<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 September 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 November
10, 1998 was 8,127,314.
<PAGE>
NOVASTAR FINANCIAL, INC.
FORM 10-Q
QUARTER ENDED SEPTEMBER 30, 1998
INDEX
<TABLE>
<CAPTION>
Page
<S> <C> <C>
PART I FINANCIAL INFORMATION
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............................. 6
PART II OTHER INFORMATION
Item 1. Legal Proceedings............................................... 31
Item 2. Changes in Securities........................................... 31
Item 3. Defaults Upon Senior Securities................................. 31
Item 4. Submission of Matters to a Vote of Security Holders............. 31
Item 5. Other Information............................................... 31
Item 6. Exhibits and Reports on Form 8-K................................ 31
Signatures...................................................... 32
</TABLE>
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share amounts)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
September 30, 1998 December 31, 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.
1
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited; in thousands)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
For the Nine Months Ended For the Three Months
September 30, Ended September 30,
-------------------------- ---------------------------
1998 1997 1998 1997
<S> <C> <C> <C> <C>
Interest income:
Mortgage loans.............................................. $56,274 $14,749 $22,312 $ 7,670
Mortgage securities......................................... 22,881 6,796 6,485 4,555
------- ------- ------- -------
Total interest income........................................ 79,155 21,545 28,797 12,225
Interest expense............................................. 60,948 16,224 22,088 9,786
------- ------- ------- -------
Net interest income.......................................... 18,207 5,321 6,709 2,439
Provision for credit losses.................................. 3,400 1,444 1,179 726
------- ------- ------- -------
Net interest income after provision for credit losses........ 14,807 3,877 5,530 1,713
Fees from NovaStar Mortgage, Inc............................. 3,766 -- 3,349 --
Other income................................................. 2,012 326 919 259
Equity in earnings (loss) of NFI Holding Corporation......... (2,455) (141) (2,446) 290
General and administrative expenses:
Services provided by NovaStar Mortgage, Inc................. 5,700 2,450 2,100 1,200
Loan servicing.............................................. 3,163 694 1,547 123
Compensation and benefits................................... 1,374 701 478 332
Forgiveness of notes receivable from founders............... 812 -- 270 --
Office administration....................................... 681 201 276 89
Professional and outside services........................... 649 430 296 181
Other....................................................... 184 288 (9) 160
------- ------- ------- -------
Total general and administrative expenses................. 12,563 4,764 4,958 2,085
------- ------- ------- -------
Net income (loss)............................................ $ 5,567 $ (702) $ 2,394 $ 177
======= ======= ======= =======
Basic earnings per share..................................... $ 0.69 $ (0.19) $ 0.29 $ 0.05
======= ======= ======= =======
Diluted earnings per share................................... $ 0.64 $ (0.19) $ 0.29 $ 0.05
======= ======= ======= =======
Dividends declared per share................................. $ 1.00 $ 0.18 $ 0.35 $ 0.08
======= ======= ======= =======
Basic weighted average shares outstanding.................... 8,033 3,767 8,124 3,767
======= ======= ======= =======
Diluted weighted average shares outstanding.................. 8,639 3,767 8,157 3,804
======= ======= ======= =======
</TABLE>
See notes to consolidated financial statements.
2
<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.
3
<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 short-term 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 fee serves as incentive
for GMAC/RFC to enter the financing arrangement under adverse conditions and to
insure that the arrangement would be committed for the 90-day period. 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 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.
4
<PAGE>
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 For the Three Months
Ended September 30 Ended September 30
------------------- --------------------
1998 1997 1998 1997
<S> <C> <C> <C> <C>
Net income (loss)..................................... $ 5,567 $ (702) $ 2,394 $ 177
Other comprehensive income -- net change in unrealized
gain (loss) on available-for-sale securities......... (9,130) 2,255 (4,828) 872
------- ------ ------- ------
Comprehensive income (loss)........................... $(3,563) $1,553 $(2,434) $1,049
======= ====== ======= ======
</TABLE>
5
<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.
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.
Events Subsequent to September 30, 1998
As of September 30, 1998, the Company had an arrangement with an 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. The lender experienced its own liquidity
shortage as a result of global market conditions. In order to respond to the
liquidity shortage and mitigate exposure to credit risk, the lender restricted
its lending to subprime mortgage companies. As a result, 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 short-term financing agreement
with GMAC/Residential Funding Corporation, secured by certain mortgage interests
of the Company. Under the terms of the agreement, the Company received a $15
million loan to support immediate cash needs. The loan bears interest at one-
month LIBOR plus five percent. The Company is required to pay a $3 million
commitment fee upon maturity of the note. 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 for a long-term
strategic alliance. However, no assurances can be given that an alliance will in
fact be executed. Upon execution of a strategic alliance, GMAC/RFC will refund
$2 million of the commitment fees discussed above and NovaStar will issue
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 above-described
events, they affect the Company's liquidity position.
6
<PAGE>
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.
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
7
<PAGE>
1998 changed the liquidity position of the Company. Options available to the
Company for financing sources have been restricted.
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>
<CAPTION>
Table II
Liquidity Resources
November 9, 1998 (dollars in thousands)
- ------------------------------------------------------------------------------------------------------
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 --
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.
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.
8
<PAGE>
Financial Condition
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 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>
<CAPTION>
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)
- ----------------------------------------------------------------------------------------------
Wholesale Originations (A) Bulk Acquisitions (B) Total
--------------------------------------------------------------------------
Number Principal Number Principal Number Principal
of Loans Amount of Loans Amount of 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.
9
<PAGE>
<TABLE>
<CAPTION>
Table IV
1998 and 1997 Quarterly Wholesale Loan Originations (A)
(dollars in thousands)
- --------------------------------------------------------------------------------------------------------------
Weighted Average
-----------------------------
Average Loan-to- Credit Percent with
Number Loan Price Paid to Value Rating (B) Coupon Prepayment
of Loans Principal Balance Broker 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 their
credit grades.
<TABLE>
<CAPTION>
Table V
Mortgage Loans by Credit Grade
September 30, 1998 (dollars in thousands)
- ----------------------------------------------------------------------------------------
Maximum Weighted Weighted
Allowed Loan-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, 1 x 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>
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 by state.
10
<PAGE>
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
- ------------------------
<TABLE>
<CAPTION>
Percent of Portfolio (based on
original principal balance)
Collateral Location
Percent
<S> <C>
California............... 19%
Florida.................. 12
Washington............... 8
Oregon................... 5
All other states......... 56
</TABLE>
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 million 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.
11
<PAGE>
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..... 80,237 823 -- 101.0 6.40
Association.................................
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..... 2,202 87 -- 104.0 7.40
Corporation....................................
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 (dollars in thousands)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
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>
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.
12
<PAGE>
Table X
Borrowings
September 30, 1998 (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
========
</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 XI displays the amounts outstanding under collateralized
mortgage obligations as of September 30, 1998.
Table XI
Collateralized Mortgage Obligations
September 30, 1998 (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................... $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.
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.
13
<PAGE>
<TABLE>
<CAPTION>
Table XII
Prepayment Speed
- --------------------------------------------------------------------------------
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.
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>
<CAPTION>
Table XIII
Mortgage Assets Activity (thousands)
- ---------------------------------------------------------------------------------------------------------------
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 3,758 270,059 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>
14
<PAGE>
<TABLE>
<CAPTION>
Table XIV
Premium as a Percent of Principal
- --------------------------------------------------------------------------------
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 Loss
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 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 XV is a summary of the
Company's mortgage assets by type, presenting their current and fully indexed
weighted-average coupons.
<TABLE>
<CAPTION>
Table XV
Mortgage Assets by Product/Type and Weighted Average Coupon
September 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.. $ 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>
15
<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 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
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....................... $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 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,l55 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 577
Instruments hedging liabilities....... 1,637 ------- 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>
16
<PAGE>
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 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.
17
<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>
<CAPTION>
Table XIX
Rollforward of Reserve for Credit Losses
Nine Months Ended September 30, 1998 and Year Ended December 31, 1997
- -----------------------------------------------------------------------------------------------------------------------
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.
<TABLE>
<CAPTION>
Table XX
Loan Delinquencies (90 days and greater)
Nine Months Ended September 30, 1998 and Year Ended December 31, 1997 (A)
- --------------------------------------------------------------------------------------------------------------------------
1998 1997
--------------------------------- -----------------------------------------------
September 30 June 30 March 31 December 31 September 30 June 30 March 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.
18
<PAGE>
<TABLE>
<CAPTION>
Table XXI
Delinquencies, Defaults and Losses
September 30, 1998 (dollars in thousands)
- --------------------------------------------------------------------------------------------------------------------
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.
19
<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
1998:
<S> <C>
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 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.
20
<PAGE>
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>
<CAPTION>
Assets
<S> <C>
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>
21
<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.
Management 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). Table XXVII provides estimates of the value of the mortgage loans in
the portfolio and assumptions used in generating those estimates. Estimated
values can vary dramatically based upon assumptions used.
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.
22
<PAGE>
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>
<CAPTION>
Table XXVII
Estimated Market Price on Entire Loan Portfolio
As of September 30, 1998
- ---------------------------------------------------------------------------------------------------------------------------
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............ 8.25% 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 Speed (CPR)... Assumed Prepayment 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)
------------------------- ------------------------
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 Speed (CPR)... Assumed Prepayment 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%
<CAPTION>
Table XXVIII
Estimated Market Price of Loans Originated in Third Quarter of 1998
Third Quarter 1998
- ---------------------------------------------------------------------------------------------------------------------------
Estimated Market Price Estimated Market Price
------------------------- ------------------------
Two- and Three-year Six-month LIBOR Loan
Fixed Loan Products Products
------------------------- ------------------------
Bond Equivalent Yield............ 8.25% 8.50% 8.75% Bond Equivalent Yield............ 7.50% 7.75% 8.00%
Spread to Index.................. 3.00% 3.25% 3.50% Spread to Index.................. 2.25% 2.50% 2.75%
Assumed Prepayment Speed (CPR)... Assumed Prepayment Speed (CPR)...
30............................... 105.4% 104.9% 104.3% 30............................... 104.2% 103.6% 103.0%
35............................... 104.6% 104.1% 103.6% 35............................... 103.6% 103.1% 102.6%
40............................... 103.9% 103.5% 103.1% 40............................... 103.1% 102.7% 102.3%
<CAPTION>
One-year CMT Loan 30/15-year Fixed and
Products Balloon Loan Products
------------------------- ------------------------
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 Speed (CPR)... Assumed Prepayment Speed (CPR)...
30............................... 104.3% 103.7% 103.1% 25............................... 106.4% 105.7% 105.1%
35............................... 103.7% 103.2% 102.7% 30............................... 105.5% 105.0% 104.4%
40............................... 103.2% 102.8% 102.3% 35............................... 104.8% 104.3% 103.8%
</TABLE>
23
<PAGE>
Table XXIX
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 -- Three Months Ended September 30, 1998 Compared to Three
Months Ended September 30, 1997
Net Income
During the three months ended September 30, 1998, the Company realized net
income of $2.4 million compared with net income of $177,000 for the same period
of 1997. The components of net income are discussed in the following
paragraphs.
Net Interest Income
Table XXX presents a summary of the average interest-earning assets,
average interest-bearing liabilities and the related yields and rates thereon
for the three months ended September 30, 1998.
Table XXX
Interest Analysis
Three 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......................... $927,132 $22,312 9.63% $412,335 $6,485 6.29% $1,339,467 $28,797 8.60%
======== ======== ==========
Liabilities.............................
Repurchase agreements................. $144,041 2,303 6.40% $419,901 6,121 5.83% $ 563,942 8,424 5.98%
Collateralized mortgage obligations... 821,739 12,734 6.20 821,739 12,734 6.20
Other borrowings...................... 10,446 111 4.25 10,446 111 4.25
-------- ---------
Cost of derivative financial
Instruments hedging liabilities....... 638 181 819
------- ------ -------
Total borrowings.................... $976,226 15,786 6.47 $419,901 6,302 6.00 $1,396,127 $22,088 6.33
======== ------- ======== ------ ========== =======
Net interest income................... $ 6,526 $ 183 $ 6,709
======= ====== =======
Net interest spread................... 3.16% 0.29% 2.27%
==== ==== ====
Net yield............................. 2.82% 0.18% 2.00%
==== ==== ====
</TABLE>
The Company had average interest-earning assets of $1.34 billion during the
three months ended September 30, 1998, compared with $629.0 million for the
three months ended September 30, 1997. During the three month period ended
September 30, 1998, mortgage securities earned $6.5 million, or a yield of 6.3
percent, while mortgage loans earned $22.3 million, or a yield of 9.6 percent.
For the same period of 1997, mortgage securities earned $4.6 million, or a
yield of 6.6 percent, while mortgage loans earned $7.7 million, or a yield of
8.7 percent. In total, assets earned $28.8 million -- a yield of 8.6 percent
for the period ending September 30, 1998 compared with $12.2 million, or a yield
of 7.8 percent for the period ending September 30, 1997.
During the three months ended September 30, 1998, borrowed funds for the
Company averaged $1.4 billion on which interest was incurred of $22.1 million,
or 6.3 percent. In comparison, for the three months ended September 30, 1997,
borrowed
24
<PAGE>
funds for the Company averaged $593.2 million on which interest was incurred of
$9.8 million, or 6.6 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 September 30, 1998 was
$6.7 million, or 2.00 percent of average interest-earning assets compared with
$2.4 million, or 1.53 percent of average interest-earning assets for the three
month period ending September 30, 1997. Net interest spread for the Company was
2.27 percent versus 1.18 percent during the three months ended September 30,
1998 and September 30, 1997, respectively.
Provisions for Credit Losses
During the three months ended September 30, 1998, the Company provided $1.2
million for credit losses compared with $726,000 for the three months ended
September 30, 1997. Credit losses recognized during the three-month period
ended September 30, 1998 were $1.8 million. The Company recognized no losses on
its mortgage loan portfolio during the three-month period ended September 30,
1997. As mentioned earlier, reserves are maintained for losses management
expects to incur on loans in the portfolio.
Fees provided by NovaStar Mortgage, Inc. and Other Income
Fees paid by NovaStar Mortgage to the Company in accordance with the
Mortgage Loan Sale and Purchase Agreement aggregated $3.3 million during the
third quarter 1998.
During the three months ended, September 30, 1998, the Company recognized a
$200,000 gain on sale of mortgage loans, pooling $4.7 million of mortgage loans
in the transaction. Also, included in other income during the third quarter of
1998, are prepayment penalties of $625,000 and interest on founders' notes
receivable of $129,000.
General and Administrative Expenses
General and administrative expenses during the three months ended September
30, 1998 and September 30, 1997, respectively, were $5.0 million and $2.1
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
September 30, 1998 compared with $1.2 million for the three month period ended
September 30, 1997. Compensation and benefits totaled $478,000 during the third
quarter of 1998 compared with $332,000 for the third quarter of 1997.
Professional and outside services include legal fees and contract labor for
the development of information systems. These expenses were $296,000 and
$181,000 for the third quarter of 1998 and 1997, respectively.
Loan servicing costs were $1.5 million compared with $123,000 for the three
month period ending September 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.
The loans servicing fee charged by NovaStar Mortgage increased dramatically
during the fourth quarter of 1997 and into 1998 after NovaStar Financial
securitized its loans. The fee increased to 50 basis points on the outstanding
principal when loans are securitized from a flat fee per loan prior to their
securitization.
Equity in Earnings (Loss) of NFI Holding Corporation
For the three months ended September 30, 1998, Holding recognized a net
loss of $2.5 million of which the Company recorded its portion. For the same
period of 1997, Holding realized a net income of 293,000. As mentioned earlier,
the increase in the net loss is largely due to the fee from NovaStar Mortgage to
the Company as NFI did not acquire any of NovaStar Mortgage's production during
the third quarter of 1998. This loss was partly offset by realized gains of
$798,000 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 XXXI 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.
25
<PAGE>
<TABLE>
<CAPTION>
Table XXXI
Taxable Income (Loss)
Nine months Ended September 30, 1998 (in thousands)
- ---------------------------------------------------------------------------------------------------------
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 XXXII details the
Company's Interest Rate Sensitivity as of September 30, 1998.
<TABLE>
<CAPTION>
Table XXXII
Interest Rate Sensitivity (A) (B)
September 30, 1998
- ------------------------------------------------------------------------------------------------
Basis Point Increase (Decrease) in Interest Rate (C)
----------------------------------------------------
(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.
(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.
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.
26
<PAGE>
Sensitivity as of September 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 9.50 percent. 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.
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 XXXIII
Capital Allocation Guidelines
September 30, 1998
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------------------------
(A) (B) (C) (D) (E) (F) (F)
Minimum Duration Liquidity (c+d) (bxe) (a + f)
Lender Estimated 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 XXXIV 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.
27
<PAGE>
<TABLE>
<CAPTION>
Table XXXIV
Required Equity
- ----------------------------------------------------------------------------------------------------------------------
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 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.
28
<PAGE>
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.
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.
29
<PAGE>
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.
30
<PAGE>
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
As of September 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
Not applicable
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits filed with this report are as follows:
10.1 Master repurchase agreement with First Union National Bank
10.2 Primary mortgage insurance agreement with Commonwealth Mortgage
Assurance Company
11.1 Schedule regarding computation of per share earnings
21.1 Subsidiaries of the Registrant
27.1 Financial data schedule
99.1 Press release dated October 29, 1998
(b) The Company has filed the following Form 8-K's:
. Regarding certain amendments made to its charter filed on July 6,
1998.
. Regarding announcement of current market conditions and postponement
of the third quarter dividend filed on October 12, 1998.
. Regarding announcement of $15 million 90-day committed secured
financing agreement to address immediate liquidity needs filed on
October 13, 1998.
. Regarding announcement of steps taken to address immediate liquidity
needs filed on October 15, 1998.
31
<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.
DATE: February 12, 1999 /s/ Scott F. Hartman
--------------------
Scott F. Hartman
Chairman of the Board, Secretary and
Chief Executive Officer
(Principal Executive Officer)
DATE: February 12, 1999 /s/ Rodney E. Schwatken
-----------------------
Rodney E. Schwatken
Vice President, Controller and
Assistant Treasurer
(Principal Accounting Officer)
32
