<PAGE>
AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON DECEMBER 24, 1998
REGISTRATION NO. 333-43471
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- --------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------
POST-EFFECTIVE
AMENDMENT NO. 1
TO
FORM S-11
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
OF SECURITIES OF CERTAIN REAL ESTATE COMPANIES
----------------
NOVASTAR FINANCIAL, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS GOVERNING INSTRUMENTS)
1901 WEST 47TH PLACE, SUITE 105
WESTWOOD, KS 66205
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
SCOTT F. HARTMAN
CHAIRMAN OF THE BOARD, SECRETARY AND CHIEF EXECUTIVE OFFICER
NOVASTAR FINANCIAL, INC.
1901 WEST 47TH PLACE, SUITE 105
WESTWOOD, KS 66205
(913) 362-1090
(NAME AND ADDRESS OF AGENT FOR SERVICE)
COPIES TO:
W. LANCE ANDERSON PHILLIP R. POLLOCK, ESQ.
PRESIDENT AND CHIEF OPERATING OFFICER TOBIN & TOBIN
NOVASTAR FINANCIAL, INC. 500 SANSOME STREET, 8TH FLOOR
1900 WEST 47TH PLACE, SUITE 205 SAN FRANCISCO, CA 94104
WESTWOOD, KS 66205 (415) 433-1400
(913) 362-1090
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Approximate Date of Commencement of Proposed Sale to the Public: At any time
and from time to time after the effective date of this Post-effective Amendment
to Registration Statement
If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, please check the following
box and list the Securities Act registration number of the earlier effective
registration statement for the same offering. [_]
If this Form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
registration number of the earlier effective registration statement for the
same offering. [_]
If this Form is a post-effective amendment filed pursuant to Rule 462(d)
under the Securities Act, check the following box and list the Securities Act
registration number of the earlier effective registration statement for the
same offering. [_]
If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. [_]
If any of the securities being registered on this form are to be offered on a
delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, check box: [X]
----------------
THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT
SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION
STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF
THE SECURITIES ACT OF 1933 OR UNTIL THIS REGISTRATION STATEMENT SHALL BECOME
EFFECTIVE ON SUCH DATE AS THE COMMISSION ACTING PURSUANT TO SAID SECTION 8(A),
MAY DETERMINE.
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<PAGE>
PROSPECTUS
7,199,998 SHARES COMMON STOCK
3,649,999 STOCK PURCHASE WARRANTS
NOVASTAR FINANCIAL, INC.
Consider carefully the
risk factors beginning on
page 15 of this
prospectus, including the
following:
. We have limited
operating history and
expect to incur
significant losses in
the 4th quarter of 1998.
. Our profitability is
dependent upon our
ability to borrow money
in sufficient amounts
and on favorable terms.
Currently, the subprime
mortgage market is
facing a liquidity
crisis with respect to
the availability of
short-term borrowings
from major lenders and
long-term borrowings
through securitizations.
There is no assurance
that these circumstances
will not have a material
adverse effect upon us.
. Our $18 million 90-day
financing arrangement is
due to mature, unless
extended, on January 13,
1999. There is no
assurance that the
arrangement can be
extended or replaced.
. Unexpected or rapid
changes in interest
rates could negatively
effect our subprime
mortgage lending
business.
NovaStar Financial, Inc., organized in 1996, is a self-advised and self-
managed specialty finance company. We acquire single family residential
subprime mortgage loans; we leverage our assets using warehouse facilities,
including repurchase agreements; we issue collateralized debt obligations to
finance our subprime mortgage loans in the long-term; we purchase mortgage
securities in the secondary mortgage market; and we manage the resulting
combined portfolio of mortgage assets in a tax-advantaged real estate
investment trust or "REIT" structure. Wholesale mortgage loans are originated
by our taxable affiliate NovaStar Mortgage, Inc. and either sold to us or to
others.
This prospectus relates to 3,549,999 shares of our common stock, par value
$.01 per share, being offered by certain selling securityholders; 3,649,999
stock purchase warrants, each warrant exercisable for one share of our common
stock, and 3,649,999 shares of common stock issuable upon the exercise of
warrants. The warrants are exercisable until February 3, 2001 at a $15.00
exercise price, subject to certain anti-dilution protections.
The selling securityholders or their successors may offer these securities
for sale from time to time either through underwriters or directly to other
purchasers. The sales may be in one or more transactions in the over-the-
counter market or in private transactions. They may sell these securities at
prices and on terms then prevailing or at negotiated prices. Under certain
circumstances, the selling securityholders and any broker-dealers that act in
connection with the sales 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.
We will not receive any proceeds from the sale of securities by the selling
securityholders. We will receive the proceeds from the issuance and sale of
common stock pursuant to the exercise of the warrants.
<TABLE>
<CAPTION>
PRICE TO UNDERWRITING PROCEEDS
PUBLIC DISCOUNT (BEFORE EXPENSES)
- ----------------------------------------------------------------
<S> <C> <C> <C>
Per exercised
warrant $15.00 $0.00 $15.00
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Total $54,749,985.00 $0.00 $54,749,985.00
</TABLE>
Our stock is subject to certain restrictions on ownership and transferability
which generally prohibit any person from owning more than 9.8% of our
outstanding shares, with certain exceptions.
Our common stock is listed on the New York Stock Exchange under the symbol
"NFI". On December 21, 1998, the last reported sale price was $6 7/8 per share.
Our warrants trade through market makers, such as Stifel, Nicolaus & Company,
Incorporated, using the NASD's bulletin board service.
NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE SECURITIES
COMMISSION HAS APPROVED OR DISAPPROVED OF THESE SECURITIES OR DETERMINED IF
THIS PROSPECTUS IS ACCURATE OR COMPLETE. ANY REPRESENTATION TO THE CONTRARY IS
A CRIMINAL OFFENSE.
DECEMBER [ ], 1998
<PAGE>
TABLE OF CONTENTS
<TABLE>
<S> <C>
PROSPECTUS SUMMARY......................................................... 3
Overview of NovaStar Financial, Inc....................................... 3
Summary Risk Factors...................................................... 5
Business Strategies and Advantages........................................ 7
Mortgage Lending Strategies............................................... 7
Portfolio Management Strategies........................................... 8
Competitive Advantages.................................................... 9
Structural Benefits....................................................... 9
Dividend Policy, Distributions and Reinvestment........................... 11
The Offering.............................................................. 12
Recent Developments....................................................... 12
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
Our Dependence Upon Borrowings............................................ 15
Forgivable Notes May Adversely Affect Results of Operations............... 15
Dependence on Key Personnel for Successful Operations..................... 16
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.................... 19
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............................................. 22
Limitations on Effective Hedging.......................................... 23
Potential Adverse Effect of the Use of Financial Instruments in Hedging... 23
Loss Exposure on Single Family Mortgage Assets............................ 24
Increased Loss Exposure on Subprime Mortgage Loans........................ 24
</TABLE>
<TABLE>
<S> <C>
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............................................... 25
Failure to Refinance Outstanding Borrowings on Favorable Terms May Affect
Results of Operations.................................................... 25
Impact of Decline in Market Value of Mortgage Assets: Margin Calls........ 26
Dependence on Securitization Market....................................... 26
Lack of Loan Performance Data............................................. 27
Illiquidity of Investments................................................ 27
Lack of Geographic Diversification........................................ 27
Investment in Common Stock in the Offering................................ 27
Restrictions on Ownership of Capital Stock: Anti-takeover Effect.......... 27
Effect on Stockholders of Potential Future Offerings...................... 28
No Assurance of Active Public Trading Market.............................. 29
Possible Volatility of Stock Price........................................ 29
Securities Eligible for Future Sale....................................... 29
NOVASTAR FINANCIAL, INC.................................................... 30
USE OF PROCEEDS............................................................ 30
DIVIDEND POLICY AND DISTRIBUTIONS.......................................... 30
DIVIDEND REINVESTMENT PLAN................................................. 31
CAPITALIZATION............................................................. 31
MARKET PRICES AND DIVIDEND DATA............................................ 32
SELECTED FINANCIAL AND OTHER DATA.......................................... 33
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS.............................. 34
Safe Harbor Statement..................................................... 34
Events Subsequent to September 30, 1998................................... 34
Liquidity and Capital Resources........................................... 36
Forgivable Notes Receivable from Founders................................. 37
Financial Condition as of September 30, 1998 and December 31, 1997........ 38
Results of Operations--Nine Months Ended September 30, 1998 Compared to
Nine Months Ended September 30, 1997..................................... 46
Results of Operations--Year Ended December 31, 1997....................... 56
Inflation................................................................. 62
Impact of Recently Issued Accounting Pronouncements....................... 62
BUSINESS................................................................... 65
Mortgage Lending Operation and Portfolio Management....................... 65
MANAGEMENT................................................................. 83
Directors and Executive Officers.......................................... 83
Terms of Directors and Officers........................................... 85
Committees of the Board................................................... 86
Compensation of Directors................................................. 86
Compensation Committee Interlocks......................................... 86
Executive Compensation.................................................... 86
Stock Option Grants....................................................... 88
PRINCIPAL SECURITYHOLDERS.................................................. 93
CERTAIN TRANSACTIONS....................................................... 95
SELLING SECURITYHOLDERS.................................................... 97
FEDERAL INCOME TAX CONSIDERATIONS.......................................... 104
DESCRIPTION OF CAPITAL STOCK............................................... 112
DESCRIPTION OF WARRANTS.................................................... 118
PLAN OF DISTRIBUTION....................................................... 119
LEGAL MATTERS.............................................................. 119
EXPERTS.................................................................... 120
WHERE YOU CAN FIND MORE INFORMATION........................................ 120
GLOSSARY................................................................... 121
FINANCIAL STATEMENTS....................................................... F-1
</TABLE>
2
<PAGE>
PROSPECTUS SUMMARY
This summary highlights selected information from this prospectus and does
not contain all of the information that you need to consider in making your
investment decision. You should read this entire prospectus carefully to
understand all of the terms of the offering. Certain items used in this
prospectus have the meaning assigned in the glossary beginning on page .
OVERVIEW OF NOVASTAR FINANCIAL, INC.
GENERAL
We are a specialty finance company which:
. acquires single family residential subprime mortgage loans;
. borrows money to finance its assets using warehouse facilities, including
repurchase agreements;
. issues collateralized debt obligations to finance its subprime mortgage
loans in the long-term;
. purchases mortgage securities in the secondary mortgage market; and
. manages the resulting combined portfolio of mortgage loans and securities
in a tax-advantaged real estate investment trust structure.
We were incorporated and initially capitalized on September 13, 1996. As a
result of our private placement offering on December 9, 1996, we received net
proceeds of $47 million. We completed an initial public offering of 4,059,500
shares of common stock on December 1, 1997. We received proceeds of $67 million
from our initial public offering, after paying the underwriting discounts and
other related expenses.
We own 100 percent of the preferred stock of NFI Holding, Inc. and Scott
Hartman and Lance Anderson, our founders, own the common stock of NFI Holding.
As a result, we receive 99 percent of the income and dividends of NFI Holding
and the founders receive one percent. NFI Holding owns the common stock of
NovaStar Mortgage, Inc. and NovaStar Capital, Inc. We organized and own the
common stock of three other companies, NovaStar Assets Corporation, NovaStar
Certificates Financing Corporation and NovaStar Mortgage Funding Corporation,
all Delaware corporations. We organized these companies to facilitate the
issuance of asset-backed bonds. Each of the NovaStar companies shares common
management. Our founders serve as the sole directors of NFI Holding and
NovaStar Mortgage. An organizational chart is included later in this summary.
NovaStar Mortgage originates subprime residential mortgage loans. NovaStar
Mortgage has developed a nationwide network of wholesale loan brokers and
correspondents who submit loans to NovaStar Mortgage. These brokers and
correspondents are independent from any of the NovaStar entities. NovaStar
Mortgage underwrites these loans and funds approved loans. For the nine months
ended September 30, 1998, NovaStar Mortgage originated (funded) $735 million in
subprime mortgage loans. We have acquired many of the loans originated by
NovaStar Mortgage. However, in times where sufficient capital is not available
to us, NovaStar Mortgage will sell loans.
Based on industry sources, the estimated size of the subprime mortgage loan
market in 1997 was approximately $100 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 loan
business, we believe the subprime mortgage market is still highly fragmented,
with no single competitor having a dominant 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 mortgage loan volume at traditional financial institutions
have together drawn new participants and capital to the subprime mortgage loan
market. We refer you to "Business--Mortgage Lending Operation--Market Overview"
in this prospectus for more detail.
3
<PAGE>
Generally the people to whom NovaStar Mortgage lends money have substantial
equity in the property securing the loan. They are considered "subprime"
borrowers because they have impaired or limited credit profiles or higher debt-
to-income ratios than traditional mortgage lenders allow. These 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 NovaStar Mortgage underwriting guidelines include even levels of risk
classification, 77% of the principal balance of the loans originated by
NovaStar Mortgage and purchased by us in 1998 were to borrowers in the A credit
grade category. One important consideration in underwriting subprime loans is
the nature and value of the collateral securing the loans. We believe that the
amount of equity present in the real estate securing our loans mitigates the
risks inherent in subprime lending. Borrowers' primary residences secured
approximately 93% of the loans originated and purchased in 1998. The maximum
loan-to-value ratio allowed for first mortgage borrowers in our highest credit
grade is 95%. However, the average loan-to-value ratio on loans originated by
NovaStar Mortgage in 1998 was approximately 81%. We refer you to "Business--
Mortgage Lending Operation--Underwriting and Quality Control Strategy" in this
prospectus for more detail.
We have elected to be taxed as a REIT under the Internal Revenue Code of
1986, as amended. As a result, our earnings are generally not subject to
federal income tax to the extent that we distribute our earnings to
stockholders and maintain our qualification as a REIT. We refer you to "Federal
Income Tax Considerations" in this prospectus for more detail. We believe the
REIT structure is the most desirable for owning mortgage loans and securities
due to the elimination of corporate-level income taxation. In addition, we are
not structured as a traditional financial institution, which accepts deposits.
Therefore, we are subject to substantially less regulatory oversight and expect
to incur lower compliance expenses compared to banks, thrifts and many other
originators or holders of mortgage loans and securities. We are self-advised
and self-managed.
MANAGEMENT
Executive Officers. Scott F. Hartman, Chairman and Chief Executive Officer,
is a former executive officer of Dynex Capital, Inc., formerly Resource
Mortgage Capital, Inc., 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. 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.
Mark J. Kohlrus, Senior Vice President, Treasurer and Chief Financial Officer
(NovaStar Financial and NovaStar Mortgage), was previously in the Financial
Services practice of KPMG Peat Marwick LLP.
Michael L. Bamburg, Senior Vice President, Chief Investment Officer of
NovaStar Financial and NovaStar Mortgage most recently served as a Principal of
Smith Breeden Associates, a financial institution consulting and money
management firm specializing in the evaluation and hedging of Mortgage Backed
Securities.
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.
4
<PAGE>
Manuel X. Palazzo, Senior Vice President and Chief Credit Officer of 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.
We refer you to "Management" in this prospectus for further information
regarding management.
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. We have
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.
We incurred significant net losses in the fourth quarter of 1998.
. Our Dependence Upon Borrowings. Our profitability is dependent upon our
ability to borrow money on favorable terms. In October 1998, the subprime
mortgage market faced a liquidity crisis with respect to the availability
of short-term borrowings from major lenders and long-term borrowings
through securitization. We faced significant liquidity constraints.
. Forgivable Notes May Adversely Affect Results of Operations. In our
private placement, Messrs. Hartman and Anderson each acquired units paid
for with promissory notes. Principal due on the notes will be forgiven 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 our results of operations and
dividends paid to stockholders during periods forgiven.
. Dependence on Key Personnel for Successful Operations. Our operations and
those of 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 our businesses and results of operations. We have 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 us will become effective. Although we believe
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 our employ.
. Consequence of Failure to Maintain REIT Status: NovaStar Financial, Inc.
Subject to Tax as a Regular Corporation. If we fail to maintain our
qualification as a REIT, we would be subject to federal income tax as a
regular corporation. We intend to conduct our 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. Our
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 our ability to acquire mortgage loans in expected volumes
necessary to support fixed overhead expense levels.
5
<PAGE>
. Intense Competition in the Subprime Mortgage Industry. We face intense
competition, primarily from commercial banks, savings and loans, other
independent mortgage lenders, and certain other mortgage REITs. Any
increase in the competition among lenders to originate or purchase
subprime mortgage loans may 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.
Any failure by us to adequately address the risks of subprime lending
would have a material adverse impact on our results of operations,
financial condition and business prospects.
. Lack of Loan Performance Data. The mortgage loans we purchased 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 we 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. We are currently dependent upon a few
lenders to provide the primary credit facilities for our 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 our lending operations.
. Decrease in Net Interest Income Due to Interest Rate Fluctuations.
Interest rate fluctuations may affect our earnings as a result of
potential changes in the spread between the interest rates on our
borrowings and the interest rates on our 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 our 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 our exposure
to interest rate changes. Moreover, compliance with the REIT provisions
of the Code may prevent us from effectively implementing the strategies
that we determine, absent such compliance, would best insulate us from
the risks associated with changing interest rates.
. Loss Exposure on Single Family Mortgage Assets. A substantial portion of
our mortgage assets consists of (i) single family mortgage loans or (ii)
mortgage securities evidencing interests in single family mortgage loans.
We will be subject to the risk of loss on such mortgage assets arising
from borrower defaults to the extent not covered by third-party credit
enhancement.
. Market Factors May Limit the NovaStar Financial'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 we will be able to acquire sufficient mortgage
assets from mortgage suppliers at spreads above our cost of funds.
. Restrictions on Ownership of Capital Stock: Anti-takeover Effect. In
order for us to meet the requirements for qualification as a REIT, our
charter generally prohibits any person from acquiring or holding,
directly or indirectly, shares of common stock in excess of 9.8% of the
outstanding shares. This restriction may inhibit market activity and the
resulting opportunity for the holders of our common stock to receive a
premium for their stock that might otherwise exist in the absence of such
restrictions.
6
<PAGE>
BUSINESS STRATEGIES AND ADVANTAGES
There are two general aspects to our business: (i) mortgage lending through
NovaStar Mortgage, primarily in the subprime market; and (ii) management of a
portfolio of mortgage loans and securities, including loans acquired from
NovaStar Mortgage and through secondary market purchases.
MORTGAGE LENDING STRATEGIES
Our primary source of mortgage loans is subprime mortgage loans originated by
NovaStar Mortgage. NovaStar Mortgage is a taxable affiliate and shares common
management with us. Following are strategies followed by NovaStar Mortgage in
its mortgage lending operations. These strategies impact our loan portfolio.
. NovaStar Mortgage uses its sales force to establish a nationwide network
of unaffiliated loan brokers and correspondents. By offering subprime
mortgage products at competitive prices delivered with responsive
customer service, NovaStar Mortgage competes for broker and correspondent
loans. Management believes that this network allows NovaStar Mortgage and
us to acquire mortgage loans at more attractive prices than are available
through secondary market purchases. As of September 30, 1998, the
mortgage lending operation of NovaStar Mortgage had a staff of 215,
including 55 account executives organized in three regions throughout the
United States.
. Prepayment penalties, generally through a loan's first two years, are
emphasized in mortgage loan originations to protect us from the impact of
early prepayments on loans purchased at a premium. For the nine months
ended September 30, 1998, 72% of NovaStar Mortgage's wholesale mortgage
loan originations had prepayment penalties. As of September 30, 1998, 72%
of mortgage loans owned by us 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 on
mortgage loans owned by us. NovaStar Mortgage has placed experienced
management and staff to service mortgage loans.
7
<PAGE>
NovaStar Mortgage opened its wholesale origination operation in January 1997
and originated its first mortgage loan in February 1997. Loan production has
increased as shown below. We acquired substantially all loans originated by
NovaStar Mortgage through June 30, 1998. After June 30, 1998, NovaStar Mortgage
has retained virtually all of its loans to be sold to independent companies.
<TABLE>
<CAPTION>
WHOLESALE MORTGAGE LOAN
ORIGINATIONS
--------------------------------
NUMBER OF LOANS PRINCIPAL AMOUNT
--------------- ----------------
(IN THOUSANDS)
<S> <C> <C>
1996: -- $ --
1997, by quarter:
First.................................. 68 12,688
Second................................. 509 77,692
Third.................................. 1,025 136,582
Fourth................................. 1,552 183,012
----- --------
Total--1997.......................... 3,154 $409,974
===== ========
First.................................. 2,033 $207,976
Second................................. 3,133 294,303
Third.................................. 2,576 232,333
----- --------
Total--1998.......................... 7,742 $734,612
===== ========
</TABLE>
During the nine months ended September 30, 1998, we also acquired mortgage
loans with an aggregate principal amount of $498.3 million and agency-issued
mortgage securities with an aggregate principal amount of and $350.3 million.
PORTFOLIO MANAGEMENT STRATEGIES
In our portfolio management, we:
. acquire mortgage securities and mortgage loans which satisfy our
requirements for the overall asset/liability strategy;
. borrow funds under repurchase agreements and other warehouse facilities
to finance subprime mortgage loan securities acquisitions.
. issue debt obligations securitized by mortgage loans to provide long-term
non-recourse financing;
. monitor interest rate sensitivity through progressive analytical
techniques and seek 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 loans and securities; and
. adhere to our Capital Allocation Guidelines ("CAG") in the application of
equity and debt financing to acquire mortgage loans and securities.
We use a combination of equity and borrowings to finance our acquisition of
mortgage loans and securities. All investments are evaluated in the context of
the CAG and investment policy, both of which have been approved by the Board of
Directors. We use borrowed funds to enhance the return to stockholders. The CAG
detail the borrowing limits to be used given the composition of mortgage loans
and securities. 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.
8
<PAGE>
COMPETITIVE ADVANTAGES
Our principal competitors 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. Our principal competitors
in the business of holding mortgage loans and 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. We effectively compete due
to our:
. experienced management team;
. tax advantaged status as a REIT;
. vertical integration through its relationship with NovaStar Mortgage,
which originates and services mortgage loans;
. freedom from certain regulatory-related administrative and oversight
costs;
. direct access to capital markets to securitize our assets; and
. cost-efficient operations.
STRUCTURAL BENEFITS
A primary distinction between our competitors and us is our REIT tax status.
We will attempt to maximize our after-tax return advantage over non-REIT
financial companies by holding mortgage loans and securities and earning REIT-
qualifying income over time.
Generally, we do not intend to sell our mortgage loans in order to realize
gain on sale for financial accounting or tax reporting purposes. Rather, we
intend to finance our mortgages through structured debt vehicles where the
emphasis is on earning net interest income and not taking gain on the sale of
assets. The strategy is to build and hold a portfolio of mortgage loans and
securities for investment that generates a net interest margin over time and
allows us to take full advantage of our 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 we will produce a tax-advantaged stream of income and a more
stable dividend flow to stockholders because our earnings will be dependent on
the size of the portfolio of mortgage loans and securities, rather than on our
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 us 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 our
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.
While the above is the optimal strategy for us, that strategy is dependent
upon having sufficient capital to increase our mortgage loan and security
portfolio. During periods where market conditions do not allow us to increase
our capital base, we can sell loans in the open market to sustain loan
production.
Management believes it has an advantage over other mortgage REITs through our
infrastructure that allows us to acquire wholesale loan production through our
taxable affiliate, NovaStar Mortgage at a total cost lower than purchasing
those mortgage loans in the secondary market. Moreover, the relationship we
have with NovaStar Mortgage results in a vertically integrated organization.
Because of this integration, there are no
9
<PAGE>
potential conflicts between the interests of the mortgage lending operation and
the portfolio management operation. Conflicts may 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 that
have external management contracts or situations where management's
compensation is not directly related with the company's performance or return
to stockholders. Our primary management incentive programs are dependent on
return on equity (the annual bonus plan) and stock price appreciation
(forgivable loans to founders and stock option plan). We refer you to
"Management--Executive Compensation" in this prospectus for more detail.
We file our own income tax return, while NFI Holding files consolidated
income tax returns that include NovaStar Mortgage. This structure is designed
to legally separate the mortgage loan origination operation from our operations
(i.e. the REIT entity). This structure also allows for certain activities and
transactions to be entered into by NovaStar Mortgage, Inc., while preserving
our REIT status. 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 NFI Holding. NFI 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 us in the amount of $1,980,000. Mr.
Hartman and Mr. Anderson receive one percent of the economic benefits derived
from dividends and distributions of NFI Holding as a result of their common
stock ownership. We receive 99 percent of the dividends of NFI Holding as a
result of our preferred stock ownership. Accordingly, we indirectly receive 99
percent of the dividends of NovaStar Mortgage by virtue of our ownership
interest in NFI Holding. In addition, Mr. Hartman and Mr. Anderson serve as the
sole Directors of both Holding and NovaStar Mortgage.
In contracts with us, NovaStar Mortgage has agreed to:
. sell subprime mortgage loans NovaStar Mortgage originates to us, if we
agree to acquire the loans,
. service our subprime mortgage loans, and
. provide certain administrative services to us.
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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 NFI 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. We refer you to "Risk Factors--Lack of Voting
Control of Taxable Affiliates" and "Certain Transactions--Transactions with
Management" in this prospectus for more detail.
[ORGANIZATION CHART OF NOVASTAR FINANCIAL, INC. APPEARS HERE]
DIVIDEND POLICY, DISTRIBUTIONS AND REINVESTMENT
We distribute to stockholders each year substantially all of our net taxable
income to qualify for the tax benefits accorded to REITs under the Code.
Taxable income does not ordinarily equal net income as determined in accordance
with generally accepted accounting principles. We declared dividends in the
amount of $0.28 per share during 1997. During 1998, we declared dividends of
$1.00 per share, of which $0.35 will be paid in January 1999.
We intend 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 at the
discretion of the Board of Directors. Distributions will depend on our taxable
income, financial condition, maintenance of REIT status and other factors as
the Board of Directors deems relevant.
We may adopt a dividend reinvestment plan at some point in the future. The
plan will allow stockholders to reinvest their dividends in additional shares
of common stock. Generally, under a dividend reinvestment plan, dividends paid
with respect to shares of stock are automatically invested in additional shares
of stock at a discount to the then current market price.
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<PAGE>
Stockholders who own more than a specified number of shares of common stock
will be eligible to participate in the dividend reinvestment plan following the
effectiveness of the registration of securities issuable thereunder. This
offering is not related to the proposed dividend reinvestment plan, nor has a
registration statement been filed with the SEC registering the shares to be
issued under the dividend reinvestment plan. Prior to buying shares through the
dividend reinvestment plan, participants will be provided with a dividend
reinvestment plan prospectus, which will constitute a part of such dividend
reinvestment plan registration statement. Our transfer agent will act as the
trustee and administrator of the dividend reinvestment plan.
Stockholders will not be automatically enrolled in the dividend reinvestment
plan. Each stockholder desiring to participate in the dividend reinvestment
plan must complete and deliver to the Agent an enrollment form, which will be
sent to each eligible stockholder following the effectiveness of the
registration of the shares to be issued under the dividend reinvestment plan.
Participation in the dividend reinvestment plan will commence with all
dividends and distributions payable after receipt of a participant's
authorization, provided that the authorization must be received by the Agent at
least two business days prior to the record date for any dividends in order for
any stockholder to be eligible for reinvestment of such dividends.
THE OFFERING
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 common stock that may be subsequently
acquired by the selling securityholders upon the exercise of warrants, and (b)
offerings by us of up to 3,649,999 shares of common stock that may be issued
pursuant to the exercise of warrants.
USE OF PROCEEDS
We will receive no proceeds from the sale of the offered common stock or
warrants by the selling securityholders. We will use the proceeds from the
issuance of the underlying common stock pursuant to the exercise of the
warrants to fund the acquisition of mortgage loans, as described in this
prospectus and, pending such use, to reduce borrowings.
RECENT DEVELOPMENTS
As a result of significant liquidity constraints imposed upon us by certain
key lenders subsequent to September 30, 1998, management took the following
actions in October 1998:
On October 11, 1998, our Board of Directors agreed to defer payment of the
dividend we declared on September 22, 1998 ($0.35 per share, $2.8 million in
total) until January 15, 1999.
On various dates during October 1998, we, along with NovaStar Mortgage,
executed contracts for the sale of all securities we owned. All securities
sales settled during October at an aggregate loss of $15.4 million.
On various dates during October 1998, we executed contracts for the
termination of interest rate swap agreements with a notional amount of $455
million, representing 42 percent of all interest rate agreements we owned. The
terminations settled in October 1998 at an aggregate loss of $8.0 million. We
continue to own interest rate cap agreements, but have significantly reduced
liquidity risk exposure relating to our interest rate agreements.
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<PAGE>
On October 13, 1998, we executed a 90-day financing agreement with
GMAC/Residential Funding Corporation, secured by certain mortgage interests.
Under the terms of the agreement, we borrowed $15 million to support immediate
cash needs. In addition, we agreed to pay a $3 million commitment fee at
maturity of the note. The resulting $18 million obligation bears interest at
one-month LIBOR plus five percent. Additionally, subject to completion of a
warrant agreement GMAC/RFC will acquire 1,624,650 warrants for the purchase of
our common stock at a price of $4.5625, the closing price of the common stock
on October 12, 1998. We are presently in negotiations with GMAC/RFC regarding
terms to establish a long-term strategic alliance. However, no assurance can be
given that the alliance will be established. If a strategic alliance is
successfully negotiated, GMAC/RFC has the option to waive $2 million of the
commitment fees discussed above. If a strategic alliance is not negotiated, we
have the option, which we expect to exercise, to repurchase 811,919 of the
warrants at an aggregate price of $1 per share.
Additional events, as described below, occurred subsequent to September 30,
1998. Although these events were not a direct result of the events discussed
above, they affect our liquidity position.
On various dates during October 1998, NovaStar Mortgage accepted bids from
third parties for the sale of approximately $221 million, or 94 percent of
loans it owned as of September 30, 1998. Final terms of the sales will be
determined after due diligence is performed on subject loans. We expect
closings on these sales to be prior to December 31, 1998. Management of
NovaStar Mortgage expects to continue marketing its originated loans for sale
to third parties.
On October 21, 1998, we finalized the second closing on the securitization of
asset-backed bonds, the first closing of which was during the third quarter. In
the second closing, approximately $43 million of loans were added to the trust
assets of NovaStar Home Equity Series 1998-2.
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<PAGE>
SUMMARY FINANCIAL AND OTHER DATA
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
FOR THE NINE MONTHS
ENDED
SEPTEMBER 30, FOR THE
-------------------- FOR THE YEAR ENDED PERIOD ENDED
1998 1997 DECEMBER 31, 1997 DECEMBER 31, 1996(1)
---------- -------- ------------------ -----------------
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS
DATA
Interest income........ $ 79,155 $ 21,545 $ 36,961 $ 155
Interest expense....... 60,948 16,224 28,185 --
Net interest income.... 18,207 5,321 8,776 155
Provision for credit
losses................ 3,400 1,444 2,453 --
Net interest income
after provision for
credit losses......... 14,807 3,877 6,323 155
Equity in loss of NFI
Holding Corporation... (2,455) (141) 28 --
General and
administrative
expenses.............. 12,563 4,764 8,241 457
Net income (loss)...... 5,567 (702) (1,135) (302)
Basic earnings (loss)
per share............. $ 0.69 $ (0.19) $ (0.26) $ (0.08)
Diluted earnings (loss)
per share(2).......... $ 0.64 $ (0.19) $ (0.26) $ (0.08)
<CAPTION>
AS OF SEPTEMBER 30, AS OF DECEMBER 31,
-------------------- ------------------------------------
1998 1997 1997 1996
---------- -------- ------------------ -----------------
<S> <C> <C> <C> <C>
BALANCE SHEET DATA
Mortgage assets:
Mortgage loans......... $ 944,228 $418,897 $ 574,984 --
Mortgage securities.... 390,276 267,835 517,246 $13,239
Total assets........... 1,693,325 699,133 1,126,252 59,811
Collateralized mortgage
obligations........... 948,590 -- 408,867 --
Repurchase agreements.. 579,697 644,195 556,443 --
Stockholders' equity... 109,848 47,036 116,489 46,380
<CAPTION>
AS OF FOR THE
PERIOD ENDED
SEPTEMBER 30, AS OF OR FOR THE AS OF OR FOR THE
-------------------- YEAR ENDED PERIOD ENDED
1998 1997 DECEMBER 31, 1997 DECEMBER 31, 1996(1)
---------- -------- ------------------ -----------------
<S> <C> <C> <C> <C>
OTHER DATA
Acquisition of
wholesale loan
production of NovaStar
Mortgage:
Principal at funding... $ 734,612 $226,961 $ 409,974 --
Average principal
balance per loan...... $ 95 $ 142 $ 130 --
Weighted average
interest rate:
Adjustable-rate
mortgage loans....... 10.0% 10.0% 10.13% --
Fixed rate mortgage
loans................ 10.0% 10.6% 10.46% --
Loans with prepayment
penalties............. 72% 73% 73% --
Weighted average
prepayment penalty
period (in years)(4).. 2.4 2.7 2.4 --
Net interest spread.... 2.20% 1.73% 1.30% --
Net yield.............. 1.93% 2.02% 1.84% --
Annualized return on
average assets, before
forgiveness of notes
receivable from
founders.............. 0.60% (0.25)% (0.01)% (0.50)%
Annualized return on
average equity, before
forgiveness of notes
receivable from
founders.............. 7.52% (1.75)% (0.06)% (0.65)%
Taxable income (loss).. $ 9,031 $ 871 $ 1,434 $ (173)
Taxable income (loss)
per share............. $ 1.11 $ 0.12 $ 0.18 $ (0.05)
Dividends declared per
share(3).............. $ 1.00 $ 0.18 $ 0.28 --
Number of account
executives............ 55 29 36 --
</TABLE>
- --------
(1) NovaStar Financial, Inc. was formed on September 13, 1996. Operations began
in substance after the Private Placement, which closed on December 9, 1996.
(2) Diluted earnings (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.
(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."
(4) Includes only those loans with a prepayment penalty.
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<PAGE>
RISK FACTORS
OVERALL ENTERPRISE OF NOVASTAR FINANCIAL, INC.
Limited Operating History of NovaStar Financial, Inc. and Net Losses Incurred
We began operations in December 1996 after the closing of a private
placement. Our affiliate, NovaStar Mortgage, began its mortgage lending
operation in late January 1997 and began servicing loans on July 15, 1997.
Because we have not developed an extensive earnings history nor experienced a
wide variety of interest rate or market conditions, our historical operating
performance may not predict our future performance. Although we generated net
income in the first three quarters of 1998, we will incur significant net
losses for the fourth quarter of 1998 due to certain events that occurred early
in the fourth quarter of 1998 as discussed in the "Management's Discussion and
Analysis of Financial Condition and Results of Operations, Events Subsequent to
September 30, 1998" section of this Prospectus.
Our Dependence Upon Borrowings
Our profitability is dependent upon our ability to borrow money on favorable
terms. In October 1998, the subprime mortgage market faced a liquidity crisis
with respect to the availability of short-term borrowings from major lenders
and long-term borrowings through securitization. We faced significant liquidity
constraints. We refer you to "Recent Developments" in the prospectus summary
and "Events Subsequent to September 30, 1998" in "Management's Discussion and
Analysis of Financial Condition and Results of Operation" for more detail about
those constraints and our $18 million 90-day financing arrangement. That
arrangement is due to mature, unless extended, on January 13, 1999. There is no
assurance that the arrangements can be extended or replaced. We refer you for
more detail on the risks related to liquidity to the "Risk Factors" entitled
"Need for Additional Equity Financing to Support Future Growth," "Availability
of Funding Sources," "Substantial Leverage and Potential Net Interest and
Operating Losses in Connection with Borrowings," "Failure to Refinance
Outstanding Borrowings on Favorable Terms May Affect Results of Operations,"
"Impact of Decline in Market Value of Mortgage Assets Margin Calls," and
"Dependence on Securitization Market."
Forgivable Notes May Adversely Affect Results of Operations
Messrs. Hartman and Anderson each acquired 108,333 units at the price of
$15.00 per unit in our private placement. Hartman and Anderson paid for the
Units by delivering promissory notes to us. Each promissory note was in the
amount of $1,624,995, bearing interest at eight percent per annum, and was
secured by the units acquired. The principal amount of the notes was divided
into three equal tranches. We will forgive principal due if the return to
private placement investors meets certain benchmarks as follows: one tranche
will be forgiven if we generate a total return to the private placement
investors equal to or greater than 15% in any one fiscal year; all tranches
will be forgiven if the total cumulative return to private placement investors
reaches 100% prior to December 31, 2001. Return to investors includes dividends
paid and any appreciation in the average price per share of the common stock
and the related warrant during the period. For each tranche forgiven, we will
recognize a non-cash charge against earnings of $1,083,330 for the related
accounting period. One tranche was forgiven in 1997. Based on our performance
and stock price during the first three quarters of the year, management
anticipated forgiveness of the second tranche of these notes. As a result, non-
cash charges to earnings of $812,000 were recorded during the first three
quarters of 1998. Based on actions taken by management as described in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Events Subsequent to September 30, 1998," of this Prospectus and
the current value of our stock, it appears unlikely that the second tranche of
the notes receivable from founders will be forgiven. Final determination
regarding forgiveness will be made during the fourth quarter of 1998. If the
second tranche is not forgiven, all amounts that have been charged off during
1998 will be reinstated. If the entire remaining amount of notes is forgiven,
we will recognize a non-cash charge against earnings of $2,166,660. Such
charges resulting from forgiveness of the notes could have a material adverse
effect on the results of our operations and on the dividends paid to
shareholders, including investors in this offering, during periods forgiven. We
refer you to "Management--Executive Compensation."
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<PAGE>
Dependence on Key Personnel for Successful Operations
Our operations and the operations of NovaStar Mortgage depend heavily on the
contributions of Scott Hartman and Lance Anderson. Both Mr. Hartman and Mr.
Anderson would be difficult to replace. Although Mr. Hartman and Mr. Anderson
have both signed employment agreements which provide for initial terms through
December 31, 2001, we cannot be assured completely that these individuals will
remain our employees. The loss of either of these individuals could materially
adversely effect our business and operating results. 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 that a restriction against competing with us will become
effective. Although we believe these forfeiture and non-compete provisions
would generally be enforceable, you cannot be assured that despite these
provisions, the employee will not terminate the agreement early. We refer you
to "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 ours. In addition, the members of our management do not have
executive experience working together as a management team.
Need for Additional Equity Financing to Support Future Growth
To fully implement our strategy to grow our portfolio of mortgage assets, we
will need to raise additional capital periodically. Accordingly, we expect to
undertake both future equity offerings and long-term securitized debt
offerings. There is no assurance that we will successfully and economically
raise the capital it will require through such offerings. We refer you to "Risk
Factors--Effect on Stockholders of Potential Future Offerings."
Consequences of Failure to Maintain REIT Status: Company Subject to Tax as a
Regular Corporation
We intend to operate so as to qualify as a REIT for federal income tax
purposes. In order to maintain our classification as a REIT for federal income
tax purposes, we must satisfy certain tests with respect to the sources of our
income, the nature and type of our assets, the amount of our distributions to
stockholders, and concentration of the ownership of our stock. If we fail to
qualify as a REIT in any taxable year and certain relief provisions of the Code
do not apply, we would be subject to federal income tax as a regular, domestic
corporation and our stockholders would be subject to the same tax treatment as
stockholders of such corporation. Distributions to stockholders in any year in
which we fail to qualify as a REIT would not be deductible in computing our
taxable income. As a result, we could be subject to income tax liability and
the cash available for distribution to our stockholders would be significantly
reduced or eliminated. Further, we could also be disqualified from re-electing
REIT status for the four taxable years following the year we became
disqualified.
There is no assurance that future legislation, regulations, administrative
interpretations or court decisions will not significantly change the tax laws
with respect to our qualification as a REIT or with respect to the federal
income tax consequences of such qualification. Any such changes may reduce or
eliminate our competitive advantage over non-REIT competitors. We refer you to
"Federal Income Tax Considerations--Qualification as a REIT" and "--Taxation of
the Company."
Lack of Voting Control of Taxable Affiliates
We formed NFI Holding to serve as a holding company for our taxable
affiliates in order to legally separate certain lines of business, such as the
mortgage loan origination operation, from the REIT entity. This was done for
regulatory, tax, risk management and other reasons. Scott Hartman and Lance
Anderson own
16
<PAGE>
100% of the voting common stock of NFI Holding while we own 100% of NFI
Holding's nonvoting preferred stock. The common stock is entitled to one
percent of dividend distributions of NFI Holding and the preferred stock is
entitled to 99% of such distributions. NFI Holding wholly owns NovaStar
Mortgage, and the REIT thus owns a beneficial interest in 99% of any future
dividend distributions from NovaStar Mortgage. NovaStar Mortgage has contracted
with us to: sell subprime mortgage loans it originates to us, service subprime
mortgage loans for us, provide certain administrative services to us. Without
voting control of NovaStar Mortgage, you cannot be assured that our contracts
with 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, you cannot be
assured that the agreement will be enforced in a timely manner against the
individuals, their heirs or representatives. We refer you to "Certain
Transactions--Transactions with Management."
Consequences of Failure to Qualify for Investment Company Act Exemption
We conduct our business so as not to become regulated as an investment
company under the Investment Company Act. Accordingly, we do 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 we fail to qualify for exemption from
registration as an investment company, our ability to use leverage would be
substantially reduced and we would be unable to conduct our business. Any such
failure to qualify for such exemption could have a material adverse effect on
us.
Future Revisions in Policies and Strategies as the Discretion of Board of
Directors
Management has established our operating policies and strategies set forth in
this Prospectus. 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
Any period of unexpected or rapid changes in interest rates is likely to
adversely affect results of our operations. For example, a substantial or
sustained increase in interest rates could adversely affect our ability to
acquire subprime mortgage loans in expected volumes necessary to support fixed
overhead expense levels. Decrease in interest rates cause loans in the
portfolio to prepay more quickly. This could result in our amortizing more of
the premium we paid for the mortgage loans and would, therefore, decrease net
interest income.
Intense Competition in the Subprime Mortgage Industry
NovaStar Financial and NovaStar Mortgage 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 entities leaving and exiting 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 to allocate resources to the
origination of subprime mortgage loans. Certain
17
<PAGE>
of these larger mortgage companies and commercial banks have begun to offer
products similar to those which are offered by NovaStar Mortgage and have begun
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 Fannie Mae and Freddie Mac, formerly known as FNMA and FHLMC,
respectively. For example, Freddie Mac has issued securities collateralized by
subprime mortgage loans originated by a financial institution.
The entrance of these competitors into NovaStar Mortgage's market could have
a material adverse effect on our operating results and on our financial
condition. Increased competition could result in either reduced net interest
income on subprime mortgage loans compared to present levels or in 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 for its competitors. There is no assurance
that NovaStar Mortgage will be able to compete successfully in this market
environment. Any failure in this regard could have a material adverse effect on
our operating results and on our 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 us. During periods of declining rates,
competitors may solicit our customers to refinance their loans. In addition,
during periods of economic slowdown or recession, our borrowers may face
financial difficulties and be more receptive to the offers of our competitors
to refinance their loans.
High Loan-to-Value Products
Our current underwriting guidelines allow for the acquisition of originated
loans with up to a 95% loan-to-value ratio. The higher the loan-to-value ratio,
the greater the risk that we may be unable to recover full amounts due on our
mortgage loans when a borrower defaults and we foreclose and sell the
underlying collateral. As of September 30, 1998, the average loan-to-value
ratio of our mortgage loan portfolio was 79%. Our failure to adequately address
the risk of high loan-to-value products would have a material adverse effect on
our operating results and on our 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 our loans are made to
borrowers who do not qualify for loans from conventional mortgage lenders. As
of September 30, 1998, 7% of our mortgage loan portfolio was comprised of loans
made to borrowers graded "C" and 2% of our portfolio was comprised of loans
made to borrowers graded "D", "C" and "D" being our two lowest credit grade
classifications. There is no assurance that our underwriting criteria or
methods will afford adequate protection against the higher risks associated
with loans made to subprime mortgage borrowers. Our failure to adequately
address the risk of subprime lending would have a material adverse impact on
our operating results, our financial condition and our business prospects.
Availability of Funding Sources
We finance substantially all of the mortgage loans through interim financing
facilities including our bank warehouse credit line and repurchase agreements,
and with equity. These borrowings have been and will be repaid with the
proceeds we receive from financing mortgage loans through securitization or
selling them for cash. We are dependent upon a few lenders to provide the
primary credit facilities for our mortgaging loan originations and
acquisitions. Any failure to renew or obtain adequate funding under these
financing arrangements, find buyers for loan originations or issue asset-backed
bonds could have a material adverse impact on our lending operations.
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Dependence Upon Independent Brokers and Correspondents
NovaStar Financial and NovaStar Mortgage depend upon independent mortgage
loan brokers and mortgage lenders for our originations and purchases of new
mortgage loans. Our competitors also seek to establish relationships with
brokers and correspondents. Our 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 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 our 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 us.
The businesses of NovaStar Financial and NovaStar Mortgage are subject to
extensive regulation, supervision and licensing by federal, state and local
governmental authorities. They are also subject to various laws and judicial
and administrative decisions imposing requirements and restrictions on all or
part of the businesses' operations. We are regulated with respect to 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 or "TILA", and
Regulation Z promulgated thereunder, contain disclosure requirements designed
to provide consumers with uniform, understandable information with respect to
the terms and conditions of loans and credit transactions so consumers have the
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 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. We are also
required to comply with the Equal Credit Opportunity Act of 1974, as amended,
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. We will also be subject to the Real Estate Settlement
Procedures Act and the Debt Collection Practices Act pursuant to the Home
Mortgage Disclosure Act. We will also be subject to the rules and regulations
of, and examinations by, the Government National Mortgage Association, HUD and
state regulatory authorities with respect to originating, processing,
underwriting, selling and servicing loans. You cannot be assured that we 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 us. 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, all of which could cause a
material adverse impact on our profitability.
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The laws and regulations described above are subject to legislative,
administrative and judicial interpretation, and certain of these laws and
regulations have been infrequently interpreted or only recently enacted.
Infrequent interpretations of these laws and regulations or an insignificant
number of interpretations of recently enacted regulations can result in
ambiguity with respect to permitted conduct under these laws and regulations.
Any ambiguity under the regulations to which we are subject may lead to
regulatory investigations or enforcement actions and private causes of action,
such as class action law suits, with respect to our 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 law suits 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 the circumstance of that particular 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. Our broker
compensation programs currently utilize such payments. Future regulatory
interpretations or judicial decisions may require us to change our broker
compensation programs or else face material monetary judgments or other
penalties. Any such changes or penalties may have a material adverse effect on
our operating results, financial condition and on our business prospects. We
refer you to "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 we are forced to foreclose on a defaulted mortgage loan on that
property, we may be subject to environmental liabilities regardless of whether
we were responsible for the contamination. While we intend 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 may be discovered on
properties during our ownership or after a sale thereof to a third party. If
such hazardous substances are discovered on properties, we 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 our profitability. In addition, we 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 we generally hedge our interest rate risk, the results of our
mortgage assets portfolio operation are affected by various factors, many of
which are beyond our control. The performance of our mortgage assets portfolio
depends on, among other things, the level of net interest income generated by
our mortgage assets, the market value of such mortgage assets and the supply
and demand for such mortgage assets. Our 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,
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interest rates, borrowing costs and credit losses depend upon the nature and
terms of the mortgage assets, the geographic location of the properties
securing the mortgage loans included in or underlying the mortgage assets,
conditions in financial markets, the fiscal and monetary policies of the U.S.
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 our activities, our operating results depend, on
large part, upon our ability to manage our interest rate and prepayment risks
while maintaining our status as a REIT. Prolonged failure to manage such risks
would adversely affect our profitability. We refer you to "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
Our adjustable-rate mortgage assets bear adjustable interest or pass-through
rates based on short-term interest rates, and substantially all of our
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 our net interest income. While rising short-term interest rates
generally increase the yields on our adjustable rate mortgage assets, rising
short-term interest rates also increase the cost of our borrowings which are
utilized to fund the mortgage assets. To the extent such costs escalate more
rapidly than the yields, our net interest income may be reduced or a net loss
may result. Conversely, falling short-term interest rates may decrease the
interest cost on our borrowings more rapidly than the yields on the mortgage
assets and hence may increase our net interest income. There is no assurance as
to the amount or timing of changes in interest rates or their effect on our
mortgage assets or net interest income.
As of September 30, 1998, 67% of our mortgage loans, $623 million, had
adjustable rate characteristics. 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 we own have adjustable terms
today or are fixed today, but will adjust at some point in the future. Interest
rates on our borrowings are and generally will be based on short-term indices.
To the extent any of our mortgage assets are financed with borrowings bearing
interest based on or varying with an index different from that used for the
related mortgage assets, so-called "basis" interest rate risk will arise. In
this 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, our net interest income will be
adversely affected in periods of increasing market interest rates.
Additionally, our ARM 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 financing we utilize. Accordingly, in a period of increasing
interest rates, we 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 our 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. Our
borrowings will not be subject to similar restrictions. Hence, in a period of
rapidly increasing interest rates, we 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 our 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 our receipt of less cash income
on our ARMs than is required to pay interest on the related borrowings, which
will not have such payment caps.
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As of September 30, 1998, 76% of our mortgage assets bear adjustable rates.
These assets adjust with either six month LIBOR or the one-year CMT rate. All
of our borrowings bear variable rates of interest. Rates on our repurchase
agreements are variable based on the terms to maturity of individual
agreements. As of September 30, 1998, these agreements were tied to one-month
LIBOR. The rate on our 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 our 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 ARMs, although such
effects are not predictable. Prepayment experience may also 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
by and by conditions in the fixed-rate mortgage market. If the interest rate on
ARMs increase at a rate greater than the interest rate 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. We 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 and investing in
certain mortgage security structures which have prepayment protection. In
addition, we may purchase interest-only strips to a limited extent. The basis
risk that will exist between an interest-only strips and the other assets in
the portfolio could increase our risk in interest rate environments where
interest-only strip would amortize quickly.
Changes in anticipated prepayment rates of mortgage assets could affect us in
several adverse ways. Faster than anticipated prepayment of any mortgage asset
that we purchased at a premium would generally result in a faster than
anticipated write-off of any remaining capitalized premium amount and
consequent reduction of our net interest income by such amount. A portion of
the adjustable-rate single family mortgage loans which we may acquire (either
directly as mortgage loans or through mortgage securities backed by ARMs) will
generally 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 asset prepays faster than anticipated
prior to or soon after the time of adjustment to a fully-indexed rate, we will
have experienced an adverse effect on our net interest income during the time
we 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
Our operating strategy subjects us to interest rate risks as described under
"--Decrease in Net Interest Income Due to Interest Rate Fluctuations" above. We
follow an asset/liability management program intended to protect against
interest rate changes and prepayments. We refer you to "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 us from risks associated with interest rate changes and
prepayments. In addition, there is no assurance that our hedging activities
will have the desired beneficial impact on our operating results or financial
condition. Hedging typically involves costs, including transaction
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costs, which increase dramatically as the period covered by the hedge increases
and which also increase during periods of rising and volatile interest rates.
We may increase our hedging activity, and thus increase our 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 our ability to engage in asset/liability management
transactions. Such federal tax laws may prevent us from effectively
implementing hedging strategies that we determine, absent such restrictions,
would best insulate us from the risks associated with changing interest rates
and prepayments. We refer you to "Federal Income Tax Considerations--
Qualification as a REIT--Sources of Income."
Limitations on Effective Hedging
We purchase 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,
we intend generally to hedge as much of the interest rate risk as management
determines is in our best interests given the cost of such hedging transactions
and the need to maintain our status as a REIT. In this regard, the amount of
income we may earn from interest rate swaps and caps is subject to substantial
limitations under the REIT provisions of the Code. We may hedge the risk of our
borrowing costs on our variable rate liabilities increasing faster than our
income, due to the effect of the periodic and lifetime caps on our 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%
income test, but not the 75% income test for REIT qualification purposes, and
(c) other hedging instruments, whose income qualifies for neither the 95%
income test nor the 75% income test. See "Federal Income Tax Considerations--
Qualification as a REIT--Sources of Income." The latter form of hedging may be
accomplished through one of our taxable affiliates. We refer you to "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 us 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 we purchase 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,
we may be forced to unwind our interest rate agreements with such provider and
may take a loss on such interest rate agreements. Although we intend to
purchase interest rate agreements only from financially sound institutions and
to monitor the financial strength of such institutions on a periodic basis,
there is no assurance that we can avoid such third party risks.
We accept legal risk in entering into interest rate swap and cap agreements.
Although we take 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 us to unexpected
interest rate risk and have a material adverse affect on results of operations.
We also accept 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, we hedge our borrowing to mitigate interest rate risk
of mortgage assets that are fixed or we 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, we 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 our 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.
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We are not regulated in regards to our hedging activities. However, in order
to maintain our exemption from the registration requirements of the Commodities
Exchange Act, we are 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 our investment portfolio consists of single family
mortgage loans or mortgage assets evidencing interests in single family
mortgage loans. We will generally bear the risk of loss on any such mortgage
assets we purchase in the secondary mortgage market or through our mortgage
lending business. With respect to the mortgage securities we acquire in the
secondary market, if such securities are either agency certificates or are
generally structured with one or more types of credit enhancement, our credit
risk will be reduced or eliminated. To the extent third parties have been
contracted to provide the credit enhancement, we are dependent in part upon the
credit worthiness 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 us.
Accordingly, during the time we hold such mortgage loans, we 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 us, including, without limitation, resulting from higher default
levels as a result of declining property values and worsening economic
conditions, among other factors, we 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 us out of other
funds until ultimately liquidated, resulting in increased financing costs and
reduced net income or a net loss.
We may pool and finance or sell through securitizations a substantial portion
of the single family mortgage loans we acquire. In securitizations, we continue
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 Fannie Mae and Freddie Mac 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 us to the extent that we invest in those 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 extend the foreclosure process. In addition, the condition of a property
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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 Our Ability to Acquire Mortgage Assets at Yields
Which Are
Favorable Relative to Borrowing Costs
Our net income depends, in large part, on our ability to acquire mortgage
assets at favorable spreads over our borrowing costs. In acquiring mortgage
assets, we compete with other REITs, securities dealers, savings and loan
associations, banks, mortgage bankers, insurance companies, mutual funds, other
lenders, Ginnie Mae, Fannie Mae, Freddie Mac and other entities purchasing
mortgage assets. In addition, there are several mortgage REITs similar to us,
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 our purchase.
Despite management's experience in the acquisition of mortgage assets and its
relationships with various mortgage suppliers, there is no assurance that we
will be able to acquire sufficient mortgage assets from mortgage suppliers at
spreads above our cost of funds. We will also face competition for financing
sources, and the effect of the existence of additional mortgage REITs may be to
deny us access to sufficient funds to carry out our business strategy and/or to
increase the cost of funds to us.
Substantial Leverage and Potential Net Interest and Operating Losses in
Connection with Borrowings
We employ a financing strategy to increase the size of our mortgage asset
portfolio by borrowing a substantial portion of the market value of our
mortgage assets. The portion borrowed may vary depending upon the mix of the
mortgage assets in our portfolio and the application of our policies with
respect to such mix or mortgage assets. If the returns on the mortgage assets
purchased with borrowed funds fail to cover the cost of the borrowings, we 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 our mortgage securities), decreases in the
market value of our mortgage assets, increases in interest rate volatility,
availability of financing in the market, circumstances then applicable in the
lending market and other factors, we may not be able to achieve the degree of
leverage we believe to be optimal. This may cause us to be less profitable than
we might be otherwise. We use our Capital Allocation Guidelines (CAG) to manage
the amount of debt incurred and leverage employed in our balance sheet. These
CAG have been approved by the Board of Directors, who also have the ability to
change the CAG. We refer you to "Business--Portfolio Management--Capital and
Leverage Policies." As of September 30, 1998, our equity represented 6.5% of
assets.
Failure to Refinance Outstanding Borrowings on Favorable Terms May Affect
Results of Operations
Additionally, our ability to achieve our investment objectives depends not
only on our ability to borrow money in sufficient amounts and on favorable
terms but also on our ability to renew or replace on a continuous basis our
maturing short-term borrowings. Our business strategy relies on short-term
financing agreements to fund mortgage asset originations and purchases. We have
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, we may enter into one or more of such
commitment agreements in the future if deemed favorable. In the event we not
able to renew or replace maturing borrowings, we could be required to sell
mortgage assets under adverse market conditions and could incur losses as a
result. In addition, in such event, we may be required to terminate hedge
positions, which could result in further costs us. 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 our 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 our liquidity capital is invested may have
decreased. A number of such factors in combination may cause us difficulties,
including a possible liquidation of a major portion of our mortgage assets at
disadvantageous prices with consequent losses, which could have a materially
adverse effect on our profitability and our solvency.
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A majority of our borrowings are collateralized borrowings, primarily in the
form of reverse repurchase agreements and similar borrowings, the availability
of which are based on the market value of the mortgage assets pledged to secure
the specific borrowings, availability of financing in the market, circumstances
then applicable in the lending market and other factors. The cost of borrowings
under reverse repurchase agreements generally corresponds to LIBOR or the
Federal Funds rate plus a spread. The cost of borrowings under other sources of
funding which we may use may refer or correspond to other short-term indices,
plus 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, we may experience
reduced net interest income.
Impact of Decline in Market Value of Mortgage Assets: Margin Calls
A decline in the market value of our portfolio of mortgage assets may limit
our ability to borrow or result in lenders initiating margin calls (that is,
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. We 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
our capital base. If these sales were made at prices lower than the amortized
cost of the Mortgage Assets, we would experience losses. A default by us under
our 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 our bankruptcy, 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 we had a reverse repurchase
agreement, we might experience difficulty recovering the collateral subject to
such agreement if the agreement were to be repudiated and our claim against the
bankrupt lender for damages resulting therefrom were to be treated simply as
one of an unsecured creditor. Should this occur, our claims would be subject to
significant delay and recoveries, if and when received, may be substantially
less than the damages we actually suffered. Although we have entered, and
intend to continue to enter, into reverse repurchase agreements with several
different parties and have developed policies to reduce our exposure to such
risks, there is no assurance that will be able to avoid such third-party risks.
To the extent that we are compelled to liquidate mortgage assets that are
Qualified REIT Assets to repay borrowings, we may be unable to comply with the
REIT provisions of the Code regarding assets and sources of income
requirements. This could ultimately jeopardize our status as a REIT or could
result in the imposition of substantial punitive taxes to us. We refer you to
"Risk Factors--Consequences of Failure to Maintain REIT Status: Company Subject
to Tax as a Regular Corporation" and "Federal Income Tax Considerations--
Taxation of the Company."
As discussed in "Management's Discussion and Analysis of Financial Condition
and Results of Operations--Events Subsequent to September 30, 1998," of this
Prospectus, in October 1998, we terminated all our interest rate swap
agreements, sold all securities owned by NovaStar Financial and NovaStar
Mortgage and paid off the related repurchase agreement financing.
Dependence on Securitization Market
Adverse changes in the securitization market could impair our ability to
acquire and finance mortgage loans through securitizations on a favorable or
timely basis. Any such impairment could have a material
26
<PAGE>
adverse effect on our operating results and financial condition. In addition,
in order to gain access to the securitization market, we generally expect to
rely upon credit enhancements provided by one or more monoline insurance
carriers. Any substantial reductions in the size or availability of the
securitization market for the Company's loans, or the unwillingness of
insurance companies to provide credit enhancement for our mortgage securities
could have a material adverse effect on our operating results and financial
condition.
Lack of Loan Performance Data
The loans we purchased 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 we
will be able to sustain delinquency, foreclosure and loan loss rates, at their
present levels as the portfolio becomes more seasoned.
Illiquidity of Investments
Until October 1998, a substantial portion of our portfolio was 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, we 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 that may limit our ability to sell them
when it might be most desirable to do so. Although we expect that most of our
investments will be in mortgage securities for which a resale market exists,
certain of our investments may lack a regular trading market and may be
illiquid. In addition, during turbulent market conditions, the liquidity of all
of our mortgage assets may be adversely impacted. There is no limit in the
percentage of our investments that may be invested in illiquid mortgage assets.
Lack of Geographic Diversification
We seek geographic diversification of the properties underlying our mortgage
assets and have established a diversification policy. We refer you to
"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, 1998, 19% and 12% of our mortgage loan portfolio was
comprised of loans secured by California and Florida real estate, respectively.
We refer you to "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
Our 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 NovaStar Financial 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 our ability to make dividend distributions to the holders of
Common Stock.
In order that we 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% in value of the aggregate
of the outstanding shares of capital stock or in excess of 9.8% (in value or in
number of
27
<PAGE>
shares, whichever is more restrictive) of the aggregate of the outstanding
shares of common stock of NovaStar Financial. 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%
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% 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. We refer you to
"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. We refer you
to "Description of Capital Stock--Repurchase of Shares and Restriction on
Transfer."
Every owner of more than 5% (or such lower percentage as required by the Code
or the regulations promulgated thereunder) of all classes or series of our
stock, within 30 days after the end of each taxable year, is required to give
us written notice stating the name and address of such owner, the number of
shares of each class and series of stock of NovaStar Financial beneficially
owned and a description of the manner in which such shares are held. Each such
owner shall provide us with such additional information as we may request in
order to determine the effect, if any, of such beneficial ownership on our
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 our 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 us 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 NovaStar Financial which would
be beneficial to shareholders and might otherwise result in a premium over then
prevailing market prices. We refer you to "Management" and "Description of
Capital Stock."
Effect on Stockholders of Potential Future Offerings
We expect to increase our 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 our liquidation. Additional equity
offerings may dilute the equity of our stockholders or reduce the price of
shares of our common stock, or both. We are unable to estimate the amount,
timing or nature of additional offerings as they will depend upon market
conditions and other factors.
28
<PAGE>
No Assurance of Active Public Trading Market
Although our common stock is listed on the New York Stock Exchange, there is
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 our
common stock may experience fluctuations unrelated to our operating
performance. In particular, the price of our 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 our common stock will be influenced by
any variation between the net yield on our mortgage assets and prevailing
market interest rates and by the markets perception of our ability to achieve
earnings growth. Our earnings will be derived primarily from any positive
spread between the yield on our mortgage assets and the cost of our borrowings.
During the period immediately following our receipt of new proceeds from an
offering or other source, prior to the time we have fully implemented our
financing strategy to employ those proceeds, our earnings and levels of
dividend distributions may be lower than if the financing strategy were fully
implemented, which may affect the market value of our common stock. In
addition, the positive spread between the yield on our 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 our business
strategy to achieve such result. Accordingly, in periods of high interest
rates, our net income and, therefore, the dividend yield on our common stock
may be less attractive compared with alternative investments, which could
negatively impact the price of our common stock. If the anticipated or actual
net yield on our 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 our borrowings, the market price of our 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 our portfolio of mortgage assets, the
market price of the common stock may be adversely affected. During any period
when the market price of our common stock has been adversely affected due to
any of the foregoing reasons, the liquidity of our common stock may be
negatively impacted and stockholders who may desire or be required to sell
their shares of common stock may experience losses.
Securities Eligible for Future Sale
At December 1, 1998, we had outstanding 8,127,314 shares of common stock. We
also had outstanding 3,649,818 warrants, of which 3,549,818 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 securities
offered hereby may be sold without restriction pursuant to the Shelf
Registration Statement, subject to certain restrictions. As described in
"Recent Developments" in the prospectus summary, an additional 1,624,650 were
issued in October 1998 to GMAC/Residential Funding Corporation and are expected
to be subject to their own shelf registration statement. An additional 216,666
shares of common stock not being offered in this offering are "restricted
securities" within the meaning of Rule 144 under the Securities Act. Such
restricted securities will be available for resale, subject to the volume
limitations imposed by Rule 144 and, unless held by our affiliates, 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. We refer to you to
"Description of Capital Stock--Registration Rights."
As of September 30, 1998, options to purchase 286,250 shares of common stock
were outstanding under our Stock Option Plan, which will vest on various dates
extending through May 14, 2002. We filed a Form S-8 registration statement to
permit shares issued pursuant to the exercise of options to be sold.
29
<PAGE>
NOVASTAR FINANCIAL, INC.
We were founded by Scott Hartman and Lance Anderson and incorporated in the
State of Maryland on September 13, 1996. We have elected to be a REIT for
federal income tax purposes. As a result of our REIT status, we will be
permitted to deduct dividend distributions to stockholders, thereby effectively
eliminating the "double taxation" that generally results when a corporation
earns income and distributes that income to stockholders in the form of
dividends. See "Federal Income Tax Considerations--Taxation of the Company."
NFI Holding, Inc. was incorporated in the State of Delaware on February 6,
1997. One hundred percent of the voting common stock of NFI Holding is owned
equally by our founders. See "Management." We own one hundred percent of the
preferred stock of NFI Holding, for which we receive 99 percent of dividends
paid by NFI Holding. NFI Holding owns NovaStar Mortgage and NovaStar Capital.
NovaStar Mortgage was incorporated in the State of Virginia on May 16, 1996.
Although NovaStar Mortgage was formed in 1996, substantial operations did not
commence until January 1997. NovaStar Capital, a Delaware corporation, was
incorporated on June 24, 1998. On October 1, 1997, we founded NAC, a wholly-
owned, REIT-qualifying subsidiary, in conjunction with our first issuance of a
CMO, and on December 3, 1997, we founded NCFC, a second wholly-owned REIT-
qualifying subsidiary. NovaStar Capital Access Corporation, an inactive
corporation organized in Delaware on February 26, 1998, is also one of our
wholly-owned REIT-qualifying subsidiaries.
Our basic function is to manage our mortgage loans and securities. NovaStar
Mortgage serves as a source for loan origination--a primary source of our
mortgage loans. In addition, NovaStar Mortgage services our loans. Through June
30, 1998, we purchased substantially all of NovaStar Mortgage's loan
originations. Beginning July 1, 1998, NovaStar Mortgage began retaining the
loans it originates to be sold in the open market. See "Certain Transactions."
We are self-advised and self-managed. Our management oversees our day-to-day
operations, subject to supervision by our Board of Directors. Our management
team has considerable expertise in the origination, acquisition and management
of mortgage loans and securities and asset/liability management. We refer you
to "Management." Our principal executive offices are at 1901 W. 47th Place,
Suite 105, Westwood, Kansas 66205, telephone (913) 362-1090.
USE OF PROCEEDS
We will receive no proceeds from the sale of common stock or warrants by the
selling securityholders, but we will receive the net proceeds from the sale of
underlying common stock. Net proceeds from the sale of the underlying common
stock will be used to purchase mortgage assets and 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. We anticipate that we will fully invest our net proceeds in
mortgage loans or securities as soon as reasonably practicable upon receipt of
such proceeds. No mortgage assets have been specifically identified in which to
invest our net proceeds of this Offering.
DIVIDEND POLICY AND DISTRIBUTIONS
We generally intend to distribute substantially all of our taxable income
each year to our stockholders so as to comply with the REIT provisions of the
Code. Taxable income does not ordinarily equal net income as calculated in
accordance with GAAP. We generally intend to make dividend distributions
quarterly. We intend 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 at the discretion of the Board of Directors. Dividends will depend on
taxable income, our financial condition, maintenance of REIT status and other
factors as the Board of Directors deems relevant. We refer you to "Federal
Income Tax Considerations--Qualification as a REIT--Distributions."
30
<PAGE>
Distributions to stockholders will generally be subject to tax as ordinary
income, although a portion of such distributions may be designated by us as
capital gain or may constitute a tax-free return of capital. We will annually
furnish to each of our 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 us. We refer you to "Federal Income Tax
Considerations--Taxation of the Company's Stockholders."
DIVIDEND REINVESTMENT PLAN
We may adopt a dividend reinvestment plan for stockholders who wish to
reinvest all or part of their distributions in additional shares of common
stock. Generally, under a dividend reinvestment plan dividends paid with
respect to shares of capital stock are automatically invested in additional
shares of 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 dividend reinvestment plan following the
effectiveness of the registration of securities issuable thereunder. This
offering is not related to the proposed dividend reinvestment plan, nor have we
prepared or filed a registration statement with the SEC registering the shares
to be issued under the dividend reinvestment plan. Prior to buying shares
through the dividend reinvestment plan, participants will be provided with a
dividend reinvestment plan prospectus, which will constitute a part of such
dividend reinvestment plan registration statement. Our transfer agent will act
as the trustee and administrator of the dividend reinvestment plan.
Stockholders will not be automatically enrolled in the dividend reinvestment
plan. Each stockholder desiring to participate in the dividend reinvestment
plan must complete and deliver to the agent an enrollment form, which will be
sent to each eligible stockholder following the effectiveness of the
registration of the shares to be issued under the dividend reinvestment plan.
Participation in the dividend reinvestment plan will commence with all
dividends and distributions payable after receipt of a participant's
authorization, provided that the authorization must be received by the agent at
least two business days prior to the record date for any dividends in order for
any stockholder to be eligible for reinvestment of such dividends.
CAPITALIZATION
The table below sets forth our capitalization as of September 30, 1998 and as
adjusted to give effect to and the exercise of all warrants.
<TABLE>
<CAPTION>
AS OF SEPTEMBER 30,
1998
------------------------
ACTUAL AS ADJUSTED(1)
-------- --------------
(IN THOUSANDS)
<S> <C> <C>
STOCKHOLDERS' EQUITY:
Capital stock, $0.01 par value, 50,000,000
shares authorized:
Common Stock; 8,127,314 (actual) and
11,777,313 (as adjusted) shares issued and
outstanding.................................. 81 117
Additional paid-in capital...................... 121,358 176,071
Accumulated deficit(2).......................... (5,416) (5,416)
Other comprehensive deficit..................... (4,777) (4,777)
Forgivable notes receivable from founders....... (1,398) (1,398)
-------- --------
Total....................................... $109,848 $164,597
======== ========
</TABLE>
- --------
(1) Does not include 286,250 shares of common stock options outstanding under
our Stock Option Plan, of which 160,000 are outstanding to executive
officers and directors. We refer you to "Management--Executive
Compensation."
(2) Does not include the significant losses incurred in the fourth quarter 1998
as discussed in "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Events Subsequent to September 30,
1998" of this Prospectus.
31
<PAGE>
MARKET PRICES AND DIVIDEND DATA
Our common stock is traded on the NYSE under the symbol "NFI." The warrants
are traded 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
stock.
<TABLE>
<CAPTION>
CASH DIVIDENDS
------------------------------------------------
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
3/25/98 4/14/98 $0.30
6/23/98 7/14/98 $0.35
9/22/98 1/15/99(2) $0.35
</TABLE>
<TABLE>
<CAPTION>
COMMON STOCK PRICES
-------------------
HIGH LOW
-------------------
<S> <C> <C>
10/31/97 to
12/31/97(1) 18 13/16 14 1/2
1/1/98 to 3/31/98 21 1/8 15 15/16
4/1/98 to 6/30/98 21 16 3/8
7/1/98 to 9/30/98 17 13/16 11 3/8
10/1/98 to 12/4/98 12 7/8 3
</TABLE>
- --------
(1) Our common stock began trading on October 31, 1997.
(2) We deferred the payment of this dividend due to certain events that
occurred early in the fourth quarter of 1998 as discussed in the
"Management's Discussion and Analysis of Financial Condition and Results of
Operations, Events Subsequent to September 30, 1998" section of this
Prospectus.
On December 21, 1998, the last reported sales price for the common stock was
$6 7/8 per share. As of December 1, 1998, our 8,127,314 shares of common stock
were held by more than 2,000 stockholders.
We generally intend to pay quarterly dividends. We intend to make
distributions to our stockholders of all or substantially all of our taxable
income in each year (subject to certain adjustments) so as to qualify for the
tax benefits accorded to a REIT under the Internal Revenue Code. All
distributions will be made at the discretion of the Board of Directors and will
depend on our earnings, our financial condition, maintenance of REIT status and
other factors as the Board of Directors may deem relevant from time to time. We
refer you to "Dividend Policy and Distributions."
32
<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, 1998 are not necessarily indicative of the results that may
be expected for the year ending December 31, 1998.
<TABLE>
<CAPTION>
FOR THE YEAR FOR THE
FOR THE NINE ENDED PERIOD ENDED
MONTHS ENDED DECEMBER 31, DECEMBER 31,
SEPTEMBER 30, 1997 1996(1)
------------------- ------------ ------------
1998 1997
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA
Interest income............... $ 79,155 $ 21,545 $ 36,961 $ 155
Interest expense.............. 60,948 16,224 28,185 --
Net interest income........... 18,207 5,321 8,776 155
Provision for credit losses... 3,400 1,444 2,453 --
Net interest income after
provision for credit losses.. 14,807 3,877 6,323 155
Equity in loss of NFI Holding
Corporation.................. (2,455) (141) 28 --
General and administrative
expenses..................... 12,563 4,764 8,241 457
Net income (loss)............. 5,567 (702) (1,135) (302)
Basic earnings (loss) per
share........................ $ 0.69 $ (0.19) $ (0.26) $ (0.08)
Diluted earnings (loss) per
share(2)..................... $ 0.64 $ (0.19) $ (0.26) $ (0.08)
<CAPTION>
AS OF SEPTEMBER
30, AS OF DECEMBER 31,
------------------- --------------------------
1998 1997 1997 1996
<S> <C> <C> <C> <C>
BALANCE SHEET DATA
Mortgage assets:
Mortgage loans................ $ 944,228 $418,897 $ 574,984 --
Mortgage securities........... 390,276 267,835 517,246 $13,239
Total assets.................. 1,693,325 699,133 1,126,252 59,811
Collateralized mortgage
obligations.................. 948,590 -- 408,867 --
Repurchase agreements......... 579,697 644,195 556,443 --
Stockholders' equity.......... 109,848 47,036 116,489 46,380
<CAPTION>
AS OF OR FOR AS OF OR FOR
THE YEAR THE PERIOD
AS OF OR FOR THE ENDED ENDED
PERIOD ENDED DECEMBER 31, DECEMBER 31,
SEPTEMBER 30, 1997 1996(1)
------------------- ------------ ------------
1998 1997
<S> <C> <C> <C> <C>
OTHER DATA
Acquisition of wholesale loan
production of NovaStar
Mortgage:
Principal at funding.......... $ 734,612 $226,962 $ 409,974 --
Average principal balance per
loan......................... $ 95 $ 142 $ 130 --
Weighted average interest
rate:
Adjustable-rate mortgage
loans....................... 10.0% 10.0% 10.13% --
Fixed rate mortgage loans.... 10.0% 10.6% 10.46% --
Loans with prepayment
penalties.................... 72% 73% 73% --
Weighted average prepayment
penalty period (in years)
(4).......................... 2.4 2.7 2.4 --
Net interest spread........... 2.20% 1.73% 1.30% --
Net yield..................... 1.93% 2.02% 1.84% --
Annualized return on average
assets, before forgiveness of
notes receivable from
founders..................... 0.60% (0.25)% (0.01)% (0.50)%
Annualized return on average
equity, before forgiveness of
notes receivable from
founders..................... 7.52% (1.75)% (0.06)% (0.65)%
Taxable income (loss)......... $ 9,031 $ 871 $ 1,434 $ (173)
Taxable income (loss) per
share........................ $ 1.11 $ 0.12 $ 0.18 $ (0.05)
Dividends declared per
share(3)..................... $ 1.00 $ 0.18 $ 0.28 --
Number of account executives.. 55 29 36 --
</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) Diluted earnings (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.
(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. We refer
you to "Dividend Policy and Distributions."
(4) Includes only those loans with a prepayment penalty.
33
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the preceding
Selected Financial and Other Data and the Company's Financial Statements and
the Notes thereto, included elsewhere in this Prospectus as well as the
Company's Annual Report to Shareholders and Annual Report on Form 10-K for the
fiscal year ended December 31, 1997.
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 risks 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. In addition, there are many important factors that could cause
NovaStar's actual results to differ materially from those indicated in the
forward-looking statements. These factors include, but are not limited to,
general economic conditions, interest rate levels and risk, prepayment speeds,
delinquency and loss rates, changes (legislative and otherwise) in the asset
securitization industry or the REIT provisions of the Internal Revenue Code,
demand for NovaStar's service, the impact of certain covenants in loan
agreements of NovaStar, the degree to which NovaStar is leveraged, its needs
for and availability of financing, its access to capital and other risks
identified in NovaStar's Securities and Exchange Commission filings. In
addition, it should be noted that past financial and operational performance of
the Company is not necessarily indicative of future financial and operational
performance.
BASIS OF PRESENTATION
The Company owns 100 percent of the common stock of NovaStar Assets
Corporation, NovaStar Certificates Financing Corporation and NovaStar Mortgage
Funding Corporation. These entities were established as special purpose
entities used in the Company's issuance of collateralized mortgage obligations.
The consolidated financial statements of the Company include the financial
condition and results of operations of these entities.
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. Scott Hartman and Lance Anderson, the Company's founders, own the
voting common stock of Holding. NovaStar Mortgage, Inc. 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. In June 1998, Holding
formed NovaStar Capital, Inc. to purchase and sell mortgage loans. The Company
accounts for its investment in Holding using the equity method.
FINANCIAL CONDITION AND RESULTS OF OPERATIONS AS OF AND FOR THE PERIOD ENDED
DECEMBER 31, 1996
The Company was incorporated on September 13, 1996 and commenced operations
in December 1996 after raising $47 million through a private placement
offering. During the period from inception to December 31, 1996, investments
earned $155,000, while general and administrative costs were $457,000,
resulting in a net loss of $302,000. Those operating results are not meaningful
to the on-going operations of the Company.
EVENTS SUBSEQUENT TO SEPTEMBER 30, 1998
As of September 30, 1998, the Company had an arrangement with a lender
whereby the Company could borrow up to 50 percent of the value of the residual
interests in the Company's collateralized mortgage obligations. Borrowing
capacity under this arrangement was in excess of $30 million. However, the
lender restricted the Company's access to funds under this arrangement to $25
million as of September 30, 1998. In
34
<PAGE>
October, the lender withdrew its financing under this arrangement. This event,
combined with declining market prices for its securities and off-balance-sheet
financial instruments, caused management to take several actions, as discussed
in following paragraphs, to restore the Company's liquidity and to reduce
further exposure to liquidity risk. As a result of these actions, the Company
anticipates incurring a significant net loss during the fourth quarter of 1998.
On October 11, 1998, the Board of Directors of the Company agreed to defer
payment of the third quarter dividend ($0.35 per share) until January 15, 1999.
On various dates during October 1998, the Company and NovaStar Mortgage
executed contracts for the sale of all securities owned by the Company and
NovaStar Mortgage. All securities sales settled during October at an aggregated
loss of $15.4 million.
On various dates during October 1998, the Company terminated interest rate
swap agreements with a notional amount of $455 million, representing 42 percent
of all interest rate agreements owned by the Company. The terminations settled
in October 1998 at an aggregate loss of $8.0 million.
On October 13, 1998, the Company executed a 90-day financing agreement with
GMAC/Residential Funding Corporation, secured by certain mortgage interests of
the Company. Under the terms of the agreement, the Company borrowed a $15
million loan to support immediate cash needs. In addition, we agreed to pay a
$3 million commitment fee at maturity of the note. The resulting, $18 million
obligation bears interest at one-month LIBOR plus five percent. Additionally,
GMAC/RFC will acquire 1,624,650 warrants for the purchase of the Company's
common stock at a price of $4.5625, the closing price of the common stock on
October 12, 1998. The Company is presently in negotiations with GMAC/RFC
regarding terms to establish a long-term strategic alliance. However, no
assurance can be given that an alliance will in fact be executed. If a
strategic alliance is successfully negotiated, GMAC/RFC has the option to waive
$2 million of the commitment fees discussed above. If a strategic alliance is
not negotiated, we have the option, which we expect to exercise, to repurchase
811,919 of the warrants at an aggregate price of $1 per share.
Additional events, as described below, occurred subsequent to September 30,
1998. Although these events were not a direct result of the above-described
events, they affect the Company's liquidity position.
On various dates during October 1998, NovaStar Mortgage has accepted bids for
the sale of approximately $221 million, or 94 percent of loans it owned as of
September 30, 1998. However, final terms of these sales will be determined
after due diligence is performed on subject loans. Closing on these sales is
expected to take place prior to December 31, 1998.
On October 21, 1998, the Company finalized the second closing on the
securitization of asset-backed bonds, the first closing of which occurred
during the second quarter. In the second closing, approximately $43 million of
loans were added to the trust assets of NovaStar Home Equity Series 1998-2.
After completing the above transactions, the Company's balance sheet will
consist primarily of subprime mortgage loans financed with non-recourse asset-
backed bonds. Table I is a condensed balance sheet as of September 30, 1998
with a comparative pro-forma balance sheet assuming the foregoing transactions
had been executed on that date, excluding the sales of mortgage loans expected
to occur during the fourth quarter.
35
<PAGE>
TABLE I
CONDENSED BALANCE SHEETS
SEPTEMBER 30, 1998
<TABLE>
<CAPTION>
SEPTEMBER 30, 1998
---------------------
ACTUAL PRO FORMA
<S> <C> <C>
ASSETS
Cash and cash equivalents........................ $ -- $ 15,638
Restricted cash.................................. 55,383 12,683
Mortgage loans................................... 944,228 987,781
Available-for-sale securities.................... 408,276 --
Due from NFI Holding Corporation................. 259,312 215,758
Other assets..................................... 26,126 21,008
---------- ----------
Total assets................................. $1,693,325 $1,252,868
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Collateralized mortgage obligations............ $ 948,590 $ 948,590
Repurchase agreements.......................... 579,697 151,521
Warehouse line of credit....................... 46,779 35,079
Short-term note payable........................ -- 18,000
Accounts payable and accrued expenses.......... 8,411 8,346
---------- ----------
Total liabilities............................ 1,583,477 1,161,536
Stockholders' equity........................... 109,848 91,332
---------- ----------
Total liabilities and stockholders' equity... $1,693,325 $1,252,868
========== ==========
</TABLE>
In the foreseeable future, the Company does not expect to purchase a
significant amount of loans originated by NovaStar Mortgage, and NovaStar
Mortgage is expected to sell a majority of the mortgage loans it originates to
unrelated entities for cash. Net income for the Company will be generated from
the spread on securitized loans, general and administrative expenses and equity
in earnings of NFI Holding Corporation. Earnings of NFI Holding Corporation
will primarily include gains on the sales of mortgage loans originated by
NovaStar Mortgage and general and administrative expenses.
Additional information regarding the Company's liquidity position and events
subsequent to September 30, 1998 are included in "Liquidity and Capital
Resources."
LIQUIDITY AND CAPITAL RESOURCES
Subsequent to September 30, 1998, access to a key financing source was
withdrawn, as discussed in "Events Subsequent to September 30, 1998." The
events and actions discussed therein are important to the discussion below
regarding the liquidity and capital resources of the Company.
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 loans,
principal repayment and interest on borrowings, operating expenses and dividend
payments. The Company's business requires substantial cash to support its
operating activities. The Company has a certain amount of cash on hand to fund
operations. Principal, interest and fees received on mortgage assets will serve
to support the cash needs of the Company. Drawing upon various borrowing
arrangements typically satisfies major cash requirements. Historically, the
Company demonstrated the ability to access public markets as a source of long-
term cash resources. The events in early October 1998 changed the liquidity
position of the Company. Options available to the Company for financing sources
have been restricted.
36
<PAGE>
Actions of the Company, during unfavorable market conditions as discussed in
"Events Subsequent to September 30, 1998" were taken to restore liquidity and
mitigate additional margin call risk. Although these actions will result in a
significant net loss for the fourth quarter of 1998, management believes they
were necessary under the circumstances.
In addition to the mortgage loans that have been securitized and are
reflected on the Company's balance sheet, NovaStar Mortgage continues to
originate subprime mortgage loans expected to be sold to third parties. As of
September 30, 1998, NovaStar Mortgage had $238 million of subprime mortgage
loans. The Company provides financing for these loans through its own warehouse
and repurchase credit facilities. Sales commitments have been accepted for $221
million of these loans. Management expects to continue selling loans originated
by NovaStar Mortgage during the fourth quarter of 1998 and into 1999. Loans
financed with warehouse and repurchase credit facilities are subject to
changing market valuation and margin calls.
Table II is a summary of financing arrangements and available borrowing
capacity under those arrangements as of November 9, 1998.
TABLE II
LIQUIDITY RESOURCES
NOVEMBER 9, 1998 (DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
MAXIMUM
BORROWING VALUE OF
RESOURCE LIMIT COLLATERAL BORROWINGS AVAILABILITY
-------- --------- ---------- ---------- ------------
<S> <C> <C> <C> <C>
First Union National Bank:
Committed warehouse line of
credit......................... $ 75,000 $ 34,895 $ 16,913 $17,982
Committed secured whole loan
repurchase agreement........... 100,000 85,816 85,816 --
Merrill Lynch Mortgage Capital,
Inc.............................. 150,100 150,100 150,100 --
Residual financing available under
CMOs............................. 18,000 (A) 18,000
-------- -------
Total......................... $270,829 $17,982
======== =======
Total availability as percent of:
Total assets.................... 1.06%
=======
Total stockholders' equity...... 16.37%
=======
</TABLE>
- --------
(A) The Company's estimates of the value of the residuals range from $50 to $70
million.
During the nine months ended September 30, 1998, the Company's operating and
financing activities generated cash of $4 million and $533 million, while
investing activities used cash of $537 million.
FORGIVABLE NOTES RECEIVABLE FROM FOUNDERS
The Company's founders purchased 216,666 units in the 1996 private placement
in exchange for forgivable promissory notes. A unit consisted of one share of
convertible preferred stock and one common stock warrant. Principal on these
notes will be forgiven if certain incentive performance targets are achieved.
The incentive tests relate to the return generated to investors in the private
placement, including the appreciation in the Company's stock price, the value
of the warrants, and dividends paid. One tranche will be forgiven for each
fiscal year the Company generates a return of 15 percent to investors in the
private placement. All three tranches will be forgiven if the Company generates
a 100 percent return within five years. For the period from the closing of the
private placement through December 31, 1997, the Company generated a return
exceeding 15 percent to the private placement investors and the first tranche
of these notes was forgiven resulting in a non-cash charge of $1,083,000 during
the fourth quarter of 1997.
37
<PAGE>
Based on the Company's performance and stock price during the first three
quarters of the year, the Company's management anticipated forgiveness of the
second tranche of these notes. As a result, non-cash charges to earnings have
been recorded during the first three quarters of 1998 in the amount of
$812,000. Based on actions taken by management as described in "Events
Subsequent to September 30, 1998" and the current value of Company's stock, it
appears unlikely that the second tranche of the notes receivable from founders
will be forgiven. Final determination regarding forgiveness will be made during
the fourth quarter of 1998. If the second tranche is not forgiven, all amounts
that have been charged off during 1998 will be reinstated.
FINANCIAL CONDITION AS OF SEPTEMBER 30, 1998 AND DECEMBER 31, 1997
During the nine months ended September 30, 1998, NovaStar Mortgage originated
approximately 8,000 subprime residential mortgage loans with an aggregate
principal amount of $735 million, of which $498 million was acquired by the
Company. However, unlike previous periods, the Company discontinued virtually
all of its purchase of NovaStar Mortgage's loan originations during the third
quarter of 1998 as NovaStar Mortgage intends to sell the majority of its third
quarter production to independent third parties. The Company's balance sheet
continues to become more heavily weighted toward subprime mortgage loans. As of
September 30, 1998, subprime mortgage loans comprise 71 percent of the mortgage
assets owned by the Company compared with 51 percent at December 31, 1997.
During the nine months ended September 30, 1998, the Company sold $7.5
million of loans purchased from NovaStar Mortgage to unrelated third parties
for cash, recognizing gains on these transactions of $315,000. The Company also
completed two securitizations during the nine months ended September 30, 1998,
pooling $618 million of mortgage loans as collateral of which $43 million was
added during the fourth quarter of 1998.
Table III is a summary of wholesale loan originations and bulk acquisitions
for 1998 and 1997. Table IV presents a more detailed analysis of wholesale loan
originations.
TABLE III
WHOLESALE LOAN ORIGINATIONS (A) AND BULK ACQUISITIONS (B)
NINE MONTHS ENDED SEPTEMBER 30, 1998 AND YEAR ENDED DECEMBER 31, 1997
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
WHOLESALE BULK
ORIGINATIONS (A) ACQUISITIONS (B) TOTAL
---------------- ---------------- ----------------
NUMBER NUMBER NUMBER
OF PRINCIPAL OF PRINCIPAL OF PRINCIPAL
LOANS AMOUNT LOANS AMOUNT LOANS AMOUNT
------ --------- ------ --------- ------ ---------
<S> <C> <C> <C> <C> <C> <C>
1998:
Third quarter.............. 2,576 $232,333 79 $ 8,165 2,655 $240,498
Second quarter............. 3,133 294,303 -- -- 3,133 294,303
First quarter.............. 2,033 207,976 -- -- 2,033 207,976
----- -------- ----- -------- ----- --------
1998 total............... 7,742 $734,612 79 $ 8,165 7,821 $742,777
===== ======== ===== ======== ===== ========
1997:
Fourth quarter............. 1,552 $183,012 -- $ -- 1,552 $183,012
Third quarter.............. 1,025 136,582 -- -- 1,025 136,582
Second quarter............. 509 77,692 530 49,808 1,039 127,500
First quarter.............. 68 12,688 1,422 157,432 1,490 170,120
----- -------- ----- -------- ----- --------
1997 total............... 3,154 $409,974 1,952 $207,240 5,106 $617,214
===== ======== ===== ======== ===== ========
</TABLE>
- --------
(A) Loans originated by NovaStar Mortgage
(B) First two quarters of 1997 represent bulk acquisitions by NFI; third
quarter of 1998 represents bulk acquisitions by NovaStar Capital, Inc.
38
<PAGE>
TABLE IV
1998 AND 1997 QUARTERLY WHOLESALE LOAN ORIGINATIONS (A)
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
WEIGHTED AVERAGE
PRICE ------------------- PERCENT
NUMBER AVERAGE PAID LOAN- CREDIT WITH
OF LOAN TO TO- RATING PREPAYMENT
LOANS PRINCIPAL BALANCE BROKER VALUE (B) COUPON PENALTY
------ --------- ------- ------ ----- ------ ------ ----------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
1998:
Third quarter......... 2,576 $232,333 $ 90 101.4 81% 4.37 10.11% 79%
Second quarter........ 3,133 294,303 94 101.3 81 4.43 9.93 71
First quarter......... 2,033 207,976 102 101.4 81 4.45 9.93 65
----- --------
1998 total.......... 7,742 $734,612 95 101.4 81 4.42 9.99 72
===== ========
1997:
Fourth quarter........ 1,552 $183,012 118 101.6 81 4.32 10.09 71
Third quarter......... 1,025 136,582 133 101.6 79 4.21 10.12 66
Second quarter........ 509 77,692 153 102.1 77 4.23 10.17 84
First quarter......... 68 12,688 187 102.3 75 4.22 9.64 78
----- --------
1997 total.......... 3,154 $409,974 130 101.7 79 4.26 10.10 73
===== ========
</TABLE>
- --------
(A) Loans originated by NovaStar Mortgage
(B) AAA= 7, AA=6, A=5, A-=4, B=3, C=2, D=1
The Company's subprime borrowers generally include individuals that do not
qualify for agency/conventional lending programs because of a lack of available
documentation or previous credit difficulties, but have equity in their homes.
Often, they are individuals or families who have built up high-rate consumer
debt and are attempting to use the equity in their home to consolidate debt and
lower their monthly payments. The credit grade assigned is a function of the
relative strength or weakness of the borrower's credit and/or the nature and
extent of documents that can be provided to support income. NovaStar Mortgage
underwrites the loans acquired by the Company using guidelines that have been
approved by the Company.
Table V is a presentation of loans as of September 30, 1998 and December 31,
1997 and their credit grades.
TABLE V
MORTGAGE LOANS BY CREDIT GRADE
AS OF SEPTEMBER 30, 1998 AND DECEMBER 31, 1997 (DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
AS OF SEPTEMBER 30, 1998
MAXIMUM --------------------------------
LOAN- WEIGHTED WEIGHTED
ALLOWED TO- CURRENT AVERAGE AVERAGE
CREDIT RATING MORTGAGE LATES VALUE PRINCIPAL COUPON LOAN-TO-VALUE
- ------------- --------------- ------- --------- -------- -------------
<S> <C> <C> <C> <C> <C>
AA.................... 0 x 30 95 $115,975 9.48 83.3%
A..................... 1 x 30 90 367,921 9.82 79.6
A-.................... 2 x 30 90 222,011 10.25 80.7
B..................... 3 x 30, 1x 60 85 141,165 10.52 77.5
5 x 30, 2 x 60,
C..................... 1 x 90 80 62,965 11.09 72.3
D..................... 6 x 30, 3 x 60,
2 x 90 65 14,398 11.97 62.2
--------
Total............... $924,435 10.11 79.2
========
</TABLE>
39
<PAGE>
<TABLE>
<CAPTION>
AS OF DECEMBER 31, 1997
---------------------------
MAXIMUM WEIGHTED
LOAN- WEIGHTED AVERAGE
ALLOWED TO- CURRENT AVERAGE LOAN-TO-
CREDIT RATING MORTGAGE LATES VALUE PRINCIPAL COUPON VALUE
- ------------- --------------- ------- --------- -------- --------
<S> <C> <C> <C> <C> <C>
AA.......................... 0 x 30 95 $ 16,654 9.61% 85.4%
A........................... 1 x 30 90 251,751 9.91 77.9
A-.......................... 2 x 30 90 145,314 10.20 78.4
B........................... 3 x 30, 1x 60 85 99,317 10.50 76.5
C........................... 5 x 30, 2 x 60,
1 x 90 80 35,483 11.09 71.1
D........................... 6 x 30, 3 x 60,
2 x 90 65 10,917 12.05 63.7
-------- ----- ----
Total..................... $559,436 10.20% 77.3%
======== ===== ====
</TABLE>
Table VI is a summary of loans originated by NovaStar Mortgage by state.
Table VII is a summary of all mortgage loans owned by the Company as of
September 30, 1998 compared with December 31, 1997 by state.
TABLE VI
MORTGAGE LOAN ORIGINATIONS BY STATE (A)
NINE MONTHS ENDED SEPTEMBER 30, 1998 AND YEAR ENDED DECEMBER 31, 1997
<TABLE>
<CAPTION>
PERCENT OF TOTAL ORIGINATIONS DURING QUARTER
(BASED ON ORIGINAL PRINCIPAL BALANCE)
--------------------------------------------
1998 1997
------------------ -------------------------
COLLATERAL LOCATION THIRD SECOND FIRST FOURTH THIRD SECOND FIRST
- ------------------- ----- ------ ----- ------ ----- ------ -----
<S> <C> <C> <C> <C> <C> <C> <C>
Florida............................ 17% 16% 12% 9% 10% 8% 1%
California......................... 6 9 15 19 24 26 40
Washington......................... 5 6 7 8 11 16 15
Michigan........................... 5 5 5 5 3 -- --
Texas.............................. 5 3 3 3 4 7 2
North Carolina..................... 5 3 2 1 1 1
Ohio............................... 4 5 2 2 2 2 --
Nevada............................. 4 3 6 5 4 2 --
Oregon............................. 3 4 5 6 6 9 7
Maryland........................... 2 3 4 5 6 5 13
Utah............................... 2 3 3 6 6 9 13
Virginia........................... 2 2 2 5 6 2 --
Oklahoma........................... -- 1 1 1 1 2 5
All other states................... 40 40 35 26 17 12 4
</TABLE>
- --------
(A) Loans originated by NovaStar Mortgage, Inc.
TABLE VII
MORTGAGE LOANS BY STATE
AS OF SEPTEMBER 30, 1998 AND DECEMBER 31, 1997
<TABLE>
<CAPTION>
PERCENT OF PORTFOLIO
(BASED ON ORIGINAL PRINCIPAL
BALANCE)
------------------------------------
COLLATERAL LOCATION SEPTEMBER 30, 1998 DECEMBER 31, 1997
------------------- ------------------ -----------------
<S> <C> <C>
California........................... 19% 27%
Florida.............................. 12 8
Washington........................... 8 9
Oregon............................... 5 6
Utah................................. 4 6
Texas................................ 4 5
All other states..................... 48 39
</TABLE>
40
<PAGE>
As of September 30, 1998, the carrying value of mortgage securities totaled
$390.3 million compared with $517.2 million as of December 31, 1997. As more of
the Company's capital is allocated to subprime mortgage loans, less is
available for mortgage securities. As a result, during the nine months ended
September 30, 1998, the Company sold mortgage securities with an amortized cost
of $323.3 million compared with $100.6 million for the period ended September
30, 1997. The Company acquired mortgage securities with an aggregate cost of
$354.9 million for the period ended September 30, 1998 compared with $376.0 for
the same period of 1997. Tables VIII and XI are summaries of the securities
acquired during 1998 and 1997 by quarter and the portfolio as of September 30,
1998 and December 31, 1997.
TABLE VIII
MORTGAGE SECURITY ACQUISITIONS
NINE MONTHS ENDED SEPTEMBER 30, 1998 AND YEAR ENDED DECEMBER 31, 1997 (DOLLARS
IN THOUSANDS)
<TABLE>
<CAPTION>
NET WEIGHTED
PRICE TO AVERAGE
PRINCIPAL PREMIUM DISCOUNT PAR COUPON
--------- ------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
1998:
Third quarter................... $ -- $ -- $ -- -- -- %
Second quarter--Federal National
Mortgage Association........... 80,237 823 -- 101.0 6.40
First quarter:
Federal National Mortgage
Association.................. 40,929 444 -- 101.1 6.12
Government National Mortgage
Association.................. 229,130 3,726 (364) 101.5 6.39
1997:
Fourth quarter:
Federal National Mortgage
Association.................. 46,779 1,856 -- 104.0 8.00
Government National Mortgage
Association.................. 233,546 2,649 (1,457) 100.5 5.74
Third quarter--Federal Home Loan
Mortgage Corporation........... 2,202 87 -- 104.0 7.40
Second quarter:
Federal National Mortgage
Association.................. 247,219 5,174 -- 102.1 7.48
Federal Home Loan Mortgage
Corporation.................. 102,083 2,450 -- 102.4 6.90
First quarter:
Federal National Mortgage
Association.................. 7,491 231 -- 103.1 7.57
Government National Mortgage
Association.................. 8,931 174 -- 101.9 7.13
</TABLE>
TABLE IX
MORTGAGE SECURITY PORTFOLIO
AS OF SEPTEMBER 30, 1998 AND DECEMBER 31, 1997 (DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
AS OF SEPTEMBER 30, 1998
---------------------------------------------------
GROSS
---------------------- WEIGHTED
UNAMORTIZED UNACCRETED CARRYING AVERAGE
PRINCIPAL PREMIUM DISCOUNT VALUE COUPON
--------- ----------- ---------- -------- --------
<S> <C> <C> <C> <C> <C>
Federal National Mortgage
Association.............. $259,860 $5,565 $ -- $265,424 7.04%
Government National
Mortgage Association..... 123,211 282 (225) 123,268 5.40
Federal Home Loan Mortgage
Corporation.............. 4,160 136 -- 4,296 7.54
-------- ------ ----- --------
$387,231 $5,983 $(225) 392,989 6.52%
======== ====== =====
Net unrealized loss....... (2,713)
--------
Carrying value............ $390,276
========
</TABLE>
41
<PAGE>
<TABLE>
<CAPTION>
AS OF DECEMBER 31, 1997
--------------------------------------------------
GROSS
---------------------- WEIGHTED
UNAMORTIZED UNACCRETED CARRYING AVERAGE
PRINCIPAL PREMIUM DISCOUNT VALUE COUPON
--------- ----------- ---------- -------- --------
<S> <C> <C> <C> <C> <C>
Federal National Mortgage
Association............... $266,083 $6,690 $ -- $272,773 7.55%
Government National
Mortgage Association...... 233,407 2,640 1,302 234,745 5.74
Federal Home Loan Mortgage
Corporation............... 5,357 177 -- 5,534 7.71
-------- ------ ------ --------
$504,847 $9,507 $1,302 513,052 6.98%
======== ====== ======
Net unrealized gain........ 4,194
--------
Carrying value............. $517,246
========
</TABLE>
As described under the section labeled "Events Subsequent to September 30,
1998", all of the securities portfolio at September 30, 1998 was sold in
October 1998 at losses aggregating $15.4 million.
Mortgage loan originations are funded with various warehouse facilities prior
to securitization. Loans originated through the lending operations of NovaStar
Mortgage have typically been funded initially through a $75 million warehouse
line with First Union National Bank under which the Company and NovaStar
Mortgage are co-borrowers. The Company also uses repurchase agreements to
finance mortgage loan purchases. Funds borrowed against master repurchase
agreements are also used to acquire loans from NovaStar Mortgage. Residual
financing is another short-term borrowing instrument currently available to the
Company.
Using individual assets as collateral for repurchase agreements, the Company
has financed acquisitions of agency-issued mortgage securities. These
agreements have been executed with a number of reputable securities dealers.
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 capital available to cover this "haircut."
Table X displays the amounts outstanding under borrowing arrangements as of
September 30, 1998 and December 31, 1997.
TABLE X
BORROWINGS
SEPTEMBER 30, 1998 AND DECEMBER 31, 1997 (DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
AS OF
SEPTEMBER 30,
1998
-----------------
WEIGHTED AVERAGE DAILY
WEIGHTED DAYS TO BALANCE DURING THE
AVERAGE RESET OR NINE MONTHS ENDED
RATE MATURITY BALANCE SEPTEMBER 30, 1998
-------- -------- -------- -------------------
<S> <C> <C> <C> <C>
Repurchase agreements secured
by mortgage securities........ 5.44% 4 $397,176 $511,460
Master repurchase agreement
secured by mortgage loans..... 6.38 31 182,521 156,854
--------
Total repurchase agreements.. 579,697
Warehouse line of credit....... Demand 46,779 20,043
--------
Total borrowings............. $626,476
========
<CAPTION>
AS OF
DECEMBER 31, 1997
-----------------
WEIGHTED AVERAGE DAILY
WEIGHTED DAYS TO BALANCE DURING THE
AVERAGE RESET OR TWELVE MONTHS ENDED
RATE MATURITY BALANCE DECEMBER 31, 1997
-------- -------- -------- -------------------
<S> <C> <C> <C> <C>
Repurchase agreements secured
by mortgage securities........ 5.92% 87 $501,430 $172,829
Master repurchase agreement
secured by mortgage loans..... 6.69 31 55,013 170,344
--------
Total repurchase agreements.. 556,443
Warehouse line of credit....... Demand 40,250 18,402
--------
Total borrowings............. $596,693
========
</TABLE>
42
<PAGE>
On a long-term basis, the Company finances its mortgage loans using
collateralized mortgage obligations (CMOs). Investors in CMOs are repaid based
on the performance of the mortgage loans collateralizing the CMOs. CMOs are
outstanding as long as the mortgage loans are outstanding. However, under the
CMOs issued by NovaStar, the Company has the right to reacquire the mortgage
loans collateralizing the CMO when certain events occur. These non-recourse
financing arrangements match the loans with the financing arrangement for long
periods of time, as compared to repurchase agreements that mature frequently
with interest rates that reset frequently and have liquidity risk in the form
of margin calls. Table XI displays the amounts outstanding under collateralized
mortgage obligations as of September 30, 1998 and December 31, 1997.
TABLE XI
COLLATERALIZED MORTGAGE OBLIGATIONS
SEPTEMBER 30, 1998 AND DECEMBER 31, 1997 (DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
AS OF SEPTEMBER 30, 1998
-------------------------------------------------------
COLLATERALIZED
MORTGAGE
OBLIGATION UNDERLYING MORTGAGE LOANS
------------------- -----------------------------------
ESTIMATED
WEIGHTED WEIGHTED
REMAINING INTEREST CARRYING AVERAGE AVERAGE MONTHS
PRINCIPAL RATE VALUE COUPON TO MATURITY
--------- -------- -------- -------- --------------
<S> <C> <C> <C> <C> <C>
NovaStar Home Equity
Series:
Issue 1997-1.......... $181,770 5.97% $192,084 10.43% 24
Issue 1997-2.......... 179,371 5.84 184,013 10.45 26
Issue 1998-1.......... 283,020 5.70 290,240 10.14 24
Issue 1998-2.......... 308,986 5.70 273,308(A) 9.99 37
Debt issuance costs,
net.................. (4,557) --
-------- --------
$948,590 $939,645
======== ========
</TABLE>
- --------
(A) Does not include $43 million of loans added as collateral during October
1998.
<TABLE>
<CAPTION>
AS OF DECEMBER 31, 1997
-------------------------------------------------------
COLLATERALIZED
MORTGAGE
OBLIGATION UNDERLYING MORTGAGE LOANS
------------------- -----------------------------------
ESTIMATED
WEIGHTED WEIGHTED
REMAINING INTEREST CARRYING AVERAGE AVERAGE MONTHS
PRINCIPAL RATE VALUE COUPON TO MATURITY
--------- -------- -------- -------- --------------
<S> <C> <C> <C> <C> <C>
NovaStar Home Equity
Series:
Issue 1997-1.......... $250,262 5.95% $263,468 10.28% 35
Issue 1997-2.......... 160,376 6.25 170,298(A) 10.20 36
Debt issuance costs,
net.................. (1,771) --
-------- --------
$408,867 $433,766
======== ========
</TABLE>
- --------
(A) Does not include $50 million of loans added as collateral during January
1998
In periods of decreasing interest rates, borrowers are more likely to
refinance their mortgages to obtain a lower interest rate and monthly payment.
Even in rising rate environments, borrowers tend to collectively repay their
mortgage principal balances earlier than is required by the terms of their
mortgages. This is particularly true for subprime borrowers who are seeking to
upgrade their credit rating to obtain a lower interest rate. Table XII displays
the historical prepayment speeds for mortgage loans collateralizing the
Company's CMOs. Table XVI provides an analysis of prepayment characteristics of
the Company's mortgage loan portfolio.
43
<PAGE>
TABLE XII
PREPAYMENT SPEED
<TABLE>
<CAPTION>
CONSTANT PREPAYMENT RATE (ANNUAL
PERCENT)
---------------------------------------
ONE-MONTH THREE-MONTH TWELVE-MONTH LIFE
--------- ----------- ------------ ----
<S> <C> <C> <C> <C>
AS OF SEPTEMBER 30, 1998
NovaStar Home Equity Series:
1997-1................................ 35.5 34.9 -- 29.8
1997-2................................ 28.3 26.0 -- 17.7
1998-1................................ 13.3 12.8 -- 9.6
1998-2................................ 9.4 -- -- 7.8
AS OF DECEMBER 31, 1997
NovaStar Home Equity Series:
1997-1................................ 18.6 15.7 -- 15.7
1997-2................................ 10.5 -- -- 10.5
</TABLE>
To mitigate the Company's exposure to prepayment risk and in order for the
Company to retain those borrowers whose credit is considered desirable, the
Company created a portfolio retention department in the latter part of 1997
that encourages borrowers who have satisfactorily met their obligations to
refinance or rate modify their loans with NovaStar. Of the loans that prepaid
during the first nine months of 1998, $11.5 million, or ten percent of the
loans were successfully refinanced and $1.9 million, or two percent of the
loans, were rate-modified. For the third quarter of 1998, $5.1 million, or
eleven percent of the loans were successfully refinanced and $1.2 million or
three percent of the loans were rate-modified. Although these loans are
considered prepayments for the purposes of the information in Table XII, they
remain in the NovaStar loan portfolio.
44
<PAGE>
Table XIII summarizes quarterly mortgage asset activity during 1998 and 1997
and Table XIV details the amount of premium as a percent of principal at
quarter end for 1998 and 1997.
TABLE XIII
MORTGAGE ASSETS ACTIVITY (THOUSANDS)
<TABLE>
<CAPTION>
MORTGAGE
MORTGAGE LOANS SECURITIES TOTAL
------------------ ------------------ -------------------
PRINCIPAL PREMIUM PRINCIPAL PREMIUM PRINCIPAL PREMIUM
--------- ------- --------- ------- ---------- -------
<S> <C> <C> <C> <C> <C> <C>
Balance, January 1,
1997................... $ -- $ -- $ 12,821 $ 434 $ 12,821 $ 434
Acquisitions............ 170,120 10,530 16,422 405 186,542 10,935
Principal repayments and
amortization........... (338) (53) (977) (28) (1,315) (81)
-------- ------- --------- ------- ---------- -------
Balance, March 31,
1997................... 169,782 10,477 28,266 811 198,048 11,288
Acquisitions............ 127,500 4,100 349,302 7,624 476,802 11,724
Principal repayments and
amortization........... (6,989) (420) (2,332) (133) (9,321) (553)
Dispositions............ -- -- (98,267) (2,309) (98,267) (2,309)
-------- ------- --------- ------- ---------- -------
Balance, June 30, 1997.. 290,293 14,157 276,969 5,993 567,262 20,150
Acquisitions............ 136,582 2,449 2,202 87 138,784 2,536
Principal repayments and
amortization........... (22,227) (913) (19,291) (383) (41,518) (1,296)
-------- ------- --------- ------- ---------- -------
Balance, September 30,
1997................... 404,648 15,693 259,880 5,697 664,528 21,390
Acquisitions............ 183,012 3,314 280,325 3,048 463,337 6,362
Principal repayments and
amortization........... (28,224) (1,146) (26,095) (363) (54,319) (1,509)
Dispositions............ -- -- (9,263) (177) (9,263) (177)
-------- ------- --------- ------- ---------- -------
Balance, December 31,
1997................... 559,436 17,861 504,847 8,205 1,064,283 26,066
Acquisitions............ 207,976 3,758 270,059 3,806 478,035 7,564
Principal repayments and
amortization........... (27,224) (1,160) (63,892) (731) (91,116) (1,891)
Dispositions............ -- -- (310,113) (5,294) (310,113) (5,294)
-------- ------- --------- ------- ---------- -------
Balance, March 31,
1998................... 740,188 20,459 400,901 5,986 1,141,089 26,445
Acquisitions............ 290,350 5,148 80,237 823 370,587 5,971
Principal repayments and
amortization........... (43,849) (1,506) (47,201) (451) (91,050) (1,957)
Dispositions............ (2,843) (53) -- -- (2,843) (53)
-------- ------- --------- ------- ---------- -------
Balance, June 30, 1998.. 983,846 24,048 433,937 6,358 1,417,783 30,406
Acquisitions............ -- -- -- -- -- --
Principal repayments and
amortization........... (54,745) (1,442) (38,925) (493) (93,670) (1,935)
Dispositions............ (4,666) (56) (7,781) (107) (12,447) (163)
-------- ------- --------- ------- ---------- -------
Balance, September 30,
1998................... $924,435 $22,550 $ 387,231 $ 5,758 $1,311,666 $28,308
======== ======= ========= ======= ========== =======
</TABLE>
45
<PAGE>
TABLE XIV
PREMIUM AS A PERCENT OF PRINCIPAL
<TABLE>
<CAPTION>
TOTAL
MORTGAGE MORTGAGE MORTGAGE
LOANS SECURITIES ASSETS
-------- ---------- --------
<S> <C> <C> <C>
As of:
September 30, 1998......................... 2.44% 1.49% 2.16%
June 30, 1998.............................. 2.44 1.47 2.14
March 31, 1998............................. 2.76 1.49 2.32
December 31, 1997.......................... 3.19 1.63 2.45
September 30, 1997......................... 3.88 2.19 3.22
June 30, 1997.............................. 4.88 2.16 3.55
March 31, 1997............................. 6.17 2.87 5.70
</TABLE>
RESULTS OF OPERATIONS--NINE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO NINE
MONTHS ENDED SEPTEMBER 30, 1997
Net Income
During the nine months ended September 30, 1998, the Company recorded net
income of $5,567,000, a diluted $0.64 per share, compared with a net loss of
$702,000, a diluted $0.19 per share, for the nine months ended September 30,
1997.
Net Interest Income
Interest Income. The Company had average interest-earning assets of $1.3
billion during the nine months ended September 30, 1998, including $781.8
million of mortgage loans and $478.1 million of mortgage securities compared
with average interest-earning assets of $351.6 million during the nine months
ended September 30, 1997. During the nine months ended September 30, 1998,
mortgage loans earned $56.3 million, or a yield of 9.6 percent, compared with
$14.7 million, or a yield of 9.1 percent for the nine months ended September
30, 1997. Mortgage securities earned $22.9 million for the nine months ended
September 30, 1998, or a yield of 6.4 percent, compared with $6.8 million, or a
yield of 6.7 percent for the nine months ended September 30, 1997. In total,
assets earned $79.2 million, or a 8.4 percent yield for the nine months ended
September 30, 1998. During the nine months ended September 30, 1997, assets
earned $21.5 million or an 8.2 percent yield.
A substantial portion of the mortgage assets owned by the Company has
interest rates that fluctuate with short-term market interest rates. However,
many of these assets have initial coupons that are lower than current market
rates ("teaser" rates). Rates on the Company's assets are expected to increase
to their full potential as the assets "season". Table XV is a summary of the
Company's mortgage assets by type, presenting their current and fully indexed
weighted-average coupons.
46
<PAGE>
TABLE XV
MORTGAGE ASSETS BY PRODUCT/TYPE AND WEIGHTED AVERAGE COUPON
SEPTEMBER 30, 1998 (DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
WEIGHTED
AVERAGE COUPON
---------------
OUTSTANDING FULLY
PRODUCT/TYPE PRINCIPAL CURRENT INDEXED
------------ ----------- ------- -------
<S> <C> <C> <C>
Mortgage loans:
Two and three year fixed/adjustable
thereafter............................... $ 521,535 10.15% 10.90%
Fixed rate (30 Yr, 15 Yr, 30/15).......... 301,087 10.02 --
Other (1 year CMT, 6 month LIBOR)......... 101,813 10.19 10.81
----------
Total mortgage loans.................... 924,435
Mortgage securities issued by:
Federal National Mortgage Association..... 259,860 7.04 6.64
Government National Mortgage Association.. 123,211 5.40 6.87
Federal Home Loan Mortgage Corporation.... 4,160 7.54 6.81
----------
Total mortgage securities............... 387,231
----------
Total....................................... $1,311,666
==========
</TABLE>
The Company acquires substantially all of its mortgage assets at a premium.
Premiums are amortized as a reduction of interest income over the estimated
lives of the assets. See Tables XII, XIII and XIV for the dollar impact of
principal payments on amortization. To mitigate the effect of prepayments on
interest income from mortgage loans, the Company generally strives to acquire
mortgage loans that have some form of prepayment penalty. During the nine
months ended September 30, 1998 and the third quarter of 1998, the Company
collected $1.3 million and $625,000, respectively, in prepayment penalties from
borrowers. Table XVI is an analysis of mortgage loans and prepayment penalties.
Prepayments on mortgage loans of the Company have been consistent with
management's expectations.
TABLE XVI
MORTGAGE LOAN PREPAYMENT PENALTIES
SEPTEMBER 30, 1998 (DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
WEIGHTED AVERAGE
-------------------------
REMAINING
PREPAYMENT
PENALTY
PERCENT PERIOD (IN
WITH LOAN- YEARS)--
CURRENT PREPAYMENT TO- LOANS WITH
PRINCIPAL PREMIUM PENALTY COUPON VALUE PENALTY
--------- ------- ---------- ------ ----- ----------
<S> <C> <C> <C> <C> <C> <C>
Loans collateralizing
NovaStar Home Equity
Series (CMO):
1997-1................ $183,760 $ 9,375 70.6% 10.45% 75.02% 1.44
1997-2................ 181,329 3,049 70.8 10.31 78.14 1.77
1998-1................ 286,746 4,306 68.7 9.99 81.04 2.43
1998-2................ 268,312 5,266 69.6 9.90 80.88 3.13
All other loans......... 4,288 554 70.1 9.39 81.96 3.41
-------- -------
Total................... $924,435 $22,550 69.8% 10.11% 79.24% 2.31
======== =======
</TABLE>
As noted above, interest income is a function of volume and rates. Management
will continue to monitor the market for mortgage securities and whole loan
mortgage pools and will acquire mortgage assets that are
47
<PAGE>
appropriate for its overall asset/liability strategy. Increasing the 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 $60.9
million during the nine months ended September 30, 1998, or 6.2 percent of
average borrowings, compared with $16.2 million for the nine months ended
September 30, 1997, or 6.4 percent of average borrowings. Advances under the
warehouse line of credit bear interest based on the Federal Funds rate, plus a
spread. The Company receives credits to warehouse line interest based on
restricted cash balances maintained with First Union. Advances under the master
repurchase agreement bear interest at rates based on LIBOR, plus a spread.
During the nine months ended September 30, 1998 and 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.
Table XVII 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, 1998.
TABLE XVII
INTEREST ANALYSIS
NINE MONTHS ENDED SEPTEMBER 30, 1998 (DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
MORTGAGE LOANS MORTGAGE SECURITIES TOTAL
------------------------ ------------------------ --------------------------
INTEREST ANNUAL INTEREST ANNUAL INTEREST ANNUAL
AVERAGE INCOME/ YIELD/ AVERAGE INCOME/ YIELD/ AVERAGE INCOME/ YIELD/
BALANCE EXPENSE RATE BALANCE EXPENSE RATE BALANCE EXPENSE RATE
-------- -------- ------ -------- -------- ------ ---------- -------- ------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Mortgage Assets......... $781,786 $56,274 9.60% $478,125 $22,881 6.38% $1,259,911 $79,155 8.38%
======== ======== ==========
Liabilities
Repurchase
agreements............ $156,854 7,643 6.50 $511,460 20,785 5.42% $ 668,314 28,428 5.67%
Collateralized
mortgage
obligations........... 626,960 29,659 6.31 626,960 29,659 6.31
Other borrowings....... 20,043 647 4.30 21,492 647 4.01
-------- ----------
Cost of derivative
financial Instruments
hedging liabilities... 1,637 577 2,214
------- ------- -------
Total borrowings..... $803,857 39,586 6.57 $511,460 21,362 5.57 $1,316,766 60,948 6.18
======== ------- ======== ------- ========== -------
Net interest income.... $16,688 $ 1,519 $18,207
======= ======= =======
Net interest spread.... 3.03% 0.81% 2.20%
==== ==== ====
Net yield.............. 2.85% 0.42% 1.93%
==== ==== ====
</TABLE>
Net Interest Income and Spread. Net interest income during the nine months
ended September 30, 1998 was $18.2 million or 1.93 percent of average interest-
earning assets, compared with 5.3 million, or 2.02 percent of average interest-
earning assets during the nine months ended September 30, 1997. Net interest
spread for the Company was 2.20 percent during the nine months ended September
30, 1998 compared with 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. The Company's cost of funds
has remained relatively low and stable during 1998. This lower cost of funds
offsets, to some degree, the lower yield on "teased" assets discussed above.
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. The Company has entered into certain
interest rate agreements and financial futures contracts designed to mitigate
exposure to interest rate risk. Interest rate cap agreements
48
<PAGE>
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. Other agreements executed by the Company include simple fixed to floating
interest rate swaps. These agreements are used to alter, in effect, the
interest rates on funding costs to more closely match the yield on interest-
earning assets. During the nine months ended September 30, 1998, the Company
incurred net interest expense on these agreements of $2.2 million, which is
included as a component of interest expense. The net interest expense for the
same period ending September 30, 1997 was $808,000. Table XVIII details the
Company's interest rate agreements as of September 30, 1998 (dollars in
thousands):
TABLE XVIII
INTEREST RATE AGREEMENTS
AS OF SEPTEMBER 30, 1998 (DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
WEIGHTED AVERAGE
UNREALIZED WEIGHTED INTEREST RATE ACCRUED INTEREST
NOTIONAL ------------- DAYS TO CAP ------------------ ------------------
VALUE GAINS LOSSES MATURITY RATE RECEIVABLE PAYABLE RECEIVABLE PAYABLE
---------- ----- ------- -------- ---- ---------- ------- ---------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Interest rate swap
agreements-- fixed rate
pay.................... $ 455,000 $-- $ 7,845 674 NA 5.64% 6.11% $2,671 $2,736
Interest rate cap
agreements............. 625,000 -- 3,645 710 6.27% NA NA -- --
---------- ---- -------
$1,080,000 $-- $11,490
========== ==== =======
</TABLE>
As discussed in the section, "Events Subsequent to September 30, 1998", the
Company terminated all swap agreements and paid off the liabilities pertaining
to these hedging instruments in October 1998, recognizing losses aggregating
$8.0 million.
FEES FROM NOVASTAR MORTGAGE, INC.
The Company and NovaStar Mortgage are party to a Mortgage Loan Sale and
Purchase Agreement whereby the Company has committed to acquire the wholesale
loan originations of NovaStar Mortgage. Under the terms of the agreement, if
NovaStar Mortgage chooses to sell its loan originations to other parties, it
pays a fee to the Company for not delivering its production under the purchase
commitment. During the first two quarters of 1998, the Company acquired
virtually all of the mortgage loans originated by NovaStar Mortgage. As a
result, there were no significant fees paid to the Company during the first
half of 1998. During the 1998 third quarter, NovaStar Mortgage retained
substantially all of its production with the intent of selling loans to third
parties. Under the terms of the Mortgage Loan Sale and Purchase Agreement,
NovaStar Mortgage remitted fees aggregating $3.8 million to the Company during
the nine months ended September 30, 1998.
OTHER INCOME
The Company may deem it appropriate to sell securities and loans, from time
to time, to reallocate the Company's capital. During the nine months ended
September 30, 1998, the Company recognized $108,000 in net gains on sales of
mortgage securities with a principal balance of $318 million. Also, during this
same period, the company sold two separate pools of loans (principal of $7.5
million) recognizing gains of $315,000.
Additional components of other income during the nine months ended September
30, 1998 are prepayment penalties of $1.3 million and interest earned on notes
receivable from founders of $300,000.
As discussed in "Events Subsequent to September 30, 1998" the Company and
NovaStar Mortgage sold all mortgage securities at an aggregate loss of $15.4
million during October 1998.
49
<PAGE>
PROVISIONS FOR CREDIT LOSSES
The Company provides regular reserves for credit losses, including principal
and interest, on its mortgage loans. Management continuously 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 management. The Company believes that loan defaults occur
throughout the life of a loan or group of loans. As a result, provisions for
credit losses are recorded against income over the estimated life of the loans,
rather than immediately upon acquisition of the loan. During the nine months
ended September 30, 1998, the Company provided $3.4 million for credit losses,
compared with $1.4 million during the nine months ended September 30, 1997.
During the third quarter of 1998, the Company and NovaStar Mortgage executed
an agreement with Commonwealth Mortgage Acceptance Corporation (CMAC) whereby
CMAC will provide insurance coverage on certain mortgage loans owned by the
Company and NovaStar Mortgage. As of September 30, 1998, approximately 29
percent of the loans owned by the Company and substantially all of the loans
owned by NovaStar Mortgage are covered under this agreement. During the third
quarter of 1998, total premiums paid to CMAC totaled $291,000, which are
included as a component of loan servicing expenses on the Company's financial
statements. Management believes that its exposure to credit loss on loans
insured by CMAC is minimal and, therefore, has not included these loans in
determining its loan loss provision. Management expects that a substantial
portion of loans originated in future periods will be covered under similar
insurance arrangements.
The Company charges off a loan when in management's best judgment the loan is
uncollectable. In addition, the Company will charge off a loan to the lower of
cost or market when it takes title of the property collateralizing the loan. As
of September 30, 1998, the Company had 86 loans in real estate owned with a
principal balance of $9.6 million and a carrying value of $7.3 million. Charge-
offs during the nine months ended September 30, 1998 were $3.0 million. The
Company had no charge-offs during the same period of 1997. As the portfolio
continues to season, management expects that the actual loss rate may continue
to increase. Table XIX is a rollforward of the reserve for credit losses during
1998 and 1997.
TABLE XIX
ROLLFORWARD OF RESERVE FOR CREDIT LOSSES
NINE MONTHS ENDED SEPTEMBER 30, 1998 AND YEAR ENDED DECEMBER 31, 1997
<TABLE>
<CAPTION>
1998 1997
------------------------------ -----------------------------------------
SEPTEMBER 30 JUNE 30 MARCH 31 DECEMBER 31 SEPTEMBER 30 JUNE 30 MARCH 31
------------ ------- -------- ----------- ------------ ------- --------
<S> <C> <C> <C> <C> <C> <C> <C>
Beginning balance....... $3,341 $2,871 $2,313 $1,444 $ 718 $170 $--
Provision for credit
losses............... 1,179 1,145 1,076 1,009 726 548 170
Amounts charged off,
net of recoveries.... (1,763) (675) (518) (140) -- -- --
------ ------ ------ ------ ------ ---- ----
Ending Balance.......... $2,757 $3,341 $2,871 $2,313 $1,444 $718 $170
====== ====== ====== ====== ====== ==== ====
</TABLE>
Table XX is a summary of delinquent loans as of September 30, 1998 and 1997
by quarter. Table XXI provides summaries of the Company's delinquencies,
defaults, and loss statistics as of September 30, 1998 and 1997 by quarter.
Other information regarding the credit quality of the Company's mortgage loans
are provided in Tables V, VI and VII.
50
<PAGE>
TABLE XX
LOAN DELINQUENCIES (90 DAYS AND GREATER)
NINE MONTHS ENDED SEPTEMBER 30, 1998 AND YEAR ENDED DECEMBER 31, 1997 (A)
<TABLE>
<CAPTION>
1998 1997
--------------------- -----------------------------
SEPTEMBER JUNE MARCH DECEMBER SEPTEMBER JUNE MARCH
30 30 31 31 30 30 31
--------- ---- ----- -------- --------- ---- -----
<S> <C> <C> <C> <C> <C> <C> <C>
Mortgage loans
collateralizing NovaStar
Home Equity series
(CMO):
1997-1 (Issued October
1, 1997).............. 5.97% 5.86% 4.39% 2.71% -- -- --
1997-2 (Issued December
11, 1997)............. 4.97 4.72 2.23 -- -- -- --
1998-1 (Issued April
30, 1998)............. 2.06 -- -- -- -- -- --
1998-2 (Issued April
30, 1998)............. 0.40 -- -- -- -- -- --
All mortgage loans....... 2.45 2.53 2.28 1.80 1.47% -- --
</TABLE>
- --------
(A) Includes loans in foreclosure or bankruptcy.
TABLE XXI
DELINQUENCIES, DEFAULTS AND LOSSES
SEPTEMBER 30, 1998 (DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
NOVASTAR HOME EQUITY SERIES
--------------------------------------
1997-1 1997-2 1998-1 1998-2 OTHER(A) ALL LOANS
-------- -------- -------- -------- -------- ----------
<S> <C> <C> <C> <C> <C> <C>
Loan servicing
portfolio.............. $187,838 $185,093 $286,891 $267,744 $251,295 $1,178,861
======== ======== ======== ======== ======== ==========
Reserve for Credit
Losses:
Balance, July 1,
1998................. $ 1,446 $ 1,118 $ 585 $ -- $ 192 $ 3,341
Provision for credit
losses............... 179 204 460 270 65 1,179
Amounts charged off,
net of recoveries.... (575) (957) (233) -- 3 (1,763)
-------- -------- -------- -------- -------- ----------
Balance, September 30,
1998................. $ 1,050 $ 365 $ 812 $ 270 $ 260 $ 2,757
-------- -------- -------- -------- -------- ----------
Defaults as a percent of
loan servicing
Portfolio, September 30,
1998:
Delinquent loans...... 3.99% 5.19% 3.05% 2.84% 0.55% 2.95%
======== ======== ======== ======== ======== ==========
Loans in foreclosure.. 4.87 3.57 1.94 0.82 0.14 2.02
======== ======== ======== ======== ======== ==========
Real estate owned..... 2.24 1.99 0.15 -- 0.50 0.81
======== ======== ======== ======== ======== ==========
</TABLE>
<TABLE>
<CAPTION>
1998 1997
----------------------------- -----------------------------------------
SEPTEMBER 30 JUNE 30 MARCH 31 DECEMBER 31 SEPTEMBER 30 JUNE 30 MARCH 31
------------ ------- -------- ----------- ------------ ------- --------
<S> <C> <C> <C> <C> <C> <C> <C>
Total defaults:
Delinquent loans...... 2.95% 1.95% 1.92 1.76% 4.44% 3.09% --
==== ==== ==== ==== ==== ==== ===
Loans in foreclosure.. 2.02 2.28 2.29 2.05 0.47 0.01 --
==== ==== ==== ==== ==== ==== ===
Real estate owned
(%).................. 0.81 0.52 0.24 0.05 -- -- --
==== ==== ==== ==== ==== ==== ===
</TABLE>
- --------
(A) Primarily loans owned by NovaStar Mortgage, Inc.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses for the nine months ended September 30,
1998 and September 30, 1997 are provided in table XXII. Table XXIII displays
the relationship of portfolio expenses to net interest income during the nine
months ended September 30, 1998 and 1997 by quarter.
51
<PAGE>
TABLE XXII
GENERAL AND ADMINISTRATIVE EXPENSES
NINE MONTHS ENDED SEPTEMBER 30, 1998 AND SEPTEMBER 30, 1997 (DOLLARS IN
THOUSANDS)
<TABLE>
<CAPTION>
NINE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, 1998 SEPTEMBER 30, 1997
-------------------- -------------------
PERCENT OF PERCENT OF
NET INTEREST NET INTEREST
INCOME INCOME
------------ ------------
<S> <C> <C> <C> <C>
Loan servicing....................... $ 3,163 27.5% $ 701 13.2%
Compensation and benefits............ 1,374 11.9 694 13.0
Professional and outside services.... 649 5.6 430 8.1
Office administration................ 681 5.9 201 3.8
Other................................ 184 1.6 288 5.4
------- ---- ------ ----
Total portfolio-related expenses..... 6,051 52.6% 2,314 43.5%
==== ====
Forgiveness of notes receivable from
founders............................ 812
Administrative services provided by
NovaStar Mortgage................... 5,700 2,450
------- ------
Total.............................. $12,563 $4,764
======= ======
</TABLE>
TABLE XXIII
PORTFOLIO RELATED EXPENSES AS A
PERCENT OF NET INTEREST INCOME
NINE MONTHS ENDED SEPTEMBER 30, 1998 (DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
PERCENT OF NET
INTEREST INCOME
---------------
<S> <C>
1998:
Third quarter............................................. 38.6%
Second quarter............................................ 33.6
First quarter............................................. 26.3
1997:
Fourth quarter............................................ 65.9
Third quarter............................................. 36.3
Second quarter............................................ 62.1
First quarter............................................. 42.0
</TABLE>
The monthly administrative service fee paid by the Company to NovaStar
Mortgage represents compensation for certain services, including the
development of loan products, underwriting, funding, and quality control. The
increase in this fee for the nine months ended September 30, 1998 compared with
September 30, 1997 is primarily a result of an increase in the extent of
services required.
Compensation and benefits include employee base salaries, benefit costs and
incentive bonus awards. The increase in compensation and benefits for the nine
months ended September 30, 1998 compared with the nine months ended September
30, 1997 is due to adding portfolio, accounting and finance management staff
throughout 1997 and 1998. In addition, during the first nine months of 1998 the
Company recognized $812,000 of expense for the anticipated forgiveness of a
second tranche of founders' debt, as mentioned earlier in the Forgivable Notes
Receivable from Founders section of this document. No debt forgiveness was
recognized during the same period of 1997.
Loan servicing consists of direct costs associated with the mortgage loan
servicing operation. The fee the Company pays for servicing its mortgage loan
portfolio is based on volume as well as number of delinquencies and
foreclosures. During the first six months of 1997, the Company contracted the
servicing of its mortgage
52
<PAGE>
portfolio with an independent third party. Beginning July 15, 1997, NovaStar
Mortgage began servicing the Company's mortgage loan portfolio. The increase in
loan servicing during the nine months ended September 30, 1998 compared with
September 30, 1997 is primarily due to the significant growth in the Company's
mortgage loan portfolio during the period ended September 30, 1998 compared
with September 30, 1997.
Professional and outside services include fees for legal and accounting
services. In the normal course of business, the Company incurs fees for
professional services related to general corporate matters and specific
transactions. Office administration includes items such as rent, depreciation,
telephone, office supplies, postage, delivery, maintenance and repairs. The
increases in both these financial statement captions can be attributable to
additional personnel and the general growth of the Company.
EQUITY IN EARNINGS (LOSS) OF NFI HOLDING CORPORATION
For the nine months ended September 30, 1998, NFI Holding Corporation
(Holding) recorded a net loss of $2.48 million compared with a net loss of
$143,000 for the nine months ended September 30, 1997. The Company records its
portion of these losses as equity in net loss of Holding in its income
statement, which includes the net loss of its affiliates--NovaStar Mortgage and
NovaStar Capital, Inc. Net income generated by Holding is primarily a function
of the fees earned by NovaStar Mortgage relating to the origination and
servicing of loans for the Company and the costs of these activities. As the
Company did not purchase any of NovaStar Mortgage's production during the third
quarter of 1998, NovaStar Mortgage incurred significant losses during this
period. These losses were offset to a degree by net gains on sales of $1.0
million on $25 million of mortgage loan production. General and administrative
expenses consist largely of compensation and benefits for the marketing,
underwriting, funding and servicing staffs. NovaStar Mortgage incurs
significant general and administrative expenses in generating loan production
and servicing loans and will vary, as a general rule, with loan production. Net
losses incurred by NovaStar Capital, Inc. were $162,000 during the nine months
ended September 30, 1998 as this company started operations during the third
quarter of 1998.
Tables XXIV and XXV are summary financial statements for NFI Holding
Corporation as of and for the nine months ended September 30, 1998. Table XXVI
is a summary of loan costs for NovaStar Mortgage relative to its wholesale loan
originations.
TABLE XXIV
NFI HOLDING CORPORATION--BALANCE SHEET
SEPTEMBER 30, 1998 (DOLLARS IN THOUSANDS)
<TABLE>
<S> <C>
ASSETS
Restricted cash............................................... $ 18,997
Mortgage loans................................................ 238,207
Mortgage securities........................................... 8,686
Other assets.................................................. 5,186
--------
Total assets................................................ $271,076
========
LIABILITIES AND STOCKHOLDERS' EQUITY
Securities under repurchase agreements........................ $ 8,559
Due to NovaStar Financial, Inc................................ 259,312
Other liabilities............................................. 3,614
--------
Total liabilities............................................. 271,485
Stockholders' equity.......................................... (409)
--------
Total liabilities and stockholders' equity.................. $271,076
========
</TABLE>
53
<PAGE>
TABLE XXV
NFI HOLDING CORPORATION--STATEMENT OF OPERATIONS
NINE MONTHS ENDED SEPTEMBER 30, 1998 (DOLLARS IN THOUSANDS)
<TABLE>
<S> <C>
Net interest income............................................. $ 1,730
Services provided to NovaStar Financial, Inc.................... 6,031
Fees from third parties......................................... 879
Gains on sale of mortgage assets................................ 1,209
Expenses:
Production.................................................... 6,189
Servicing..................................................... 2,170
Other......................................................... 3,970
-------
Net loss........................................................ $(2,480)
=======
</TABLE>
TABLE XXVI
COST OF LOAN PRODUCTION--NOVASTAR MORTGAGE, INC.
NINE MONTHS ENDED SEPTEMBER 30, 1998 AND YEAR ENDED DECEMBER 31, 1997 (DOLLARS
IN THOUSANDS)
<TABLE>
<CAPTION>
1998 1997
---------------------------- ------------------------------------
THIRD SECOND FIRST FOURTH THIRD SECOND FIRST
QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER
-------- -------- -------- -------- -------- ------- -------
<S> <C> <C> <C> <C> <C> <C> <C>
Total costs of loan
production(A).......... $ 4,975 $ 3,837 $ 3,079 $ 2,096 $ 1,938 $ 1,401 $ 410
Wholesale loan
origination--
principal.............. 232,333 294,303 207,974 183,012 136,582 77,692 12,688
Premium paid to broker.. 3,322 3,679 2,935 2,896 2,119 1,618 295
-------- -------- -------- -------- -------- ------- -------
Total acquisition
cost(B)................ $240,630 $301,819 $213,988 $188,004 $140,639 $80,711 $13,393
======== ======== ======== ======== ======== ======= =======
Costs as a percent of
principal:
Loan production....... 2.1% 1.3% 1.5% 1.1% 1.4% 1.8% 3.2%
======== ======== ======== ======== ======== ======= =======
Premium paid to
broker............... 1.4% 1.3% 1.4% 1.6% 1.6% 2.1% 2.3%
======== ======== ======== ======== ======== ======= =======
Total acquisition
cost................. 3.6% 2.6% 2.9% 2.7% 3.0% 3.9% 5.6%
======== ======== ======== ======== ======== ======= =======
</TABLE>
- --------
(A) Loan production general and administrative as reported for GAAP, plus net
deferred loan costs.
(B) Principal, premium and general administrative expenses associated with loan
production.
VALUE OF MORTGAGES ADDED THROUGH WHOLESALE OPERATIONS
By establishing a wholesale lending operation to originate subprime
residential mortgage loans, NovaStar has developed a process to add mortgage
assets to its balance sheet at amounts management believes are below what it
would generally cost, in most market environments, to acquire the same assets
in bulk through open market purchases. In effect, the value created by
generating assets at this lower cost is creating future economic benefit, or
value, for our stockholders. This added value is demonstrated in the estimated
fair value of our loan portfolio. The values presented in tables XXVII and
XXVIII are management's estimates based on market conditions as of September
30, 1998. As discussed in "Events Subsequent to September 30, 1998," market
conditions changed during October 1998. The change in market conditions has,
among other things, caused supply of to be greater than demand for subprime
mortgage loans. As a result, the prices reflected below may not be indicative
of market prices subsequent to September 30, 1998.
54
<PAGE>
Table XXVII provides management's estimates of the value of the mortgage
loans in its portfolio, given the assumptions presented. Because any estimated
value assigned can vary dramatically based upon the assumptions used, the
Company has presented a range of assumptions to allow readers to apply their
own judgment in determining an estimated value. The Company estimates the
weighted-average value of its mortgage loan portfolio as of September 30, 1998
to be between 103 and 104 (in terms of price to par).
As presented in Table XXVI, during 1998, NovaStar originated mortgage loans
at an all-in cost of 103.6 percent of principal, including direct costs of
acquisition, such as broker premiums, and general overhead expenses. This cost
is higher than in recent quarters. However, NovaStar Mortgages operated during
the third quarter at less than full capacity. If NovaStar Mortgage had operated
at or near full capacity, the all-in cost would be similar to prior quarters.
Direct costs of acquisition are capitalized as premium and amortized as an
adjustment of yield over the life of the loan.
The weighted-average premium on mortgage loans outstanding at September 30,
1998 represented 2.44 percent of principal. Using the estimated market values
from above, this implies an estimated unrealized gain (or additional value) in
the Company's mortgage loan portfolio at September 30, 1998 of between 1.0 and
2.0
percent. Applying this percent to the balance of mortgage loans outstanding of
$1.2 billion results in an estimated unrealized gain of between $12 and $24
million. This additional value results in an estimated mark-to-market equity of
between $122 and $134 million, or $15 per outstanding share.
TABLE XXVII
ESTIMATED MARKET PRICE ON ENTIRE LOAN PORTFOLIO
AS OF SEPTEMBER 30, 1998
<TABLE>
<CAPTION>
ESTIMATED MARKET PRICE ESTIMATED MARKET PRICE
------------------------- -------------------------
TWO- AND THREE-YEAR SIX-MONTH LIBOR LOAN
FIXED LOAN PRODUCTS PRODUCTS
------------------------- -------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Bond Equivalent Yield... 8.25% 8.50% 8.75% Bond Equivalent Yield.. 9.00% 9.25% 9.50%
Spread to Index......... 3.00% 3.25% 3.50% Spread to Index........ 3.75% 4.00% 4.25%
Assumed Prepayment Assumed Prepayment
Speed (CPR) Speed (CPR)
30...................... 105.6% 105.0% 104.4% 35..................... 104.6% 104.1% 103.6%
35...................... 104.7% 104.2% 103.7% 40..................... 104.4% 103.5% 103.1%
40...................... 104.0% 103.6% 103.2% 45..................... 103.4% 102.9% 102.5%
<CAPTION>
30/15-YEAR FIXED AND
ONE-YEAR CMT LOAN BALLOON LOAN PRODUCTS
PRODUCTS (THREE-YEAR TREASURY)
------------------------- -------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Bond Equivalent Yield... 7.64% 7.89% 8.14% Bond Equivalent Yield.. 7.75% 8.00% 8.25%
Spread to Index......... 3.25% 3.50% 3.75% Spread to Index........ 3.50% 3.75% 4.00%
Assumed Prepayment Assumed Prepayment
Speed (CPR) Speed (CPR)
30...................... 104.9% 104.3% 103.7% 25..................... 106.3% 105.6% 104.9%
35...................... 104.1% 103.6% 103.2% 30..................... 105.4% 104.9% 104.3%
40...................... 103.6% 103.2% 102.7% 35..................... 104.7% 104.2% 103.7%
</TABLE>
55
<PAGE>
TABLE XXVIII
CARRYING VALUE OF LOANS BY PRODUCT/TYPE
AS OF SEPTEMBER 30, 1998 (IN THOUSANDS)
<TABLE>
<CAPTION>
PRODUCT/TYPE AMOUNT
------------ --------
<S> <C>
Two- and three-year fixed....................................... $521,535
Six-month LIBOR................................................. 61,342
One-year CMT.................................................... 40,471
30/15-year fixed and balloon.................................... 301,087
--------
Outstanding principal......................................... 924,435
Premium......................................................... 22,550
Reserve for credit losses....................................... (2,757)
--------
Carrying Value................................................ $944,228
========
Carrying value as a percent of principal........................ 102.4%
========
</TABLE>
RESULTS OF OPERATIONS--YEAR ENDED DECEMBER 31, 1997
Net Loss
During 1997, the Company recorded a net loss of $1,135,000, or $0.26 per
share. Excluding the forgiveness of the notes receivable from founders, the
Company incurred a loss of $52,000, or $0.01 per share. During much of 1997,
the Company focused on the hiring of key employees and the development of
policies and procedures. The results for the year ended December 31, 1997 also
reflect the significant cost of developing operations.
Net Interest Income
Table XXIX presents a summary of the average interest-earning assets, average
interest-bearing liabilities and the related yields and rates thereon for the
year ended December 31, 1997.
TABLE XXIX
INTEREST ANALYSIS
YEAR ENDED DECEMBER 31, 1997 (DOLLAR AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
MORTGAGE LOANS MORTGAGE SECURITIES
------------------------ ------------------------
INTEREST ANNUAL INTEREST ANNUAL
AVERAGE INCOME/ YIELD/ AVERAGE INCOME/ YIELD/
BALANCE EXPENSE RATE BALANCE EXPENSE RATE
-------- -------- ------ -------- -------- ------
<S> <C> <C> <C> <C> <C> <C>
Mortgage Assets.............. $294,111 $25,154 8.56% $182,140 $11,807 6.48%
======== ========
Liabilities
Master repurchase
agreement................. $170,344 11,972 7.03 -- -- --
Other repurchase
agreements................ 172,829 10,336 5.98
Collateralized mortgage
obligations............... 74,511 4,736 6.36 -- -- --
Other borrowings........... 18,402 1,141 6.20 -- -- --
-------- ------- -------- -------
Total borrowings......... $263,257 17,849 6.49 $172,829 10,336 5.98
======== ------- ======== -------
Net interest income.......... $ 7,305 $ 1,471
======= =======
Net interest spread.......... 2.07% 0.50%
==== ====
Net yield.................... 2.48% 0.81%
==== ====
</TABLE>
Interest Income. The Company had average interest-earning assets of $476.3
million during 1997, including $294.1 million of mortgage loans and $182.1
million of mortgage securities. During the year,
56
<PAGE>
mortgage loans earned $25.2 million, or a yield of 8.6 percent, while mortgage
securities earned $11.8 million, or a yield of 6.5 percent. In total, assets
earned $37.0 million, or a 7.8 percent yield.
Interest Expense. The cost of borrowed funds for the Company was $28.2
million during the year ended December 31, 1997, or 6.5 percent of average
borrowings. During the year ended December 31, 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.
Net Interest Income and Spread. Net interest income during 1997 was $8.8
million, or 1.8 percent of average interest-earning assets. Net interest spread
for the Company was 1.3 percent during the year ended December 31, 1997. Net
interest income and the spread are functions of the yield of the Company's
assets relative to its costs of funds. During 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 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. As of December 31, 1997, the Company had
interest rate cap agreements, with a combined notional amount of $270 million
and interest rate swap agreements with an aggregate notional amount of $276
million. During 1997, the Company incurred net interest expense on these
agreements of $1.0 million, which is included as a component of interest
expense.
Other Income
During the year ended December 31, 1997, the Company recognized $51,000 in
net gains on sales of mortgage securities with a principal balance of $107,530.
The Company did not sell any of its mortgage loan portfolio during this same
period of 1997. Prepayment penalty income and interest earned on notes
receivable from founders during the year ended December 31, 1997 was $425,000
and $195,000, respectively.
Provisions for Credit Losses
During the year ended December 31, 1997, the Company provided $2.5 million
for credit losses while credit losses for this same period of 1997 were
$140,000. As mentioned earlier, reserves are maintained for losses management
expects to incur on the loans in the portfolio.
General and Administrative Expenses
General and administrative expenses for the year ended December 31, 1997 are
provided in Table XXX.
TABLE XXX
GENERAL AND ADMINISTRATIVE EXPENSES
YEAR ENDED DECEMBER 31, 1997 (DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
PERCENT OF
NET INTEREST
INCOME
------------
<S> <C> <C>
Loan servicing...................................... $1,246 14.2%
Compensation and benefits........................... 839 9.6%
Professional and outside services................... 676 7.7%
Office administration............................... 299 3.4%
Other............................................... 448 5.1%
------ ----
Total portfolio-related expenses.................... 3,508 40.0%
====
Forgiveness of notes receivable from founders....... 1,083
Administrative services provided by NovaStar
Mortgage........................................... 3,650
------
Total............................................. $8,241
======
</TABLE>
57
<PAGE>
Administrative services provided by NovaStar Mortgage during the year ended
December 31, 1997 totaled $3,650,000. Compensation and benefits totaled
$839,000 during the year ended 1997. The number of employees and the related
compensation costs increased throughout 1997 as the Company continued to hire
staff.
Loan servicing costs were $1.2 million for the year ended December 31, 1997.
Loan servicing consists of direct costs associated with the mortgage loan
servicing operation, which the Company outsourced until July 15, 1997. These
costs will vary depending on overall volume of loans and the number of
delinquencies and foreclosures.
Professional and outside services include contract labor as well as fees for
legal and accounting services. Management used contract labor services fairly
extensively during 1997, particularly in the area of systems development.
During the year ended December 31, 1997, these expenses totaled $676,000.
Office administration during the twelve months ended December 31, 1997 were
$299,000. Certain of these items were necessarily high during the start up
phase of the Company. However, management expects many of these expenses to
continue to increase relative to increasing personnel.
EARNINGS OF NFI HOLDING CORPORATION
For the year ended December 31, 1997, Holding recorded net income of $28,000,
of which the Company recorded its portion $28,000. Tables XXXI and XXXII are
summary financial statements for NFI Holding Corporation as of and for the year
ended December 31, 1997.
TABLE XXXI
NFI HOLDING CORPORATION--BALANCE SHEET
DECEMBER 31, 1997 (DOLLARS IN THOUSANDS)
<TABLE>
<S> <C>
Assets
Mortgage securities............................................ $55,195
Other assets................................................... 1,675
-------
Total assets................................................. $56,870
=======
Liabilities and stockholders' equity
Securities under repurchase agreements......................... $53,490
Other liabilities.............................................. 1,192
-------
Total liabilities.............................................. 54,682
Stockholders' equity........................................... 2,188
-------
Total liabilities and stockholders' equity................... $56,870
=======
</TABLE>
TABLE XXXII
NFI HOLDING CORPORATION--STATEMENT OF OPERATIONS
YEAR ENDED DECEMBER 31, 1997 (DOLLARS IN THOUSANDS)
<TABLE>
<S> <C>
Net interest income............................................... $ 191
Services provided to NovaStar Financial, Inc...................... 4,155
Fees from third parties........................................... 581
Gains on sale of mortgage assets.................................. 690
Expenses:
Production...................................................... 2,953
Other........................................................... 2,024
Servicing....................................................... 612
------
Net income........................................................ $ 28
======
</TABLE>
58
<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 are based on taxable income. Table XXXIII is a summary of the differences
between the Company's net income or loss reported for GAAP the three month
period ended September 30, 1998 and 1997 by quarter and its taxable income.
TABLE XXXIII
TAXABLE INCOME (LOSS)
NINE MONTHS ENDED SEPTEMBER 30, 1998 AND YEAR ENDED DECEMBER 31, 1997 (IN
THOUSANDS)
<TABLE>
<CAPTION>
1998 1997
------------------------- ---------------------------------
THIRD SECOND FIRST FOURTH THIRD SECOND FIRST
QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER QUARTER
------- ------- ------- ------- ------- ------- -------
<S> <C> <C> <C> <C> <C> <C> <C>
Net income (loss)....... $ 2,394 $1,894 $1,279 $ (433) $ 177 $(1,073) $194
Results of Holding and
subsidiary............. 2,447 -- 273 (169) (393) 126 408
Provision for credit
losses................. 1,179 1,145 1,076 1,009 726 547 171
Loans charged-off....... (1,762) (675) (518) (140) -- -- --
Other, net.............. 95 208 (4) 296 (4) (8) --
------- ------ ------ ------ ----- ------- ----
Taxable income
(loss)............... $ 4,353 $2,572 $2,106 $ 563 $ 506 $ (408) $773
======= ====== ====== ====== ===== ======= ====
</TABLE>
As discussed under "Events Subsequent to September 30, 1998," the Company
executed several transactions during October 1998 that included the sale of
assets and termination of hedging arrangements. Management anticipates the
significant losses resulting from these transactions will eliminate taxable
income for 1998.
Interest rate sensitivity. 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. Table XXXIV details the
Company's Interest Rate Sensitivity as of September 30, 1998 compared with
December 31, 1997.
TABLE XXXIV
INTEREST RATE SENSITIVITY
SEPTEMBER 30, 1998 AND DECEMBER 31, 1997
<TABLE>
<CAPTION>
BASIS POINT INCREASE (DECREASE)
IN INTEREST RATE(C)
---------------------------------
AS OF SEPTEMBER 30, 1998(A)(B) (100) BASE(D) 100
------------------------------ ---------- ---------- ----------
<S> <C> <C> <C>
Market value of:
Assets............................. $1,715,188 $1,703,308 $1,687,861
Liabilities........................ 1,594,020 1,593,078 1,592,136
Interest rate agreements........... 69 571 2,977
---------- ---------- ----------
Net market value..................... $ 121,237 $ 110,801 $ 98,702
========== ========== ==========
Cumulative change in value(D)........ $ 10,436 -- $ (12,099)
========== ========== ==========
Percent change from base assets(E)... 0.83% -- (0.95)%
========== ========== ==========
Percent change of capital(F)......... 9.50% -- (11.01)%
========== ========== ==========
</TABLE>
- --------
(A) Management analyzes the interest sensitivity of the Company and NovaStar
Mortgage on a combined basis. The assets and liabilities of NovaStar
Mortgage consist primarily of mortgage loans with a carrying value of
$238,207 and securities with a current face of $8.5 million and their
related repurchase agreement financing.
59
<PAGE>
(B) Reflects the sale of all securities and all swap terminations made in
October 1998.
(C) Value of asset, liability or interest rate agreement in a parallel shift in
the yield curve, up and down 1%.
(D) Total change in estimated market value, in dollars, from "base." "Base" is
the estimated market value at October 15, 1998.
(E) Total change in estimated market value, as a percent, from base.
(F) Total change in estimated market value as a percent of total stockholders'
equity at September 30, 1998.
<TABLE>
<CAPTION>
BASIS POINT INCREASE (DECREASE)
IN INTEREST RATE(B)
----------------------------------
AS OF DECEMBER 31, 1997(A) (100) BASE(D) 100
-------------------------- ---------- ---------- ----------
<S> <C> <C> <C>
Market value of:
Assets.................. $1,222,869 $1,211,591 $1,194,896
Liabilities............. 1,066,611 1,064,944 1,063,290
Interest rate
agreements............. (6,517) (178) 8,268
---------- ---------- ----------
Net market value.......... $ 151,406 $ 148,134 $ 141,539
========== ========== ==========
Cumulative change in
value(C)................. $ 3,272 -- $ (6,595)
========== ========== ==========
Percent change from base
assets(D)................ 0.27% -- (0.54)%
========== ========== ==========
Percent change of
capital(E)............... 2.81% -- (5.66)%
========== ========== ==========
</TABLE>
- --------
(A) Management analyzes the interest sensitivity of the Company and NovaStar
Mortgage on a combined basis. The assets and liabilities of NovaStar
Mortgage consist primarily of mortgage loans with a carrying value of
$238,207 and securities with a current face of $8.5 million and their
related repurchase agreement financing.
(B) Value of asset, liability or interest rate agreement in a parallel shift in
the yield curve, up and down 1%.
(C) Total change in estimated market value, in dollars, from "base." "Base" is
the estimated market value at December 31, 1997.
(D) Total change in estimated market value, as a percent, from base.
(E) Total change in estimated market value as a percent of total stockholders'
equity at December 31, 1997.
Interest Rate Sensitivity Analysis. 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, 1998. 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%) 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% 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.
Sensitivity as of September 30, 1998 and December 31, 1997. As shown in the
table above, if interest rates were to decrease one percent (-100 basis
points), the value of the Company's capital would increase by an estimated 9.50
percent and 2.81% as of September 30, 1998 and December 31, 1997, respectively.
If interest rates rise by one percent (+100 basis points), the value of the
Company's capital would decrease by an estimated 11.01 percent and 5.66 percent
as of September 30, 1998 and December 31, 1997, respectively.
Capital Allocation Guidelines (CAG). The Company's goal is to strike a
balance between the under-utilization of leverage, which reduces returns to
stockholders, and the over-utilization of leverage, which could reduce the
Company's ability to meet its obligations during adverse market conditions. The
Company's CAG have been approved by the Board of Directors. The CAG are
intended to keep the Company properly leveraged by (i) matching the amount of
leverage allowed to the riskiness (return and liquidity) of an asset and (ii)
monitoring the credit and prepayment performance of each investment to adjust
the required capital. This analysis takes into account the Company's various
hedges and other risk programs discussed below. In this way, the use of balance
sheet leverage will be controlled. Following presents a summary of the
Company's CAG for the following levels of capital for the types of assets it
owns.
60
<PAGE>
TABLE XXXV
CAPITAL ALLOCATION GUIDELINES
SEPTEMBER 30, 1998
<TABLE>
<CAPTION>
(A) (B) (C) (D) (E) (F) (F)
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
GNMA Fixed Rates...... 3.00 5.00 50 -- 50 2.50 5.50
Corporate Bonds....... 10.00 3.50 225 25 250 8.75 18.75
Mortgage loans:
Collateral for
warehouse financing.. 2.00 3.00 100 50 150 4.50 7.50
Collateral for CMO.... 5.80 -- -- -- -- -- 5.80
Delinquent............ 100.00 -- -- -- -- -- 100.00
Hedging................. -- -- -- -- -- -- 5.80
Other................... 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 the lender 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.
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.
Table XXXVI is a summary of the capital allocation for NovaStar as they apply
to the Company's mortgage assets and hedging instruments during 1998 and 1997.
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TABLE XXXVI
REQUIRED EQUITY
<TABLE>
<CAPTION>
1998 1997
------------------------------- -----------------------------------------
CATEGORY SEPTEMBER 30 JUNE 30 MARCH 31 DECEMBER 31 SEPTEMBER 30 JUNE 30 MARCH 31
- -------- ------------ -------- -------- ----------- ------------ ------- --------
<S> <C> <C> <C> <C> <C> <C> <C>
Mortgage loans:
Current............... $ 14,567 $ 21,566 $ 23,628 $ 6,675 $33,832 $22,780 $15,958
Delinquent............ 452 601 1,200 1,600 2,376
Securitized loans..... 55,822 37,766 23,478 22,500
Mortgage securities..... 19,514 24,904 27,426 36,170 12,763 13,549 1,646
Other assets............ 20,682 13,782 10,733 -- -- -- --
Hedging instruments..... (688) (232) (203) 5,500 427 1,787 2,804
-------- -------- -------- -------- ------- ------- -------
Required equity......... 110,349 98,387 86,262 72,445 49,398 38,116 20,408
Stockholders' equity.... 109,848 114,875 115,798 116,489 47,036 46,337 46,202
Market value in excess
of the carrying value
of assets and
hedges(A).............. 2,331 31,999 20,685 -- -- -- --
-------- -------- -------- -------- ------- ------- -------
Excess equity........... $ 1,830 $ 48,487 $ 50,221 $ 44,044 $(2,362) $ 8,221 $25,794
======== ======== ======== ======== ======= ======= =======
</TABLE>
- --------
(A) The Company revised its CAG model during the first quarter of 1998 to
include the market value in excess of the carrying value of assets and
hedges as the Company has the ability to borrow against this residual.
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 based upon the
Company's taxable income. In each case, the Company's activities and balance
sheet are measured with reference to historical cost or fair market value
without considering inflation.
IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
Note 1 to the consolidated financial statements of the Annual Report to
Shareholders and Annual Report on Form 10-K for the year ended December 31,
1997 describes certain recently issued accounting pronouncements. Management
believes the implementation of these pronouncements and others that have gone
into effect since the date of these reports, will not have a material impact on
the consolidated financial statements.
During June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 133, Accounting for Derivative
Instruments and Hedging Activities (SFAS No. 133). SFAS No. 133 requires that
entities recognize all derivatives as either assets or liabilities in the
statement of financial position and measure those instruments at fair value.
Derivatives meeting certain conditions may be designated as hedging
instruments, for which SFAS No. 133 prescribes accounting treatment, depending
on the type of hedge. For those derivatives not designated as a hedging
instrument, the gain or loss is recognized in earnings in the period of change.
For the Company, SFAS No. 133 must be applied not later than for the fiscal
year beginning January 1, 2000. Management is currently evaluating the impact
of SFAS No. 133 to the company's financial statements.
Statement of Financial Accounting Standards No. 134, Accounting for Mortgage-
Backed Securities Retained after the Securitization of Mortgage Loans Held for
Sale by a Mortgage Banking Enterprise was issued by the FASB during October
1998. SFAS No. 134 amends SFAS No. 65 and 115, and requires entities to
classify retained mortgage-backed securities after the securitization of
mortgage loans held for sale in
62
<PAGE>
accordance with SFAS No. 115. However, a mortgage banking enterprise must
classify as trading retained mortgage-backed securities that it commits to
sell before or during the securitization process. This statement is effective
for the first fiscal quarter beginning after December 15, 1998. Management
does not expect the adoption of this standard to have a material impact on the
Company's financial position and results of operations.
THE YEAR 2000
The Company is highly dependent on purchased and leased computer software to
conduct business. In addition, the Company is highly dependent on computer
software used by market counterparties and vendors, including banks, in
conducting business. The Company recognizes that some computer software may
not have the ability to correctly identify dates beyond December 31, 1999. The
Company's successful modification of computer software, or the vendors'
successful modification of their programs, to be year 2000 compliant is
critical to the Company's viability.
NovaStar uses three major, and a number of smaller, internal automation
solutions to conduct its business operations. The three computer systems
considered the most significant to the Company's operations are as follows:
. The internally developed loan origination and database system
. The externally provided loan servicing system
. The purchased accounting system
In addition, the Company integrates with a number of outside entities in our
normal business transactions. Interfaces with other businesses and third party
solution providers are used to conduct some of our business processes. Certain
other processes are supported by systems created internally.
NovaStar is using the Federal Financial Institutions Examination Council's
(FFIEC) "Year 2000 Project Management Awareness" document to guide our year
2000 readiness effort. Each program/system interface used by the Company is
being reviewed and tested for year 2000 compliance. The FFIEC guide calls for
a three-phase approach to assess year 2000 compliance.
In the Assessment Phase, the Company has determined which business
processes/interfaces rely on dates and date arithmetic. Most of the Company's
business processes/interfaces rely on dates and date arithmetic. These
business processes/interfaces are being tested internally for compliance. The
Company has asked its market counterparties and vendors to document that they
have assessed software for year 2000 compliance.
Solution updates to non-compliant Year 2000 software should be made in the
Correction Phase. Corrections on Company developed software will be made
internally and are expected to be insignificant. The Company is requiring all
market counterparties and vendors to document they have made all corrections.
The Company will conduct "mock" business as if it is in the year 2000 during
the Validation Phase. During this phase, the Company will test all internally
developed software as well as vendor software.
NovaStar has contacted all of its significant outside market counterparties
and vendors to obtain documentation regarding their process and status for
assuring year 2000 compliance. The Company has asked that each party adhere to
the same FFIEC guidelines and to provide documents of progress during each
phase. Recent status reports have been received from Alltel Residential
Lending Solutions (vendor of the Company's servicing system) and Baan/CODA
(vendor of the Company's accounting system) and are as follows:
. Alltel, vendor of the servicing platform expects to complete testing by
December 31, 1998 and maintains they will be fully year 2000 compliant by
the first quarter of 1999.
. Baan/CODA, vendor of the accounting system has provided the Company
written confirmation that the version the Company currently uses is fully
year 2000 compliant.
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<PAGE>
All internally developed software was designed to be year 2000 compliant. In
addition, the Company has contacted its significant financial counterparty,
First Union National Bank, who is completing their internal review of year 2000
compliance.
The Company believes that its greatest risk in regards to year 2000
compliance is the software and systems used to service its subprime mortgage
loans. NovaStar Mortgage, Inc., an affiliate of the Company, services the
Company's loans. NovaStar Mortgage uses systems developed by Alltel for loan
servicing. If these systems fail, NovaStar Mortgage will not be able to
continue on a manual basis. In this worst case scenario, loans would not be
serviced until the failed system could be remedied. If the loans go
"unserviced" for an extended period of time--several weeks--the result could
have a material adverse impact on the Company.
The Company is also at significant risk in the event the systems of financial
institutions, on which the Company is relying for financing and cash
management, fail. In a worst case scenario, the Company and NovaStar Mortgage
may not be able to meet financial obligations during the period of failure--an
unknown timeframe. The result could have a material adverse impact on the
Company.
The Company is exposed to smaller risks in the event other systems, including
those developed internally, fail to perform beyond December 31, 1999. However,
management believes functions, other than servicing, can be maintained on a
manual basis should systems fail. Although processing and performance would be
slow, risk of material adverse impact to the Company for these systems failures
is expected to be minimal.
Management expects, through the completion of its year 2000 plan, the
likelihood of a material business disruption is not significant. The major
risks presented above involve year 2000 remediation efforts of third party
vendors used by the Company. Based on the information provided, the Company
believes these vendors will meet their obligation for resolution of year 2000
issues.
The Company estimates it has incurred less than $75,000 in costs to date in
carrying out its year 2000 compliance plan and estimates it will spend less
than $100,000 in completing the plan. However, the costs could increase
dramatically if the Company determines that any market counterparty will not be
year 2000 compliant.
The Company has not developed formal contingency plans to be used in the
event any of its hardware, software or other computerized systems, or those of
a vendor, are not ready for the year 2000. A full contingency plan will be
developed prior to March 31, 1999.
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<PAGE>
BUSINESS
Generally, we acquire and manage a portfolio of mortgage loans, primarily
subprime, and mortgage securities. Through June 30, 1998, a substantial portion
of the loans we acquired was originated by our affiliate, NovaStar Mortgage,
Inc. Mortgage securities were acquired in the open marketplace. As our capital
was depleted and liquidity tightened, we ceased acquiring mortgage assets and
sold certain of our mortgage assets as discussed in "Recent Developments" in
the prospectus summary.
NovaStar Mortgage continues to originate loans for sale to third parties and
we consider that function integral to our business. As additional capital is
raised, we expect to resume acquiring mortgage loans originated by NovaStar
Mortgage. We continue to own and manage a portfolio of mortgage loans that are,
substantially, financed with long-term, non-recourse asset-backed bonds.
Following are summaries of the lending operation and our portfolio management
strategy.
MORTGAGE LENDING OPERATION
Market Overview
During 1997, total mortgage loan originations were approximately $875
billion. Approximately 90 percent of these loans were classified as "prime"
mortgages which generally means they have credit quality and documentation
sufficient to qualify for a guarantee by GNMA, FNMA or FHLMC. More than $100
billion of the total loans originated in 1997 were classified as "subprime."
Overall loan origination volume in 1998 is expected to be similar to the volume
in 1997.
We believe 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 1997. While
the prime market experienced a decline in originations due primarily to an
increase in interest rates, loan originations in the subprime market continued
to grow.
The size of the subprime mortgage loan market in 1997 was approximately $100
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, our management 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.
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<PAGE>
Management 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.
Management expects more competitors to attempt to enter the market. While
this may cause profit margins to narrow, management 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.
Our principal business is mortgage lending, through our 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 our origination 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, 1998, 72 percent of the mortgage loans originated by
NovaStar Mortgage had 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 distinctive 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 us 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, we will be able
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<PAGE>
to differentiate ourselves from other end investors who purchase their
production in bulk from other originators. From time to time, we may
participate in the bulk acquisition market depending on market conditions and
the availability of capital.
Management 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, management believes it can be successful in developing a profitable
business in this segment of the market. While many new competitors have
recently entered the subprime mortgage loan market, We believe that the
experience of our management in this industry and the infrastructure, which has
been established, allows it to effectively compete in this segment. See "Risk
Factors--Intense Competition in the Subprime Mortgage Industry."
Mortgage Products. NovaStar Mortgage offers a broad menu of products in order
to serve our 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 31 percent and 69
percent, respectively. NovaStar Mortgage categorizes the loans that it
originates into one of six different credit risk classifications. Loans are
assigned a credit classification based on several factors consisting of such
things as loan-to-value ("LTV's") 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 95 percent based on the credit risk
classification and the loan amount. For loans originated since inception the
average LTV ratio is 80 percent and the average loan amount is $105,000.
Wholesale Channel. NovaStar Mortgage's wholesale origination consists of a
network of brokers and correspondents that offer our line of mortgage products.
Management believes that our 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, two underwriting and processing centers to underwrite,
close and fund mortgage loans and systems to process data. As of November 30,
1998, we had a staff of 58 account executives, located in offices nationwide,
whose job is to call on brokers. Supporting the sales force is a combined staff
of 124 in Orange County, California and Boca Raton, Florida. 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 when our
mortgage lending operation is running at full capacity.
Management believes it has been, and will continue to be, successful in
competing in the wholesale business for several reasons. First, we are
vertically integrated with our 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, management believes our
REIT status gives us a pricing advantage over non-REIT mortgage investors.
Third, 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 us as it required the least infrastructure to operate and it
allowed us to acquire subprime mortgage loans very quickly. Although it
generally carries a lower margin than the wholesale channel, from time to time
we 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.
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<PAGE>
Due diligence with respect to bulk acquisitions may be performed from time to
time by contract underwriters under the guidance of our 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 our 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 only field personnel consisting of the sales force strategically located in
select markets. Through this production channel, capital quickly invested in
pools of subprime mortgage loans.
Retail Channel. Neither NovaStar Mortgage nor NovaStar Financial, Inc. has
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 NovaStar Mortgage or NovaStar Financial, Inc. 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,
management 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 management
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, we 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, we intend to avoid supporting a
channel, which has been unprofitable over time. 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, management can make the proper decisions in
deciding where to invest our 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 originates loans only in
compliance with the Company's Underwriting Guidelines.
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.
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
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<PAGE>
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 $600,000.
On a case-by-case basis, exceptions to the Underwriting Guidelines are made
where compensating factors exist. Compensating factors may consist of factors
like length of time in residence, lowering of the borrower's monthly debt
service payments, the loan to value ratio on the loan or other criteria that in
the judgment of the underwriter warrants an exception. 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 twelve 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.
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Our 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>
AA RISK A RISK A RISK B RISK C RISK
-------------------- ---------------- ------------------ ----------------- ------------------
<S> <C> <C> <C> <C> <C>
Mortgage
History........ No mortgage Maximum one Maximum two Maximum three Maximum five
lates allowed 30-day late 30-day lates and 30 day lates and 30 day lates,
within the last 24 and no 60-day no 60-day lates one 60 day late and two 60
months lates within the within the last within the last day lates,
last 12 months 12 months 12 months and one 90
day late within
the last 12 months
Other Credit....
Limited 30 day Limited 30 day Limited 30 day Limited 60 day Limited 90 day
lates within the lates within the lates within lates within the lates with-in
last 24 months. last 12 months. the last 12 months last 12 months the last 12
Generally paid Generally paid months
as agreed as agreed
Bankruptcy
Filings........ Chapter 13 Chapter 13 Chapter 13 must be Chapter 13 must Chapter 13 no
must be must be discharged minimum be discharged seasoning required
discharged discharged of 1 year with minimum of 1 on discharge
minimum of 2 minimum of 2 reestablished year with with evidence of
years with years with credit; Chapter 7 reestablished satisfactory
reestablished reestablished must be discharged credit; Chapter 7 discharge;
credit; credit; Chapter minimum of 2 must be Chapter 7
Chapter 7 must 7 must be years with discharged minimum
be discharged discharged reestablished minimum of 2 discharge of
minimum of 3 minimum of 3 credit years with 1 year
years with years with reestablished
reestablished credit reestablished credit
credit
Debt Service
Ratio.......... 45% 45% 80% 50% 55%
Maximum Loan-to-
Value Ratio:
Full documenta-
tion........... 95% 90% 80% 85% 75%
Limited docu-
mentation......
90% 85% 80% 80% 70%
Stated income...
85% 80% 80% 75% 65%
<CAPTION>
D RISK
---------------------
<S> <C>
Mortgage
History........ Maximum six
30 day lates,
and three 60 day
lates and two
90 day lates
within the last
12 months. Must
be current at time
of origination
Other Credit....
Discretionary--credit
is generally
expected to be
late pay
Bankruptcy
Filings........ Chapter 13
and 7 no
seasoning
required on
discharge
with evidence
of satisfactory
discharge;
Debt Service
Ratio.......... 55%
Maximum Loan-to-
Value Ratio:
Full documenta-
tion........... 65%
Limited docu-
mentation......
60%
Stated income...
NA
</TABLE>
Loan Portfolio by Credit Risk Category. Table V of the Management's
Discussion and Analysis of Financial Condition and Results of Operations sets
forth our mortgage loan portfolio by credit grade as of September 30, 1998 and
December 31, 1997, all of which are non-conforming.
Geographic Diversification. Close attention is paid to geographic
diversification in managing our credit risk. We believe one of the best tools
for managing credit risk is to diversify the markets in which we originate and
purchase mortgage loans. We have 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 we own higher than twice that
market's percentage of the total national market share. While there generally
is some geographic
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concentration in mortgage loans originated through the bulk acquisition
channel, over time our mortgage lending operation plans to diversify our credit
risk by selecting target markets through the wholesale channel. Presented in
Table VII of the Management's Discussion and Analysis of Financial Condition
and Results of Operations section of this Prospectus is a breakdown of our
current geographic diversification as of September 30, 1998 and December 31,
1997.
Collateral Valuation. Collateral valuation also receives close attention in
our underwriting of our mortgage loans. Given that we primarily lend to
subprime borrowers, we place great emphasis on the ability of collateral to
protect against losses in the event of default by borrowers. We have
established an appraisal policy as part of our 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
appraisal policies and state and federal regulations.
Mortgage Loan Servicing Strategy
Overview. We plan to acquire the large majority of mortgage loans we purchase
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 we acquired. Effective, July 15, 1997, NovaStar Mortgage began
servicing our mortgage loans. The servicing operation is located in the
Westwood, Kansas office and is currently staffed with 60 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 company
guidelines.
NovaStar Mortgage's focus for the servicing of our 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. We also
believe we can better manage prepayment risk by servicing our mortgage loans
through our affiliate. Through our servicing function, we intend 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
NovaStar Mortgage will be able to effectively service our loans at a cost less
than the cost to outsource this to an unrelated company.
Procedures. We have prescribed procedures for servicing our 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.
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The first 30 days of a delinquency are, in management's view, the crucial
period for resolving the delinquency. At a minimum, all borrowers who have not
made their mortgage payment by the 10th day of the month in which it is due
receive a call from a collector. Borrowers whose payment history exhibits signs
that the borrower may be having financial difficulty receive more attention.
For example, any borrowers who made their previous months payment after the
late charge date (generally the 15th of the month) receive a call from a
collector no later than the second business day of the current month if their
payment has not yet been received. This allows 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.
Our 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,
management believes it will be able to keep the level of delinquencies and
losses in our mortgage loans in line with industry standards.
PORTFOLIO MANAGEMENT
We build our 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
infrastructure of subprime mortgage lending, we have relied less on purchasing
mortgage loans in bulk and more on wholesale origination. Ultimately,
management expects a substantial portion of our portfolio to consist of
retained interests in wholesale loans originated by NovaStar Mortgage
collateralizing our structured debt instruments.
Types of Mortgage Assets
The mortgage assets we purchased 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 our mortgage assets bear adjustable interest rates or have a fixed-rate
coupon that has been paired with an interest rate cap, so that we have the
proper matching of assets and liabilities.
We have not and generally will not acquire residuals, first loss subordinated
bonds rated below BBB, or mortgage securities rated below B. We could retain
the subordinate class from mortgage loans securitized through our taxable
affiliate. We may acquire interest-only or principal-only mortgage strips to
assist in the hedging of prepayment or other risks. In addition, as discussed
above we may create a variety of different types of assets, including the types
mentioned in this paragraph, through the normal process of securitization of
our own mortgage assets. In no event will we (exclusive of our taxable
affiliates) acquire or retain any REMIC
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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 us. See "Federal Income Tax
Considerations--Taxation of Tax--Exempt Entities."
Single Family Mortgage Loans. In future periods, we may acquire conforming
mortgage loans--those that comply with the requirements for inclusion in a loan
guarantee program sponsored by other FHLMC or FNMA. To date, we have acquired
only nonconforming mortgage loans. We 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. We expect 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 our 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. We have 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 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 us as of and during the
period since inception and through September 30, 1998, have consisted of
mortgage securities issued by corporations sponsored by the United States
government, including FNMA, GNMA and FHLMC. As discussed in "Management's
Discussion and Analysis of Financial Condition and Results of Operations--
Events Subsequent to September 30, 1998," of this Prospectus, in October 1998,
we sold all securities owned by NovaStar Financial and NovaStar Mortgage and
paid off the related repurchase agreement financing, recognizing an aggregate
loss of $15.4 million.
Mortgage assets purchased by us 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.
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(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 we will seek to acquire
any mortgage assets either backed by or secured by commercial property, we
intend 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. We will only acquire commercial mortgage loans
when we believe we have the necessary expertise to evaluate and manage them and
only if they are consistent with our 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, we have not acquired commercial
mortgage loans.
Asset Acquisition Policies
We acquire only those mortgage assets in the secondary mortgage market that
we believe we have the necessary expertise to evaluate and manage and which are
consistent with our risk management objectives. Our strategy is to focus
primarily on the acquisition of single family mortgage loans, single family
mortgage securities, multifamily mortgage loans and multifamily mortgage
securities. We focus primarily on the acquisition of floating-rate and
adjustable-rate assets, so that assets and liabilities remain matched. Our
asset acquisition strategy will change over time as market conditions change
and as we evolve.
Our investment policy allows for the acquisition of mortgage assets and
certain other liquid investments, such as federal agency securities and
commercial paper. We do not presently intend to invest in real estate,
interests in real estate, or interests in persons primarily engaged in real
estate activities.
We may also purchase the stock of other mortgage REITs or similar companies
when we believe that such purchases will yield attractive returns on capital
employed. We may in the future acquire mortgage assets by offering our debt or
equity securities in exchange for such Mortgage Assets. We do 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.
We generally intend to hold mortgage assets to maturity. In addition, the
REIT provisions of the Code limit in certain respects our ability to sell
mortgage assets. See "Federal Income Tax Considerations."
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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
We finance our 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.
Our subprime mortgage lending operation is managed through a taxable affiliate,
which provides us the flexibility to sell our 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, we enter 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 us based on various factors, including market conditions
and the expected volume of mortgage loan purchases. We believe our strategy of
issuing long-term structured debt securities will also assist us in managing
interest rate risk. See "Business--Portfolio Management--Interest Rate Risk
Management."
Acquisitions of mortgage securities are generally financed using repurchase
agreements.
Mortgage Loans Held as Collateral for Structured Debt
We intend to securitize the subprime mortgage loans produced by the mortgage
lending operation as part of our 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"). We intend to securitize by
issuing structured debt. Under this approach, for accounting purposes the
mortgage loans securitized remain on the balance sheet as assets and the debt
obligations (i.e., the CMOs) appear as liabilities. A securitization results
only in rearranging our 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,
1998 and December 31, 1997."
Proceeds from securitizations have been used 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.
Our 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
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"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. We anticipate such sales will
generally be made through one or more of our taxable affiliates. See "Interest
Rate Risk Management" below. We may conduct securitization activities through
one or more taxable affiliates or Qualified REIT subsidiaries formed for such
purpose.
We expect our retained interests in our 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 our 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 us.
We will structure our securitizations so as to avoid the attribution of any
excess inclusion income to our stockholders. See "Federal Income Tax
Considerations--Taxation of the Company's Stockholders." NovaStar management is
experienced in the securitization of subprime and other single family
residential mortgage loans.
We have financed our retained interests in our securitizations through a
combination of equity and secured debt financings.
Credit Risk Management Policies
Mortgage Loans. With respect to our mortgage loan portfolio, we attempt to
control and mitigate credit risk through:
(i) ensuring that established underwriting guidelines are followed;
(ii) geographic diversification of our loan portfolio;
(iii) the use of early intervention, aggressive collection and loss
mitigation techniques in servicing our mortgage loans;
(iv) the use of insurance and the securitization process to limit the
amount of credit risk that it is exposed to on our retained interests in
securitizations; and
(v) maintenance of appropriate capital reserve levels.
A summary of the credit quality and diversification of our loan portfolio as
of September 30, 1998 and December 31, 1997 is presented in Tables V and VII of
"Management's Discussion and Analysis of Financial Condition and Results of
Operations Financial Condition as of September 30, 1998 and December 31, 1997."
Secondary Market Acquisitions. With respect to our mortgage assets purchased
in the secondary market, we review the credit risk associated with each
investment and determine the appropriate allocation of capital to apply to such
investment under our CAG. Because the risks presented by single family,
multifamily and commercial mortgage assets are different, we analyze the risk
of loss associated with such mortgage assets separately. In addition, we
attempt to diversify our portfolio to avoid undue geographic, issuer, industry
and certain other types of concentrations. We attempt 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 our purchased mortgage assets, we are 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 us will
have some degree of protection from normal credit losses. Credit loss
protection for Privately Issued Certificates is achieved through
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the subordination of other interests in the pool to the interest held by us,
through pool insurance or through other means. The degree of credit protection
varies substantially among the Privately Issued Certificates held by us. While
Privately Issued Certificates held by us 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 our pro rata share of the remaining
mortgage pool, but in no event could exceed our investment in such Privately
Issued Certificate.
With respect to purchases of mortgage assets in the form of mortgage loans,
we have developed a quality control program to monitor the quality of loan
underwriting at the time of acquisition and on an ongoing basis. We will
conduct 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, we 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, we or our agents will underwrite all multifamily and
commercial mortgage loans. During the time it holds mortgage loans, we 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. We will generally not obtain credit
enhancements such as mortgage pool or special hazard insurance for our 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). Management'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 our
ability to meet our obligations during adverse market conditions. Our CAG have
been approved by the Board of Directors. The CAG are intended to keep us
properly leveraged by (i) matching the amount of leverage allowed to the
riskiness (return and liquidity) of an asset and (ii) monitoring the credit and
prepayment performance of each investment to adjust the required capital. This
analysis takes into account our various hedges and other risk programs
discussed below. In this way, the use of balance sheet leverage will be
controlled. The following table presents our CAG for the following levels of
capital for the types of assets it owns.
<TABLE>
<CAPTION>
(F)
(E) (B X E) (G)
(A) (B) (C) (D) (C + D) EQUITY (A + F)
MINIMUM ESTIMATED DURATION LIQUIDITY TOTAL CUSHION CAG
LENDER PRICE SPREAD SPREAD SPREAD (% OF EQUITY
ASSET CATEGORY HAIRCUT DURATION CUSHION CUSHION CUSHION 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
GNMA Fixed Rates...... 3.00 5.00 50 -- 50 2.50 5.50
Corporate Bonds....... 10.00 3.50 225 25 250 8.75 18.75
Mortgage loans:
Collateral for
warehouse financing.. 2.00 3.00 100 50 150 4.50 7.50
Collateral for CMO.... 5.80 -- -- -- -- -- 5.80
Delinquent............ 100.00 -- -- -- -- -- 100.00
Hedging................. -- -- -- -- -- -- 5.80
Other................... 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 the lender 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
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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 us
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.
Implementation of the CAG--Mark to Market. Each month, we mark our assets to
market. This process consists of two steps: (i) valuing our mortgage assets
acquired in the secondary market and (ii) valuing our non-security
investments, such as our mortgage loans. For the purchased mortgage assets
portfolio, we obtain market quotes for our mortgage assets from traders that
make markets in securities similar to those in our portfolio. Market values
for our 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 our assets (and hedges). This is
the current market value of our equity. This number is compared to the
required capital as determined by the CAG. If our actual equity falls below
the capital required by the CAG, we 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
our prepayment and credit performance relative to the market and our ability
to predict or hedge the risk of the asset.
Interest Rate Risk Management
We address the interest rate risk to which our mortgage portfolio is subject
in part through our securitization strategy, which is designed to provide
long-term financing for our mortgage loan production while maintaining a
consistent spread in a variety of interest rate environments. In order to
address any remaining mismatch of assets and liabilities, we follow the
hedging section of our investment policy, as approved by the Board.
Specifically our interest rate risk management program is formulated with the
intent to offset the potential adverse effects resulting from rate adjustment
limitations on our mortgage loans and mortgage assets and the differences
between interest rate adjustment indices and interest rate adjustment periods
of our adjustable-rate mortgage loans and related borrowings.
We currently use interest rate caps and may, from time to time, purchase
interest rate swaps interest-only REMIC regular interests and similar
instruments to attempt to mitigate the risk of the cost of our variable rate
liabilities increasing at a faster rate than the earnings on our assets during
a period of rising rates. In this way, we intend generally to hedge as much of
the interest rate risk as management determines is in the best interests of
our stockholders, given the cost of such hedging transactions and the need to
maintain our 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 us 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. We may also, to the extent consistent
with our 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.
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We seek to build a balance sheet and undertake an interest rate risk
management program which is likely, in management's view, 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 agreements are legal contracts between us and a third party
firm (the "counter-party"). The counter-party agrees to make payments to us in
the future should the one or three month LIBOR interest rate rise above the
"strike" rate specified in the contract. Under some of the contracts, we make
quarterly premium payments to the counterparty under the contract. Under other
interest cap agreements, we have paid the premium upfront. Each contract has a
fixed "notional face" amount and a fixed interest rate, on which the interest
is computed, and a set term to maturity. Should the reference LIBOR interest
rate rise above the contractual strike rate, we will earn cap income.
Interest rate swap agreements we have entered into through September 30, 1998
stipulate we will pay a fixed rate of interest to the counterparty. In return,
the counterparty pays us 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. As discussed in the "Management's
Discussion and Analysis of Financial Condition and Results of Operations--
Events Subsequent to September 30, 1998", we terminated all swap agreements and
paid off the liabilities pertaining to these hedging instruments in October
1998, recognizing losses aggregating $8.0 million.
In all of our interest rate risk management transactions, we follow certain
procedures designed to limit credit exposure to counterparties, including
dealing only with counterparties whose financial strength meets our
requirements. We refer you to "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 our assessment of the interest sensitivity and as an indication of our
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. However, management believes the interest
sensitivity model used is a valuable tool to manage our exposure to interest
rate risk. Our Interest Rate Sensitivity Analysis as of September 30, 1998 and
December 31, 1997 is presented in the "Management's Discussion and Analysis of
Financial Condition and Results of Operations" section of this Prospectus.
Interest Rate Sensitivity Analysis. The sensitivity table is a tool used by
management in assessing the impact of changing interest rates on our assets,
liabilities and interest rate agreements. The values under the heading "Base"
are management's estimates of market values of our assets, liabilities and
interest rate agreements as of a specific point in time. 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 our portfolio by adding or removing interest
rate cap or swap agreements.
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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 our subprime mortgage
loan holdings. The following paragraphs discuss the nature of the process used
in estimating the market value of our assets, liabilities and interest rate
agreements that are used in the interest rate sensitivity analysis. The
estimates and assumptions have a significant impact on the results of this
sensitivity 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 our carrying value.
Our analysis for assessing interest rate sensitivity on our 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)
. 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 our model.
<TABLE>
<CAPTION>
PREPAYMENT FACTOR INCREASE PREPAYMENTS DECREASE PREPAYMENTS
----------------- -------------------- --------------------
<S> <C> <C>
Refinancing Incentives/Current
Mortgage rates Lower Mortgage Rates Higher 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. Our
prepayment model takes this fact into account over a continuum of credit
grades.
The loan-to-value ratio is another important factor in our 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.
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<PAGE>
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.
We attempt 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 management in portfolio
management. ACTUAL RESULTS MAY DIFFER FROM THE ESTIMATES AND ASSUMPTIONS USED
IN OUR MODEL AND THE PROJECTED RESULTS AS SHOWN IN THE INTEREST RATE
SENSITIVITY ANALYSIS AS OF SEPTEMBER 30. 1998 AND DECEMBER 31, 1997 AS
PRESENTED IN THE "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS" SECTION OF THIS PROSPECTUS.
Our 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 our assets.
The Interest Rate Sensitivity Analysis as presented in the "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
section of this Prospectus displays an estimate of the market value of our
assets, liabilities and interest rate agreements as of September 30, 1998 and
December 31, 1997. The analysis also shows the estimated changes in the fair
value of financial instruments should interest rates increase or decrease one
percent (100 basis points). Management uses this information to determine the
impact on stockholders' equity of changing interest rates and to monitor the
effectiveness of the interest rate risk management techniques discussed above.
Although management evaluates the portfolio using interest rate increases and
decreases greater than one percent, management focuses on the one percent
increase as any further increase in interest rates would require action to
adjust the portfolio to adapt to changing rates. Our 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.
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 us
to match the elasticity of our assets with the elasticity of our liabilities.
Prepayment Risk Management
We seek to minimize the effects of faster or slower than anticipated
prepayment rates in our 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 our servicing of the mortgage loans and our portfolio
retention department 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 our revenues, net earnings, dividends, cash flow and
net balance sheet market value.
Although we believe we have 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 us from the effects of
interest rate changes, prepayments and defaults by counterparties. Further,
certain of the federal
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<PAGE>
income tax requirements that we must satisfy to qualify as a REIT limit our
ability to fully hedge our interest rate and prepayment risks. See "Federal
Income Tax Considerations--Qualification as a REIT--Sources of Income."
Taxable Affiliates
We have implemented, and will continue to implement, portions of our business
strategy from time to time through one of our 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 our case, the voting common
stock of Holding, our 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. We hold a class of preferred stock of the taxable affiliate holding
company, which preferred stock is entitled to substantially all (up to 99
percent) of the dividends and liquidation proceeds distributable from Holding.
Taxable affiliates are not Qualified REIT Subsidiaries and would be subject
to federal and state income taxes. In order to comply with the nature of asset
tests applicable to us as a REIT, as of the last day of each calendar quarter,
the value of the securities of any such affiliate held by us must be limited to
less than five percent of the value of our total assets and no more than ten
percent of the voting securities of any such affiliate may be owned by us. 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 us and our other stockholders. Any dividend income received by
us from any such taxable affiliate (combined with all other income generated
from our assets, other than Qualified REIT Assets) must not exceed 25 percent
of the gross income of us. See "Federal Income Tax Considerations--
Qualification as a REIT--Sources of Income." Before we form any additional
taxable affiliate corporations, we will obtain an opinion of counsel to the
effect that the formation and contemplated method of operation of such
corporation will not cause us to fail to satisfy the nature of assets and
sources of income tests applicable to it as a REIT.
Properties
Our executive and administrative offices are located in Westwood, Kansas, and
consist of approximately 6,000 square feet. The lease on the premises expires
December 2002. The current annual rent for these offices is approximately
$116,000.
NovaStar Mortgage leases space for its mortgage lending operations in Orange
County, California and Boca Raton, Florida. Currently, these offices consist of
approximately 35,000 and 15,000 square feet, respectively. The lease on the
Orange County premises expires January 2005, and the current annual rent is
approximately 917,000. The lease on the Boca Raton premise expires January 2004
and the current annual rent is approximately $264,000.
NovaStar Mortgage also leases space for its mortgage servicing operation in
Westwood, Kansas. The square footage on these premises is approximately 28,000,
with annual rent of approximately $382,000, and a lease scheduled to expire in
January 2007.
Legal Proceedings
We occasionally become 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 our financial position or results of operations.
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MANAGEMENT
DIRECTORS AND EXECUTIVE OFFICERS
Our directors and executive officers and their positions are as follows:
<TABLE>
<CAPTION>
NAME POSITION
---- --------
<S> <C>
Scott F. Hartman(1)........ Chairman of the Board, Secretary and
Chief Executive Officer
W. Lance Anderson(1)....... Director, President and Chief Operating Officer
Mark J. Kohlrus............ Senior Vice President, Treasurer and
Chief Financial Officer
Michael L. Bamburg......... Senior Vice President and Chief Investment Officer
Edward W. Mehrer(2)(3)(4).. Director
Gregory T. Barmore(2)(4)... Director
Bart Johnson(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 our directors and
officers follows:
Directors and Executive Officers
SCOTT F. HARTMAN, age 39, is our co-founder, 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 our portfolio of
investments, interact with the capital markets and oversee the securitization
of our 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 38, is our co-founder, President and Chief Operating
Officer and has been a member of the Board of Directors since 1996. His main
responsibility is to manage our 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 startup 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.
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MARK J. KOHLRUS, age 39, is Senior Vice President, Treasurer and Chief
Financial Officer of NovaStar Financial, Inc. 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 us 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.
MICHAEL L. BAMBURG, age 36, is Senior Vice President and Chief Investment
Officer of NovaStar Financial, Inc. and NovaStar Mortgage. Mr. Bamburg is
responsible for managing our portfolio of investments, interacting with the
capital markets, overseeing the securitization of our mortgage loan production,
and developing new business lines for us. Mr. Bamburg most recently served as a
Principal of Smith Breeden Associates, a financial institution consulting and
money management firm specializing in the evaluation and hedging of Mortgage
Backed Securities. Mr. Bamburg spent over 11 years with Smith Breeden where he
analyzed and traded hundreds of millions of dollars of Mortgage Backed
Securities and consulted with various financial institutions regarding
investments and asset/liability management issues. During the last 3 years with
Smith Breeden, Mr. Bamburg spent most of his time marketing Smith Breeden's
money management products.
EDWARD W. MEHRER, age 59, 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 57, 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 our Board as an Independent Director without regard to the GE
Capital investment and accordingly there are no arrangements with GE Capital or
our affiliates regarding his term of office or other aspects of his service on
the Board.
BART JOHNSON, age 50, has been a member of the Board since 1998. He is
currently President of GE Capital Residential Connections, a division of GE
Capital Mortgage Corporation, and is a 25-year mortgage industry veteran.
Before joining GE in 1997, Johnson served as Chief Financial Officer and
National Residential Production Manager at Mellon Bank's Mortgage Banking
Group. He also has held senior management positions at Manufacturers Hanover
Mortgage Corporation (now Source One Mortgage), leading the Acquisitions &
Business Development function as well as the mortgage securities subsidiary.
Other Senior Officers
JAMES H. ANDERSON, age 35, 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
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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 48, is Senior Vice President and Chief Credit Officer
(NovaStar Financial 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 33, 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.
TERMS OF DIRECTORS AND OFFICERS
Our 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 Mr. Johnson are Class III directors.
Class I, Class II and Class III directors will stand for reelection at the
annual meetings of stockholders held in 2000, 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. We
intend 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, each
of whom shall serve on the Audit and/or Compensation Committees. Mr. Johnson is
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 our
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.
Our Bylaws 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
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officers or our employees or any affiliate or our subsidiary. GE Capital and
our affiliates are expressly deemed not to be our affiliates 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. We have 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 our internal accounting
controls.
Compensation Committee. We have established a Compensation Committee composed
of two Independent Directors. The Compensation Committee determines the
compensation of our 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.
COMPENSATION OF DIRECTORS
We pay Independent Directors $10,000 per year plus $500 for each meeting
attended in person. Independent Directors also receive automatic stock options
pursuant to our Stock Option Plan. However, as the GE Capital nominee, Mr.
Johnson do not receive any compensation (including fees and stock options) for
their services on the Board of Directors. See "--Executive Compensation--Stock
Option Plan--Automatic Grants to Non-Employee Directors." None of our directors
have 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 us will receive separate
compensation for services rendered as a director.
COMPENSATION COMMITTEE INTERLOCKS
No interlocking relationship exists between our 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 our own compensation
packages as well as those of all our managers 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 our
profitability (measured by return on stockholders' equity) and the stock price.
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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(4) 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(4) 40,000 -- --
President and Chief 1996 70,000 -- -- 144,666 -- --
Operating Officer
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
Michael L. Bamburg(5)... 1997 -- -- -- -- -- --
Senior Vice President 1996 -- -- -- -- -- --
and Chief Investment
Officer
</TABLE>
- --------
(1) Mr. Hartman and Mr. Anderson were reimbursed by us for services provided by
them that were necessary and prudent in connection with our formation and
our Private Placement in 1996, including payments in lieu of salary and for
expenses directly attributable to our formation. Mr. Hartman and Mr.
Anderson are employed by us at a base salary of $185,000 per year.
(2) Mr. Kohlrus' employment with us began on December 16, 1996 and 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 in 1997.
(3) Options granted to Mr. Hartman and Mr. Anderson which vested 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 DERs.
(4) Represents forgiveness of one tranche of founders' forgivable debt.
(5) Mr. Bamburg's employment with us began in February 1998.
Bonus Incentive Compensation Plan. A bonus incentive compensation plan has
been established for certain executive and key officers of us and our
affiliates, and was effective commencing with the fiscal year beginning January
1, 1998. The annual bonus pursuant to the bonus incentive compensation plan
will be paid one-half in cash and one-half in shares of our common stock,
annually, following receipt of the audit for the related fiscal year. This
program will award bonuses annually to those officers out of a total pool
determined by stockholder return on equity ("ROE") as follows:
<TABLE>
<CAPTION>
ROE(1) IN EXCESS OF BASE RATE(2) BY: BONUS AS PERCENT OF AVERAGE NET WORTH(3) OUTSTANDING
------------------------------------ ----------------------------------------------------
<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 our monthly Net Income (adjusted to an
annual rate) by our Average Net Worth for such month. For such
calculations, the "Net Income" of us means the net income or net loss of us
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 us.
(2) "Base Rate" is the average for each month of the Ten-Year U.S. Treasury
Rate, plus four percent.
87
<PAGE>
(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 us 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) our 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 have been granted at exercise prices greater than or equal to the
estimated fair value of the underlying stock at the date of grant. Options vest
over four years and expire ten years after the date of grant, except for the
founders' options, which vested upon the closing of the Company's initial
public offering in October 1997. Options to acquire 286,250 shares of common
stock are outstanding to the date of this Prospectus under our 1996 Stock
Option Plan.
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 FOR
INDIVIDUAL GRANTS OPTION TERM
----------------------------------------------------- ---------------------------
PERCENT OF TOTAL
OPTIONS GRANTED EXERCISE PRICE
NO. TO EMPLOYEES OR BASE PRICE EXPIRATION
NAME GRANTED(1) DURING THE YEAR ($/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 11/4/97 $ 588,402.07 $ 933,747.29
------- ------
Total to 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 except for the options
granted to Mr. Barmore and Mr. Mehrer.
The following table sets forth certain information with respect to the value
of the options as of December 31, 1996 held by the named directors and
executive officers.
FISCAL YEAR END OPTION VALUE
<TABLE>
<CAPTION>
NUMBER OF SECURITIES VALUE OF UNEXERCISED
UNDERLYING UNEXERCISED IN-THE-MONEY
OPTIONS AS OF OPTIONS AS OF
DECEMBER 31, 1997 DECEMBER 31, 1996(1)
------------------------- -------------------------
NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
---- ----------- ------------- ----------- -------------
<S> <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...... -- 27,500 -- 99,844
</TABLE>
- --------
(1) "In-the-Money" options whose exercise 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.
88
<PAGE>
Units Acquired with Forgivable Debt. Messrs. Hartman and Anderson have 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 us promissory notes,
bearing interest at eight percent per annum compounded annually and secured by
the Units being acquired. Interest began accruing during the first year and was
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 us, 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 we
generate a total return to investors in Units equal to or greater than
15 percent. The debt on the first tranche was forgiven and we
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 we have generated a total cumulative return to
investors in Units (from date of initial issuance of the notes) equal
to or greater than 100 percent.
. For purposes of calculating the returns to such investors:
--The term "fiscal period" will refer to each of five periods. The
first period commenced with the closing of the Private Placement on
December 9, 1996, and ends 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 is traded in 1997), and (c) any increase or decrease in
the price per Warrant during such fiscal period, determined in the same
manner as in (b). For purposes of the fiscal period 15 percent return
test, the total return for a given period will be equal to the sum of
(a), (b) and (c) during the period, and for purposes of the cumulative
100 percent return test, the amounts in (a), (b) and (c) will all be
measured from the beginning of the first fiscal period. The amount of
that "return" will then be measured as a percentage of the 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 us 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. Thus as a result of the 1997 forgiveness, we issued notes
receivable to Mssrs. Hartman and Anderson aggregating $845,585, which
bear interest based on one-month LIBOR, which resets monthly. These notes
are secured by the proportionate number of common stock that had secured
the forgiven tranche of the notes and will mature upon the earlier of the
sale of these common shares or the termination of the officer's
employment with us.
Employment Agreements. We have 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
89
<PAGE>
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 us 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 our
book equity value (exclusive of valuation adjustments) and a minimum of
$360,000. In that instance, the subject officer is prohibited from competing
with us 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 us for federal income tax purposes. "Change of Control" for purposes
of the agreements would include a merger or consolidation of NovaStar
Financial, Inc., a sale of all or substantially all of our assets, changes in
the identity of a majority of the members of our Board of Directors (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 our capital stock, subject to
certain limitations. Absent a "Change in Control," if we terminate 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 combined maximum base salary and actual bonus compensation for the
preceding year, subject in each case to a maximum amount of one percent of our
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 us for a period of one year following
the resignation. Although we 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 our employ.
Stock Option Plan
General. Our 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 us.
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 us. 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
90
<PAGE>
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 our discretion.
Eligible Persons. Our officers and directors and employees and other persons
expected to provide significant services to us are eligible to participate in
the 1996 Stock Option Plan. ISOs may be granted to the officers and our key
employees. NQSOs and Awards may be granted to our directors, officers, key
employees, agents and consultants or any of subsidiaries.
Under current law, ISOs may not be granted to any of our directors who are
not also an employee, or to directors, officers and other employees of entities
unrelated to us. 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
our equity stock.
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 our
total outstanding shares at any time, provided that no more than 320,000 shares
of Common Stock shall be cumulatively available for grant as Incentive Stock
Options. If an option granted under the 1996 Stock Option Plan expires or
terminates, or an Award is forfeited, the shares subject to any unexercised
portion of such option or Award will again become available for the issuance of
further options or Awards under the 1996 Stock Option Plan. In connection with
any reorganization, merger, consolidation, recapitalization, stock split or
similar transaction, the Compensation Committee shall appropriately adjust the
number of shares of Common Stock subject to outstanding options, Awards and
DERs and the total number of shares for which options, Awards or DERs may be
granted under the Plan.
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
our 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.
91
<PAGE>
Option Exercise. The exercise price of any option granted under the 1996
Stock Option Plan is payable in full in cash, or our equivalent as determined
by the Committee. We may make loans available to option 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 of our non-employee
directors are automatically granted NQSOs to purchase 5,000 shares of Common
Stock with DERs upon becoming a director, 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 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.
92
<PAGE>
PRINCIPAL SECURITYHOLDERS
BENEFICIAL OWNERSHIP OF COMMON STOCK BY LARGE SECURITYHOLDERS
The following table sets forth certain information known to us with respect
to beneficial ownership of our common stock as of September 30, 1998, by each
person other than members of management known to us to beneficially own more
than five percent (5%) of our common stock. The table below does not include
GMAC/Residential Funding Corporation who may acquire 1,624,650 warrants as part
of the financing arrangement as discussed in "Recent Developments" in the
prospectus summary. Unless otherwise indicated in the footnotes to the table,
the beneficial owners named have, to the knowledge of us, 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>
Wallace R. Weitz & Company(2)....................... 2,800,833 29.69%
1125 South 103rd Street
Suite 600
Omaha, NE 68124-6008
Lindner Dividend Fund(3)............................ 1,583,334 18.00%
7711 Carondolet Avenue, Suite 700
St. Louis, MO 63104
General Electric Capital Corporation(4)............. 1,333,332 15.16%
260 Long Ridge Road
Stamford, CT 06927
Wellington Management Company(5).................... 450,700 5.55%
75 State Street
Boston, MA 02109
</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) Consists of 1,495,833 shares of Common Stock currently outstanding, and
1,305,000 shares of Common Stock issuable upon the exercise of Warrants.
(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) Consists of 315,500 shares of Common Stock currently outstanding,
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; 135,200 shares of Common Stock
currently outstanding 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.
93
<PAGE>
(4) 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 November
30, 1998, 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
NAME OF BENEFICIAL OWNER COMMON STOCK(1)
------------------------ -----------------
NUMBER PERCENT
<S> <C> <C>
Scott F. Hartman(2)................................... 529,065 6.40
W. Lance Anderson(3).................................. 539,465 6.52
Edward W. Mehrer(4)................................... 39,750 *
Gregory T. Barmore(5)................................. 3,886 *
Bart O. Johnson....................................... -- --
Michael L. Bamburg(6)................................. 76,988 *
Mark J. Kohlrus(7).................................... 16,050 *
All Directors and Executive Officers as a Group (7
persons)............................................. 1,205,204 --
</TABLE>
- --------
*Less than one percent.
(1) Assuming no exercise of the Warrants and exercisable options (except by the
listed Securityholder named separately).
(2) Consists of 390,732 shares of Common Stock and 128,333 warrants, including
224,066 of common stock and 20,000 of warrants owned jointly with his wife,
and 10,000 shares of Common Stock issuable upon the exercise of options.
(3) Consists of 395,932 shares of Common Stock and 133,533, including 287,599
of common stock and 25,200 of warrants owned jointly with his wife, and
10,000 shares of Common Stock issuable upon the exercise of options.
(4) Consists of 24,000 shares of Common Stock and 12,000 of Warrants, including
2,000 of each owned by his wife, and 3,750 shares of Common Stock issuable
upon the exercise of options.
(5) Consists of 2,636 shares of Common Stock and 1,250 shares of Common Stock
issuable upon the exercise of options.
(6) Consists of 46,188 shares of Common Stock and 23,300 warrants, including
1,228 shares of common stock owned by his wife, 300 warrants owned by his
wife, 20,110 warrants owned jointly with his wife, and 7,500 shares of
Common Stock issuable upon the exercise of options.
(7) Includes 7,050 shares of Common Stock and 1,500 Warrants, all of which are
owned jointly with his wife, except for 550 shares of common stock which
are controlled by Mr. Kohlrus as custodian for his children, and 7,500
shares of Common Stock issuable upon the exercise of options.
94
<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 our Private
Placement, NovaStar Mortgage began obtaining required licenses and permits,
developing guidelines for the origination of mortgage loans through our
wholesale lending channel and, hiring critical senior personnel to put in place
the infrastructure for our mortgage lending and servicing operations.
Following the close of the Private Placement of Units in December 1997, we
moved to implement the portion of our 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 we 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 we are 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, we thus own a
beneficial interest in 99 percent of the future dividend distributions
attributable to NovaStar Mortgage.
We have entered into a loan sale and purchase agreement with NovaStar
Mortgage pursuant to which we agree to buy from time to time and NovaStar
Mortgage agrees to sell to us 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. Also, under the terms of this agreement, if NovaStar
Mortgage chooses to sell its loan originations to other parties, it pays a fee
to us for not delivering our production under the purchase commitment. NovaStar
Mortgage and NovaStar Financial, Inc. also entered into a flow subservicing
agreement under which NovaStar Mortgage agrees to service our mortgage loans
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. NovaStar
Mortgage and NovaStar Financial, Inc. further entered into an Administrative
Services Outsourcing Agreement, dated as of January 30, 1998, pursuant to which
NovaStar Mortgage will provide to us 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 us 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 our Private Placement of Units in 1996, we
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 us. The current director serving
pursuant to these provisions is Bart Johnson, who replaced Jenne Britell in
1998. He has been elected to serve as an Independent Director with a term
running until the 1999 annual meeting of stockholders.
95
<PAGE>
We also agreed, unless GE Capital waives our compliance, (i) to give GE
Capital's insurance affiliate FGIC three years' right of first offer to issue
credit enhancements on our securitizations, (ii) to permit GE Capital's
mortgage company affiliate GE Capital Mortgage Corporation to sell subprime
mortgage loans, conforming to underwriting guidelines, to us 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, we will obtain two independent prices related to any such transaction.
96
<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(1) 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 1.2 100,000 100,000 -- --
National Automobile &
Casualty Insurance
Co.................... 33,333 0.4 33,333 33,333 -- --
General Electric
Capital Corporation... 666,666 8.2 666,666 666,666 -- --
Lindner Dividend Fund.. 666,667 5.2 666,667 666,667 -- --
First Financial Fund,
Inc................... 466,700 5.7 466,700 466,700 -- --
Wellington Management
Co.................... 275,000 3.4 -- -- 275,000 3.5
Bay Pond Partners,
L.P................... 200,000 2.5 200,000 200,000 -- --
Wallace Weitz & Co..... 250,000 3.1 -- -- 250,000 3.2
Weitz Series Fund,
Inc.--Hickory
Portfolio............. 20,000 0.2 20,000 20,000 -- --
Weitz Partners, Inc.--
Partners Value Fund... 125,000 1.5 65,000 65,000 60,000 0.8
Weitz Series Fund,
Inc.--Value
Portfolio............. 375,000 4.6 185,000 185,000 190,000 2.4
Weitz Partners III
Limited Partnership... 63,333 0.8 63,333 63,333 -- --
UMB F/B/O/ John Adams
M.D. IRA R/O.......... 3,000 -- 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 40.2 2,490,199 2,490,199 775,000 9.9
First Fidelity
Incorporated
c/o First Union Capital
Market Groups.......... 186,667 2.3 186,667 186,667 -- --
Allis & Co.............. 10,000 0.1 10,000 10,000 -- --
Lynne K. Anderson IRA... 200 -- 200 200 -- --
Walter Lance Anderson(2)
and Rania Habiby
Anderson............... 16,700 0.2 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(18)
Spousal IRA Acct. No.
1313-3536.............. 943 -- 300 300 643 --
Michael L. Bamburg(19).. 23,600 0.3 11,100 11,100 12,500 0.2
</TABLE>
97
<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(1) STOCK PERCENT
- ---- ----------- ------- ----------- ------------ ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Marianthe Mewkill, TEE
Smith Breeden Profit
Sharing Plan DTD
12/29/83, FBO Michael
Lee Bamburg(19)........ 5,645 0.1 1,900 1,900 3,745 --
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 -- 3,400 3,400 -- --
W. Coleman Bitting(4)
and Jean M. Bitting.... 8,700 0.1 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 -- 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 0.3 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 0.1 11,400 11,400 -- --
David P. Dunlap......... 6,000 0.1 6,000 6,000 -- --
E.K.S. Investments,
L.P.................... 10,000 0.1 3,000 3,000 7,000 0.1
Stephen A. Eason and
Kathryn Ellis Eason,
Tenants in Common...... 7,000 0.1 7,000 7,000 -- --
David R. Eidelman....... 2,500 -- 2,500 2,500 -- --
Jack R. Eidelman,
Trustee Jack R.
Eidelman Rev. Trust dtd
4/18/80................ 4,000 -- 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 -- 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(20)..... 23,045 0.3 6,666 6,666 16,379 0.2
</TABLE>
98
<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(1) 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 0.3 12,800 12,800 9,500 0.1
Martha B. Fisher........ 3,000 -- 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 -- 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 -- 3,300 3,300 -- --
Michael J. Giarla and
Ellen H. Michelson..... 27,000 0.3 3,000 3,000 24,000 0.3
Mark Glass.............. 2,000 -- 2,000 2,000 -- --
Marion Glicksberg....... 3,300 -- 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 -- 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 -- 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 0.1 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 -- 3,000 3,000 -- --
Matthew E. Just, Jr. ... 6,666 0.1 6,666 6,666 -- --
Paul Just............... 4,000 -- 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 -- 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 -- 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>
99
<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(1) STOCK PERCENT
- ---- ----------- ------- ----------- ------------ ----------- -------
<S> <C> <C> <C> <C> <C> <C>
Joel A. Kunin........... 2,000 -- 2,000 2,000 -- --
William M. LaWarre...... 15,333 0.2 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 -- 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 -- 3,000 3,000 -- --
Gerald J. Madigan....... 4,000 -- 4,000 4,000 -- --
Lawrence A. Manica(4)
and Charla M. Manica... 2,500 -- 2,000 2,000 500 --
Rickey E. Maples(4) and
Laurie H. Maples....... 10,000 0.1 10,000 10,000 -- --
Charlotte C. Mehrer..... 2,000 -- 2,000 2,000 -- --
Edward W. Mehrer,
Jr.(12)................ 22,000 0.3 10,000 10,000 12,000 0.2
F. Jack Meyering, TTEE
F. Jack Meyering Trust
DTD 11/27/89........... 10,000 0.1 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 -- 3,400 3,400 -- --
Kevin M. Moore and
Kimberly A. Moore...... 13,300 0.2 13,300 13,300 -- --
Eugene J. McCabe, M.D... 2,000 -- 2,000 2,000 -- --
Kenneth K. Newton....... 3,000 -- 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 0.1 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 -- 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 -- 2,000 2,000 2,000 --
Edward A. Roach,
Trustee, Edward A.
Roach M.D. Trust DTD
9/28/89................ 3,000 -- 2,000 2,000 1,000 --
Helene B. Roberson...... 3,300 3,300 3,300 -- --
William C. Rosenbaum,
Jr..................... 7,666 0.1 6,666 6,666 1,000 --
Kenneth J. Rosenthal,
Trustee, Kenneth J.
Rosenthal Revocable
Trust Dtd 6/3/93....... 3,300 -- 3,300 3,300 -- --
Louis G. Rothschild
III.................... 2,000 -- 2,000 2,000 -- --
Timothy D. Rowe......... 10,000 0.1 10,000 10,000 -- --
Zsolt Rumy.............. 8,000 0.1 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 0.1 10,000 10,000 -- --
Odis E. Shoaf, Jr.(14).. 2,000 -- 2,000 2,000 -- --
Charles W. Smith........ 3,000 -- 2,000 2,000 1,000 --
</TABLE>
100
<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(1) 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 0.1 7,000 7,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Richard A. Baldwin III
IRA.................... 500 -- 319 319 181 --
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 -- 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 -- 4,000 4,000 -- --
Stifel, Nicolaus & Co.,
Inc., Custodian for
Girard A. Munsch,
Jr.(4) IRA Acct. No.
6099-6176.............. 3,000 -- 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 -- 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 -- 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 -- 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 0.2 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>
101
<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(1) 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 0.4 36,111 36,111 -- --
Scott F. Hartman(6)..... 36,111 0.4 36,111 36,111 -- --
Scott F. Hartman(6)..... 36,111 0.4 36,111 36,111 -- --
W. Lance Anderson(2).... 36,111 0.4 36,111 36,111 -- --
W. Lance Anderson(2).... 36,111 0.4 36,111 36,111 -- --
W. Lance Anderson(2).... 36,111 0.4 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 14.6 1,059,619 1,159,619 129,798 1.6
--------- ----- ---------- --------- --------- -----
Subtotal............. 4,454,616 54.8 3,549,818 3,649,818 904,798 11.1
Warrants exercised... 181 181
Shareholders not
subject to this
filing.............. 3,672,698 45.2 (3,549,999) -- 7,222,516 88.9
--------- ----- ---------- --------- --------- -----
Total................ 8,127,314 100.0% 3,549,999 3,649,999 8,127,314 100.0%
========= ===== ========== ========= ========= =====
</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 NovaStar
Financial, Inc.
(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
NovaStar Financial, Inc.
(7) Senior Vice President, Treasurer and Chief Financial Officer of NovaStar
Financial, Inc. and wife.
(8) Vice President of Stifel and his spouse.
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(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 NovaStar Financial, Inc.
(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 NovaStar Financial, Inc.
(18) Warrants issued to Stifel pursuant to the terms of the Purchase Terms
Agreement and subsequently divided by Stifel among the employees shown.
(19) Senior Vice President and Chief Investment Officer of NovaStar Financial,
Inc. or his spouse.
(20) Vice President of NovaStar Financial, Inc.
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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, 1998, 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 1998 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
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the Service will agree with this opinion. In addition, qualification as a REIT
depends on future transactions and events that cannot be known at this time. 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.
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. Pursuant to its compliance guidelines, the Company intends
to monitor closely (on not less than a quarterly
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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, 1998, 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 two 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, 1998, 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
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<PAGE>
from which does not qualify for purposes of the 95 percent of income test.
Moreover, in order to help ensure compliance with the 95 percent of income test
and the 75 percent of income test, the Company intends to limit substantially
all of the assets that it acquires (other than the shares of the preferred
stock of any taxable affiliate and Qualified Hedges) to Qualified REIT Assets.
The policy of the Company to maintain REIT status may limit the type of assets,
including hedging contracts, that the Company otherwise might acquire. As of
September 30, 1998, 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."
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 and the 95
percent of income test. 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.
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 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. The Company
generally distributes dividends equal to 100% of its Taxable Income to
eliminate corporate level tax. See "Dividend Policy and Distributions."
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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. 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 sells 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 it
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
generally will declare its fourth regular annual dividend during the final
quarter of the year and make such dividend distribution no later than thirty-
one (31) days after the end of the year in order to avoid imposition of the
excise tax. Such a distribution would be taxed to the stockholders in the year
that the distribution was declared, not in the year paid. Imposition of the
excise tax on the Company would reduce the amount of cash available for
distribution to the Company's stockholders.
As a publicly held corporation, the Company will not be allowed a deduction
for applicable employee remuneration with respect to any covered employee in
excess of $1 million per year (the "Million Dollar Limit"). The Million Dollar
Limit on deductibility is subject to certain exceptions, including the
exception for "performance based compensation" meeting each of the following
criteria: (i) the agreement must have been approved by the corporation's
stockholders, (ii) the agreement must have been approved by a compensation
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. The common stock is the sole
class of voting stock of Holding,
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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 Holding and will not own any of the
Holding's common stock. The Company will monitor the value of its investment in
Holding 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
Holding 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." Holding 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 Holding creates a taxable mortgage pool, such pool itself will constitute a
separate taxable subsidiary of Holding. Holding 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 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.
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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 will notify stockholders after the close of the Company's taxable
year as to the portions of the distributions which constitute ordinary income,
return of capital and capital gain. Dividends and distributions declared in the
last quarter of any year payable to stockholders of record on a specified date
in such month will be deemed to have been received by the stockholders and paid
by the Company on December 31 of the record year, provided that such dividends
are paid before February 1 of the following year.
TAXATION OF TAX-EXEMPT ENTITIES
In general, a Tax-Exempt Entity that is a stockholder of the Company is not
subject to tax on distributions. The Service has ruled that amounts distributed
by a REIT to an exempt employees' pension trust do not constitute UBTI and thus
should be nontaxable to such a Tax-Exempt Entity. 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
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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 maintains 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.
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
Our authorized capital stock will consist of 46,450,000 shares of common
stock, of which 8,127,314 shares will be outstanding, and 3,550,000 shares of
unclassified capital stock, none of which will be outstanding.
HISTORICAL CAPITAL STRUCTURE
Our authorized capital stock consists of 50,000,000 shares of capital stock,
$0.01 par value. These shares of capital stock were initially classified as
common stock. Our 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, we supplemented our charter to divide and classify 3,550,000 shares of
our capital stock into a class of preferred stock. The preferred stock had the
rights and privileges of, and was subject to the conditions and terms set forth
in, our Articles Supplementary. On December 9, 1996, we issued (i) 3,333,333
shares of preferred stock as part of the units sold in our private placement,
each unit consisting of one share of preferred stock and one warrant; 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 our initial public offering
in December 1997, such shares of outstanding preferred stock automatically
converted to common stock. Shares of the preferred stock which we received 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 our charter. A copy of our charter has been filed with
the Commission as an exhibit to the Shelf Registration Statement of which this
Prospectus is a part. Additionally, you 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 our capital stock. Our
charter does not provide for cumulative voting. 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.
We hold annual meetings of our stockholders. 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. Our charter 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 our initial public offering, the
holders of shares of our common stock have become entitled to receive dividends
when, as, and if declared by the Board of Directors out of funds that are
legally available. In the event of liquidation, dissolution or winding up of
NovaStar Financial, the holders of our common stock will share ratably in all
the assets of NovaStar Financial 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
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available for possible future financing of, or acquisitions by, NovaStar
Financial and for general corporate purposes without any legal requirement that
further stockholder authorization for issuance be obtained. The issuance of
preferred stock could have the effect of making more difficult any attempt to
gain control of NovaStar Financial by means of a merger, tender offer, proxy
contest or otherwise. Preferred stock, if issued, would have a preference on
dividend payments. This would affect our ability to make dividend distributions
to the holders of our common stock.
REGISTRATION RIGHTS
Each purchaser of units in our private placement is entitled to certain
rights with respect to registration under the Securities Act. With respect to
the shares of our common stock into which the shares of preferred stock have
been converted, the warrants and the shares of underlying common stock, there
is a Registration Rights Agreement. According to the Registration Rights
Agreement, we have agreed to file with the Commission, within six months after
the closing of our initial public offering, and then to use our best efforts to
effectuate, the Shelf Registration Statement of which this Prospectus is a
part. We also agreed to use our best efforts to have the shares of common
stock, upon the effectiveness of the initial public offering, and the warrants,
upon the effectiveness of the Shelf Registration Agreement, approved for
quotation on the NYSE. We 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 our counsel, 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% or more of the units sold in the
private placement, a "5% purchaser", we have agreed to include with each
registration statement we file that relates to a new issuance of common stock
during the term of the Registration Rights Agreement, shares of common stock of
such 5% 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. If this is the case, the number of
such shares included will be reduced pro rata among such 5% purchasers
proposing to participate according to the number of such shares proposed to be
sold. Provided, however, that with respect to our 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. Following the end of the effectiveness of the Shelf
Registration Statement, each 5% purchaser shall have two demand registration
rights, unless, in a written opinion of our counsel which is reasonably
acceptable to such purchaser, such registration is not necessary for such 5%
purchaser to sell its shares in the manner contemplated in compliance with
applicable securities laws. If requested by any participating 5% purchaser, our
management will conduct road shows to assist such 5% 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
shares of our common stock held by such holders, subject to certain conditions
and limitations, within any of our proposed registration statements under the
Securities Act 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).
PRIVATE PLACEMENT PURCHASE TERMS AGREEMENT
According to a Purchase Terms Agreement between NovaStar Financial and the
placement agent in our private placement, we 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 our initial public offering; (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 our status as
a REIT; (vii) changes in the capital allocation guidelines and hedge policies;
(viii) undertaking to carry out a liquidation of NovaStar Financial upon the
vote of a majority of the stockholders recommending such action and (ix)
prohibition on grants of stock options (or other awards) under our 1996 Stock
Option Plan prior to our initial public offering other than those stock options
described in "Management--Executive Compensation."
Since our initial public offering or, in the case of clauses (iv) and (v)
above, for one year following our initial public offering, the provisions of
clauses (ii) through (vii) above may be modified or waived by a majority of
independent directors. During such one-year period, 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 our initial public offering.
REPURCHASE OF SHARES AND RESTRICTION ON TRANSFER
Two of the requirements of qualification for the tax benefits accorded by the
REIT provisions of the Code are that (1) during the last half of each taxable
year not more than 50% in value of the outstanding shares may be owned directly
or indirectly by five or fewer individuals (the "50%/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 we 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% in value of the aggregate of the outstanding
shares of capital stock or in excess of 9.8% (in value or in number of shares,
whichever is more restrictive) of the aggregate of the outstanding shares of
our common stock. 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%/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% 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% 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% of the shares outstanding may
nevertheless be in violation of the ownership limitations set forth in our
charter. Ownership of shares of our capital stock through such attribution is
generally referred to as constructive ownership. The 100 stockholder test is
determined by actual, and not constructive, ownership. We have 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.
Our 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 shares)
shall be automatically transferred to the trustee of a trust for the exclusive
benefit of one
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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 our discovery 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. Our
Board of Directors, in their discretion, waive these requirements on owning
shares in excess of the ownership limitations.
Within 20 days of receiving notice from us 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 NovaStar Financial, or our 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 we, or
our designee, accept such offer. We shall have the right to accept such offer
until the trustee has sold shares held in the trust. Upon such a sale to
NovaStar Financial, 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 our 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 5% (or such lower percentage as required by the Code
or the regulations promulgated thereunder) of all classes or series of our
stock, within 30 days after the end of each taxable year, is required to give
us written notice stating the name and address of such owner, the number of
shares of each class and series of our stock beneficially owned and a
description of the manner in which such shares are held.
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Each such owner shall provide us with such additional information as we may
request in order to determine the effect, if any, of such beneficial ownership
on our status as a REIT and to ensure compliance with the ownership
limitations.
Subject to certain limitations, our Board of Directors may increase or
decrease the ownership limitations. In addition, to the extent consistent with
the REIT provisions of the Code, our Board of Directors may waive the ownership
limitations for and at the request of certain purchasers in this offering or
subsequent purchasers.
The provisions described above may inhibit market activity and the resulting
opportunity for the holders of our 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 us an unsuitable investment
vehicle for any person seeking to obtain ownership of more than 9.8% of the
outstanding shares of capital stock.
INDEMNIFICATION
Our charter obligates us to indemnify our 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. Our charter contains a provision providing for elimination
of the liability of our directors and officers to NovaStar Financial or our
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 10% 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% 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% 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
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in the same form as previously paid by the interested stockholder for its
shares. These provisions of Maryland law do not apply, however, to business
combinations that are approved or exempted by the board of directors of the
corporation prior to the time that the interested stockholder becomes an
interested stockholder. Our Board of Directors 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 NovaStar Financial. 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. We have adopted a provision in our bylaws that
exempts our 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
We have appointed UMB Bank N.A. as transfer agent and registrar with respect
to the common stock and the warrants.
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DESCRIPTION OF WARRANTS
The warrants were issued pursuant to a warrant agreement (the "warrant
agreement") dated as of December 9, 1996 between NovaStar Financial and the
warrant agent (the "warrant agent"). We were previously acting as the initial
warrant agent. The following summary of certain provisions of the warrant
agreement is not 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 our initial public offering, 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. The warrants are exercisable beginning on the earlier of the date of
effectiveness of the Shelf Registration Statement (see "Description of Capital
Stock--Registration Rights") or six months following the closing of our initial
public offering. The warrants will remain exercisable until the third
anniversary of the exercise date at an exercise price of $15.00 per share of
common stock (the "Exercise Price") and will be subject to anti-dilution
protection.
Each warrant, when exercised, will entitle its holder to receive one share of
our common stock at the exercise price. The exercise price per warrant was
established at the time of our initial private placement of units, prior to our
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, the accompanying form
of election to purchase properly completed and executed, and 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 NovaStar
Financial or (b) by surrendering additional warrants or shares of our common
stock for cancellation to the extent we may lawfully accept shares of our
common stock, with the value of such shares of our common stock for such
purpose to equal the average trading price of our 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 our 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 our 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 our common stock will be issued upon exercise of the
warrants. The holders of the warrants have no right to vote on matters
submitted to our stockholders and have no right to receive dividends. The
holders of the warrants not yet exercised are not entitled to share in the
assets of NovaStar Financial in the event of our liquidation, our dissolution
or the winding up of our affairs.
The exercise price will be appropriately adjusted if we (i) pay a dividend or
makes a distribution on our common stock in shares of our common stock, (ii)
subdivide our outstanding shares of our common stock into a greater number of
shares, (iii) combine our outstanding shares of our common stock into a smaller
number of
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shares, (iv) issue by reclassification of our common stock any shares of our
capital stock, or (v) issue 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
our initial public offering.
In case of certain consolidations or mergers of NovaStar Financial, or our
liquidation or the sale of all or substantially all of our assets 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 our common stock since our initial public offering,
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 in this Prospectus, 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 us 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 our
securities for a period beginning 10 days prior to, and ending 90 days
following, the closing of an underwritten public offering by NovaStar
Financial.
LEGAL MATTERS
The validity of the common stock offered hereby and certain legal matters
will be passed upon by Tobin & Tobin, a professional corporation, San
Francisco, California. Certain tax matters will be passed on by Jeffers,
Wilson, Shaff & Falk, LLP, Irvine, California.
119
<PAGE>
EXPERTS
Our balance sheets as of December 31, 1997 and 1996 and our statements of
operations, stockholders' equity and cash flows for the year ended December 31,
1997 and for the period from September 13, 1996 (inception) to December 31,
1996 have been incorporated by reference in this Prospectus, in reliance on the
report of KPMG Peat Marwick LLP, independent accountants, given on the
authority of that firm as experts in accounting and auditing.
WHERE YOU CAN FIND MORE INFORMATION
We file annual, quarterly and special reports, proxy statements and other
information with the SEC. Our SEC filings are available to the public over the
Internet at the SEC's web site at http://www.sec.gov. You may also read and
copy any document we file at the SEC's public reference rooms in Washington,
D.C., New York, New York and Chicago, Illinois. Please call the SEC at 1-800-
SEC-0300 for further information on the public reference rooms.
The SEC allows us to "incorporate by reference" the information we file with
them, which means that we can disclose important information to you by
referring you to those documents. The information incorporated by reference is
an important part of this prospectus, and information that we file later with
the SEC will automatically update and supersede this information. We
incorporate by reference the documents listed below and any future filings made
with the SEC under Sections 13(a), 13(c), 14 and 15(d) of the Securities
Exchange Act of 1934 until we sell all of the securities.
. Annual Report on Form 10-K for the year ended December 31, 1997;
. Quarterly Reports on Form 10-Q for the quarters ended March 31, 1998,
June 30, 1998 and September 30, 1998; and
. Current Reports on Form 8-K, filed July 6, 1998, October 12, 1998,
October 13, 1998, October 15, 1998 and December 22, 1998.
You may request a copy of these filings at no cost, by writing or telephoning
us at the following address:
Corporate Secretary
NovaStar Financial, Inc.
1901 West 47th Place, Suite 105
Westwood, Kansas 66205
(913) 362-1090
You should rely only on the information incorporated by reference or provided
in this prospectus or any Prospectus supplement. We have not authorized anyone
else to provide you with different information. We are not making an offer of
these securities in any state where the offer is not permitted. You should not
assume that the information in this prospectus or any Prospectus supplement is
accurate as of any date other than the date on the front of those documents.
120
<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.
121
<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 consisted 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).
122
<PAGE>
"Real Estate Asset" means interests in real property, interests in mortgages
on real property, and regular or residual interests in REMICs.
"REIT" means Real Estate Investment Trust as defined under Section 856 of the
Code.
"REMIC" means Real Estate Mortgage Investment Conduit as defined under
Section 860D of the Code.
"reverse repurchase agreement" means a secured borrowing device evidenced by
an agreement to sell securities or other assets to a third party and a
simultaneous agreement to repurchase them at a specified future date and price,
the price difference constituting the interest on the borrowing.
"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.
"VA" means the United States Department of Veterans Affairs.
123
<PAGE>
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
SEPTEMBER 30, 1998
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
DECEMBER 31, 1997
NOVASTAR FINANCIAL, INC.
Audited Financial Statements:
Balance Sheets........................................................... F-7
Statements of Operations................................................. F-8
Statements of Stockholders' Equity....................................... F-9
Statements of Cash Flows................................................. F-10
Notes to Financial Statements............................................ F-11
Independent Auditors' Report............................................... F-21
</TABLE>
F-1
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1998 1997
------------- ------------
(UNAUDITED)
<S> <C> <C>
ASSETS
Cash and cash equivalents......................... $ -- $ --
Restricted cash................................... 55,383 20,424
Mortgage loans.................................... 944,228 574,984
Available-for-sale securities:
Mortgage securities............................. 390,276 517,246
Other........................................... 18,000 --
Accrued interest receivable....................... 11,046 7,088
Investment in NFI Holding Corporation............. (409) 2,188
Due from NFI Holding Corporation.................. 259,312 --
Other assets...................................... 15,489 4,322
---------- ----------
Total assets.................................. $1,693,325 $1,126,252
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Collateralized mortgage obligations............. $ 948,590 $ 408,867
Repurchase agreements........................... 579,697 556,443
Warehouse line of credit........................ 46,779 40,250
Accounts payable and accrued expenses........... 8,411 4,203
---------- ----------
Total liabilities............................. 1,583,477 1,009,763
Stockholders' equity:
Capital stock, $0.01 par value, 50,000,000
shares authorized:
Common stock, 8,127,314 and 7,828,665 shares
issued and outstanding, respectively.......... 81 78
Additional paid-in capital...................... 121,358 117,084
Accumulated deficit............................. (5,416) (2,859)
Accumulated other comprehensive income
(deficit)...................................... (4,777) 4,353
Forgivable notes receivable from founders....... (1,398) (2,167)
---------- ----------
Total stockholders' equity.................... 109,848 116,489
---------- ----------
Total liabilities and stockholders' equity.... $1,693,325 $1,126,252
========== ==========
</TABLE>
See notes to consolidated financial statements.
F-2
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED; IN THOUSANDS)
<TABLE>
<CAPTION>
FOR THE NINE
MONTHS ENDED
SEPTEMBER 30,
----------------
1998 1997
------- -------
<S> <C> <C>
Interest income:
Mortgage loans.............................................. $56,274 $14,749
Mortgage securities......................................... 22,881 6,796
------- -------
Total interest income......................................... 79,155 21,545
Interest expense.............................................. 60,948 16,224
------- -------
Net interest income........................................... 18,207 5,321
Provision for credit losses................................... 3,400 1,444
------- -------
Net interest income after provision for credit losses......... 14,807 3,877
Fees from NovaStar Mortgage, Inc.............................. 3,766 --
Other income.................................................. 2,012 326
Equity in earnings (loss) of NFI Holding Corporation.......... (2,455) (141)
General and administrative expenses:
Services provided by NovaStar Mortgage, Inc................. 5,700 2,450
Loan servicing.............................................. 3,163 694
Compensation and benefits................................... 1,374 701
Forgiveness of notes receivable from founders............... 812 --
Office administration....................................... 681 201
Professional and outside services........................... 649 430
Other....................................................... 184 288
------- -------
Total general and administrative expenses................. 12,563 4,764
------- -------
Net income (loss)............................................. $ 5,567 $ (702)
======= =======
Basic earnings per share...................................... $ 0.69 $ (0.19)
======= =======
Diluted earnings per share.................................... $ 0.64 $ (0.19)
======= =======
Dividends declared per share.................................. $ 1.00 $ 0.18
======= =======
Basic weighted average shares outstanding..................... 8,033 3,767
======= =======
Diluted weighted average shares outstanding................... 8,639 3,767
======= =======
</TABLE>
See notes to consolidated financial statements.
F-3
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED; IN THOUSANDS)
<TABLE>
<CAPTION>
FOR THE NINE MONTHS
ENDED SEPTEMBER 30,
--------------------
1998 1997
--------- ---------
<S> <C> <C>
NET CASH PROVIDED BY OPERATING ACTIVITIES $ 4,191 $ 3,281
CASH FLOW FROM INVESTING ACTIVITIES:
Mortgage loans purchased from NovaStar Mortgage, Inc... (510,267) (229,364)
Mortgage loans sold to others.......................... 7,933 --
Mortgage loans purchased from others................... -- (219,995)
Mortgage loan repayments............................... 125,818 27,402
Purchases of available-for-sale securities............. (375,051) (380,820)
Proceeds from sales of available-for-sale securities... 323,631 99,794
Proceeds from paydowns on and maturities of available-
for-sale securities................................... 150,018 22,506
Settlement of amounts payable to brokers............... -- (12,676)
Net change in amounts due from NFI Holding
Corporation........................................... (259,035) 5,861
Investment in NFI Holding Corporation.................. -- (1,980)
--------- ---------
Net cash used in investing activities.................. (536,953) (689,272)
CASH FLOW FROM FINANCING ACTIVITIES:
Net change in restricted cash.......................... (34,959) --
Proceeds from issuing collateralized mortgage
obligations........................................... 665,000 --
Payments on collateralized mortgage obligations........ (125,277) --
Net borrowings under repurchase agreements and
warehouse line........................................ 29,783 644,195
Exercise of stock options and warrants................. 4,365 --
Registration costs of stock options and warrants....... (88) --
Additional private placement offering costs............ -- (48)
Dividends paid......................................... (6,062) (354)
--------- ---------
Net cash provided by financing activities.............. 532,762 643,793
--------- ---------
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................................. $ 60,312 $ 15,416
========= =========
Dividends payable...................................... $ 2,845 $ 284
========= =========
</TABLE>
See notes to consolidated financial statements.
F-4
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1998 (UNAUDITED)
NOTE 1. FINANCIAL STATEMENT PRESENTATION
The consolidated financial statements as of and for the periods ended
September 30, 1998 and 1997 are unaudited. In the opinion of management all
adjustments have been made, which were of a normal and recurring nature,
necessary for a fair presentation of the balance sheets and results of
operations. The consolidated financial statements should be read in conjunction
with Management's Discussion and Analysis of Financial Condition and Results of
Operations and the Consolidated Financial Statements of the Company and the
Notes thereto, included in the Company's Annual Report to Shareholders and
Annual Report on Form 10-K for the fiscal year ended December 31, 1997.
The Company owns 100 percent of the common stock of three special purpose
entities--NovaStar Assets Corporation, NovaStar Certificates Financing
Corporation and NovaStar Mortgage Funding Corporation. The Company formed these
entities in connection with the issuance of collateralized mortgage
obligations. The consolidated financial statements of the Company include the
accounts of these entities. Significant intercompany accounts and transactions
have been eliminated in consolidation.
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, Inc. and NovaStar Capital, Inc. are wholly owned
subsidiaries of Holding. Certain key officers of the Company serve as officers
of Holding, NovaStar Mortgage and NovaStar Capital. The Company accounts for
its investment in Holding using the equity method.
NOTE 2. SUBSEQUENT EVENTS
As a result of significant liquidity constraints imposed upon the Company by
certain key lenders subsequent to September 30, 1998, management took the
following actions in October 1998:
On October 11, 1998, the Board of Directors of the Company agreed to defer
payment of the dividend it declared on September 22, 1998 ($0.35 per share,
$2.8 million in total) until January 15, 1999.
On various dates during October 1998, the Company and NovaStar Mortgage
executed contracts for the sale of all securities owned by the Company and
NovaStar Mortgage. All securities sales settled during October at an aggregate
loss of $15.4 million.
On various dates during October 1998, the Company executed contracts for the
termination of interest rate swap agreements with a notional amount of $455
million, representing 42 percent of all interest rate agreements owned by the
Company. The terminations settled in October 1998 at an aggregate loss of $8.0
million. The Company continues to own interest rate cap agreements, but has
significantly reduced liquidity risk exposure relating to its interest rate
agreements.
On October 13, 1998, the Company executed a 90-day financing agreement with
GMAC/Residential Funding Corporation, secured by certain mortgage interests of
the Company. Under the terms of the agreement, the Company borrowed $15 million
to support immediate cash needs. In addition, the Company agreed to pay a $3
million commitment fee at maturity of the note. The resulting $18 million
obligation bears interest at one-month LIBOR plus five percent. Additionally,
GMAC/RFC acquired 812,731 warrants for the purchase of the Company's common
stock at a price of $4.5625, the closing price of the common stock on October
12, 1998. The Company and GMAC/RFC are presently in negotiations regarding
terms to establish a long-term strategic alliance. However, no assurance can be
given that the alliance will be established. If a strategic alliance is
successfully negotiated, GMAC/RFC has the option to waive $2 million of the
commitment fees discussed
F-5
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
above in exchange for an additional 811,919 warrants for the purchase of the
Company's stock at a price of $4.5625 per share.
Additional events, as described below, occurred subsequent to September 30,
1998. Although these events were not a direct result of the event discussed
above, they affect the Company's liquidity position.
On various dates during October 1998, NovaStar Mortgage accepted bids from
third parties for the sale of approximately $221 million, or 94 percent of
loans it owned as of September 30, 1998. Final terms of the sales will be
determined after due diligence is performed on subject loans. Closings on these
sales are expected to be prior to December 31, 1998. Management of NovaStar
Mortgage expects to continue marketing its originated loans for sale to third
parties.
On October 21, 1998, the Company finalized the second closing on the
securitization of asset-backed bonds, the first closing of which was during the
third quarter. In the second closing, approximately $43 million of loans were
added to the trust assets of NovaStar Home Equity Series 1998-2.
NOTE 3. RELATED PARTY RECEIVABLE
Prior to July 1, 1998, the Company acquired all mortgage loans originated by
NovaStar Mortgage, Inc. These acquisitions were financed using warehouse and
repurchase lending arrangements with commercial and investment banks. During
the third quarter of 1998, NovaStar Mortgage discontinued virtually all its
sales of mortgage loans to the Company in order to market and sell these loans
to third parties. However, the Company continues to provide financing for these
loans on behalf NovaStar Mortgage. As a result, the Company has a receivable as
of September 30, 1998 of $259.3 million from NovaStar Mortgage. The receivable
represents its interest in mortgage loans, restricted cash and other assets
related to mortgage loans recorded on the balance sheet of NovaStar Mortgage,
Inc. These advances will be repaid when the loans are sold (see Note 2), and
the Company will, in turn, repay borrowings.
NOTE 4. COMPREHENSIVE INCOME
Effective January 1, 1998, the Company adopted the provisions of Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income."
Comprehensive income includes net income and revenues, expenses, gains and
losses that are not included in net income. Currently, the only components of
comprehensive income for the Company are the net change in the unrealized gain
(loss) on available-for-sale securities and net income. The adoption of SFAS
No. 130 did not result in an adjustment to assets, liabilities, stockholders'
equity or net income. The consolidated balance sheets of the Company as of and
for the year ended December 31, 1997 are comparable to those as of September
30, 1998. However, the caption for comprehensive income has appropriately been
identified.
Following is a summary of comprehensive income for the three- and nine-month
periods ended September 30, 1998.
<TABLE>
<CAPTION>
FOR THE NINE
MONTHS ENDED
SEPTEMBER 30,
---------------
1998 1997
------- ------
<S> <C> <C>
Net income (loss)...................................... $ 5,567 $ (702)
Other comprehensive income--net change in unrealized
gain (loss) on available-for-sale securities.......... (9,130) 2,255
------- ------
Comprehensive income (loss)............................ $(3,563) $1,553
======= ======
</TABLE>
F-6
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<TABLE>
<CAPTION>
DECEMBER 31,
-------------------
1997 1996
---------- -------
<S> <C> <C>
ASSETS
Cash and cash equivalents............................... $ -- $46,434
Restricted cash......................................... 20,424 --
Mortgage securities--available-for-sale................. 517,246 13,239
Mortgage loans, net..................................... 574,984 --
Accrued interest receivable............................. 7,088 29
Investment in NFI Holding Corporation................... 2,188 --
Other assets............................................ 4,322 109
---------- -------
Total assets........................................ $1,126,252 $59,811
========== =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Repurchase agreements................................. $ 556,443 $ --
Collateralized mortgage obligations................... 408,867 --
Warehouse line of credit.............................. 40,250 --
Amounts due to brokers and dealers for unsettled
securities Purchases................................. -- 13,255
Accounts payable and other liabilities................ 4,203 176
---------- -------
Total liabilities................................... 1,009,763 13,431
Commitments and contingencies
Stockholders' equity:
Capital stock, $0.01 par value, 50,000,000 shares
authorized:
Convertible preferred stock, 3,549,999 shares issued
and outstanding as of December 31, 1996............. -- 36
Common stock, 7,828,665 and 216,666 shares issued and
outstanding, respectively............................ 78 2
Additional paid-in capital............................ 117,084 49,910
Accumulated deficit................................... (2,859) (302)
Net unrealized gain (loss) on available-for-sale
securities........................................... 4,353 (16)
Forgivable notes receivable from founders............. (2,167) (3,250)
---------- -------
Total stockholders' equity.......................... 116,489 46,380
---------- -------
Total liabilities and stockholders' equity.......... $1,126,252 $59,811
========== =======
</TABLE>
See notes to consolidated financial statements.
F-7
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
FOR THE YEAR FOR THE PERIOD FROM
ENDED SEPTEMBER 13, 1996
DECEMBER 31, (INCEPTION) TO
1997 DECEMBER 31, 1996
------------ -------------------
<S> <C> <C>
Interest income:
Mortgage loans.............................. $25,154 $ --
Mortgage securities......................... 11,807 155
------- ------
Total interest income......................... 36,961 155
Interest expense.............................. 28,185 --
------- ------
Net interest income........................... 8,776 155
Provision for credit losses................... 2,453 --
------- ------
Net interest income after provision for credit
losses....................................... 6,323 155
Other income.................................. 755 --
Equity in net income of NFI Holding
Corporation.................................. 28 --
General and administrative expenses:
Administrative services provided by NovaStar
Mortgage, Inc.............................. 3,650 --
Loan servicing.............................. 1,246 --
Forgiveness of notes receivable from
founders................................... 1,083 --
Compensation and benefits................... 839 199
Professional and outside services........... 676 200
Office administration....................... 299 --
Other....................................... 448 58
------- ------
Total general and administrative expenses... 8,241 457
------- ------
Net loss...................................... $(1,135) $( 302)
======= ======
Basic and diluted loss per share.............. $ (0.26) $(0.08)
======= ======
Weighted average shares outstanding........... 4,430 3,767
======= ======
</TABLE>
See notes to consolidated financial statements.
F-8
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<TABLE>
<CAPTION>
NET
UNREALIZED
GAIN (LOSS) FORGIVABLE
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 (inception)....... $-- $-- $ -- $ -- $ -- $ -- $ --
Issuance of 216,666
shares of common
stock.................. -- 2 -- -- -- -- --
Proceeds from private
placement of 3,333,333
units, net of costs of
$3,304................. 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)
---- ---- -------- ------- ------ ------- --------
Balance, December 31,
1996................... 36 2 49,910 (302) (16) (3,250) 46,380
Private placement
issuance costs......... -- -- (48) -- -- -- (48)
Proceeds from initial
public offering of
common stock, net of
issuance costs of
$5,848................. (36) 76 67,216 -- -- -- 67,256
Exercise of stock
options................ -- -- 6 -- -- -- 6
Net loss................ -- -- -- (1,135) -- -- (1,135)
Net change in unrealized
gain (loss) on
available-for-sale
securities............. -- -- -- -- 4,369 -- 4,369
Dividends on convertible
preferred stock ($0.18
per share)............. -- -- -- (639) -- -- (639)
Dividends on common
stock ($0.10 per
share)................. -- -- -- (783) -- -- (783)
Forgiveness of founders'
notes receivable ...... -- -- -- -- -- 1,083 1,083
---- ---- -------- ------- ------ ------- --------
Balance, December 31,
1997................... $-- $78 $117,084 $(2,859) $4,353 $(2,167) $116,489
==== ==== ======== ======= ====== ======= ========
</TABLE>
See notes to consolidated financial statements.
F-9
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
FOR THE
PERIOD FROM
SEPTEMBER 13,
1996
FOR THE YEAR (INCEPTION)
ENDED TO
DECEMBER 31, DECEMBER 31,
1997 1996
------------ -------------
<S> <C> <C>
CASH FLOW FROM OPERATING ACTIVITIES:
Net loss........................................... $ (1,135) $ (302)
Adjustments to reconcile net loss to cash used in
operating activities:
Amortization of premiums on mortgage loans....... 2,532 --
Amortization of premiums on mortgage securities.. 908 --
Provision for credit losses...................... 2,453 --
Forgiveness of notes receivable from founders.... 1,083 --
Equity in net income of NFI Holding Corporation.. (28) --
Gains on sales of mortgage securities............ (51) --
Change in:
Accrued interest receivable.................... (7,059) (29)
Other assets................................... (4,213) (109)
Other liabilities.............................. 3,223 176
---------- -------
Net cash used in operating activities........ (2,287) (264)
CASH FLOW FROM INVESTING ACTIVITIES:
Purchases of available-for-sale securities....... (659,415) --
Settlement of amounts due to brokers............. (13,255) --
Proceeds from sales of available-for-sale
securities...................................... 110,067 --
Proceeds from paydowns on available-for-sale
securities...................................... 48,694 --
Investment in NFI Holding Corporation............ (1,980) --
Mortgage loans purchased from NovaStar Mortgage,
Inc............................................. (417,752) --
Mortgage loans purchased from others............. (219,995) --
Mortgage loan repayments......................... 57,778 --
---------- -------
Net cash used in investing activities........ (1,095,858) --
CASH FLOW FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock, net of
offering costs.................................. 67,256 2
Exercise of stock options........................ 6 --
Net borrowings under repurchase agreements and
warehouse line.................................. 596,693 --
Net change in restricted cash.................... (20,424) --
Proceeds from issuance in collateralized mortgage
obligations..................................... 424,674 --
Payments on collateralized mortgage obligations.. (15,807) --
Proceeds from private placement, net of offering
costs........................................... (48) 46,696
Dividends paid................................... (639) --
---------- -------
Net cash provided by financing activities.... 1,051,711 46,698
---------- -------
Net increase (decrease) in cash and cash
equivalents....................................... (46,434) 46,434
Cash and cash equivalents, beginning of period..... 46,434 --
---------- -------
Cash and cash equivalents, end of period........... $ -- $46,434
========== =======
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest............................. $ 27,436 $ --
========== =======
Issuance of units acquired with forgivable debt.... $ -- $ 3,250
========== =======
Dividends payable.................................. $ 783 $ --
========== =======
</TABLE>
See notes to consolidated financial statements.
F-10
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1997
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
NovaStar Financial, Inc. (NovaStar or the Company) is a Maryland corporation
formed on September 13, 1996. 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. The Company uses estimates and employs the judgements of management in
determining the amount of its reserve for credit losses, amortizing premiums or
accreting discounts on its mortgage assets, and establishing the fair value of
its mortgage securities. While the financial statements and footnotes reflect
the best estimates and judgments of management at the time, actual results
could differ from those estimates. For example, it is possible that credit
losses or prepayments could rise to levels that would adversely affect
profitability if such levels were sustained for more than brief periods of
time.
The Company owns 100 percent of the common stock of two special purpose
entities--NovaStar Assets Corporation and NovaStar Certificates Financial
Corporation. The Company formed these entities in connection with the issuance
of collateralized mortgage obligations. The consolidated financial statements
of the Company include the accounts of these entities. Significant intercompany
accounts and transactions have been eliminated in consolidation.
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), a mortgage loan originator and servicer. NMI serves as NovaStar's
principal source of subprime residential mortgage loans. The founders of
NovaStar own 100 percent 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.
Restricted Cash Restricted cash of the Company includes cash held in escrow
for payment of borrowers' taxes and insurance, principal and interest payments
of loans held in trust as required under the Company's collateralized mortgage
obligations, and cash pledged as collateral on certain interest rate
agreements.
Mortgage Securities 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 and discounts are accreted as
yield adjustments over the estimated lives of the securities using a method
that approximates the interest method. Amortization includes the effect of
prepayments. 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 are amortized and discounts accreted as yield adjustments over
the estimated lives of the loans using a method that approximates the interest
method. Amortization includes the effect of prepayments.
F-11
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
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. The
accrual of interest on loans is discontinued when, in management's opinion, the
interest will not be collectible in the normal course of business, but in no
case beyond ninety days. The Company charges off any accrued interest
receivable on loans greater than 90 days delinquent. Interest collected on non-
accrual loans is recognized as income upon receipt.
NovaStar maintains a reserve for credit losses at a level deemed appropriate
by management. The reserve 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, overall loan to value, delinquency status and other factors
deemed to warrant consideration. The reserve is maintained through ongoing
provisions charged to operating income, reduced by loans that are charged off.
Included in other assets are properties acquired through foreclosure. These
properties are transferred from loans at their fair value at date of
foreclosure.
Financial Instruments with Off-balance-sheet Risk The Company has entered
into interest rate swap and cap agreements and financial futures contracts
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 interest rate swap and cap agreements is accounted for on
the accrual method and is recorded as an adjustment of 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 if the matched funding
source is also extinguished. If 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. Unmatched swap or cap agreements are
recorded at fair value with changes in the unrealized gains or losses recorded
in current earnings.
Realized and unrealized gains and losses on futures contracts that meet the
criteria for deferral accounting are deferred and amortized as an adjustment to
interest expense over the remaining life of the underlying financial
instrument. The estimated fair values of futures contracts that do not qualify
for deferral accounting are recorded at fair value, with changes in their fair
value recorded in current operations.
Earnings (Loss) Per Share The Company has adopted the provisions of Statement
of Financial Accounting Standards 128, "Earnings Per Share" (SFAS No. 128),
which requires the presentation of basic and diluted earnings (loss) per share
(EPS). Basic EPS excludes dilution and is computed by dividing income (loss)
available to common stockholders by the weighted-average number of common
shares outstanding for the period. For purposes of computing Basic EPS, the
Company has treated the convertible preferred stock, which was converted into
common stock on October 31, 1997, as if it had been converted at inception of
the Company. 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 calculated assuming that all
options and warrants on the Company's common stock have been exercised, unless
such exercise would be anti-dilutive. EPS for all periods have been restated to
conform to the requirements of SFAS No. 128.
Income Taxes NovaStar intends to operate and qualify as a Real Estate
Investment Trust (REIT) under the requirements of the Internal Revenue Code. As
a result, NovaStar, and its qualified REIT subsidiaries, will generally not be
subject to federal income taxes at the corporate level on taxable income
distributed to stockholders. Requirements for qualification as a REIT include
various restrictions on common stock ownership and 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
F-12
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
taxed as a corporation and distributions to stockholders will not be deductible
in computing taxable income. If NovaStar fails to qualify as a REIT in any tax
year, it will not be permitted to qualify for the succeeding four years. The
most significant difference between GAAP earnings and taxable income relates to
the reserve for credit losses in that only actual amounts charged off are
deductible for income tax purposes. NovaStar's non-REIT affiliate, Holding
files a consolidated federal income tax return with NMI.
New Accounting Pronouncements SFAS No. 125, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities," as amended
by SFAS No. 127, is effective for all transfers and servicing of financial
assets and extinguishments of liabilities occurring after December 31, 1996,
except for secured borrowings and collateral, repurchase agreements, dollar
rolls, securities lending and similar transactions, which transfers will be
effective for transactions occurring after December 31, 1997. This statement
provides accounting and reporting standards for transfers and servicing of
financial assets and extinguishments of liabilities based on consistent
application of financial-components approach that focuses on control. It
distinguishes transfers of financial assets that are sales from transfers that
are secured borrowings.
Under the financial-components approach, after a transfer occurs, an entity
recognizes all financial and servicing assets it controls and liabilities it
has incurred and derecognizes financial assets it no longer controls and
liabilities that have been extinguished. Many of these assets and liabilities
are components of financial assets that existed prior to the transfer. If a
transfer does not meet the criteria for a sale, the transfer is accounted for
as a secured borrowing with a pledge of collateral. Management believes
adoption of SFAS No. 125, as amended by SFAS No. 127, did not 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. 130, "Reporting Comprehensive Income" requires companies to classify
items of other comprehensive income by their nature in a financial statement
and display the accumulated balance of other comprehensive income separately
from retained earnings and additional paid-in capital in the equity section of
a statement of financial position. This statement is effective for financial
statements issued for fiscal years beginning after December 15, 1997.
NOTE 2. MORTGAGE SECURITIES
Mortgage securities, all classified as available-for-sale, consisted of the
following as of December 31, 1997 (dollars in thousands):
<TABLE>
<CAPTION>
WEIGHTED UNREALIZED
AVERAGE AMORTIZED ----------- CARRYING
COUPON COST GAIN LOSS VALUE
-------- --------- ------ ---- --------
<S> <C> <C> <C> <C> <C>
Mortgage securities issued by:
Federal National Mortgage
Association........................ 7.55% $272,773 $3,394 $(32) $276,135
Government National Mortgage
Association........................ 5.74 234,745 845 (26) 235,564
Federal Home Loan Mortgage
Corporation........................ 7.71 5,534 13 -- 5,547
-------- ------ ---- --------
$513,052 $4,252 $(58) $517,246
======== ====== ==== ========
</TABLE>
As of December 31, 1996, mortgage securities consisted of obligations of the
Federal National Mortgage Association with a weighted-average coupon of 7.77
percent. These securities had gross unrealized losses of $16,000.
The contractual maturities of mortgage securities were approximately 28 years
as of December 31, 1997. The expected maturities of mortgage securities may
differ from contractual maturities since borrowers have the right to prepay the
obligations.
F-13
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Proceeds from the sales of mortgage securities during the year ended December
31, 1997 were $110 million. Gross gains of $51,000, included in other income,
were realized on these sales.
All mortgage securities are pledged as collateral under various borrowing
arrangements as described in Note 4.
As of December 31, 1997, the unrealized gain on available-for-sale securities
as reported on the Company's balance sheet includes $159,000 in net unrealized
gains on the investments of Holding.
NOTE 3. MORTGAGE LOANS
Mortgage loans, all of which are secured by residential properties, consisted
of the following as of December 31, 1997 (in thousands):
<TABLE>
<S> <C>
Outstanding principal........................................... $559,436
Net unamortized premium......................................... 17,861
--------
Amortized cost.................................................. 577,297
Reserve for credit losses:
Provision for credit losses................................... (2,453)
Amounts charged off........................................... 140
--------
Reserve for credit losses....................................... (2,313)
--------
$574,984
========
</TABLE>
All the mortgage loans serve as collateral for various borrowing arrangements
as discussed in Note 4. The weighted-average interest rate on these loans at
December 31, 1997 was 10.20%.
Collateral for 27 percent of mortgage loans outstanding as of December 31,
1997 was located in California. The Company has no other significant
concentration of credit risk.
The following table presents certain information regarding impaired loans as
of December 31, 1997 (in thousands):
<TABLE>
<S> <C>
Total recorded investment in impaired loans...................... $11,595
=======
Allowance for loan losses allocated to impaired loans............ $ 1,710
=======
</TABLE>
The average balance of impaired loans for 1997 was $4,100,000. The net amount
of interest income recorded on these loans during their impairment period
aggregated $385,000 in 1997, all of which was recorded on a cash basis.
NOTE 4. BORROWINGS
Short-term Financing Arrangements The Company has a $300 million master
repurchase agreement with Merrill Lynch Mortgage Capital, Inc. and Merrill
Lynch Credit Corporation. Borrowings under the master repurchase agreement bear
interest at various rates priced in connection with respective purchases of
mortgage assets. The Company is a co-borrower with NMI under a warehouse line
of credit agreement with First Union National Bank of Charlotte with a maximum
borrowing amount of $50 million. Advances under the line bear interest based on
the Federal Funds rate. These agreements expire in the first quarter of 1998.
As of December 31, 1997, the Company was in compliance with all covenants and
expects the agreements to be renewed at maturity.
F-14
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Other repurchase agreements used to finance mortgage securities bear interest
at market rates and mature in 30 days to one year.
The following tables present a summaries of the Company's short-term
borrowings (dollars in thousands):
<TABLE>
<CAPTION>
AS OF DECEMBER 31, 1997
--------------------------- AVERAGE DAILY
WEIGHTED BALANCE DURING
WEIGHTED DAYS TO THE YEAR ENDED
AVERAGE RESET OR DECEMBER 31,
RATE MATURITY BALANCE 1997
-------- -------- -------- --------------
<S> <C> <C> <C> <C> <C>
Repurchase agreements
secured by mortgage
securities............... 5.92% 87 $501,430 $172,829
Master repurchase
agreement secured by
mortgage loans........... 6.69 31 55,013 170,344
--------
Total repurchase
agreements........... 556,443
Warehouse line of credit.. 7.09 Demand 40,250 18,402
--------
Total borrowings...... $596,693
========
<CAPTION>
DAYS TO RESET OR MATURITY
------------------------------------------
DAILY 0 TO 30 30 TO 90 90 AND GREATER TOTAL
-------- -------- -------- -------------- --------
<S> <C> <C> <C> <C> <C>
Repurchase agreements
secured by mortgage
securities............... $ -- $299,120 $ -- $202,310 $501,430
Master repurchase
agreement secured by
mortgage loans........... -- -- 55,013 -- 55,013
Warehouse line of credit.. 40,250 -- -- -- 40,250
------- -------- -------- -------- --------
Total borrowings...... $40,250 $299,120 $ 55,013 $202,310 $596,693
======= ======== ======== ======== ========
</TABLE>
Following is a summary of counterparties that are considered concentrations
of risk under various repurchase agreements as of December 31, 1997 (in
thousands):
<TABLE>
<CAPTION>
AMOUNT AT WEIGHTED
RISK UNDER DAYS TO
REPURCHASE RESET OR
COUNTERPARTY AGREEMENTS MATURITY
------------ ---------- --------
<S> <C> <C>
Merrill Lynch Mortgage Capital, Inc........................ $25,161 31
Societe Generale Securities Corporation.................... 11,029 27
Donaldson, Lufkin and Jenrette Securities Corporation...... 7,505 175
-------
$43,695
=======
</TABLE>
The amount considered at risk is the fair value of the collateral under
repurchase agreements plus accrued interest receivable less the Company's
obligation to the counterparty.
Collateralized Mortgage Obligations (CMOs) The Company issues CMOs secured by
its mortgage loans as a means for long-term financing. For financial reporting
and tax purposes, the mortgage loans held as collateral for CMOs are recorded
as assets of the Company and the CMOs are recorded as debt. In a CMO
transaction, the Company sells the loans to its wholly owned qualified-REIT
subsidiary, NovaStar Assets Corporation (NAC). NAC, in turn, transfers the
loans to a trustee who administers the CMO. Interest and principal on each CMO
issue is payable only from principal and interest on the underlying mortgage
loans
F-15
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
collateralizing the CMO. Following is a summary of outstanding CMOs as of
December 31, 1997 (dollars in thousands):
<TABLE>
<CAPTION>
COLLATERALIZED
MORTGAGE
OBLIGATION UNDERLYING MORTGAGE LOANS
------------------- --------------------------------
ESTIMATED
WEIGHTED WEIGHTED
REMAINING INTEREST CARRYING AVERAGE AVERAGE MONTHS
PRINCIPAL RATE VALUE COUPON TO MATURITY
--------- -------- -------- -------- --------------
<S> <C> <C> <C> <C> <C>
NovaStar Home Equity
Series:
Issue 1997-1........... $250,262 5.95% $263,468 10.28% 35
Issue 1997-2 (A)....... 160,376 6.25 170,298 10.20 36
Debt issuance costs,
net................... (1,771) -- -- -- --
-------- --------
$408,867 $433,766
======== ========
</TABLE>
- --------
A) Excludes $50 million in loans added during second closing for the
transaction on January 20, 1998.
Interest rates reset monthly based on one-month LIBOR plus 25 basis points.
The weighted-average months to maturity are when management expects the
underlying pool of mortgage loans to repay. This expectation is based on
estimates and assumptions made by management. The actual maturity may differ
from expectations.
Under the terms of supplemental financing agreements with Merrill Lynch
Mortgage Capital, Inc., the Company may borrow 65 percent of the estimated
value of the residual interests in its CMOs. Availability under these
agreements was $29.7 million as of December 31, 1997. Borrowings under these
agreements bear interest at one-month LIBOR plus 250 basis points and are due
upon demand. No amounts were borrowed under these arrangements as of December
31, 1997.
NOTE 5. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK
NovaStar's interest rate swap and cap agreements and financial futures
contracts result in off-balance-sheet risk. 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's exposure to credit risk on interest rate swap and cap
agreements is limited to the cost of replacing contracts should the
counterparty fail. 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 agreements, 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.
Financial futures contracts are exchange-traded, and, as such, credit risk is
considered nominal.
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 product
of these transactions is a "matched" position for NovaStar. 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, 1997 and December 31,
1996.
F-16
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Other Risk Considerations NovaStar is cognizant of the risks involved with
financial derivatives. The Company's policies and procedures seek to mitigate
risk associated with the use of financial derivatives in ways appropriate to
its business activities, considering its risk profile as a limited end-user.
The Company did not enter into any interest rate agreements during 1996.
Derivatives held for purposes other than trading consisted of the following as
of December 31, 1997 (dollars in thousands):
<TABLE>
<CAPTION>
WEIGHTED AVERAGE
UNREALIZED WEIGHTED INTEREST RATE ACCRUED INTEREST
NOTIONAL ------------- DAYS TO CAP ------------------ ------------------
VALUE GAINS LOSSES MATURITY RATE RECEIVABLE PAYABLE RECEIVABLE PAYABLE
-------- ------ ------ -------- ---- ---------- ------- ---------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Interest rate swap
agreements--fixed rate
pay.................... $276,000 $ -- $1,380 670 NA 5.91% 6.27% $2,157 $2,291
Interest rate cap
agreements............. 270,000 1,268 -- 770 5.99% NA NA -- --
Financial futures
contracts:
Eurodollar March
1998................. 200,000 -- 20 77 NA NA NA NA NA
Eurodollar June 1998.. 200,000 -- 46 168 NA NA NA NA NA
-------- ------ ------
$946,000 $1,268 $1,446
======== ====== ======
</TABLE>
During the year ended December 31, 1997, the Company recognized $1,047,000 in
interest expense relating to off-balance-sheet financial instruments.
NOTE 6. 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
December 31, 1997 are as follows (in thousands):
<TABLE>
<CAPTION>
CARRYING FAIR
VALUE VALUE
-------- --------
<S> <C> <C>
Financial assets:
Mortgage securities.................................. $517,246 $517,246
Mortgage loans....................................... 574,984 608,550
Financial liabilities:
Repurchase agreements................................ 556,443 556,783
Collateralized mortgage obligations.................. 408,867 409,322
Warehouse line of credit............................. 40,250 40,250
Off-balance-sheet financial instruments................ -- (178)
</TABLE>
Market quotations are received for estimating the fair value of mortgage
securities. The fair value of all other financial instruments is estimated by
discounting projected future cash flows, including projected prepayments for
mortgage assets, at current market rates. The fair value of cash and cash
equivalents and accrued interest receivable and payable approximates its
carrying value.
F-17
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
As of December 31, 1996, fair values of financial instruments approximated
carrying values.
NOTE 7. STOCKHOLDERS' EQUITY
The Company was formed and capitalized by its founders in September 1996. In
December 1996, the Company successfully completed a private placement offering
of 3,549,999 units, each unit consisted of one share of convertible preferred
stock and one warrant which entitled the holder to purchase one share of common
stock for $15.00 per share. The underwriter received 100,000 warrants in
addition to underwriting discounts. The Company raised $47 million in the
offering, net of $3 million of offering costs. The warrants become exercisable
in February 1998 and remain exercisable until February 2001 at an exercise
price of $15.00 per share.
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 these 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. 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
targets are achieved. These notes have been reflected as a reduction of
stockholders' equity in the accompanying consolidated balance sheets. During
1997, the Company surpassed its first incentive target resulting in the
forgiveness of one-third of the notes and the recognition of compensation
expense in December 1997 of $1,083,000.
On December 1, 1997, the Company completed the sale of its common stock in an
initial public offering of 4,059,500 shares at a price of $18.00 per share. The
Company raised $67 million in net proceeds from this offering. Under the
provisions of the Private Placement agreements, the preferred stock
automatically converted to common stock at the closing of the initial public
offering. As a result, 3,549,999 additional shares of preferred stock converted
into common stock on November 4, 1997. At December 31, 1997, 3,649,000 warrants
were outstanding.
NOTE 8. 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 employees of the Company. NQSOs and
awards may be granted to the directors, officers, 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.
Options have been granted at exercise prices greater than or equal to the
estimated fair value of the underlying stock at the date of grant. Options vest
over four years and expire ten years after the date of grant, except for the
founders' options, which vested upon the closing of the Company's initial
public offering in October 1997. The following table summarizes option grants
to date:
<TABLE>
<CAPTION>
GRANT EXERCISE
RECIPIENT DATE QUANTITY PRICE
--------- ----- -------- --------
<S> <C> <C> <C>
Non-officer directors............................. 09/96 10,000 $ 0.01
Founders.......................................... 12/96 289,332 15.00
Employees......................................... 12/96 35,000 2.50
Non-officer directors and employees............... 10/97 215,640 18.00
-------
549,972
=======
</TABLE>
F-18
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The 10,000 options granted in September 1996, the 35,000 options granted in
December 1996, and the 10,000 options granted to non-officer directors in
October 1997 were granted with dividend equivalent rights (DERs). Under the
terms of the DERs, a recipient is entitled to receive additional shares of
stock upon the exercise of options. The DERs accrue at a rate equal to the
number of options outstanding times the dividends per share amount at each
dividend date. The accrued DERs convert to shares based on the stock's fair
value on the dividend declaration date. Compensation expense relating to the
DERs during the year ended December 31, 1997 aggregated $14,000, representing
881 shares of common stock.
Options to exercise 2,500 options at $2.50 per share were exercised by an
officer in December 1997. At December 31, 1997 and December 31, 1996, total
options outstanding aggregated 547,472 and 334,332, respectively. These options
had a weighted-average exercise prices of $15.17 and $13.24, respectively. As
of December 31, 1997, 298,082 options were exercisable. No options were
exercisable as of December 31, 1996.
The Company has chosen not to adopt the optional accounting provisions of
SFAS 123, "Accounting for Stock-Based Compensation," and, accordingly, there
has been no expense recognized in the accompanying financial statements. 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 would have recognized $34,000 as
compensation expense in 1997, and the resulting pro forma basic and diluted
loss per share would have been $0.26 in 1997.
The following table summarizes the weighted average fair value of the options
granted during 1997 and 1996 and the assumptions used in their determination.
The fair value was determined using the Black-Scholes option pricing model.
<TABLE>
<CAPTION>
1997 1996
---- -----
<S> <C> <C>
Weighted average fair value.................................. $-- $0.18
Expected life in years....................................... 7 5
Annual risk-free interest rate............................... 6.5% 7.0%
Volatility................................................... -- --
Dividend yield............................................... 8.0% --
</TABLE>
NOTE 9. RELATED PARTY TRANSACTIONS
NovaStar and NMI are parties to a Mortgage Loan Purchase and Sale Agreement,
an Administrative Services Outsourcing Agreement and 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
December 31, 1997, the Company acquired all mortgage loans originated by NMI.
In that regard, NovaStar reimbursed NMI $1,030,000 of interest during 1997. The
Company has reflected such cost as interest expense in the accompanying
statement of operations. Under the Outsourcing Services Agreement, the Company
pays NMI a 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
$4,155,000 during the twelve months ended December 31, 1997, of which $505,000
is included in loan servicing expenses in the accompanying financial
statements. In addition, through December 31, 1997, NovaStar had purchased 100
percent of the mortgage loans originated by NMI, which was $418 million.
NOTE 10. INCOME TAXES
NovaStar has elected to be taxed as a REIT and accordingly has deducted for
income tax purposes, all dividends paid on its common and preferred stock.
Because NovaStar has paid or will pay dividends in amounts approximating its
taxable income for the year ended December 31, 1997, no provision for income
taxes has been provided in the accompanying financial statements.
F-19
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
NOTE 11. COMMITMENTS AND CONTINGENCIES
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.
The Company leases facilities and equipment under operating leases. Rent
expense and future obligations under these leases are not material to the
financial statements.
NOTE 12. CONDENSED FINANCIAL STATEMENTS OF NFI HOLDING CORPORATION
NFI Holding Corporation and its subsidiary, NMI had no operations, revenues
or expenses prior to February 1997, when NMI began originating subprime
mortgage loans through a network of wholesale brokers and correspondents. NMI
generally intends to sell the mortgage loans it originates to the Company.
Effective July 15, 1997, NMI began servicing mortgage loans on behalf of
NovaStar. Holding has no operations of its own and, therefore, its consolidated
financial statements generally reflect the operations of NMI. Following are the
condensed consolidated balance sheet and statement of operations of NFI Holding
Corporation for 1997 (in thousands):
NFI HOLDING CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEET
DECEMBER 31, 1997
<TABLE>
<S> <C>
ASSETS
Mortgage securities available-for-sale................................. $55,195
Other assets........................................................... 1,675
-------
Total assets..................................................... $56,870
=======
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Repurchase agreements.............................................. $53,490
Accounts payable and other liabilities............................. 1,192
Stockholders' equity............................................... 2,188
-------
Total liabilities and stockholders' equity....................... $56,870
=======
</TABLE>
NFI HOLDING CORPORATION
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
FOR THE PERIOD FROM FEBRUARY 6, 1997 (INCEPTION) TO DECEMBER 31, 1997
<TABLE>
<S> <C>
Interest income--mortgage securities.................................... $1,136
Interest expense........................................................ 945
------
Net interest income................................................. 191
Fee income:
Administrative and service fees received from NovaStar Financial,
Inc.................................................................. 4,155
Other................................................................. 1,271
------
Total Fee Income.................................................... 5,426
General and administrative expenses..................................... 5,569
------
Net income before taxes................................................. 48
Income tax expense...................................................... 20
------
Net income.............................................................. $ 28
======
</TABLE>
F-20
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Directors
NovaStar Financial, Inc.:
We have audited the accompanying consolidated balance sheets of NovaStar
Financial, Inc. and subsidiaries as of December 31, 1997 and 1996 and the
related consolidated statements of operations, stockholders' equity and cash
flows for the year ended December 31, 1997 and the period from September 13,
1996 (inception) to December 31, 1996. These consolidated financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these consolidated financial statements based on our
audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of NovaStar
Financial, Inc. and subsidiaries as of December 31, 1997 and 1996 and the
results of their operations and their cash flows for the year ended December
31, 1997 and the period from September 13, 1996 (inception) to December 31,
1996, in conformity with generally accepted accounting principles.
/s/ KPMG Peat Marwick LLP
Kansas City, Missouri
January 30, 1998
F-21
<PAGE>
- --------------------------------------------------------------------------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Prospectus Summary....................................................... 3
Risk Factors............................................................. 15
NovaStar Financial, Inc.................................................. 30
Use of Proceeds.......................................................... 30
Dividend Policy and Distributions........................................ 30
Dividend Reinvestment Plan............................................... 31
Capitalization........................................................... 31
Market Prices and Dividend Data.......................................... 32
Selected Financial and Other Data........................................ 33
Management's Discussion and Analysis of Financial Condition and Results
of Operations........................................................... 34
Business................................................................. 65
Management............................................................... 83
Principal Securityholders................................................ 93
Certain Transactions..................................................... 95
Federal Income Tax Considerations........................................ 104
Description of Capital Stock............................................. 112
Description of Warrants.................................................. 118
Plan of Distribution..................................................... 119
Legal Matters............................................................ 119
Experts.................................................................. 120
Where You Can Find More Information...................................... 120
Glossary................................................................. 121
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
NOVASTAR FINANCIAL INC.
STOCK PURCHASE WARRANTS
---------------
Prospectus
December 24, 1998
---------------
- --------------------------------------------------------------------------------
<PAGE>
PART II
INFORMATION NOT REQUIRED IN PROSPECTUS
ITEM 31. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION.
The expenses expected to be incurred in connection with the issuance and
distribution of the securities being registered are as set forth below. All
such expenses, except for the SEC registration and filing fees, are estimated:
<TABLE>
<S> <C>
SEC Registration................ $ 50,000
Exchange Listing Fee............ 70,000
Legal Fees and Expenses......... 15,000
Accounting Fees and Expenses.... 5,000
Printing Fees................... 5,000
Other........................... 5,000
--------
Total......................... $150,000
========
</TABLE>
ITEM 32. SALES TO SPECIAL PARTIES.
None.
ITEM 33. RECENT SALES OF UNREGISTERED SECURITIES.
In September and December 1996 the Registrant sold 216,666 shares of Common
Stock to the two founders of the Registrant for $2,167 cash. Such shares were
sold without registration under the Securities Act of 1933, as amended (the
"Act"), in reliance on the exemption provided by Section 4(2) thereof.
In December 1996 the Registrant sold an aggregate of 3,333,333 Units, each
Unit consisting of one share of Class A Convertible Preferred Stock and one
Stock Purchase Warrant, to approximately 180 "accredited investors" (as such
term is defined under Rule 501(a) promulgated under the Act) for $49,999,995
cash and an additional 216,666 Units to the two founders of the Registrant for
$3,249,999 in forgivable notes. Stifel, Nicolaus & Company, Incorporated acted
as placement agent (the "Placement Agent") in connection with such issuance and
received commissions and reimbursement of expenses totaling approximately
$3,000,000 along with 100,000 Stock Purchase Warrants. Such shares were sold
without registration under the Securities Act of 1933, as amended, in reliance
on the exemption provided by Section 4(2) thereof and on Regulation D
promulgated thereunder.
ITEM 34. INDEMNIFICATION OF DIRECTORS AND OFFICERS.
Section 2-418 of the Corporations and Associations Article of the Annotated
Code of Maryland provides that a Maryland corporation may indemnify any
director of the corporation and any person who, while a director of the
corporation, is or was serving at the request of the corporation as a director,
officer, partner, trustee, employee, or agent of another foreign or domestic
corporation, partnership, joint venture, trust, or other enterprise or employee
benefit plan, is made a party to any proceeding by reason of service in that
capacity unless it is established that the act or omission of the director was
material to the matter giving rise to the proceeding and was committed in bad
faith or was the result of active and deliberate dishonesty; or the director
actually received an improper personal benefit in money, property or services;
or, in the case of any criminal proceeding, the director had reasonable cause
to believe that the act or omission was unlawful. Indemnification may be
against judgments, penalties, fines, settlements, and reasonable expenses
actually incurred by the director in connection with the proceeding, but if the
proceeding was one by or in the right of the corporation, indemnification may
not be made in respect of any proceeding in which the director shall have been
adjudged
II-1
<PAGE>
to be liable to the corporation. Such indemnification may not be made unless
authorized for a specific proceeding after a determination has been made, in
the manner prescribed by the law, that indemnification is permissible in the
circumstances because the director has met the applicable standard of conduct.
On the other hand, the director must be indemnified for expenses if he has been
successful in the defense of the proceeding or as otherwise ordered by a court.
The law also prescribes the circumstances under which the corporation may
advance expenses to, or obtain insurance or similar protection for, directors.
The law also provides for comparable indemnification for corporate officers
and agents.
The Registrant's Articles of Incorporation provide that our directors and
officers shall, and our agents in the discretion of the Board of Directors may,
be indemnified to the fullest extent required or permitted from time to time by
the laws of Maryland.
The Maryland GCL permits the charter of a Maryland corporation to include a
provision limiting the liability of our directors and officers to the
corporation and our stockholders for money damages except to the extent that
(i) it is proved that the person actually received an improper benefit or
profit in money, property or services for the amount of the benefit or profit
in money, property or services actually received, or (ii) a judgment or other
final adjudication is entered in a proceeding based on a finding that the
person's action, or failure to act, was the result of active and deliberate
dishonesty and was material to the cause of action adjudicated in the
proceeding. Our Articles of Incorporation contain a provision providing for
elimination of the liability of our directors and officers or our stockholders
for money damages to the maximum extent permitted by Maryland law from time to
time.
The Purchase Terms Agreement, Registration Rights Agreement and Founders
Registration Rights Agreement, included as Exhibits 10.1, 10.2 and 10.4,
respectively, to this Registration Statement, provide for indemnification of
the Registrant, our directors and certain of our officers against certain
liabilities, including liabilities under the Act.
ITEM 35. TREATMENT OF PROCEEDS FROM STOCK BEING REGISTERED.
Not applicable.
ITEM 36. FINANCIAL STATEMENTS AND EXHIBITS.
(a) Financial Statements (each included in the Prospectus):
Balance Sheets
Statements of Operations
Statements of Stockholders' Equity
Statements of Cash Flows
Notes to Consolidated Financial Statements
(b) Exhibits:
<TABLE>
<C> <S> <C>
3.1* Articles of Amendment and Restatement of the Registrant
3.2* Articles Supplementary of the Registrant
3.3* Bylaws of the Registrant
4.1* Specimen Common Stock Certificate
4.2* Specimen Warrant Certificate
5.1* Opinion of Tobin & Tobin, a professional corporation, as
to legality (including consent of such firm)
5.2* Opinion of Piper & Marbury L.L.P., as to legality
(including consent of such firm)
8.1* Opinion of Jeffers, Wilson, Shaff & Falk, LLP, as to
certain tax matters (including consent of such firm)
</TABLE>
II-2
<PAGE>
<TABLE>
<C> <S> <C>
10.1* Purchase Terms Agreement, dated December 6, 1996, between
the Registrant and the Placement Agent.
10.2* Registration Rights Agreement, dated December 9, 1996,
between the Registrant and the Placement Agent.
10.3* Warrant Agreement, dated December 9, 1996, between the
Registrant and the Holders of the Warrants Acting Through
the Registrant as the Initial Warrant Agent.
10.4* Founders Registration Rights Agreement, dated December 9,
1996, between the Registrant and the original holders of
Common Stock of the Registrant.
10.5* Commitment Letter dated October 3, 1996 from General
Electric Capital Group accepted by the Registrant.
10.6* Master Repurchase Agreement dated as of January 31, 1997
among Merrill Lynch Mortgage Capital Inc., Merrill Lynch
Credit Corporation and the Registrant.
10.7* Mortgage Loan Warehousing Agreement dated as of February
20, 1997 between First Union National Bank of North
Carolina and the Registrant.
10.8* Employment Agreement, dated September 30, 1996, between
the Registrant and Scott F. Hartman.
10.9* Employment Agreement, dated September 30, 1996, between
the Registrant and W. Lance Anderson.
10.10* Promissory Note by Scott F. Hartman to the Registrant,
dated December 9, 1996.
10.11* Promissory Note by W. Lance Anderson to the Registrant,
dated December 9, 1996.
10.12* Stock Pledge Agreement between Scott F. Hartman and the
Registrant, dated December 9, 1996.
10.13* Stock Pledge Agreement between W. Lance Anderson and the
Registrant, dated December 9, 1996.
10.14* 1996 Executive and Non-Employee Director Stock Option
Plan, as last amended December 6, 1996.
10.15* Administrative Services Outsourcing Agreement, dated June
30, 1997, between the Registrant and NovaStar Mortgage,
Inc.
10.16* Mortgage Loan Sale and Purchase Agreement, dated as of
June 30, 1997, between the Registrant and NovaStar
Mortgage, Inc.
10.17* Flow Loan Subservicing Agreement, dated as of June 30,
1997, between the Registrant and NovaStar Mortgage, Inc.
10.18* Certificate of Incorporation of NFI Holding Corporation.
10.19* Agreement of Shareholders of Common Stock NFI Holding
Corporation.
10.20** Term Loan and Security Agreement between NovaStar
Certificates Financing Corporation and Reliance Funding
Corporation dated as of October 13, 1998 and related
agreements including Guaranty of even date by Registrant.
11.1 Statement regarding computation of per share earnings.
21.1* Subsidiaries of the Registrant (set forth in "Prospectus
Summary," "The Company" and "Certain Transactions" in the
Prospectus)
23.1* Consent of Tobin & Tobin, a professional corporation
(included in Exhibit 5.1)
23.2* Consent of Piper & Marbury L.L.P. (included in Exhibit
5.2)
23.3* Consent of Jeffers, Wilson, Shaff & Falk, LLP (included in
Exhibit 8.1)
</TABLE>
II-3
<PAGE>
<TABLE>
<C> <S> <C>
23.4 Consent of KPMG Peat Marwick LLP.
24.1* Power of Attorney
27.1 Financial Data Schedule
</TABLE>
- --------
* Previously filed.
**Incorporated by reference to the correspondingly numbered exhibit to Form
8-K filed by the Registrant with the SEC on December 22, 1998.
ITEM 39. UNDERTAKINGS.
Insofar as indemnification for liabilities arising under the Securities Act
of 1933 may be permitted to directors, officers and controlling persons of the
Registrant, pursuant to the foregoing provisions, or otherwise, the Registrant
has been advised that in the opinion of the Securities and Exchange Commission,
such indemnification is against public policy as expressed in the Act and is,
therefore, unenforceable. In the event that a claim for indemnification against
such liabilities (other than the payment by the Registrant of expenses incurred
or paid by a director, officer or controlling person of the Registrant in the
successful defense of any action, suit or proceeding) is asserted by such
director, officer or controlling person in connection with the securities begin
registered, the Registrant will, unless in the opinion of our counsel the
matter has been settled by controlling precedent, submit to court of
appropriate jurisdiction the question whether such indemnification by it is
against public policy as expressed in the Act and will be governed by the final
adjudication of such issue.
The undersigned Registrant hereby undertakes that: (1) for purposes of
determining any liability under the Securities Act of 1933, the information
omitted from the form of Prospectus filed as part of this Registration
Statement in reliance upon Rule 430A and contained in a form of Prospectus
filed by the Registrant pursuant to Rule 424(b)(1) or (4) or 497(h) under the
Securities Act of 1933 shall be deemed to be part of this Registration
Statement as of the time it was declared effective; and (2) for the purpose of
determining any liability under the Securities Act of 1933, each post-effective
amendment that contains a form of Prospectus shall be deemed to be a new
Registration Statement relating to the securities offered therein and the
offering of such securities at that time shall be deemed to be the initial bona
fide offering thereof.
II-4
<PAGE>
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1933, AS AMENDED, THE
REGISTRANT CERTIFIES THAT IT HAS REASONABLE GROUNDS TO BELIEVE THAT IT MEETS
ALL OF THE REQUIREMENTS FOR FILING ON FORM S-11 AND HAS DULY CAUSED THIS POST-
EFFECTIVE AMENDMENT NO. 1 TO THE SHELF REGISTRATION STATEMENT TO BE SIGNED ON
OUR BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, IN THE CITY OF
WESTWOOD, STATE OF KANSAS, ON DECEMBER 24, 1998.
Novastar Financial, Inc.
*/s/ Scott F. Hartman
By: _________________________________
Scott F. Hartman
Chairman of the Board and
Chief Executive Officer
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1933, AS AMENDED, THIS
POST-EFFECTIVE AMENDMENT NO. 1 TO THE SHELF REGISTRATION STATEMENT HAS BEEN
SIGNED BY THE FOLLOWING PERSONS IN THE CAPACITIES AND ON THE DATES INDICATED:
<TABLE>
<CAPTION>
SIGNATURE POSITION DATE
--------- -------- ----
<S> <C> <C>
*/s/ Scott F. Hartman Chairman of the Board, Chief December 24, 1998
____________________________________ Executive Officer and
Scott F. Hartman Director (Principal
Executive Officer)
*/s/ W. Lance Anderson President, Chief Operating December 24, 1998
____________________________________ Officer and Director
W. Lance Anderson
*/s/ Mark J. Kohlrus Senior Vice President, December 24, 1998
____________________________________ Treasurer and Chief
Mark J. Kohlrus Financial Officer
(Principal Financial
Officer)
*/s/ Rodney E. Schwatken Vice President, Controller, December 24, 1998
____________________________________ and Assistant Treasurer
Rodney E. Schwatken (Principal Accounting
Officer)
*/s/ Gregory T. Barmore Director December 24, 1998
____________________________________
Gregory T. Barmore
*/s/ Edward W. Mehrer Director December 24, 1998
____________________________________
Edward W. Mehrer
Director December 24, 1998
____________________________________
Bart O. Johnson
/s/ Rodney E. Schwatken
____________________________________
*Rodney E. Schwatken,
Attorney-in-Fact
</TABLE>
II-5
<PAGE>
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT NO. DESCRIPTION OF DOCUMENT
----------- -----------------------
<C> <S> <C>
3.1* Articles of Amendment and Restatement of the Registrant
3.2* Articles Supplementary of the Registrant
3.3* Bylaws of the Registrant
4.1* Specimen Common Stock Certificate
4.2* Specimen Warrant Certificate
5.1* Opinion of Tobin & Tobin, a professional corporation, as to
legality (including consent of such firm)
5.2* Opinion of Piper & Marbury L.L.P., as to legality (including
consent of such firm)
8.1* Opinion of Jeffers, Wilson, Shaff & Falk, LLP, as to certain
tax matters (including consent of such firm)
10.1* Purchase Terms Agreement, dated December 6, 1996, between
the Registrant and the Placement Agent.
10.2* Registration Rights Agreement, dated December 9, 1996,
between the Registrant and the Placement Agent.
10.3* Warrant Agreement, dated December 9, 1996, between the
Registrant and the Holders of the Warrants Acting Through
the Registrant as the Initial Warrant Agent.
10.4* Founders Registration Rights Agreement, dated December 9,
1996, between the Registrant and the original holders of
Common Stock of the Registrant.
10.5* Commitment Letter dated October 3, 1996 from General
Electric Capital Group accepted by the Registrant.
10.6* Master Repurchase Agreement dated as of January 31, 1997
among Merrill Lynch Mortgage Capital Inc., Merrill Lynch
Credit Corporation and the Registrant.
10.7* Mortgage Loan Warehousing Agreement dated as of February 20,
1997 between First Union National Bank of North Carolina
and the Registrant.
10.8* Employment Agreement, dated September 30, 1996, between the
Registrant and Scott F. Hartman.
10.9* Employment Agreement, dated September 30, 1996, between the
Registrant and W. Lance Anderson.
10.10* Promissory Note by Scott F. Hartman to the Registrant, dated
December 9, 1996.
10.11* Promissory Note by W. Lance Anderson to the Registrant,
dated December 9, 1996.
10.12* Stock Pledge Agreement between Scott F. Hartman and the
Registrant, dated December 9, 1996.
10.13* Stock Pledge Agreement between W. Lance Anderson and the
Registrant, dated December 9, 1996.
10.14* 1996 Executive and Non-Employee Director Stock Option Plan,
as last amended December 6, 1996.
10.15* Administrative Services Outsourcing Agreement, dated June
30, 1997, between the Registrant and NovaStar Mortgage,
Inc.
10.16* Mortgage Loan Sale and Purchase Agreement, dated as of June
30, 1997, between the Registrant and NovaStar Mortgage,
Inc.
10.17* Flow Loan Subservicing Agreement, dated as of June 30, 1997,
between the Registrant and NovaStar Mortgage, Inc.
10.18* Certificate of Incorporation of NFI Holding Corporation.
10.19* Agreement of Shareholders of Common Stock NFI Holding
Corporation.
</TABLE>
II-6
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT NO. DESCRIPTION OF DOCUMENT
----------- -----------------------
<C> <S> <C>
10.20** Term Loan and Security Agreement between NovaStar
Certificates Financing Corporation and Reliance Funding
Corporation dated as of October 13, 1998 and related
agreements including Guaranty of even date by Registrant.
11.1 Statement regarding computation of per share earnings.
21.1* Subsidiaries of the Registrant (set forth in "Prospectus
Summary," "The Company" and "Certain Transactions" in the
Prospectus)
23.1* Consent of Tobin & Tobin, a professional corporation
(included in Exhibit 5.1)
23.2* Consent of Piper & Marbury L.L.P. (included in Exhibit 5.2)
23.3* Consent of Jeffers, Wilson, Shaff & Falk, LLP (included in
Exhibit 8.1)
23.4 Consent of KPMG Peat Marwick LLP
24.1* Power of Attorney
27.1 Financial Data Schedule
</TABLE>
- --------
* Previously filed.
**Incorporated by reference to the correspondingly numbered exhibit to Form
8-K filed by the Registrant with the SEC on December 22, 1998.
II-7
<PAGE>
EXHIBIT 11.1
SCHEDULE REGARDING COMPUTATION OF PER SHARE EARNINGS (LOSS)
(000'S EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
NINE MONTHS TWELVE MONTHS
ENDED SEPTEMBER 30, ENDED DECEMBER 31,
-------------------- ---------------------
1998 1997 1997 1996
---- ---- ---- ----
<S> <C> <C> <C> <C>
Net income (loss) $5,567 $ (702) $(1,135) $ (302)
====== ====== ======= ======
Basic weighted average shares outstanding 8,033 3,767 4,430 3,767
Common equivalent shares:
Dilutive stock options 51 -- -- --
Dilutive warrants 555 -- -- --
------ ------ ------- ------
Diluted weighted average shares outstanding 8,639 3,767 4,430 3,767
====== ====== ======= ======
Basic earnings (loss) per share $ 0.69 $(0.19) $ (0.26) $(0.08)
====== ====== ======= ======
Diluted earnings (loss) per share $ 0.64 $(0.19) $ (0.26) $(0.08)
====== ====== ======= ======
</TABLE>
<PAGE>
Exhibit 23.4
ACCOUNTANTS' CONSENT
--------------------
The Board of Directors
NovaStar Financial, Inc.
We consent to the inclusion of our report, dated January 30, 1998 relating to
the consolidated balance sheets of NovaStar Financial, Inc. and subsidiaries as
of December 31, 1997 and 1996 and related consolidated statements of earnings,
retained earnings, and cash flows for the year ended December 31, 1997 and the
period from September 13, 1996 (inception) to December 31, 1996, in the
Registration Statement No. 33343471 on Form S-11 of NovaStar Financial, Inc.
KPMG Peat Marwick LLP
Kansas City, Missouri
December 24, 1998
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND> THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM
THE COMPANY'S FORM S-11 FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1998 AND YEARS
ENDED DECEMBER 31, 1997 AND 1996 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE
TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C> <C> <C>
<PERIOD-TYPE> 9-MOS 12-MOS 12-MOS
<FISCAL-YEAR-END> DEC-31-1998 DEC-31-1997 DEC-31-1996
<PERIOD-START> DEC-31-1997 DEC-31-1996 SEP-13-1996
<PERIOD-END> SEP-30-1998 DEC-31-1997 DEC-31-1996
<CASH> 55,383 20,424 46,434
<SECURITIES> 408,276 517,246 13,239
<RECEIVABLES> 944,228 574,984 0
<ALLOWANCES> 2,757 2,313 0
<INVENTORY> 0 0 0
<CURRENT-ASSETS> 0 0 0
<PP&E> 0 0 0
<DEPRECIATION> 0 0 0
<TOTAL-ASSETS> 1,693,325 1,126,252 59,811
<CURRENT-LIABILITIES> 0 0 0
<BONDS> 0 0 0
0 0 0
0 0 36
<COMMON> 81 78 2
<OTHER-SE> 109,767 116,411 46,342
<TOTAL-LIABILITY-AND-EQUITY> 1,693,325 1,262,252 59,811
<SALES> 79,155 36,961 155
<TOTAL-REVENUES> 84,933 37,716 155
<CGS> 0 0 0
<TOTAL-COSTS> 76,911 38,879 457
<OTHER-EXPENSES> 0 0 0
<LOSS-PROVISION> 3,400 2,453 0
<INTEREST-EXPENSE> 60,948 28,185 0
<INCOME-PRETAX> 5,567 (1,135) (302)
<INCOME-TAX> 0 0 0
<INCOME-CONTINUING> 5,567 (1,135) (302)
<DISCONTINUED> 0 0 0
<EXTRAORDINARY> 0 0 0
<CHANGES> 0 0 0
<NET-INCOME> 5,567 (1,135) (302)
<EPS-PRIMARY> 0.69 0 0
<EPS-DILUTED> 0.64 0 0
</TABLE>
