NOVASTAR FINANCIAL INC, 424B3, 1998-03-06

NOVASTAR FINANCIAL INC
424B3, 1998-03-06
FINANCE SERVICES

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PROSPECTUS

7,199,998 SHARES COMMON STOCK
LOGO

3,649,999 STOCK PURCHASE WARRANTS
NOVASTAR FINANCIAL, INC.

NovaStar Financial, Inc. ("NovaStar" or "the Company"), organized in 1996, is
a self-advised and self-managed specialty finance company which: (i) acquires
single family residential subprime mortgage loans; (ii) leverages its assets
using warehouse facilities, including repurchase agreements; (iii) issues
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. The Company expects that a primary source of wholesale mortgage
loans will be loans originated by NovaStar Mortgage, Inc. ("NovaStar
Mortgage"), a taxable affiliate of the Company. Certain directors and officers
of the Company also serve as directors and officers of NovaStar Mortgage. Under
a separate agreement, NovaStar Mortgage also services mortgage loans owned by
the Company.

This Prospectus relates to (i) 3,549,999 shares of the Company's Common Stock,
par value $.01 per share ("Common Stock"), being offered by the Selling
Securityholders ("Selling Securityholders") herein ("Offered Common Stock"),
(ii) 3,649,999 Stock Purchase Warrants ("Warrants"), each Warrant exercisable
for one share of the Company's Common Stock, and (iii) 3,649,999 shares of
Common Stock issuable upon the exercise of Warrants ("Underlying Common Stock")
(continued next page)

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

SEE "RISK FACTORS" BEGINNING ON PAGE 15 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 operating . The lack of loan performance data
history and net losses incurred. on the Company's loan portfolio and
. The possible forgiveness of the expectation of increasing
incentive notes receivable from the delinquency, foreclosure and loss
Company's founders, which may rates as the portfolio becomes more
materially adversely affect results seasoned.
of operations and dividends paid . The Company's inability to hedge
for the affected period. against potential interest rate
. Dependence on key personnel. changes.
. The possibility of failure to . The potential inability of the
maintain REIT status, which would Company to acquire Mortgage Assets
subject the Company to tax as a in the secondary market at
regular corporation. favorable yields.
. The potential effects of unexpected . Restrictions on ownership of
or rapid changes in interest rates, capital stock in the charter, which
which would negatively impact the may inhibit market activity in the
results of operations from the Common Stock and discourage
subprime mortgage lending business. takeover attempts.
. The generally higher risk of
delinquency and foreclosure on
Company's subprime mortgage loans
which may result in higher levels
of realized losses.

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

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 COMPANY(1)
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<S> <C> <C> <C>
Per exercised Warrant............... $15.00 $0.00 $15.00
- --------------------------------------------------------------------------------
Total............................... $54,749,985.00 $0.00 $54,749,985.00
</TABLE>
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- --------------------------------------------------------------------------------
(1) Before deducting expenses payable by the Company, estimated to be $150,000.

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

THE DATE OF THIS PROSPECTUS IS FEBRUARY 3, 1998.
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(the "Offering"). The Warrants are exercisable until the third anniversary of
the date of this Prospectus at an exercise price of $15.00 per Warrant, and
are subject to certain anti-dilution protections. See "Description of
Warrants." For purposes of this Prospectus, the Offered Common Stock, the
Warrants and the Underlying Common Stock issuable upon the exercise of
Warrants are referred to hereinafter as the "Securities" unless the context
requires otherwise.

The Offered Common Stock, the Warrants and the Underlying Common Stock
subsequently acquired by the Selling Securityholders pursuant to the exercise
of Warrants, may be offered for sale from time to time by the Selling
Securityholders named herein, or by their pledgees, donees, transferees or
other successors in interest, to or through underwriters or directly to other
purchasers or through agents in one or more transactions in the over-the-
counter market, in one or more private transactions, or in a combination of
such methods of sale, at prices and on terms then prevailing, at prices
related to such prices, or at negotiated prices. Under certain circumstances,
the Selling Securityholders and any broker-dealers that act in connection with
the sales of such Common Stock or Warrants may be deemed to be "underwriters"
within the meaning of Section 2(11) of the Securities Act of 1933, as amended
(the "Securities Act"), and any commissions or discounts and other
compensation paid to such persons may be deemed to be underwriting discounts
and commissions under the Securities Act.

The Company will not receive any proceeds from the sale of Offered Common
Stock or Warrants by the Selling Securityholders. The Company will receive the
proceeds from the issuance and sale of the Underlying Common Stock pursuant to
the exercise of the Warrants. The Company will bear the costs relating to the
registration of the Common Stock or Warrants being offered hereby of
approximately $150,000.

The Company's Common Stock is listed on the New York Stock Exchange (the
"NYSE") under the symbol "NFI." On February 3, 1998, the last reported sale
price for the Common Stock on the NYSE was $17 3/16 per share. The Company's
Warrants are expected to trade through market makers, such as Stifel, Nicolaus
& Company, Incorporated, using The NASD's OTC Bulletin Board Service. See
"Market Prices and Dividend Date."

The Company began operations in December 1996 following the closing of a
private placement of units (the "Private Placement"), each consisting of one
share of the former Class A Convertible Preferred Stock (the "Preferred
Stock") and one Warrant exercisable for a share of Common Stock at $15.00
regardless of any prevailing market price (together, a "Unit"). In the Private
Placement, the Company's two founders each acquired Units paid for 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 on each tranche will be forgiven by the Company if the return to
Private Placement investors meets certain benchmarks and the Company will then
recognize a non-cash charge against earnings. To date, one tranche has been
forgiven. Such charges against earnings could have a material adverse effect
on the Company's results of operations and dividends paid to stockholders for
the affected period. See "Risk Factors" and "Management-Executive
Compensation."

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

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, SYNDICATE SHORT COVERING TRANSACTIONS AND PENALTY BIDS. SUCH
STABILIZING, IF COMMENCED, MAY BE DISCONTINUED AT ANY TIME.

IN CONNECTION WITH THIS OFFERING, CERTAIN UNDERWRITERS (AND SELLING GROUP
MEMBERS) MAY ENGAGE IN PASSIVE MARKET MAKING TRANSACTIONS IN COMMON STOCK ON
THE NEW YORK STOCK EXCHANGE IN ACCORDANCE WITH RULE 10-B6A UNDER THE
SECURITIES EXCHANGE ACT OF 1934. FOR A DESCRIPTION OF THESE ACTIVITIES, SEE
"PLAN OF DISTRIBUTION."
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TABLE OF CONTENTS
<TABLE>
<S> <C>
PROSPECTUS SUMMARY.......................................................... 4
The Company................................................................ 4
Summary Risk Factors....................................................... 6
Business Strategies and Advantages......................................... 8
Mortgage Lending Strategies................................................ 8
Portfolio Management Strategies............................................ 9
Competitive Advantages..................................................... 10
Structural Benefits........................................................ 10
Dividend Policy, Distributions and Reinvestment............................ 12
The Offering............................................................... 12
Recent Developments........................................................ 13
Summary Financial and Other Data........................................... 14
RISK FACTORS................................................................ 15
Overall Enterprise of the Company.......................................... 15
Limited Operating History of the Company and Net Losses Incurred........... 15
Forgivable Notes May Adversely Affect Results of Operations................ 15
Dependence on Key Personnel for Successful Operations...................... 15
Limited Experience of Management in Starting-up New Business............... 16
Need for Additional Equity Financing to Support Future Growth.............. 16
Consequences of Failure to Maintain REIT Status:
Company Subject to Tax as a Regular Corporation........................... 16
Lack of Voting Control of Taxable Affiliates............................... 16
Consequences of Failure to Qualify for Investment Company Act Exemption.... 17
Future Revisions in Policies and Strategies at the Discretion of Board of
Directors................................................................. 17
Subprime Mortgage Lending Operation........................................ 17
Changes in Interest Rates May Adversely Affect Results of Operations....... 17
Intense Competition in the Subprime Mortgage Industry...................... 17
High Loan-to-Value Products................................................ 18
Higher Delinquency and Loss Rates with Subprime Mortgage Borrowers......... 18
Availability of Funding Sources............................................ 18
Dependence Upon Independent Brokers and Correspondents..................... 18
Legislation and Regulation................................................. 19
Elimination of Lender Payments to Brokers.................................. 20
Environmental Liabilities.................................................. 20
Acquisition and Management of a Portfolio of Mortgage Assets............... 20
General Economic and Financial Conditions May Affect Results of Operations. 20
Decrease in Net Interest Income Due to Interest Rate Fluctuations.......... 21
Interest Rate Indices on Company Borrowings Differ from Indexes on Related
Mortgage Assets........................................................... 21
Changes in Anticipated Prepayment Rates May Adversely Affect Net Interest
Income.................................................................... 22
Failure to Hedge Effectively Against Interest Rate Change May Adversely
Affect Results of Operations.............................................. 23
Limitations on Effective Hedging........................................... 23
Potential Adverse Effect of the Use of Financial Instruments in Hedging.... 24
Loss Exposure on Single Family Mortgage Assets............................. 24
</TABLE>
<TABLE>
<S> <C>
Increased Loss Exposure on Subprime Mortgage Loans........................ 25
Market Factors May Limit the Company's Ability to Acquire Mortgage Assets
at Yields Which Are Favorable Relative to Borrowing Costs................ 25
Substantial Leverage and Potential Net Interest and Operating Losses in
Connection with Borrowings............................................... 26
Failure to Refinance Outstanding Borrowings on Favorable Terms May Affect
Results of Operations.................................................... 26
Impact of Decline in Market Value of Mortgage Assets: Margin Calls........ 27
Dependence on Securitization Market....................................... 27
Lack of Loan Performance Data............................................. 28
Illiquidity of Investments................................................ 28
Lack of Geographic Diversification........................................ 28
Investment in Common Stock in the Offering................................ 28
Restrictions on Ownership of Capital Stock: Anti-takeover Effect.......... 28
Effect on Stockholders of Potential Future Offerings...................... 29
No Assurance of Active Public Trading Market.............................. 30
Possible Volatility of Stock Price........................................ 30
Securities Eligible for Future Sale....................................... 30
THE COMPANY................................................................ 31
USE OF PROCEEDS............................................................ 31
DIVIDEND POLICY AND DISTRIBUTIONS.......................................... 32
DIVIDEND REINVESTMENT PLAN................................................. 32
CAPITALIZATION............................................................. 33
MARKET PRICES AND DIVIDEND DATA............................................ 33
SELECTED FINANCIAL AND OTHER DATA.......................................... 34
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS............................. 35
Safe Harbor Statement..................................................... 35
Overview.................................................................. 35
Forgivable Notes Receivable from Founders................................. 36
Financial Condition as of September 30, 1997.............................. 36
Results of Operations--Nine Months Ended September 30, 1997............... 38
Results of Operations--Six Months Ended June 30, 1997..................... 44
Liquidity and Capital Resources........................................... 48
Inflation................................................................. 49
Impact of Recently Issued Accounting Pronouncements....................... 49
BUSINESS................................................................... 50
Mortgage Lending Operation Portfolio Management........................... 50
MANAGEMENT................................................................. 68
Directors and Executive Officers.......................................... 68
Terms of Directors and Officers........................................... 70
Committees of the Board................................................... 70
Compensation of Directors................................................. 71
Compensation Committee Interlocks......................................... 71
Executive Compensation.................................................... 71
Stock Option Grants....................................................... 72
PRINCIPAL SECURITYHOLDERS.................................................. 77
CERTAIN TRANSACTIONS....................................................... 79
SELLING SECURITYHOLDERS.................................................... 81
FEDERAL INCOME TAX CONSIDERATIONS.......................................... 88
DESCRIPTION OF CAPITAL STOCK............................................... 97
DESCRIPTION OF WARRANTS.................................................... 102
PLAN OF DISTRIBUTION....................................................... 104
LEGAL MATTERS.............................................................. 104
EXPERTS.................................................................... 105
AVAILABLE INFORMATION...................................................... 105
GLOSSARY................................................................... 106
FINANCIAL STATEMENTS....................................................... F-1
</TABLE>

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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 beginning
at page 106. The Company's current taxable affiliates include NFI Holding
Corporation ("Holding"), which owns NovaStar Mortgage, Inc. ("NovaStar
Mortgage"). The Company owns 100 percent of the preferred stock of Holding, for
which it receives 99 percent of the dividends paid by Holding. Holding wholly-
owns NovaStar Mortgage. The Company and its taxable affiliates share common
management. The Company's founders serve as the sole directors of Holding and
Mortgage. See "Prospectus Summary--Organization Structure" and "Management."
NovaStar Mortgage serves as a vehicle for loan origination--a primary source of
Mortgage Assets for the Company. NovaStar Mortgage also services loans for the
Company. The Company also has two wholly-owned, REIT-qualifying subsidiaries,
NovaStar Assets Corporation ("NAC") and NovaStar Certificates Financing
Corporation ("NCFC"), both Delaware corporations.

THE COMPANY

GENERAL

NovaStar Financial, Inc. ("NovaStar" or "the Company") is a specialty finance
company which:

(i) acquires single family residential subprime mortgage loans;

(ii) leverages its assets using warehouse facilities, including
repurchase agreements;

(iii) issues 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 the Private Placement offering on December 9, 1996, the Company
received net proceeds of $47 million. The Company completed its initial public
offering of 4,059,500 shares of Common Stock (the "IPO" or the "Initial Public
Offering") on December 1, 1997, receiving net proceeds (i.e., less the
underwriting discount but prior to deducting the expenses of the IPO) of $68
million. Upon closing of the IPO, each share of Preferred Stock automatically
converted into a share of Common Stock and the Warrants detached and became
separately transferable.

NovaStar Mortgage originates subprime residential mortgage loans through a
nationwide network of unaffiliated wholesale loan brokers and correspondents.
For the nine months ended September 30, 1997, NovaStar Mortgage originated $227
million in subprime mortgage loans, including $51.3 million in the month of
September. The Company expects that its primary source of wholesale loan
acquisitions will be from the purchase of loans from NovaStar Mortgage. Through
September 30, 1997, the Company has acquired all loans originated by NovaStar
Mortgage. In addition, the Company has purchased bulk pools of loans from
independent entities.

4
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together drawn new participants and capital to the subprime mortgage loan
market. See "Business--Mortgage Lending Operation--Market Overview."

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 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, loan volume
is expected to 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, 72 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 (A and A-). 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 91 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 by NovaStar Mortgage and purchased by the Company in 1997 was
approximately 78 percent. Substantially all of the loans 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 financial institution 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

Messrs. Hartman and Anderson and other members of senior management have
generally worked exclusively for established business organizations during
their careers and have limited or no experience in starting up a new business
entity such as the Company. In addition, the members of management of the
Company do not have experience working together as a management team.

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. Mr. Hartman also serves as a Director and Vice-
Chairman of NovaStar Mortgage.

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. Mr. Anderson also serves as Chairman of the Board of Directors,
President and Chief Executive Officer of NovaStar Mortgage.

5
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Mark J. Kohlrus, Senior Vice President, Treasurer and Chief Financial Officer
(for the Company and NovaStar Mortgage), 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 for NovaStar Mortgage, 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 (for the
Company and NovaStar Mortgage), 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 of
NovaStar Mortgage, previously managed the collection operations of Option One
Mortgage Corporation.

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

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 nine months ended September 30, 1997, the Company
has incurred net losses.

. 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. To date, one of the three
tranches has been forgiven upon meeting the required benchmarks. See
"Management."

. Dependence on Key Personnel for Successful Operations. Operations of the
Company and NovaStar Mortgage 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 those Companies' businesses 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. Each
employment agreement also provides that if the employee terminates his
employment without "good reason" prior to expiration of the term of the
agreement, certain incentive and severance benefits will be forfeited and
a restriction against competing with the Company will become effective.
Although the Company believes these forfeiture and non-compete provisions
would generally be enforceable, there can be no assurance that the
employee will not elect to terminate the agreement early despite these
provisions and no longer remain in the Company's employ. See
"Management--Executive Compensation."

. Limited Experience of Management in Starting-up New Business. Messrs.
Hartman and Anderson and other members of senior management have
generally worked exclusively for established business organizations
during their careers and have limited or no experience in starting up a
new business entity such as the Company. In addition, the members of
management of the Company do not have experience working together as a
management team.

6
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. 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
Company's results of operations 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 acquire mortgage loans in
expected volumes necessary to support fixed overhead expense levels.

. Intense Competition in the Subprime Mortgage Industry. The Company and
NovaStar Mortgage 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.

. Lack of Loan Performance Data. The mortgage loans 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 and NovaStar Mortgage are
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 (i) single family mortgage
loans or (ii) pass-through certificates and CMOs ("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.

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. 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.

. 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 Stock: Anti-takeover Effect."

BUSINESS STRATEGIES AND ADVANTAGES

There are two general aspects to the business of the Company: (i) mortgage
lending through the Company's taxable affiliate--NovaStar Mortgage, primarily
in the subprime market; and (ii) management of a portfolio of Mortgage Assets,
including Mortgage Assets acquired from NovaStar Mortgage and through secondary
market purchases.

MORTGAGE LENDING STRATEGIES

A primary source of Mortgage Assets for the Company are Subprime Mortgage
loans originated by NovaStar Mortgage. NovaStar Mortgage is a taxable affiliate
of and shares common management with the Company. Following are strategies
followed by NovaStar Mortgage in its mortgage lending operations and the impact
of those strategies on the loan portfolio of the Company as of and for the nine
months ended September 30, 1997.

. NovaStar Mortgage 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 believes
that this network allows for the Company to acquire mortgage assets at
more attractive prices than are available through secondary market
purchases. As of September 30, 1997, the mortgage lending operation of
NovaStar Mortgage had a staff of 72, including 29 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 nine months ended
September 30, 1997, 90 percent of NovaStar Mortgage's wholesale mortgage
loan originations had adjustable rates. As of September 30, 1997, 80
percent of the Company's mortgage loan portfolio had adjustable rates.

. Prepayment penalties, generally through a loan's first two years, are
emphasized in mortgage loan originations to protect the Company from the
impact of early prepayments on loans purchased at a premium. For the nine
months ended September 30, 1997, 73 percent of NovaStar Mortgage's
wholesale mortgage loan originations had prepayment penalties. As of
September 30, 1997, 66 percent of the Company's 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. NovaStar Mortgage has put in place an
experienced management team and staff to service its mortgage loans.

8
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Since inception, NovaStar Mortgage has concentrated on obtaining experienced
professionals and developing the infrastructure for its wholesale mortgage loan
origination operation. NovaStar Mortgage 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. All
loans originated by NovaStar Mortgage through September 30, 1997 were acquired
upon funding by the Company.

<TABLE>
<CAPTION>
WHOLESALE MORTGAGE LOAN
ORIGINATIONS
--------------------------------
NUMBER OF LOANS PRINCIPAL 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
September.............................. 389 51,280
----- --------
Total................................ 1,602 $226,961
===== ========
</TABLE>

During the nine months ended September 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 other warehouse facilities
to finance subprime mortgage loan 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 nine month period ended September 30, 1997, the Company has operated at
substantially below a fully leveraged position based upon the CAG.

9
<PAGE>

COMPETITIVE ADVANTAGES

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, 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 through its relationship with NovaStar
Mortgage, which originates and services mortgage loans;

(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 its
competitors. 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 loans 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 acquire wholesale loan production
through its taxable affiliate, NovaStar Mortgage at a total cost lower than
purchasing those mortgage loans in the secondary market. Moreover, the
Company's relationship with NovaStar Mortgage results in a vertically
integrated organization which is self-advised and self-managed. Because of this
integration, 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

10
<PAGE>

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."

The Company files its own income tax return, while Holding files consolidated
income tax returns that include NovaStar Mortgage. 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 The Company.
These activities include such items as the sale of assets, certain hedging
techniques and certain forms of indebtedness. Holding was formed in order to
provide an efficient means of adding additional taxable affiliates to the
organization.

Scott Hartman and Lance Anderson own 100 percent of the voting common stock
of Holding. Holding was capitalized through the purchase of common stock by
Scott Hartman and Lance Anderson in the amount of $20,000, and the purchase of
non-voting preferred stock by the Company 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 Holding as a result of their common stock
ownership. The Company receives 99 percent of the dividends of Holding as a
result of its preferred stock ownership. Accordingly, the Company indirectly
receives 99 percent of the dividends of NovaStar Mortgage by virtue of its
ownership interest in Holding. In addition, Mr. Hartman and Mr. Anderson serve
as the sole Directors of both Holding and NovaStar Mortgage.

In contracts with the Company, NovaStar Mortgage has agreed to (i) sell
subprime mortgage loans it originates to the Company, (ii) service subprime
mortgage loans for the Company and (iii) provide certain administrative
services to the Company. Without voting control of NovaStar Mortgage, there can
be no assurance that these contracts, which are subject to renewal, will
continue indefinitely. In addition, while Messrs. Hartman and Anderson have
entered into an agreement of shareholders which contains certain management and
control provisions and restrictions on transfer of Holding common stock, there
can be no assurance that the agreement will be enforced in a timely manner
against the individuals, their heirs or representatives. See "Risk Factors--
Lack of Voting Control of Taxable Affiliates" and "Certain Transactions--
Transactions with Management."

LOGO

11
<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 and $0.08 per share for the third quarter of 1997. All these
dividends were declared on Preferred Stock. Following the closing of the IPO,
the Company intends to declare quarterly dividends on its Common Stock. The
first such dividend, for the fourth quarter of 1997, was declared for $0.10 per
share of 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 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 "Plan Administrator").

Stockholders will not be automatically enrolled in the DRP. Each stockholder
desiring to participate in the DRP must complete and deliver to the Plan
Administrator 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 Plan Administrator 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

SECURITIES OFFERED

This Prospectus covers (a) offerings by Selling Securityholders of up to
3,549,999 shares of issued and outstanding Offered Common Stock and 3,649,999
Warrants that are owned by the Selling Securityholders at the date of this
Prospectus and up to 3,649,999 shares of Underlying Common Stock that may be
subsequently acquired by the Selling Securityholders upon the exercise of
Warrants, and (b) offerings by the Company of up to 3,649,999 shares of
Underlying Common Stock that may be issued pursuant to the exercise of
Warrants.

USE OF PROCEEDS

There will be no proceeds to the Company from the sale of the Offered Common
Stock or Warrants by the Selling Securityholders. The Company will use the
proceeds from the issuance of the Underlying Common Stock pursuant to the
exercise of the Warrants to fund the acquisition of the wholesale loan
production of NovaStar Mortgage and the acquisition of Mortgage Securities as
described herein and, pending such use, to reduce borrowings.

12
<PAGE>

RECENT DEVELOPMENTS

ISSUANCE OF COLLATERALIZED MORTGAGE OBLIGATIONS

On December 1, 1997, Company completed its Initial Public Offering of Common
Stock through the closing of the underwriters' over-allotment option. The over-
allotment was exercised to the extent of 309,500 additional shares of common
stock, which provided the Company with additional net proceeds of approximately
$5 million.

ISSUANCE OF COLLATERALIZED MORTGAGE OBLIGATIONS

On December 11, 1997, the Company completed its second securitization of
mortgage loans in a public transaction. Mortgage loans with a face amount of
approximately $223 million serve as collateral for CMO debt of approximately
$212 million.

FOURTH QUARTER DIVIDEND

On December 18, 1997, the Company's Board of Directors declared a dividend of
$0.10 per share on its outstanding common stock, which includes the shares sold
in the Company's recent IPO and the shares being registered in this Offering.
The dividend was paid on January 27, 1998 to stockholders of record as of
December 31, 1997.

13
<PAGE>

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

<TABLE>
<CAPTION>
FOR THE NINE MONTHS FOR THE SIX MONTHS
ENDED ENDED FOR THE PERIOD ENDED
SEPTEMBER 30, 1997 JUNE 30, 1997 DECEMBER 31, 1996(1)
------------------- ------------------ --------------------
<S> <C> <C> <C>
STATEMENT OF OPERATIONS
DATA
Interest income........ $21,545 $9,320 $155
Interest expense....... 16,224 6,438 --
Net interest income.... 5,321 2,882 155
Provision for credit
losses................ 1,444 718 --
Net interest income
after provision for
credit losses......... 3,877 2,164 155
Equity in loss of NFI
Holding Corporation... (141) (432) --
General and
administrative
expenses.............. 4,764 2,679 457
Net loss............... (702) (879) (302)
Pro forma net loss per
share(2).............. (0.16) (0.21) (0.07)
<CAPTION>
AS OF SEPTEMBER 30, AS OF JUNE 30, AS OF DECEMBER 31,
1997 1997 1996
------------------- ------------------ --------------------
<S> <C> <C> <C>
BALANCE SHEET DATA
Mortgage assets:
Mortgage securities.... $267,835 $284,348 $13,239
Mortgage loans......... 418,897 303,732 --
Total assets........... 699,133 601,865 59,796
Repurchase agreements.. 644,195 540,040 --
Stockholders' equity... 47,036 46,337 46,365
<CAPTION>
AS OF OR FOR THE AS OF OR FOR THE AS OF OR FOR THE
NINE MONTHS ENDED SIX MONTHS ENDED PERIOD ENDED
SEPTEMBER 30, 1997 JUNE 30, 1997 DECEMBER 31, 1996(1)
------------------- ------------------ --------------------
<S> <C> <C> <C>
OTHER DATA
Acquisition of
wholesale loan
production of NovaStar
Mortgage:
Principal at funding... $226,961 $90,380 --
Average principal
balance per loan...... $142 $157 --
Weighted average
interest rate:
Adjustable-rate
mortgage loans....... 10.0% 10.0% --
Fixed rate mortgage
loans................ 10.6% 10.6% --
Loans with prepayment
penalties............. 73% 82% --
Weighted average
prepayment penalty
period (in years)..... 2.7 2.7 --
Loans purchased in
bulk:
Principal at purchase.. $207,240 $207,240 --
Average principal
balance per loan...... $106 $106 --
Weighted average
interest rate:
Adjustable-rate
mortgage loans....... 9.6% 9.6% --
Fixed rate mortgage
loans................ 10.5% 10.5% --
Loans with prepayment
penalties............. 54% 54% --
Weighted average
prepayment penalty
period (in years)..... 3.0 3.0 --
Net interest spread.... 1.73% 1.77% --
Net yield.............. 2.02% 2.51% --
Return on assets....... (0.13)% (0.29)% (1.69)%
Return on equity....... (1.99)% (3.79)% (2.18)%
Taxable income (loss).. $871 $365 $(173)
Taxable income (loss)
per preferred share... $0.23 $0.10 $(0.05)
Dividends per preferred
share(3).............. $0.18 $0.10 --
Number of account
executives............ 29 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) 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."

14
<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 Securities 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.

OVERALL ENTERPRISE OF THE COMPANY

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 of NovaStar Mortgage began
in late January 1997 and NovaStar Mortgage began servicing loans on July 15,
1997. Accordingly, extensive earnings history have not been developed nor has
the Company 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 $702,000 for the period since
inception to December 31, 1996 and for the nine months ended September 30,
1997, respectively. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."

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.
For each tranche forgiven, the Company will recognize a non-cash charge
against earnings of $1,083,330 for the related accounting period. To date, one
tranche has been forgiven. 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 and dividends paid to
shareholders during periods forgiven-- including investors in this Offering.
See "Management--Executive Compensation."

Dependence on Key Personnel for Successful Operations

Operations of the Company and NovaStar Mortgage 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. Each

15
<PAGE>

employment agreement also provides that if the employee terminates his
employment without "good reason" prior to expiration of the term of the
agreement, certain incentive and severance benefits will be forfeited and a
restriction against competing with the Company will become effective. Although
the Company believes these forfeiture and non-compete provisions would
generally be enforceable, there can be no assurance that the employee will not
elect to terminate the agreement early despite these provisions and no longer
remain in the Company's employ. See "Management--Executive Compensation."

Limited Experience of Management in Starting-up New Business

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 additional
capital periodically. 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."

Lack of Voting Control of Taxable Affiliates

Holding was formed to serve as a holding company for the Company's taxable
affiliates in order to legally separate certain lines of business, such as the
mortgage loan origination operation, from the REIT entity, for regulatory,
tax, risk management and other reasons. Scott Hartman and Lance Anderson own
100 percent of the voting common stock of Holding while the Company owns 100
percent of its nonvoting preferred stock. The common stock is entitled to one
percent of the dividend distributions of Holding and the preferred stock is
entitled to 99 percent of such distributions. Holding wholly owns NovaStar
Mortgage, and the REIT thus owns a beneficial interest in 99 percent of any
future dividend distributions from NovaStar Mortgage. In contracts with the
Company, NovaStar Mortgage has agreed to (i) sell subprime mortgage loans it
originates to the Company, (ii) service subprime mortgage loans for the
Company and (iii) provide certain administrative services to the

16
<PAGE>

Company. Without voting control of NovaStar Mortgage, there can be no
assurance that these contracts between the Company and NovaStar Mortgage,
which are subject to renewal, will continue indefinitely. In addition, while
Messrs. Hartman and Anderson have entered into an agreement of shareholders
which contains certain management and control provisions and restrictions on
transfer of the common stock, there can be no assurance that the agreement
will be enforced in a timely manner against the individuals, their heirs or
representatives. See "Certain Transactions--Transactions with Management."

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.

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 acquire subprime mortgage 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

The Company and NovaStar Mortgage will face intense competition, primarily
from commercial banks, savings and loans, other independent mortgage lenders,
and certain other mortgage REITs. As NovaStar Mortgage 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
NovaStar Mortgage and to target customers similar to those targeted by
NovaStar Mortgage. In the future, NovaStar Mortgage may also face competition
from government-sponsored entities, such as the Federal National Mortgage
Association ("FNMA") and the Federal Home Loan Mortgage Corporation ("FHLMC").
For example, the FHLMC has recently issued securities collateralized by
subprime mortgage loans originated by a financial institution.

17
<PAGE>

The entrance of these competitors into NovaStar Mortgage'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 NovaStar Mortgage's experienced personnel and the
potential that such personnel will leave NovaStar Mortgage for its
competitors. There can be no assurance that NovaStar Mortgage 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 NovaStar
Mortgage 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.

High Loan-to-Value Products

The Company's current underwriting guidelines allow for the acquisition of
originated loans with up to a 90 percent loan-to-value ratio. See "Mortgage
Lending Operation--Underwriting and Quality Control Strategy." The higher the
loan-to-value ratio, the greater the risk that the Company may be unable to
recover full amounts due on its mortgage loans in the event the borrower
defaults and the Company forecloses and sells the underlying collateral. As of
September 30, 1997, the average loan-to-value ratio of the Company's mortgage
loan portfolio was 75 percent. The failure of the Company to adequately
address the risk of high loan-to-value products would have a material adverse
effect on the Company's results of operations and financial condition.

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. Most of the Company's loans
are made to borrowers who do not qualify for loans from conventional mortgage
lenders and, as of September 30, 1997, approximately seven percent and three
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 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 and NovaStar Mortgage depend upon independent mortgage loan
brokers and mortgage lenders for their originations and purchases of new
mortgage loans. The Company's competitors also seek to

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<PAGE>

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.

Legislation and Regulation

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 businesses of the Company and NovaStar Mortgage are 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 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 ("HUD") pursuant to the Home
Mortgage Disclosure Act ("HMDA"). The Company will also be subject to the
rules and regulations of, and examinations by, the Government National
Mortgage Association ("GNMA"), 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

19
<PAGE>

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, NovaStar Mortgage 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 Certain 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. Several federal
district courts construing RESPA in these cases have reached conflicting
results. On January 9, 1998, in the only appellate decision addressing the
issue to date, the United States Court of Appeals for the Eleventh Circuit
ruled in Culpepper v. Inland Mortgage Corporation that the payment by the
lender to the broker in that case constituted a prohibited referral fee under
RESPA. The case was remanded to the district court for further proceedings. If
the pending cases on lender payments to brokers are ultimately 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 currently utilize 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--Legislation and Regulation."

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 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.

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

20
<PAGE>

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 May Adversely Affect Results of Operations."

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.

As of September 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 September 30, 1997 (dollars in thousands).

<TABLE>
<CAPTION>
PERCENT OF MONTHS TO
PRINCIPAL TOTAL RESET
--------- ---------- ---------
<S> <C> <C> <C>
Adjustable rate loans:
One Year CMT............................. $ 22,629 5.6% 10
Two year fixed/six month LIBOR........... 205,159 50.7 21
Three year fixed/six month LIBOR......... 10,929 2.7 31
Six month LIBOR.......................... 86,460 21.4 4
-------- -----
325,177 80.4
Fixed Rate loans........................... 79,471 19.6
-------- -----
$404,648 100.0%
======== =====
</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 the Company have
adjustable terms today or are fixed today, but will adjust at some point in
the future. For instance, the Company's portfolio includes a high percentage
of mortgage loans with fixed rates for two years, at which time it becomes an
adjustable-rate mortgage (an "ARM"). As of September 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

21
<PAGE>

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 September 30, 1997, 88 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 agreements. As of
September 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

22
<PAGE>

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.

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 "--Decrease in Net Interest Income Due to Interest Rate
Fluctuations" 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

23
<PAGE>

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.

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

24
<PAGE>

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 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.

25
<PAGE>

In addition, in fluctuating interest rate environments, the spread between
ARM interest rates and interest rates on fixed-rate mortgage loans may
decrease, 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 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 September 30, 1997, the Company's equity
represented 6.7% 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

26
<PAGE>

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

27
<PAGE>

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 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 its 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 September 30, 1997, 31 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.

INVESTMENT IN THE COMMON STOCK IN THE OFFERING

Restrictions on Ownership of Capital Stock: Anti-takeover Effect

The Company's 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 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 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

28
<PAGE>

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."

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 (the
"Maryland GCL") 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.

29
<PAGE>

No Assurance of Active Public Trading Market

Although the Common Stock is listed on the New York Stock Exchange, there
can be no assurance that an active public trading market for the Common Stock
will be sustained.

Possible Volatility of Stock Price

In the active trading market for the Common Stock, 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.

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 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

At December 1, 1997, the Company had outstanding 7,516,665 shares of Common
Stock and 3,649,999 Warrants, of which 3,549,999 shares of Common Stock,
together with the Warrants (and a like number of shares of Underlying Common
Stock issuable upon exercise of those Warrants) are covered by the Shelf
Registration Statement of which this Prospectus is a part (the "Shelf
Registration Statement"). The Securities offered hereby became salable without
restriction upon effectiveness of the Shelf Registration Statement on February
3, 1998 (subject to a 90-day "lock-up" period following the closing of future
public offerings by the Company), subject to certain restrictions. An
additional 216,666 shares of Common Stock not being offered in this Offering
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 remaining
restricted shares of Common Stock have certain registration rights with
respect to such shares. See "Description of Capital Stock--Registration
Rights."

Options to purchase 549,972 shares of Common Stock were outstanding under
the Company's Stock Option Plan, which will vest on various dates extending
through November 4, 2007. The Company will file a Form S-8 registration
statement to permit shares issued pursuant to the exercise of options to be
sold.

30
<PAGE>

THE COMPANY

The Company was founded by Scott Hartman and Lance Anderson, the founders,
and incorporated 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, the Company 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."

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." The Company 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. NovaStar Mortgage was incorporated in the
State of Virginia on May 16, 1996 and is a wholly-owned subsidiary of Holding.
Although NovaStar Mortgage was formed in 1996, substantial operations did not
commence until January 1997. On October 1, 1997, NAC, a wholly-owned, REIT-
qualifying subsidiary, was founded by the Company in conjunction with its
first issuance of a CMO, and on December 3, 1997, NCFC, a second wholly-owned
REIT-qualifying subsidiary, was founded by the Company.

The basic function of the Company is to manage its Mortgage Assets. NovaStar
Mortgage serves as a source for loan origination--a primary source of Mortgage
Assets for the Company. In addition, NovaStar Mortgage will service loans
owned by the Company. Through September 30, 1997, all loans originated by
NovaStar Mortgage were sold to the Company and the Company 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 Company will receive no proceeds from the sale of Common Stock or
Warrants by the Selling Securityholders, but it will receive the net proceeds
from the sale of Underlying Common Stock. The Company anticipates using
approximately 90 percent of the net proceeds from the Underlying Common Stock
to fund the acquisition of the wholesale loan production of NovaStar Mortgage
and the acquisition of Mortgage Securities, in accordance with its business
strategies. The remaining 10 percent of the net 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 its net proceeds of this Offering in Mortgage Assets as soon as
reasonably practicable upon receipt of such proceeds. The Company has not
specifically identified any Mortgage Assets in which to invest its net
proceeds of this Offering.

31
<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 all or part 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 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 "Plan Administrator").

Stockholders will not be automatically enrolled in the DRP. Each stockholder
desiring to participate in the DRP must complete and deliver to the Plan
Administrator 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 Plan
Administrator 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.

32
<PAGE>

CAPITALIZATION

The table below sets forth the capitalization of the Company as of September
30, 1997 and as adjusted to give effect to the sale by the Company of
4,059,500 shares of Common Stock sold in the IPO, the conversion of all
outstanding Preferred Stock into Common Stock and the exercise of all
Warrants.

<TABLE>
<CAPTION>
AS OF SEPTEMBER 30, 1997
--------------------------
ACTUAL AS ADJUSTED(1)(2)
------- -----------------
(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 11,476,164
(as adjusted) shares issued and outstanding.... 2 115
Additional paid-in capital........................ 49,862 171,658
Accumulated deficit............................... (1,643) (1,643)
Net unrealized gain on available-for-sale
securities....................................... 2,239 2,239
Forgivable notes receivable from founders......... (3,460) (3,460)
------- --------
Total......................................... $47,036 $168,909
======= ========
</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 offering expenses and underwriting discounts on the IPO and
this Offering total $5,947,970.

MARKET PRICES AND DIVIDEND DATA

The Common Stock of the Company is traded on the NYSE under the symbol "NFI.
The Company's Warrants are expected to trade through market makers, such as
Stifel, Nicolaus & Company, Incorporated, using the NASD's OTC Bulletin Board
Service. The following table sets forth, for the periods indicated, the high
and low sales prices per share of Common Stock on the NYSE and the cash
dividends paid or payable per share of Capital Stock.

COMMON STOCK PRICES CASH DIVIDENDS

<TABLE>
<CAPTION>
DATE DATE PAID AMOUNT
CLASS DECLARED OR PAYABLE PER SHARE
----- -------- ---------- ---------
<S> <C> <C> <C>
Preferred Stock. 3/13/97 4/30/97 $0.05
6/18/97 7/30/97 $0.05
9/18/97 10/20/97 $0.08
Common Stock.... 12/19/97 1/27/98 $0.10
</TABLE>
<TABLE>
<CAPTION>

HIGH LOW
------ ------
<S> <C> <C>
10/31/97 to 12/31/97(1).... 22 3/8 15 1/4
</TABLE>
- --------
(1) The Company's Common Stock began trading on October 31, 1997. There has
not yet been a full quarter of trading information which may be reported.

On February 3, 1998, the last reported sales price for the Common Stock was
$17 3/16 per share. As of December 31, 1997, the Company's 7,828,665 shares of
Common Stock were held by over 2,000 stockholders.

The Company intends to pay quarterly dividends. The Company intends to make
distributions to its stockholders of all or substantially all of its taxable
income in each year (subject to certain adjustments) so as to qualify for the
tax benefits accorded to a REIT under the Code. All distributions will be made
by the Company at the discretion of the Board of Directors and will depend on
the earnings of the Company, financial condition of the Company, maintenance
of REIT status and such other factors as the Board of Directors may deem
relevant from time to time. See "Dividend Policy and Distributions."

33
<PAGE>

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

The following selected financial data are derived from the 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 nine months
ended September 30, 1997 are not necessarily indicative of the results that
may be expected for the year ending December 31, 1997.

<TABLE>
<CAPTION>
FOR THE NINE MONTHS ENDED FOR THE SIX MONTHS ENDED FOR THE PERIOD ENDED
SEPTEMBER 30, 1997 JUNE 30, 1997 DECEMBER 31, 1996(1)
------------------------- ------------------------ --------------------
<S> <C> <C> <C>
STATEMENT OF OPERATIONS
DATA
Interest income........ $ 21,545 $ 9,320 $ 155
Interest expense....... 16,224 6,438 --
Net interest income.... 5,321 2,882 155
Provision for credit
losses................ 1,444 718 --
Net interest income
after provision for
credit losses......... 3,877 2,164 155
Equity in loss of NFI
Holding Corporation... (141) (432) --
General and
administrative
expenses.............. 4,764 2,679 457
Net loss............... (702) (879) (302)
Pro forma net loss per
share(2).............. (0.16) (0.21) (0.07)
<CAPTION>
AS OF
AS OF SEPTEMBER 30, 1997 AS OF JUNE 30, 1997 DECEMBER 31, 1996
------------------------- ------------------------ --------------------
<S> <C> <C> <C>
BALANCE SHEET DATA
Mortgage assets:
Mortgage securities.... $267,835 $284,348 $13,239
Mortgage loans......... 418,897 303,732
Total assets........... 699,133 601,865 59,796
Repurchase agreements.. 644,195 540,040 --
Stockholders' equity... 47,036 46,337 46,365
<CAPTION>
AS OF OR FOR THE NINE AS OF OR FOR THE SIX AS OF OR FOR THE
MONTHS ENDED MONTHS ENDED PERIOD ENDED
SEPTEMBER 30, 1997 JUNE 30, 1997 DECEMBER 31, 1996(1)
------------------------- ------------------------ --------------------
<S> <C> <C> <C>
OTHER DATA
Acquisition of
wholesale loan
production of NovaStar
Mortgage:
Principal at funding... $226,961 $ 90,380 --
Average principal
balance per loan...... $ 142 $ 157 --
Weighted average
interest rate:
Adjustable-rate
mortgage loans....... 10.0% 10.0% --
Fixed rate mortgage
loans................ 10.6% 10.6% --
Loans with prepayment
penalties............. 73% 82% --
Weighted average
prepayment penalty
period (in years)..... 2.7 2.7 --
Loans purchased in
bulk:
Principal at purchase.. $207,240 $207,240 --
Average principal
balance per loan...... $ 106 $ 106 --
Weighted average
interest rate:
Adjustable-rate
mortgage loans....... 9.6% 9.6% --
Fixed rate mortgage
loans................ 10.5% 10.5% --
Loans with prepayment
penalties............. 54% 54% --
Weighted average
prepayment penalty
period (in years)..... 3.0 3.0 --
Net interest spread.... 1.73% 1.77% --
Net yield.............. 2.02% 2.51% --
Return on assets....... (0.13)% (0.29)% (1.69)%
Return on equity....... (1.99)% (3.79)% (2.18)%
Taxable income (loss).. $ 871 $ 365 $ (173)
Taxable income (loss)
per preferred share... $ 0.23 $ 0.10 $ (0.05)
Dividends per preferred
share(3).............. $ 0.18 $ 0.10 --
Number of account
executives............ 29 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) 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."

34
<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 Financial and Other Data and the Company's Financial Statements and
the Notes thereto, included elsewhere in this Prospectus.

SAFE HARBOR STATEMENT

"Safe Harbor" statement under the Private Securities Litigation Reform Act
of 1995: Statements in this discussion regarding NovaStar Financial, Inc. (the
Company) and its business which are not historical facts are "forward-looking
statements" that involve risk and uncertainties. For a discussion of such
risks and uncertainties, which could cause actual results to differ from those
contained in the forward-looking statements, see "Risk Factors" commencing on
page 15.

OVERVIEW

The Company is a specialty finance company engaged in the business of
acquiring primarily single family residential subprime mortgage loans. The
Company was incorporated on September 13, 1996. Through a private placement,
the Company raised $47 million in December 1996, allowing it to commence
operations. 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 $699 million as of
September 30, 1997. The operating results and financial condition of the
Company reflect this growth and should be interpreted accordingly.

The Company owns 100 percent of the non-voting preferred stock of NFI
Holding Corporation (Holding) for which it receives 99 percent of any
dividends paid by Holding. The founders of the Company own the voting common
stock of Holding. NovaStar Mortgage is a wholly owned subsidiary of Holding.
Certain key officers of the Company serve as officers of Holding and NovaStar
Mortgage and the founders are the only members of the Board of Directors of
Holding and NovaStar Mortgage. The Company accounts for its investment in
Holding using the equity method.

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. 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, it 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 acquisitions.

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 yield on Mortgage Assets and the cost of
related borrowings. However, to the extent that borrowing costs adjust at
different times or amounts relative to the yield on Mortgage Assets, the
Company is subject to interest rate risk. When the cost of borrowings
increases more rapidly than the yield 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 yield on assets causing
an increase in net interest income. Management monitors and aggressively
manages interest rate risk. However, the Company's Mortgage Asset portfolio
cannot be completely hedged against changing interest rates.

35
<PAGE>

A major component of the operations of the Company is the equity in earnings
(loss) of NFI Holding Corporation, which includes the results of NovaStar
Mortgage. Many costs of NovaStar Mortgage 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 $51.3
million in September 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 nine 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 that infrastructure will allow NovaStar
Mortgage to originate Mortgage Assets at favorable prices compared to those
which could be acquired in the secondary market.

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 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, it is expected that the volume of loans originated by NovaStar
Mortgage will be less dependent on the general level of interest rates or home
sales and therefore less cyclical than conventional mortgage lending.

Principally through the mortgage lending operation of NovaStar Mortgage, the
Company will continue adding interest-earning assets to its balance sheet.
Prior to the initial public offering, the Company 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 initial public offering increased the Company's capital
base by issuing shares of Common Stock. Capital will, in the short term, be
used to retire certain borrowings. In the long term, proceeds would be used
primarily to acquire additional Mortgage Assets. 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 received 216,666 units upon closing of the 1996
private placement. A unit consisted of one share of convertible preferred
stock and one common stock warrant. Payment for these units was made by the
founders delivering forgivable promissory notes. Principal on these notes will
be forgiven if certain incentive performance targets are achieved. 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, the value of the warrant, and dividends paid. One tranche will be
forgiven for each fiscal period that the Company generates a total return of
15 percent to investors in the private placement. The debt on the first
tranche was forgiven and the Company recognized a non-cash charge against
earnings of $1,083,330 for the fiscal period ending December 31, 1997. All
tranches will be forgiven if the Company generates a 100 percent return. As of
September 30, 1997, the aggregate amount receivable from founders was $3.4
million, including $210,000 of accrued interest.

Investors in the 1996 private placement offering paid $15 for each unit
acquired. Warrants issued in connection with the private placement were
assigned a value of $1.50. During October 1997, the Company completed an
initial public offering of its common stock at a price of $18 per share.
Accordingly, the Company achieved a 15% return to private placement investors
during 1997, resulting in the forgiveness of one tranche of the forgivable
notes. This resulted in the recognition of $1.1 million non-cash charge to
earnings during the 1997 fourth quarter.

FINANCIAL CONDITION AS OF SEPTEMBER 30, 1997

During the first five months of 1997, the Company added over $200 million in
mortgage loans to its balance sheet through the purchase of bulk pools of
loans originated by other mortgage lenders. After that time, the Company has
not purchased any bulk pools of loans. During February 1997, NovaStar Mortgage
originated its first wholesale production loans. From that time through
September 30, 1997, NovaStar Mortgage has originated

36
<PAGE>

1,602 wholesale production loans with an aggregate principal amount of $227
million. The Company has purchased all loans originated by NovaStar Mortgage
during 1997. Table I is a summary of wholesale loan originations and bulk
acquisitions by month.

TABLE I
WHOLESALE LOAN ORIGINATIONS(1) AND ACQUISITIONS
NINE MONTHS ENDED SEPTEMBER 30, 1997 (DOLLARS IN THOUSANDS)

<TABLE>
<CAPTION>
WHOLESALE
ORIGINATIONS(1) 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
July.................. 271 35,228 -- -- 271 35,228
August................ 365 50,073 -- -- 365 50,073
September............. 389 51,280 -- -- 389 51,280
----- -------- ----- -------- ----- --------
Total............. 1,602 $226,961 1,952 $207,240 3,554 $434,201
===== ======== ===== ======== ===== ========
</TABLE>
- --------
(1) Loans originated by NovaStar Mortgage and purchased by the Company.

Further details regarding mortgage loans outstanding as of September 30,
1997 are given in various sections of "Business".

The Company has been an active investor in mortgage securities issued by
Government-sponsored entities. During the nine months ended September 30,
1997, the Company acquired securities with an aggregate cost of $380.8 million
and sold securities with an aggregate carrying value, at the time of sale, of
$99.8 million. As of September 30, 1997, mortgage securities totaled $267.8
million.

Loans originated through the lending operations of NovaStar Mortgage have
typically been funded through NovaStar Mortgage's $50 million mortgage loan
warehouse agreement with First Union National Bank. The Company has a $300
million master repurchase line with Merrill Lynch Mortgage Capital, Inc. and
Merrill Lynch Credit Corporation to fund acquisitions of Mortgage loans.
During the third quarter, the line was temporarily increased to $400 million
while the Company was preparing for the private placement of its CMO. During
the first nine months of 1997, funds borrowed under this agreement were used
to acquire some of the largest pools of mortgage loans acquired by the
Company. Funds borrowed against the master repurchase agreement are also used
to buy loans from NovaStar Mortgage, which in turn pays down advances under
its 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 operation.

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 using this method to finance its acquisition of
mortgage securities.

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.
Management expects to use proceeds from future capital issuances in this
manner.

37
<PAGE>

Amounts outstanding under borrowing arrangements aggregated $644.2 million
as of September 30, 1997.

The Company expects to make a regular practice of aggregating 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 repay amounts borrowed under its repurchase and
other short-term financing agreements. This will free those facilities for
further asset acquisitions.

The Company issued its first CMO during October 1997 in a private
transaction in which approximately $276 million in mortgage loans serve as
collateral of debt issued with a face amount of $264 million. The debt
issuance has an estimated life of 2.0 years and bears interest based on one
month LIBOR plus 25 basis points, which resets monthly. Proceeds from the
issuance of this CMO were used to repay amounts borrowed under the Company's
master repurchase agreement.

RESULTS OF OPERATIONS--NINE MONTHS ENDED SEPTEMBER 30, 1997

Net Interest Income

Interest Income. The Company had average interest-earning assets of $351.6
million during the nine months ended September 30, 1997, including $135.4
million of mortgage securities, and $216.2 million of mortgage loans. During
the nine month period, mortgage securities earned $6.8 million, or a yield of
6.7 percent, while mortgage loans earned $14.7 million, or a yield of 9.1
percent. In total, assets earned $21.5 million, or an 8.2 percent yield.

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 current market
rates ("teaser" rates). As a result, during the first nine months of 1997
these assets, collectively, have not adjusted upward to their full potential
coupon rate. This results in a temporarily 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 to the Company.

The Company 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 acquire mortgage loans that have
some form of prepayment penalty. Of all loans acquired from NovaStar Mortgage
during the nine months ended September 30, 1997, 73 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 its Mortgage Asset portfolio to continue to increase
through wholesale loan originations. Management will continue to monitor the
market 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 $16.2
million during the nine months ended September 30, 1997, or 6.4 percent of
average borrowings. Advances under the master repurchase agreement bear
interest at rates based on LIBOR, plus a spread. During the nine months ended
September 30, 1997, the 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. Rates on
other borrowings generally fluctuate with short-term market interest rates,
such as LIBOR or the Federal Funds rate.

38
<PAGE>

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

TABLE II
INTEREST ANALYSIS NINE MONTHS ENDED SEPTEMBER 30, 1997 (DOLLAR
AMOUNTS IN THOUSANDS)

<TABLE>
<CAPTION>
DAILY
AVERAGE INTEREST ANNUAL
BALANCE INCOME/EXPENSE YIELD/RATE
-------- -------------- ----------
<S> <C> <C> <C>
ASSETS
Mortgage securities.................. $135,380 $ 6,796 6.69%
Mortgage loans....................... 216,233 14,749 9.09
-------- ------- ----
Total interest-earning assets...... $351,613 21,545 8.17
========
LIABILITIES
Master repurchase agreement.......... $191,671 9,747 6.78
Other repurchase agreements.......... 127,911 5,646 5.89
Other borrowings (1)................. 16,397 831 6.76
-------- ------- ----
Total borrowings................... $355,981 16,224 6.44
======== -------
Net interest income.................... $ 5,321
=======
Net interest spread.................... 1.73%
====
Net yield.............................. 2.02%
====
</TABLE>
--------
(1) Represents borrowings of NovaStar Mortgage and interest
paid thereon. The Company reimburses interest expenses
incurred by NovaStar Mortgage under the terms of an
Administrative Services Outsourcing Agreement. See Note 9
to the Company's financial statements.

Net Interest Income and Spread. Net interest income during the first nine
months of 1997 was $5.3 million, or 2.02 percent of average interest-earning
assets. Net interest spread for the Company was 1.73 percent during the nine
months ended September 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. This lower cost of funds offsets, to some degree, the lower yield on
"teased" assets, as discussed above. In addition, the Company has entered into
interest rate agreements to mitigate the exposure to 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.

Impact of Interest Rate Agreements. During the nine months ended September
30, 1997, the Company entered into certain interest rate agreements designed
to mitigate exposure to interest rate risk. Two of these agreements are
interest rate cap agreements, with a combined notional amount of $170 million,
which require the Company to pay a monthly fixed premium while allowing it 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 nine months
ended September 30, 1997, the Company incurred net interest expense on these
agreements of $808,000. 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.

Gains and Losses on Securities Sales

The Company classifies its mortgage securities as available-for-sale because
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
any mortgage loans and, as a general rule the Company does not intend to sell
mortgage

39
<PAGE>

loans in the future. The Company's strategy 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 nine months ended September 30, 1997, the
Company provided $1,444,000 for credit losses.

Table III presents a summary of delinquent loans as of September 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 SEPTEMBER 30, 1997

<TABLE>
<CAPTION>
PERCENT
OF TOTAL
MORTGAGE OUTSTANDING
LOANS PRINCIPAL
-------- -----------
<S> <C> <C>
Loans delinquent 60 to 90 days....................... 1.77% $ 7,179
Loans delinquent greater than 90 days................ 1.47% 5,941
----- -------
Total............................................ 3.24% $13,120
===== =======
</TABLE>

General and Administrative Expenses

Table IV displays general and administrative expenses for the nine months
ended September 30, 1997.

TABLE IV
GENERAL AND ADMINISTRATIVE EXPENSES
NINE MONTHS ENDED SEPTEMBER 30, 1997 (IN THOUSANDS)

<TABLE>
<S> <C>
Administrative services provided by NovaStar Mortgage............. $2,450
Loan servicing.................................................... 701
Compensation and benefits......................................... 694
Professional and outside services................................. 430
Office administration............................................. 201
Other............................................................. 288
------
Total............................................................. $4,764
======
</TABLE>

40
<PAGE>

The primary component of general and administrative expenses is the
administrative service fee paid to NovaStar Mortgage. NovaStar Mortgage
provides mortgage loan underwriting and funding services on behalf of the
Company. During the nine months ended September 30, 1997, the fee paid for
these services was $2,450,000.

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 engaged NovaStar Mortgage to service its
mortgage loans. Management believes that by servicing its own mortgage loans
(through NovaStar Mortgage), 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".

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
nine months ended September 30, 1997, particularly in the area of 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 nine months ended September 30, 1997 relate to the execution of
numerous agreements with market counterparties.

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.

Equity in Earnings of Unconsolidated Subsidiary

The Company owns 100 percent of the preferred stock and receives 99 percent
of the economic benefits of Holding, which wholly owns NovaStar Mortgage. The
Company accounts for its investment in Holding on the equity method. For the
nine months ended September 30, 1997, Holding incurred a loss of $143,000, of
which the Company recorded its portion ($142,000). The loss generated by
Holding is a result of the significant general and administrative expense
incurred by NovaStar Mortgage in building its wholesale lending
infrastructure. NovaStar Mortgage incurs significant general and
administrative expenses in generating loan production. The Company pays
NovaStar Mortgage an administrative outsourcing fee for costs associated with
its loan production operation as the Company purchases these loans at the time
of funding.

During the first nine months of 1997, NovaStar Mortgage incurred significant
costs in developing its infrastructure for the loan origination operation. The
primary expense for NovaStar Mortgage is compensation and benefits for its
sales, underwriting and supporting staffs. Substantial expenses related to
professional fees were also incurred.

Net Loss

During the nine months ended September 30, 1997, the Company recorded a net
loss of $702,000, primarily as a result of the significant costs associated
with the development of its operations and NovaStar Mortgage. During the first
part of 1997, the Company focused on the hiring of key employees and the
development of policies and procedures. The results for the nine months ended
September 30, 1997 also reflect the significant cost of developing operations.
During the Company's rapid expansion in 1997, the Company's operating expenses
have increased more rapidly than its revenues.

41
<PAGE>

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 financial reporting purposes includes the results of
Holding under the equity method. 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
NINE MONTHS ENDED SEPTEMBER 30, 1997 (IN THOUSANDS)

<TABLE>
<S> <C>
Net loss......................................................... $ (702)
Results of Holding and subsidiary................................ 143
Provision for credit losses...................................... 1,444
Other, net....................................................... (14)
------
Taxable income............................................... $ 871
======
</TABLE>

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. In addition the Company has
purchased all loans originated by NovaStar Mortgage. During February 1997,
NovaStar Mortgage originated its first wholesale production loans. From that
time until June 30, 1997 NovaStar Mortgage has originated 577 wholesale
production loans with an aggregate principal amount of $90 million. Table VI
summarizes the Company's loan originations and bulk acquisitions by month.

TABLE VI
WHOLESALE LOAN ORIGINATIONS(1) AND ACQUISITIONS
SIX MONTHS ENDED JUNE 30, 1997 (DOLLARS IN THOUSANDS)

<TABLE>
<CAPTION>
WHOLESALE
ORIGINATIONS(1) 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>
--------
(1) Loans originated by NovaStar Mortgage and purchased by the
Company.

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

42
<PAGE>

As an alternative investment while NovaStar Mortgage's 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 Company's financial
statements.

Loans originated through the lending operations of NovaStar Mortgage have
typically been funded through NovaStar Mortgage's $50 million mortgage loan
warehouse agreement with First Union National Bank. The Company has a $300
million master repurchase agreement with Merrill Lynch Mortgage Capital, Inc.
and Merrill Lynch Credit Corporation to fund acquisitions of Mortgage loans.
During the first half of 1997, funds borrowed under this agreement were used
to acquire some of the largest pools of mortgage loans acquired by the
Company. Funds borrowed against the master repurchase agreement are also used
to buy loans from NovaStar Mortgage, which in turn pays down advances under
its 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 by the Company 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 the Company's borrowing arrangements aggregated
$540.0 million as of June 30, 1997. Details of these borrowings are included
in Note 4 to the Company's financial statements. In addition, as of June 30,
1997 the Company had $14.1 million due to NovaStar Mortgage for the purchase
of mortgage loans.

The Company expects to make a regular practice of aggregating substantially
all of its outstanding mortgage loans to serve as collateral for the issuance
of its own collateralized mortgage obligations ("CMOs"). Proceeds from issuing
CMOs will be used to repay amounts borrowed master repurchase agreements. This
will free those facilities for further asset acquisitions.

The Company intends to structure these transactions as financing
arrangements, as opposed to sales of mortgage loans. See "Business--Portfolio
Management--Mortgage Loans held as Collateral for Structured Debt." As a
result, the consummation of these transactions will not significantly alter
the financial position of the Company. Although the Company may experience
some change in its overall financing costs through issuing CMOs, management
does not expect the impact to the results of operations for the Company to be
significant.

CMO offerings will be credit enhanced in two ways. CMOs will be over-
collateralized in the amount of approximately two to five percent, meaning
that the unpaid principal on the underlying collateral will be approximately
102 to 105 percent of the debt issued. Overcollateralization provides
assurance to the debt-holders

43
<PAGE>

that the collateral underlying the debt securities will be sufficient to cover
debt obligations. Also, the Company will buy insurance to guarantee, in the
event of default, that the Company's CMO obligations will be met.

The Company issued its first CMO during October 1997 in a private
transaction in which approximately $275 million in mortgage loans serve as
collateral for debt issued with a face amount of $265 million. See Note 12 to
the Company's financial statements.

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

Net Interest Income

Table VII 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.

The Company 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 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 NovaStar Mortgage 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 bear interest at rates based on LIBOR, plus a spread.
During the six months ended June 30, 1997, 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. Rates on other borrowings generally fluctuate with short-term
market interest rates, such as LIBOR or the Federal Funds rate.

44
<PAGE>

TABLE VII
INTEREST ANALYSIS
SIX MONTHS ENDED JUNE 30, 1997 (DOLLARS AMOUNTS IN THOUSANDS)

<TABLE>
<CAPTION>
DAILY 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
Other repurchase agreements.................... 56,226 1,637 5.82
Other borrowings(1)............................ 13,711 442 6.44
-------- ------
Total borrowings............................. $202,874 6,438 6.35
======== ======
Net interest income.............................. $2,882
======
Net interest spread.............................. 1.77%
====
Net yield........................................ 2.51%
====
</TABLE>
- --------
(1) Represents borrowings of NovaStar Mortgage and interest paid thereon. The
Company reimburses interest expenses incurred by NovaStar Mortgage under
the terms of an Administrative Services Outsourcing Agreement. See Note 9
to the Company's financial statements.

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 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.

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 Notes 4 and 5 to the Company's
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

45
<PAGE>

sold mortgage loans and 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

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 VIII 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 VIII
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>

General and Administrative Expenses

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

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

<TABLE>
<S> <C>
Administrative services provided by NovaStar Mortgage.............. $1,250
Loan servicing..................................................... 571
Compensation and benefits.......................................... 369
Professional and outside services.................................. 249
Office administration.............................................. 112
Other.............................................................. 128
------
Total.......................................................... $2,679
======
</TABLE>

The primary component of general and administrative expenses is the
administrative service fee paid to NovaStar Mortgage for loan origination.
During the six months ended June 30, 1997, this fee was $1,250,000. See Note 9
to the Company's financial statements.

46
<PAGE>

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 engaged NovaStar Mortgage to service its
mortgage loans. Management believes that by servicing its own mortgage loans
(via its taxable affiliate), 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."

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 area of 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.

Equity in Earnings of Unconsolidated Subsidiary

The Company owns 100 percent of the preferred stock and receives 99 percent
of the economic benefits of Holding, which wholly owns NovaStar Mortgage. The
Company accounts for its investment in Holding on the equity method. For the
six months ended June 30, 1997, Holding incurred a loss of $436,000, of which
the Company recorded its portion ($432,000). The loss generated by Holding is
a result of the significant general and administrative expenses incurred by
NovaStar Mortgage in building its wholesale lending infrastructure. NovaStar
Mortgage incurs significant general and administrative expenses in generating
loan production. The Company pays NovaStar Mortgage an administrative
outsourcing fee for costs associated with its loan production operation as the
Company purchases these loans at the time of funding.

During the first six months of 1997, NovaStar Mortgage incurred significant
costs in developing its infrastructure for the loan origination operation. The
primary expense for NovaStar Mortgage is compensation and benefits for its
sales, underwriting and supporting staffs. Substantial expenses related to
professional fees were also incurred.

The consolidated financial statements for Holding are presented beginning at
page F-19.

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 and those of NovaStar Mortgage. From the
date of the closing of the Private Placement in December 1996 through June 30,
1997, the Company's and NovaStar Mortgage'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.

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<PAGE>

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, the
equity in the net loss of Holding is not deductible by the Company. Table X is
a summary of the differences between the net loss reported for GAAP, as
reported herein, and taxable income.

TABLE X
TAXABLE INCOME
SIX MONTHS ENDED JUNE 30, 1997 (IN THOUSANDS)

<TABLE>
<S> <C>
Net loss........................................................... $(879)
Results of Holding and subsidiary.................................. 536
Provision for credit losses........................................ 718
Other, net......................................................... (10)
-----
Taxable income..................................................... $ 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 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 credit facilities to
fund its acquisition of wholesale loan originations and mortgage securities.
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 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 securities. 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 to
provide additional cash for liquidity needs.

On December 1, 1997, the Company also successfully completed its initial
public offering of 4,059,500 shares of common stock at $18 per share. Net
proceeds of the offering were $68 million, which approximately 90 percent of
the proceeds will be used to fund the acquisition of the wholesale loan
production of NovaStar Mortgage and the acquisition of mortgage securities, in
accordance with its business strategies. The remaining 10 percent of the net
proceeds will be used for working capital and general corporate purposes.

The Company's business requires substantial cash to support its operating
activities and growth plans. Management believes that net proceeds from the
initial public 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.

For the nine months ended September 30, 1997, operating activities and
financing activities provided cash of $3.3 million and $649.5 million, while
investing activities used cash of $695.1 million.

48
<PAGE>

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 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 June 30, 1997 financial statements describes certain recently
issued accounting pronouncements. Management believes the implementation of
these pronouncements will not have a material impact on the financial
statements.

49
<PAGE>

BUSINESS

There are two general aspects to the business of the Company: (i)
acquisition of Mortgage Assets, most notably the subprime mortgage loans
originated by NovaStar Mortgage and (ii) management of a portfolio of Mortgage
Assets. NovaStar Mortgage is a primary supplier of Mortgage Assets to the
Company. The mortgage lending operations of NovaStar Mortgage are integral to
the business of the Company.

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 was 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.

50
<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 is mortgage lending, through
the Company's taxable affiliate, NovaStar Mortgage. Loans originated are
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. NovaStar Mortgage targets 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, NovaStar Mortgage 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.

Originations have primarily 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. Through September 30, 1997, 73 percent of the mortgage
loans originated by NovaStar Mortgage and acquired by the Company have
included a prepayment penalty.

Marketing and Production Strategy

General. NovaStar Mortgage's competitive strategy is to build efficient
channels of production for originating subprime mortgage loans. NovaStar
Mortgage has generated mortgage product through two distinct production
channels: (i) direct origination through a wholesale broker network; and (ii)
bulk acquisitions from originators. NovaStar Mortgage'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

51
<PAGE>

many new competitors have recently entered the subprime mortgage loan market,
the Company believes that the 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 affiliate 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 NovaStar
Mortgage is 20 percent and 80 percent, respectively. NovaStar Mortgage
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. NovaStar Mortgage 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 78 percent and the
average loan amount is $142,000.

Wholesale Channel. NovaStar Mortgage'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 NovaStar
Mortgage 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
NovaStar Mortgage 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 November 30,
1997, the Company had a staff of 33 account executives, located in offices
nationwide, whose job is to call on brokers. Supporting the sales force is a
staff of 44 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
vertically integrated with its wholesale originator. 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 NovaStar Mortgage 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 with respect to bulk acquisitions may be performed from time
to time by contract underwriters under the guidance of the Company's Chief
Credit Officer. The Chief 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 Chief Credit Officer. Only the Chief Credit Officer and the
President can make the ultimate decision to approve a loan when the borrower
has an open bankruptcy. Personnel for this channel are centralized in the
mortgage operations headquarters with the

52
<PAGE>

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.

Retail Channel. Neither the Company or NovaStar Mortgage have 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 or NovaStar Mortgage do 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 purchases loans in accordance with its
underwriting guidelines (the "Underwriting Guidelines") described herein.
These Underwriting Guidelines were developed by the Company's senior
management 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.

NovaStar Mortgage underwrites all mortgage loans it originates through its
wholesale channel. Loans acquired by the Company in bulk pools are subject to
the same Underwriting Guidelines as established for NovaStar Mortgage
production. NovaStar Mortgage has hired experienced underwriters who work
under the supervision of the Chief Credit Officer. The underwriters hired by
NovaStar Mortgage all have substantial experience in the underwriting of
subprime mortgage loans and generally have a minimum of ten years experience.
As of September 30, 1997, NovaStar Mortgage employed twelve 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

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<PAGE>

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. The
Chief Credit Officer and the President have the authority to approve a loan
when the potential borrower has an open bankruptcy.

Each loan applicant completes an application that includes information with
respect to the applicant's 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 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, verification of
income is not required. However, personal or business bank statements for the
most recent six months are required as evidence of cash flows. 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 History. Maximum one Maximum two Maximum three Maximum five Maximum six 30-day
30-day late and no 30-day lates and 30-day lates and 30-day lates lates, three
60-day lates within no 60-day lates one 60-day late and two 60-day 60-day lates and
last 12 months within last 12 months within the last lates within the last two 90-day lates
12 months 12 months within the last
12 months. Must
be current at time
of origination
Other Credit..... Limited 30-day Limited 60-day Limited 60-day Limited 90-day Discretionary--
lates within the last lates within the lates within the lates within credit is generally
12 months. last 12 months last 12 months the last 12 months expected to be
Generally paid as late pay
agreed
Bankruptcy Chapter 13 must be Chapter 13 must Chapter 13 must Chapter 13 no Chapter 13 no
Filings......... discharged min- be discharged be discharged seasoning required seasoning required
imum of 1 year minimum of 1 minimum of on discharge with on discharge with
with reestablished year with re- 1 year with evidence of evidence of
credit; Chapter 7 established credit; reestablished satisfactory satisfactory
must be discharged Chapter 7 must credit; Chapter 7 discharge; discharge;
minimum of 2 be discharged must be discharged Chapter 7 Chapter 7
years with reestab- minimum of minimum of minimum minimum
lished credit 2 years with re- 2 years with discharge of discharge
established credit reestablished credit 2 years of 1 year
Debt to Service 45% 45% 50% 55% 60%
Ratio...........
Maximum Loan-to-Value Ratio:
Full 90% 90% 85% 75% 65%
documentation...
Limited 85% 80% 75% 70% 60%
documentation...
Stated income.... 80% 75% 70% 65% 60%
</TABLE>

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<PAGE>

Loan Portfolio by Credit Risk Category. The following table sets forth the
Company's mortgage loan portfolio by credit grade as of September 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........................................ $179,715 44.4% 76.1%
A-....................................... 112,794 27.9 77.0
B........................................ 73,369 18.1 75.2
C........................................ 28,367 7.0 69.8
D........................................ 10,403 2.5 63.8
-------- -----
Total................................ $404,648 100.0% 75.4%
======== =====
</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 September 30, 1997.

<TABLE>
<CAPTION>
PRINCIPAL PERCENT
AMOUNT OF TOTAL
--------- --------
(IN THOUSANDS)
<S> <C> <C>
California............................................. $126,679 31.0%
Washington............................................. 35,980 9.0
Florida................................................ 26,803 7.0
Utah................................................... 24,733 6.0
Texas.................................................. 22,925 6.0
Others................................................. 167,528 41.0
-------- -----
Total.............................................. $404,648 100.0%
======== =====
</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 established 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. Reviews are performed on 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. Appraisal reviews and compliance reviews are also
performed as part of the quality control process to ensure adherence to
Company appraisal policies and state and federal regulations.

Mortgage Loan Servicing Strategy

Overview. The Company plans to acquire the large majority of mortgage loans
it 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 acquired by the Company. Effective, July 15,
1997, NovaStar

55
<PAGE>

Mortgage began servicing the Company's mortgage loans. The servicing operation
is located in the Westwood, Kansas office and is currently staffed with 26
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 for the servicing of its subprime mortgage loans is
based on effective credit risk. NovaStar Mortgage intends to employ the proper
resources to mitigate the losses on the mortgage loans serviced. The Company
also believes it can better manage prepayment risk by servicing its mortgage
loans through its affiliate. Through its servicing function, the Company
intends to pre-select borrowers that have an incentive to refinance and retain
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 to an unrelated company.

Procedures. The Company has prescribed procedures for servicing its mortgage
loans which are to be followed by NovaStar Mortgage. In servicing subprime
mortgage loans, NovaStar Mortgage 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) NovaStar Mortgage 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) NovaStar Mortgage 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 month's 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 NovaStar Mortgage to be
more aggressive with those borrowers who need the most attention and also
focuses the efforts of the collection staff of NovaStar Mortgage 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's policy allows for reasonable discretion to extend appropriate
relief to borrowers who encounter hardship and who are cooperative and
demonstrate proper regard for their obligation. NovaStar Mortgage 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.

PORTFOLIO MANAGEMENT

The Company builds its Mortgage Asset portfolio from two sources--loans
originated in the mortgage lending operation of NovaStar Mortgage and
purchases in the secondary mortgage and securities markets. Initially, the
portfolio was comprised of purchased Mortgage Assets. As NovaStar Mortgage has
developed its

56
<PAGE>

infrastructure for subprime mortgage lending, the Company has relied less on
purchasing mortgage loans in bulk and more on wholesale origination.
Ultimately, the Company expects a substantial portion of its portfolio to
consist of retained interests in wholesale loans originated by NovaStar
Mortgage 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
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 only 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
multifamily mortgage loans. However, these types of loans may be acquired 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 loans. For
example, the credit quality of a multifamily mortgage loan typically depends
upon the existence and terms of

57
<PAGE>

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 September 30, 1997, have
consisted of mortgage securities issued by corporations sponsored by the
United States government, including FNMA, GNMA and FHLMC.

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 financing 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's investment policy allows for the acquisition of Mortgage
Assets and certain other liquid investments, such as federal Agency securities
and commercial paper. The Company does not presently intend to invest in real
estate, interests in real estate, or interests in persons primarily engaged in
real estate activities.

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 purchases through interim financing
facilities such as repurchase agreements. A 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.

A 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 interest rate risk, 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."

59
<PAGE>

Acquisitions of Mortgage Securities are generally financed using repurchase
agreements.

Mortgage Loans Held as Collateral for Structured Debt

The Company intends to securitize the subprime mortgage loans produced by
the 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. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Financial Condition as of September 30, 1997."

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) ensuring that established underwriting guidelines are followed;

(ii) geographic diversification of its loan portfolio;

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<PAGE>

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

(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.

A summary of the credit quality and diversification of the Company's loan
portfolio as of September 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.

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

61
<PAGE>

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)
MINIMUM ESTIMATED DURATION LIQUIDITY (C + D) (B X E) (A + F)
LENDER PRICE SPREAD SPREAD TOTAL SPREAD EQUITY CUSHION CAG EQUITY
ASSET CATEGORY 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 haircut. On the other extreme, "B" rated
securities and securities not registered with the Securities and Exchange
Commission (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
management's 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 Company's portfolio. Market values for the Company's mortgage loan
portfolio are 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.

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

62
<PAGE>

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 September
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--Failure to
Effectively Hedge Against Interest Rate Changes; May Adversely Affect Results
of Operations," "--Limitations on Effectively Hedging" and "--Potential
Adverse Effect of the Use of Financial Instruments in Hedging."

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. 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.

63
<PAGE>

INTEREST RATE SENSITIVITY
SEPTEMBER 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....................... $ 714,041 $ 706,221 $ 696,471 1.24%
Liabilities.................. (656,603) (654,652) (652,720) 0.30%
Interest rate agreements..... (3,158) 427 5,372 1.18%
--------- --------- ---------
Net market value............... $ 54,280 $ 51,996 $ 49,123
========= ========= =========
Cumulative change in value(B).. $ 2,284 -- $ (2,873)
========= ========= =========
Percent change from base
assets(C)..................... 0.32% -- (0.41)% 0.41%
========= ========= ========= =====
Percent change of capital(D)... 4.86% -- (6.11)% 6.30%
========= ========= ========= =====
</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 September 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 September 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.

Interest Rate Sensitivity Analysis. The above sensitivity table is a tool
used by management in assessing the impact of changing interest rates on the
Company's assets, liabilities and interest rate agreements. The values under
the heading "Base" are management's estimates of market values of the
Company's assets, liabilities and interest rate agreements on September 30,
1997. The values under the headings "100" and "(100)" are management's
estimates of the market value of those same assets, liabilities and interest
rate agreements assuming that interest rates were 100 basis points (1 percent)
higher and lower. The cumulative change in value represents the change in
value of assets from base, net of the change in value of liabilities and
interest rate agreements from base.

The interest sensitivity analysis is prepared regularly (at least monthly).
If the analysis demonstrates that a 100 basis point shift (up or down) in
interest rates would result in 10 percent or more cumulative change in value
from base, management will modify the Company's portfolio by adding or
removing interest rate cap or swap agreements.

Assumption Used in Interest Rate Sensitivity Analysis. Management uses
estimates in determining the market (or fair) value of assets, liabilities and
interest rate agreements. The estimation process is dependent upon a variety
of assumptions, especially in determining the fair value of its subprime
mortgage loan holdings. The following paragraphs discuss the nature of the
process used in estimating the market value of its assets, liabilities and
interest rate agreements that are used in the above analysis. The estimates
and assumptions have a significant impact on the results of the interest rate
sensitivity analysis, the results of which are shown as of September 30, 1997.

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 analysis for assessing interest rate sensitivity on its
subprime mortgage loans relies significantly on estimates for prepayment
speeds. A prepayment model has been internally developed based upon four main
factors:

. Refinancing incentives (the interest rate of the mortgage compared with
the current mortgage rates available to the borrower)

64
<PAGE>

. Borrower credit grades (a higher letter means a higher grade)

. Loan-to-value ratios

. Prepayment penalties, if any

These factors are weighted based on management's experience and an
evaluation of the important trends observed in the subprime mortgage
origination industry. The following table is designed to display the impact of
a change in each of the factors on prepayment speeds within the Company's
model.

<TABLE>
<CAPTION>
PREPAYMENT FACTOR INCREASE PREPAYMENTS DECREASE PREPAYMENTS
----------------- -------------------- --------------------
<S> <C> <C>
Refinancing Lower Mortgage Rates Higher Mortgage Rates
Incentives/Current
Mortgage rates
Credit Grade Better Credit Worse Credit
Loan-to-value Lower Loan-to-value Higher loan-to-value
Prepayment Penalty Lower Prepayment Penalty Cost Higher Prepayment Penalty Cost
</TABLE>

The refinancing incentive measures the gain the borrower realizes from
refinancing at current mortgage rates. The greater the incentive to refinance
(interest rates lower than when the mortgage was originated), the higher the
prepayment speeds. Conversely, if interest rates rise, the borrower is less
likely to payoff their loan.

A borrower's credit grade impacts projected prepayment due to the
availability of refinancing options. "A" credit borrowers have more lenders
willing to make mortgage loans to them than do "D" credit borrowers. The
Company's prepayment model takes this fact into account over a continuum of
credit grades.

The loan-to-value ratio is another important factor in the Company's
prepayment model. Loans with a low loan-to-value ratio have more equity in
their property and are more likely to take equity out of the homes through a
cash-out refinancing. Borrowers with high loan-to-value ratios have fewer
options and little equity to be taken out of the property, presumably
resulting in lower prepayment speeds.

The length and amounts of the prepayment penalty is another factor that
drives the level of projected mortgage prepayments. A borrower with a
significant prepayment penalty effectively increases the current mortgage
rate, which reduces the refinancing incentive. Conversely, a borrower without
a prepayment penalty has fewer financial barriers to realize the gains from
refinancing an existing mortgage into a lower rate mortgage loan.

The prepayment projections have limits on how fast or how slow a pool of
loans prepay. If interest rates rise, some borrowers still prepay their
mortgages due to factors such as relocation or the purchase of a new home. If
interest rates fall, some borrowers will not refinance their mortgage,
regardless of their economic incentives to do so.

The Company attempts to model the interrelation of these factors. The
prepayment projections are estimates intended to provide management an
indication of the change in cash flow in different interest rate scenarios.
These estimates are used in preparing interest sensitivity analyses used by
the Company's management in portfolio management. ACTUAL RESULTS MAY DIFFER
FROM THE ESTIMATES AND ASSUMPTIONS USED IN THE COMPANY'S MODEL AND THE
PROJECTED RESULTS AS SHOWN IN THE ABOVE TABLE.

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
September 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).

65
<PAGE>

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 decrease 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.

Sensitivity as of September 30, 1997. 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 4.86 percent. If interest rates rise
by one percent (+100 basis points), the value of the Company's capital would
decrease by 6.30 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 options 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 acquiring
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 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.

66
<PAGE>

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.

NovaStar Mortgage leases space for its mortgage lending operations in
Irvine, California. As of September 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 approximately $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.

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<PAGE>

MANAGEMENT

DIRECTORS AND EXECUTIVE OFFICERS

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

<TABLE>
<CAPTION>
NAME POSITION
---- --------
<C> <S>
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 a co-founder of the Company, Chairman of the
Board of Directors and Chief Executive Officer and has been a member of the
Board of Directors since 1996. 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 REIT. His responsibilities while at Dynex included managing
the 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. Mr. Hartman also serves as a Director and Vice Chairman of
NovaStar Mortgage.

W. LANCE ANDERSON, age 37, is a co-founder of the Company, President and
Chief Operating Officer of the Company and has been a member of the Board of
Directors since 1996. 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. Mr. Anderson was
also responsible for re-focusing the conduit on the subprime mortgage market
in late 1993. Mr. Anderson also serves as Chairman of the Board of Directors,
President and Chief Executive Officer of NovaStar Mortgage.

MARK J. KOHLRUS, age 38, is Senior Vice President, Treasurer and Chief
Financial Officer of the Company and NovaStar Mortgage. 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 in December 1996, 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.

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<PAGE>

EDWARD W. MEHRER, age 58, has been a member of the Board of Directors since
1996. He is presently 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 56, was most recently Chairman of the Board of GE
Capital Mortgage Corporation (GECMC), a subsidiary of General Electric Capital
Corporation (GE Capital) headquartered in Raleigh, North Carolina. He has
served on the Board of Directors since 1996. 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 a member of the Board since 1996. Ms.
Britell served in 1996 and 1997 as President and General Manager of G.E.
Capital Mortgage Services, Inc. (GECMS) and is currently serving as Group Vice
President Europe. 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 of NovaStar Mortgage. His primary responsibilities include overseeing
the overall marketing efforts of NovaStar Mortgage, 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
(the Company and NovaStar Mortgage). His primary responsibility is to manage
the underwriting and funding functions. 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 of NovaStar Mortgage. 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.

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<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.

70
<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
OTHER ANNUAL UNDERLYING ALL OTHER
NAME AND POSITION YEAR SALARY BONUS COMPENSATION OPTIONS(#) DER'S(3) COMPENSATION
----------------- ---- -------- ------ ------------ ---------- -------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Scott F. Hartman(1)..... 1997 $130,833 -- 549,635 40,000 -- --
Chairman of the Board, 1996 70,000 -- -- 144,666 --
Secretary and Chief
Executive Officer --
W. Lance Anderson(1).... 1997 130,833 -- 549,635 40,000 -- --
President and Chief --
Operating Officer 1996 70,000 -- 144,666 -- --
Mark J. Kohlrus(2)...... 1997 100,000 90,000 -- 20,000 700 --
Senior Vice President, 1996 4,000 -- -- 10,000 -- --
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 $185,000 per year.

(2) Mr. Kohlrus' employment with the Company began on December 16, 1996. He
currently has an annual base salary of $120,000 per year. Mr. Kohlrus is
eligible to receive an annual bonus of up to 75 percent of his annual
salary.

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

Bonus Incentive Compensation Plan. A bonus incentive compensation plan has
been established for certain executive and key officers of the Company and its
affiliates, effective commencing with the fiscal year beginning January 1,
1998. The annual bonus pursuant to the bonus incentive compensation plan will
be paid

71
<PAGE>

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>
BONUS AS PERCENT OF
ROE(1) IN EXCESS OF AVERAGE NET WORTH(3)
BASE RATE(2) BY: OUTSTANDING
------------------- --------------------
<S> <C>
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 that may be issued 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 in the future), 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 of Common Stock were granted during 1996
under the Company's 1996 Stock Option Plan. Of these options, 10,000 were
granted to two non-employee directors and an additional 35,000 were granted to
current employees (excluding the founders) and vested 25 percent on September
1, 1997 and will vest 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 $2.50 per share.
All such options were granted with related DERs. The remaining options were
granted to the founders, exercisable at $15 per share, and vested upon closing
of the initial public 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 the closing of the initial
public offering. See "Description of Capital Stock--Purchase Terms Agreement."

72
<PAGE>

The following table sets forth information concerning stock options granted
during 1997 to each of the Board of Director members and Executive Officers.
<TABLE>
<CAPTION>
POTENTIAL REALIZABLE VALUE
AT ASSUMED ANNUAL RATES OF
STOCK PRICE APPRECIATION
INDIVIDUAL GRANTS FOR OPTION TERM
------------------------------------------------------ ---------------------------
PERCENT OF TOTAL
OPTIONS GRANTED EXERCISE
NO. TO EMPLOYEES PRICE OR BASE EXPIRATION
NAME GRANTED(1) DURING THE YEAR PRICE ($/SHARE) DATE 5% ($) 10% ($)
---- ---------- ---------------- --------------- ---------- ------ -------
<S> <C> <C> <C> <C> <C> <C>
Scott F. Hartman ....... 40,000 18.55% $18.00 11/4/07 $1,172,804.13 $1,867,494.57
W. Lance Anderson....... 40,000 18.55% $18.00 11/4/07 $1,172,804.13 $1,867,949.57
Gregory T. Barmore...... 5,000 2.32% $18.00 11/4/07 $146,600.52 $233,438.82
Edward W. Mehrer........ 5,000 2.32% $18.00 11/4/07 $146,600.52 $233,438.82
Mark J. Kohlrus......... 20,000 9.27% $18.00 11/4/07 $588,402.07 $933,747.29
------- ------
Total of Directors and
Executive Officers..... 110,000 51.01%
======= ======
Total shares granted
under SOP.............. 215,640
=======
</TABLE>

- --------
(1) Twenty-five percent of the options granted will vest in 1998 and 25
percent in each year thereafter. Options do not include DERs.

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(1)
SHARES OPTIONS AS OF OPTIONS AS OF
ACQUIRED VALUE DECEMBER 31, 1997 DECEMBER 31, 1997(3)
ON EXERCISE REALIZED(2) ------------------------- -------------------------
NAME (# OF SHARES) ($) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
---- ------------- ----------- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C>
Scott F. Hartman........ -- -- 144,666 40,000 $117,541 --
W. Lance Anderson....... -- -- 144,666 40,000 117,541 --
Gregory T. Barmore...... -- -- 1,250 8,750 19,753 $59,259
Edward W. Mehrer........ -- -- 1,250 8,750 19,753 59,259
Mark J. Kohlrus......... 2,500 33,275 -- 27,500 -- 99,844
</TABLE>
- --------

(1) "In-the-Money" options are options whose exercise price was less than the
market price of Common Stock at December 31, 1997.

(2) The "value realized" represents the difference between the exercise price
of the option shares and the market price of the option shares on the date
the option was exercised. The value realized was determined without
considering any taxes which may have been owed.

(3) Assuming a stock price of $15.8125 per share, which was the closing price
of a share of Common Stock reported for the New York Stock Exchange--
Composite Transactions on December 31, 1997.

Units Acquired with Forgivable Debt. Messrs. Hartman and Anderson each
acquired 108,333 Units (each Unit consisting of one share of Preferred Stock
which converted to Common Stock at the closing of the initial public offering
and one Warrant) which were acquired at the price of $15 per Unit on December
9, 1996. Payment for such 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 compounded annually and secured by the Units being acquired.
Interest began accruing during the first year and is added to principal due
under the note. Thereafter, interest became 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. The debt on the first tranche was forgiven and
the Company recognized a non-cash charge against earnings of $1,083,330
for the fiscal period ending December 31, 1997.

--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.

73
<PAGE>

. 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 Private Placement on December
9, 1996, and ended on December 31, 1997, and, thereafter, each
succeeding fiscal period extends for twelve months and ends on each
December 31.

. 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 the initial public 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
the Private Placement 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 was 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 investor's
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 officer's 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
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 officer's employment without cause, or
if the officer resigns for "good reason," the officer receives an amount,
payable immediately, equal to such officer's

74
<PAGE>

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 these forfeiture
and non-compete provisions would generally be enforceable, there can be no
assurance that the employee will not elect to terminate the agreement early
despite these provisions and no longer remain in the Company's employ.

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 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 Securities Exchange Act of 1934, as amended (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 the grants 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, 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.

75
<PAGE>

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
339,332 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.

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 will 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.

76
<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 November
30, 1997, 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
OF COMMON STOCK(1)
-----------------------
NAME AND ADDRESS OF BENEFICIAL OWNER SHARES PERCENT
------------------------------------ ------------ ----------
<S> <C> <C>
Wellington Management Company(2).................. 1,608,400 18.93%
75 State Street
Boston, MA 02109
Lindner Dividend Fund(3).......................... 1,583,334 18.64
7711 Carondolet Avenue, Suite 700
St. Louis, MO 63104
General Electric Capital Corporation(4)........... 1,333,332 15.69
260 Long Ridge Road
Stamford, CT 06927
First Financial Fund, Inc.(5)..................... 933,400 11.25
c/o Wellington Management Company
75 State Street
Boston, MA 02109
Wallace R. Weitz & Company(6)..................... 916,666 11.23
1125 South 103rd Street
Suite 600
Omaha, NE 68124-6008
</TABLE>
- --------
(1) Assuming no exercise of Warrants (except by the Securityholder named,
separately) and no purchases by any of the listed Securityholders in this
Offering.

(2) Includes 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.
(3) Includes 666,667 shares of Common Stock issuable upon the exercise of
Warrants.
(4) Includes 666,666 shares of Common Stock issuable upon the exercise of
Warrants.

(5) 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 2.

(6) Includes 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.; 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
Parterres III Limited Partnership, may be deemed to beneficially own such
shares of Common Stock.

77
<PAGE>

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 December
31, 1997, by (i) each director, (ii) the Company's 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
COMMON STOCK(1)
-----------------
NAME OF BENEFICIAL OWNER NUMBER PERCENT
------------------------ --------- -------
<S> <C> <C>
Scott F. Hartman (2)................................... 509,665 6.29
W. Lance Anderson (3).................................. 520,065 6.42
Edward W. Mehrer (4)................................... 37,250 *
Gregory T. Barmore (5)................................. 1,250 *
Jenne K. Britell....................................... -- --
Mark J. Kohlrus (6).................................... 8,700 *
All Directors and Executive Officers as a Group (6
persons).............................................. 1,076,930 13.31
</TABLE>
- --------
* Less than one percent.

(1) Assuming no exercise of the Warrants and exercisable options (except by
the Securityholder named, separately).

(2) Consists of 236,666 shares of Common Stock and 128,333 Warrants, including
20,000 of each owned jointly with his wife, and 144,666 shares of Common
Stock issuable upon the exercise of options.

(3) Consists of 241,866 shares of Common Stock and 133,533 warrants, all of
which are owned jointly with his wife, and 144,666 shares of Common Stock
issuable upon the exercise of options.

(4) Consists of 24,000 shares of Common Stock and 12,000 Warrants, including
2,000 of each owned by his wife, and 1,250 shares of Common Stock issuable
upon the exercise of options.

(5) Consists of 1,250 shares of Common Stock issuable upon the exercise of
options.

(6) Consists of 6,700 shares of Common Stock and 1,500 Warrants.

78
<PAGE>

CERTAIN TRANSACTIONS

TRANSACTIONS WITH MANAGEMENT

In May 1996, Messrs. Hartman and Anderson formed NovaStar Mortgage for the
purpose of engaging in the subprime lending business. Following the Company's
Private Placement, NovaStar Mortgage began obtaining required licenses and
permits, developing guidelines for the origination of mortgage loans through
its wholesale lending channel and hiring 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, the
Company moved to implement the portion of its business strategy to be
conducted through taxable affiliates. In February 1997, Holding was formed to
serve as a holding company for such taxable affiliates. In March 1997, Messrs.
Hartman and Anderson acquired all of the outstanding non-voting common stock
of Holding for a total price of $20,000 and the Company acquired all of the
outstanding non-voting preferred stock of Holding for a total price of
$1,980,000. The voting common stock is entitled to one 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 the
Company 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 February 1997, Holding acquired all of the outstanding common stock of
NovaStar Mortgage from Messrs. Hartman and Anderson. NovaStar Mortgage thereby
became a wholly-owned subsidiary of Holding. Through Holding, the Company thus
owns a beneficial interest in 99 percent of the future dividend distributions
attributable to NovaStar Mortgage.

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

INDEBTEDNESS OF MANAGEMENT

Messrs. Hartman and Anderson are indebted to the Company 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 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

79
<PAGE>

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.

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 the subsequent
closing of the Private Placement, GE Capital's reasonable legal and consulting
fees up to $40,000 incurred in the Private Placement. To ensure that any
purchases of subprime mortgage loans from GE Capital Mortgage Corporation are
executed at arms-length, the Company will obtain two independent prices
related to any such transaction.

80
<PAGE>

SELLING SECURITYHOLDERS

At the date of this Prospectus, the number of shares of Offered Common Stock
and Warrants which may be offered pursuant to this Prospectus by the Selling
Securityholders is as set forth below. In addition, at the date of this
Prospectus, none of the Underlying Common Stock is currently held by the
Selling Securityholders but may be issued to them pursuant to the exercise of
Warrants, all of which Underlying Common Stock, to the extent acquired by such
Selling Securityholders, may be offered pursuant to this Prospectus.

<TABLE>
<CAPTION>
BENEFICIAL SECURITIES COVERED BY BENEFICIAL
OWNERSHIP BEFORE SHELF REGISTRATION OWNERSHIP AFTER
OFFERING STATEMENT OFFERING
------------------- ------------------------ -------------------
NO. SHARES NO. SHARES NO. SHARES
OUTSTANDING OUTSTANDING NO. WARRANTS OUTSTANDING
COMMON COMMON OR COMMON COMMON
NAME STOCK PERCENT STOCK STOCK STOCK PERCENT
- ---- ----------- ------- ----------- ------------ ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Cede & Co.
c/o The Depository Trust
Company as beneficial
owner for:
Eugene Whitney Harris
Revocable Trust....... 2,500 -- 2,500 2,500 -- --
L. Rothschild, Jr. & L.
Rothschild III, TTEE
Edith Rothschild Tr.
DTD 12/11/89 FBO L.
Rothschild, Jr. & L.
Rothschild III........ 3,000 -- 3,000 3,000 -- --
L. Rothschild, Jr. & L.
Rothschild III, TTEE
Louis Rothschild Tr.
DTD 12/11/89 FBO L.
Rothschild, Jr. & L.
Rothschild III........ 2,000 -- 2,000 2,000 -- --
NACLE Distributors,
Inc. PSP, U/A DTD
01/01/83, W. Chris
Elcan TTEE............ 2,000 -- 2,000 2,000 -- --
Ilma Glaser Isaac...... 2,000 -- 2,000 2,000 -- --
Actor's Fund of
America............... 7,000 0.1 7,000 7,000 -- --
Acceptance Insurance
Company............... 100,000 1.3 100,000 100,000 -- --
National Automobile &
Casualty Insurance
Co.................... 33,333 0.4 33,333 33,333 -- --
General Electric
Capital Corporation... 666,666 2.5 666,666 666,666 -- --
Lindner Dividend Fund.. 666,667 8.5 666,667 666,667 -- --
First Financial Fund,
Inc................... 466,700 6.0 466,700 466,700 -- --
Wellington Management
Co.................... 275,000 3.5 -- -- 275,000 3.5
Bay Pond Partners,
L.P................... 200,000 2.6 200,000 200,000 -- --
Wallace Weitz & Co..... 250,000 3.2 -- -- 250,000 3.2
Weitz Series Fund,
Inc.--Hickory
Portfolio............. 20,000 0.3 20,000 20,000 -- --
Weitz Partners, Inc.--
Partners Value Fund... 125,000 1.6 65,000 65,000 60,000 0.8
Weitz Series Fund,
Inc.--Value Portfolio. 375,000 8.4 185,000 185,000 190,000 2.4
Weitz Partners III
Limited Partnership... 63,333 1.4 63,333 63,333 -- --
UMB F/B/O/ John Adams
M.D. IRA R/O.......... 3,000 0.1 3,000 3,000 -- --
United Missouri Bank
N.A. Cust. Agent for
Technical Products
Supply Inc.
P/S R.J. BJORSETH 37
8022-02-4............. 2,000 -- 2,000 2,000 -- --
--------- --------- --------- -------
Cede & Co. Subtotal.. 3,265,199 41.7 2,490,199 2,490,199 775,000 9.9
First Fidelity
Incorporated
c/o First Union Capital
Market Groups.......... 186,667 4.2 186,667 186,667 -- --
Allis & Co.............. 10,000 0.2 10,000 10,000 -- --
Lynne K. Anderson IRA... 200 -- 200 200 -- --
Walter Lance Anderson(2)
and Rania Habiby
Anderson............... 16,700 0.4 16,700 16,700 -- --
Stifel, Nicolaus & Co.
William Anderson IRA
Acct. No. 1163-3334.... 1,200 -- 1,200 1,200 -- --
William M. Anderson and
Lynne K. Anderson...... 1,300 -- 1,300 1,300 -- --
Stifel, Nicolaus &
Co.(3), C/F William G.
Ash IRA R/O Account No.
1220-4030.............. 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus, C/F
Julie Bamburg Spousal
IRA Acct. No. 1313-
3536................... 943 -- 300 300 643 --
Michael L. Bamburg...... 23,600 0.5 11,100 11,100 12,500 0.2
Marianthe Mewkill, TEE
Smith Breeden Profit
Sharing Plan DTD
12/29/83, FBO Michael
Lee Bamburg............ 5,645 0.3 1,900 1,900 3,745 --
</TABLE>

81
<PAGE>

<TABLE>
<CAPTION>
BENEFICIAL SECURITIES COVERED BY BENEFICIAL
OWNERSHIP BEFORE SHELF REGISTRATION OWNERSHIP AFTER
OFFERING STATEMENT OFFERING
------------------- ------------------------ -------------------
NO. SHARES NO. SHARES NO. SHARES
OUTSTANDING OUTSTANDING NO. WARRANTS OUTSTANDING
COMMON COMMON OR COMMON COMMON
NAME STOCK PERCENT STOCK STOCK STOCK PERCENT
- ---- ----------- ------- ----------- ------------ ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Stifel, Nicolaus & Co.,
C/F Stuart Beath IRA
Acct. No. 1419-6385.... 6,600 0.1 6,600 6,600 -- --
Larry Bender............ 4,253 0.1 4,253 4,253 -- --
Stifel, Nicolaus & Co.,
C/F W. Coleman Bitting
IRA Acct. No. 1574-
1789................... 3,400 0.1 3,400 3,400 -- --
W. Coleman Bitting(4)
and Jean M. Bitting.... 8,700 0.2 6,700 6,700 2,000 --
Martin J. Bloom, TTEE
Martin J. Bloom Family
Trust, U/A DTD 8/18/93. 6,500 0.1 6,500 6,500 -- --
Ivan Bowen.............. 2,000 -- 2,000 2,000 -- --
George W. Bull.......... 5,000 0.1 5,000 5,000 -- --
Juan O. Carden, TTEE
Juan O. Carden
Revocable Living Trust
7/17/95................ 2,000 -- 2,000 2,000 -- --
Steven R. Carrico and
Tammy M. Carrico....... 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus Cust.
for William S. Carter.. 6,600 0.1 6,600 6,600 -- --
Craig J. Cerny.......... 1,625 -- 1,625 1,625 -- --
Marianthe Mewskill, TTEE
Smith Breeden Profit
Sharing and 401K Plan
U/A
12/29/93, FBO Craig
Cerny (401K)4.......... 875 -- 875 875 -- --
Stifel, Nicolaus & Co.,
C/F Henry W. Clever,
Jr. IRA R/O Acct. No.
2243-5082.............. 2,000 -- 2,000 2,000 -- --
Victor G. Clever, Sr. &
Maureen Clever, TTEES
Victor G. Clever, Sr.
REV Tr; U/A Dtd 2/9/96;
FBO Victor G. Clever
Sr..................... 2,000 -- 2,000 2,000 -- --
William C. Cohen........ 2,000 -- 2,000 2,000 -- --
Marcus T. Cohn and
Francine M. Cohn....... 6,000 0.1 4,000 4,000 2,000 --
Stifel, Nicolaus & Co.,
C/F John Steven Cole
IRA Acct. No. 2293-
8436................... 2,000 -- 2,000 2,000 -- --
Richard P. Conerly and
Iva J. Conerly......... 4,000 0.1 4,000 4,000 -- --
Stella A. Corley, TTEE
or Her Successors Under
Ind. Trust DTD 6/16/88,
Stella A. Corley,
Grantor................ 2,000 -- 2,000 2,000 -- --
Leslie M. Cruvant....... 6,600 0.1 6,600 6,600 -- --
Marilyn Joyce Dame...... 2,000 -- 2,000 2,000 -- --
Robert V. Dawson........ 2,000 -- 2,000 2,000 -- --
Daniel C. Dektar and
Nancy I. Kalow......... 23,333 0.5 13,333 13,333 10,000 0.1
Walter DeVries and Cora
DeVries, Joint Tenants. 2,000 -- 2,000 2,000 -- --
Robert M. Dolgin and
Deborah R. Dolgin...... 3,300 0.1 3,300 3,300 -- --
Stifel, Nicolaus & Co.,
C/F Douglas G. Draper
IRA Acct. No. 2850-
0523................... 11,400 0.3 11,400 11,400 -- --
David P. Dunlap......... 6,000 0.1 6,000 6,000 -- --
E.K.S. Investments,
L.P.................... 10,000 0.2 3,000 3,000 7,000 0.1
Stephen A. Eason and
Kathryn Ellis Eason,
Tenants in Common...... 7,000 0.2 7,000 7,000 -- --
David R. Eidelman....... 2,500 0.1 2,500 2,500 -- --
Jack R. Eidelman,
Trustee Jack R.
Eidelman Rev. Trust dtd
4/18/80................ 4,000 0.1 2,000 2,000 2,000 --
Rachel Eidelman, TTEE
FBO Eidelman Family
Trust, U/W/O Jacob Reby
DTD 6/3/91............. 2,000 -- 2,000 2,000 -- --
David G. Estes(5) and
Astrid G. Estes........ 2,000 -- 2,000 2,000 -- --
David S. Evans.......... 6,000 0.1 6,000 6,000 -- --
Elton P. Evans Jr.,
Trustee FBO The Elton
P. Evans Jr.
Declaration of Trust
DTD 6/28/96............ 3,500 0.1 3,500 3,500 -- --
William S. Fagan IRA
(Separate Property),
Bear Stearns Securities
Corp., Custodian....... 5,500 0.1 5,500 5,500 -- --
Sharon E. Fankhauser and
Jamie S. Fankhauser.... 2,000 -- 2,000 2,000 -- --
David L. Farris......... 23,045 0.5 6,666 6,666 16,379 0.2
</TABLE>

82
<PAGE>

<TABLE>
<CAPTION>
BENEFICIAL SECURITIES COVERED BY BENEFICIAL
OWNERSHIP BEFORE SHELF REGISTRATION OWNERSHIP AFTER
OFFERING STATEMENT OFFERING
------------------- ------------------------ -------------------
NO. SHARES NO. SHARES NO. SHARES
OUTSTANDING OUTSTANDING NO. WARRANTS OUTSTANDING
COMMON COMMON OR COMMON COMMON
NAME STOCK PERCENT STOCK STOCK STOCK PERCENT
- ---- ----------- ------- ----------- ------------ ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Stifel, Nicolaus & Co.,
C/F Robert M. Feibel
IRA Acct. No. 3135-
0587................... 2,000 -- 2,000 2,000 -- --
Bernard H. Feinstein,
Trustee for Bernard H.
Feinstein Rev. Living
Trust 5/17/95.......... 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus,
Custodian for Leon A.
Felman Keogh Profit
Sharing Plan........... 22,300 0.5 12,800 12,800 9,500 0.1
Martha B. Fisher........ 3,000 0.1 2,000 2,000 1,000 --
Stifel, Nicolaus & Co.,
C/F Robert J. Fleming
IRA R/O Acct. No. 3257-
4805................... 6,600 0.1 6,600 6,600 -- --
Jeremiah T. Flowers..... 5,000 0.1 5,000 5,000 -- --
Jeffrey Gendelman, TTEE
Jeffrey Gendelman
Revocable Trust DTD
5/7/91................. 2,700 0.1 2,700 2,700 -- --
Margaret A. Gerber and
William J. Gerber...... 2,000 -- 2,000 2,000 -- --
Everett N. Gertsen and
Carol E. Gertsen....... 3,300 0.1 3,300 3,300 -- --
Michael J. Giarla and
Ellen H. Michelson..... 27,000 0.6 3,000 3,000 24,000 0.3
Mark Glass.............. 2,000 -- 2,000 2,000 -- --
Marion Glicksberg....... 3,300 0.1 3,300 3,300 -- --
Guenter Goldsmith & Ann
Goldsmith TTEE Guenter
& Ann Goldsmith
Revocable Living Trust
DTD 5/30/88............ 2,000 -- 2,000 2,000 -- --
Selma K. Goldstein,
Trustee for Selma K.
Goldstein 2/29/84...... 2,000 -- 2,000 2,000 -- --
Sidney Guller........... 4,000 0.1 4,000 4,000 -- --
Ann Robin Gwozdz and
Michael J. Gwozdz...... 1,250 -- 700 700 550 --
Douglas B. Hansen....... 2,000 -- 2,000 2,000 -- --
Scott F. Hartman(6) and
Cathleen A. Hartman.... 20,000 -- 20,000 20,000 -- --
Peter T. Healy(5)....... 5,000 -- 5,000 5,000 -- --
Lore Herzberg, TTEE UAD
DTD 11/3/89; FBO Lore
Herzberg............... 4,000 0.1 2,000 2,000 2,000 --
Craig R. Hildreth and
Elizabeth C. Hildreth.. 2,000 -- 1,000 1,000 1,000 --
Frank Hoffman........... 7,000 0.2 7,000 7,000 -- --
R. Russell Hogan........ 2,000 -- 2,000 2,000 -- --
Homebaker Brand Profit
Sharing Plan; Leon A.
Felman TTEE............ 5,900 0.1 5,900 5,900 -- --
Insurance Management
Associates, Inc........ 6,000 0.1 6,000 6,000 -- --
Stifel, Nicolaus & Co.,
C/F Gerald A. Jabaay
IRA R/O Acct. No. 4434-
9290................... 6,700 0.1 6,700 6,700 -- --
James Lee Johnson III,
Trustee James Leon
Johnson III Revocable
Trust, Dated 5/4/85.... 3,000 0.1 3,000 3,000 -- --
Matthew E. Just, Jr. ... 6,666 0.1 6,666 6,666 -- --
Paul Just............... 4,000 0.1 4,000 4,000 -- --
Philip G. Kaplan and
Judith A. Kaplan....... 2,000 -- 2,000 2,000 -- --
Dr. Bruce A. Kauk and
Janet L. Kauk.......... 2,000 -- 2,000 2,000 -- --
Michael F. Kickham, TTEE
Michael F. Kickham Tr
Dtd 9/5/90............. 4,000 0.1 2,000 2,000 2,000 --
Myron Klevens, Trustee
Myron J. Klevens Trust
DTD 9/15/94............ 2,000 -- 2,000 2,000 -- --
Jean R. Kluge, Trustee,
Jean R. Kluge Living
Trust U/I 11/18/87..... 2,000 -- 2,000 2,000 -- --
Mark J. Kohlrus(7) and
Lisa M. Kohlrus........ 4,200 0.1 1,500 1,500 2,700 --
Bernard G. Kohm and
Barbara Kohm(8)........ 2,000 -- 2,000 2,000 -- --
Mark J. Koster(9)....... 2,650 -- 2,650 2,650 -- --
Matthew J. Koster....... 4,400 0.1 2,400 2,400 2,000 --
Patrick R. Koster(10)... 4,000 0.1 4,000 4,000 -- --
Stribling Koster........ 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus & Co.,
C/F Ken Kranzberg IRA
Spousal Acct. No. 4932-
9221................... 2,000 -- 2,000 2,000 -- --
</TABLE>

83
<PAGE>

<TABLE>
<CAPTION>
BENEFICIAL SECURITIES COVERED BY BENEFICIAL
OWNERSHIP BEFORE SHELF REGISTRATION OWNERSHIP AFTER
OFFERING STATEMENT OFFERING
------------------- ------------------------ -------------------
NO. SHARES NO. SHARES NO. SHARES
OUTSTANDING OUTSTANDING NO. WARRANTS OUTSTANDING
COMMON COMMON OR COMMON COMMON
NAME STOCK PERCENT STOCK STOCK STOCK PERCENT
- ---- ----------- ------- ----------- ------------ ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Joel A. Kunin........... 2,000 -- 2,000 2,000 -- --
William M. LaWarre...... 15,333 0.3 13,333 13,333 2,000 --
Arnold J. Levin and
Roslyn J. Levin........ 2,000 -- 2,000 2,000 -- --
Stephen Levin and Amy
Levin.................. 4,000 0.1 4,000 4,000 -- --
Michael Litwack
Revocable Trust DTD
3/8/83................. 5,000 0.1 2,000 2,000 3,000 --
Brent R. Locke.......... 2,000 -- 2,000 2,000 -- --
David S. Lundeen........ 3,000 0.1 3,000 3,000 -- --
Gerald J. Madigan....... 4,000 0.1 4,000 4,000 -- --
Lawrence A. Manica(4)
and Charla M. Manica... 2,500 0.1 2,000 2,000 500 --
Rickey E. Maples(4) and
Laurie H. Maples....... 10,000 0.2 10,000 10,000 -- --
Charlotte C. Mehrer..... 2,000 -- 2,000 2,000 -- --
Edward W. Mehrer,
Jr.(12)................ 22,000 0.5 10,000 10,000 12,000 0.2
F. Jack Meyering, TTEE
F. Jack Meyering Trust
DTD 11/27/89........... 10,000 0.2 10,000 10,000 -- --
Theodore Miedema, TTEE
Theodore Miedema Trust
DTD 10/9/93............ 2,000 -- 2,000 2,000 -- --
Jacob C. Mol............ 3,400 0.1 3,400 3,400 -- --
Kevin M. Moore and
Kimberly A. Moore...... 13,300 0.3 13,300 13,300 -- --
Eugene J. McCabe, M.D... 2,000 -- 2,000 2,000 -- --
Kenneth K. Newton....... 3,000 0.1 3,000 3,000 -- --
Harold W. Nicholas...... 2,000 -- 2,000 2,000 -- --
NorDruk Partners
Investment Co.(13)..... 2,000 -- 2,000 2,000 -- --
Bruce P. Novak.......... 6,600 0.1 6,600 6,600 -- --
Charles D. O'Kieffe III,
TTEE Charles D.
O'Kieffe III Trust U/A
DTD 2/2/96............. 10,000 0.2 10,000 10,000 -- --
Aaron Oshevow, Trustee
for The Oshevow Trust,
Dated 9/11/89 (314)
726-3288............... 2,000 -- 2,000 2,000 -- --
Louis Pechersky and
Sarah Pechersky........ 2,000 -- 2,000 2,000 -- --
David P. Peterson
Revocable Trust........ 6,700 0.1 6,700 6,700 -- --
Douglas L. Phillips
Inter Vivos Trust dtd
8/19/88, Douglas L.
Phillips, Trustee...... 2,000 -- 2,000 2,000 -- --
Janelle Phillips........ 2,000 -- 2,000 2,000 -- --
Richard P. Proctor, Jr.. 5,000 0.1 2,000 2,000 3,000 --
William F. Quinn........ 2,700 0.1 2,700 2,700 -- --
Melvin Rabushka, Trustee
Melvin Rabushka Rev Tr
DT 9-29-92............. 2,000 -- 2,000 2,000 -- --
Adele Reby.............. 2,000 -- 2,000 2,000 -- --
Robert E. Ribbe, TTEE
Robert E. Ribbe Trust
DTD 3/15/91............ 4,000 0.1 2,000 2,000 2,000 --
Edward A. Roach,
Trustee, Edward A.
Roach M.D. Trust DTD
9/28/89................ 3,000 0.1 2,000 2,000 1,000 --
Helene B. Roberson...... 3,300 3,300 3,300 -- --
William C. Rosenbaum,
Jr..................... 7,666 0.2 6,666 6,666 1,000 --
Kenneth J. Rosenthal,
Trustee, Kenneth J.
Rosenthal Revocable
Trust Dtd 6/3/93....... 3,300 0.1 3,300 3,300 -- --
Louis G. Rothschild III. 2,000 -- 2,000 2,000 -- --
Timothy D. Rowe......... 10,000 0.2 10,000 10,000 -- --
Zsolt Rumy.............. 8,000 0.2 8,000 8,000 -- --
Fred R. Sale & Susan W.
Sale TTEE Fred R. Sale
Tr. UA 8/5/83.......... 2,000 -- 2,000 2,000 -- --
Julian Seeherman,
Trustee of the Julian
Seeherman Revocable
Trust, FBO Julian
Seehermen, DTD 2/26/90. 10,000 0.2 10,000 10,000 -- --
Odis E. Shoaf, Jr.(14).. 2,000 -- 2,000 2,000 -- --
Charles W. Smith........ 3,000 0.1 2,000 2,000 1,000 --
</TABLE>

84
<PAGE>

<TABLE>
<CAPTION>
BENEFICIAL SECURITIES COVERED BY BENEFICIAL
OWNERSHIP BEFORE SHELF REGISTRATION OWNERSHIP AFTER
OFFERING STATEMENT OFFERING
------------------- ------------------------ -------------------
NO. SHARES NO. SHARES NO. SHARES
OUTSTANDING OUTSTANDING NO. WARRANTS OUTSTANDING
COMMON COMMON OR COMMON COMMON
NAME STOCK PERCENT STOCK STOCK STOCK PERCENT
- ---- ----------- ------- ----------- ------------ ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Forrest M. Smith(10).... 200 -- 100 100 100 --
Kenneth Smith(9) and
Lawrence Guillot-Smith. 2,000 -- 2,000 2,000 -- --
David Soshnik(4),
Trustee for David
Soshnik Trust, DTD
8/2/93................. 2,000 -- 2,000 2,000 -- --
Joseph A. Stieven(4) and
Mary K. Stieven........ 7,000 0.2 7,000 7,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Richard A. Baldwin III
IRA.................... 500 -- 500 500 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Robert G. Brackett IRA
R/O #2 Acct. No. 1725-
7881................... 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
James J. Brennan....... 3,334 0.1 3,334 3,334 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for A.
Ray Cercle(10) IRA
SPSL................... 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Robert L. Desmond
I.R.A.................. 6,666 0.1 6,666 6,666 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Raymond J. Ellingsworth
IRA Acct. No. 2992-
4481................... 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Leon A. Felman IRA
Rollover............... 4,300 0.1 4,300 4,300 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Milton Goldenberg IRA
R/O.................... 4,000 0.1 4,000 4,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Girard A. Munsch,
Jr.(4) IRA Acct. No.
6099-6176.............. 3,000 0.1 3,000 3,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Michael A. Murphy(4)
IRA Rollover........... 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Paul E. Pazdan IRA R/O. 3,400 0.1 3,400 3,400 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Frederick W. Sammons
IRA R/O................ 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Stephen I. Schneider(4)
IRA.................... 2,500 0.1 2,500 2,500 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Michael L. Sklar IRA
Spousal................ 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Julia S. Sylvester IRA. 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Carl W. Webb IRA....... 2,000 -- 2,000 2,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Earl J. Wipfler, Jr.
IRA Rollover Acct. No.
8800-7061.............. 4,000 0.1 4,000 4,000 -- --
Mike Straneva........... 300 -- 300 300 -- --
Robert L. Suffian and
Carolyn C. Suffian..... 2,000 -- 2,000 2,000 -- --
Russell E. Tackett and
Terry D. Tackett....... 2,000 -- 2,000 2,000 -- --
Daryl Ter Harr and
Patricia Ter Harr...... 2,000 -- 2,000 2,000 -- --
Thomas A. Thoma TTEE U/A
DTD 03/31/90 by Thomas
A. Thoma............... 2,000 -- 2,000 2,000 -- --
Michael J. Tompkins..... 13,300 0.3 13,300 13,300 -- --
Stifel, Nicolaus & Co.,
C/F Jerrold Vesper IRA
Acct. No. 8368-5961.... 2,000 -- 2,000 2,000 -- --
Garry Vickar IRA........ 2,000 -- 2,000 2,000 -- --
Mary G. VonGontard, TTRE
Mary G. VonGontard Liv
Trust Dtd 10/12/93..... 2,000 -- 2,000 2,000 -- --
George H. Walker
III(15)................ 5,000 0.1 2,000 2,000 3,000 --
Bertha L. Wallbrunn..... 1,000 -- 1,000 1,000 -- --
Stephen S. Wasserman(4)
& Judith B.Wasserman,
TTEES Stephen S.
Wasserman Rev Tr DTD
3/26/94................ 2,000 -- 2,000 2,000 -- --
</TABLE>

85
<PAGE>

<TABLE>
<CAPTION>
BENEFICIAL SECURITIES COVERED BY BENEFICIAL
OWNERSHIP BEFORE SHELF REGISTRATION OWNERSHIP AFTER
OFFERING STATEMENT OFFERING
------------------- ------------------------- -------------------
NO. SHARES NO. SHARES NO. SHARES
OUTSTANDING OUTSTANDING NO. WARRANTS OUTSTANDING
COMMON COMMON OR COMMON COMMON
NAME STOCK PERCENT STOCK STOCK STOCK PERCENT
- ---- ----------- ------- ----------- ------------ ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Nancy N. Weaver, TTEE
Nancy N. Weaver Rev.
Trust DTD 7/24/95...... 3,000 -- 3,000 3,000 -- --
Christopher J. Whybrow
and Cynthia C. Whybrow. 2,000 -- 2,000 2,000 -- --
Peter Douglas Wierenga.. 2,000 -- 2,000 2,000 -- --
R. Keith Wilson(16) and
Barbara A. Wilson...... 2,000 -- 2,000 2,000 -- --
Woodsmill Limited....... 2,000 -- 2,000 2,000 -- --
W. Lance Anderson(2) and
Rania H. Anderson...... 8,500 0.1 8,500 8,500 -- --
Phillip R. Pollock(17).. 1,000 -- 1,000 1,000 -- --
Scott F. Hartman(6)..... 36,111 0.5 36,111 36,111 -- --
Scott F. Hartman(6)..... 36,111 0.5 36,111 36,111 -- --
Scott F. Hartman(6)..... 36,111 0.5 36,111 36,111 -- --
W. Lance Anderson(2).... 36,111 0.5 36,111 36,111 -- --
W. Lance Anderson(2).... 36,111 0.5 36,111 36,111 -- --
W. Lance Anderson(2).... 36,111 0.5 36,111 36,111 -- --
Stanley Edelstein and
Susan G. Edelstein,
TTEES Stanley M.
Edelstein Revocable
Trust U/A DTD 5/4/95... 2,000 -- 2,000 2,000 -- --
Julius Weissman, TTEE
FBO Julius Weissman U/A
DTD 11/30/89........... 2,000 -- 2,000 2,000 -- --
William Wallbrunn....... 1,000 -- 1,000 1,000 -- --
Stifel Warrant
Recipients(18) -- --
W. Coleman Biting(4)... -- -- -- 5,000 -- --
W. Coleman Biting(4)... -- -- -- 5,000 -- --
W. Coleman Biting(4)... -- -- -- 5,000 -- --
Ricky E. Maples(4)..... -- -- -- 6,819 -- --
Ricky E. Maples(4)..... -- -- -- 6,819 -- --
Ricky E. Maples(4)..... -- -- -- 6,820 -- --
Patrick R. Koster(10).. -- -- -- 1,581 -- --
Patrick R. Koster(10).. -- -- -- 1,581 -- --
Patrick R. Koster(10).. -- -- -- 1,582 -- --
Kenneth C. Smith(9).... -- -- -- 741 -- --
Kenneth C. Smith(9).... -- -- -- 741 -- --
Kenneth C. Smith(9).... -- -- -- 742 -- --
Mark J. Ross........... -- -- -- 741 -- --
Mark J. Ross........... -- -- -- 741 -- --
Mark J. Ross........... -- -- -- 742 -- --
Shelly Swan............ -- -- -- 33 -- --
Shelly Swan............ -- -- -- 33 -- --
Shelly Swan............ -- -- -- 34 -- --
Stifel, Nicolaus &
Company, Incorporated. -- -- -- 55,250 -- --
--------- ---------- --------- ---------
Stifel, Nicolaus &
Company,
Incorporated
Subtotal............ -- -- -- 100,000 -- --
--------- ---------- --------- ---------
Subtotal............. 1,189,417 15.2 1,059,800 1,159,800 129,617 1.7
--------- ----- ---------- --------- --------- -----
Subtotal............. 4,454,616 56.9 3,549,999 3,649,199 904,617 11.6
Shareholders not
subject to this
filing.............. 3,374,049 43.1 (3,549,999) -- 6,924,048 88.4
--------- ----- ---------- --------- --------- -----
Total................ 7,828,665 100.0% 3,549,999 3,649,199 7,828,665 100.0%
========= ===== ========== ========= ========= =====
</TABLE>
- --------
(1) Reflects shares of Common Stock issuable to such holder upon the exercise
of Warrants at the exercise price of $15.00 as required pursuant to the
terms of the Warrants.
(2) Co-founder, Director, President and Chief Operating Officer of the
Company.
(3) Stifel, Nicolaus & Company, Inc., was the Placement Agent for the Private
Placement offering of Units.
(4) Senior Vice President of Stifel.
(5) Attorney at O'Melveny & Myers LLP, counsel to Stifel.
(6) Co-founder, Chairman of the Board, Secretary and Chief Executive Officer
of the Company.
(7) Senior Vice President, Treasurer and Chief Financial Officer of the
Company and wife.
(8) Vice President of Stifel and his spouse.

86
<PAGE>

(9) Assistant Vice President of Stifel.
(10) First Vice President of Stifel.
(11) Senior Vice President of Stifel and his spouse.
(12) Independent Director of the Company.
(13) A subsidiary of Stifel.
(14) Former employee of Stifel.
(15) Chairman of the Board of Stifel.
(16) Vice President of Stifel.
(17) Attorney at Tobin & Tobin, counsel to the Company.
(18) Warrants issued to Stifel pursuant to the terms of the Purchase Terms
Agreement and subsequently divided by Stifel among the employees shown:

87
<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 investor's 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 "--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, the IPO, 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 September 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 been considered by the courts or the Service. There can be no
assurance that the courts or the Service will agree

88
<PAGE>

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, this section of the Prospectus 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."

The opinions of Special Tax Counsel are also based upon existing law
including the Code, 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."

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.

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.

89
<PAGE>

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 September 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 September 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 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

90
<PAGE>

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 September
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

91
<PAGE>

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 a 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 securitizes 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 four 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

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approved by the corporation's stockholders, (ii) the agreement must have been
approved by a compensation 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 Holding
and NovaStar Mortgage, 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 Hartman 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 in
Holding. The assets of Holding consist of the issued capital stock of NovaStar
Mortgage 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.

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

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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.

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 available for non-REIT 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
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 unrelated trade or business income as defined in
Section 512 of the Code ("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.

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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, 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.

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 statement,
under penalty of perjury, that he or she is not subject to backup withholding.

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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.

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 plan, 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 7,516,665
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 the class of Preferred Stock. The
Preferred Stock has the rights and privileges of, 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 consisting of one
share of Preferred Stock and one Warrant, in the Company's Private Placement;
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 the IPO, such
shares of outstanding Preferred Stock automatically converted to Common Stock.
Shares of the Preferred Stock received by the Company upon the conversion and
all remaining authorized shares of Preferred Stock were restored to the status
of authorized but unissued shares of Capital Stock, without designation as to
class.

The following summary of the rights of the Common Stock is qualified in its
entirety by reference to the Company's Charter a copy of which has been filed
with the Commission as an exhibit to the Shelf Registration Statement of which
this Prospectus is a part. Additionally, investors should note the possible
effect of any future preferred stock issuances should such an issuance occur,
as summarized below.

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. Since the conversion of all
outstanding shares of Preferred Stock upon the closing of the IPO, the holders
of shares of Common Stock have become 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, classes 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

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. Preferred Stock would be available for
possible future financing of, or acquisitions by, the Company and for general
corporate purposes

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without any legal requirement that further stockholder authorization for
issuance be obtained. The issuance 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. Preferred stock, if issued,
would have a preference on dividend payments 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 the IPO, and to use its
best efforts to cause to become effective as soon as practicable thereafter,
the Shelf Registration Statement of which this Prospectus is a part, with
respect to the shares of Common Stock into which the shares of Preferred Stock
have been converted and 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
IPO and the Shelf Registration Statement, respectively. 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 exceeding a $50 million threshold, 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 the IPO; (ii) approval by a
majority of Independent Directors of material increases in management
compensation; (iii) restrictions on affiliated transactions (excluding
transactions with GE Capital and its affiliates); (iv) prohibitions on
entering unrelated lines of business (including, but not limited

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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 the IPO other than those stock options
described in "Management--Executive Compensation."

Since the IPO or, in the case of clauses (iv) and (v) above, for one year
following the IPO, the provisions of clauses (ii) through (vii) above may be
modified or waived by a majority of Independent Directors. During such one-
year period, clauses (iv) and (v) may be waived by a unanimous vote of the
Board of Directors. Clauses (viii) and (ix) terminated upon the closing of the
IPO.

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 the Trustee as trustee of the
Trust for the exclusive benefit of one or more Charitable Beneficiaries, 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 or, 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

100
<PAGE>

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.

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 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

101
<PAGE>

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 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 has appointed UMB Bank N.A. as 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 was previously acting as the initial
Warrant Agent. The following summary of certain provisions of the Warrant

102
<PAGE>

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 Shelf Registration Statement of which this
Prospectus is a part.

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 the IPO, each share of Preferred Stock
automatically converted into one share of Common Stock and the registered
holder of the Preferred Stock received a stock certificate representing the
Common Stock and 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 Underlying Common Stock are being registered under the
Shelf Registration Statement of which this Prospectus forms a part. Holders of
the Warrants have certain registration rights with respect to the Common Stock
issued upon conversion of the Underlying Common Stock. The Warrants became
exercisable on February 3, 1998 the date of effectiveness of the Shelf
Registration Statement of which this Prospectus becomes a part (see
"Description of Capital Stock--Registration Rights") and will remain
exercisable until February 3, 2001, at an exercise price of $15.00 per share
of Common Stock (the "Exercise Price") and will be subject to anti-dilution
protection. The Company's Warrants are expected to trade through market
makers, such as Stifel, Nicolaus & Company, Incorporated, using the NASD's OTC
Bulletin Board Service.

Each Warrant, when exercised, will entitle the holder thereof to receive one
share of Common Stock at 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 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. This clause (v)
did not apply to the IPO.

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<PAGE>

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 and into shares of Common Stock since
the IPO, less the Exercise Price.

PLAN OF DISTRIBUTION

The Offered Common Stock, the Warrants and the Underlying Common Stock
subsequently acquired by the Selling Securityholders pursuant to the exercise
of outstanding Warrants, may be offered for sale from time to time by the
Selling Securityholders named herein, or by their pledgees, donees,
transferees or other successors in interest, to or through underwriters or
directly to other purchasers or through agents in one or more transactions in
the over-the-counter market, in one or more private transactions, or in a
combination of such methods of sale, at prices and on terms then prevailing,
at prices related to such prices, or at negotiated prices. Under certain
circumstances, the Selling Securityholders and any broker-dealers that act in
connection with the sale of such Securities may be deemed to be "underwriters"
within the meaning of Section 2(11) of the Securities Act, and any commissions
or discounts and other compensation paid to such persons may be deemed to be
underwriting discounts and commissions under the Securities Act. At any time a
particular offer of Offered Common Stock, Warrants or Underlying Common Stock
is made, if required, a Prospectus Supplement will be distributed that will
set forth the aggregate amount of such Securities being offered and the terms
of the offering, including the name or names of any underwriters, dealers or
agents, any discounts, commissions and other items constituting compensation
from the Selling Securityholders and any discounts, commissions or concessions
allowed or reallowed or paid to dealers. Such Prospectus Supplement and, if
necessary, a post-effective amendment to the Shelf Registration Statement of
which this Prospectus is a part, will be filed with the Commission to reflect
the disclosure of additional information with respect to the distribution of
such Securities.

The Underlying Common Stock offered hereby will be sold directly by the
Company to the Warrantholder at the exercise price of the Warrants and
pursuant to the terms and conditions of the Warrant Agreement governing the
Warrants, a copy of which has been filed as an exhibit to the Shelf
Registration Statement of which this Prospectus is a part. The exercise price
per Warrant was established at the time of the Private Placement, prior to its
commencement of operations, and was fixed by management at the per Unit
offering price.

To comply with the securities laws of certain jurisdictions, the Securities
offered hereby may be offered or sold in such jurisdictions only through
registered or licensed brokers or dealers. In addition, in certain
jurisdictions the securities offered hereby may not be offered or sold unless
they have been registered or qualified for sale in such jurisdictions or an
exemption from registration or qualification is available and is complied
with.

Pursuant to the Registration Rights Agreement entered into in connection
with the Private Placement, the holders of the Securities covered by this
Prospectus have agreed not to effect any public sale or distribution of any of
the Company's securities for a period beginning 10 days prior to, and ending
90 days following, the closing of an underwritten public offering by the
Company. Thus, because the IPO, an underwritten public offering, initially
closed on November 4, 1997, assuming no other such underwritten public
offerings occur for the 90-day period following the IPO closing, no sales of
the Securities herein could have taken place prior to February 3, 1998.

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. Tobin & Tobin, a professional corporation, and
Jeffers, Wilson, Shaff & Falk, 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.

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<PAGE>

EXPERTS

The financial statements of NovaStar Financial, Inc. 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 and the
consolidated financial statements of NFI Holding Corporation and Subsidiary as
of June 30, 1997 and for the period from February 6, 1997 (inception) to June
30, 1997 have been included herein and in the Company's Shelf Registration
Statement. Reliance upon the report has been provided by 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 Commission in Washington, D.C., a Shelf
Registration Statement on Form S-11 under the Securities Act with respect to
the Securities offered hereby. This Prospectus does not contain all of the
information set forth in the Shelf 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 Securities offered hereby, reference is made to the Shelf
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. The Company is subject to the informational
requirements of the Exchange Act, and in accordance therewith files 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 listed on the NYSE
under the symbol "NFI." The Company's Warrants are expected to trade through
market makers, such as Stifel, Nicolaus & Company, Incorporated, using the
NASD's OTC Bulletin Board Service. 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.

105
<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.

"CAG" means Capital Allocation Guidelines adopted by the Company's Board of
Directors.

"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.

"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.

"DER" means dividend equivalent rights, an element of the Company's stock
option plan, which are granted together with certain stock options.

"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.

"Holding" means NFI Holding Corporation, a taxable affiliate of the Company.

"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.

"IPO" means the Company's initial public offering, which closed on December
1, 1997.

106
<PAGE>

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

"LTV" or "loan-to-value ratio" 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.

"Maryland GCL" means the general corporation laws of the State of Maryland,
the state in which the Company is incorporated.

"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.

"NCFC" means NovaStar Certificates Financing Corporation, a wholly-owned,
REIT-qualifying subsidiary of the Company.

"NovaStar Mortgage" means NovaStar Mortgage, Inc., a taxable affiliate of
the Company.

"NQSOs" means Non-Qualified Stock Options, an element of the Company's stock
option plan regulated by Section 422 of the Code.

"NYSE" means the New York Stock Exchange.

"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.

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<PAGE>

"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.

"SMMEA" means the Secondary Mortgage Market Enhancement Act of 1984.

"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.

108
<PAGE>

INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
SEPTEMBER 30, 1997
NOVASTAR FINANCIAL, INC.
Unaudited Financial Statements:
Balance Sheets........................................................... F-2
Statements of Operations................................................. F-3
Statements of Cash Flows................................................. F-4
Notes to Financial Statements............................................ F-5
JUNE 30, 1997
NOVASTAR FINANCIAL, INC.
Independent Auditors' Report............................................... F-7
Audited Financial Statements:
Balance Sheets........................................................... F-8
Statements of Operations................................................. F-9
Statements of Stockholders' Equity....................................... F-10
Statements of Cash Flows................................................. F-11
Notes to Financial Statements............................................ F-12
NFI HOLDING CORPORATION
Independent Auditors' Report............................................... F-20
Audited Financial Statements:
Balance Sheets........................................................... F-21
Statements of Operations................................................. F-22
Statements of Stockholders' Equity....................................... F-23
Statements of Cash Flows................................................. F-24
Notes to Financial Statements............................................ F-25
</TABLE>

F-1
<PAGE>

NOVASTAR FINANCIAL, INC.

BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)

<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1997 1996
------------- ------------
(UNAUDITED)
<S> <C> <C>
ASSETS
Cash and cash equivalents......................... $ 4,236 $46,434
Mortgage securities available-for-sale............ 267,835 13,239
Mortgage loans.................................... 418,897 --
Accrued interest receivable....................... 4,891 14
Investment in NFI Holding Corporation............. 1,857 --
Other assets...................................... 1,417 109
-------- -------
Total assets.................................. $699,133 $59,796
======== =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Repurchase agreements........................... $644,195 $ --
Due to NovaStar Mortgage, Inc................... 5,861 --
Amounts due to brokers and dealers for unsettled
mortgage securities purchases.................. -- 13,255
Accounts payable and accrued expenses........... 2,041 176
-------- -------
Total liabilities............................. 652,097 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............................. (1,643) (302)
Net unrealized gain (loss) on available-for-sale
securities..................................... 2,239 (16)
Forgivable notes receivable from founders....... (3,460) (3,265)
-------- -------
Total stockholders' equity.................... 47,036 46,365
-------- -------
Total liabilities and stockholders' equity ... $699,133 $59,796
======== =======
</TABLE>

See notes to financial statements.

F-2
<PAGE>

NOVASTAR FINANCIAL, INC.

STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
FOR THE NINE FOR THE THREE FOR THE PERIOD FROM
MONTHS ENDED MONTHS ENDED SEPTEMBER 13, 1996
SEPTEMBER 30, 1997 SEPTEMBER 30, 1997 (INCEPTION) TO
(UNAUDITED) (UNAUDITED) SEPTEMBER 30, 1996
<S> <C> <C> <C>
Interest income:
Mortgage securities... $ 6,796 $ 4,555 $ --
Mortgage loans........ 14,749 7,670 --
------- ------- -----
Total interest income... 21,545 12,225 --
Interest expense........ 16,224 9,786 --
------- ------- -----
Net interest income..... 5,321 2,439 --
Provision for credit
losses................. 1,444 726 --
------- ------- -----
Net interest income
after provision for
credit losses.......... 3,877 1,713 --
Other income............ 326 259 --
Equity in net loss of
NFI Holding
Corporation............ (141) 290 --
General and
administrative
expenses:
Administrative
services provided by
NovaStar Mortgage,
Inc. ................ 2,450 1,200 --
Compensation and
benefits............. 701 332 --
Loan servicing........ 694 123 --
Professional and
outside services..... 430 181 --
Office administration. 201 89 --
Other................. 288 160 --
------- ------- -----
Total general and
administrative
expenses............. 4,764 2,085 --
------- ------- -----
Net loss................ $ (702) $ 177 $ --
======= ======= =====
Pro forma net loss per
share.................. $ (0.16) $ 0.04 $ --
======= ======= =====
Weighted average number
of shares outstanding.. 4,273 4,273 --
======= ======= =====
</TABLE>

See notes to financial statements.

F-3
<PAGE>

NOVASTAR FINANCIAL, INC.

STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

<TABLE>
<CAPTION>
FOR THE NINE FOR THE PERIOD FROM
MONTHS ENDED SEPTEMBER 13, 1996
SEPTEMBER 30, 1997 (INCEPTION) TO
(UNAUDITED) SEPTEMBER 30, 1996
<S> <C> <C>
CASH FLOW FROM OPERATING ACTIVITIES:
$
Net loss ............................... $ (702) --
Adjustments to reconcile net loss to
cash used in operating activities:
Amortization of premiums.............. 2,228 --
Provision for credit losses........... 1,444 --
Interest on forgivable notes
receivable from founders............. (195) --
Equity in net loss of NFI Holding
Corporation.......................... 123 --
Gains on sales of mortgage securities. (42) --
Change in:
Accrued interest receivable......... (4,877) --
Other assets........................ 4,299 --
Other liabilities................... 1,003 --
--------- ----
Net cash provided by (used in)
operating activities............. 3,281 --
CASH FLOW FROM INVESTING ACTIVITIES:
Purchases of available-for-sale
securities............................ (380,820)
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............................ 22,506 --
Investment in NFI Holding Corporation.. (1,980) --
Mortgage loans acquired from NovaStar
Mortgage, Inc......................... (229,364) --
Mortgage loans acquired from others.... (219,995) --
Mortgage loan repayments............... 27,402 --
--------- ----
Net cash used in investing
activities....................... (695,133) --
CASH FLOW FROM FINANCING ACTIVITIES:
Proceeds from private placement, net of
offering costs........................ -- --
Private placement offering costs....... (48) --
Proceeds from issuance of common stock. -- --
Net borrowings under repurchase
agreements............................ 644,195 --
Net change in amount due to
unconsolidated affiliate.............. 5,861 --
Dividends paid on convertible preferred
stock................................. (354) --
--------- ----
Net cash provided by financing
activities....................... 649,654 --
--------- ----
Net increase (decrease) in cash and cash
equivalents............................ (42,198) --
Cash and cash equivalents, beginning of
period................................. 46,434 --
--------- ----
Cash and cash equivalents, end of
period................................. $ 4,236 $--
========= ====
SUPPLEMENTAL DISCLOSURE OF CASH FLOW
INFORMATION:
Cash paid for interest ................ $ 15,416 $--
========= ====
Issuance of units acquired with
forgivable debt ...................... $ -- $--
========= ====
Dividends payable...................... $ 284 $--
========= ====
</TABLE>

See notes to financial statements.

F-4
<PAGE>

NOVASTAR FINANCIAL, INC.

NOTES TO FINANCIAL STATEMENTS

SEPTEMBER 30, 1997

NOTE 1. FINANCIAL STATEMENT PRESENTATION

The financial statements as of and for the period ended September 30, 1997
are unaudited. In the opinion of management all adjustments, which were of a
normal recurring nature, necessary for a fair presentation of the balance
sheet and results of operations, have been made. The financial statements
should be read in conjunction with Management's Discussion and Analysis of
Financial Condition and Results of Operations.

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates that
affect the reported amount of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements.
These estimates and assumptions also impact reported amounts of revenues and
expenses during the reporting period. Actual results could differ from these
estimates.

The Company owns 100 percent of the preferred stock of NFI Holding
Corporation (Holding) for which it receives 99 percent of any dividends paid
by Holding. The founders of the Company own the voting common stock of
Holding. NovaStar Mortgage is a wholly owned subsidiary of Holding. Certain
key officers of the Company serve as officers of Holding and NovaStar Mortgage
and the founders are the only members of the Board of Directors of Holding and
NovaStar Mortgage. The Company accounts for its investment in Holding using
the equity method.

NOTE 2. SUBSEQUENT EVENTS

On October 30, 1997, the Company completed its initial public offering of
common stock. The Company sold 3,750,000 shares in the offering at a price of
$18.00 per share and received approximately $62 million in net proceeds.
Approximately 90 percent of the proceeds will be used to fund the acquisition
of the wholesale loan production of NovaStar Mortgage and the acquisition of
mortgage securities, in accordance with its business strategies. The remaining
10 percent of the net proceeds will be used for working capital and general
corporate purposes.

On October 1, 1997 the Company issued $264 million in a privately-placed
Collateralized Mortgage Obligation (CMO), secured primarily by subprime
residential mortgage loans. For accounting purposes, the mortgage loans
financed through the issuance of the CMO are treated as assets, and borrowings
under the CMO are treated as debt of the Company. Borrowings under the CMO are
fully payable from the principal and interest payments on the underlying
mortgage loans collateralizing such debt. Proceeds from this issue were used
to repay amounts borrowed under the Company's master repurchase agreement.

F-5
<PAGE>

INDEPENDENT AUDITORS' REPORT

The Board of Directors
NovaStar Financial, Inc.:

We have audited the accompanying balance sheets of NovaStar Financial, Inc.
as of June 30, 1997 and December 31, 1996 and the related 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 financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these 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 financial statements referred to above present fairly,
in all material respects, the financial position of NovaStar Financial, Inc.
as of June 30, 1997 and December 31, 1996 and the results of its operations
and its 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
except for note 12, which is
as of October 1, 1997

F-6
<PAGE>

NOVASTAR FINANCIAL, INC.

BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)

<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
1997 1996
<S> <C> <C>
ASSETS
Cash and cash equivalents............................. $ 24 $46,434
Mortgage securities available-for-sale................ 284,348 13,239
Mortgage loans........................................ 303,732 --
Accrued interest receivable........................... 6,244 14
Investment in NFI Holding Corporation................. 1,548 --
Other assets.......................................... 5,969 109
-------- -------
Total assets.................................... $601,865 $59,796
======== =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Repurchase agreements............................... $540,040 $ --
Due to NovaStar Mortgage, Inc. ..................... 14,112 --
Amounts due to brokers and dealers for unsettled
mortgage securities purchases...................... -- 13,255
Accounts payable and accrued expenses............... 1,376 176
-------- -------
Total liabilities............................... 555,528 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...... $601,865 $59,796
======== =======
</TABLE>

See notes to financial statements.

F-7
<PAGE>

NOVASTAR FINANCIAL, INC.

STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
FOR THE SIX FOR THE PERIOD FROM
MONTHS ENDED SEPTEMBER 13, 1996
JUNE 30, (INCEPTION) TO
1997 DECEMBER 31, 1996
<S> <C> <C>
Interest income:
Mortgage securities......................... $2,241 $ 1155
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.................................. 68 --
Equity in net loss of NFI Holding Corporation. (432) --
General and administrative expenses:
Administrative services provided by NovaStar
Mortgage, Inc. ............................ 1,250 --
Loan servicing.............................. 571 200
Compensation and benefits................... 369 199
Professional and outside services........... 249 --
Office administration....................... 112 --
Other....................................... 128 58
------ ------
Total general and administrative expenses .. 2,679 457
------ ------
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 financial statements.

F-8
<PAGE>

NOVASTAR FINANCIAL, INC.

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

<TABLE>
<CAPTION>
NET
UNREALIZED
GAIN FORGIVABLE
(LOSS) ON NOTES
CONVERTIBLE ADDITIONAL AVAILABLE- RECEIVABLE TOTAL
PREFERRED COMMON PAID-IN ACCUMULATED 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. -- 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 financial statements.

F-9
<PAGE>

NOVASTAR FINANCIAL, INC.

STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

<TABLE>
<CAPTION>
FOR THE SIX FOR THE PERIOD FROM
MONTHS ENDED SEPTEMBER 13, 1996
JUNE 30, (INCEPTION) TO
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 --
Provision for credit losses................. 718 --
Interest on forgivable notes receivable from
founders................................... (130) (15)
Equity in net loss of NFI Holding
Corporation................................ 432 --
Gains on sales of mortgage securities....... (42) --
Change in:
Accrued interest receivable............... (6,230) (14)
Other assets.............................. (251) (109)
Other liabilities......................... 444 176
--------- -------
Net cash used in operating activities... (5,238) (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............... 3,210 --
Investment in NFI Holding Corporation........ (1,980) --
Mortgage loans acquired from NovaStar
Mortgage, Inc............................... (92,781) --
Mortgage loans acquired from others.......... (219,995) --
Mortgage loan repayments..................... 7,855 --
--------- -------
Net cash used in investing activities... (595,099) --
CASH FLOW FROM FINANCING ACTIVITIES:
Proceeds from private placement, net of
offering costs.............................. -- 50,000
Private placement offering costs............. (48) (3,304)
Proceeds from issuance of common stock....... -- 2
Net borrowings under repurchase agreements... 540,040 --
Net change in amount due to unconsolidated
affiliate................................... 14,112 --
Dividends paid on convertible preferred
stock....................................... (177) --
--------- -------
Net cash provided by financing
activities............................. 553,927 46,698
--------- -------
Net increase (decrease) in cash and cash
equivalents.................................. (46,410) 46,434
Cash and cash equivalents, beginning of
period....................................... 46,434 --
--------- -------
Cash and cash equivalents, end of period...... $ 24 $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 financial statements.

F-10
<PAGE>

NOVASTAR FINANCIAL, INC.

NOTES TO FINANCIAL STATEMENTS

JUNE 30, 1997

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Business

NovaStar Financial, Inc. (NovaStar or 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 acquires subprime mortgage loans and
mortgage securities and manages the resulting portfolio of mortgage assets.

Financial Statement Presentation

The Company's 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.

The Company accounts for its investment in NFI Holding Corporation (Holding)
using the equity method. NovaStar owns 100 percent of the nonvoting preferred
stock of Holding, for which it receives 99 percent of any dividends paid by
Holding. The preferred stock was purchased in February 1997 for $1,980,000.
Holding owns 100 percent of the outstanding common stock of NovaStar Mortgage,
Inc. (NMI). NMI serves as NovaStar's principal source of subprime mortgage
loans. The founders of NovaStar own 100% of the common stock of Holding, and
serve as officers and directors of Holding and NMI.

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 NMI'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.
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 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.

F-11
<PAGE>

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

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 12)
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.

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

F-12
<PAGE>

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

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.

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

F-13
<PAGE>

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

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 repurchase agreements with brokerage firms and short-term advances
from NMI. The Company reimburses NMI for any interest costs incurred related
to borrowings of NMI to originate loans purchased by NovaStar (See note 9).
The Company has a $300 million master repurchase agreement with Merrill Lynch
Mortgage Capital, Inc. and Merrill Lynch Credit Corporation as its primary
source of short-term financing. 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 includes customary covenants. As of June 30, 1997, the
Company was in compliance with all covenants under the agreement.

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>
AVERAGE
AS OF JUNE 30, 1997 DAILY BALANCE
------------------------------- DURING THE
WEIGHTED WEIGHTED SIX MONTHS
AVERAGE DAYS TO RESET ENDED
RATE OR MATURITY BALANCE JUNE 30, 1997
<S> <C> <C> <C> <C>
Repurchase agreements secured by
mortgage securities............. 6.00 8 $275,790 $ 56,226
Master repurchase agreement
secured by mortgage loans....... 6.44 3 264,250 132,937
--------
Total borrowings............. $540,040
========
</TABLE>

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

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
-----------------------------------------
90 AND
DAILY 0 TO 30 30 TO 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
---- -------- ------- -------- --------
$-- $281,673 $11,261 $247,106 $540,040
==== ======== ======= ======== ========
</TABLE>

F-14
<PAGE>

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

The Company uses interest rate swap and cap agreements to modify the
interest rate on borrowings under its master repurchase agreement, aggregating
$264,250,000 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. 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.

As discussed in note 12, the Company refinanced a significant portion of its
borrowings under the master repurchase agreement on October 1, 1997 through
the issuance of collateralized mortgage obligations.

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 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 been 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.

F-15
<PAGE>

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

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.
The Company used an independent appraisal firm to value the options granted in
1996. The outside firm considered three valuation approaches in developing a
value for the options, including (1) market comparison using comparable public
companies (2) underlying asset method using the Company's individual assets
and (3) discounted future returns analysis based on an expected value discount
model. These approaches considered the financial projections included in the
Company's 1996 Private Placement Memorandum. In addition, in discounting
future returns, various initial public offering scenarios at $18 per share
were assigned an equal probability of occurring. The discount rate used in the
model was developed by adding together the risk free rate (long-term treasury
rate), a large capitalization stock risk premium, and a specific premium for
the Company. The Company specific premium was based on the Company's
comparison to other publicly traded companies and included the risk of small
capitalization stocks. 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.

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

F-16
<PAGE>

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

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.

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:
Repurchase agreements........................ 540,040 541,038
Off-balance sheet items--interest rate
agreements.................................... 1,180
</TABLE>

F-17
<PAGE>

NOVASTAR FINANCIAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONCLUDED)

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. RELATED PARTY TRANSACTIONS

NovaStar and NMI are parties to a Mortgage Loan Purchase and Sale Agreement,
an Administrative Services Outsourcing Agreement and, effective July 15, 1997,
a Loan Servicing Agreement. Under the terms of the Mortgage Loan Purchase and
Sale Agreement, mortgage loans originated by NMI are purchased by the Company
at prices that vary with the nature and terms of the underlying mortgage
loans. Through June 30, 1997, all mortgage loans originated by NMI were
acquired by the Company. Under the Outsourcing Services Agreement, the Company
pays NMI a fixed monthly fee for providing certain services, including the
development of loan products, underwriting, funding, and quality control, as
well as for any interest costs incurred related to borrowings obtained by NMI
to originate loans that are purchased by NovaStar. The Company paid NMI
$1,250,000 during the six months ended June 30, 1997 related to outsourcing
services performed by NMI in the areas of loan product development,
underwriting, funding and quality control. In addition, through June 30, 1997,
NovaStar had purchased 100 percent of the mortgage loans originated by NMI. In
that regard, NovaStar reimbursed NMI $440,000 of interest for the six month
period then ended. The Company has reflected such cost as interest expense in
the accompanying statement 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 financial
statements.

NOTE 11. 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
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 12. SUBSEQUENT EVENTS

Subsequent to June 30, 1997, the Company filed a registration statement on
Form S-11 for the purpose of registering 3,750,000 shares of common stock for
sale in an initial public offering. The Company expects to issue these shares
at $17.00 per share.

The Company issues Collateralized Mortgage Obligations (CMOs) secured
primarily by subprime residential mortgage loans as a means to finance its
long-term mortgage asset portfolio. For accounting and income tax purposes,
the mortgage loans financed through the issuance of CMOs are treated as assets
of the Company and the CMOs are treated as debt of the Company. Each issue of
CMOs is fully payable from the principal and interest payments on the
underlying mortgage loans collateralizing such debt. The Company issued its
first CMO on October 1, 1997 in a private transaction. Approximately $275
million in mortgage loans serve as collateral for debt issued with a face
amount of $265 million.

F-18
<PAGE>

INDEPENDENT AUDITORS' REPORT

The Board of Directors
NFI Holding Corporation:

We have audited the accompanying consolidated balance sheet of NFI Holding
Corporation and subsidiary as of June 30, 1997 and the related consolidated
statements of operations, stockholders' equity and cash flows for the period
from February 6, 1997 (inception) to June 30, 1997. 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 audit.

We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit 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 audit provides 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 NFI Holding Corporation and subsidiary as of June 30, 1997 and the
consolidated results of their operations and their cash flows for the period
from February 6, 1997 (inception) to June 30, 1997, in conformity with
generally accepted accounting principles.

KPMG Peat Marwick LLP

Kansas City, Missouri
July 25, 1997

F-19
<PAGE>

NFI HOLDING CORPORATION

CONSOLIDATED BALANCE SHEET

JUNE 30, 1997
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)

<TABLE>
<S> <C>
ASSETS
Cash and cash equivalents........................................... $ 849
Due from NovaStar Financial, Inc.................................... 14,112
Other assets........................................................ 571
-------
Total assets.................................................... $15,532
=======
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Borrowings........................................................ $13,600
Accounts payable and accrued expenses............................. 368
-------
Total liabilities............................................... 13,968
Commitments and contingencies
Stockholders' equity:
Common stock, $0.01 par value, 1,000 shares authorized; 200 shares
outstanding...................................................... --
Preferred stock, $0.01 par value, 10,000 shares authorized; 1,980
shares outstanding............................................... --
Additional paid-in capital........................................ 2,000
Accumulated deficit............................................... (436)
-------
Total stockholders' equity...................................... 1,564
-------
Total liabilities and stockholders' equity...................... $15,532
=======
</TABLE>

See notes to consolidated financial statements.

F-20
<PAGE>

NFI HOLDING CORPORATION

CONSOLIDATED STATEMENT OF OPERATIONS

FOR THE PERIOD FROM FEBRUARY 6, 1997 (INCEPTION) TO JUNE 30, 1997
(IN THOUSANDS)

<TABLE>
<S> <C>
Fee income:
Service fees received from NovaStar Financial, Inc................... $1,250
Other................................................................ 43
------
Total fee income................................................... 1,293
General and administrative expenses:
Compensation and benefits............................................ 763
Professional and outside services.................................... 347
Office administration................................................ 222
Travel and public relations.......................................... 197
Occupancy............................................................ 110
Other................................................................ 90
------
Total general and administrative expenses.......................... 1,729
------
Net loss............................................................... $ (436)
======
</TABLE>

See notes to consolidated financial statements.

F-21
<PAGE>

NFI HOLDING CORPORATION

CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY

FOR THE PERIOD FROM FEBRUARY 6, 1997 (INCEPTION) TO JUNE 30, 1997
(DOLLARS IN THOUSANDS)

<TABLE>
<CAPTION>
ADDITIONAL TOTAL
COMMON PREFERRED PAID-IN ACCUMULATED STOCKHOLDERS'
STOCK STOCK CAPITAL DEFICIT EQUITY
<S> <C> <C> <C> <C> <C>
Balance, February 6,
1997.................... $-- $-- $ -- $ -- $ --
Issuance of 200 shares of
common stock............ -- -- 20 -- 20
Issuance of 1,980 shares
of preferred stock...... -- -- 1,980 -- 1,980
Net loss................. -- -- -- (436) (436)
---- ---- ------ ----- ------
Balance, June 30, 1997... $-- $-- $2,000 $(436) $1,564
==== ==== ====== ===== ======
</TABLE>

See notes to consolidated financial statements.

F-22
<PAGE>

NFI HOLDING CORPORATION

CONSOLIDATED STATEMENT OF CASH FLOWS

FOR THE PERIOD FROM FEBRUARY 6, 1997 (INCEPTION) TO JUNE 30, 1997
(IN THOUSANDS)

<TABLE>
<S> <C>
CASH FLOW FROM OPERATING ACTIVITIES:
Net loss........................................................... $ (436)
Adjustments to reconcile net loss to cash used in operating
activities:
Change in:
Due from NovaStar Financial, Inc............................... (14,112)
Other assets................................................... (571)
Accounts payable and accrued expenses.......................... 368
--------
Net cash used in operating activities........................ (14,751)
CASH FLOW FROM INVESTING ACTIVITIES:
Mortgage loans originated.......................................... (92,781)
Proceeds from sales of mortgage loans to NovaStar Financial, Inc... 92,781
--------
Net cash provided by investing activities.................... --
CASH FLOW FROM FINANCING ACTIVITIES:
Net borrowings under warehouse line of credit...................... 13,600
Proceeds from issuance of capital stock............................ 2,000
--------
Net cash provided by financing activities.................... 15,600
--------
Net increase in cash and cash equivalents.......................... 849
Cash and cash equivalents, beginning of period..................... --
--------
Cash and cash equivalents, end of period........................... $ 849
========
</TABLE>

See notes to consolidated financial statements.

F-23
<PAGE>

NFI HOLDING CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

JUNE 30, 1997

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING PRINCIPLES

Business

NFI Holding Corporation (Holding or the Company) was incorporated on
February 6, 1997. In connection therewith, two individuals contributed $20,000
and their common stock ownership in NovaStar Mortgage, Inc. in exchange for
shares of the Company's common stock. At that same time NovaStar Financial,
Inc. (NovaStar) purchased 100% of the Company's preferred stock for
$1,980,000. The Company's two common stockholders are also officers, directors
and common stockholders of NovaStar. Substantially all of the proceeds from
the Company's initial capitalization were contributed to NMI, a company
incorporated by these same two individuals in June 1996.

NMI had no operations, revenues or expenses prior to February 1997, when it
began originating subprime mortgage loans through a network of wholesale
brokers and correspondents. NMI generally intends to sell the mortgage loans
it originates to NovaStar. Effective July 15, 1997, NMI began servicing
mortgage loans on behalf of NovaStar. Holding has no substantive operations of
its own and, therefore, its consolidated financial statements generally
reflect the operations of NMI.

Financial Statement Presentation

The Company's consolidated financial statements include the accounts of
Holding and NMI, and 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

Cash and cash equivalents include cash on hand and demand deposits.

Sale of Mortgage Loans

NMI generally sells the mortgage loans it originates to NovaStar at the time
of funding. Accordingly, no interest income is earned from mortgage loans.
Loans are sold to NovaStar at NMI's cost, including deferred fees received and
direct costs incurred.

Income Taxes

The Company will file consolidated income tax returns with NMI. The Company
will record deferred tax assets and liabilities for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective
income tax bases. Deferred tax assets and liabilities are measured using
enacted tax rates applied to taxable income in the years in which those
temporary differences are expected to be recovered or settled. The effect on
deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period that includes the enactment date.

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 transactions occurring after December 31, 1996, except for secured
borrowings, repurchase agreements, dollar rolls, securities lending and
similar transactions, for which SFAS 125 is effective for transactions
occurring after December 31, 1997. SFAS 125 provides accounting and reporting
standards for transfers and servicing of financial assets and extinguishments
of liabilities based on the consistent application of a financial-components
approach that focuses on control. It

F-24
<PAGE>

distinguishes transfers that are sales from those that are secured borrowings.
Under SFAS 125, after a transfer of financial assets, an entity recognizes all
assets it controls and liabilities it has incurred, and derecognizes assets it
no longer controls and liabilities that have been extinguished. 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. The adoption of SFAS No. 125,
as amended by SFAS No. 127, will not have a material effect on the Company's
financial position or results of operations.

NOTE 2. RELATED PARTY TRANSACTIONS

Under the terms of the Company's Certificate of Incorporation, NovaStar, by
virtue of its preferred stock investment, is entitled to 99 percent of the
dividends, if any, that are paid by the Company.

In addition, NovaStar and NMI are parties to a Mortgage Loan Purchase and
Sale Agreement, an Administrative Services Outsourcing Agreement and,
effective July 15, 1997, a Loan Servicing Agreement. Under the terms of the
Mortgage Loan Purchase and Sale Agreement, mortgage loans originated by NMI
are purchased by NovaStar at prices that vary with the nature and terms of the
underlying mortgage loans. Through June 30, 1997, all mortgage loans
originated by NMI were sold to NovaStar. Under the Outsourcing Services
Agreement, NovaStar pays NMI a fixed monthly fee for providing certain
services, including the development of loan products, underwriting, funding,
and quality control, as well as for any interest costs incurred related to
borrowings obtained by NMI to originate loans that are purchased by NovaStar.
NovaStar paid NMI $1,250,000 during 1997 related to outsourcing services
performed by NMI in the areas of loan product development, underwriting
funding and quality control. In addition, through June 30, 1997, NovaStar had
purchased 100 percent of the mortgage loans originated by NMI. In that regard,
NovaStar reimbursed NMI $440,000 of interest for the six month period then
ended. As a result of the reimbursement, the accompanying 1997 statement of
operations does not reflect any interest expense.

NOTE 3. BORROWINGS

As of June 30, 1997, borrowings represent advances under NMI's $50 million
warehouse line of credit with First Union National Bank. Advances under this
agreement bear interest at the Federal Funds rate plus a spread (8.12 percent
as of June 30, 1997) with interest payable monthly. The average daily balance
under this facility during the period ended June 30, 1997 was $13.7 million.
The warehouse facility matures in February 1998 and includes financial and
non-financial covenants. As the interest rate resets daily on amounts
outstanding under the warehouse line of credit, fair value is the same as
carrying value. As discussed in note 2, NMI is reimbursed by NovaStar for any
interest cost incurred related to Mortgage loans purchased by NovaStar.

NOTE 4. INCOME TAXES

As a newly formed entity, the Company has not recorded an income tax benefit
related to the net loss incurred through June 30, 1997. That loss will be
available to offset future profits, and the related tax benefit will be
recognized when the Company demonstrates the ability to achieve profitability.

NOTE 5. COMMITMENTS AND CONTINGENCIES

NMI leases certain facilities and equipment under various operating lease
agreement. Rent expense and future obligations under these leases are not
material to the consolidated financial statements.

F-25
<PAGE>

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

TABLE OF CONTENTS

<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Prospectus Summary........................................................ 4
Risk Factors.............................................................. 15
The Company............................................................... 31
Use of Proceeds........................................................... 31
Dividend Policy and Distributions......................................... 32
Dividend Reinvestment Plan................................................ 32
Capitalization............................................................ 33
Market Prices and Dividend Data........................................... 33
Selected Financial and Other Data......................................... 34
Management's Discussion and Analysis of Financial Condition and Results of
Operations............................................................... 35
Business.................................................................. 50
Management................................................................ 68
Principal Securityholders................................................. 77
Certain Transactions...................................................... 79
Federal Income Tax Considerations......................................... 88
Description of Capital Stock.............................................. 97
Description of Warrants................................................... 102
Plan of Distribution...................................................... 104
Legal Matters............................................................. 104
Experts................................................................... 105
Available Information..................................................... 105
Glossary.................................................................. 106
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.

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

7,199,998 SHARES

NOVASTAR FINANCIAL, INC.

COMMON STOCK

3,649,999

NOVA STAR FINANCIAL INC.

STOCK PURCHASE WARRANTS

LOGO

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

Prospectus

February 3, 1998

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

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