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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K/A
Amendment No. 1 to
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 1998
[_] 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, 66205
KS (Zip Code)
(Address of principal executive office)
Registrant's telephone number, including area code: (913) 362-1090
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Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on Which
Common Stock, $0.01 par value Registered
New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
None
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 [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
The aggregate market value of voting stock held by non-affiliates of the
registrant as of March 10, 1999 was approximately $41,080,000 as reported by
the New York Stock Exchange Composite Transactions on such date.
The number of shares of the Registrant's Common Stock outstanding on March
10, 1999 was 8,130,069.
Documents incorporated by reference
Items 10, 11, 12, and 13 of Part III are incorporated by reference to the
NovaStar Financial, Inc. definitive proxy statement to shareholders, which
will be filed with the Commission no later than 120 days after December 31,
1998.
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NOVASTAR FINANCIAL, INC.
FORM 10-K
For the Fiscal Year Ended December 31, 1998
TABLE OF CONTENTS
<TABLE>
<C> <S> <C>
PART I
Item 1. Business........................................................ 2
Item 2. Properties...................................................... 16
Item 3. Legal Proceedings............................................... 16
Item 4. Submission of Matters to a Vote of Security Holders............. 16
PART II
Market For Registrant's Common Equity and Related Stockholder
Item 5. Matters......................................................... 16
Item 6. Selected Consolidated Financial Data............................ 18
Management's Discussion and Analysis of Financial Condition and
Item 7. Results of Operations........................................... 19
Item 7A. Quantitative and Qualitative Disclosures about Market Risk...... 45
Item 8. Financial Statements and Supplementary Data..................... 46
Changes in and Disagreements with Accountants on Accounting and
Item 9. Financial Disclosure............................................ 63
PART III
Item 10. Directors and Executive Officers of the Registrant.............. 63
Item 11. Executive Compensation.......................................... 63
Item 12. Security Ownership of Certain Beneficial Owners and Management.. 63
Item 13. Certain Relationships and Related Transactions.................. 63
PART IV
Exhibits, Financial Statement Schedules, and Reports on Form 8-
Item 14. K............................................................... 64
</TABLE>
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PART I
Item 1. Business
Overview
NovaStar Financial, Inc. is a Maryland corporation formed on September 13,
1996 as an investor in mortgage assets, with a focus on subprime mortgage
loans. NovaStar Financial's mortgage assets are primarily generated from the
wholesale origination of single-family subprime loans of its affiliate,
Novastar Mortgage, Inc.
Management believes the tax-advantaged structure of a real estate investment
trust (REIT) is the most efficient method of owning the cash flows associated
with mortgage assets. NovaStar Financial must meet numerous rules established
by the Internal Revenue Service to retain its status as a REIT. The rules are
extensive and complicated. In short, they require NovaStar to:
. Restrict its investing to certain real estate related assets,
. Avoid certain investment trading and hedging activities, and
. Distribute taxable income to stockholders.
As long as NovaStar Financial maintains its REIT status, distributions to
stockholders will generally be deductible for income tax purposes. This
deduction effectively eliminates corporate level income taxes. Management
believes it has and will continue to meet the requirements to maintain its REIT
status.
1998 in Review
NovaStar was presented with tremendous challenges in 1998 as the marketplace
changed dramatically during the fourth quarter. When the year began, NovaStar
Financial had recently completed its initial public offering of common stock,
which raised nearly $70 million of capital. That capital allowed NovaStar to
start the year with ample liquidity to continue building its portfolio of
mortgage assets.
During the first half of 1998, NovaStar Mortgage originated over $500
million in subprime mortgage loans, the majority of which were purchased by
NovaStar Financial.
By the end of the second quarter, NovaStar Financial had deployed a
substantial amount of its capital through the acquisition of mortgage assets.
As access to the capital markets was limited, NovaStar modified its strategy of
holding loans in portfolio and began the transition to a seller of loans. Sales
are primarily conducted through NovaStar Mortgage. During 1998, NovaStar
Mortgage sold $134 million of its subprime mortgages recognizing aggregate
gains of $3 million. NovaStar Financial sold $7.9 million of mortgage loans at
aggregate gains of $305,000.
As circumstances evolved in the latter part of 1998 due to global market
conditions and liquidity shortages faced by the subprime lending industry, a
key lender withdrew access to a secured financing arrangement NovaStar relied
on for backup liquidity purposes. This forced NovaStar Financial to take
drastic measures to improve its liquidity position. Investment securities
financed using short-term repurchase agreements were sold and related interest
rate agreements were terminated. These actions greatly reduced NovaStar's
exposure to margin call risk. To address its short-term liquidity needs,
NovaStar Financial executed a short-term secured arrangement with
GMAC/Residential Funding Corporation. More importantly, in February 1999
NovaStar executed three separate committed lending arrangements with First
Union National Bank that increase NovaStar's borrowing capacity to $395
million. More information regarding the events of the fourth quarter 1998 are
discussed in "Management's Discussion and Analysis of Financial Condition and
Results of Operations" in this annual report.
The impact of the fourth quarter events was severe. The sale of investment
securities and the termination of related hedging instruments resulted in
aggregate losses of $23 million. Financing costs related to the short-term
lending arrangement with GMAC/RFC were $4 million. As a result of these items,
NovaStar incurred a net loss during the fourth quarter of $27 million. The
significance of the fourth quarter loss resulted in a net loss for the year of
$22 million, or $2.71 per share. NovaStar Financial's 1998 operating results
are discussed in further detail in "Management's Discussion and Analysis of
Financial Condition and Results of Operations" in this annual report.
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The Organizational Structure of NovaStar Financial and Principal Affiliates
Scott Hartman and Lance Anderson own 100% of the voting common stock of NFI
Holding Corporation. NFI Holding was capitalized through the purchase of
$20,000 in common stock by Scott Hartman and Lance Anderson and the purchase of
non-voting preferred stock by NovaStar Financial in the amount of $1,980,000.
Mr. Hartman and Mr. Anderson receive 1% of the economic benefits derived from
dividends and distributions of NFI Holding as a result of their common stock
ownership. NovaStar Financial receives 99% of the economics of NFI Holding as a
result of its preferred stock ownership. Accordingly, NovaStar Financial
indirectly receives 99% of the economics of NovaStar Mortgage by virtue of its
ownership interest in NFI Holding. In addition, Mr. Hartman and Mr. Anderson
serve as the sole directors of both NFI Holding and NovaStar Mortgage.
Through contracts with NovaStar Financial, NovaStar Mortgage has agreed to:
. Sell subprime mortgage loans that it originates to NovaStar Financial, if
NovaStar Financial agrees to acquire the loans,
. Service NovaStar Financial's subprime mortgage loans, and
. Provide certain administrative services to NovaStar Financial.
Without voting control of NovaStar Mortgage, there can be no assurance that
these contracts, which are subject to renewal, will continue indefinitely. In
addition, while Messrs. Hartman and Anderson have entered into an agreement
with shareholders, which contains certain management and control provisions and
restrictions on transfer of NFI Holding common stock, there can be no assurance
that the agreement will be enforced in a timely manner against the individuals,
their heirs or representatives.
[CHART APPEARS HERE]
Subprime Mortgage Lending
NovaStar Financial invests in subprime residential mortgage loans. A primary
source of NovaStar Financial's assets have been the loans originated by
NovaStar Mortgage, which shares common management. NovaStar Mortgage lends to
individuals that generally do not qualify for agency/conventional lending
programs because of a lack of available documentation or previous credit
difficulties, but generally have substantial equity in their homes. Often,
these are individuals or families who have built high-rate consumer debt and
are attempting to use the equity in their home to consolidate debt and lower
their total monthly payments.
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The sales force of NovaStar Mortgage, which includes over 60 account
executives covering 37 states, develops and maintains relationships with a
network of independent retail brokers. In 1997 and in much of 1998, NovaStar
Financial financed and acquired the mortgage loans originated by NovaStar
Mortgage.
During the first half of 1999, NovaStar Mortgage intends to sell a majority
of its loan production to buyers other than NovaStar Financial. Later in the
year, the business plan is to raise additional capital that will allow NovaStar
Financial to buy loans from NovaStar Mortgage to be held in portfolio. Selling
loans provides a source of cash and enables the funding of more loans through
NovaStar Mortgage. NovaStar Mortgage's loan sales can also generate profits and
capital for NovaStar Financial as profits earned by NovaStar Mortgage are
shared through NovaStar's indirect equity ownership.
Two primary avenues are available for selling subprime mortgage loans: 1)
Directly to independent, third parties for cash and 2) securitization
transactions that are treated for tax and accounting purposes as loan sales.
During 1998, NovaStar management began developing relationships with large-
block purchasers of whole loans. Through these relationships, $142 million in
loans were sold during 1998, resulting in gains of $3.3 million on a combined
basis.
On a short-term basis, NovaStar finances mortgage loans through a warehouse
facility and repurchase agreement with First Union National Bank in which
NovaStar Financial and NovaStar Mortgage are co-borrowers. In addition,
NovaStar has access to facilities secured by residual interests in asset-back
bonds. Details regarding available financing arrangements and amounts
outstanding under those arrangements are included in "Management's Discussion
and Analysis of Financial Condition and Results of Operations" and Note 4 to
the consolidated financial statements.
For long-term financing, NovaStar Financial securitizes its loans by issuing
collateralized mortgage obligations, commonly called CMOs. CMOs are debt
arrangements whereby the investor in the CMO is paid based on the performance
of the mortgage loans collateralizing the debt. As NovaStar borrowers repay
principal and pay interest on their mortgages, the funds are segregated to
repay the investors in the NovaStar CMO. Although these CMOs are non-recourse
debt, NovaStar retains the credit, prepayment and interest rate risks
associated with the loans.
During 1997 and 1998, CMO transactions executed by NovaStar Financial were
designed to meet accounting rules that result in securitizations being treated
as financing transactions. The mortgage loans and related debt continue to be
presented on NovaStar Financial's balance sheet, and no gain is recorded.
Details regarding CMOs issued by NovaStar Financial can be found in "Business--
Risk Management--Credit Risk, Management's Discussion and Analysis of Financial
Condition and Results of Operations" and Note 4 to NovaStar Financial's
consolidated financial statements.
Securitization transactions may also be structured as sales for accounting
and tax purposes. On January 29, 1999, NovaStar Mortgage completed this type of
securitization in which it sold loans with an aggregate principal value of $165
million to an unaffiliated entity. The loans are serving as collateral for
asset-backed bonds issued by the unaffiliated entity. NovaStar Mortgage, Inc.
retained the subordinate bonds and residual certificates in the bond
transaction.
Underwriting
NovaStar Mortgage employs account executives that develop relationships with
retail brokers and strives to provide a competitive menu of mortgage loan
products. NovaStar Mortgage underwrites, processes, funds and services the
mortgage loans sourced through its broker network.
In the latter part of 1998, constraints on liquidity and concerns about
subprime lending risk decreased investor appetite for subprime mortgage loans.
In response, NovaStar modified its underwriting guidelines to reflect the
changing environment. NovaStar must originate loans that are marketable in
today's business environment. In addition, NovaStar Mortgage has reduced broker
premiums, thereby reducing loan costs and increasing profit potential.
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Further details regarding the loans originated by NovaStar Mortgage and
purchased by NovaStar Financial are provided in "Business--Risk Management--
Credit Risk, --Prepayment Risk, Management's Discussion and Analysis of
Financial Condition and Results of Operations" and Note 2 to NovaStar
Financial's consolidated financial statements.
Loan Servicing
Loan servicing remains a critical part of NovaStar's operation. In the
opinion of management, maintaining contact with NovaStar Financial's customers
is critical in managing credit risk and in borrower retention. Subprime
borrowers are prone to late payments and are more likely to default on their
obligations than conventional borrowers. By servicing its own loans, NovaStar
strives to identify problems with borrowers early and take quick action to
address problems. Borrowers may be able to improve their personal credit and
thereby seek to refinance their loan to obtain a lower interest rate and
payment. By keeping in close touch with borrowers, NovaStar Financial can
provide them with information about Company products to entice them to
refinance with NovaStar. Common sense underwriting and thorough quality control
reviews also control exposure to credit risk. During 1998, NovaStar acquired
mortgage insurance coverage to further reduce the credit risk on mortgage
loans.
Market in Which NovaStar Operates and Competition
In the November 16, 1998 issue of National Mortgage News, NovaStar Mortgage
was ranked number 15 in subprime mortgage lenders based on mortgage lending
volume for the nine months ended September 30, 1998. Based on market
capitalization, as published in National Mortgage News, NovaStar Financial
ranked number 16 of 24 publicly traded subprime lenders. Management's research
of the asset size of these companies indicated NovaStar Financial ranks number
11 of the 24.
NovaStar Financial faces intense competition in the business of originating,
purchasing, selling and securitizing sub-prime mortgage loans. The number of
participants is believed to be well in excess of 100 companies and no single
participant holds a dominant share of the sub-prime market. In addition to
other residential mortgage REITs, NovaStar is in competition for sub-prime
borrowers with consumer finance companies, conventional mortgage bankers,
commercial banks, credit unions and thrift institutions. NovaStar also competes
for holding mortgage loans with life insurance companies, institutional
investors and other well-capitalized publicly owned mortgage lenders. Many of
these competitors are substantially larger and have considerably greater
financial, technical and marketing resources than NovaStar.
Competition among industry participants can take many forms, including
convenience in obtaining a loan, amount and term of the loan, customer service,
marketing/distribution channels, loan origination fees and interest rates. To
the extent any competitor significantly expands their activities in the
subprime market, NovaStar Financial could be materially adversely affected.
NovaStar believes that one of its key competitive strengths is its employees
and the level of service they are able to provide its borrowers. By servicing
its loan portfolio directly, NovaStar is able to stay in close contact with its
borrowers and identify potential problems early. NovaStar's servicing staff is
comprised of seasoned mortgage professionals with significant experience in the
subprime marketplace.
NovaStar Financial effectively competes due to its:
. experienced management team;
. tax advantaged status as a REIT;
. vertical integration through its relationship with NovaStar Mortgage,
which originates and services mortgage loans;
. cost-efficient operations; and
. direct access to capital markets to securitize its assets.
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NovaStar is competitively disadvantaged because of its youth and relatively
low production volume. NovaStar Mortgage has been in the business of
originating subprime mortgage loans for two years and is still developing its
lending network. Until the infrastructure is completely refined and developed,
NovaStar Mortgage will not have the high volume/low cost per loan production
experienced by its competition. In addition, NovaStar Financial requires
significant capital to acquire assets and maximize earnings potential. Many
competitors of NovaStar Financial have larger market capitalization. A larger
market capitalization generally affords larger trading volume, more recognition
in the marketplace and, therefore, greater ability to raise capital.
Risk Management
Management recognizes the following primary risks associated with the
business and industry in which it operates.
. Credit
. Prepayment
. Interest Rate/Market
. Liquidity
Credit Risk
Credit risk is the risk that NovaStar will not fully collect the principal
it has invested in mortgage loans or securities. Subprime mortgage loans
compose 100% of the mortgage assets owned by NovaStar Financial as of December
31, 1998 compared with 51% as of December 31, 1997. As discussed in "Events of
the Fourth Quarter 1998" all mortgage and corporate securities were sold during
October 1998. NovaStar's subprime borrowers include individuals that do not
qualify for agency/conventional lending programs because of a lack of available
documentation or previous credit difficulties, but have substantial 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 to lower their monthly payments. The credit grade that is
assigned to the borrower is a reflection of their historical credit and the
amount of documents the borrower can produce to support income.
NovaStar Mortgage underwrites the loans acquired by NovaStar Financial using
guidelines that have been approved by NovaStar Financial. The underwriting
guidelines are intended to evaluate the credit history of the potential
borrower, the capacity and willingness of the borrower to repay the loan and
the adequacy of the collateral securing the loan.
Loans acquired by NovaStar Financial in bulk pools were subject to the same
underwriting guidelines as established for NovaStar Mortgage production.
NovaStar Mortgage employs an experienced underwriting staff who works under the
supervision of their chief credit officer. The underwriters hired by NovaStar
Mortgage all have substantial experience in the underwriting of subprime
mortgage loans.
Underwriters are given approval authority only after the chief credit
officer has reviewed their work for a period of at least two weeks. Thereafter,
the chief credit officer re-evaluates the authority levels of all underwriting
personnel on an ongoing basis. All loans in excess of $350,000 currently
require the approval of the chief credit officer. In addition, the president
approves all loans in excess of $600,000.
The underwriting guidelines take into consideration the number of times the
potential borrower has recently been late on a mortgage payment and whether the
late payment was 30, 60 or 90 days late. Lateness on consumer/revolving debt is
also considered. Discharged bankruptcy filings are allowed under all credit
ratings. However, to obtain an "A" or "B" rating, the borrower must have at
least a one-year seasoning on its discharged Chapter 13 filing and two years
for a Chapter 7 filing. Maximum loan-to-value ratios for each credit rating
depend on the level of income documentation provided by the potential borrower.
In no cases do the guidelines allow a loan-to-value ratio greater than 95%.
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Depending on circumstances, exceptions to the underwriting guidelines are
approved by underwriting supervisors, the chief credit officer or the president
of NovaStar Mortgage.
Table 4 of "Management's Discussion and Analysis of Financial Condition and
Results of Operations" sets forth NovaStar Financial's mortgage loan portfolio
by credit grade as of December 31, 1998 and 1997, all of which are non-
conforming.
Close attention is paid to geographic diversification in managing NovaStar's
credit risk. Management believes one of the best tools for managing credit risk
is to diversify the markets in which NovaStar Mortgage originates and NovaStar
Financial purchases mortgage loans. Presented in Tables 5 and 6 of
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" section of this annual report is a breakdown of NovaStar
Financial's geographic diversification as of December 31, 1998 and 1997. Detail
regarding loan delinquencies and loans charged off during 1998 are disclosed in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" under the heading "Provision for Credit Losses."
Prepayment Risk
A significant portion of mortgage assets are acquired at a premium. When
mortgage loans are originated, a premium of 1/2 a percent to 2% is generally
paid to the retail brokers. For the most part, mortgage securities have been
acquired with premiums also. Premiums are amortized over the life of the asset
as an adjustment of the coupon received. When borrowers repay the principal on
their mortgage loans early, the effect is to shorten the period over which
premiums are amortized. The shorter this period the lower the overall yield on
the mortgage asset.
Management attempts to mitigate prepayment risk by acquiring loans that are
originated with a penalty if the borrower repays the loan in the early months
of the loan's life. For the majority of its loans, a prepayment penalty is
charged equal to six months interest on the principal balance that is to be
paid in full. Table 2 is a summary of the loans originated by NovaStar Mortgage
demonstrating the nature of prepayment penalties. As of December 31, 1998, 70%
of all loans owned had a prepayment penalty compared with 68% at December 31,
1997. The remaining weighted-average years to which the prepayment period
applies was 1.5 at December 31, 1998 compared with 2.4 at December 31, 1997. In
addition, the percent of loans NovaStar Mortgage originated with prepayment
penalties during 1998 increased from 65% during the first quarter of 1998 to
88% in the fourth quarter of 1998. Table 9 of "Management's Discussion and
Analysis of Financial Condition and Results of Operations" details prepayment
speeds as of December 31, 1998 and 1997 and Tables 2 and 13 of "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
detail the prepayment characteristics of NovaStar Financial's mortgage loan
portfolio.
Interest Rate/Market Risk
Price volatility. Under its current mode of operation, NovaStar depends
heavily on the market for wholesale subprime mortgage loans. Without capital to
support the purchase and retention of mortgage loans, most loans originated by
NovaStar Mortgage will be sold to outside parties. The financial results of
NovaStar will depend, in part, on the ability to find purchasers for the loans
at prices that cover origination expenses. NovaStar Mortgage originates loans
at a relatively low all-in cost, when it is operating at or near capacity, and
therefore mitigates price volatility. Price volatility will be eliminated when
NovaStar can raise capital and resume acquisition and retention of its subprime
mortgage loans.
Interest rate risk. Interest rate risk is the risk that the market value of
assets will increase or decrease at different rates than that of the
liabilities. Expressed another way, this is the risk that NovaStar's net asset
value will experience an adverse change when interest rates change. When
interest rates on the assets do not adjust at the same rates as liabilities or
when the assets have fixed rates and the liabilities are adjusting, future
earnings potential is affected. Management primarily uses financing sources
where the interest rate resets frequently. As
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of December 31, 1998, borrowings under all financing arrangements adjust daily,
monthly, or quarterly. On the other hand, very few of the mortgage assets owned
by NovaStar, as of December 31, 1998, adjust on a monthly basis and none adjust
daily. Most of the mortgage loans contain features where their rates are fixed
for some period of time and then adjust frequently thereafter. For example, one
of NovaStar's loan products is the "2/28" loan. This loan is fixed for its
first two years and then adjusts every six months thereafter.
While short-term borrowing rates are low and long-term asset rates are high,
this portfolio structure produces good results. However, if short-term interest
rates rise rapidly, earning potential could be significantly effected as the
asset rate resets would "lag" borrowing rate resets. The converse can be true
when sharp declines in short-term interest rates cause interest costs to fall
faster than asset rate resets, thereby increasing earnings.
In its assessment of the interest sensitivity and as an indication of
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.
Table 26 of "Management's Discussion and Analysis of Financial Condition and
Results of Operations" is a summary of NovaStar Financial's interest
sensitivity analysis as of December 31, 1998.
The interest sensitivity analysis is prepared monthly. If the analysis
demonstrates that a 100 basis point shift up or down in interest rates would
result in 10% or more cumulative decrease in income from base, policy requires
management to adjust the portfolio by adding or removing interest rate cap or
swap agreements. Management acknowledges that NovaStar Financial is currently
not within policy. Management will take steps to correct this once its capital
position safely allows it to do so.
Assumptions used in interest rate sensitivity analysis. Management uses
estimates in determining the income of assets, liabilities and interest rate
agreements. The estimation process is dependent upon a variety of assumptions,
especially in determining the income of its subprime mortgage loan holdings.
The estimates and assumptions have a significant impact on the results of the
interest rate sensitivity analysis, the results of which are shown as of
December 31, 1998.
Management's analysis for assessing interest rate sensitivity on its
subprime mortgage loans relies significantly on estimates for prepayment
speeds. A prepayment model has been internally developed based upon four main
factors:
. Refinancing incentives (the interest rate of the mortgage compared with
the current mortgage rates available to the borrower)
. Borrower credit grades
. Loan-to-value ratios
. Prepayment penalties, if any
Generally speaking, when market interest rates decline, borrowers are more
likely to refinance their mortgages. The higher the interest rate a borrower
currently has on his or her mortgage, the more incentive he or she has to
refinance the mortgage when rates decline. In addition, the higher the credit
grade, the more incentive there is to refinance when credit ratings improve.
When a borrower has a low loan-to-value ratio, he or she is more likely to do a
"cash-out" refinance. Each of these factors presumably increases the chance for
higher prepayment speeds during the term of the loan. On the other hand,
prepayment penalties serve to mitigate the risk that loans will prepay, under
the assumption that the penalty is a deterrent to refinancing.
These factors are weighted based on management's experience and an
evaluation of the important trends observed in the subprime mortgage
origination industry. Actual results may differ from the estimates and
assumptions used in the model and the projected results as shown in the above
table.
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NovaStar's projected prepayment rates in each interest rate scenario start
at a prepayment speed less than 5% in month one and increase to a long-term
prepayment speed in nine to 18 months, to account for the seasoning of the
loans. The long-term prepayment speed ranges from 20% to 40% and depends on the
characteristics of the loan which include type of product (adjustable or fixed
rate), note rate, credit grade, loan-to-value, gross margin, weighted average
maturity and lifetime and periodic caps and floors. This prepayment curve is
also multiplied by a factor of 60% on average for periods when a prepayment
penalty is in effect on the loan. These assumptions change with levels of
interest rates.
Historical rates of prepayment experienced on the loans owned by NovaStar
Financial are shown in Table 9 of "Management's Discussion and Analysis of
Financial Condition and Results of Operations." These speeds represent the
actual weighted average rate of prepayment for all loans in each securitized
pool. As shown in Table 9, the historical prepayment rates on loans that have
been held in portfolio for shorter periods are slower than the estimated
prepayment rates projected in the interest rate sensitivity analysis as
described in the preceding paragraph. However, this table also indicates that
as pools of loans held in portfolio season, the actual prepayment rates are
more consistent with the long term prepayment rates used in the interest
sensitivity analysis.
The investment policy for NovaStar Financial sets the following general
goals:
. Maintain the net interest margin between assets and liabilities, and
. Diminish the effect of changes in interest rate levels on the market
value of assets.
Although management evaluates the portfolio using interest rate increases
and decreases greater than 1%, management focuses on the 1% increase. The
investment policy for NovaStar Financial allows for no more than a 10% decrease
in the spread income of the portfolio when interest rates rise or fall by 1%.
Hedging with off-balance-sheet financial instruments. In order to address a
mismatch of assets and liabilities, the hedging section of the investment
policy is followed, as approved by the Board. Specifically, the interest rate
risk management program is formulated with the intent to offset the potential
adverse effects resulting from rate adjustment limitations on its mortgage
assets and the differences between interest rate adjustment indices and
interest rate adjustment periods of its adjustable-rate mortgage loans and
related borrowings.
NovaStar Financial uses interest rate cap and swap agreements and financial
futures contracts to mitigate the risk of the cost of its variable rate
liabilities increasing at a faster rate than the earnings on its assets during
a period of rising rates. In this way, management intends generally to "hedge"
as much of the interest rate risk as determined to be in the best interest of
NovaStar, given the cost of hedging transactions and the need to maintain REIT
status.
NovaStar Financial seeks to build a balance sheet and undertake an interest
rate risk management program that is likely, in management's view, to enable
NovaStar to maintain an equity liquidation value sufficient to maintain
operations given a variety of potentially adverse circumstances. Accordingly,
the hedging program addresses both income preservation, as discussed in the
first part of this section, and capital preservation concerns.
Interest rate cap agreements are legal contracts between NovaStar Financial
and a third party firm or "counter-party". The counter-party agrees to make
payments to NovaStar Financial in the future should the one- or three-month
LIBOR interest rate rise above the "strike" rate specified in the contract.
NovaStar Financial either makes quarterly premium payments or has chosen to pay
the premiums upfront to the counterparties under contract. Each contract has a
fixed "notional face" amount, on which the interest is computed, and a set term
to maturity. Should the reference LIBOR interest rate rise above the
contractual strike rate, NovaStar Financial will earn cap income. Payments on
an annualized basis equal the contractual notional face amount times the
difference between actual LIBOR and the strike rate.
Interest rate swap agreements stipulate that NovaStar Financial pay a fixed
rate of interest to the counterparty. In return, the counterparty pays NovaStar
Financial a variable rate of interest based on the notional amount. The
agreements have fixed notional amounts, on which the interest is computed, and
set terms
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to maturity. As discussed in "Events of the Fourth Quarter 1998", NovaStar
Financial terminated all swap agreements and paid off the liabilities
pertaining to these hedging instruments in October 1998, recognizing losses
aggregating $7.9 million.
A futures contract is a standardized, transferable agreement to buy or sell
a given financial instrument on a specific future date at a set price. The
futures contracts entered into by NovaStar are interest rate futures, under
which settlements are made in cash rather than physical delivery of the
underlying security. The value of the cash settlement depends on how market
prices fluctuate during the term of the contract. Depending on market prices,
NovaStar may be in a gain or loss position. Futures contracts are exchange
traded, which means the exchange accepts counterparty credit risk and generally
requires cash deposits as collateral.
NovaStar is subject to credit risk under its interest rate agreements
because the counterparty may fail on its obligation to NovaStar. To limit
counterparty credit risk, NovaStar:
. enters into ISDA Master Agreements with each counterparty,
. deals with counterparties with BBB/Baa ratings or higher from S&P and
Moody's, respectively
. measures the risk on at least a monthly basis,
. obtains bilateral cross collateralization agreements on each agreement,
and
. obtains the right for margin calls when hedges are in loss positions.
The net market value of all agreements with each counterparty is in a loss
position as of December 31, 1998, exposing NovaStar to no counterparty risk at
that date.
All interest rate agreements are tied to either one- or three-month LIBOR.
All financing agreements reset based on one-month LIBOR or short-term
repurchase agreement rates. Therefore, the extent of the basis risk of NovaStar
Financial lies in the differences in movements between one and three-month
LIBOR and short-term repurchase agreements rates versus one-month and three-
month LIBOR. Historically, the basis movements between these rates have been
minimal.
ISDA Master Agreements set the legal framework for transactions with
counterparties in over-the-counter derivative markets. NovaStar considers its
exposure to legal enforcement risk to be minimal. Corporate counsel reviews
legal documents at the discretion of management.
When analyzed in isolation, the cost of a hedging transaction over the life
of the agreement may exceed the benefit of the transaction if market interest
rates move against the hedge. However, if analyzed in the context of the entire
portfolio, losses on hedging transactions in downward interest rate movements
will be offset by gains on the asset side of the balance sheet.
In order to retain REIT status, NovaStar Financial must meet requirements
established by the Internal Revenue Code. Income from hedges that reduce the
interest rate risk of REIT liabilities is treated as qualifying income under
the Internal Revenue Code. All hedging instruments owned by NovaStar are REIT-
qualifying. Further details regarding qualification as a REIT and income
restrictions is provided under the heading "Federal Income Tax Consequences" of
NovaStar Financial's 1998 Annual Report on Form 10K.
Note 5 to the consolidated financial statements provides additional
information regarding hedging instruments owned by NovaStar.
Liquidity Risk
See "Liquidity and Capital Resources" for a discussion of liquidity
resources available to NovaStar Financial as of December 31, 1998.
10
<PAGE>
Capital allocation guidelines. Management's goal is to balance between the
under-utilization of leverage, which reduces returns to stockholders, and the
over-utilization of leverage, which could reduce the ability of NovaStar to
meet its obligations during adverse market conditions. Capital allocation
guidelines have been approved by the Board of Directors. The guidelines are
intended to keep NovaStar properly leveraged by:
. Matching the amount of leverage allowed to the riskiness on return and
liquidity of an asset; and
. Monitoring the credit and prepayment performance of each investment to
adjust the required capital.
This analysis takes into account hedging instruments and other risk programs
discussed below. Balance sheet leverage is controlled by monitoring capital
allocation. Following presents a summary of the capital allocation guidelines
for the following levels of capital for various types of assets it owns.
Capital Allocation Guidelines
December 31, 1998
<TABLE>
<CAPTION>
(F)
(E) (b x e) (F)
(A) (B) (C) (D) (c + d) Equity (a + f)
Minimum Estimated Duration Liquidity Total Cushion CAG
Lender Price Spread Spread Spread (% of Equity
Asset Category Haircut Duration Cushion Cushion Cushion MV) Required
- -------------- ------- --------- -------- --------- ------- ------- --------
<S> <C> <C> <C> <C> <C> <C> <C>
Agency-issued:
Conventional ARMs...... 3.00% 3.50% 50 -- 50 1.75% 4.75%
GNMA ARMs.............. 3.00 4.50 50 -- 50 2.25 5.25
GNMA Fixed Rates....... 3.00 5.00 50 -- 50 2.50 5.50
Mortgage loans:
Collateral for
warehouse financing... 2.00 3.00 100 50 150 4.50 7.50
Collateral for CMO..... 5.00 -- -- -- -- -- 5.00
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 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 U. S. 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
NovaStar Financial from lender margin calls. The size of each cushion is
based on management's experience with the price volatility and liquidity in
the various asset categories. Individual assets that have exposure to
substantial credit risk will be measured individually and the leverage
adjusted as actual delinquencies, defaults and losses differ with
management's expectations.
Implementation of capital allocation guidelines--mark to market. Each month,
assets are marked to market. Market values for mortgage loan portfolio are
calculated internally using assumptions for losses, prepayments and discount
rates. Mortgage securities are valued using independent market quotes.
The face amount of all financing used for securities and mortgage loans is
subtracted from the current market value of the assets and hedges. This is the
current market value of equity. This number is compared to
11
<PAGE>
the required capital as determined by the capital allocation guidelines. If the
actual equity falls below the capital required by the capital allocation
guidelines, NovaStar must prepare a plan to bring the actual capital above the
level required by the capital allocation guidelines.
Each quarter, management presents to the Board of Directors the results of
the capital allocation guidelines 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 to predict or hedge the risk of the asset.
Historical capital allocation is presented in Table 29 of "Management's
Discussion and Analysis of Financial Condition and Results of Operations".
Other Risk Factors
Although NovaStar Financial's management considers the above risk components
to be its primary business risks, the following are other risks that should be
considered by NovaStar Financial's investors. Further information regarding
these risks is included in NovaStar Financial's registration statements filed
with the Commission on Form S-11.
. NovaStar's dependence upon borrowings can result in significant liquidity
constraints. NovaStar Financial's profitability is dependent upon its
ability to borrow money on favorable terms. In October 1998, the subprime
mortgage market faced a liquidity crisis with respect to the availability
of short-term borrowings from major lenders and long-term borrowings
through securitization. NovaStar faced significant liquidity constraints.
. NovaStar Financial has a limited operating history and incurred
significant net losses in the fourth quarter of 1998. NovaStar Financial
has not yet developed an extensive earnings history or experienced a wide
variety of interest rate or market conditions. Historical operating
performance may be of limited relevance in predicting future performance.
NovaStar Financial incurred significant net losses in the fourth quarter
of 1998.
. Forgivable notes may adversely affect results of operations. In
NovaStar's private placement, Messrs. Hartman and Anderson each acquired
units paid for with promissory notes. Principal due on the notes will be
forgiven if return to private placement investors meets certain
benchmarks. The non-cash charge against earnings that results from the
forgiveness of the notes could have a material adverse effect on its
results of operations and dividends paid to stockholders during periods
forgiven.
. NovaStar depends on key personnel for successful operations. NovaStar
Financial's operations and those of NovaStar Mortgage depend heavily upon
the contributions of Scott Hartman and Lance Anderson, both of whom would
be difficult to replace. The loss of either of these individuals could
have a material adverse effect upon its businesses and results of
operations.
. Should NovaStar Financial fail to maintain REIT status, NovaStar
Financial would be subject to tax as a regular corporation. If NovaStar
Financial fails to maintain qualification as a REIT, NovaStar Financial
would be subject to federal income tax as a regular corporation. NovaStar
Financial intends to conduct its business at all times in a manner
consistent with the REIT provisions of the Code.
. Changes in interest rates may adversely affect results of operation.
NovaStar Financial's results of operations are likely to be adversely
affected during any period of unexpected or rapid changes in interest
rates. For example, a substantial or sustained increase in interest rates
could adversely affect its ability to acquire mortgage loans in expected
volumes necessary to support fixed overhead expense levels.
. Interest rate fluctuations may adversely affect the value of mortgage
loans held for sale or securitization. Declines and increases in interest
rates will cause the value of a loan to rise and fall respectively if the
yield spread, or basis, between the loan and the duration-matched
treasury remains the same. The basis does fluctuate over time, however,
and NovaStar may experience mark-to-market
12
<PAGE>
gains and losses on its unsecuritized portfolio even though interest rates
may have remained stable. This may effect the value of future
securitizations to the company if the decrease in market value on loans
was caused by basis widening in the securitization market, which would
make long-term, non-recourse financing more expensive. Basis changes may
not have an effect on future securitizations if, for example, there was
simply an over supply in the whole loan market and securitization spreads
had remained constant.
. Financing with repurchase agreements may lead to margin calls if the
market value of mortgage assets decline. NovaStar uses repurchase
agreements to finance the acquisition of mortgage assets in the short-
term. In a repurchase agreement, NovaStar sells an asset and agrees to
repurchase the same asset at some period in the future. Generally, the
repurchase agreements entered into by NovaStar stipulate that it must
repurchase the asset in 30 days. For financial accounting purposes, these
arrangements are treated as secured financings. NovaStar retains the
assets on its balance sheet and records an obligation to repurchase the
asset. The amount NovaStar can borrow under these arrangements is
generally 96% to 98% of the asset market value. When asset market values
decrease, NovaStar is required to repay the margin, or difference in
market value. To the extent the market values of assets financed with
repurchase agreements decline rapidly, NovaStar will be required to meet
cash margin calls. If cash is unavailable, NovaStar may be forced to
default under the terms of the repurchase agreement. In that event, the
lender retains the right to liquidate the collateral to settle the amount
due from NovaStar.
. Intense competition in the subprime mortgage industry may result in
reduced net income or in revised underwriting standards which would
adversely affect operations. NovaStar faces intense competition,
primarily from commercial banks, savings and loans, other independent
mortgage lenders, and certain other mortgage REITs. Any increase in the
competition among lenders to originate or purchase subprime mortgage
loans may result in either reduced interest income on mortgage loans
compared to present levels or revised underwriting standards permitting
higher loan-to-value ratios on properties securing subprime mortgage
loans.
. Loans made to subprime mortgage borrowers entail higher delinquency and
loss rates. Lenders in the subprime mortgage banking industry make loans
to borrowers who have impaired or limited credit histories, limited
documentation of income and higher debt-to-income ratios than traditional
mortgage lenders allow. Loans made to subprime mortgage borrowers
generally entail a higher risk of delinquency and foreclosure than loans
made to borrowers with better credit and may result in higher levels of
realized losses. Any failure by NovaStar to adequately address the risks
of subprime lending would have a material adverse impact on its results
of operations, financial condition and business prospects.
. Lack of loan performance data inhibits prediction of future results. The
mortgage loans NovaStar Financial purchased have been outstanding for a
relatively short period of time. Consequently, the delinquency,
foreclosure and loss experience of these loans to date may not be
indicative of future results. It is unlikely that NovaStar Financial will
be able to sustain delinquency, foreclosure and loan loss rates at their
present levels as the portfolio becomes more seasoned.
. Failure to renew or obtain adequate funding under warehouse facilities
and repurchase agreements may materially adversely impact NovaStar
Mortgage's lending operations. NovaStar Financial and NovaStar Mortgage
are currently dependent upon one lender to provide the primary credit
facilities for its funding of mortgage loan originations and
acquisitions. Any failure to renew or obtain adequate funding under these
financing arrangements could have a material adverse effect on its
lending operations.
. Interest rate fluctuations may result in a decrease in net interest
income. Interest rate fluctuations may affect its earnings as a result of
potential changes in the spread between the interest rates on NovaStar's
borrowings and the interest rates on its mortgage assets. In addition,
mortgage prepayment rates vary depending on such factors as mortgage
interest rates and market conditions. Changes in anticipated prepayment
rates may adversely affect its earnings.
13
<PAGE>
. Failure to hedge effectively against interest rate changes may adversely
affect results of operations. Asset/liability management hedging
strategies involve risk and may not be effective in reducing its exposure
to interest rate changes. Moreover, compliance with the REIT provisions
of the Code may prevent NovaStar Financial from effectively implementing
the strategies that management determine, absent such compliance, would
best insulate NovaStar from the risks associated with changing interest
rates.
. NovaStar Financial faces loss exposure due to the underlying real estate.
A substantial portion of its mortgage assets consists of (1) single
family mortgage loans or (2) mortgage securities evidencing interests in
single family mortgage loans. NovaStar Financial will be subject to the
risk of loss on mortgage assets arising from borrower defaults to the
extent not covered by third-party credit enhancement.
. Market factors may limit NovaStar Financial's ability to acquire mortgage
assets at yields which are favorable relative to borrowing costs. Despite
management's experience in the acquisition of mortgage assets and its
relationships with various mortgage suppliers, there can be no assurance
that NovaStar Financial will be able to acquire sufficient mortgage
assets from mortgage suppliers at spreads above its cost of funds.
. Restrictions on ownership of capital stock may inhibit market activity
and the resulting opportunity for holders of NovaStar Financial's capital
stock and warrants to receive a premium for their securities. In order
for NovaStar Financial to meet the requirements for qualification as a
REIT, its charter generally prohibits any person from acquiring or
holding, directly or indirectly, shares of common stock in excess of 9.8%
of the outstanding shares. This restriction may inhibit market activity
and the resulting opportunity for the holders of its common stock to
receive a premium for their stock that might otherwise exist in the
absence of these restrictions.
Federal Income Tax Consequences
General. NovaStar Financial believes it has complied, and intends to comply
in the future, with the requirements for qualification as a REIT under the
Internal Revenue Code ("the Code"). To the extent that NovaStar qualifies as a
REIT for federal income tax purposes, it generally will not be subject to
federal income tax on the amount of its income or gain that is distributed to
shareholders. However, origination operations are conducted through NovaStar
Mortgage, which is not a qualified REIT subsidiary. Consequently, all of the
taxable income of NovaStar Mortgage is subject to federal and state income
taxes.
The REIT rules generally require that a REIT invest primarily in real
estate-related assets, its activities be passive rather than active and it
distribute annually to its shareholders substantially all of its taxable
income. NovaStar Financial could be subject to a number of taxes if it failed
to satisfy those rules or if it acquired certain types of income-producing real
property through foreclosure. Although no complete assurance can be given,
NovaStar Financial does not expect that it will be subject to material amounts
of such taxes.
Failure to satisfy certain Code requirements could cause loss in REIT
status. If NovaStar failed to qualify as a REIT for any taxable year, it would
be subject to federal income tax (including any applicable minimum tax) at
regular corporate rates and would not receive deductions for dividends paid to
shareholders. As a result, the amount of after-tax earnings available for
distribution to shareholders would decrease substantially. While NovaStar
intends to operate in a manner that will enable it to qualify as a REIT in
future taxable years, there can be no certainty that such intention will be
realized.
NovaStar Financial's qualification as a REIT. Qualification as a REIT
requires that NovaStar Financial satisfy a variety of tests relating to its
income, assets, distributions and ownership. The significant tests are
summarized below. NovaStar Financial will make available more detailed
information regarding its compliance with the REIT rules upon request.
14
<PAGE>
Sources of income. To qualify as a REIT in 1998 and thereafter, NovaStar
Financial must satisfy two tests with respect to the sources of its income: the
75% income test, and the 95% income test. The 75% income test requires that
NovaStar derive at least 75% of its gross income, excluding gross income from
prohibited transactions, from certain real estate-related sources.
In order to satisfy the 95% income test, at least an additional 20% of
NovaStar Financial's gross income for the taxable year must consist either of
income that qualifies under the 75% income test or dividends and interest.
Nature and diversification of assets. As of the last day of each calendar
quarter, NovaStar Financial must meet three asset tests. Under the 75% asset
test, at least 75% of the value of NovaStar Financial's total assets must
represent cash or cash items (including receivables), government securities or
real estate assets. Under the 10% asset test, NovaStar Financial may not own
more than 10% of the outstanding voting securities of any single non-
governmental issuer, if these securities do not qualify under the 75% asset
test. Under the 5% asset test, ownership of any stocks or securities that do
not qualify under the 75% asset test must be limited, in respect of any single
non-governmental issuer, to an amount not greater than 5% of the value of its
total assets. The definition of security for this purpose includes financial
contracts and instruments that NovaStar Financial acquires in the normal course
of business.
If NovaStar Financial inadvertently fails to satisfy one or more of the
asset tests at the end of a calendar quarter, such failure would not cause it
to lose its REIT status. NovaStar Financial still could avoid disqualification
by eliminating any discrepancy within 30 days after the close of the calendar
quarter in which the discrepancy arose.
Ownership of Common Stock. The capital stock of NovaStar Financial must be
held by a minimum of 100 persons for at least 335 days of each year. In
addition, at all times during the second half of each taxable year, no more
than 50% in value of the capital stock of NovaStar Financial may be owned
directly or indirectly by 5 or fewer individuals. NovaStar Financial uses the
calendar year as its taxable year for income tax purposes. The Code requires
NovaStar Financial to send its annual information questionnaires to specified
shareholders in order to assure compliance with the ownership tests.
Distributions. NovaStar Financial generally must distribute to its
shareholders an amount equal to at least 95% of the sum of its taxable income
and any after-tax net income from certain types of foreclosure property minus
any excess non-cash income. The Code provides that distributions relating to a
particular year may be made early in the following year, under certain
circumstances. NovaStar Financial expects to make distributions equal to 100%
of its taxable income to avoid corporate level taxation.
Taxable income. NovaStar Financial uses the calendar year for both tax and
financial reporting purposes. However, there may be differences between taxable
income and income computed in accordance with generally accepted accounting
principles (GAAP). These differences primarily arise from timing and character
differences in the recognition of revenue and expense and gains and losses for
tax and GAAP purposes. Additionally, NovaStar Financial's taxable income does
not include the taxable income of its taxable affiliate, although the
affiliate's operating results are included in NovaStar Financial's GAAP
results.
Proposed Tax Legislation. The Clinton Administration has introduced a
proposal in the fiscal 2000 federal budget that would limit the aggregate value
of businesses undertaken by a REIT through taxable subsidiaries to 5% or less
of the REIT's total assets. NovaStar Financial operates through NovaStar
Holding, Inc. and its subsidiaries to hold assets that may generate income that
could have an adverse effect on classes of NovaStar Financial's shareholders.
NovaStar Financial does not reasonably expect that the value of NovaStar
Holding and any other taxable subsidiaries, in the aggregate, ever to exceed 5%
of NovaStar Financial's assets and therefore NovaStar Financial does not
anticipate that the proposal, if enacted, would have a material effect on
NovaStar Financial's operations.
Personnel
As of December 31, 1998, NovaStar Financial employed 20 people. NovaStar
Mortgage employed 310 people and NovaStar Capital, Inc. employed 13 people on
December 31, 1998.
15
<PAGE>
Item 2. Properties
The executive and administrative offices of NovaStar Financial and NovaStar
Mortgage are located in Westwood, Kansas, and consist of approximately 6,000
square feet. The lease on the premises expires December 2002. The current
annual rent for these offices is approximately $116,000.
NovaStar Mortgage leases space for its mortgage lending operations in Orange
County, California. Currently, these offices consist of approximately 35,000
square feet. The lease on the premise expires January 2005, and the current
annual rent is approximately $917,000.
NovaStar Mortgage also leases space for its mortgage servicing operation in
Westwood, Kansas. The square footage on these premises is approximately 28,000,
with annual rent of approximately $382,000, and a lease scheduled to expire in
January 2007.
Item 3. Legal Proceedings
NovaStar Financial occasionally becomes involved in litigation arising in
the normal course of business. Management believes that any liability with
respect to such legal actions, individually or in the aggregate, will not have
a material adverse effect on its financial position or results of operations.
Item 4. Submission of Matters to a Vote of Security Holders
None
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
The common stock of NovaStar Financial is traded on the NYSE under the
symbol "NFI". NovaStar Financial's warrants trade through market makers, such
as Stifel, Nicolaus & Company, Incorporated, using the NASD's bulletin board
service. The following table sets forth, for the periods indicated, the high
and low sales prices per share of common stock on the NYSE and the cash
dividends paid or payable per share of capital stock.
<TABLE>
<CAPTION>
Common Stock Prices Cash Dividends
- -------------------------------- -------------------------------------------
Date Amount
Date Paid or Per
High Low Class Declared Payable Share
---- --- ----- -------- ------- ------
<S> <C> <C> <C> <C> <C> <C>
10/31/97 to
12/31/97(A) 18 13/16 14 1/2 Preferred Stock 3/13/97 4/30/97 $0.05
1/1/98 to
3/31/98 21 1/8 15 15/16 6/18/97 7/30/97 0.05
4/1/98 to
6/30/98 21 16 3/8 9/18/97 10/20/97 0.08
7/1/98 to
9/30/98 17 13/16 11 3/8
10/1/98 to
12/31/98 12 7/8 3 Common Stock 12/19/97 1/27/98 0.10
Common Stock 3/25/98 4/14/98 0.30
Common Stock 6/23/98 7/14/98 0.35
Common Stock 9/22/98 4/15/99(B) 0.35
</TABLE>
- --------
(A) NovaStar Financial's Common Stock began trading on October 31, 1997.
(B) NovaStar Financial deferred the payment of this dividend due to events that
occurred early in the fourth quarter of 1998 as discussed in "Management's
Discussion and Analysis of Financial Condition and Results of Operations".
16
<PAGE>
As of March 10, 1999, approximately 2,750 stockholders, based on registered
and security position listings, held NovaStar Financial's 8,130,069 shares of
common stock.
NovaStar Financial generally intends to pay quarterly dividends. NovaStar
Financial intends to make distributions to its stockholders of all or
substantially all of its taxable income in each year, subject to certain
adjustments, so as to qualify for the tax benefits accorded to a REIT under the
Code. All distributions will be made by NovaStar Financial at the discretion of
the Board of Directors and will depend on the earnings of NovaStar Financial,
financial condition of NovaStar Financial, maintenance of REIT status and such
other factors as the Board of Directors may deem relevant from time to time.
Recent Sales of Securities
In September and December 1996, NovaStar Financial sold 216,666 shares of
common stock to Scott Hartman and Lance Anderson for $2,167 cash. These shares
were sold without registration under the Securities Act of 1933, as amended, in
reliance on the exemption provided by Section 4(2) thereof.
In December 1996, NovaStar Financial sold an aggregate of 3,333,333 units,
each unit consisting of one share of Class A convertible preferred stock and
one stock purchase warrant, to approximately 180 accredited investors for
$49,999,995 cash and an additional 216,666 units to Scott Hartman and Lance
Anderson for $3,249,999 in forgivable notes. Stifel, Nicolaus & Company,
Incorporated acted as placement agent in connection with the issuance and
received commissions and reimbursement of expenses totaling approximately
$3,000,000 along with 100,000 stock purchase warrants. These shares were sold
without registration under the Securities Act of 1933, as amended, in reliance
on the exemption provided by Section 4 (2) thereof and on Regulation D
promulgated thereunder.
On October 13, 1998, NovaStar Financial agreed, subject to the completion of
a warrant agreement, to issue to GMAC/Residential Funding Corporation 812,731
warrants to purchase NovaStar Financial common stock at a price of $4.5625 per
share, the closing price of NovaStar Financial's common stock on October 12,
1998. The warrants will expire on October 13, 2003.
On February 12, 1999, NovaStar Financial issued to First Union National Bank
350,000 warrants to purchase NovaStar Financial common stock at a price of
$6.9375 per share, the closing price of NovaStar Financial's common stock on
February 11, 1999. These warrants were issued in exchange for 186,667 existing
warrants with an exercise price of $15 per share, all of which will be retired.
The new warrants are exercisable until February 12, 2002.
17
<PAGE>
Item 6. Selected Consolidated Financial Data
The following selected consolidated financial data are derived from the
audited consolidated financial statements of NovaStar Financial for the periods
presented and should be read in conjunction with the more detailed information
therein and "Management's Discussion and Analysis of Financial Condition and
Results of Operations" included elsewhere in this annual report. Operating
results for the twelve months ended December 31, 1998 are not necessarily
indicative of future results. Dollars are presented in thousands.
Selected Consolidated Financial and Other Data
(dollars in thousands, except per share amounts)
<TABLE>
<CAPTION>
For the Year For the Year For the
Ended Ended Period Ended
December 31, December 31, December 31,
1998 1997 1996
------------ ------------ ------------
<S> <C> <C> <C>
Consolidated Statement of Operations
Data
Interest income....................... $100,747 $36,961 $ 155
Interest expense...................... 80,794 28,185 --
Net interest income................... 19,953 8,776 155
Provision for credit losses........... 7,430 2,453 --
Net interest income after provision
for credit losses.................... 12,523 6,323 155
Gains (losses) on sales of securities
and termination of interest rate
agreements........................... (22,939) 51 --
Other................................. 3,188 704 --
Equity in net income (loss) of NFI
Holding Corporation.................. (2,984) 28 --
General and administrative expenses... 11,609 7,158 457
Forgiveness of notes receivable from
founders............................. -- 1,083 --
Net loss.............................. (21,821) (1,135) (302)
Basic and diluted loss per share (A).. (2.71) (0.26) (0.08)
</TABLE>
<TABLE>
<CAPTION>
As of As of As of
December 31, December 31, December 31,
1998 1997 1996
------------ ------------ ------------
<S> <C> <C> <C>
Consolidated Balance Sheet Data
Mortgage Assets:
Mortgage loans......................... $ 920,697 $ 574,984 $ --
Mortgage securities.................... -- 517,246 13,239
Total assets............................. 1,002,236 1,126,252 59,811
Collateralized mortgage obligations...... 891,944 408,867 --
Short term borrowings.................... 18,000 596,693 --
Stockholders' equity..................... 87,290 116,489 46,380
</TABLE>
<TABLE>
<CAPTION>
As of or for As of or for As of or for
the Year Ended the Year Ended the Period Ended
December 31, December 31, December 31,
1998 1997 1996
-------------- -------------- ----------------
<S> <C> <C> <C>
Other Data:
Loan production of NovaStar
Mortgage:
Principal at purchase......... $876,516 $409,974 $ --
Average principal balance per
loan......................... $ 94 $ 130 --
Weighted average interest
rate: --
Adjustable rate mortgage
loans...................... 10.0 % 10.1 % --
Fixed rate mortgage loans... 9.9 % 10.5 % --
Loans with prepayment
penalties.................... 74 % 73 % --
Weighted average prepayment
period (in years)............ 2.5 2.4 --
Number of account executives.... 63 36 --
Annualized return on assets..... (2.05)% (0.01)% (1.69)%
Annualized return on equity..... (21.43)% (0.06)% (2.18)%
Taxable income (loss)........... $ (1,211) $ 1,434 $ (173)
Taxable income (loss) per
outstanding share.............. $ (0.15) $ 0.18 $(0.05)
Cash dividends declared per
share.......................... $ 1.00 $ 0.28 --
</TABLE>
18
<PAGE>
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Management's Discussion and Analysis of Financial Condition and Results of
Operations
The following discussion should be read in conjunction with the preceding
Selected Consolidated Financial and Other Data and the Consolidated Financial
Statements of NovaStar Financial, Inc. and the Notes thereto, included
elsewhere in this annual report.
Safe Harbor Statement
"Safe Harbor" statement under the Private Securities Litigation Reform Act
of 1995: Statements in this discussion regarding NovaStar Financial, Inc. 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 "Risk Management" section of this annual report. In
addition, there are many important factors that could cause 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 in
the asset securitization industry or the REIT provisions of the Internal
Revenue Code, demand for services and products offered by NovaStar, the impact
of covenants in loan agreements, the degree to which NovaStar is leveraged, the
needs for and availability of financing, 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
NovaStar Financial is not necessarily indicative of future financial and
operational performance.
Information
NovaStar's management intends to provide extensive information about the
financial position and results of operations of NovaStar Financial in a format
that is clear and easy to understand. This report and other published documents
are designed to provide a framework for understanding NovaStar's business and
the associated risks. The manner in which management conducts business and
assesses risks will determine future performance. By providing detailed
information to this extent, investors will be able to evaluate NovaStar as an
investment option and to compare NovaStar with its competition.
Basis of Presentation
NovaStar Financial owns 100% 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 issuance of collateralized mortgage obligations. The
consolidated financial statements of NovaStar Financial include the financial
condition and results of operations of these entities.
NovaStar Financial also owns 100% of the non-voting preferred stock of NFI
Holding Corporation for which it receives 99% of any dividends paid by NFI
Holding. Scott Hartman and Lance Anderson, the founders of NovaStar Financial,
own the voting common stock of NFI Holding and receive 1% of any dividends paid
by NFI Holding. NovaStar Mortgage, Inc. is a wholly owned subsidiary of NFI
Holding. Key officers of NovaStar Financial serve as officers of NFI Holding
and NovaStar Mortgage and the founders are the only members of the Board of
Directors of NFI Holding and NovaStar Mortgage. In June 1998, NFI Holding
formed NovaStar Capital, Inc. to purchase and sell mortgage loans. NovaStar
Mortgage owns 100% of NovaStar Mortgage Funding Corporation II and NovaStar
REMIC Financing Corporation. Both of these special purpose entities were
created in January 1999 for the issuance of real estate mortgage investment
conduits (REMICs). NovaStar Financial accounts for its investment in NFI
Holding using the equity method.
19
<PAGE>
Recent Events
On February 12, 1999, NovaStar executed agreements with First Union National
Bank to extend the mortgage warehouse line of credit and repurchase agreements.
The borrowing limit for the repurchase agreement was increased to $300 million.
Two additional financing agreements were executed with First Union whereby
NovaStar can borrow up to an aggregate $20 million secured by residual interest
in collateralized mortgage obligations owned by NovaStar. These agreements are
committed for one year and are discussed further in Note 4 to the consolidated
financial statements.
Events of the Fourth Quarter 1998
As of September 30, 1998, NovaStar Financial had a secured financing
arrangement with a lender whereby NovaStar Financial could borrow up to 50% of
the value of the residual interests in collateralized mortgage obligations.
Borrowing capacity under this arrangement was in excess of $30 million. The
lender limited or reduced borrowing availability under this arrangement to $25
million as of September 30, 1998. In early October, the lender withdrew its
financing under this arrangement at a time when NovaStar required funds to meet
margin calls and other demands. 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 the following paragraphs,
to restore liquidity and to further reduce exposure to liquidity and margin
call risk.
On October 11, 1998, the Board of Directors deferred payment of the third
quarter dividend ($0.35 per share) until January 15, 1999. On January 12, 1999,
the Board of Directors further delayed dividend payment until April 15, 1999.
On various dates during October 1998, NovaStar Financial and NovaStar
Mortgage executed contracts for the sale of all mortgage and corporate
securities and certain interest rate agreements, resulting in losses
aggregating more than $23 million.
On October 13, 1998, NovaStar Financial executed a 90-day financing
agreement with GMAC/Residential Funding Corporation secured by mortgage
interests of NovaStar Financial. Under the terms of the agreement, NovaStar
Financial borrowed $15 million to support immediate cash needs. In addition,
NovaStar agreed to pay a $3 million commitment fee at maturity of the note. The
fee served as incentive for GMAC/RFC to enter the financing arrangement under
adverse market 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 5%. Additionally, GMAC/RFC will receive 812,731 warrants
for the purchase of NovaStar Financial's common stock at a price of $4.5625,
the closing price of the common stock on October 12, 1998. In January 1999,
this financing agreement was extended through February 28, 1999. On February
26, 1999, NovaStar used financing arrangements at First Union to pay off this
debt as described in "Liquidity and Capital Resources".
On various dates during the fourth quarter 1998, NovaStar Mortgage sold
residential subprime mortgage loans aggregating $110 million at a net gain of
$2 million.
On October 21, 1998, NovaStar Financial finalized the second closing on the
securitization of asset-backed bonds, the first closing of which occurred
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.
After completing the above transactions, the balance sheet consists
primarily of subprime mortgage loans financed with non-recourse asset-backed
bonds.
In the near future, NovaStar Financial 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 or in securitizations. Net income 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 for cash or from securitizations and general
and administrative expenses.
20
<PAGE>
Additional information regarding liquidity is included in "Liquidity and
Capital Resources."
Forgivable Notes Receivable from Founders
The founders of NovaStar Financial 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 stock price,
the value of the warrants, and dividends paid. One tranche will be forgiven for
each fiscal year NovaStar Financial generates a return of 15% to investors in
the private placement. All three tranches will be forgiven if a return of 100%
is generated within five years.
During the period from the closing of the private placement through December
31, 1997, NovaStar Financial's stock price averaged $17.08 per share, dividends
of $0.28 were declared and the value of each warrant was $2.08. The combination
of these produced a return to investors in the private placement exceeding 15%.
As a result, the first tranche of these notes was forgiven resulting in a non-
cash charge of $1,083,000 during the fourth quarter of 1997. As a result of
NovaStar Financial's significant loss in the fourth quarter 1998 and the market
price of its stock during the same period, the second tranche of the notes
receivable from founders was not forgiven in 1998.
Financial Condition and Results of Operations as of and for the Period Ended
December 31, 1996
NovaStar Financial was incorporated on September 13, 1996 and commenced
operations in December 1996 after raising $47 million through a private
placement offering. During the period from inception to December 31, 1996,
investments earned $155,000, while general and administrative costs were
$457,000, resulting in a net loss of $302,000. NovaStar Financial did not
acquire significant mortgage assets nor hire a large staff until after December
31, 1996. As a result, operating income and expenses during 1996 were small in
comparison to 1997 and 1998. Financial results for the period from September
13, 1996 to December 31, 1996 do not provide relevant comparative financial
information.
Financial Condition as of December 31, 1998 and 1997
During the year ended December 31, 1998, NovaStar Mortgage originated more
than 9,000 subprime residential mortgage loans with an aggregate principal
amount of $877 million, of which $541 million was acquired by NovaStar
Financial. During the third quarter of 1998, NovaStar Financial discontinued
purchasing loan originations of NovaStar Mortgage. In the near future, NovaStar
Mortgage intends to sell production to independent third parties for cash or in
securitizations. As a result of the events discussed in "Events of the Fourth
Quarter 1998", virtually all mortgage assets at December 31, 1998 consist of
subprime mortgage loans whereas mortgage loans made up 51% of mortgage assets
at December 31, 1997.
During the year ended December 31, 1998, NovaStar Financial sold $7.9
million of loans purchased from NovaStar Mortgage to unrelated third parties
for cash, recognizing gains on these transactions of $305,000. NovaStar
Financial also completed two securitizations during the year ended December 31,
1998, pooling $660 million of mortgage loans as collateral.
21
<PAGE>
Table 1 is a summary of wholesale loan originations and bulk acquisitions
for NovaStar Mortgage during 1998 and 1997. Table 2 presents a more detailed
analysis of the wholesale loan originations of NovaStar Mortgage. Table 3 is a
summary of loan costs for NovaStar Mortgage relative to its wholesale loan
originations.
Table 1
Wholesale Loan Originations and Bulk Acquisitions--NovaStar Mortgage, Inc.
Years Ended December 31, 1998 and 1997
(dollars in thousands)
<TABLE>
<CAPTION>
Wholesale
Originations Bulk Acquisitions Total
------------------ ------------------ ------------------
Number Principal Number Principal Number Principal
of Loans Amount of Loans Amount of Loans Amount
-------- --------- -------- --------- -------- ---------
<S> <C> <C> <C> <C> <C> <C>
1998:
Fourth quarter...... 1,501 $133,739 -- $ -- 1,501 $133,739
Third quarter....... 2,655 240,498 -- -- 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.......... 9,322 $876,516 -- -- 9,322 $876,516
===== ======== ===== ======== ===== ========
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>
Table 2
Quarterly Wholesale Loan Originations--NovaStar Mortgage, Inc.
(dollars in thousands)
<TABLE>
<CAPTION>
Weighted Average
Average ------------------------- Percent with
Number Loan Price Paid to Loan to Credit Prepayment
of Loans Principal Balance Broker Value Rating (A) Coupon Penalty
-------- --------- ------- ------------- ------- --------- ------ ------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
1998:
Fourth quarter......... 1,501 $133,739 $ 89 100.8 81% 4.75 9.78% 88%
Third quarter.......... 2,655 240,498 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............. 9,322 $876,516 $ 94 101.3 81% 4.47 9.96% 74%
===== ======== ==== ===== === ==== ===== ===
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) AA=6, A=5, A-=4, B=3, C=2, D=1
22
<PAGE>
Table 3
Cost of Loan Production--NovaStar Mortgage, Inc.
Years Ended December 31, 1998 and December 31, 1997 (dollars in thousands)
<TABLE>
<CAPTION>
1998 1997
-------------------------------------- ------------------------------------
Fourth Third Second First Fourth Third Second First
Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter
-------- -------- -------- -------- -------- -------- ------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Total costs of loan
production (A)......... $ 6,723 $ 4,975 $ 3,837 $ 3,079 $ 2,096 $ 1,938 $ 1,401 $ 410
Wholesale loan
origination--principal. 133,739 240,498 294,303 207,976 183,012 136,582 77,692 12,688
Premium paid to broker.. 1,043 3,439 3,679 2,935 2,896 2,119 1,618 295
-------- -------- -------- -------- -------- -------- ------- -------
Total acquisition cost
(B).................... $141,505 $248,912 $301,819 $213,990 $188,004 $140,639 $80,711 $13,393
======== ======== ======== ======== ======== ======== ======= =======
Costs as a percent of
principal:
Loan production........ 5.0% 2.1% 1.3% 1.5% 1.1% 1.4% 1.8% 3.2%
======== ======== ======== ======== ======== ======== ======= =======
Premium paid to broker. 0.8% 1.4% 1.3% 1.4% 1.6% 1.6% 2.1% 2.3%
======== ======== ======== ======== ======== ======== ======= =======
Total acquisition cost. 5.8% 3.5% 2.6% 2.9% 2.7% 3.0% 3.9% 5.5%
======== ======== ======== ======== ======== ======== ======= =======
</TABLE>
- --------
(A) Loan production general and administrative expenses as reported for GAAP,
plus net deferred loan costs.
(B) Principal, premium, general and administrative expenses associated with
loan production.
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 using guidelines that have been approved by NovaStar
Financial.
Table 4 is a presentation of loans as of December 31, 1998 and 1997 and
their credit grades.
Table 4
Mortgage Loans by Credit Grade
December 31 (dollars in thousands)
<TABLE>
<CAPTION>
1998 1997
--------------------------- ---------------------------
Weighted Weighted
Allowed Weighted Average Weighted Average
Mortgage Loan-to- Current Average Loan-to- Current Average Loan-to-
Credit Rating Lates (A) value Principal Coupon value Principal Coupon value
- ------------- --------------- -------- --------- -------- -------- --------- -------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
AA...................... 0 x 30 90(B) $117,172 9.51% 83.4% $ 16,654 9.61% 85.4%
A....................... 1 x 30 90 356,994 9.84 79.7 251,751 9.91 77.9
A-...................... 2 x 30 90 214,627 10.31 81.3 145,314 10.20 78.4
B....................... 3 x 30, 1 x 60 85 138,497 10.62 77.9 99,317 10.50 76.5
5 x 30, 2 x 60,
C....................... 1 x 90 75 62,784 11.13 72.3 35,483 11.09 71.1
D....................... 6 x 30, 3 x 60,
2 x 90 65 13,328 12.14 62.2 10,917 12.05 63.7
-------- --------
Total................... $903,402 10.15% 79.5% $559,436 10.20% 77.3%
======== ===== ==== ======== ===== ====
</TABLE>
- --------
(A) Represents the number of times NovaStar allows a prospective borrower to be
late more than 30, 60 or 90 days. For instance, a 3x30, 1x60 category would
afford the prospective borrower to be more than 30 days late on three
separate occasions and 60 days late no more than one time.
(B) In some cases may be as high as 95%.
23
<PAGE>
Initially, a disproportionate number of loans generated by NovaStar Mortgage
were originated in California. As the sales force has been established
throughout the United States, the geographic credit risk has continued to
become less concentrated. Table 5 is a summary of loans originated by NovaStar
Mortgage by state for 1998 and 1997. Table 6 is a summary of all mortgage loans
owned by NovaStar Financial as of December 31, 1998 and 1997 by state.
Table 5
Mortgage Loan Originations by State (A)
Years Ended December 31, 1998 and 1997
<TABLE>
<CAPTION>
Percent of Total Originations during Quarter
(based on original principal balance)
---------------------------------------------------
1998 1997
------------------------- -------------------------
Collateral Location Fourth Third Second First Fourth Third Second First
- ------------------- ------ ----- ------ ----- ------ ----- ------ -----
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Florida..................... 24% 17% 16% 12% 9% 10% 8% 1%
Ohio........................ 9 4 5 2 2 2 2 --
Michigan.................... 6 5 5 5 5 3 -- --
Pennsylvania................ 5 4 3 2 1 -- 1 1
North Carolina.............. 4 5 3 2 1 1 -- 1
Washington.................. 3 5 6 7 8 11 16 15
Texas....................... 3 5 3 3 3 4 7 2
California.................. 2 6 9 15 19 24 26 40
Oregon...................... 2 3 4 5 6 6 9 7
Maryland.................... 2 2 3 4 5 6 5 13
Virginia.................... 2 2 2 2 5 6 2 --
Nevada...................... -- 4 3 6 5 4 2 --
Utah........................ -- 2 3 3 6 6 9 13
Oklahoma.................... -- -- 1 1 1 1 2 5
All other states............ 38 36 34 31 24 16 11 2
</TABLE>
- --------
(A) Loans originated by NovaStar Mortgage, Inc.
Table 6
Mortgage Loans by State
December 31
<TABLE>
<CAPTION>
Percent of Portfolio
(based on current principal balance)
------------------------------------
Collateral Location 1998 1997
- ------------------- ---- ----
<S> <C> <C>
California............................................................ 18% 27%
Florida............................................................... 12 8
Washington............................................................ 8 9
Oregon................................................................ 5 6
Utah.................................................................. 4 6
Texas................................................................. 4 5
All other states...................................................... 49 39
</TABLE>
NovaStar Financial acquired mortgage securities with an aggregate cost of
$354.9 million for the year ended December 31, 1998 compared with $659.4
million for the same period of 1997. During the last quarter of 1997 and first
half of 1998, NovaStar Financial purchased securities utilizing capital from
its initial public offering. As more of NovaStar Financial's capital was
deployed for mortgage loan acquisition, NovaStar Financial did not purchase
securities during the second and third quarters of 1998. In October 1998,
NovaStar
24
<PAGE>
Financial was forced to sell all of its securities as a result of circumstances
discussed in "Events of the Fourth Quarter 1998". Mortgage securities with an
amortized cost of $700.9 million were sold during 1998, compared with $110.0
million in 1997. Net losses of $15.3 million were recognized on the 1998 sales
versus net gains of $51,000 in 1997. Tables 7 and 8 are summaries of the
securities acquired during 1998 and 1997 by quarter and the portfolio as of
December 31, 1997.
Table 7
Mortgage Security Acquisitions
Years Ended December 31, 1998 and 1997 (dollars in thousands)
<TABLE>
<CAPTION>
Net
Price Weighted
to Average
Principal Premium Discount Par Coupon
--------- ------- -------- ----- --------
<S> <C> <C> <C> <C> <C>
1998:
Fourth quarter..................... $ -- $ -- $ -- -- -- %
Third quarter...................... -- -- -- -- --
Second quarter--Federal National
Mortgage Association.............. 80,237 823 -- 101.0 6.40
First quarter:
Federal National Mortgage
Association..................... 40,929 444 -- 101.1 6.12
Government National Mortgage
Association..................... 229,130 3,726 (364) 101.5 6.39
1997:
Fourth quarter:
Federal National Mortgage
Association..................... 46,779 1,856 -- 104.0 8.00
Government National Mortgage
Association..................... 233,546 2,649 (1,457) 100.5 5.74
Third quarter--Federal Home Loan
Mortgage Corporation.............. 2,202 87 -- 104.0 7.40
Second quarter:
Federal National Mortgage
Association..................... 247,219 5,174 -- 102.1 7.48
Federal Home Loan Mortgage
Corporation..................... 102,083 2,450 -- 102.4 6.90
First quarter:
Federal National Mortgage
Association..................... 7,491 231 -- 103.1 7.57
Government National Mortgage
Association..................... 8,931 174 -- 101.9 7.13
</TABLE>
Table 8
Mortgage Security Portfolio
December 31, 1997 (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................ $266,083 $6,690 $ -- $272,773 7.55%
Government National Mortgage
Association................ 233,407 2,640 1,302 234,745 5.74
Federal Home Loan Mortgage
Corporation................ 5,357 177 -- 5,534 7.71
-------- ------ ------ --------
$504,847 $9,507 $1,302 513,052 6.98%
======== ====== ======
Net unrealized loss......... 4,194
--------
Carrying value.............. $517,246
========
</TABLE>
25
<PAGE>
Mortgage loan originations are funded with a warehouse facility prior to
securitization. Loans originated through the lending operations of NovaStar
Mortgage are funded initially through a $75 million warehouse line with First
Union National Bank under which NovaStar Financial and NovaStar Mortgage are
co-borrowers. Repurchase agreements are used to finance mortgage loans prior to
sale or securitization. Financing secured by residual interests in asset-backed
bonds issued by NovaStar are another borrowing instrument currently available.
Using individual assets as collateral for repurchase agreements, NovaStar
Financial financed acquisitions of agency-issued mortgage securities. These
agreements were executed with a number of reputable securities dealers. Under
the terms of all financing arrangements, lending institutions require "over-
collateralization" from NovaStar Financial. The value of the collateral
generally must exceed the allowable borrowing by 2 to 5%. As a result, NovaStar
Financial must have capital available to cover this "haircut."
On a long-term basis, NovaStar Financial finances its mortgage loans using
collateralized mortgage obligations commonly called CMOs. Investors in CMOs are
repaid based on the performance of the mortgage loans collateralizing the CMOs.
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. Under the terms of its CMOs, NovaStar
Financial is entitled to repurchase the mortgage loan collateral, and repay the
remaining CMO, when their aggregate principal balance falls below 35% for issue
97-01 and 25% for issues 97-02, 98-01 and 98-02. Subprime mortgage loans are
not readily obtainable financial assets. NovaStar Financial retains effective
control over the transferred assets as defined in paragraph 9c. of Statement of
Financial Accounting Standards (SFAS) No. 125, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities and further
clarified by paragraph 30 of SFAS No. 125. Accordingly, NovaStar Financial
records its CMO transactions as secured borrowings, rather than sales of the
transferred loans.
Under its CMOs, NovaStar retains the mortgage loans and incurs the
obligation to pay the CMO bondholders. NovaStar earns the net spread between
the interest income on the loans and the interest expense on the bonds. The
spread earned by NovaStar also is reduced by credit losses on the portfolio.
Prepayments on the mortgage loans serve to reduce the term over which NovaStar
earns its spread. The longer the mortgage collateral is outstanding, the longer
the period for which NovaStar will receive cash flow. To the extent the
borrowers prepay, it shortens the life of the CMO and the period over which
NovaStar receives cash flow. The cash flow to NovaStar will change when
interest rates on the bonds fluctuate at amounts or times that are different
from the mortgage loan collateral, thereby subjecting NovaStar to interest rate
risk. NovaStar addresses these risks as discussed in the Risk Management
portion of this Annual Report.
Amounts outstanding under borrowing arrangements aggregated $910 million and
$1.0 billion as of December 31, 1998 and 1997, respectively, and are further
detailed in Note 4 to the consolidated financial statements.
In periods of decreasing interest rates, borrowers are more likely to
refinance their mortgages. Even in rising rate environments, some 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.
26
<PAGE>
Prepayment rates in the table below represent the percent of loan principal
that pre-pays in the most recent one, three and twelve month periods and over
the life of the pool of loans. Percents are presented on an annual basis. For
instance, 44.2%, on an annual basis, of the principal of the loans
collateralizing CMO issue 1997-1 pre-paid during December 1998. Percentages for
the life of the pool represent the percent that has paid off since the loans
were pooled as collateral for the CMO. Virtually all loans are used as
collateral for CMOs and NovaStar does not monitor prepayment speeds for loans
not financing CMOs.
Table 9
Prepayment Speed
<TABLE>
<CAPTION>
Constant Prepayment Rate (Annual
Weighted Average Percent)
Age at Inception ---------------------------------------
Issue Date (in months) One-month Three-month Twelve-month Life
---------- ---------------- --------- ----------- ------------ ----
<S> <C> <C> <C> <C> <C> <C> <C>
As of December 31, 1998
NovaStar Home Equity Series:
1997-1................ October 1, 1997 7 44.2 35.5 33.2 31.0
1997-2................ December 11, 1997 3 41.6 32.2 22.4 21.1
1998-1................ April 30, 1998 3 19.6 17.1 -- 12.2
1998-2................ August 18, 1998 3 18.0 10.3 -- 9.3
As of December 31, 1997
NovaStar Home Equity Series:
1997-1................ October 1, 1997 7 18.6 15.7 -- 15.7
1997-2................ December 11, 1997 3 10.5 -- -- 10.5
</TABLE>
To mitigate exposure to prepayment risk and in order for NovaStar to retain
those borrowers whose credit is considered desirable, a portfolio retention
department was created 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 year ended December
31, 1998, $13.1 million, or 8% of the loans were successfully refinanced and
$2.0 million, or 1% of the loans, were rate-modified. Although these loans are
considered prepayments for the purposes of the information in Table 9, they
remain in the NovaStar loan portfolio.
27
<PAGE>
Table 10 summarizes mortgage asset activity during 1998 and 1997 and Table
11 details the amount of premium as a percent of principal at quarter end for
1998 and 1997.
Table 10
Mortgage Assets Activity (thousands)
<TABLE>
<CAPTION>
Mortgage
Mortgage Loans Securities Total
------------------ ------------------ -------------------
Principal Premium Principal Premium Principal Premium
--------- ------- --------- ------- ---------- -------
<S> <C> <C> <C> <C> <C> <C>
Balance, January 1,
1997................... $ -- $ -- $ 12,821 $ 434 $ 12,821 $ 434
Acquisitions............ 170,120 10,530 16,422 405 186,542 10,935
Principal repayments and
amortization........... (338) (53) (977) (28) (1,315) (81)
-------- ------- --------- ------- ---------- -------
Balance, March 31, 1997. 169,782 10,477 28,266 811 198,048 11,288
Acquisitions............ 127,500 4,100 349,302 7,624 476,802 11,724
Principal repayments and
amortization........... (6,989) (420) (2,332) (133) (9,321) (553)
Dispositions............ -- -- (98,267) (2,309) (98,267) (2,309)
-------- ------- --------- ------- ---------- -------
Balance, June 30, 1997.. 290,293 14,157 276,969 5,993 567,262 20,150
Acquisitions............ 136,582 2,449 2,202 87 138,784 2,536
Principal repayments and
amortization........... (22,227) (913) (19,291) (383) (41,518) (1,296)
-------- ------- --------- ------- ---------- -------
Balance, September 30,
1997................... 404,648 15,693 259,880 5,697 664,528 21,390
Acquisitions............ 183,012 3,314 280,325 3,048 463,337 6,362
Principal repayments and
amortization........... (28,224) (1,146) (26,095) (363) (54,319) (1,509)
Dispositions............ -- -- (9,263) (177) (9,263) (177)
-------- ------- --------- ------- ---------- -------
Balance, December 31,
1997................... 559,436 17,861 504,847 8,205 1,064,283 26,066
Acquisitions............ 207,976 3,758 270,059 3,806 478,035 7,564
Principal repayments and
amortization........... (27,224) (1,160) (63,892) (731) (91,116) (1,891)
Dispositions............ -- -- (310,113) (5,294) (310,113) (5,294)
-------- ------- --------- ------- ---------- -------
Balance, March 31, 1998. 740,188 20,459 400,901 5,986 1,141,089 26,445
Acquisitions............ 290,350 5,148 80,237 823 370,587 5,971
Principal repayments and
amortization........... (43,849) (1,506) (47,201) (451) (91,050) (1,957)
Dispositions............ (2,843) (53) -- -- (2,843) (53)
-------- ------- --------- ------- ---------- -------
Balance, June 30, 1998.. 983,846 24,048 433,937 6,358 1,417,783 30,406
Acquisitions............ -- -- -- -- -- --
Principal repayments and
amortization........... (54,745) (1,442) (38,925) (493) (93,670) (1,935)
Dispositions............ (4,666) (56) (7,781) (107) (12,447) (163)
-------- ------- --------- ------- ---------- -------
Balance, September 30,
1998................... 924,435 22,550 387,231 5,758 1,311,666 28,308
Acquisitions............ 42,298 458 -- -- 42,298 458
Principal repayments and
amortization........... (62,953) (2,135) (15,215) (173) (78,168) (2,308)
Dispositions............ (378) (5) (372,016) (5,585) (372,394) (5,590)
-------- ------- --------- ------- ---------- -------
Balance, December 31,
1998................... $903,402 $20,868 $ -- $ -- $ 903,402 $20,868
======== ======= ========= ======= ========== =======
</TABLE>
28
<PAGE>
Table 11
Premium as a Percent of Principal
<TABLE>
<CAPTION>
Total
Mortgage Mortgage Mortgage
Loans Securities Assets
-------- ---------- --------
<S> <C> <C> <C>
As of:
December 31, 1998................................ 2.31% -- % 2.31%
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--Year Ended December 31, 1998 Compared to the Year Ended
December 31, 1997
Net Loss
During the year ended December 31, 1998, NovaStar Financial recorded a net
loss of $21.8 million, $2.71 per diluted share, compared with a net loss of
$1.1 million, $0.26 per diluted share, for 1997.
Net Interest Income
Interest income. Average interest-earning assets were $1.2 billion during
the year ended December 31, 1998, including $822.2 million of mortgage loans
and $375.2 million of mortgage securities compared with average interest-
earning assets of $476.3 million during 1997. During 1998, mortgage loans
earned $76.8 million, or a yield of 9.3%, compared with $25.2 million, or a
yield of 8.6% for 1997. Mortgage securities earned $24.0 million for 1998, or
a yield of 6.4%, compared with $11.8 million, or a yield of 6.5% for 1997. In
total, assets earned $100.7 million, or an 8.4% yield for 1998. During 1997,
assets earned $37.0 million or a 7.8% yield.
A substantial portion of mortgage assets 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. Rates on the assets
are expected to increase to their full potential as the assets season. Table
12 is a summary of mortgage assets by type, presenting their current and fully
indexed weighted-average coupons.
Table 12
Mortgage Assets by Product/Type and Weighted Average Coupon
December 31, 1998 (dollars in thousands)
<TABLE>
<CAPTION>
Weighted
Average Coupon
---------------
Outstanding Fully
Product/Type Principal Current Indexed
- ------------ ----------- ------- -------
<S> <C> <C> <C>
Mortgage loans:
Two and three year fixed/adjustable thereafter.... $511,824 10.19% 11.34%
Fixed rate (30 Yr, 15 Yr, 30/15).................. 302,620 10.03 --
Other (1 year CMT, 6 month LIBOR)................. 88,958 10.32 10.86
--------
Total mortgage loans............................ $903,402
========
</TABLE>
29
<PAGE>
NovaStar 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 10, 11 and 13 for the impact of principal
payments on amortization. To mitigate the effect of prepayments on interest
income from mortgage loans, NovaStar generally strives to acquire mortgage
loans that have some form of prepayment penalty. During 1998, NovaStar
collected $2.0 million in prepayment penalties from borrowers. Table 13 is an
analysis of mortgage loans and prepayment penalties. Prepayments on mortgage
loans have generally been consistent with management's expectations.
Table 13
Mortgage Loan Prepayment Penalties
December 31, 1998 (dollars in thousands)
<TABLE>
<CAPTION>
Weighted Average
-----------------------------------
Remaining
Prepayment Penalty
Percent with Period (in
Current Prepayment Loan-to- 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................ $162,423 $ 7,975 65% 10.57% 75.1% 0.89
1997-2................ 163,049 3,403 72 10.37 78.5 1.10
1998-1................ 270,640 4,651 69 10.01 81.1 1.51
1998-2................ 301,527 4,703 71 9.95 81.1 2.09
All other loans......... 5,763 136 65 9.91 80.0 1.59
-------- -------
Total................... $903,402 $20,868 70% 10.15% 79.5% 1.52
======== ======= === ===== ==== ====
</TABLE>
As noted above, interest income is a function of volume and rates.
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 was $80.8 million during the
year ended December 31, 1998, or 6.6% of average borrowings, compared with
$28.2 million for 1997, or 6.5% of average borrowings. Advances under the
warehouse line of credit bear interest based on the federal funds rate, plus a
spread. NovaStar receives credit to warehouse line interest based on cash
balances maintained with First Union. Advances under the master repurchase
agreement bear interest at rates based on LIBOR, plus a spread. During 1998 and
1997, the one-month LIBOR averaged 5.6%. As with interest income, 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.
30
<PAGE>
Table 14 presents a summary of average interest-earning assets and
liabilities and the related yields and rates thereon for 1998.
Table 14
Interest Analysis
Year Ended December 31, 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......... $822,180 $76,751 9.34% $375,222 $23,996 6.40% $1,197,402 $100,747 8.41%
======== ======== ==========
Liabilities (A)
Repurchase agreements.. $118,380 $ 7,817 6.60% $392,859 $21,891 5.57% $ 511,239 $ 29,708 5.81%
Collateralized
mortgage obligations.. 703,328 43,287 6.15 -- -- -- 703,328 43,287 6.15
Other borrowings....... 18,936 4,908 25.92 -- -- -- 18,936 4,908 25.92
-------- -------- ----------
Cost of derivative
financial Instruments
hedging liabilities... 2,162 729 2,891
------- ------- --------
Total borrowings..... $840,644 58,174 6.92 $392,859 22,620 5.76 $1,233,503 80,794 6.55
======== ======= ======== ------- ========== --------
Net interest income..... $18,577 $ 1,376 $ 19,953
======= ======= ========
Net interest spread..... 2.42% 0.64% 1.86%
===== ==== =====
Net yield............... 2.26% 0.37% 1.67%
===== ==== =====
</TABLE>
- --------
(A) NovaStar Financial's average borrowings were greater than average assets
during 1998 as borrowings on securities and loans are a function of the
underlying collateral's market value, which for the majority of 1998 was
greater than par. Also, in 1998, NovaStar Financial borrowed against the
residual interests of its securitizations, which are not recorded on its
balance sheet as the securitizations were treated as financing
transactions.
Table 23 presents comparative information for 1997.
Net interest income and spread. Net interest income during 1998 was $20.0
million or 1.7% of average interest-earning assets, compared with $8.8 million,
or 1.8% of average interest-earning assets during 1997. Net interest spread was
1.9% during the year ended December 31, 1998 compared with 1.3% during the year
ended December 31, 1997. Net interest income and the spread are functions of
asset yield relative to its costs of funds. Cost of funds has remained
relatively low and stable during most of 1998 and 1997. During the fourth
quarter of 1998, NovaStar Financial experienced increasing funding costs
associated with impaired liquidity resources. Special interest costs of $4
million were incurred to obtain a short-term financing arrangement from
GMAC/RFC as discussed in "Events of the Fourth Quarter 1998". The volume of
assets and liabilities and how well the spread between earnings on assets and
the cost of funds is managed will dictate future net interest income.
Management expects, in general, that financing rates will be 25 to 50 basis
points higher in 1999 than in 1998 and 1997. No predictions can be made beyond
1999.
Impact of interest rate agreements. NovaStar Financial has entered into
interest rate agreements and financial futures contracts designed to mitigate
exposure to interest rate risk. Interest rate cap agreements require NovaStar
Financial 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 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. As discussed
in the section, "Events of the Fourth Quarter 1998", NovaStar Financial
terminated all swap agreements and paid off the liabilities pertaining to these
hedging instruments in October 1998, recognizing losses aggregating $8.0
million. These agreements were related to the financing for disposed mortgage
loans and securities.
During 1998 and 1997, net interest expense was incurred on hedging
agreements of $2.9 million and $1.0 million, respectively, which is included as
a component of interest expense. Note 5 of the consolidated financial
statements provides details of the interest rate agreements as of December 31,
1998 and 1997.
31
<PAGE>
Other Income
Other income during 1998 primarily consists of prepayment penalties of $2.0
million, interest earned on securitization funds held in trust of $749,000, and
interest earned on notes receivable from founders of $441,000. Other income for
1997 primarily consisted of prepayment penalties of $414,000 and interest
earned on notes receivable from founders of $260,000.
Gain (Loss) On Sales of Securities and Mortgage Loans
As discussed earlier in "Events of the Fourth Quarter 1998", NovaStar
Financial sold all investment securities at an aggregate loss of $15.4 million
during October 1998. Gross gains and losses on sales of securities are detailed
in Note 3 to the consolidated financial statements. During 1998, NovaStar
Financial also recognized $305,000 in net gains on sale of $7.9 million of
mortgage loans.
Provisions for Credit Losses
NovaStar provides regular allowances for credit losses on its mortgage
loans. Management continuously evaluates the potential for credit losses for
mortgage loans held in portfolio. Provisions have been made based on NovaStar's
historical experience, general industry trends and management's judgement. Loan
defaults occur throughout the life of a 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 loans. Provisions are
based upon total expected losses and an estimated loss curve. Losses are
recognized and loans are charged off upon foreclosure. Foreclosure assets are
recorded at the lower of the remaining unpaid loan balance or the estimated net
realizable value of the foreclosed asset.
During 1998, NovaStar Financial provided $7.4 million to the allowance for
credit losses, compared with $2.5 million during 1997. During the second half
of 1998, charge-offs increased. Management believes the increase in charge-offs
was due principally to losses occurring earlier in the overall life of the
loans than originally anticipated. Management accelerated provisions during the
1998 fourth quarter in recognition of this trend. NovaStar Financial expects to
continue to make somewhat higher provisions during 1999, compared to the first
three quarters of 1988, to ensure the credit allowance is maintained at an
adequate level.
During the third quarter of 1998, NovaStar Financial and NovaStar Mortgage
executed an agreement with Commonwealth Mortgage Acceptance Corporation (CMAC)
whereby CMAC will provide insurance coverage on mortgage loans. As of December
31, 1998, approximately 26% of the loans owned by NovaStar Financial and
substantially all of the loans owned by NovaStar Mortgage are covered under
this agreement. During 1998, total premiums paid to CMAC totaled $744,000 and
are included as a component of loan servicing expense in the financial
statements. Management believes that its exposure to credit loss on loans
insured by CMAC is minimal. Management expects that a substantial portion of
loans originated in future periods will be covered under similar insurance
arrangements.
As of December 31, 1998, NovaStar Financial had 126 loans in real estate
owned with a carrying value of $10.6 million. Charge-offs during 1998 were $6.2
million compared with $140,000 during 1997. As the portfolio continues to
season, management expects that the actual loss rate may continue to increase.
Table 15 is a rollforward of the allowance for credit losses during 1998 and
1997.
Table 15
Rollforward of Allowance for Credit Losses
Years Ended December 31, 1998 and December 31, 1997
<TABLE>
<CAPTION>
1998 1997
------------------------------------------ -----------------------------------------
December 31 September 30 June 30 March 31 December 31 September 30 June 30 March 31
----------- ------------ ------- -------- ----------- ------------ ------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Beginning balance....... $ 2,757 $ 3,341 $2,871 $2,313 $1,444 $ 718 $170 $--
Provision for credit
losses................. 4,030 1,179 1,145 1,076 1,009 726 548 170
Amounts charged off, net
of recoveries.......... (3,214) (1,763) (675) (518) (140) -- -- --
------- ------- ------ ------ ------ ------ ---- ----
Ending Balance.......... $ 3,573 $ 2,757 $3,341 $2,871 $2,313 $1,444 $718 $170
======= ======= ====== ====== ====== ====== ==== ====
</TABLE>
32
<PAGE>
Table 16 is a summary of delinquent loans as of December 31, 1998 and 1997
by quarter. Table 17 provides summaries of delinquencies, defaults, and loss
statistics as of December 31, 1998 and 1997 by quarter. The information
presented in both tables includes NovaStar Financial's securitization portfolio
as well as loans owned by its affiliates. Management considers this information
meaningful, as these are all loans serviced by NovaStar Mortgage. Other
information regarding the credit quality of mortgage loans is provided in
Tables 4, 5 and 6.
Table 16
Loan Delinquencies (90 days and greater)
Years Ended December 31, 1998 and December 31, 1997 (A)
<TABLE>
<CAPTION>
1998 1997
----------------------------------------- -----------------------------------------
December 31 September 30 June 30 March 31 December 31 September 30 June 30 March 31
----------- ------------ ------- -------- ----------- ------------ ------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Mortgage loans
collateralizing
NovaStar Home Equity
series (CMO):
1997-1 (Issued October
1, 1997)............... 5.45% 5.97% 5.86% 4.39% 2.71% -- -- --
1997-2 (Issued December
11, 1997).............. 5.62 4.97 4.72 2.23 -- -- -- --
1998-1 (Issued April 30,
1998).................. 4.44 2.06 -- -- -- -- -- --
1998-2 (Issued August
18, 1998).............. 2.35 0.40 -- -- -- -- -- --
All loans in servicing
portfolio.............. 3.35 2.45 2.53 2.28 1.80 1.47% -- --
</TABLE>
- -------
(A) Includes loans in foreclosure or bankruptcy.
33
<PAGE>
Table 17
Delinquencies, Defaults and Losses
December 31, 1998 (dollars in thousands)
<TABLE>
<CAPTION>
NovaStar Home Equity Series
--------------------------------------
Other
1997-1 1997-2 1998-1 1998-2 (A) All Loans
-------- -------- -------- -------- -------- ----------
<S> <C> <C> <C> <C> <C> <C>
Loan servicing
portfolio.............. $168,255 $167,685 $273,583 $301,857 $268,587 $1,179,967
======== ======== ======== ======== ======== ==========
Allowance for Credit
Losses:
Balance, January 1,
1998................. $ 1,063 $ 967 $ -- $ -- $ 283 $ 2,313
Provision for credit
losses............... 1,895 2,257 1,878 222 1,178 7,430
Amounts charged off,
net of recoveries.... (2,142) (2,175) (715) 124 (1,262) (6,170)
-------- -------- -------- -------- -------- ----------
Balance, December 31,
1998................. $ 816 $ 1,049 $ 1,163 $ 346 $ 199 $ 3,573
======== ======== ======== ======== ======== ==========
Defaults as a percent of
loan servicing
Portfolio, December 31,
1998:
Delinquent loans...... 6.45% 5.95% 4.89% 4.06% 2.01% 4.40%
======== ======== ======== ======== ======== ==========
Loans in foreclosure.. 2.63% 2.96% 3.60% 2.06% 0.40% 2.25%
======== ======== ======== ======== ======== ==========
Real estate owned..... 3.54% 2.76% 1.01% 0.09% 0.23% 3.55%
======== ======== ======== ======== ======== ==========
</TABLE>
<TABLE>
<CAPTION>
1998 1997
----------------------------------------- -----------------------------------------
December 31 September 30 June 30 March 31 December 31 September 30 June 30 March 31
----------- ------------ ------- -------- ----------- ------------ ------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Total defaults:
Delinquent loans...... 4.40% 2.95% 1.95% 1.92% 1.76% 4.44% 3.09% -- %
===== ===== ===== ===== ===== ===== ===== ====
Loans in foreclosure.... 2.25% 2.02% 2.28% 2.29% 2.05% 0.47% 0.01% -- %
===== ===== ===== ===== ===== ===== ===== ====
Real estate owned....... 3.55% 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 years ended December 31, 1998
and 1997 are provided in Table 18. Table 19 displays the relationship of
portfolio expenses to net interest income during the 1998 and 1997 by quarter.
Table 18
General and Administrative Expenses
Years Ended December 31, 1998 and 1997 (dollars in thousands)
<TABLE>
<CAPTION>
Year Ended Year Ended
December 31, December 31,
1998 1997
---------------- ---------------
Percent Percent
of Net of Net
Interest Interest
Income Income
-------- --------
<S> <C> <C> <C> <C>
Compensation and benefits..................... $ 1,785 8.9% $ 839 9.6%
Professional and outside services............. 1,117 5.6 676 7.7
Other loan servicing.......................... 1,071 5.4 741 8.4
Office administration......................... 903 4.5 299 3.4
Other......................................... 247 1.2 448 5.1
------- ---- ------ ----
Total portfolio-related expenses.............. 5,123 25.6% 3,003 34.2%
==== ====
Forgiveness of notes receivable from founders. -- 1,083
Fees for services provided by NovaStar
Mortgage, Inc................................ 6,486 4,155
------- ------
Total..................................... $11,609 $8,241
======= ======
</TABLE>
34
<PAGE>
Table 19
Portfolio Related Expenses as a
Percent of Net Interest Income
Years Ended December 31, 1998 and 1997
<TABLE>
<CAPTION>
Percent of Net
Interest Income
---------------
<S> <C>
1998:
1998.......................................................... 25.6%
Fourth quarter................................................ 89.7
Third quarter................................................. 22.3
Second quarter................................................ 20.1
First quarter................................................. 15.6
1997:
1997.......................................................... 34.2%
Fourth quarter................................................ 37.1
Third quarter................................................. 38.8
Second quarter................................................ 33.9
First quarter................................................. 31.2
</TABLE>
The fees for services provided by NovaStar Mortgage, Inc. represent
compensation for services, including the development of loan products,
underwriting, funding, quality control, and servicing. NovaStar Mortgage pays a
commitment fee to NovaStar Financial when originated loans are not sold to
NovaStar Financial. No fee is paid if NovaStar Financial is unable or unwilling
to purchase the mortgage loans originated by NovaStar Mortgage. The increase in
this fee for 1998 compared with 1997 is primarily a result of an increase in
the extent of services required and the increase in loan volume. These fees are
discussed in greater detail in Note 9 to consolidated financial statements.
Compensation and benefits include employee base salaries, benefit costs and
incentive compensation awards. The increase in compensation and benefits for
the year ended December 31, 1998 compared with the year ended December 31, 1997
is due to adding portfolio and finance staff and management.
Other loan servicing in 1998 consists primarily of the fees paid to CMAC as
discussed under the "Provisions for Credit Losses." Also included as a
component of loan servicing are the direct costs associated with the mortgage
loan servicing operation that are paid directly to independent third parties
for such things as property appraisals and borrower location services. These
fees vary based on loan volume, delinquencies and foreclosures. However, loan
servicing fees recognized in 1997 were primarily the fees paid during the first
half of 1997 to an independent third party for servicing its portfolio while
NovaStar Mortgage's servicing operation was being developed.
Professional and outside services include fees for legal and accounting
services. In the normal course of business, fees are incurred for professional
services related to general corporate matters and specific transactions. Office
administration includes rent, depreciation, telephone, office supplies,
postage, delivery, maintenance and repairs. The increases in both these
financial statement captions is attributed to additional personnel and general
company growth.
Equity in Earnings (Loss) of NFI Holding Corporation
For the year ended December 31, 1998, NFI Holding Corporation recorded a net
loss of $3.0 million compared with net income of $28,000 for the year ended
December 31, 1997. NovaStar Financial records its portion of the income (loss)
as equity in net earnings (loss) of NFI Holding in its income statement, which
35
<PAGE>
includes the net earnings (loss) of NovaStar Mortgage and NovaStar Capital,
Inc., subsidiaries of NFI Holding. Net income generated by NFI Holding is
primarily a function of the fees earned by NovaStar Mortgage relating to the
origination and servicing of loans for NovaStar Financial and the costs of
these activities.
During 1998 the loan production volume of NovaStar Mortgage increased
dramatically compared to 1997. The cost of producing loans increased more than
its fee and interest income, which primarily consists of the administrative
fees received from NovaStar Financial as discussed above and in Note 9 of the
consolidated financial statements. Also, during the last half of 1998, NovaStar
Mortgage retained its mortgage loans versus selling them to NovaStar Financial.
As discussed above and in Note 9 of the consolidated financial statements,
NovaStar Mortgage pays NovaStar Financial a fee when it does not sell its
mortgage loan production to NovaStar Financial. NovaStar Mortgage did not pay
this fee in 1997, as NovaStar Financial acquired all of NovaStar Mortgage's
loan production. The additional expense incurred by NovaStar Mortgage in 1998
was offset to a degree by net gains of $3.0 million on the sale of $134 million
of subprime residential mortgage loans to third parties. For these reasons,
NovaStar Mortgage, and therefore, NFI Holding Corporation, incurred a larger
net loss during 1998 when compared to the same period in 1997.
Condensed consolidated financial statements for NFI Holding are presented in
Note 12 to the consolidated financial statements.
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 NovaStar Financial's stockholders. This added value is demonstrated
in the estimated fair value of NovaStar Financial's loan portfolio. The values
presented in Tables 20 and 21 are management's estimates based on market
conditions as of December 31, 1998.
Management estimates the weighted-average value of its mortgage loan
portfolio as of December 31, 1998 to be between 103 and 105 in terms of price
to par, based upon return assumptions and secondary market prices. Management
believes the inherent returns in the mortgage loans originated by NovaStar
Mortgage should warrant a value of 105. However, recent events have resulted in
whole loan prices being severely reduced. Accordingly, any value assigned to
December 31, 1998 loans should take into consideration at what value the loans
could be sold in the open market. During the 1998 fourth quarter, NovaStar
Financial sold a number of whole loan packages at prices that averaged between
103.5 and 104.0. Tables 20 and 21 provide management's estimates of the value
of the mortgage loans in its portfolio and 1998 fourth quarter production and
the assumptions used for estimating fair value. Because any estimated value can
vary dramatically based upon the assumptions used, a range of assumptions is
used to determine the estimated value.
During 1998, NovaStar originated mortgage loans at an all-in cost of 103.4%
of principal, including direct costs of acquisition, such as broker premiums,
and general overhead expenses. Table 3 displays the cost of production for each
quarter. The cost of production during the 1998 third and fourth quarters is
higher than previous quarters as a result of lower production levels. NovaStar
Mortgage operated significantly below capacity during the second half of 1998.
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.
In addition, NovaStar Mortgage took measures at the end of the fourth quarter
of 1998 to reduce operating costs to be in line with expected short-term
production volume.
The weighted-average premium on mortgage loans outstanding as of December
31, 1998 represented 2.3% of principal. Using the estimated fair values from
above, this implies an estimated unrealized gain, or additional value in the
mortgage loan portfolio as of December 31, 1998 of between 1.0% and 3.0%.
Applying this percent to the balance of mortgage loans outstanding of $921
million results in an estimated unrealized gain of between $9 and $28 million.
This additional value results in an estimated mark-to-market equity as of
36
<PAGE>
December 31, 1998 of $96-115 million, or $11.81-14.15 per outstanding share,
compared with a book value per outstanding share of $10.74. On a diluted basis,
book value per share as of December 31, 1998 is $10.14, while an estimate of
mark-to-market book value per share is $10.69-12.81.
Table 20
Estimated Market Price on Entire Loan Portfolio
December 31, 1998
<TABLE>
<CAPTION>
Two- and Three-
year Fixed Loan
Products
-------------------
<S> <C> <C> <C>
Bond Equivalent
Yield............ 8.31% 8.56% 8.81%
Spread to Index... 3.25% 3.50% 3.75%
Assumed Prepayment
Speed (CPR)......
30................ 105.3% 104.7% 104.1%
35................ 104.5% 104.0% 103.5%
40................ 103.9% 103.4% 103.0%
</TABLE>
<TABLE>
<CAPTION>
Six-month LIBOR
Loan Products
-------------------
<S> <C> <C> <C>
Bond Equivalent Yield.................................. 9.06% 9.31% 9.56%
Spread to Index........................................ 4.00% 4.25% 4.50%
Assumed Prepayment Speed (CPR).........................
35..................................................... 104.1% 103.6% 103.1%
40..................................................... 103.6% 103.1% 102.7%
45..................................................... 103.1% 102.8% 102.4%
</TABLE>
<TABLE>
<CAPTION>
30/15-year Fixed
and Balloon Loan
Products (Three-
year Treasury)
-------------------
<S> <C> <C> <C>
Bond Equivalent Yield............. 8.03% 8.28% 8.53%
Spread to Index................... 3.50% 3.75% 4.00%
Assumed Prepayment Speed (CPR)....
25................................ 105.4% 104.7% 104.1%
30................................ 104.6% 104.1% 103.5%
35................................ 104.0% 103.5% 103.1%
</TABLE>
<TABLE>
<CAPTION>
One-year CMT Loan
Products
-------------------
<S> <C> <C> <C>
Bond Equivalent
Yield............. 8.02% 8.27% 8.52%
Spread to Index.... 3.50% 3.75% 4.00%
Assumed Prepayment
Speed (CPR).......
30................. 104.2% 103.6% 103.0%
35................. 103.6% 103.1% 102.6%
40................. 103.1% 102.7% 102.2%
</TABLE>
Table 21
Estimated Market Price of Loans Originated in Fourth Quarter of 1998
<TABLE>
<CAPTION>
Two- and Three-year
Fixed Loan Products
---------------------
<S> <C> <C> <C>
Bond Equivalent
Yield........... 8.06% 8.31% 8.56%
Spread to Index.. 3.00% 3.25% 3.50%
Assumed
Prepayment Speed
(CPR)...........
30............... 105.1% 104.5% 103.9%
35............... 104.3% 103.8% 103.3%
40............... 103.7% 103.3% 102.8%
</TABLE>
<TABLE>
<CAPTION>
Six-month LIBOR
Loan Products
---------------------
<S> <C> <C> <C>
Bond Equivalent Yield................................ 8.31% 8.56% 8.81%
Spread to Index...................................... 3.25% 3.50% 3.75%
Assumed Prepayment Speed (CPR).......................
35................................................... 103.9% 103.4% 102.9%
40................................................... 103.4% 102.9% 102.5%
45................................................... 102.9% 102.5% 102.2%
</TABLE>
<TABLE>
<CAPTION>
One-year CMT Loan
Products
---------------------
<S> <C> <C> <C>
Bond Equivalent
Yield........... 7.52% 7.77% 8.02%
Spread to Index.. 3.00% 3.25% 3.50%
Assumed
Prepayment Speed
(CPR)...........
30............... 104.0% 103.4% 102.8%
35............... 103.3% 102.8% 102.3%
40............... 102.8% 102.4% 102.0%
</TABLE>
<TABLE>
<CAPTION>
30/15-year Fixed
and
Balloon Loan
Products
---------------------
<S> <C> <C> <C>
Bond Equivalent Yield................................ 7.78% 8.03% 8.28%
Spread to Index...................................... 3.25% 3.50% 3.75%
Assumed Prepayment Speed (CPR).......................
25................................................... 105.3% 104.6% 104.0%
30................................................... 104.5% 104.0% 103.4%
35................................................... 103.9% 103.4% 103.0%
</TABLE>
37
<PAGE>
Table 22
Carrying Value of Loans by Product/Type
December 31 (in thousands)
<TABLE>
<CAPTION>
Product/Type 1998 1997
- ------------ -------- --------
<S> <C> <C>
Two- and three-year fixed................................... $511,824 $314,918
Six-month LIBOR............................................. 54,158 87,629
One-year CMT................................................ 34,800 32,754
30/15-year fixed and balloon................................ 302,620 124,135
-------- --------
Outstanding principal..................................... 903,402 559,436
Premium..................................................... 20,868 17,861
Allowance for credit losses................................. (3,573) (2,313)
-------- --------
Carrying Value............................................ $920,697 $574,984
======== ========
Carrying value as a percent of principal.................... 101.91% 102.78%
======== ========
</TABLE>
Results of Operations--Year Ended December 31, 1997
Net Loss
During 1997, NovaStar Financial recorded a net loss of $1,135,000, or $0.26
per share. Excluding the forgiveness of the notes receivable from founders,
NovaStar Financial incurred a loss of $52,000, or $0.01 per share. During much
of 1997, NovaStar Financial focused on the hiring of key employees and the
development of policies and procedures. The results for the year ended December
31, 1997 also reflect the significant cost of developing operations.
Net Interest Income
Table 23 presents a summary of the average interest-earning assets, average
interest-bearing liabilities and the related yields and rates thereon for the
year ended December 31, 1997.
Table 23
Interest Analysis
Year Ended December 31, 1997 (dollar amounts in thousands)
<TABLE>
<CAPTION>
Mortgage Loans Mortgage Securities
------------------------ ------------------------
Interest Annual Interest Annual
Average Income/ Yield/ Average Income/ Yield/
Balance Expense Rate Balance Expense Rate
-------- -------- ------ -------- -------- ------
<S> <C> <C> <C> <C> <C> <C>
Mortgage Assets.............. $294,111 $25,154 8.56% $182,140 $11,807 6.48%
======== ========
Liabilities
Master repurchase
agreement.................. $170,344 $11,972 7.03 $ -- $ -- --%
Other repurchase
agreements................. 172,829 10,336 5.98
Collateralized mortgage
obligations................ 74,511 4,736 6.36 -- -- --
Other borrowings............ 18,402 1,141 6.20 -- -- --
-------- ------- -------- -------
Total borrowings.......... $263,257 $17,849 6.78% $172,829 $10,336 5.98%
======== ------- ======== -------
Net interest income.......... $ 7,305 $ 1,471
======= =======
Net interest spread.......... 1.78% 0.50%
==== ====
Net yield.................... 2.48% 0.81%
==== ====
</TABLE>
38
<PAGE>
Interest income. Interest-earning assets averaged $476.3 million during
1997, including $294.1 million of mortgage loans and $182.1 million of mortgage
securities. During the year, mortgage loans earned $25.2 million, or a yield of
8.6%, while mortgage securities earned $11.8 million, or a yield of 6.5%. In
total, assets earned $37.0 million, or a 7.8% yield.
Interest expense. The cost of borrowed funds was $28.2 million during the
year ended December 31, 1997, or 6.5% of average borrowings. During the year
ended December 31, 1997, the one-month LIBOR averaged 5.6%. As with interest
income, the cost of funds in the future will largely depend on market
conditions, most notably levels of short-term interest rates.
Net interest income and spread. Net interest income during 1997 was $8.8
million, or 1.8% of average interest-earning assets. Net interest spread was
1.3% during the year ended December 31, 1997. Net interest income and the
spread are functions of the asset yield relative to cost of funds. During 1997,
the cost of funds was relatively low and stable. This lower cost of funds
offsets, to some degree, the lower yield on assets discussed above. In
addition, NovaStar Financial entered into interest rate agreements to mitigate
the exposure to variations in interest rates on interest-earning assets that
are different from the variations in interest incurred on borrowings.
Impact of interest rate agreements. As of December 31, 1997, NovaStar
Financial had interest rate cap agreements, with a combined notional amount of
$270 million and interest rate swap agreements with an aggregate notional
amount of $276 million. During 1997, net interest expense was incurred on these
agreements of $1.0 million, which is included as a component of interest
expense.
Other Income
During the year ended December 31, 1997, NovaStar Financial recognized
$51,000 in net gains on sales of mortgage securities with a principal balance
of $108 million. NovaStar Financial did not sell any of its mortgage loan
portfolio during this same period of 1997. Prepayment penalty income and
interest earned on notes receivable from founders during the year ended
December 31, 1997 was $414,000 and $260,000, respectively.
Provisions for Credit Losses
During the year ended December 31, 1997, NovaStar Financial provided $2.5
million for credit losses while credit losses for this same period of 1997 were
$140,000. As mentioned earlier, allowances are maintained for losses management
expects to incur on the loans in the portfolio.
General and Administrative Expenses
General and administrative expenses for the year ended December 31, 1997 are
provided in Table 24.
Table 24
General and Administrative Expenses
Year Ended December 31, 1997
(dollars in thousands)
<TABLE>
<CAPTION>
Percent of Net
Interest
Income
--------------
<S> <C> <C>
Compensation and benefits................................. $ 839 9.6%
Professional and outside services......................... 676 7.7%
Loan servicing............................................ 741 8.4%
Office administration..................................... 299 3.4%
Other..................................................... 448 5.1%
------ -----
Total portfolio-related expenses.......................... 3,003 34.2%
=====
Forgiveness of notes receivable from founders............. 1,083
Fees for services provided by NovaStar Mortgage........... 4,155
------
Total................................................. $8,241
======
</TABLE>
39
<PAGE>
Fees for services provided by NovaStar Mortgage during the year ended
December 31, 1997 totaled $4,155,000 and the components of these are further
detailed in Note 9 of the consolidated financial statements. Compensation and
benefits totaled $839,000 during the year ended 1997. The number of employees
and the related compensation costs increased throughout 1997 as staff was
hired.
Loan servicing costs were $741,000 for the year ended December 31, 1997 and
consist primarily of the fees paid to an outside servicer while NovaStar
Mortgage developed its servicing operation during the first half of the year.
NovaStar Mortgage did not begin servicing NovaStar Financial's loans until July
15, 1997. The servicing fee that NovaStar Mortgage charges NovaStar Financial
is based on 50 basis points on the outstanding principal when loans are
securitized and a flat fee per loan prior to securitization. These fees are
included as a component of the fees for services provided by NovaStar Mortgage.
Professional and outside services include contract labor as well as fees for
legal and accounting services. Management used contract labor services fairly
extensively during 1997, particularly in the area of systems development.
During the year ended December 31, 1997, these expenses totaled $676,000.
Office administration during the twelve months ended December 31, 1997 were
$299,000. Certain of these items were necessarily high during the start up
phase.
Earnings of NFI Holding Corporation
For the year ended December 31, 1997, NFI Holding recorded net income of
$28,000, of which NovaStar Financial recorded its portion $28,000. Condensed
consolidated financial statements for NFI Holding are presented in Note 123 to
the consolidated financial statements.
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 25 is a summary of the differences
between net income or loss reported for GAAP and taxable income or loss during
each quarter of 1998 and 1997.
Table 25
Taxable Income (Loss)
Years Ended December 31, 1998 and 1997 (in thousands)
<TABLE>
<CAPTION>
1998 1997
----------------------------------- ---------------------------------
Fourth Third Second First Fourth Third Second First
Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter
-------- ------- ------- ------- ------- ------- ------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Net income (loss)....... $(27,388) $ 2,394 $1,894 $1,279 $ (433) $ 177 $(1,073) $194
Results of NFI Holding.. 529 2,447 -- 273 (169) (393) 126 408
Provision for credit
losses................. 4,030 1,179 1,145 1,076 1,009 726 547 171
Loans charged-off....... (3,214) (1,762) (675) (518) (140) -- -- --
Capital losses.......... 15,450 -- -- -- -- -- -- --
Other, net.............. 351 95 208 (4) 296 (4) (8) --
-------- ------- ------ ------ ------ ----- ------- ----
Estimated taxable income
(loss)................. $(10,242) $ 4,353 $2,572 $2,106 $ 563 $ 506 $ (408) $773
======== ======= ====== ====== ====== ===== ======= ====
</TABLE>
As discussed under "Events of the Fourth Quarter 1998," NovaStar Financial
executed several transactions during October 1998 that included the sale of
assets and termination of hedging arrangements, which eliminated taxable income
for 1998.
40
<PAGE>
Interest Rate Sensitivity
Table 26 details the interest rate sensitivity of NovaStar Financial as of
December 31, 1998. A discussion of the assumptions used by management in
preparing this analysis are discussed under "Risk Management"
Table 26
Interest Rate Sensitivity
December 31, 1998(A) (dollars in thousands)
<TABLE>
<CAPTION>
Basis Point Increase
(Decrease) in Interest
Rate
---------------------------
(100)(B) Base(C) 100(B)
------- ------- -------
<S> <C> <C> <C>
Income from:
Assets.......................................... $80,507 $82,310 $83,966
Liabilities..................................... (47,546) (55,259) (63,233)
Interest rate agreements........................ (2,244) (2,244) 107
------- ------- -------
Net spread income................................. $30,717 $24,807 $20,840
======= ======= =======
Cumulative change in income from base(C).......... $ 5,910 -- $(3,967)
======= ======= =======
Percent change from base spread income(D)......... 23.8% -- (16.0)%
======= ======= =======
Percent change of capital(E)...................... 6.77% -- (4.54)%
======= ======= =======
</TABLE>
- --------
(A) The securitized mortgage assets of NovaStar Financial are managed on a
spread income basis.
(B) Income of asset, liability or interest rate agreement in a parallel shift
in the yield curve, up or down 1%.
(C) Total change in estimated spread income, in dollars, from "base." "Base" is
the estimated spread income at December 31, 1998.
(D) Total change in estimated spread income, as a percent, from base.
(E) Total change in estimated spread income as a percent of total stockholders'
equity at December 31, 1998.
Interest rate sensitivity analysis. The values under the heading "Base" are
management's estimates of spread income for assets, liabilities and interest
rate agreements on December 31, 1998. The values under the headings "100" and
"(100)" are management's estimates of the income value of those same assets,
liabilities and interest rate agreements assuming that interest rates were 100
basis points, or 1% higher and lower. The cumulative change in income
represents the change in income of assets from base, net of the change in
income of liabilities and interest rate agreements from base.
Sensitivity as of December 31, 1998. As shown in the above table, if
interest rates were to decrease 1% (-100 basis points), the spread income would
increase by an estimated 6.77% of capital as of December 31, 1998. If interest
rates rise by 1% (+100 basis points), the spread income would decrease by an
estimated 4.54% of capital as of December 31, 1998.
Liquidity and Capital Resources
As discussed in "Events of the Fourth Quarter 1998", during October 1998, a
lender withdrew access to a key financing facility. Management believes this
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, including NovaStar. Consequently, the events and actions during the
1998 fourth quarter are important to this discussion regarding the liquidity
and capital resources of NovaStar Financial.
Liquidity means the need for, access to and uses of cash. NovaStar's primary
needs for cash include the acquisition of mortgage loans, principal repayment
and interest on borrowings, operating expenses and dividend payments.
Substantial cash is required to support the operating activities of the
business, especially the mortgage origination operation. Principal, interest
and fees received on mortgage assets and residual interests
41
<PAGE>
on CMOs will serve to support cash needs. Drawing upon various borrowing
arrangements typically satisfies major cash requirements. Historically,
NovaStar Financial demonstrated the ability to access public capital markets as
a source of long-term cash resources. The events in early October 1998 changed
the liquidity position of NovaStar Financial and many other subprime companies
and REITs. The number of options available to NovaStar Financial with regard to
financing and capital resources have been restricted.
Actions during unfavorable market conditions in the fourth quarter 1998 were
taken to restore liquidity and mitigate additional margin call risk. Although
these actions resulted in a significant net loss for the 1998 fourth quarter,
management believes they were necessary under the circumstances. These actions
have significantly reduced the cash requirements of NovaStar Financial. The
mortgage loans owned by NovaStar Financial have minimal liquidity risk as they
are financed with non-recourse CMOs. Management expects that interest income on
the loans will generate sufficient cash to meet financing and operating costs.
NovaStar Mortgage requires substantial cash to fund loan originations and
operating costs. In the short-term, management expect to sell a substantial
amount of the whole loan production of NovaStar Mortgage to generate adequate
cash to meet the significant cash needs of the wholesale loan operation.
NovaStar will continue to sell the majority of loans originated to third
parties until sufficient capital can be efficiently raised to return to its
primary business strategy of holding loans in portfolio. Management believes
NovaStar can operate indefinitely in this manner, providing the level of loan
originations are at or near the capacity of its production infrastructure.
Table 27 is a summary of financing arrangements and available borrowing
capacity under those arrangements as of December 31, 1998:
Table 27
Liquidity Resources
December 31, 1998 (dollars in thousands)
<TABLE>
<CAPTION>
Maximum
Borrowing Value of
Resource Limit Collateral Borrowings Availability
- -------- --------- ---------- ---------- ------------
<S> <C> <C> <C> <C>
First Union National Bank (A):
Committed warehouse line of
credit....................... $75,000 $31,727 $ 26,651 $5,076
Committed secured whole loan
repurchase agreement......... 200,000(C) 175,863 175,863 --
Residual financing available
under CMOs..................... 18,000(C) (B) 18,000 --
-------- ------
Total....................... $220,514 $5,076
======== ======
Total availability as a percent
of:
Total assets................ 0.51%
======
Total stockholders' equity.. 5.82%
======
</TABLE>
- --------
(A) Value of collateral and borrowings include amounts for both NovaStar
Financial and NovaStar Mortgage as they are co-borrowers under the
arrangements with First Union National Bank.
(B) Management estimates the value of the residuals range from $50 to $70
million not including the value of mortgage servicing rights.
(C) During February 1999, NovaStar executed agreements increasing the whole
loan repurchase agreement to $300 million and the residual financing to $20
million.
NovaStar Mortgage continues to originate subprime mortgage loans that are
expected to be sold to third parties. During the first quarter of 1999,
NovaStar Mortgage issued asset-backed bonds totaling $160 million. Unlike
NovaStar Financial's asset-backed bond transactions, this transaction was
treated as a sale and NovaStar Mortgage recognized a gain of $1.3 million. As
of December 31, 1998, NovaStar Mortgage had $209 million
42
<PAGE>
of subprime mortgage loans. NovaStar Mortgage provides financing for these
loans through the First Union warehouse and repurchase credit facilities. Loans
financed with warehouse and repurchase credit facilities are subject to
changing market valuation and margin calls. Management expects to continue
selling or securitizing loans originated by NovaStar Mortgage. However,
management's intent is to raise sufficient capital during the first part of
1999 to begin acquiring a majority of NovaStar Mortgage's production during the
second half of 1999.
During February 1999, NovaStar Financial and NovaStar Mortgage finalized
agreements with First Union National Bank that increased total financing
capacity to $395 million under the four separate facilities that are committed
for one year. Financing is available under the warehouse agreement ($75
million), a master repurchase agreement ($300 million) and borrowings secured
by the residual interests in CMOs ($20 million). See note 4 to the consolidated
financial statements of NovaStar Financial.
Cash activity during the years ended December 31, 1998 and 1997 are
presented in the consolidated statement of cash flows.
Capital allocation guidelines. Each quarter, management presents to the
Board of Directors the results of the capital allocation guidelines 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 management to
predict or hedge the risk of the asset.
Table 28 is a summary of the capital allocation for NovaStar as they apply
to mortgage assets and hedging instruments during 1998 and 1997.
Table 28
Required Equity
<TABLE>
<CAPTION>
1998 1997
------------------------------------------ -----------------------------------------
Category December 31 September 30 June 30 March 31 December 31 September 30 June 30 March 31
- -------- ----------- ------------ ------- -------- ----------- ------------ ------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Mortgage loans:
Current................ $12,648 $14,567 $21,566 $23,628 $ 6,675 $ 33,832 $22,780 $15,958
Delinquent............. 3,918 452 601 1,200 1,600 2,376 -- --
Securitized loans...... 62,315 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............ 12,536 20,682 13,782 10,733 -- -- -- --
Hedging instruments..... (179) (688) (232) (203) 5,500 427 1,787 2,804
------- ------- ------- ------- ------- -------- ------- -------
Required equity......... 91,238 110,349 98,387 86,262 72,445 49,398 38,116 20,408
Stockholders' equity.... 87,204 109,848 114,875 115,798 116,489 47,036 46,337 46,202
Market value in excess
of the carrying value
of assets and
hedges(A).............. 5,961 2,331 31,999 20,685 -- -- -- --
------- ------- ------- ------- ------- -------- ------- -------
Excess equity........... $ 1,927 $ 1,830 $48,487 $50,221 $44,044 $(2,362) $ 8,221 $25,794
======= ======= ======= ======= ======= ======== ======= =======
</TABLE>
- --------
(A) NovaStar Financial revised its capital allocation guidelines model during
the first quarter of 1998 to include the market value in excess of the
carrying value of assets and hedges as NovaStar has the ability to borrow
against this excess.
43
<PAGE>
Inflation
Virtually all assets and liabilities of NovaStar Financial are financial in
nature. As a result, interest rates and other factors drive company performance
far more than does inflation. Changes in interest rates do not necessarily
correlate with inflation rates or changes in inflation rates. The financial
statements of NovaStar Financial are prepared in accordance with generally
accepted accounting principles and the dividends are based on taxable income.
In each case, financial activities and balance sheets are measured with
reference to historical cost or fair market value without considering
inflation.
Impact of Recently Issued Accounting Pronouncements
Note 1 to the consolidated financial statements describes certain recently
issued accounting pronouncements. Management believes the implementation of
these pronouncements did not or will not have a material impact on the
consolidated financial condition or results of operations. Management is
currently evaluating the impact of SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities. SFAS No. 133 is effective beginning January
1, 2000 for NovaStar.
The Year 2000
NovaStar is highly dependent on purchased and leased computer software to
conduct business. In addition, NovaStar is highly dependent on computer
software used by market counterparties and vendors, including banks, in
conducting business. Management recognizes that some computer software may not
have the ability to correctly identify dates beyond December 31, 1999.
Successful modification of computer software, or the vendors' successful
modification of their programs, to be year 2000 compliant is critical to the
viability of NovaStar Financial.
NovaStar uses three major, and a number of smaller, internal automation
solutions to conduct its operations. The systems considered the most
significant to operations are as follows:
. Internally developed loan origination and database system
. Externally provided loan servicing system
. Purchased accounting system
In addition, NovaStar integrates and interfaces with a number of outside
entities in conducting normal business transactions. 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 its year
2000 readiness effort. Each program/system interface used by NovaStar is being
reviewed and tested for year 2000 compliance. NovaStar's three-phase approach
is presented below:
44
<PAGE>
In the assessment phase, management has determined which business
processes/interfaces rely on dates and date arithmetic. Most business
processes/interfaces rely on dates and date arithmetic. NovaStar is still
working with its many 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. NovaStar is requiring all market counterparties and vendors
to document they have made all corrections.
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. Management has asked that each party adhere to
the same FFIEC guidelines and to provide documents of progress during each
phase. NovaStar has received written confirmation from Alltel Residential
Lending Solutions, vendor of NovaStar's servicing system, and Baan/CODA, vendor
of NovaStar's accounting system, stating that the versions currently used by
NovaStar are fully year 2000 compliant.
Management has contacted its significant financial counterparty, First Union
National Bank, who is completing their internal review of year 2000 compliance.
NovaStar staff will conduct "mock" business as if it is in the year 2000
during the validation phase. During this phase, NovaStar will test all
internally developed software as well as vendor software.
Management believes the greatest risk in regards to year 2000 compliance is
the software and systems used to service its subprime mortgage loans. NovaStar
Mortgage services the loans owned by NovaStar Financial using 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 to NovaStar.
NovaStar is also at significant risk in the event the systems of financial
institutions, on which NovaStar is relying for financing and cash management
fail. In a worst case scenario, NovaStar Financial 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 NovaStar.
NovaStar 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 NovaStar for these systems' failure 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 NovaStar. Based on the information provided, management
believes these vendors will meet their obligation for resolution of year 2000
issues.
Management 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 management determines that any market counterparty will not be
year 2000 compliant.
Item 7A. Quantitiative and Qualitative Disclosures About Market Risk
Information with respect to Item 305 of Regulation S-K is included in the
"Business--Risk Management" section of this annual report.
45
<PAGE>
Item 8. Financial Statements and Supplementary Data
NOVASTAR FINANCIAL, INC.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share amounts)
<TABLE>
<CAPTION>
December 31,
----------------------
1998 1997
Assets ---------- ----------
<S> <C> <C>
Mortgage loans, net.................................... $ 920,697 $ 574,984
Mortgage securities--available-for-sale................ -- 517,246
Accrued interest receivable............................ 9,702 7,088
Due from affiliates.................................... 51,528 20,701
Investment in NFI Holding Corporation.................. 13 2,188
Amounts due from founders.............................. 5,354 763
Assets acquired through foreclosure.................... 10,583 156
Other assets........................................... 4,359 3,126
---------- ----------
Total assets....................................... $1,002,236 $1,126,252
========== ==========
<CAPTION>
Liabilities and Stockholders' Equity
<S> <C> <C>
Liabilities:
Borrowings........................................... $ 909,944 $1,005,560
Dividends payable.................................... 2,845 783
Accounts payable and other liabilities............... 2,157 3,420
---------- ----------
Total liabilities.................................. 914,946 1,009,763
Commitments and contingencies
Stockholders' equity:
Capital stock, $0.01 par value, 50,000,000 shares
authorized:
Common stock, 8,130,069 and 7,828,665 shares issued
and outstanding, respectively....................... 81 78
Additional paid-in capital........................... 122,180 117,084
Accumulated deficit.................................. (32,804) (2,859)
Accumulated other comprehensive income............... -- 4,353
Forgivable notes receivable from founders............ (2,167) (2,167)
---------- ----------
Total stockholders' equity......................... 87,290 116,489
---------- ----------
Total liabilities and stockholders' equity......... $1,002,236 $1,126,252
========== ==========
</TABLE>
See notes to consolidated financial statements.
46
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share amounts)
<TABLE>
<CAPTION>
For the Year For the period
Ended from
December 31, September 13, 1996
----------------- (inception) to
1998 1997 December 31, 1996
-------- ------- ------------------
<S> <C> <C> <C>
Interest income:
Mortgage loans......................... $ 76,751 $25,154 $ --
Mortgage securities.................... 23,996 11,807 155
-------- ------- ------
Total interest income.................... 100,747 36,961 155
Interest expense......................... 80,794 28,185 --
-------- ------- ------
Net interest income...................... 19,953 8,776 155
Provision for credit losses.............. 7,430 2,453 --
-------- ------- ------
Net interest income after provision for
credit losses........................... 12,523 6,323 155
Gain (loss) on sales of securities and
mortgage loans.......................... (14,962) 51 --
Loss on termination of interest rate
agreements.............................. (7,977) --
Equity in net income (loss) of NFI
Holding Corporation..................... (2,984) 28 --
Other income............................. 3,188 704 --
General and administrative expenses:
Loan servicing fees paid to NovaStar
Mortgage, Inc......................... 3,803 505 --
Fees for other services provided by
NovaStar Mortgage, Inc................ 2,683 3,650 --
Compensation and benefits.............. 1,785 839 199
Professional and outside services...... 1,117 676 200
Other loan servicing expenses.......... 1,071 741 --
Office administration.................. 903 299 --
Forgiveness of notes receivable from
founders.............................. -- 1,083 --
Other.................................. 247 448 58
-------- ------- ------
Total general and administrative
expenses.............................. 11,609 8,241 457
-------- ------- ------
Net loss................................. $(21,821) $(1,135) $ (302)
======== ======= ======
Basic and diluted loss per share......... $ (2.71) $ (0.26) $(0.08)
======== ======= ======
Weighted average shares outstanding...... 8,057 4,430 3,767
======== ======= ======
</TABLE>
See notes to consolidated financial statements
47
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(dollars in thousands, except share amounts)
<TABLE>
<CAPTION>
Accumulated Forgivable
Convertible Additional Other Notes Total
Preferred Common Paid-in Accumulated Comprehensive Receivable Stockholders'
Stock Stock Capital Deficit Income from Founders Equity
----------- ------ ---------- ----------- ------------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance, September 13,
1996 (inception)....... $ -- $ -- $ -- $ -- $ -- $ -- $ --
Issuance of 216,666
shares of Common
stock.................. -- 2 -- -- -- -- 2
Proceeds from private
placement of 3,333,333
units, net of costs of
$3,304................. 34 -- 46,662 -- -- -- 46,696
Units (216,666) acquired
with forgivable debt... 2 -- 3,248 -- -- (3,250) --
Comprehensive loss:
Net loss............... -- -- -- (302) -- -- (302)
Other comprehensive
loss--change in
unrealized gain
(loss) on available-
for-sale securities... -- -- -- -- (16) -- (16)
---- ---- -------- -------- ------- ------- --------
Total comprehensive
loss................ -- -- -- (302) (16) -- (318)
---- ---- -------- -------- ------- ------- --------
Balance, December 31,
1996................... 36 2 49,910 (302) (16) (3,250) 46,380
Private placement
issuance costs......... -- -- (48) -- -- -- (48)
Proceeds from initial
public offering of
common stock, net of
issuance costs of
$5,848................. (36) 76 67,216 -- -- -- 67,256
Exercise of stock
options................ -- -- 6 -- -- -- 6
Dividends on convertible
preferred stock ($0.18
per share)............. -- -- -- (639) -- -- (639)
Dividends on common
stock ($0.10 per
share)................. -- -- -- (783) -- -- (783)
Forgiveness of founders'
notes receivable....... -- -- -- -- -- 1,083 1,083
Comprehensive income
(loss):
Net loss............... -- -- -- (1,135) -- -- (1,135)
Other comprehensive
income (loss)--change
in unrealized gain
(loss) on available-
for-sale securities,
net of
reclassification
adjustments of $51
for gains included in
net loss.............. -- -- -- -- 4,369 -- 4,369
---- ---- -------- -------- ------- ------- --------
Total comprehensive
income (loss)....... -- -- -- (1,135) 4,369 -- 3,234
---- ---- -------- -------- ------- ------- --------
Balance, December 31,
1997................... -- 78 117,084 (2,859) 4,353 (2,167) 116,489
Initial public offering
of common stock
issuance costs......... -- -- (88) -- -- -- (88)
Exercise of stock
options and warrants... -- 3 5,184 -- -- -- 5,187
Dividends on common
stock ($1.00 per
share)................. -- -- -- (8,124) -- -- (8,124)
Comprehensive loss:
Net loss............... -- -- -- (21,821) -- -- (21,821)
Other comprehensive
loss--change in
unrealized gain
(loss) on available-
for-sales securities,
net of
reclassification
adjustments of
$15,268 for losses
included in net loss.. -- -- -- -- (4,353) -- (4,353)
---- ---- -------- -------- ------- ------- --------
Total comprehensive
loss................ -- -- -- (21,821) (4,353) -- (26,174)
---- ---- -------- -------- ------- ------- --------
Balance, December 31,
1998................... $ -- $ 81 $122,180 $(32,804) $ -- $(2,167) $ 87,290
==== ==== ======== ======== ======= ======= ========
</TABLE>
See notes to consolidated financial statements
48
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
For the period
from
September 13,
For the Year Ended 1996
December 31, (inception) to
---------------------- December 31,
1998 1997 1996
--------- ----------- --------------
<S> <C> <C> <C>
Cash flow from operating activities:
Net loss................................. $ (21,821) $ (1,135) $ (302)
Adjustments to reconcile net loss to cash
provided by (used in) operating
activities:
Amortization of premiums on mortgage
loans................................. 5,768 2,532 --
Amortization of premiums on mortgage
securities............................ 1,852 908 --
Amortization of deferred debt costs.... 4,562 93 --
Provision for credit losses............ 7,430 2,453 --
Forgiveness of notes receivable from
founders.............................. -- 1,083 --
Equity in net loss (income) of NFI
Holding Corporation................... 2,984 (28) --
Losses (gains) on sales of mortgage
loans and securities.................. 14,962 (51) --
Loss on terminations of interest rate
agreements............................ 7,977 --
Change in:
Accrued interest receivable.......... (2,614) (7,059) (29)
Other assets......................... (1,638) (3,780) (109)
Other liabilities.................... (9,219) 3,223 176
--------- ----------- -------
Net cash provided by (used in)
operating activities.............. 10,243 (1,761) (264)
Cash flow from investing activities:
Mortgage loans purchased from NovaStar
Mortgage, Inc......................... (556,158) (417,752) --
Mortgage loans purchased from others... -- (219,995) --
Mortgage loans sold to others.......... 8,307 -- --
Mortgage loan repayments............... 178,818 57,622 --
Purchases of available-for-sale
securities............................ (375,051) (659,415) --
Settlement of amounts due to brokers... -- (13,255) --
Proceeds from sales of available-for-
sale securities....................... 705,906 110,067 --
Proceeds from paydowns on available-
for-sale securities................... 165,233 48,694 --
Investment in NFI Holding Corporation.. (990) (1,980) --
Net change in amounts due from NFI
Holding Corporation................... (30,827) (20,701) --
--------- ----------- -------
Net cash provided by (used in)
investing activities.............. 95,238 (1,116,715) --
Cash flow from financing activities:
Proceeds from issuance of
collateralized mortgage obligations... 665,000 424,674 --
Payments on collateralized mortgage
obligations........................... (179,851) (13,596) --
Debt issuance costs paid on
collateralized mortgage obligations... (2,821) (2,304) --
Change in short-term borrowings........ (581,693) 596,693 --
Proceeds from issuance of capital stock
and exercise of equity instruments,
net of offering costs................. (54) 67,214 46,698
Dividends paid......................... (6,062) (639) --
--------- ----------- -------
Net cash provided by (used in)
financing activities.............. (105,481) 1,072,042 46,698
--------- ----------- -------
Net increase (decrease) in cash and cash
equivalents............................. -- (46,434) 46,434
Cash and cash equivalents, beginning of
period.................................. -- 46,434 --
--------- ----------- -------
Cash and cash equivalents, end of period. $ -- $ -- $46,434
========= =========== =======
Supplemental disclosure of cash flow
information:
Cash paid for interest................. $ 80,604 $ 27,436 $ --
========= =========== =======
Note received in exchange for options
exercised by founders................. $ 4,591 $ -- $ --
========= =========== =======
Dividends payable...................... $ 2,845 $ 783 $ --
========= =========== =======
Assets acquired through foreclosure.... $ 17,242 $ 156 $ --
========= =========== =======
Issuance of units acquired with
forgivable debt....................... $ -- $ -- $ 3,250
========= =========== =======
</TABLE>
See notes to consolidated financial statements.
49
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1998
Note 1. Summary of Significant Accounting Policies
NovaStar Financial, Inc. (the Company) is a Maryland corporation formed on
September 13, 1996. The Company acquires subprime mortgage loans and mortgage
securities and manages the resulting portfolio of mortgage assets.
Financial Statement Presentation The Company's financial statements have
been prepared in conformity with generally accepted accounting principles and
prevailing practices within the financial services industry. The preparation of
financial statements requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities at the date of the
financial statements and the reported amounts of income and expense during the
period. The Company uses estimates and employs the judgments of management in
determining the amount of its allowance for credit losses, amortizing premiums
or accreting discounts on its mortgage assets, and establishing the fair value
of its mortgage securities. While the financial statements and footnotes
reflect the best estimates and judgments of management at the time, actual
results could differ from those estimates. For example, it is possible that
credit losses or prepayments could rise to levels that would adversely affect
profitability if such levels were sustained for more than brief periods of
time.
The Company owns 100 percent of the common stock of three special purpose
entities--NovaStar Assets Corporation, NovaStar Mortgage Funding Corporation
and NovaStar Certificates Financial Corporation. The Company formed these
entities in connection with the issuance of collateralized mortgage
obligations. The consolidated financial statements of the Company include the
accounts of these entities. Significant intercompany accounts and transactions
have been eliminated in consolidation.
The Company accounts for its investment in NFI Holding Corporation using the
equity method. NovaStar Financial, Inc. owns 100 percent of the nonvoting
preferred stock of NFI Holding Corporation, for which it receives 99 percent of
any dividends paid by NFI Holding Corporation. The preferred stock was
purchased in February 1997 for $1,980,000 and the Company contributed another
$990,000 of capital to NFI Holding Corporation during 1998. NFI Holding
Corporation owns 100 percent of the outstanding common stock of NovaStar
Mortgage, Inc., a mortgage loan originator and servicer. NovaStar Mortgage
originated a substantial portion of the subprime residential mortgage loans
owned by the Company. The founders of the Company own 100 percent of the common
stock of NFI Holding Corporation and serve as officers and directors of NFI
Holding Corporation and NovaStar Mortgage. NFI Holding Corporation also owns
100 percent of the outstanding common stock of NovaStar Capital, Inc., which
was formed to trade whole loans.
Cash and Cash Equivalents The Company considers investments with maturities
of three months or less at the date of purchase to be cash equivalents.
Mortgage Loans Mortgage loans include loans acquired from NovaStar Mortgage
and in bulk pools from other originators and securities dealers. Mortgage loans
are generally purchased at a premium over the outstanding principal balance and
are stated at amortized cost. Premiums are amortized and discounts accreted as
yield adjustments over the estimated lives of the loans using a method that
approximates the interest method. Amortization includes the effect of
prepayments.
Interest is recognized as revenue when earned according to the terms of the
mortgage loans and when, in the opinion of management, it is collectible. The
accrual of interest on loans is discontinued when, in management's opinion, the
interest is not collectible in the normal course of business, but in no case
beyond when a loan becomes ninety days delinquent. Interest collected on non-
accrual loans is recognized as income upon receipt.
The Company maintains an allowance for credit losses at a level deemed
appropriate by management. The allowance is based upon the assessment by
management of various factors affecting its mortgage loan portfolio, including
current and projected economic conditions, the makeup of the portfolio based on
credit grade, loan to value, delinquency status and other factors deemed to
warrant consideration. The allowance is maintained through ongoing provisions
charged to operating income and is reduced by loans that are charged off.
50
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Mortgage Securities The Company classifies all of its mortgage securities as
available-for-sale and, therefore, reports them at their estimated fair value
with unrealized gains and losses reported as a separate component of
stockholders' equity. Premiums are amortized and discounts are accreted as
yield adjustments over the estimated lives of the securities using a method
that approximates the interest method. Amortization includes the effect of
prepayments. Gains or losses on sales of securities are recognized using the
specific identification method.
Assets Acquired Through Foreclosure Real estate owned, which consists of
residential real estate acquired in satisfaction of loans, is carried at the
lower of cost or estimated fair value less estimated selling costs. Adjustments
to the loan carrying value required at time of acquisition are charged to the
allowance for credit losses. Losses or gains from the ultimate disposition of
real estate owned are charged or credited to income.
Transfers of Assets The Company uses the financial components approach when
accounting for transfers of mortgage loans in repurchase and securitization
transactions. Because the Company retains control over the loans, repurchase
and securitization transactions are accounted for as secured borrowings rather
than as sales. The borrowings under repurchase agreements and collateralized
mortgage obligations included in the accompanying consolidated balance sheets
represent the remaining principal amount of funds received in the transfer.
Stock-based Compensation Compensation expense for services the Company
receives as consideration for stock issued through its employee stock option
plans is measured by the quoted market price of the stock at the measurement
date less the amount, if any, that the employee is required to pay.
Income Taxes The Company intends to operate and qualify as a Real Estate
Investment Trust (REIT) under the requirements of the Internal Revenue Code. As
a result, The Company, and its qualified REIT subsidiaries, will generally not
be subject to federal income taxes at the corporate level on taxable income
distributed to stockholders. Requirements for qualification as a REIT include
various restrictions on common stock ownership and the nature of assets and
sources of income. In addition, a REIT must distribute at least 95 percent of
its annual taxable income to its stockholders. If in any tax year, The Company
does not qualify as a REIT, it will be taxed as a corporation and distributions
to stockholders will not be deductible in computing taxable income. If the
Company fails to qualify as a REIT in any tax year, it will not be permitted to
qualify for the succeeding four years. The most significant difference between
GAAP earnings and taxable income relates to provisions for credit losses, which
are not deductible for income tax purposes. The Company's non-REIT affiliate,
NFI Holding Corporation files a consolidated federal income tax return with
NMI.
Earnings (Loss) Per Share Basic earnings per share (EPS) excludes dilution
and is computed by dividing income (loss) available to common stockholders by
the weighted-average number of common shares outstanding for the period. For
purposes of computing basic EPS, the Company has treated the convertible
preferred stock, which was converted into common stock on October 31, 1997, as
if it had been converted at inception of the Company. Diluted EPS reflects the
potential dilution that could occur if securities or other contracts to issue
common stock were exercised or converted into common stock or resulted in the
issuance of common stock that then shared in the earnings of the entity.
Diluted EPS is calculated assuming that all options and warrants on the
Company's common stock have been exercised, unless such exercise would be anti-
dilutive.
Financial Instruments with Off-balance-sheet Risk The Company has entered
into interest rate swap and cap agreements and financial futures contracts
designed to, in effect, alter the interest rates on its funding costs to more
closely match the yield on interest-earning assets. Net income earned from or
expense incurred on interest rate swap and cap agreements is accounted for on
the accrual method and is recorded as an adjustment of interest expense. The
gain or loss on early termination, sale or disposition of an interest rate swap
or cap agreement is recognized in current earnings if the matched funding
source is also extinguished. If the matched funding source is not extinguished,
the unrealized gain or loss on the related interest rate swap or cap agreement
is deferred and amortized as a component of interest expense over the remaining
term of the
51
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
matched funding source. Unmatched swap or cap agreements are recorded at fair
value with changes in the unrealized gains or losses recorded in current
earnings.
Realized and unrealized gains and losses on futures contracts that meet the
criteria for deferral accounting are deferred and amortized as an adjustment to
interest expense over the remaining life of the underlying financial
instrument. The estimated fair values of futures contracts that do not qualify
for deferral accounting are recorded at fair value, with changes in their fair
value recorded in current operations.
Comprehensive Income Effective January 1, 1998, the Company adopted the
provisions of Statement of Financial Accounting Standards (SFAS) No. 130,
Reporting Comprehensive Income. Comprehensive income includes net income and
revenues, expenses, gains and losses that are not included in net income. The
adoption of SFAS No. 130 did not result in an adjustment to assets,
liabilities, stockholders' equity or net loss.
Segment Information Effective January 1, 1998, the Company adopted the
provisions of SFAS No. 131, Disclosures about Segments of an Enterprise and
Related Information. SFAS No. 131 requires public business enterprises to
report financial and descriptive information about its reportable operating
segments. Operating segments are components of an enterprise about which
separate financial information is available that is evaluated regularly by the
chief operating decision-maker in deciding how to allocate resources and in
assessing performance. Generally, financial information is required to be
reported on the basis that it is used internally for evaluating segment
performance and deciding how to allocate resources to segments. The Company has
one reportable operating segment. The adoption of SFAS No. 131 did not result
in an adjustment to assets, liabilities, stockholders' equity or net loss.
New Accounting Pronouncements During 1998, the Financial Accounting
Standards Board (FASB) issued SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities. SFAS No. 133 standardizes the accounting
for derivative instruments, including certain instruments embedded in other
contracts, by requiring that an entity recognize those items as assets or
liabilities in the balance sheet and measure them at fair value. If certain
conditions are met, an entity may elect to designate a derivative instrument
either as a cash flow hedge, a fair value hedge or a hedge of foreign currency
exposure. Generally, SFAS No. 133 provides for matching the timing of gain or
loss recognition on the hedging instrument with the recognition of the changes
in the fair value of hedge asset or liability that is attributable to the hedge
risk or 2) the earnings effect of the hedge forecasted transaction. SFAS No.
133 is effective for fiscal years beginning after June 15, 1999. Management is
evaluating the effect of the adoption of SFAS No. 133 to have a material impact
on the financial statements of the Company.
SFAS 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.
Note 2. Mortgage Loans
Mortgage loans, all of which are secured by residential properties,
consisted of the following as of December 31 (in thousands):
<TABLE>
<CAPTION>
1998 1997
-------- --------
<S> <C> <C>
Outstanding principal................................. $903,402 $559,436
Net unamortized premium............................... 20,868 17,861
-------- --------
Amortized cost........................................ 924,270 577,297
Allowance for credit losses........................... (3,573) (2,313)
-------- --------
$920,697 $574,984
======== ========
</TABLE>
52
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Activity in the allowance for credit losses is as follows for the years
ended December 31, 1998 and 1997 (in thousands):
<TABLE>
<CAPTION>
1998 1997
------ ------
<S> <C> <C>
Balance, January 1........................................ $2,313 $ --
Provision for credit losses............................... 7,430 2,453
Amounts charged off, net of recoveries.................... (6,170) (140)
------ ------
Balance, December 31...................................... $3,573 $2,313
====== ======
</TABLE>
All mortgage loans serve as collateral for various borrowing arrangements as
discussed in Note 4. The weighted-average interest rate on these loans at
December 31, 1998 and 1997 was 10.2%.
Collateral for 18, 12 and 8 percent of the mortgage loans outstanding as of
December 31, 1998 was located in California, Florida and Washington,
respectively. The Company has no other significant concentration of credit
risk.
Note 3. Mortgage and Other Securities
Mortgage securities, all classified as available-for-sale, consisted of the
following as of December 31, 1997 (dollars in thousands):
<TABLE>
<CAPTION>
Weighted Unrealized
Average Amortized ----------- Carrying
Coupon Cost Gain Loss Value
-------- --------- ------ ---- --------
<S> <C> <C> <C> <C> <C>
Mortgage securities issued by:
Federal National Mortgage
Association........................ 7.55% $272,773 $3,394 $(32) $276,135
Government National Mortgage
Association........................ 5.74 234,745 845 (26) 235,564
Federal Home Loan Mortgage
Corporation........................ 7.71 5,534 13 -- 5,547
-------- ------ ---- --------
$513,052 $4,252 $(58) $517,246
======== ====== ==== ========
</TABLE>
The contractual maturities of mortgage securities were approximately 28
years as of December 31, 1997. The expected maturities of mortgage securities
may differ from contractual maturities since borrowers have the right to prepay
the obligations.
Gross gains and losses on sales of securities were as follows (in
thousands):
<TABLE>
<CAPTION>
Year Ended For the period from
December 31, September 13, 1996
-------------- (inception) to
1998 1997 December 31, 1996
-------- ---- -------------------
<S> <C> <C> <C>
Gross gains................................. $ 222 $51 --
Gross losses................................ 15,490 -- --
-------- ---
Gains (losses) on the sale of mortgage and
other securities........................... $(15,268) $51 --
======== ===
</TABLE>
All mortgage securities were pledged as collateral under various borrowing
arrangements as described in Note 4. As of December 31, 1997, the unrealized
gain on available-for-sale securities as reported on the Company's balance
sheet included $159,000 in net unrealized gains on the investments of NFI
Holding Corporation.
53
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Note 4. Borrowings
Collateralized Mortgage Obligations (CMOs) The Company issues CMOs secured
by its mortgage loans as a means for long-term financing. For financial
reporting and tax purposes, the mortgage loans held as collateral for CMOs are
recorded as assets of the Company and the CMOs are recorded as debt. Interest
and principal on each CMO is payable only from principal and interest on the
underlying mortgage loans collateralizing the CMO. Interest rates reset monthly
and are indexed to one-month LIBOR. The estimated weighted-average months to
maturity is based on estimates and assumptions made by management. The actual
maturity may differ from expectations. However, the Company retains the option
to repay the CMO, and reacquire the mortgage loans, when the remaining unpaid
principal balance of the underlying mortgage loans falls below 35 percent of
their original amounts for issue 97-01 and 25 percent on 97-02, 98-01 and 98-
02.
Following is a summary of outstanding CMOs (dollars in thousands):
<TABLE>
<CAPTION>
Collateralized
Mortgage Obligation Mortgage Loans
----------------------- ---------------------------------
Estimated
Weighted Weighted
Remaining Interest Remaining Average Average Months
Principal Rate Principal Coupon to Maturity
----------- --------- --------- -------- --------------
<S> <C> <C> <C> <C> <C>
As of December 31, 1998:
NovaStar Home Equity
Series:
Issue 1997-1........ $ 163,419 5.88% $166,821 10.56% 29
Issue 1997-2........ 164,496 5.88 166,544 10.37 31
Issue 1998-1........ 268,152 5.69 272,742 10.01 35
Issue 1998-2........ 300,161 5.74 301,749 9.95 38
Unamortized debt
issuance costs,
net................ (4,284) -- -- -- --
-----------
$ 891,944
===========
As of December 31, 1997:
NovaStar Home Equity
Series:
Issue 1997-1........ $ 250,262 5.95% $252,166 10.28% 35
Issue 1997-2 (A).... 160,376 6.25 168,712 10.20 36
Unamortized debt
issuance costs,
net................ (1,771) -- -- -- --
-----------
$408,867
===========
</TABLE>
- --------
(A) Excludes $50 million of additional borrowings and mortgage loans added
during second closing for the transaction on January 20, 1998.
Short-term Financing Arrangements As of December 31, 1998, the Company had a
short-term financing arrangement with GMAC/Residential Funding Corporation
(GMAC/RFC) secured by residual interests in the Company's CMOs. In 1998, the
Company borrowed $15 million from GMAC/RFC. Under the terms of the agreement,
at maturity the Company will pay principal and a $3 million financing fee. The
$15 million in principal and the $3 million fee are included in borrowings in
the accompanying December 31, 1998 consolidated balance sheet. In connection
with the agreement, the Company issued 812,731 warrants to GMAC/RFC for the
purchase of the Company's stock at $4.63 per share. Originally, the agreement
matured on January 15, 1999 but was extended to February 28, 1999. Interest is
payable monthly at one-month LIBOR plus five percent (10.63 percent as of
December 31, 1998). The financing fee and the estimated value of the warrants
($813,000) were recognized as additional interest expense. The Company had no
other short-term borrowings outstanding as of December 31, 1998.
During 1998, the average daily balance for repurchase agreements secured by
mortgage securities, repurchase agreements secured by mortgage loans,
borrowings under the warehouse line of credit and other short-term borrowings
were $392,859,000, $118,380,000, $14,991,000, and $3,945,000, respectively.
54
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
As of December 31, 1997, the Company had a $300 million master repurchase
agreement with Merrill Lynch Mortgage Capital, Inc. and Merrill Lynch Credit
Corporation. Interest on borrowings under the master repurchase agreement was
paid at various rates priced in connection with respective purchases of
mortgage assets.
The Company also had a $75 million warehouse line of credit agreement with
First Union National Bank. Interest on advances under the line were based on
the Federal Funds rate. Other repurchase agreements were used to finance
mortgage securities bear interest at market rates and mature in 30 days to one
year.
The following tables summarize the Company's short-term borrowings as of
December 31, 1997 (dollars in thousands):
<TABLE>
<CAPTION>
Weighted Average Daily
Weighted Days to Balance During the
Average Reset or Year Ended
Rate Maturity Balance December 31, 1997
-------- -------- -------- ------------------
<S> <C> <C> <C> <C>
Repurchase agreements secured by
mortgage securities............. 5.92% 87 $501,430 $172,829
Master repurchase agreement
secured by mortgage loans....... 6.69 31 55,013 170,344
--------
Total repurchase agreements.. 556,443
Warehouse line of credit......... 7.09 Demand 40,250 18,402
--------
Total borrowings............. $596,693
========
</TABLE>
The Company is a co-borrower with NovaStar Mortgage under warehouse lending
and master repurchase agreements with First Union National Bank. The Company
and NovaStar Mortgage can borrower up to $75 million under the warehouse
lending agreement and $300 million under the master repurchase agreement. As of
December 31, 1998, the Company had no borrowings outstanding and NovaStar
Mortgage had borrowings of $203,341,000 outstanding under these arrangements.
Borrowings under these arrangements are secured by mortgage loans owned by the
Company or NovaStar Mortgage. The interest rate on borrowings under the
warehouse lending arrangement is indexed to the Federal funds rate. Under the
master repurchase agreement, borrowings are indexed to one-month LIBOR.
On February 12, 1999, the lending agreements with First Union National Bank
were renewed for a one-year term. The borrowing limit for the master repurchase
agreement was increased to $200 million. Interest rate structures for
borrowings under the agreements did not change. At the same time, two
additional one-year agreements were executed with First Union whereby the
Company and/or NovaStar Mortgage can borrow up to $20 million secured by
residual interests in asset-backed bonds issued by the Company, its affiliates
or subsidiaries. Borrowings under these arrangements bear interest at one-month
LIBOR plus five percent. The arrangements require NovaStar to maintain minimum
tangible net worth, meet equity ratio tests and comply with other customary
debt covenants. The Company was in compliance with the covenants as of February
12, 1999. In connection with executing the renewals and additional agreements,
the Company issued warrants to First Union to acquire 350,000 shares of
NovaStar common stock for $6.94 per share. In exchange for the new warrants,
First Union returned 186,667 warrants that were purchased in the Company's
private placement as described in Note 7. The new warrants expire on February
12, 2002.
Note 5. Financial Instruments with Off-balance-sheet Risk
The Company's interest rate swap and cap agreements and financial futures
contracts result in off-balance-sheet risk. These instruments involve, to
varying degrees, elements of credit and market risk in addition to the amount
recognized in the financial statements.
Credit Risk The Company's exposure to credit risk on interest rate swap and
cap agreements is limited to the cost of replacing contracts should the
counterparty fail. The Company seeks to minimize credit risk through the use of
credit approval and review processes, the selection of only the most
creditworthy counterparties,
55
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
continuing review and monitoring of all counterparties, exposure reduction
techniques and through legal scrutiny of agreements. Prior to engaging in
negotiated derivative transactions with any counterparty, The Company has in
place fully executed written agreements. Agreements with counterparties also
call for full two-way netting of payments. Under such agreements, on each
payment exchange date all gains and losses of a counterparty are netted into a
single amount, limiting exposure to the counterparty to any net positive value.
Financial futures contracts are exchange-traded, and, as such, credit risk
is considered nominal.
Market Risk The potential for financial loss due to adverse changes in
market interest rates is a function of the sensitivity of each position to
changes in interest rates, the degree to which each position can affect future
earnings under adverse market conditions, the source and nature of funding for
the position, and the net effect due to offsetting positions. The synthetic
product of these transactions is a "matched" position for The Company. The
combination of off-balance-sheet instruments with on-balance-sheet liabilities
leaves The Company in a market risk position that is designed to be a better
position than if the derivative had not been used in interest rate risk
management. Derivatives instruments used in matched transactions as described
above are classified as derivatives held for purposes other than trading. No
derivatives were held for trading purposes during the periods ended December
31, 1998, 1997 and 1996.
Other Risk Considerations The Company is cognizant of the risks involved
with financial derivatives. The Company's policies and procedures seek to
mitigate risk associated with the use of financial derivatives in ways
appropriate to its business activities, considering its risk profile as a
limited end-user.
Information regarding the Company's financial instruments with off-balance-
sheet risk is as follows.
<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>
As of December 31, 1998:
Interest rate cap
agreements............ $625,000 $1,194 $ -- 709 6.27% NA NA -- --
======== ====== ======
As of December 31, 1997:
Interest rate swap
agreements--fixed rate
pay................... $276,000 $ -- $1,380 670 NA 5.91% 6.27% $2,157 $2,291
Interest rate cap
agreements............ 270,000 1,268 -- 770 5.99% NA NA -- --
Financial futures
contracts:
Eurodollar March 1998.. 200,000 -- 20 77 NA NA NA NA NA
Eurodollar June 1998... 200,000 -- 46 168 NA NA NA NA NA
-------- ------ ------
$946,000 $1,268 $1,446
======== ====== ======
</TABLE>
During the year ended December 31, 1998 and 1997, the Company recognized
$2,891,000 and $1,047,000, respectively, in interest expense relating to off-
balance-sheet financial instruments. The Company terminated interest rate
agreements with an aggregate notional value of $469 million as a result of the
sale of the Company's portfolio of mortgage securities and repayment of the
related financing under repurchase agreements in 1998, incurring net losses of
$7,977,000.
Note 6. Fair Value of Financial Instruments
The following disclosure of the estimated fair value of financial
instruments presents amounts that have been determined using available market
information and appropriate valuation methodologies. However, considerable
judgment is required to interpret market data to develop the estimates of fair
value. Accordingly, the estimates presented herein are not necessarily
indicative of the amounts that could be realized in a current market exchange.
The use of different market assumptions or estimation methodologies could have
a material impact on the estimated fair value amounts.
56
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The estimated fair values of the Company's financial instruments are as
follows as of December 31 (in thousands):
<TABLE>
<CAPTION>
1998 1997
----------------- -----------------
Carrying Fair Carrying Fair
Value Value Value Value
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Financial assets:
Mortgage loans.......................... $920,697 $925,800 $574,984 $608,600
Mortgage securities..................... -- -- 517,246 517,200
Financial liabilities:
Collateralized mortgage obligations..... 891,944 883,000 408,867 409,300
Other borrowings........................ 18,000 18,000 -- --
Repurchase agreements................... -- -- 556,443 556,800
Warehouse line of credit................ -- -- 40,250 40,200
Off-balance-sheet financial
instruments............................ 1,157 1,200 -- (200)
</TABLE>
Market quotations were used to estimate the fair value of mortgage
securities. The fair value of all other financial instruments is estimated by
discounting projected future cash flows, including projected prepayments for
mortgage assets, at current market rates. The fair value of cash and cash
equivalents and accrued interest receivable and payable approximates its
carrying value.
Note 7. Stockholders' Equity
The Company was formed and capitalized by its founders in September 1996. In
December 1996, the Company successfully completed a private placement offering
of 3,549,999 units. Each unit consisted of one share of convertible preferred
stock and one warrant, which entitled the holder to purchase one share of
common stock for $15.00 per share. The underwriter received 100,000 warrants in
addition to underwriting discounts. The Company raised $47 million in the
offering, net of $3 million of offering costs. The warrants became exercisable
in February 1998 and remain exercisable until February 2001 at an exercise
price of $15.00 per share. During 1998, warrants to acquire 181 shares were
exercised as of December 31, 1998, 3,649,818 warrants remained outstanding and
exercisable.
Included in the units issued in the Company private placement were 108,333
units acquired by each of the two founders at a price of $15.00 per unit.
Payment was made by the founders delivering to the Company forgivable
promissory notes, bearing interest at eight percent per annum and secured by
the units acquired. Thereafter, interest is payable quarterly, upon forgiveness
or at maturity of the notes on December 31, 2001. During 1998, the Company
accrued interest on these notes totaling $189,000, of which the founders paid
$103,000. The principal amount of the notes is divided into three equal
tranches. Payment of principal on each tranche will be forgiven if certain
incentive targets are achieved. These notes have been reflected as a reduction
of stockholders' equity in the accompanying consolidated balance sheets. During
1997, the Company surpassed its first incentive target resulting in the
forgiveness of one-third of the notes and the recognition of compensation
expense in December 1997 of $1,083,000. The Company did not meet the incentive
targets in 1998 and, accordingly, no debt forgiveness occurred.
On December 1, 1997, the Company completed the sale of its common stock in
an initial public offering of 4,059,500 shares at a price of $18.00 per share.
The Company raised $67 million in net proceeds from this offering. Under the
provisions of the private placement agreements, the preferred stock
automatically converted to common stock at the closing of the initial public
offering. As a result, 3,549,999 shares of preferred stock were converted into
common stock on November 4, 1997.
57
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Note 8. Stock Option Plan
The Company's 1996 Stock Option Plan (the Plan) provides for the grant of
qualified incentive stock options (ISOs), non-qualified stock options (NQSOs),
deferred stock, restricted stock, performance shares, stock appreciation and
limited stock awards, and dividend equivalent rights (DERs). ISOs may be
granted to the officers and employees of the Company. NQSOs and awards may be
granted to the directors, officers, employees, agents and consultants of the
Company or any subsidiaries. Under the terms of the Plan the number of shares
available for issuance is equal to 10 percent of the Company's outstanding
common stock with a current cap on ISO grants at 339,332. Unless previously
terminated by the Board of Directors, the Plan will terminate on September 1,
2006.
All options have been granted at exercise prices greater than or equal to
the estimated fair value of the underlying stock at the date of grant.
Outstanding options vest over four years and expire ten years after the date of
grant. The following table summarizes option activity under the 1996 Plan for
1998, 1997 and 1996, respectively:
<TABLE>
<CAPTION>
1998 1997 1996
------------------ ----------------- ----------------
Weighted Weighted Weighted
Average Average Average
Shares Price Shares Price Shares Price
-------- -------- ------- -------- ------- --------
<S> <C> <C> <C> <C> <C> <C>
Outstanding at the
beginning of year....... 557,472 $15.22 334,332 $13.24 -- --
Granted.................. 148,000 9.38 225,640 18.00 334,332 $13.24
Exercised................ (300,582) 14.51 (2,500) 2.50 -- --
Canceled................. (21,070) 18.00 -- -- -- --
-------- ------ ------- ------ ------- ------
Outstanding at the end of
year.................... 383,820 $13.37 557,472 $15.22 334,332 $13.24
======== ====== ======= ====== ======= ======
Exercisable at the end of
year.................... 61,625 $15.70 298,082 $14.61 -- $ --
======== ====== ======= ====== ======= ======
</TABLE>
Certain options granted during 1998, 1997, and 1996 were granted with DERs.
Under the terms of the DERs, a recipient is entitled to receive additional
shares of stock upon the exercise of options. The DERs accrue at a rate equal
to the number of options outstanding times the dividends per share amount at
each dividend date. The accrued DERs convert to shares based on the stock's
fair value on the dividend declaration date. Certain options exercised in 1998
had DERs attached to them. As a result of these exercises, an additional 641
shares of common stock were issued in 1998. No DERs were converted to common
stock upon the exercise of options in 1997 and 1996. As discussed in Note 9,
the Company's two founders exercised options to acquire 289,332 shares of
common stock in 1998.
The following table presents information on stock options outstanding as of
December 31, 1998.
<TABLE>
<CAPTION>
Outstanding Exercisable
----------------------------- -----------------
Weighted
Average
Remaining Weighted Weighted
Contractual Average Average
Life Exercise Exercise
Quantity (years) Price Quantity Price
-------- ----------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
$0.01-$2.50............. 31,250 7.9 $ 1.90 8,750 $ 1.79
$6.38................... 108,000 10.0 6.38 -- --
$17.01-$20.81........... 244,570 8.9 17.92 52,875 18.00
------- ---- ------ ------ ------
Outstanding at the end
of year................ 383,820 9.1 $13.37 61,625 $15.70
======= ==== ====== ====== ======
</TABLE>
58
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
In accordance with generally accepted accounting principles, the Company has
chosen to not record the fair value of stock options at their grant date. If
recorded, the expense would not have been material and the Company's diluted
loss per share for 1998, 1997 and 1996 would have been unchanged. The following
table summarizes the weighted average fair value of the options granted during
1998, 1997 and 1996, determined using the Black-Scholes option pricing model
and the assumptions used in their determination.
<TABLE>
<CAPTION>
1998 1997 1996
----- ---- -----
<S> <C> <C> <C>
Weighted average:
Fair value.......................................... $4.59 $-- $0.18
Expected life in years.............................. 5 7 5
Annual risk-free interest rate...................... 5.1% 6.5% 7.0%
Volatility.......................................... 4.0 -- --
Dividend yield...................................... 5.0% 8.0% --
</TABLE>
Note 9. Related Party Transactions
The Company and NovaStar Mortgage, Inc. are parties to a mortgage loan
purchase and sale agreement, an administrative services outsourcing agreement
and loan servicing agreements. Under the terms of the mortgage loan purchase
and sale agreement, the Company purchases mortgage loans originated by NovaStar
Mortgage at prices that vary with the nature and terms of the underlying
mortgage loans. The agreement was modified effective January 1, 1998 to include
a purchase commitment fee. If NovaStar Mortgage chooses to retain the mortgage
loans it originates or sell them to third parties, it pays a fee to the Company
for not delivering its loan production under the purchase commitment. During
1998, NovaStar Mortgage originated $877 million, of which the Company acquired
approximately $500 million. During 1997, NovaStar Mortgage originated $735
million in subprime mortgage loans, all acquired by the Company.
Under the outsourcing services agreement, the Company pays NovaStar Mortgage
a fee for providing certain services, including the development of loan
products, underwriting, funding, and quality control. Under the terms of loan
servicing agreements, NovaStar Mortgage services loans owned by the Company.
Individual agreements have been executed for each pool of loans serving as
collateral for the Company's CMOs. A separate agreement exists between the
Company and NovaStar Mortgage for those loans that do not serve as collateral
for CMOs.
Following is a summary of the fees, in thousands, paid to and received from
NovaStar Mortgage.
<TABLE>
<CAPTION>
Year Ended
December 31,
--------------
1998 1997
------ ------
<S> <C> <C>
Amounts paid to NovaStar Mortgage:
Administrative fees..................................... $7,800 $3,650
Loan servicing fees..................................... 3,803 505
Amounts received from NovaStar Mortgage--purchase
commitment fee........................................... (5,117) --
------ ------
$6,486 $4,155
====== ======
</TABLE>
As discussed in Note 8, during 1998 the founders of the Company exercised
options to acquire 289,332 shares of common stock. In payment for the acquired
common stock, the founders issued notes payable to the Company. Unpaid
principal on the notes was $4,340,000 as of December 31, 1998. During 1998, the
Company accrued interest of $220,000 and the founders paid $78,000 in interest
on these notes.
As discussed in Note 7, during 1997 the founders issued notes payable to the
Company for the units acquired in the Company's private placement offering of
capital stock. In accordance with the terms of the
59
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
private placement, the Company agreed to advance funds for the payment of the
founders' personal tax liability arising from the forgiveness of the private
placement notes receivable. The founders have issued notes payable to the
Company for the repayment of the tax liability and interest accrued on
forgivable notes through December 31, 1997. Unpaid principal on the notes was
$843,000 and $763,000 as of December 31, 1998 and 1997, respectively. During
1998, the Company accrued interest on these amounts totaling $47,000 and the
founders paid interest totaling $18,000 on these notes.
Interest on notes due from founders accrues monthly at one-month LIBOR plus
one percent (6.54 percent as of December 31, 1998) and is payable quarterly.
The notes mature on the earlier of the founder's employment termination or
their sale of the common stock. Common stock of the Company owned by the
founders serves as collateral for the notes. The aggregate amounts due under
these arrangements was $5,354,000 and $763,000 as of December 31, 1998 and
1987, respectively, and are included as amounts due from founders in the
Company's consolidated balance sheets.
Note 10. Income Taxes
The Company has elected to be taxed as a REIT and accordingly has deducted
for income tax purposes, all dividends paid on its common and preferred stock.
Because the Company has paid or will pay dividends in amounts approximating its
taxable income or has a taxable loss, no provision for income taxes has been
provided in the accompanying financial statements for the years ended December
31, 1998 and 1997.
Note 11. Commitments and Contingencies
A dividend of $0.35 per share was declared by the Board of Directors during
September 1998 to be paid to stockholders of record on October 15, 1998.
Subsequently, the dividend was deferred and is scheduled for payment on April
15, 1999.
In the normal course of its business, the Company is subject to various
legal proceedings and claims, the resolution of which, in the opinion of
management, will not have a material adverse effect on the Company's financial
condition or results of operations.
The Company leases facilities and equipment under operating leases. Rent
expense and future obligations under these leases are not material to the
financial statements.
60
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Note 12. Condensed Financial Statements of NFI Holding Corporation
NFI Holding Corporation and its subsidiary, NovaStar Mortgage had no
operations, revenues or expenses prior to February 1997, when NovaStar Mortgage
began originating subprime mortgage loans through a network of wholesale
brokers and correspondents. Effective July 15, 1997, NovaStar Mortgage began
servicing mortgage loans on behalf of the Company. NFI Holding Corporation has
no operations of its own and, therefore, its consolidated financial statements
generally reflect the operations of NovaStar Mortgage. Following are the
condensed consolidated balance sheet and statement of operations of NFI Holding
Corporation for 1998 and 1997 (in thousands):
NFI Holding Corporation
Condensed Consolidated Balances Sheets
<TABLE>
<CAPTION>
December 31,
----------------
1998 1997
-------- -------
<S> <C> <C>
Assets
Cash and cash equivalents............................. $ 5,759 $ --
Restricted cash....................................... 33,007 20,424
Mortgage loans........................................ 216,839 --
Mortgage securities................................... -- 55,195
Other assets.......................................... 4,492 1,675
-------- -------
Total assets........................................ $260,097 $77,294
======== =======
Liabilities and Stockholders' Equity
Liabilities:
Borrowings............................................ $203,341 $53,490
Due to NovaStar Financial, Inc........................ 51,528 20,701
Accounts payable and other liabilities................ 5,215 915
Stockholders' equity.................................. 13 2,188
-------- -------
Total liabilities and stockholders' equity.......... $260,097 $77,294
======== =======
</TABLE>
NFI Holding Corporation
Condensed Consolidated Statements of Operations
<TABLE>
<CAPTION>
For the period from
February 6, 1997
Year Ended (inception) to
December 31, 1998 December 31, 1997
----------------- -------------------
<S> <C> <C>
Interest income.......................... $11,812 $1,136
Interest expense......................... 7,501 945
------- ------
Net interest income.................... 4,311 191
Other income:
Fees from third parties................ 2,829 1,271
Fees received from, net of paid to,
NovaStar Financial, Inc............... 6,486 4,155
Net gain on sales of mortgage assets... 3,148 --
------- ------
Total other income................... 12,463 5,426
General and administrative expenses...... 19,789 5,569
------- ------
Net income (loss) before taxes........... (3,015) 48
Income tax expense....................... -- 20
------- ------
Net income (loss)........................ $(3,015) $ 28
======= ======
</TABLE>
61
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Directors
NovaStar Financial, Inc.:
We have audited the accompanying consolidated balance sheets of NovaStar
Financial, Inc. and subsidiaries as of December 31, 1998 and 1997 and the
related consolidated statements of operations, stockholders' equity and cash
flows for the years ended December 31, 1998 and 1997 and the period from
September 13, 1996 (inception) to December 31, 1996. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of NovaStar
Financial, Inc. and subsidiaries as of December 31, 1998 and 1997 and the
results of their operations and their cash flows for the years ended December
31, 1998 and 1997 and the period from September 13, 1996 (inception) to
December 31, 1996, in conformity with generally accepted accounting principles.
KPMG LLP
Kansas City, Missouri
January 29, 1999, except for
the last paragraph of Note 4,
as to which the date is
February 12, 1999
62
<PAGE>
Item 9. Changes in and Disagreements With Accountants on Accounting and
Financial Disclosure
None
PART III
Item 10. Directors and Executive Officers of the Registrant
Information with respect to Item 401 of Regulation S-K is incorporated by
reference to the information included on NovaStar Financial's Proxy Statement
dated on or about March 25, 1999, for the Annual Meeting of Shareholders to be
held at 10 a.m., June 9, 1999, Sheraton Suites, 770 West 47th Street, Kansas
City, Missouri, 64111.
Item 11. Executive Compensation
Information with respect to Item 402 of Regulation S-K is incorporated by
reference to the information included on NovaStar Financial's Proxy Statement
dated on or about March 25, 1999, for the Annual Meeting of Shareholders to be
held at 10 a.m., June 9, 1999, Sheraton Suites, 770 West 47th Street, Kansas
City, Missouri, 64111.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Information with respect to Item 403 of Regulation S-K is incorporated by
reference to the information included on NovaStar Financial's Proxy Statement
dated on or about March 25, 1999, for the Annual Meeting of Shareholders to be
held at 10 a.m., June 9, 1999, Sheraton Suites, 770 West 47th Street, Kansas
City, Missouri, 64111.
Item 13. Certain Relationships and Related Transactions.
Information with respect to Item 404 of Regulation S-K is incorporated by
reference to the information included on NovaStar Financial's Proxy Statement
dated on or about March 25, 1999, for the Annual Meeting of Shareholders to be
held at 10 a.m., June 9, 1999, Sheraton Suites, 770 West 47th Street, Kansas
City, Missouri, 64111.
63
<PAGE>
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) Financial Statements and Schedules
(1) The financial statements as set forth under Item 8 of this report
on Form 10-K are included herein.
(2) The required financial statement schedules are omitted because they
are not applicable to NovaStar Financial.
(b) Reports on Form 8K
NovaStar Financial, Inc. has filed the following Form 8-K's during the
fourth quarter of 1998 and the first quarter of 1999:
. 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 need
filed on October 15, 1998.
. Regarding final term Loan and Security Agreement, between Novastar
Certificates Financing Corporation and Residential Funding Corporation
and related agreements filed on December 22, 1998.
. Regarding the announcement of the financing arrangement with First Union
National Bank and the filing of the material financing documents filed on
February 23, 1999.
(c) Exhibit Listing
<TABLE>
<CAPTION>
Exhibit
No. Description of Document
------- -----------------------
<C> <S>
3.1* Articles of Amendment and Restatement of the Registrant
3.2* Articles Supplementary of the Registrant
3.3* Bylaws of the Registrant
4.1* Specimen Common Stock Certificate
4.2* Specimen Warrant Certificate
10.1* Purchase Terms Agreement, dated December 6, 1996, between the
Registrant and the Placement Agent.
10.2* Registration Rights Agreement, dated December 9, 1996, between the
Registrant and the Placement Agent.
10.3* Warrant Agreement, dated December 9, 1996, between the Registrant
and the Holders of the Warrants Acting Through the Registrant as
the Initial Warrant Agent.
10.4* Founders Registration Rights Agreement, dated December 9, 1996,
between the Registrant and the original holders of Common Stock of
the Registrant.
10.5* Commitment Letter dated October 3, 1996 from General Electric
Capital Group accepted by the Registrant.
10.6* Form of Master Repurchase Agreement for mortgage loan financing
10.7* Mortgage Loan Warehousing Agreement dated as of November 24, 1997
between First Union National Bank of North Carolina, NovaStar
Mortgage, Inc. and the Registrant.
</TABLE>
64
<PAGE>
<TABLE>
<CAPTION>
Exhibit
No. Description of Document
------- -----------------------
<C> <S>
10.7a* Amendment No. 6 dated as of February 12, 1999 to Mortgage Loan
Warehousing Agreement dated as of February 20, 1997 between First
Union National Bank and Registrant.
10.8* Employment Agreement, dated September 30, 1996, between the
Registrant and Scott F. Hartman.
10.9* Employment Agreement, dated September 30, 1996, between the
Registrant and W. Lance Anderson.
10.10* Promissory Note by Scott F. Hartman to the Registrant, dated
December 9, 1996.
10.11* Promissory Note by W. Lance Anderson to the Registrant, dated
December 9, 1996.
10.12* Stock Pledge Agreement between Scott F. Hartman and the
Registrant, dated December 9, 1996.
10.13* Stock Pledge Agreement between W. Lance Anderson and the
Registrant, dated December 9, 1996.
10.14* 1996 Executive and Non-Employee Director Stock Option Plan, as
last amended December 6, 1996.
10.15* Administrative Services Outsourcing Agreement, dated June 30,
1997, between the Registrant and NovaStar Mortgage, Inc.
10.16* Mortgage Loan Sale and Purchase Agreement, dated as of June 30,
1997, between the Registrant and NovaStar Mortgage, Inc.
10.17* Flow Loan Subservicing Agreement, dated as of June 30, 1997,
between the Registrant and NovaStar Mortgage, Inc.
10.18* Certificate of Incorporation of NFI Holding Corporation.
10.19* Agreement of Shareholders of Common Stock NFI Holding Corporation.
10.20* Term Loan and Security Agreement between NovaStar Certificates
Financing Corporation and Reliance Funding Corporation dated as of
October 13, 1998 and related agreements including Guaranty of even
date by Registrant.
10.21* Addendum to Master Repurchase Agreement dated as of February 12,
1999 among NovaStar Financial, Inc., NovaStar Capital, Inc. and
NovaStar Mortgage, Inc., as sellers, and First Union National
Bank, as buyer.
10.22* Form of Addendum to Master Repurchase Agreement dated as of
February 12, 1999 between Registrant's taxable affiliate, as
seller, and First Union Bank, as buyer, with respect to the
residual interest on certain asset-backed bonds.
10.23* Warrant Agreement dated as of February 12, 1999 between the
Registrant and First Union National Bank.
11.1 Statement regarding computation of per share earnings.
21.1* Subsidiaries of the Registrant (set forth in Form 10-K).
23.1* Consent of Tobin & Tobin, a professional corporation.
23.2* Consent of Piper & Marbury, LLP
23.3* Consent of Jeffers, Wilson, Shaff & Falk, LLP
23.4 Consent of KPMG, LLP
27.1 Financial Data Schedule
</TABLE>
- --------
*Previously filed.
65
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
(Registrant)
<TABLE>
<CAPTION>
Signature Title Date
--------- ----- ----
<S> <C> <C>
/s/ Rodney E. Schwatken Vice President, Controller April 1, 1999
____________________________________ and Assistant Treasurer
Rodney E. Schwatken (Chief Accounting Officer)
</TABLE>
66
<PAGE>
Exhibit 23.4
Accountants' Consent
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The Board of Directors
NovaStar Financial, Inc.
We consent to the incorporation by reference in the Registration Statement No.
333-44977 on Form S-8 of NovaStar Financial, Inc. of our report dated January
29, 1999, except for the last paragraph of Note 4, as to which the date is
February 12, 1999, relating to the consolidated balance sheets of NovaStar
Financial, Inc. and subsidiaries as of December 31, 1998 and 1997 and the
related consolidated statements of operations, stockholders' equity, and cash
flows for the years ended December 31, 1998 and 1997 and the period from
September 13, 1996 (inception) to December 31, 1996, which report appears in the
December 31, 1998 Annual Report on Form 10-K of NovaStar Financial, Inc.
/s/ KPMG LLP
April 1, 1999
