<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q/A
Amendment No. 1 to
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1998.
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from ___________________ to ___________________.
Commission File Number: 001-13533
NovaStar Financial, Inc.
------------------------
(Exact name of registrant as specified in its charter)
Maryland 74-2830661
- ------------------------------- ------------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
1901 W. 47th Place, Suite 105, Westwood, KS 66205
-------------------------------------------------
(Address of principal executive offices)
(Zip Code)
(913) 362-1090
--------------
(Registrant's telephone number, including area code)
______________________________________________
(Former name, former address and former fiscal year, if changed since last
report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
--- ---
The number of shares of the registrant's common stock outstanding as of August
10, 1998 was 8,125,360.
<PAGE>
NOVASTAR FINANCIAL, INC.
FORM 10-Q
QUARTER ENDED JUNE 30, 1998
INDEX
<TABLE>
<CAPTION>
Page
PART I FINANCIAL INFORMATION
<S> <C> <C>
Item 1. Consolidated Financial Statements:
Balance Sheets.................................................. 1
Statements of Operations........................................ 2
Statements of Cash Flows........................................ 3
Notes........................................................... 4
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations............................. 5
PART II OTHER INFORMATION
Item 1. Legal Proceedings................................................ 24
Item 2. Changes in Securities............................................ 24
Item 3. Defaults Upon Senior Securities.................................. 24
Item 4. Submission of Matters to a Vote of Security Holders.............. 24
Item 5. Other Information................................................ 24
Item 6. Exhibits and Reports on Form 8-K................................. 25
Signatures....................................................... 26
</TABLE>
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share amounts)
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------
June 30, 1998 December 31, 1997
(unaudited)
<S> <C> <C>
Assets
Cash and cash equivalents.......................... $ 48 $ --
Restricted cash.................................... 28,434 20,424
Mortgage loans..................................... 1,003,518 574,984
Available-for-sale securities:
Mortgage securities.............................. 440,322 517,246
Other............................................ 19,998 --
Accrued interest receivable........................ 11,998 7,088
Investment in NFI Holding Corporation.............. 2,163 2,188
Other assets....................................... 12,919 4,322
---------- ----------
Total assets.......................... $1,519,400 $1,126,252
========== ==========
Liabilities and Stockholders' Equity
Liabilities:
Repurchase agreements.............................. $ 649,935 $ 556,443
Collateralized mortgage obligations................ 688,366 408,867
Warehouse line of credit........................... 56,529 40,250
Accounts payable and accrued expenses.............. 9,695 4,203
---------- ----------
Total liabilities........................... 1,404,525 1,009,763
Stockholders' equity:
Capital stock, $0.01 par value, 50,000,000
shares authorized:
Common stock, 8,124,042 and 7,828,665
shares issued and outstanding, respectively...... 81 78
Additional paid-in capital......................... 121,377 117,084
Accumulated deficit................................ (4,966) (2,859)
Accumulated comprehensive income................... 51 4,353
Forgivable notes receivable from founders.......... (1,668) (2,167)
---------- ----------
Total stockholders' equity.................. 114,875 116,489
---------- ----------
Total liabilities and stockholders' equity......... $1,519,400 $1,126,252
========== ==========
</TABLE>
See notes to consolidated financial statements.
1
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited; in thousands)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
For the Six Months For the Three Months
Ended June 30, Ended June 30,
---------------------- --------------------
1998 1997 1998 1997
<S> <C> <C> <C> <C>
Interest income:
Mortgage loans....................................... $33,961 $7,079 $19,412 $ 5,276
Mortgage securities.................................. 16,397 2,241 7,032 1,668
------- ------ ------- -------
Total interest income........................................ 50,358 9,320 26,444 6,944
Interest expense............................................. 38,860 6,438 20,418 5,176
------- ------ ------- -------
Net interest income.......................................... 11,498 2,882 6,026 1,768
Provision for credit losses.................................. 2,221 718 1,145 548
------- ------ ------- -------
Net interest income after provision for credit losses........ 9,277 2,164 4,881 1,220
Other income................................................. 1,288 68 1,015 (15)
Net gain on sales of mortgage assets......................... 223 -- 131 --
Equity in earnings (loss) of NFI Holding Corporation......... (8) (432) 262 (67)
General and administrative expenses:
Services provided by NovaStar Mortgage, Inc............ 3,600 1,250 2,100 1,250
Loan servicing......................................... 1,616 571 942 535
Compensation and benefits.............................. 896 369 460 84
Forgiveness of notes receivable from founders.......... 542 -- 271 --
Office administration.................................. 405 112 224 85
Professional and outside services...................... 353 249 297 180
Other.................................................. 196 128 101 77
------- ------ ------- -------
Total general and administrative expenses.............. 7,608 2,679 4,395 2,211
------- ------ ------- -------
Net income (loss)............................................ $ 3,172 $ (879) $ 1,894 $(1,073)
======= ======= ======= =======
Basic earnings per share..................................... $ 0.40 $(0.23) $ 0.23 $ (0.28)
======= ====== ======= =======
Diluted earnings per share................................... $ 0.36 $(0.23) $ 0.21 $ (0.28)
======= ====== ======= =======
Dividends declared per share................................. $ 0.65 $ 0.10 $ 0.35 $ 0.05
======= ====== ======= =======
Basic weighted average shares outstanding.................... 7,987 3,767 8,121 3,767
======= ====== ======= =======
Diluted weighted average shares outstanding.................. 8,841 3,806 9,015 3,806
======= ====== ======= =======
</TABLE>
See notes to consolidated financial statements.
2
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited; in thousands)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
For the Six Months Ended
June 30,
-------------------------
1998 1997
<S> <C> <C>
Net cash provided by (used in) operating activities $ (768) $ 3,198
Cash flow from investing activities:
Mortgage loans purchased from NovaStar Mortgage, Inc. ...................... (507,390) (92,254)
Mortgage loans sold to others............................................... 3,011 --
Mortgage loans purchased from others........................................ -- (219,995)
Mortgage loan repayments.................................................... 71,074 7,328
Purchases of available-for-sale securities.................................. (375,051) (373,753)
Proceeds from sales of available-for-sale securities........................ 315,743 100,618
Proceeds from paydowns on and maturities of available-for-sale securities... 111,093 3,290
Settlement of amounts payable to brokers.................................... -- (12,676)
Investment in NFI Holding Corporation....................................... -- (1,980)
-------- ---------
Net cash used in investing activities....................................... (381,520) (589,422)
Cash flow from financing activities:
Net change in restricted cash............................................... (8,010) --
Proceeds from issuing collateralized mortgage obligations................... 350,000 --
Payments on collateralized mortgage obligations............................. (70,501) --
Net borrowings under repurchase agreements and warehouse line............... 109,771 540,040
Exercise of stock options and warrants...................................... 4,384 --
Registration costs of stock options and warrants............................ (88) --
Additional private placement offering costs................................. -- (48)
Dividends paid.............................................................. (3,220) (178)
-------- ---------
Net cash provided by financing activities..................................... 382,336 539,814
-------- ---------
Net increase (decrease) in cash and cash equivalents........................ 48 (46,410)
Cash and cash equivalents, beginning of period.............................. -- 46,434
-------- ---------
Cash and cash equivalents, end of period.................................... $ 48 $ 24
========= =========
Supplemental disclosure of cash flow information:
Cash paid for interest...................................................... $ 38,102 $ 5,631
========= =========
Dividends payable........................................................... $ 2,843 $ 177
========= =========
</TABLE>
See notes to consolidated financial statements.
3
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 1998 (Unaudited)
- --------------------------------------------------------------------------------
Note 1. Financial Statement Presentation
The consolidated financial statements as of and for the periods ended June 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 is a wholly owned subsidiary of Holding. Certain key officers of the
Company serve as officers of Holding and NovaStar Mortgage and the founders of
the Company are the only members of the Board of Directors of Holding and
NovaStar Mortgage. The Company accounts for its investment in Holding using the
equity method.
Note 2. 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, stockholder's
equity or net income. The consolidated financial statements of the Company as
of and for the year ended December 31, 1997 are comparable to those as of June
30, 1998. However, the caption for comprehensive income has appropriately been
identified.
Following is a summary of comprehensive income for the three- and six-month
periods ended June 30, 1998.
<TABLE>
<CAPTION>
For the Six Months For the Three Months
Ended June 30 Ended June 30
------------------ --------------------
1998 1997 1998 1997
<S> <C> <C> <C> <C>
Net income (loss)......................... $ 3,172 $ (879) $1,894 $(1,073)
Other comprehensive income--net change
in unrealized gain(loss) on
available-for-sale securities............. (4,302) 1,383 (194) 1,451
------- ------ ------ -------
Comprehensive income (loss)............... (1,130) 504 1,700 378
======= ====== ====== =======
</TABLE>
4
<PAGE>
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion should be read in conjunction with the preceding
Consolidated Financial Statements of the Company and the Notes thereto 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. Risks and uncertainties,
which could cause results to differ from those discussed in the forward-looking
statements herein, are listed in the Company's Annual Report filed on form 10K.
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 three 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 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. Subsequent to June 30, 1998,
Holding formed NovaStar Capital, Inc. to purchase and sell mortgage loans. The
Company accounts for its investment in Holding using the equity method.
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. The Company has recorded a non-cash charge of $542,000
to earnings during the six months ended June 30, 1998 for the anticipated
forgiveness of the second tranche.
Financial Condition
For the six months ended June 30, 1998, NovaStar Mortgage originated over
5,000 subprime residential mortgage loans with an aggregate principal amount of
$502 million. NovaStar Financial purchased $498 million of these loans,
resulting in the Company having consolidated assets of $1.5 billion at June 30,
1998. The Company's balance sheet continues to become more heavily weighted
towards subprime mortgage loans, as its mortgage securities pay off or are sold.
During June 1998, the Company sold $2.8 million of 1998 loans to an unrelated
third party for cash, recognizing a gain on the transaction of $115,000. The
Company completed its first 1998 securitization on April 30, 1998, pooling $303
million of mortgage loans as collateral.
Table I is a summary of wholesale loan originations and bulk acquisitions for
1998 and 1997. Table II presents a more detailed analysis of wholesale loan
originations.
5
<PAGE>
Table I
Wholesale Loan Originations (A) and Bulk Acquisitions
Six Months Ended June 30, 1998 and Year Ended December 31, 1997 (dollars in
thousands)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Wholesale Bulk Acquisitions Total
Originations(A)
--------------------------------------------------------------------------
Number Principal Number Principal Number Principal
Of Loans Amount of Loans Amount of Loans Amount
1998:
<S> <C> <C> <C> <C> <C> <C>
Second quarter. 3,133 $294,303 -- -- 3,133 $294,303
First quarter.. 2,033 207,976 -- -- 2,033 207,976
1998 total..... 5,166 $502,279 -- -- 5,166 $502,279
===== ======== ===== ======== ===== ========
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
Table II
1998 and 1997 Quarterly Wholesale Loan Originations (A)
(dollars in thousands)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Weighted Average
-------------------------------
Average Percent with
Number Loan Price Paid to Loan-to- Credit Prepayment
of Loans Principal Balance Broker value Rating (B) Coupon Penalty
<S> <C> <C> <C> <C> <C> <C> <C> <C>
1998:
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
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) AA=6, A=5, A-=4, B=3, C=2,D=1
Subprime mortgage loans compose 70 percent of the mortgage assets owned by
the Company as of June 30, 1998 compared with 51 percent at December 31, 1997.
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 III is a presentation of loans as of June 30, 1998 and their credit
grades.
6
<PAGE>
<TABLE>
<CAPTION>
Table III
Mortgage Loans by Credit Grade
June 30, 1998 (dollars in thousands)
- -------------------------------------------------------------------------------------------------------------
Maximum Weighted Weighted
Allowed Mortgage Loan-to- Current Average Average
Credit Rating Lates value Principal Coupon Loan-to-value
<S> <C> <C> <C> <C> <C>
AA.................. 0 x 30 95% $117,304 9.50% 83.5%
A................... 1 x 30 90 388,997 9.82 79.5
A-.................. 2 x 30 90 237,436 10.22 80.5
B................... 3 x 30, 1 x 60 85 153,267 10.53 77.6
5 x 30, 2 x 60,
C................... 1 x 90 80 70,542 11.09 72.6
D................... 6 x 30, 3 x 60,
2 x 90 65 16,300 11.94 62.3
--------
Total............. $983,846 10.12% 79.2%
======== ====== =====
</TABLE>
Table IV is a summary of loans originated by NovaStar Mortgage by state.
The Company's portfolio continues to become more geographically diversified. The
second quarter of 1998 marked the first quarter California did not represent the
state with the largest percent of loan principal originations. Loan origination
volume in Florida was $47.7 million in the second quarter of 1998 versus $25.6
million in California. Table V is a summary of all mortgage loans owned by the
Company as of June 30, 1998 by state.
<TABLE>
<CAPTION>
Table IV Table V
Mortgage Loan Originations by State Mortgage Loans by State
Six Months Ended June 30, 1998 and Year Ended December 31, 1997 As of June 30, 1998
- ------------------------------------------------------------------------------- ------------------------------
Percent of Portfolio
Percent of Total Originations during Quarter (based on original principal
(based on original principal balance) balance)
------------------------------------------------------ -----------------------------
1998 1997
-------------------- -------------------------------
Collateral
Collateral Location Second First Fourth Third Second First Location
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Florida.................. 16% 12% 9% 10% 8% 1% California.......... 19%
California............... 9 15 19 24 26 40 Florida............. 12
Washington............... 6 7 8 11 16 15 Washington.......... 8
Ohio..................... 5 2 2 2 2 -- Oregon.............. 5
Michigan................. 5 5 5 3 -- -- All other states.... 56
Oregon................... 4 5 6 6 9 7
Nevada................... 3 6 5 4 2
Maryland................. 3 4 5 6 5 13
Utah..................... 3 3 6 6 9 13
Texas.................... 3 3 3 4 7 2
Virginia................. 2 2 5 6 2 --
Oklahoma................. 1 1 1 1 2 5
All other states......... 40 35 26 17 12 4
</TABLE>
The Company continues to be an investor in mortgage securities issued by
Government-sponsored entities. However, as more of the Company's capital is
allocated to the acquisition of subprime mortgage loans, less capital is
available for mortgage securities. As of June 30, 1998, the carrying value of
mortgage securities totaled $440.3 million compared with $517.2 million as of
December 31, 1997. During the six months ended June 30, 1998, the Company
acquired mortgage securities with an aggregate cost of $354.9 million at an
average price of 101.0 and sold mortgage securities with an amortized cost of
$315.4 million resulting in a net gain of $108,000. Tables VI and VII are
summaries of the securities acquired during the first six months of 1998 and
1997 by quarter and the portfolio as of June 30, 1998.
7
<PAGE>
<TABLE>
<CAPTION>
Table VI
Mortgage Security Acquisitions
Six Months Ended June 30, 1998 and Year Ended December 31, 1997 (dollars in thousands)
- -------------------------------------------------------------------------------------------------------------------
Net Weighted
Price to Average
Principal Premium Discount Par Coupon
<S> <C> <C> <C> <C> <C>
1998:
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>
<CAPTION>
Table VII
Mortgage Security Portfolio
As of June 30, 1998 (in thousands)
- --------------------------------------------------------------------------------------------------------------------
Gross
-------------------------- Weighted
Unamortized Unaccreted Carrying Average
Principal Premium Discount Value Coupon
<S> <C> <C> <C> <C> <C>
Federal National Mortgage Association.......... $296,323 $6,347 $ -- $302,670 7.08%
Government National Mortgage Association....... 133,247 431 (574) 133,104 5.47
Federal Home Loan Mortgage Corporation......... 4,367 154 -- 4,521 7.55
-------- ------ -------- --------
$433,937 $6,932 $ (574) 440,295 6.59%
======== ====== ========
Net unrealized gain............................ 27
--------
Carrying value................................. $440,322
========
</TABLE>
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 has a $400 million master
repurchase line with Merrill Lynch Mortgage Capital, Inc. and Merrill Lynch
Credit Corporation and $200 million master repurchase lines with Bear Stearns
Home Equity Trust and Lehman Commercial Paper, Inc. Management is negotiating
with other reputable dealers for additional financing arrangements. Funds
borrowed against the master repurchase agreement are also used to acquire loans
from NovaStar Mortgage. Residual financing is another short-term borrowing
instrument 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.
Management expects to continue using this method to finance its acquisition of
mortgage securities.
Under the terms of all financing arrangements, lending institutions require
"over-collateralization" from the Company. The value of the collateral generally
must exceed the allowable borrowing by two to five percent. As a result, the
Company must have capital available to cover this "haircut."
Table VIII displays the amounts outstanding under borrowing arrangements as
of June 30, 1998.
8
<PAGE>
<TABLE>
<CAPTION>
Table VIII
Borrowings
June 30, 1998 (dollars in thousands)
- --------------------------------------------------------------------------------------------------------------------
As of June 30, 1998
-----------------------------------
Weighted Average Daily
Weighted Days to Balance During the
Average Reset or Six Months Ended
Rate Maturity Balance June 30, 1998
<S> <C> <C> <C> <C>
Repurchase agreements secured by mortgage securities..... 5.64% 23 $444,406 $521,824
Master repurchase agreement secured by mortgage loans.... 6.39 31 205,529 163,471
--------
Total repurchase agreements............................ 649,935
Warehouse line of credit................................. 6.81 Demand 56,529 24,535
--------
Total borrowings ..................................... $706,464
========
</TABLE>
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 IX displays the amounts outstanding under collateralized
mortgage obligations as of June 30, 1998.
<TABLE>
<CAPTION>
Table IX
Collateralized Mortgage Obligations
June 30, 1998 (dollars in thousands)
- ----------------------------------------------------------------------------------------------------------------
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.................... $204,103 5.96% $218,218 10.42% 27
Issue 1997-2.................... 192,207 5.91 198,938 10.28 30
Issue 1998-1.................... 295,298 5.73 300,962 9.97 27
Debt issuance costs, net........ (3,242) --
-------- --------
$688,366 $718,118
======== ========
</TABLE>
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 X displays
the historical prepayment speeds for mortgage loans collateralizing the
Company's CMOs. Table XIV provides an analysis of prepayment characteristics of
the Company's mortgage loan portfolio.
9
<PAGE>
<TABLE>
<CAPTION>
Table X
Prepayment Speed
- ---------------------------------------------------------------------------------------
Constant Prepayment Rate (Annual Percent)
-----------------------------------------------
One-month Three-month Twelve-month Life
<S> <C> <C> <C> <C>
As of June 30, 1998
NovaStar Home Equity Series:
1997-1............................ 35.5 35.0 -- 28.2
1997-2............................ 18.0 18.7 -- 14.3
1998-1............................ 9.8 6.5 -- 6.5
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 to refinance or rate modify their loans with NovaStar. Of
the loans that prepaid during the first six months of 1998, $6.4 million, or ten
percent of the loans were successfully refinanced and $631,000, or one percent
of the loans, were rate modified. For the second quarter of 1998, $4.0 million,
or ten percent of the loans were successfully refinanced and $196,000, or one
percent of the loans were rate modified. Although these loans are considered
prepayments for the purposes of the information in Table X - they remain in the
NovaStar loan portfolio.
Tables XI summarizes quarterly mortgage asset activity during 1998 and 1997
and Table XII details the amount of premium as a percent of principal at quarter
end for 1998 and 1997.
<TABLE>
<CAPTION>
Table XI
Mortgage Assets Activity
- -----------------------------------------------------------------------------------------------------------------
Mortgage Loans Mortgage 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 3,323 270,059 3,806 478,035 7,129
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 20,024 400,901 5,986 1,141,089 26,010
Acquisitions............................ 290,350 4,548 80,237 823 370,587 5,371
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 $23,013 $ 433,937 $ 6,358 $1,417,783 $29,371
======== ======= ========= ======= ========== =======
</TABLE>
10
<PAGE>
<TABLE>
<CAPTION>
Table XII
Premium as a Percent of Principal
- --------------------------------------------------------------------------------
Total
Mortgage Mortgage Mortgage
Loans Securities Assets
<S> <C> <C> <C>
As of:
June 30, 1998....................... 2.34% 1.47% 2.07%
March 31, 1998...................... 2.71 1.49 2.28
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 -- Six Months Ended June 30, 1998 Compared to Six Months
Ended June 30, 1997
Net Loss
During the six months ended June 30, 1998, the Company recorded net income
of $3,172,000, a diluted $0.36 per share, compared with a net loss of $879,000,
a diluted $0.23 per share, for the six months ended June 30, 1997. Excluding the
forgiveness of the notes receivable from founders, the Company earned $3,714,000
(a diluted $0.42 per share) for the half of 1998.
Net Interest Income
Interest Income. The Company had average interest-earning assets of $1.2
billion during the six months ended June 30, 1998, including $719.1 million of
mortgage loans and $511.4 million of mortgage securities compared with average
interest-earning assets of $229.7 million during the six months ended June 30,
1997. During the six months ended June 30, 1998, mortgage loans earned $34.0
million, or a yield of 9.5 percent, compared with $7.1 million, or a yield of
8.5 percent for the six months ended June 30, 1997. Mortgage securities earned
$16.4 million for the six months ended June 30, 1998, or a yield of 6.4 percent,
compared with $2.2 million, or a yield of 7.1 percent for the six months ended
June 30, 1997. In total, assets earned $50.4 million, or an 8.2 percent yield
for the six months ended June 30, 1998. During the six months ended June 30,
1997, assets earned $9.3 million or an 8.1 percent yield.
A substantial portion of the mortgage assets owned by the Company have
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 XIII is a summary of the
Company's mortgage assets by type, presenting their current and fully indexed
weighted-average coupons.
<TABLE>
<CAPTION>
Table XIII
Mortgage Assets by Product/Type and Weighted Average Coupon
June 30, 1998 (dollars in thousands)
- --------------------------------------------------------------------------------
Weighted Average
Coupon
----------------
Outstanding Fully
Product/Type Principal Current Indexed
<S> <C> <C> <C>
Mortgage loans:
Two and three year fixed/adjustable thereafter.. $ 554,241 10.15% 11.44%
Fixed rate (30 Yr, 15 Yr, 30/15)................ 308,755 10.07
Other (1 year CMT, 6 month LIBOR)............... 120,850 10.06 11.43
----------
Total mortgage loans........................ 983,846
Mortgage securities issued by:
Federal National Mortgage Association........... 296,323 7.08 7.61
Government National Mortgage Association........ 133,247 5.47 6.87
Federal Home Loan Mortgage Corporation.......... 4,367 7.55 7.60
----------
Total mortgage securities................... 433,937
----------
Total............................................. $1,417,783
==========
</TABLE>
11
<PAGE>
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 X, XI and XII 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 second quarter of
1998, the Company collected $678,000 in prepayment penalties from borrowers.
Table XIV is an analysis of mortgage loans and prepayment penalties. Prepayments
on mortgage loans of the Company have been consistent with management's
expectations.
<TABLE>
<CAPTION>
Table XIV
Mortgage Loan Prepayment Penalties
June 30, 1998 (dollars in thousands)
- -------------------------------------------------------------------------------------------------------
Weighted Average
-------------------------------------
Percent with Prepayment Penalty
Current Prepayment Loan-to- Period (in years) -
Principal Premium Penalty Coupon value Loans with Penalty
<S> <C> <C> <C> <C> <C> <C>
Loans collateralizing NovaStar
Home Equity Series (CMO):
1997-1........................ $209,162 $10,377 70.1% 10.42% 75.0% 1.65
1997-2........................ 196,920 3,261 70.5 10.28 78.2 1.99
1998-1........................ 297,099 4,448 67.8 9.97 81.0 2.69
All other loans................. 280,665 4,927 68.6 9.93 80.8 3.33
-------- -------
Total........................... $983,846 $23,013 69.1 10.12 79.2 2.51
======== =======
</TABLE>
As noted above, interest income is a function of volume and rates.
Management expects its mortgage asset portfolio to continue to increase,
primarily through wholesale loan production. Management will continue to monitor
the market for mortgage securities and whole loan mortgage pools and will
acquire mortgage assets that are appropriate for its overall asset/liability
strategy. Increasing 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 $38.9
million during the six months ended June 30, 1998, or 6.3 percent of average
borrowings, compared with $6.4 million for the six months ended June 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 six months ended
June 30, 1998, the one-month LIBOR averaged 5.7 percent compared with 5.6
percent for the six months ended June 30, 1997. 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 XV presents a summary of the average interest-earning assets, average
interest-bearing liabilities and the related yields and rates thereon for the
six months ended June 30, 1998.
<TABLE>
<CAPTION>
Table XV
Interest Analysis
Six Months Ended June 30, 1998 (dollars in thousands)
- --------------------------------------------------------------------------------
Mortgage Loans
--------------------------
Interest Annual
Average Income/ Yield/
Balance Expense Rate
<S> <C> <C> <C>
Mortgage Assets............................... $719,081 $33,961 9.45%
--------
Liabilities
Repurchase agreements....................... $163,471 5,342 6.54%
Collateralized mortgage obligations......... 528,014 16,925 6.41
Other borrowings............................ 24,535 537 4.37
--------
Cost of derivative financial
instruments hedging liabilities............. 999
-------
Total borrowings........................ $716,020 23,802 6.37
======== =======
Net interest income......................... $10,159
=======
Net interest spread......................... 3.08%
----
Net yield................................... 2.83%
====
</TABLE>
<TABLE>
<CAPTION>
Mortgage Securities
----------------------------------------
Interest Annual
Average Income/ Yield/ Average
Balance Expense Rate Balance
<S> <C> <C> <C> <C>
Mortgage Assets........................ $511,385 $16,397 6.41% $1,230,466
-------- ----------
Liabilities
Repurchase agreements................ $521,824 14,622 5.62% 685,295
Collateralized mortgage obligations.. -- -- -- 528,014
Other borrowings..................... -- -- -- 24,535
----------
Cost of derivative financial
instruments hedging liabilities...... -- 395
-------- -------
Total borrowings................. $521,824 15,057 5.77 $1,237,844
======== ==========
Net interest income.................. $ 1,340
=======
Net interest spread.................. 0.79%
----
Net yield............................ 0.52%
====
</TABLE>
<TABLE>
<CAPTION>
Total
----------------
Interest Annual
Income/ Yield/
Expense Rate
<S> <C> <C>
Mortgage Assets............................... $50,358 8.19%
Liabilities
Repurchase agreements....................... 20,004 5.84%
Collateralized mortgage obligations......... 16,925 6.41
Other borrowings............................ 537 4.37
Cost of derivative financial
instruments hedging liabilities............. 1,394
-------
Total borrowings........................ $38,860 6.28
=======
Net interest income......................... $11,498
=======
Net interest spread......................... 1.91%
----
Net yield................................... 1.87%
====
</TABLE>
12
<PAGE>
Net Interest Income and Spread. Net interest income during the six months
ended June 30, 1998 was $11.5 million or 1.87 percent of average interest-
earning assets, compared with 9.3 million, or 2.51 percent of average interest-
earning assets during the six months ended June 30, 1997. Net interest spread
for the Company was 1.91 percent during the six months ended June 30, 1998
compared with 1.77 percent during the six months ended June 30, 1997. Net
interest income and the spread are functions of the yield of the Company's
assets relative to its costs of funds. The cost of funds has remained relatively
low and stable. 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 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 are 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 six months
ended June 30, 1998, the Company incurred net interest expense on these
agreements of $1.4 million, which is included as a component of interest
expense. The net interest expense for the six months ended June 30, 1997 was
$346,000 . Table XVI details the Company's interest rate agreements as of June
30, 1998 (dollars in thousands):
Table XVI
Interest Rate Agreements
As of June 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...... $448,000 $ 136 $1,900 936 NA 5.67% 6.12% $2,630 $2,731
Interest rate cap agreements.. 445,000 1,439 -- 877 5.90% NA NA -- --
-------- ------ ------
$893,000 $1,575 $1,900
======== ====== ======
</TABLE>
Gains and Losses on Mortgage Assets
The Company classifies its securities as available-for-sale because
management may deem it appropriate to sell securities, from time to time, to
reallocate the Company's capital. During the six months ended June 30, 1998,
the Company recognized $108,000 in net gains on sales of mortgage securities
with a principal balance of $310 million. Also, the Company sold a pool of
loans in June 1998 with a principal balance of $2.8 million and recognized a
gain of $115,000 on the transaction.
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 six months
ended June 30, 1998, the Company provided $2.2 million for credit losses,
compared with $718,000 during the six months ended June 30, 1997.
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 June 30, 1998, the Company had 42 loans in real estate owned with a
principal balance of $5.1 million. During the six months ended June 30, 1998,
the Company sold 15 properties and as a result recorded net losses of $315,000,
which were taken against the Company's reserve. As the portfolio seasons,
management expects the actual loss rate to increase. Table XVII is a rollforward
of the reserve for credit losses during 1998 and 1997.
13
<PAGE>
Table XVII
Rollforward of Reserve for Credit Losses
Six Months Ended June 30, 1998 and Year Ended December 31, 1997
- -------------------------------------------------------------------------------
<TABLE>
<CAPTION>
1998 1997
------------------- ---------------------------------------------
June 30 March 31 December 31 September 30 June 30 March 31
<S> <C> <C> <C> <C> <C> <C>
Beginning balance......................... $2,871 $2,313 $1,444 $ 718 $170 $ --
Provision for credit losses............. 1,145 1,076 1,009 726 548 170
Amounts charged off, net of recoveries.. (675) (518) (140) -- -- --
------ ------ ------ ------ ---- ----
Ending Balance............................ $3,341 $2,871 $2,313 $1,444 $718 $170
====== ====== ====== ====== ==== ====
</TABLE>
Table XVIII is a summary of delinquent loans as of June 30, 1998 and 1997 by
quarter. Other information regarding the credit quality of the Company's
mortgage loans are provided in Tables III, IV and V.
Table XVIII
Loan Delinquencies (90 days and greater)
Six Months Ended June 30, 1998 and Year Ended December 31, 1997 (A)
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------
1998 1997
------------------------- ---------------------------------------------------
June 30 March 31 December 31 September 30 June 30 March 31
<S> <C> <C> <C> <C> <C> <C>
Mortgage loans collateralizing
NovaStar Home Equity series (CMO):
1997-1 (Issued October 1, 1997)... 5.86% 4.39% 2.71% -- -- --
1997-2 (Issued December 11, 1997.. 4.72 2.23 -- -- -- --
1998-1 (Issued April 30, 1998).... -- -- -- -- -- --
All mortgage loans.................. 2.53 2.28 1.80 1.47% -- --
</TABLE>
- ---------------------------------
(A) Includes loans in foreclosure or bankruptcy.
General and Administrative Expenses
General and administrative expenses for the six months ended June 30, 1998
and June 30, 1997 are provided in table XIX. Table XX displays the relationship
of portfolio expenses to net interest income during the six months ending June
30, 1998 and 1997 by quarter.
Table XIX
General and Administrative Expenses
Six Months Ended June 30, 1998 and June 30, 1997 (dollars in thousands)
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------
Six Months
Ended Six Months Ended
June 30, 1998 June 30, 1997
------------------------ ----------------------
Percent of Percent of
Net Interest Net Interest
Income Income
<S> <C> <C> <C> <C>
Loan servicing............................................ $1,616 14.1% $ 571 19.8%
Compensation and benefits................................. 896 7.8 369 12.8
Professional and outside services......................... 353 3.1 249 8.6
Office administration..................................... 405 3.5 112 3.9
Other..................................................... 196 1.7 128 4.4
------ ----- ------ ----
Total portfolio-related expenses.......................... 3,466 30.2% 1,429 49.5%
===== ====
Forgiveness of notes receivable from founders............. 542 --
Administrative services provided by NovaStar Mortgage..... 3,600 1,250
------ ------
Total.................................................. $7,608 $2,679
====== ======
</TABLE>
14
<PAGE>
<TABLE>
<CAPTION>
Table XX
Portfolio Related Expenses as a
Percent of Net Interest Income
Six Months Ended June 30, 1998 (dollars in thousands)
- -----------------------------------------------------
Percent of Net
Interest
Income
<S> <C>
1998:
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 six months ended June 30, 1998 compared with June 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 six
months ended June 30, 1998 compared with the six months ended June 30, 1997 is
due to adding portfolio, accounting and finance management staff throughout 1997
and 1998. In addition, during the first six months of 1998 the Company
recognized $542,000 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 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 six months ended June 30,
1998 compared with June 30, 1997 is primarily due to the significant growth in
the Company's mortgage loan portfolio during the period ended June 30, 1998
compared with June 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. The increase relates to additional personnel and the general
growth of the Company.
Office administration includes items such as rent, depreciation, telephone,
office supplies, postage, delivery, maintenance and repairs. The increase in
office administration during the six months ended June 30, 1998 is largely
attributable to the significant growth in number of employees.
Earnings of NFI Holding Corp.
For the six months ended June 30, 1998, NFI Holding Corp. recorded a net
loss of $9,000 compared with a net loss of $432,000 for the six months ended
June 30, 1997. The Company records its portion of these losses as equity in net
loss of NFI Holding in its income statement. Net income generated by Holding is
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.
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. During the six months ended June 30, 1998, NovaStar Mortgage
recognized $175,000, in net gains on sales of mortgage loans with a principal
balance of $4.0 million.
During the six months ended June 30, 1997, NovaStar Mortgage incurred
significant costs to develop the infrastructure to produce and service mortgage
loans. Loan production began in February 1997 and NovaStar Mortgage began
servicing loans in July 1997. Fee income is dependent upon loan origination
volume and loan servicing. NovaStar Mortgage generated significantly more fees
in the six months ended June 30, 1998 as compared to the six-month period ended
June 30, 1997. The increase in fee income outpaced the increase in costs, which
caused a significant decrease in the net loss when comparing the two six-month
periods. As noted above, NovaStar Financial pays fees to NovaStar Mortgage for
administrative services.
Tables XXI and XXII are summary financial statements for NFI Holding Corporation
as of and for the six months ended June 30, 1998 and 1997. Table XXIII is a
summary of loan costs for NovaStar Mortgage relative to its wholesale loan
originations.
15
<PAGE>
<TABLE>
<CAPTION>
Table XXI
NFI Holding Corporation - Balance Sheet
June 30 (dollars in thousands)
- ---------------------------------------------------------------------
1998 1997
<S> <C> <C>
Assets
Mortgage loans................................. -- $ --
Mortgage securities............................ $62,387 --
Other assets................................... 1,680 15,532
------- -------
Total assets................................. $64,067 $15,532
======= =======
Liabilities and stockholder's equity
Borrowings..................................... $60,871 $13,600
Other liabilities.............................. 1,034 368
------- -------
Total liabilities.............................. 61,905 13,968
Stockholder's equity........................... 2,162 1,564
------- -------
Total liabilities and stockholders' equity... $64,067 $15,532
======= =======
</TABLE>
<TABLE>
<CAPTION>
Table XXII
NFI Holding Corporation - Statement of Income
Six Months Ended June 30 (dollars in thousands)
- --------------------------------------------------------------
1998 1997
<S> <C> <C>
Other income............................. $8,683 $1,297
Gains on sale of mortgage assets......... 412 --
Expenses:
Interest............................... 2,019 --
Production............................. 5,765 1,729
Servicing.............................. 1,296 --
Other.................................. 24 --
------ ------
Net loss................................. (9) $ (436)
====== ======
</TABLE>
<TABLE>
<CAPTION>
Table XXIII
Cost of Loan Production - NovaStar Mortgage, Inc.
Six Months Ended June 30, 1998 and Year Ended December 31, 1997 (dollars in thousands)
- ------------------------------------------------------------------------------------------------------
1998 1997
------------------- ---------------------------------------
Second First Fourth Third Second First
Quarter Quarter Quarter Quarter Quarter Quarter
<S> <C> <C> <C> <C> <C> <C>
Total costs of loan production (A)..... $ 3,837 $ 3,079 $ 2,096 $ 1,938 $ 1,401 $ 410
Wholesale loan origination - principal. 294,303 207,974 183,012 136,582 77,692 12,688
Premium paid to broker................. 3,679 2,935 2,896 2,119 1,618 295
-------- -------- -------- -------- ------- -------
Total acquisition cost (B)............. $301,819 $213,988 $188,004 $140,639 $80,711 $13,393
======== ======== ======== ======== ======= =======
Costs as a percent of principal:
Loan production........................ 1.3% 1.5% 1.1% 1.4% 1.8% 3.2%
=== === === === === ===
Premium paid to broker................. 1.3% 1.4% 1.6% 1.6% 2.1% 2.3%
=== === === === === ===
Total acquisition cost................. 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.
16
<PAGE>
Management continually monitors its costs of loan production. Management
estimates on average total costs of loan production and principal should be 1.5
percent of principal.
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.
Table XXIV 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 June 30, 1998 to be between
105.5 and 106.0 (in terms of price to par).
As presented in Table XXI, NovaStar is currently originating mortgage loans
at an all-in cost of 103 percent of principal. This figure includes both direct
costs of acquisition, such as broker premiums, and general overhead expenses.
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 June 30, 1998 represented 2.34 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 June 30, 1998 of between approximately 3.0 and 3.5 percent.
Applying this percent to the balance of mortgage loans outstanding of $984
million results in an estimated unrealized gain of between approximately $30 and
$35 million. This additional value results in an estimated mark-to-market equity
of approximately $150 million, or $18 per outstanding share. By acquiring and
accumulating assets at prices that are 2-3 points less in cost, the Company is
providing additional value to stockholders in the form of higher asset yields
that will be realized through higher future interest income and thereby higher
net earnings and dividends. By not recording its securitized loans using "gain
on the sale" accounting, which would recognize the above-discussed added value
as current income, the Company lessens the risk of future write-downs should
market conditions not prove to be as favorable as assumed at the time the loans
are securitized.
17
<PAGE>
Table XXIV
Estimated Market Price on Entire Loan Portfolio
As of June 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>
Bond Equivalent Yield............... 8.03% 8.28% 8.53% Bond Equivalent Yield........ 8.53% 8.78% 9.03%
Spread to Index..................... 2.25% 2.50% 2.75% Spread to Index.............. 2.75% 3.00% 3.25%
Assumed Prepayment Speed Assumed Prepayment Speed
(CPR)............................. (CPR)......................
25.................................. 108.1% 107.3% 106.6% 30........................... 107.5% 106.9% 106.3%
30.................................. 106.7% 106.1% 105.5% 35........................... 106.4% 105.9% 105.4%
35.................................. 105.6% 105.1% 104.6% 40........................... 105.5% 105.1% 104.6%
30/15-year Fixed and
One-year CMT Loan Balloon Loan Products
Products (Three-year Treasury)
-------------------------- --------------------------
Bond Equivalent Yield............... 7.37% 7.62% 7.87% Bond Equivalent Yield........ 7.74% 7.99% 8.24%
Spread to Index..................... 2.00% 2.25% 2.50% Spread to Index............. 2.25% 2.50% 2.75%
Assumed Prepayment Speed Assumed Prepayment Speed
(CPR)............................. (CPR)......................
30.................................. 107.1% 106.5% 105.9% 20........................... 107.4% 106.6% 105.8%
35.................................. 106.0% 105.5% 105.0% 25........................... 106.4% 105.7% 105.1%
40.................................. 105.1% 104.6% 104.2% 30........................... 105.5% 105.0% 104.4%
</TABLE>
Table XXV
Estimated Market Price of Loans Originated in Second Quarter of 1998
Second Quarter 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>
Bond Equivalent Yield............... 8.03% 8.28% 8.53% Bond Equivalent Yield........ 8.03% 8.28% 8.53%
Spread to Index..................... 2.25% 2.50% 2.75% Spread to Index.............. 2.25% 2.50% 2.75%
Assumed Prepayment Speed Assumed Prepayment Speed
(CPR)............................. (CPR)......................
25.................................. 107.7% 107.0% 106.3% 25........................... 107.8% 107.1% 106.4%
30.................................. 106.3% 105.7% 105.1% 30........................... 106.4% 105.2% 104.6%
35.................................. 105.3% 104.8% 104.3% 35........................... 105.3% 104.8% 104.3%
One-year CMT Loan 30/15-year Fixed and
Products Balloon Loan Products
-------------------------- ---------------------------
Bond Equivalent Yield............... 7.37% 7.62% 7.87% Bond Equivalent Yield........ 7.49% 7.74% 7.99%
Spread to Index..................... 2.00% 2.25% 2.50% Spread to Index.............. 2.00% 2.25% 2.50%
Assumed Prepayment Speed Assumed Prepayment Speed
(CPR)............................. (CPR)......................
25.................................. 107.4% 106.7% 106.0% 20........................... 107.6% 106.8% 106.0%
30.................................. 106.1% 105.5% 104.9% 25........................... 106.6% 105.9% 105.2%
35.................................. 105.0% 104.5% 104.0% 30........................... 105.7% 105.1% 104.6%
</TABLE>
18
<PAGE>
Table XXVI
Carrying Value of Loans by Product/Type
As of June 30, 1998
- ------------------------------------------------------------------
<TABLE>
<CAPTION>
Product/Type Carrying Value
<S> <C>
Two- and three-year fixed.................... $ 554,241
Six-month LIBOR.............................. 75,786
One-year CMT................................. 45,064
30/15-year fixed and balloon................. 308,755
----------
Outstanding principal............. 983,846
Premium...................................... 23,013
Reserve...................................... (3,341)
----------
Carrying Value................... $1,003,518
==========
Carrying value as a percent of principal..... 102.0%
==========
</TABLE>
Results of Operations -- Three Months Ended June 30, 1998 Compared to Three
Months Ended June 30, 1997
Net Income
During the three months ended June 30, 1998, the Company realized net
income of $1.9 million compared with a net loss of $1.1 million for the same
period of 1997. The components of net income are discussed in the following
paragraphs.
Net Interest Income
The Company had average interest-earning assets of $1.26 billion during the
three months ended June 30, 1998, compared with $350.1 million for the three
months ended June 30, 1997. During the three month period ended June 30, 1998,
mortgage securities earned $7.0 million, or a yield of 6.4 percent, while
mortgage loans earned $19.4 million, or a yield of 9.5 percent. For the same
period of 1997, mortgage securities earned $1.7 million, or a yield of 6.6
percent, while mortgage loans earned $5.3 million, or a yield of 8.6 percent. In
total, assets earned $26.4 million -- a yield of 8.4 percent for the period
ending June 30, 1998 compared with $6.9 million, or a yield of 7.93 percent for
the period ending June 30, 1997.
During the three months ended June 30, 1998, borrowed funds for the Company
averaged $1.3 billion on which interest was incurred of $20.4 million, or 6.3
percent. In comparison, for the three months ended June 30, 1997, borrowed funds
for the Company averaged $290.9 million on which interest was incurred of $5.2
million, or 7.1 percent. Rates on other borrowings generally fluctuate with
short-term market interest rates, such as LIBOR or the Federal Funds rate.
Net interest income during the three months ended June 30, 1998 was $6.0
million, or 1.91 percent of average interest-earning assets compared with $1.8
million, or 2.04 percent of average interest-earning assets for the three month
period ending June 30, 1997. Net interest spread for the Company was 2.10
percent versus 0.90 percent during the three months ended June 30, 1998 and June
30, 1997, respectively.
Provisions for Credit Losses
During the three months ended June 30, 1998, the Company provided $1.1
million for credit losses compared with $548,000 for the three months ended June
30, 1997. Credit losses recognized during the three-month period ended June 30,
1998 were $675,000. The Company recognized no losses on its mortgage loan
portfolio during the three-month period ended June 30, 1997. As mentioned
earlier, reserves are maintained for losses management expects to incur on loans
in the portfolio.
General and Administrative Expenses
General and administrative expenses during the three months ended June 30,
1998 and June 30, 1997, respectively, were $4.4 million and $2.2 million.
Consistent with prior periods, the single largest component of general and
administrative expenses is the administrative outsourcing fee paid to NovaStar
Mortgage, which was $2.1 million for the three month period ending June
19
<PAGE>
30, 1998 compared with $1.3 million for the three month period ended June 30,
1997. Compensation and benefits totaled $460,000 during the second quarter of
1998 compared with $84,000 for the second quarter of 1997.
Professional and outside services include legal fees and contract labor for
the development of information systems. These expenses were $297,000 and
$180,000 for the second quarter of 1998 and 1997, respectively.
Loan servicing costs were $942,000 compared with $535,000 for the three
month period ending June 30, 1998 and 1997, respectively. Loan servicing costs
include direct costs of managing the loan portfolio which are not reimbursable
by the borrower. In addition, loan servicing costs include fees associated with
the service provider who services the Company's loans. These fees were paid to
NovaStar Mortgage in 1998 and to an outside party during the same period of 1997
as the Company outsourced this service until July 15, 1997.
Equity in Earnings of Unconsolidated Affiliate
For the three months ended June 30, 1998, Holding realized net income of
$265,000, of which the Company recorded its portion. For the same period of
1997, Holding realized a net loss of 68,000. The significant increase in 1998
is primarily due to the increase in the administrative fee received from the
Company related to building its wholesale lending infrastructure and to gains
realized on the sale of mortgage securities and loans.
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 XXV is a summary of the
differences between the Company's net income or loss reported for GAAP the three
month period ended June 30, 1998 and 1997 by quarter and its taxable income.
Table XXVII
Taxable Income (Loss)
Six months Ended June 30, 1998 (in thousands)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
1998 1997
--------------------------------------------------------------------
Second First Fourth Third Second First
Quarter Quarter Quarter Quarter Quarter Quarter
<S> <C> <C> <C> <C> <C> <C>
Net income (loss).................... $1,894 $1,279 $ (433) $ 177 $(1,073) $194
Results of Holding and subsidiary.... -- (A) 273 (169) (393) 126 408
Provision for credit losses.......... 1,145 1,076 1,009 726 547 171
Loans charged-off.................... (675) (518) (140) -- -- --
Other, net........................... 208 (4) 296 (4) (8) --
------ ------ ------ ----- ------- ----
Taxable income (loss)................ $2,572 $2,106 $ 563 $ 506 $ (408) $773
====== ====== ====== ===== ======= ====
</TABLE>
- -----------------
(A) Anticipated to be paid as dividends at 1998 year end, therefore, is excluded
from computation.
Liquidity and Capital Resources
Liquidity, as used herein, means the need for, access to and uses of cash.
During the six months ended June 30, 1998, the Company's financing activities
generated cash of $382 million. Cash was used during the six months ended June
30, 1998 in investing activities ($382 million) and in operating activities
($768,000). The Company's primary needs for cash include the acquisition of
mortgage assets, principal repayment and interest on borrowings, operating
expenses and dividend payments. The Company's business requires substantial cash
to support its operating activities and growth plans. The Company has a certain
amount of cash on hand to fund operations. The Company requires access to short-
term credit facilities to fund its acquisition of wholesale loan originations
and mortgage securities. Also, principal, interest and fees received on mortgage
assets will serve to support the cash needs of the Company. Drawing upon various
borrowing arrangements typically satisfies major cash requirements. The Company
has demonstrated the ability to access public markets as a source of long-term
cash resources.
The Company has available borrowing capacity of $800 million under master
repurchase agreements to acquire mortgage loans. Management is negotiating with
other dealers for additional borrowing capacity. In addition, the Company has
been approved as a borrower from reputable securities dealers for repurchase
agreements to fund the acquisition of mortgage securities. On a long-term
basis, the Company pools its mortgage loans to serve as collateral for its CMOs.
By doing so, the loans will be cleared as collateral from the master repurchase
agreement and the warehouse line of credit, freeing those arrangements to fund
further loan originations. All mortgage securities are classified as available-
for-sale and could be sold in the
20
<PAGE>
open market to provide additional cash for liquidity needs. In addition,
management believes a liquid market exists for its mortgage loans and the
mortgage loan production of NovaStar Mortgage. Mortgage loans could be sold to
generate cash flow. Table XXVI is a summary of financing arrangements and
available borrowing capacity under those arrangements as of June 30, 1998.
Table XXVIII
Liquidity Resources
June 30, 1998 (dollars in thousands)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Maximum
Borrowing Value of
Resource Limit Collateral Borrowings Availability
<S> <C> <C> <C> <C>
First Union National Bank..................... $ 75,000 $ 69,003 $ 56,529 $12,474
Merrill Lynch Mortgage Capital, Inc........... 400,000 212,242 205,529 6,713
Bear Stearns Home Equity Trust................ 200,000 -- -- --
Lehman Commercial Paper, Inc.................. 200,000 -- -- --
Residual financing available under CMOs....... 38,243 58,835 -- 38,243
-------- -------
Total........................... $262,058 $57,430
======== =======
Total availability as percent of:
Total assets................................ 3.78%
=======
Total stockholders' equity.................. 50.0%
=======
</TABLE>
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 XXVII details the
Company's Interest Rate Sensitivity as of June 30, 1998.
Table XXIX
Interest Rate Sensitivity (A)
June 30, 1998
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Basis Point Increase (Decrease) in Interest Rate(B)
---------------------------------------------------
(100) Base(C) 100
---------- ---------- ----------
<S> <C> <C> <C>
Market value of:
Assets.............................. $1,634,869 $1,617,985 $1,595,622
Liabilities......................... 1,465,663 1,464,478 1,463,300
Interest rate agreements............ (8,739) (325) 11,552
---------- ---------- ----------
Net market value...................... $ 160,467 $ 153,155 $ 143,874
========== ========== ==========
Cumulative change in value(C)......... $ 7,312 -- $ (9,281)
========== ========== ==========
Percent change from base assets(D).... 0.47% -- (0.60%)
========== ========== ==========
Percent change of capital(E).......... 6.37% -- (8.08%)
========== ========== ==========
</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 securities with a current face of
$65.3 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 June 30, 1998.
(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 June 30, 1998.
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 June 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.
21
<PAGE>
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 June 30, 1998. 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 6.37 percent. If interest
rates rise by one percent (+100 basis points), the value of the Company's
capital would decrease by an estimated 8.08 percent.
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.
Table XXX
Capital Allocation Guidelines
June 30, 1998
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
(A) (B) (C) (D) (E) (F) (F)
Minimum Duration Liquidity (c + d) (b x e) (a + f)
Asset Category Lender Estimated Price Spread Spread Total Spread Equity Cushion CAG Equity
-------------- Haircut Duration Cushion Cushion Cushion (% of MV) Required
Agency-issued:
<S> <C> <C> <C> <C> <C> <C> <C>
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..... 3.00 3.00 100 50 150 4.50 7.50
Collateral for CMO...... 5.00 -- -- -- -- -- 5.00
Delinquent.............. 30.00 -- -- -- -- 10.00 40.00
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 XXIX 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.
22
<PAGE>
Table XXXII
Required Equity
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
1998 1997
------------------------ ---------------------------------------------
Category June 30 March 31 December 31 September 30 June 30 March 31
<S> <C> <C> <C> <C> <C> <C>
Mortgage loans:
Current.................................... $ 21,566 $ 23,628 $ 6,675 $ 33,832 $22,780 $15,958
Delinquent................................. 601 1,200 1,600 2,376 -- --
Securitized loans.......................... 37,766 23,478 22,500 -- -- --
Mortgage securities.......................... 24,904 27,426 36,170 12,763 13,549 1,646
Other assets................................. 13,782 10,733 -- -- -- --
Hedging instruments.......................... (232) (203) 5,500 427 1,787 2,804
-------- -------- -------- --------- ------- -------
Required equity.............................. 98,387 86,262 72,445 49,398 38,116 20,408
Stockholders' equity......................... 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).................... 31,999 20,685 -- -- -- --
-------- -------- -------- --------- ------- -------
Excess equity................................ $ 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 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.
The Year 2000
Management is aware of potential Year 2000 issues. The Company has focused
its internal system resources to ensure that Year 2000 software issues will not
adversely affect its operations and financial systems. Primarily as a result of
recently developing or purchasing all software used by the Company, management
expects to incur no significant costs in conjunction with becoming Year 2000
compliant. The Company is requiring all outside vendors to provide written
assurance to the Company that their products are Year 2000 compliant.
23
<PAGE>
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
As of June 30, 1998, there were no material legal proceedings pending
to which the Company was a party or of which any of its property was
subject.
Item 2. Changes in Securities
Not applicable
Item 3. Defaults upon Senior Securities
Not applicable
Item 4. Submission of Matters of Vote of Security Holders
(a) The 1998 annual meeting of shareholders of the Company was held on
May 13, 1998.
(b) The following matters were voted on at the annual meeting:
<TABLE>
<CAPTION>
Vote
---------------------------------------------------
For Against Abstain Broker Non-Votes
---------------------------------------------------
<S> <C> <C> <C> <C>
1. Election of Director
W. Lance Anderson 4,972,926 0 1,227,542 1,628,197
Gregory T. Barmore 4,972,426 0 1,228,042 1,628,197
</TABLE>
The following Directors' terms of office continue after the
meeting:
Scott F. Hartman
Edward W. Mehrer
Jenne K. Britell
<TABLE>
<CAPTION>
Vote
---------------------------------------------------
For Against Abstain Broker Non-Votes
---------------------------------------------------
<S> <C> <C> <C> <C>
2. Ratification of KPMG Peat Marwick LLP
as the Company's independent public
accountants for 1998 6,178,492 5,412 16,564 1,628,197
Vote
---------------------------------------------------
For Against Abstain Broker Non-Votes
---------------------------------------------------
3. Approval of technical amendments to the
Company's charter to conform to the
requirements of the New York Stock
Exchange and to clarify the application
of the Company's 9.8% REIT-qualifying
stock ownership restriction 6,185,424 14,414 630 1,628,197
</TABLE>
Item 5. Other Information
None
24
<PAGE>
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits filed with this report are as follows:
10.1 Master repurchase agreement with Lehman Brothers
11.1 Schedule regarding computation of per share earnings
21.1 Subsidiaries of the Registrant
27.1 Financial data schedule
(b) The Company filed no reports on Form 8-K during the quarter ended June 30,
1998. However, the Company filed a Form 8-K regarding certain amendments
made to its charter on July 6, 1998.
25
<PAGE>
NOVASTAR FINANCIAL, INC.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
NOVASTAR FINANCIAL, INC.
/s/ Scott F. Hartman
DATE: March 12, 1999 -------------------------------------
Scott F. Hartman
Chairman of the Board, Secretary and
Chief Executive Officer
(Principal Executive Officer)
DATE: March 12, 1999 /s/ Rodney E. Schwatken
-------------------------------------
Rodney E. Schwatken
Vice President, Controller and
Assistant Treasurer
(Principal Accounting Officer)
26
