NOVASTAR FINANCIAL INC, S-11/A, 1997-09-10

NOVASTAR FINANCIAL INC
S-11/A, 1997-09-10
FINANCE SERVICES

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AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON SEPTEMBER 10, 1997

REGISTRATION NO. 333-32327
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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AMENDMENT NO. 1 TO
FORM S-11
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
OF SECURITIES OF CERTAIN REAL ESTATE COMPANIES

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NOVASTAR FINANCIAL, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS GOVERNING INSTRUMENTS)
1900 WEST 47TH PLACE, SUITE 205
WESTWOOD, KS 66205
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

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SCOTT F. HARTMAN
CHAIRMAN OF THE BOARD, SECRETARY AND CHIEF EXECUTIVE OFFICER
NOVASTAR FINANCIAL, INC.
1900 WEST 47TH PLACE, SUITE 205
WESTWOOD, KS 66205
(913) 362-1090
(NAME AND ADDRESS OF AGENT FOR SERVICE)

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COPIES TO:
W. LANCE ANDERSON PHILLIP R. POLLOCK, ESQ. PETER T. HEALY, ESQ.
PRESIDENT AND CHIEF TOBIN & TOBIN O'MELVENY & MYERS LLP
OPERATING OFFICER ONE MONTGOMERY STREET, 15TH FLOOR
EMBARCADERO CENTER WEST
NOVASTAR FINANCIAL, INC. SAN FRANCISCO, CA 94104 275 BATTERY STREET, 26TH
1900 WEST 47TH PLACE, (415) 433-1400 FLOOR
SUITE 205 SAN FRANCISCO, CA 94111
WESTWOOD, KS 66205 (415) 984-8833
(913) 362-1090

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APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC:
At any time and from time to time after the effective date of this
Registration Statement.

If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, please check the following
box and list the Securities Act registration number of the earlier effective
registration statement for the same offering. [_]

If this Form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
registration number of the earlier effective registration statement for the
same offering. [_]

If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. [_]

THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT
SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS
REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH
SECTION 8(A) OF THE SECURITIES ACT OF 1933 OR UNTIL THIS REGISTRATION
STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION ACTING
PURSUANT TO SAID SECTION 8(A), MAY DETERMINE.

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<PAGE>

++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
+INFORMATION CONTAINED HEREIN IS SUBJECT TO COMPLETION OR AMENDMENT. A +
+REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE +
+SECURITIES AND EXCHANGE COMMISSION. THESE SECURITIES MAY NOT BE SOLD NOR MAY +
+OFFERS TO BUY BE ACCEPTED PRIOR TO THE TIME THE REGISTRATION STATEMENT +
+BECOMES EFFECTIVE. THIS PROSPECTUS SHALL NOT CONSTITUTE AN OFFER TO SELL OR +
+THE SOLICITATION OF AN OFFER TO BUY, NOR SHALL THERE BE ANY SALE OF THESE +
+SECURITIES IN ANY STATE IN WHICH SUCH OFFER, SOLICITATION OR SALE WOULD BE +
+UNLAWFUL PRIOR TO REGISTRATION OR QUALIFICATION UNDER THE SECURITIES LAWS OF +
+ANY SUCH STATE. +
++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++

SUBJECT TO COMPLETION, DATED SEPTEMBER 10, 1997

PROSPECTUS
3,000,000 SHARES

NOVASTAR FINANCIAL, INC.

COMMON STOCK

NovaStar Financial, Inc. ("NovaStar" or "the Company"), organized in 1996, is
a self-advised and self-managed specialty finance company which: (i)
originates, acquires, and services single family residential subprime mortgage
loans; (ii) leverages its assets using bank warehouse lines and repurchase
agreements; (iii) will issue collateralized debt obligations to finance its
subprime mortgage loans in the long-term; (iv) purchases mortgage securities in
the secondary mortgage market; and (v) manages the resulting combined portfolio
of mortgage assets (the "Mortgage Assets") in a tax-advantaged real estate
investment trust ("REIT") structure.

Prior to this Offering, there has been no market for the Common Stock of the
Company. It is currently anticipated that the initial public offering price
will be between $16.00 and $18.00 per share. See "Underwriting" for a
discussion of the factors considered in determining the public offering price.
The Common Stock has been approved for quotation on the Nasdaq Stock Market's
National Market under the symbol "NOVA."

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SEE "RISK FACTORS" BEGINNING ON PAGE 13 FOR A DISCUSSION OF CERTAIN FACTORS
THAT SHOULD BE CONSIDERED BY PROSPECTIVE PURCHASERS OF THE COMMON STOCK OFFERED
HEREBY. THESE RISK FACTORS INCLUDE:

. The Company's limited . The possibility of failure
operating history and net to renew existing financing
losses incurred. arrangements or obtain
replacement facilities.
. The Company's dependence on
key personnel.

. The possible forgiveness of . The potential adverse
incentive notes receivable effect of fluctuations in
from the Company's short-term interest rates
founders, which may on the Company's net
materially adversely affect interest income.
results of operations and
dividends paid during the . Potential changes in
periods forgiven. anticipated prepayment
rates on the Company's
Mortgage Assets, which may
. The possibility of failure adversely affect net
to maintain REIT status, interest income.
which would subject the
Company to tax as a regular . The Company's inability to
corporation. hedge against potential
interest rate changes.
. The potential effects of
unexpected or rapid changes . The potential effects of
in interest rates, which the failure of a
would negatively impact the counterparty to a hedge
results of operations from transaction.
the subprime mortgage
lending business. . The Company's exposure to
risk of loss on its
mortgage loans, since it
. The potential effects of does not intend to obtain
increasing competition in credit enhancements for its
the subprime mortgage own benefit.
industry, which may lead to
reduced interest margins, . The potential inability of
less stringent underwriting the Company to acquire
standards and loss of Mortgage Assets in the
experienced personnel to secondary market at
competitors. favorable yields.

. The generally higher risk . The immediate dilution of
of delinquency and $3.22 per share in net
foreclosure on subprime tangible book value to
mortgage loans which may investors purchasing in
result in higher levels of this Offering.
realized losses.
. Restrictions on ownership
of capital stock in the
. The lack of loan Company's charter, which
performance data on the may inhibit market activity
Company's loan portfolio in the Common Stock and
and the expectation of discourage takeover
increasing delinquency, attempts.
foreclosure and loss rates
as the portfolio becomes
more seasoned.

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THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES
AND EXCHANGE COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION
PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY
REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.

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<TABLE>
<CAPTION>
PRICE TO UNDERWRITING PROCEEDS TO
PUBLIC DISCOUNT(1) COMPANY(2)
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<S> <C> <C> <C>
Per Share.................................... $ $ $
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Total........................................ $ $ $
</TABLE>
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(1) The Company has agreed to indemnify the Underwriters against certain
liabilities including liabilities under the Securities Act of 1933, as
amended. See "Underwriting."
(2) Before deducting expenses payable by the Company, estimated to be $500,000.

(3) The Company has granted the Underwriters an option exercisable within 30
days after the date of this Prospectus to purchase up to 450,000 additional
shares of Common Stock on the same terms and conditions set forth above to
cover over-allotments, if any. If all such shares are purchased, the total
Price to Public, Underwriting Discount and Proceeds to Company will be
$ , $ and $ , respectively. See "Underwriting".

-----------------

The Securities are offered by the Underwriters subject to receipt and
acceptance by them, prior sale and the Underwriters' right to reject any order
in whole or in part and to withdraw, cancel or modify the offer without notice.
It is expected that delivery for the shares of Common Stock will be made
through the Depository Trust Company on or about , 1997.

STIFEL, NICOLAUS & COMPANY MONTGOMERY SECURITIES
INCORPORATED

, 1997
<PAGE>

TABLE OF CONTENTS
<TABLE>
<S> <C>
PROSPECTUS SUMMARY......................................................... 3
The Company............................................................... 3
Summary Risk Factors...................................................... 5
Business Strategies and Advantages........................................ 6
Mortgage Lending Strategies............................................... 7
Portfolio Management Strategies........................................... 8
Competitive Advantages.................................................... 8
Structural Benefits....................................................... 9
Dividend Policy, Distributions and Reinvestment........................... 11
The Offering.............................................................. 11
SUMMARY CONSOLIDATED FINANCIAL AND OTHER DATA.............................. 12
RISK FACTORS............................................................... 13
Limited Operating History of the Company and Net Losses Incurred.......... 13
Dependence on Key Personnel for Successful Operations..................... 13
Forgivable Notes May Adversely Affect Results of Operations............... 13
Need for Additional Equity Financing to Support Future Growth............. 14
Consequences of Failure to Maintain REIT Status: Company Subject to Tax as
a Regular Corporation.................................................... 14
Consequences of Failure to Qualify for Investment Company Act Exemption... 14
Future Revisions in Policies and Strategies at the Discretion of Board of
Directors................................................................ 14
Changes in Interest Rates May Adversely Affect Results of Operations...... 15
Intense Competition in the Subprime Mortgage Industry..................... 15
Higher Delinquency and Loss Rates with Subprime Mortgage Borrowers........ 15
Availability of Funding Sources........................................... 16
Dependence Upon Independent Brokers and Correspondents.................... 16
Legislative and Regulatory Risk........................................... 16
Elimination of Lender Payments to Brokers................................. 17
Environmental Liabilities................................................. 17
General Economic and Financial Conditions May Affect Results of
Operations............................................................... 18
Decrease in Net Interest Income Due to Interest Rate Fluctuations......... 18
Interest Rate Indices on Company Borrowings Differ from Indexes on Related
Mortgage Assets.......................................................... 19
Changes in Anticipated Prepayment Rates May Adversely Affect Net Interest
Income................................................................... 20
Failure to Hedge Effectively Against Interest Rate Change May Adversely
Affect Results of Operations............................................. 21
Limitations on Effective Hedging.......................................... 21
Reliance on Financial Soundness of Counter Parties in Hedging
Transactions............................................................. 21
Loss Exposure on Single Family Mortgage Assets............................ 21
Increased Loss Exposure on Subprime Mortgage Loans........................ 22
Market Factors May Limit the Company's Ability to Acquire Mortgage Assets
at Yields Which Are Favorable Relative to Borrowing Costs................ 23
</TABLE>
<TABLE>
<S> <C>
Substantial Leverage and Potential Net Interest and Operating Losses in
Connection with Borrowings............................................... 23
Failure to Refinance Outstanding Borrowings on Favorable Terms May Affect
Results of Operations.................................................... 23
Impact of Decline in Market Value of Mortgage Assets: Margin Calls........ 24
Dependence on Securitization Market....................................... 25
Lack of Loan Performance Data............................................. 25
Illiquidity of Investments................................................ 25
Lack of Geographic Diversification........................................ 25
Restrictions on Ownership of Capital Stock: Anti-takeover Effect.......... 25
Effect on Stockholders of Potential Future Offerings...................... 27
Absence of Active Public Trading Market................................... 27
Possible Volatility of Stock Price........................................ 27
Securities Eligible for Future Sale....................................... 27
Immediate Dilution........................................................ 28
THE COMPANY................................................................ 29
USE OF PROCEEDS............................................................ 29
DIVIDEND POLICY AND DISTRIBUTIONS.......................................... 30
DIVIDEND REINVESTMENT PLAN................................................. 30
DILUTION................................................................... 31
CAPITALIZATION............................................................. 32
SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA............................. 33
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS................................................................ 34
Overview.................................................................. 34
Forgivable Notes Receivable from Founders................................. 35
Financial Condition as of June 30, 1997................................... 35
Results of Operations for the Six Months Ended
June 30, 1997............................................................ 36
Liquidity and Capital Resources........................................... 40
Inflation................................................................. 41
Impact of Recently Issued Accounting Pronouncements....................... 41
BUSINESS................................................................... 42
Mortgage Lending Operation................................................ 42
Portfolio Management...................................................... 49
MANAGEMENT................................................................. 58
Directors and Executive Officers.......................................... 58
Terms of Directors and Officers........................................... 60
Committees of the Board................................................... 60
Compensation of Directors................................................. 61
Compensation Committee Interlocks......................................... 61
Executive Compensation.................................................... 61
Stock Option Grants....................................................... 62
PRINCIPAL SECURITYHOLDERS.................................................. 67
CERTAIN TRANSACTIONS....................................................... 69
FEDERAL INCOME TAX CONSIDERATIONS.......................................... 71
DESCRIPTION OF CAPITAL STOCK............................................... 80
DESCRIPTION OF WARRANTS.................................................... 85
UNDERWRITING............................................................... 87
LEGAL MATTERS.............................................................. 89
EXPERTS.................................................................... 89
AVAILABLE INFORMATION...................................................... 89
GLOSSARY................................................................... 90
CONSOLIDATED FINANCIAL STATEMENTS.......................................... F-1
</TABLE>

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CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS THAT
STABILIZE, MAINTAIN, OR OTHERWISE AFFECT THE PRICE OF THE SHARES OF COMMON
STOCK. SUCH TRANSACTIONS MAY INCLUDE STABILIZING BIDS AND PURCHASES IN THE
OPEN MARKET, OVERALLOTMENTS, SYNDICATE SHORT COVERING TRANSACTIONS AND PENALTY
BIDS. FOR A DESCRIPTION OF THESE ACTIVITIES, SEE "UNDERWRITING."

2
<PAGE>

PROSPECTUS SUMMARY

The following summary is qualified in its entirety by the more detailed
information appearing in this Prospectus. Certain capitalized and other terms
used herein shall have the meanings assigned to them in the Glossary. Unless
the context otherwise requires, references to the "Company" herein shall
include REIT-qualifying subsidiaries or taxable subsidiaries through which the
Company may carry on its business. The Company's current taxable subsidiaries
include NFI Holding Corporation ("Holding"), which owns NovaStar Mortgage, Inc.
("NMI"), also considered a taxable subsidiary. NMI serves as a vehicle for loan
origination--a primary source of Mortgage Assets for the Company. "NFI" used
herein shall refer to the REIT as a stand alone entity. NFI manages the
Mortgage Assets of the Company. All information in the Prospectus assumes that
the over-allotment option described in "Underwriting" is not exercised.

THE COMPANY

GENERAL

NovaStar Financial, Inc. is a specialty finance company which:

(i) originates, acquires, and services single family residential
subprime mortgage loans;

(ii) leverages its assets using bank warehouse lines and repurchase
agreements;

(iii) will issue collateralized debt obligations to finance its subprime
mortgage loans in the long-term;

(iv) purchases mortgage securities in the secondary mortgage market; and

(v) manages the resulting combined portfolio of Mortgage Assets in a
tax-advantaged REIT structure.

The Company was incorporated and initially capitalized on September 13, 1996.
As a result of a private placement offering on December 9, 1996, the Company
received net proceeds of $47 million (the "Private Placement").

The Company originates subprime residential mortgage loans through a
nationwide network of unaffiliated wholesale loan brokers and correspondents
and purchases bulk pools of closed loans. For the six months ended June 30,
1997, the Company originated $90 million in subprime mortgage loans, including
$28.5 million in the month of June.

The Company's borrowers generally have substantial equity in the property
securing the loan, but are considered "subprime" borrowers because they have
impaired or limited credit profiles or higher debt-to-income ratios than
traditional mortgage lenders allow. See "Business--Mortgage Lending Operation--
Underwriting and Quality Control Strategy." The Company's borrowers also
include individuals who, due to self-employment or other circumstances, have
difficulty verifying their income. These types of borrowers are generally
willing to pay higher mortgage loan origination fees and interest rates than
those charged by conventional lending

3
<PAGE>

sources. Because these borrowers typically use the proceeds of the loans to
consolidate and refinance debt and to finance home improvements, education and
other consumer needs, the Company believes that its loan volume will be less
dependent on general levels of interest rates or home sales and therefore less
cyclical than conventional mortgage lending. Although the Company's
underwriting guidelines include five levels of risk classification, 69 percent
of the principal balance of the loans originated and purchased by the Company
in 1997 were to borrowers within the Company's two highest credit grades. See
"Business--Mortgage Lending Operation--Underwriting and Quality Control
Strategy." One important consideration in underwriting subprime loans is the
nature and value of the collateral securing the loans. The Company believes
that the amount of equity present in the real estate securing its loans
mitigates the risks inherent in subprime lending. In that regard, approximately
92 percent of the loans originated and purchased in 1997 were secured by
borrowers' primary residences. The maximum loan-to-value ratio allowed for
first mortgage borrowers in the Company's highest credit grade is 90 percent.
However, the average loan-to-value ratio on loans originated and purchased by
the Company in 1997 was approximately 73 percent. Substantially all of the
loans originated and purchased by the Company during 1997 were secured by first
mortgages.

The Company has elected to be taxed as a REIT under the Internal Revenue Code
of 1986, as amended (the "Code"). As a result, the Company is generally not
subject to federal income tax to the extent that it distributes its earnings to
stockholders and maintains its qualification as a REIT. See "Federal Income Tax
Considerations." The Company has elected REIT status primarily for the tax
advantages associated with that structure. Management believes the REIT
structure is the most desirable for owning Mortgage Assets due to the
elimination of corporate-level income taxation. In addition, because the
Company is not structured as a traditional lender which accepts deposits, it is
subject to substantially less regulatory oversight and expects to incur lower
compliance expenses compared to banks, thrifts and many other originators or
holders of Mortgage Assets. The Company is self-advised and self-managed.

MANAGEMENT

Executive Officers. Scott F. Hartman, Chairman and Chief Executive Officer,
is a former executive officer of Dynex Capital, Inc., formerly Resource
Mortgage Capital, Inc. ("Dynex"), a New York Stock Exchange REIT. From February
1995 to May 1996, Mr. Hartman managed Dynex's mortgage investment portfolio and
loan securitization program.

W. Lance Anderson, President and Chief Operating Officer, is also a former
executive officer of Dynex. From February 1994 to May 1996, Mr. Anderson served
as president of Dynex's single family mortgage loan affiliate, Saxon Mortgage,
Inc. ("Saxon"). Prior to becoming President of Saxon, Mr. Anderson served as
Executive Vice President in charge of sales, marketing, underwriting and
operations.

Mark J. Kohlrus, Senior Vice President, Treasurer and Chief Financial
Officer, was previously in the Financial Services practice of KPMG Peat Marwick
LLP.

Other Senior Officers. James H. Anderson, Senior Vice President and National
Sales Manager, was most recently President of his own marketing consulting
firm. Prior to that, he was Regional Vice President of Marketing for Saxon
Mortgage.

Manuel X. Palazzo, Senior Vice President and Chief Credit Officer, was most
recently Senior Vice President of Credit and Administration for Long Beach
Mortgage Company. Mr. Palazzo has been involved in the consumer finance
industry since 1972.

Christopher S. Miller, Senior Vice President and Servicing Manager,
previously managed the collection operations of Option One Mortgage
Corporation.

See "Management" for further information regarding management of the Company.

4
<PAGE>

SUMMARY RISK FACTORS

Prior to making an investment decision, prospective investors should
carefully consider all of the information set forth in this prospectus and, in
particular, should evaluate the factors set forth in "Risk Factors." These risk
factors include:

. Limited Operating History of the Company and Net Losses Incurred. The
Company has not yet developed an extensive earnings history or
experienced a wide variety of interest rate or market conditions.
Historical operating performance may be of limited relevance in
predicting future performance. For the period since inception to December
31, 1996 and for the six months ended June 30, 1997, the Company has
incurred net losses.

. Dependence on Key Personnel for Successful Operations. The Company's
operations depend heavily upon the contributions of Scott Hartman and
Lance Anderson, both of whom would be difficult to replace. The loss of
either of these individuals could have a material adverse effect upon the
Company's business and results of operations. The Company has entered
into employment agreements with these individuals which provide for
initial terms through December 31, 2001. The employment agreements
contain compensation arrangements including base salaries, incentive
bonuses and severance arrangements. Although the Company believes the
agreements are enforceable, there are no guarantees that these
individuals will remain in the Company's employ. See "Management--
Executive Compensation."

. Forgivable Notes May Adversely Affect Results of Operations. In the
Company's Private Placement, Messrs. Hartman and Anderson each acquired
Units paid for by delivering to the Company promissory notes. Principal
due on the notes will be forgiven by the Company if the return to Private
Placement investors meets certain benchmarks. The non-cash charge against
earnings resulting from forgiveness of the notes could have a material
adverse effect on the Company's results of operations and dividends paid
to stockholders during periods forgiven. See "Management."

. Consequence of Failure to Maintain REIT Status: Company Subject to Tax as
a Regular Corporation. If the Company fails to maintain its qualification
as a REIT, the Company will be subject to federal income tax as a regular
corporation. The Company intends to conduct its business at all times in
a manner consistent with the REIT provisions of the Code.

. Changes in Interest Rates May Adversely Affect Results of Operation. The
profitability of the Company's subprime mortgage lending operation is
likely to be adversely affected during any period of unexpected or rapid
changes in interest rates. For example, a substantial or sustained
increase in interest rates could adversely affect the ability of the
Company to originate and purchase mortgage loans in expected volumes
necessary to support fixed overhead expense levels.

. Intense Competition in the Subprime Mortgage Industry. As an originator
and purchaser of subprime mortgage loans, the Company will face intense
competition, primarily from commercial banks, savings and loans, other
independent mortgage lenders, and certain other mortgage REITs. The
increasing level of capital resources being devoted to subprime mortgage
lending may increase the competition among lenders to originate or
purchase subprime mortgage loans and result in either reduced interest
income on such mortgage loans compared to present levels or revised
underwriting standards permitting higher loan-to-value ratios on
properties securing subprime mortgage loans.

. Higher Delinquency and Loss Rates with Subprime Mortgage Borrowers.
Lenders in the subprime mortgage banking industry make loans to borrowers
who have impaired or limited credit histories, limited documentation of
income and higher debt-to-income ratios than traditional mortgage lenders
allow. Loans made to subprime mortgage borrowers generally entail a
higher risk of delinquency and foreclosure than loans made to borrowers
with better credit and may result in higher levels of realized losses.
The failure of the Company to adequately address the risks of subprime
lending would have a material adverse impact on the Company's results of
operations, financial condition and business prospects.

5
<PAGE>

. Lack of Loan Performance Data. The mortgage loans originated and
purchased by the Company have been outstanding for a relatively short
period of time. Consequently, the delinquency, foreclosure and loss
experience of these loans to date may not be indicative of future
results. It is unlikely that the Company will be able to sustain
delinquency, foreclosure and loan loss rates at their present levels as
the portfolio becomes more seasoned.

. Availability of Funding Sources. The Company is currently dependent upon
a few lenders to provide the primary credit facilities for its funding of
mortgage loan originations and acquisitions. Any failure to renew or
obtain adequate funding under these financing arrangements could have a
material adverse effect on the Company's lending operations.

. Decrease in Net Interest Income Due to Interest Rate
Fluctuations. Interest rate fluctuations may affect the Company's
earnings as a result of potential changes in the spread between the
interest rates on its borrowings and the interest rates on its Mortgage
Assets. In addition, mortgage prepayment rates vary depending on such
factors as mortgage interest rates and market conditions. Changes in
anticipated prepayment rates may adversely affect the Company's earnings.

. Failure to Effectively Hedge Against Interest Rate Changes May Adversely
Affect Results of Operations. Asset/liability management hedging
strategies involve risk and may not be effective in reducing the
Company's exposure to interest rate changes. Moreover, compliance with
the REIT provisions of the Code may prevent the Company from effectively
implementing the strategies that the Company determines, absent such
compliance, would best insulate the Company from the risks associated
with changing interest rates.

. Loss Exposure on Single Family Mortgage Assets. A substantial portion of
the Mortgage Assets of the Company consists of single family mortgage
loans or Mortgage Securities evidencing interests in single family
mortgage loans. The Company will be subject to the risk of loss on such
Mortgage Assets arising from borrower defaults to the extent not covered
by third-party credit enhancement.

. Market Factors May Limit the Company's Ability to Acquire Mortgage Assets
at Yields Which are Favorable Relative to Borrowing Costs. Despite
management's experience in the acquisition of Mortgage Assets and its
relationships with various mortgage suppliers, there can be no assurance
that the Company will be able to acquire sufficient Mortgage Assets from
mortgage suppliers at spreads above the Company's cost of funds.

. Immediate Dilution. The initial public offering price is higher than the
net tangible book value per share of Common Stock in this Offering.
Investors purchasing shares of Common Stock in the Offering will be
subject to immediate dilution of $3.22 per share in net tangible book
value. See "Dilution."

. Restrictions on Ownership of Capital Stock: Anti-takeover Effect. In
order for the Company to meet the requirements for qualification as a
REIT, the Charter generally prohibits any person from acquiring or
holding, directly or indirectly, shares of Common Stock in excess of 9.8
percent of the outstanding shares. This restriction may inhibit market
activity and the resulting opportunity for the holders of the Company's
Common Stock to receive a premium for their stock that might otherwise
exist in the absence of such restrictions. See "Risk Factors--
Restrictions on Ownership of Capital Stocks: Anti-takeover Effect."

BUSINESS STRATEGIES AND ADVANTAGES

There are two general aspects to the business of the Company: (i) mortgage
lending, primarily in the subprime market; and (ii) management of a portfolio
of Mortgage Assets, including Mortgage Assets originated through the lending
operation of the Company and acquired through secondary market purchases.

6
<PAGE>

MORTGAGE LENDING STRATEGIES

In its mortgage lending operation, the Company follows the strategies listed
below.

. The Company uses its sales force to establish a nationwide network of
unaffiliated loan brokers and correspondents and competes for their
origination volume by offering subprime mortgage products at competitive
prices delivered with responsive customer service. Management of the
Company believes that this network allows the Company to create
investments at more attractive prices than are available through
secondary market purchases. As of August 31, 1997, the Company's mortgage
lending operation had a staff of 69, including 25 account executives
organized in three regions throughout the United States.

. Focus is placed on originating mortgage loans that have adjustable rates
in order to mitigate interest rate risk. For the six months ended June
30, 1997, 90 percent of the Company's wholesale mortgage loan
originations had adjustable rates. As of June 30, 1997, 81 percent of its
mortgage loan portfolio had adjustable rates.

. Prepayment penalties, generally through a loan's first two years, are
emphasized in the Company's mortgage loan originations to protect the
Company from the impact of early prepayments on loans purchased at a
premium. For the six months ended June 30, 1997, 82 percent of wholesale
mortgage loan originations had prepayment penalties. As of June 30, 1997,
63 percent of its mortgage loan portfolio had prepayment penalties.

. Centralized loan underwriting, appraisal evaluation, loan funding and
loan pricing are used to assist in maintaining control over risks and
expenses.

. Emphasis is placed on the use of early intervention, aggressive
collection and loss mitigation techniques in the servicing process
designed to manage and reduce delinquencies and minimize losses in its
mortgage loans portfolio. The Company has put in place an experienced
management team and staff to service its mortgage loans.

7
<PAGE>

Since inception, the Company has concentrated on obtaining experienced
professionals and developing the infrastructure for its wholesale mortgage loan
origination operation. The Company opened its wholesale origination operation
in late January 1997 and originated its first mortgage loan in February 1997.
Loan production has increased during 1997 as shown below.

<TABLE>
<CAPTION>
WHOLESALE MORTGAGE LOAN ORIGINATIONS
----------------------------------------
NUMBER PRINCIPAL
OF LOANS AMOUNT
---------------- ---------------------
(IN THOUSANDS)
<S> <C> <C>
1996................................... -- $ --
1997:
January............................... -- --
February.............................. 17 2,941
March................................. 51 9,747
April................................. 132 19,219
May................................... 173 29,964
June.................................. 204 28,509
July.................................. 271 35,228
August................................ 365 50,073
---------------- -------------------
Total.............................. 1,213 $ 175,681
================ ===================
</TABLE>

During the six months ended June 30, 1997, the Company also acquired Mortgage
Assets through the acquisition of bulk pools of mortgage loans and agency-
issued Mortgage Securities with aggregate principal amounts of $207.2 million
and $370.6 million, respectively.

PORTFOLIO MANAGEMENT STRATEGIES

In its portfolio management, the Company:

. acquires mortgage securities and mortgage loans which satisfy the
Company's requirements for its overall asset/liability strategy;

. borrows funds under repurchase agreements and its warehouse line of
credit to finance subprime mortgage loan originations and acquisitions
and mortgage securities acquisitions;

. will issue debt obligations securitized by mortgage loans to provide
long-term non-recourse financing;

. monitors interest rate sensitivity through progressive analytical
techniques and seeks to mitigate interest rate risk by using various
hedging techniques to match the cost and terms of funding sources with
that of the yield and terms of Mortgage Assets; and

. adheres to its Capital Allocation Guidelines ("CAG") in the application
of equity and debt financing to acquire Mortgage Assets.

The Company uses a combination of equity and borrowings to finance its
acquisition of Mortgage Assets. All investments are evaluated in the context of
the CAG and investment policy, both of which have been approved by the Board of
Directors. The Company will use leverage to enhance the return to stockholders.
The CAG detail the borrowing limits to be used given the composition of
Mortgage Assets. Management focuses on the CAG to determine the appropriate
amount of equity and borrowings to balance the risks and returns associated
with potential investments and the existing portfolio. Until the Company is
fully leveraged, the Company will not reach its full earnings potential. During
the six month period ended June 30, 1997, the Company has operated at
substantially below a fully leveraged position based upon the CAG.

COMPETITIVE ADVANTAGES

The Company's principal competition in the business of originating, acquiring
and servicing subprime mortgage loans are financial institutions such as banks,
thrifts and other independent wholesale mortgage lenders,

8
<PAGE>

and certain other mortgage acquisition companies structured as REITs. The
Company's principal competition in the business of holding mortgage loans and
Mortgage Securities are life insurance companies, institutional investors such
as mutual funds and pension funds, other well-capitalized publicly-owned
mortgage lenders and certain other mortgage acquisition companies structured as
REITs. The Company anticipates that it will be able to effectively compete due
to its:

(i) experienced management team;

(ii) tax advantaged status as a REIT;

(iii) vertical integration as originator, servicer and investor;

(iv) freedom from certain regulatory-related administrative and oversight
costs;

(v) direct access to capital markets to securitize its assets; and

(vi) cost-efficient operations.

STRUCTURAL BENEFITS

The REIT tax status is a primary distinction between the Company and many
other subprime mortgage originators. The Company will attempt to maximize its
after-tax return advantage over non-REIT financial companies by holding
Mortgage Assets and earning REIT-qualifying income over time through the
Company.

Generally, the Company does not intend to sell its mortgage loan production
in order to realize gain on sale for financial accounting or tax reporting
purposes. Rather, the Company intends to finance its mortgages through
structured debt vehicles where the emphasis is on earning net interest income
and not taking gain on the sale of assets. The Company's strategy is to build
and hold a portfolio of Mortgage Assets for investment that generates a net
interest margin over time and allows the Company to take full advantage of its
REIT status. While selling mortgage loans presents greater earnings and taxable
income during the period of production (assuming constant portfolio
assumptions) due to the current income recognition of the present value of
future cash flows, management believes that over the long term the Company will
produce a tax-advantaged stream of income and a more stable dividend flow to
stockholders because its earnings will be dependent on the size of the
Company's portfolio of Mortgage Assets, rather than on its quarterly mortgage
loan production level. The accounting for gain on sale presents, as current
income, the present value of expected future cash flows from the mortgage loans
sold. Future performance expectations are subject to revision should actual
losses, interest rates and prepayment experience differ from the assumed
levels. Holding the mortgage loans as investments allows the Company to record
income as interest is earned. While management intends to aggressively manage
costs in all production cycles, holding the mortgage loans and recording income
as interest is earned provides management the flexibility to reduce its
mortgage loan production rate during periods in which management believes the
market conditions for subprime mortgage loans are unattractive without
necessarily experiencing an immediate decline in net income. Companies
utilizing gain on sale accounting will typically experience a decline in net
income during periods of declining mortgage loan origination volume.

The Company believes it has an advantage over other mortgage REITs through
its infrastructure that allows the Company to originate mortgage loans to its
specifications at a total cost lower than purchasing those mortgage loans in
the secondary market. Moreover, because the Company and its subsidiaries are a
vertically integrated and consolidated organization, which is self-advised and
self-managed, there are no potential conflicts between the interests of the
mortgage lending operation and the portfolio management operation. Such
conflicts can arise in REITs where the incentives and interest of management
are dependent on asset size rather than return on equity or stockholder
returns. Conflict may arise in entities which have external management
contracts or situations where management's compensation is not directly related
with the company's performance or return to stockholders. The Company's primary
management incentive programs are dependent on return on equity (the annual
bonus plan, of which half is paid in stock) and stock price appreciation
(forgivable loans to founders and stock option plan). See "Management--
Executive Compensation."

9
<PAGE>

The following diagram depicts the structure of the Company as it presently
exists. NovaStar Financial, Inc. files its own income tax return, while NFI
Holding Corporation files consolidated income tax returns that include NovaStar
Mortgage, Inc. This structure is designed to legally separate the mortgage loan
origination operations from the REIT entity, and allows for certain activities
and transactions to be entered into by NovaStar Mortgage, Inc., while
preserving the REIT status of NovaStar Financial, Inc. These activities include
such items as the sale of assets, certain hedging techniques and certain forms
of indebtedness. NFI Holding Corporation was formed in order to provide an
efficient means of adding additional taxable affiliates to the organization.

As the diagram presents, Scott Hartman and Lance Anderson own 100 percent of
the voting common stock of NFI Holding Corporation. NFI Holding Corporation was
capitalized through the purchase of common stock by Scott Hartman and Lance
Anderson in the amount of $20,000, and the purchase of preferred stock by
NovaStar Financial, Inc. in the amount of $1,980,000. Mr. Hartman and Mr.
Anderson receive one percent of the economic benefits derived from dividends
and distributions of NFI Holding Corporation as a result of their common stock
ownership. NovaStar Financial, Inc. receives 99 percent of the dividends of NFI
Holding Corporation as a result of its preferred stock ownership. Accordingly,
NovaStar Financial, Inc. indirectly receives 99 percent of the dividends of
NovaStar Mortgage, Inc. by virtue of its ownership interest in NFI Holding
Corporation. In addition, Mr. Hartman and Mr. Anderson serve as the sole
Directors of both NFI Holding Corporation and NovaStar Mortgage, Inc.

LOGO

10
<PAGE>

DIVIDEND POLICY, DISTRIBUTIONS AND REINVESTMENT

The Company generally intends to distribute to stockholders each year
substantially all of its net taxable income (which does not ordinarily equal
net income as determined in accordance with generally accepted accounting
principles) to qualify for the tax benefits accorded to REITs under the Code.
The Company has declared dividends of $0.05 per share for each of the first and
second quarters of 1997. Both of these dividends were declared on Preferred
Stock. It is expected that the 1997 third quarter dividend will be declared on
Preferred Stock. Subsequent to the closing of this Offering, the Company
intends to declare quarterly dividends on its Common Stock.

The Company intends to distribute any taxable income remaining after the
distribution of the regular quarterly dividends annually in a special dividend
on or prior to the date of the first regular quarterly dividend payment date of
the following taxable year. The dividend policy is subject to revision at the
discretion of the Board of Directors. All distributions will be made by the
Company at the discretion of the Board of Directors and will depend on the
taxable income and financial condition of the Company, maintenance of REIT
status and such other factors as the Board of Directors deems relevant.

The Company expects to adopt a dividend reinvestment plan ("DRP") for
stockholders who wish to reinvest their quarterly dividends in additional
shares of Common Stock. Generally, under a DRP, dividends paid with respect to
shares of Capital Stock are automatically invested in additional shares of
Common Stock at a discount to the then current market price. Stockholders are
not automatically enrolled in the DRP.

Stockholders who own more than a specified number of shares of Common Stock
will be eligible to participate in the DRP following the effectiveness of the
registration of securities issuable thereunder. This Offering is not related to
the proposed DRP, nor has the Company prepared or filed a registration
statement with the SEC registering the shares to be issued under the DRP. Prior
to buying shares through the DRP, participants will be provided with a DRP
prospectus which will constitute a part of such DRP registration statement. The
Company's transfer agent will act as the trustee and administrator of the DRP
(the "Agent").

Stockholders will not be automatically enrolled in the DRP. Each stockholder
desiring to participate in the DRP must complete and deliver to the Agent an
enrollment form, which will be sent to each eligible stockholder following the
effectiveness of the registration of the shares to be issued under the DRP.
Participation in the DRP will commence with all dividends and distributions
payable after receipt of a participant's authorization, provided that the
authorization must be received by the Agent at least two business days prior to
the record date for any dividends in order for any stockholder to be eligible
for reinvestment of such dividends.

THE OFFERING

Common Stock Offered by the Company(1).... 3,000,000 Shares

Common Stock to be outstanding after the 6,766,665 Shares
Offering(2)..............................

Use of Proceeds...........................
The Company will use the proceeds
to fund its origination of and
investment in Mortgage Assets, and
for working capital.

Nasdaq National Market symbol........ Nova
- --------
(1)Assumes the Underwriters' over-allotment option is not exercised. See
"Underwriting".

(2) Includes the conversion of 3,549,999 shares of Preferred Stock in
connection with the Offering. Does not reflect the exercise of the
3,649,999 warrants and the 334,332 common stock options which are
outstanding as of June 30, 1997. Dividend equivalent rights were granted
with 45,000 of the common stock options. See "Description of Warrants" and
"Management--Executive Compensation".

11
<PAGE>

SUMMARY CONSOLIDATED FINANCIAL AND OTHER DATA
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
FOR THE SIX MONTHS ENDED FOR THE PERIOD ENDED
JUNE 30, 1997 DECEMBER 31, 1996(1)
------------------------ --------------------------
<S> <C> <C>
STATEMENT OF OPERATIONS
DATA
Interest income........... $ 9,320 $ 155
Interest expense.......... 6,438 --
Net interest income....... 2,882 155
Provision for credit
losses................... 718 --
Net interest income after
provision for credit
losses................... 2,164 155
Other income.............. 213 --
General and administrative
expenses................. 3,256 457
Net loss.................. (879) (302)
Pro forma net loss per
share(2)................. (0.21) (0.07)
<CAPTION>
AS OF JUNE 30, 1997 AS OF DECEMBER 31, 1996
------------------------ --------------------------
<S> <C> <C>
BALANCE SHEET DATA
Mortgage assets:
Mortgage securities....... $284,348 $13,239
Mortgage loans............ 303,732 --
Total assets.............. 601,741 59,796
Borrowings................ 553,640 --
Stockholders' equity...... 46,337 46,365
<CAPTION>
AS OF OR FOR THE SIX
MONTHS AS OF OR FOR THE PERIOD
ENDED JUNE 30, 1997 ENDED DECEMBER 31, 1996(1)
------------------------ --------------------------
<S> <C> <C>
OTHER DATA
Wholesale loans
originations:
Production................ $ 90,380 --
Average principal balance
per loan................. $ 157 --
Weighted average interest
rate:
Adjustable rate mortgage
loans................... 10.0% --
Fixed rate mortgage
loans................... 10.6% --
Loans with prepayment
penalties................ 82% --
Weighted average
prepayment penalty period
(in years)............... 2.7 --
Loans purchased in bulk:
Principal at purchase..... $207,240 --
Average principal balance
per loan................. $ 106 --
Weighted average interest
rate:
Adjustable rate mortgage
loans................... 9.6% --
Fixed rate mortgage
loans................... 10.5% --
Loans with prepayment
penalties................ 54% --
Weighted average
prepayment penalty period
(in years)............... 3.0 --
Net interest spread....... 1.77% --
Net yield................. 2.51% --
Return on assets.......... (0.29)% (1.69)%
Return on equity.......... (3.79)% (2.18)%
Taxable income (loss)--
NovaStar Financial,
Inc...................... $ 365 $ (173)
Taxable income (loss) per
preferred share--NovaStar
Financial, Inc........... $ 0.10 $ (0.05)
Dividends per preferred
share(3)................. $ 0.10 --
Number of account
executives............... 17 --
</TABLE>
- --------
(1) The Company was formed on September 13, 1996. Operations began in substance
after the Private Placement which closed on December 9, 1996.

(2) Pro forma net loss per share is based on the weighted average shares of
Common Stock and Preferred Stock outstanding, and includes the effect of
warrants and options using the treasury stock method.
(3) No dividends have been declared on the Common Stock. The level of quarterly
dividends is determined by the Board of Directors based upon its
consideration of a number of factors and should not be deemed indicative of
taxable income for the quarter in which declared or future quarters, or of
income calculated in accordance with GAAP. See "Dividend Policy and
Distributions."

12
<PAGE>

RISK FACTORS

In addition to the other information contained in this Prospectus, the
following risk factors should be carefully considered in evaluating the
Company and its business before purchasing any of the shares of Common Stock
offered hereby. This Prospectus contains forward-looking statements.
Discussions containing such forward-looking statements may be found in the
material set forth under "Prospectus Summary," "Use of Proceeds,"
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Business," as well as within this Prospectus generally.
Actual results could differ materially from those described in the forward-
looking statements as a result of the risks and uncertainties set forth below
and within this Prospectus generally. The Company cautions the reader,
however, that this discussion of risk factors may not be exhaustive.

RISKS ASSOCIATED WITH THE COMPANY'S OVERALL ENTERPRISE

Limited Operating History of the Company and Net Losses Incurred

The Company began operations in December 1996 following the closing of the
Private Placement. The mortgage lending operation began in late January 1997
and the Company began servicing loans on July 15, 1997. Accordingly, the
Company has not yet developed an extensive earnings history or experienced a
wide variety of interest rate or market conditions and, as such, historical
operating performance may be of limited relevance in predicting future
performance. Although the Company has grown its assets dramatically since the
beginning of operations, there can be no assurances that it will be able to
continue to successfully operate its business as described in this Prospectus.
In addition, management of the Company does not have extensive experience
working together as a management team. The Company has incurred net losses of
$302,000 and $879,000 for the period since inception to December 31, 1996 and
for the six months ended June 30, 1997, respectively. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations."

Dependence on Key Personnel for Successful Operations

The Company's operations depend heavily upon the contributions of Scott
Hartman and Lance Anderson, both of whom would be difficult to replace.
Although Mr. Hartman and Mr. Anderson have both signed employment agreements,
there can be no assurance that these individuals will remain employees of the
Company. The loss of either of these individuals could have a material adverse
effect upon the Company's business and results of operations. The Company has
entered into employment agreements with these individuals which provide for
initial terms through December 31, 2001. The employment agreements contain
compensation arrangements including base salaries, incentive bonuses and
severance arrangements. Although the Company believes the agreements are
enforceable, there are no guarantees that these individuals will remain in the
Company's employ. See "Management."

Forgivable Notes May Adversely Affect Results of Operations

In the Company's Private Placement, Messrs. Hartman and Anderson each
acquired 108,333 Units at the price of $15.00 per Unit. Payment for the Units
was made by delivering to the Company promissory notes, each in the amount of
$1,624,995, bearing interest at eight percent per annum and secured by the
Units acquired. The principal amount of the notes was divided into three equal
tranches. Principal due will be forgiven by the Company if the return to
Private Placement investors meets certain benchmarks as follows: one tranche
will be forgiven if the Company generates a total return to the Private
Placement investors equal to or greater than 15 percent in any one fiscal year
and all tranches will be forgiven if the total cumulative return to Private
Placement investors reaches 100 percent prior to December 31, 2001. Return to
investors includes dividends paid as well as any appreciation in the average
price per share of the Common Stock and the related Warrant during the period.
If one tranche is forgiven, the Company will recognize a non-cash charge
against earnings of $1,083,330 for the

13
<PAGE>

related accounting period. If the entire amount of the notes is forgiven, the
Company will recognize a non-cash charge against earnings of $3,249,990. Such
charges resulting from forgiveness of the notes could have a material adverse
effect on the Company's results of operations on dividends paid to
shareholders during periods forgiven-- including investors in this Offering.
See "Management--Executive Compensation."

Need for Additional Equity Financing to Support Future Growth

To implement fully the Company's strategy to continue rapid growth in its
portfolio of Mortgage Assets, the Company will be required to raise capital in
addition to that raised by the Offering. Accordingly, the Company expects to
undertake future equity offerings, in addition to long-term securitized debt
offerings. There can be no assurance that the Company will successfully and
economically raise the capital it will require through such offerings. See
"Risk Factors--Effect on Stockholders of Potential Future Offerings."

Consequences of Failure to Maintain REIT Status: Company Subject to Tax as a
Regular Corporation

The Company intends, at all times, to operate so as to qualify as a REIT for
federal income tax purposes. In order to maintain its qualification as a REIT
for federal income tax purposes, the Company must satisfy certain tests with
respect to the sources of its income, the nature and diversification of its
assets, the amount of its distributions to stockholders and the ownership of
its stock. If the Company fails to qualify as a REIT in any taxable year and
certain relief provisions of the Code do not apply, the Company would be
subject to federal income tax as a regular, domestic corporation, and its
stockholders would be subject to tax in the same manner as stockholders of
such corporation. Distributions to stockholders in any year in which the
Company fails to qualify as a REIT would not be deductible by the Company in
computing its taxable income. As a result, the Company could be subject to
income tax liability, thereby significantly reducing or eliminating the amount
of cash available for distribution to its stockholders. Further, the Company
could also be disqualified from re-electing REIT status for the four taxable
years following the year during which it became disqualified.

No assurance can be given that future legislation, regulations,
administrative interpretations or court decisions will not significantly
change the tax laws with respect to the Company's qualification as a REIT or
the federal income tax consequences of such qualification, which changes may
reduce or eliminate the Company's competitive advantage over non-REIT
competitors. See "Federal Income Tax Considerations--Qualification as a REIT"
and "--Taxation of the Company."

Consequences of Failure to Qualify for Investment Company Act Exemption

The Company at all times intends to conduct its business so as not to become
regulated as an investment company under the Investment Company Act.
Accordingly, the Company does not expect to be subject to the restrictive
provisions of the Investment Company Act. The Investment Company Act exempts
entities that are "primarily engaged in the business of purchasing or
otherwise acquiring mortgages and other liens on and interests in real
estate." If the Company fails to qualify for exemption from registration as an
investment company, its ability to use leverage would be substantially reduced
and it would be unable to conduct its business as described herein. Any such
failure to qualify for such exemption could have a material adverse effect on
the Company.

Future Revisions in Policies and Strategies at the Discretion of Board of
Directors

Management has established the operating policies and strategies set forth
in this Prospectus as the operating policies and strategies of the Company.
However, these policies and strategies may be modified or waived by the Board
of Directors, subject in certain cases to approval by a majority of the
Independent Directors, without stockholder approval. The ultimate effect of
these changes may be positive or negative.

14
<PAGE>

RISKS ASSOCIATED WITH SUBPRIME MORTGAGE LENDING OPERATION

Changes in Interest Rates May Adversely Affect Results of Operations

The results of operations of the Company are likely to be adversely affected
during any period of unexpected or rapid changes in interest rates. For
example, a substantial or sustained increase in interest rates could adversely
affect the ability of the Company to originate and purchase loans in expected
volumes necessary to support fixed overhead expense levels. Decreases in
interest rates cause loans in the portfolio to prepay more quickly. This could
result in the Company amortizing more of the premium it paid for the mortgage
loans and, therefore, decreasing net interest income.

Intense Competition in the Subprime Mortgage Industry

As an originator and purchaser of subprime mortgage loans, the Company will
face intense competition, primarily from commercial banks, savings and loans,
other independent mortgage lenders, and certain other mortgage REITs. As the
Company expands into the national market and particular geographic markets, it
will face competition from lenders with established positions in these
locations. Competition can take place on various levels, including convenience
in obtaining a loan, service, marketing, origination channels and pricing.

The subprime market is currently undergoing substantial changes. There are
new entrants into the market creating a changing competitive environment.
Furthermore, certain large national finance companies and prime mortgage
originators have begun to implement plans to adapt their prime mortgage
origination programs and allocate resources to the origination of subprime
mortgage loans. Certain of these larger mortgage companies and commercial
banks have begun to offer products similar to those which are offered by the
Company and to target customers similar to those targeted by the Company. In
the future, the Company may also face competition from government-sponsored
entities, such as the Federal National Mortgage Association and the Federal
Home Loan Mortgage Corporation. For example, the Federal Home Loan Mortgage
Corporation has recently issued securities collateralized by subprime mortgage
loans originated by a financial institution.

The entrance of these competitors into the Company's market could have a
material adverse effect upon the Company's results of operations and financial
condition. In particular, the increasing level of capital resources being
devoted to subprime mortgage lending may increase the competition among
lenders to originate or purchase subprime loans and result in either reduced
net interest income on such mortgage loans compared to present levels or
revised underwriting standards permitting higher loan-to-value ratios on
properties securing subprime mortgage loans. Increased competition may also
increase the demand for the Company's experienced personnel and the potential
that such personnel will leave the Company for its competitors. There can be
no assurance that the Company will be able to compete successfully in this
market environment and any failure in this regard could have a material
adverse effect on the Company's results of operations and financial condition.
Fluctuations in interest rates and general and localized economic conditions
may also affect the competition the Company faces. Competitors with lower
costs of capital have a competitive advantage over the Company. During periods
of declining rates, competitors may solicit the Company's customers to
refinance their loans. In addition, during periods of economic slowdown or
recession, the Company's borrowers may face financial difficulties and be more
receptive to the offers of the Company's competitors to refinance their loans.

Higher Delinquency and Loss Rates with Subprime Mortgage Borrowers

Lenders in the subprime mortgage banking industry make loans to borrowers
who have impaired or limited credit histories, limited documentation of income
and higher debt-to-income ratios than traditional mortgage lenders allow.
Loans made to subprime mortgage borrowers generally entail a higher risk of
delinquency and foreclosure than loans made to borrowers with better credit
and may result in higher levels of realized loss.

15
<PAGE>

Most of the Company's loans are made to borrowers who do not qualify for loans
from conventional mortgage lenders and, as of June 30, 1997, approximately
eight percent and four percent of the Company's mortgage loan portfolio was
comprised of loans made to borrowers graded "C" or "D," respectively, the
Company's two lowest credit grade classifications. See "Business-Mortgage
Lending-Underwriting and Quality Control Strategy." No assurances can given
that the Company's underwriting criteria or methods will afford adequate
protection against the higher risks associated with loans made to subprime
mortgage borrowers. The failure of the Company to adequately address the risk
of subprime lending would have a material adverse impact on the Company's
results of operations, financial condition and business prospects.

Availability of Funding Sources

The Company finances substantially all of the mortgage loans which it
originates or acquires through interim financing facilities including its bank
warehouse credit line and repurchase agreements, and with equity. These
borrowings have been, and will going forward be, repaid with the proceeds
received by the Company from financing mortgage loans through securitization.
The Company is currently dependent upon a few lenders to provide the primary
credit facilities for its mortgage loan originations and acquisitions. Any
failure to renew or obtain adequate funding under these financing arrangements
could have a material adverse effect on the Company's lending operations.

Dependence Upon Independent Brokers and Correspondents

The Company depends upon independent mortgage loan brokers and mortgage
lenders for its originations and purchases of new mortgage loans. The
Company's competitors also seek to establish relationships with brokers and
correspondents. The Company's future results may become more exposed to
fluctuations in the volume and cost of acquiring its mortgage loans resulting
from competition from other prospective purchasers of such mortgage loans.

Legislative and Regulatory Risk

Members of Congress and government officials from time to time have
suggested the elimination of the mortgage interest deduction for federal
income tax purposes, either entirely or in part, based on borrower income,
type of mortgage loan or principal amount. Because many of the Company's
mortgage loans will be made to borrowers for the purpose of consolidating
consumer debt or financing other consumer needs, the competitive advantages of
tax deductible interest, when compared with alternative sources of financing,
could be eliminated or seriously impaired by such government action.
Accordingly, the reduction or elimination of these tax benefits could have a
material adverse effect on the demand for mortgage loans offered by the
Company.

The Company's business is subject to extensive regulation, supervision and
licensing by federal, state and local governmental authorities and will be
subject to various laws and judicial and administrative decisions imposing
requirements and restrictions on part or all of its operations. Regulated
matters include, without limitation, mortgage loan origination marketing
efforts, credit application and underwriting activities, maximum finance and
other charges, disclosure to customers, certain rights of rescission on
mortgage loans, closing and servicing mortgage loans, collection and
foreclosure procedures, qualification and licensing requirements for doing
business in various jurisdictions and other trade practices. Mortgage loan
origination activities are subject to the laws and regulations in each of the
states in which those activities are conducted. Activities as a lender are
also subject to various federal laws. The Truth in Lending Act ("TILA") and
Regulation Z promulgated thereunder, as both are amended from time to time,
contain disclosure requirements designed to provide consumers with uniform,
understandable information with respect to the terms and conditions of loans
and credit transactions in order to give them ability to compare credit terms.
TILA also guarantees consumers a three-day right to cancel certain credit
transactions. TILA also imposes disclosure, underwriting and documentation
requirements on mortgage loans, known as "Section 32 loans," with (i) total
points and fees upon origination in excess of eight percent of the mortgage
loan amount or (ii) an annual percentage rate of more than ten percentage
points higher than comparably maturing U.S. treasury securities. The Company
is also required to comply with

16
<PAGE>

the Equal Credit Opportunity Act of 1974, as amended ("ECOA"), which prohibits
creditors from discriminating against applicants on the basis of race, color,
sex, age or marital status. Regulation B promulgated under ECOA restricts
creditors from obtaining certain types of information from loan applicants. It
also requires certain disclosures by the lender regarding consumer rights and
requires lenders to advise applicants of the reasons for any credit denial. In
instances where the applicant is denied credit or the rate or charge for a
loan increases as a result of information obtained from a consumer credit
agency, the Fair Credit Reporting Act of 1970, as amended, requires the lender
to supply the applicant with a name and address of the reporting agency. The
Company will also be subject to the Real Estate Settlement Procedures Act
("RESPA") and the Debt Collection Practices Act and will be required to file
an annual report with the Department of Housing and Urban Development pursuant
to the Home Mortgage Disclosure Act ("HMDA"). The Company will also be subject
to the rules and regulations of, and examinations by, GNMA, the Department of
Housing and Urban Development ("HUD") and state regulatory authorities with
respect to originating, processing, underwriting, selling and servicing loans.
There can be no assurance that the Company will maintain compliance with these
requirements in the future without additional expenses, or that more
restrictive local, state or federal laws, rules and regulations will not be
adopted or that existing laws and regulations will not be interpreted in a
more restrictive manner, which would make compliance more difficult for the
Company. Failure to comply with these requirements can lead to loss of
approved status, termination or suspension of servicing contracts without
compensation to the servicer, demands for indemnifications or mortgage loan
repurchases, certain rights of rescission for mortgage loans, class action
lawsuits and administrative enforcement actions, any of which could cause a
material adverse effect on the Company's profitability.

The laws and regulations described above are subject to legislative,
administrative and judicial interpretation, and certain of these laws and
regulations have been infrequently interpreted or only recently enacted.
Infrequent interpretations of these laws and regulations or an insignificant
number of interpretations of recently enacted regulations can result in
ambiguity with respect to permitted conduct under these laws and regulations.
Any ambiguity under the regulations to which the Company is subject may lead
to regulatory investigations or enforcement actions and private causes of
action, such as class action lawsuits, with respect to the Company's
compliance with the applicable laws and regulations. As a mortgage lender, the
Company will be subject to regulatory enforcement actions and private causes
of action from time to time with respect to its compliance with applicable
laws and regulations.

Elimination of Lender Payments to Brokers

Class-action lawsuits have been filed against a number of mortgage lenders
alleging that such lenders have violated RESPA by making certain payments to
independent mortgage brokers. These lawsuits have generally been filed on
behalf of a purported nationwide class of borrowers and allege that payments
made by a lender to a broker in addition to payments made by the borrower to a
broker are prohibited by RESPA, and are therefore illegal. If these cases are
resolved against the lenders, it may cause an industry-wide change in the way
independent mortgage brokers are compensated. The Company's broker
compensation programs permit such payments. Future regulatory interpretations
or judicial decisions may require the Company to change its broker
compensation programs or subject it to material monetary judgments or other
penalties. Any such changes or penalties may have a material adverse effect on
the Company's results of operations, financial condition and business
prospects. See "Risk Factors--Legislative and Regulatory Risk."

Environmental Liabilities

Certain properties securing mortgage loans may be contaminated by hazardous
substances. As a result, the value of the real property may be diminished. In
the event that the Company is forced to foreclose on a defaulted mortgage loan
on that property, the Company may be subject to environmental liabilities
regardless of whether the Company was responsible for the contamination. While
the Company intends to exercise due diligence to discover potential
environmental liabilities prior to the acquisition of any property through
foreclosure, hazardous substances or wastes, contaminants, pollutants or
sources thereof (as defined by state and federal laws and regulations) may be
discovered on properties during the Company's ownership or after a sale
thereof to a third

17
<PAGE>

party. If such hazardous substances are discovered on a property, the Company
may be required to remove those substances or sources and clean up the
property. The Company may also be liable to tenants and other users of
neighboring properties. Such clean-up costs and liabilities may be extensive
and may materially and adversely affect the Company's profitability. In
addition, the Company may find it difficult or impossible to sell the property
prior to or following any such clean up.

RISKS ASSOCIATED WITH THE ACQUISITION AND MANAGEMENT OF A PORTFOLIO OF
MORTGAGE ASSETS

General Economic and Financial Conditions May Affect Results of Operations

Although the Company hedges its interest rate risk, the results of the
Company's Mortgage Assets portfolio operation are affected by various factors,
many of which are beyond the control of the Company. The performance of the
Company's Mortgage Assets portfolio depends on, among other things, the level
of net interest income generated by the Company's Mortgage Assets, the market
value of such Mortgage Assets and the supply of and demand for such Mortgage
Assets. The Company's net interest income varies primarily as a result of
changes in short-term interest rates, borrowing costs and prepayment rates,
the behavior of which involve various risks and uncertainties as set forth
below. Prepayment rates, interest rates, borrowing costs and credit losses
depend upon the nature and terms of the Mortgage Assets, the geographic
location of the properties securing the mortgage loans included in or
underlying the Mortgage Assets, conditions in financial markets, the fiscal
and monetary policies of the United States government and the Board of
Governors of the Federal Reserve System, international economic and financial
conditions, competition and other factors, none of which can be predicted with
any certainty. Because changes in interest rates may significantly affect the
Company's activities, the operating results of the Company depend, in large
part, upon the ability of the Company effectively to manage its interest rate
and prepayment risks while maintaining its status as a REIT. Prolonged failure
to manage such risks would adversely affect the Company's profitability. See
"Risk Factors--Risks of Failing to Hedge Effectively Against Interest Rate
Changes; Risk of Losses Associated with Hedging; Counterparty Risks."

Decrease in Net Interest Income Due to Interest Rate Fluctuations

The Company's adjustable rate Mortgage Assets bear adjustable interest or
pass-through rates based on short-term interest rates, and substantially all
of the Company's borrowings bear interest at short-term rates and have
maturities of less than one year. Consequently, changes in short-term interest
rates may significantly influence the Company's net interest income. While
rising short-term interest rates generally increase the yields on the
Company's adjustable-rate Mortgage Assets, rising short-term rates also
increase the costs of borrowings by the Company which are utilized to fund the
Mortgage Assets and, to the extent such costs escalate more rapidly than the
yields, the Company's net interest income may be reduced or a net loss may
result. Conversely, falling short-term interest rates may decrease the
interest cost on the Company's borrowings more rapidly than the yields on the
Mortgage Assets and hence may increase the Company's net interest income. No
assurance can be given as to the amount or timing of changes in interest rates
or their effect on the Company's Mortgage Assets or net interest income.

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<PAGE>

As of June 30, 1997, all Mortgage Securities owned by the Company had
adjustable rates based on the one-year Constant Maturity Treasury (CMT) index.
The following table presents the adjustable rate characteristics of the
Company's mortgage loans as of June 30, 1997 (dollars in thousands).

<TABLE>
<CAPTION>
PERCENT OF MONTHS TO
PRINCIPAL TOTAL RESET
--------- ---------- ---------
<S> <C> <C> <C>
Adjustable rate loans:
One year CMT............................. $ 12,391 4.3% 10
Two year fixed/six month LIBOR........... 127,857 44.0 20
Three year fixed/six month LIBOR......... 9,264 3.2 33
Six month LIBOR.......................... 91,735 31.6 3
-------- -----
241,247 83.1
Fixed rate loans........................... 49,046 16.9
-------- -----
$290,293 100.0
======== =====
</TABLE>

Adjustable rate mortgage loans are inherently riskier than fixed rate
mortgage loans. These loans have interest rates that may rise, resulting in
higher mortgage payments for the borrower. Adjustable rate loans are usually
underwritten at a higher interest rate, to ensure that the borrower has the
ability to make mortgage payments as the rate on the mortgage loan increases.
An increasing interest rate environment will force the borrower to make higher
mortgage payments, which could result in higher delinquencies, foreclosures
and losses.

Interest Rate Indices on Company Borrowings Differ from Indexes on Related
Mortgage Assets

A substantial portion of all mortgage loans owned by Company have adjustable
terms today or are fixed today, but will adjust at some point in the future.
For instance, the Company's most popular product to date has been a mortgage
with a rate fixed for two years, at which time it becomes an adjustable rate
mortgage. As of June 30, 1997, all of the Company's Mortgage Securities were
backed by ARMs. Interest rates on the Company's borrowings are and generally
will be based on short-term indices. To the extent any of the Company's
Mortgage Assets are financed with borrowings bearing interest based on or
varying with an index different from that used for the related Mortgage
Assets, so-called "basis" interest rate risk will arise. In such event, if the
index used for the Mortgage Assets is a "lagging" index (such as the 11th
District Cost of Funds) that reflects market interest rate changes on a
delayed basis, and the rate borne by the related borrowings reflects market
rate changes more rapidly, the Company's net interest income will be adversely
affected in periods of increasing market interest rates. Additionally, the
Company's adjustable-rate Mortgage Assets will be subject to periodic rate
adjustments which may be more or less frequent than the increases or decreases
in rates borne by the borrowings or financings utilized by the Company.
Accordingly, in a period of increasing interest rates, the Company could
experience a decrease in net interest income or a net loss because the
interest rates on borrowings could adjust faster than the interest rates on
the Company's ARMs or Mortgage Assets backed by ARMs. Moreover, ARMs are
typically subject to periodic and lifetime interest rate caps that limit the
amount an ARM interest rate can change during any given period. The Company's
borrowings will not be subject to similar restrictions. Hence, in a period of
rapidly increasing interest rates, the Company could also experience a
decrease in net interest income or a net loss in the absence of effective
hedging because the interest rates on borrowings could increase without
limitation while the interest rates on the Company's ARMs and Mortgage Assets
backed by ARMs would be limited by caps. Further, some ARMs may be subject to
periodic payment caps that result in some portion of the interest accruing on
the ARM being deferred and added to the principal outstanding. This could
result in receipt by the Company of less cash income on its ARMs than is
required to pay interest on the related borrowings, which will not have such
payment caps.

As of June 30, 1997, 90 percent of the Company's Mortgage Assets bear
adjustable rates. All mortgage securities adjust based on the one-year CMT
rate. The Company's adjustable rate mortgage loans adjust with either six
month LIBOR or the one-year CMT rate. All of the Company's borrowings bear
variable rates of interest. Rates on the Company's repurchase agreements are
variable based on the terms to maturity of individual

19
<PAGE>

agreements. As of June 30, 1997, these agreements were tied primarily to one-
month LIBOR. The rate on the Company's warehouse line of credit adjusts based
upon the Federal Funds rate.

Changes in Anticipated Prepayment Rates May Adversely Affect Net Interest
Income

Prepayment rates vary from time to time and may cause changes in the amount
of the Company's net interest income. Prepayments of ARMs and Mortgage Assets
backed by ARMs usually can be expected to increase when mortgage interest
rates fall below the then-current interest rates on such ARMs and decrease
when mortgage interest rates exceed the then-current interest rate on the
ARMs, although such effects are not predictable. Prepayment experience also
may be affected by the geographic location of the property securing the
mortgage loans, the assumability of the mortgage loans, conditions in the
housing and financial markets and general economic conditions. In addition,
prepayments on ARMs are affected by the ability of the borrower to convert an
ARM to a fixed-rate loan and by conditions in the fixed-rate mortgage market.
If the interest rates on ARMs increase at a rate greater than the interest
rates on fixed-rate mortgage loans, prepayments on ARMs may tend to increase.
In periods of fluctuating interest rates, interest rates on ARMs may exceed
interest rates on fixed-rate mortgage loans, which may tend to cause
prepayments on ARMs to increase at a rate greater than anticipated. Mortgage
Securities backed by single family mortgage loans are often structured so that
certain classes are provided protection from prepayments for a period of time.
However, in a period of extremely rapid prepayments, during which earlier-
paying classes may be retired faster than expected, the protected classes may
receive unscheduled payments of principal earlier than expected and would have
average lives that, while longer than the average lives of the earlier-paying
classes, would be shorter than originally expected. The Company will seek to
minimize prepayment risk through a variety of means, which may include (to the
extent capable of being implemented at reasonable cost at various points in
time) structuring a diversified portfolio with a variety of prepayment
characteristics, investing in Mortgage Assets with prepayment prohibitions and
penalties, investing in certain Mortgage Security structures which have
prepayment protection, and balancing assets purchased at a premium with assets
purchased at a discount. In addition, the Company may in the future purchase
interest-only strips to a limited extent. The basis risk that will exist
between an interest-only strip and the other assets in the portfolio could
increase the Company's risk in interest rate environments where the interest-
only strip would amortize quickly. No strategy can completely insulate the
Company from prepayment risks arising from the effects of interest rate
changes. There is also probably more uncertainty about prepayment rates on
subprime mortgage loans since there is less information and historical data
than exists for prime mortgage loans. Certain Mortgage Assets may consist of
mortgage loans that are, and Mortgage Securities evidencing interests in, ARMs
convertible to fixed-rate loans. Because converted mortgage loans are required
to be repurchased by the applicable Agency or servicer, the conversion of a
mortgage loan results, in effect, in the prepayment of such mortgage loan.

Changes in anticipated prepayment rates of Mortgage Assets could affect the
Company in several adverse ways. Faster than anticipated prepayment of any
Mortgage Asset that had been purchased at a premium by the Company would
generally result in a faster than anticipated write-off of any remaining
capitalized premium amount and consequent reduction of the Company's net
interest income by such amount. A portion of the adjustable-rate single family
mortgage loans which may be acquired by the Company (either directly as
mortgage loans or through Mortgage Securities backed by ARMs) will have been
recently originated and will still bear initial interest rates which are lower
than their "fully-indexed" rates (the applicable index plus margin). In the
event that such an ARM is prepaid faster than anticipated prior to or soon
after the time of adjustment to a fully-indexed rate, the Company will have
experienced an adverse effect on its net interest income during the time it
held such ARM compared with holding a fully-indexed ARM and will have lost the
opportunity to receive interest at the fully-indexed rate over the expected
life of the ARM. These effects may be mitigated to the extent such ARMs were
acquired at a discount.

Subprime borrowers are frequently in a unique position to receive economic
gain from refinancing due to improving their mortgage and consumer credit
profiles through timely payments on outstanding loans. As a result, a subprime
borrower may be able to lower the rate on their home loan without a change in
interest rates.

20
<PAGE>

Failure to Hedge Effectively Against Interest Rate Changes May Adversely
Affect Results of Operations

The Company's operating strategy subjects it to interest rate risks as
described under "--Risk of Decrease in Net Interest Income Due to Interest
Rate Fluctuations; Prepayment Risks of Mortgage Assets" above. The Company
follows an asset/liability management program intended to protect against
interest rate changes and prepayments. See "Business--Portfolio of Mortgage
Assets--Interest Rate Risk Management." Nevertheless, developing an effective
asset/liability management strategy is complex and no strategy can completely
insulate the Company from risks associated with interest rate changes and
prepayments. In addition, there can be no assurance that the Company's hedging
activities will have the desired beneficial impact on the Company's results of
operations or financial condition. Hedging typically involves costs, including
transaction costs, which increase dramatically as the period covered by the
hedge increases and which also increase during periods of rising and volatile
interest rates. The Company may increase its hedging activity, and thus
increase its hedging costs, during such periods when interest rates are
volatile or rising and hedging costs have increased. Moreover, federal tax
laws applicable to REITs may substantially limit the Company's ability to
engage in asset/liability management transactions. Such federal tax laws may
prevent the Company from effectively implementing hedging strategies that the
Company determines, absent such restrictions, would best insulate the Company
from the risks associated with changing interest rates and prepayments. See
"Federal Income Tax Considerations--Qualification as a REIT--Sources of
Income."

Limitations on Effective Hedging

The Company has purchased interest rate caps and interest rate swaps to
attempt to mitigate the risk of variable rate liabilities increasing at a
faster rate than the earnings on its assets during a period of rising interest
rates. In this way, the Company intends generally to hedge as much of the
interest rate risk as management determines is in the best interests of the
Company given the cost of such hedging transactions and the need to maintain
the Company's status as a REIT. In this regard, the amount of income the
Company may earn from its interest rate swaps and caps is subject to
substantial limitations under the REIT provisions of the Code. The Company may
hedge the risk of its borrowing costs on its variable rate liabilities
increasing faster than its income, due to the effect of the periodic and
lifetime caps on its Mortgage Assets, through the acquisition of (a) Qualified
REIT Assets, such as interest-only REMIC regular interests, that function in a
manner similar to hedging instruments, (b) Qualified Hedges, the income from
which qualifies for the 95 percent income test, but not the 75 percent income
test for REIT qualification purposes, and (c) other hedging instruments, whose
income qualifies for neither the 95 percent income test nor the 75 percent
income test. See "Federal Income Tax Considerations--Qualification as a REIT--
Sources of Income." The latter form of hedging may be accomplished through a
taxable affiliate of the Company. See "Business--Interest Rate Risk
Management" and "Federal Income Tax Considerations--Qualification as a REIT--
Sources of Income." This determination may result in management electing to
have the Company bear a level of interest rate risk that could otherwise be
hedged when management believes, based on all relevant facts, that bearing
such risk is advisable.

Potential Adverse Effect of the Use of Financial Instruments in Hedging

In the event that the Company purchases interest rate caps or other interest
rate agreements to hedge against lifetime and periodic rate or payment caps,
and the provider of interest rate agreements becomes financially unsound or
insolvent, the Company may be forced to unwind its interest rate agreements
with such provider and may take a loss on such interest rate agreements.
Although the Company intends to purchase interest rate agreements only from
financially sound institutions and to monitor the financial strength of such
institutions on a periodic basis, no assurance can be given that the Company
can avoid such third party risks.

The Company accepts legal risk in entering into interest rate swap and cap
agreements. Although the Company takes precautions to assure the legality of
each interest rate swap and cap agreement, no assurance can be given as to the
enforceability of these agreements. An agreement that is not enforceable may
subject the Company to unexpected interest rate risk and have a material
adverse affect on results of operations.

21
<PAGE>

The Company also accepts basis risk in entering into interest rate swap and
cap agreements. Basis risk occurs as the performance of hedged financing
sources vary from expectations and differ from the performance of the hedging
instrument. For instance, the Company hedges its borrowing to mitigate
interest rate risk of Mortgage Assets that are fixed or reprice at different
times or based on different indices. Although the hedging item may reduce
interest rate risk, borrowers may prepay at speeds which vary from initial
expectation. Absent proper monitoring, the Company could have a hedging
instrument in place without an underlying financing source. The consequence of
which may be a material adverse effect on results of operations. Although the
Company's Board of Directors has approved an investment policy and Capital
Allocation Guidelines to mitigate basis risk related to hedging instruments,
no assurance can be given that the policy will be effective in mitigating
risk.

The Company is not regulated in regards to its hedging activities. However,
in order to maintain its exemption from the registration requirements of the
Commodities Exchange Act, the Company is limited with respect to investments
in futures contracts, options on futures contracts and options on commodities.

Loss Exposure on Single Family Mortgage Assets

A substantial portion of the investment portfolio of the Company consists of
single family mortgage loans or Mortgage Assets evidencing interests in single
family mortgage loans. The Company will bear the risk of loss on any such
Mortgage Assets it purchases in the secondary mortgage market or through its
mortgage lending business. In particular, the Mortgage Securities that the
Company retains from its securitizations are subordinated Mortgage Securities,
are not supported by credit enhancements, are not rated and have limited
liquidity. With respect to the Mortgage Securities the Company acquires in the
secondary market, if such securities are either Agency Certificates or are
generally structured with one or more types of credit enhancement, the credit
risk to the Company will be reduced or eliminated. To the extent third parties
have been contracted to provide the credit enhancement, the Company is
dependent in part upon the creditworthiness and claims-paying ability of the
insurer and the timeliness of reimbursement in the event of a default on the
underlying obligations. Further, the insurance coverage for various types of
losses is limited in amount and losses in excess of the limitation would be
borne by the Company.

Prior to securitization, the Company generally does not intend to obtain
credit enhancements such as mortgage pool or special hazard insurance for its
single family mortgage loans, other than FHA insurance, VA guarantees and
private mortgage insurance, in each case relating only to individual mortgage
loans. Accordingly, during the time it holds such mortgage loans for which
third party insurance is not obtained, the Company will be subject to risks of
borrower defaults and bankruptcies and special hazard losses that are not
covered by standard hazard insurance (such as those occurring from earthquakes
or floods). In the event of a default on any single family mortgage loan held
by the Company, including, without limitation, resulting from higher default
levels as a result of declining property values and worsening economic
conditions, among other factors, the Company would bear the risk of loss of
principal to the extent of any deficiency between the value of the related
real property, plus any payments from an insurer or guarantor, and the amount
owing on the mortgage loan. Defaulted mortgage loans would also cease to be
eligible collateral for borrowings and would have to be financed by the
Company out of other funds until ultimately liquidated, resulting in increased
financing costs and reduced net income or a net loss.

The Company may pool and finance or sell through securitizations a
substantial portion of the single family mortgage loans it acquires. In
securitizations, the Company continues to bear risk of loss on the underlying
mortgage loans.

Increased Loss Exposure on Subprime Mortgage Loans

Credit risks associated with non-conforming mortgage loans, especially
subprime mortgage loans, may be greater than those associated with prime
mortgage loans that conform to FNMA and FHLMC guidelines. The principal
difference between non-conforming subprime mortgage loans and conforming
mortgage loans include

22
<PAGE>

the applicable loan-to-value ratios, the credit and income histories of the
borrowers, the documentation required for approval of the borrowers, the types
of properties securing the mortgage loans, loan sizes and the borrowers
occupancy status with respect to the mortgaged property. As a result of these
and other factors, the interest rates charged on non-conforming mortgage loans
are often higher than those charged for conforming mortgage loans. The
combination of different underwriting criteria and higher rates of interest may
lead to higher delinquency rates and/or credit losses for non-conforming as
compared to conforming mortgage loans and could have an adverse effect on the
Company to the extent that the Company invests in such mortgage loans or
securities secured by such mortgage loans.

Many of the risks of holding subprime mortgage loans and retaining, after
securitization, credit risk derived therefrom reflect the risks of investing
directly in the real estate securing the underlying mortgage loans. This may be
especially true in the case of a relatively small or less diverse pool of
subprime mortgage loans. In the event of a default on the underlying mortgage
loan, the ultimate extent of the loss, if any, may only be determined after a
foreclosure of the mortgage encumbering the property and, if the lender takes
title to the property, upon liquidation of the property. Factors such as the
title to the property or its physical condition (including environmental
considerations) may make a third party unwilling to purchase the property at a
foreclosure sale or for a price sufficient to satisfy the obligations with
respect to the related Mortgage Securities. Foreclosure laws in various states
may protract the foreclosure process. In addition, the condition of a property
may deteriorate during the pendency of foreclosure proceedings. Certain
borrowers on underlying mortgages may become subject to bankruptcy proceedings,
in which case the amount and timing of amounts due may be materially adversely
affected.

Market Factors May Limit the Company's Ability to Acquire Mortgage Assets at
Yields Which Are Favorable Relative to Borrowing Costs

The Company's net income depends, in large part, on the Company's ability to
acquire Mortgage Assets at favorable spreads over the Company's borrowing
costs. In acquiring Mortgage Assets, the Company competes with other REITs,
securities dealers, savings and loan associations, banks, mortgage bankers,
insurance companies, mutual funds, other lenders, GNMA, FNMA, FHLMC and other
entities purchasing Mortgage Assets. In addition, there are several mortgage
REITs similar to the Company, and others may be organized in the future. The
effect of the existence of additional REITs may be to increase competition for
the available supply of Mortgage Assets suitable for purchase by the Company.

In addition, in fluctuating interest rate environments, the spread between
ARM interest rates and interest rates on fixed-rate mortgage loans may
decrease, and may cease to exist or become negative. Under such conditions,
mortgagors tend to favor fixed-rate mortgage loans, thereby decreasing the
supply of ARMs available to the Company for purchase. The relative availability
of ARMs may also be diminished by a number of other market and regulatory
considerations.

Despite management's experience in the acquisition of Mortgage Assets and its
relationships with various mortgage suppliers, there can be no assurance that
the Company will be able to acquire sufficient Mortgage Assets from mortgage
suppliers at spreads above the Company's cost of funds. The Company will also
face competition for financing sources, and the effect of the existence of
additional mortgage REITs may be to deny the Company access to sufficient funds
to carry out its business strategy and/or to increase the cost of funds to the
Company.

Substantial Leverage and Potential Net Interest and Operating Losses in
Connection with Borrowings

The Company employs a financing strategy to increase the size of its Mortgage
Assets portfolio by borrowing a substantial portion (which may vary depending
upon the mix of the Mortgage Assets in the Company's portfolio and the
application of the Company's policies with respect to such mix of Mortgage
Assets) of the market value of its Mortgage Assets. If the returns on the
Mortgage Assets purchased with borrowed funds fail to cover the cost of the
borrowings, the Company will experience net interest losses and may experience
net

23
<PAGE>

losses. In addition, due to increases in haircuts (i.e., the discount from face
value applied by a lender or purchaser with respect to the Company's Mortgage
Securities), decreases in the market value of the Company's Mortgage Assets,
increases in interest rate volatility, availability of financing in the market,
circumstances then applicable in the lending market and other factors, the
Company may not be able to achieve the degree of leverage it believes to be
optimal, which may cause the Company to be less profitable than it might be
otherwise. The Company uses its Capital Allocation Guidelines (CAG) to manage
the amount of debt incurred and leverage employed in its balance sheet. These
CAG have been approved by the Board of Directors, who also have the ability to
change the CAG. See "Business--Portfolio Management--Capital and Leverage
Policies". At June 30, 1997, the Company's equity represented 7.7% of assets.

Failure to Refinance Outstanding Borrowings on Favorable Terms May Affect
Results of Operations

Additionally, the ability of the Company to achieve its investment objectives
depends not only on its ability to borrow money in sufficient amounts and on
favorable terms but also on the Company's ability to renew or replace on a
continuous basis its maturing short-term borrowings. The Company's business
strategy relies on short-term reverse repurchase agreements to fund Mortgage
Asset originations and purchases. The Company has not at the present time
entered into any commitment agreements under which a lender would be required
to enter into new borrowing agreements during a specified period of time;
however, the Company may enter into one or more of such commitment agreements
in the future if deemed favorable to the Company. In the event the Company is
not able to renew or replace maturing borrowings, the Company could be required
to sell Mortgage Assets under adverse market conditions and could incur losses
as a result. In addition, in such event, the Company may be required to
terminate hedge positions, which could result in further costs to the Company.
An event or development such as a sharp rise in interest rates or increasing
market concern about the value or liquidity of a type or types of Mortgage
Assets in which the Company's portfolio is concentrated will reduce the market
value of the Mortgage Assets, which would likely cause lenders to require
additional collateral. At the same time, the market value of the assets in
which the Company's liquidity capital is invested may have decreased. A number
of such factors in combination may cause difficulties for the Company,
including a possible liquidation of a major portion of the Company's Mortgage
Assets at disadvantageous prices with consequent losses, which could have a
materially adverse effect on the Company's profitability and its solvency.

A majority of the Company's borrowings are collateralized borrowings,
primarily in the form of reverse repurchase agreements and similar borrowings,
the availability of which are based on the market value of the Mortgage Assets
pledged to secure the specific borrowings, availability of financing in the
market, circumstances then applicable in the lending market and other factors.
The cost of borrowings under reverse repurchase agreements generally
corresponds to LIBOR or the Federal Funds rate plus or minus a spread, although
most of such agreements do not expressly incorporate an index. The cost of
borrowings under other sources of funding which the Company may use may refer
or correspond to other short-term indices, plus or minus a margin. The margins
on such borrowings over or under LIBOR, the Federal Funds rate or such other
short-term indices vary depending upon the lender, the nature and liquidity of
the underlying collateral, the movement of interest rates, the availability of
financing in the market and other factors. If the actual cash flow
characteristics are other than as expected, the Company may experience reduced
net interest income.

Impact of Decline in Market Value of Mortgage Assets: Margin Calls

A decline in the market value of the Company's portfolio of Mortgage Assets
may limit the Company's ability to borrow or result in lenders initiating
margin calls (i.e., requiring a pledge of cash or additional Mortgage Assets to
re-establish the ratio of the amount of the borrowing to the value of the
collateral). This remains true despite effective hedging against such
fluctuations as the hedging instruments may not be part of the collateral
securing the collateralized borrowings. Additionally, it may be difficult to
realize the full value of the hedging instrument when desired for liquidity
purposes due to the applicable REIT provisions of the Code. The Company could
be required to sell Mortgage Assets under adverse market conditions in order to
maintain liquidity. Such sales may be effected by management when deemed by it
to be necessary in order to preserve the

24
<PAGE>

capital base of the Company. If these sales were made at prices lower than the
amortized cost of the Mortgage Assets, the Company would experience losses. A
default by the Company under its collateralized borrowings could also result in
a liquidation of the collateral, including any cross-collateralized assets, and
a resulting loss of the difference between the value of the collateral and the
amount borrowed. Additionally, in the event of a bankruptcy of the Company,
certain reverse repurchase agreements may qualify for special treatment under
the Bankruptcy Code, the effect of which is, among other things, to allow the
creditors under such agreements to avoid the automatic stay provisions of the
Bankruptcy Code and to liquidate the collateral under such agreements without
delay. Conversely, in the event of the bankruptcy of a party with whom the
Company had a reverse repurchase agreement, the Company might experience
difficulty recovering the collateral subject to such agreement if the agreement
were to be repudiated and the Company's claim against the bankrupt lender for
damages resulting therefrom were to be treated simply as one of an unsecured
creditor. Should this occur, the Company's claims would be subject to
significant delay and recoveries, if and when received, may be substantially
less than the damages actually suffered by the Company. Although the Company
has entered, and intends to continue to enter, into reverse repurchase
agreements with several different parties and has developed policies to reduce
its exposure to such risks, no assurance can be given that the Company will be
able to avoid such third-party risks.

To the extent the Company is compelled to liquidate Mortgage Assets that are
Qualified REIT Assets to repay borrowings, the Company may be unable to comply
with the REIT provisions of the Code regarding assets and sources of income
requirements, ultimately jeopardizing the Company's status as a REIT. The Code
does not provide for any mitigating provisions with respect to the 30 percent
of income limit (which has been repealed effective December 31, 1997).
Accordingly, if the Company failed to meet the 30 percent of income limit for
1997, its status as a REIT would terminate automatically. Failure to maintain
REIT status would eliminate the Company's competitive advantage over non-REIT
competitors and subject the Company to federal taxation. See "Risk Factors--
Failure to Maintain REIT Status" and "Federal Income Tax Considerations--
Qualification as a REIT--The 30 percent Limit."

Dependence on Securitization Market

Adverse changes in the securitization market could impair the Company's
ability to originate, acquire and finance mortgage loans through
securitizations on a favorable or timely basis. Any such impairment could have
a material adverse effect upon the Company's results of operations and
financial condition. In addition, in order to gain access to the securitization
market, the Company generally expects to rely upon credit enhancements provided
by one or more monoline insurance carriers. Any substantial reductions in the
size or availability of the securitization market for the Company's loans, or
the unwillingness of insurance companies to provide credit enhancement for the
Company's Mortgage Securities could have a material adverse effect upon the
Company's results of operations and financial condition.

Lack of Loan Performance Data

The loans originated and purchased by the Company have been outstanding for a
relatively short period of time. Consequently, the delinquency, foreclosure and
loss experience of these loans to date may not be indicative of future results.
It is unlikely that the Company will be able to sustain delinquency,
foreclosure and loan loss rates, at their present levels as the portfolio
becomes more seasoned.

Illiquidity of Investments

A substantial portion of the Company's portfolio may be invested in Mortgage
Securities for which the secondary trading market is not as well developed as
the market for certain other Mortgage Securities (or which are otherwise
considered less marketable or illiquid). In addition, the Company may invest in
Mortgage Securities which have been sold in private placements and have not
been registered under the Securities Act. Unregistered Mortgage Securities may
be subject to restrictions on resale which may limit the ability of the Company
to sell them when it might be most desirable to do so. Although the Company
expects that most of the

25
<PAGE>

Company's investments will be in Mortgage Securities for which a resale market
exists, certain of the Company's investments may lack a regular trading market
and may be illiquid. In addition, during turbulent market conditions, the
liquidity of all of the Company's Mortgage Assets may be adversely impacted.
There is no limit in the percentage of the Company's investments that may be
invested in illiquid Mortgage Assets.

Lack of Geographic Diversification

The Company seeks geographic diversification of the properties underlying its
Mortgage Assets and has established a diversification policy. See "Business--
Mortgage Lending Operation--Underwriting and Quality Control Strategy."
Nevertheless, properties underlying such Mortgage Assets may be located in the
same or a limited number of geographical regions. For example, as of June 30,
1997, 36 percent of the Company's mortgage loan portfolio was comprised of
loans secured by California real estate. See "Business-Mortgage Lending
Operation-Underwriting and Quality Control Strategy-Geographic
Diversification." To the extent that properties underlying such Mortgage Assets
are located in the same geographical region, such Mortgage Assets may be
subject to a greater risk of default than other comparable Mortgage Assets in
the event of adverse economic, political or business developments and natural
hazard risks that may affect such region and, ultimately, the ability of
property owners to make payments of principal and interest on the underlying
mortgages.

RISKS ASSOCIATED WITH AN INVESTMENT IN THE COMMON STOCK IN THE OFFERING

Restrictions on Ownership of Capital Stock: Anti-takeover Effect

Subject to the limitations set forth in the Articles Supplementary creating
the Preferred Stock, the Charter authorizes the Board of Directors to
reclassify any of the unissued shares of authorized capital stock into a class
or classes of preferred stock. The issuance of additional preferred stock could
have the effect of making an attempt to gain control of the Company more
difficult by means of a merger, tender offer, proxy contest or otherwise. The
additional preferred stock, if issued, could have a preference on dividend
payments over the Common Stock which could affect the ability of the Company to
make dividend distributions to the holders of Common Stock.

In order that the Company may meet the requirements for qualification as a
REIT at all times, the Charter prohibits any person from acquiring or holding,
directly or indirectly, shares of Capital Stock in excess of 9.8 percent in
value of the aggregate of the outstanding shares of Capital Stock or in excess
of 9.8 percent (in value or in number of shares, whichever is more restrictive)
of the aggregate of the outstanding shares of Common Stock of the Company. For
this purpose, the term "ownership" is defined in accordance with REIT
provisions of the Code and the constructive ownership provisions of Section 544
of the Code, as modified by Section 856(h)(1)(B) of the Code. Under such rules,
for example, certain types of entities such as widely-held corporations may
hold in excess of the 9.8 percent limit because shares held by such entities
are attributed to such entities' stockholders. Conversely, shares of Capital
Stock owned or deemed to be owned by a person who individually owns less than
9.8 percent of the shares outstanding may nevertheless be in violation of the
ownership limitations set forth in the Charter if, under certain circumstances,
shares owned by others (such as family members or partners) are attributed to
such individual. See "Federal Income Tax Considerations--Qualification as a
REIT--Ownership of Stock." The Charter further prohibits (1) any person from
beneficially or constructively owning shares of Capital Stock that would result
in the Company being "closely held" under Section 856(h) of the Code or
otherwise cause the Company to fail to qualify as a REIT, and (2) any person
from transferring shares of Capital Stock if such transfer would result in
shares of Capital Stock being owned by fewer than 100 persons. If any transfer
of shares of Capital Stock occurs which, if effective, would result in any
person beneficially or constructively owning shares of Capital Stock in excess
or in violation of the above transfer or ownership limitations, then that
number of shares of Capital Stock the beneficial or constructive ownership of
which otherwise would cause such person to violate such limitations (rounded to
the nearest whole shares) shall be automatically transferred to a trustee (the
"Trustee") as trustee of a trust (the "Trust") for the exclusive benefit of one
or more charitable beneficiaries (the "Charitable Beneficiary"), and the
intended transferee shall not acquire any rights in such shares. See
"Description of Capital Stock--Repurchase of Shares and Restriction on
Transfer."

26
<PAGE>

Every owner of more than 5 percent (or such lower percentage as required by
the Code or the regulations promulgated thereunder) of all classes or series of
the Company's stock, within 30 days after the end of each taxable year, is
required to give written notice to the Company stating the name and address of
such owner, the number of shares of each class and series of stock of the
Company beneficially owned and a description of the manner in which such shares
are held. Each such owner shall provide to the Company such additional
information as the Company may request in order to determine the effect, if
any, of such beneficial ownership on the Company's status as a REIT and to
ensure compliance with the ownership limitations.

Subject to certain limitations, the Board of Directors may increase or
decrease the ownership limitations. In addition, to the extent consistent with
the REIT provisions of the Code, the Board of Directors may waive the ownership
limitations for and at the request of individual investors.

The provisions described above may inhibit market activity and the resulting
opportunity for the holders of the Company's Capital Stock and Warrants to
receive a premium for their Securities that might otherwise exist in the
absence of such provisions. Such provisions also may make the Company an
unsuitable investment vehicle for any person seeking to obtain ownership of
more than 9.8 percent of the outstanding shares of Capital Stock.

In addition, certain provisions of the Maryland General Corporation Law
relating to "business combinations" and a "control share acquisition" and of
the Charter and Bylaws (e.g., staggered terms for directors) may also have the
effect of delaying, deterring or preventing a takeover attempt or other change
in control of the Company which would be beneficial to shareholders and might
otherwise result in a premium over then prevailing market prices. See
"Management" and "Description of Capital Stock."

Effect on Stockholders of Potential Future Offerings

The Company expects in the future to increase its capital resources by making
additional offerings of equity and debt securities, including classes of
preferred stock, Common Stock, commercial paper, medium-term notes, mortgage-
backed obligations and senior or subordinated debt. All debt securities and
classes of preferred stock will be senior to the Common Stock in the event of a
liquidation of the Company. Additional equity offerings may dilute the equity
of stockholders of the Company or reduce the price of shares of the Company's
Common Stock, or both. The Company is unable to estimate the amount, timing or
nature of additional offerings as they will depend upon market conditions and
other factors.

Absence of Active Public Trading Market

There is currently no trading market for the Common Stock and there can be no
assurance that an active trading market for the Common Stock will develop.
Although the Common Stock is expected to be approved for quotation on the
Nasdaq National Market, there can be no assurance that an active public trading
market for the Common Stock will develop after this Offering or that, if
developed, it will be sustained. The initial public offering price of the
Common Stock offered hereby was determined by negotiations among the Company
and representatives of the Underwriters and may not be indicative of the price
at which the Common Stock will trade after the Offering. See "Underwriting."
Consequently, there can be no assurance that the market price for the Common
Stock will not fall below the initial public offering price.

Possible Volatility of Stock Price

In the event an active trading market for the Common Stock does develop, the
market price of the Common Stock may experience fluctuations unrelated to the
operating performance of the Company. In particular, the price of the Common
Stock may be affected by general market price movements as well as developments
specifically related to the specialty finance industry such as interest rate
movements and credit quality trends.

In the event that an active trading market for the Common Stock does develop,
it is likely that the market price of the Common Stock will be influenced by
any variation between the net yield on the Company's

27
<PAGE>

Mortgage Assets and prevailing market interest rates and by the markets
perception of the Company's ability to achieve earnings growth. The Company's
earnings will be derived primarily from any positive spread between the yield
on the Company's Mortgage Assets and the cost of the Company's borrowings.
During the period immediately following the receipt by the Company of new
proceeds from an offering or other source, prior to the time the Company has
fully implemented its financing strategy to employ those proceeds, the
Company's earnings and levels of dividend distributions may be lower than if
the financing strategy were fully implemented, which may affect the market
value of the Common Stock. In addition, the positive spread between the yield
on the Company's Mortgage Assets and the cost of borrowings will not
necessarily be larger in high interest rate environments than in low interest
rate environments regardless of the Company's business strategy to achieve such
result. Accordingly, in periods of high interest rates, the net income of the
Company and, therefore, the dividend yield on the Common Stock may be less
attractive compared with alternative investments, which could negatively impact
the price of the Common Stock. If the anticipated or actual net yield on the
Company's Mortgage Assets declines or if prevailing market interest rates rise,
thereby decreasing the positive spread between the net yield on the Mortgage
Assets and the cost of the Company's borrowings, the market price of the Common
Stock may be materially adversely affected. In addition, if the market price of
other REIT stocks decline for any reason, or there is a broad-based decline in
real estate values or in the value of the Company's portfolio of Mortgage
Assets, the market price of the Common Stock may be adversely affected. During
any period when the market price of the Common Stock has been adversely
affected due to any of the foregoing reasons, the liquidity of the Common Stock
may be negatively impacted and stockholders who may desire or be required to
sell their Common Stock may experience losses.

Securities Eligible for Future Sale

Following the closing of this Offering (and assuming that the Underwriters'
over-allotment option is not exercised), there will be outstanding 6,766,665
shares of Common Stock and 3,649,999 Warrants, of which (i) 3,000,000 shares of
Common Stock are being offered hereby (ii) 3,549,999 shares of Common Stock,
together with 3,649,999 Warrants and a like number of shares of Common Stock
issuable upon exercise of those Warrants, will be covered by the Shelf
Registration Statement and (iii) 216,666 shares of Common Stock are not being
offered in this Offering or under the Shelf Registration Statement. The
3,549,999 shares of Common Stock, 3,649,999 Warrants, together with the Common
Stock issuable pursuant to the exercise of the 3,649,999 outstanding Warrants
set forth in (ii) above, may be sold without restriction upon effectiveness of
the Shelf Registration Statement (subject to a 90-day "lock-up" period
following the closing of this Offering), subject to certain restrictions. The
216,666 shares of Common Stock not being offered in this Offering or under the
Shelf Registration Statement, are "restricted securities" within the meaning of
Rule 144 ("Rule 144") under the Securities Act. Such restricted securities will
be available for resale pursuant to Rule 144 following a holding period ending
one year from the date of issuance, subject to the volume limitations imposed
by Rule 144 and, unless held by affiliates of the Company, will become
unrestricted two years from the date of issuance. Future sales of restricted
securities could have an adverse effect on the market price of the Common
Stock. The holders of the currently restricted shares of Common Stock have
certain registration rights with respect to such shares. See "Description of
Capital Stock--Registration Rights."

As of June 30, 1997, options to purchase 334,332 shares of Common Stock were
outstanding under the Company's Stock Option Plan, which will vest on various
dates extending through September 1, 2000. The Company will file a Form S-8
registration statement approximately 90 days following the effective date of
this Offering to permit shares issued pursuant to the exercise of options to be
sold.

Immediate Dilution

The initial public offering price is higher than the net tangible book value
per share of Common Stock in this Offering. Investors purchasing shares of
Common Stock in the Offering will be subject to immediate dilution of $3.22 per
share in net tangible book value. See "Dilution."

28
<PAGE>

THE COMPANY

NovaStar Financial, Inc. (on a non-consolidated basis, "NFI") was
incorporated by Scott Hartman and Lance Anderson, the founders, in the State
of Maryland on September 13, 1996 and has elected to be a REIT for federal
income tax purposes. As a result of its REIT status, NFI will be permitted to
deduct dividend distributions to stockholders, thereby effectively eliminating
the "double taxation" that generally results when a corporation earns income
and distributes that income to stockholders in the form of dividends. See
"Federal Income Tax Considerations--Taxation of the Company."

NFI Holding Corporation, Inc. ("Holding") was incorporated in the State of
Delaware on February 6, 1997. One hundred percent of the voting common stock
of Holding is owned equally by the Company's founders. See "Management." NFI
owns one hundred percent of the preferred stock of Holding, for which it
receives 99 percent of dividends paid by Holding. As currently structured,
Holding exists solely for the purpose of owning NovaStar Mortgage, Inc.
("NMI"). NMI was incorporated in the State of Virginia on May 16, 1996 and is
a wholly-owned subsidiary of Holding. Although NMI was formed in 1996,
substantial operations did not commence until January 1997. This Prospectus
refers to these three entities collectively as "NovaStar" or "the Company."

The basic function of NFI is to manage the Mortgage Assets of the Company.
NMI serves as a vehicle for loan origination--a primary source of Mortgage
Assets for the Company. In addition, NMI will sub-service loans owned by the
Company. Through June 30, 1997, all loans originated by NMI were sold to NFI
and NFI has the contractual right to continue to acquire the same. See
"Certain Transactions."

The Company is self-advised and self-managed. Management oversees the day-
to-day operations of the Company, subject to supervision by the Company's
Board of Directors. The management team of the Company has considerable
expertise in the origination, acquisition and management of mortgage loans and
Mortgage Assets and asset/liability management. See "Management." The
principal executive offices of the Company are at 1900 W. 47th Place, Suite
205, Westwood, Kansas 66205, telephone (913) 362-1090. Principal offices for
the Company's mortgage lending operations are in Irvine, California.

USE OF PROCEEDS

The net proceeds of this Offering are estimated to be $46,930,000, assuming
a public offering price of $17.00 per share and that the Underwriters' over-
allotment option is not exercised and $54,044,500 if the underwriters'
overallotment is exercised in full. The Company anticipates that substantially
all of the net proceeds from this Offering will be used to fund wholesale loan
originations and the acquisition of mortgage securities, in accordance with
its business strategies. Any remaining balance of such proceeds will be used
for working capital and general corporate purposes. Pending these uses, the
net proceeds may be temporarily invested to the extent consistent with the
REIT provisions of the Code, or alternatively, may be used to temporarily pay
down warehouse borrowing facilities. The Company anticipates that it will
fully invest the net proceeds of this Offering in Mortgage Assets as soon as
reasonably practicable after the closing of this Offering. The Company has not
specifically identified any Mortgage Assets in which to invest the net
proceeds of this Offering.

29
<PAGE>

DIVIDEND POLICY AND DISTRIBUTIONS

The Company generally intends to distribute substantially all of its taxable
income each year (which does not ordinarily equal net income as calculated in
accordance with GAAP) to its stockholders so as to comply with the REIT
provisions of the Code. The Company intends to make dividend distributions
quarterly. The Company intends to distribute any taxable income remaining
after the distribution of the final regular quarterly dividend each year
together with the first regular quarterly dividend payment of the following
taxable year or in a special dividend distributed prior thereto. The dividend
policy is subject to revision at the discretion of the Board of Directors. All
distributions will be made by the Company at the discretion of the Board of
Directors and will depend on the taxable income of the Company, the financial
condition of the Company, maintenance of REIT status and such other factors as
the Board of Directors deems relevant. See "Federal Income Tax
Considerations--Qualification as a REIT--Distributions."

Distributions to stockholders will generally be subject to tax as ordinary
income, although a portion of such distributions may be designated by the
Company as capital gain or may constitute a tax-free return of capital. The
Company generally does not intend to declare dividends that would result in a
return of capital. The Company will annually furnish to each of its
stockholders a statement setting forth distributions paid during the preceding
year and their characterization as ordinary income, capital gains, or return
of capital. For a discussion of the federal income tax treatment of
distributions by the Company, see "Federal Income Tax Considerations--Taxation
of the Company's Stockholders."

DIVIDEND REINVESTMENT PLAN

The Company expects to adopt a dividend reinvestment plan ("DRP") for
stockholders who wish to reinvest their distributions in additional shares of
Common Stock. Generally, under a DRP dividends paid with respect to shares of
Capital Stock are automatically invested in additional shares of Common Stock
at a discount to the then current market price. Stockholders will not be
automatically enrolled in the DRP.

Stockholders who own more than a specified number of shares of Common Stock
will be eligible to participate in the DRP following the effectiveness of the
registration of securities issuable thereunder. This Offering is not related
to the proposed DRP, nor has the Company prepared or filed a registration
statement with the SEC registering the shares to be issued under the DRP.
Prior to buying shares through the DRP, participants will be provided with a
DRP prospectus which will constitute a part of such DRP registration
statement. The Company's transfer agent will act as the trustee and
administrator of the DRP (the "Agent").

Stockholders will not be automatically enrolled in the DRP. Each stockholder
desiring to participate in the DRP must complete and deliver to the Agent an
enrollment form, which will be sent to each eligible stockholder following the
effectiveness of the registration of the shares to be issued under the DRP.
Participation in the DRP will commence with all dividends and distributions
payable after receipt of a participant's authorization, provided that the
authorization must be received by the Agent at least two business days prior
to the record date for any dividends in order for any stockholder to be
eligible for reinvestment of such dividends.

30
<PAGE>

DILUTION

The net tangible book value of the Company as of June 30, 1997 was $46.3
million, or $12.29 per share of Common and Preferred Stock. Net tangible book
value per share represents the total tangible assets of the Company, reduced
by the amount of its total liabilities, and divided by the number of shares of
Common and Preferred Stock outstanding as of that date. The following
calculations include 216,666 Units issued to the founders acquired with
forgivable debt, assumed to be for no consideration.

After giving effect to the net proceeds from the sale of Common Stock
offered hereby at an assumed initial public offering price of $17.00 per
share, and assuming full conversion of the Preferred Stock and no exercise of
Warrants or options to acquire Common Stock, the pro forma net tangible book
value of the Company as of June 30, 1997 would have been $93,222,000 or $13.78
per share of Common Stock. This represents an immediate dilution of $3.22 per
share to new investors purchasing Common Stock at $17.00 per share.

The following table illustrates the per share dilution in net tangible book
value to new investors as of June 30, 1997.

<TABLE>
<S> <C> <C>
Assumed initial public offering price per share............... $17.00
Net tangible book value per share before this Offering........ $12.29
Increase attributable to purchase of Common Stock by new
investors in this Offering................................... 1.49
------
Pro forma net tangible book value per share of Common Stock
after giving effect to the consummation of this Offering..... $13.78 13.78
====== ------
Dilution of net tangible book value per share to investors in
this Offering................................................ $ 3.22
======
</TABLE>

The above calculations assume no exercise of the Warrants or any outstanding
options to acquire Common Stock. As of June 30, 1997, options to acquire
10,000 shares of Common Stock were outstanding at an exercise price of $0.01
per share and options to acquire 35,000 shares of Common Stock were
outstanding at an exercise price of $1.06 per share, which options vest 25
percent on September 1, 1997 and 25 percent on each anniversary of such date
thereafter. Options to purchase an additional 289,332 shares of Common Stock
granted to founders at an exercise price of $15.00 per share vest upon closing
of this Offering. If all of the Warrants and options are exercised upon
vesting, dilution to investors in this Offering would be $2.83.

The following table summarizes on a pro forma basis as of June 30, 1997 the
differences between the total consideration paid and the average price per
share of Common Stock paid by the existing stockholders prior to the Private
Placement, by the investors in the Private Placement and by the new investors
in this Offering (assuming an initial public offering price of $17.00 per
share), assuming full conversion of the Preferred Stock and no exercise of the
Warrants or options to acquire Common Stock:

<TABLE>
<CAPTION>
SHARES PURCHASED TOTAL CONSIDERATION
----------------- -------------------- AVERAGE PRICE
NUMBER PERCENT AMOUNT PERCENT PER SHARE
<S> <C> <C> <C> <C> <C>
Existing Common
Stockholders........... 216,666 3.2 $ 2,167 -- $ 0.01
Private Placement
investors.............. 3,549,999 52.5 49,999,995 49.5 14.08
New investors in this
Offering............... 3,000,000 44.3 51,000,000 50.5 17.00
--------- ----- ------------ -----
Total............... 6,766,665 100.0 $101,002,162 100.0 $14.93
========= ===== ============ ===== ======
</TABLE>

31
<PAGE>

CAPITALIZATION

The table below sets forth the capitalization of the Company as of June 30,
1997 and as adjusted to give effect to the sale by the Company of 3,000,000
shares of Common Stock offered hereby and the conversion of all outstanding
Preferred Stock into Common Stock.

<TABLE>
<CAPTION>
AS OF JUNE 30, 1997
-----------------------------
ACTUAL AS ADJUSTED(1)(2)(3)
(IN THOUSANDS)
<S> <C> <C>
STOCKHOLDERS' EQUITY:
Capital stock, $0.01 par value, 50,000,000
shares authorized:
Convertible preferred stock; 3,549,999
(actual) and 0 (as adjusted) shares issued
and outstanding........................... $ 36 $ --
Common Stock; 216,666 (actual) and
6,766,665 (as adjusted) shares issued and
outstanding............................... 2 68
Additional paid-in capital(4)............... 49,862 96,762
Accumulated deficit......................... (1,535) (1,535)
Net unrealized gain on available-for-sale
securities................................. 1,367 1,367
Forgivable notes receivable from founders... (3,395) (3,395)
------- -------
Total.................................... $46,337 $93,267
======= =======
</TABLE>
- --------
(1) Does not include 334,332 shares of Common Stock options granted under
Company's Stock Option Plan, of which 309,332 have been granted to
executive officers and directors of the Company. See "Management--
Executive Compensation."
(2) Assumes that no Warrants are exercised, that the Underwriters over-
allotment options is not exercised and that the underwriting discounts and
other offering expenses total $4,070,000.
(3) Assumes conversion of all Preferred Stock into Common Stock. Conversion is
automatic upon closing of the Offering.
(4) Based on an assumed initial public offering price of $17.00.

32
<PAGE>

SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

The following selected financial data are derived from the audited
consolidated financial statements of the Company for the periods presented and
should be read in conjunction with the more detailed information therein and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" included elsewhere in this Prospectus. Operating results for the
six months ended June 30, 1997 are not necessarily indicative of the results
that may be expected for the year ending December 31, 1997.

<TABLE>
<CAPTION>
FOR THE SIX MONTHS ENDED FOR THE PERIOD ENDED
JUNE 30, 1997 DECEMBER 31, 1996(1)
------------------------ --------------------
<S> <C> <C>
STATEMENT OF OPERATIONS DATA
Interest income................. $ 9,320 $ 155
Interest expense................ 6,438 --
Net interest income............. 2,882 155
Provision for credit losses..... 718 --
Net interest income after
provision for credit losses.... 2,164 155
Other income.................... 213 --
General and administrative
expenses....................... 3,256 457
Net loss........................ (879) (302)
Pro forma net loss per
share(2)....................... (0.21) (0.07)
<CAPTION>
AS OF AS OF
JUNE 30, 1997 DECEMBER 31,1996
------------------------ --------------------
<S> <C> <C>
BALANCE SHEET DATA
Mortgage assets:
Mortgage securities............. $284,348 $13,239
Mortgage loans.................. 303,732 --
Total assets.................... 601,741 59,796
Borrowings...................... 553,640 --
Stockholders' equity............ 46,337 46,365
<CAPTION>
AS OF OR FOR AS OF OR FOR
THE SIX MONTHS ENDED THE PERIOD ENDED
JUNE 30, 1997 DECEMBER 31, 1996(1)
------------------------ --------------------
<S> <C> <C>
OTHER DATA
Wholesale loan originations:
Production...................... $ 90,380 --
Average principal balance per
loan........................... $ 157 --
Weighted average interest rate:
Adjustable rate mortgage
loans......................... 10.0% --
Fixed rate mortgage loans...... 10.6% --
Loans with prepayment
penalties...................... 82% --
Weighted average prepayment
penalty period (in years)...... 2.7 --
Loans purchased in bulk:
Principal at purchase........... $207,240 --
Average principal balance per
loan........................... $ 106 --
Weighted average interest rate:
Adjustable rate mortgage
loans......................... 9.6% --
Fixed rate mortgage loans...... 10.5% --
Loans with prepayment
penalties...................... 54% --
Weighted average prepayment
penalty period (in years)...... 3.0 --
Net interest spread............. 1.77% --
Net yield....................... 2.51% --
Return on assets................ (0.29)% (1.69)%
Return on equity................ (3.79)% (2.18)%
Taxable income (loss)--NovaStar
Financial, Inc................. $ 365 $ (173)
Taxable income (loss) per
preferred share--NovaStar
Financial, Inc................. $ 0.10 $ (0.05)
Dividends per preferred
share(3)....................... $ 0.10 --
Number of account executives.... 17 --
</TABLE>
- --------
(1) The Company was formed on September 13, 1996. Operations began in
substance after the Private Placement, which closed on December 9, 1996.

(2) Pro forma net loss per share is based on the weighted average shares of
Common Stock and Preferred Stock outstanding, and includes the effect of
warrants and options using the treasury stock method.
(3) No dividends have been declared on the Common Stock. The level of
quarterly dividends is determined by the Board of Directors based upon
its consideration of a number of factors and should not be deemed
indicative of taxable income for the quarter in which declared or future
quarters, or of income calculated in accordance with GAAP. See "Dividend
Policy and Distributions."

33
<PAGE>

MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the preceding
Selected Consolidated Financial and Other Data and the Company's Consolidated
Financial Statements and the Notes thereto, included elsewhere in this
Prospectus.

OVERVIEW

NovaStar Financial, Inc. is a specialty finance company engaged in the
business of originating, acquiring and servicing primarily single family
residential subprime mortgage loans. See "Risk Factors--Subprime Mortgage
Banking Industry." The Company was incorporated on September 13, 1996 by the
founders. Through a Private Placement, the Company raised $47 million in
December 1996, allowing the Company to commence operations. Those operations
consisted of developing the infrastructure to begin the loan origination
operation and of investing proceeds from the Private Placement in short-term
liquid assets. Investments earned $155,000, while general and administrative
costs were $457,000, resulting in a net loss of $302,000 during the period
from inception to December 31, 1996. Those operating results are not
meaningful to the on-going operations of the Company. The asset size of the
Company has grown since the initial capitalization to a total of $602 million
as of June 30, 1997. The 1997 operating results and financial condition of the
Company reflect this growth and should be interpreted accordingly.

The Company generates income principally from the earnings on its Mortgage
Assets. The Company uses a combination of equity and borrowings to finance the
acquisition of its Mortgage Assets. The Board of Directors has established
Capital Allocation Guidelines ("CAG") which assist management in assessing the
appropriate combination of equity and debt financings. The CAG are intended to
keep the Company properly leveraged by (i) matching the amount of leverage
allowed to the riskiness (return and liquidity) of an asset and (ii)
monitoring the credit and prepayment performance of each investment to adjust
the required capital. Until the Company is fully leveraged, the Company will
not reach its full earnings potential. Since inception, the Company has used
less debt financing than the maximum allowed under the CAG as it has reserved
the use of equity funding for future loan originations. The Company's short-
term borrowings are provided through a $50 million warehouse line of credit
with First Union National Bank and through repurchase agreements with various
securities dealers.

A significant portion of the Company's Mortgage Assets earn adjustable
interest rates based on short-term interest rates. All of the Company's
borrowings bear short-term rates of interest. As a result, net interest income
depends on prevailing market rates, as well as the volume of interest-earning
assets and interest-bearing liabilities. Increases in short-term interest
rates will generally increase the yields on Mortgage Assets and the costs of
borrowings. However, to the extent that borrowing costs adjust at different
times or amounts relative to the yield on the Mortgage Assets, the Company is
subject to interest rate risk. When the costs of borrowings increase more
rapidly than yields on assets, net interest income may be reduced. Conversely,
decreases in short-term rates may decrease the interest cost on the Company's
borrowings more rapidly than the yields on assets causing an increase in net
interest income. Management monitors and aggressively manages interest rate
risk. However, the Company's portfolio cannot be completely hedged against
changing interest rates. See "Business--Portfolio Management--Interest Rate
Risk Management."

Many costs of the Company are directly related to the infrastructure
necessary to support current period wholesale loan production, which has grown
from a monthly total of $2.9 million in February 1997 to a monthly total of
$28.5 million in June 1997. Revenue, on the other hand, is dependent on the
size and composition of the Company's Mortgage Asset portfolio. As a result,
during the first six months of 1997, the Company's operating results reflect
the substantial costs related to building the mortgage lending and servicing
infrastructure and have exceeded the income from the Company's portfolio of
Mortgage Assets. Management believes the established infrastructure allows for
the addition of Mortgage Assets that will provide a higher return on equity
than could otherwise be acquired in the secondary market. Management also
believes that, over time, earnings will reflect the value of the
infrastructure.

The Company's borrowers generally have substantial equity in the property
securing the loan, but have impaired or limited credit profiles or higher
debt-to-income ratios than traditional mortgage lenders allow. The

34
<PAGE>

Company's borrowers also include individuals who, due to self-employment or
other circumstances, have difficulty verifying their income, as well as
individuals who prefer the prompt and personalized service provided by the
Company. Because these borrowers typically use the proceeds of the loan to
consolidate and refinance debt, and to finance home improvements, education
and other consumer needs, the Company believes its loan origination volume
will be less dependent on the general level of interest rates or home sales
and therefore less cyclical than conventional mortgage lending.

Through its mortgage lending operation, the Company will continue adding
interest-earning assets to its balance sheet. Management projects that, at or
near the completion of this Offering, the Company will have reached the
maximum level of interest-earning assets for the debt/equity mix allowed under
its CAG. Securing additional capital allows the Company to further develop and
grow its balance sheet. The Company is seeking to increase its capital base by
issuing shares of Common Stock in this Offering. Capital will, in the short
term, be used to retire certain borrowings. In the long term, the proceeds
from the Offering will be used primarily to originate and acquire additional
Mortgage Assets. Upon completion of the Offering, the Company expects to be
able to continue adding interest-earning assets to more effectively utilize
the Company's human and other resources.

FORGIVABLE NOTES RECEIVABLE FROM FOUNDERS

The Company's founders, Messrs. Hartman and Anderson, received 216,666 Units
upon closing of the Private Placement. Payment for these Units was made by the
founders delivering to the Company forgivable promissory notes. Payment of the
original principal on these notes will be forgiven if certain incentive
performance targets are achieved. One tranche will be forgiven for each fiscal
period that the Company generates a total return to investors in the Private
Placement of 15 percent. All tranches will be forgiven when the Company has
generated a 100 percent return. As of June 30, 1997, the aggregate amount
receivable from founders was $3,395,000, of which $145,000 is accrued
interest. See Note 7 to the consolidated financial statements. The incentive
tests relate to the total return generated to investors in the Private
Placement. Total return includes the appreciation of the Company's stock price
and dividends paid. In the event the incentive tests are reached during 1997,
one or more of the tranches of the forgivable notes could be forgiven,
resulting in compensation expense during the 1997 fourth quarter. Management
estimates that if one or more of the tranches are forgiven in 1997, the
resulting recognition of compensation expense could have a material effect on
the Company's results of operations for that period, including resulting in a
net loss for the quarter, and possibly for the 1997 fiscal year. See
"Management--Executive Compensation."

FINANCIAL CONDITION AS OF JUNE 30, 1997

During the first half of 1997, the Company added over $200 million in
mortgage loans to the balance sheet through the purchase of bulk pools of
loans originated by other mortgage lenders. During February 1997, the Company
originated its first wholesale production loans. From that time until June 30,
1997 the Company has originated 577 wholesale production loans with an
aggregate principal amount of $90 million. Table I summarizes the Company's
loan originations and bulk acquisitions by month.

TABLE I
WHOLESALE LOAN ORIGINATIONS AND ACQUISITIONS
SIX MONTHS ENDED JUNE 30, 1997 (DOLLARS IN THOUSANDS)

<TABLE>
<CAPTION>
WHOLESALE ORIGINATIONS BULK ACQUISITIONS TOTAL
-------------------------- ------------------ ------------------
NUMBER PRINCIPAL NUMBER PRINCIPAL NUMBER PRINCIPAL
OF LOANS AMOUNT OF LOANS AMOUNT OF LOANS AMOUNT
<S> <C> <C> <C> <C> <C> <C>
January.... -- $ -- 851 $ 94,710 851 $ 94,710
February... 17 2,941 376 41,784 393 44,725
March...... 51 9,747 195 20,938 246 30,685
April...... 132 19,219 427 39,753 559 58,972
May........ 173 29,964 103 10,055 276 40,019
June....... 204 28,509 -- -- 204 28,509
--------- ------------- ----- -------- ----- --------
Total.... 577 $ 90,380 1,952 $207,240 2,529 $297,620
========= ============= ===== ======== ===== ========
</TABLE>

35
<PAGE>

Further details regarding mortgage loans outstanding as of June 30, 1997 are
given in various sections of "Business" and in Note 3 to the consolidated
financial statements.

As an alternative investment while its wholesale production has been
growing, the Company has been an active investor in Mortgage Securities issued
by government-sponsored entities. During the six months ended June 30, 1997,
the Company acquired securities with an aggregate cost of $378.5 million and
sold securities with an aggregate carrying value, at the time of sale, of
$99.8 million. Proceeds from these sales were reinvested in other Mortgage
Securities issued by government-sponsored entities, deemed by the Company to
be preferable under its asset liability management strategy. As of June 30,
1997, Mortgage Securities totaled $284.3 million. Details of Mortgage
Securities are provided in Note 2 to the consolidated financial statements.

Wholesale loans and smaller pools of bulk loans originated through the
lending operations of the Company have typically been funded through a $50
million mortgage loan warehouse agreement with First Union National Bank. As
advances under the line approach the maximum available borrowing under the
warehouse line, mortgage loan collateral is transferred to a $300 million
master repurchase agreement with Merrill Lynch Mortgage Capital, Inc. and
Merrill Lynch Credit Corporation. During the first half of 1997, funds
borrowed under this agreement have been used to acquire some of the largest
pools of mortgage loans acquired by the Company. Funds borrowed against the
master repurchase agreement are used to pay off amounts borrowed against the
warehouse line of credit to free its use for further wholesale production.
Management expects to continue using this method for the short-term financing
of its mortgage lending operations.

Acquisitions of agency-issued Mortgage Securities have been financed by
using individual assets as collateral for repurchase agreements. These
agreements have been executed with a number of reputable securities dealers.
Management expects to continue to finance the acquisition of Mortgage
Securities using this method.

Under the terms of all financing arrangements, lending institutions require
"over-collateralization" from the Company. The value of the collateral
generally must exceed the allowable borrowing by two to five percent. As a
result, the Company must have resources available to cover this "haircut."
Proceeds from the Private Placement have been used for such purpose. Proceeds
from future capital issuances, including this Offering, will also be used in
this manner.

Amounts outstanding under borrowing arrangements aggregated $553.6 million
as of June 30, 1997. Details of these borrowings are included in Note 4 to the
consolidated financial statements.

The Company expects to aggregate substantially all of its outstanding
mortgage loans to serve as collateral for the issuance of its own
collateralized mortgage obligations ("CMO"). Proceeds from these issuances
will be used to pay off amounts borrowed under the master repurchase agreement
and warehouse line of credit. Management intends to make a regular practice of
issuing collateralized debt as part of its normal asset/liability management.
The Company expects to benefit from this practice by lowering its overall
financing costs.

RESULTS OF OPERATIONS--SIX MONTHS ENDED JUNE 30, 1997

Net Interest Income

Table II presents a summary of the average interest-earning assets, average
interest-bearing liabilities, and the related yields and rates thereon for the
six months ended June 30, 1997.

Interest Income. The Company had average interest-earning assets of $229.7
million during the six months ended June 30, 1997. Of these, $63.0 million
were Mortgage Securities, and $166.6 million were mortgage loans. During the
period, mortgage securities earned $2.2 million, or a yield of 7.1 percent,
while mortgage loans earned $7.1 million, or a yield of 8.5 percent. In total,
the Company earned $9.3 million, or a yield of 8.1 percent.

A substantial portion of the mortgage loans owned by the Company have
interest rates that fluctuate with short-term market interest rates. However,
many of these mortgage loans have initial coupons lower than market rates
("teaser" rates). As a result, during the first six months of 1997, the
assets, collectively, have not adjusted upward to their full potential coupon
rate. The effect of this is a temporary lower rate and lower interest yield to
the Company. As these assets "season," they should increase to their higher
rates and result in higher yields.

36
<PAGE>

The Company originates and acquires substantially all of its mortgage loans
at a premium. Such premiums are amortized as a reduction of interest income
over the estimated lives of the assets. If mortgage principal repayment rates
accelerate, the Company will recognize more premium amortization, thereby
reducing the effective yield on the assets. Decelerating repayment rates will
have the opposite effect on asset yields. To mitigate the effect of
prepayments, the Company generally strives to originate and acquire mortgage
loans that have some form of prepayment penalty. Of all the loans originated
during the six months ended June 30, 1997, 82 percent had prepayment penalties
for at least the first two years of the loan. Fifty-four percent of the loans
acquired through bulk purchases by the Company had prepayment penalties. For
loans with prepayment penalties the weighted average prepayment penalty period
is 2.7 years for mortgage loans originated by the Company and 3.0 years for
those acquired through bulk purchases.

As noted above, interest income is a function of volume and rates.
Management expects the asset portfolio to continue to increase through its
wholesale loan origination operation. Management will continue to monitor the
markets for Mortgage Securities and whole loan mortgage pools and will acquire
Mortgage Assets that are appropriate for its overall asset/liability strategy.
Increasing volume of assets will cause future increases in interest income,
while declining balances will reduce interest income. Market interest rates
will also affect future interest income.

Interest Expense. The cost of borrowed funds for the Company was $6.4
million during the six months ended June 30, 1997. Advances under the master
repurchase agreement and the warehouse facility bear interest at rates based
on short-term interest rate indexes, such as the Federal Funds rate and LIBOR,
plus a spread. During the six months ended June 30, 1997, the Federal Funds
rate averaged 5.4 percent and one month LIBOR averaged 5.6 percent. As with
interest income, the Company's cost of funds in the future will largely depend
on market conditions, most notably levels of short-term interest rates.

TABLE II
INTEREST ANALYSIS
SIX MONTHS ENDED JUNE 30, 1997 (DOLLAR AMOUNTS IN THOUSANDS)

<TABLE>
<CAPTION>
INTEREST ANNUAL
AVERAGE INCOME/ YIELD/
BALANCE EXPENSE RATE
<S> <C> <C> <C>
ASSETS
Mortgage securities.............................. $ 63,025 $2,241 7.11%
Mortgage loans................................... 166,644 7,079 8.50
-------- ------
Total interest-earning assets................... $229,669 9,320 8.12
========
LIABILITIES
Master repurchase agreement...................... $132,937 4,359 6.56
Warehouse line of credit......................... 13,711 442 6.44
Other repurchase agreements...................... 56,226 1,637 5.82
-------- ------
Total borrowings................................ $202,874 6,438 6.35
======== ------
Net interest income............................... $2,882
======
Net interest spread............................... 1.77%
====
Net yield......................................... 2.51%
====
</TABLE>

Net Interest Income and Spread. Net interest income during the first six
months of 1997 was $2.9 million, or 2.51 percent of average interest-earning
assets. Net interest spread, the difference between the annual yield earned on
interest-earning assets and the rate paid on borrowings, for the Company was
1.77 percent during the six months ended June 30, 1997. Net interest income
and the spread are functions of the yield of the Company's assets relative to
its costs of funds. During the first half of 1997, the cost of funds was
relatively low and stable. The low cost of funds offset, to some degree, the
lower yield on the assets due to their teaser rates, as discussed above. In
addition, the Company has entered into interest rate agreements to mitigate
the exposure to

37
<PAGE>

variations in interest rates on interest-earning assets that are different
from the variations in interest incurred on borrowings. The volume of assets
and liabilities and how well the Company manages the spread between earnings
on assets and the cost of funds will dictate future net interest income.

As discussed more fully in "Business--Portfolio Management--Interest Rate
Risk Management," the Company is subject to interest rate risk. As of June 30,
1997, stockholders' equity was more sensitive to falling rates than rising
rates. As of June 30, 1997, a one percent fall in interest rates (-100 basis
points) would increase equity by 15.28 percent, while a one percent rise (+100
basis points) would increase equity by 4.05 percent.

Impact of Interest Rate Agreements. During the six months ended June 30,
1997, the Company entered into interest rate agreements designed to mitigate
exposure to interest rate risk. See "Business--Portfolio Management." Two of
these agreements are interest rate cap agreements, with a combined notional
amount of $75 million, which require the Company to pay a monthly fixed
premium while allowing the Company to receive a rate that adjusts with LIBOR,
when rates rise above a certain agreed-upon rate. The other agreements are
simple fixed to floating interest rate swaps with an aggregate notional amount
of $191 million. These agreements are used to, in effect, alter the interest
rates on funding costs to more closely match the yield on interest-earning
assets. During the six months ended June 30, 1997, the Company incurred net
interest expense on these agreements of $346,000. Net income earned from or
expense incurred on these agreements is accounted for on the accrual method
and is recorded as an adjustment to interest expense. Further details
regarding these agreements are provided in Note 5 to the consolidated
financial statements.

Gains and Losses on Sales

The Company classifies its Mortgage Securities as available-for-sale.
Management may deem it appropriate to sell securities, from time to time, to
reallocate the Company's capital. Since inception, the Company has not sold
mortgage loans and, as a general rule the Company does not intend to sell
mortgage loans in the future. The strategy of the Company is to hold and
service mortgage loans in order to earn the spread over the life of the loans,
rather than sell the loans and recognize the gain or loss in the current
period.

Provisions for Credit Losses

In 1997, the Company started providing regular allowances for credit losses
in connection with its initial bulk purchases of loans and wholesale
originations. The Company has not experienced any credit losses to date, but
management expects that losses will be incurred in the future. The Company
regularly evaluates the potential for credit losses for mortgage loans held in
its portfolio. Since the Company has limited actual performance history for
its loan portfolio, losses have been provided for primarily based on general
industry trends and on the judgement of the Company's management.

The Company believes that loan defaults occur throughout the life of a loan
or group of loans. As a result, the Company believes it is appropriate to
record provisions for credit losses against income over the estimated life of
the loans, rather than immediately upon acquisition of the loan. Currently,
the Company provides for credit losses depending on the type and credit grade
of loans comprising the portfolio. The amount of the provision as a percent of
the loans will vary. During the six months ended June 30, 1997, the Company
provided $718,000 for credit losses.

Table III presents a summary of delinquent loans as of June 30, 1997. The
low level of delinquencies is reflective of the short amount of time loans
originated or acquired by the Company have been outstanding. Management
expects to experience higher rates of delinquency in the future and has
established the appropriate staff and policies to monitor delinquencies.

TABLE III
LOAN DELINQUENCIES
AS OF JUNE 30, 1997

<TABLE>
<CAPTION>
PERCENT OF
TOTAL
MORTGAGE LOANS
<S> <C>
Loans delinquent 60 to 90 days.............................. 0.98%
Loans delinquent greater than 90 days....................... 0.87%
</TABLE>

38
<PAGE>

General and Administrative Expenses

Table IV displays general and administrative expenses for the six months
ended June 30, 1997.

TABLE IV
GENERAL AND ADMINISTRATIVE EXPENSES
SIX MONTHS ENDED JUNE 30, 1997 (IN THOUSANDS)

<TABLE>
<S> <C>
Compensation and benefits.......................................... $1,234
Professional and outside services.................................. 596
Loan servicing..................................................... 571
Office administration.............................................. 334
Travel and public relations........................................ 248
Occupancy.......................................................... 162
Other.............................................................. 111
------
Total............................................................ $3,256
======
</TABLE>

During the first six months of 1997, the Company recognized income on
average interest-earning assets of $230 million, while realizing expenses on
the origination of $90 million in mortgage loans. The Company's general and
administrative expenses are typically impacted by current production and the
Company's net interest income is the result of the size of the Company's
portfolio. As the Company's portfolio grows, management expects the income
from the portfolio to exceed general and administrative expenses.

Compensation and benefits include employee base salaries, benefit costs and
incentive bonus awards. The number of employees and the related compensation
costs have increased throughout the first six months of 1997 as the Company
has continued to hire staff. Certain personnel costs directly related to the
origination of mortgage loans are deferred and recognized as a yield
adjustment on such mortgage loans, using the interest method.

Professional and outside services includes the cost of contract labor, as
well as fees for legal and accounting services. Management has used contract
labor services extensively during the development of its operations during the
six months ended June 30, 1997, particularly in the areas of loan underwriting
and systems development. As permanent employees are hired, management
anticipates using contract labor to a lesser extent during the remainder of
1997. Legal fees during the six months ended June 30, 1997 relate to the
execution of numerous agreements with market counterparties and the Company's
ongoing compliance with state and local licensing efforts. The Company has
also incurred expenses for professional services relating to staff
recruitment.

Loan servicing consists of direct costs associated with the mortgage loan
servicing operation, which the Company outsourced until July 15, 1997.
Effective July 15, 1997, the Company assumed the servicing for all of its
mortgage loans. Management believes that by servicing its own mortgage loans,
the Company will be able to more readily monitor and control delinquencies and
defaults. Management believes this is particularly important in the subprime
sector of the mortgage industry. In addition, management believes cost
efficiencies can be gained from servicing the Company's loans in house.

Office administration includes such items as telephone, office supplies,
postage, delivery, maintenance and repairs. Certain of these items have been
necessarily high during the start up phase of the Company. Management expects
many of these expenses to increase relative to production in future periods.

Travel and public relations includes costs of account executives in
developing customer relationships. In addition, the Company operates from
offices in Kansas and California. Management and staff incur travel related
costs in managing those operations. This category also includes travel
incurred by sales managers in recruiting account executives. Management
expects these costs to continue to be incurred.

39
<PAGE>

Occupancy expense includes the rent on office space for the Company's two
main offices in Kansas and California. In addition, office space and equipment
is leased for certain members of its sales force.

Net Loss

During the six months ended June 30, 1997, the Company recorded a net loss
of $879,000, primarily as a result of the significant costs associated with
the development of its operations. From the date of the closing of the Private
Placement in December 1996 through June 30, 1997, the Company's focus was on
the hiring of key employees and the development of policies and procedures.
The Company did not generate significant income during 1996. In addition, the
results for the six months ended June 30, 1997 reflect the significant cost of
developing operations. During the Company's rapid expansion during 1997, the
Company's operating expenses have increased more rapidly than its revenues.

Taxable Income (Loss)

Income reported for financial reporting purposes as calculated in accordance
with generally accepted accounting principles (GAAP) differs from income
computed for income tax purposes. This distinction is important as dividends
paid to the Company's stockholders are based on taxable income. For tax
purposes, the provision for credit losses is not deductible. In addition,
income reported for consolidated financial reporting purposes includes the
accounts of its taxable affiliates. Such entities are excluded in the
preparation of the Company's income tax returns. Table V is a summary of the
differences between the net loss reported for GAAP, as reported herein, and
taxable income of NFI.

TABLE V
TAXABLE INCOME--NFI
SIX MONTHS ENDED JUNE 30, 1997 (IN THOUSANDS)

<TABLE>
<S> <C>
Net loss.......................................................... $(879)
Results of NFI Holding Corporation and subsidiary, net of
intercompany transactions........................................ 536
-----
NFI loss.......................................................... (343)
Provision for credit losses....................................... 718
Other, net........................................................ (10)
-----
Taxable income--NFI............................................... $ 365
=====
</TABLE>

LIQUIDITY AND CAPITAL RESOURCES

Liquidity, as used herein, means the need for, access to and uses of cash.
The Company's primary needs for cash include the acquisition and origination
of Mortgage Assets, principal repayment and interest on borrowings, operating
expenses and dividend payments. The Company has a certain amount of cash on
hand to fund operations. The Company requires access to short term warehouse
and credit facilities to fund its wholesale loan originations. Also,
principal, interest and fees received on Mortgage Assets will serve to support
the cash needs of the Company. Major cash requirements are typically satisfied
by drawing upon various borrowing arrangements.

The Company has a $50 million warehouse line of credit to fund current loan
funding and operations. The Company also has available a $300 million master
repurchase agreement. In addition, the Company has been approved as a borrower
from other reputable securities dealers for repurchase agreements to fund the
acquisition of Mortgage Assets. On a long term basis, the Company will pool
its mortgage loans to serve as collateral for its CMOs. By doing so, the loans
will be cleared as collateral for the master repurchase agreement and the
warehouse line of credit, freeing those arrangements to fund further loan
originations. Although it generally does not intend to do so, all Mortgage
Securities are classified as available-for-sale and could be sold in the open
market in order to provide additional cash for liquidity needs.

40
<PAGE>

The Company's business requires substantial cash to support its operating
activities and growth plans. Management believes that net proceeds from the
Offering, together with existing funds and amounts available under credit
facilities, will be sufficient to fund its operations for the next twelve
months, if future operations are consistent with management's expectations. If
the Company's wholesale loan originations exceed expectations, the timing of
liquidity and capital needs would accelerate. In the event the Offering is not
consummated, the Company would have to arrange alternative financial, or
possibly, sell Mortgage Securities or its wholesale loans.

Cash used by operating activities during the six months ended June 30, 1997
was $5.9 million, consisting primarily of the net loss adjusted for accrued
interest receivable which increased $6.2 million during the period. Cash used
by investing activities was $593.1 million, consisting primarily of purchases
and originations of mortgage assets, net of sales and repayments. Cash
provided by financing activities aggregated $553.4 million, consisting
primarily of net borrowings and advances under the lines of credit and the
repurchase agreements.

The Company uses a combination of equity and borrowings to finance the
acquisition of its Mortgage Assets. The Board of Directors has established
Capital Allocation Guidelines ("CAG") which assist management in assessing the
appropriate combination of equity and debt financings. The mix of debt and
equity is dependent upon the level of risk associated with individual assets,
which determines the amount of over-collateralization required by the lender.
See "Business--Portfolio Management--Capital and Leverage Policies."

INFLATION

Virtually all of the Company's assets and liabilities are financial in
nature. As a result, interest rates and other factors drive the company's
performance far more than does inflation. Changes in interest rates do not
necessarily correlate with inflation rates or changes in inflation rates. The
Company's consolidated financial statements are prepared in accordance with
generally accepted accounting principles and the Company's dividends are
determined by the Company's net income as calculated for tax purposes. In each
case, the Company's activities and balance sheet are measured with reference
to historical cost or fair market value without considering inflation.

IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

Note 1 to the consolidated financial statements describes certain recently
issued accounting pronouncements. Management believes the implementation of
these pronouncements will not have a material impact on the consolidated
financial statements.

41
<PAGE>

BUSINESS

There are two general aspects to the business of the Company: (i) mortgage
lending, targeting primarily the subprime market, and (ii) management of a
portfolio of Mortgage Assets, both those originated and acquired.

MORTGAGE LENDING OPERATION

Market Overview

Over the last three years, the residential mortgage market generated annual
volume in excess of $600 billion per year. The majority of these originations
(approximately 80 to 90 percent) were classified as "prime" mortgages which
generally means they have credit quality and documentation sufficient to
qualify for guarantee by GNMA, FNMA or FHLMC. The remaining 10 to 20 percent
(approximately $85 to $150 billion) of the originations were classified as
"subprime."

The Company believes there is strong national demand by borrowers for
subprime mortgage loans. Across the country, many borrowers have suffered
dislocation and temporary unemployment, resulting in negative entries on their
credit reports. Erratic market and economic conditions and other factors have
resulted in high ratios of debts to assets and high levels of credit card and
other installment debt for these individuals. In addition, more borrowers are
choosing to become self-employed. These are some of the circumstances which
create the market for subprime mortgage loans.

One of the significant differences between the prime and subprime mortgage
loan markets has been the comparative dependence upon the overall level of
interest rates. Generally, the subprime mortgage loan market's historical
performance has been more consistent without regard to interest rates. This is
evident by the growth in subprime originations from 1993 through 1995. While
the prime market experienced a decline in originations of more than 40 percent
due primarily to an increase in interest rates, loan originations in the
subprime market continued to grow at an annual rate of 10 to 15 percent over
the same three-year period.

Based on industry sources, the estimated size of the subprime mortgage loan
market in 1997 is approximately $85 to $150 billion in annual originations.
Historically, the subprime mortgage loan market has been a highly fragmented
niche market dominated by local brokers with direct ties to investors who
owned and serviced this relatively higher margin, riskier product. Although
there have recently been several new entrants into the subprime mortgage
business, the Company believes the subprime mortgage market is still highly
fragmented, with no single competitor having more than a six percent market
share.The growth and profitability of the subprime mortgage loan market, the
demise of numerous financial institutions in the late 1980s which had served
this market, and reduced profits and loan volume at traditional financial
institutions have together drawn new participants and capital to the subprime
mortgage loan market. Management believes the subprime mortgage loan market
requires more business judgement from underwriters in evaluating borrowers
with previous credit problems. Subprime lending is also generally a lower
volume/higher profit margin business rather than the generally higher
volume/lower profit margin prime mortgage business to which traditional
mortgage bankers have become accustomed. Subprime mortgage lending is also
more capital intensive than the prime mortgage market due to the fact that the
securitization function requires a higher level of credit enhancement which
must be provided by the issuer in the form of over-collateralization or
subordination.

The Company believes that the subprime mortgage market will continue to grow
and to generate relatively attractive risk-adjusted returns over the long term
due in part to the following reasons: (i) growth in the number of existing
homeowners with negative entries on their credit reports; (ii) growth in the
number of immigrants with limited credit histories who are in the prime home
buying ages of 25 to 34; (iii) growth in the number of self-employed
individuals who have sources of income which are inconsistent and difficult to
document; (iv) growth in consumer debt levels which are causing many borrowers
to have higher debt/income ratios; and (v) growth in consumer bankruptcy
filings which cause borrowers to be classified as subprime.

42
<PAGE>

The Company believes that more competitors may attempt to enter the market.
While this may cause profit margins to narrow, the Company believes that the
subprime mortgage market will be able to sustain attractive profit margins due
to certain barriers to entry which include (i) the capital intensive nature of
the business as issuers of securities backed by subprime mortgage loans are
required to retain the credit and prepayment risks; (ii) the higher level of
expertise required to underwrite the mortgage loans; (iii) the higher cost to
service the mortgage loans due to the additional emphasis required on
collections and loss mitigation; and (iv) the highly fragmented nature of
business due to the difficulty of sourcing the mortgage loans.

One of the Company's two principal businesses will be originating, acquiring
and servicing primarily subprime mortgage loans, generally secured by first
liens on single family residential properties. Subprime mortgage lending
involves lending to individuals whose borrowing needs are generally not being
served by traditional financial institutions due to poor credit history and/or
other factors which make it difficult for them to meet prime mortgage loan
underwriting criteria. The Company will target as potential customers
individuals with relatively significant equity value in their homes, but who
(i) have impaired credit profiles, (ii) are self-employed, tend to experience
some volatility in their income or have difficult-to-document sources of
income, or (iii) are otherwise unable to qualify for traditional prime
mortgage loans. Loan proceeds are used by borrowers for a variety of purposes
such as to consolidate consumer credit card and other installment debt, to
finance home improvements and to pay educational expenses. These borrowers are
often seeking to lower their monthly payments by reducing the rate of interest
they would otherwise pay or extending their debt amortization period or doing
both. Customer service is emphasized by providing prompt responses and
flexible terms to broker-initiated customer borrowing requests. Through this
approach, the Company expects to originate new loans and purchase closed loans
with relatively higher interest rates than are typically charged by lenders
for prime mortgage loans while having comparable or lower loan-to-value
ratios. The pricing differential between typical prime non-conforming mortgage
loans and subprime mortgage loans is often as much as 300 basis points. With
proper management of the credit risk, most of this additional spread may
become additional profit for the owner of these loans.

The majority of the Company's originations have been made for debt
consolidation purposes, with the remainder of its originations either
rate/term refinances or purchase money loans. Given the borrowers needs,
subprime mortgage lending tends to be less interest rate sensitive than the
prime mortgage purchase market or rate/term refinance market, since borrowings
secured by real estate are generally less expensive than credit card or
installment debt. Subprime borrowers are also generally more willing to accept
a prepayment penalty since they have fewer options for obtaining financing
then the typical prime mortgage loan borrower. To date, 82 percent of the
mortgage loans originated by the Company have included a prepayment penalty.

Marketing and Production Strategy

General. The Company's competitive strategy is to build efficient channels
of production for originating subprime mortgage loans. The Company has
generated mortgage product through two distinct production channels: (i)
direct origination through a wholesale broker network; and (ii) bulk
acquisitions from originators. The Company's long-term strategy is to
emphasize production through the wholesale broker network. Management believes
that production channels that allow the Company to get closer to the customer
and eliminate as many intermediaries as possible will generally be the most
efficient over the long-term and that, by developing the direct origination
channel through a mortgage broker network, the Company will be able to
differentiate itself from other end investors who purchase their production in
bulk from other originators. From time to time, the Company may participate in
the bulk acquisition market depending on market conditions and the
availability of capital.

The Company believes that subprime mortgage loans provide a relatively
attractive net earnings profile, producing higher yields without
commensurately higher credit risks when compared to prime mortgage loans. With
the proper focus on underwriting, appraisal, management and servicing of
subprime mortgage loans, the Company believes it can be successful in
developing a profitable business in this segment of the market. While many new
competitors have recently entered the subprime mortgage loan market, the
Company believes that the

43
<PAGE>

experience of its management in this industry and the infrastructure which has
been established allows it to effectively compete in this segment. Moreover,
there are few public companies competing in the subprime market that are
operated as REITs, which the Company believes to be the most efficient
structure for competing in this segment of the market. See "Risk Factors--
Intense Competition in the Subprime Mortgage Industry."

Mortgage Products. The Company's mortgage lending operation offers a broad
menu of products in order to serve its customers. These products are comprised
of both fixed rate and adjustable rate mortgages. Since inception, the
percentage of fixed rate and adjustable rate loans originated by the Company
is 10 percent and 90 percent, respectively. The Company categorizes the loans
that it originates into one of five different credit risk classifications.
Loan are assigned a credit classification based on several factors consisting
of such things as loan to value (LTV) ratios, the credit history of the
borrower, debt ratios of the borrower and other characteristics. The Company
provides loans up to a maximum LTV ratio of 90 percent based on the credit
risk classification and the loan amount. For loans originated since inception
the average LTV ratio is 76.6 percent and the average loan amount is $157,000.

Wholesale Channel. The Company's wholesale origination consists of a network
of brokers and correspondents that offer its line of mortgage products.
Management believes that its wholesale channel allows the Company to originate
loans at a lower cost, including the cost to originate the loan, than it could
purchase the loan in the market. For example, assume the price to purchase a
loan in bulk is 106 percent of the face amount. If the Company can originate
the same loan at 102 percent of face amount and incurs origination costs of
two percent of par, the wholesale loan would be two percent less expensive
than the loan purchased in bulk.

The wholesale origination infrastructure consists of a sales force to call
on mortgage loan brokers, an underwriting and processing center to underwrite,
close and fund mortgage loans and systems to process data. As of June 30,
1997, the Company had a staff of 25 account executives, located in offices
nationwide, whose job is to call on brokers. Supporting the sales force is a
staff of 40 in Irvine, California. Management believes it can originate loans
through the wholesale channel at a price 1.5 to 2.0 percent lower than the
cost of acquiring mortgage loans in bulk.

Management believes it has been, and will continue to be, successful in
competing in the wholesale business for several reasons. First, the Company is
a vertically integrated wholesale originator and investor. Management believes
this approach will provide a competitive advantage over many competitors who
either only originate loans or only act as end investors because of the
elimination of redundancy in separating the two functions. Second, the Company
believes its REIT status gives it a pricing advantage over non-REIT mortgage
investors. Third, the Company believes it has assembled a mortgage loan
production staff with extensive experience and contacts in the subprime
mortgage loan market. Management believes that important factors influencing
success or failure in the wholesale channel are offering competitive prices,
consistent application of underwriting guidelines, and responsive service.

Bulk Acquisitions. The bulk acquisition channel was the first channel
developed by the Company as it requires the least infrastructure to operate
and it allowed the Company to acquire Mortgage Assets very quickly. Although
it generally carries a lower margin than the wholesale channel, from time to
time the Company may still acquire mortgage loans through this channel. In
bulk acquisitions, pools of mortgage loans ranging in size from $2 million to
in excess of $25 million are acquired from large originators of mortgage
loans.

Due diligence is often performed by contract underwriters under the guidance
of the Company's Senior Credit Officer. The Senior Credit Officer personally
reviews the resumes of each contract underwriter prior to the performance of
the due diligence process. Any exceptions to the Company's underwriting
guidelines must be approved by the Senior Credit Officer. Personnel for this
channel are centralized in the mortgage operations headquarters with the only
field personnel consisting of the sales force strategically located in select
markets. Through this production channel, the Company is able to quickly
invest its capital in pools of subprime mortgage loans.

44
<PAGE>

Retail Channel. The Company has not yet established a retail or direct
origination channel to the consumer. This is the typical finance company model
with a local office in a strip center and commissioned loan originators.
Retail origination is the most expensive and potentially the most profitable
origination channel. The overhead cost to originate retail mortgage loans can
be as high as four to six percent of the face amount of the loan. However, the
gross profit on such a mortgage loan can be as high as 10 percent of the face
amount of the mortgage loan and the prepayment risk is mitigated due to the
loan being funded at a discount to par. Success in retail origination often
times depends on the branch's ability to generate leads, access to an outlet
to sell mortgage loan products which are attractive to borrowers, and
flexible, common sense underwriting. This segment of the mortgage industry
remains highly fragmented and dominated by local brokers. While the Company
does not have plans to implement a retail production channel initially, it may
test a variety of direct consumer marketing strategies in the future.

Profitability and Capital Allocation by Production Channel. In general, the
Company believes that the closer it gets to the consumer in the mortgage
process chain, the more profitable the production channel will be due to the
elimination of unnecessary intermediaries. While over the long term the
Company believes this to be true, there may be times when market conditions
are such that the bulk acquisition channel (the furthest from the customer) is
the most profitable. In order to properly manage the allocation of capital,
the Company will measure the profitability of each channel on a stand-alone
basis. Direct expenses will be tracked by channel and measured against
mortgage loans originated via each channel.

By measuring each channel independently, the Company intends to avoid
supporting a channel which has been unprofitable over time. This is an
important exercise to go through especially since the Company does not intend
to enter transactions which would result in gains on sales. In addition, by
knowing the profitability of each channel at any given point in time, as well
as on average over a specified time period, the Company can make the proper
decisions in deciding where to invest its capital to obtain the best return
for stockholders.

Underwriting and Quality Control Strategy

Underwriting Guidelines. The Company originates or purchases loans in
accordance with its underwriting guidelines (the "Underwriting Guidelines")
described herein. These Underwriting Guidelines were developed by the
Company's President and Chief Credit Officer utilizing their experience in the
industry. The Underwriting Guidelines are intended to evaluate the credit
history of the potential borrower, the capacity and willingness of the
borrower to repay the loan and the adequacy of the collateral securing the
loan.

The Company underwrites all mortgage loans it originates or purchases
through its wholesale channel. The Company has hired experienced underwriters
who work under the supervision of the Chief Credit Officer. The underwriters
hired by the Company all have substantial experience in the underwriting of
subprime mortgage loans and generally have a minimum of ten years experience.
As of June 30, 1997, the Company employed nine underwriters with an average of
ten years experience in subprime mortgage lending.

Underwriters are given approval authority only after their work has been
reviewed by the Chief Credit Officer for a period of at least two weeks.
Thereafter, the Chief Credit Officer re-evaluates the authority levels of all
underwriting personnel on an ongoing basis. All loans in excess of $350,000
currently require the approval of the Chief Credit Officer. In addition, the
President approves all loans in excess of $750,000.

On a case-by-case basis, exceptions to the Underwriting Guidelines are made
where compensating factors exist. Compensating factors may consist of factors
like length of time in residence, lowering of the borrower's monthly debt
service payments, the loan to value ratio on the loan or other criteria that
in the judgment of the underwriter warrants an exception.

Each loan applicant completes an application that includes information with
respect to the applicants income, assets, liabilities and employment history.
A credit report is also submitted by the broker along with the loan
application which provides detailed information concerning the payment history
of the borrower on all of

45
<PAGE>

their debts. Prior to issuing an approval on the loan, the underwriter runs an
independent credit report to verify that the information submitted by the
broker is still accurate and up-to-date. An appraisal is also required on all
loans and in many cases a review appraisal or second appraisal may be required
depending on the value of the property and the underwriters comfort with the
original valuation. All appraisals are required to conform to the Uniform
Standards of Professional Appraisal Practice adopted by the Appraisal
Standards Board of the Appraisal Foundation and are generally on forms
acceptable to FNMA and FHLMC.

The Underwriting Guidelines include three levels of applicant documentation
requirements, referred to as "Full Documentation", "Limited Documentation",
and "Stated Income". Under the Full Documentation program applicants generally
are required to submit two written forms of verification of stable income for
at least 12 months. Under the Limited Documentation program, one such form of
verification of income is required. Under the Stated Income Documentation
program, an applicant may be qualified based on monthly income as stated in
the loan application.

The Company's categories and criteria for grading the credit history of
potential and the maximum loan to value ratios allowed for each category are
shown below.

<TABLE>
<CAPTION>
A RISK A- RISK B RISK C RISK D RISK
------------- ------------- ------------- ------------- ---------------
<S> <C> <C> <C> <C> <C>
Mortgage Maximum one Maximum two Maximum three Maximum five Maximum six 30
History..... 30-day late 30-day lates 30 day lates 30 day lates day lates,
and no 60-day and no 60-day and one 60 and two 60 three 60 day
lates within lates within day late day lates lates and two
last 12 last 12 within the within the 90 day lates
months months last 12 last 12 within the last
months months 12 months. Must
be current at
time of
origination
Other Limited 30 Limited 60 Limited 60 Limited 90 Discretionary--
Credit...... day lates day lates day lates day lates credit is
within the within the within the within the generally
last 12 last 12 last 12 last 12 expected to be
months. months months months late pay
Generally
paid as
agreed
Bankruptcy
Filings..... Chapter 13 Chapter 13 Chapter 13 Chapter 13 no Chapter 13 no
must be must be must be seasoning seasoning
discharged discharged discharged required on required on
minimum of 1 minimum of 1 minimum of 1 discharge discharge with
year with year with year with with evidence evidence of
reestablished reestablished reestablished of satisfactory
credit; credit; credit; satisfactory discharge;
Chapter 7 Chapter 7 Chapter 7 discharge; Chapter 7
must be must be must be Chapter 7 minimum
discharged discharged discharged minimum discharge of 1
minimum of 2 minimum of 2 minimum of 2 discharge of year
years with years with years with 2 years
reestablished reestablished reestablished
credit credit credit
Debt to
Service 45% 45% 50% 55% 60%
Ratio.......
Maximum Loan-
to-Value
Ratio:
Full
documentation.. 90% 90% 85% 75% 65%
Limited
documentation.. 85% 80% 75% 70% 60%
Stated
income...... 80% 75% 70% 65% 60%
</TABLE>

46
<PAGE>

Loan Portfolio by Credit Risk Category. The following table sets forth the
Company's mortgage loan portfolio by credit grade as of June 30, 1997, all of
which are non-conforming.

<TABLE>
<CAPTION>
PRINCIPAL PERCENT OF LOAN TO
BALANCE TOTAL VALUE RATIO
(IN
THOUSANDS)
<S> <C> <C> <C>
A........................................ $125,198 43.1% 74.0%
A-....................................... 75,292 25.9 74.5
B........................................ 54,847 18.9 73.3
C........................................ 23,980 8.3 69.1
D........................................ 10,976 3.8 63.5
-------- -----
Total.................................. $290,293 100.0% 73.2%
======== =====
</TABLE>

Geographic Diversification. Close attention is paid to geographic
diversification in managing the Company's credit risk. The Company believes
one of the best tools for managing credit risk is to diversify the markets in
which it originates and purchases mortgage loans. The Company has established
a diversification policy to be followed in managing this credit risk which
states that no one market can represent a percentage of total mortgage loans
owned by the Company higher than twice that market's percentage of the total
national market share. While there generally is some geographic concentration
in mortgage loans originated through the bulk acquisition channel, over time
the Company's mortgage lending operation plans to diversify its credit risk by
selecting target markets through the wholesale channel. Presented below is a
breakdown of the Company's current geographic diversification for both its
wholesale and bulk channels combined as of June 30, 1997.

<TABLE>
<CAPTION>
PRINCIPAL PERCENT
AMOUNT OF TOTAL
(IN
THOUSANDS)
<S> <C> <C>
California............................................. $103,747 35.7%
Illinois............................................... 24,401 8.4
Washington............................................. 20,618 7.1
Utah................................................... 17,954 6.2
Texas.................................................. 17,592 6.1
Others................................................. 105,981 36.5
-------- -----
Total................................................ $290,293 100.0%
======== =====
</TABLE>

Collateral Valuation. Collateral valuation also receives close attention in
the Company's underwriting of its mortgage loans. Given that the Company
primarily lends to subprime borrowers, it places great emphasis on the ability
of collateral to protect against losses in the event of default by borrowers.
The Company has established an appraisal policy as part of its underwriting
guidelines. This policy includes requiring second and/or review appraisals on
certain properties in order to verify the value of the property.

Quality Control. Quality control reviews are conducted to ensure that all
mortgage loans, whether originated or purchased, meet the Company's quality
standards. The type and extent of the reviews depend on the production channel
through which the mortgage loan was obtained and the characteristics of the
mortgage loan. The Company reviews a high percentage of mortgage loans with
(i) principal balances in excess of $450,000, (ii) higher loan to value ratios
(in excess of 75%), (iii) limited documentation, or (iv) made for "cash out"
refinance purposes. The Company also performs appraisal reviews and compliance
reviews as part of the quality control process to ensure adherence to Company
appraisal policies and state and federal regulations.

47
<PAGE>

Mortgage Loan Servicing Strategy

Overview. The Company plans to acquire the large majority of mortgage loans
it originates and purchases on a servicing released basis and thereby acquire
the servicing rights. Through July 14, 1997, Advanta Mortgage Corp. USA was
acting as sub-servicer for the mortgage loans originated and acquired by the
Company. Effective, July 15, 1997, the Company began servicing its own
mortgage loans. The servicing operation is located in the Westwood, Kansas
office and is currently staffed with 11 employees. Servicing includes
collecting and remitting loan payments, making required advances, accounting
for principal and interest, holding escrow or impound funds for payment of
taxes and insurance, making required inspections of the property, contacting
delinquent borrowers and supervising foreclosures and property disposition in
the event of unremedied defaults in accordance with the Company's guidelines.

The Company's focus as a servicer of subprime mortgage loans is on effective
credit risk. The Company intends to employ the proper resources to mitigate
losses on the mortgage loans being serviced. The Company also believes it can
better manage prepayment risk by servicing its own mortgage loans. Through its
servicing function, the Company intends to pre-select borrowers that have an
incentive to refinance and re-capture those mortgage loans by soliciting the
borrowers directly rather than losing them to another mortgage lender.
Although it is not a primary focus, management estimates that the Company will
be able to effectively service its loans at a cost less than the cost to
outsource this function.

Procedures. In servicing subprime mortgage loans, the Company uses
collection procedures that are generally more stringent than those typically
employed by a servicer of prime mortgage loans consistent with applicable
laws. Management believes one of the first steps in effectively servicing
subprime mortgage loans is to establish contact with the borrower prior to any
delinquency problems. To achieve this objective, each borrower is telephoned
ten days prior to the first payment due date on the mortgage loan. This
initial telephone call serves several purposes: (i) the Company ensures it has
the proper telephone number for the borrower, (ii) the borrower will be aware
of who is servicing the loan, where payment is to be made, and has a contact
to call in the event of any questions, and (iii) the Company is able to stress
to the borrower the importance of making payments in a complete and timely
manner.

The first 30 days of a delinquency are, in the Company's view, the crucial
period for resolving the delinquency. At a minimum, all borrowers who have not
made their mortgage payment by the 10th day of the month in which it is due
receive a call from a collector. Borrowers whose payment history exhibits
signs that the borrower may be having financial difficulty receive more
attention. For example, any borrowers who made their previous months payment
after the late charge date (generally the 15th of the month) receive a call
from a collector no later than the second business day of the current month if
their payment has not yet been received. This allows the Company to be more
aggressive with those borrowers who need the most attention and also focuses
the efforts of the Company's collection staff on the higher risk borrowers.

For accounts that have become 60 days or more delinquent, the collection
follow-up is increased and a full financial analysis of the borrower is
performed, a Notice of Intent to Foreclose is filed, and efforts to establish
a work out plan with the borrower are instituted.

The Company uses reasonable discretion to extend appropriate relief to
borrowers who encounter hardship and who are cooperative and demonstrate
proper regard for their obligation. As servicer, the Company is available to
offer some guidance and make personal contact with delinquent borrowers as
often as possible to seek to achieve a solution that will bring the mortgage
loan current. However, no relief will be granted unless there is reasonable
expectation that the borrower can bring the mortgage loan current within 180
days following the initial default.

If properly managed from both an underwriting and a servicing standpoint,
the Company believes it will be able to keep the level of delinquencies and
losses in its mortgage loans in line with industry standards.

48
<PAGE>

PORTFOLIO MANAGEMENT

The Company builds its Mortgage Asset portfolio from two sources--loans
originated in its mortgage lending operation and purchases in the secondary
mortgage and securities markets. Initially, the portfolio was comprised of
purchased Mortgage Assets. As the Company has developed its infrastructure for
subprime mortgage lending, the Company has relied less on purchasing mortgage
loans in bulk and more on its wholesale origination function. Ultimately, the
Company expects a substantial portion of its portfolio to consist of retained
interests in originated loans collateralizing the Company's structured debt
instruments.

Types of Mortgage Assets

The Mortgage Assets purchased by the Company in the secondary mortgage
market are principally single family mortgage loans and Mortgage Securities
backed by single family mortgage loans, as well as from time to time
multifamily mortgage loans and Mortgage Securities backed by multifamily
mortgage loans and commercial mortgage loans and Mortgage Securities backed by
commercial mortgage loans. Single family mortgage loans are mortgage loans
secured solely by first mortgages or deeds of trust on single family (one-to-
four unit) residences. Multifamily mortgage loans are mortgage loans secured
solely by first mortgages or deeds of trust on multifamily (more than four
units) residential properties. Commercial mortgage loans are secured by
commercial properties. Substantially all of its Mortgage Assets of the Company
bear adjustable interest rates or have a fixed-rate coupon that has been
paired with an interest rate swap, so that the Company has the proper matching
of assets and liabilities.

The Company has not and generally will not acquire residuals, first loss
subordinated bonds rated below BBB, or mortgage securities rated below B. The
Company could retain the subordinate class from mortgage loans securitized
through its taxable affiliate. The Company may acquire interest-only or
principal-only mortgage strips to assist in the hedging of prepayment or other
risks. In addition, as discussed above the Company may create a variety of
different types of assets, including the types mentioned in this paragraph,
through the normal process of securitization of the Company's own Mortgage
Assets. In no event will the Company (exclusive of its taxable affiliates)
acquire or retain any REMIC residual interest that may give rise to excess
inclusion income as defined under Section 860E of the Code. Excess inclusion
income realized by a taxable affiliate is not passed through to stockholders
of the Company. See "Federal Income Tax Considerations--Taxation of Tax--
Exempt Entities."

Single Family Mortgage Loans. In future periods, the Company may acquire or
originate conforming mortgage loans--those that comply with the requirements
for inclusion in a loan guarantee program sponsored by either FHLMC or FNMA.
To date, the Company has acquired or originated nonconforming mortgage loans.
The Company also may acquire FHA Loans or VA Loans, which qualify for
inclusion in a pool of mortgage loans guaranteed by GNMA. Under current
regulations, the maximum principal balance allowed on conforming mortgage
loans ranges from $214,600 ($321,900 for mortgage loans secured by properties
located in either Alaska or Hawaii) for one-unit to $412,450 ($618,675 for
mortgage loans secured by properties located in either Alaska or Hawaii) for
four-unit residential loans. Nonconforming single family mortgage loans are
single family mortgage loans that do not qualify in one or more respects for
purchase by FNMA or FHLMC. The Company expects that a majority of the
nonconforming mortgage loans it purchases will be nonconforming because they
have original principal balances which exceed the requirements for FHLMC or
FNMA programs or generally because they vary in certain other respects from
the requirements of such programs including the requirements relating to
creditworthiness of the mortgagors. A substantial portion of the Company's
nonconforming mortgage loans meet the requirements for sale to national
private mortgage conduit programs in the secondary mortgage market which focus
upon the subprime mortgage lending market.

Multifamily Mortgage Loans. The Company has not, to date, acquired or
originated multifamily mortgage loans. However, these types of loans may be
acquired or originated in future periods. Multifamily mortgage loans generally
involve larger principal amounts per loan than single family mortgage loans
and require more complex credit and property evaluation analysis. Multifamily
mortgage loans share many of the characteristics and risks associated with
commercial mortgage loans and are often categorized as commercial loans rather
than residential

49
<PAGE>

loans. For example, the credit quality of a multifamily mortgage loan
typically depends upon the existence and terms of underlying leases, tenant
credit quality and the historical and anticipated level of vacancies and rents
on the mortgaged property and on the competitive market condition of the
mortgaged property relative to other competitive properties in the same
region, among other factors. Multifamily mortgage loans, however, constitute
"qualified mortgages" for purposes of the REMIC regulations and the favorable
tax treatment associated therewith and, when securitized, certain of the
resulting rated classes of multifamily Mortgage Securities qualify as
"mortgage-related securities" and for the favorable treatment accorded such
securities under the Secondary Mortgage Market Enhancement Act of 1984
("SMMEA").

Mortgage Securities. Mortgage Securities owned by the Company as of and
during the period since inception and through June 30, 1997, have consisted of
mortgage securities issued by corporations sponsored by the United States
government, including FNMA, GNMA and FHLMC. Mortgage Securities owned by the
Company as of June 30, 1997 are detailed in Note 2 to the consolidated
financial statements.

Mortgage Assets purchased by the Company in the future may include Mortgage
Securities as follows:

(1) Single Family and Multifamily Privately Issued Certificates. Single
family and multifamily Privately Issued Certificates are issued by
originators of, investors in, and other owners of mortgage loans, including
savings and loan associations, savings banks, commercial banks, mortgage
banks, investment banks and special purpose "conduit" subsidiaries of such
institutions. Single family and multifamily Privately Issued Certificates
are generally covered by one or more forms of private (i.e., non-
governmental) credit enhancements. Forms of credit enhancements include,
but are not limited to, surety bonds, limited issuer guarantees, reserve
funds, private mortgage guaranty pool insurance, over-collateralization and
subordination.

(2) Agency Certificates. At present, all GNMA Certificates are backed by
single family mortgage loans. FNMA Certificates and FHLMC Certificates may
be backed by pools of single family or multifamily mortgage loans. The
interest rate paid on Agency Certificates may be fixed rate or adjustable
rate.

(3) Commercial Mortgage Securities. To the extent the Company will seek
to acquire any Mortgage Assets either backed by or secured by commercial
property, the Company intends to favor the acquisition of Mortgage
Securities backed by commercial mortgage loans rather than direct
acquisition of commercial mortgage loans. These Mortgage Securities
generally have been structured as Pass-Through Certificates with private
(i.e., non-governmental) credit enhancements or as CMOs. Because of the
great diversity in characteristics of the commercial mortgage loans that
secure or underlie these Mortgage Securities, such securities will also
have diverse characteristics. Although many are backed by large pools of
commercial mortgage loans with relatively small individual principal
balances, these Mortgage Securities may be backed by commercial mortgage
loans collateralized by only a few commercial properties or a single
commercial property. Because the risk involved in single commercial
property financings is highly concentrated, single commercial property
Mortgage Securities to date have tended to be limited to extremely
desirable commercial properties with excellent values and/or lease
agreements with extremely creditworthy and reliable tenants, such as major
corporations.

Commercial Mortgage Loans. The Company will only acquire commercial mortgage
loans when it believes it has the necessary expertise to evaluate and manage
them and only if they are consistent with the Company's CAG. Commercial
mortgage loans are secured by commercial properties, such as industrial and
warehouse properties, office buildings, retail space and shopping malls,
hotels and motels, hospitals, nursing homes and senior living centers.
Commercial mortgage loans have certain distinct risk characteristics:
commercial mortgage loans generally lack standardized terms, which may
complicate their structure (although certain of the new conduits are
introducing standard form documents for use in their programs); commercial
mortgage loans tend to have shorter maturities than single family mortgage
loans; they may not be fully amortizing, meaning that they may have a
significant principal balance or "balloon" due on maturity; and commercial
properties, particularly industrial and warehouse properties, are generally
subject to relatively greater environmental risks than non-commercial
properties and the corresponding burdens and costs of compliance with
environmental laws and regulations. To date, the Company has not acquired
commercial mortgage loans.

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<PAGE>

Asset Acquisition Policies

The Company acquires only those Mortgage Assets in the secondary mortgage
market that it believes it has the necessary expertise to evaluate and manage
and which are consistent with the Company's risk management objectives. The
Company's strategy is to focus primarily on the acquisition of single family
mortgage loans, Single Family mortgage securities, multifamily mortgage loans
and multifamily Mortgage Securities. The Company focuses primarily on the
acquisition of floating-rate and adjustable-rate assets, so that assets and
liabilities remain matched. The Company's asset acquisition strategy will
change over time as market conditions change and as the Company evolves.

The Company may also purchase the stock of other mortgage REITs or similar
companies when the Company believes that such purchases will yield attractive
returns on capital employed. The Company may in the future acquire Mortgage
Assets by offering its debt or equity securities in exchange for such Mortgage
Assets. The Company does not, however, presently intend to invest in the
securities of other issuers for the purpose of exercising control or to
underwrite securities of other issuers.

The Company generally intends to hold Mortgage Assets to maturity. In
addition, the REIT provisions of the Code limit in certain respects the
ability of the Company to sell Mortgage Assets. See "Federal Income Tax
Considerations." Management may decide to sell assets from time to time,
however, for a number of reasons, including, without limitation, to dispose of
an asset as to which credit risk concerns have arisen, to reduce interest rate
risk, to substitute one type of Mortgage Asset for another to improve yield or
to maintain compliance with the 55 percent requirement under the Investment
Company Act, and generally to restructure the balance sheet when management
deems such action advisable. Management will select any Mortgage Assets to be
sold according to the particular purpose such sale will serve. The Board of
Directors has not adopted a policy that would restrict management's authority
to determine the timing of sales or the selection of Mortgage Assets to be
sold.

Financing for Mortgage Lending Operations and Mortgage Security Acquisitions

The Company finances its mortgage loan originations and purchases through
interim financing facilities such as bank warehouse credit lines and reverse
repurchase agreements. A reverse repurchase agreement is a borrowing device
evidenced by an agreement to sell securities or other assets to a third-party
and a simultaneous agreement to repurchase them at a specified future date and
price, the price differential constituting interest on the borrowing.

The Company's subprime mortgage lending operation is a capital intensive
business. Depending on the type of product originated and the production
channel, the amount of capital required as a percentage of the balance of
mortgage loans originated may range from 6 percent to 12 percent. For
illustration purposes only, based on a hypothetical monthly volume of $25
million, this will equate to a capital requirement of $1.5 to $3 million per
month, and on a hypothetical volume of $50 million, this requirement doubles
to $3 to $6 million per month. The Company's subprime mortgage lending
operation is managed through a taxable affiliate, which provides the Company
the flexibility to sell its mortgage loan production as whole loans or in the
form of pass-through securities in the event it encounters restrictions in
accessing the capital markets.

To mitigate the interest rate risk in its mortgage lending operation, the
Company enters into transactions designed to hedge interest rate risk, which
may include mandatory and optional forward selling of mortgage loans or
Mortgage Assets, interest rate caps, floors and swaps, buying and selling of
futures and options on futures, and acquisition of interest-only REMIC regular
interests. The nature and quantity of these hedging transactions will be
determined by the Company based on various factors, including market
conditions and the expected volume of mortgage loan purchases. The Company
believes its strategy of issuing long-term structured debt securities will
also assist it in managing interest rate risk. See "Business--Portfolio
Management--Interest Rate Risk Management."

Acquisitions of Mortgage Securities are generally financed using repurchase
agreements. A summary of amounts outstanding under all borrowing arrangements
as of June 30, 1997 is included in Note 4 to the consolidated financial
statements.

51
<PAGE>

Mortgage Loans Held as Collateral for Structured Debt

The Company intends to securitize the subprime mortgage loans produced by
its mortgage lending operation as part of its overall asset/liability
strategy. Securitization is the process of pooling mortgage loans and issuing
equity securities, such as mortgage pass throughs, or debt securities, such as
Collateralized Mortgage Obligations ("CMOs"). The Company intends to
securitize by issuing structured debt. Under this approach, for accounting
purposes the mortgage loans so securitized remain on the balance sheet as
assets and the debt obligations (i.e., the CMOs) appear as liabilities. A
securitization, as executed by the Company, results only in rearranging the
Company's borrowings, as proceeds from the structured debt issuance are
applied against preexisting borrowings (i.e., advances under the warehouse
line of credit or borrowings under repurchase agreements). Issuing structured
debt in this matter serves to lock in less expensive, non-recourse long-term
financing that better matches the terms of the loans serving as collateral for
the debt.

Proceeds from such securitizations will be available to support new mortgage
loan originations. Securitizations are long-term financing and are not subject
to a margin call if a rapid increase in rates would reduce the value of the
underlying mortgages.

The Company's investment in retained interests under securitizations, as
discussed above, reflects the excess of the mortgage loan collateral over the
related liabilities on the balance sheet. The resulting stream of expected
"spread" income will be recognized over time through the tax-advantaged REIT
structure. Other forms of securitizations may also be employed from time to
time under which a "sale" of interests in the mortgage loans occurs and a
resulting gain or loss is reflected for accounting purposes at the time of
sale. Under this form, only the net retained interest in the securitized
mortgage loans remains on the balance sheet. The Company anticipates such
sales will generally be made through one or more of its taxable affiliates.
See "Interest Rate Risk Management" below. The Company may conduct certain of
its securitization activities through one or more taxable affiliates or
Qualified REIT Subsidiaries formed for such purpose.

The Company expects that its retained interests in its securitizations,
regardless of the form used, will be subordinated to the classes of securities
issued to investors in such securitizations with respect to losses of
principal and interest on the underlying mortgage loans. Accordingly, any such
losses incurred on the underlying mortgage loans will be applied first to
reduce the remaining amount of the Company's retained interest, until reduced
to zero. Thereafter, any further losses would be borne by the investors or, if
used, the monoline insurers in such securitizations rather than the Company.

The Company will structure its securitizations so as to avoid the
attribution of any excess inclusion income to the Company's stockholders. See
"Federal Income Tax Considerations--Taxation of the Company's Stockholders."
The Company's management is experienced in the securitization of subprime and
other single family residential mortgage loans.

The Company plans to finance the retained interests in its securitizations
through a combination of equity and secured debt financings.

Credit Risk Management Policies

Mortgage Loans. With respect to its mortgage loan portfolio, the Company
attempts to control and mitigate credit risk through:

(i) the underwriting of each loan to ensure it meets the guidelines
established;

(ii) geographic diversification of its loan originations and purchases;

(iii) the use of early intervention, aggressive collection and loss
mitigation techniques in the servicing process;

(iv) the use of insurance and the securitization process to limit the
amount of credit risk that it is exposed to on its retained interests
in securitizations; and

(v) maintenance of appropriate capital reserve levels.

52
<PAGE>

A summary of the credit quality and diversification of the Company's loan
portfolio as of June 30, 1997 is presented in "Business--Mortgage Lending
Operations."

Secondary Market Acquisitions. With respect to its Mortgage Assets purchased
in the secondary market, the Company reviews the credit risk associated with
each investment and determines the appropriate allocation of capital to apply
to such investment under its CAG. Because the risks presented by single
family, multifamily and commercial Mortgage Assets are different, the Company
analyzes the risk of loss associated with such Mortgage Assets separately. In
addition, the Company attempts to diversify its portfolio to avoid undue
geographic, issuer, industry and certain other types of concentrations. The
Company attempts to obtain protection against some risks from sellers and
servicers through representations and warranties and other appropriate
documentation. The Board of Directors will monitor the overall portfolio risk
and determine appropriate levels of provision for losses.

With respect to its purchased Mortgage Assets, the Company is exposed to
various levels of credit and special hazard risk, depending on the nature of
the underlying Mortgage Assets and the nature and level of credit enhancements
supporting such securities. Each of the Mortgage Assets acquired by the
Company will have some degree of protection from normal credit losses. Credit
loss protection for Privately Issued Certificates is achieved through the
subordination of other interests in the pool to the interest held by the
Company, through pool insurance or through other means. The degree of credit
protection varies substantially among the Privately Issued Certificates held
by the Company. While Privately Issued Certificates held by the Company will
have some degree of credit enhancement, the majority of such assets are, in
turn, subordinated to other interests. Thus, should such a Privately Issued
Certificate experience credit losses, such losses could be greater than the
Company's pro rata share of the remaining mortgage pool, but in no event could
exceed the Company's investment in such Privately Issued Certificate.

With respect to purchases of Mortgage Assets in the form of mortgage loans,
the Company has developed a quality control program to monitor the quality of
loan underwriting at the time of acquisition and on an ongoing basis. The
Company will conduct, or cause to be conducted, a legal document review of
each mortgage loan acquired to verify the accuracy and completeness of the
information contained in the mortgage notes, security instruments and other
pertinent documents in the file. As a condition of purchase, the Company will
select a sample of mortgage loans targeted to be acquired, focusing on those
mortgage loans with higher risk characteristics, and submit them to a third
party, nationally recognized underwriting review firm for a compliance check
of underwriting and review of income, asset and appraisal information. In
addition, the Company or its agents will underwrite all multifamily and
commercial mortgage loans. During the time it holds mortgage loans, the
Company will be subject to risks of borrower defaults and bankruptcies and
special hazard losses (such as those occurring from earthquakes or floods)
that are not covered by standard hazard insurance. The Company will not
generally obtain credit enhancements such as mortgage pool or special hazard
insurance for its mortgage loans, although individual loans may be covered by
FHA insurance, VA guarantees or private mortgage insurance and, to the extent
securitized into Agency Certificates, by such government sponsored entity
obligations or guarantees.

53
<PAGE>

Capital and Leverage Policies

Capital Allocation Guidelines (CAG). The Company's goal is to strike a
balance between the under-utilization of leverage, which reduces potential
returns to stockholders, and the over-utilization of leverage, which could
reduce the Company's ability to meet its obligations during adverse market
conditions. The Company's CAG have been approved by the Board of Directors.
The CAG are intended to keep the Company properly leveraged by (i) matching
the amount of leverage allowed to the riskiness (return and liquidity) of an
asset and (ii) monitoring the credit and prepayment performance of each
investment to adjust the required capital. This analysis takes into account
the Company's various hedges and other risk programs discussed below. In this
way, the use of balance sheet leverage will be controlled. The following table
presents the Company's CAG for the following levels of capital for the types
of assets it owns.

<TABLE>
<CAPTION>
(A) (B) (C) (D) (E) (F) (G)
(C + D) (B X E) (A + F)
MINIMUM ESTIMATED DURATION LIQUIDITY TOTAL EQUITY CAG
ASSET CATEGORY LENDER PRICE SPREAD SPREAD SPREAD CUSHION EQUITY
- -------------- HAIRCUT DURATION CUSHION CUSHION CUSHION (% OF MV) REQUIRED
<S> <C> <C> <C> <C> <C> <C> <C>
Agency-issued:
Conventional ARMs...... 3.00% 3.50% 50 -- 50 1.75% 4.75%
GNMA ARMs.............. 3.00 4.50 50 -- 50 2.25 5.25
Mortgage loans.......... 3.00 3.00 100 50 150 4.50 7.50
Hedging instruments..... 100.00 -- -- -- -- -- 100.00
</TABLE>
- --------
(a) Indicates the minimum amount of equity a typical lender would require with
an asset from the applicable asset category. There is some variation in
haircut levels among lenders, from time to time. From the lenders
perspective, this is a "cushion" to protect capital in case the borrower
is unable to meet a margin call. The size of the haircut depends on the
liquidity and price volatility of the asset. Agency securities are very
liquid, with price volatility in line with the fixed income markets which
means a lender requires a smaller haircuts. On the other extreme, "B"
rated securities and securities not registered with the Commission are
substantially less liquid, and have more price volatility than Agency
securities, which results in a lender requiring a larger haircut.
Particular securities that are performing below expectations would also
typically require a larger haircut.
(b) Duration is the price-weighted average term to maturity of financial
instruments' cash flows.
(c) Estimated cushion need to protect against investors requiring a higher
return compared to Treasury securities, assuming constant interest rates.
(d) Estimated cushion required due to a potential imbalance of supply and
demand resulting in a wider bid/ask spread.
(e) Sum of duration (c) and liquidity (d) spread cushions.
(f) Product of estimated price duration (b) and total spread cushion. The
additional equity, as determined by management, to reasonably protect the
Company from lender margin calls. The size of each cushion is based on
managements experience with the price volatility and liquidity in the
various asset categories. Individual assets that have exposure to
substantial credit risk will be measured individually and the leverage
adjusted as actual delinquencies, defaults and losses differ with
management's expectations.
(g) The sum of the minimum lender haircut (a) and the Company's equity cushion
(f).

Implementation of the CAG--Mark to Market. Each quarter, the Company marks
its assets to market. This process consists of two steps: (i) valuing the
Company's Mortgage Assets acquired in the secondary market and (ii) valuing
the Company's non-security investments, such as its mortgage loans. For the
purchased Mortgage Assets portfolio, the Company obtains market quotes for its
Mortgage Assets from traders that make markets in securities similar to those
in the Companys portfolio. Market values for the Company's mortgage loan
portfolio is calculated internally using assumptions for losses, prepayments
and discount rates.

The face amount of all financing used for securities and mortgage loans is
subtracted from the current market value of the Company's assets (and hedges).
This is the current market value of the Company's equity. This number is
compared to the required capital as determined by the CAG. If the actual
equity of the Company falls below the capital required by the CAG, the Company
must prepare a plan to bring the actual capital above the level required by
the CAG.

Each quarter, management presents to the Board of Directors the results of
the CAG compared to actual equity. Management may propose changing the capital
required for a class of investments or for an individual investment based on
its prepayment and credit performance relative to the market and the ability
of the Company to predict or hedge the risk of the asset.

54
<PAGE>

Interest Rate Risk Management

The Company addresses the interest rate risk to which its mortgage portfolio
is subject in part through its securitization strategy, which is designed to
provide long-term financing for its mortgage loan production while maintaining
a consistent spread in a variety of interest rate environments. In order to
address any remaining mismatch of assets and liabilities, the Company follows
the hedging section of its investment policy, as approved by the Board.
Specifically, the Company's interest rate risk management program will be
formulated with the intent to offset the potential adverse effects resulting
from rate adjustment limitations on its mortgage loans and Mortgage Assets and
the differences between interest rate adjustment indices and interest rate
adjustment periods of its adjustable-rate mortgage loans and related
borrowings.

The Company uses interest rate caps and interest rate swaps and may, from
time to time, purchase interest-only REMIC regular interests and similar
instruments to attempt to mitigate the risk of the cost of its variable rate
liabilities increasing at a faster rate than the earnings on its assets during
a period of rising rates. In this way, the Company intends generally to hedge
as much of the interest rate risk as management determines is in the best
interests of the stockholders of the Company, given the cost of such hedging
transactions and the need to maintain the Company's status as a REIT. See
"Federal Income Tax Considerations-Qualification as a REIT--Sources of
Income." This determination may result in management electing to have the
Company bear a level of interest rate risk that could otherwise be hedged when
management believes, based on all relevant facts, that bearing such risk is
advisable. The Company may also, to the extent consistent with its compliance
with the REIT gross income tests and applicable law, utilize financial futures
contracts, options and forward contracts as a hedge against future interest
rate changes.

The Company seeks to build a balance sheet and undertake an interest rate
risk management program which is likely, in management's view, to enable the
Company to generate positive earnings and maintain an equity liquidation value
sufficient to maintain operations given a variety of potentially adverse
circumstances. Accordingly, the hedging program addresses both income
preservation, as discussed in the first part of this section, and capital
preservation concerns.

Interest rate cap agreement are legal contracts between the Company and a
third party firm (the "counter-party"). The counter-party agrees to make
payments to the Company in the future should the one or three month LIBOR
interest rate rise above the "strike" rate specified in the contract. The
Company makes monthly premium payments to the counterparty under the contract.
Each contract has a fixed "notional face" amount, on which the interest is
computed, and a set term to maturity. Should the reference LIBOR interest rate
rise above the contractual strike rate, the Company will earn cap income.
Payments on an annualized basis equal the contractual notional face amount
times the difference between actual LIBOR and the strike rate.

Interest rate swap agreements entered into by the Company through June 30,
1997 stipulate that the Company will pay a fixed rate of interest to the
counterparty. In return, the counterparty pays the Company a variable rate of
interest based on the notional amount. The agreements have fixed notional
amounts, on which the interest is computed, and set terms to maturity.

In all of its interest rate risk management transactions, the Company
follows certain procedures designed to limit credit exposure to
counterparties, including dealing only with counterparties whose financial
strength meets the Company's requirements. See "Risk Factors-Operations Risks
and Risks of Failing to Effectively Hedge Against Interest Rate Changes; Risks
of Losses Associated with Hedging; Counterparty Risks."

In its assessment of the interest sensitivity and as an indication of the
Company's exposure to interest rate risk, management relies on models of
financial information in a variety of interest rate scenarios. Using these
models, the fair value and interest rate sensitivity of each financial
instrument (or groups of similar instruments) is estimated, and then
aggregated to form a comprehensive picture of the risk characteristics of the
balance sheet. The following table depicts the interest sensitivity of the
Company's financial instruments as of June 30, 1997. These amounts contain
estimates and assumptions regarding prepayments and future interest rates.
Actual economic conditions may produce results significantly different from
the results depicted below. However, management believes the interest
sensitivity model used is a valuable tool to manage the Company's exposure to
interest rate risk.

55
<PAGE>

INTEREST RATE SENSITIVITY
JUNE 30, 1997

<TABLE>
<CAPTION>
BASIS POINT INCREASE (DECREASE)
IN INTEREST RATE(A)
------------------------------------------
(100) BASE(B) 100 ELASTICITY(E)
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Market value of:
Assets.................. $616,216 $602,690 $597,554 1.53%
Liabilities............. 558,976 556,402 553,866 0.46%
Interest rate
agreements............. (2,692) 1,180 5,657 1.57%
Cumulative change in
value(B)................ $ 7,080 -- $ 1,877
======== ======== ========
Percent change from base
assets(C)............... 1.17% -- 0.31% 0.43%
======== ======== ======== ====
Percent change of
capital(D).............. 15.28% -- 4.05% 5.61%
======== ======== ======== ====
</TABLE>
- --------
(A)Value of asset, liability or interest rate agreement in a parallel shift in
the yield curve, up and down one percent.
(B)Total change in estimated market value, in dollars, from "base." "Base" is
the estimated market value at June 30, 1997.
(C)Total change in estimated market value, as a percent, from base.
(D)Total change in estimated market value as a percent of total stockholders'
equity at June 30, 1997.
(E)Elasticity is the average percentage change in estimated market value from
base over a range of up and down interest rate scenarios.

For the above analysis, market quotations are used in estimating the fair
value of the Mortgage Securities. The fair value of all other financial
instruments is estimated by discounting projected future cash flows, including
projected prepayments for mortgage loans, at prevailing market rates. The fair
value of cash, cash equivalents, accrued interest receivable and payable and
other assets and liabilities approximates its carrying value.

The Company's investment policy sets the following general goals:

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

(2) Diminish the effect of changes in interest rate levels on the market
value of the Company's assets.

The above interest sensitivity analysis displays an estimate of the market
value of the Company's assets, liabilities and interest rate agreements as of
June 30, 1997. The analysis also shows the estimated changes in the fair value
of financial instruments should interest rates increase or decrease one
percent (100 basis points). Management uses this information to determine the
impact on stockholders' equity of changing interest rates and to monitor the
effectiveness of the interest rate risk management techniques discussed above.
Although management evaluates the portfolio using interest rate increases and
decreases greater than one percent, management focuses on the one percent
increase as any further increase in interest rates would require action to
adjust the portfolio to adapt to changing rates. The Company's investment
policy allows for no more than a ten percent change in the net fair value of
assets when interest rates rise or fall by one percent.

The Company's equity is more sensitive to falling interest rates than rising
interest rates. As shown in the table above, if interest rates fall one
percent (-100 basis points), the value of the Company's capital would increase
by 15.2 percent. If interest rates rise by one percent (+100 basis points),
the value of the Company's capital would increase by 4.05 percent.

Another measure of interest risk is elasticity, a refinement of duration.
Duration is the price-weighted average term to maturity of financial
instruments' cash flows. Elasticity is the change, expressed as a percent, in
market value of a financial instrument, given a 100 basis point change in
interest rates. Financial companies with relatively long duration assets
financed by shorter duration liabilities generally experience market value
losses when rates increase and market value gains when rates decrease. This
pattern is complicated because many mortgages have prepayment options which
result in shorter mortgage durations as these prepayment option are exercised
in falling rate environment. Management's dynamic hedging strategies allow the
Company to match the elasticity of its assets with the elasticity of its
liabilities.

Prepayment Risk Management

The Company seeks to minimize the effects of faster or slower than
anticipated prepayment rates in its Mortgage Assets portfolio by originating
mortgage loans with prepayment penalties, utilizing various financial
instruments and the production of new mortgage loans as a hedge against
prepayment risk, and capturing through

56
<PAGE>

its servicing of the mortgage loans a large portion of those loans which are
refinanced. Under certain state laws, prepayment charges may not be imposed or
may be limited as to amount or period of time they can be imposed. Prepayment
risk is monitored by management and through periodic review of the impact of a
variety of prepayment scenarios on the Company's revenues, net earnings,
dividends, cash flow and net balance sheet market value.

Although the Company believes it has developed a cost-effective
asset/liability management program to provide a level of protection against
interest rate and prepayment risks, no strategy can completely insulate the
Company from the effects of interest rate changes, prepayments and defaults by
counterparties. Further, certain of the federal income tax requirements that
the Company must satisfy to qualify as a REIT limit the Company's ability to
fully hedge its interest rate and prepayment risks. See "Federal Income Tax
Considerations--Qualification as a REIT--Sources of Income."

Taxable Affiliates

The Company has implemented, and will continue to implement, portions of its
business strategy from time to time through one of its taxable affiliates.
Other taxable affiliates may be used to implement future business strategies.
For a REIT, a taxable affiliate refers to a corporation that is a consolidated
subsidiary for purposes of financial reporting under GAAP because the REIT is
entitled to up to 99 percent of dividends distributed by such corporation. The
voting common stock of such corporation, however, is owned by persons other
than the REIT due to the provisions of the Code limiting ownership by REITs of
the voting stock of non-REIT qualifying entities. See "Federal Income Tax
Considerations--Qualification as a REIT--Nature of Assets." In the Company's
case, the voting common stock of Holding, its taxable affiliate holding
company, is held by Messrs. Hartman and Anderson. See "Certain Transactions."
Such common stock will at all times have at least one percent of the dividends
and liquidation rights of Holding. The Company holds a class of preferred
stock of the taxable affiliate holding company, which preferred stock is
entitled to substantially all (up to 99 percent) of the dividends and
liquidation proceeds distributable from Holding.

Taxable affiliates are not Qualified REIT Subsidiaries and would be subject
to federal and state income taxes. In order to comply with the nature of asset
tests applicable to the Company as a REIT, as of the last day of each calendar
quarter, the value of the securities of any such affiliate held by the Company
must be limited to less than five percent of the value of the Company's total
assets and no more than ten percent of the voting securities of any such
affiliate may be owned by the Company. See "Federal Income Tax
Considerations--Qualification as a REIT--Nature of Assets." Taxable affiliates
have not elected REIT status and distribute any net profit after taxes to the
Company and its other stockholders. Any dividend income received by the
Company from any such taxable affiliate (combined with all other income
generated from the Company's assets, other than Qualified REIT Assets) must
not exceed 25 percent of the gross income of the Company. See "Federal Income
Tax Considerations--Qualification as a REIT--Sources of Income." Before the
Company forms any additional taxable affiliate corporations, the Company will
obtain an opinion of counsel to the effect that the formation and contemplated
method of operation of such corporation will not cause the Company to fail to
satisfy the nature of assets and sources of income tests applicable to it as a
REIT.

Properties

The Company's executive and administrative offices are located in Westwood,
Kansas, and consist of approximately 7,000 square feet. The lease on the
premises expires February 2000. The current annual rent for these offices is
approximately $101,000.

The Company also leases space for its mortgage lending operations in Irvine,
California. As of June 30, 1997, these offices consisted of approximately
5,000 square feet. The lease on the premises expires November 2001 and the
current annual rent is approximatley $84,000.

Legal Proceedings

The Company occasionally becomes involved in litigation arising in the
normal course of business. Management believes that any liability with respect
to such legal actions, individually or in the aggregate, will not have a
material adverse effect on the Company's financial position or results of
operations.

57
<PAGE>

MANAGEMENT

DIRECTORS AND EXECUTIVE OFFICERS

The directors and executive officers of the Company and their positions are
as follows:

<TABLE>
<CAPTION>
NAME POSITION
---- --------
<S> <C>
Scott F. Hartman(1)..... Chairman of the Board, Secretary and Chief Executive Officer
W. Lance Anderson(1).... Director, President and Chief Operating Officer
Mark J. Kohlrus......... Senior Vice President, Treasurer and Chief Financial Officer
Edward W.
Mehrer(2)(3)(4)........ Director
Gregory T.
Barmore(2)(4).......... Director
Jenne K. Britell(2)(3).. Director
</TABLE>
- --------
(1)Founder of the Company.
(2)Independent Director.
(3)Member of the Audit Committee.
(4)Member of the Compensation Committee.

Information regarding the background and experience of the Company's
directors and officers follows:

Directors and Executive Officers

SCOTT F. HARTMAN, age 38, is Chairman of the Board of Directors and Chief
Executive Officer. His main responsibilities are to manage the Company's
portfolio of investments, interact with the capital markets and oversee the
securitization of the Company's mortgage loan production. Mr. Hartman most
recently served as Executive Vice President of Dynex Capital, Inc., (Dynex)
formerly Resource Mortgage Capital, Inc., a New York Stock Exchange listed
Real Estate Investment Trust. His responsibilities while at Dynex included
managing a $4 billion investment portfolio, overseeing the securitization of
mortgage loans originated through Dynex's mortgage operation and the
administration of the securities issued by Dynex. Mr. Hartman left Dynex in
June 1996 to pursue this opportunity. Prior to joining Dynex in February 1995,
Mr. Hartman served as a consultant to Dynex for three years during which time
he was involved in designing and overseeing the development of Dynex's
analytical and securities structuring system.

W. LANCE ANDERSON, age 37, is President and Chief Operating Officer of the
Company and is a member of the Board of Directors. His main responsibility is
to manage the Company's mortgage origination and servicing operations. Mr.
Anderson most recently served as Executive Vice President of Dynex. In
addition, Mr. Anderson was President and Chief Executive Officer of Dynex's
Single Family mortgage operation, Saxon Mortgage. In this role he was
responsible for the origination, underwriting, servicing, quality control and
pricing functions for Saxon. He served in this capacity for two years prior to
which he was Executive Vice President in charge of production for the Single
Family operation. Mr. Anderson served from October 1989 at Dynex where he was
responsible for the start up of the Single Family operation, building it from
a five-person company to become the fourth largest conduit in the country with
annual fundings in excess of $5 billion in a matter of two years. Mr. Anderson
was also responsible for re-focusing the conduit on the subprime mortgage
market in late 1993 and by the end of 1994 had established it as one of the
five largest originators of subprime mortgage loans in the country with annual
originations in excess of $1 billion.

MARK J. KOHLRUS, age 38, is Senior Vice President, Treasurer and Chief
Financial Officer. In that role, Mr. Kohlrus is responsible for all accounting
and finance functions, including external reporting and compliance with REIT
regulations. Prior to his joining the Company, Mr. Kohlrus was employed by the
public accounting firm of KPMG Peat Marwick LLP (KPMG) in Kansas City,
Missouri for nearly 15 years. During his tenure with KPMG, Mr. Kohlrus worked
extensively in the firm's Financial Services practice and was involved in
several public stock and debt offerings.

58
<PAGE>

EDWARD W. MEHRER, age 58, is Chief Financial Officer of Cydex, a
pharmaceutical company based in Overland Park, Kansas. Mr. Mehrer was
previously associated with Hoechst Marion Roussel (Marion), formerly Marion
Merrell Dow, Inc., an international pharmaceutical company, for approximately
ten years until his retirement in December 1995. From December 1991, he served
as Executive Vice President, Chief Financial Officer and a Director of Marion.
Prior to that position, he served in a number of financial and administrative
positions. Prior to joining Marion, Mr. Mehrer was a partner with the public
accounting firm of Peat Marwick Mitchell & Co. in Kansas City, Missouri.

GREGORY T. BARMORE, age 54, was most recently Chairman of the Board of GE
Capital Mortgage Corporation (GECMC) headquartered in Raleigh, North Carolina.
He was responsible for overseeing the strategic development of GECMC's
residential real estate-affiliated financial businesses, including mortgage
insurance, mortgage services and mortgage funding. Prior to joining GECMC in
1986, Mr. Barmore was Chief Financial Officer of Employers Reinsurance
Corporation (ERC), one of the nation's largest property and casualty
reinsurance companies and also a subsidiary of GE Capital. Prior to his
appointment at ERC, he held a number of financial and general management
positions within GE. Mr. Barmore was selected to serve on the Company's Board
as an Independent Director without regard to the GE Capital investment and
accordingly there are no arrangements with GE Capital or its affiliates
regarding his term of office or other aspects of his service on the Board.

JENNE K. BRITELL, age 55, has been President and General Manager of G.E.
Capital Mortgage Services, Inc. (GECMS) since July 1996. Before joining GECMS,
she was Executive Vice President and Chief Lending Officer of Dime Savings
Bank of New York, FSB, the nation's fifth largest thrift, for three years.
Prior to these positions she was Chairman and Chief Executive Officer of
HomePower, Inc, an international consulting firm, from March 1990 to April
1993. She also served as President of the Polish American Mortgage Bank,
Warsaw, Poland, the first private residential construction and mortgage
lending institution based on Western models, in Eastern Europe.

Other Senior Officers

JAMES H. ANDERSON, age 34, is Senior Vice President and National Sales
Manager. His primary responsibilities include overseeing the Company's overall
marketing efforts, including managing the sales force of account executives.
Prior to joining NovaStar in November 1996, Mr. Anderson was President of his
own marketing consulting business. From August 1992 through September 1996,
Mr. Anderson was employed by Saxon, where he served as Vice President of
Marketing, in charge of the Western Region of the United States. In addition,
Mr. Anderson was in charge of Saxon's national sales force for correspondent
lending.

MANUAL X. PALAZZO, age 47, is Senior Vice President and Chief Credit
Officer. His primary responsibility is to manage the Company's underwriting
and funding departments. Prior to joining NovaStar in December 1996, Mr.
Palazzo was Senior Vice President of Credit and Administration of Long Beach
Mortgage Company since October 1995. From May 1994 Mr. Palazzo was with
Household Financial as Director of Underwriting. Prior to his tenure at
Household Mr. Palazzo spent eight years as manager of the wholesale lending
business for Novus Financial. Mr. Palazzo has been involved in the consumer
finance industry since 1972.

CHRISTOPHER S. MILLER, age 32, is Senior Vice President and Servicing
Manager. Mr. Miller is a former Vice President of Option One Mortgage
Corporation, a subsidiary of Fleet Mortgage Corporation. From July 1995 to
March 1997 Mr. Miller's responsibilities included managing the Collections
Department, Customer Service Department, Escrow Analysis, Payoff Department,
and Reconveyance. Prior to his tenure at Option One Mortgage in 1995, Mr.
Miller spent over seven years at Novus Financial Corporation, a subsidiary of
Dean Witter Financial Services, where he managed multiple servicing
departments. Mr. Miller brings to NovaStar a diverse servicing background with
an emphasis on default management.

59
<PAGE>

TERMS OF DIRECTORS AND OFFICERS

The Company's Board of Directors consists of such number of persons as shall
be fixed by the Board of Directors from time to time by resolution to be
divided into three classes, designated Class I, Class II and Class III, with
each class to be as nearly equal in number of directors as possible. Currently
there are five directors. Mr. Mehrer is a Class I director, Mr. Anderson and
Mr. Barmore are Class II directors and Mr. Hartman and Ms. Britell are Class
III directors. Class I, Class II and Class III directors will stand for
reelection at the annual meetings of stockholders held in 1997, 1998 and 1999,
respectively. At each annual meeting, the successors to the class of directors
whose term expires at that time are to be elected to hold office for a term of
three years, and until their respective successors are elected and qualified,
so that the term of one class of directors expires at each such annual
meeting. The Company intends to maintain the composition of the Board so that
there will be no more than six directors, with a majority of Independent
Directors at all times after the issuance of the Units, each of whom shall
serve on the Audit and/or Compensation Committees. Ms. Britell joined the
Board as the GE Capital nominee. Such nominee will serve as a Class III
director with a term running until the 1999 annual meeting of stockholders. In
the case of any vacancy on the Board of Directors, including a vacancy created
by an increase in the number of directors, the vacancy may be filled by
election of the Board of Directors or the stockholders, with the director so
elected to serve until the next annual meeting of stockholders (if elected by
the Board of Directors) or for the remainder of the term of the director being
replaced (if elected by the stockholders); any newly-created directorships or
decreases in directorships are to be assigned by the Board of Directors so as
to make all classes as nearly equal in number as possible. Directors may be
removed only for cause and then only by vote of a majority of the combined
voting power of stockholders entitled to vote in the election for directors.
Subject to the voting rights of the holders of the Preferred Stock, the
Charter may be amended by the vote of a majority of the combined voting power
of stockholders, provided that amendments to the Article dealing with
directors may only be amended if it is advised by at least two-thirds of the
Board of Directors and approved by vote of at least two-thirds of the combined
voting power of stockholders. The effect of the foregoing as well as other
provisions of the Company's Charter and Bylaws may discourage takeover
attempts and make more difficult attempts by stockholders to change
management. Prospective investors are encouraged to review the Charter and
Bylaws in their entirety.

The Bylaws of the Company provide that, except in the case of a vacancy, a
majority of the members of the Board of Directors will at all times be
Independent Directors. Independent Directors are defined as directors who are
not officers or employees of the Company or any affiliate or subsidiary of the
Company. GE Capital and its affiliates are expressly deemed not to be
affiliates of the Company for this purpose. Vacancies occurring on the Board
of Directors among the Independent Directors may be filled by a vote of a
majority of the remaining directors, including a majority of the remaining
Independent Directors. Officers are elected annually and serve at the
discretion of the Board of Directors. There are no family relationships
between the executive officers or directors.

COMMITTEES OF THE BOARD

Audit Committee. The Company has established an Audit Committee composed of
two Independent Directors. The Audit Committee makes recommendations
concerning the engagement of independent public accountants, reviews with the
independent public accountants the plans and results of any audits, reviews
other professional services provided by the independent public accountants,
reviews the independence of the independent public accountants, considers the
range of audit and non-audit fees and reviews the adequacy of the Company's
internal accounting controls.

Compensation Committee. The Company has established a Compensation Committee
composed of two Independent Directors. The Compensation Committee determines
the compensation of the Company's executive officers.

Other Committees. The Board of Directors may establish other committees as
deemed necessary or appropriate from time to time, including, but not limited
to, an Executive Committee of the Board of Directors.

60
<PAGE>

COMPENSATION OF DIRECTORS

The Company pays Independent Directors $10,000 per year plus $500 for each
meeting attended in person. Independent Directors also receive automatic stock
options pursuant to the Company's Stock Option Plan. However, as the GE
Capital nominee, Ms. Britell does not receive any compensation (including fees
and stock options) for her services on the Board of Directors. See "--
Executive Compensation--Stock Option Plan--Automatic Grants to Non-Employee
Directors." None of the directors of the Company has received any separate
compensation for service on the Board of Directors or on any committee
thereof. In addition, each Independent Director has been granted options to
purchase 5,000 shares of Common Stock at the fair market value of the Common
Stock upon becoming a director and options to purchase 2,500 shares at the
fair market value of the Common Stock on the day after each annual meeting of
stockholders. All directors receive reimbursement of reasonable out-of-pocket
expenses incurred in connection with meetings of the Board of Directors. No
director who is an employee of the Company will receive separate compensation
for services rendered as a director.

COMPENSATION COMMITTEE INTERLOCKS

No interlocking relationship exists between the Company's Board of Directors
or officers responsible for compensation decisions and the board of directors
or compensation committee of any other company, nor has any such interlocking
relationship existed in the past.

EXECUTIVE COMPENSATION

The objective of senior management in constructing its own compensation
packages as well as those of all the managers of the Company is to align the
interests of management as closely as possible with those of the stockholders.
This is accomplished by basing a large percentage of key managers'
compensation on the profitability of the Company (measured by return on
stockholders' equity) and the stock price.

EXECUTIVE OFFICER SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
-------------------
SECURITIES
NAME AND POSITION OTHER ANNUAL UNDERLYING ALL OTHER
- ----------------- YEAR SALARY BONUS COMPENSATION OPTIONS(#) DER'S(3) COMPENSATION
<S> <C> <C> <C> <C> <C> <C> <C>
Scott F. Hartman(1)..... 1996 $70,000 -- -- 144,666 -- --
Chairman of the Board,
Secretary and Chief
Executive Officer
W. Lance Anderson(1).... 1996 70,000 -- -- 144,666 -- --
President and Chief
Operating Officer
Mark J. Kohlrus(2)...... 1996 4,000 -- -- 10,000 -- --
Senior Vice President,
Treasurer and Chief
Financial Officer
</TABLE>
- --------
(1) Mr. Hartman and Mr. Anderson were reimbursed by the Company for services
provided by them that were necessary and prudent in connection with the
formation of the Company and its Private Placement in 1996, including
payments in lieu of salary and for expenses directly attributable to the
formation of the Company. Mr. Hartman and Mr. Anderson are employed by the
Company at a base salary of $120,000 per annum which will increase upon
the closing of the Offering to $185,000.
(2) Mr. Kohlrus' employment with the Company began on December 16, 1996 at an
annual base salary of $96,000 which will increase upon the closing of
this Offering to $120,000 per annum. Mr. Kohlrus is eligible to receive
an annual bonus of up to 75 percent of his annual salary in 1997.

(3) Options granted to Mr. Hartman and Mr. Anderson which vest on the closing
of this Offering were granted without Dividend Equivalent Rights
("DERs"). Options granted to Mr. Kohlrus which begin to vest in December,
1997, were granted with DER's. See "Management--Stock Option Grants."

61
<PAGE>

Bonus Incentive Compensation Plan. A bonus incentive compensation plan will
be established for certain executive and key officers of the Company and its
subsidiaries, to be effective commencing with the first full fiscal year after
this Offering. The annual bonus pursuant to the bonus incentive compensation
plan will be paid one-half in cash and one-half in shares of Common Stock of
the Company, annually, following receipt of the audit for the related fiscal
year. This program will award bonuses annually to those officers out of a
total pool determined by stockholder return on equity ("ROE") as follows:

<TABLE>
<CAPTION>
ROE(1) IN EXCESS OF BASE RATE(2) BY: BONUS AS PERCENT OF AVERAGE NET WORTH(3) OUTSTANDING
------------------------------------ ----------------------------------------------------
<C> <S>
zero or less 0%
greater than 0% but less than 6% 10% X (actual ROE - Base Rate)
Greater than 6% (10% X 6%) + 15% X (Actual
ROE - (Base Rate + 6%))
</TABLE>

Of the amount so determined, one-half will be deemed contributed to the
total pool in cash and the other half deemed contributed to the total pool in
the form of shares of Common Stock, with the number of shares to be calculated
based on the average price per share during the preceding year. The total pool
may not exceed $1 million for fiscal years ending December 31, 1998 and
December 31, 1999.
- --------
(1) "ROE" is determined for the fiscal year by averaging the monthly ratios
calculated each month by dividing the Company's monthly Net Income
(adjusted to an annual rate) by its Average Net Worth for such month. For
such calculations, the "Net Income" of the Company means the net income or
net loss of the Company determined according to GAAP, but after deducting
any dividends paid or payable on preferred stock issued after the Offering
and before giving effect to the bonus incentive compensation or any
valuation allowance adjustment to stockholders' equity. The definition
"ROE" is used only for purposes of calculating the bonus incentive
compensation payable pursuant to the bonus incentive compensation plan,
and is not related to the actual distributions received by stockholders.
The bonus payments will be an operating expense of the Company.
(2) "Base Rate" is the average for each month of the Ten-Year U.S. Treasury
Rate, plus four percent.
(3) "Average Net Worth" for any month means the arithmetic average of the sum
of (i) the net proceeds from all offerings of equity securities by the
Company since formation including exercise of Warrants and stock options
and pursuant to the proposed DRP (but excluding any offerings of preferred
stock subsequent to the Offering), after deducting any underwriting
discounts and commissions and other expenses and costs relating to the
offerings, plus (ii) the Company's retained earnings (without taking into
account any losses incurred in prior fiscal years, after deducting any
amounts reflecting taxable income to be distributed as dividends and
without giving effect to any valuation allowance adjustment to
stockholders' equity) computed by taking the daily average of such values
during such period.

STOCK OPTION GRANTS

Options to acquire 334,332 shares were granted under the Company's 1996
Stock Option Plan. Of these options, 10,000 have been granted to two non-
employee directors and an additional 35,000 were granted to current employees
(excluding the founders) and will vest 25 percent on September 1, 1997 and 25
percent on each anniversary of such date thereafter. Options granted to non-
employee directors are exercisable at $0.01 per share. The 35,000 options
granted to employees are exercisable at $1.06 per share. All such options were
granted with related DERs. The remaining options were granted to the founders,
exercisable at $15 per share, and shall vest only upon closing this Offering.
These options were granted without DERs. The Purchase Terms Agreement in the
Company's Private Placement restricted further grants of stock options (or
other Awards) prior to this Offering. See "Description of Capital Stock--
Purchase Terms Agreement."

62
<PAGE>

The following table sets forth information concerning stock options granted
during 1996 to each of the Board of Director members and Executive Officers.

OPTION/SAR GRANTS IN LAST FISCAL YEAR
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS
----------------------------------------------------
POTENTIAL REALIZABLE
VALUE AT
ASSUMED ANNUAL
PERCENT OF RATES OF
TOTAL OPTIONS STOCK PRICE
GRANTED TO APPRECIATION FOR
EMPLOYEES EXERCISE PRICE OPTION TERM
NAME DURING THE OR BASE PRICE EXPIRATION ---------------------
---- GRANTED(#) YEAR ($/SHARE) DATE 5% ($) 10% ($)
<S> <C> <C> <C> <C> <C> <C>
Scott F. Hartman........ 144,666(1) 43.27 $15.00 12/6/06 $3,534,685 $5,628,395
W. Lance Anderson....... 144,666(1) 43.27 15.00 12/6/06 3,534,685 5,628,395
Gregory T. Barmore...... 5,000(2) 1.50 0.01 9/27/06 81 130
Edward W. Mehrer........ 5,000(2) 1.50 0.01 9/27/06 81 130
Mark J. Kohlrus......... 10,000(2) 2.99 1.06 12/10/06 40,722 64,844
------- -----
Total shares granted
under SOP to Directors
and Executive
Officers............... 309,332 92.53
======= =====
</TABLE>
- --------
(1) Options granted vest upon closing of this Offering.

(2) 25 percent of the options granted will vest in 1997 and 25 percent in each
year thereafter.

The following table sets forth certain information with respect to the value
of the options as of December 31, 1996 held by the named directors and
executive officers.

FISCAL YEAR END OPTION VALUE

<TABLE>
<CAPTION>
NUMBER OF SECURITIES VALUE OF UNEXERCISED
UNDERLYING UNEXERCISED IN-THE-MONEY
OPTIONS AS OF OPTIONS AS OF
DECEMBER 31, 1996 DECEMBER 31, 1996(1)
------------------------- -------------------------
EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
NAME <S> <C> <C> <C>
Scott F. Hartman........ -- 144,666 -- --
W. Lance Anderson....... -- 144,666 -- --
Gregory T. Barmore...... -- 5,000 -- $12,450
Edward W. Mehrer........ -- 5,000 -- 12,450
Mark J. Kohlrus......... -- 10,000 -- 14,400
</TABLE>
- --------
(1) The amounts set forth represents the difference between the estimated fair
market value of $2.50 per share as of December 31, 1996 and the exercise
price of the options, multiplied by the applicable number of shares
underlying the options.

Units Acquired with Forgivable Debt. Messrs. Hartman and Anderson each
received 108,333 Units which were acquired at the price of $15 per Unit.
Payment for such Units was made by delivering to the Company promissory notes,
bearing interest at eight percent per annum compounded annually and secured by
the Units being acquired. Interest accrues during the first year and is added
to principal due under the note. Thereafter, interest is payable quarterly and
upon forgiveness or at maturity of the notes, which is at the end of the fifth
fiscal period (as defined below).

The principal amount of the notes is divided into three equal tranches.
Payment of principal on each tranche will be forgiven by the Company, if the
following incentive performance tests are achieved:

. During the first five fiscal periods after issuance of the notes:

--One tranche will be forgiven for each fiscal period as to which the
Company generates a total return to investors in Units equal to or
greater than 15 percent.

--At the end of each of the five fiscal periods, all remaining tranches
will be forgiven if the Company has generated a total cumulative return
to investors in Units (from date of initial issuance of the notes) equal
to or greater than 100 percent.

. For purposes of calculating the returns to such investors:

--The term "fiscal period" will refer to each of five periods, the first
period commenced with the closing of the Offering of Units on December
9, 1996, and ends on December 31, 1997, and each succeeding fiscal
period extending for twelve months and ending on each December 31.

63
<PAGE>

. The term "return" for each fiscal period will mean the sum of (on a per
Unit basis) (a) all cash dividends paid during (or declared with respect
to) such fiscal period per share of Preferred Stock (or per share of
Common Stock following conversion of the Preferred Stock upon completion
of a the Offering), (b) any increase or decrease in the price per share
of Preferred Stock (or resulting Common Stock) during such fiscal period,
measured by using the price per Unit to investors in this Offering as the
starting price ($15.00), and using the average public trading price
during the last 90 days of each succeeding fiscal period for such
succeeding periods (except such shorter period as the Common Stock is
traded in 1997), and (c) any increase or decrease in the price per
Warrant during such fiscal period, determined in the same manner as in
(b). For purposes of the fiscal period 15 percent return test, the total
return for a given period will be equal to the sum of (a), (b), and (c)
during the period, and for purposes of the cumulative 100 percent return
test, the amounts in (a), (b) and (c) will all be measured from the
beginning of the first fiscal period. The amount of that "return" will
then be measured as a percentage of the investors investment in the Units
(on a per Unit basis) without regard to timing of receipt of dividends or
timing of increases in per share or per Warrant prices.

. If one of the incentive tests is met, the amount of loan forgiveness for
each tranche will be the principal amount of such tranche of the note. In
addition, a loan will be made by the Company to Messrs. Hartman and
Anderson in the amount of (i) personal tax liability resulting from the
forgiveness of debt, and (ii) interest accrued during the first year of
the forgiven tranches. The note will bear interest at a floating market
rate, will be secured by that proportionate number of Units that had
secured the forgiven tranche of the note and will mature upon the earlier
of the sale of those Units (or the underlying securities) or the
termination of the officers employment with the Company.

Employment Agreements. The Company has entered into employment agreements
with the Founders, Mr. Hartman and Mr. Anderson. Each employment agreement
provides for a term through December 31, 2001 and will be automatically
extended for an additional year at the end of each year of the agreement,
unless either party provides a prescribed prior written notice to the
contrary. Each employment agreement provides for the annual base salary set
forth in the compensation table above and for participation by the subject
officer in the Bonus Incentive Compensation Plan. Each employment agreement
provides for the subject officer to receive his annual base salary and bonus
compensation to the date of the termination of employment by reason of death,
disability or resignation and to receive base compensation to the date of the
termination of employment by reason of a termination of employment for cause
as defined in the agreement. Each employment agreement also provides for the
subject officer to receive, if the subject officer resigns for "good reason"
or is terminated without cause after a "Change in Control" of the Company as
those terms are defined in the agreement, an amount, 50 percent payable
immediately and 50 percent payable in monthly installments over the succeeding
twelve months, equal to three times such officer's combined maximum base
salary and actual bonus compensation for the preceding year, subject in each
case to a maximum amount of one percent of the Company's book equity value
(exclusive of valuation adjustments) and a minimum of $360,000. In that
instance, the subject officer is prohibited from competing with the Company
for a period of one year. In addition, all outstanding options granted to the
subject officer under the 1996 Stock Option Plan shall immediately vest.
Section 280G of the Code may limit the deductibility of the payments to such
loan officer by the Company for federal income tax purposes. "Change of
Control" for purposes of the agreements would include a merger or
consolidation of the Company, a sale of all or substantially all of the assets
of the Company, changes in the identity of a majority of the members of the
Board of Directors of the Company (other than due to the death, disability or
age of a director) or acquisitions of more than 25 percent of the combined
voting power of the Company's capital stock, subject to certain limitations.
Absent a "Change in Control," if the Company terminates the officers
employment without cause, or if the officer resigns for "good reason," the
officer receives an amount, payable immediately, equal to such officers
combined maximum base salary and actual bonus compensation for the preceding
year, subject in each case to a maximum amount of one percent of the Company's
book value (exclusive of valuation adjustments) and a minimum of $120,000. If
the officer resigns for any other reason, there is no severance payment and
the officer is prohibited from competing with the Company for a period of one
year following the resignation. Although the Company believes the agreements
are enforceable, there are no guarantees that these individuals will remain in
the Company's employ.

64
<PAGE>

Stock Option Plan

General. The Company's 1996 Executive and Non-Employee Director Stock Option
Plan (the "1996 Stock Option Plan") provides for the grant of qualified
incentive stock options ("ISOs") which meet the requirements of Section 422 of
the Internal Revenue Code, stock options not so qualified ("NQSOs"), deferred
stock, restricted stock, performance shares, stock appreciation and limited
stock awards ("Awards") and dividend equivalent rights ("DERs").

Purpose. The 1996 Stock Option Plan is intended to provide a means of
performance-based compensation in order to attract and retain qualified
personnel and to afford additional incentive to others to increase their
efforts in providing significant services to the Company.

Administration. The 1996 Stock Option Plan is administered by the
Compensation Committee of the Board of Directors (the "Committee"), which
shall at all times be composed solely of non-employee directors as required by
Rule 16b-3 under the Exchange Act. Members of the Committee are eligible to
receive only NQSOs pursuant to automatic grants of stock options discussed
below.

Options and Awards. Options granted under the 1996 Stock Option Plan will
become exercisable in accordance with the terms of grant made by the
Committee. Awards will be subject to the terms and restrictions of the Awards
made by the Committee. Option and Award recipients shall enter into a written
stock option agreement with the Company. The Committee has discretionary
authority to select participants from among eligible persons and to determine
at the time an option or Award is granted when and in what increments shares
covered by the option or Award may be purchased or will vest and, in the case
of options, whether it is intended to be an ISO or a NQSO provided, however,
that certain restrictions applicable to ISOs are mandatory, including a
requirement that ISOs not be issued for less than 100 percent of the then fair
market value of the Common Stock (110 percent in the case of a grantee who
holds more than ten percent of the outstanding Common Stock) and a maximum
term of ten years (five years in the case of a grantee who holds more than ten
percent of the outstanding Common Stock). Fair market value means as of any
given date, with respect to any option or Award granted, at the discretion of
the Board of Directors or the Committee, (i) the closing sale price of the
Common Stock on such date as reported in the Western Edition of the Wall
Street Journal or (ii) the average of the closing price of the Common Stock on
each day of which it was traded over a period of up to twenty trading days
immediately prior to such date, or (iii) if the Common Stock is not publicly
traded (e.g., prior to this Offering), the fair market value of the Common
Stock as otherwise determined by the Board of Directors or the Committee in
the good faith exercise of its discretion.

Eligible Persons. Officers and directors and employees of the Company and
other persons expected to provide significant services to the Company are
eligible to participate in the 1996 Stock Option Plan. ISOs may be granted to
the officers and key employees of the Company. NQSOs and Awards may be granted
to the directors, officers, key employees, agents and consultants of the
Company or any of its subsidiaries.

Under current law, ISOs may not be granted to any director of the Company
who is not also an employee, or to directors, officers and other employees of
entities unrelated to the Company. No options or Awards may be granted under
the Stock Option Plan to any person who, assuming exercise of all options held
by such person, would own or be deemed to own more than 25 percent of the
outstanding shares of equity stock of the Company.

Shares Subject to the Plan. The 1996 Stock Option Plan authorizes the grant
of options to purchase, and Awards of, an aggregate of up to ten percent of
the Company's total outstanding shares at any time, provided that no more than
320,000 shares of Common Stock shall be cumulatively available for grant as
Incentive Stock Options. If an option granted under the 1996 Stock Option Plan
expires or terminates, or an Award is forfeited, the shares subject to any
unexercised portion of such option or Award will again become available for
the issuance of further options or Awards under the 1996 Stock Option Plan. In
connection with any reorganization, merger, consolidation, recapitalization,
stock split or similar transaction, the Compensation Committee shall
appropriately adjust the number of shares of Common Stock subject to
outstanding options, Awards and DERs and the total number of shares for which
options, Awards or DERs may be granted under the Plan.

65
<PAGE>

Term of the Plan. Unless previously terminated by the Board of Directors,
the 1996 Stock Option Plan will terminate on September 1, 2006, and no options
or Awards may be granted under the 1996 Stock Option Plan thereafter, but
existing options or Awards remain in effect until the options are exercised or
the options or Awards are terminated by their terms.

Term of Options. Each option must terminate no more than ten years from the
date it is granted (or five years in the case of ISOs granted to an employee
who is deemed to own an excess of 10 percent of the combined voting power of
the Company's outstanding equity stock). Options may be granted on terms
providing for exercise either in whole or in part at any time or times during
their restrictive terms, or only in specified percentages at stated time
periods or intervals during the term of the option.

DERs. The Plan provides for granting of DERs in tandem with any options
granted under the Plan. Such DERs accrue for the account of the optionee
shares of Common Stock upon the payment of dividends on outstanding shares of
Common Stock. The number of shares accrued is determined by a formula and such
shares may be made transferable to the optionee either upon exercise of the
related option or on a "current-pay" basis so that payments would be made to
the optionee at the same time as dividends are paid to holders of outstanding
Common Stock. Holders of DERs may be made eligible to participate not only in
cash distributions but also in distributions of stock or other property made
to holders of outstanding Common Stock. Shares of Common Stock accrued for the
account of the optionee are eligible to receive dividends and distributions.
DERs may also be made "performance based" by conditioning the right of the
holder of the DER to receive any dividend equivalent payment or accrual upon
the satisfaction of specified performance objectives.

Option Exercise. The exercise price of any option granted under the 1996
Stock Option Plan is payable in full in cash, or its equivalent as determined
by the Committee. The Company may make loans available to options holders to
exercise options evidenced by a promissory note executed by the option holder
and secured by a pledge of Common Stock with fair value at least equal to the
principal of the promissory note unless otherwise determined by the Committee.

Automatic Grants to Non-Employee Directors. Each non-employee director of
the Company is automatically granted NQSOs to purchase 5,000 shares of Common
Stock with DERs upon becoming a director of the Company, and is also
automatically granted NQSOs to purchase 2,500 shares of Common Stock (with
DERs) the day after each annual meeting of stockholders upon re-election to or
continuation on the Board. Such automatic grants of stock options vest 25
percent on the anniversary date in the year following the date of the grant
and 25 percent on each anniversary date thereafter. The exercise price for
such automatic grants of stock options is the fair market value of the Common
Stock on the date of grant, and is required to be paid in cash.

Amendment and Termination of Stock Option Plan. The Board of Directors may,
without affecting any outstanding options or Awards, from time to time revise
or amend the 1996 Stock Option Plan, and may suspend or discontinue it at any
time. However, no such revision or amendment may, without stockholder
approval, increase the number of shares subject to the 1996 Stock Option Plan,
modify the class of participants eligible to receive options or Awards granted
under the 1996 Stock Option Plan or extend the maximum option term under the
1996 Stock Option Plan.

66
<PAGE>

PRINCIPAL SECURITYHOLDERS

BENEFICIAL OWNERSHIP OF COMMON STOCK BY LARGE SECURITYHOLDERS

The following table sets forth certain information known to the Company with
respect to beneficial ownership of the Company's Common Stock as of June 30,
1997, after giving effect to the conversion of the Preferred Stock into Common
Stock and as adjusted to reflect the sale of Common Stock being offered
hereby, by each person other than members of management known to the Company
to beneficially own more than five percent (5%) of the Company's Common Stock.
Unless otherwise indicated in the footnotes to the table, the beneficial
owners named have, to the knowledge of the Company, sole voting and investment
power with respect to the shares beneficially owned, subject to community
property laws where applicable.

<TABLE>
<CAPTION>
BENEFICIAL OWNERSHIP BENEFICIAL OWNERSHIP
OF COMMON STOCK OF COMMON STOCK
BEFORE OFFERING(1) AFTER OFFERING(2)
----------------------- -----------------------
NAME AND ADDRESS OF BENEFICIAL
OWNER SHARES PERCENT SHARES PERCENT
- ------------------------------ ------------ ---------- ------------ ----------
<S> <C> <C> <C> <C>
Wellington Management 1,333,400 31.62% 1,333,400 18.48%
Company(3)....................
75 State Street
Boston, MA 02109
Lindner Dividend Fund(4)...... 1,333,334 31.62 1,333,334 18.48
7711 Carondolet Avenue, Suite
700
St. Louis, MO 63104
General Electric Capital 1,333,332 31.62 1,333,332 18.48
Corporation(5)................
260 Long Ridge Road
Stamford, CT 06927
First Financial Fund, 933,400 23.24 933,400 13.30
Inc.(6).......................
c/o Wellington Management
Company
75 State Street
Boston, MA 02109
Wallace R. Weitz & 666,666 17.17 666,666 9.69
Company(7)....................
1125 South 103rd Street
Suite 600
Omaha, NE 68124-6008
Weitz Series Fund, Inc.(8).... 410,000 10.92 410,000 6.07
c/o Wallace R. Weitz & Company
1125 South 103rd Street,
Suite 600
Omaha, NE 68124-6008
Bay Pond Partners, L.P.(9).... 400,000 10.67 400,000 5.93
c/o Wellington Management
Company
75 State Street
Boston, MA 02109
</TABLE>

- --------
(1)Assuming conversion of all of the Securityholders' Preferred Stock into
Common Stock and the exercise of the listed Securityholder's Warrants.
(2)Assuming no exercise of Underwriter's over-allotment option, no exercise
of Warrants (except by the Securityholder named, separately) and no
purchases by any of the listed Securityholders in this Offering.
(3) Consists of 466,700 shares of Common Stock currently outstanding, and
466,700 shares of Common Stock issuable upon the exercise of Warrants, in
each case beneficially owned by First Financial Fund, Inc., for whom
Wellington Management Company ("Wellington") acts as investment advisor
and over which Wellington has shared investment power; 200,000 shares of
Common Stock currently outstanding, and 200,000 shares of Common Stock
issuable upon the exercise of Warrants, in each case beneficially owned
by Bay Pond Partners, L.P., for whom Wellington acts as investment
advisor and over which Wellington has shared voting and investment power.
(4) Includes 666,667 shares of Common Stock issuable upon the exercise of
Warrants.

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(5) Includes 666,666 shares of Common Stock issuable upon the exercise of
Warrants.
(6) Includes 466,700 shares of Common Stock issuable upon the exercise of
Warrants. Wellington acts as investment advisor and shares investment
power with First Financial Fund, Inc. See footnote 3.

(7) Consists of 205,000 shares of Common Stock currently outstanding, and
205,000 shares of Common Stock issuable upon the exercise of Warrants, in
each case beneficially owned by Weitz Series Fund, Inc. (see footnote 8);
65,000 shares of Common Stock currently outstanding, and 65,000 shares of
Common Stock issuable upon the exercise of Warrants, in each case
beneficially owned by Weitz Partners, Inc,; and 63,333 shares of Common
Stock issuable upon the exercise of Warrants, in each case beneficially
owned by Weitz Partners III Limited Partnership. Wallace R. Weitz, as
President of Weitz Series Fund, Inc. and Weitz Partners, Inc. and as
general partner of Weitz Parters III Limited Partnership, may be deemed
to beneficially own such shares of Common Stock.
(8) Includes 185,000 shares of Common Stock beneficially owned by Weitz
Series Fund, Inc. --Value Portfolio and 20,000 shares of Common Stock
beneficially owned by Weitz Series Fund, Inc.--Hickory Portfolio and the
related 205,000 shares of Common Stock issuable upon the exercise of
Warrants. Wallace R. Weitz & Company has sole voting and investment power
with respect to these shares.
(9) Includes 200,000 shares of Common Stock issuable upon the exercise of
Warrants. Wellington also acts as investment advisor and shares
investment power with Bay Pond Partners, L.P. See footnote 3.

BENEFICIAL OWNERSHIP OF COMMON STOCK BY DIRECTORS AND MANAGEMENT

The following table sets forth certain information known to the Company with
respect to beneficial ownership of the Company's Common Stock as of June 30,
1997, after giving effect to the conversion of the Preferred Stock into Common
Stock and as adjusted to reflect the sale of Common Stock being offered
hereby, by (i) each director and nominee for director, (ii) the Company's
Named Executive Officers, and (iii) all directors and executive officers as a
group. Unless otherwise indicated in the footnotes to the table, the
beneficial owners named have, to the knowledge of the Company, sole voting and
investment power with respect to the shares beneficially owned, subject to
community property laws where applicable.

<TABLE>
<CAPTION>
BENEFICIAL OWNERSHIP OF BENEFICIAL OWNERSHIP OF
COMMON STOCK COMMON STOCK
NAME AND ADDRESS OF BEFORE OFFERING (1) AFTER OFFERING (2)
BENEFICIAL OWNER ----------------------------------------------------
- ------------------- NUMBER PERCENT NUMBER PERCENT
<S> <C> <C> <C> <C>
Scott F. Hartman (3)........ 509,665 13.86 509,665 7.63
W. Lance Anderson (3)....... 520,065 14.12 520,065 7.78
Edward W. Mehrer (4)........ 29,000 * 29,000 *
Gregory T. Barmore (5)...... 5,000 * 5,000 *
Jenne K. Britell............ -- -- -- --
Mark J. Kohlrus (6)......... 13,000 * 13,000 *
All Directors and Executive
Officers as a Group
(6 persons) ............... 1,076,730 -- 1,076,730 --
</TABLE>
- --------
*Less than one percent.
(1)Assuming conversion of all of the Securityholders' Preferred Stock into
Common Stock and the exercise of the listed Securityholder's Warrants and
currently exercisable options.
(2)Assuming no exercise of Underwriter's over-allotment option, no exercise of
Warrants (except by Securityholder named, separately), no purchases by any
of the listed Securityholders in this table and that all shares eligible to
be sold hereunder are sold.
(3)Messrs. Hartman and Anderson acquired (i) Units with promissory notes (see
"Management--Executive Compensation"), (ii) Common Stock as Founders (see
"Capitalization"), (iii) Units as purchasers in the Private Placement, and
(iv) Stock Options (see "Management--Executive Compensation").
(4)Consists of 12,000 Units purchased in the Private Placement, including
2,000 owned by his wife, and 5,000 shares of Common Stock issuable upon the
exercise of options.
(5)Includes 5,000 shares of Common Stock issuable upon the exercise of
options.
(6)Includes 1,500 Units purchased in the Private Placement and 10,000 shares
of Common Stock issuable upon the exercise of options.

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CERTAIN TRANSACTIONS

TRANSACTIONS WITH MANAGEMENT

In May 1996, Messrs. Hartman and Anderson formed NovaStar Mortgage Inc.
("NMI") for the purpose of engaging in the subprime lending business. During
the remainder of 1996, NMI obtained required licenses and permits, developed
guidelines for the origination of mortgage loans through its wholesale lending
channel and, following the Company's Private Placement, began to hire critical
senior personnel to put in place the infrastructure for its mortgage lending
and servicing operations.

Following the close of the Private Placement of Units in December 1996,
NovaStar Financial, Inc. (in its non-consolidated, parent only capacity,
"NFI") moved to implement the portion of its business strategy to be conducted
through taxable subsidiaries. In February 1997, NFI Holding Corporation
("Holding") was formed to serve as a holding company for such taxable
subsidiaries. In March 1997, Messrs. Hartman and Anderson acquired all of the
outstanding voting Common Stock of Holding for a total price of $20,000 and
NFI acquired all of the outstanding preferred stock of Holding for a total
price of $1,980,000. The Common Stock is entitled to 1 percent of the dividend
distributions of Holding and the preferred stock is entitled to 99 percent of
such distributions. At the time of acquisition of the common stock, Messrs.
Hartman and Anderson entered into an agreement of shareholders, to which NFI
is a party, which contains certain management and control provisions and
restrictions on transfer of the common stock. The obligations of Messrs.
Hartman and Anderson under the agreement of shareholders are secured by the
pledge of their common stock in Holding.

In March 1997, Holding acquired all of the outstanding common stock of NMI
from Messrs. Hartman and Anderson for a total price of $250,000, the amount of
cash previously invested by them in NMI. NMI thereby became a wholly-owned
subsidiary of Holding. Through Holding, NFI thus owns a beneficial interest in
99 percent of the future dividend distributions attributable to NMI.

During the three months ended June 30, 1997, NFI entered into a loan
purchase agreement with NMI pursuant to which NFI agrees to buy from time to
time and NMI agrees to sell to NFI mortgage loans originated or acquired by
NMI. The loan purchase agreement is non-exclusive as to both parties and
provides for an arm's-length, fair market value transfer of mortgage loans,
generally on a servicing-released basis. NFI and NMI also entered into a flow
subservicing agreement under which NMI agrees to service mortgage loans for
NFI initially for a fixed dollar fee per loan based on the fee in comparable,
arm's-length subservicing arrangements. The subservicing agreement became
effective with the commencement of NMI's servicing operation in July 1997. NFI
and NMI further entered into an Administrative Services Outsourcing Agreement
dated as of June 30, 1997 pursuant to which NMI will provide NFI on a fee
basis certain administrative services, including consulting with respect to
the development of mortgage loan products, loan underwriting and loan funding.

INDEBTEDNESS OF MANAGEMENT

Messrs. Hartman and Anderson are indebted to NFI pursuant to forgivable
promissory notes as described under "Management--Executive Compensation--Units
Acquired with Forgivable Debt."

CERTAIN BUSINESS RELATIONSHIPS

In connection with a commitment from General Electric Capital Corporation
("GE Capital") to purchase Units in the Company's Private Placement of Units
in 1996, the Company agreed that so long as GE Capital owns at least ten
percent of the outstanding Common Stock, assuming full conversion of the
Preferred Stock and full exercise of all Warrants, GE Capital will have the
right to appoint one director (of up to six authorized directors) or,
alternatively, to have board observation rights so long as it maintains more
than 20 percent of its initial investment in the Company. The current director
serving pursuant to these provisions is Jenne K. Britell, who was elected to
serve as an Independent Director with a term running until the 1999 annual
meeting of stockholders.

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The Company also agreed, unless GE Capital waives its compliance, (i) to
give GE Capital's insurance affiliate FGIC three years' right of first offer
to issue credit enhancements on the Company's securitizations, (ii) to permit
GE Capital's mortgage company affiliate GE Capital Mortgage Corporation to
sell subprime mortgage loans, conforming to underwriting guidelines, to the
Company on an arm's-length basis, and (iii) to pay, subject to closing of the
Private Placement, GE Capital's reasonable legal and consulting fees up to
$40,000 incurred in the Private Placement.

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<PAGE>

FEDERAL INCOME TAX CONSIDERATIONS

The following discussion summarizes the material federal income tax
considerations that may be relevant to a prospective purchaser of units. This
discussion is based on current law. The following discussion is not exhaustive
of all possible tax considerations. It does not give a detailed discussion of
any state, local or foreign tax considerations, nor does it discuss all of the
aspects of federal income taxation that may be relevant to a prospective
investor in light of such investors' particular circumstances or to certain
types of investors (including insurance companies, certain tax-exempt
entities, financial institutions, broker/dealers, foreign corporations and
persons who are not citizens or residents of the United States) subject to
special treatment under federal income tax laws.

EACH PROSPECTIVE PURCHASER OF THE COMMON STOCK IS URGED TO CONSULT WITH HIS
OR HER OWN TAX ADVISOR REGARDING THE SPECIFIC CONSEQUENCES TO HIM OR HER OF
THE PURCHASE, OWNERSHIP AND SALE OF THE COMMON STOCK, INCLUDING THE FEDERAL,
STATE, LOCAL, FOREIGN AND OTHER TAX CONSIDERATIONS OF SUCH PURCHASE, OWNERSHIP
AND SALE AND THE POTENTIAL CHANGES IN APPLICABLE TAX LAWS.

GENERAL

The Code provides special tax treatment for organizations that qualify and
elect to be taxed as REITs. The discussion below summarizes the material
provisions applicable to the Company as a REIT for federal income tax purposes
and to its stockholders in connection with their ownership of shares of stock
of the Company. However, it is impractical to set forth in this Prospectus all
aspects of federal, state, local and foreign tax law that may have tax
consequences with respect to an investor's purchase of the Common Stock. The
discussion of various aspects of federal taxation contained herein is based on
the Code, administrative regulations, judicial decisions, administrative
rulings and practice, all of which are subject to change. In brief, if certain
detailed conditions imposed by the Code are met, entities that invest
primarily in real estate assets, including mortgage loans, and that otherwise
would be taxed as corporations are, with certain limited exceptions, not taxed
at the corporate level on their taxable income that is currently distributed
to their stockholders. This treatment eliminates most of the "double taxation"
(at the corporate level and then again at the stockholder level when the
income is distributed) that typically results from the use of corporate
investment vehicles. A qualifying REIT, however, may be subject to certain
excise and other taxes, as well as normal corporate tax, on Taxable Income
that is not currently distributed to its stockholders. See "Federal Income Tax
Considerations--Taxation of the Company."

The Company elected to be taxed as a REIT under the Code commencing with its
taxable year ended December 31, 1996.

OPINION OF SPECIAL TAX COUNSEL

Jeffers, Wilson, Shaff & Falk, LLP ("Special Tax Counsel"), special tax and
ERISA counsel to the Company, has advised the Company in connection with the
formation of the Company, the Private Placement, this Offering and the
Company's election to be taxed as a REIT. Based on existing law and certain
representations made to Special Tax Counsel by the Company, Special Tax
Counsel is of the opinion that the Company (exclusive of any taxable
affiliates) operated in a manner consistent with its qualifying as a REIT
under the Code since the beginning of its taxable year ended December 31, 1996
through June 30, 1997, the date of the Company's unaudited balance sheet and
income statement made available to Counsel, and the organization and
contemplated method of operation of the Company are such as to enable it to
continue to so qualify throughout the balance of 1997 and in subsequent years.
However, whether the Company will in fact so qualify will depend on actual
operating results and compliance with the various tests for qualification as a
REIT relating to its income, assets, distributions, ownership and certain
administrative matters, the results of which may not be reviewed by Special
Tax Counsel. Moreover, certain aspects of the Company's method of operations
have not

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<PAGE>

been considered by the courts or the Service. There can be no assurance that
the courts or the Service will agree with this opinion. In addition,
qualification as a REIT depends on future transactions and events that cannot
be known at this time. Accordingly, Special Tax Counsel is unable to opine
whether the Company will in fact qualify as a REIT under the Code in all
events. In the opinion of Special Tax Counsel, the section of the Prospectus
entitled "Federal Income Tax Considerations" identifies and fairly summarizes
the federal income tax considerations that are likely to be material to a
holder of the Common Stock and to the extent such summaries involve matters of
law, such statements of law are correct under the Code. Special Tax Counsel's
opinions are based on various assumptions and on the factual representations
of the Company concerning its business and assets. Accordingly, no assurance
can be given that the actual results of the Company's operation for any one
taxable year will satisfy such requirements. See "Termination or Revocation of
REIT Status" below.

The opinions of Special Tax Counsel are based upon existing law including
the Internal Revenue Code of 1986, as amended, existing Treasury Regulations,
Revenue Rulings, Revenue Procedures, proposed regulations and case law, all of
which is subject to change either prospectively or retroactively. Moreover,
relevant laws or other legal authorities may change in a manner that could
adversely affect the Company or its stockholders. Special Tax Counsel's
opinions also are based in part on the opinion of special Maryland counsel,
Piper & Marbury, L.L.P., Baltimore, Maryland, that the Company is duly
organized and existing under Maryland law.

In the event the Company does not qualify as a REIT in any year, it will be
subject to federal income tax as a domestic corporation and its stockholders
will be taxed in the same manner as stockholders of ordinary corporations. To
the extent the Company would, as a consequence, be subject to potentially
significant tax liabilities, the amount of earnings and cash available for
distribution to its stockholders would be reduced. See "Termination or
Revocation of REIT Status" below.

QUALIFICATION AS A REIT

To qualify for tax treatment as a REIT under the Code, the Company must meet
certain tests which are described immediately below.

Ownership of Stock. For all taxable years after the first taxable year for
which a REIT election is made, the Company's shares of stock must be
transferable and must be held by a minimum of 100 persons for at least 335
days of a 12 month year (or a proportionate part of a short tax year). Since
the closing of its Private Placement, the Company has had more than 100
shareholders of record. The Company must also use the calendar year as its
taxable year. In addition, at all times during the second half of each taxable
year, no more than 50 percent in value of the shares of any class of the stock
of the Company may be owned directly or indirectly by five or fewer
individuals. In determining whether the Company's shares are held by five or
fewer individuals, the attribution rules of Section 544 of the Code apply. For
a description of these attribution rules, see "Description of Capital Stock."
The Company's Charter imposes certain repurchase provisions and transfer
restrictions to avoid more than 50 percent by value of any class of the
Company's stock being held by five or fewer individuals (directly or
constructively) at any time during the last half of any taxable year. Such
repurchase and transfer restrictions will not cause the stock not to be
treated as "transferable" for purposes of qualification as a REIT. The Company
has satisfied and intends to continue satisfying both the 100 stockholder and
50 percent/5 stockholder individual ownership limitations described above for
as long as it seeks qualification as a REIT. See "Description of Capital
Stock." The Company uses the calendar year as its taxable year for income tax
purposes.

Nature of Assets. On the last day of each calendar quarter at least 75
percent of the value of the Company's assets must consist of Qualified REIT
Assets, government securities, cash and cash items (the "75 percent of assets
test"). The Company expects that substantially all of its assets, other than
the preferred stock of the Company's taxable affiliate, will be "Qualified
REIT Assets." Qualified REIT Assets include interests in real property,
interests in mortgage loans secured by real property and interests in REMICs.
The Company has complied with the 75 percent of assets test for each quarter
since inception of its REIT election.

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On the last day of each calendar quarter, of the investments in securities
not included in the 75 percent of assets test, the value of any one issuer's
securities may not exceed 5 percent by value of the Company's total assets and
the Company may not own more than ten percent of any one issuer's outstanding
voting securities. Pursuant to its compliance guidelines, the Company intends
to monitor closely (on not less than a quarterly basis) the purchase and
holding of the Company's assets in order to comply with the above assets
tests. In particular, as of the end of each calendar quarter the Company
intends to limit and diversify its ownership of securities of any taxable
affiliate of the Company, hedging contracts and other mortgage securities that
do not constitute Qualified REIT Assets to less than 25 percent, in the
aggregate, by value of its portfolio, to less than 5 percent by value as to
any single issuer, including the stock of any taxable affiliate of the
Company, and to less than 10 percent of the voting stock of any single issuer
(collectively the "25 percent of assets limits"). If such limits are ever
exceeded, the Company intends to take appropriate remedial action to dispose
of such excess assets within the 30 day period after the end of the calendar
quarter, as permitted under the Code. As of June 30, 1997, the Company
complied with the tests described in this paragraph.

When purchasing mortgage-related securities, the Company may rely on
opinions of counsel for the issuer or sponsor of such securities given in
connection with the offering of such securities, or statements made in related
offering documents, for purposes of determining whether and to what extent
those securities (and the income therefrom) constitute Qualified REIT Assets
(and income) for purposes of the 75 percent of assets test (and the source of
income tests discussed below). If the Company invests in a partnership, the
Company will be treated as receiving its share of the income and loss of the
partnership and owning a proportionate share of the assets of the partnership
and any income from the partnership will retain the character that it had in
the hands of the partnership.

Sources of Income. The Company must meet three separate income-based tests
each year in order to qualify as a REIT.

1. The 75 percent Test. At least 75 percent of the Company's gross income
(the "75 percent of income test") for the taxable year must be derived from
the following sources among others: (i) interest (other than interest based in
whole or in part on the income or profits of any person) on obligations
secured by mortgages on real property or on interests in real property; (ii)
gains from the sale or other disposition of interests in real property and
real estate mortgages, other than gain from property held primarily for sale
to customers in the ordinary course of the Company's business ("dealer
property"); (iii) income from the operation, and gain from the sale, of
property acquired at or in lieu of a foreclosure of the mortgage secured by
such property or as a result of a default under a lease of such property
("foreclosure property"); (iv) income received as consideration for entering
into agreements to make loans secured by real property or to purchase or lease
real property (including interests in real property and interests in mortgages
on real property) (for example, commitment fees); (v) rents from real
property; and (vi) income attributable to stock or debt instruments acquired
with the proceeds from the sale of stock or certain debt obligations ("new
capital") of the Company received during the one-year period beginning on the
day such proceeds were received ("qualified temporary investment income"). The
investments that the Company intends to make (as described under "Business--
Portfolio of Mortgage Assets") will give rise primarily to mortgage interest
qualifying under the 75 percent of income test. As of June 30, 1997, the
Company complied with the 75 percent income test on an annualized basis.

2. The 95 percent Test. In addition to deriving 75 percent of its gross
income from the sources listed above, at least an additional 20 percent of the
Company's gross income for the taxable year must be derived from those
sources, or from dividends, interest or gains from the sale or disposition of
stock or other securities that are not dealer property (the "95 percent of
income test"). Income attributable to assets other than Qualified REIT Assets,
such as income from or gain on the disposition of Qualified Hedges, that the
Company holds, dividends on stock (including any dividends from a taxable
affiliate), interest on any other obligations not secured by real property,
and gains from the sale or disposition of stock or other securities that are
not Qualified REIT Assets will constitute qualified income for purposes of the
95 percent of income test only, and will not be qualified income for purposes
of the 75 percent of income test. Income from mortgage servicing, loan
guarantee fees (or other contracts under which the Company would earn fees for
performing services) and hedging (other

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than from Qualified REIT Assets) will not qualify for either the 95 percent or
75 percent of income tests. The Company intends to severely limit its
acquisition of any assets or investments the income from which does not
qualify for purposes of the 95 percent of income test. Moreover, in order to
help ensure compliance with the 95 percent of income test and the 75 percent
of income test, the Company intends to limit substantially all of the assets
that it acquires (other than the shares of the preferred stock of any taxable
affiliate and Qualified Hedges) to Qualified REIT Assets. The policy of the
Company to maintain REIT status may limit the type of assets, including
hedging contracts, that the Company otherwise might acquire. As of June 30,
1997, the Company complied with the 95 percent income test on an annualized
basis.

For purposes of determining whether the Company complies with the 75 percent
of income test and the 95 percent of income test detailed above, gross income
does not include gross income from "prohibited transactions." A "prohibited
transaction" is one involving a sale of dealer property, other than
foreclosure property. Net income from "prohibited transactions" is subject to
a 100 percent tax. See "--Taxation of the Company."

3. The 30 percent Limit. Until the end of the 1997 year, the Company must
also derive less than 30 percent of its gross income from the sale or other
disposition of (i) Qualified REIT Assets held for less than four years, other
than foreclosure property or property involuntarily or compulsorily converted
through destruction, condemnation or similar events, (ii) stock or securities
held for less than one year (including Qualified Hedges) and (iii) property in
a prohibited transaction (together the "30 percent of income limit"). As a
result of the Company's having to closely monitor such gains, the Company may
have to hold mortgage loans and Mortgage Assets for four or more years and
securities (other than securities that are Qualified REIT Assets) and hedges
for one year or more at times when the Company might otherwise have opted for
the disposition of such assets for short term gains, in order to ensure that
it maintains compliance with the 30 percent of income limit. Recent
legislation repealed the 30 percent income limit effective with the Company's
1998 fiscal year.

The Company intends to maintain its REIT status by carefully monitoring its
income, including income from hedging transactions, futures contracts and
sales of Mortgage Assets to comply with the 75 percent of income test, the 95
percent of income test and as to the 1997 year the 30 percent of income limit
as well. See "--Taxation of the Company" for a discussion of the potential tax
cost of the Company's selling certain Mortgage Assets on a regular basis. In
order to help insure its compliance with the REIT requirements of the Code,
the Company has adopted guidelines the effect of which will be to limit the
Company's ability to earn certain types of income, including income from
hedging, other than hedging income from Qualified REIT Assets and from
Qualified Hedges. See "Business--Portfolio of Mortgage Assets--Interest Rate
Risk Management."

If the Company fails to satisfy one or both of the 75 percent or 95 percent
of income tests for any year, it may face either (a) assuming such failure was
for reasonable cause and not willful neglect, a 100 percent tax on the greater
of the amounts of income by which it failed to comply with the 75 percent test
of income or the 95 percent of income test, reduced by estimated related
expenses or (b) loss of REIT status. There can be no assurance that the
Company will always be able to maintain compliance with the gross income tests
for REIT qualification despite the Company's periodic monitoring procedures.
Moreover, there is no assurance that the relief provisions for a failure to
satisfy either the 95 percent or the 75 percent of income tests will be
available in any particular circumstance. There are no comparable relief
provisions which could mitigate the consequences of a failure to satisfy the
30 percent of income limit as to 1996 or 1997.

Distributions. The Company must distribute to its stockholders on a pro rata
basis each year an amount equal to (i) 95 percent of its Taxable Income before
deduction of dividends paid and excluding net capital gain, plus (ii) 95
percent of the excess of the net income from foreclosure property over the tax
imposed on such income by the Code, less (iii) any "excess noncash income"
(the "95 percent distribution test"). See "Dividend Policy and Distributions."
The Company intends to make distributions to its stockholders in amounts
sufficient to meet this 95 percent distribution requirement. Such
distributions must be made in the taxable year to which they relate or, if
declared before the timely filing of the Company's tax return for such year
and paid not later than the first regular dividend payment after such
declaration, in the following taxable year. A nondeductible excise tax, equal
to 4 percent of the excess of such required distributions over the amounts
actually distributed

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will be imposed on the Company for each calendar year to the extent that
dividends paid during the year (or declared during the last quarter of the
year and paid during January of the succeeding year) are less than the sum of
(i) 85 percent of the Company's "ordinary income," (ii) 95 percent of the
Company's capital gain net income, and (iii) income not distributed in earlier
years.

If the Company fails to meet the 95 percent distribution test as a result of
an adjustment to the Company's tax returns by the Service, the Company by
following certain requirements set forth in the Code, may pay a deficiency
dividend within a specified period which will be permitted as a deduction in
the taxable year to which the adjustment is made. The Company would be liable
for interest based on the amount of the deficiency dividend. A deficiency
dividend is not permitted if the deficiency is due to fraud with intent to
evade tax or to a willful failure to file timely tax return.

TAXATION OF THE COMPANY

In any year in which the Company qualifies as a REIT, it generally will not
be subject to federal income tax on that portion of its taxable income or net
capital gain which is distributed to its stockholders. The Company will,
however, be subject to tax at normal corporate rates upon any net income or
net capital gain not distributed. The Company intends to distribute
substantially all of its taxable income to its stockholders on a pro rata
basis in each year. See "Dividend Policy and Distributions."

In addition, the Company will also be subject to a tax of 100 percent of net
income from any prohibited transaction and will be subject to a 100 percent
tax on the greater of the amount by which it fails either the 75 percent or 95
percent of income tests, reduced by approximated expenses, if the failure to
satisfy such tests is due to reasonable cause and not willful neglect and if
certain other requirements are met. The Company may be subject to the
alternative minimum tax on certain items of tax preference.

If the Company acquires any real property as a result of foreclosure, or by
a deed in lieu of foreclosure, the Company may elect to treat such real
property as "foreclosure property." Net income from the sale of foreclosure
property is taxable at the maximum federal corporate rate, currently 35
percent. Income from foreclosure property will not be subject to the 100
percent tax on prohibited transactions and, as to any foreclosure in 1997,
will not be included in income subject to the 30 percent of income limit. See
"30 Percent Limit" above. The Company will determine whether to treat such
real property as foreclosure property on the tax return for the fiscal year in
which such property is acquired. The Company expects to so elect.

The Company will securitize mortgage loans and sell such mortgage loans
through one or more taxable affiliates. However, if the Company itself were to
sell such Mortgage Assets on a regular basis, there is a substantial risk that
they would be deemed "dealer property" and that all of the profits from such
sales would be subject to tax at the rate of 100 percent as income from
prohibited transactions. Such taxable affiliate will not be subject to this
100 percent tax on income from prohibited transactions, which is only
applicable to REITs.

The Company will also be subject to the nondeductible 4 percent excise tax
discussed above if it fails to make timely dividend distributions for each
calendar year. See "--Qualification as a REIT-Distributions." The Company
intends to declare its fourth regular annual dividend during the final quarter
of the year and to make such dividend distribution no later than thirty-one
(31) days after the end of the year in order to avoid imposition of the excise
tax. Such a distribution would be taxed to the stockholders in the year that
the distribution was declared, not in the year paid. Imposition of the excise
tax on the Company would reduce the amount of cash available for distribution
to the Company's stockholders.

As a publicly held corporation, the Company will not be allowed a deduction
for applicable employee remuneration with respect to any covered employee in
excess of $1 million per year (the "Million Dollar Limit"). The Million Dollar
Limit on deductibility is subject to certain exceptions, including the
exception for "performance based compensation" meeting each of the following
criteria: (i) the agreement must have been approved by the corporation's
stockholders, (ii) the agreement must have been approved by a compensation

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committee consisting solely of two or more non-employee directors of the
corporation and (iii) under the agreement compensation payable to the employee
must be based on objective performance criteria and the meeting of this
criteria is certified by the compensation committee. Based on certain
representations of the Company, Counsel is of the opinion that it is more
likely than not that the deduction for compensation to the officers under the
agreements would not be disallowed under the Million Dollar Limit.

TAXATION OF TAXABLE AFFILIATES

The Company has caused, and will continue to cause, the creation and sale of
Mortgage Assets or conduct certain hedging activities through one or more
taxable affiliates. To date, the Company has caused the formation of NFI
Holding Corporation, Inc. (Holding) and NovaStar Mortgage, Inc. (NMI), the
wholly owned subsidiary of Holding. The Company owns all of the preferred
stock issued by Holding, which is entitled to 99 percent of the dividends to
be distributed by Holding. Scott Harman and Lance Anderson each own 50 percent
of the common stock of Holding. The common stock of Holding is entitled to one
percent of the dividends and liquidating distributions to be distributed by
Holding. The common stock is the sole class of voting stock of Holding,
although the Company would be entitled to vote on any matter that could
adversely affect the rights of its preferred stock. The assets of Holding
consist of the issued capital stock of NMI and a nominal amount of cash.

In order to ensure that the Company will not violate the prohibition on
ownership of more than 10 percent of the voting stock of a single issuer and
the prohibition on investing more than 5 percent of the value of its assets in
the stock or securities of a single issuer, the Company will primarily own
only shares of nonvoting preferred stock of the taxable affiliate and will not
own any of the taxable affiliates' common stock. The Company will monitor the
value of its investment in the taxable affiliate on a quarterly basis to limit
the risk of violating any of the tests that comprise the 25 percent of assets
limits. In addition, the dividends that the taxable affiliate pays to the
Company will not qualify as income from Qualified REIT Assets for purposes of
the 75 percent of income test, and in all events would have to be limited,
along with the Company's other interest, dividends, gains on the sale of
securities, hedging income, and other income not derived from Qualified REIT
Assets to less than 25 percent of the Company's gross revenues in each year.
See "Qualification as a REIT--Nature of Assets" and "--Sources of Income." The
taxable affiliate will not elect REIT status, will be subject to income
taxation on its net earnings and will generally be able to distribute only its
net earnings to its stockholders, including the Company, as dividend
distributions. If the taxable affiliate creates a taxable mortgage pool, such
pool itself will constitute a separate taxable subsidiary of the taxable
affiliate. The taxable affiliate would be unable to offset the income derived
from such a taxable mortgage pool with losses derived from any other
activities.

TAXATION OF THE COMPANY'S STOCKHOLDERS

General. For any taxable year in which the Company is treated as a REIT for
federal income purposes, amounts distributed by the Company to its
stockholders out of current or accumulated earnings and profits will be
includible by the stockholders as ordinary income for federal income tax
purposes unless properly designated by the Company as capital gain dividends.
In the latter case, the distributions will be taxable to the stockholders as
long-term capital gains.

Distributions of the Company will not be eligible for the dividends received
deduction for corporations. Stockholders may not deduct any net operating
losses or capital losses of the Company.

Any loss on the sale or exchange of shares of the stock of the Company held
by a stockholder for six months or less will be treated as a long-term capital
loss to the extent of any capital gain dividend received on the stock held by
such stockholders.

If the Company makes distributions to its stockholders in excess of its
current and accumulated earnings and profits, those distributions will be
considered first a tax-free return of capital, reducing the tax basis of a

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stockholder's shares until the tax basis is zero. Such distributions in excess
of the tax basis will be taxable as gain realized from the sale of the
Company's shares.

The Company (exclusive of its taxable affiliates) does not expect to acquire
or retain residual interests issued by REMICs. Such residual interests, if
acquired by a REIT, would generate excess inclusion income to shareholders of
the REIT. Excess inclusion income cannot be offset by net operating losses of
a stockholder. If the stockholder is a Tax-Exempt Entity, the excess inclusion
income is fully taxable as UBTI. If allocated to a foreign stockholder, the
excess inclusion income is subject to Federal income tax withholding without
reduction pursuant to any otherwise applicable tax treaty. Excess inclusion
income realized by a taxable affiliate is not passed through to stockholders
of the Company. Potential investors, and in particular Tax Exempt Entities,
are urged to consult with their tax advisors concerning this issue.

The Company intends to finance the acquisition of Mortgage Assets by
entering into reverse repurchase agreements, which are essentially loans
secured by the Company's Mortgage Assets. The Company expects to enter into
master repurchase agreements with secured lenders known as "counterparties."
Typically, such master repurchase agreements have cross-collateralization
provisions that afford the counterparty the right to foreclose on the Mortgage
Assets pledged as collateral. If the Service were to successfully take the
position that the cross-collateralization provisions of the master repurchase
agreements result in the Company having issued debt instruments (the reverse
repurchase agreements) with differing maturity dates secured by a pool of
mortgage loans, a portion of the Company's income could be characterized as
"excess inclusion income." Special Tax Counsel has advised the Company that it
is more likely than not that the cross-collateralization provisions of the
master repurchase agreements will not cause the Company to realize excess
inclusion income. Nevertheless, in the absence of any definitive authority on
this issue, Special Tax Counsel cannot give complete assurance.

The Company will notify stockholders after the close of the Company's
taxable year as to the portions of the distributions which constitute ordinary
income, return of capital and capital gain. Dividends and distributions
declared in the last quarter of any year payable to stockholders of record on
a specified date in such month will be deemed to have been received by the
stockholders and paid by the Company on December 31 of the record year,
provided that such dividends are paid before February 1 of the following year.

TAXATION OF TAX-EXEMPT ENTITIES

In general, a Tax-Exempt Entity that is a stockholder of the Company is not
subject to tax on distributions. The Service has ruled that amounts
distributed by a REIT to an exempt employees' pension trust do not constitute
UBTI and thus should be nontaxable to such a Tax-Exempt Entity. Based on that
ruling, but subject to the discussion of excess inclusion income set forth
under the heading "Taxation of the Company's Stockholders," Special Tax
Counsel is of the opinion that indebtedness incurred by the Company in
connection with the acquisition of real estate assets such as mortgage loans
will not cause dividends of the Company paid to a stockholder that is a Tax-
Exempt Entity to be UBTI, provided that the Tax-Exempt Entity has not financed
the acquisition of its stock with "acquisition indebtedness" within the
meaning of the Code. Under certain conditions, if a tax-exempt employee
pension or profit sharing trust were to acquire more than 10 percent of the
Company's stock, a portion of the dividends on such stock could be treated as
UBTI.

For social clubs, voluntary employee benefit associations, supplemental
unemployment benefit trusts, and qualified group legal services plans exempt
from federal income taxation under Code Sections 501(c)(7), (c)(9), (c)(17)
and (c)(20), respectively, income from an investment in the Company will
constitute UBTI unless the organization is able to properly deduct amounts set
aside or placed in reserve for certain purposes so as to offset the UBTI
generated by its investment in the Company. Such entities should review Code
Section 512(a)(3) and should consult their own tax advisors concerning these
"set aside" and reserve requirements.

FOREIGN INVESTORS

The preceding discussion does not address the federal income tax
consequences to foreign investors (non-resident aliens and foreign
corporations as defined in the Code) of an investment in the Company. In
general,

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foreign investors will be subject to special withholding tax requirements on
income and capital gains distributions attributable to their ownership of the
Company's stock. Foreign investors in the Company should consult their own tax
advisors concerning the federal income tax consequences to them of a purchase
of shares of the Company's stock including the federal income tax treatment of
dispositions of interests in, and the receipt of distributions from, REITs by
foreign investors. In addition, federal income taxes must be withheld on
certain distributions by a REIT to foreign investors unless reduced or
eliminated by an income tax treaty between the United States and the foreign
investor's country. A foreign investor eligible for reduction or elimination
of withholding must file an appropriate form with the Company in order to
claim such treatment.

RECORDKEEPING REQUIREMENT

A REIT is required to maintain records regarding the actual and constructive
ownership of its shares, and other information, and within 30 days after the
end of its taxable year, to demand statements from persons owning above a
specified level of the REIT's shares (e.g., if the Company has over 200 but
fewer than 2,000 stockholders of record, from persons holding 1 percent or
more of the Company's outstanding shares of stock and if the Company has 200
or fewer stockholders of record, from persons holding 1/2 percent or more of
the stock) regarding their ownership of shares. The Company must maintain, as
part of the Company's records, a list of those persons failing or refusing to
comply with this demand. Stockholders who fail or refuse to comply with the
demand must submit a statement with their tax returns setting forth the actual
stock ownership and other information. The Company intends to maintain the
records and demand statements as required by these regulations.

TERMINATION OR REVOCATION OF REIT STATUS

The Company's election to be treated as a REIT will be terminated
automatically if the Company fails to meet the requirements described above.
In that event, the Company will not be eligible again to elect REIT status
until the fifth taxable year which begins after the year for which the
Company's election was terminated unless all of the following relief
provisions apply: (i) the Company did not willfully fail to file a timely
return with respect to the termination taxable year, (ii) inclusion of
incorrect information in such return was not due to fraud with intent to evade
tax, and (iii) the Company establishes that failure to meet requirements was
due to reasonable cause and not willful neglect. The Company may also
voluntarily revoke its election, although it has no intention of doing so, in
which event the Company will be prohibited, without exception, from electing
REIT status for the year to which the revocation relates and the following
four taxable years.

If the Company fails to qualify for taxation as a REIT in any taxable year,
and the relief provisions do not apply, the Company would be subject to tax
(including any applicable alternative minimum tax) on its taxable income at
regular corporate rates. Distributions to stockholders of the Company with
respect to any year in which the Company fails to qualify as a REIT would not
be deductible by the Company nor would they be required to be made. Failure to
qualify as a REIT would result in the Company's reduction of its distributions
to stockholders in order to pay the resulting taxes. If, after forfeiting REIT
status, the Company later qualifies and elects to be taxed as a REIT again,
the Company could face significant adverse tax consequences.

BACKUP WITHHOLDING

The Code imposes a modified form of "backup withholding" for payments of
interest and dividends. This withholding applies only if a stockholder, among
other things, (i) fails to furnish the Company with a properly certified
taxpayer identification number, (ii) furnishes the Company with an incorrect
taxpayer identification number, (iii) fails properly to report interest or
dividends from any source, or (iv) under certain circumstances fails to
provide the Company or the stockholder's securities broker with a certified
statements, under penalty of perjury, that he or she is not subject to backup
withholding.

The backup withholding rate is 31 percent of "reportable payments", which
include the Company's dividends. Stockholders should consult their tax
advisors as to the procedure for insuring that Company distributions to them
will not be subject to backup withholding.

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The Company will report to its stockholders and the Service the amount of
dividends paid during each calendar year and the amount of tax withheld, if
any.

STATE AND LOCAL TAXES

State and local tax laws may not correspond to the federal income tax
principles discussed in this section. Accordingly, prospective stockholders
should consult their tax advisers concerning the state and local tax
consequences of an investment in the Company's stock.

ERISA INVESTORS

A fiduciary of a pension, profit-sharing, stock bonus plan or individual
retirement account, including a plan for self-employed individuals and their
employees or any other employee benefit plan subject to the prohibited
transaction provisions of the Code or the fiduciary responsibility provisions
of the Employee Retirement Income Security Act of 1974 ("ERISA")
(collectively, a "Plan"), should consider (i) whether the ownership of the
Company's stock is in accordance with the documents and instruments governing
the Plan, (ii) whether the ownership of the Company's stock is consistent with
the fiduciary's responsibilities and satisfies the requirements of Part 4 of
Subtitle A of Title I of ERISA (if applicable) and, in particular, the
diversification, prudence and liquidity requirements of Section 404 of ERISA,
(iii) the prohibitions under ERISA on improper delegation of control over, or
responsibility for "plan assets" and ERISA's imposition of co-fiduciary
liability on a fiduciary who participates in, or permits (by action or
inaction) the occurrence of, or fails to remedy a known breach of duty by
another fiduciary with respect to plan assets, and (iv) the need to value the
assets of the Plan annually.

As to the "plan assets" issue noted in clause (iii) above, based on certain
representations of the Company, Special Tax Counsel is of the opinion that the
Company's Common Stock will qualify as "publicly offered securities" within
the meaning of the regulations defining "plan assets" and therefore, in most
circumstances, the Common Stock, and not the underlying assets of the Company,
will be considered the assets of a Plan investing in the Common Stock.

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DESCRIPTION OF CAPITAL STOCK

GENERAL

Upon the closing of this Offering, the authorized capital stock of the
Company will consist of 46,450,000 shares of Common Stock, of which 6,766,665
shares of Common Stock will be outstanding, and 3,550,000 shares of the
Company's unclassified capital stock, none of which will be outstanding.

HISTORICAL CAPITAL STRUCTURE

The authorized capital stock of the Company consists of 50,000,000 shares of
Capital Stock, $0.01 par value ("Capital Stock"). All such shares of Capital
Stock were initially classified as Common Stock. The Company's Charter
authorizes the Board of Directors to reclassify any of the unissued shares of
authorized Capital Stock into other classes or series of Capital Stock,
including classes or series of preferred stock. On December 6, 1996, the
Company supplemented its Charter to divide and classify 3,550,000 shares of
the Capital Stock of the Company into a series of preferred stock designated
as the Company's Class A Convertible Preferred Stock (the "Preferred Stock").
The Preferred Stock has the rights and privileges and is subject to the
conditions set forth in the Articles Supplementary establishing the terms of
the Preferred Stock. On December 9, 1996, the Company issued (i) 3,333,333
shares of Preferred Stock as part of the Units, each Unit consisted of one
share of Preferred Stock and one Warrant, in the Company's Private Placement
of Units; and (ii) 216,666 shares of Preferred Stock as part of the Units
acquired by the founders with forgivable debt. Effective on the closing of
this Offering, such shares of outstanding Preferred Stock will automatically
convert to Common Stock. Shares of the Preferred Stock received by the Company
upon the conversion will be restored to the status of authorized but unissued
shares of Capital Stock, without designation as to class, and the Company
intends to so reclassify all remaining authorized shares of Preferred Stock.

The following summary of the respective rights of the Common Stock and the
Preferred Stock is qualified in its entirety by reference to the Company's
Charter and Articles Supplementary, copies of which have been filed with the
Commission as exhibits to the Registration Statement of which this Prospectus
is a part.

COMMON STOCK

Voting. Each holder of Common Stock is entitled to one vote for each share
of record on each matter submitted to a vote of holders of Capital Stock of
the Company. The Company's Charter does not provide for cumulative voting and,
accordingly, the holders of a majority of the outstanding shares of Capital
Stock have the power to elect all directors to be elected each year.

Annual meetings of the stockholders of the Company will be held, and special
meetings may be called by any member of the Board of Directors, by the
President or generally by stockholders holding at least 20 percent of the
outstanding shares of Capital Stock entitled to be voted at the meeting. The
Charter of the Company may be amended in accordance with Maryland law, subject
to certain limitations set forth in the Charter.

Dividends; Liquidation; Other Rights. So long as the Class A Convertible
Preferred Stock remains outstanding, the holders of Common Stock shall not be
entitled to dividends or distributions. Following conversion of all
outstanding shares of Preferred Stock upon the closing of this Offering, the
holders of shares of Common Stock are entitled to receive dividends when, as,
and if declared by the Board of Directors out of funds legally available
therefor. In the event of liquidation, dissolution or winding up of the
Company, the holders of Common Stock will share ratably in all assets of the
Company remaining after the payment of liabilities and after payment of the
liquidation preference of any shares or series of preferred stock that may be
issued and outstanding. There are no preemptive or other subscription rights,
conversion rights or redemption or sinking fund provisions with respect to
shares of Common Stock.

PREFERRED STOCK

Additional preferred stock may be issued from time to time in one or more
classes or series, with such distinctive designations, rights and preferences
as shall be determined by the Board of Directors. Additional

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series of preferred stock would be available for possible future financing of,
or acquisitions by, the Company and for general corporate purposes without any
legal requirement that further stockholder authorization for issuance be
obtained. The issuance of additional series of preferred stock could have the
effect of making an attempt to gain control of the Company more difficult by
means of a merger, tender offer, proxy contest or otherwise. Additional series
of preferred stock, if issued, would have a preference on dividend payments
(as does the Preferred Stock) which would affect the ability of the Company to
make dividend distributions to the holders of Common Stock.

REGISTRATION RIGHTS

Each purchaser of Units in the Company's Private Placement is entitled to
certain rights with respect to registration under the Securities Act. Pursuant
to a Registration Rights Agreement, the Company has agreed to (i) file with
the Commission, within six months after the closing of this Offering, and use
its best efforts to cause to become effective as soon as practicable
thereafter, a shelf registration statement (the "Shelf Registration
Statement") with respect to the shares of Common Stock into which the shares
of Preferred Stock have been converted, the Warrants and the shares of Common
Stock issuable pursuant to the exercise of the Warrants and (ii) use its best
efforts to have such shares of Common Stock and the Warrants approved for
quotation on the Nasdaq National Market or listed on a stock exchange upon
effectiveness of the Shelf Registration Statement. The Company will be
required to keep the Shelf Registration Statement effective until the sooner
of three years or such time as, in the written opinion of counsel to the
Company, such registration is not required for the unrestricted resale of
shares of Common Stock or Warrants entitled to registration rights under the
Registration Rights Agreement. In addition, with respect to each investor who
purchased 5 percent or more of the Units sold in the Private Placement (a "5
percent purchaser"), the Company has agreed to include with each registration
statement it files relating to a new issuance of Common Stock during the term
of the Registration Rights Agreement shares of Common Stock of such 5 percent
purchaser resulting from the conversion of the Preferred Stock or the exercise
of Warrants, subject to certain conditions. Such conditions provide, among
other things, that the managing underwriter in any offering being so
registered may determine that all of such shares of Common Stock proposed to
be included in the offering cannot be sold, in which case the number of such
shares included will be reduced pro rata among such 5 percent purchasers
proposing to participate according to the number of such shares proposed to be
sold, provided, however, that with respect to the Company's first two public
offerings of Common Stock, such purchasers will be entitled to participate pro
rata in any amount that can be sold in excess of $50 million per offering. In
addition, following the end of the effectiveness of the Shelf Registration
Statement, each 5 percent purchaser shall have two demand registration rights,
unless, in the written opinion of counsel to the Company (which opinion is
reasonably acceptable to such purchaser), such registration is not necessary
for such 5 percent purchaser to sell its shares in the manner contemplated in
compliance with applicable securities laws. If requested by any participating
5 percent purchaser, the Company's management will conduct road shows to
assist such 5 percent purchaser in selling its shares under either the Shelf
Registration Statement or the demand registrations.

Messrs. Hartman and Anderson, as holders of the 216,666 shares of currently
outstanding Common Stock, are entitled to certain rights with respect to
registration under the Securities Act of such Common Stock. Under the terms of
a Founders Registration Rights Agreement, such holders are entitled to include
within any registration statement under the Securities Act proposed by the
Company with respect to a firm commitment underwritten public offering of
Common Stock (either for its own account or for the account of other security
holders) shares of Common Stock held by such holders, subject to certain
conditions and limitations.

PRIVATE PLACEMENT PURCHASE TERMS AGREEMENT

Pursuant to a Purchase Terms Agreement between the Company and the placement
agent in the Company's Private Placement, the Company agreed to a number of
provisions for the benefit of the purchasers of Units. The Purchase Terms
Agreement included, among other covenants, the following: (i) financial
reporting and information requirements prior to this Offering; (ii) approval
by a majority of Independent Directors of material increases in management
compensation; (iii) restrictions on affiliated transactions (excluding
transactions with

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GE Capital and its affiliates); (iv) prohibitions on entering unrelated lines
of business (including, but not limited to, investments in commercial and
multifamily mortgage and mortgage-backed securities or other REITs); (v)
maintenance of Key Man life insurance on Messrs. Hartman and Anderson for five
years; (vi) maintenance of the Company's status as a REIT; (vii) changes in
the capital allocation guidelines and hedge policies; (viii) undertaking to
carry out a liquidation of the Company upon the vote of a majority of the
stockholders recommending such action; and (ix) prohibition on grants of stock
options (or other Awards) under the Company's 1996 Stock Option Plan prior to
this Offering other than those stock options described in "Management--
Executive Compensation."

Following this Offering or, in the case of clauses (iv) and (v) above, one
year following this Offering, the provisions of clauses (ii) through (vii)
above may be modified or waived by a majority of Independent Directors. During
such one-year period, clause (iv) and (v) may be waived by a unanimous vote of
the Board of Directors. Clauses (viii) and (ix) will terminate upon the
closing of this offering.

REPURCHASE OF SHARES AND RESTRICTION ON TRANSFER

Two of the requirements of qualification for the tax benefits accorded by
the REIT provisions of the Code are that (1) during the last half of each
taxable year not more than 50 percent in value of the outstanding shares may
be owned directly or indirectly by five or fewer individuals (the "50
percent/5 stockholder test") and (2) there must be at least 100 stockholders
on 335 days of each taxable year of 12 months.

In order that the Company may meet these requirements at all times, the
Charter prohibits any person from acquiring or holding, directly or
indirectly, shares of Capital Stock in excess of 9.8 percent in value of the
aggregate of the outstanding shares of Capital Stock or in excess of 9.8
percent (in value or in number of shares, whichever is more restrictive) of
the aggregate of the outstanding shares of Common Stock of the Company. For
this purpose, the term "ownership" is defined in accordance with the REIT
provisions of the Code and the constructive ownership provisions of Section
544 of the Code, as modified by Section 856(h)(1)(B) of the Code.

For purposes of the 50 percent/5 stockholder test, the constructive
ownership provisions applicable under Section 544 of the Code attribute
ownership of securities owned by a corporation, partnership, estate or trust
proportionately to its stockholders, partners or beneficiaries, attribute
ownership of securities owned by family members and partners to other members
of the same family, treat securities with respect to which a person has an
option to purchase as actually owned by that person, and set forth rules as to
when securities constructively owned by a person are considered to be actually
owned for the application of such attribution provisions (i.e.,
"reattribution"). Thus, for purposes of determining whether a person holds
shares of Capital Stock in violation of the ownership limitations set forth in
the Charter, many types of entities may own directly more than the 9.8 percent
limit because such entities shares are attributed to its individual
stockholders. For example, it is contemplated that GE Capital and perhaps
other corporate investors will own in excess of 9.8 percent of the Capital
Stock outstanding immediately after the Offering. On the other hand, a person
will be treated as owning not only shares of Capital Stock actually or
beneficially owned, but also any shares of Capital Stock attributed to such
person under the attribution rules described above. Accordingly, under certain
circumstances, shares of Capital Stock owned by a person who individually owns
less than 9.8 percent of the shares outstanding may nevertheless be in
violation of the ownership limitations set forth in the Charter. Ownership of
shares of the Company's Capital Stock through such attribution is generally
referred to as constructive ownership. The 100 stockholder test is determined
by actual, and not constructive, ownership. The Company has greater than 100
shareholders of record.

Under the constructive ownership provisions of Section 544 of the Code, a
holder of a Warrant will be treated as owning the number of shares of Capital
Stock into which such Warrant may be converted.

The Charter further provides that if any transfer of shares of Capital Stock
occurs which, if effective, would result in any person beneficially or
constructively owning shares of Capital Stock in excess or in violation of the
above transfer or ownership limitations, then that number of shares of Capital
Stock the beneficial or constructive ownership of which otherwise would cause
such person to violate such limitations (rounded to the nearest whole

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shares) shall be automatically transferred to a trustee (the "Trustee") as
trustee of a trust (the "Trust") for the exclusive benefit of one or more
charitable beneficiaries (the "Charitable Beneficiary"), and the intended
transferee shall not acquire any rights in such shares. Shares held by the
Trustee shall be issued and outstanding shares of Capital Stock. The intended
transferee shall not benefit economically from ownership of any shares held in
the Trust, shall have no rights to dividends, and shall not possess any rights
to vote or other rights attributable to the shares held in the Trust. The
Trustee shall have all voting rights and rights to dividends or other
distributions with respect to shares held in the Trust, which rights shall be
exercised for the exclusive benefit of the Charitable Beneficiary. Any
dividend or other distribution paid to the intended transferee prior to the
discovery by the Company that shares of Common Stock have been transferred to
the Trustee shall be paid with respect to such shares to the Trustee by the
intended transferee upon demand and any dividend or other distribution
authorized but unpaid shall be paid when due to the Trustee. The Board of
Directors of the Company may, in their discretion, waive these requirements on
owning shares in excess of the ownership limitations.

Within 20 days of receiving notice from the Company that shares of Capital
Stock have been transferred to the Trust, the Trustee shall sell the shares
held in the Trust to a person, designated by the Trustee, whose ownership of
the shares will not violate the ownership limitations set forth in the
Charter. Upon such sale, the interest of the Charitable Beneficiary in the
shares sold shall terminate and the Trustee shall distribute the net proceeds
of the sale to the intended transferee and to the Charitable Beneficiary as
follows. The intended transferee shall receive the lesser of (1) the price
paid by the intended transferee for the shares or, if the intended transferee
did not give value for the shares in connection with the event causing the
shares to be held in the Trust (e.g., in the case of a gift, devise or other
such transaction), the Market Price (as defined below) of the shares on the
day of the event causing the shares to be held in the Trust and (2) the price
per share received by the Trustee from the sale or other disposition of the
shares held in the Trust. Any net sales proceeds in excess of the amount
payable to the intended transferee shall be immediately paid to the Charitable
Beneficiary. In addition, shares of Capital Stock transferred to the Trustee
shall be deemed to have been offered for sale to the Company, or its designee,
at a price per share equal to the lesser of (i) the price per share in the
transaction that resulted in such transfer to the Trust (or, in the case of a
devise or gift, the Market Price at the time of such devise or gift) and (ii)
the Market Price on the date the Company, or its designee, accepts such offer.
The Company shall have the right to accept such offer until the Trustee has
sold shares held in the Trust. Upon such a sale to the Company, the interest
of the Charitable Beneficiary in the shares sold shall terminate and the
Trustee shall distribute the net proceeds of the sale to the intended
transferee.

The term "Market Price" on any date shall mean, with respect to any class or
series of outstanding shares of the Company's stock, the Closing Price (as
defined below) for such shares on such date. The "Closing Price" on any date
shall mean the last sale price for such shares, regular way, or, in case no
such sale takes place on such day, the average of the closing bid and asked
prices, regular way, for such shares, in either case as reported in the
principal consolidated transaction reporting system with respect to securities
listed or admitted to trading on the NYSE or, if such shares are not listed or
admitted to trading on the NYSE, as reported on the principal consolidated
transaction reporting system with respect to securities listed on the
principal national securities exchange on which such shares are listed or
admitted to trading or, if such shares are not listed or admitted to trading
on any national securities exchange, the last quoted price, or, if not so
quoted, the average of the high bid and low asked prices in the over-the-
counter market, as reported by the National Association of Securities Dealers,
Inc. Automated Quotation System of, if such system is no longer in use, the
principal other automated quotation system that may then be in use or, if such
shares are not quoted by any such organization, the average of the closing bid
and asked prices as furnished by a professional market maker making a market
in such shares selected by the Board of Directors or, in the event that no
trading price is available for such shares, the fair market value of the
shares, as determined in good faith by the Board of Directors.

Every owner of more than five percent (or such lower percentage as required
by the Code or the regulations promulgated thereunder) of all classes or
series of the Company's stock, within 30 days after the end of each taxable
year, is required to give written notice to the Company stating the name and
address of such owner, the number of shares of each class and series of stock
of the Company beneficially owned and a description of the manner in which
such shares are held. Each such owner shall provide to the Company such
additional

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information as the Company may request in order to determine the effect, if
any, of such beneficial ownership on the Company's status as a REIT and to
ensure compliance with the ownership limitations.

Subject to certain limitations, the Board of Directors may increase or
decrease the ownership limitations. In addition, to the extent consistent with
the REIT provisions of the Code, the Board of Directors may waive the
ownership limitations for and at the request of certain purchasers in this
Offering or subsequent purchasers.

The provisions described above may inhibit market activity and the resulting
opportunity for the holders of the Company's Capital Stock and Warrants to
receive a premium for their shares or warrants that might otherwise exist in
the absence of such provisions. Such provisions also may make the Company an
unsuitable investment vehicle for any person seeking to obtain ownership of
more than 9.8 percent of the outstanding shares of Capital Stock.

INDEMNIFICATION

The Company's Charter obligates the Company to indemnify its directors and
officers and to pay or reimburse expenses for such individuals in advance of
the final disposition of a proceeding to the maximum extent permitted from
time to time by Maryland law. The Maryland General Corporation Law (the
"Maryland GCL") permits a corporation to indemnify its present and former
directors and officers, among others, against judgments, penalties, fines,
settlements and reasonable expenses actually incurred by them in connection
with any proceeding to which they may be made a party by reason of their
service in those or other capacities, unless it is established that (a) the
act or omission of the director or officer was material to the matter giving
rise to the proceeding and (i) was committed in bad faith, or (ii) was a
result of active and deliberate dishonesty, (b) the director or officer
actually received an improper personal benefit in money, property or services,
or (c) in the case of any criminal proceeding, the director or officer had
reasonable cause to believe that the act or omission was unlawful.

LIMITATION OF LIABILITY

The Maryland GCL permits the charter of a Maryland corporation to include a
provision limiting the liability of its directors and officers to the
corporation and its stockholder for money damages, except to the extent that
(i) it is proved that the person actually received an improper benefit or
profit in money, property or services, or (ii) a judgment or other final
adjudication adverse to the person is entered in a proceeding based on a
finding that the person's action, or failure to act, was the result of active
and deliberate dishonesty and was material to the cause of action adjudicated
in the proceeding. The Company's Charter contains a provision providing for
elimination of the liability of its directors and officers to the Company or
its stockholders for money damages to the maximum extent permitted by Maryland
law as amended or interpreted.

BUSINESS ACQUISITIONS STATUTES

Under the Maryland GCL, certain "business combinations" (including a merger,
consolidation, share exchange, or, in certain circumstances, an asset transfer
or issuance or reclassification of equity securities) between a Maryland
corporation and any person who beneficially owns ten percent or more of the
voting power of the corporations shares or an affiliate of the corporation
which, at any time within the two-year period prior to the date in question,
was the beneficial owner of 10 percent or more of the voting power of the
then-outstanding voting stock of the corporation (an "Interested Stockholder")
or an affiliate thereof are prohibited for five years after the most recent
date on which the Interested Stockholder became an Interested Stockholder.
Thereafter, any such business combination must be recommended by the board of
directors of such corporation and approved by the affirmative vote of at least
(a) 80 percent of the votes entitled to be cast by holders of outstanding
voting shares of the corporation and (b) two-thirds of the votes entitled to
be cast by holders of outstanding voting shares of the corporation other than
shares held by the Interested Stockholder with whom the business combination
is to be effected, unless, among other things, the corporation's stockholders
receive a minimum price (as defined in the Maryland GCL) for their shares and
the consideration is received in cash or in the same form as previously paid
by the Interested Stockholder for its shares. These provisions of Maryland law
do not apply, however, to business combinations that are approved or exempted
by the board of directors of the corporation prior to the time that the
Interested Stockholder becomes an Interested Stockholder. The Board of
Directors of the Company

84
<PAGE>

has adopted a resolution to the effect that the foregoing provisions of
Maryland law shall not apply to any future business combination with any
purchaser of Units in the Private Placement (or an affiliate thereof) or to
any other future business combination with the Company. No assurance can be
given that such provision will not be amended or eliminated at any point in
the future with respect to business combinations not involving a purchaser of
Units.

CONTROL SHARE ACQUISITIONS

The Maryland GCL provides that "control shares" of a Maryland corporation
acquired in a "control share acquisition" have no voting rights except to the
extent approved by a vote of two-thirds of the votes entitled to be cast on
the matter, excluding shares of stock owned by the acquiror or by officers or
directors who are employees of the corporation. "Control shares" are voting
shares of stock which, if aggregated with all other shares of stock owned by
such a person, would entitle the acquiror to exercise voting power in electing
directors within one of the following ranges of voting power: (i) one-fifth or
more but less than one third, (ii) one-third or more but less than a majority,
or (iii) a majority or more of all voting power. "Control shares" do not
include shares of stock the acquiring person is then entitled to vote as a
result of having owned stockholder approval. A "control share acquisition"
means, subject to certain exceptions, the acquisition of, ownership of, or the
power to direct the exercise of voting power with respect to, control shares.

A person who has made or proposes to make a "control share acquisition,"
upon satisfaction of certain conditions (including an undertaking to pay
expenses), may compel the Board of Directors to call a special meeting of
stockholders to be held within 50 days of demand to consider the voting rights
of the shares. If no request for a meeting is made, the corporation may itself
present the question at any stockholders' meeting. If voting rights are not
approved at the meeting or if the acquiring person does not deliver an
acquiring person statement as permitted by the statute, then, subject to
certain conditions and limitations, the corporation may redeem any or all of
the "control shares" (except those for which voting rights have previously
been approved) for fair value determined, without regard to absence of voting
rights, as of the date of the last control share acquisition or of any meeting
of stockholders at which the voting rights of such shares are considered and
not approved. If voting rights for "control shares" are approved at a
stockholders meeting and the acquiror becomes entitled to vote a majority of
the shares entitled to vote, all other stockholders may exercise appraisal
rights. The fair value of the stock, as determined for purposes of such
appraisal rights may not be less than the highest price per share paid in the
control share acquisition, and certain limitations and restrictions otherwise
applicable to the exercise of dissenters rights do not apply in the context of
"control share acquisitions."

The "control share acquisition" statute does not apply to stock acquired in
a merger, consolidation or share exchange if the corporation is a party to the
transaction, or to acquisitions approved or exempted by a provision of the
articles of incorporation or bylaws of the corporation adopted prior to the
acquisition of the shares. The Company has adopted a provision in its Bylaws
that exempts the Company's shares of Capital Stock from application of the
control share acquisition statute. No assurance can be given, however, that
such Bylaw provision may not be removed at any time by amendment of the
Bylaws.

TRANSFER AGENT AND REGISTRAR

The Company expects to appoint an outside transfer agent and registrar with
respect to the Common Stock and the Warrants.

DESCRIPTION OF WARRANTS

The Warrants were issued pursuant to a warrant agreement (the "Warrant
Agreement") dated as of December 9, 1996 between the Company and the warrant
agent (the "Warrant Agent"). The Company is initially acting as Warrant Agent.
The following summary of certain provisions of the Warrant Agreement does not
purport to be complete and is qualified in its entirety by reference to the
Warrant Agreement including the definitions therein of certain terms used
below. A copy of the Warrant Agreement is filed with the Commission along with
the Registration Statement of which this Prospectus is a part.

85
<PAGE>

The Warrants were originally issued as part of the Units, each Unit
consisting of one share of Preferred Stock and one Warrant. The Warrants were
represented by the Preferred Stock, which have an endorsement representing
beneficial ownership of the related Warrants on deposit with the Warrant Agent
as custodian for the registered holders of the Warrant. Prior to conversion,
transfer of a share of Preferred Stock to which the related Warrant has not
been exercised constituted transfer of a holder's beneficial interest in the
related Warrant. Upon closing of this Offering, each share of Preferred Stock
will automatically convert into one share of Common Stock and the registered
holder of the Preferred Stock will receive a stock certificate representing
the Common Stock, a certificate from the Warrant Agent evidencing a separately
transferable Warrant (the "Warrant Certificate"). Certain Warrants issued to
the placement agent are evidenced by Warrant Certificates issued at that time.
The Warrants and the Warrant Shares have not been registered under the
Securities Act and are subject to certain transfer restrictions. Holders of
the Warrants have certain registration rights with respect to the Common Stock
issued upon conversion of the Warrant Shares. The Warrants are exercisable
beginning on the earlier of the date of effectiveness of a Shelf Registration
Statement (see "Description of Capital Stock--Registration Rights") or six
months following the closing of the Offering and will remain exercisable until
the third anniversary of the exercise date at an exercise price of $15.00 per
share of Common Stock and will be subject to anti-dilution protection.

Each Warrant, when exercised, will entitle the holder thereof to receive one
share of Common Stock at an exercise price of $15.00 per share (the "Exercise
Price.") The exercise price per Warrant was established at the time of the
Company's initial Private Placement of Units, prior to its commencement of
operations, and was fixed by management at the per Unit offering price.

The Warrants may be exercised by surrendering to the Warrant Agent the
definitive Warrant Certificates evidencing such Warrants, with the
accompanying form of election to purchase properly completed and executed,
together with payment of the Exercise Price. Payment of the Exercise Price may
be made (a) in the form of cash or by certified or official bank check payable
to the order of the Company or (b) by surrendering additional Warrants or
shares of Common Stock for cancellation to the extent the Company may lawfully
accept shares of Common Stock, with the value of such shares of Common Stock
for such purpose to equal the average trading price of the Common Stock during
the ten trading days preceding the date surrendered and the value of the
Warrants to equal the difference between the value of a share of Common Stock
and the Exercise Price. Upon surrender of the Warrant Certificate and payment
of the Exercise Price and any other applicable amounts, the Warrant Agent will
deliver or cause to be delivered, to or upon the written order of such holder,
stock certificates representing the number of whole shares of Common Stock or
other securities or property to which such holder is entitled. If less than
all of the Warrants evidenced by a Warrant Certificate are to be exercised, a
new Warrant Certificate will be issued for the remaining number of Warrants.

No fractional shares of Common Stock will be issued upon exercise of the
Warrants. The holders of the Warrants have no right to vote on matters
submitted to the stockholders of the Company and have no right to receive
dividends. The holders of the Warrants not yet exercised are not entitled to
share in the assets of the Company in the event of liquidation, dissolution or
the winding up of the affairs of the Company.

The Exercise Price of the Warrants will be appropriately adjusted if the
Company (i) pays a dividend or makes a distribution on its Common Stock in
shares of its Common Stock, (ii) subdivides its outstanding shares of Common
Stock into a greater number of shares, (iii) combines its outstanding shares
of Common Stock into a smaller number of shares, (iv) issues by
reclassification of its Common Stock any shares of its capital stock, or (v)
issues shares of Capital Stock at a price below the greater of (a) $15 or (b)
fair market value, provided that this clause (v) shall not apply to this
Offering.

In case of certain consolidations or mergers of the Company, or the
liquidation of the Company or the sale of all or substantially all of the
assets of the Company to another corporation, each Warrant will thereafter be
deemed exercised for the right to receive the kind and amount of shares of
stock or other securities or property to which such holder would have been
entitled as a result of such consolidation, merger or sale had the Warrants
been exercised immediately prior thereto (for shares of Preferred Stock if
prior to the conversion of the Preferred Stock and shares of Common Stock if
after the conversion), less the Exercise Price.

86
<PAGE>

UNDERWRITING

The underwriters named below (the "Underwriters"), represented by Stifel,
Nicolaus & Company, Incorporated and Montgomery Securities (the
"Representatives"), have severally agreed to purchase, and the Company has
agreed to sell, subject to the terms and conditions set forth in an
underwriting agreement (the "Underwriting Agreement"), the respective number
of shares of Common Stock set forth opposite their names below. The
Underwriting Agreement provides that the obligations of the Underwriters are
subject to certain conditions precedent and that the Underwriters will be
obligated to purchase all of the shares if any are purchased.

<TABLE>
<CAPTION>
NUMBER OF SHARES
UNDERWRITER TO BE PURCHASED
----------- ----------------
<S> <C>
Stifel, Nicolaus & Company, Incorporated....................
Montgomery Securities.......................................
---------
Total............................................... 3,000,000
=========
</TABLE>

The Underwriters, through the Representatives, have advised the Company that
they propose to offer the shares to the public at the Price to Public set
forth on the cover page of this Prospectus. The Underwriters may allow to
selected dealers a concession of not more than $ per share, and the
Underwriters may allow, and such dealers may reallow, a concession of not more
than $ per share to certain other dealers. After the initial public
offering, the public offering price, concession and reallowance may be changed
by the representatives. The Common Stock is offered subject to receipt and
acceptance by the Underwriters, and to certain other conditions, including the
right to reject orders in whole or in part.

The Company has granted the Underwriters an option exercisable for 30 days
after the date hereof to purchase up to 450,000 additional shares to cover
over-allotments, if any, at the initial public offering price less the
underwriting discount. If the Underwriters exercise this option, each of the
Underwriters will have a firm commitment, subject to certain conditions, to
purchase approximately the same percentage of such additional shares as the
number of shares to be purchased by it shown in the foregoing table bears to
the shares initially offered hereby. The Underwriters may purchase such shares
only to cover over-allotments in connection with this Offering.

Prior to this Offering, there has been no public market for the Common
Stock. Consequently, the public offering price will be determined by
negotiation between the Company and the Representatives and may not bear any
relation to the book value or assets of the Company or any other recognized
criteria of value. Among the factors considered in such negotiations were the
nature of the Company's business, its prospects and management, and the
general conditions of the securities markets at the time of the offering.
There can be no assurance, however, that the prices at which the shares will
sell to the public market after the public offering will not be lower than the
price at which they are sold by the Underwriters.

The Company has agreed to indemnify the several Underwriters against certain
civil liabilities, including liabilities under the Securities Act of 1933, as
amended or to contribute to payments which the Underwriters may be required to
make in respect thereof. The Company has been advised that in the opinion of
the Securities and Exchange Commission such indemnification is against public
policy as expressed in the Securities Act and therefore unenforceable.

The Representatives have informed the Company that they do not expect to
make sales to accounts over which they exercise discretionary authority in
excess of five percent of the number of shares of Common Stock offered hereby.

The Company and the officers and directors of the Company have agreed that,
for a period of 180 days from the date of this Prospectus, they will not,
without the prior written consent of Stifel, Nicolaus & Company, Incorporated,
directly or indirectly, sell, offer to sell, grant any option for the sale of,
or otherwise dispose of

87
<PAGE>

any shares of Common Stock or any security convertible into Common Stock,
except for options granted pursuant to the Company's stock option plan.

Stifel, Nicolaus & Company, Inc. has in the past performed, and may continue
to perform, investment banking and financial advisory services for the Company
and has received customary compensation therefor.

Out of the 3,000,000 shares to be sold by the Company pursuant to this
Offering (not including the Underwriters' over-allotment option), the
Underwriters have accepted the Company's request to sell up to 5 percent of
such shares at the price to public set forth on the cover page of this
Prospectus to employees and other persons designated by the Company.

Current Stifel, Nicolaus & Company, Incorporated personnel purchased 83,450
Units in the Company's Private Placement of Units and, accordingly, hold that
number of shares of Preferred Stock (approximately two percent of the
Preferred Stock outstanding) and of Warrants. In addition, Stifel, Nicolaus &
Company Incorporated received Warrants to purchase 100,000 shares of Common
Stock at a price of $15.00 per share in connection with the Private Placement.

The Common Stock has been approved for quotation on the Nasdaq Stock
Market's National Market under the symbol "NOVA."

The Company has been advised by the Representatives that each of the
Representatives presently intends to make a market in the Common Stock offered
hereby; however, the Representatives are not obligated to do so, and any
market making activity may be discontinued at any time. Until the
Representatives' participations in the distribution of the Common Stock is
complete, any such passive market making activities will be conducted in
accordance with Rule 103 of Regulation M under the Securities Exchange Act of
1934. There can be no assurance that an active public market for the Common
Stock will develop and continue after this Offering.

Until the distribution of the Common Stock is completed, rules of the
Securities and Exchange Commission may limit the ability of the Underwriters
and certain selling group members to bid for and purchase the Units, Warrants
and Common Stock. As an exception to these rules, the Representatives are
permitted to engage in certain transactions that stabilize the price of the
Common Stock. Such transactions consist of bids or purchases for the purpose
of pegging, fixing or maintaining the price of such securities. If the
Representatives over-allot, i.e., if they sell more shares of Common Stock
than is set forth on the cover page of this Prospectus and thereby create a
short position in the Common Stock in connection with this Offering, then the
Representatives may reduce that short position by purchasing Common Stock in
the open market. The Representatives may also elect to reduce any short
position by exercising all or part of the over-allotment option described
herein. The Representatives may also impose a penalty bid on certain
Underwriters and selling group members. This means that if the Representatives
purchase shares of Common Stock in the open market to reduce the Underwriters
short position or to stabilize the price of the Common Stock, they may reclaim
the amount of the selling concession from the Underwriters and selling group
members who sold those securities as part of the Offering. In general,
purchases of securities for the purpose of stabilization or to reduce a short
position could cause the price of the security to be higher than it might be
in the absence of such purchases. The imposition of a penalty bid might also
have an effect on the price of a security to the extent that it were to
discourage resales of the security. These transactions may be effected on the
Nasdaq National Market or otherwise. Neither the Company nor any of the
Underwriters makes any representation or prediction as to the direction or
magnitude of any effect that the transactions described above may have on the
price of the Common Stock. In addition, neither the Company nor any of the
Underwriters makes any representation that the Representatives will engage in
such transactions or that such transactions, once commenced, will not be
discontinued without notice.

88
<PAGE>

LEGAL MATTERS

The validity of the Common Stock offered hereby will be passed on for the
Company by Tobin & Tobin, a professional corporation, San Francisco,
California. Certain tax matters will be passed on by Jeffers, Wilson, Shaff &
Falk, LLP, Irvine, California. Certain legal matters will be passed upon for
the Underwriters by O'Melveny & Myers LLP, San Francisco, California. Attorneys
at such firm own 5,333 shares of Preferred Stock and Warrants in the Company.
Tobin & Tobin, a professional corporation, Jeffers, Wilson, Shaff & Falk, LLP
and O'Melveny & Myers LLP will rely as to all matters of Maryland law upon the
opinion of special Maryland counsel to the Company, Piper & Marbury L.L.P.,
Baltimore, Maryland.

EXPERTS

The consolidated financial statements of NovaStar Financial, Inc. and
subsidiary as of June 30, 1997 and December 31, 1996 and for the six-months
ended June 30, 1997 and for the period from September 13, 1996 (inception) to
December 31, 1996, have been included herein and in the registration statement
in reliance upon the report of KPMG Peat Marwick LLP, independent auditors,
appearing elsewhere herein, and upon the authority of said firm as experts in
accounting and auditing.

AVAILABLE INFORMATION

The Company has filed with the Securities and Exchange Commission (the
"Commission"), in Washington, D.C., a Registration Statement on Form S-11 under
the Securities Act with respect to the Common Stock offered hereby. This
Prospectus does not contain all of the information set forth in the
Registration Statement and the exhibits thereto. Certain items are omitted in
accordance with the rules and regulations of the Commission. For further
information with respect to the Company and the Common Stock offered hereby,
reference is made to the Registration Statement and the exhibits filed as a
part thereof. Statements contained in this Prospectus as to the contents of any
contract or any other document referred to are not necessarily complete and, in
each instance, if such contract or document is filed as an exhibit, reference
is made to the copy of such contract or document filed as an exhibit to the
Registration Statement, each such statement being qualified in all respects by
such reference to such exhibit. Upon completion of the Offering the Company
will subject to the informational requirements of the Securities and Exchange
Act of 1934, as amended (the "Exchange Act"), and in accordance therewith will
file reports and other information with the Commission. Reports, proxy
statements and other information filed by the Company may be inspected and
copied at the public reference facilities maintained by the Commission at 450
Fifth Street, N.W., Washington, D.C. 20549, and at the Commission's regional
offices located at Seven World Trade Center, 13th Floor, New York, New York
10048, and at 500 West Madison Street, Chicago, Illinois 60661. Copies of such
materials can also be obtained at prescribed rates from the Public Reference
Section of the Commission at 450 Fifth Street, N.W., Washington, D.C. 20549.
Electronic filings made through the Electronic Data Gathering Analysis and
Retrieval System are publicly available through the Commission's Web Site
(http://www.sec.gov). The Common Stock of the Company is expected to be
approved for quotation on the Nasdaq National Market. Holders of the Common
Stock will receive annual reports containing audited financial statements with
a report thereon by the Company's independent certified public accountants, and
quarterly reports containing unaudited financial information for each of the
first three quarters of each fiscal year.

89
<PAGE>

GLOSSARY

As used in this Prospectus, the capitalized and other terms listed below
have the meanings indicated.

"Agency" means FNMA, FHLMC or GNMA.

"Agency Certificates" means Pass-Through Certificates guaranteed by FNMA,
FHLMC or GNMA.

"ARM" or "Adjustable Rate Mortgage" means a mortgage loan (including any
mortgage loan underlying a Mortgage Security) that features adjustments of the
underlying interest rate at predetermined times based on an agreed margin to
an established index. An ARM is usually subject to periodic interest rate
and/or payment caps and a lifetime interest rate cap.

"Capital Stock" means the shares of capital stock issuable by the Company
under its Charter, and includes Common Stock and Preferred Stock.

"CMO" or "Collateralized Mortgage Obligations" means adjustable or short-
term fixed-rate debt obligations (bonds) that are collateralized by mortgage
loans or Pass-Through Certificates and issued by private institutions or
issued or guaranteed by GNMA, FNMA or FHLMC.

"Code" means the Internal Revenue Code of 1986, as amended.

"Company" means NovaStar Financial, Inc., a Maryland corporation, and
includes any subsidiaries thereof except when the context otherwise requires.

"conforming mortgage loans" means mortgage loans that either comply with
requirements for inclusion in credit support programs sponsored by FHLMC or
FNMA or are FHA or VA Loans, all of which are secured by first mortgages or
deeds of trust on single family (one to four units) residences.

"ERISA" means the Employee Retirement Income Security Act of 1974.

"Exchange Act" means the Securities Exchange Act of 1934, as amended.

"FHA" means the United States Federal Housing Administration.

"FHLMC" means the Federal Home Loan Mortgage Corporation.

"founders" means Scott F. Hartman and W. Lance Anderson.

"FNMA" means the Federal National Mortgage Association.

"GAAP" means generally accepted accounting principles.

"GNMA" means the Government National Mortgage Association.

"Independent Directors" means a director of the Company who is not an
officer or employee of the Company or any affiliate (excluding GE Capital and
its affiliates) or subsidiary of the Company.

"ISOs" means qualified incentive stock options granted under the Stock
Option Plan which meet the requirements of Section 422 of the Code.

"LTV" means loan-to-value ratio which is the percentage obtained by dividing
the principal amount of a loan by the lower of the sales price or appraised
value of the mortgaged property when the loan is originated.

"Mortgage Assets" means (i) mortgage loans, and (ii) Mortgage Securities,
and (iii) other Qualified REIT Assets.

"Mortgage Securities" means (i) Pass-Through Certificates and (ii) CMOs.

"Net interest spread" means the difference between the annual yield earned
on interest-earning assets and the rate paid on borrowings.

90
<PAGE>

"Pass-Through Certificates" means securities (or interests therein) which
are Qualified REIT Assets evidencing undivided ownership interests in a pool
of mortgage loans, the holders of which receive a "pass-through" of the
principal and interest paid in connection with the underlying mortgage loans
in accordance with the holders' respective undivided interests in the pool.

"Private Placement" means the Company's private placement of Units which
closed December 9, 1996. Each Unit consists of one share of Convertible
Preferred Stock and one Warrant to purchase one share of Common Stock.

"Qualified Hedge" means (i) for the years 1996 and 1997 a hedging contract
that has each of the following attributes: (a) the hedging contract must be a
swap or cap agreement, as contemplated by Section 1.446-3 of the Treasury
Regulations; (b) the swap or cap agreement must be a bona fide interest rate
swap or cap agreement entered into by the Company to hedge any variable rate
indebtedness of the Company incurred or to be incurred to acquire or carry
real estate assets; (c) the Company will not treat as a Qualified Hedge any
hedging instrument acquired to hedge an asset of the Company; and (d) the
Company will only treat as a Qualified Hedge a hedging instrument acquired to
hedge a variable rate indebtedness secured by a variable rate asset that
itself is subject to periodic or lifetime interest rate caps, or a variable
rate indebtedness that is subject to a different interest rate index from that
of the Company's asset securing such variable rate indebtedness; (ii) for 1998
and thereafter, a Qualified Hedge is any interest rate swap or cap agreement,
option, futures contract, forward rate agreement, or any similar financial
instrument, entered into by the Company in a transaction to reduce the
Company's interest rate risk with respect to indebtedness (including the
Company's reverse repurchase obligations) incurred or to be incurred by the
Company to acquire and carry Mortgage Assets or other real estate assets.

"Qualified REIT Assets" means Pass-Through Certificates, mortgage loans,
Agency Certificates and other assets of the type described in Code Section
856(c)(6)(B).

"Real Estate Asset" means interests in real property, interests in mortgages
on real property, and regular or residual interests in REMICs.

"REIT" means Real Estate Investment Trust as defined under Section 856 of
the Code.

"REMIC" means Real Estate Mortgage Investment Conduit as defined under
Section 860D of the Code.

"Reverse Repurchase Agreement" means a secured borrowing device evidenced by
an agreement to sell securities or other assets to a third party and a
simultaneous agreement to repurchase them at a specified future date and
price, the price difference constituting the interest on the borrowing.

"Securities Act" means the Securities Act of 1933, as amended.

"single family" means, with respect to mortgage loans, loans secured by one-
to four-unit residential property.

"Special Tax Counsel" means the law firm of Jeffers, Wilson, Shaff & Falk,
LLP.

"Tax-Exempt Entity" means a qualified pension, profit-sharing or other
employee retirement benefit plan, Keogh Plans, bank commingled trust funds for
such plans, IRAs and other similar entities intended to be exempt from Federal
income taxation.

"taxable income" means for any year the taxable income of the Company for
such year (excluding any net income derived either from property held
primarily for sale to customers or from foreclosure property) subject to
certain adjustments provided in Section 857 of the Code.

"UBTI" means "unrelated trade or business income" as defined in Section 512
of the Code.

"Underwriters" shall have the meaning under the heading "Underwriting."

"VA" means the United States Department of Veterans Affairs.

91
<PAGE>

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Independent Auditors' Report............................................... F-2
Consolidated Financial Statements:
Balance Sheets........................................................... F-3
Statements of Operations................................................. F-4
Statements of Stockholders' Equity....................................... F-5
Statements of Cash Flows................................................. F-6
Notes to Consolidated Financial Statements................................. F-7
</TABLE>

F-1
<PAGE>

INDEPENDENT AUDITORS' REPORT

The Board of Directors
NovaStar Financial, Inc.:

We have audited the accompanying consolidated balance sheets of NovaStar
Financial, Inc. and subsidiary as of June 30, 1997 and December 31, 1996 and
the related consolidated statements of operations, stockholders' equity and
cash flows for the six months ended June 30, 1997 and the period from
September 13, 1996 (inception) to December 31, 1996. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of NovaStar Financial, Inc. and subsidiary as of June 30, 1997 and December
31, 1996 and the consolidated results of their operations and their cash flows
for the six months ended June 30, 1997 and the period from September 13, 1996
(inception) to December 31, 1996, in conformity with generally accepted
accounting principles.

KPMG Peat Marwick LLP

Kansas City, Missouri
July 25, 1997

F-2
<PAGE>

NOVASTAR FINANCIAL, INC.

CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)

<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1997 1996
<S> <C> <C>
ASSETS
Cash and cash equivalents............................. $ 874 $46,434
Mortgage securities available-for-sale................ 284,348 13,239
Mortgage loans........................................ 303,732 --
Accrued interest receivable........................... 6,244 14
Other assets.......................................... 6,543 109
-------- -------
Total assets...................................... $601,741 $59,796
======== =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Borrowings:
Repurchase agreements.............................. $540,040 $ --
Warehouse line of credit........................... 13,600 --
-------- -------
Total borrowings.................................. 553,640 --
Amounts due to brokers and dealers for unsettled
mortgage securities purchases...................... -- 13,255
Accounts payable and accrued expenses............... 1,764 176
-------- -------
Total liabilities................................. 555,404 13,431
Commitments and contingencies
Stockholders' equity:
Capital stock, $0.01 par value, 50,000,000 shares
authorized:
Convertible preferred stock, 3,549,999 issued and
outstanding....................................... 36 36
Common stock, 216,666 shares issued and
outstanding....................................... 2 2
Additional paid-in capital.......................... 49,862 49,910
Accumulated deficit................................. (1,535) (302)
Net unrealized gain (loss) on available-for-sale
securities......................................... 1,367 (16)
Forgivable notes receivable from founders........... (3,395) (3,265)
-------- -------
Total stockholders' equity........................ 46,337 46,365
-------- -------
Total liabilities and stockholders' equity........ $601,741 $59,796
======== =======
</TABLE>

See notes to consolidated financial statements.

F-3
<PAGE>

NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
FOR THE PERIOD FROM
FOR THE SIX SEPTEMBER 13, 1996
MONTHS ENDED (INCEPTION) TO
JUNE 30, 1997 DECEMBER 31, 1996
<S> <C> <C>
Interest income:
Mortgage securities....................... $2,241 $ 155
Mortgage loans............................ 7,079 --
------ ------
Total interest income....................... 9,320 155
Interest expense............................ 6,438 --
------ ------
Net interest income......................... 2,882 155
Provision for credit losses................. 718 --
------ ------
Net interest income after provision for
credit losses.............................. 2,164 155
Other income................................ 213 --
General and administrative expenses:
Compensation and benefits................. 1,234 199
Professional and outside services......... 596 --
Loan servicing............................ 571 200
Office administration..................... 334 --
Travel and public relations............... 248 --
Occupancy................................. 162 27
Other..................................... 111 31
------ ------
Total general and administrative
expenses................................. 3,256 457
------ ------
Net loss.................................... $ (879) $ (302)
====== ======
Pro forma net loss per share................ $(0.21) $(0.07)
====== ======
Weighted average number of shares
outstanding................................ 4,273 4,273
====== ======
</TABLE>

See notes to consolidated financial statements.

F-4
<PAGE>

NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)

<TABLE>
<CAPTION>
FORGIVABLE
NET UNREALIZED NOTES
CONVERTIBLE ADDITIONAL GAIN (LOSS) ON RECEIVABLE TOTAL
PREFERRED COMMON PAID-IN ACCUMULATED AVAILABLE-FOR-SALE FROM STOCKHOLDERS'
STOCK STOCK CAPITAL DEFICIT SECURITIES FOUNDERS EQUITY
<S> <C> <C> <C> <C> <C> <C> <C>
Balance, September 13,
1996................... $ -- $ -- $ -- $ -- $ -- $ -- $ --
Issuance of 216,666
shares of common stock
for cash............... -- 2 -- -- -- -- 2
Net proceeds from
private placement of
3,333,333 units........ 34 -- 46,662 -- -- -- 46,696
Units (216,666) acquired
with forgivable debt... 2 -- 3,248 -- -- (3,250) --
Net loss................ -- -- -- (302) -- -- (302)
Net change in unrealized
gain (loss) on
available-for-sale
securities............. -- -- -- -- (16) -- (16)
Interest on forgivable
notes receivable from
founders............... -- -- -- -- -- (15) (15)
----- ----- ------- ------- ------ ------- -------
Balance, December 31,
1996................... 36 2 49,910 (302) (16) (3,265) 46,365
Private placement
issuance costs......... -- -- (48) -- -- -- (48)
Net loss................ -- -- -- (879) -- -- (879)
Net change in unrealized
gain (loss) on
available-for-sale
securities............. -- -- -- -- 1,383 -- 1,383
Dividends on convertible
preferred stock ($0.10
per share)............. -- -- -- (354) -- -- (354)
Interest on forgivable
notes receivable from
founders............... -- -- -- -- -- (130) (130)
----- ----- ------- ------- ------ ------- -------
Balance, June 30, 1997.. $ 36 $ 2 $49,862 $(1,535) $1,367 $(3,395) $46,337
===== ===== ======= ======= ====== ======= =======
</TABLE>

See notes to consolidated financial statements.

F-5
<PAGE>

NOVASTAR FINANCIAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

<TABLE>
<CAPTION>
FOR THE PERIOD FROM
FOR THE SIX SEPTEMBER 13, 1996
MONTHS ENDED (INCEPTION) TO
JUNE 30, 1997 DECEMBER 31, 1996
<S> <C> <C>
CASH FLOW FROM OPERATING ACTIVITIES:
Net loss..................................... $ (879) $ (302)
Adjustments to reconcile net loss to cash
used in operating activities:
Amortization of premiums................... 700 --
Interest on forgivable notes receivable
from founders............................. (130) (15)
Provision for credit losses................ 718 --
Gains on sales of mortgage securities...... (42) --
Change in:
Accrued interest receivable.............. (6,230) (14)
Other assets............................. (826) (109)
Other liabilities........................ 832 176
--------- -------
Net cash used in operating activities.. (5,857) (264)
CASH FLOW FROM INVESTING ACTIVITIES:
Purchases of available-for-sale securities.. (378,526) --
Settlement of amounts due to brokers........ (12,676) --
Proceeds from sales of available-for-sale
securities................................. 99,794 --
Proceeds from paydowns on and maturities of
available-for-sale securities.............. 3,211 --
Mortgage loans acquired..................... (219,995) --
Mortgage loans originated................... (92,781) --
Mortgage loan repayments.................... 7,855 --
--------- -------
Net cash used in investing activities.. (593,118) --
CASH FLOW FROM FINANCING ACTIVITIES:
Proceeds from private placement............. -- 50,000
Private placement offering costs............ (48) (3,304)
Proceeds from issuance of common stock...... -- 2
Net borrowings under repurchase agreements.. 540,040 --
Net advances under warehouse line of
credit..................................... 13,600 --
Dividends paid on convertible preferred
stock...................................... (177) --
--------- -------
Net cash provided by financing
activities............................ 553,415 46,698
--------- -------
Net increase (decrease) in cash and cash
equivalents................................. (45,560) 46,434
Cash and cash equivalents, beginning of
period...................................... 46,434 --
--------- -------
Cash and cash equivalents, end of period..... $ 874 $46,434
========= =======
SUPPLEMENTAL DISCLOSURE OF CASH FLOW
INFORMATION:
Cash paid for interest...................... $ 5,631 $ --
========= =======
Issuance of units acquired with forgivable
debt....................................... $ -- $ 3,250
========= =======
Dividends payable........................... $ 177 $ --
========= =======
</TABLE>

See notes to consolidated financial statements.

F-6
<PAGE>

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 1997

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Business

NovaStar Financial, Inc. (NovaStar, or, collectively with its consolidated
affiliates, the Company) is a Maryland corporation formed on September 13,
1996. The Company completed a private placement offering of units, consisting
of convertible preferred stock and warrants in December 1996 (see Note 7). The
Company originates and acquires subprime mortgage loans, acquires mortgage
securities and manages the resulting portfolio of mortgage assets.

Financial Statement Presentation

The Company's consolidated financial statements include the accounts of
NovaStar, NFI Holding Corporation (Holding) and NovaStar Mortgage, Inc. (NMI).
NovaStar owns 100 percent of the nonvoting preferred stock of Holding, for
which it receives 99 percent of the dividends paid by Holding. The common
stock of Holding is owned by the founders of NovaStar. Holding owns 100
percent of the outstanding stock of NMI. NMI serves as the Company's principal
source of subprime mortgage loans. NovaStar manages the assets and liabilities
of the Company.

The Company's consolidated financial statements have been prepared in
conformity with generally accepted accounting principles 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.
Actual results could differ from those estimates.

Cash and Cash Equivalents

The Company considers investments with maturities of three months or less at
the date of purchase to be cash equivalents. As of December 31, 1996, cash
equivalents include $35 million in commercial paper.

Mortgage Securities

Although the Company generally intends to hold its mortgage securities to
maturity, it may on occasion deem it necessary to sell securities.
Accordingly, the Company classifies all of its mortgage securities as
available-for-sale and, therefore, reports them at their estimated fair value
with unrealized gains and losses reported as a separate component of
stockholders' equity. Premiums are amortized as a yield adjustment over the
estimated lives of the securities using the interest method. Gains or losses
on sales of securities are recognized using the specific identification
method.

Mortgage Loans

Mortgage loans include loans originated through the Company's wholesale
production operation and those acquired in bulk pools from other originators
and securities dealers. Loans are generally purchased at a premium over the
outstanding principal balance. Mortgage loans are stated at amortized cost.
For originated loans, cost includes deferred fees received and direct costs
incurred, which, along with premiums paid, are amortized as a yield adjustment
over the estimated lives of the loans using the interest method.

Interest is recognized as revenue when earned according to the terms of the
mortgage loans and when, in the opinion of management, it is collectible.
Accrual of interest on non-performing loans is suspended when, in

F-7
<PAGE>

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

the opinion of management, the collection of interest or the related principal
is less than probable. Any interest received on non-accrual loans is credited
to principal.

Credit Risk

NovaStar maintains an allowance for credit losses at a level it deems
appropriate for both known losses and unidentified potential losses in its
mortgage loan portfolio. The allowance for credit losses is based upon the
assessment by management of various factors affecting its mortgage loan
portfolio, including current and projected economic conditions, the makeup of
the portfolio based on credit grade, delinquency status and other factors
deemed to warrant consideration. The allowance is maintained through ongoing
provisions charged to operating income, reduced by net charge-offs.

Interest Rate Agreements

The Company has entered into interest rate swap and cap agreements designed
to, in effect, alter the interest rates on its funding costs to more closely
match the yield on interest-earning assets. Net income earned from or expense
incurred on these agreements is accounted for on the accrual method and is
recorded as an adjustment to interest expense.

The gain or loss on early termination, sale or disposition of an interest
rate swap or cap agreement is recognized in current earnings when the matched
funding source is also extinguished. When the matched funding source is not
extinguished, the unrealized gain or loss on the related interest rate swap or
cap agreement is deferred and amortized as a component of interest expense over
the remaining term of the matched funding source. Subsequently, the unmatched
swap or cap agreement is recorded at fair value with changes in the unrealized
gains or losses recorded in current earnings.

Pro Forma Net Loss Per Share

Pro forma net loss per share is based on the weighted average shares of
common stock and convertible preferred stock outstanding, including all
warrants and options outstanding using the treasury stock method. For this
purpose, all warrants and options have been considered to be outstanding for
all periods presented, and the estimated initial offering price (see Note 11)
has been used in applying the treasury stock method.

Income Taxes

NovaStar intends to operate and qualify as a real estate investment trust
(REIT) under the requirements of the Internal Revenue Code. Requirements for
qualification as a REIT include various restrictions on ownership of the stock
of NovaStar and certain restrictions on the nature of assets and sources of
income. In addition, a REIT must distribute at least 95 percent of its annual
taxable income to its stockholders. If in any tax year NovaStar does not
qualify as a REIT, it will be taxed as a corporation and distributions to
stockholders will not be deductible in computing taxable income. If the Company
fails to qualify as a REIT in any tax year, it will not be permitted to qualify
for the succeeding four years. For tax purposes, the REITs deduction for credit
losses is limited to actual net charge-offs.

Holding and NMI are not operated as REITs, will file Federal and state income
tax returns separately from NovaStar and will record income taxes using the
asset and liability method.

F-8
<PAGE>

New Accounting Pronouncements

SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities," as amended by SFAS No. 127, is effective
for all transfers and servicing of financial assets and extinguishments of
liabilities occurring after December 31, 1996, except for secured borrowings
and collateral, repurchase agreements, dollar rolls, securities lending and
similar transactions, which transfers will be effective for transactions
occurring after December 31, 1997. This statement provides accounting and
reporting standards for transfers and servicing of financial assets and
extinguishments of liabilities based on consistent application of financial-
components approach that focuses on control. It distinguishes transfers of
financial assets that are sales from transfers that are secured borrowings.
Under the financial-components approach, after a transfer occurs, an entity
recognizes all financial and servicing assets it controls and liabilities it
has incurred and derecognizes financial assets it no longer controls and
liabilities that have been extinguished. Many of these assets and liabilities
are components of financial assets that existed prior to the transfer. If a
transfer does not meet the criteria for a sale, the transfer is accounted for
as a secured borrowing with a pledge of collateral. Management believes
adoption of SFAS No. 125, as amended by SFAS No. 127, did and will not have a
material effect on the financial position or results of operations, nor did or
will adoption require any significant additional capital resources.

SFAS No. 128, "Earnings Per Share" is effective for the fiscal year ending
December 31, 1997, with earlier adoption prohibited. SFAS No. 128 supersedes
APB Opinion No. 15 (APB No. 15) and specifies the computation, presentation,
and disclosure requirements for earnings per share (EPS) for entities with
publicly held common stock or potential common stock. SFAS No. 128 was issued
to simplify the computation of EPS and to make the U.S. standard more
compatible with the EPS standards of other countries and the International
Accounting Standards Committee (IASC). It replaces the presentation of primary
EPS with a presentation of basic EPS and fully diluted EPS with diluted EPS.
Basic EPS, unlike primary EPS, excludes dilution and is computed by dividing
income available to common stockholders by the weighted-average number of
common shares outstanding for the period. Diluted EPS reflects the potential
dilution that could occur if securities or other contracts to issue common
stock were exercised or converted into common stock or resulted in the
issuance of common stock that then shared in the earnings of the entity.
Diluted EPS is computed similarly to fully diluted EPS under APB No. 15.
Retroactive application will be required.

NOTE 2. MORTGAGE SECURITIES

Mortgage securities, all classified as available-for-sale, consist of the
following as of June 30, 1997 (dollars in thousands):
<TABLE>
<CAPTION>
WEIGHTED UNREALIZED
AVERAGE AMORTIZED ------------- CARRYING
RATE COST GAINS LOSSES VALUE
<S> <C> <C> <C> <C> <C>
Mortgage securities issued by:
Federal National Mortgage
Association................... 8.02% $270,821 $1,355 $20 $272,156
Government National Mortgage
Association................... 7.88 8,334 29 -- 8,363
Federal Home Loan Mortgage
Corporation................... 8.44 3,826 8 5 3,829
-------- ------ --- --------
$282,981 $1,392 $25 $284,348
======== ====== === ========
</TABLE>

As of December 31, 1996, mortgage securities consisted of obligations of the
Federal National Mortgage Association with a weighted average rate of 7.77
percent. These securities had gross unrealized losses of $16,233.

The contractual maturities of mortgage securities were approximately 25.7
years as of June 30, 1997. The expected maturities of mortgage securities may
differ from contractual maturities since borrowers have the right to prepay
the obligations.

Proceeds from the sales of two mortgage securities during the six months
ended June 30, 1997 were $99.8 million. Gross gains of $42,112 were realized
on these sales.

F-9
<PAGE>

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

All mortgage securities are pledged as collateral under various borrowing
arrangements as described in Note 4.

NOTE 3. MORTGAGE LOANS

Mortgage loans, all of which are secured by residential properties, consist
of the following as of June 30, 1997 (in thousands):

<TABLE>
<S> <C>
Outstanding principal.............................................. $290,293
Unamortized premium................................................ 14,157
--------
Amortized cost..................................................... 304,450
Reserve for credit losses.......................................... (718)
--------
$303,732
========
</TABLE>

Mortgage loans serve as collateral for various borrowing arrangements as
discussed in Note 4.

Collateral for approximately 36 percent of mortgage loans outstanding as of
June 30, 1997 was located in California. The Company has no other significant
concentration of credit risk. The Company expects the portfolio to become more
diversified as a national sales force is fully developed. As of June 30, 1997,
the Company's mortgage loans consisted primarily of single family mortgage
residential loans, with interest rates ranging from 7.5 to 18.0 percent, none
of which individually exceeded one percent of the outstanding aggregate
balance of mortgage loans.

NOTE 4. BORROWINGS

NovaStar has financed its mortgage assets through various arrangements,
including a warehouse line of credit and repurchase agreements with brokerage
firms. Mortgage loan originations have been financed in the short-term through
a $50 million warehouse facility with First Union National Bank. In addition,
the Company has a $300 million repurchase agreement with Merrill Lynch
Mortgage Capital, Inc. and Merrill Lynch Credit Corporation as another source
of short-term financing. Borrowings under the warehouse facility generally
bear interest at a spread over the Federal Funds rate. The warehouse facility
matures in February 1998 and includes financial and non-financial covenants.
Borrowings under the master repurchase agreement bear interest at various
rates priced in connection with respective purchases of mortgage assets. The
master repurchase agreement matures in January 1998 and also includes
customary covenants. As of June 30, 1997, the Company was in compliance with
all covenants under both agreements.

Repurchase agreements used to finance mortgage securities bear interest at
prevailing market rates and mature in 30 days to one year.

The following table presents a summary of the Company's borrowings (dollars
in thousands):

<TABLE>
<CAPTION>
AS OF JUNE 30, 1997
--------------------------
WEIGHTED AVERAGE DAILY
WEIGHTED DAYS TO BALANCE DURING THE
AVERAGE RESET OR SIX MONTHS ENDED
RATE MATURITY BALANCE JUNE 30, 1997
<S> <C> <C> <C> <C>
Repurchase agreements secured by
mortgage securities............ 6.00% 85 $275,790 $ 56,226
Master repurchase agreement
secured by mortgage loans...... 6.44 30 264,250 132,937
Warehouse line of credit secured
by mortgage loans.............. 8.12 1 13,600 13,711
--------
Total borrowings.............. $553,640
========
</TABLE>

No amounts were outstanding under borrowing arrangements as of December 31,
1996.

F-10
<PAGE>

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

Following is a summary of the resets or maturities of borrowings as of June
30, 1997 (in thousands):

<TABLE>
<CAPTION>
DAYS TO RESET OR MATURITY
------------------------------------------
30 TO 90 AND
DAILY 0 TO 30 90 GREATER TOTAL
<S> <C> <C> <C> <C> <C>
Repurchase agreements secured by
mortgage securities............... $ -- $17,423 $11,261 $247,106 $275,790
Master repurchase agreement secured
by mortgage loans................. -- 264,250 -- -- 264,250
Warehouse facility secured by
mortgage loans.................... 13,600 -- -- -- 13,600
------- -------- ------- -------- --------
$13,600 $281,673 $11,261 $247,106 $553,640
======= ======== ======= ======== ========
</TABLE>

The Company uses interest rate swap and cap agreements to modify the interest
rate on borrowings under its master repurchase agreement and its warehouse
facility, aggregating $277,850,000 as of June 30, 1997. As discussed in Note 5,
interest rate swap agreements having an aggregate notional amount of $191
million as of June 30, 1997 have been entered into whereby the Company pays a
fixed rate of interest and receives from its counterparty a variable rate. The
variable rate on the interest rate swap adjusts with the Company's borrowings
under its master repurchase agreement and its warehouse facility. The Company
has also entered into interest rate cap agreements with an aggregate notional
amount of $75 million as of June 30, 1997. In accordance with the terms of the
cap agreements, the Company will receive interest from its counterparty when
rates rise above the cap rate. Cap rates for the Company's agreements are based
on indexes similar to the index rates of the Company's borrowings. Any amounts
received under the cap agreements will serve to lower the overall cost of
financing for the Company.

NOTE 5. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK

INTEREST RATE SWAP AND CAP AGREEMENTS NovaStar engages in various
transactions which result in off-balance sheet risk. Interest rate swap and cap
agreements are used in conjunction with on balance sheet liabilities to
mitigate the exposure to variations in interest rates on interest-earning
assets that are different from the variations in interest incurred on
borrowings. These instruments involve, to varying degrees, elements of credit
and market risk in addition to the amount recognized in the financial
statements.

Credit Risk NovaStar is exposed to credit risk on derivatives, limited to the
cost of replacing contracts should the counterparty fail. The contract or
notional value is not at risk in derivative contracts. NovaStar 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 through
legal scrutiny of agreements. Prior to engaging in negotiated derivative
transactions with any counterparty, NovaStar has in place fully executed
written agreements. Agreements with counterparties also call for full two-way
netting of payments. Under such an agreement, on each payment exchange date all
gains and losses of a counterparty are netted into a single amount, limiting
exposure to the counterparty to any net positive value.

Market Risk The 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 synthetic
products created through these transactions are "matched" transactions for
NovaStar. In these transactions, NovaStar generally does not take a market
position, which could either positively or negatively affect its market risk
exposure. The combination of off-balance sheet instruments with

F-11
<PAGE>

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

on-balance sheet liabilities leaves NovaStar in a market risk position that is
designed to be a better position than if the derivative had not be used in
interest rate risk management. Derivatives instruments used in matched
transactions as described above are classified as derivatives held for
purposes other than trading. No derivatives were held for trading purposes
during the periods ended December 31, 1996 and June 30, 1997.

Other Risk Considerations NovaStar is cognizant of the risks involved with
financial derivatives. The Company's policies and procedures seek to mitigate
risk associated with the use of financial derivatives in ways appropriate to
its business activities, considering its risk profile as a limited end-user.

The Company did not enter into any interest rate agreements during 1996.
Derivatives held for purposes other than trading consisted of the following as
of June 30, 1997 (dollars in thousands):

<TABLE>
<CAPTION>
WEIGHTED AVERAGE
UNREALIZED WEIGHTED INTEREST RATE ACCRUED INTEREST
NOTIONAL ------------ DAYS TO ------------------ ------------------
VALUE GAINS LOSSES MATURITY RECEIVABLE PAYABLE RECEIVABLE PAYABLE
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Interest rate swap
agreements--
Fixed rate pay........ $191,000 $17 $282 681 5.80% 6.33% $2,180 $2,206
</TABLE>

As of June 30, 1997, the Company had also entered into interest rate cap
agreements with a notional amount of $75 million. Under the terms of these
agreements, the Company receives a variable rate of interest when three-month
LIBOR rises above a contractual rate for which it pays a monthly premium. The
agreements have a weighted cap rate of 6.30 percent and have weighted average
maturity of 542 days. The Company had no amounts receivable under these
agreements as of June 30, 1997.

NOTE 6. STOCK OPTION PLAN

The Company's 1996 Stock Option Plan (the Plan) provides for the grant of
qualified incentive stock options (ISOs), stock options not so qualified
(NQSOs), deferred stock, restricted stock, performance shares, stock
appreciation and limited stock awards, and dividend equivalent rights (DERs).
ISOs may be granted to the officers and key employees of the Company. NQSOs
and awards may be granted to the directors, officers, key employees, agents
and consultants of the Company or any subsidiaries. Unless previously
terminated by the Board of Directors, the Plan will terminate on September 1,
2006.

In September 1996, options to acquire 10,000 shares of common stock were
granted to non-officer directors for $.01 per share, an amount believed to be
the fair value of such shares at that time. In December 1996, options to
acquire 289,332 shares of common stock were granted to the founders (see note
7) for $15 per share, an amount believed to be greater than the fair value of
such shares at that time. Also in December 1996, options to acquire 35,000
shares of common stock were granted to certain officers for $1.06 per share.
In accordance with the provisions of APB Opinion No. 25, the Company will
recognize compensation expense for the difference between such exercise price
and the estimated fair value of the underlying shares, aggregating
approximately $50,000 over their vesting period. Such options, along with the
options granted to non-officer directors, vest over 4 years, have ten year
terms and were granted with DERs. Compensation recognized during the six
months ended June 30, 1997 aggregated $18,000. The options granted to the
founders vest only after a qualified initial public offering (IPO) of common
stock at a price of at least $15 per share, and were granted without DERs.

No additional options were granted after December 1996; as of June 30, 1997,
no options have been exercised or are eligible to be exercised.

F-12
<PAGE>

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

If the Company had recorded expense based on the fair value of the stock
options at the grant date under SFAS No. 123, the Company's net loss would not
have been materially different than as presented herein. The weighted average
minimum fair value of stock options granted during 1996 was estimated to be
$0.18 per share on the date of the grant. This value was determined using the
Black-Scholes option pricing model assuming an expected life of five years, an
annual risk-free interest rate of 7.0 percent, no assumed volatility, and no
annual expected dividend yield, as holders of common stock receive no dividend
as long as preferred stock is outstanding.

Pro forma net losses reflect only options granted and vested in fiscal 1996.
Therefore, the full impact of calculating compensation expense for stock
options under SFAS No. 123 is not reflected in the pro forma net loss amount
described above because compensation expense is reflected over the options'
vesting period.

NOTE 7. STOCKHOLDERS' EQUITY

The Company was initially capitalized by its founders in September 1996. In
December 1996, the Company successfully completed its private placement
offering of 3,549,999 units. Each unit consists of one share of convertible
preferred stock and one warrant which entitles the holder thereof to purchase
one share of common stock for $15.00 per share. The underwriter received
100,000 warrants in addition to underwriting discounts. The preferred stock
automatically converts to one share of common stock upon the closing of a
qualified IPO of at least $20 million and a price per share of at least
$15.00. Alternatively, the preferred stock may convert at a lesser amount of
proceeds or a lower price, if approved by two-thirds of the preferred
shareholders, or at any time after December 1999 at the option of the holder.
As long as the preferred stock is outstanding, holders thereof will receive
100 percent of dividends paid. The warrants become exercisable within six
months following the closing of a qualified IPO and will remain exercisable
until the third anniversary at an exercise price of $15.00 per share. The
Company raised $47 million in the offering, net of $3 million of offering
expenses.

In addition, 216,666 units were issued in equal amounts to the two founders
at a price of $15.00 per unit upon the closing of the private placement
offering. Payment for such units was made by the founders delivering to the
Company forgivable promissory notes, bearing interest at eight percent per
annum and secured by the units acquired. Interest accrues during the first
year and is added to principal due under the note. Thereafter, interest is
payable quarterly, upon forgiveness or at maturity of the notes on December
31, 2001. The principal amount of the notes will be divided into three equal
tranches. Payment of principal on each tranche will be forgiven if certain
incentive performance tests are achieved. These notes have been reflected as a
reduction of stockholders' equity in the accompanying consolidated balance
sheets. The forgiveness of the notes will result in compensation expense
during the periods of forgiveness.

NOTE 8. FAIR VALUE OF FINANCIAL INSTRUMENTS

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

F-13
<PAGE>

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

The estimated fair values of the Company's financial instruments as of June
30, 1997 are as follows (dollars in thousands):

<TABLE>
<CAPTION>
CARRYING VALUE FAIR VALUE
<S> <C> <C>
Financial assets:
Mortgage securities............................ $284,348 $284,348
Mortgage loans................................. 303,732 304,681
Financial liabilities:
Warehouse lines of credit...................... 13,600 13,600
Repurchase agreements.......................... 540,040 541,038
Off-balance sheet items--interest rate
agreements...................................... -- 1,180
</TABLE>

Market quotations are received for estimating the fair value of mortgage
securities. The fair value of all other financial instruments is estimated by
discounting projected future cash flows, including projected prepayments for
mortgage loans, at prevailing market rates. The fair value of cash and cash
equivalents and accrued interest receivable and payable approximates its
carrying value.

As of December 31, 1996, fair values of financial instruments approximated
carrying values.

NOTE 9. COMMITMENTS AND CONTINGENCIES

The Company leases facilities and equipment under operating leases. Rent
expense and future obligations under these leases are not material to the
consolidated financial statements.

In the normal course of its business, the Company is subject to various
legal proceedings and claims, the resolution of which, in the opinion of
management, will not have a material adverse effect on the Company's financial
condition or results of operations.

NOTE 10. INCOME TAXES

NovaStar has elected to be taxed as a REIT and accordingly will deduct, for
income tax purposes, dividends paid on its common and preferred stock. Because
NovaStar intends to pay dividends in amounts approximating its taxable income
for the year ended December 31, 1997, no provision for income tax on the
earnings of NovaStar have been provided in the accompanying consolidated
financial statements. NMI and Holding are subject to Federal and state income
taxes. However, during the periods ended December 31, 1996 and June 30, 1997,
those entities experienced net operating losses. Because of uncertainties
about these entities' ability to achieve profitable operations, no tax benefit
has been recorded in the accompanying consolidated financial statements.

NOTE 11. INITIAL PUBLIC OFFERING

The Company has filed a registration statement on Form S-11 for the purpose
of registering 3,000,000 shares of common stock for sale in an initial public
offering. The Company expects to issue these shares at $17.00 per share.

F-14
<PAGE>

- --------------------------------------------------------------------------------

TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Prospectus Summary....................................................... 3
Risk Factors............................................................. 13
The Company.............................................................. 29
Use of Proceeds.......................................................... 29
Dividend Policy and Distributions........................................ 30
Dividend Reinvestment Plan............................................... 30
Dilution................................................................. 31
Capitalization........................................................... 32
Selected Consolidated Financial and Other Data........................... 33
Management's Discussion and Analysis of Financial Condition and Results
of Operations........................................................... 34
Business................................................................. 42
Management............................................................... 58
Principal Securityholders................................................ 67
Certain Transactions..................................................... 69
Federal Income Tax Considerations........................................ 71
Description of Capital Stock............................................. 80
Description of Warrants.................................................. 85
Underwriting............................................................. 87
Legal Matters............................................................ 89
Experts.................................................................. 89
Available Information.................................................... 89
Glossary................................................................. 90
Consolidated Financial Statements........................................ F-1
</TABLE>

---------------

NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS IN CONNECTION WITH THIS OFFERING OTHER THAN THOSE CONTAINED IN
THIS PROSPECTUS AND, IF GIVEN OR MADE, SUCH OTHER INFORMATION AND
REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED BY THE
COMPANY OR ANY OTHER PERSON. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY
SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE ANY IMPLICATION THAT
THERE HAS BEEN NO CHANGE IN THE AFFAIRS OF THE COMPANY SINCE THE DATE HEREOF OR
THAT THE INFORMATION CONTAINED HEREIN IS CORRECT AS OF ANY TIME SUBSEQUENT TO
ITS DATE. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL OR A
SOLICITATION OF AN OFFER TO BUY SECURITIES OTHER THAN THE SECURITIES TO WHICH
IT RELATES. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL OR A
SOLICITATION OF AN OFFER TO BUY SUCH SECURITIES IN ANY CIRCUMSTANCES IN WHICH
SUCH OFFER OR SOLICITATION IS UNLAWFUL.

UNTIL (25 DAYS AFTER THE DATE OF THIS PROSPECTUS), ALL DEALERS EFFECTING
TRANSACTIONS IN THE SECURITIES OFFERED HEREBY, WHETHER OR NOT PARTICIPATING IN
THIS DISTRIBUTION, MAY BE REQUIRED TO DELIVER A PROSPECTUS. THIS IS IN ADDITION
TO THE OBLIGATION OF DEALERS TO DELIVER A PROSPECTUS WHEN ACTING AS
UNDERWRITERS AND WITH RESPECT TO THEIR UNSOLD ALLOTMENTS OR SUBSCRIPTIONS.

- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

3,000,000 SHARES

NOVASTAR FINANCIAL, INC.

COMMON STOCK

---------------

Prospectus
, 1997

---------------

STIFEL, NICOLAUS & COMPANY
INCORPORATED

MONTGOMERY SECURITIES

- --------------------------------------------------------------------------------
<PAGE>

PART II

INFORMATION NOT REQUIRED IN PROSPECTUS

ITEM 31. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION.

The expenses expected to be incurred in connection with the issuance and
distribution of the securities being registered are as set forth below. All
such expenses, except for the SEC registration and filing fees, are estimated:

<TABLE>
<S> <C>
SEC Registration.................................................. $18,818
NASD Filing Fee................................................... 6,710
Nasdaq National Market Listing Fee................................ *
Legal Fees and Expenses........................................... *
Accounting Fees and Expenses...................................... *
Printing Fees..................................................... *
Transfer Agent and Registrar Fees................................. *
-------
Total........................................................... $ *
=======
</TABLE>
- --------
* To be provided by amendment.

ITEM 32. SALES TO SPECIAL PARTIES.

None.

ITEM 33. RECENT SALES OF UNREGISTERED SECURITIES.

In September and December 1996 the Registrant sold 216,666 shares of Common
Stock to the two founders of the Registrant for $2,167 cash. Such shares were
sold without registration under the Securities Act of 1933, as amended (the
"Act"), in reliance on the exemption provided by Section 4(2) thereof.

In December 1996 the Registrant sold an aggregate of 3,333,333 Units, each
Unit consisting of one share of Class A Convertible Preferred Stock and one
Stock Purchase Warrant, to approximately 180 "accredited investors" (as such
term is defined under Rule 501(a) promulgated under the Act) for $49,999,995
cash and an additional 216,666 Units to the two founders of the Registrant for
$3,249,999 in forgivable notes. Stifel, Nicolaus & Company, Incorporated acted
as placement agent (the "Placement Agent") in connection with such issuance
and received commissions and reimbursement of expenses totaling approximately
$3,000,000 along with 100,000 Stock Purchase Warrants. Such shares were sold
without registration under the Securities Act of 1933, as amended, in reliance
on the exemption provided by Section 4(2) thereof and on Regulation D
promulgated thereunder.

ITEM 34. INDEMNIFICATION OF DIRECTORS AND OFFICERS.

Section 2-418 of the Corporations and Associations Article of the Annotated
Code of Maryland provides that a Maryland corporation may indemnify any
director of the corporation and any person who, while a director of the
corporation, is or was serving at the request of the corporation as a
director, officer, partner, trustee, employee, or agent of another foreign or
domestic corporation, partnership, joint venture, trust, or other enterprise
or employee benefit plan, is made a party to any proceeding by reason of
service in that capacity unless it is established that the act or omission of
the director was material to the matter giving rise to the proceeding and was
committed in bad faith or was the result of active and deliberate dishonesty;
or the director actually received an improper personal benefit in money,
property or services; or, in the case of any criminal proceeding, the director
had reasonable cause to believe that the act or omission was unlawful.
Indemnification may be against judgments, penalties, fines, settlements, and
reasonable expenses actually incurred by the director in connection with the
proceeding, but if the proceeding was one by or in the right of the
corporation, indemnification may not be made in respect of any proceeding in
which the director shall have been adjudged to

II-1
<PAGE>

be liable to the corporation. Such indemnification may not be made unless
authorized for a specific proceeding after a determination has been made, in
the manner prescribed by the law, that indemnification is permissible in the
circumstances because the director has met the applicable standard of conduct.
On the other hand, the director must be indemnified for expenses if he has
been successful in the defense of the proceeding or as otherwise ordered by a
court. The law also prescribes the circumstances under which the corporation
may advance expenses to, or obtain insurance or similar protection for,
directors.

The law also provides for comparable indemnification for corporate officers
and agents.

The Registrant's Articles of Incorporation provide that its directors and
officers shall, and its agents in the discretion of the Board of Directors
may, be indemnified to the fullest extent required or permitted from time to
time by the laws of Maryland.

The Maryland GCL permits the charter of a Maryland corporation to include a
provision limiting the liability of its directors and officers to the
corporation and its stockholders for money damages except to the extent that
(i) it is proved that the person actually received an improper benefit or
profit in money, property or services for the amount of the benefit or profit
in money, property or services actually received, or (ii) a judgment or other
final adjudication is entered in a proceeding based on a finding that the
person's action, or failure to act, was the result of active and deliberate
dishonesty and was material to the cause of action adjudicated in the
proceeding. The Company's Articles of Incorporation contain a provision
providing for elimination of the liability of its directors and officers to
the Company or its stockholders for money damages to the maximum extent
permitted by Maryland law from time to time.

The Underwriting Agreement, the Purchase Terms Agreement, Registration
Rights Agreement and Founders Registration Rights Agreement, included as
Exhibits 1.1, 10.1, 10.2 and 10.4, respectively, to the Registration
Statement, provide for indemnification of the Registrant, its directors and
certain of its officers against certain liabilities, including liabilities
under the Securities Act.

ITEM 35. TREATMENT OF PROCEEDS FROM STOCK BEING REGISTERED.

Not applicable.

ITEM 36. FINANCIAL STATEMENTS AND EXHIBITS.

(a) Consolidated Financial Statements (each included in the Prospectus):

Balance Sheets
Statements of Operations
Statements of Stockholders' Equity
Statements of Cash Flows
Notes to Consolidated Financial Statements

(b) Exhibits:

<TABLE>
<C> <S>
1.1** Form of Underwriting Agreement
3.1* Articles of Amendment and Restatement of the Registrant
3.2* Articles Supplementary of the Registrant
3.3* Bylaws of the Registrant
4.1 Specimen Common Stock Certificate
5.1** Opinion of Tobin & Tobin, a professional corporation, as to
legality (including consent of such firm)
5.2** Opinion of Piper & Marbury L.L.P., as to legality (including
consent of such firm)
</TABLE>

II-2
<PAGE>

<TABLE>
<C> <S>
8.1** Opinion of Jeffers, Wilson, Shaff & Falk, LLP, as to certain tax
matters (including consent of such firm)
10.1* Purchase Terms Agreement, dated December 6, 1996, between the
Registrant and the Placement Agent.
10.2* Registration Rights Agreement, dated December 9, 1996, between
the Registrant and the Placement Agent.
10.3* Warrant Agreement, dated December 9, 1996, between the Registrant
and the Holders of the Warrants Acting Through the Registrant as
the Initial Warrant Agent.
10.4* Founders Registration Rights Agreement, dated December 9, 1996,
between the Registrant and the original holders of Common Stock
of the Registrant.
10.5* Commitment Letter dated October 3, 1996 from General Electric
Capital Group accepted by the Registrant.
10.6* Master Repurchase Agreement dated as of January 31, 1997 among
Merrill Lynch Mortgage Capital Inc., Merrill Lynch Credit
Corporation and the Registrant.
10.7* Mortgage Loan Warehousing Agreement dated as of February 20, 1997
between First Union National Bank of North Carolina and the
Registrant.
10.8* Employment Agreement, dated September 30, 1996, between the
Registrant and Scott F. Hartman.
10.9* Employment Agreement, dated September 30, 1996, between the
Registrant and W. Lance Anderson.
10.10* Promissory Note by Scott F. Hartman to the Registrant, dated
December 9, 1996.
10.11* Promissory Note by W. Lance Anderson to the Registrant, dated
December 9, 1996.
10.12* Stock Pledge Agreement between Scott F. Hartman and the
Registrant, dated December 9, 1996.
10.13* Stock Pledge Agreement between W. Lance Anderson and the
Registrant, dated December 9, 1996.
10.14* 1996 Executive and Non-Employee Director Stock Option Plan, as
last amended December 6, 1996.
10.15* Administrative Services Outsourcing Agreement, dated June 30,
1997, between the Registrant and NovaStar Mortgage, Inc.
10.16* Mortgage Loan Sale and Purchase Agreement, dated as of June 30,
1997, between the Registrant and NovaStar Mortgage, Inc.
10.17* Flow Loan Subservicing Agreement, dated as of June 30, 1997,
between the Registrant and NovaStar Mortgage, Inc.
11.1 Statement regarding computation of per share earnings.
21.1* Subsidiaries of the Registrant (set forth in "The Company" in the
Prospectus)
23.1** Consent of Tobin & Tobin, a professional corporation (included in
Exhibit 5.1)
23.2** Consent of Piper & Marbury L.L.P. (included in Exhibit 5.2)
23.3** Consent of Jeffers, Wilson, Shaff & Falk, LLP (included in
Exhibit 8.1)
23.4 Consent of KPMG Peat Marwick LLP.
</TABLE>

II-3
<PAGE>

<TABLE>
<C> <S>
24.1* Power of Attorney (set forth on signature page)
27.1* Financial Data Schedule
</TABLE>
- --------

* Previously filed.

** To be filed by amendment.

ITEM 39. UNDERTAKINGS.

The Registrant hereby undertakes to provide to the Underwriters at the
closing specified in the Underwriting Agreement certificates in such
denominations and registered in such names as required by the Underwriters to
permit prompt delivery to each purchaser.

Insofar as indemnification for liabilities arising under the Securities Act
of 1933 may be permitted to directors, officers and controlling persons of the
Registrant, pursuant to the foregoing provisions, or otherwise, the Registrant
has been advised that in the opinion of the Securities and Exchange
Commission, such indemnification is against public policy as expressed in the
Act and is, therefore, unenforceable. In the event that a claim for
indemnification against such liabilities (other than the payment by the
Registrant of expenses incurred or paid by a director, officer or controlling
person of the Registrant in the successful defense of any action, suit or
proceeding) is asserted by such director, officer or controlling person in
connection with the securities begin registered, the Registrant will, unless
in the opinion of its counsel the matter has been settled by controlling
precedent, submit to court of appropriate jurisdiction the question whether
such indemnification by it is against public policy as expressed in the Act
and will be governed by the final adjudication of such issue.

The undersigned Registrant hereby undertakes that: (1) for purposes of
determining any liability under the Securities Act of 1933, the information
omitted from the form of Prospectus filed as part of this Registration
Statement in reliance upon Rule 430A and contained in a form of Prospectus
filed by the Registrant pursuant to Rule 424(b)(1) or (4) or 497(h) under the
Securities Act of 1933 shall be deemed to be part of this Registration
Statement as of the time it was declared effective; and (2) for the purpose of
determining any liability under the Securities Act of 1933, each post-
effective amendment that contains a form of Prospectus shall be deemed to be a
new Registration Statement relating to the securities offered therein and the
offering of such securities at that time shall be deemed to be the initial
bona fide offering thereof.

II-4
<PAGE>

SIGNATURES

PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1933, THE REGISTRANT
CERTIFIES THAT IT HAS REASONABLE GROUNDS TO BELIEVE THAT IT MEETS ALL OF THE
REQUIREMENTS FOR FILING ON FORM S-11 AND HAS DULY CAUSED THIS AMENDMENT NO. 1
TO THE REGISTRATION STATEMENT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED,
THEREUNTO DULY AUTHORIZED, IN THE CITY OF WESTWOOD, STATE OF KANSAS, ON
SEPTEMBER 9, 1997.

NovaStar Financial, Inc.

/s/ Scott F. Hartman
By: __________________________________
Scott F. Hartman
Chairman of the Board and
Chief Executive Officer

<TABLE>
<CAPTION>
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1933, THIS
REGISTRATION STATEMENT HAS BEEN SIGNED BY THE FOLLOWING PERSONS IN THE
CAPACITIES AND ON THE DATES INDICATED:
<S> <C> <C>
SIGNATURE POSITION DATE

/s/ Scott F. Hartman
- ------------------------------- Chairman of the Board, September 9, 1997
Scott F. Hartman Secretary and Chief Executive
Officer (Principal Executive
Officer)

/s/ W. Lance Anderson President, Chief Operating
- ------------------------------- Officer and Director September 9, 1997
W. Lance Anderson

/s/ Mark J. Kohlrus Senior Vice President,
- ------------------------------- Treasurer, Chief Financial September 9, 1997
Mark J. Kohlrus Officer (Principal Financial
Officer)

</TABLE>
II-5
<PAGE>
<TABLE>
<CAPTION>

SIGNATURE POSITION DATE
<S> <C> <C>

/s/ Rodney E. Schwatken Vice President, Controller,
- ------------------------------- Assistant Treasurer, September 9, 1997
Rodney E. Schwatken (Principal Accounting
Officer)

Director
*/s/ Edward W. Mehrer September 9, 1997
- -------------------------------
Edward W. Mehrer

Director
*/s/ Gregory T. Barmore September 9, 1997
- -------------------------------
Gregory T. Barmore

Director
*/s/ Jenne K. Britell September 9, 1997
- -------------------------------
Jenne K. Britell

- -------------------------------

*By Mark J. Kohlrus, attorney-
in-fact
</TABLE>

II-6
<PAGE>

EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT PAGE
NO. DESCRIPTION OF DOCUMENT NUMBER
------- ----------------------- ------
<C> <S> <C>
1.1** Form of Underwriting Agreement
3.1* Articles of Amendment and Restatement of the Registrant
3.2* Articles Supplementary of the Registrant
3.3* Bylaws of the Registrant
4.1 Specimen Common Stock Certificate
5.1** Opinion of Tobin & Tobin, a professional corporation, as to
legality (including consent of such firm)
5.2** Opinion of Piper & Marbury L.L.P., as to legality (including
consent of such firm)
8.1** Opinion of Jeffers, Wilson, Shaff & Falk, LLP, as to certain
tax matters (including consent of such firm)
10.1* Purchase Terms Agreement, dated December 6, 1996, between
the Registrant and the Placement Agent.
10.2* Registration Rights Agreement, dated December 9, 1996,
between the Registrant and the Placement Agent.
10.3* Warrant Agreement, dated December 9, 1996, between the
Registrant and the Holders of the Warrants Acting Through
the Registrant as the Initial Warrant Agent.
10.4* Founders Registration Rights Agreement, dated December 9,
1996, between the Registrant and the original holders of
Common Stock of the Registrant.
10.5* Commitment Letter dated October 3, 1996 from General
Electric Capital Group accepted by the Registrant.
10.6* Master Repurchase Agreement dated as of January 31, 1997
among Merrill Lynch Mortgage Capital Inc., Merrill Lynch
Credit Corporation and the Registrant.
10.7* Mortgage Loan Warehousing Agreement dated as of February 20,
1997 between First Union National Bank of North Carolina
and the Registrant.
10.8* Employment Agreement, dated September 30, 1996, between the
Registrant and Scott F. Hartman.
10.9* Employment Agreement, dated September 30, 1996, between the
Registrant and W. Lance Anderson.
10.10* Promissory Note by Scott F. Hartman to the Registrant, dated
December 9, 1996.
10.11* Promissory Note by W. Lance Anderson to the Registrant,
dated December 9, 1996.
10.12* Stock Pledge Agreement between Scott F. Hartman and the
Registrant, dated December 9, 1996.
10.13* Stock Pledge Agreement between W. Lance Anderson and the
Registrant, dated December 9, 1996.
10.14* 1996 Executive and Non-Employee Director Stock Option Plan,
as last amended December 6, 1996.
</TABLE>
<PAGE>

<TABLE>
<CAPTION>
EXHIBIT PAGE
NO. DESCRIPTION OF DOCUMENT NUMBER
------- ----------------------- ------
<C> <S> <C>
10.15* Administrative Services Outsourcing Agreement, dated June
30, 1997 between the Registrant and NovaStar Mortgage, Inc.
10.16* Mortgage Loan Sale and Purchase Agreement, dated as of June
30, 1997 between the Registrant and NovaStar Mortgage, Inc.
10.17* Flow Loan Subservicing Agreement, dated as of June 30, 1997
between the Registrant and NovaStar Mortgage, Inc.
11.1 Statement regarding computation of per share earnings
21.1* Subsidiaries of the Registrant (set forth in "The Company"
in the Prospectus)
23.1** Consent of Tobin & Tobin, a professional corporation
(included in Exhibit 5.1)
23.2** Consent of Piper & Marbury L.L.P. (included in Exhibit 5.2)
23.3** Consent of Jeffers, Wilson, Shaff & Falk, LLP (included in
Exhibit 8.1)
23.4 Consent of KPMG Peat Marwick LLP.
24.1* Power of Attorney (set forth on signature page)
27.1* Financial Data Schedule
</TABLE>
- --------

* Previously filed.

** To be filed by amendment.

<PAGE>

EXHIBIT 4.1

[FRONT]

INCORPORATED UNDER THE LAWS OF THE STATE OF MARYLAND
Number Shares
------ ------
[___] [___]

SEPTEMBER 13, 1996

NOVASTAR FINANCIAL, INC.

THIS CERTIFIES THAT ________________________________________________________
IS THE REGISTERED

HOLDER OF _________________________________________________________________
Shares of the Common Stock of

NovaStar Financial, Inc.

HEREINAFTER DESIGNATED "THE CORPORATION," TRANSFERABLE ON THE SHARE REGISTER OF
THE CORPORATION UPON SURRENDER OF THIS CERTIFICATE PROPERLY ENDORSED OR
ASSIGNED.

This certificate and the shares represented thereby shall be held subject to all
of the provisions of the Articles of Incorporation and the Bylaws of said
Corporation, a copy of each of which is on file at the office at the
Corporation, and made a part hereof as fully as though the provisions of said
Articles of Incorporation and Bylaws were imprinted in full on this certificate,
to all of which the holder of this certificate, by acceptance hereof, assents
and agrees to be bound.

Any shareholder may obtain from the principal office of the Corporation, upon
request and without charge, a statement of the number of shares constituting
each class or series of stock and the designation thereof; and a copy of the
rights, preferences, privileges and restrictions granted to or imposed upon the
respective classes or series of stock upon which the holders thereof by said
Articles of Incorporation and the Bylaws.

WITNESS THE SEAL OF THE CORPORATION AND THE SIGNATURES OF ITS DULY
AUTHORIZED OFFICERS.

DATED:

_____________________________ ________________________________
Secretary President

[SEAL]
________________________________________________________________________________

[BACK]

FOR VALUE RECEIVED, _________ hereby sell, assign and transfer unto
_______________________________________________ Shares represented by the within
Certificate and do hereby irrevocably constitute and appoint ___________________
_________________ Attorney to transfer the said Shares on the books of the
within named Corporation with full power of substitution in the premises.

Dated: _____________________________
______________________________

In the Presence of

____________________________________

NOTICE: THE SIGNATURE OF THIS ASSIGNMENT MUST CORRESPOND
WITH THE NAME AS WRITTEN UPON THE FACE OF THE CERTIFICATE,
IN EVERY PARTICULAR, WITHOUT ALTERATION OR
ENLARGEMENT, OR ANY CHANGE WHATEVER

<PAGE>

EXHIBIT 11.1

NovaStar Financial, Inc.

Statement re computation of pro forma per share earnings

<TABLE>
<CAPTION>
FOR THE
SIX FOR THE PERIOD FROM
MONTHS SEPTEMBER 13, 1996
ENDED (INCEPTION) TO
JUNE 30, DECEMBER 31,
1997 1996
--------- -------------------
<S> <C> <C>
Primary and fully diluted pro forma
loss per share:
Net loss available to common
Stockholders (1) ($879,000) ($302,000)
========= =========
Weighted average shares outstanding
(2) 4,272,928 4,272,928
Pro forma net loss per share ($0.21) ($0.07)
========= =========
</TABLE>

(1) Net loss available to common stockholders assumes that the convertible
preferred stock is converted to common stock and therefore, the preferred
stock dividends paid by NovaStar Financial, Inc. are not added to the
Company's net loss.

(2) Warrants and options have been considered to be outstanding for all
periods presented and an estimated initial offering of $17.00 per share
has been used in applying the treasury stock method, including periods
where the impact of incremental shares is anti-dilutive.

<PAGE>

EXHIBIT 23-4

INDEPENDENT AUDITORS' CONSENT

We consent to the use of our report on the consolidated financial statements
of NovaStar Financial, Inc. and subsidiary as of June 30, 1997 and December
31, 1996 and for the six months ended June 30, 1997 and the period from
September 13, 1996 (inception) to December 31, 1996 included herein and to the
reference to our firm under the heading "Experts" in the prospectus.

KPMG Peat Marwick LLP
Kansas City, Missouri

September 9, 1997