
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|Supplemental
      Disclosure of Cash Flow Information                   |                           
|(unaudited; dollars in
      thousands)                                  |                           
|                                                                         | For the Three Months Ended
|                                                                         | March 31,                 
|                                                                         | 2009                      
|Cash paid for interest                                                   | $                         
|Cash paid for
      income taxes                                         |                           
|Non-cash investing and financing activities:                             |                           
|Assets acquired through
      foreclosure                                |                           
|Preferred stock dividends accrued, not yet paid                          |                           
|See notes to condensed
      consolidated financial statements.          |                           

5

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|NOVASTAR
      FINANCIAL, INC.                                           
|-------------------------------------------------------------------------
|NOTES TO
      CONDENSED CONSOLIDATED FINANCIAL STATEMENTS               
|As of and for the quarterly period
      ended March 31, 2009 (Unaudited)

Note 1. Financial Statement
Presentation

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

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

On April 26, 2009, the Company acquired a
majority interest in Advent Financial Services, LLC, a start-up operation which
will provide access to tailored banking accounts, small dollar banking products
and related services to meet the needs of low and moderate income level
individuals. Management is continuing to evaluate opportunities to invest excess
cash as it is available.

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

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.

As of January 1, 2009, the Company adopted
SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statementsan
amendment of ARB No. 51 (SFAS 160). SFAS 160 requires that noncontrolling
interests (formerly known as minority interests) be displayed in the
consolidated balance sheet as a separate component of shareholders equity and
that the consolidated net earnings attributable to the noncontrolling interests
be clearly indentified and presented in the consolidated statement of earnings.
The Company previously acquired StreetLinks, and as part of the acquisition
certain of StreetLinks former owners retained ownership interests in the
business. At the time of purchase, StreetLinks had a net deficit, therefore the
beginning noncontrolling interests balance was zero. From the acquisition date
to the end of 2008, StreetLinks had a net loss so no losses were attributed to
the noncontrolling interests since it was already at zero, therefore the
beginning balance of the noncontrolling interests at January 1, 2009 was zero.
These interests are presented on its condensed consolidated balance sheet as
noncontrolling interests. In addition, earnings attributable to the
noncontrolling interests are shown on its condensed consolidated statement of
operations for the three months ended March 31, 2009.

On January 1, 2009, the Company adopted
Financial Accounting Standards Board (FASB) Staff Position EITF 03-6-1,
Determining Whether Instruments Granted in Share-Based Payment Transactions Are
Participating Securities (EITF 03-6-1). EITF 03-6-1 states that unvested
share-based payment awards that contain nonforfeitable rights to dividends or
dividend equivalents are participating securities as defined in EITF 03-6,
Participating Securities and the Two-Class Method under FASB Statement No. 128
(EITF 03-6), and therefore should be included in computing EPS using the
two-class method. The Companys adoption of EITF 03-6-1 required us to recast
previously reported EPS, and did not have a significant impact on EPS.

Going Concern Considerations-As of March 31, 2009, the Companys total
liabilities exceeded its total assets under GAAP, resulting in a shareholders
deficit. The Companys losses, negative cash flows, shareholders deficit, and
lack of significant business operations raise substantial doubt about the
Companys ability to continue as a going concern and, therefore, may not realize
its assets and discharge its liabilities in the normal course of business. There
is no assurance that cash flows will be sufficient to meet the Companys
obligations. The Companys consolidated financial statements have been prepared
on a going concern basis of accounting which contemplates continuity of
operations, realization of assets, liabilities and commitments in the normal
course of business. The Companys condensed consolidated financial statements do
not reflect any adjustments relating to the recoverability and classification of
recorded asset amounts or to the amounts and classification of liabilities that
may be necessary should the Company be unable to continue as a going
concern.

6

---

The Companys condensed consolidated
financial statements as of March 31, 2009 and for the three months ended March
31, 2009 and 2008 are unaudited. In the opinion of management, all necessary
adjustments have been made, which were of a normal and recurring nature, for a
fair presentation of the condensed consolidated financial statements. There have
been no reclassifications to prior year amounts to conform to current year
presentation.

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

Current Liquidity and Near-Term
Obligations- As of July 10, 2009, the
Company had approximately $20.7 million in available cash on hand (including $6.1
million in restricted cash). In addition to the Companys operating expenses,
the Company has quarterly interest payments due on its trust preferred
securities and intends to make payments in settlement of obligations related to
its discontinued lending and servicing operations. The Companys current
projections indicate sufficient available cash and cash flows from its mortgage
securities to meet these payment needs during the remainder of 2009. However,
the cash flow from the Companys mortgage securities is volatile and uncertain
in nature, and the amounts the Company receives could vary materially from its
projections. Therefore, no assurances can be given that the Company will be able
to meet its cash flow needs, in which case it may seek protection of applicable
bankruptcy laws.

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

Business Plan-The Company 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 the
current assumptions. The Company also has significant obligations with respect
to junior subordinated notes relating to the trust preferred securities. In
April 2009, the Company restructured its obligations under the junior
subordinated notes relating to trust preferred securities. The details of this
restructuring are discussed in Note 6.

As discussed above, the Company acquired a
controlling interest in an appraisal management company, StreetLinks, in August
2008 and in April 2009, the Company acquired a controlling interest in Advent
Financial Services LLC.

Note 2. New Accounting Pronouncements

In June 2009, the FASB issued SFAS No.
167, Amendments to FASB Interpretation No. 46(R) (SFAS 167), which amends
the consolidation guidance applicable to variable interest entities (VIEs).
The amendments to the consolidation guidance affect all entities currently
within the scope of FIN 46(R), as well as qualifying special-purpose entities
(QSPEs) that are currently excluded from the scope of FIN 46(R). SFAS 167 is
effective as of the beginning of the first fiscal year that begins after
November 15, 2009.The Company is continuing to evaluate the impact that SFAS 167
would have on its financial condition and results of operation upon adoption.

In June 2009, the FASB issued SFAS No.
166, Accounting for Transfers of Financial Assets  an amendment of FASB
Statement No. 140 (SFAS 166). SFAS 166 amends the derecognition accounting
and disclosure guidance relating to SFAS 140. SFAS 166 eliminates the exemption
from consolidation for QSPEs, it also requires a transferor to evaluate all
existing QSPEs to determine whether it must be consolidated in accordance with
SFAS 167. SFAS 166 is effective for financial asset transfers occurring after
the beginning of an entitys first fiscal year that begins after November 15,
2009. The Company is continuing to evaluate the impact that SFAS 166 would have
on its financial condition and results of operation upon adoption.

In May 2009, the FASB issued SFAS No. 165,
Subsequent Events (SFAS 165), which establish general standards of
accounting for and disclosure of events that occur after the balance sheet date
but before financial statements are issued. SFAS 165 is for interim or annual
periods ending after June 15, 2009. The adoption of SFAS 165 is not expected to
have a material effect on the Companys financial statements.

7

---

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 the Company
as of January 1, 2009. SinceSFAS No. 161 only
requires certain additional disclosures, it did not have an effect on the
Companys financial statements. See Note 10 for further information regarding
these disclosures.

In December 2007, FASB issued Statement of
Financial Accounting Standards 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 non-controlling 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 Company adopted SFAS
141(R) effective January 1, 2009. The adoption of this standard may have an
impact on the accounting for certain costs related to any future acquisitions.

Note 3. Mortgage Loans  Held in
Portfolio

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

|                                                 | March 31, |           | December 31,
|------------------------------------------------ | --------- | --------- | ------------
|                                                 | 2009      |           | 2008        
|Mortgage
      loans  held-in-portfolio:        |           |           |             
|Outstanding
principal                            | $         | 2,379,622 |             
|Net unamortized deferred
      origination costs |           | 17,716    |             
|Amortized cost                                   |           | 2,397,338 |             
|Allowance for credit
      losses                |           | (793,679  | )           
|Mortgage loans 
      held-in-portfolio         | $         | 1,603,659 |             
|Weighted average
    coupon                      |           | 7.73%     |             
|                                                

Mortgage loans held-in-portfolio consist
of loans that the Company has securitized in structures that are accounted for
as financings. These securitizations are structured legally as sales, but for
accounting purposes are treated as financings under SFAS 140, Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities 
a replacement of FASB Statement 125 (SFAS 140). See below for details of the
Companys securitization transactions structured as financings.

These securitizations are structured
legally as sales, but for accounting purposes are treated as financings as
defined by SFAS No. 140. 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 these
securitizations remain on the balance sheet as Mortgage loans -
held-in-portfolio. Given this treatment, retained interests are not created,
and securitization bond financing is reflected on the balance sheet as a
liability. The Company records interest income on loans held-in-portfolio and
interest expense on the bonds issued in the securitizations over the life of the
securitizations. Deferred debt issuance costs and discounts related to the bonds
are amortized on a level yield basis over the estimated life of the
bonds.

At March 31, 2009 all of the loans
classified as held-in-portfolio were pledged as collateral for financing
purposes.

8

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Activity in the allowance for credit
losses on mortgage loans  held-in-portfolio is as follows for the three months
ended March 31, 2009 and 2008, respectively (dollars in thousands):

|                                  | For the Three Months
|--------------------------------- | --------------------
|                                  | Ended March 31,     
|                                  | 2009                
|Balance, beginning of period      | $                   
|Provision for
      credit losses |                     
|Charge-offs, net of recoveries    |                     
|Balance, end of
      period      | $                   
|                                 

FSP FAS 140-4 and FIN 46(R)-8, which were
adopted by the Company on December 31, 2008, provide the disclosure requirements
for transactions with variable interest entities (VIEs) or special purpose
entities (SPEs) and transfers of financial assets in securitizations or
asset-backed financing arrangements. Under this guidance, the Company is
required to disclose information for consolidated VIEs, for VIEs in which the
Company is the sponsor as defined below or is a significant variable interest
holder (Sponsor/Significant VIH) and for VIEs that are established for
securitizations and asset-backed financing arrangements. FSP FAS 140-4 and FIN
46(R)-8 has expanded the population of VIEs for which disclosure is required.

The Company has defined sponsor to
include all transactions where the Company has transferred assets to a VIE
and/or structured the VIE, regardless of whether or not the asset transfer has
met the sale conditions in SFAS No. 140. The Company discloses all instances
where continued involvement with the assets exposes it to potential economic
gain/(loss), regardless of whether or not that continued involvement is
considered to be a variable interest in the VIE.

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

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

Securitization
transactions For the purposes of this
disclosure, securitization transactions include transactions where the Company
transferred mortgage loans and accounted for the transfer as a sale. This
category includes both QSPEs and non-QSPEs and is reflected in the
securitization section of this Note. QSPEs are commonly used by the Company in
securitization transactions as described below. In accordance with SFAS No. 140
and FIN 46(R),the Company does not consolidate QSPEs.

Mortgage Loan VIEs- The Company consolidates securitization transactions that
are structured legally as sales, but for accounting purposes are treated as
financings as defined by SFAS 140. 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 were able to acquire derivatives
relating to beneficial interests retained by the Company. Additionally, the
Company had the unilateral ability to repurchase a limited number of loans back
from the trusts. These provisions were removed effective September 30, 2008.
Since the removal of these provisions was not considered substantive, 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. These
transactions continue to fail QSPE status and require consolidation and related
disclosures. The Company has no control over the mortgage loans held by these
VIEs due to their legal structure. Therefore, these mortgage loans have been
pledged to the bondholders in the VIEs, and these assets are included in the
firm-owned assets pledged balance reported within this note. In most instances,
the beneficial interest holders in these VIEs have no recourse to the general
credit of the Company; rather their investments are paid exclusively from the
assets in the VIE. Securitization VIEs hold loan assets and are financed through
the issuance of several classes of debt (i.e., tranches) with ratings that range
from AAA to unrated residuals.

Collateralized Debt Obligations
(CDO)- In the first quarter of 2007 the
Company closed a CDO. The collateral for this securitization consisted of
subordinated securities which the Company retained from its loan securitizations
as well as subordinated securities purchased from other issuers. This
securitization was structured legally as a sale, but for accounting purposes was
accounted for as a financing under SFAS 140. This securitization did not meet
the qualifying special purpose entity criteria under SFAS 140. Accordingly, the
securities remain on the Companys balance sheet, retained interests were not
created, and securitization bond financing replaced the short-term debt used to
finance the securities.

9

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

Variable Interest
Entities

FIN 46(R) requires an entity to
consolidate a VIE if that entity holds a variable interest that will absorb a
majority of the VIEs expected losses, receive a majority of the VIEs expected
residual returns, or both. The entity required to consolidate a VIE is known as
the primary beneficiary. VIEs are reassessed for consolidation when
reconsideration events occur. Reconsideration events include, changes to the
VIEs governing documents that reallocate the expected losses/returns of the VIE
between the primary beneficiary and other variable interest holders or sales and
purchases of variable interests in the VIE.

There were no material reconsideration
events during the period.

The table below provides the disclosure
information required by FSP FAS 140-4 and FIN 46(R)-8 for VIEs that are
consolidated by the Company (dollars in thousands):

|                        |              |           |              | Assets After
    Intercompany |                | Liabilities After |              |                
|----------------------- | ------------ | --------- | ------------ | ----------------------------- | -------------- | ----------------- | ------------ | ---------------
|                        |              |           |              | Eliminations                  |                | Intercompany      |              | Recourse to the
|Consolidated
      VIEs | Total Assets |           | Unrestricted |                               | Restricted (A) |                   | Eliminations |                
|March 31,
      2009    |              |           |              |                               |                |                   |              |                
|Mortgage Loan VIEs(C)   | $            | 1,780,121 |              | $                             | -              |                   | $            | 1,770,813      
|CDOs(D)                 |              | 3,934     |              | -                             |                |                   | 3,677        |                
|December 31,
      2008 |              |           |              |                               |                |                   |              |                
|Mortgage Loan VIEs(C)   | $            | 1,930,063 |              | $                             | -              |                   | $            | 1,920,610      
|CDOs(D)                 |              | 7,242     |              |                               | -              |                   |              | 6,842          

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

Securitizations

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

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

|                        | Size/Principal |           | Assets on |   | Liabilities      |  | Maximum     |   | Year to   |   | Year to            
|----------------------- | -------------- | --------- | --------- | - | ---------------- |  | ----------- | - | --------- | - | -------------------
|                        | Outstanding    |           | Balance   |   | on
      Balance |  | Exposure to |   | Date Loss |   | **Date
      Cash**
|                        | (A)            |           | Sheet(B)  |   | Sheet(B)         |  | Loss(C)     |   | on Sale   |   | Flows              
|March 31,
      2009    |                |           |           |   |                  |  |             |   |           |   |                    
|Residential mortgage    |                |           |           |   |                  |  |             |   |           |   |                    
|loans(D)                | $              | 7,818,874 |           | $ | 12,366           |  | $           | - |           | $ | 12,366             
|December 31,
      2008 |                |           |           |   |                  |  |             |   |           |   |                    
|Residential mortgage    |                |           |           |   |                  |  |             |   |           |   |                    
|loans(D)                | $              | 8,121,668 |           | $ | 15,919           |  | $           | - |           | $ | 15,919             
|                       

|(A) |  | Size/Principal
      Outstanding reflects the estimated principal of the underlying assets held
      by the VIE/SPEs.                                                                                                                                                                                                                                                                                                                                               
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(B) |  | Assets and Liabilities
      on the Companys Balance Sheet reflect the effect of FIN 39 balance sheet
      netting, if applicable.                                                                                                                                                                                                                                                                                                                                 
|(C) |  | The maximum exposure
      to loss includes the following: the assets held by the Company  including
      the value of derivatives that are in an asset position and retained
      interests in the VIEs/SPEs; and the notional amount of liquidity and other
      support generally provided through total return swaps. The maximum
      exposure to loss for liquidity and other support assumes a total loss on
      the referenced assets held by the VIE.
|(D) |  | For residential
      mortgage loans QSPEs, assets on balance sheet are primarily securities
      issued by the entity and are recorded in Mortgage
      securities-available-for-sale and Mortgage
  securities-trading.                                                                                                                                                                                                                                          

10

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

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

Retained interests are reviewed
periodically for impairment. Retained interests in securitized assets held as
available-for-sale and trading were approximately $11.6 million and $13.5
million at March 31, 2009 and December 31, 2008, respectively.

The following table presents information
on retained interests excluding the offsetting benefit of financial instruments
used to hedge risks, held by the Company as of March 31, 2009 arising from the
Companys residential mortgage-related securitization transactions. The pre-tax
sensitivities of the current fair value of the retained interests to immediate
10% and 25% adverse changes in assumptions and parameters are also shown
(dollars in thousands):

|Carrying amount/fair value of
      residual interests                                             | $ | 11,619
|-------------------------------------------------------------------------------------------------- | - | ------
|Weighted average
      life (in years)                                                             |   | 3.71  
|Weighted average prepayment speed assumption (CPR)
    (percent)                                   |   | 18    
|Fair value after a 10%
      increase in prepayment speed                                          | $ | 11,024
|Fair value after a 25%
      increase in prepayment speed                                          | $ | 10,196
|Weighted average
      expected annual credit losses (percent of current collateral
      balance) |   | 25.3  
|Fair value after a 10%
      increase in annual credit losses                                      | $ | 10,142
|Fair value after a 25%
      increase in annual credit losses                                      | $ | 8,926 
|Weighted average residual cash flows discount rate
    (percent)                                   |   | 25.3  
|Fair value after a 500 basis
      point increase in discount rate                                 | $ | 11,106
|Fair value after a 1000 basis
      point increase in discount rate                                | $ | 10,636
|Market interest
      rates:                                                                       |   |       
|Fair value after a 100 basis
      point increase in market rates                                  | $ | 6,870 
|Fair value after a 200 basis point increase in market rates                                        | $ | 4,312 

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

Note 4. Mortgage Securities 
Available-for-Sale

As of March 31, 2009, and December 31,
2008, mortgage securities  available-for-sale consisted entirely of the
Companys investment in the residual securities issued by securitization trusts
sponsored by the Company, but did not include the NMFT Series 2007-2 residual
security, which was designated as trading as a result of the Companys adoption
of SFAS 155, Accounting for Certain Hybrid Financial Instruments, an amendment
of SFAS 133 and SFAS 140 (SFAS 155) on January 1, 2007. 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.

11

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

|                        |            |       |      |            |        |                  | Unrealized Losses |                |           |         |        | 
|----------------------- | ---------- | ----- | ---- | ---------- | ------ | ---------------- | ----------------- | -------------- | --------- | ------- | ------ | 
|                        |            |       |      | Unrealized |        | Less Than Twelve |                   | Estimated Fair |           | Average
|                        | Cost Basis |       | Gain |            | Months |                  | Value             |                | Yield (A)
|As of March 31, 2009    | $          | 4,194 |      | $          | 6,897  |                  | $                 | -              |           | $       | 11,091 | 
|As of December 31, 2008 | $          | 3,771 |      | $          | 9,017  |                  | $                 | -              |           | $       | 12,788 | 

|(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. Since a number of these securities have a minimal or
      zero-cost basis this information is not
meaningful.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

During the three months ended March 31,
2009 and 2008, management concluded that the decline in value on certain
securities in the Companys mortgage securities  available-for-sale portfolio
were other-than-temporary. As a result, the Company recognized impairments on
mortgage securities  available-for-sale of $0.2 million and $19.4 million
during the three months ended March 31, 2009 and 2008, respectively.

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

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

|                                       |               |         |       | Amortized Cost |            |  |           |       | Average
|-------------------------------------- | ------------- | ------- | ----- | -------------- | ---------- |  | --------- | ----- | -------
|                                       | Original Face |         | Basis |                | Fair Value |  | Yield (A)
|As of March
      31, 2009             |               |         |       |                |            |  |           |       |        
|Subordinated securities pledged to CDO | $             | 332,489 |       | $              | 324,847    |  | $         | 2,766 |        
|Other
      subordinated securities    |               | 102,625 |       |                | 98,306     |  |           | 473   |        
|Residual securities                    |               | -       |       |                | 15,247     |  |           | 528   |        
|Total                                  | $             | 435,114 |       | $              | 438,400    |  | $         | 3,767 |        
|                                      
|As of December 31, 2008                | $             | 435,114 |       | $              | 433,968    |  | $         | 7,085 |        
|                                      

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

The Company recognized net trading losses
of $7.7 million and $51.6 million for the three months ended March 31, 2009 and
2008, respectively. These net trading losses are included in the fair value
adjustments line on the companys condensed consolidated statements of
operations.

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

Note 6. Borrowings

Junior Subordinated
Debentures

NFIs wholly owned subsidiary NovaStar
Mortgage, Inc. (NMI) has approximately $77.4 million in principal amount of
unsecured notes (collectively, the Notes) outstanding to NovaStar Capital
Trust I and NovaStar Capital Trust II (collectively, the Trusts) which secure
trust preferred securities issued by the Trusts. NFI has guaranteed NMI's
obligations under the Notes.

NMI failed to make quarterly interest
payments that were due on 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 was in default under the related indentures and NFI was in default
under the related guarantees as of March 31, 2009.

12

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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 24, 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.

Note 7. Commitments and
Contingencies

Contingencies

Trust Preferred Settlement.See Note 6Borrowings for a detailed
discussion of the settlement terms and restructuring of the Companys junior
subordinated debentures, including the dismissal of the involuntary Chapter 7
bankruptcy filed against NovaStar Mortgage, Inc. (Case No. 08-12125-CSS) by the
holders of the trust preferred securities in U.S. Bankruptcy Court for the
District of Delaware in Wilmington, Delaware.

Litigation.

At this time, the Company cannot predict
the probable outcome of the following claims and as such no amounts have been
accrued in the consolidated financial statements.

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

In May 2007, a lawsuit entitledNational Community Reinvestment Coalition v.
NovaStar Financial, Inc.,et al., was filed against
the Company in the United States District Court for the District of Columbia.
Plaintiff, a non-profit organization, alleges that the Company maintains
corporate policies of not making loans on Indian reservations, on dwellings used
for adult foster care or on rowhouses in Baltimore, Maryland in violation of the
federal Fair Housing Act. The lawsuit seeks injunctive relief and damages,
including punitive damages, in connection with the lawsuit. On May 30, 2007, the
Company responded to the lawsuit by filing a motion to dismiss certain of
plaintiffs claims. On March 31, 2008 that motion was denied by the Court. 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. On May 15,
2009 the Court granted Companys motion to dismiss. The City of Cleveland has
filed a notice of intent to appeal. The Company believes that these claims are
without merit and will vigorously defend against them.

13

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

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

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

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

On October 21, 2008, EHD Holdings, LLC
(EHD), 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. On April 24, 2009, EHD filed a motion
for summary judgment seeking approximately $3.3 million, in past due rent and
charges, included in the Accounts payable and other liabilities line item of the
balance sheet, plus accruing rent and charges for future periods, plus attorney
fees. On June 30, 2009, the Company executed a settlement agreement with EHD
whereby the Company is released from all past and future obligations under its
lease agreement and paid $5 million to EHD in July 2009. EHD and the Company
also agreed to take the necessary steps for the dismissal of all legal
proceedings related to the lease agreement.

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

14

---

Note 8. Comprehensive
Income

The following is a rollforward of
accumulated other comprehensive income for the three months ended March 31, 2009
and 2008 (dollars in thousands):

|                                                                                         | For the Three Months
|---------------------------------------------------------------------------------------- | --------------------
|                                                                                         | Ended March 31,     
|                                                                                         | 2009                
|Net loss                                                                                 | $                   
|Other
      comprehensive income (loss):                                                 |                     
|Change in unrealized loss on
      mortgage securities  available-for-sale              |                     
|Impairment on mortgage
      securities - available-for-sale reclassified to earnings    |                     
|Change in unrealized gain on
      derivative instruments used in cash flow hedges       |                     
|Net settlements of derivative
      instruments used in cash flow hedges reclassified to |                     
|earnings                                                                                 |                     
|Other comprehensive income (loss)                                                        |                     
|Total
      comprehensive loss                                                           |                     
|Comprehensive loss attributable to noncontrolling
    interests                          |                     
|Total comprehensive loss attributable to NovaStar Financial,
Inc.                        | $                   
|                                                                                        

Note 9. Fair Value Accounting

Fair Value Measurements (SFAS
157)

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

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

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

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

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

|                                               |                    |        |                  | Fair
      Value Measurements at Reporting Date Using
|---------------------------------------------- | ------------------ | ------ | ---------------- | -----------------------------------------------------
|                                               |                    |        |                  | Quoted Prices                                        
|                                               |                    |        |                  | in
      Active                                      
|                                               | Fair Value         |        | Markets for      |                                                      
|                                               | at
      March 31, |        | Identical Assets |                                                      
|Description                                    | 2009               |        | (Level 1)        |                                                      
|Assets:                                        |                    |        |                  |                                                      
|Mortgage securities -trading                   | $                  | 3,767  |                  | $                                                    
|Mortgage
      securities  available-for-sale |                    | 11,091 |                  |                                                      
|Total assets                                   | $                  | 14,858 |                  | $                                                    
|                                               |                    |        |                  |                                                      
|Liabilities:                                   |                    |        |                  |                                                      
|Asset-backed bonds secured by mortgage         |                    |        |                  |                                                      
|securities                                     | $                  | 3,073  |                  | $                                                    
|Derivative instruments,
      net              |                    | 8,564  |                  |                                                      
|Total
      liabilities                        | $                  | 11,637 |                  | $                                                    
|                                              

15

---

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

The following tables provide a
reconciliation of the beginning and ending balances for the Companys mortgage
securities  trading which are measured at fair value on a recurring basis using
significant unobservable inputs (Level 3) for the three months ended March 31,
2009 and 2008 (dollars in thousands):

|                                                               |            |         |                 |  |            |          |   |  | Estimated Fair
|-------------------------------------------------------------- | ---------- | ------- | --------------- |  | ---------- | -------- | - |  | --------------
|                                                               |            |         |                 |  |            |          |   |  | Value of      
|                                                               |            |         |                 |  |            |          |   |  | Mortgage      
|                                                               | Cost Basis |         | Unrealized Loss |  | Securities
|As of December 31, 2008                                        | $          | 433,968 |                 |  | $          | (426,883 | ) |  | $             
|Increases (decreases) to
      mortgage securities  trading:  |            |         |                 |  |            |          |   |  |               
|Accretion of income                                            |            | 6,917   |                 |  |            | -        |   |  |               
|Proceeds from paydowns of
      securities                     |            | (2,485  | )               |  |            | -        |   |  |               
|Mark-to-market value
      adjustment                          |            | -       |                 |  |            | (7,750   | ) |  |               
|Net (decrease) increase to
      mortgage securities - trading |            | 4,432   |                 |  |            | (7,750   | ) |  |               
|As of March 31, 2009                                           | $          | 438,400 |                 |  | $          | (434,633 | ) |  | $             
|                                                              
|                                                              
|                                                               |            |         |                 |  |            |          |   |  | Estimated Fair
|                                                               |            |         |                 |  |            |          |   |  | Value of      
|                                                               |            |         |                 |  |            |          |   |  | Mortgage      
|                                                               | Cost Basis |         | Unrealized Loss |  | Securities
|As of December 31, 2007                                        | $          | 41,275  |                 |  | $          | (16,534  | ) |  | $             
|Increases (decreases) to
      mortgage securities  trading:  |            |         |                 |  |            |          |   |  |               
|Accretion of income                                            |            | 2,286   |                 |  |            | -        |   |  |               
|Proceeds from paydowns of
      securities                     |            | (12,578 | )               |  |            | -        |   |  |               
|Mark-to-market value
      adjustment                          |            | -       |                 |  |            | 2,585    |   |  |               
|Net (decrease) increase to
      mortgage securities - trading |            | (10,292 | )               |  |            | 2,585    |   |  |               
|As of March
      31, 2008                                     | $          | 30,983  |                 |  | $          | (13,949  | ) |  | $             
|                                                              

16

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The following tables provide a
reconciliation of the beginning and ending balances for the Companys mortgage
securities  available-for-sale which are measured at fair value on a recurring
basis using significant unobservable inputs (Level 3) for the three months ended
March 31, 2009 and 2008 (dollars in thousands):

|                                                                          |            |        |                 |  |            |        |   |  | Estimated Fair
|------------------------------------------------------------------------- | ---------- | ------ | --------------- |  | ---------- | ------ | - |  | --------------
|                                                                          |            |        |                 |  |            |        |   |  | Value of      
|                                                                          |            |        |                 |  |            |        |   |  | Mortgage      
|                                                                          | Cost Basis |        | Unrealized Gain |  | Securities
|As of December 31, 2008                                                   | $          | 3,771  |                 |  | $          | 9,017  |   |  | $             
|Increases (decreases) to
      mortgage securities  available-for-sale:  |            |        |                 |  |            |        |   |  |               
|Accretion of
      income (A)                                             |            | 4,522  |                 |  |            | -      |   |  |               
|Proceeds from
      paydowns of securities (A) (B)                        |            | (3,897 | )               |  |            | -      |   |  |               
|Impairment on mortgage
      securities  available-for-sale              |            | (202   | )               |  |            | -      |   |  |               
|Mark-to-market value
      adjustment                                     |            | -      |                 |  |            | (2,120 | ) |  |               
|Net (decrease) increase to
      mortgage securities  available-for-sale |            | 423    |                 |  |            | (2,120 | ) |  |               
|As of March 31,
      2009                                                | $          | 4,194  |                 |  | $          | 6,897  |   |  | $             
|                                                                         

|(A) |  | Cash received on
      mortgage securities with no cost basis was $32,000 for the three months
      ended March 31, 2009.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(B) |  | For mortgage
      securities with a remaining cost basis, the Company reduces the cost basis
      by the amount of cash that is contractually due from the securitization
      trusts. In contrast, for mortgage securities in which the cost basis has
      previously reached zero, the Company records in interest income the amount
      of cash that is contractually due from the securitization trusts. In both
      cases, there are instances where the Company may not receive a portion of
      this cash until after the balance sheet reporting date. Therefore, these
      amounts are recorded as receivables from the securitization trusts. As of
      March 31, 2009, the Company had no receivables from securitization trusts
      related to mortgage securities available-for-sale with a remaining cost
      basis.

|                                                                          |            |         |                 |  |            |         |          |  | Estimated Fair
|------------------------------------------------------------------------- | ---------- | ------- | --------------- |  | ---------- | ------- | -------- |  | --------------
|                                                                          |            |         |                 |  |            |         |          |  | Value of      
|                                                                          |            |         |                 |  |            |         | Mortgage
|                                                                          | Cost Basis |         | Unrealized Gain |  | Securities
|As of December 31, 2007                                                   | $          | 33,302  |                 |  | $          | 69      |          |  | $             
|Increases (decreases) to
      mortgage securities  available-for-sale:  |            |         |                 |  |            |         |          |  |               
|Accretion of
      income (A)                                             |            | 1,940   |                 |  |            | -       |          |  |               
|Proceeds from
      paydowns of securities (A)                            |            | (4,049  | )               |  |            | -       |          |  |               
|Impairment on mortgage securities 
      available-for-sale              |            | (19,380 | )               |  |            | 19,380  |          |  |               
|Mark-to-market value adjustment                                           |            | -       |                 |  |            | (16,128 | )        |  |               
|Net (decrease) increase to
      mortgage securities  available-for-sale |            | (21,489 | )               |  |            | 3,252   |          |  |               
|As of March 31,
      2008                                                | $          | 11,813  |                 |  | $          | 3,321   |          |  | $             
|                                                                         

|(A) |  | 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
      March 31, 2008 and December 31, 2007, the Company had receivables from
      securitization trusts of $2.7 million and $12.5 million, respectively,
      related to mortgage securities available-for-sale with a remaining cost
      basis.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

17

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

|                  |  |             |        |                                                          
|----------------- |  | ----------- | ------ | ---------------------------------------------------------
|                  |  |             |        | **Fair Value Measurements at Reporting Date
      Using**
|                  |  |             |        | Quoted Prices in                                         
|                  |  |             |        | Active Markets for                                       
|                  |  | Real Estate |        | Identical Assets                                         
|Fair Value at     |  |             | Owned  |                                                          
|March 31, 2009    |  | $           | 91,279 |                                                          
|December 31, 2008 |  |             | 70,480 |                                                          

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

The following table provides a summary of
the impact to earnings for the three months ended March 31, 2009 and 2008 from
the Companys assets and liabilities related to continuing operations which are
measured at fair value on a recurring and nonrecurring basis as of March 31,
2009 (dollars in thousands):

|                                               |  | Fair Value  |  | Fair Value Adjustments For
      the |         |                                  
|---------------------------------------------- |  | ----------- |  | ------------------------------------ | ------- | ---------------------------------
|Asset or
      Liability Measured              |  | Measurement |  | Three Months Ended March 31,         |         | Statement
      of Operation Line
|at Fair Value                                  |  | Frequency   |  | 2009                                 |         |                                  
|Mortgage securities - trading                  |  | Recurring   |  | $                                    | (7,750  | )                                
|                                               |  |             |  |                                      |         |                                  
|Mortgage securities 
      available-for-sale |  | Recurring   |  |                                      | (202    | )                                
|                                               |  |             |  |                                      |         |                                  
|Derivative instruments, net                    |  | Recurring   |  |                                      | (4,195  | )                                
|Asset-backed
      bonds secured by            |  |             |  |                                      |         |                                  
|mortgage securities                            |  | Recurring   |  |                                      | 2,040   |                                  
|Total fair value gains (losses)                |  |             |  | $                                    | (10,107 | )                                

Valuation Methods

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

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

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

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

18

---

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

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

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

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

The Company elected the fair value option
for the asset-backed bonds issued from NovaStar ABS CDO I, which closed in the
first quarter of 2007. The Company elected the fair value option for these
liabilities to help reduce earnings volatility which otherwise would arise if
the accounting method for this debt was not matched with the fair value
accounting for the related mortgage securities - trading. The asset-backed bonds
which are being carried at fair value are included in the Asset-backed bonds
secured by mortgage securities line item on the condensed consolidated balance
sheets. The Company recognized a fair value adjustment of $2.0 million and $38.9
million during the three months ended March 31, 2009 and 2008, respectively,
which is included in the Fair value adjustments line item on the condensed
consolidated statements of operations. The Company calculates interest expense
for these asset-backed bonds based on the prevailing coupon rates of the
specific classes of debt and records interest expense in the period incurred.
Interest expense amounts are included in the Interest expense line item of the
condensed consolidated statements of operations.

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

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

|                                     |  | Asset-Backed     |         |                   |   |           
|------------------------------------ |  | ---------------- | ------- | ----------------- | - | ----------
|                                     |  | Bonds Secured by |         |                   |   |           
|                                     |  | Mortgage         |         | Year to Date Gain |   |           
|Unpaid Principal Balance as
      of |  | Securities       |         | Recognized        |   | Fair Value
|March 31, 2009                       |  | $                | 323,707 |                   | $ | 2,040     
|December 31, 2008                    |  |                  | 324,243 |                   |   | 38,888    

Substantially all of the $2.0 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.

Note 10. Derivative Instruments and
Hedging Activities

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

The derivative instruments used by the
Company to manage this risk are interest rate caps and interest rate swaps.
Interest rate caps are contracts in which the Company pays either an upfront
premium or monthly or quarterly premium to a counterparty. In return, the
Company receives payments from the counterparty when interest rates rise above a
certain rate specified in the contract. During the three months ended March 31,
2009 and 2008, premiums paid pursuant to interest rate cap agreements related to
continuing operations aggregated $20,000 and $0.1 million, respectively. When
premiums are financed by the Company, a liability is recorded for the premium
obligation. Premiums due to counterparties as of March 31, 2009 and December 31,
2008, respectively were $40,000 and $0.1 million, respectively, and had a
weighted average interest rate of 3.9% for both periods. The future contractual
maturities of premiums due to counterparties as of March 31, 2009 are $40,000
due during 2009. There is no future contractual maturities premium due in 2010
or thereafter. The interest rate swap agreements to which the Company is party
stipulate that the Company pay a fixed rate of interest to the counterparty and
the counterparty pays the company a variable rate of interest based on the
notional amount of the contract. The liabilities the Company hedges are
asset-backed bonds as discussed in Note 3.

19

---

During 2007, the Company entered into
several inter-related transactions involving credit default swaps (CDS) and
other investments. A CDS is an agreement to provide credit event protection
based on a specific security in exchange for receiving an upfront premium and a
fixed-rate fee over the life of the contract. The additional investments
purchased bear yields that mirror LIBOR. The result of the transaction is to
create an instrument that mirrors the results of thereferenced securities underlying the CDS. 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. The fair value was $0.1 million
and $0.2 million as of March 31, 2009 and December 31, 2008, respectively. The
Company recorded losses related to fair value adjustments of $0.1 million and
$1.1million for the three months ended March 31, 2009 and 2008, respectively.
These losses are included in the Losses on derivative instruments line item of
the Companys condensed consolidated statements of operations.

These CDS are accounted for as non-cash
flow hedging derivative instruments, reported at fair value with the changes in
fair value recognized through the Companys statements of operations. The value
of these contracts decrease for a variety of reasons, including when the
probability of the occurrence of a specific credit event increases, when the
markets perceptions of default risk in general change, or when there are
changes in the supply and demand of these instruments.

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

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

|                                             |  |                 |         |            |   | Maximum 
|-------------------------------------------- |  | --------------- | ------- | ---------- | - | --------
|                                             |  |                 |         |            |   | Days to 
|                                             |  | Notional Amount |         | Fair Value |   | Maturity
|As of March
      31, 2009:                  |  |                 |         |            |   |         
|Non-hedge derivative instruments             |  | $               | 461,500 |            | $ | (8,564  
|                                            
|As of
      December 31, 2008:               |  |                 |         |            |   |         
|Non-hedge derivative instruments             |  | $               | 461,500 |            | $ | (9,034  
|Cash flow
      hedge derivative instruments |  |                 | 40,000  |            |   | (68     

The Company recognized net expense of $1.4
million and $0.8 million during the three months ended March 31, 2009 and March
31, 2008, respectively, on derivative instruments qualifying as cash flow
hedges, which is recorded as a component of interest expense.

During the three months ended March 31,
2009 and 2008, respectively, hedge ineffectiveness was insignificant.

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

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

20



---

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

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

Note 11. Income Taxes

Based on the evidence available as of
March 31, 2009 and December 31, 2008, including the significant pre-tax losses
incurred by the Company since 2007, the liquidity issues facing the Company and
the decision by the Company to close all of its mortgage lending and loan
servicing operations, the Company believes that it is more likely than not that
the Company will not realize its deferred tax assets. Based on these
conclusions, the Company recorded a valuation allowance against its entire net
deferred tax assets as of March 31, 2009 and December 31, 2008.

The Company recognizes tax benefits in
accordance with FIN 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 March
31, 2009 and December 31, 2008, the total gross amount of unrecognized tax
benefits was $0.5 million and $0.5 million, respectively.

Note 12. Segment
Reporting

As of March 31, 2009, the Company reviews,
manages and operates its business in one segment: portfolio management.
Portfolio management operating results come from the income generated on the
mortgage assets the Company manages less associated costs. The portfolio
management segments operating results for the three months ended March 31, 2009
and 2008 are the same as the Companys condensed consolidated statements of
operations.

21



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Note 13. Loss Per Share



The computations of basic and diluted loss
per share for the three months ended March 31, 2009 and 2008 (dollars in
thousands, except per share amounts):

|                                                                       |  | For the Three Months Ended
|---------------------------------------------------------------------- |  | --------------------------
|                                                                       |  | March 31,                 
|                                                                       |  | 2009                      
|Numerator:                                                             |  |                           
|Loss from continuing operations                                        |  | $                         
|Less loss attributable to noncontrolling interests                     |  |                           
|Dividends on preferred shares                                          |  |                           
|Loss from continuing operations available to common
      shareholders |  |                           
|Loss from discontinued operations, net of
      income tax             |  |                           
|Loss available to common shareholders                                  |  | $                         
|                                                                      
|Denominator:                                                           |  |                           
|Weighted average common shares outstanding  basic                     |  |                           
|                                                                      
|Weighted average
      common shares outstanding  dilutive:           |  |                           
|Weighted average common shares outstanding 
      basic               |  |                           
|Stock options                                                          |  |                           
|Restricted stock                                                       |  |                           
|Weighted average
      common shares outstanding  dilutive            |  |                           
|                                                                      
|Basic
      earnings per share:                                        |  |                           
|Loss from continuing operations                                        |  | $                         
|Less loss attributable to noncontrolling
      interests               |  |                           
|Dividends on preferred shares                                          |  |                           
|Loss from continuing operations available to
      common shareholders |  |                           
|Loss from discontinued operations, net of income tax                   |  |                           
|Net loss available to common
      shareholders                        |  | $                         
|                                                                      
|Diluted
      earnings per share:                                      |  |                           
|Loss from continuing operations                                        |  | $                         
|Less loss attributable to noncontrolling
      interests               |  |                           
|Dividends on preferred shares                                          |  |                           
|Loss from continuing operations available to
      common shareholders |  |                           
|Loss from discontinued operations, net of income tax                   |  |                           
|Net loss available to common
      shareholders                        |  | $                         
|                                                                      

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

|                                       |  | For the Three Months Ended
|-------------------------------------- |  | --------------------------
|                                       |  | March 31,                 
|                                       |  | 2009                      
|Number of stock options (in thousands) |  |                           
|Weighted average exercise
      price  |  | $                         

22

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

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

Executive Overview

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

Because of severe declines in housing
prices and national and international economic crises, we have suffered
significant losses since 2007 because of declining values of our investments in
mortgage loans and securities. Liquidity constraints forced us to reduce
operations and administrative staff and take other measures to conserve
cash.

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

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

Going Concern Considerations -If the cash flows from our mortgage
securities are less than currently anticipated, and if we are unable to generate
positive cash flow and earnings from our operations and/or restructure our
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
federal and state bankruptcy laws. Due to the fact that we have a negative net
worth, and that we do not currently have ongoing significant business operations
that are profitable, 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.

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. There is substantial doubt that we
will be able to continue as a going concern and, therefore, may be unable to
realize our assets and discharge our 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 nor to the
amounts and classification of liabilities that may be necessary should we be
unable to continue as a going concern.

Impact of Recently Issued Accounting
Pronouncements -In June 2009, the FASB
issued SFAS No. 167,Amendments to FASB
Interpretation No. 46(R) (SFAS 167), which amends the consolidation guidance
applicable to variable interest entities (VIEs). The amendments to the
consolidation guidance affect all entities currently within the scope of FIN
46(R), as well as qualifying special-purpose entities (QSPEs) that are
currently excluded from the scope of FIN 46(R). SFAS 167 is effective as of the
beginning of the first fiscal year that begins after November 15, 2009. The
Company is continuing to evaluate the impact that SFAS 167 would have on its
financial condition and results of operation upon adoption.

In June 2009, the FASB issued SFAS No.
166, Accounting for Transfers of Financial Assets  an amendment of FASB
Statement No. 140 (SFAS 166). SFAS 166 amends the derecognition accounting
and disclosure guidance relating to SFAS 140. SFAS 166 eliminates the exemption
from consolidation for QSPEs, it also requires a transferor to evaluate all
existing QSPEs to determine whether it must be consolidated in accordance with
SFAS 167. SFAS 166 is effective for financial asset transfers occurring after
the beginning of an entitys first fiscal year that begins after November 15,
2009. The Company is continuing to evaluate the impact that SFAS 166 would have
on its financial condition and results of operation upon adoption.

23

---

In May 2009, the FASB issued SFAS No. 165,
Subsequent Events (SFAS 165), which establish general standards of
accounting for and disclosure of events that occur after the balance sheet date
but before financial statements are issued. SFAS 165 is for interim or annual
periods ending after June 15, 2009. The adoption of SFAS 165 is not expected to
have a material effect on the Companys financial statements.

In June 2008, the FASB issued FASB Staff
Position No. EITF 03-6-1 "Determining Whether Instruments Granted in Share-Based
Payment Transactions Are Participating Securities" (FSP EITF 03-6-1). FSP EITF
03-6-1 was issued to clarify that instruments granted in share-based payment
transactions can be participating securities prior to the requisite service
having been rendered. The guidance in FSP EITF 03-6-1 applies to the calculation
of Earnings Per Share ("EPS") under Statement 128 for share-based payment awards
with rights to dividends or dividend equivalents. Unvested share-based payment
awards that contain non-forfeitable rights to dividends or dividend equivalents
(whether paid or unpaid) are participating securities and shall be included in
the computation of EPS pursuant to the two-class method. FSP EITF 03-6-1 is
effective January 1, 2009. All prior-period EPS data presented shall be adjusted
retrospectively (including interim financial statements, summaries of earnings,
and selected financial data) to conform with the provisions of FSP EITF 03-6-1.
The adoption of FSP EITF 03-6-1 required the Company to include certain
restricted stock shares in its earnings per share calculations but did not have
a significant impact on the Companys 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 the Company
as of January 1, 2009. SinceSFAS No. 161 only
requires certain additional disclosures, it did not have an effect on the
Companys financial statements. See Note 10 for further information regarding
these disclosures.

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 January 1, 2009. The adoption of SFAS 160
required the Company to present the noncontrolling interests on the condensed
consolidated balance sheet, statement of operations, and statement of
shareholders deficit.

In December 2007, FASB issued Statement of
Financial Accounting Standards 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 non-controlling 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 Company adopted SFAS
141(R) effective January 1, 2009. The adoption of this standard may have an
impact on the accounting for certain costs related to any future acquisitions.

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

The key performance measures for executive
management are:

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

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

24

---

|Table 1  Summary of Financial Highlights and Key Performance
      Metrics
|---------------------------------------------------------------------------
|(dollars in thousands; except per
      share amounts)                     
|                                                                           
|                                                                           
|Cash and cash equivalents, including restricted cash                       
|                                                                           
|                                                                           
|                                                                           
|                                                                           
|Net loss available to common
      shareholders, per diluted share         

Liquidity During the first quarter of 2009, we received $6.1 million in
cash on our securities portfolio. We received $1.7 million in gross appraisal
fee income. We used cash to pay for current operating and administrative costs,
invest in StreetLinks and pay for costs related to our legacy mortgage lending
and servicing operations. As of March 31, 2009, we had $26.1 million in cash,
cash equivalents and restricted cash, a decrease of $4.8 million from December
31, 2008. As of July 10, 2009, we have $20.7 million in cash and cash equivalents
(including restricted cash of $6.1 million). See Liquidity and Capital
Resources for further discussion of our liquidity position and steps we have
taken to preserve liquidity levels.

As part of our near-term future strategy,
we will focus on building our operating businesses, minimizing losses,
preserving liquidity and, if and when cash is available, investing in
opportunities that can contribute positively to our liquidity position. Our
mortgage securities are a primary source of new cash flows. Based on the current
projections, the cash flows from our mortgage securities will 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. While StreetLinks is generating
significant cash, it is using all cash generated in building its infrastructure
to sustain growth. We have no outstanding lending facilities available for
liquidity purposes. We have significant outstanding obligations relating to our
discontinued operations, as well as payment obligations with respect to
unsecured debt. Our liquidity consists solely of cash and cash
equivalents.

Significant Recent
EventsIn April 2009, we restructured our junior subordinated
debenture. See Note 6 to the condensed consolidated financial statements for
discussion of the restructuring. As discussed above, subsequent to March 31,
2009, we acquired a majority ownership in Advent Financial Services LLC. On June
30, 2009, the Company executed a settlement agreement with EHD whereby the
Company is released from all past and future obligations under its lease
agreement and paid $5 million to EHD in July 2009. EHD and the Company also
agreed to take the necessary steps for the dismissal of all legal proceedings
related to the lease agreement.

Impact of Consolidation of Securitized
Mortgage Assets on Our Financial Statements

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

Financial Condition as of March 31,
2009 as Compared to December 31, 2008

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

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

25

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

The mortgage loans  held-in-portfolio
balance has declined as their value has decreased significantly. The value is
dependent largely in part on their credit quality and the borrowers repayment
performance. The credit quality of the portfolio continues to decline.
Specifically, during recent months, the loss severity rate on foreclosed and
liquidated loans has increased. Therefore, we continue to increase the allowance
for losses on these loans. The allowance has increased from $776.0 as of
December 31, 2008 to $793.7 million as of March 31, 2009. Additionally, the
balance of mortgage loans  held-in-portfolio has decreased due to regular
borrower repayments. During the first quarter of 2009 the trusts received
repayments of the mortgage loans totaling $25.6 million. These balances will
continue to decline either through normal borrower repayments or through
continued devaluation as delinquencies, foreclosures and losses occur.

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

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

The following tables provide details of
our mortgage securities.

|Table 2  Values of
      Individual Mortgage Securities  Available-for-Sale                                                   
|--------------------------------------------------------------------------------------------------------------------------------
|(dollars in thousands)                                                                                                          
|                                                                                                                                
|                                                                                                                                
|**Securitization**                                                                                                              
|**Trust (A)**                                                                                                                   
|NMFT Series:                                                                                                                    
|2002-3                                                                                                                          
|2003-1                                                                                                                          
|2003-2                                                                                                                          
|2003-3                                                                                                                          
|2003-4                                                                                                                          
|2004-1                                                                                                                          
|2004-2                                                                                                                          
|2004-3                                                                                                                          
|2004-4                                                                                                                          
|2005-1                                                                                                                          
|2005-2                                                                                                                          
|2005-3                                                                                                                          
|2005-4                                                                                                                          
|2006-2                                                                                                                          
|2006-3                                                                                                                          
|2006-4                                                                                                                          
|2006-5                                                                                                                          
|2006-6                                                                                                                          
|Total                                                                                                                           
|                                                                                                                                
|                                                                                                                                
|(A)     We
      established the trust upon securitization of the underlying loans, which
      generally were originated by us.

26

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|Table 3  Mortgage Securities - Trading |  |                     |         |       |                |            |  |            |       |                     |   
|--------------------------------------- |  | ------------------- | ------- | ----- | -------------- | ---------- |  | ---------- | ----- | ------------------- | --
|(dollars in thousands)                  |  |                     |         |       |                |            |  |            |       |                     |   
|As of March 31,
      2009              |  |                     |         |       |                |            |  |            |       |                     |   
|                                        |  |                     |         |       | Amortized Cost |            |  |            |       | Number of           |   
|S&P
      Rating                        |  | Original
      Face |         | Basis |                | Fair Value |  | Securities |       | Average
      Yield
|Subordinated Securities:                |  |                     |         |       |                |            |  |            |       |                     |   
|Investment
      Grade (A)              |  | $                   | 12,505  |       | $              | 12,040     |  | $          | 345   |                     | 3 
|Non-investment Grade (B)                |  |                     | 422,609 |       |                | 411,112    |  |            | 2,894 |                     | 87
|Total Subordinated Securities           |  |                     | 435,114 |       |                | 423,152    |  |            | 3,239 |                     | 90
|Residual Securities:                    |  |                     |         |       |                |            |  |            |       |                     |   
|Unrated                                 |  |                     | 59,500  |       |                | 15,247     |  |            | 528   |                     | 1 
|Total                                   |  | $                   | 494,614 |       | $              | 438,399    |  | $          | 3,767 |                     | 91
|                                       
|As of December 31,
      2008           |  |                     |         |       |                |            |  |            |       |                     |   
|                                        |  |                     |         |       | Amortized Cost |            |  |            |       | Number of           |   
|S&P
      Rating                        |  | Original
      Face |         | Basis |                | Fair Value |  | Securities |       | Average
      Yield
|Subordinated Securities:                |  |                     |         |       |                |            |  |            |       |                     |   
|Investment
      Grade (A)              |  | $                   | 12,505  |       | $              | 11,891     |  | $          | 833   |                     | 3 
|Non-investment Grade (B)                |  |                     | 422,609 |       |                | 406,125    |  |            | 5,547 |                     | 87
|Total Subordinated Securities           |  |                     | 435,114 |       |                | 418,016    |  |            | 6,380 |                     | 90
|Residual Securities:                    |  |                     |         |       |                |            |  |            |       |                     |   
|Unrated                                 |  |                     | 59,500  |       |                | 15,952     |  |            | 705   |                     | 1 
|Total                                   |  | $                   | 494,614 |       | $              | 433,968    |  | $          | 7,085 |                     | 91
|                                        |  |                     |         |       |                |            |  |            |       |                     |   

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

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

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

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

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

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

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

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

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

27

---

Stockholders
Deficit.As of March 31, 2009 our total liabilities exceeded our total assets
under GAAP by $973.7 million.

The liabilities of the securitization
trusts exceed the assets of those trusts as of March 31, 2009 and December 31,
2008 by $994.5 million and $932.1 million, respectively. These amounts do
include any adjustments for intercompany eliminations, see table 9 for further
detail. The severe devaluation of the mortgage assets, as discussed in the
respective categories above, has resulted in the significant deficit of these
trusts. The assets and liabilities of these trusts are consolidated under GAAP.
Due to the significant impact to our financial statements of these trusts, we
have also provided the assets and liabilities of the trusts on a separate and
combined basis under the heading Assets and Liabilities of Consolidated
Securitization Trusts.

The significant increase in our
shareholders deficit during the first quarter of 2009 results from our large
net loss, driven primarily by valuation allowances taken on our mortgage loans.

Results of Operations  Consolidated
Earnings Comparisons

Quarter Ended March 31, 2009 as
Compared to the Quarter Ended March 31, 2008

Net Interest (Expense) Income.As discussed above, in general, our
mortgage assets have been significantly impaired due to national and
international economic crises, housing price deterioration and mortgage loan
credit defaults. Interest income has declined as these assets have become
impaired and due to repayments and liquidations. Interest expense has declined
as the related principals balances have declined. We repaid all short-term
borrowings during 2008. Interest expense is adjustable, generally based on a
spread to LIBOR.

|Table 4  Net
      Interest Expense                         |                       |          |      |  |   |          |  
|------------------------------------------------------------ | --------------------- | -------- | ---- |  | - | -------- | -
|(dollars in thousands)                                       |                       |          |      |  |   |          |  
|                                                             | For the Quarter Ended
|                                                             | March 31,            
|                                                             | 2009                  |          | 2008
|Interest
      income:                                       |                       |          |      |  |   |          |  
|Mortgage securities                                          | $                     | 11,407   |      |  | $ | 14,730   |  
|Mortgage loans held-in-portfolio                             |                       | 29,273   |      |  |   | 56,025   |  
|Other interest income                                        |                       | 187      |      |  |   | 710      |  
|Total interest income                                        |                       | 40,867   |      |  |   | 71,465   |  
|Interest
      expense:                                      |                       |          |      |  |   |          |  
|Short-term borrowings secured by mortgage securities         |                       | -        |      |  |   | 376      |  
|Asset-backed bonds secured by mortgage loans                 |                       | 5,289    |      |  |   | 30,359   |  
|Asset-backed bonds secured by mortgage securities            |                       | 1,878    |      |  |   | 3,685    |  
|Junior subordinated debentures                               |                       | 1,192    |      |  |   | 1,861    |  
|Total
      interest expense                                 |                       | 8,359    |      |  |   | 36,281   |  
|Net interest income before provision for credit
      losses |                       | 32,508   |      |  |   | 35,184   |  
|Provision for credit losses                                  |                       | (101,474 | )    |  |   | (249,316 | )
|Net interest
      (expense) income                          | $                     | (68,966  | )    |  | $ | (214,132 | )
|                                                             |                       |          |      |  |   |          |  

Provision for Credit Losses.The provision for credit losses relates
to mortgage loans which have been securitized. As discussed above, in general,
the credit quality of the securitized mortgage loans significantly deteriorated
beginning in 2007 due to national and international economic crises, housing
price deterioration and mortgage loan credit defaults. The performance of the
loans continues to deteriorate. A significant portion of the securitized loans
have become uncollectible or will only be partially collected. For the NHEL
0601, MTA 0601 and NHEL 2007-1 transactions, we valued REO property at 50%, 50%
and 40% of its current principal balance as of March 31, 2009 compared to 55%,
55% and 40% as of December 31, 2008, respectively. Provisions for these losses
have increased in connection with the declining credit quality of the
loans.

28

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***(Losses) Gains on Derivative
Instruments***. We have entered into
derivative instrument contracts that do not meet the requirements for hedge
accounting treatment, but contribute to our overall risk management strategy by
serving toreduce interest rate risk related to short-term borrowing
rates. The derivative instruments for which the value is on our balance sheet
are owned by securitization trusts. Derivative instruments transferred into a
securitization trust are administered by the trustee in accordance with the
trust documents. These derivative instruments are used to mitigate interest rate
risk within the related securitization trust and will generally increase in
value as short-term interest rates increase and decrease in value as rates
decrease.

We also entered into three credit default
swaps (CDS) during 2007 as part of our CDO transaction previously discussed.
The CDS had a notional amount of $16.5 million and a fair value of $6.1 million
at the date of purchase and are pledged as collateral against the CDO ABB.

The losses on derivative instruments from
continuing operations resulted from declining interest rates and declining
values of the CDS. The lower loss in 2009 compared to 2008 is generally due to
the declining notional amount of the outstanding derivatives.

Fair Value Adjustments.Adjustment for changes in value on our
trading securities and the asset-backed bonds issued in our CDO are recorded as
Fair Value Adjustments. The significant value declines are a result of
significant spread widening in the subprime mortgage market for these types of
asset-backed securities as well as poor credit performance of the underlying
mortgage loans. By the end of 2007, the total value of the trading securities
and the asset-backed bonds had declined significantly, resulting in a lower
overall adjustment in the first quarter of 2009 when compared to the first
quarter of 2008.

Impairment on Mortgage Securities 
Available-for-Sale.To the extent that the cost basis of mortgage securities 
available-for-sale exceeds the fair value and the unrealized loss is considered
to be other than temporary, an impairment charge is recognized and the amount
recorded in accumulated other comprehensive income or loss is reclassified to
earnings as a realized loss. The large impairment in the first quarter of 2008
was primarily driven by an increase in actual and projected losses due to the
deteriorating credit quality of the loans underlying the securities. By the end
of 2007, the total value of the available-for-sale securities had declined
significantly, resulting in a lower overall impairment in the first quarter of
2009 when compared to the first quarter of 2008.

Appraisal Fee Income and Expense.We acquired a majority interest in
StreetLinks on August 1, 2008. Fees are collected from customers (borrowers or
lenders), a portion of which is paid to independent mortgage loan appraisers.
Fee income and expense is recognized when the appraisal is completed and
delivered to the customer.

General and Administrative Expenses.During late 2007 and into early 2008, we
eliminated a significant portion of our administrative overhead. We terminated
officers and staff in our executive, information systems, legal, human resource
and finance/accounting departments. We also terminated numerous contracts for
professional services. One of managements key focuses during 2008 was to reduce
or eliminate all unnecessary general and administrative expenses. As a result,
excluding the impact on operating expenses for StreetLinks, operating expenses
have declined when comparing general and administrative expenses for the
quarters ended March 31, 2009 and 2008.

Contractual Obligations

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

The following table summarizes our
contractual obligations for both continuing and discontinued operations, as of
March 31, 2009, other than short-term borrowing arrangements.

|Table 5 
      Contractual Obligations  |  |                        |            |      |  |             |          |           |  |               |          |   |  |   |          |   |  |   |           |  
|---------------------------------------- |  | ---------------------- | ---------- | ---- |  | ----------- | -------- | --------- |  | ------------- | -------- | - |  | - | -------- | - |  | - | --------- | -
|(dollars in thousands)                   |  |                        |            |      |  |             |          |           |  |               |          |   |  |   |          |   |  |   |           |  
|                                         |  | Payments Due by Period
|                                         |  |                        |            |      |  | Less than 1 |          |           |  |               |          |   |  |   |          |   |  |  
|Contractual
      Obligations            |  | Total                  |            | Year |  | 1-3 Years   |          | 3-5 Years |  | After 5 Years
|Long-term debt paydown (A)               |  | $                      | 3,031,164  |      |  | $           | 674,376  |           |  | $             | 918,986  |   |  | $ | 487,849  |   |  | $ | 949,953   |  
|Junior
      subordinated debentures (B) |  |                        | 181,533    |      |  |             | 10,160   |           |  |               | 7,331    |   |  |   | 7,331    |   |  |   | 156,711   |  
|Operating leases (C)                     |  |                        | 14,268     |      |  |             | 6,515    |           |  |               | 6,475    |   |  |   | 746      |   |  |   | 532       |  
|Total,
      consolidated obligations    |  |                        | 3,226,965  |      |  |             | 691,051  |           |  |               | 932,792  |   |  |   | 495,926  |   |  |   | 1,107,196 |  
|Non-recourse obligations                 |  |                        | (3,031,164 | )    |  |             | (674,376 | )         |  |               | (918,986 | ) |  |   | (487,849 | ) |  |   | (949,953  | )
|                                        
|Recourse obligations                     |  | $                      | 195,801    |      |  | $           | 16,675   |           |  | $             | 13,806   |   |  | $ | 8,077    |   |  | $ | 157,243   |  
|                                         |  |                        |            |      |  |             |          |           |  |               |          |   |  |   |          |   |  |   |           |  

|(A) |  | The asset-backed bonds
      will be repaid only to the extent there is sufficient cash receipts on the
      underlying mortgage loans, which collateralize the debt. The trusts that
      own these assets and asset-backed obligations have no recourse to us for
      any shortfall. The timing of the repayment of these mortgage loans is
      affected by prepayments. These amounts include expected interest payments
      on the obligations. Interest obligations on our variable-rate long-term
      debt are based on the prevailing interest rate as of March 31, 2009 for
      each respective obligation.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

29

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|(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 as of
      March 31, 2009 for each respective obligation. On February 18, 2009, the
      Company, NMI, NovaStar Capital Trust I and NovaStar Capital Trust II (the
      Trusts) and the trust preferred security holders entered into agreements
      to exchange the existing preferred obligations for new preferred
      obligations. 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. See Note 6 to the condensed consolidated
      financial statements for additional details.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(C) |  | The operating lease
      obligations do not include rental income of $1.7 million to be received
      under sublease contracts. The operating lease obligations do not reflect
      the settlement of the lease with EHD, see Note 7 to the condensed
      consolidated financial statements for additional
  information.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

Liquidity and Capital
Resources

We have taken numerous actions to reduce
our cash needs and liquidity risk. However, we continue to have liquidity risk
as our operating businesses are generally not providing net positive cash flow
and the cash from our mortgage securities is expected to decline.

Our residual and subordinated mortgage
securities are a primary source of significant cash flows. Based on the current
projections, the cash flows from our mortgage securities will decrease in the
next several months as the underlying mortgage loans are repaid, and could be
significantly less than the current projections if losses on the underlying
mortgage loans exceed the current assumptions or if short-term interest rates
increase significantly. We have operating expenses associated with our
administration, as well as payment obligations with respect to unsecured debt,
including periodic interest payments with respect to junior subordinated
debentures. As discussed in Item 1. Legal Proceedings we are the subject of
various legal proceedings, the outcome of which is uncertain. We may also face
demands in the future that are unknown to us today related to our legacy lending
and servicing operations. If the cash flows from our mortgage securities are
less than currently anticipated, our operating businesses do not generate
positive cash flow and we cannot restructure our unsecured debt 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 federal and state
bankruptcy laws.

As of July 10, 2009, we had approximately
$20.7 million in cash on hand (including restricted cash of $6.1 million). In addition to our
operating expenses, which currently range from approximately $750,000 to $1.5
million per month we have quarterly interest payments due on our trust preferred
securities. The next payment on the trust preferred securities is due on
September 30, 2009 and totals $0.2 million. Our current projections indicate
sufficient available cash and cash flows from our mortgage assets to meet these
payment needs. However, our mortgage asset cash flows are currently volatile and
uncertain in nature, and the amounts we receive could vary materially from our
projections. Therefore, no assurances can be given that we will be able to meet
our cash flow needs, in which case we would be required to seek protection of
applicable bankruptcy laws.

Overview of Cash Flow for the Quarter
Ended March 31, 2009

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

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

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

30

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|**Table 6  Primary
      Sources Cash Receipts and Disbursements** |             |        |  
|------------------------------------------------------------------- | ----------- | ------ | -
|**(dollars in thousands)**                                          |             |        |  
|                                                                    | For the    
|                                                                    | Quarter    
|                                                                    | Ended March
|Primary
      sources:                                              | 31, 2009   
|Payments received on mortgage securities                            | $           | 6,382  |  
|Receipts for appraisal management services                          |             | 1,483  |  
|                                                                   
|Primary
      uses:                                                 |             |        |  
|Payment of corporate general, administrative and capital            |             |        |  
|expenditures                                                        |             | (9,779 | )
|Payments
      for appraisals and related administrative costs      |             | (2,891 | )

Statement of Cash Flows - Operating,
Investing and Financing Activities

The following table provides a summary of
our operating, investing and financing cash flows as taken from our consolidated
statements of cash flows for the three months ended March 31, 2009 and
2008.

|Table 7  Summary of
      Operating, Investing and Financing Cash Flows |                           
|------------------------------------------------------------------------ | --------------------------
|(dollars in thousands)                                                   |                           
|                                                                         | For the Three
      Months
|                                                                         | Ended March 31,           
|                                                                         | 2009                      
|Consolidated Statements of
      Cash Flows:                             |                           
|Cash provided by
      (used in) operating activities                    | $                         
|Cash flows provided by investing
      activities                        |                           
|Cash flows used in financing activities                                  |                           

Operating
Activities.Net cash used in operating activities increased by $27.5 million in 2009
as compared to 2008. The increase was substantially related to the increase in
the balance of the amounts due to servicer. See a discussion of the impact of
the consolidated loan trusts under the heading Assets and Liabilities of
Consolidated Securitization Trusts.

Investing
Activities.In the first quarter of 2009, net cash provided by investing activities
decreased to $52.9 million as compared to $166.0 million in the first quarter of
2008. Our mortgage loan portfolio declined significantly and borrower defaults
increased, resulting in lower repayments of our mortgage loans
held-in-portfolio. Cash proceeds from the sale of assets acquired through
foreclosure have increased as our foreclosed loan activity has increased
significantly. We also experienced a decrease in paydowns on our mortgage
securities  available-for-sale during 2009 as compared to 2008 as a result of
poor credit performance of the underlying loans.

Financing
Activities.Net cash used in financing activities decreased to $78.2 million in 2009
as compared 2008. All short term borrowings were paid off in 2008 and we also
experienced a decrease in paydowns of our asset-backed bonds during the
year.

Future Sources and Uses of Cash

Primary Sources of
Cash

Cash Received From Our Mortgage
Securities Portfolio.A major driver of
cash flows is the proceeds we receive from our mortgage securities. For the
three months ended March 31, 2009 we received $6.1 million in proceeds from
repayments on mortgage securities. The cash flows we receive on our mortgage
securitiesavailable-for-sale are highly dependent on the interest rate spread
between the underlying collateral and the bonds issued by the securitization
trusts and default and prepayment experience of the underlying collateral. The
following factors have been the significant drivers in the overall fluctuations
in these cash flows:

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

31

---

Collateral Returned from Surety Bond
Holders.See discussion under Restricted
Cash. We have $6.0 million collateral outstanding for surety bond holders. When
the cash collateralizing the surety bond letters of credit is released, it will
become unrestricted and available for general corporate purposes. We cannot
predict the timing of the release.

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

Primary Uses of Cash

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

Investment in Assets or Operating
Businesses.To the extent we have cash
available to invest in assets or operating businesses, management intends to do
so. During the first quarter of 2009, we invested $1.4 million in StreetLinks.
Subsequent to the first quarter of 2009, we invested $2 million to acquire
Advent.

Repayments of Long-Term Borrowings.As of March 31, 2009, we had $78.1
million in outstanding principal of junior subordinated debentures relating to
the trust preferred securities of NovaStar Capital Trust I and NovaStar Capital
Trust II We have unamortized debt issue costs of $700,000 and therefore a
carrying value for the debt of $77.4 million.Subsequent to the first quarter of 2009, we restructured our obligations
under the junior subordinated debentures, which we expect to reduce cash
requirements for interest in the near term. As part of the restructuring, we
repaid all interest accrued through December 31, 2008, totaling $5.3 million.
Details of the restructuring are included in Note 6 to the condensed
consolidated financial statements. See Table 5 for an estimate of our
contractual obligations related to these junior subordinated debentures.

Assets and Liabilities of Consolidated
Securitization Trusts

During 2006 and 2007, we executed loan
securitization transactions that did not meet the criteria necessary for
derecognition of the securitized assets and liabilities pursuant to Statement of
Financial Accounting Standards No. 140, Accounting for Transfers and Servicing
of Financial Assets and Extinguishments of Liabilities  a replacement of FASB
Statement No. 125 (SFAS 140) and related authoritative accounting literature.
As a result, the assets and liabilities relating to this securitization are
included in our consolidated financial statements.

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

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

32

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

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

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

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

33

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|Table 8  Assets and Liabilities of Securitization
      Trusts (A) (B) |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 
|----------------------------------------------------------------------- |  | -------------- | ------- | ----------------- |  | ---- | -------- | ------ |  | ----- | -------- | ------- |  | ------ | --------- | ---- |  | ------ | ---------- | ----- | 
|(dollars in
      thousands)                                            |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 
|                                                                        |  | March 31, 2009 |         | December 31, 2008
|                                                                        |  |                |         |                   |  |      |          |        |  | NHES  |          |         |  |        |           |      |  |        |            |       | 
|                                                                        |  |                |         | NHES              |  | 2006 |          | NHES   |  |       |          |         |  |        |           | NHES |  | 2006   |            | NHES  | 
|                                                                        |  | **CDO**        |         | 2006-1            |  | MTA1 |          | 2007-1 |  | Total |          | **CDO** |  | 2006-1 |           | MTA1 |  | 2007-1 |            | Total
|Assets                                                                  |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 
|Mortgage loans  held                                                   |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 
|in portfolio, net of                                                    |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 
|allowance                                                               |  | $              | -       |                   |  | $    | 363,362  |        |  | $     | 479,596  |         |  | $      | 770,008   |      |  | $      | 1,612,966  |       | 
|Trading securities                                                      |  |                | 3,023   |                   |  |      | -        |        |  |       | -        |         |  |        | -         |      |  |        | 3,023      |       | 
|Real estate owned                                                       |  |                | -       |                   |  |      | 29,022   |        |  |       | 12,765   |         |  |        | 49,315    |      |  |        | 91,102     |       | 
|Accrued interest                                                        |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 
|receivable                                                              |  |                | -       |                   |  |      | 21,453   |        |  |       | 9,277    |         |  |        | 45,323    |      |  |        | 76,053     |       | 
|Other assets                                                            |  |                | 911     |                   |  |      | -        |        |  |       | -        |         |  |        | -         |      |  |        | 911        |       | 
|Total assets                                                            |  | $              | 3,934   |                   |  | $    | 413,837  |        |  | $     | 501,638  |         |  | $      | 864,646   |      |  | $      | 1,784,055  |       | 
|                                                                       
|Liabilities and net deficiency in
      assets                          |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 
|Liabilities:                                                            |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 
|Asset-backed                                                            |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 
|bonds secured                                                           |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 
|by mortgage                                                             |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 
|loans                                                                   |  | $              | -       |                   |  | $    | 540,691  |        |  | $     | 685,115  |         |  | $      | 1,342,525 |      |  | $      | 2,568,331  |       | 
|Asset-backed                                                            |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 
|bonds secured                                                           |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 
|by mortgage                                                             |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 
|securities                                                              |  |                | 3,073   |                   |  |      | -        |        |  |       | -        |         |  |        | -         |      |  |        | 3,073      |       | 
|Other liabilities                                                       |  |                | 24,872  |                   |  |      | 50,558   |        |  |       | 26,127   |         |  |        | 114,301   |      |  |        | 215,858    |       | 
|Total liabilities                                                       |  |                | 27,945  |                   |  |      | 591,249  |        |  |       | 711,242  |         |  |        | 1,456,826 |      |  |        | 2,787,262  |       | 
|Total net deficiency                                                    |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 
|**in
      assets**                                                     |  |                | (24,011 | )                 |  |      | (177,412 | )      |  |       | (209,604 | )       |  |        | (592,180  | )    |  |        | (1,003,207 | )     | 
|                                                                       
|Total liabilities and                                                   |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 
|net deficiency in                                                       |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 
|assets                                                                  |  | $              | 3,934   |                   |  | $    | 413,837  |        |  | $     | 501,638  |         |  | $      | 864,646   |      |  | $      | 1,784,055  |       | 
|                                                                        |  |                |         |                   |  |      |          |        |  |       |          |         |  |        |           |      |  |        |            |       | 

|(A) |  | Stand-alone balances
      do not include impact of intercompany eliminations.
|--- |  | ------------------------------------------------------------------------------
|(B) |  | The above financial
      information is considered non-GAAP.                 

34

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|Table 9  Operating Results of Securitization Trusts (A)
      (B)
|------------------------------------------------------------------
|(dollars in thousands)                                            
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|                                                                  
|Interest Income                                                   
|Interest
      expense                                            
|Provision for credit                                              
|losses                                                            
|Servicing
      fee                                               
|expense                                                           
|Mortgage insurance                                                
|Other
      income                                                
|General and                                                       
|administrative                                                    
|expenses                                                          
|Net loss before
      tax                                         
|expense                                                           
|                                                                  
|Tax
      expense                                                 
|                                                                  
|Net loss                                                          
|                                                                  

|(A) |  | Stand-alone balances
      do not include impact of intercompany eliminations.
|--- |  | ------------------------------------------------------------------------------
|(B) |  | The above financial
      information is considered non-GAAP.                 
|   

|Table 10  Cash Flows of Securitization Trusts (A)
      (B)
|------------------------------------------------------------
|(dollars in
      thousands)                                
|                                                            
|                                                            
|                                                            
|                                                            
|Net cash flow from:                                         
|Operating activities                                        
|Investing activities                                        
|Financing activities                                        
|                                                            
|Net cash flow                                               
|Cash, beginning of year                                     
|                                                            
|Cash, end of year                                           
|                                                            

|(A) |  | Stand-alone balances
      do not include impact of intercompany eliminations.
|--- |  | ------------------------------------------------------------------------------
|(B) |  | The above financial
      information is considered non-GAAP.                 

35

---

Item 3. Quantitative and Qualitative
Disclosures About Market Risk

As a small business filer, we are not
required to provide the information required by this Item.

Item 4. Controls and Procedures

Disclosure Controls and
Procedures

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

Internal Control over Financial
Reporting

Managements Report on Internal Control
over Financial Reporting

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

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

Management of the Company has assessed the
effectiveness of the Companys internal control over financial reporting as of
March 31, 2009. To make this assessment, management used the criteria for
effective internal control over financial reporting described inInternal ControlIntegrated Framework, issued by the Committee of Sponsoring Organizations of the
Treadway Commission. Based on our assessment under the framework inInternal ControlIntegrated
Framework,management concluded that the
Companys internal control over financial reporting was not effective as of
March 31, 2009 because of the existence of a material weakness in internal
controls over financial reporting related to the lack of segregation of duties
within our accounting department

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

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

Management has taken steps to remedy the
material weakness by hiring additional accounting department staff, and
reallocating duties, including responsibilities for financial reporting, among
the Companys employees. However, based on the overall lack of accounting
department resources, this material weakness was not remediated as of March 31,
2009.

Changes in Internal Control over
Financial Reporting

There were no changes in our internal
controls over financial reporting during the quarter ended March 31, 2009 that
have materially affected, or are reasonably likely to materially affect, our
internal controls over financial reporting.

36

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Trust Preferred Settlement.See Note 6Borrowings for a detailed
discussion of the settlement terms and restructuring of the Companys junior
subordinated debentures, including the dismissal of the involuntary Chapter 7
bankruptcy filed against NovaStar Mortgage, Inc. (Case No. 08-12125-CSS) by the
holders of the trust preferred securities in U.S. Bankruptcy Court for the
District of Delaware in Wilmington, Delaware.

Litigation.

At this time, the Company cannot predict
the probable outcome of the following claims and as such no amounts have been
accrued in the consolidated financial statements.

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

In May 2007, a lawsuit entitledNational Community Reinvestment Coalition v.
NovaStar Financial, Inc.,et al., was filed against
the Company in the United States District Court for the District of Columbia.
Plaintiff, a non-profit organization, alleges that the Company maintains
corporate policies of not making loans on Indian reservations, on dwellings used
for adult foster care or on rowhouses in Baltimore, Maryland in violation of the
federal Fair Housing Act. The lawsuit seeks injunctive relief and damages,
including punitive damages, in connection with the lawsuit. On May 30, 2007, the
Company responded to the lawsuit by filing a motion to dismiss certain of
plaintiffs claims. On March 31, 2008 that motion was denied by the Court. 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. On May 15,
2009 the Court granted Companys motion to dismiss. The City of Cleveland has
filed a notice of intent to appeal. The Company believes that these claims are
without merit and will vigorously defend against them.

On January 31, 2008, two purported
shareholders filed separate derivative actions in the Circuit Court of Jackson
County, Missouri against various former and current officers and directors and
named the Company as a nominal defendant. The essentially identical petitions
seek monetary damages alleging that the individual defendants breached fiduciary
duties owed to the Company, alleging insider selling and misappropriation of
information, abuse of control, gross mismanagement, waste of corporate assets,
and unjust enrichment between May 2006 and December 2007. On June 24, 2008 a
third, similar case was filed in United States District Court for the Western
District of Missouri. 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.

37

---

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

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

On October 21, 2008, EHD Holdings, LLC
(EHD), 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. On April 24, 2009, EHD filed a motion
for summary judgment seeking approximately $3.3 million, in past due rent and
charges, included in the Accounts payable and other liabilities line item of the
balance sheet, plus accruing rent and charges for future periods, plus attorney
fees. On June 30, 2009, the Company executed a settlement agreement with EHD
whereby the Company is released from all past and future obligations under its
lease agreement and paid $5 million to EHD. EHD and the Company also agreed to
take the necessary steps for the dismissal of all legal proceedings related to
the lease agreement.

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

Item 1A. Risk Factors

Risk Factors

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

38

---

|Item 2. Unregistered Sales of
      Equity Securities and Use of Proceeds(dollars in thousands)
|-----------------------------------------------------------------------------------------------
|Issuer Purchases of Equity
      Securities                                                    
|                                                                                               
|                                                                                               
|                                                                                               
|                                                                                               
|                                                                                               
|                                                                                               
|                                                                                               
|January 1, 2009  January 31, 2009                                                             
|February 1, 2009
       February 28, 2009                                                     
|March 1, 2009  March 31,
      2009                                                           

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

Item 3. Defaults Upon Senior Securities

NFIs wholly owned subsidiary NovaStar
Mortgage, Inc. (NMI) has approximately $77.4 million in principal amount of
unsecured notes (collectively, the Notes) outstanding to NovaStar Capital
Trust I and NovaStar Capital Trust II (collectively, the Trusts) which secure
trust preferred securities issued by the Trusts. NFI has guaranteed NMI's
obligations under the Notes.

NMI failed to make quarterly interest
payments that were due on 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 was in default under the related indentures and NFI was in default
under the related guarantees as of March 31, 2009.

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 24, 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.

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

None

39

---

Item 5. Other Information

None

Item 6. Exhibits

Exhibit Listing

|Exhibit No. |  | Description of
    Document                                                                                                                                                                                                                                                                                                          
|----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1(1)      |  | Amendment to the Amended and
      Restated Bylaws of NovaStar Financial, Inc.                                                                                                                                                                                                                                                       
|            |  |                                                                                                                                                                                                                                                                                                                                      
|10.1(2)     |  | Settlement Agreement, dated as of
      February 18, 2009, among NovaStar Mortgage, Inc., NovaStar Financial,
      Inc., Taberna Preferred Funding I, Ltd., Taberna Preferred Funding II,
      Ltd. and Kodiak CDO I, Ltd.                                                                                                         
|            |  |                                                                                                                                                                                                                                                                                                                                      
|10.2(3)     |  | Escrow Agreement, dated as of
      February 18, 2009, by an among NovaStar Mortgage, Inc., NovaStar
      Financial, Inc., Taberna Preferred Funding I, Ltd., Taberna Preferred
      Funding II, Ltd., Kodiak CDO I, Ltd. and WolfBlock LLP                                                                                        
|            |  |                                                                                                                                                                                                                                                                                                                                      
|10.3(4)     |  | Exchange Agreement, dated as of
      February 18, 2009, by and among NovaStar Mortgage, Inc., NovaStar
      Financial, Inc., NovaStar Capital Trust I/B, NovaStar Capital Trust II/B,
      Taberna Preferred Funding I, Ltd., Taberna Preferred Funding II, Ltd. and
      Kodiak CDO I, Ltd.                                     
|            |  |                                                                                                                                                                                                                                                                                                                                      
|10.4(5)     |  | Amended and Restated Trust
      Agreement, dated as of February 18, 2009, by and among, NovaStar Mortgage,
      Inc., The Bank of New York Mellon Trust Company, National Association, BNY
      Mellon Trust of Delaware and certain administrative trustees (including
      the form of Preferred Securities Certificate) (I/B) 
|            |  |                                                                                                                                                                                                                                                                                                                                      
|10.5(6)     |  | Junior Subordinated Indenture, dated
      as of February 18, 2009, between NovaStar Mortgage, Inc. and The Bank of
      New York Mellon Trust Company, National Association (I/B)                                                                                                                                                  
|            |  |                                                                                                                                                                                                                                                                                                                                      
|10.6(7)     |  | Parent Guarantee Agreement, dated as
      of February 18, 2009, between NovaStar Financial, Inc. and The Bank of New
      York Mellon Trust Company, National Association (I/B)                                                                                                                                                    
|            |  |                                                                                                                                                                                                                                                                                                                                      
|10.6(8)     |  | Amended and Restated Trust
      Agreement, dated as of February 18, 2009, by and among, NovaStar Mortgage,
      Inc., The Bank of New York Mellon Trust Company, National Association, BNY
      Mellon Trust of Delaware and certain administrative trustees (including
      the form of Preferred Securities Certificate) (II/B)
|            |  |                                                                                                                                                                                                                                                                                                                                      
|10.7(9)     |  | Junior Subordinated Indenture, dated
      as of February 18, 2009, between NovaStar Mortgage, Inc. and The Bank of
      New York Mellon Trust Company, National Association (II/B)                                                                                                                                                 
|            |  |                                                                                                                                                                                                                                                                                                                                      
|10.8(10)    |  | Parent Guarantee Agreement, dated as
      of February 18, 2009, between NovaStar Financial, Inc. and The Bank of New
      York Mellon Trust Company, National Association (II/B)                                                                                                                                                   
|            |  |                                                                                                                                                                                                                                                                                                                                      
|10.9(11)    |  | Securities Purchase Agreement, dated
      as of April 26, 2009, by and among NovaStar Financial, Inc., Advent
      Financial Services, LLC and Mark A. Ernst                                                                                                                                                                       
|            |  |                                                                                                                                                                                                                                                                                                                                      
|10.10(12)   |  | Release and Settlement Agreement
      dated as of June 30, 2009 by and between NovaStar Financial, Inc. and
      EHMD, LLC, EHD Holdings, LLC and EHD Properties, LLC                                                                                                                                                              
|            |  |                                                                                                                                                                                                                                                                                                                                      
|11.1(13)    |  | Statement Regarding Computation of
      Per Share Earnings                                                                                                                                                                                                                                                                          
|            |  |                                                                                                                                                                                                                                                                                                                                      
|31.1        |  | Chief Executive Officer
      Certification - Section 302 of the Sarbanes-Oxley Act of
  2002                                                                                                                                                                                                                                        
|            |  |                                                                                                                                                                                                                                                                                                                                      
|31.2        |  | Principal Financial Officer
      Certification - Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                      
|            |  |                                                                                                                                                                                                                                                                                                                                      
|32.1        |  | Chief Executive
      Officer Certification - Section 906 of the Sarbanes-Oxley Act of
2002                                                                                                                                                                                                                                          
|            |  |                                                                                                                                                                                                                                                                                                                                      
|32.2        |  | Principal Financial
      Officer Certification - Section 906 of the Sarbanes-Oxley Act of
  2002                                                                                                                                                                                                                                    

40

---

|(1)  |  | Incorporated by reference to
      Exhibit 3.2.1 to Form 8-K filed by the Registrant with the SEC on March
      16, 2009.   
|---- |  | -----------------------------------------------------------------------------------------------------------------------------
|     |  |                                                                                                                              
|(2)  |  | Incorporated by reference to
      Exhibit 10.53 to Form 8-K filed by the Registrant with the SEC on February
      24, 2009.
|    
|(3)  |  | Incorporated by reference to
      Exhibit 10.54 to Form 8-K filed by the Registrant with the SEC on February
      24, 2009.
|    
|(4)  |  | Incorporated by reference to
      Exhibit 10.55 to Form 8-K filed by the Registrant with the SEC on February
      24, 2009.
|    
|(5)  |  | Incorporated by reference to
      Exhibit 10.56 to Form 8-K filed by the Registrant with the SEC on February
      24, 2009.
|    
|(6)  |  | Incorporated by reference to
      Exhibit 10.57 to Form 8-K filed by the Registrant with the SEC on February
      24, 2009.
|    
|(7)  |  | Incorporated by reference to
      Exhibit 10.58 to Form 8-K filed by the Registrant with the SEC on February
      24, 2009.
|    
|(8)  |  | Incorporated by reference to
      Exhibit 10.59 to Form 8-K filed by the Registrant with the SEC on February
      24, 2009.
|    
|(9)  |  | Incorporated by reference to
      Exhibit 10.60 to Form 8-K filed by the Registrant with the SEC on February
      24, 2009.
|    
|(10) |  | Incorporated by reference to
      Exhibit 10.61 to Form 8-K filed by the Registrant with the SEC on February
      24, 2009.
|    
|(11) |  | Incorporated by reference to
      Exhibit 10.62 to Form 8-K filed by the Registrant with the SEC on April
      30, 2009.   
|    
|(12) |  | Incorporated by reference to
      Exhibit 10.1 to Form 8-K filed by the Registrant with the SEC on July 1,
      2009.      
|    
|(13) |  | See Note 13 to the condensed
      consolidated financial statements.                                                        

41

---

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: July 10,
      2009 | /s/ W. Lance Anderson              | 
|------------------------- | ---------------------------------- | 
|                          | W. Lance Anderson, Chairman of the
|                          | Board of Directors and Chief      
|                          | Executive Officer                 
|                          | (Principal Executive Officer)     
|                         
|DATE: July 10,
      2009 | /s/ Rodney E. Schwatken            | 
|                          | Rodney E. Schwatken, Chief        
|                          | Financial Officer                 
|                          | (Principal Financial Officer)     

42

---