<PAGE>
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
----------------
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 1999.
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to .
Commission File Number: 001-13533
NovaStar Financial, Inc.
(Exact name of registrant as specified in its charter)
----------------
Maryland 74-2830661
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
66205
1901 W. 47th Place, (Zip Code)
Suite 105, Westwood, KS
(Address of principal executive
offices)
(913) 362-1090
(Registrant's telephone number, including area code)
----------------
(Former name, former address and former fiscal year, if changed since last
report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
The number of shares of the registrant's common stock outstanding as of May
10, 1999 was 8,130,069.
- -------------------------------------------------------------------------------
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<PAGE>
NOVASTAR FINANCIAL, INC.
FORM 10-Q
QUARTER ENDED MARCH 31, 1999
INDEX
<TABLE>
<CAPTION>
Page
----
<S> <C> <C>
PART I FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements:
Balance Sheets......................................................................... 1
Statements of Operations............................................................... 2
Statements of Cash Flows............................................................... 3
Notes.................................................................................. 4
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.. 6
Item 3. Quantitative and Qualitative Disclosures about Market Risk............................. 38
PART II OTHER INFORMATION
Item 1. Legal Proceedings...................................................................... II-1
Item 2. Changes in Securities.................................................................. II-1
Item 3. Defaults Upon Senior Securities........................................................ II-2
Item 4. Submission of Matters to a Vote of Security Holders.................................... II-2
Item 5. Other Information...................................................................... II-2
Item 6. Exhibits and Reports on Form 8-K....................................................... II-2
Signatures............................................................................. II-3
</TABLE>
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share amounts)
<TABLE>
<CAPTION>
March 31, 1999 December 31, 1998
-------------- -----------------
(unaudited)
<S> <C> <C>
Assets
Cash and cash equivalents................... $ 2,403 $ --
Mortgage loans, net......................... 847,744 920,697
Accrued interest receivable................. 9,357 9,702
Due from affiliates......................... 61,071 51,528
Investment in NFI Holding Corporation....... 2,147 13
Assets acquired through foreclosure......... 14,173 10,583
Amounts due from founders................... 5,561 5,354
Other assets................................ 1,867 4,359
-------- ----------
Total assets.............................. $944,323 $1,002,236
======== ==========
Liabilities and Stockholders' Equity
Liabilities:
Collateralized mortgage obligations......... $819,899 $ 891,944
Residual interest financing................. -- 18,000
Dividends payable........................... 2,876 2,845
Accounts payable and accrued expenses....... 1,836 2,157
-------- ----------
Total liabilities......................... 824,611 914,946
Stockholders' equity:
Capital stock, $0.01 par value, 50,000,000
shares
authorized:
Preferred stock, 4,285,714 shares of Class B
7% cumulative convertible preferred
stock issued and outstanding as of
March 31, 1999 with a redemption and
liquidation value of $7 per share.......... 43 --
Common stock, 8,130,069 shares issued and
outstanding................................ 81 81
Additional paid-in capital.................. 151,247 122,180
Accumulated deficit......................... (31,108) (32,804)
Accumulated other comprehensive income...... 1,616 --
Forgivable notes receivable from founders... ( 2,167) (2,167)
-------- ----------
Total stockholders' equity................ 119,712 87,290
-------- ----------
Total liabilities and stockholders'
equity................................... $944,323 $1,002,236
======== ==========
</TABLE>
See notes to consolidated financial statements.
1
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited; in thousands, except per share amounts)
<TABLE>
<CAPTION>
For the Three
Months Ended
March 31,
----------------
1999 1998
------- -------
<S> <C> <C>
Interest income:
Mortgage loans.............................................. $19,550 $14,550
Mortgage securities......................................... -- 9,364
------- -------
Total interest income......................................... 19,550 23,914
Interest expense.............................................. 13,209 18,442
------- -------
Net interest income........................................... 6,341 5,472
Provision for credit losses................................... 2,299 1,076
------- -------
Net interest income after provision for credit losses......... 4,042 4,396
Other income.................................................. 935 364
Equity in earnings (loss) of NFI Holding Corporation.......... 551 (271)
General and administrative expenses:
Loan servicing fees paid to NovaStar Mortgage, Inc.......... 1,115 630
Fees for other services provided by NovaStar Mortgage,
Inc........................................................ 1,050 1,500
Compensation and benefits................................... 585 436
Professional and outside services........................... 332 56
Other loan servicing expenses............................... 470 44
Forgiveness of notes receivable from founders............... -- 271
Office administration....................................... 208 181
Other....................................................... 42 92
------- -------
Total general and administrative expenses................. 3,802 3,210
------- -------
Net income.................................................... $ 1,726 $ 1,279
======= =======
Preferred stock dividends..................................... (31) --
------- -------
Income available to common stockholders....................... $ 1,695 $ 1,279
======= =======
Basic earnings per common share............................... $ 0.21 $ 0.16
======= =======
Diluted earnings per common share............................. $ 0.20 $ 0.15
======= =======
Dividends declared per common share........................... $ -- $ 0.30
======= =======
</TABLE>
See notes to consolidated financial statements.
2
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited; in thousands)
<TABLE>
<CAPTION>
For the Three
Months
Ended March 31,
------------------
1999 1998
------- ---------
<S> <C> <C>
Net cash provided by operating activities $ 5,812 $ 2,913
Cash flow from investing activities:
Mortgage loans purchased from NovaStar Mortgage, Inc..... -- (208,632)
Mortgage loan repayments................................. 57,029 22,515
Mortgage loans sold to others............................ 4,545 --
Sales of assets acquired through foreclosure............. 3,757 --
Purchases of available-for-sale securities............... -- (293,992)
Proceeds from sales of available-for-sale securities..... -- 315,573
Proceeds from paydowns on and maturities of available-
for-sale securities..................................... -- 63,892
Net change in amounts due from affiliates................ (7,427) (3,570)
------- ---------
Net cash provided by (used in) investing activities...... 57,904 (104,214)
Cash flow from financing activities:
Proceeds from issuing collateralized mortgage
obligations............................................. -- 50,000
Payments on collateralized mortgage obligations.......... (72,395) (29,324)
Debt issuance costs paid on collateralized mortgage
obligations............................................. -- (367)
Change in short-term borrowings.......................... (18,029) 85,646
Proceeds from issuance of capital stock and exercise of
equity instruments,
net of offering costs of 1,240.......................... 29,111 7
Dividends paid........................................... -- (783)
------- ---------
Net cash provided by (used in) financing activities...... (61,313) 105,179
------- ---------
Net increase in cash and cash equivalents................ 2,403 3,878
Cash and cash equivalents, beginning of period........... -- --
Cash and cash equivalents, end of period................. $ 2,403 $ 3,878
======= =========
Supplemental disclosure of cash flow information:
Note received in exchange for options exercised by
founders................................................ $ -- $ 4,340
======= =========
Cash paid for interest................................... $13,487 $ 18,543
======= =========
Dividends payable........................................ $ 2,876 $ 2,436
======= =========
Assets acquired through foreclosure...................... $ 7,270 $ 1,524
======= =========
</TABLE>
See notes to consolidated financial statements.
3
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 1999 (Unaudited)
Note 1. Financial Statement Presentation
The consolidated financial statements as of and for the periods ended March
31, 1999 and 1998 are unaudited. In the opinion of management, all adjustments
have been made which were of a normal and recurring nature, necessary for a
fair presentation of the balance sheets and results of operations. The
consolidated financial statements should be read in conjunction with
Management's Discussion and Analysis of Financial Condition and Results of
Operations and the consolidated financial statements of NovaStar Financial and
the notes thereto, included in NovaStar Financial's annual report to
shareholders and annual report on Form 10-K for the fiscal year ended December
31, 1998.
NovaStar Financial owns 100 percent of the common stock of three special
purpose entities NovaStar Assets Corporation, NovaStar Certificates Financing
Corporation and NovaStar Mortgage Funding Corporation. NovaStar Financial
formed these entities in connection with the issuance of collateralized
mortgage obligations. The consolidated financial statements of NovaStar
Financial include the accounts of these entities. Significant intercompany
accounts and transactions have been eliminated in consolidation.
NovaStar Financial owns 100 percent of the preferred stock of NFI Holding
Corporation for which it receives 99 percent of any dividends paid by NFI
Holding. The founders of NovaStar Financial own the voting common stock of NFI
Holding. NovaStar Mortgage, Inc. and NovaStar Capital, Inc. are wholly owned
subsidiaries of NFI Holding. NovaStar Mortgage Funding Corporation II and
NovaStar REMIC Financing Corporation are subsidiaries of NovaStar Mortgage.
NovaStar Financial accounts for its investment in Holding using the equity
method.
Note 2. Stockholders' Equity
In March 1999, NovaStar Financial issued 4,285,714 shares of Class B 7%
cumulative convertible preferred stock. The preferred shares have no voting
rights, are senior to any other class of NovaStar Financial capital stock and
have a stated and liquidation value of $7 per share. Each holder of the
preferred stock is entitled to quarterly dividends that accrue at 7% per annum
on the stated value. Holders of the Class B preferred shares have the right, at
any time, to convert all or a portion of their preferred stock into an equal
number of shares of common stock. NovaStar Financial has the right to redeem
the Class B preferred stock at any time on or after March 31, 2002 at a price
of $7.00 per share, payable in cash.
Comprehensive income includes net income and revenues, expenses, gains and
losses that are not included in net income. Currently, the only component of
comprehensive income for NovaStar Financial is the net change in the unrealized
gain (loss) on available-for-sale securities. Following is a summary of
comprehensive income for the three months ended March 31, 1999 and 1998.
<TABLE>
<CAPTION>
For the Three Months
Ended March, 31
--------------------
1999 1998
--------------------
<S> <C> <C>
Net income............................................. $ 1,726 $ 1,279
Other comprehensive income--net change in unrealized
gain (loss) on available-for-sale securities.......... 1,616 (4,108)
--------- ----------
Comprehensive income (loss)............................ $ 3,342 $ (2,829)
========= ==========
</TABLE>
4
<PAGE>
Note 3. Earnings Per Share
The computations of basic and diluted EPS computations for the three months
ended March 31, 1999 and 1998 are as follows (in thousands, except per share
amounts):
<TABLE>
<CAPTION>
For the three months
ended March 31,
----------------------
1999 1998
---------- ----------
<S> <C> <C>
Numerator:
Net Income.............................................. $ 1,726 $ 1,279
Less: Preferred stock dividends......................... (31) --
---------- ----------
Income available to common
stockholders--basic ................................... $ 1,695 $ 1,279
========== ==========
Plus: Preferred stock dividends......................... 31 --
---------- ----------
Income available to common
stockholders--diluted.................................. $ 1,726 $ 1,279
========== ==========
Denominator:
Weighted average common
shares outstanding--basic.............................. 8,130 7,855
========== ==========
Warrants................................................ 232 708
Stock options........................................... 22 97
Convertible preferred stock............................. 254 --
---------- ----------
Weighted average common
shares outstanding--dilutive .......................... 8,638 8,660
========== ==========
Basic earnings per share................................ $ 0.21 $ 0.16
========== ==========
Diluted earnings per share.............................. $ 0.20 $ 0.15
========== ==========
</TABLE>
The following stock options and warrants to purchase shares of common stock
were outstanding during each period presented, but were not included in the
computation of diluted earnings per share because the options' weighted-average
exercise price was greater than the average market price of the common shares
for the periods presented, therefore, the effect would be antidilutive (in
thousands, except per share amounts):
<TABLE>
<CAPTION>
Three months ended
March 31,
--------------------
1999 1998
---------- ---------
<S> <C> <C>
Number of stock options and warrants........................ 4,417 --
Weighted average exercise price............................. $11.61 --
</TABLE>
5
<PAGE>
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion should be read in conjunction with the preceding
consolidated financial statements of NovaStar Financial and the accompanying
notes as well as NovaStar Financial's annual report to shareholders and annual
report on form 10-K for the fiscal year ended December 31, 1998.
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 Financial is
leveraged, the needs for and availability of financing, access to capital and
other risks identified in NovaStar Financial'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
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 Financial'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
Financial as an investment option and to compare NovaStar Financial 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. A significant component of the financial results of NovaStar Financial
are derived from the operations of NovaStar Mortgage, Inc. 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.
A separate section of this MD&A discusses the financial results of NovaStar
Mortgage.
6
<PAGE>
Description of Business
Business of NovaStar Financial:
. NovaStar Financial was founded in 1996 as a specialty finance lender to
invest in mortgage assets;
. NovaStar Financial's assets have primarily come from the wholesale
origination of single-family nonconforming loans by its affiliate,
NovaStar Mortgage;
. NovaStar Financial operates as a long-term portfolio investor;
. NovaStar Financial's loans are financed on a short-term basis through a
mortgage loan repurchase facility. Long-term financing is provided
through securitization where asset-backed bonds are issued in financing-
structured transactions;
. Earnings are generated from spread income on the mortgage loan portfolio
and indirectly by gains associated with the sale of loans to outside
parties or through securitization transactions of NovaStar Mortgage.
Business of NovaStar Mortgage:
. NovaStar Mortgage's customer is the retail mortgage broker who deals
with the borrower. NovaStar Mortgage's account executives work with over
3,000 brokers to solicit loans.
. NovaStar Mortgage's borrowers generally are individuals or families who
do not qualify for agency/conventional lending programs because of a
lack of available documentation or previous credit difficulties. Often,
these borrowers have built up high-rate consumer debt and are attempting
to use equity in their home to consolidate debt and lower their total
monthly payments.
. NovaStar Mortgage's loans are financed on a short-term basis through
warehouse facilities. Long-term financing is provided through
securitization where asset-backed bonds are issued in transactions that
are structured as a sale.
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 is divided into three equal parts, called "tranches",
and 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. NovaStar recorded
a non-cash charge of $271,000 to earnings during the three months ended March
31, 1998 in anticipation of the forgiveness of the second tranche. However, as
a result of NovaStar Financial's significant loss in the fourth quarter of 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. NovaStar Financial
has not recognized any forgiveness of the second tranche in 1999 because
management is uncertain of whether the incentive performance targets will be
met.
7
<PAGE>
Financial Condition of NovaStar Financial, Inc. as of March 31, 1999 and
December 31, 1998
NovaStar Financial's balance sheets at March 31, 1999 and December 31, 1998
primarily consist of mortgage loans purchased from NovaStar Mortgage, which
serve as collateral on its collateralized mortgage obligations. The carrying
value of mortgage loans at March 31, 1999 was $848 million versus $921 million
at December 31, 1998. The carrying value of collateralized mortgage obligations
at March 31, 1999 was $820 million at March 31, 1999 compared with $892 million
at December 31, 1998. The decline in both balance sheet items is primarily a
result of principal paydowns that occurred during the first quarter of 1999.
Table 1 is a presentation of loans as of March 31, 1999 and December 31,
1998 and their credit grades. Table 2 is a summary of all mortgage loans owned
by NovaStar Financial as of March 31, 1999 and December 31, 1998 by state.
Table 1
Mortgage Loans by Credit Grade
(dollars in thousands)
<TABLE>
<CAPTION>
March 31, 1999 December 31, 1998
--------------------------- ---------------------------
Weighted Weighted
Allowed Weighted Average Weighted Average
Mortgage Maximum Loan- Current Average Loan-to- Current Average Loan-to-
Credit Grade Lates (A) to-value Principal Coupon value Principal Coupon value
------------ --------------- ------------- --------- -------- -------- --------- -------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
AA...................... 0 x 30 95(B) $ 109,172 9.53% 83.5% $117,172 9.51% 83.4%
A....................... 1 x 30 90 330,437 9.86 79.7 356,994 9.84 79.7
A....................... 2 x 30 90 198,285 10.31 81.5 214,627 10.31 81.3
B....................... 3 x 30, 1x 60 85 124,250 10.66 78.1 138,497 10.62 77.9
5 x 30, 2 x 60,
C....................... 1 x 90 75 58,280 11.18 72.4 62,784 11.13 72.3
D....................... 6 x 30, 3 x 60, 65 11,853 12.09 62.0 13,328 12.14 62.2
2 x 90
--------- --------
Total................... $ 832,277 10.17% 79.6% $903,402 10.15% 79.5%
========= ===== ==== ======== ===== ====
</TABLE>
- --------
A Represents the number of times NovaStar Financial 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 Fixed purchases; all other maximum of 90%.
Table 2
Mortgage Loans by State
Percent of Portfolio (based on current principal balance)
<TABLE>
<CAPTION>
March 31, 1999 and
Collateral Location December 31, 1998
- ------------------- ------------------
<S> <C>
California................................................... 18%
Florida...................................................... 12
Washington................................................... 8
Oregon....................................................... 5
All other states............................................. 57
---
Total...................................................... 100%
===
</TABLE>
8
<PAGE>
Table 3 provides a summary of NovaStar Financial's mortgage loans by type
and carrying value as of March 31, 1999 and December 31, 1998.
Table 3
Carrying Value of Loans by Product/Type
March 31, 1999 and December 31, 1998 (in thousands)
<TABLE>
<CAPTION>
March 31, December 31,
Product/Type 1999 1998
------------ --------- ------------
<S> <C> <C>
Two- and three-year fixed............................ $471,002 $511,824
Six-month LIBOR and one-year CMT..................... 75,201 88,958
30/15-year fixed and balloon......................... 286,074 302,620
-------- --------
Outstanding principal.............................. 832,277 903,402
Premium.............................................. 18,959 20,868
Allowance for credit losses.......................... (3,492) (3,573)
-------- --------
Carrying Value..................................... $847,744 $920,697
======== ========
Carrying value as a percent of principal............. 101.86% 101.91%
======== ========
</TABLE>
During the first half of 1998, NovaStar Financial purchased securities as a
temporary use of capital from its initial public offering. As NovaStar
Financial's capital was deployed for mortgage loan acquisition, NovaStar
Financial discontinued purchasing securities. In October 1998, NovaStar
Financial was forced to sell all of its securities due to the liquidity crisis
faced by the capital markets. Since that time, as indicated in the table below,
NovaStar Financial has not purchased any additional securities.
Table 4 is a summary of the securities acquired during 1999 and 1998 by
quarter.
Table 4
Mortgage Security Acquisitions
Three Months Ended March 31, 1999 and 1998 (dollars in thousands)
<TABLE>
<CAPTION>
Net Weighted
Price Average
Principal Premium Discount to Par Coupon
--------- ------- -------- ------- --------
<S> <C> <C> <C> <C> <C>
1999:
First quarter.................... $ -- $ -- $ -- -- -- %
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
</TABLE>
Short-term Financing Arrangements. NovaStar Financial is a co-borrower with
NovaStar Mortgage under warehouse lending and master repurchase agreements with
First Union National Bank which are scheduled to mature in February 2000. As of
March 31, 1999, NovaStar Financial and NovaStar Mortgage can borrow up to $75
million under the warehouse lending agreement and $300 million under the master
9
<PAGE>
repurchase agreement. NovaStar Financial had no borrowings outstanding as of
March 31, 1999 and December 31, 1998, and NovaStar Mortgage had borrowings of
$65,155,000 and $203,341,000 outstanding, respectively under these
arrangements. Borrowings under these arrangements are secured by mortgage
loans. 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, two additional one-year agreements were executed with
First Union whereby NovaStar Financial and/or NovaStar Mortgage can borrow up
to $20 million secured by residual interests in CMOs issued by NovaStar
Financial, its affiliates or subsidiaries. Borrowings under these arrangements
bear interest at one-month LIBOR plus five percent. As of March 31, 1999,
NovaStar Financial had no borrowings under this financing arrangement. In
connection with executing the renewals and additional agreements, NovaStar
Financial 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 NovaStar Financial's 1996
private placement. The new warrants expire on February 12, 2002.
All arrangements with First Union require NovaStar Financial and NovaStar
Mortgage to maintain minimum tangible net worth, meet equity ratio tests and
comply with other customary debt covenants.
As of December 31, 1998, NovaStar Financial also had a short-term financing
arrangement with GMAC/Residential Funding Corporation (GMAC/RFC) secured by
residual interests in NovaStar Financial's CMOs. In 1998, NovaStar Financial
borrowed $15 million from GMAC/RFC, which included a $3 million financing fee.
In connection with the agreement, NovaStar Financial issued 812,731 warrants to
GMAC/RFC for the purchase of NovaStar Financial's stock at $4.63 per share.
NovaStar Financial had no other short-term borrowings outstanding as of
December 31, 1998. In February of 1999, NovaStar Financial used financing
sources at First Union to pay this debt in full.
Collateralized mortgage obligations. 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. As a result, 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 Financial retains the mortgage loans and incurs the
obligation to pay the CMO bondholders. NovaStar Financial earns the net spread
between the interest income on the loans and the interest expense on the bonds.
The spread earned also is reduced by credit losses on the portfolio.
Prepayments on the mortgage loans serve to reduce the term over which interest
spread is earned. The longer the mortgage collateral is outstanding, the longer
the period of cash flow. To the extent the borrowers prepay, it shortens the
life of the CMO and the period over which cash flow is received. The cash flow
will change when interest rates on the bonds fluctuate at amounts or times that
are different from the mortgage loan collateral, thereby subjecting NovaStar
Financial to interest rate risk.
10
<PAGE>
Following is a summary of outstanding CMOs as of March 31, 1999 and December
31, 1998 (dollars in thousands):
Table 5
Collateralized Mortgage Obligations
March 31, 1999 and December 31, 1998 (dollars in thousands)
<TABLE>
<CAPTION>
Collateralized Mortgage Obligation Mortgage Loans
-------------------------------------- ------------------
Estimated Weighted Weighted
Remaining Interest Average Months Remaining Average
Principal Rate to Call Principal Coupon
--------- -------- ------------------ --------- --------
<S> <C> <C> <C> <C> <C>
As of March 31, 1999:
NovaStar Home Equity
Series:
Issue 1997-1.......... $141,994 5.19% 27 $146,350 10.64%
Issue 1997-2.......... 147,394 5.19 29 153,355 10.36
Issue 1998-1.......... 248,060 5.01 33 253,709 10.16
Issue 1998-2.......... 286,384 5.05 37 291,419 10.08
Unamortized debt
issuance costs, net.. (3,933)
--------
$819,899
========
As of December 31, 1998:
NovaStar Home Equity
Series:
Issue 1997-1.......... $163,419 5.88% 29 $166,821 10.56%
Issue 1997-2.......... 164,496 5.88 31 166,544 10.37
Issue 1998-1.......... 268,152 5.69 35 272,742 10.01
Issue 1998-2.......... 300,161 5.74 38 301,749 9.95
Unamortized debt
issuance costs, net.. (4,284)
--------
$891,944
========
</TABLE>
NovaStar Financial 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 6, 7, 8 and 9 for the impact of
principal payments on amortization. To mitigate the effect of prepayments on
interest income from mortgage loans, NovaStar Financial generally strives to
acquire mortgage loans that have some form of prepayment penalty. During the
three months ended March 31, 1999, NovaStar Financial collected $656,000 in
prepayment penalties from borrowers compared with the $200,000 during the same
period of 1998. Table 6 is an analysis of mortgage loans and prepayment
penalties. Prepayments on mortgage loans have generally been consistent with
management's expectations.
11
<PAGE>
Table 6
Mortgage Loan Prepayment Penalties
March 31, 1999 and December 31, 1998 (dollars in thousands)
<TABLE>
<CAPTION>
Weighted Average
-----------------------------------
Remaining
Prepayment Penalty
Percent with Period (in years)
Current Prepayment Loan-to- - Loans with
Principal Premium Penalty Coupon value Penalty
--------- ------- ------------ ------ -------- ------------------
<S> <C> <C> <C> <C> <C> <C>
As of March 31, 1999
Loans collateralizing
NovaStar Home Equity
Series (CMO):
1997-1................ $142,019 $ 6,972 63% 10.64% 75.1% 0.80
1997-2................ 149,392 3,118 73 10.36 78.6 0.94
1998-1................ 249,901 4,295 69 10.05 81.1 1.34
1998-2................ 289,815 4,524 72 9.95 81.1 1.93
All other loans......... 1,150 50 49 11.31 76.8 0.87
-------- -------
Total................... $832,277 $18,959 70% 10.17% 79.6% 1.38
======== =======
<CAPTION>
Weighted Average
-----------------------------------
Remaining
Prepayment Penalty
Percent with Period (in years)
Current Prepayment Loan-to- - Loans with
Principal Premium Penalty Coupon value Penalty
--------- ------- ------------ ------ -------- ------------------
<S> <C> <C> <C> <C> <C> <C>
As of December 31, 1998
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>
In periods of decreasing interest rates, borrowers are more likely to
refinance their mortgages to obtain a better interest rate. Even in rising rate
environments, borrowers tend to collectively repay their mortgage principal
balances earlier than is required by the terms of their mortgages. This is
particularly true for subprime borrowers who are seeking to upgrade their
credit rating to obtain a lower interest rate.
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, the CPR for 1998-1 in December 1998 was 20. This means that if you
ascribe the prepayment of loans for that month for one year, 20% of the loans
outstanding at the beginning of the year would prepay during the year.
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.
12
<PAGE>
Table 7
Prepayment Speeds
<TABLE>
<CAPTION>
Weighted Constant Prepayment Rate
Average Age (Annual Percent)
Current of Loans at -------------------------
Principal Inception One- Three- Twelve-
Issue Date Balance (in months) month month month Life
----------------- --------- ----------- ----- ------ ------- ----
<S> <C> <C> <C> <C> <C> <C> <C>
As of March 31, 1999
NovaStar Home Equity
Series:
1997-1................ October 1, 1997 $142,019 7 45 40 37 33
1997-2................ December 11, 1997 149,392 3 25 27 26 22
1998-1................ April 30, 1998 249,901 3 26 24 -- 15
1998-2................ August 18, 1998 289,815 3 15 12 -- 10
As of December 31, 1998
NovaStar Home Equity
Series:
1997-1................ October 1, 1997 $162,423 7 44 36 33 31
1997-2................ December 11, 1997 163,049 3 42 32 22 21
1998-1................ April 30, 1998 270,640 3 20 17 -- 12
1998-2................ August 18, 1998 301,527 3 18 10 -- 9
</TABLE>
To mitigate exposure to prepayment risk, NovaStar attempts to retain those
borrowers whose credit is considered desirable. NovaStar Financial encourages
borrowers who have satisfactorily met their obligations to refinance or rate
modify their loans with NovaStar Financial. Of the loans that prepaid during
the first quarter of 1999, $783,000, or 2% of the loans were successfully
refinanced. No loans were rate-modified during the period. 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 7, they remain in NovaStar Financial's loan portfolio.
13
<PAGE>
Table 8 summarizes mortgage asset activity during 1999 and 1998 and Table 9
details the amount of premium as a percent of principal at quarter end for 1999
and 1998.
Table 8
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, 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
======== ======= ========= ======= ========== =======
Acquisitions............ -- -- -- -- -- --
Principal repayments and
amortization........... (66,679) (1,830) -- -- (66,679) (1,830)
Dispositions............ (4,446) (79) -- -- (4,446) (79)
-------- ------- --------- ------- ---------- -------
Balance, March 31,
1999................... $832,277 $18,959 $ -- $ -- $ 832,277 $18,959
======== ======= ========= ======= ========== =======
</TABLE>
Table 9
Premium as a Percent of Principal
<TABLE>
<CAPTION>
Total
Mortgage Mortgage Mortgage
Loans Securities Assets
-------- ---------- --------
<S> <C> <C> <C>
As of:
March 31, 1999................................... 2.28% --% 2.28%
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
</TABLE>
14
<PAGE>
Stockholders' equity. During the first quarter of 1999, NovaStar Financial
increased its equity from $87 million at December 31, 1998 to $120 million at
March 31, 1999. This was primarily a result of the issuance of 4,285,714 shares
of Class B 7% cumulative convertible preferred stock in March 1999. Gross
proceeds on the issuance aggregated $30 million. The issuance of these
preferred shares will have an impact on future earnings per share as discussed
under "Net Income" below.
Also, included in the accumulated other comprehensive income component of
stockholders' equity as of March 31, 1999 is NovaStar Financial's portion of
the unrealized gain on available-for-sale securities held by NovaStar Mortgage.
NovaStar Mortgage sold its first asset backed bonds in January 1999, which for
accounting and tax purposes was treated as a sale. The residual interests in
those transactions have been classified as available-for-sale securities.
Residual interests are discussed further under "Financial Statement Condition
as of March 31, 1999 and December 31, 1998--NovaStar Mortgage, Inc."
Results of Operations of NovaStar Financial, Inc.--Three Months Ended March 31,
1999 Compared to the Three Months Ended March 31, 1998
Net Income
During the three months ended March 31, 1999, NovaStar Financial recorded
net income of $1.7 million, $0.20 per diluted share, compared with net income
of $1.3 million, $0.15 per diluted share, for the three months ended March 31,
1998. In computing earnings per share, shares issued during the period are
weighted for the portion of the period they are outstanding. If the preferred
shares would have been outstanding for the entire first quarter of 1999,
NovaStar Financial's pro forma diluted earnings per share for the three months
ended March 31, 1999, would have been $0.14 per share.
NovaStar Financial's main sources of revenue are interest earned on its
securitized mortgage loan portfolio and prepayment penalty income. In addition,
results indirectly reflect gains from the sale of whole loan packages to third
parties and securitizations of NovaStar Mortgage.
15
<PAGE>
Net Interest Income
Table 10 presents a summary of the average interest-earning assets, average
interest-bearing liabilities and the related yields and rates thereon for the
three months ended March 31, 1999 and 1998.
Table 10
Interest Analysis
Three Months Ended March 31, 1999 and 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/
March 31, 1999 Balance Expense Rate Balance Expense Rate Balance Expense Rate
- -------------- -------- -------- ------ -------- -------- ------ ---------- -------- ------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Interest-earning
mortgage assets........ $830,558 $19,550 9.42% $ -- $ -- --% $ 830,558 $19,550 9.42%
======== ======== ==========
Interest-bearing
liabilities
Repurchase
agreements............ $ -- $ -- --% $ -- $ -- --% $ -- $ -- --%
Collateralized
mortgage
obligations........... 862,559 12,139 5.63 -- -- -- 862,559 12,139 5.63
Other borrowings....... 17,051 490 11.47 -- -- -- 17,051 490 11.47
Cost of derivative
financial
Instruments hedging
liabilities........... 580 580
------- -------
Total borrowings..... $879,610 $13,209 6.01 $ -- $ 879,610 $13,209 6.01
======== ------- ----- ======== ========== ======= -----
Net interest income.... $ 6,341 $ -- $ 6,341
======= =======
Net interest spread.... 3.41% --% 3.41%
===== ==== =====
Net yield.............. 3.05% -- % 3.05%
===== ==== =====
<CAPTION>
Mortgage Loans Mortgage Securities Total
------------------------ ------------------------ --------------------------
Interest Annual Interest Annual Interest Annual
Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/
March 31, 1998 Balance Expense Rate Balance Expense Rate Balance Expense Rate
- -------------- -------- -------- ------ -------- -------- ------ ---------- -------- ------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Interest-earning
mortgage assets........ $619,666 $14,550 9.39% $582,264 $9,364 6.43% $1,201,930 $23,914 7.96%
======== ======== ==========
Interest-bearing
liabilities
Repurchase
agreements............ $136,145 $ 1,836 5.39% $589,267 8,421 5.72% $ 725,412 $10,257 5.66%
Collateralized
mortgage
obligations........... 435,940 7,214 6.62 -- -- -- 435,940 7,214 6.62
Other borrowings....... 27,173 324 4.77 -- -- -- 27,173 324 4.77
-------- -------- ----------
Cost of derivative
financial
Instruments hedging
liabilities........... 467 180 647
------- ------ -------
Total borrowings..... $599,258 $ 9,841 6.57 $589,267 8,601 5.84 $1,188,525 $18,422 6.21
======== ------- ----- ======== ------ ========== ======= -----
Net interest income.... $ 4,709 $ 763 $ 5,472
======= ====== =======
Net interest spread.... 2.82% 0.59% 1.75%
===== ==== =====
Net yield.............. 3.04% 0.52% 1.82%
===== ==== =====
</TABLE>
16
<PAGE>
Interest income. Average interest-earning assets were $830.6 million during
the three months ended March 31, 1999, all of which were mortgage loans,
compared with average interest-earning assets of $1.2 billion for the same
period of 1998, which included $582.3 million of mortgage securities. As
mentioned earlier, NovaStar Financial sold all of its mortgage securities in
October 1998 to meet short-term liquidity needs faced in the fourth quarter of
1998. Accordingly, no interest income was recognized on mortgage securities
during the three months ended March 31, 1999. Mortgage securities earned $9.4
million for the months ended March 31, 1998, or a yield of 6.4%. During the
three months ended March 31, 1999, mortgage loans earned $19.6 million, or a
yield of 9.4%, compared with $14.6 million, or a yield of 9.4% for the same
period of 1998. In total, assets earned $19.6 million, or an 9.4% yield for
three months ended March 31, 1999. During the same period of 1998, assets
earned $23.9 million or a 8.0% 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.
As noted in Table 10, 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 $13.2 million during the
three months ended March 31, 1999, or 6.0% of average borrowings, compared with
$18.4 million for the same period of 1998, or 6.2% of average borrowings. The
make up of interest expense is significantly different for the three months
ended March 31, 1999 compared with same period of 1998. This is due to the
following factors:
. The majority of mortgage loans serve as collateral on collateralized
mortgage obligations at March 31, 1999. At March 31, 1998, 60% of
mortgage loans served as collateral on collateralized mortgage
obligations while the remaining loans served as collateral on higher-
rate warehouse and repurchase facility debt. The change in financing
composition is primarily due to the fact that NovaStar Financial
discontinued purchasing mortgage loans from NovaStar Mortgage during the
last half of 1998. Prior to that point in time, NovaStar Financial had
purchased 100% of NovaStar Mortgage's loan production. Loans held in
portfolio prior to securitization were financed by repurchase
facilities. Under agreements with NovaStar Mortgage, NovaStar Financial
reimbursed NovaStar Mortgage for its warehousing costs incurred prior to
sale. Repurchase and warehouse facility costs for the three months ended
March 31, 1998 are included under repurchase agreements and other
borrowings in Table 10.
. NovaStar sold all its mortgage securities in October 1998 and paid off
all related repurchase financing on these assets. No mortgage securities
have been purchased since that time.
. Due to the liquidity crisis faced in the last quarter of 1998,
GMAC/Residential Funding Corporation provided additional financing under
a residual line that was secured by mortgage interests in NovaStar's
asset-backed bonds. This debt was paid off in February 1999 with funds
from a similar facility provided by First Union National Bank. The
interest on this facility during the three months ended is included as a
component of other borrowings in Table 10.
Advances under the warehouse line of credit bear interest based on the
federal funds rate plus a spread. NovaStar Financial and NovaStar Mortgage
receive credits 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 the three months ended March 31,
1999, the one-month LIBOR averaged 4.95 percent compared with 5.65 percent for
the three months ended March 31, 1998. 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. Rates on other borrowings generally
fluctuate with short-term market interest rates, such as LIBOR or the federal
funds rate.
17
<PAGE>
Net interest income and spread. Net interest income during the three months
ended March 31, 1999 was $6.3 million or 3.0% of average interest-earning
assets, compared with $5.5 million, or 1.8% of average interest-earning assets
during the same period of 1998. Net interest spread was 3.4% during the three
months ended March 31, 1999 compared with 1.8% during the three months ended
March 31, 1998. The significant increase in net margin and spread for the three
months ended March 31, 1999 compared with the three months ended March 31, 1998
is due to the change in NovaStar Financial's asset and liability composition.
During the latter part of 1998, NovaStar Financial sold all mortgage securities
and paid off related financing. NovaStar Financial has not purchased any more
of these lower-yielding mortgage assets. Net interest income and the spread are
functions of asset yields relative to its costs of funds. 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.
Impact of interest rate agreements. NovaStar Financial has entered into
interest rate agreements 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. These agreements are used to alter, in
effect, the interest rates on funding costs to more closely match the yield on
interest-earning assets.
During the three months ended March 31, 1999 and 1998, net interest expense
was incurred on hedging agreements of $580,000 and $647,000, respectively,
which is included as a component of interest expense. The following table
provides details of the interest rate agreements as of March 31, 1999 and
December 31, 1998.
Table 11
Interest Rate Agreements
March 31, 1999 and December 31, 1998
(dollars in thousands)
<TABLE>
<CAPTION>
Unrealized
------------
Weighted
Notional Days to Cap
Value Gains Losses Maturity Rate
-------- ----- ------ -------- ----
<S> <C> <C> <C> <C> <C>
As of March 31, 1999:
Interest rate cap agreements............... $625,000 $-- $1,914 644 6.27%
======== ==== ======
As of December 31, 1998:
Interest rate cap agreements............... $625,000 $-- $2,483 734 6.27%
======== ==== ======
</TABLE>
Other Income
Other income during the three months ended March 31, 1999 primarily consists
of prepayment penalties of $656,000, net gains recognized on the sale of real
estate owned properties of $77,000, interest earned on securitization funds
held in trust of $57,000, and interest earned on notes receivable from founders
of $120,000. Other income for the same period of 1998 primarily consisted of
prepayment penalties of $200,000, net gains on mortgage security sales of
$92,000 and interest earned on notes receivable from founders of $57,000.
Provisions for Credit Losses
NovaStar Financial 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 Financial'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.
Losses upon final liquidation are reflected in earnings. Foreclosed assets are
recorded at the lower of the remaining unpaid loan balance or the estimated net
realizable value of the foreclosed asset.
18
<PAGE>
During the three months ended March 31, 1999, NovaStar Financial provided
$2.3 million to the allowance for credit losses, compared with $1.0 million
during the same period of 1998. The increase is due partly to the increase in
NovaStar Financial's securitized mortgage loan portfolio, overall seasoning of
the portfolio and changes in the timing of foreclosures. Management has
accelerated provisions in 1999 in recognition of this trend to ensure the
credit allowance is maintained at an adequate level. Charge-offs during the
three months ended March 31, 1999 were $2.4 million compared with $518,000
during the same period of 1998. Management believes the increases in charge-
offs are principally for the same reasons as discussed for the loan loss
provision.
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 March 31,
1999 and December 31, 1998, approximately 27% and 26% of the loans owned by
NovaStar Financial and substantially all of the loans owned by NovaStar
Mortgage are covered under this agreement. During the three months ended March
31, 1999, total premiums paid to CMAC totaled $457,000 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 March 31, 1999, NovaStar Financial had 149 loans in real estate owned
with a carrying value of $14.2 million compared with 126 loans with a carrying
value of $10.6 million as of December 31, 1998.
Table 12 is a rollforward of the allowance for credit losses during 1999 and
1998.
Table 12
Rollforward of Allowance for Credit Losses
1999 and 1998
<TABLE>
<CAPTION>
1999 1998
-------- -----------------------------------------
June
March 31 December 31 September 30 30 March 31
-------- ----------- ------------ ------ --------
<S> <C> <C> <C> <C> <C>
Beginning balance.......... $3,573 $2,757 $3,341 $2,871 $2,313
Provision for credit
losses.................... 2,299 4,030 1,179 1,145 1,076
Amounts charged off, net
of recoveries............. (2,380) (3,214) (1,763) (675) (518)
------ ------ ------ ------ ------
Ending Balance............. $3,492 $3,573 $2,757 $3,341 $2,871
====== ====== ====== ====== ======
</TABLE>
Loans owned by NovaStar Financial are serviced by NovaStar Mortgage. Details
regarding the delinquencies, defaults, and loss statistics of the loan
servicing portfolio are presented in Tables 21 and 22, in "Financial Condition
of NovaStar Mortgage as of March 31, 1999 and December 31, 1998".
19
<PAGE>
General and Administrative Expenses
General and administrative expenses for the three months ended March 31,
1999 and 1998 are provided in Table 13. Table 14 displays the relationship of
portfolio expenses to net interest income during 1999 and 1998 by quarter.
Table 13
General and Administrative Expenses
(dollars in thousands)
<TABLE>
<CAPTION>
Three Months Ended Three Months Ended
March 31, 1999 March 31, 1998
------------------- -------------------
Percent of Percent of
Net Interest Net Interest
Income Income
------------ ------------
<S> <C> <C> <C> <C>
Compensation and benefits............. $ 585 9.2% $ 436 8.0%
Professional and outside services..... 332 5.2 56 1.0
Other loan servicing.................. 470 7.4 44 0.8
Office administration................. 208 3.3 181 3.3
Other................................. 42 0.7 92 1.7
------ ---- ------ ----
Total portfolio-related expenses...... 1,637 25.8% 809 14.8%
==== ====
Forgiveness of notes receivable from
founders............................. -- 271
Fees for services provided by NovaStar
Mortgage, Inc........................ 2,165 2,130
------ ------
Total................................ $3,802 $3,210
====== ======
</TABLE>
Table 14
Portfolio Related Expenses as a
Percent of Net Interest Income
1999 and 1998
<TABLE>
<CAPTION>
Percent of Net
Interest Income
---------------
<S> <C>
1998:
First quarter............................................. 25.8%
1998:
1998...................................................... 25.6%
Fourth quarter............................................ 89.7
Third quarter............................................. 22.3
Second quarter............................................ 20.1
First quarter............................................. 14.8
</TABLE>
Compensation and benefits includes employee base salaries, benefit costs and
incentive compensation awards. The increase in compensation and benefits for
the three months ended March 31, 1999 compared with the same period of 1998 is
primarily due to salary increases and bonus accruals.
Other loan servicing for the three months ended March 31, 1999 consists
principally of the fees paid to CMAC as discussed under the "Provisions for
Credit Losses." For the same period of 1998, these fees included 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.
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. The
significant increase in the first quarter of 1999 is a result of legal fees
incurred on the
20
<PAGE>
structuring of various financing arrangements, the filing of shelf registration
statements and general company growth. Office administration includes items
such as rent, depreciation, telephone, office supplies, postage, delivery,
maintenance and repairs.
The following is a summary of the fees, in thousands, paid to NovaStar
Mortgage for the three months ended March 31, 1999 and 1998:
<TABLE>
<CAPTION>
Three Months
Ended March 31,
---------------
1999 1998
------- -------
<S> <C> <C>
Amounts paid to NovaStar Mortgage:
Loan servicing fees..................................... $ 1,115 $ 630
Administrative fees..................................... 1,050 1,500
------- -------
$ 2,165 $ 2,130
======= =======
</TABLE>
The fees for services provided by NovaStar Mortgage represent the following:
. Administrative fees for services, including the development of loan
products, underwriting, funding, and quality control.
. Servicing fees to NovaStar Mortgage. NovaStar Mortgage receives 50 basis
points on the collected principal balance of loans serviced for NovaStar
Financial.
The increase in loan servicing fees paid to NovaStar Mortgage for the three
months ended March 31, 1999 compared with the three months ended March 31, 1998
is due to the increase in NovaStar Financial's mortgage loan portfolio serviced
by NovaStar Mortgage.
The decline in the administrative fees paid to NovaStar Mortgage during
these same periods is a result of the reduction in NovaStar Mortgage's
production volumes as indicated in Table 17. The decline in first quarter 1999
originations reflect decisions made by management as a result of constrained
liquidity circumstances the subprime mortgage industry faced during the latter
part of 1998. Accordingly, the administrative fees NovaStar Financial paid to
NovaStar Mortgage during this same period were reduced.
Equity in Earnings (Loss) of NFI Holding Corporation
For the three months ended March 31, 1999, NFI Holding recorded net income
of $557,000 compared with a net loss of $274,000 for the same period of 1998.
NovaStar Financial records its portion of the income (loss) as equity in net
earnings (loss) of NFI Holding in its income statement. NFI Holding's net
income (loss) includes the net earnings of NovaStar Mortgage and NovaStar
Capital, Inc., subsidiaries of NFI Holding as discussed under "Basis of
Presentation". NFI Holding's financial position and results of operation for
the three month period ended March 31, 1999 and 1998 are discussed further
under the heading "NFI Holding Corporation".
21
<PAGE>
Taxable Income (Loss)
Income reported for financial reporting purposes as calculated in accordance
with generally accepted accounting principles (GAAP) differs from income
computed for income tax purposes. This distinction is important as dividends
paid are based on taxable income. Table 15 is a summary of the differences
between net income or loss reported for GAAP and taxable income for 1999 and
1998.
Table 15
Taxable Income (Loss)
1999 and 1998 (in thousands)
<TABLE>
<CAPTION>
1999 1998
------- -----------------------------------
First Fourth Third Second First
Quarter Quarter Quarter Quarter Quarter
------- -------- ------- ------- -------
<S> <C> <C> <C> <C> <C>
Net income (loss)................ $1,726 $(27,388) $2,394 $1,894 $1,279
Results of NFI Holding and
subsidiaries.................... (551) 320 2,447 -- 271
Provision for credit losses...... 2,299 4,030 1,179 1,145 1,076
Loans charged-off................ (2,380) (3,214) (1,763) (675) (518)
Capital losses................... -- 14,963 -- -- --
Other, net....................... 381 (370) 96 208 (2)
------ -------- ------ ------ ------
Estimated taxable income (loss).. $1,475 $(11,659) $4,353 $2,572 $2,106
====== ======== ====== ====== ======
</TABLE>
The net loss realized during the 1998 fourth quarter resulted in NovaStar
Financial incurring a net loss for both financial reporting and income tax
purposes for the 1998 fiscal year. NovaStar Financial has a net operating loss
carryforward of approximately $2.6 million available to offset taxable income
in 1999, and thereby reduce the amount of required distributions under REIT
guidelines. In addition, the $0.35 per common share, $2.8 million dividend paid
on April 15, 1999 represents a distribution of 1999 taxable income.
NFI Holding Corporation
Since NovaStar Financial discontinued its original strategy of purchasing
loans from NovaStar Mortgage and holding them in portfolio in the latter part
of 1998, NovaStar Mortgage has had a larger impact on NovaStar Financial's
operational results. Instead of selling loans to NovaStar Financial, NovaStar
Mortgage has sold loans to outside third parties. Through its indirect equity
ownership of NFI Holding, NovaStar Financial has shared in the profits of
NovaStar Mortgage's loan sales.
22
<PAGE>
The following table presents NFI Holding's consolidated financial statements
as of March 31, 1999 and 1998, which primarily consist of the assets,
liabilities, and operational results of NovaStar Mortgage. Accordingly, the
discussion that follows focuses on NovaStar Mortgage.
Table 16
NFI Holding Corporation
Condensed Consolidated Balance Sheets (in thousands)
<TABLE>
<CAPTION>
March 31, December 31,
1999 1998
----------- ------------
(unaudited)
<S> <C> <C>
Assets
Cash and cash equivalents............................ $ 249 $ 5,759
Restricted cash...................................... 28,300 33,007
Mortgage loans....................................... 87,456 216,839
Mortgage securities (available-for-sale)............. 9,860 --
Other assets......................................... 6,860 4,492
-------- --------
Total assets..................................... $132,725 $260,097
======== ========
Liabilities and Stockholders' Equity
Liabilities:
Borrowings......................................... 65,155 203,341
Due to NovaStar Financial, Inc..................... 61,071 51,528
Accounts payable and other liabilities............. 4,352 5,215
Stockholders' equity............................... 2,147 13
-------- --------
Total liabilities and stockholders' equity....... $132,725 $260,097
======== ========
</TABLE>
NFI Holding Corporation
Condensed Consolidated Statements of Operations
Three months ended March 31 (unaudited; in thousands)
<TABLE>
<CAPTION>
1999 1998
------ -----
<S> <C> <C>
Interest income.................................................. $2,745 $ 990
Interest expense................................................. 1,561 874
------ -----
Net interest income.......................................... 1,184 116
Income:
Fees from third parties........................................ 342 680
Administrative servicing fees received from NovaStar
Financial..................................................... 2,165 2,130
Net gain on sales of mortgage loans............................ 2,847 --
------ -----
Total Income................................................. 5,354 2,810
General and administrative expenses.............................. 5,747 3,200
------ -----
Income (loss) before taxes....................................... 791 (274)
Income tax expense............................................... 234 --
------ -----
Net income or (loss)............................................. $ 557 $(274)
====== =====
</TABLE>
23
<PAGE>
Financial Condition of NovaStar Mortgage, Inc. as of March 31, 1999 and
December 31, 1998
Mortgage Loan Originations. NovaStar Mortgage originated more than 800
subprime residential mortgage loans during the three months ended March 31,
1999 with an aggregate principal amount of $82 million. Virtually all of
NovaStar Mortgage's mortgage assets at March 31, 1999 and December 31, 1998
consist of subprime mortgage loans that will be sold directly to independent
buyers of whole loans or through securitization transactions that are treated
for tax and accounting purposes as sales.
Table 17 is a summary of wholesale loan originations for 1999 and 1998.
Table 18 presents a summary of mortgage loan sales of NovaStar Mortgage during
1999 and 1998. Table 19 is a summary of loan costs for NovaStar Mortgage
relative to its wholesale loan originations.
Table 17
1999 and 1998 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>
1999:
First quarter......... 865 $ 82,495 $ 95 100.5 81% 4.95 9.88% 89%
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%
===== ======== ==== ===== === ==== ===== ===
</TABLE>
- --------
(A) AAA=7, AA=6, A=5, A-=4, B=3, C=2, D=1
24
<PAGE>
Table 18
Mortgage Loan Sales to Third Parties--NovaStar Mortgage, Inc.
Three Months Ended March 31, 1999 and Year Ended December 31, 1998
(dollars in thousands)
<TABLE>
<CAPTION>
Weighted
Average Percent
Principal Gain Price To Gain of
Amount Recognized Par Principal
--------- ---------- -------- ---------
<S> <C> <C> <C> <C>
1999:
First quarter......................... $ 73,743 $1,576 103.6 2.14%
1998:
Fourth quarter........................ $108,800 $1,985 103.6 1.82%
Third quarter......................... 18,133 826 106.0 4.56
Second quarter........................ 6,742 173 106.0 2.57
First quarter......................... -- -- -- --
-------- ------ ----- ----
1998 total............................ $133,675 $2,984 104.0 2.23%
======== ====== ===== ====
</TABLE>
Table 19
Costs of Loan Production NovaStar--Mortgage, Inc.
Three Months Ended March 31, 1999 and Year Ended December 31, 1998
(dollars in thousands)
<TABLE>
<CAPTION>
1999 1998
------- --------------------------------------
First Fourth Third Second First
Quarter Quarter Quarter Quarter Quarter
------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
Total costs of loan
production (A).............. $ 4,778 $ 6,723 $ 4,975 $ 3,837 $ 3,079
Wholesale loan origination--
principal................... 82,495 133,739 240,498 294,303 207,974
Premium paid to broker....... 441 1,043 3,439 3,679 2,935
------- -------- -------- -------- --------
Total acquisition cost (B)... $87,714 $141,505 $248,912 $301,819 $213,988
======= ======== ======== ======== ========
Costs as a percent of
principal:
Loan production............ 5.8% 5.0% 2.1% 1.3% 1.5%
=== === === === ===
Premium paid to broker..... 0.5% 0.8% 1.4% 1.3% 1.4%
=== === === === ===
Total acquisition cost..... 6.3% 5.8% 3.5% 2.6% 2.9%
=== === === === ===
</TABLE>
- --------
(A) Loan production general and administrative expenses as reported for GAAP,
plus net deferred loan costs.
(B) Principal, premium and general and administrative expenses associated with
loan production.
Table 20 is a summary of loans originated by NovaStar Mortgage by state for
1999 and 1998 by quarter. NovaStar Mortgage has continued to add more account
executives throughout the United States. As of March 31, 1999, NovaStar
Mortgage had 62 account executives covering nearly 40 states.
25
<PAGE>
Table 20
Mortgage Loan Originations by State--NovaStar Mortgage, Inc.
1999 and 1998
<TABLE>
<CAPTION>
Percent of Total Originations during Quarter
(based on original principal balance)
------------------------------------------------------
1999 1998
-------- -------------------------------------------
Collateral Location First Fourth Third Second First
- ------------------- -------- --------- -------- --------- --------
<S> <C> <C> <C> <C> <C>
Florida............... 15% 24% 17% 16% 12%
Michigan.............. 12 6 5 5 5
Tennessee............. 9 6 4 4 4
Ohio.................. 8 9 4 5 2
California............ 6 2 6 9 15
Pennsylvania.......... 4 5 4 3 2
North Carolina........ 2 4 5 3 2
Washington............ 3 3 5 6 7
Texas................. 2 3 5 3 3
All other states...... 39 38 45 46 48
</TABLE>
- --------
(A) Loans originated by NovaStar Mortgage, Inc.
NovaStar Mortgage's loan originations are funded through warehouse and
repurchase facilities at First Union and are discussed further in "Financial
Condition of NovaStar Financial as of March 31, 1999 and December 31, 1998" and
"Results of Operations of NovaStar Financial, Inc.--Three Months Ended March
31, 1999 Compared to the Three Months Ended March 31, 1998".
Mortgage Loan Sales. In a securitization executed by NovaStar Mortgage
during the first quarter of 1999, $165 million in loans were sold to a Special
Purpose Entity (SPE), of which $26 million settled in April 1999. Proceeds of
bonds issued by the SPE, $160 million, were used to pay for the mortgage loans
acquired from NovaStar Mortgage. The loans were sold without recourse by
NovaStar Mortgage. NovaStar Mortgage retained a residual certificate issued by
the SPE. As the owner of the residual certificate, NovaStar Mortgage will
receive the net cash flow of the SPE--the cash received from the mortgage loans
less interest, loan losses and other costs related to bond administration.
NovaStar Mortgage also retained loan servicing rights for the loans sold to the
SPE. The value of the retained interests--the residual certificate and the
mortgage servicing rights--have been recorded as assets and the loans sold have
been removed from the balance sheet of NovaStar Mortgage.
NovaStar Mortgage allocates its basis in the mortgage loans between the
portion of the mortgage loans sold and the retained assets based on the
relative fair values of those portions at the time of sale. An active market
exists for this type of mortgage loan sale and, therefore, their value was
estimated based on prevailing market prices. Management is not aware of an
active market for the purchase of residual certificates and mortgage servicing
rights. The values of these assets were determined by discounting estimated
future cash flows using the cash out method. Following are the significant
values and assumptions used in determining the values of the assets sold and
values of the resulting retained assets.
<TABLE>
<S> <C>
Estimated average value of mortgage loans sold.................... 103.0%
Assumptions used in determining future cash flow:
Estimated prepayment speeds................................... 30 to 35 CPR
Estimated rate of default..................................... 70 CDR
Discount rate................................................... 16.5%
Value of residual certificate................................... $ 9,700,000
Value of mortgage servicing rights.............................. $ 646,000
Aggregate gain.................................................. $ 1,605,000
</TABLE>
26
<PAGE>
Of the aggregate gain recognized in the securitization, $355,000 will be
recorded upon the April closing.
The value of the residual interest has been classified as an available-for-
sale mortgage security on NovaStar Mortgage's balance sheet and had a carrying
value of $9.9 million as of March 31, 1999.
NovaStar Mortgage also sold more than $73 million of its whole loan
portfolio to unrelated third parties for cash.
Mortgage loan servicing. Loan servicing is also a critical part of NovaStar
Mortgage's business. The majority of the loans serviced by NovaStar Mortgage
are owned by NovaStar Financial. In the opinion of management, maintaining
contact with borrowers is vital 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. NovaStar Mortgage
strives to identify issues and trends with borrowers early and take quick
action to address such matters.
Table 21 is a summary of delinquent loans in NovaStar Mortgage's servicing
portfolio as of March 31, 1999 and 1998 by quarter. Table 22 provides
summaries of delinquencies, defaults, and loss statistics as of March 31, 1999
and 1998 by quarter. The information presented in both tables include mortgage
loans owned by NovaStar Financial and its affiliates. Other information
regarding the credit quality of NovaStar Financial's mortgage loans is
provided in Table 1.
Table 21
Loan Delinquencies (90 days and greater) (A)
March 31, 1999 and 1998
<TABLE>
<CAPTION>
1999 1998
-------- -----------------------------------------
March 31 December 31 September 30 June 30 March 31
-------- ----------- ------------ ------- --------
<S> <C> <C> <C> <C> <C>
Mortgage loans
collateralizing NovaStar
Home Equity series (CMO):
1997-1 (Issued October 1,
1997).................... 4.37% 5.45% 5.97% 5.86% 4.39%
1997-2 (Issued December
11, 1997)................ 5.38 5.62 4.97 4.72 2.23
1998-1 (Issued April 30,
1998).................... 4.64 4.44 2.06 -- --
1998-2 (Issued August 18,
1998).................... 3.72 2.35 0.40 -- --
1999-1 (Issued January 29,
1999) (B)................ 2.35 -- -- -- --
All loans in servicing
portfolio.................. 5.00 3.35 2.45 2.53 2.28
</TABLE>
- --------
A) Includes loans in foreclosure or bankruptcy.
B) This securitization was treated as a sale under SFAS 125 and accordingly
the mortgage loans and related liability are not included on NovaStar's
balance sheet.
27
<PAGE>
Table 22
Delinquencies, Defaults and Losses
March 31, 1999 and December 31, 1998
(dollars in thousands)
<TABLE>
<CAPTION>
NovaStar Home Equity Series (A)
--------------------------------------
March 31, 1999 1997-1 1997-2 1998-1 1998-2 1999-1 Other (C) All Loans
-------------- -------- -------- -------- -------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C> <C>
Loan servicing portfolio (B)........... $147,609 $167,685 $254,837 $291,747 $136,279 $ 74,237 $1,072,393
======== ======== ======== ======== ======== ========== ==========
Allowance for Credit Losses:
Balance, December 31, 1998............ $ 816 $ 1,049 $ 1,163 $ 346 $ -- $ 353 $ 3,727
Provision for credit losses........... 450 458 768 617 -- 176 2,469
Amounts charged off, net of
recoveries........................... (597) (707) (696) (302) -- 21 (2,281)
-------- -------- -------- -------- -------- ---------- ----------
Balance, March 31, 1999............... $ 669 $ 800 $ 1,235 $ 661 $ -- $ 550 $ 3,915
======== ======== ======== ======== ======== ========== ==========
Defaults as a percent of loan servicing
Delinquent loans...................... 6.74% 5.07% 3.42% 3.51% 3.97% 1.91% 4.12%
==== ==== ==== ==== ==== ==== ====
Loans in foreclosure.................. 3.29 3.84 4.08 3.28 2.26 2.66 3.39
==== ==== ==== ==== ==== ==== ====
Real estate owned..................... 3.54 3.07 2.00 0.52 -- 1.13 1.66
==== ==== ==== ==== === ==== ====
<CAPTION>
NovaStar Home Equity Series (A)
--------------------------------------
December 31, 1998 1997-1 1997-2 1998-1 1998-2 Other (C) All Loans
----------------- -------- -------- -------- -------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C> <C>
Loan servicing portfolio (B)............ $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 1,388 7,640
Amounts charged off, net of
recoveries........................... (2,142) (2,175) (715) 124 (1,318) (6,226)
-------- -------- -------- -------- -------- ----------
Balance, December 31, 1998............ $ 816 $ 1,049 $ 1,163 $ 346 $ 353 $ 3,727
======== ======== ======== ======== ======== ==========
Defaults as a percent of loan servicing
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 1.21
==== ==== ==== ==== ==== ====
</TABLE>
<TABLE>
<CAPTION>
1999 1998
-------- -----------------------------------------
March 31 December 31 September 30 June 30 March 31
-------- ----------- ------------ ------- --------
<S> <C> <C> <C> <C> <C>
Total defaults:
Delinquent loans........... 4.12% 4.40% 2.95% 1.95% 1.92%
==== ==== ==== ==== ====
Loans in foreclosure....... 3.39 2.25 2.02 2.28 2.29
==== ==== ==== ==== ====
Real estate owned.......... 1.66 1.21 0.81 0.52 0.24
==== ==== ==== ==== ====
</TABLE>
- --------
(A) Loans owned by NovaStar Financial
(B) Includes assets acquired through foreclosure
(C) Includes loans owned by NovaStar Financial and NovaStar Mortgage
28
<PAGE>
The following table presents a summary of the mortgage loan activity of
NovaStar Mortgage for 1999 and 1998.
Table 23
Mortgage Loan Activity--NovaStar Mortgage, Inc.
(dollars in thousands)
<TABLE>
<CAPTION>
1999 1998
------------------ ------------------
Principal Premium Principal Premium
--------- ------- --------- -------
<S> <C> <C> <C> <C>
Balance, January 1...... $ 206,495 $ 3,114 $ -- $ --
Originations............ 82,495 997 207,976 3,758
Sales to NovaStar
Financial, Inc......... -- -- (207,976) (3,758)
Sales to third parties.. (204,280) (2,759) -- --
Principal repayments and
amortization........... (1,963) (45) -- --
--------- ------- --------- -------
Balance, March 31....... $ 82,747 $ 1,307 $ -- $ --
Originations............ 294,303 5,207
Sales to NovaStar
Financial, Inc......... (290,350) (5,148)
Sales to third parties.. (3,953) (59)
Principal repayments and
amortization........... -- --
--------- -------
Balance, June 30........ $ -- $ --
Originations............ 240,498 4,035
Sales to NovaStar
Financial, Inc......... -- --
Sales to third parties.. (12,836) (517)
Principal repayments and
amortization........... (1,567) (7)
--------- -------
Balance, September 30... $ 226,095 $ 3,511
Originations............ 133,739 1,821
Sales to NovaStar
Financial, Inc......... -- --
Sales to third parties.. (116,886) (2,156)
Principal repayments and
amortization........... (36,453) (62)
--------- -------
Balance, December 31.... $ 206,495 $ 3,114
========= =======
</TABLE>
29
<PAGE>
Results of Operations of NovaStar Mortgage, Inc.--Three Months Ended March 31,
1999 Compared to the Three Months Ended March 31, 1998
The following table presents a summarized income statement of NovaStar
Mortgage, Inc. for the three months ended March 31, 1999 and 1998:
Table 24
NovaStar Mortgage, Inc.--Statements of Operations
Three Months Ended March 31 (dollars in thousands)
<TABLE>
<CAPTION>
1999 1998
------ ------
<S> <C> <C>
Net interest income....................................... $1,172 $ 116
Services provided to NovaStar Financial, Inc.............. 2,165 2,130
Fees from third parties................................... 342 680
Gains on sale of mortgage assets.......................... 2,826 --
Expenses:
Production.............................................. 2,334 1,744
Servicing............................................... 1,215 596
Other................................................... 1,944 860
------ ------
Income (loss) before taxes................................ 1,012 (274)
Income tax expense........................................ 234 --
------ ------
Net income (loss)......................................... $ 778 $ (274)
====== ======
</TABLE>
The following summarizes the explanation for the increase in net earnings of
NovaStar Mortgage for the three months ended March 31, 1999 compared with the
same period of 1998:
. Beginning July 1, 1998, NovaStar Mortgage retained its mortgage loan
production to sell to third parties or securitize versus selling them
directly to NovaStar Financial. Prior to this point in time, NovaStar
Financial acquired 100% of NovaStar Mortgage's wholesale loan
production. Accordingly, NovaStar Mortgage recognized approximately $1
million in net interest income on these loans for the three months ended
March 31, 1999. The net interest income NovaStar Mortgage recognized in
1998 was a result of interest earned on mortgage securities. NovaStar
Mortgage sold all of its mortgage securities during the latter part of
1998.
. During the three months ended March 31, 1999, NovaStar Mortgage
recognized net gains of $2.8 million on mortgage loan sales. $1.3
million of the gains recognized was a result of the closing of NovaStar
Mortgage's first securitization transaction. The remainder of the gain
is due to various mortgage loan sales to independent third parties.
NovaStar Mortgage did not sell any of its mortgage assets during the
same period of 1998.
. NovaStar Mortgage's wholesale origination operation was not operating at
full capacity during the three months ended March 31, 1999 compared with
the three months ended March 31, 1998. NovaStar Mortgage's costs of loan
production as a percent of principal averaged 5.8% for the first quarter
of 1999 versus 1.5% during the first quarter of 1998 as detailed in
Table 19. Accordingly, in 1999 NovaStar Mortgage capitalized a lower
percentage of its origination costs--which under GAAP are amortized as
an adjustment of the yield over the life of the loan versus expensed in
the period incurred.
. NovaStar Mortgage's servicing staff doubled from March 31, 1998 to March
31, 1999. This increase is due to growth in the loan servicing
portfolio, which averaged $671 million for the three months ended March
31, 1998 compared with $1.1 billion for the three months ended March 31,
1999.
30
<PAGE>
. NovaStar Mortgage recognized $159,000 in provisions for credit losses
for the three months ended March 31, 1999, which are included as a
component of other expenses. No provisions were recognized during the
same period of 1998 as NovaStar Mortgage did not begin holding loans in
portfolio until July 1, 1998.
. NovaStar Mortgage remitted $150,000 in premium payments to CMAC during
the three months ended March 31, 1999, which are included as a component
of other expenses. The agreement with CMAC was executed during the third
quarter of 1998.
. Other departments of NovaStar Mortgage, including systems, quality
control, and administration added staff from March 31,1998 to March 31,
1999 to compensate for general company growth.
Recent Developments of NFI Holding, Inc.
NovaStar Capital, Inc. was formed to focus on acquiring nonconforming
residential mortgage loans from banks, thrifts and credit unions. Management
plans to build a sales force of account executives to develop a nationwide
network of financial institutions to complement the wholesale origination
operation of NovaStar Mortgage. Management believes this is another effective
means of acquiring mortgage loans at a lower cost than achieved in secondary
market purchases. The short-term intent is to treat these loans similar to
NovaStar Mortgage's wholesale loan originations--to hold in portfolio to be
sold either to independent third parties or in securitizations.
Value of Mortgages Added through Wholesale Operations
By establishing a wholesale lending operation to originate subprime
residential mortgage loans, NovaStar Financial 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 25 and 26 are management's estimates based on market
conditions as of March 31, 1999.
Management estimates the weighted-average value of its mortgage loan
portfolio as of March 31, 1999 to be between 103 and 105 in terms of price to
par, based upon certain return assumptions and secondary market prices.
Management believes the inherent returns in the mortgage loans it is
originating should warrant a value of 105. However, recent events have resulted
in whole loan prices being severely reduced. Accordingly, any value assigned to
March 31, 1999 loans should take into consideration at what value the loans
could be sold in the open market. During the 1999 first quarter, NovaStar
Financial sold a number of whole loan packages at prices that averaged between
103 and 104. Tables 25 and 26 provide management's estimates of the value of
the mortgage loans in its portfolio and 1999 first 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 1999, NovaStar Mortgage originated mortgage loans at an all-in cost
of 105.8% of principal, including direct costs of acquisition, such as broker
premiums, and general overhead expenses. Table 19 displays costs of production
for each quarter. The cost of production during the first quarter of 1999 and
1998 third and fourth quarters is higher than previous quarters as a result of
lower production levels. NovaStar Mortgage operated at less than full capacity
during the second half of 1998, partly by design. 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.
31
<PAGE>
The weighted-average premium on mortgage loans outstanding at March 31, 1999
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 at March 31, 1999 of between 1.0% and 3.0%. Applying this percent to
the balance of mortgage loans outstanding of $848 million results in an
estimated unrealized gain of between $9 and $26 million. This additional value
results in an estimated mark-to-market equity at March 31, 1999 of $129-$146
million, or $10.39-11.76 per outstanding share, compared with a book value per
outstanding share of $9.64. On a diluted basis, book value per share at March
31, 1999 is $9.23, while a mark-to-market book value is $9.40-10.64.
Table 25
Estimated Market Price on Entire Loan Portfolio
As of March 31, 1999
<TABLE>
<CAPTION>
Estimated Market Price
-------------------------
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% 103.0%
</TABLE>
<TABLE>
<CAPTION>
Estimated Market
Price
--------------------
Two- and Three-year
Fixed Loan Products
--------------------
<S> <C> <C> <C>
Bond Equivalent
Yield.............. 7.81% 8.06% 8.31%
Spread to Index..... 2.75% 3.00% 3.25%
Assumed Prepayment
Speed (CPR)
35.................. 104.9% 104.4% 103.9%
40.................. 104.2% 103.8% 103.4%
45.................. 103.7% 103.3% 102.9%
</TABLE>
<TABLE>
<CAPTION>
One-year CMT Loan
Products
--------------------
<S> <C> <C> <C>
Bond Equivalent
Yield.............. 7.27% 7.52% 7.77%
Spread to Index..... 2.75% 3.00% 3.25%
Assumed Prepayment
Speed (CPR)
35.................. 104.7% 104.2% 103.7%
40.................. 104.1% 103.7% 103.3%
45.................. 103.6% 103.2% 102.9%
</TABLE>
<TABLE>
<CAPTION>
Six-month LIBOR 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)
40............... 105.0% 104.6% 104.2%
45............... 104.4% 104.0% 103.7%
50............... 103.8% 103.5% 103.2%
</TABLE>
Table 26
Estimated Market Price of Loans Originated in First Quarter of 1999
<TABLE>
<CAPTION>
Estimated Market
Price
--------------------
Two- and Three-year
Fixed Loan Products
--------------------
<S> <C> <C> <C>
Bond Equivalent
Yield.............. 7.81% 8.06% 8.31%
Spread to Index..... 2.75% 3.00% 3.25%
Assumed Prepayment
Speed (CPR)
30.................. 105.1% 104.5% 103.9%
35.................. 104.3% 103.8% 103.4%
40.................. 103.8% 103.3% 102.9%
</TABLE>
<TABLE>
<CAPTION>
Estimated Market Price
-------------------------
30/15-year Fixed and
Balloon Loan Products
-------------------------
<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>
32
<PAGE>
Liquidity and Capital Resources
Liquidity means the need for, access to and uses of cash. The 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 on CMOs will serve to
support cash needs. Drawing upon various borrowing arrangements typically
satisfies major cash requirements. During the first quarter of 1999, NovaStar
Financial also improved its equity and liquidity positions significantly by:
. Increasing borrowing capacity with First Union National Bank to nearly
$400 million in February 1999.
. Raising additional capital through the issuance of 4 million shares of
Class B 7% cumulative convertible preferred stock in March 1999; gross
proceeds aggregating $30 million.
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.
The actions taken by management in the fourth quarter of 1998 to restore
liquidity and mitigate additional margin call risk have significantly reduced
cash requirements. 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. As of March 31, 1999, NovaStar Mortgage owned $84 million of
subprime mortgage loans. NovaStar Mortgage provides financing for these loans
through warehouse and repurchase credit facilities at First Union. Loans
financed with warehouse and repurchase credit facilities are subject to
changing market valuation and margin calls. Management expects to continue
selling loans originated by NovaStar Mortgage or securitizing those loans at a
profit to meet the significant cash needs of the wholesale loan operation.
However, management intends to raise sufficient capital during 1999 to begin
acquiring a majority of NovaStar Mortgage's production during the second half
of the year. Management believes NovaStar Financial can operate indefinitely in
this manner, provided that the level of loan originations are at or near the
capacity of its production infrastructure.
33
<PAGE>
Table 27 is a summary of financing arrangements and available borrowing
capacity under those arrangements as of March 31, 1999:
Table 27
Liquidity Resources
March 31, 1999 (dollars in thousands)
<TABLE>
<CAPTION>
Maximum
Borrowing Value of
Limit Collateral Borrowings Availability
--------- ---------- ---------- ------------
<S> <C> <C> <C> <C>
Resource
Cash.............................. $ 2,403
First Union National Bank (A):
Committed warehouse line of
credit......................... $ 75,000 $42,403 $22,660 19,743
Committed secured whole loan
repurchase agreement........... 300,000 42,495 42,495 --
Committed residual financing
available under CMOs........... 20,000 (B) -- 20,000
------- -------
Total......................... $65,155 $42,146
======= =======
Total availability as a percent
of:
Total assets.................... 4.46%
=======
Total stockholders' equity...... 3.52%
=======
</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 and does not include the value of mortgage servicing rights.
Cash activity during the three months ended March 31, 1999 and 1998 are
presented in the consolidated statement of cash flows.
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.
34
<PAGE>
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
March 31, 1999
<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 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 the capital allocation guidelines--mark to market. Each
month, assets are marked to market. Market values of the 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 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 Financial 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 of the management to predict or hedge the risk of
the asset.
35
<PAGE>
Table 28 is a summary of the capital allocation for NovaStar Financial as
they apply to mortgage assets and hedging instruments during 1999 and 1998.
Table 28
Required Equity
<TABLE>
<CAPTION>
1999 1998
-------- -------------------------------------------
March 31 December 31 September 30 June 30 March 31
-------- ----------- ------------ -------- --------
<S> <C> <C> <C> <C> <C>
Category
Mortgage loans:
Current unsecuritized
loans................ $ 3,823 $12,648 $ 14,567 $ 21,566 $ 23,628
Delinquent
unsecuritized loans.. 1,197 1,685 452 601 1,200
Securitized loans..... 49,894 64,548 55,822 37,766 23,478
Mortgage securities..... -- -- 19,514 24,904 27,426
Other assets............ 13,861 12,536 20,682 13,782 10,733
Hedging instruments..... (100) (179) (688) (232) (203)
-------- ------- -------- -------- --------
Required equity......... 68,675 91,238 110,349 98,387 86,262
Stockholders' equity.... 119,712 87,204 109,848 114,875 115,798
Market value in excess
of the carrying value
of assets and
hedges............... 1,482 5,961 2,331 31,999 20,685
-------- ------- -------- -------- --------
Excess equity........... $ 52,519 $ 1,927 $ 1,830 $ 48,487 $ 50,221
======== ======= ======== ======== ========
</TABLE>
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 sheet are measured with
reference to historical cost or fair market value without considering
inflation.
Impact of Recently Issued Accounting Pronouncements
Note 1 to the consolidated financial statements of the annual report to
shareholders and annual report on Form 10-K for the year ended December 31,
1998 describes certain recently issued accounting pronouncements. Management
believes the implementation of these pronouncements and others that have gone
into effect since the date of these reports, will not have a material impact on
the consolidated financial statements.
The Year 2000
NovaStar Financial and NovaStar Mortgage are highly dependent on purchased
and leased computer software to conduct business. In addition, NovaStar
Financial and NovaStar Mortgage are 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
and NovaStar Mortgage.
36
<PAGE>
NovaStar Financial and NovaStar Mortgage use three major, and a number of
smaller, internal automation solutions to conduct its business operations. The
three computer systems considered the most significant to operations are as
follows:
.The internally developed loan origination and database system
.The externally provided loan servicing system
.The purchased accounting system
In addition, NovaStar Financial and NovaStar Mortgage integrate with a
number of outside entities in normal business transactions. Interfaces with
other businesses and third party solution providers are used to conduct some
business processes. Other processes are supported by systems created
internally.
NovaStar Financial and NovaStar Mortgage are using the Federal Financial
Institutions Examination Council's (FFIEC) "Year 2000 Project Management
Awareness" document to guide year 2000 readiness efforts. Each program/system
interface used by NovaStar Financial and NovaStar Mortgage are being reviewed
and tested for year 2000 compliance. The FFIEC guide calls for a three-phase
approach to assess year 2000 compliance. Based on this three-phase approach
NovaStar Financial's and NovaStar Mortgage's projected timeline is as follows:
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. All internally
developed business processes/interfaces have been tested for compliance. Based
on these tests, all software and automation solutions created by NovaStar
Financial and NovaStar Mortgage are year 2000 compliant. As of April 15, 1999
NovaStar Financial and NovaStar Mortgage have updated all internal operating
systems and software with year 2000 compliant versions. NovaStar Financial and
NovaStar Mortgage are still working with market counterparties and vendors to
document that they have assessed software for year 2000 compliance.
Solution updates to non-complaint Year 2000 software should be made in the
correction phase. Corrections on NovaStar Financial and NovaStar Mortgage
developed software will be made internally and are expected to be
insignificant. NovaStar Financial and NovaStar Mortgage are requiring all
market counterparties and vendors to document they have made all corrections.
NovaStar Financial and NovaStar Mortgage staff will conduct "mock" business
as if it is in the year 2000 during the validation phase, scheduled for the
second quarter of 1999. During this phase, NovaStar Financial and NovaStar
Mortgage will test all internally developed software as well as vendor
software.
NovaStar Financial and NovaStar Mortgage have contacted all 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
37
<PAGE>
documents of progress during each phase. NovaStar Financial and NovaStar
Mortgage have received written confirmation from Alltel Residential Lending
Solutions, vendor of NovaStar Mortgage's servicing system and Baan/CODA, vendor
of NovaStar Financial's and NovaStar Mortgage's accounting system stating that
the versions currently used are fully year 2000 compliant.
All internally developed software was designed to be year 2000 complaint. In
addition, management has contacted its significant financial counterparty,
First Union National Bank, who is completing their internal review of year 2000
compliance.
Management believes the greatest risk in regard 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. NovaStar Mortgage uses
systems developed by Alltel for loan servicing. If these systems fail, NovaStar
Mortgage will not be able to continue on a manual basis. In this worst case
scenario, loans would not be serviced until the failed system could be
remedied. If the loans go "unserviced" for an extended period of time--several
weeks--the result could have a material adverse impact to NovaStar Financial
and NovaStar Mortgage.
NovaStar Financial and NovaStar Mortgage are also at significant risk in the
event the systems of financial institutions, on which NovaStar Financial and
NovaStar Mortgage are 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
Financial and NovaStar Mortgage.
NovaStar Financial and NovaStar Mortgage are 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 Financial and NovaStar Mortgage 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 Financial and NovaStar Mortgage. 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 3. Quantitative and Qualitative Disclosures About Market Risk
Interest Rate/Market Risk
Price volatility. Under its current mode of operation, NovaStar Financial
depends heavily on the market for wholesale subprime mortgage loans. Without
capital to support the purchase and retention of mortgage loans, NovaStar will
sell loans originated by NovaStar Mortgage. The financial results of NovaStar
Financial 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 low all-in cost and therefore mitigates price volatility. Price volatility
will be eliminated when NovaStar Financial 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 Financial'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 our
liabilities or when the assets are fixed rates and the liabilities are
adjusting,
38
<PAGE>
future earnings potential is affected. Management primarily uses financing
sources where the interest rate resets frequently. As of March 31, 1999,
borrowings under all financing arrangements adjust daily, monthly, or
quarterly. On the other hand, very few of the mortgage assets owned by NovaStar
Financial, as of March 31, 1999, 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 our 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 29 is a summary of the analysis as of March 31, 1999 and December 31,
1998.
Table 29
Interest Rate Sensitivity
March 31, 1999 and December 31, 1998
<TABLE>
<CAPTION>
Basis Point Increase (Decrease) in Interest
-------------------------------------------
Rate(B)
----------------
As of March 31, 1998(A) (100) Base(C) 100
----------------------- -------------- ------------------------------
<S> <C> <C> <C>
Income from:
Assets.................. $84,496 $86,728 $88,879
Liabilities............. 50,519 58,330 66,412
Interest rate
agreements............. (1,781) (1,781) 570
-------------- -------------- --------------
Net spread income......... $32,196 $26,617 $23,037
============== ============== ==============
Cumulative change in
income from base (C)..... $ 5,579 -- $ (3,580)
Percent change from base
spread income (D)........ 21.0% -- (13.4)%
============== ============== ==============
Percent change of
capital(E)............... 4.66% -- (2.99)%
============== ============== ==============
</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 and down 1%.
(C) Total change in estimated spread income, in dollars, from "base." "Base" is
the estimated spread income at March 31, 1999.
(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 March 31, 1999.
39
<PAGE>
<TABLE>
<CAPTION>
Basis Point Increase (Decrease) in Interest
-------------------------------------------
Rate(G)
----------------
As of December 31, 1998(F) (100) Base(H) 100
-------------------------- -------------- ------------------------------
<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 (H).............. $ 5,910 -- $ 3,967
Percent change from base
spread income (I).......... 23.8% -- (16.0)%
============== ============== ==============
Percent change of
capital(J)................. 6.77% -- (4.54)%
============== ============== ==============
</TABLE>
- --------
(F) The securitized mortgage assets of NovaStar Financial are managed on a
spread income basis.
(G) Income of asset, liability or interest rate agreement in a parallel shift
in the yield curve, up and down 1%.
(H) Total change in estimated spread income, in dollars, from "base." "Base" is
the estimated spread income at December 31, 1998.
(I) Total change in estimated spread income, as a percent, from base.
(J) 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 percent 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.
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 percent 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. The Board of Directors reviews and approves NovaStar
Financial's interest sensitivity and hedged position quarterly.
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 March
31, 1999 and 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
40
<PAGE>
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.
NovaStar Financial'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 (ARM or fixed
rate), note rate, credit grade, LTV, 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. The actual historical speeds experienced on NovaStar Financial's loans
shown in Table 7 are weighted average speeds of all loans in each deal.
As shown in Table 7, actual prepayment rates on loans that have been held in
portfolio for shorter periods are slower than long term prepayment rates used
in the interest rate sensitivity analysis. 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:
(1)Maintain the net interest margin between assets and liabilities, and
(2)Diminish the effect of changes in interest rate levels on the market
value of assets.
Although management evaluates the portfolio using interest rate increases
and decreases greater than one percent, management focuses on the one percent
increase as any further increase in interestrates would require action to
adjust the portfolio to adapt to changing rates. The investment policy for
NovaStar Financial allows for no more than a ten percent decrease in the spread
income of the portfolio when interest rates rise or fall by one percent.
Sensitivity as of March 31, 1999 and December 31, 1998. As shown in the
above table, if interest rates were to decrease one percent (-100 basis
points), the spread income of capital would increase by an estimated 4.66% and
6.77% of capital as of March 31, 1999 and December 31, 1998, respectively. If
interest rates rise by one percent (+100 basis points), the spread income of
capital would decrease by an estimated 2.99% and 4.54% of capital as of March
31, 1999 and December 31, 1998, respectively.
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 Financial, 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 managements's view, to enable
NovaStar Financial to maintain an equity liquidation value
41
<PAGE>
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 to maturity. As mentioned earlier, NovaStar Financial terminated all
swap agreements and paid off the liabilities pertaining to these hedging
instruments in October 1998.
NovaStar Financial is subject to credit risk under its interest rate
agreements because the counterparty may fail on its obligation to NovaStar
Financial. To limit counterparty credit risk, NovaStar Financial:
.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 gain positions for
NovaStar Financial.
The net market value of all agreements with each counterparty is in a loss
position as of March 31, 1999, exposing NovaStar Financial to no credit 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 Financial
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 Financial
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.
Table 11 of "Management's Discussion and Analysis of Financial Condition and
Results of Operations" provides a summary of hedging instruments owned by
NovaStar Financial as of March 31, 1999 and December 31, 1998.
42
<PAGE>
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
As of March 31, 1999, there were no material legal proceedings pending to
which NovaStar Financial was a party or of which any of its property was
subject.
Item 2. Changes in Securities
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 the common stock on February 11, 1999.
These warrants were issued in exchange for 186,667 existing warrants with an
exercise price of $15.00 per share, all of which will be retired. The new
warrants are exercisable until February 12, 2002.
On March 10, 1999, NovaStar Financial issued 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. These warrants will expire on October 13, 2003. In
connection with this same warrant agreement, NovaStar Financial issued to
GMAC/Residential Funding Corporation 364,982 "tag-along" warrants to purchase
NovaStar Financial common stock at a price of $15.00 per share, which are
exercisable until February 3, 2001.
On March 29, 1999, NovaStar Financial completed the private placement and
issuance of 4,285,714 shares of Class B 7% cumulative convertible preferred
stock at a price of $7.00 per share, resulting in total proceeds of
approximately $30 million, which includes approximately $25 million acquired by
Wallace R. Weitz & Company. Stifel, Nicolaus & Company, Incorporated acted as
placement agent in connection with the issuance and received commissions and
reimbursement of expenses totaling approximately $1,240,000. Each share of the
preferred stock is convertible, at the option of the holder, into one share of
common stock and is redeemable at par by NovaStar Financial at any time after
March 31, 2002.
The issuance of the preferred stock and the earlier issuance of warrants in
connection with the financing arrangement entered into with First Union and
GMAC/Residential Funding Corporation resulted in a reduction of the $15.00
exercise price of the warrants issued in NovaStar Financial's private placement
in December 1996. The GMAC/Residential Funding Corporation's "tag-along"
warrants are similarly affected. Pursuant to anti-dilution provisions contained
in the 1996 warrants, each warrant exercised at $15.00 will purchase 1.29
shares of common stock, which represents an effective exercise price of $11.62
per share.
II-1
<PAGE>
Item 3. Defaults upon Senior Securities
Not applicable
Item 4. Submission of Matters of Vote of Security Holders
Not applicable
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits filed with this report are as follows:
11.1 Schedule regarding computation of per share earnings
21.1 Subsidiaries of the Registrant
27.1 Financial data schedule
(b) NovaStar Financial has filed the following Form 8-K's:
. Regarding the announcement of the financing arrangement with First Union
National Bank and related material financing documents and warrant
agreement, filed on February 23, 1999.
. Regarding the March 1999 Class B 7% cumulative convertible preferred
stock, the GMAC/RFC warrant agreement and the reduction in the 1996
warrant effective exercise price, filed on April 6, 1999.
II-2
<PAGE>
NOVASTAR FINANCIAL, INC.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
NOVASTAR FINANCIAL, INC.
DATE: May 12, 1999 /s/ Scott F. Hartman
_____________________________________
Scott F. Hartman
Chairman of the Board, Secretary and
Chief Executive Officer
(Principal Executive Officer)
DATE: May 12, 1999 /s/ Rodney E. Schwatken
_____________________________________
Rodney E. Schwatken
Vice President, Controller and
Assistant Treasurer
(Principal Accounting Officer)
II-3
<PAGE>
EXHIBIT 11.1
SCHEDULE REGARDING COMPUTATION OF PER SHARE EARNINGS
(000's except per share data)
<TABLE>
<CAPTION>
Three Months
Ended March
31,
--------------
1999 1998
------ ------
<S> <C> <C>
Net income (loss)............................................... $1,726 $1,279
Less preferred stock dividends.................................. (31) --
------ ------
Income available to common stockholders--basic.................. $1,695 $1,279
====== ======
Less preferred stock dividends.................................. 31 --
------ ------
Income available to common stockholders--diluted................ $1,726 $1,279
====== ======
Basic weighted average shares outstanding....................... 8,130 7,855
Common equivalent shares:
Dilutive stock options........................................ 22 97
Dilutive warrants............................................. 232 708
Convertible preferred stock................................... 254 --
------ ------
Diluted weighted average shares outstanding..................... 8,638 8,660
====== ======
Basic earnings (loss) per share................................. $ 0.21 $ 0.16
====== ======
Diluted earnings (loss) per share............................... $ 0.20 $ 0.15
====== ======
</TABLE>
<PAGE>
EXHIBIT 21.1
SUBSIDIARIES OF THE REGISTRANT
NovaStar Financial, Inc., a Maryland corporation, and its subsidiaries
. NovaStar Assets Corporation, a Delaware corporation
. NovaStar Mortgage Funding Corporation, a Delaware corporation
. NovaStar Certificates Financing Corporation, a Delaware corporation
. NovaStar Capital Access Corporation, a Delaware corporation
NFI Holding Corporation, a Delaware corporation, and its subsidiaries
. NovaStar Mortgage, a Virginia corporation
. The Hiresource, Inc., a Delaware corporation
. NovaStar Capital, Inc., a Delaware corporation
. NovaStar Mortgage Funding Corporation II, a Delaware corporation
. NovaStar REMIC Financing Corporation, a Delaware corporation
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM NOVASTAR
FINANCIAL'S FORM 10-Q FOR THE THREE MONTHS ENDED MARCH 31, 1999 AND IS QUALIFIED
IN ITS ENTIRETY BY REFERENCE TO SUCH CONSOLIDATED FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> MAR-31-1999
<CASH> 2,403
<SECURITIES> 0
<RECEIVABLES> 847,744
<ALLOWANCES> 3,492
<INVENTORY> 0
<CURRENT-ASSETS> 0
<PP&E> 0
<DEPRECIATION> 0
<TOTAL-ASSETS> 944,323
<CURRENT-LIABILITIES> 0
<BONDS> 0
0
0
<COMMON> 81
<OTHER-SE> 119,631
<TOTAL-LIABILITY-AND-EQUITY> 944,323
<SALES> 19,550
<TOTAL-REVENUES> 20,485
<CGS> 0
<TOTAL-COSTS> 19,310
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 2,299
<INTEREST-EXPENSE> 13,209
<INCOME-PRETAX> 1,726
<INCOME-TAX> 0
<INCOME-CONTINUING> 1,726
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,726
<EPS-PRIMARY> 0.21
<EPS-DILUTED> 0.20
