NOVASTAR FINANCIAL INC
424B3, 1999-06-02
REAL ESTATE INVESTMENT TRUSTS
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<PAGE>

                                                    Rule 424(b)(3)
                                                    Form S-11 Registration
                                                    Statement
                                                    (Registration No. 333-
                                                    77375)
Prospectus
                            NovaStar Financial, Inc.
                                                              [LOGO OF NOVASTAR]

              4,285,714 Shares Class B Convertible Preferred Stock
                         5,813,427 Shares Common Stock
                       1,527,713 Stock Purchase Warrants

 Consider carefully the
 risk factors beginning on
 page 11 of this
 prospectus, including the
 following:

 . limited operating
   history

 . significant losses in
   the fourth quarter of
   1998

 . dependence upon short-
   term borrowings from
   major lenders

 . dependence upon long-
   term borrowings
   through
   securitizations

 . impact of unexpected
   or rapid changes in
   interest rates

 . restrictions on
   ownership and
   transferability of our
   stock

  This prospectus relates to:

  . 4,285,714 shares of our preferred stock held by selling securityholders;

  . 1,527,713 stock purchase warrants held by selling securityholders, each
    warrant exercisable for one share of our common stock; and

  . 5,813,427 shares of common stock issuable upon the exercise of warrants
    and conversion of preferred stock.

  Under some circumstances, the selling securityholders and any broker-dealers
that act in connection with the sales may be deemed to be "underwriters" within
the meaning of Section 2(11) of the Securities Act, and any commissions or
discounts and other compensation paid to such persons may be deemed to be
underwriting discounts and commissions under the Securities Act.

  We will not receive any proceeds from the sale of securities by the selling
securityholders. We will receive the proceeds from the issuance and sale of
common stock pursuant to the exercise of the warrants. If all warrants
outstanding as of the date of this prospectus are exercised at the price
issued, we would receive proceeds, before expenses, of $11,610,940.18.

  Our common stock is listed on the New York Stock Exchange under the symbol
"NFI". On April 27, 1999, the last reported sale price was $6 1/8 per share.
Our warrants trade through market makers, such as Stifel, Nicolaus & Company,
Incorporated, using the NASD's bulletin board service. There can be no
assurance as to the development or liquidity of a market for our preferred
stock.

  Neither the Securities and Exchange Commission nor any state securities
commission has approved or disapproved of these securities or determined if
this prospectus is accurate or complete. Any representation to the contrary is
a criminal offense.

                                  May 12, 1999
<PAGE>

                               TABLE OF CONTENTS
<TABLE>
<S>                                                                         <C>
PROSPECTUS SUMMARY........................................................    4
 Overview of NovaStar Financial, Inc......................................    4
 The Offering.............................................................    5
 Securities Offered.......................................................    5
 Use of Proceeds..........................................................    5
 The Structure of Our Company and Principal Affiliates....................    5
 Recent Developments......................................................    6
 Summary Risk Factors.....................................................    8
 Summary Financial and Other Data.........................................   10
RISK FACTORS..............................................................   11
 Overall Enterprise of NovaStar Financial, Inc. ..........................   11
 Our dependence upon borrowings can result in significant liquidity
  constraints.............................................................   11
 We have a limited operating history and incurred significant net losses
  in the fourth quarter of 1998...........................................   11
 Forgivable notes may adversely affect results of operations..............   11
 We depend on key personnel for successful operations.....................   11
 We need additional equity financing to support future growth.............   12
 Should we fail to maintain REIT status, we would be subject to tax as a
  regular corporation.....................................................   12
 We lack voting control of our taxable affiliate NovaStar Mortgage........   12
 Failure to qualify for Investment Company Act exemption may adversely
  affect our ability to use leverage and to conduct our business..........   12
 Future revisions in policies and strategies at the discretion of Board of
  Directors may adversely affect operations...............................   13
 Subprime Mortgage Lending Operation......................................   13
 Changes in interest rates may adversely affect results of operations.....   13
 Intense competition in the subprime mortgage loan industry may result in
  reduced net income or in revised underwriting standards which would
  adversely affect operations.............................................   13
 Higher loan-to-value ratios increase the risk that we may not recover, on
  default, full amounts due on mortgage loans.............................   14
 Loans made to subprime mortgage borrowers entail higher delinquency and
  loss rates..............................................................   14
 Failure to renew or obtain adequate funding under warehouse facilities
  and repurchase agreements may materially adversely impact our lending
  operations..............................................................   14
 Financing with repurchase agreements may lead to margin calls if the
  market value of mortgage assets declines................................   14
 Interest rate fluctuations may adversely affect the value of our mortgage
  loans in process or held for sale or securitization.....................   14
 Competition with other prospective purchasers of mortgage loans for
  business with independent brokers and lenders may result in fluctuations
  in volume and cost of acquiring mortgage loans..........................   15
 New laws and regulations, new administrative or judicial interpretations
  or our failure to comply with existing federal, state, and local
  legislation or regulation could adversely affect our operations.........   15
 Failure to comply with future regulatory interpretations or judicial
  decisions regarding broker compensation programs may adversely affect
  results of operations...................................................   16
</TABLE>
<TABLE>
<S>                                                                         <C>
 Contamination of properties securing mortgage loans by hazardous
  substances would result in our facing environmental liabilities.........   16
 Acquisition and Management of a Portfolio of Mortgage Assets.............   16
 General economic and financial conditions in mortgage and financial
  markets may affect our results of operations............................   16
 Interest rate fluctuations may result in a decrease in net interest
  income..................................................................   17
 Interest rates on our borrowings adjust differently than those on related
  adjustable rate mortgages which may adversely affect our net interest
  income..................................................................   17
 Interest rate caps on adjustable rate mortgages may adversely affect our
  net interest income.....................................................   17
 Changes in anticipated prepayment rates may adversely affect net interest
  income..................................................................   18
 Failure to hedge effectively against interest rate changes may adversely
  affect results of operations............................................   18
 Limitations on effective hedging may adversely affect attempts to
  mitigate risk of variable rate liabilities..............................   19
 Hedging poses a credit risk..............................................   19
 Hedging poses a legal risk...............................................   19
 Hedging poses a basis risk...............................................   19
 We face loss exposure on single family mortgage assets...................   20
 We face loss exposure due to the credit risks of subprime mortgage
  loans...................................................................   20
 We face loss exposure due to the underlying real estate..................   20
 Market factors may limit our ability to acquire mortgage assets at yields
  which are favorable relative to borrowing costs.........................   21
 We face substantial leverage and potential net interest and operating
  losses in connection with borrowings....................................   21
 Our failure to refinance outstanding borrowings on favorable terms may
  affect results of operations............................................   21
 Decline in market value of mortgage assets may limit our ability to
  borrow, result in lenders initiating margin calls and require us to sell
  mortgage assets in adverse market conditions............................   22
 Adverse changes in the securitization market could impair our ability to
  acquire and finance mortgage loans through securitizations on a
  favorable or timely basis...............................................   22
 Mortgage loan performance may adversely affect future results............   23
 Illiquidity of investments restricts resale of mortgage securities.......   23
 Lack of geographic diversification of properties underlying mortgage
  assets may subject such mortgage assets to greater risk of default in
  event of hazards that affect such region................................   23
 Investment in the Securities in the Offering.............................   23
 Restrictions on ownership of capital stock may inhibit market activity
  and the resulting opportunity for holders of our capital stock and
  warrants to receive a premium for their securities......................   23
 Future sales of securities may dilute the equity of our stockholders or
  reduce the price of shares of our common stock..........................   24
 There is no assurance of an active public trading market.................   24
</TABLE>

                                       2
<PAGE>

                         TABLE OF CONTENTS--(Continued)

<TABLE>
<S>                                                                          <C>
 Possible volatility of stock price may adversely impact the liquidity of
  our common stock and may result in losses to stockholders who sell shares
  of common stock..........................................................   24
NOVASTAR FINANCIAL, INC....................................................   25
USE OF PROCEEDS............................................................   25
DIVIDEND POLICY AND DISTRIBUTIONS..........................................   26
DIVIDEND REINVESTMENT PLAN.................................................   26
CAPITALIZATION.............................................................   27
MARKET PRICES AND DIVIDEND DATA............................................   27
SELECTED FINANCIAL AND OTHER DATA..........................................   28
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
 OPERATIONS................................................................   29
 Safe Harbor Statement.....................................................   29
 Basis of Presentation.....................................................   29
 Financial Condition and Results of Operations as of and for the Period
  Ended December 31, 1996..................................................   29
 Events of the Fourth Quarter 1998.........................................   30
 Liquidity and Capital Resources...........................................   30
 Forgivable Notes Receivable from Founders.................................   32
 Financial Condition as of December 31, 1998 and 1997......................   32
 Results of Operations--Year Ended December 31, 1998 Compared to the Year
  Ended December 31, 1997..................................................   40
  Other Income.............................................................   43
  Gain or Loss on Sales of Securities and Mortgage Loans...................   43
  Provisions for Credit Losses.............................................   43
  General and Administrative Expenses......................................   46
  Equity in Earnings or Loss of NFI Holding  Corporation...................   47
  Value of Mortgages Added through Wholesale Operations....................   47
 Results of Operations--Year Ended December 31, 1997.......................   49
 Earnings of NFI Holding Corporation.......................................   51
 Taxable Income or Loss....................................................   52
 Interest Rate Sensitivity.................................................   52
 Capital Allocation Guidelines.............................................   53
 Inflation.................................................................   54
 Impact of Recently Issued Accounting Pronouncements.......................   54
 The Year 2000.............................................................   54
BUSINESS...................................................................   57
 Mortgage Lending Operation ...............................................   57
 Market Overview...........................................................   57
 Competition...............................................................   58
 Loan Origination..........................................................   60
 Marketing and Production Strategy.........................................   61
 Underwriting and Quality Control Strategy.................................   62
 Mortgage Loan Servicing Strategy..........................................   65
 Portfolio Management......................................................   66
 Types of Mortgage Assets..................................................   66
 Asset Acquisition Policies................................................   68
 Financing for Mortgage Lending Operations and Mortgage Security
  Acquisitions.............................................................   69
 Mortgage Loans Held as Collateral for Structured Debt.....................   69
 Credit Risk Management Policies...........................................   70
 Capital and Leverage Policies.............................................   72
 Interest Rate Risk Management.............................................   73
 Prepayment Risk Management................................................   76
 Taxable Affiliates........................................................   77
</TABLE>
<TABLE>
<S>                                                                          <C>
 Properties................................................................   77
 Legal Proceedings.........................................................   77
MANAGEMENT.................................................................   78
 Directors and Executive Officers..........................................   78
 Other Senior Officers.....................................................   79
 Terms of Directors and Officers...........................................   80
 Committees of the Board...................................................   81
 Compensation of Directors.................................................   81
 Compensation Committee Interlocks.........................................   81
 Executive Compensation....................................................   82
 Stock Option Grants.......................................................   84
PRINCIPAL SECURITYHOLDERS..................................................   89
 Beneficial Ownership of Common Stock by Large Securityholders.............   89
 Beneficial Ownership of Common Stock by Directors and Management..........   90
CERTAIN TRANSACTIONS.......................................................   91
 Transactions with Management..............................................   91
 Indebtedness of Management................................................   92
 Certain Business Relationships............................................   92
 Conflict of Interest Policy...............................................   93
SELLING SECURITYHOLDERS....................................................   94
FEDERAL INCOME TAX CONSEQUENCES............................................   95
 General...................................................................   95
 Opinion of tax counsel....................................................   95
 Qualification as a REIT...................................................   96
 Taxation of NovaStar Financial............................................   98
 Taxation of Taxable Affiliates............................................   99
 Termination or Revocation of REIT Status..................................  100
 Taxation of the Company's Stockholders....................................  100
 Redemption and Conversion of Preferred Stock..............................  101
 Warrants..................................................................  102
 Taxation of Tax-Exempt Entities...........................................  102
 Foreign Investors.........................................................  103
 Recordkeeping Requirement.................................................  103
 Backup Withholding........................................................  103
 State and Local Taxes.....................................................  103
 ERISA Investors...........................................................  104
DESCRIPTION OF CAPITAL STOCK...............................................  105
 General...................................................................  105
 Historical Capital Structure..............................................  105
 Preferred Stock...........................................................  105
 Common Stock..............................................................  108
 Registration Rights.......................................................  109
 Private Placement Purchase Terms Agreement................................  110
 Repurchase of Shares and Restriction on Transfer..........................  110
 Indemnification...........................................................  112
 Limitation of Liability...................................................  112
 Business Acquisitions Statutes............................................  113
 Control Share Acquisitions................................................  113
 Transfer Agent and Registrar..............................................  114
DESCRIPTION OF WARRANTS....................................................  115
PLAN OF DISTRIBUTION.......................................................  118
LEGAL MATTERS..............................................................  119
EXPERTS....................................................................  119
WHERE YOU CAN FIND MORE INFORMATION........................................  119
GLOSSARY...................................................................  120
FINANCIAL STATEMENTS.......................................................  F-1
</TABLE>

                                       3
<PAGE>

                               PROSPECTUS SUMMARY

  This summary highlights selected information from this prospectus and does
not contain all of the information that you need to consider in making your
investment decision. You should read this entire prospectus carefully to
understand all of the terms of the offering. We include a glossary beginning on
page 120.

                      Overview of NovaStar Financial, Inc.

  We are a finance company which:

  . acquires single family residential subprime mortgage loans, primarily
    from our affiliate NovaStar Mortgage;

  . borrows money to finance its assets using warehouse facilities, including
    repurchase agreements;

  . issues collateralized debt obligations to finance its subprime mortgage
    loans in the long-term;

  . purchases mortgage securities; and

  . manages the resulting combined portfolio of mortgage loans and securities
    in a tax-advantaged real estate investment trust structure.


  NovaStar Mortgage originates subprime residential mortgage loans. NovaStar
Mortgage has developed a nationwide network of wholesale loan brokers and
mortgage lenders who submit mortgage loans to NovaStar Mortgage. These brokers
and mortgage lenders are independent from any of the NovaStar entities.
NovaStar Mortgage underwrites these mortgage loans and funds approved mortgage
loans. During 1998, NovaStar Mortgage originated $877 million in subprime
mortgage loans. We have acquired many of the mortgage loans originated by
NovaStar Mortgage. However, in times where sufficient capital is not available
to us, NovaStar Mortgage will sell mortgage loans.

  Generally the people to whom NovaStar Mortgage lends money have substantial
equity in the property securing the mortgage loan. They are considered
"subprime" borrowers because they have impaired or limited credit profiles or
higher debt-to-income ratios than traditional mortgage lenders allow. These
borrowers also include individuals who, due to self-employment or other
circumstances, have difficulty verifying their income. These types of borrowers
are generally willing to pay higher mortgage loan origination fees and interest
rates than those charged by conventional lending sources. Because these
borrowers typically use the proceeds of the mortgage loans to consolidate and
refinance debt and to finance home improvements, education and other consumer
needs, loan volume is less dependent on general levels of interest rates or
home sales and therefore less cyclical than conventional mortgage lending.

  We have elected to be taxed as a REIT under the Internal Revenue Code of
1986, as amended. As a result, our earnings are generally not subject to
federal income tax to the extent that we distribute our earnings to
stockholders and maintain our qualification as a REIT. We believe the REIT
structure is the most desirable for owning mortgage loans and mortgage
securities due to the elimination of corporate-level income taxation. We are
self-advised and self-managed. We have neither an outside advisor to provide
portfolio investment advice nor an outside manager to take care of the day-to-
day administration of our business operations. We believe that this is a
structure that distinguishes us from many other mortgage REITs.


                                       4
<PAGE>

                                  The Offering

Securities Offered

  This prospectus covers offerings of up to:

  . 4,285,714 shares of issued and outstanding preferred stock held by the
    selling securityholders;

  . 1,527,713 warrants that are owned by the selling securityholders; and

  . 5,813,427 shares of common stock that may be subsequently acquired by the
    selling securityholders from us upon the exercise of warrants and
    conversion of preferred stock.

  Each share of preferred stock:

  . is convertible, at the option of the holder, into one share of common
    stock;

  . has a cumulative dividend payable at the rate of 7.0% per annum; and

  . may be redeemed at a price of $7.00 by NovaStar Financial at any time
    after March 31, 2002.

  The warrants consist of:

  . 350,000 warrants expiring February 12, 2002 issued with an exercise price
    of $6.9375;

  . 812,731 warrants expiring October 13, 2003 issued with an exercise price
    of $4.5625; and

  . 364,982 warrants expiring February 3, 2001 issued with an exercise price
    of $15.00.

Use of Proceeds

  We will receive no proceeds from the sale of preferred stock or warrants by
the selling securityholders. We will use the net proceeds from the issuance of
common stock pursuant to the exercise of the warrants to fund the acquisition
of mortgage loans, as described in this prospectus and, pending such use, to
reduce borrowings.

             The Structure of Our Company and Principal Affiliates

  Scott Hartman and Lance Anderson own 100 percent of the voting common stock
of NFI Holding. NFI Holding was capitalized through the purchase of voting
common stock by Scott Hartman and Lance Anderson in the amount of $20,000 and
the purchase of non-voting preferred stock by NovaStar Financial in the amount
of $1,980,000. Mr. Hartman and Mr. Anderson receive one percent of the economic
benefits derived from dividends and distributions of NFI Holding as a result of
their common stock ownership. We receive 99 percent of the economics of NFI
Holding as a result of our preferred stock ownership. Accordingly, we
indirectly receive 99 percent of the economics of NovaStar Mortgage by virtue
of our ownership interest in NFI Holding. In addition, Mr. Hartman and Mr.
Anderson serve as the sole directors of both NFI Holding and NovaStar Mortgage.

  In contracts with us, NovaStar Mortgage has agreed to:

  . sell subprime mortgage loans which NovaStar Mortgage originates to us, if
    we agree to acquire such mortgage loans;

  . service our subprime mortgage loans; and

  . provide administrative services to us.

                                       5
<PAGE>


  Without voting control of NovaStar Mortgage, there can be no assurance that
these contracts, which are subject to renewal, will continue indefinitely. In
addition, while Messrs. Hartman and Anderson have entered into an agreement of
shareholders, which contains management and control provisions and restrictions
on transfer of NFI Holding common stock, there can be no assurance that the
agreement will be enforced in a timely manner against the individuals, their
heirs or representatives.

         [ORGANIZATION CHART OF NOVASTAR FINANCIAL, INC. APPEARS HERE]

                              Recent Developments

  On February 12, 1999, we entered into several loan agreements with First
Union National Bank for one year. NovaStar Financial is a co-borrower with
NovaStar Mortgage under warehouse line of credit and master repurchase
agreements with First Union, which allow borrowings of up to $75 million and
$300 million, respectively, secured by mortgage loans. At the same time, two
additional loan agreements were executed with First Union whereby we can borrow
up to $20 million secured by the residual interests of our asset-backed bonds.
We used proceeds from these financing arrangements to pay off our October 1998
short term financing arrangement with GMAC/Residential Funding Corporation. We
refer you to "Events of the Fourth Quarter 1998" in Management's Discussion and
Analysis of Financial Condition and Results of Operations for further
information regarding that short term financing arrangement.

  In connection with the master repurchase agreement, we issued First Union
350,000 warrants to purchase common stock at $6.9375 per share, the closing
price on February 11, 1999, in exchange for 186,667 of our December 9, 1996
warrants originally issued at $15.00 per share. The warrants expire on February
12, 2002.

  On March 10, 1999, we issued warrants to GMAC/Residential Funding Corporation
pursuant to our earlier short term financing arrangement. We issued 812,731
warrants to purchase common stock at $4.5625 per share, the closing price on
October 12, 1998, and 364,982 tag along warrants to purchase common stock on
the terms of our December 9, 1996 warrants which were issued at $15.00 per
share.


                                       6
<PAGE>

  On March 29, 1999, NovaStar Financial completed the 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. 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.

  This issuance of the preferred stock and the earlier issuance of warrants in
connection with financing arrangements entered into with First Union and
GMAC/Residential Funding Corporation resulted in a reduction of the effective
exercise price for holders of NovaStar's December 9, 1996 warrants to acquire
common stock at $15.00 per share. 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.

  Our warrant agreements with First Union and GMAC/Residential Funding
Corporation contain anti-dilution protections and registration rights for
warrantholders. We have also entered into a registration rights agreement for
the benefit of the holders of the preferred stock. We have agreed to file a
shelf registration statement with the SEC covering the warrants and the
preferred stock. This prospectus is a part of that shelf registration
statement.

                                       7
<PAGE>

                              Summary Risk Factors

  Prior to making an investment decision, prospective investors should
carefully consider all of the information set forth in this prospectus and, in
particular, should evaluate the factors set forth in "Risk Factors." These risk
factors include:

  . Our dependence upon borrowings can result in significant liquidity
    constraints. Our profitability is dependent upon our ability to borrow
    money on favorable terms. In October 1998, the subprime mortgage loan
    market faced a liquidity crisis with respect to the availability of
    short-term borrowings from major lenders and long-term borrowings through
    securitization. We faced significant liquidity constraints.

  . We have a limited operating history and incurred significant net losses
    in the fourth quarter of 1998. We have not yet developed an extensive
    earnings history or experienced a wide variety of interest rate or market
    conditions. Historical operating performance may be of limited relevance
    in predicting future performance. We incurred significant net losses in
    the fourth quarter of 1998.

  . Forgivable notes may adversely affect results of operations. In our
    private placement, Messrs. Hartman and Anderson each acquired units paid
    for with promissory notes. Principal due on the notes will be forgiven if
    the return to private placement investors meets benchmarks. The non-cash
    charge against earnings resulting from forgiveness of the notes could
    have a material adverse effect on our results of operations and dividends
    paid to stockholders during periods forgiven.

  . We depend on key personnel for successful operations. Our operations and
    those of NovaStar Mortgage depend heavily upon the contributions of Scott
    Hartman and Lance Anderson, both of whom would be difficult to replace.
    The loss of either of these individuals could have a material adverse
    effect upon our businesses and results of operations.

  . Should we fail to maintain REIT status, we would be subject to tax as a
    regular corporation. If we fail to maintain our qualification as a REIT,
    we would be subject to federal income tax as a regular corporation. We
    intend to conduct our business at all times in a manner consistent with
    the REIT provisions of the Code.

  . Changes in interest rates may adversely affect results of operations. Our
    results of operations are likely to be adversely affected during any
    period of unexpected or rapid changes in interest rates. For example, a
    substantial or sustained increase in interest rates could adversely
    affect our ability to acquire mortgage loans in expected volumes
    necessary to support our fixed overhead expense levels.

  . Intense competition in the subprime mortgage loan industry may result in
    reduced net income or in revised underwriting standards which would
    adversely affect operations. We face intense competition, primarily from
    commercial banks, savings and loans, other independent mortgage lenders,
    and other mortgage REITs. Any increase in the competition among lenders
    to originate or purchase subprime mortgage loans may result in either
    reduced interest income on such mortgage loans compared to present levels
    or revised underwriting standards permitting higher loan-to-value ratios
    on properties securing subprime mortgage loans.

  . Loans made to subprime mortgage borrowers entail higher delinquency and
    loss rates. Lenders in the subprime mortgage banking industry make loans
    to borrowers who have impaired or limited credit histories, limited
    documentation of income and higher debt-to-income ratios than traditional
    mortgage lenders allow. Mortgage loans made to subprime mortgage loan
    borrowers generally entail a higher risk of delinquency and foreclosure
    than mortgage loans made to borrowers with better credit and may result
    in higher levels of realized losses. Any failure by us to adequately
    address the risks of subprime lending would have a material adverse
    impact on our results of operations, financial condition and business
    prospects.

                                       8
<PAGE>

  . Lack of mortgage loan performance data inhibits prediction of future
    results. The mortgage loans we purchased have been outstanding for a
    relatively short period of time. Consequently, the delinquency,
    foreclosure and loss experience of these mortgage loans to date may not
    be indicative of future results. It is unlikely that we will be able to
    sustain delinquency, foreclosure and mortgage loan loss rates at their
    present levels as the portfolio becomes more seasoned.

  . Failure to renew or obtain adequate funding under warehouse facilities
    and repurchase agreements may materially adversely impact our lending
    operations. We are currently dependent upon a few lenders to provide the
    primary credit facilities for our funding of mortgage loan originations
    and acquisitions. Any failure to renew or obtain adequate funding under
    these financing arrangements could have a material adverse effect on our
    lending operations and our overall performance.

  . Interest rate fluctuations may result in a decrease in net interest
    income. Interest rate fluctuations may affect our earnings as a result of
    potential changes in the spread between the interest rates on our
    borrowings and the interest rates on our mortgage assets. In addition,
    mortgage prepayment rates vary depending on such factors as mortgage
    interest rates and market conditions. Changes in anticipated prepayment
    rates may adversely affect our earnings.

  . Failure to hedge effectively against interest rate changes may adversely
    affect results of operations. Asset/liability management hedging
    strategies involve risk and may not be effective in reducing our exposure
    to interest rate changes. Moreover, compliance with the REIT provisions
    of the Code may prevent us from effectively implementing the strategies
    that we determine, absent such compliance, would best insulate us from
    the risks associated with changing interest rates.

  . We face loss exposure due to the underlying real estate. A substantial
    portion of our mortgage assets consists of (1) single family mortgage
    loans or (2) mortgage securities evidencing interests in single family
    mortgage loans. We will be subject to the risk of loss on such mortgage
    assets arising from borrower defaults to the extent not covered by third-
    party credit enhancement.

  . Market factors may limit our ability to acquire mortgage assets at yields
    which are favorable relative to borrowing costs. Despite management's
    experience in the acquisition of mortgage assets and its relationships
    with various mortgage suppliers, there can be no assurance that we will
    be able to acquire sufficient mortgage assets from mortgage suppliers at
    spreads above our cost of funds.

  . Restrictions on ownership of capital stock may inhibit market activity
    and the resulting opportunity for holders of our capital stock and
    warrants to receive a premium for their securities. In order for us to
    meet the requirements for qualification as a REIT, our charter generally
    prohibits any person from acquiring or holding, directly or indirectly,
    shares of common stock in excess of 9.8% of the outstanding shares. This
    restriction may inhibit market activity and the resulting opportunity for
    the holders of our common stock to receive a premium for their stock that
    might otherwise exist in the absence of such restrictions.

  . There is no assurance of an active public trading market. There is no
    assurance that an active public trading market for the common stock will
    be sustained. Our common stock's trading volume is relatively low
    compared to many other securities listed on the New York Stock Exchange.
    Our warrants trade through market makers, such as Stifel, Nicolaus &
    Company, Incorporated, using the NASD's bulletin board service. Shares of
    preferred stock are available for trading by qualified institutional
    buyers as defined in Rule 144A through the PORTAL market. There can be no
    assurance as to the development or liquidity of a market for the
    preferred stock, which will not be listed on a national securities
    exchange and will not be authorized for quotation on Nasdaq. The
    transferability of both the warrants and the preferred stock may be
    extremely limited.

                                       9
<PAGE>

                        Summary Financial and Other Data
                (dollars in thousands, except per share amounts)

<TABLE>
<CAPTION>
                                                                       For the
                                                                      Year Ended          For the
                                                                    December 31,        Period Ended
                                                                ----------------------  December 31,
                                                                   1998        1997         1996(1)
                                                                ----------  ----------  ------------
<S>                                                             <C>         <C>         <C>
Statement of Operations Data
 Interest income............................................... $  100,747  $   36,961    $   155
 Interest expense..............................................     80,794      28,185        --
 Net interest income...........................................     19,953       8,776        155
 Provision for credit losses...................................      7,430       2,453        --
 Net interest income after provision for credit losses.........     12,523       6,323        155
 Gains (losses) on sales of securities and termination of
  interest rate agreements.....................................    (22,939)         51        --
 Other.........................................................      3,188         704        --
 Equity in loss of NFI Holding Corporation.....................     (2,984)         28        --
 General and administrative expenses...........................     11,609       8,241        457
 Net income (loss).............................................    (21,821)     (1,135)      (302)
 Basic and diluted(2) loss per share...........................      (2.71)      (0.26)     (0.08)
<CAPTION>
                                                                        As of December 31,
                                                                ------------------------------------
                                                                   1998        1997         1996
                                                                ----------  ----------  ------------
<S>                                                             <C>         <C>         <C>
Balance Sheet Data
 Mortgage assets:
  Mortgage loans............................................... $  920,697  $  574,984        --
  Mortgage securities..........................................        --      517,246    $13,239
 Total assets..................................................  1,002,236   1,126,252     59,811
 Collateralized mortgage obligations...........................    891,944     408,867        --
 Short-term borrowings.........................................     18,000     556,443        --
 Stockholders' equity..........................................     87,290     116,489     46,380
</TABLE>

<TABLE>
<CAPTION>
                                                                As of or for the
                                                                   Year Ended         As of or for the
                                                                  December 31,          Period Ended
                                                                -------------------     December 31,
                                                                  1998       1997           1996(1)
                                                                --------   --------   ----------------
<S>                                                             <C>        <C>        <C>
Other Data
 Acquisition of wholesale loan production of NovaStar Mortgage:
  Principal at funding......................................... $876,516   $409,974           --
  Average principal balance per loan........................... $     94   $    130           --
  Weighted average interest rate:
   Adjustable-rate mortgage loans..............................     10.0%     10.13%          --
   Fixed rate mortgage loans...................................      9.9%     10.46%          --
  Loans with prepayment penalties..............................       74%        73%          --
  Weighted average prepayment penalty period (in years)(3).....      2.5        2.4           --
 Annualized return on average assets, before forgiveness of
  notes receivable from founders...............................    (2.95)%    (0.01)%       (0.50)%
 Annualized return on average equity, before forgiveness of
  notes receivable from founders...............................   (21.43)%    (0.06)%       (0.65)%
 Taxable income (loss)......................................... $ (1,211)  $  1,434        $ (173)
 Taxable income (loss) per share............................... $  (0.15)  $   0.18        $(0.05)
 Dividends declared per share(4)............................... $   1.00   $   0.28           --
 Number of account executives..................................       63         36           --
</TABLE>
- --------
(1) NovaStar Financial, Inc. was formed on September 13, 1996. Operations began
    in substance after the initial closing of the private placement on December
    9, 1996.
(2) Diluted loss per share is based on the weighted average shares of common
    stock and preferred stock outstanding, and includes the effect of warrants
    and options.
(3) Includes only those mortgage loans with a prepayment penalty.
(4) The level of quarterly dividends is determined by the Board of Directors
    based upon its consideration of a number of factors and should not be
    deemed indicative of taxable income for the quarter in which declared or
    future quarters, or of income calculated in accordance with generally
    accepted accounting principles.

                                       10
<PAGE>

                                  RISK FACTORS

Overall Enterprise of NovaStar Financial, Inc.

 Our dependence upon borrowings can result in significant liquidity
 constraints.

  Our profitability is dependent upon our ability to borrow money on favorable
terms. In October 1998, the subprime mortgage market faced a liquidity crisis
with respect to the availability of short-term borrowings from major lenders
and long-term borrowings through securitization. We faced significant liquidity
constraints and we entered into a short-term financing arrangement for
approximately $18 million. In the event the long-term securitization market
remains constrained, NovaStar Financial's ability to increase its portfolio and
earnings will be adversely affected. We refer you to "Recent Developments" in
the prospectus summary and "Events of the Fourth Quarter" in "Management's
Discussion and Analysis of Financial Condition and Results of Operation" for
more detail about the liquidity constraints, the resulting significant net
losses for the fourth quarter of 1998, and our short term financing
arrangement. Please read further in this "Risk Factors" section for more detail
on the risks related to liquidity.

 We have a limited operating history and incurred significant net losses in the
 fourth quarter of 1998.

  We began operations in December 1996 after the closing of a private
placement. Our affiliate, NovaStar Mortgage, began its mortgage lending
operation in late January 1997 and began servicing loans on July 15, 1997.
Because we have not developed an extensive earnings history nor experienced a
wide variety of interest rate or market conditions, our historical operating
performance may not predict our future performance. Although we generated net
income in the first three quarters of 1998, we incurred significant net losses
for the fourth quarter of 1998 due to certain events that occurred early in the
fourth quarter of 1998 as discussed in the "Management's Discussion and
Analysis of Financial Condition and Results of Operations" section of this
prospectus.

 Forgivable notes may adversely affect results of operations.

  Messrs. Hartman and Anderson each acquired 108,333 units at the price of
$15.00 per unit in our private placement. Hartman and Anderson paid for the
units by delivering promissory notes to us. Each promissory note was in the
amount of $1,624,995, bearing interest at eight percent per annum, and was
secured by the units acquired. The principal amount of the notes was divided
into three equal parts which we refer to as "tranches." We will forgive
principal due if the return to private placement investors meets benchmarks as
follows: one tranche will be forgiven if we generate a total return to the
private placement investors equal to or greater than 15% in any one fiscal
year; all tranches will be forgiven if the total cumulative return to private
placement investors reaches 100% prior to December 31, 2001. Return to
investors includes dividends paid and any appreciation in the average price per
share of the common stock and the related warrant during the period. For each
tranche forgiven, we will recognize a non-cash charge against earnings of
$1,083,330 for the related accounting period. Incentive targets were met and
one tranche was forgiven in 1997. Incentive targets were not met in 1998 and,
therefore, debt was not forgiven. The charges against earnings resulting from
forgiveness of the notes could have a material adverse effect on the results of
our operations and on the dividends paid to shareholders, including investors
in this offering, during periods forgiven.

 We depend on key personnel for successful operations.

  Our operations and the operations of NovaStar Mortgage depend heavily on the
contributions of Scott Hartman and Lance Anderson. Both Mr. Hartman and Mr.
Anderson would be difficult to replace. The loss of either of these individuals
could materially adversely effect our business and operating results.


                                       11
<PAGE>

 We need additional equity financing to support future growth.

  To fully implement our strategy to grow our portfolio of mortgage assets, we
will need to raise additional capital periodically. Accordingly, we expect to
undertake both future equity offerings and long-term securitized debt
offerings. There is no assurance that we will successfully and economically
raise the capital it will require through such offerings.

 Should we fail to maintain REIT status, we would be subject to tax as a
 regular corporation.

  We intend to operate so as to qualify as a REIT for federal income tax
purposes. In order to maintain our classification as a REIT for federal income
tax purposes, we must satisfy tests with respect to the sources of our income,
the nature and type of our assets, the amount of our distributions to
stockholders, and concentration of the ownership of our stock. If we fail to
qualify as a REIT in any taxable year and the relief provisions of the Code do
not apply, we would be subject to federal income tax as a regular, domestic
corporation and our stockholders would be subject to the same tax treatment as
stockholders of such corporation. Distributions to stockholders in any year in
which we fail to qualify as a REIT would not be deductible in computing our
taxable income. As a result, we could be subject to income tax liability and
the cash available for distribution to our stockholders would be significantly
reduced or eliminated. Further, we could also be disqualified from re-electing
REIT status for the four taxable years following the year we became
disqualified.

  There is no assurance that future legislation, regulations, administrative
interpretations or court decisions will not significantly change the tax laws
with respect to our qualification as a REIT or with respect to the federal
income tax consequences of such qualification. Any such changes may reduce or
eliminate our competitive advantage over non-REIT competitors.

 We lack voting control of our taxable affiliate NovaStar Mortgage.

  We formed NFI Holding to serve as a holding company for our taxable
affiliates in order to legally separate the mortgage loan origination operation
and other lines of business from the REIT entity. This was done for regulatory,
tax, risk management and other reasons. Scott Hartman and Lance Anderson own
100% of the voting common stock of NFI Holding while we own 100% of NFI
Holding's non-voting preferred stock. The common stock is entitled to 1% of
dividend distributions of NFI Holding and the preferred stock is entitled to
99% of such distributions. NFI Holding wholly owns NovaStar Mortgage, and the
REIT thus owns a beneficial interest in 99% of any future dividend
distributions from NovaStar Mortgage. NovaStar Mortgage has contracted with us
to: sell subprime mortgage loans it originates to us; service subprime mortgage
loans for us; and provide administrative services to us. Without voting control
of NovaStar Mortgage, you cannot be assured that our contracts with NovaStar
Mortgage, which are subject to renewal, will continue indefinitely. In
addition, while Messrs. Hartman and Anderson have entered into an agreement of
shareholders which contains management and control provisions and restrictions
on transfer of the common stock, you cannot be assured that the agreement will
be enforced in a timely manner against the individuals, their heirs or
representatives.

 Failure to qualify for Investment Company Act exemption may adversely affect
 our ability to use leverage and to conduct our business.

  We conduct our business so as not to become regulated as an investment
company under the Investment Company Act. The Investment Company Act exempts
entities that are "primarily engaged in the business of purchasing or otherwise
acquiring mortgages and other liens on and interests in real estate." If we
fail to qualify for exemption from registration as an investment company, our
ability to use leverage would be substantially reduced and we would be unable
to conduct our business. Any such failure to qualify for such exemption could
have a material adverse effect on us.


                                       12
<PAGE>

 Future revisions in policies and strategies at the discretion of Board of
 Directors may adversely affect operations.

  Management has established our operating policies and strategies set forth in
this prospectus. These policies and strategies may be modified or waived by the
Board of Directors, subject in some cases to approval by a majority of the
independent directors, without stockholder approval. The ultimate effect of
these changes may adversely affect our operations.

Subprime Mortgage Lending Operation

 Changes in interest rates may adversely affect results of operations.

  Any period of unexpected or rapid changes in interest rates is likely to
adversely affect results of our operations. For example, a substantial or
sustained increase in interest rates could adversely affect our ability to
acquire subprime mortgage loans in expected volumes necessary to support fixed
overhead expense levels. Decrease in interest rates generally cause mortgage
loans in the portfolio to prepay more quickly. This could result in our
amortizing more of the premium we paid for the mortgage loans and would,
therefore, decrease net interest income.

 Intense competition in the subprime mortgage loan industry may result in
 reduced net income or in revised underwriting standards which would adversely
 affect operations.

  NovaStar Financial and NovaStar Mortgage face intense competition, primarily
from commercial banks, savings and loans, other independent mortgage lenders,
and other mortgage REITs. As NovaStar Mortgage expands into the national market
and particular geographic markets, it will face competition from lenders with
established positions in these locations. Competition can take place on various
levels, including convenience in obtaining a loan, service, marketing,
origination channels and pricing.

  The subprime market is currently undergoing substantial changes. There are
new entities leaving and exiting into the market creating a changing
competitive environment. Furthermore, some large national finance companies and
prime mortgage originators have begun to implement plans to adapt their prime
mortgage loan origination programs and to allocate resources to the origination
of subprime mortgage loans. Some of these larger mortgage companies and
commercial banks have begun to offer products similar to those which are
offered by NovaStar Mortgage and have begun to target customers similar to
those targeted by NovaStar Mortgage. In the future, NovaStar Mortgage may also
face competition from government sponsored entities, such as Fannie Mae and
Freddie Mac, formerly known as FNMA and FHLMC, respectively. For example,
Freddie Mac has issued securities collateralized by subprime mortgage loans
originated by a financial institution.

  The entrance of these competitors into NovaStar Mortgage's market could have
a material adverse effect on our operating results and on our financial
condition. Increased competition could result in either reduced net interest
income on subprime mortgage loans compared to present levels or in revised
underwriting standards permitting higher loan-to-value ratios on properties
securing subprime mortgage loans. Increased competition may also increase the
demand for NovaStar Mortgage's experienced personnel and the potential that
such personnel will leave NovaStar for its competitors. There is no assurance
that NovaStar Mortgage will be able to compete successfully in this market
environment. Any failure in this regard could have a material adverse effect on
our operating results and on our financial condition. Fluctuations in interest
rates and general and localized economic conditions may also affect the
competition NovaStar Mortgage faces. Competitors with lower costs of capital
have a competitive advantage over us. During periods of declining rates,
competitors may solicit our customers to refinance their loans. In addition,
during periods of economic slowdown or recession, our borrowers may face
financial difficulties and be more receptive to the offers of our competitors
to refinance their mortgage loans.


                                       13
<PAGE>

 Higher loan-to-value ratios increase the risk that we may not recover, on
 default, full amounts due on mortgage loans.

  Our current underwriting guidelines allow for the acquisition of originated
loans with up to a 95% loan-to-value ratio. The higher the loan-to-value ratio,
the greater the risk that we may be unable to recover full amounts due on our
mortgage loans when a borrower defaults and we foreclose and sell the
underlying collateral. As of December 31, 1998, the average loan-to-value ratio
of our mortgage loan portfolio was 80%. Our failure to adequately address the
risk of high loan-to-value products would have a material adverse effect on our
operating results, our financial condition and our business prospects.

 Loans made to subprime mortgage borrowers entail higher delinquency and loss
 rates.

  Lenders in the subprime mortgage banking industry make loans to borrowers who
have impaired or limited credit histories, limited documentation of income and
higher debt-to-income ratios than traditional mortgage lenders allow. Mortgage
loans made to subprime mortgage borrowers generally entail a higher risk of
delinquency and foreclosure than mortgage loans made to borrowers with better
credit and may result in higher levels of realized loss. Most of our mortgage
loans are made to borrowers who do not qualify for mortgage loans from
conventional mortgage lenders. As of December 31, 1998, 7% of our mortgage loan
portfolio was comprised of mortgage loans made to borrowers graded "C" and 1%
of our portfolio was comprised of mortgage loans made to borrowers graded "D",
"C" and "D" being our two lowest credit grade classifications. There is no
assurance that our underwriting criteria or methods will afford adequate
protection against the higher risks associated with mortgage loans made to
subprime mortgage loan borrowers. Our failure to adequately address the risk of
subprime lending would have a material adverse impact on our operating results,
our financial condition and our business prospects.

 Failure to renew or obtain adequate funding under warehouse facilities and
 repurchase agreements may materially adversely impact our lending operations.

  We finance substantially all of our mortgage loans through interim financing
facilities including our bank warehouse credit line and repurchase agreements,
and with equity. These borrowings have been and will be repaid with the net
proceeds we receive from financing mortgage loans through securitization or
sales for cash. We are dependent upon a few lenders to provide the primary
credit facilities for our mortgaging loan originations and acquisitions. Any
failure to renew or obtain adequate funding under these financing arrangements,
find buyers for mortgage loan originations or issue asset-backed bonds could
have a material adverse impact on our lending operations.

 Financing with repurchase agreements may lead to margin calls if the market
 value of mortgage assets declines.

  In a repurchase agreement, we sell an asset and agree to repurchase the same
asset at some period in the future. Generally, the repurchase agreements we
enter into stipulate that we must repurchase the asset in 30 days. These
arrangements are treated as secured financings. The amount we can borrow under
these arrangements is generally 96% to 98% of the asset market value. When
asset market values decrease, we are required to repay the margin, or
difference in the market value. To the extent the market values of assets
financed with repurchase agreements decline rapidly, we will be required to
meet cash margin calls. If cash is unavailable, we may be forced to default
under the terms of the repurchase agreement. In that event, the lender retains
the right to liquidate the collateral to settle the amount we then owe.

 Interest rate fluctuations may adversely affect the value of our mortgage
 loans in process or held for sale or securitization.

  Changes in interest rates can have a variety of effects on our mortgage loan
origination business. The market value of fixed-rate mortgage loans has a
greater sensitivity to changes in market interest rates than

                                       14
<PAGE>

adjustable rate mortgage loans. To the extent an interest rate is established
for a mortgage loan in process prior to the time such mortgage loan is funded,
a gain or loss on the sale of the mortgage loan may result from changes in
interest rates during the period between the time the interest rate is
established and the time the mortgage loan is committed for sale. A sharp rise
in interest rates or increasing market concern about the value or liquidity of
a type or types of mortgage loans being held by us will reduce the market value
of the mortgage loans. This may cause lenders to require additional collateral.
Even with stable or declining interest rates, the market value of the type of
mortgage loans we hold could decrease, making long term securitization
expensive or unavailable. In addition, our results of operations from our
origination of mortgage loans can be adversely affected to the extent rising
interest rates decrease the volume of mortgage loan originations and the
revenue derived therefrom.

 Competition with other prospective purchasers of mortgage loans for business
 with independent brokers and lenders may result in fluctuations in volume and
 cost of acquiring mortgage loans.

  NovaStar Financial and NovaStar Mortgage depend upon independent mortgage
loan brokers and mortgage lenders for originations and purchases of new
mortgage loans. Our competitors also seek to establish relationships with
brokers and mortgage lenders. Our future results may become more exposed to
fluctuations in the volume and cost of acquiring our mortgage loans resulting
from competition from other prospective purchasers of mortgage loans.

 New laws and regulations, new administrative or judicial interpretations or
 our failure to comply with existing federal, state, and local legislation or
 regulation could adversely affect our operations.

  Members of Congress and government officials from time to time have suggested
the elimination of the mortgage interest deduction for federal income tax
purposes, either entirely or, in part, based on borrower income, type of
mortgage loan or principal amount. Because many of our mortgage loans will be
made to borrowers for the purpose of consolidating consumer debt or financing
other consumer needs, the competitive advantages of tax deductible interest,
when compared with alternative sources of financing, could be eliminated or
seriously impaired by such government action. Accordingly, the reduction or
elimination of these tax benefits could have a material adverse effect on the
demand for mortgage loans offered by us.

  The Clinton administration's fiscal 2000 budget would place several
constraints on the activities and ownership of a taxable REIT subsidiary. If
the proposal results in material changes to current rules and regulations on
taxable REIT subsidiaries, there could be a material adverse effect on our
operations.

  The businesses of NovaStar Financial and NovaStar Mortgage are subject to
extensive regulation, supervision and licensing by federal, state and local
governmental authorities. They are also subject to various laws and judicial
and administrative decisions imposing requirements and restrictions on all or
part of the businesses' operations. There can be no assurance that we will
maintain compliance with these requirements in the future without additional
expenses, or that more restrictive local, state or federal laws, rules and
regulations will not be adopted or that existing laws and regulations will not
be interpreted in a more restrictive manner, which would make compliance more
difficult for us. Failure to comply with these requirements can lead to loss of
approved status, termination or suspension of servicing contracts without
compensation to the servicer, demands for indemnifications or mortgage loan
repurchases, rights of rescission for mortgage loans, class action lawsuits and
administrative enforcement actions, all of which could cause a material adverse
impact on our profitability.

  These laws and regulations are subject to legislative, administrative and
judicial interpretation, and some have been infrequently interpreted or only
recently enacted, all of which can result in ambiguity with respect to
permitted conduct. Any ambiguity under the regulations to which we are subject
may lead to regulatory investigations or enforcement actions and private causes
of action, such as class action law suits, with respect to our compliance with
the applicable laws and regulations. As a mortgage lender, NovaStar Mortgage
will be subject to regulatory enforcement actions and private causes of action
from time to time with respect to its compliance with applicable laws and
regulations.

                                       15
<PAGE>

 Failure to comply with future regulatory interpretations or judicial decisions
 regarding broker compensation programs may adversely affect results of
 operations.

  Future regulatory interpretations or judicial decisions may require us to
change our broker compensation programs or else face material monetary
judgments or other penalties. Any such changes or penalties may have a material
adverse effect on our operating results, financial condition and on our
business prospects. Several law suits have been filed against a number of
mortgage lenders alleging that such lenders have violated the Real Estate
Settlement Procedures Act, commonly called RESPA, by making payments to
independent mortgage brokers. These lawsuits have generally been filed on
behalf of a purported nationwide class of borrowers and allege that payments
made by a lender to a broker in addition to payments made by the borrower to a
broker are prohibited by the Real Estate Settlement Procedure Act, and are
therefore illegal. Several federal district courts construing RESPA in these
cases have reached conflicting results. In 1998, the United States Court of
Appeals for the Eleventh Circuit ruled in two decisions in Culpepper v. Inland
Mortgage Corporation that the payment by the lender to the broker in the
circumstance of that particular case constituted a prohibited referral fee
under the Real Estate Settlement Procedure Act. The case was remanded to the
district court for further proceedings. If the pending cases on lender payments
to brokers are ultimately resolved against the lenders, it may cause an
industry-wide change in the way independent mortgage brokers are compensated.
Our broker compensation programs currently utilize such payments.

 Contamination of properties securing mortgage loans by hazardous substances
 would result in our facing environmental liabilities.

  Properties securing mortgage loans may be contaminated by hazardous
substances. As a result, the value of the real property may be diminished. In
the event that we are forced to foreclose on a defaulted mortgage loan on that
property, we may be subject to environmental liabilities regardless of whether
we were responsible for the contamination. While we intend to exercise due
diligence to discover potential environmental liabilities prior to the
acquisition of any property through foreclosure, hazardous substances or
wastes, contaminants, pollutants or sources thereof may be discovered on
properties during our ownership or after a sale thereof to a third party. If
such hazardous substances are discovered on properties, we may be required to
remove those substances or sources and clean up the property. The company may
also be liable to tenants and other users of neighboring properties. Such
clean-up costs and liabilities may be extensive and may materially and
adversely affect our results of operations. In addition, we may find it
difficult or impossible to sell the property prior to or following any such
clean-up.

Acquisition and Management of a Portfolio of Mortgage Assets

 General economic and financial conditions in mortgage and financial markets
 may affect our results of operations.

  The results of our mortgage assets portfolio operation are affected by
various factors, many of which are beyond our control. The performance of our
mortgage assets portfolio depends on, among other things, the level of net
interest income generated by our mortgage assets, the market value of such
mortgage assets and the supply and demand for such mortgage assets. Our net
interest income varies primarily as a result of changes in short-term interest
rates, borrowing costs and prepayment rates, the behavior of which involve
various risks and uncertainties as set forth below. Prepayment rates, interest
rates, borrowing costs and credit losses depend upon the nature and terms of
the mortgage assets, the geographic location of the properties securing the
mortgage loans included in or underlying the mortgage assets, conditions in
financial markets, the fiscal and monetary policies of the U.S. government and
the Board of Governors of the Federal Reserve System, international economic
and financial conditions, competition and other factors, none of which can be
predicted with any certainty. Because changes in interest rates may
significantly affect our activities, our operating results depend, in large
part, upon our ability to manage our interest rate and prepayment risks while
maintaining our status as a REIT. Prolonged failure to manage such risks would
adversely affect our results of operations.

                                       16
<PAGE>

 Interest rate fluctuations may result in a decrease in net interest income.

  Our adjustable rate mortgage loans bear adjustable interest or pass-through
rates based on short-term interest rates, and substantially all of our
borrowings bear interest at short-term rates and have maturities of less than
one year. Consequently, changes in short-term interest rates may significantly
influence our net interest income. While rising short-term interest rates
generally increase the yields on our adjustable rate mortgage loans, rising
short-term interest rates also increase the cost of our borrowings which are
utilized to fund the mortgage loans. To the extent such costs escalate more
rapidly than the yields, our net interest income may be reduced or a net loss
may result. Conversely, falling short-term interest rates may decrease the
interest cost on our borrowings more rapidly than the yields on the mortgage
loans and hence may increase our net interest income. There is no assurance as
to the amount or timing of changes in interest rates or their effect on our
mortgage assets or net interest income.

  As of December 31, 1998, 67% of our mortgage loans, $601 million, had
adjustable rate characteristics. Adjustable rate mortgage loans, commonly
called ARMs, are inherently riskier than fixed rate mortgage loans. These loans
have interest rates that may rise, resulting in higher mortgage payments for
the borrower. Adjustable rate mortgage loans are usually underwritten at a
higher interest rate, to ensure that the borrower has the ability to make
mortgage payments as the rate on the mortgage loan increases. An increasing
interest rate environment will force the borrower to make higher mortgage
payments, which could result in higher delinquencies, foreclosures and losses.

 Interest rates on our borrowings adjust differently than those on related
 adjustable rate mortgages which may adversely affect our net interest income.

  A substantial portion of all mortgage loans we own have adjustable terms
today or are fixed today, but will adjust at some point in the future. Interest
rates on our borrowings are and generally will be based on short-term indices.
To the extent any of our mortgage loans are financed with borrowings bearing
interest based on or varying with an index different from that used for the
related mortgage assets, so-called "basis" interest rate risk will arise. In
this event, if the index used for the mortgage assets is a "lagging" index,
such as the 11th District Cost of Funds, that reflects market interest rate
changes on a delayed basis, and the rate borne by the related borrowings
reflects market rate changes more rapidly, our net interest income will be
adversely affected in periods of increasing market interest rates.
Additionally, our adjustable rate mortgage loans will be subject to periodic
rate adjustments which may be more or less frequent than the increases or
decreases in rates borne by the borrowings or financing we utilize.
Accordingly, in a period of increasing interest rates, we could experience a
decrease in net interest income or a net loss because the interest rates on
borrowings could adjust faster than the interest rates on our adjustable rate
mortgages or mortgage assets backed by adjustable rate mortgages.

  As of December 31, 1998, 67% of our mortgage loans bear rates that adjust
semiannually, annually or are fixed for two or three years and adjust annually
thereafter. All of our borrowings bear variable rates of interest. Rates on our
repurchase agreements are variable based on the terms to maturity of individual
agreements. As of December 31, 1998, these repurchase agreements were tied to
one-month LIBOR. The rate on our warehouse line of credit adjusts based upon
the federal funds rate.

 Interest rate caps on adjustable rate mortgages may adversely affect our net
 interest income.

  Adjustable rate mortgage loans are typically subject to periodic and lifetime
interest rate caps that limit the amount an adjustable rate mortgage interest
rate can change during any given period. Our borrowings will not be subject to
similar restrictions. Hence, in a period of rapidly increasing interest rates,
we could also experience a decrease in net interest income or a net loss in the
absence of effective hedging because the interest rates on borrowings could
increase without limitation while the interest rates on our adjustable rate
mortgages and mortgage assets backed by adjustable rate mortgages would be
limited by caps. Further, some adjustable rate mortgages may be subject to
periodic payment caps that result in some portion of the interest

                                       17
<PAGE>

accruing on the adjustable rate mortgage being deferred and added to the
principal outstanding. This could result in our receipt of less cash income on
our adjustable rate mortgages than is required to pay interest on the related
borrowings, which will not have such payment caps.

 Changes in anticipated prepayment rates may adversely affect net interest
 income.

  Prepayment rates vary from time to time and may cause changes in the amount
of our net interest income. Prepayments of adjustable rate mortgages and
mortgage assets backed by adjustable rate mortgages usually can be expected to
increase when mortgage interest rates fall below the then-current interest
rates on such adjustable rate mortgages and decrease when mortgage interest
rates exceed the then-current interest rate on adjustable rate mortgages,
although such effects are not predictable. Prepayment experience may also be
affected by the geographic location of the property securing the mortgage
loans, the assumability of the mortgage loans, conditions in the housing and
financial markets and general economic conditions. In addition, prepayments on
adjustable rate mortgages are affected by the ability of the borrower to
convert an adjustable rate mortgage to a fixed-rate mortgage loan by conditions
in the fixed-rate mortgage market. If the interest rate on adjustable rates
mortgage increase at a rate greater than the interest rate on fixed-rate
mortgage loans, prepayments on adjustable rate mortgages may tend to increase.
In periods of fluctuating interest rates, interest rates on adjustable rate
mortgages may exceed interest rates on fixed-rate mortgage loans, which may
tend to cause prepayments on adjustable rate mortgages to increase at a rate
greater than anticipated. We will seek to minimize prepayment risk through a
variety of means to the extent they are available to us at reasonable cost at
various points in time. These means may include structuring a diversified
portfolio with a variety of prepayment characteristics, investing in mortgage
assets with prepayment prohibitions and penalties and investing in mortgage
security structures which have prepayment protection. In addition, we may
purchase interest-only strips to a limited extent. The basis risk that will
exist between an interest-only strips and the other assets in the portfolio
could increase our risk in interest rate environments where interest-only strip
would amortize quickly.

  Changes in anticipated prepayment rates of mortgage assets could affect us in
several adverse ways. Faster than anticipated prepayment of any mortgage asset
that we purchased at a premium would generally result in a faster than
anticipated write-off of any remaining capitalized premium amount and
consequent reduction of our net interest income by such amount. A portion of
the adjustable-rate single family mortgage loans which we may acquire, either
directly as mortgage loans or through mortgage securities backed by adjustable
rate mortgages, will generally bear initial interest rates which are lower than
their "fully-indexed" rates. In the event that such an asset prepays faster
than anticipated prior to or soon after the time of adjustment to a fully-
indexed rate, we will have experienced an adverse effect on our net interest
income during the time we held such adjustable rate mortgage compared with
holding a fully-indexed adjustable rate mortgage and will have lost the
opportunity to receive interest at the fully-indexed rate over the expected
life of the adjustable rate mortgage

  Subprime borrowers are frequently in a unique position to receive economic
gain from refinancing due to improving their mortgage and consumer credit
profiles through timely payments on outstanding loans. As a result, a subprime
borrower may be able to lower the rate on their home loan without a change in
interest rates.

 Failure to hedge effectively against interest rate changes may adversely
 affect results of operations.

  Our operating strategy subjects us to interest rate risks. We follow an
asset/liability management program intended to protect against interest rate
changes and prepayments. Nevertheless, developing an effective asset/liability
management strategy is complex and no strategy can completely insulate us from
risks associated with interest rate changes and prepayments. In addition, there
is no assurance that our hedging activities will have the desired beneficial
impact on our operating results or financial condition. Hedging typically
involves costs, including transaction costs, which increase dramatically as the
period covered by the hedge increases and which also increase during periods of
rising and volatile interest rates. We may increase our hedging activity, and
thus increase our hedging costs, during such periods when interest rates are
volatile or rising and hedging

                                       18
<PAGE>

costs have increased. Moreover, federal tax laws applicable to REITs may
substantially limit our ability to engage in asset/liability management
transactions. Such federal tax laws may prevent us from effectively
implementing hedging strategies that we determine, absent such restrictions,
would best insulate us from the risks associated with changing interest rates
and prepayments.

 Limitations on effective hedging may adversely affect attempts to mitigate
 risk of variable rate liabilities.

  We purchase interest rate caps and interest rate swaps to attempt to mitigate
the risk of variable rate liabilities increasing at a faster rate than the
earnings on its assets during a period of rising interest rates. In this way,
we intend generally to hedge as much of the interest rate risk as we determine
is in our best interests given the cost of such hedging transactions and the
need to maintain our status as a REIT. In this regard, the amount of income we
may earn from interest rate swaps and caps is subject to substantial
limitations under the REIT provisions of the Code. We may hedge the risk of our
borrowing costs on our variable rate liabilities increasing faster than our
income, due to the effect of the periodic and lifetime caps on our mortgage
assets, through the acquisition of

  . qualified REIT assets, such as interest-only REMIC regular interests,
    that function in a manner similar to hedging instruments;

  . qualified hedges, the income from which qualifies for the 95% income
    test, but not the 75% income test for REIT qualification purposes; and

  . other hedging instruments, whose income qualifies for neither the 95%
    income test nor the 75% income test.

The latter form of hedging may be accomplished through one of our taxable
affiliates.This determination may result in our election to bear a level of
interest rate risk that could otherwise be hedged when we believe, based on all
relevant facts, that bearing such risk is advisable.

 Hedging poses a credit risk.

  In the event that we purchase interest rate caps or other interest rate
agreements to hedge against lifetime and periodic rate or payment caps, and the
provider of interest rate agreements becomes financially unsound or insolvent,
we may be forced to unwind our interest rate agreements with such provider and
may take a loss on such interest rate agreements. Although we intend to
purchase interest rate agreements only from financially sound institutions and
to monitor the financial strength of such institutions on a periodic basis,
there is no assurance that we can avoid such third party risks.

 Hedging poses a legal risk.

  We accept legal risk in entering into interest rate swap and cap agreements.
No assurance can be given as to the enforceability of these agreements. An
agreement that is not enforceable may subject us to unexpected interest rate
risk and have a material adverse affect on results of operations.

 Hedging poses a basis risk.

  We also accept basis risk in entering into interest rate swap and cap
agreements. Basis risk occurs as the performance of hedged financing sources
vary from expectations and differ from the performance of the hedging
instrument. For instance, we hedge our borrowing to mitigate interest rate risk
of mortgage assets that are fixed or we reprice at different times or based on
different indices. Although the hedging item may reduce interest rate risk,
borrowers may prepay at speeds which vary from initial expectation. Absent
proper monitoring, we could have a hedging instrument in place without an
underlying financing source. The consequence of which may be a material adverse
effect on results of operations.


                                       19
<PAGE>

  We are not regulated in regards to our hedging activities. However, in order
to maintain our exemption from the registration requirements of the Commodities
Exchange Act, we are limited with respect to investments in futures contracts,
options on futures contracts and options on commodities.

 We face loss exposure on single family mortgage assets.

  A substantial portion of our investment portfolio consists of single family
mortgage loans or mortgage assets evidencing interests in single family
mortgage loans. We will generally bear the risk of loss on any such mortgage
assets we purchase in the mortgage market or through our mortgage lending
business. To the extent third parties have been contracted to provide the
credit enhancement, we are dependent in part upon the credit worthiness and
claims-paying ability of the insurer and the timeliness of reimbursement in the
event of a default on the underlying obligations. Further, the insurance
coverage for various types of losses is limited in amount and losses in excess
of the limitation would be borne by us.

  Accordingly, during the time we hold such mortgage loans, we will be subject
to risks of borrower defaults and bankruptcies and special hazard losses that
are not covered by standard hazard insurance, such as those occurring from
earthquakes or floods. In the event of a default on any single family mortgage
loan held by us, including, without limitation, resulting from higher default
levels as a result of declining property values and worsening economic
conditions, among other factors, we would bear the risk of loss of principal to
the extent of any deficiency between the value of the related real property,
plus any payments from an insurer or guarantor, and the amount owing on the
mortgage loan. Defaulted mortgage loans would also cease to be eligible
collateral for borrowings and would have to be financed by us out of other
funds until ultimately liquidated, resulting in increased financing costs and
reduced net income or a net loss.

  We may pool and finance or sell through securitizations a substantial portion
of the single family mortgage loans we acquire. In securitizations, we continue
to bear risk of loss on the underlying mortgage loans.

 We face loss exposure due to the credit risks of subprime mortgage loans.

  Credit risks associated with non-conforming mortgage loans, especially
subprime mortgage loans, may be greater than those associated with prime
mortgage loans that conform to Fannie Mae and Freddie Mac guidelines. The
principal difference between non-conforming subprime mortgage loans and
conforming mortgage loans include the applicable loan-to-value ratios, the
credit and income histories of the borrowers, the documentation required for
approval of the borrowers, the types of properties securing the mortgage loans,
loan sizes and the borrowers occupancy status with respect to the mortgaged
property. As a result of these and other factors, the interest rates charged on
non-conforming mortgage loans are often higher than those charged for
conforming mortgage loans. The combination of different underwriting criteria
and higher rates of interest may lead to higher delinquency rates and/or credit
losses for non-conforming as compared to conforming mortgage loans and could
have an adverse effect on us to the extent that we invest in those mortgage
loans or securities secured by such mortgage loans.

 We face loss exposure due to the underlying real estate.

  Many of the risks of holding subprime mortgage loans and retaining, after
securitization, credit risk derived therefrom reflect the risks of investing
directly in the real estate securing the underlying mortgage loans. This may be
especially true in the case of a relatively small or less diverse pool of
subprime mortgage loans. In the event of a default on the underlying mortgage
loan, the ultimate extent of the loss, if any, may only be determined after a
foreclosure of the mortgage encumbering the property and, if the lender takes
title to the property, upon liquidation of the property. Factors such as the
title to the property or its physical condition, including environmental
considerations, may make a third party unwilling to purchase the property at a
foreclosure sale or for a price sufficient to satisfy the obligations with
respect to the related mortgage securities. Foreclosure laws in various states
may extend the foreclosure process. In addition, the condition of a property
may deteriorate during the pendency of foreclosure proceedings. Some borrowers
on underlying mortgages may

                                       20
<PAGE>

become subject to bankruptcy proceedings, in which case the amount and timing
of amounts due may be materially adversely affected.

 Market factors may limit our ability to acquire mortgage assets at yields
 which are favorable relative to borrowing costs.

  Our net income depends, in large part, on our ability to acquire mortgage
assets at favorable spreads over our borrowing costs. In acquiring mortgage
assets, we compete with other REITs, securities dealers, savings and loan
associations, banks, mortgage bankers, insurance companies, mutual funds, other
lenders, Ginnie Mae, Fannie Mae, Freddie Mac and other entities purchasing
mortgage assets. In addition, there are several mortgage REITs similar to us,
and others may be organized in the future. The effect of the existence of
additional REITs may be to increase competition for the available supply of
mortgage assets suitable for our purchase.

  Despite management's experience in the acquisition of mortgage assets and its
relationships with various mortgage suppliers, there is no assurance that we
will be able to acquire sufficient mortgage assets from mortgage suppliers at
spreads above our cost of funds. We will also face competition for financing
sources, and the effect of the existence of additional mortgage REITs may be to
deny us access to sufficient funds to carry out our business strategy and/or to
increase the cost of funds to us.

 We face substantial leverage and potential net interest and operating losses
 in connection with borrowings.

  We employ a financing strategy to increase the size of our mortgage asset
portfolio by borrowing a substantial portion of the market value of our
mortgage assets. The portion borrowed may vary depending upon the mix of the
mortgage assets in our portfolio and the application of our policies with
respect to such mix of mortgage assets. If the returns on the mortgage assets
purchased with borrowed funds fail to cover the cost of the borrowings, we will
experience net interest losses and may experience net losses. In addition, due
to increases in haircuts, i.e., the discount from face value applied by a
lender or purchaser with respect to our mortgage securities, decreases in the
market value of our mortgage assets, increases in interest rate volatility,
availability of financing in the market, circumstances then applicable in the
lending market and other factors, we may not be able to achieve the degree of
leverage we believe to be optimal. This may cause us to be less profitable than
we might be otherwise. We use our capital allocation guidelines to manage the
amount of debt incurred and leverage employed in our balance sheet. These
guidelines have been approved by the Board of Directors, who also have the
ability to change them. As of December 31, 1998, our equity represented 8.7% of
assets.

 Our failure to refinance outstanding borrowings on favorable terms may affect
 results of operations.

  Additionally, our ability to achieve our investment objectives depends not
only on our ability to borrow money in sufficient amounts and on favorable
terms but also on our ability to renew or replace on a continuous basis our
maturing short-term borrowings. Our business strategy relies on short-term
financing agreements to fund mortgage asset originations and purchases. We have
not at the present time entered into any commitment agreements under which a
lender would be required to enter into new borrowing agreements during a
specified period of time; however, we may enter into one or more of such
commitment agreements in the future if deemed favorable. In the event we are
not able to renew or replace maturing borrowings, we could be required to sell
mortgage assets under adverse market conditions and could incur losses as a
result. In addition, in such event, we may be required to terminate hedge
positions, which could result in further costs to us. An event or development
such as a sharp rise in interest rates or increasing market concern about the
value or liquidity of a type or types of mortgage assets in which our portfolio
is concentrated will reduce the market value of the mortgage assets, which
would likely cause lenders to require additional collateral. At the same time,
the market value of the mortgage assets in which our liquidity capital is
invested may have decreased. A number of such factors in combination may cause
us difficulties, including a possible liquidation of a major portion of our

                                       21
<PAGE>

mortgage assets at disadvantageous prices with consequent losses, which could
have a materially adverse effect on our profitability and our solvency.

  A majority of our borrowings are collateralized borrowings, primarily in the
form of reverse repurchase agreements and similar borrowings, the availability
of which are based on the market value of the mortgage assets pledged to secure
the specific borrowings, availability of financing in the market, circumstances
then applicable in the lending market and other factors. The cost of borrowings
under reverse repurchase agreements generally corresponds to LIBOR or the
federal funds rate plus a spread. The cost of borrowings under other sources of
funding which we may use may refer or correspond to other short-term indices,
plus a margin. The margins on such borrowings over or under LIBOR, the federal
funds rate or such other short-term indices vary depending upon the lender, the
nature and liquidity of the underlying collateral, the movement of interest
rates, the availability of financing in the market and other factors. If the
actual cash flow characteristics are other than as expected, we may experience
reduced net interest income.

 Decline in market value of mortgage assets may limit our ability to borrow,
 result in lenders initiating margin calls and require us to sell mortgage
 assets in adverse market conditions.

  A decline in the market value of our portfolio of mortgage assets may limit
our ability to borrow or result in lenders initiating margin calls. A lender's
margin call requires a pledge of cash or additional mortgage assets to re-
establish the ratio of the amount of the borrowing to the value of the
collateral. This remains true despite the employment of hedging strategies. We
could be required to sell mortgage assets under adverse market conditions in
order to maintain liquidity. Such sales may be effected by management when
deemed by it to be necessary in order to preserve our capital base. If these
sales were made at prices lower than the amortized cost of the mortgage assets,
we would experience losses. A default by us under our collateralized borrowings
could also result in a liquidation of the collateral, including any cross-
collateralized assets, and a resulting loss of the difference between the value
of the collateral and the amount borrowed. Additionally, in the event of our
bankruptcy, reverse repurchase agreements may qualify for special treatment
under the bankruptcy laws, the effect of which is, among other things, to allow
the creditors under such agreements to avoid the automatic stay provisions of
the bankruptcy laws and to liquidate the collateral under such agreements
without delay. Conversely, in the event of the bankruptcy of a party with whom
we had a reverse repurchase agreement, we might experience difficulty
recovering the collateral subject to such agreement if the agreement were to be
repudiated and our claim against the bankrupt lender for any resulting damages
were to be treated simply as one of an unsecured creditor. Should this occur,
our claims would be subject to significant delay. In addition, recoveries, if
and when received, may be substantially less than the damages we actually
suffered. There is no assurance that we will be able to avoid such third-party
risks.

  To the extent that we are compelled to liquidate mortgage assets that are
qualified REIT assets to repay borrowings, we may be unable to comply with the
REIT provisions of the Code regarding assets and sources of income
requirements. This could ultimately jeopardize our status as a REIT or could
result in the imposition of substantial taxes and penalties.

 Adverse changes in the securitization market could impair our ability to
 acquire and finance mortgage loans through securitizations on a favorable or
 timely basis.

  Any impairment to the securitization market could have a material adverse
effect on our operating results and financial condition. In addition, in order
to gain access to the securitization market, we generally expect to rely upon
credit enhancements provided by one or more monoline insurance carriers. Any
substantial reductions in the size or availability of the securitization market
for our mortgage loans, or the unwillingness of insurance companies to provide
credit enhancement for our mortgage securities could have a material adverse
effect on our operating results and financial condition.


                                       22
<PAGE>

 Mortgage loan performance may adversely affect future results.

  The delinquency, foreclosure and loss experience to date of the mortgage
loans we have purchased may not be indicative of future results. We do maintain
reserves based on estimated delinquency, foreclosure and loan loss rates.
Actual results may differ from the estimates which may adversely affect our
results of operation.

 Illiquidity of investments restricts resale of mortgage securities.

  We may invest in mortgage securities, which have been sold in private
placements and have not been registered under the Securities Act. Unregistered
mortgage securities may be subject to restrictions on resale that may limit our
ability to sell them when it might be most desirable to do so. Some of our
investments may lack a regular trading market and may be illiquid. In addition,
during turbulent market conditions, the liquidity of all of our mortgage assets
may be adversely impacted. There is no limit in the percentage of our
investments that may be invested in illiquid mortgage assets.

 Lack of geographic diversification of properties underlying mortgage assets
 may subject such mortgage assets to greater risk of default in event of
 hazards that affect such region.

  We seek geographic diversification of the properties underlying our mortgage
assets and have established a diversification policy. Nevertheless, properties
underlying such mortgage assets may be located in the same or a limited number
of geographical regions. For example, as of December 31, 1998, 18% and 12% of
our mortgage loan portfolio was comprised of loans secured by California and
Florida real estate, respectively. To the extent that properties underlying
such mortgage assets are located in the same geographical region, such mortgage
assets may be subject to a greater risk of default than other comparable
mortgage assets in the event of adverse economic, political or business
developments and natural hazard risks that may affect such region and,
ultimately, the ability of property owners to make payments of principal and
interest on the underlying mortgages.

Investment in the Securities in the Offering

 Restrictions on ownership of capital stock may inhibit market activity and the
 resulting opportunity for holders of our capital stock and warrants to receive
 a premium for their securities.

  Our charter authorizes the Board of Directors to reclassify any of the
unissued shares of authorized capital stock into a class or classes of
preferred stock. The issuance of preferred stock could have the effect of
making an attempt to gain control of NovaStar Financial more difficult by means
of a merger, tender offer, proxy contest or otherwise. The preferred stock, if
issued, could have a preference on dividend payments over our common stock
which could affect our ability to make dividend distributions to the holders of
our common stock.

  In order that we may meet the requirements for qualification as a REIT at all
times, the charter generally prohibits any person from acquiring or holding,
directly or indirectly, shares of capital stock in excess of 9.8% of the
outstanding shares of capital stock.

  These provisions may inhibit market activity and the resulting opportunity
for the holders of our capital stock and warrants to receive a premium for
their securities that might otherwise exist in the absence of such provisions.
Such provisions also may make us an unsuitable investment vehicle for any
person seeking to obtain ownership of more than 9.8% of the outstanding shares
of capital stock.

  In addition, provisions of Maryland law relating to "business combinations"
and a "control share acquisition" and of our charter and bylaws, e.g.,
staggered terms for directors, may also have the effect of delaying, deterring
or preventing a takeover attempt or other change in control which would be
beneficial to shareholders and might otherwise result in a premium over then
prevailing market prices.


                                       23
<PAGE>

 Future sales of securities may dilute the equity of our stockholders or reduce
 the price of shares of our common stock.

  We expect to increase our capital resources by making additional offerings of
equity and debt securities, including classes of preferred stock, common stock,
commercial paper, medium-term notes, mortgage-backed obligations and senior or
subordinated debt. All debt securities and classes of preferred stock will be
senior to the common stock in the event of our liquidation. Additional equity
offerings may dilute the equity of our stockholders or reduce the price of
shares of our common stock, or both. We are unable to estimate the amount,
timing or nature of additional offerings as they will depend upon market
conditions and other factors.

  As of December 31, 1998, options to purchase 383,820 shares of common stock
were outstanding under our stock option plan, which will vest on various dates
extending through December 30, 2002. We filed a Form S-8 registration statement
to permit shares issued pursuant to the exercise of options to be sold.

 There is no assurance of an active public trading market.

  There is no assurance that an active public trading market for the common
stock will be sustained. Our common stock's trading volume is relatively low
compared to many other securities listed on the New York Stock Exchange. Our
warrants trade through market makers, such as Stifel, Nicolaus & Company,
Incorporated, using the NASD's bulletin board service. Shares of preferred
stock are available for trading by qualified institutional buyers as defined in
Rule 144A through the PORTAL market. There can be no assurance as to the
development or liquidity of a market for the preferred stock, which will not be
listed on a national securities exchange and will not be authorized for
quotation on Nasdaq. The transferability of both the warrants and the preferred
stock may be extremely limited.

 Possible volatility of stock price may adversely impact the liquidity of our
 common stock and may result in losses to stockholders who sell shares of
 common stock.

  In the active trading market for the common stock, the market price of our
common stock may experience fluctuations unrelated to our operating
performance. In particular, the price of our common stock may be affected by
general market price movements as well as developments specifically related to
the finance industry such as interest rate movements and credit quality trends.

  It is likely that the market price of our common stock will be influenced by
any variation between the net yield on our mortgage assets and prevailing
market interest rates and by the markets perception of our ability to achieve
earnings growth. Our earnings will be derived primarily from any positive
spread between the yield on our mortgage assets and the cost of our borrowings.
During the period immediately following our receipt of net proceeds from an
offering or other source, prior to the time we have fully implemented our
financing strategy to employ such net proceeds, our earnings and levels of
dividend distributions may be lower than if the financing strategy were fully
implemented, which may affect the market value of our common stock. In
addition, the positive spread between the yield on our mortgage assets and the
cost of borrowings will not necessarily be larger in high interest rate
environments than in low interest rate environments regardless of our business
strategy to achieve such result. Accordingly, in periods of high interest
rates, our net income and, therefore, the dividend yield on our common stock
may be less attractive compared with alternative investments, which could
negatively impact the price of our common stock. If the anticipated or actual
net yield on our mortgage assets declines or if prevailing market interest
rates rise, thereby decreasing the positive spread between the net yield on the
mortgage assets and the cost of our borrowings, the market price of our common
stock may be materially adversely affected. In addition, if the market price of
other REIT stocks decline for any reason, or there is a broad-based decline in
real estate values or in the value of our portfolio of mortgage assets, the
market price of the common stock may be adversely affected. During any period
when the market price of our common stock has been adversely affected due to
any of the foregoing reasons, the liquidity of our common stock may be
negatively impacted and stockholders who may desire or be required to sell
their shares of common stock may experience losses.

                                       24
<PAGE>

                            NOVASTAR FINANCIAL, INC.

  We were founded by Scott Hartman and Lance Anderson and incorporated in the
State of Maryland on September 13, 1996. We have elected to be a REIT for
federal income tax purposes. As a result of our REIT status, we will be
permitted to deduct dividend distributions to stockholders, thereby effectively
eliminating the "double taxation" that generally results when a corporation
earns income and distributes that income to stockholders in the form of
dividends.

  NFI Holding, Inc. was incorporated in the State of Delaware on February 6,
1997. Our founders own equally 100% of the voting common stock of NFI Holding.
We own 100% of the preferred stock of NFI Holding, for which we receive 99% of
dividends paid by NFI Holding. NFI Holding owns NovaStar Mortgage, NovaStar
Capital, NovaStar Mortgage Funding Corporation II and NovaStar REMIC Financing
Corporation. NovaStar Mortgage was incorporated in the State of Virginia on May
16, 1996. Although NovaStar Mortgage was formed in 1996, substantial operations
did not commence until January 1997. NovaStar Capital, a Delaware corporation,
was incorporated on September 29, 1998. NovaStar Mortgage Funding Corporation
II and NovaStar REMIC Financing Corporation were incorporated in the State of
Delaware on January 25, 1999. On October 1, 1997, we founded NovaStar Assets
Corporation, a wholly-owned, REIT-qualifying subsidiary, in conjunction with
our first issuance of a collateralized mortgage obligation, and on December 3,
1997, we founded NovaStar Certificates Financing Corporation, a second wholly-
owned REIT-qualifying subsidiary. NovaStar Capital Access Corporation, an
inactive corporation organized in Delaware on February 26, 1998, is also one of
our wholly-owned REIT-qualifying subsidiaries.

  Our basic function is to manage our mortgage loans and securities. NovaStar
Mortgage serves as a source for loan origination--a primary source of our
mortgage loans. In addition, NovaStar Mortgage services our loans. Through June
30, 1998, we purchased substantially all of NovaStar Mortgage's loan
originations. Beginning July 1, 1998, NovaStar Mortgage began retaining the
loans it originates to be sold in the open market.

  We are self-advised and self-managed. Our management oversees our day-to-day
operations, subject to supervision by our Board of Directors. Our management
team has considerable expertise in the origination, acquisition and management
of mortgage loans and securities and asset/liability management. The principal
executive offices of NovaStar Financial and NovaStar Mortgage are at
1901 W. 47th Place, Suite 105, Westwood, Kansas 66205, telephone (913) 362-
1090. Novastar Mortgage operates a loan origination facility at 23046 Avenue De
La Carlota, Laguna Hills, California 92653.

                                USE OF PROCEEDS

  We will receive no proceeds from the sale of the preferred stock or warrants
by the selling securityholders, but we will receive the net proceeds from the
sale of common stock underlying the warrants. Net proceeds from the sale of the
underlying common stock will be used to purchase mortgage assets and for
working capital and general corporate purposes. Pending these uses, the net
proceeds may be temporarily invested to the extent consistent with the REIT
provisions of the Code, or alternatively, may be used to temporarily pay down
warehouse borrowing facilities. We anticipate that we will fully invest our net
proceeds in mortgage loans or securities as soon as reasonably practicable upon
receipt of such proceeds. No mortgage assets have been specifically identified
in which to invest our net proceeds of this offering.

                                       25
<PAGE>

                       DIVIDEND POLICY AND DISTRIBUTIONS

  We generally intend to distribute substantially all of our taxable income
each year to our stockholders so as to comply with the REIT provisions of the
Code. Taxable income does not ordinarily equal net income as calculated in
accordance with generally accepted accounting principles. We generally intend
to make dividend distributions quarterly. We intend to distribute any taxable
income remaining after the distribution of the final regular quarterly dividend
each year together with the first regular quarterly dividend payment of the
following taxable year or in a special dividend distributed prior thereto. The
dividend policy is subject to revision at the discretion of the Board of
Directors. All distributions will be made at the discretion of the Board of
Directors. Dividends will depend on taxable income, our financial condition,
maintenance of REIT status and other factors as the Board of Directors deems
relevant.

  Distributions to stockholders will generally be subject to tax as ordinary
income, although a portion of such distributions may be designated by us as
capital gain or may constitute a tax-free return of capital. We will annually
furnish to each of our stockholders a statement setting forth distributions
paid during the preceding year and their characterization as ordinary income,
capital gains, or return of capital.

  No dividends will be paid or set apart for payment on shares of common stock
unless full cumulative dividends have been paid on the preferred stock.
Dividends are payable on the preferred stock quarterly at the rate of 7% per
annum and are cumulative from the date of original issuance in March 1999.

  We declared dividends in the amount of $0.28 per share during 1997. During
1998, we declared dividends of $1.00 per share, of which $0.35 were paid in
April 1999. All such dividends were paid to holders of common stock.

                           DIVIDEND REINVESTMENT PLAN

  We may adopt a dividend reinvestment plan for stockholders who wish to
reinvest all or part of their distributions in additional shares of common
stock. Generally, under a dividend reinvestment plan dividends paid with
respect to shares of capital stock are automatically invested in additional
shares of stock at a discount to the then current market price.

  Stockholders who own more than a specified number of shares of common stock
will be eligible to participate in the dividend reinvestment plan following the
effectiveness of the registration of securities issuable thereunder. This
offering is not related to the proposed dividend reinvestment plan, nor have we
prepared or filed a registration statement with the SEC registering the shares
to be issued under the dividend reinvestment plan. Prior to buying shares
through the dividend reinvestment plan, participants will be provided with a
dividend reinvestment plan prospectus, which will constitute a part of such
dividend reinvestment plan registration statement. Our transfer agent will act
as the trustee and administrator of the dividend reinvestment plan.

  Stockholders will not be automatically enrolled in the dividend reinvestment
plan. Each stockholder desiring to participate in the dividend reinvestment
plan must complete and deliver to the agent an enrollment form, which will be
sent to each eligible stockholder following the effectiveness of the
registration of the shares to be issued under the dividend reinvestment plan.
Participation in the dividend reinvestment plan will commence with all
dividends and distributions payable after receipt of a participant's
authorization, provided that the authorization must be received by the agent at
least two business days prior to the record date for any dividends in order for
any stockholder to be eligible for reinvestment of such dividends.

                                       26
<PAGE>

                                 CAPITALIZATION

  The table below sets forth our capitalization as of December 31, 1998 and as
adjusted to give effect to  the exercise of all warrants.
<TABLE>
<CAPTION>
                                                       As of December 31, 1998
                                                       ------------------------
                                                        Actual   As Adjusted(1)
                                                       --------  --------------
                                                           (in thousands)
      <S>                                              <C>       <C>
      Stockholders' Equity:
      Capital stock, $0.01 par value, 50,000,000
       shares authorized:
        Common Stock; 8,130,069 (actual) and
         13,943,496 (as adjusted) shares issued and
         outstanding.................................. $     81     $    139
      Additional paid-in capital......................  122,180      132,499
      Accumulated deficit.............................  (32,804)     (32,804)
      Forgivable notes receivable from founders.......   (2,167)      (2,167)
                                                       --------     --------
          Total....................................... $ 87,290     $ 97,667
                                                       ========     ========
</TABLE>
- --------
(1) Does not include 383,820 shares of common stock options outstanding under
    our stock option plan, of which 187,500 are outstanding to executive
    officers and directors. We refer you to "Management--Executive
    Compensation."
(2) Does not include $30 million in gross proceeds from the sale of 4,285,714
    shares of cumulative convertible preferred that occurred after December 31,
    1998.

                        MARKET PRICES AND DIVIDEND DATA

  Our common stock is traded on the NYSE under the symbol "NFI." The warrants
are traded through market makers, such as Stifel, Nicolaus & Company,
Incorporated, using the NASD's OTC Bulletin Board Service. Shares of preferred
stock are available for trading by qualified institutional buyers as defined in
Rule 144A through the PORTAL market.

  The following table sets forth, for the periods indicated, the high and low
sales prices per share of common stock on the NYSE and the cash dividends paid
or payable per share of stock.

<TABLE>
<CAPTION>
                           Common Stock
                              Prices                            Cash Dividends
                         ----------------- ----------------------------------------------------------
                                                                        Date   Date Paid     Amount
                           High     Low              Class            Declared or Payable   Per Share
                         -------- -------- -------------------------- -------- ----------   ---------
<S>                      <C>      <C>      <C>                        <C>      <C>          <C>
10/31/97 to 12/31/97(1)  18 13/16 14 1/2   Class A preferred stock(1)  3/13/97   4/30/97      $0.05
1/1/98 to 3/31/98        21 1/8   15 15/16                             6/18/97   7/30/97      $0.05
4/1/98 to 6/30/98        21       16 3/8                               9/18/97  10/20/97      $0.08
7/1/98 to 9/30/98        17 13/16 11 3/8                              12/19/97   1/27/98      $0.10
10/1/98 to 12/31/98      12 7/8    3                                   3/25/98   4/14/98      $0.30
1/1/99 to 3/31/99         7 1/8    5 3/4   Common stock                6/23/98   7/14/98      $0.35
4/1/99 to 4/27/99         6 3/16   5 5/8                               9/22/98   4/15/99(2)   $0.35
</TABLE>
- --------
(1) Our common stock began trading and our Class A preferred stock converted to
    common stock on October 31, 1997.
(2) We deferred the payment of this dividend due to events that occurred early
    in the fourth quarter of 1998 as discussed in the "Management's Discussion
    and Analysis of Financial Condition and Results of Operations--Events of
    the Fourth Quarter 1998" in this prospectus. No further dividends have been
    declared on the common stock as of the date of this prospectus.

  On April 27, 1999, the last reported sales price for the common stock was $6
1/8 per share. As of April 27, 1999, 8,130,069 shares of our common stock were
held by more than 2,000 stockholders.

                                       27
<PAGE>

                       SELECTED FINANCIAL AND OTHER DATA
                (dollars in thousands, except per share amounts)

  The following selected financial data are derived from the financial
statements of NovaStar Financial, Inc. for the periods presented and should be
read in conjunction with the more detailed information therein and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" included elsewhere in this prospectus. Operating results for the
year ended December 31, 1998 are not necessarily indicative of future results.

<TABLE>
<CAPTION>
                                                                                        For the
                                                              For the Year Ended      Period Ended
                                                                 December 31,         December 31,
                                                             ----------------------     1996(1)
                                                                1998        1997      ------------
<S>                                                          <C>          <C>         <C>
Statement of Operations Data
 Interest income...........................................  $  100,747   $  36,961     $   155
 Interest expense..........................................      80,794      28,185         --
 Net interest income.......................................      19,953       8,776         155
 Provision for credit losses...............................       7,430       2,453         --
 Net interest income after provision for credit losses.....      12,523       6,323         155
 Gains (losses) on sales of securities and termination of
  interest rate agreement..................................     (22,939)         51         --
 Other ....................................................       3,188         704         --
 Equity in loss of NFI Holding Corporation.................      (2,984)         28         --
 General and administrative expenses.......................      11,609       8,241         457
 Net income (loss).........................................     (21,821)     (1,135)       (302)
 Basic and diluted(2) earnings (loss) per share............       (2.71)      (0.26)      (0.08)
<CAPTION>
                                                                    As of December 31,
                                                             -------------------------------------
                                                                1998        1997          1996
<S>                                                          <C>          <C>         <C>
Balance Sheet Data
 Mortgage assets:
  Mortgage loans...........................................  $  920,697   $ 574,984         --
  Mortgage securities......................................         --      517,246     $13,239
 Total assets..............................................   1,002,236   1,126,252      59,811
 Collateralized mortgage obligations.......................     891,944     408,867         --
 Short-term borrowings.....................................      18,000     556,443         --
 Stockholders' equity......................................      87,290     116,489      46,380
<CAPTION>
                                                                                      As of or for
                                                               As of or for the        the Period
                                                                  Year Ended             Ended
                                                                 December 31,         December 31,
                                                             ----------------------     1996(1)
                                                                1998        1997      ------------
<S>                                                          <C>          <C>         <C>
Other Data
 Acquisition of wholesale loan production of NovaStar
  Mortgage:
  Principal at funding.....................................  $  876,516   $ 409,974         --
  Average principal balance per mortgage loan..............  $       94   $     130         --
  Weighted average interest rate:
   Adjustable-rate mortgage loans..........................        10.0%      10.13%        --
   Fixed rate mortgage loans...............................         9.9%      10.46%        --
  Loans with prepayment penalties..........................          74%         73%        --
  Weighted average prepayment penalty period (in
  years)(3)................................................         2.5         2.4         --
 Annualized return on average assets, before forgiveness of
  notes receivable from founders...........................       (2.95)%     (0.01)%     (0.50)%
 Annualized return on average equity, before forgiveness of
  notes receivable from founders...........................      (21.43)%     (0.06)%     (0.65)%
 Taxable income (loss).....................................  $   (1,211)  $   1,434     $  (173)
 Taxable income (loss) per share...........................  $    (0.15)  $    0.18     $ (0.05)
 Dividends declared per share(3)...........................  $     1.00   $    0.28         --
 Number of account executives..............................          63          36         --
</TABLE>
- --------
(1) NovaStar Financial, Inc. was formed on September 13, 1996. Operations began
    in substance after the initial closing of the private placement on December
    9, 1996.
(2) Diluted earnings (loss) per share is based on the weighted average shares
    of common stock and preferred stock outstanding, and includes the effect of
    warrants and options.
(3) Includes only those mortgage loans with a prepayment penalty.
(4) The level of quarterly dividends is determined by the Board of Directors
    based upon its consideration of a number of factors and should not be
    deemed indicative of taxable income for the quarter in which declared or
    future quarters, or of income calculated in accordance with generally
    accepted accounting principles.

                                       28
<PAGE>

                    MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                 FINANCIAL CONDITION AND RESULTS OF OPERATIONS

  The following discussion should be read in conjunction with the preceding
Selected Financial and Other Data and the Financial Statements of NovaStar
Financial, Inc. and the Notes thereto, included elsewhere in this prospectus as
well as the annual report on Form 10-K of NovaStar Financial, Inc. for the
fiscal year ended December 31, 1998, as amended.

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. For a discussion of such risks and
uncertainties, which could cause actual results to differ from those contained
in the forward-looking statements, see "Risk Factors" commencing on page 12. In
addition, there are many important factors that could cause NovaStar's actual
results to differ materially from those indicated in the forward-looking
statements. These factors include, but are not limited to, general economic
conditions, interest rate levels and risk, prepayment speeds, delinquency and
loss rates, changes in the asset securitization industry or the REIT provisions
of the Internal Revenue Code, demand for NovaStar's service, the impact of
covenants in loan agreements of NovaStar, the degree to which NovaStar is
leveraged, its needs for and availability of financing, its access to capital
and other risks identified in NovaStar's Securities and Exchange Commission
filings. In addition, it should be noted that past financial and operational
performance of NovaStar Financial is not necessarily indicative of future
financial and operational performance.

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 the issuance of collateralized mortgage obligations. The
consolidated financial statements of NovaStar Financial include the financial
condition and results of operations of these entities.

  NovaStar Financial also owns 100% of the non-voting preferred stock of NFI
Holding Corporation for which it receives 99% of any dividends paid by NFI
Holding. Scott Hartman and Lance Anderson, the founders of NovaStar Financial,
Inc., own the voting common stock of 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 or REMICs. NovaStar Financial accounts for its
investment in NFI Holding using the equity method.

Financial Condition and Results of Operations as of and for the Period Ended
December 31, 1996

  NovaStar Financial was incorporated on September 13, 1996 and commenced
operations in December 1996 after raising $47 million through a private
placement offering. During the period from inception to December 31, 1996,
investments earned $155,000, while general and administrative costs were
$457,000, resulting in a net loss of $302,000. NovaStar Financial did not
acquire significant mortgage assets nor hire a large staff until after December
31, 1996. As a result, operating income and expense during 1996 were small in
comparison to 1997 and 1998. Financial results for the period from September
13, 1996 to December 31, 1996 do not provide relevant comparative financial
information.


                                       29
<PAGE>

Events of the Fourth Quarter 1998

  As of September 30, 1998, NovaStar Financial had a secured financing
arrangement with a lender whereby NovaStar Financial could borrow up to 50% of
the value of the residual interests in collateralized mortgage obligations.
Borrowing capacity under this arrangement was in excess of $30 million. The
lender limited or reduced borrowing availability under this arrangement to $25
million as of September 30, 1998. In early October, the lender withdrew its
financing under this arrangement at a time when NovaStar required funds to meet
margin calls and other demands. This event, combined with declining market
prices for its securities and off-balance-sheet financial instruments, caused
management to take several actions, as discussed in the following paragraphs,
to restore liquidity and to further reduce exposure to liquidity and margin
call risk.

  On October 11, 1998, the Board of Directors deferred payment of the third
quarter dividend we declared on September 22, 1998 ($0.35 per share) until
January 15, 1999. On January 12, 1999, the Board of Directors further delayed
dividend payment until April 15, 1999.

  On various dates during October 1998, NovaStar Financial and NovaStar
Mortgage executed contracts for the sale of all mortgage and corporate
securities and related interest rate agreements, resulting in losses
aggregating more than $23 million.

  On October 13, 1998, NovaStar Financial executed a 90-day financing agreement
with GMAC/Residential Funding Corporation secured by mortgage interests of
NovaStar Financial. Under the terms of the agreement, NovaStar Financial
borrowed $15 million to support immediate cash needs. In addition, NovaStar
agreed to pay a $3 million commitment fee at maturity of the note. The fee
serves as incentive for GMAC/Residential Funding Corporation to enter the
financing arrangement under adverse market conditions and to insure that the
arrangement would be committed for the 90-day period. The resulting $18 million
obligation bears interest at one-month LIBOR plus 5%. Additionally,
GMAC/Residential Funding Corporation will receive 812,731 warrants for the
purchase of NovaStar Financial's common stock at a price of $4.5625, the
closing price of the common stock on October 12, 1998. In January 1999, this
financing agreement was extended through February 28, 1999. Management used
financing arrangements at First Union to pay off this debt.

  On various dates during the fourth quarter 1998, NovaStar Mortgage sold
residential subprime mortgage loans aggregating $110 million at a net gain of
$2 million.

  On October 21, 1998, NovaStar Financial finalized the second closing on the
securitization of asset-backed bonds, the first closing of which occurred
during the third quarter. In the second closing, approximately $43 million of
mortgage loans were added to the trust assets of NovaStar Home Equity Series
1998-2.

  After completing the above transactions, the balance sheet consists primarily
of subprime mortgage loans financed with non-recourse asset-backed bonds.

  In the near future, NovaStar Financial does not expect to purchase a
significant amount of loans originated by NovaStar Mortgage, and NovaStar
Mortgage is expected to sell a majority of the mortgage loans it originates to
unrelated entities for cash or in securitizations. Net income will be generated
from the spread on securitized loans, general and administrative expenses and
equity in earnings of NFI Holding Corporation. Earnings of NFI Holding
Corporation will primarily include gains on the sales of mortgage loans
originated by NovaStar Mortgage for cash or from securitizations and general
and administrative expenses.

  Additional information regarding liquidity position is included in "Liquidity
and Capital Resources."

Liquidity and Capital Resources

  As discussed in "Events of the Fourth Quarter 1998", during October 1998, a
lender withdrew access to one of our key financing facilities. This lender
experienced its own liquidity shortage as a result of global market conditions.
In order to respond to the liquidity shortage and mitigate exposure to credit
risk, the lender

                                       30
<PAGE>

restricted its lending to subprime mortgage companies, including NovaStar.
Consequently, the events and actions during the fourth quarter 1998 should be
kept in mind when reviewing this discussion regarding the liquidity and capital
resources of NovaStar Financial.

  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 collateralized mortgage
obligations will serve to support cash needs. Drawing upon various borrowing
arrangements typically satisfies major cash requirements. Historically,
NovaStar Financial demonstrated the ability to access public capital markets as
a source of long-term cash resources. The events in early October 1998 changed
the liquidity position of NovaStar Financial and many other subprime companies
and REITs. The number of options available to NovaStar Financial with regard to
financing and capital resources have been restricted.

  Actions during unfavorable market conditions in the fourth quarter 1998 were
taken to restore liquidity and mitigate additional margin call risk. Although
these actions resulted in a significant net loss for the 1998 fourth quarter,
management believes they were necessary under the circumstances. These actions
have significantly reduced the cash requirements of NovaStar Financial. The
mortgage loans owned by NovaStar Financial have minimal liquidity risk as they
are financed with non-recourse collateralized mortgage obligations. Management
expects that interest income on the mortgage loans will generate sufficient
cash to meet financing and operating costs. NovaStar Mortgage requires
substantial cash to fund mortgage loan originations and operating costs. In the
short-term, management expect to sell a substantial amount of the whole loan
production of NovaStar Mortgage to generate adequate cash to meet the
significant cash needs of the wholesale loan operation. NovaStar will continue
to sell the majority of loans originated to third parties until sufficient
capital can be efficiently raised to return to its primary business strategy of
holding loans in portfolio. Management believes NovaStar can operate
indefinitely in this manner, providing the level of loan originations are at or
near the capacity of its production infrastructure.

  Table 1 is a summary of financing arrangements and available borrowing
capacity under those arrangements as of December 31, 1998:

                                    Table 1
                              Liquidity Resources
                    December 31, 1998 (dollars in thousands)

<TABLE>
<CAPTION>
                                     Maximum
                                    Borrowing  Value of
             Resource                 Limit   Collateral Borrowings Availability
             --------               --------- ---------- ---------- ------------
<S>                                 <C>       <C>        <C>        <C>
First Union National Bank(A):
  Committed warehouse line of
   credit.........................  $ 75,000   $ 31,727   $ 26,651     $5,076
  Committed secured whole loan
   repurchase agreement...........   200,000    175,863    175,863        --
Residual financing available under
 CMOs.............................    18,000         (B)    18,000        --
                                                          --------     ------
    Total.........................                        $220,514     $5,076
                                                          ========     ======
Total availability as a percent
 of:
  Total assets....................                                       0.51%
                                                                       ======
  Total stockholders' equity......                                       5.82%
                                                                       ======
</TABLE>
- --------
(A) Value of collateral and borrowings include amounts for both NovaStar
    Financial and NovaStar Mortgage as they are co-borrowers under the
    arrangements with First Union National Bank.
(B) Management estimates the value of the residuals range from $50 to $70
    million and does not include the value of mortgage servicing rights.

  In addition to the mortgage loans that have been securitized and are
reflected on the balance sheet, NovaStar Mortgage continues to originate
subprime mortgage loans that are expected to be sold to third parties.

                                       31
<PAGE>

In addition, during the first quarter of 1999, NovaStar Mortgage issued asset-
backed bonds totaling $160 million. Unlike NovaStar Financial's asset-backed
bond transactions, this transaction was treated as a sale in which NovaStar
Mortgage recognized a gain of $1.3 million. As of December 31, 1998, NovaStar
Mortgage had $209 million of subprime mortgage loans. NovaStar Mortgage
provides financing for these loans through its own warehouse and repurchase
credit facilities. Mortgage loans financed with warehouse and repurchase credit
facilities are subject to changing market valuation and margin calls.
Management expects to continue selling mortgage loans originated by NovaStar
Mortgage or securitizing those loans at a profit. However, management's intent
is to raise sufficient capital during the first part of 1999 to begin acquiring
a majority of NovaStar Mortgage's production during the second half of 1999.

  During February 1999, NovaStar Financial and NovaStar Mortgage finalized
agreements with First Union National Bank that increased total financing
capacity to $395 million. The financing is available under the $75 million
warehouse agreement, a $300 million master repurchase agreement and $20 million
in financing secured by the residual interests in collateralized mortgage
obligations. See note 4 to the consolidated financial statements of NovaStar
Financial.

  Cash activity during the years ended December 31, 1998 and 1997 are presented
in the consolidated statement of cash flows.

Forgivable Notes Receivable from Founders

  The founders of NovaStar Financial purchased 216,666 units in the 1996
private placement in exchange for forgivable promissory notes. A unit consisted
of one share of convertible preferred stock and one common stock warrant.
Principal on these notes will be forgiven if incentive performance targets are
achieved. The incentive tests relate to the return generated to investors in
the private placement, including the appreciation in stock price, the value of
the warrants, and dividends paid. One tranche will be forgiven for each fiscal
year NovaStar Financial generates a return of 15% to investors in the private
placement. All three tranches will be forgiven if a return of 100% is generated
within five years.

  During the period from the closing of the private placement through December
31, 1997, NovaStar Financial's stock price averaged $17.08 per share, dividends
of $0.28 were declared and the value of each warrant was $2.08. The combination
of these produced a return to investors in the private placement exceeding 15%.
As a result, the first tranche of these notes was forgiven resulting in a non-
cash charge of $1,083,000 during the fourth quarter of 1997. As a result of
NovaStar Financial's significant loss in the fourth quarter 1998 and the market
price of our stock during the same period, the second tranche of the notes
receivable from founders was not forgiven in 1998.

Financial Condition as of December 31, 1998 and 1997

  During the year ended December 31, 1998, NovaStar Mortgage originated more
than 9,000 subprime residential mortgage loans with an aggregate principal
amount of $868 million, of which $541 million was acquired by NovaStar
Financial. During the third quarter of 1998, NovaStar Financial discontinued
purchasing loan originations of NovaStar Mortgage. In the near future, NovaStar
Mortgage intends to sell production to independent third parties for cash or in
securitizations at a profit. As a result of the events discussed in "Events in
the Fourth Quarter 1998", virtually all mortgage assets at December 31, 1998
consist of subprime mortgage loans whereas mortgage loans made up 51% of
mortgage assets at December 31, 1997.

  During the year ended December 31, 1998 to improve its liquidity situation,
NovaStar Financial sold $7.9 million of mortgage loans purchased from NovaStar
Mortgage to unrelated third parties for cash, recognizing gains on these
transactions of $305,000. NovaStar Financial also completed two securitizations
during the year ended December 31, 1998, pooling $660 million of mortgage loans
as collateral.


                                       32
<PAGE>

  Table 2 is a summary of wholesale mortgage loan originations and bulk
acquisitions for 1998 and 1997. Table 3 presents a more detailed analysis of
the wholesale mortgage loan originations of NovaStar Mortgage. Table 4 is a
summary of loan costs for NovaStar Mortgage relative to its wholesale mortgage
loan originations.

                                    Table 2
          Wholesale Loan Originations(A) (B) (C) and Bulk Acquisitions
                     Years Ended December 31, 1998 and 1997
                             (dollars in thousands)

<TABLE>
<CAPTION>
                               Wholesale              Bulk
                           Originations(A)(B)     Acquisitions        Total
                           -------------------  ---------------- ----------------
                           Number               Number           Number
                             of     Principal     of   Principal   of   Principal
                            Loans     Amount    Loans   Amount   Loans   Amount
                           -------  ----------  ------ --------- ------ ---------
<S>                        <C>      <C>         <C>    <C>       <C>    <C>
1998:
  Fourth quarter..........   1,501  $  133,739    --        --   1,501  $133,739
  Third quarter...........   2,655     240,498    --        --   2,655   240,498
  Second quarter..........   3,133     294,303    --        --   3,133   294,303
  First quarter...........   2,033     207,976    --        --   2,033   207,976
                           -------  ----------  -----  --------  -----  --------
    1998 total............   9,322  $  876,516    --        --   9,322  $876,516
                           =======  ==========  =====  ========  =====  ========
1997:
  Fourth quarter..........   1,552  $  183,012    --        --   1,552  $183,012
  Third quarter...........   1,025     136,582    --        --   1,025   136,582
  Second quarter..........     509      77,692    530    49,808  1,039   127,500
  First quarter...........      68      12,688  1,422   157,432  1,490   170,120
                           -------  ----------  -----  --------  -----  --------
    1997 total............   3,154  $  409,974  1,952  $207,240  5,106  $617,214
                           =======  ==========  =====  ========  =====  ========
</TABLE>
- --------
(A) Loans originated by NovaStar Mortgage
(B) Includes acquisition of loans in the third quarter of 1998 by NovaStar
    Capital, Inc., aggregating $8.2 million.
(C) NovaStar Mortgage sold $134 million of its production to independent, third
    parties for cash in 1998.

                                    Table 3
             1998 and 1997 Quarterly Wholesale Loan Originations(A)
                             (dollars in thousands)

<TABLE>
<CAPTION>
                                                            Weighted Average
                                                          ----------------------
                                                                                   Percent
                         Number           Average  Price  Loan                       with
                           of              Loan   Paid to  to    Credit           Prepayment
                         Loans  Principal Balance Broker  Value Rating(B) Coupon   Penalty
                         ------ --------- ------- ------- ----- --------  ------  ----------
<S>                      <C>    <C>       <C>     <C>     <C>   <C>       <C>     <C>
1998:
  Fourth quarter........ 1,501  $133,739   $ 89    100.8    81%   4.75     9.78%      88%
  Third quarter......... 2,655   240,498     90    101.4    81    4.37    10.11       79
  Second quarter........ 3,133   294,303     94    101.3    81    4.43     9.93       71
  First quarter......... 2,033   207,976    102    101.4    81    4.45     9.93       65
                         -----  --------   ----    -----   ---    ----    -----      ---
    1998 total.......... 9,322  $876,516   $ 94    101.3    81%   4.47     9.96%      74%
                         =====  ========   ====    =====   ===    ====    =====      ===
1997:
  Fourth quarter........ 1,552  $183,012   $118    101.6    81%   4.32    10.09%      71%
  Third quarter......... 1,025   136,582    133    101.6    79    4.21    10.12       66
  Second quarter........   509    77,692    153    102.1    77    4.23    10.17       84
  First quarter.........    68    12,688    187    102.3    75    4.22     9.64       78
                         -----  --------   ----    -----   ---    ----    -----      ---
    1997 total.......... 3,154  $409,974   $130    101.7    79%   4.26    10.10%      73%
                         =====  ========   ====    =====   ===    ====    =====      ===
</TABLE>
- --------
(A) Loans originated by NovaStar Mortgage.
(B) AAA = 7, AA = 6, A = 5, A- = 4, B = 3, C = 2, D = 1

                                       33
<PAGE>

                                    Table 4
                Cost of Loan Production--NovaStar Mortgage, Inc.
              Years Ended December 31, 1998 and December 31, 1997
                             (dollars in thousands)

<TABLE>
<CAPTION>
                                         1998                                   1997
                          --------------------------------------  ------------------------------------
                           Fourth    Third     Second    First     Fourth    Third    Second    First
                          Quarter   Quarter   Quarter   Quarter   Quarter   Quarter   Quarter  Quarter
                          --------  --------  --------  --------  --------  --------  -------  -------
<S>                       <C>       <C>       <C>       <C>       <C>       <C>       <C>      <C>
Total costs of loan
 production(A)..........  $  6,723  $  4,975  $  3,837  $  3,079  $  2,096  $  1,938  $ 1,401  $   410
Wholesale loan
 origination principal..   133,739   240,498   294,303   207,974   183,012   136,582   77,692   12,688
Premium paid to broker..     1,043     3,439     3,679     2,935     2,896     2,119    1,618      295
                          --------  --------  --------  --------  --------  --------  -------  -------
Total acquisition
 cost(B)................  $141,505  $248,912  $301,819  $213,988  $188,004  $140,639  $80,711  $13,393
                          ========  ========  ========  ========  ========  ========  =======  =======
Costs as a percent of
 principal:
  Loan production.......       5.0%      2.1%      1.3%      1.5%      1.1%      1.4%     1.8%     3.2%
                          ========  ========  ========  ========  ========  ========  =======  =======
  Premium paid to
   broker...............       0.8%      1.4%      1.3%      1.4%      1.6%      1.6%     2.1%     2.3%
                          ========  ========  ========  ========  ========  ========  =======  =======
  Total acquisition
   cost.................       5.8%      3.5%      2.6%      2.9%      2.7%      3.0%     3.9%     5.6%
                          ========  ========  ========  ========  ========  ========  =======  =======
</TABLE>
- --------
(A) Loan production general and administrative expenses as reported for
    generally accepted accounting principles, plus net deferred loan costs.
(B) Principal, premium and general and administrative expenses associated with
    loan production.

  Subprime borrowers generally include individuals that do not qualify for
agency/conventional lending programs because of a lack of available
documentation or previous credit difficulties, but have equity in their homes.
Often, they are individuals or families who have built up high-rate consumer
debt and are attempting to use the equity in their home to consolidate debt and
lower their monthly payments. The credit grade assigned is a function of the
relative strength or weakness of the borrower's credit and/or the nature and
extent of documents that can be provided to support income. NovaStar Mortgage
underwrites the mortgage loans using guidelines that have been approved by
NovaStar Financial.

  Table 5 is a presentation of mortgage loans as of December 31, 1998 and 1997
and their credit grades, as determined by NovaStar Mortgage.

                                    Table 5
                         Mortgage Loans by Credit Grade
                    As of December 31 (dollars in thousands)

<TABLE>
<CAPTION>
                                                                     1998                        1997
                                                          --------------------------- ---------------------------
                                                                             Weighted                    Weighted
                                                                    Weighted Average            Weighted Average
Credit                          Allowed          Loan-     Current  Average  Loan-to-  Current  Average  Loan-to-
Rating                      Mortgage Rates(A)   to-value  Principal  Coupon   value   Principal  Coupon   value
- ------                   ---------------------- --------  --------- -------- -------- --------- -------- --------
<S>                      <C>                    <C>       <C>       <C>      <C>      <C>       <C>      <C>
AA......................         0 x 30            90(B)  $117,172    9.51%    83.4%  $ 16,654    9.61%    85.4%
A.......................         1 x 30            90      356,994    9.84     79.7    251,751    9.91     77.9
A-......................         2 x 30            90      214,627   10.31     81.3    145,314   10.20     78.4
B.......................     3 x 30, 1 x 60        85      138,497   10.62     77.9     99,317   10.50     76.5
C....................... 5 x 30, 2 x 60, 1 x 90    75       62,784   11.13     72.3     35,483   11.09     71.1
D....................... 6 x 30, 3 x 60, 2 x 90    65       13,328   12.14     62.2     10,917   12.05     63.7
                                                          --------   -----     ----   --------   -----     ----
  Total.................                                  $903,402   10.15%    79.5%  $559,436   10.20%    77.3%
                                                          ========   =====     ====   ========   =====     ====
</TABLE>
- --------
(A) Represents the number of times NovaStar allows a prospective borrower to be
    late more than 30, 60 or 90 days. For instance, a 3x30, 1x60 category would
    afford the prospective borrower to be more than 30 days late on three
    separate occasions and 60 days late no more than one time.
(B) In some cases may be as high as 95%.

                                       34
<PAGE>

  Initially, a disproportionate number of mortgage loans generated by NovaStar
Mortgage were originated in California. As the sales force has been established
throughout the United States, the geographic credit risk has continued to
become less concentrated.

  Table 6 is a summary of loans originated by NovaStar Mortgage by state. Table
7 is a summary of all mortgage loans owned by NovaStar Financial as of December
31, 1998 and 1997 by state.

                                    Table 6
                    Mortgage Loan Originations by State (A)
                     Years Ended December 31, 1998 and 1997

<TABLE>
<CAPTION>
                                Percent of Total Originations during Quarter
                                    (based on original principal balance)
                             ---------------------------------------------------
                                       1998                      1997
                             ------------------------- -------------------------
Collateral Location          Fourth Third Second First Fourth Third Second First
- -------------------          ------ ----- ------ ----- ------ ----- ------ -----
<S>                          <C>    <C>   <C>    <C>   <C>    <C>   <C>    <C>
Florida.....................   24%    17%   16%    12%    9%    10%    8%     1%
Ohio........................    9      4     5      2     2      2     2    --
Michigan....................    6      5     5      5     5      3   --     --
Pennsylvania................    5      4     3      2     1    --      1      1
North Carolina..............    4      5     3      2     1      1   --       1
Washington..................    3      5     6      7     8     11    16     15
Texas.......................    3      5     3      3     3      4     7      2
California..................    2      6     9     15    19     24    26     40
Oregon......................    2      3     4      5     6      6     9      7
Maryland....................    2      2     3      4     5      6     5     13
Virginia....................    2      2     2      2     5      6     2    --
Nevada......................  --       4     3      6     5      4     2    --
Utah........................  --       2     3      3     6      6     9     13
Oklahoma....................  --     --      1      1     1      1     2      5
All other states............   38     36    34     31    24     16    11      2
</TABLE>
- --------
(A)Mortgage loans originated by NovaStar Mortgage, Inc.

                                    Table 7
                            Mortgage Loans by State
                               As of December 31

<TABLE>
<CAPTION>
                                                     Percent of Portfolio
                                                       (based on current
                                                      principal balance)
                                                     --------------------
      Collateral Location                               1998          1997
      -------------------                              ------        ------
      <S>                                            <C>           <C>
      California....................................          18%           27%
      Florida.......................................          12             8
      Washington....................................           8             9
      Oregon........................................           5             6
      Utah..........................................           4             6
      Texas.........................................           4             5
      All other states..............................          49            39
</TABLE>

  NovaStar Financial acquired mortgage securities with an aggregate cost of
$354.9 million for the year ended December 31, 1998 compared with $659.4
million for the same period of 1997. During the last quarter of 1997 and first
half of 1998, NovaStar Financial purchased securities utilizing capital from
the initial public offering. As more of our capital was deployed for mortgage
loan acquisition, NovaStar Financial did not purchase any more securities
during the second and third quarters of 1998. In October 1998, NovaStar
Financial was forced to sell all of its securities as a result of circumstances
discussed in "Events of the Fourth Quarter 1998". Thus, mortgage securities
with an amortized cost of $700.9 million were sold during 1998,

                                       35
<PAGE>

compared with $110.0 million in 1997. Net losses of $15.3 million were
recognized on the 1998 sales versus net gains of $51,000 in 1997. Tables 8 and
9 are summaries of the securities acquired during 1998 and 1997 by quarter and
the portfolio as of December 31, 1997.

                                    Table 8
                         Mortgage Security Acquisitions
         Years Ended December 31, 1998 and 1997 (dollars in thousands)

<TABLE>
<CAPTION>
                                                                Net    Weighted
                                                              Price to Average
                                  Principal Premium Discount    Par     Coupon
                                  --------- ------- --------  -------- --------
<S>                               <C>       <C>     <C>       <C>      <C>
1998:
Fourth quarter..................  $    --   $  --   $   --       --       -- %
Third quarter...................       --      --       --       --       -- %
Second quarter--Federal National
 Mortgage Association...........    80,237     823      --     101.0     6.40
First quarter:
  Federal National Mortgage
   Association..................    40,929     444      --     101.1     6.12
  Government National Mortgage
   Association..................   229,130   3,726     (364)   101.5     6.39
1997:
Fourth quarter:
  Federal National Mortgage
   Association..................    46,779   1,856      --     104.0     8.00
  Government National Mortgage
   Association..................   233,546   2,649   (1,457)   100.5     5.74
Third quarter--Federal Home Loan
 Mortgage Corporation...........     2,202      87      --     104.0     7.40
Second quarter:
  Federal National Mortgage
   Association..................   247,219   5,174      --     102.1     7.48
  Federal Home Loan Mortgage
   Corporation..................   102,083   2,450      --     102.4     6.90
First quarter:
  Federal National Mortgage
   Association..................     7,491     231      --     103.1     7.57
  Government National Mortgage
   Association..................     8,931     174      --     101.9     7.13
</TABLE>

                                    Table 9
                          Mortgage Security Portfolio
                 As of December 31, 1997 (dollars in thousands)

<TABLE>
<CAPTION>
                                         As of December 31, 1997
                            --------------------------------------------------
                                              Gross
                                      ----------------------          Weighted
                                      Unamortized Unaccreted Carrying Average
                            Principal   Premium    Discount   Value    Coupon
                            --------- ----------- ---------- -------- --------
<S>                         <C>       <C>         <C>        <C>      <C>
Federal National Mortgage
 Association............... $266,083    $6,690      $  --    $272,773   7.55%
Government National
 Mortgage Association......  233,407     2,640       1,302    234,745   5.74
Federal Home Loan Mortgage
 Corporation...............    5,357       177         --       5,534   7.71
                            --------    ------      ------   --------
                            $504,847    $9,507      $1,302    513,052   6.98%
                            ========    ======      ======
Net unrealized gain........                                     4,194
                                                             --------
Carrying value.............                                  $517,246
                                                             ========
</TABLE>

  Mortgage loan originations are funded with various warehouse facilities prior
to securitization. Loans originated through the lending operations of NovaStar
Mortgage have typically been funded initially through a $75 million warehouse
line with First Union National Bank under which NovaStar Financial and NovaStar
Mortgage are co-borrowers. Repurchase agreements are used to finance mortgage
loan purchases. Financing secured by residual interests in asset-backed bonds
issued by NovaStar is another short-term borrowing instrument currently
available to NovaStar Financial.

                                       36
<PAGE>

  Using individual assets as collateral for repurchase agreements, NovaStar
Financial has financed acquisitions of mortgage securities issued or guaranteed
by Fannie Mae, Freddie Mac or Ginnie Mae which we refer to as agency securities
or agency certificates. These agreements have been executed with a number of
reputable securities dealers. Under the terms of all financing arrangements,
lending institutions require "over-collateralization." The value of the
collateral generally must exceed the allowable borrowing by between 2% to 5%.
As a result, NovaStar Financial must have capital available to cover this
"haircut."

  On a long-term basis, NovaStar Financial finances its mortgage loans using
collateralized mortgage obligations, commonly called CMOs. Investors in
collateralized mortgage obligations are repaid based on the performance of the
mortgage loans collateralizing the collateralized mortgage obligations. These
non-recourse financing arrangements match the mortgage 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 collateralized
mortgage obligations, NovaStar Financial is entitled to repurchase the mortgage
loan collateral and, repay the remaining collateralized mortgage obligation,
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 collateralized mortgage obligation transactions as secured
borrowings, rather than sales of the transferred mortgage loans.

  Under its collateralized mortgage obligations, NovaStar retains the mortgage
loans and incurs the obligation to pay the collateralized mortgage obligation
bondholders. NovaStar earns the net spread between the interest income on the
mortgage loans and the interest expense on the bonds. The spread earned by
NovaStar also is reduced by credit losses on the mortgage asset portfolio.
Prepayments on the mortgage loans serve to reduce the term over which NovaStar
earns its spread. The longer the mortgage collateral is outstanding, the longer
the period for which NovaStar will receive cash flow. To the extent the
borrowers prepay, it shortens the life of the collateralized mortgage
obligation and the period over which NovaStar receives cash flow. The cash flow
to NovaStar will change when interest rates on the bonds fluctuate at amounts
or times that are different from the mortgage loan collateral, thereby
subjecting NovaStar to interest rate risk.

  Amounts outstanding under borrowing arrangements aggregated $910 million and
$1.0 billion as of December 31, 1998 and 1997, respectively, and are further
detailed in Note 4 to the consolidated financial statements.

  In periods of decreasing interest rates, borrowers are more likely to
refinance their mortgages to obtain a lower interest rate and monthly payment.
Even in rising rate environments, borrowers tend to collectively repay their
mortgage principal balances earlier than is required by the terms of their
mortgages. This is particularly true for subprime borrowers who are seeking to
upgrade their credit rating to obtain a lower interest rate. Table 10 displays
the historical prepayment speeds for mortgage loans collateralizing
collateralized mortgage obligations issued by NovaStar. Table 14 provides an
analysis of prepayment characteristics of the mortgage loans owned by NovaStar.

  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 mortgage loans. Percents are presented on an annual
basis. For instance, 44.2%, on an annual basis, of the principal of the
mortgage loans collateralizing collateralized mortgage obligation issue 1997-1
pre-paid during December 1998. Percentages for the life of the pool represent
the percent that has paid off since the mortgage loans were pooled as
collateral for the collateralized mortgage obligation. Virtually all mortgage
loans are used as collateral for collateralized mortgage obligations and
NovaStar does not monitor prepayment speeds for mortgage loans not financing
collateralized mortgage obligations.


                                       37
<PAGE>

                                    Table 10
                                Prepayment Speed

<TABLE>
<CAPTION>
                                             Weighted      Constant Prepayment Rate (Annual
                                           Average Age                 Percent)
                                           at Inception ---------------------------------------
                            Issue Date     (in months)  One-month Three-month Twelve-month Life
                         ----------------- ------------ --------- ----------- ------------ ----
<S>                      <C>               <C>          <C>       <C>         <C>          <C>
As of December 31, 1998
NovaStar Home Equity
 Series:
  1997-1................   October 1, 1997       7        44.2       35.5         33.2     31.0
  1997-2................ December 11, 1997       3        41.6       32.2         22.4     21.1
  1998-1................    April 30, 1998       3        19.6       17.1          --      12.2
  1998-2................   August 18, 1998       3        18.0       10.3          --       9.3
As of December 31, 1997
NovaStar Home Equity
 Series:
  1997-1................   October 1, 1997       7        18.6       15.7          --      15.7
  1997-2................ December 11, 1997       3        10.5        --           --      10.5
</TABLE>

  To mitigate exposure to prepayment risk and in order to retain those
borrowers whose credit is considered desirable, NovaStar created a portfolio
retention department in the latter part of 1997 that encourages borrowers who
have satisfactorily met their obligations to refinance or rate modify their
mortgage loans with NovaStar. Of the mortgage loans that prepaid during the
year ended December 31, 1998, $13.1 million, or 8% of the mortgage loans were
successfully refinanced and $2.0 million, or 1% of the mortgage loans, were
rate-modified. Although these mortgage loans are considered prepayments for the
purposes of the information in Table 10, they remain in the NovaStar mortgage
loan portfolio.

                                       38
<PAGE>

  Table 11 summarizes quarterly mortgage asset activity during 1998 and 1997
and Table 12 details the amount of premium as a percent of principal at quarter
end for 1998 and 1997.

                                    Table 11
                      Mortgage Assets Activity (thousands)

<TABLE>
<CAPTION>
                                                  Mortgage
                           Mortgage Loans        Securities             Total
                          ------------------  ------------------  -------------------
                          Principal  Premium  Principal  Premium  Principal   Premium
                          ---------  -------  ---------  -------  ----------  -------
<S>                       <C>        <C>      <C>        <C>      <C>         <C>
Balance, January 1,
 1997...................  $    --    $   --   $  12,821  $   434  $   12,821  $   434
Acquisitions............   170,120    10,530     16,422      405     186,542   10,935
Principal repayments and
 amortization...........      (338)      (53)      (977)     (28)     (1,315)     (81)
                          --------   -------  ---------  -------  ----------  -------
Balance, March 31,
 1997...................   169,782    10,477     28,266      811     198,048   11,288
Acquisitions............   127,500     4,100    349,302    7,624     476,802   11,724
Principal repayments and
 amortization...........    (6,989)     (420)    (2,332)    (133)     (9,321)    (553)
Dispositions............       --        --     (98,267)  (2,309)    (98,267)  (2,309)
                          --------   -------  ---------  -------  ----------  -------
Balance, June 30, 1997..   290,293    14,157    276,969    5,993     567,262   20,150
Acquisitions............   136,582     2,449      2,202       87     138,784    2,536
Principal repayments and
 amortization...........   (22,227)     (913)   (19,291)    (383)    (41,518)  (1,296)
                          --------   -------  ---------  -------  ----------  -------
Balance, September 30,
 1997...................   404,648    15,693    259,880    5,697     664,528   21,390
Acquisitions............   183,012     3,314    280,325    3,048     463,337    6,362
Principal repayments and
 amortization...........   (28,224)   (1,146)   (26,095)    (363)    (54,319)  (1,509)
Dispositions............       --        --      (9,263)    (177)     (9,263)    (177)
                          --------   -------  ---------  -------  ----------  -------
Balance, December 31,
 1997...................   559,436    17,861    504,847    8,205   1,064,283   26,066
Acquisitions............   207,976     3,758    270,059    3,806     478,035    7,564
Principal repayments and
 amortization...........   (27,224)   (1,160)   (63,892)    (731)    (91,116)  (1,891)
Dispositions............       --        --    (310,113)  (5,294)   (310,113)  (5,294)
                          --------   -------  ---------  -------  ----------  -------
Balance, March 31,
 1998...................   740,188    20,459    400,901    5,986   1,141,089   26,445
Acquisitions............   290,350     5,148     80,237      823     370,587    5,971
Principal repayments and
 amortization...........   (43,849)   (1,506)   (47,201)    (451)    (91,050)  (1,957)
Dispositions............    (2,843)      (53)       --       --       (2,843)     (53)
                          --------   -------  ---------  -------  ----------  -------
Balance, June 30, 1998..   983,846    24,048    433,937    6,358   1,417,783   30,406
Acquisitions............       --        --         --       --          --       --
Principal repayments and
 amortization...........   (54,745)   (1,442)   (38,925)    (493)    (93,670)  (1,935)
Dispositions............    (4,666)      (56)    (7,781)    (107)    (12,447)    (163)
                          --------   -------  ---------  -------  ----------  -------
Balance, September 30,
 1998...................   924,435    22,550    387,231    5,758   1,311,666   28,308
Acquisitions............    42,298       458        --       --       42,298      458
Principal repayments and
 amortization...........   (62,953)   (2,135)   (15,215)    (173)    (78,168)  (2,308)
Dispositions............      (378)       (5)  (372,016)  (5,585)   (372,394)  (5,590)
                          --------   -------  ---------  -------  ----------  -------
Balance, December 31,
 1998...................  $903,402   $20,868  $     --   $   --   $  903,402  $20,868
                          ========   =======  =========  =======  ==========  =======
</TABLE>

                                       39
<PAGE>

                                    Table 12
                       Premium as a Percent of Principal

<TABLE>
<CAPTION>
                                                                         Total
                                                    Mortgage  Mortgage  Mortgage
                                                     Loans   Securities  Assets
                                                    -------- ---------- --------
      <S>                                           <C>      <C>        <C>
      As of:
        December 31, 1998..........................   2.31%      -- %     2.31%
        September 30, 1998.........................   2.44      1.49      2.16
        June 30, 1998..............................   2.44      1.47      2.14
        March 31, 1998.............................   2.76      1.49      2.32
        December 31, 1997..........................   3.19      1.63      2.45
        September 30, 1997.........................   3.88      2.19      3.22
        June 30, 1997..............................   4.88      2.16      3.55
        March 31, 1997.............................   6.17      2.87      5.70
</TABLE>

Results of Operations--Year Ended December 31, 1998 Compared to the Year Ended
December 31, 1997

Net Loss

  During the year ended December 31, 1998, NovaStar Financial recorded a net
loss of $21.8 million, $2.71 per diluted share, compared with a net loss of
$1.1 million, $0.26 per diluted share, for 1997.

Net Interest Income

  Interest income. Average interest-earning assets were $1.2 billion during the
year ended December 31, 1998, including $822.2 million of mortgage loans and
$375.2 million of mortgage securities compared with average interest-earning
assets of $476.3 million during 1997. During 1998, mortgage loans earned
$76.8 million, or a yield of 9.3%, compared with $25.2 million, or a yield of
8.6% for 1997. Mortgage securities earned $24.0 million for 1998, or a yield of
6.4%, compared with $11.8 million, or a yield of 6.5% for 1997. In total,
assets earned $100.7 million, or an 8.4% yield for 1998. During 1997, assets
earned $37.0 million or a 7.8% yield.

  A substantial portion of mortgage assets have interest rates that fluctuate
with short-term market interest rates. However, many of these mortgage 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 mortgage assets
season. Table 13 is a summary of mortgage assets by type, presenting their
current and fully indexed weighted-average coupons.

                                    Table 13
          Mortgage Assets by Product/Type and Weighted Average Coupon
                    December 31, 1998 (dollars in thousands)

<TABLE>
<CAPTION>
                                                                   Weighted
                                                                Average Coupon
                                                                ---------------
                                                    Outstanding          Fully
    Product/Type                                     Principal  Current Indexed
    ------------                                    ----------- ------- -------
      <S>                                           <C>         <C>     <C>
      Mortgage loans:
      Two and three year fixed/adjustable
       thereafter..................................  $511,824    10.19%  11.34%
      Fixed rate (30 Yr, 15 Yr, 30/15).............   302,620    10.03     --
      Other (1 year CMT, 6 month LIBOR)............    88,958    10.32   10.86
                                                     --------
      Total mortgage loans.........................  $903,402
                                                     ========
</TABLE>


                                       40
<PAGE>

  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 9, 10 and 14 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 1998,
NovaStar Financial collected $2.0 million in prepayment penalties from
borrowers. Table 14 is an analysis of mortgage loans and prepayment penalties.
Prepayments on mortgage loans have generally been consistent with management's
expectations.

                                    Table 14
                       Mortgage Loan Prepayment Penalties
                    December 31, 1998 (dollars in thousands)

<TABLE>
<CAPTION>
                                                                 Weighted Average
                                                        -----------------------------------
                                                                             Remaining
                                                                         Prepayment Penalty
                                           Percent with                      Period (in
                          Current           Prepayment           Loan-     years)--Loans
                         Principal Premium   Penalty    Coupon  to-value    with Penalty
                         --------- ------- ------------ ------  -------- ------------------
<S>                      <C>       <C>     <C>          <C>     <C>      <C>
Loans collateralizing
 NovaStar Home Equity
 Series (CMO):
  1997-1................ $162,423  $ 7,975     64.9%    10.57%    75.1%         0.89
  1997-2................  163,049    3,403     71.7     10.37     78.5          1.10
  1998-1................  270,640    4,651     69.0     10.01     81.1          1.51
  1998-2................  301,527    4,703     71.3      9.95     81.1          2.09
All other loans.........    5,763      136     65.3      9.91     80.0          1.59
                         --------  -------
Total................... $903,402  $20,868     69.5%    10.15%    79.5%         1.52
                         ========  =======
</TABLE>

  As noted above, interest income is a function of volume and rates. Increasing
the volume of assets will cause future increases in interest income, while
declining balances will reduce interest income. Market interest rates will also
affect future interest income.

  Interest expense. The cost of borrowed funds was $80.8 million during the
year ended December 31, 1998, or 6.6% of average borrowings, compared with
$28.2 million for 1997, or 6.5% of average borrowings. Advances under the
warehouse line of credit bear interest based on the federal funds rate, plus a
spread. NovaStar receives 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 1998 and
1997, the one-month LIBOR averaged 5.6%. As with interest income, cost of funds
in the future will largely depend on market conditions, most notably levels of
short-term interest rates. Rates on other borrowings generally fluctuate with
short-term market interest rates, such as LIBOR or the federal funds rate.

                                       41
<PAGE>

  Table 15 presents a summary of average interest-earning assets and
liabilities and the related yields and rates thereon for 1998.

                                    Table 15
                              Interest Analysis(A)
              Year Ended December 31, 1998 (dollars in thousands)

<TABLE>
<CAPTION>
                              Mortgage Loans         Mortgage Securities              Total
                         ------------------------  ------------------------ --------------------------
                                  Interest Annual           Interest Annual            Interest Annual
                         Average  Income/  Yield/  Average  Income/  Yield/  Average   Income/  Yield/
                         Balance  Expense   Rate   Balance  Expense   Rate   Balance   Expense   Rate
                         -------- -------- ------  -------- -------- ------ ---------- -------- ------
<S>                      <C>      <C>      <C>     <C>      <C>      <C>    <C>        <C>      <C>
Mortgage Assets......... $822,180 $76,751   9.34%  $375,222 $23,996   6.40% $1,197,402 $100,747  8.41%
                         ========                  ========                 ==========
Liabilities
 Repurchase
  agreements............ $118,380   7,817   6.60%  $392,859  21,891   5.57% $  511,239   29,708  5.81%
 Collateralized
  mortgage
  obligations...........  703,328  43,287   6.15        --      --     --      703,328   43,287  6.15
 Other borrowings.......   18,936   4,908  25.92        --      --     --       18,936    4,908 25.92
                         --------                                           ----------
 Cost of derivative
  financial Instruments
  hedging liabilities...            2,162                       729                       2,891
                                  -------                   -------                    --------
   Total borrowings..... $840,644  58,174   6.92   $392,859  22,620   5.76  $1,232,503   80,794  6.55
                         ======== =======          ======== =======         ========== ========
 Net interest income....          $18,577                   $ 1,376                    $ 19,953
                                  =======                   =======                    ========
 Net interest spread....                    2.41%                     0.64%                      1.86%
                                           =====                      ====                      =====
 Net yield..............                    2.26%                     0.37%                      1.67%
                                           =====                      ====                      =====
</TABLE>
- --------
(A) NovaStar Financial's average borrowings were greater than average assets
    during 1998 as borrowings on mortgage securities and mortgage loans are a
    function of the underlying collateral's' market value, which for the
    majority of 1998 was greater than par. Also, in 1998, NovaStar Financial
    borrowed against the residual interests of its securitizations, which are
    not recorded on our balance sheet as the securitizations were treated as
    financing transactions.

  Net interest income and spread. Net interest income during 1998 was $20.0
million or 1.7% of average interest-earning assets, compared with $8.8 million,
or 1.8% of average interest-earning assets during 1997. Net interest spread was
1.9% during the year ended December 31, 1998 compared with 1.3% during the year
ended December 31, 1997. Net interest income and the spread are functions of
asset yield relative to its costs of funds. Cost of funds has remained
relatively low and stable during most of 1998 and 1997. During the fourth
quarter of 1998, NovaStar Financial experienced increasing costs of funds
associated with impaired liquidity resources. Special interest costs of $4
million were incurred to obtain a short-term financing arrangement from
GMAC/Residential Funding Corporation as discussed in "Events of the Fourth
Quarter 1998". New warehouse lending arrangements with First Union National
Bank reflect increased rates of interest. 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. We expect, in general, that
financing rates will be 25 to 50 basis points higher in 1999 than in 1998 and
1997. No predictions can be made beyond 1999.

  Impact of interest rate agreements. NovaStar Financial has entered into
interest rate agreements and financial futures contracts designed to mitigate
exposure to interest rate risk. Interest rate cap agreements require NovaStar
Financial to pay a monthly fixed premium while allowing it to receive a rate
that adjusts with LIBOR, when rates rise above an agreed-upon rate. Other
agreements executed include simple fixed to floating interest rate swaps. These
agreements are used to alter, in effect, the interest rates on funding costs to
more closely match the yield on interest-earning assets. As discussed in the
section, "Events of the Fourth Quarter 1998", NovaStar Financial terminated all
swap agreements and paid off the liabilities pertaining to these hedging
instruments in October 1998, recognizing losses aggregating $8.0 million. These
agreements were related to the financing for disposed mortgage loans and
mortgage securities.


                                       42
<PAGE>

  During 1998 and 1997, net interest expense was incurred on hedging agreements
of $2.9 million and $1.0 million, respectively, which is included as a
component of interest expense. Note 5 of the consolidated financial statements
provide details of the interest rate agreements as of December 31, 1998 and
1997.

Other Income

  Other income during 1998 primarily consists of prepayment penalties of $2.0
million, interest earned on securitization funds held in trust of $749,000, and
interest earned on notes receivable from founders of $441,000. Other income for
1997 primarily consisted of prepayment penalties of $414,000 and interest
earned on notes receivable from founders of $260,000.

Gain or Loss on Sales of Securities and Mortgage Loans

  As discussed earlier in "Events of the Fourth Quarter 1998", NovaStar
Financial sold all investment securities during October 1998 at an aggregate
loss of $15.4 million during October 1998. Gross gains and losses on sales of
securities are detailed in Note 3 to the consolidated financial statements.
During 1998, NovaStar Financial also recognized $305,000 in net gains on sale
of $7.9 million of mortgage loans.

Provisions for Credit Losses

  NovaStar provides regular allowances for credit losses on its mortgage loans.
We continuously evaluate the potential for credit losses for mortgage loans
held in portfolio. Provisions have been made based on NovaStar's historical
experience, general industry trends and our judgement. Loan defaults occur
throughout the life of a group of loans. As a result, provisions for credit
losses are recorded against income over the estimated life of the loans, rather
than immediately upon acquisition of the loans. Provisions are based upon total
expected losses and an estimated loss curve. Losses are recognized and loans
are charged off upon foreclosure. Foreclosure assets are recorded at the lower
of the remaining unpaid loan balance or the estimated net realizable value of
the foreclosed asset.

  During 1998, NovaStar Financial provided $7.4 million to the allowance for
credit losses, compared with $2.5 million during 1997. During the second half
of 1998, charge-offs increased. Management believes the increase in charge-offs
was due principally to losses occurring earlier in the overall life of the
loans than originally anticipated. Management accelerated provisions during the
1998 fourth quarter in recognition of this trend. NovaStar Financial expects to
continue to make somewhat higher provisions during 1999, compared to the first
three quarters of 1988, to ensure the credit allowance is maintained at an
adequate level.

  During the third quarter of 1998, NovaStar Financial and NovaStar Mortgage
executed an agreement with Commonwealth Mortgage Acceptance Corporation to
provide insurance coverage on mortgage loans. As of December 31, 1998,
approximately 26% percent of the loans owned by NovaStar Financial and
substantially all of the loans owned by NovaStar Mortgage are covered under
this agreement. During 1998, total premiums paid to Commonwealth Mortgage
Acceptance Corporation totaled $744,000 and are included as a component of loan
servicing expense in the financial statements. We believe that exposure to
credit loss mortgage on loans insured by Commonwealth Mortgage Acceptance
Corporation is minimal. We expect that a substantial portion of loans
originated in future periods will be covered under similar insurance
arrangements.

  As of December 31, 1998, NovaStar Financial had 126 mortgage loans in real
estate owned with a carrying value of $10.6 million. Charge-offs during 1998
were $6.2 million compared with $140,000 during 1997. As the portfolio
continues to season, we expect that the actual loss rate may continue to
increase. Table 16 is a roll-forward of the allowance for credit losses during
1998 and 1997.

                                       43
<PAGE>

                                    Table 16
                  Roll-forward of Allowance for Credit Losses
                     Years Ended December 31, 1998 and 1997

<TABLE>
<CAPTION>
                                       1998                                1997
                         ----------------------------------- ----------------------------------
                         Dec. 31  Sept. 30 June 30  March 31 Dec. 31  Sept. 30 June 30 March 31
                         -------  -------- -------  -------- -------  -------- ------- --------
<S>                      <C>      <C>      <C>      <C>      <C>      <C>      <C>     <C>
Beginning balance....... $2,757    $3,341  $2,871    $2,313  $1,444    $  718   $170     $--
  Provision for credit
   losses...............  4,030     1,179   1,145     1,076   1,009       726    548      170
  Amounts charged off,
   net of recoveries.... (3,214)   (1,763)   (675)     (518)   (140)      --     --       --
                         ------    ------  ------    ------  ------    ------   ----     ----
Ending Balance.......... $3,573    $2,757  $3,341    $2,871  $2,313    $1,444   $718     $170
                         ======    ======  ======    ======  ======    ======   ====     ====
</TABLE>

  Table 17 is a summary of delinquent mortgage loans as of December 31, 1998
and 1997 by quarter. Table 18 provides summaries of delinquencies, defaults,
and loss statistics as of December 31, 1998 and 1997 by quarter. The
information presented in both tables includes NovaStar Financial's
securitization portfolio as well as mortgage loans owned by our affiliates. We
consider this information meaningful, as these are all mortgage loans serviced
by NovaStar Mortgage. Other information regarding the credit quality of
mortgage loans is provided in Tables 5, 6 and 7.

                                    Table 17
                    Loan Delinquencies (90 days and greater)
                   Years Ended December 31, 1998 and 1997(A)

<TABLE>
<CAPTION>
                                                  1998                              1997
                                    --------------------------------- ---------------------------------
                                    Dec. 31 Sept. 30 June 30 March 31 Dec. 31 Sept. 30 June 30 March 31
                                    ------- -------- ------- -------- ------- -------- ------- --------
<S>                                 <C>     <C>      <C>     <C>      <C>     <C>      <C>     <C>
Mortgage loans collateralizing
 NovaStar Home Equity series
 (CMO):
1997-1 (Issued October 1, 1997)...   5.45%    5.97%   5.86%    4.39%   2.71%     --      --      --
1997-2 (Issued December
 11, 1997)........................   5.62     4.97    4.72     2.23     --       --      --      --
1998-1 (Issued April  30, 1998)...   4.44     2.06     --       --      --       --      --      --
1998-2 (Issued August  18, 1998)..   2.35     0.40     --       --      --       --      --      --
All loans in servicing portfolio..   3.35     2.45    2.53     2.28    1.80     1.47%    --      --
</TABLE>
- --------
(A) Includes mortgage loans in foreclosure or bankruptcy.

                                       44
<PAGE>

                                    Table 18
                       Delinquencies, Defaults and Losses
                    December 31, 1998 (dollars in thousands)

<TABLE>
<CAPTION>
                              NovaStar Home Equity Series
                          --------------------------------------
                           1997-1    1997-2    1998-1    1998-2   Other(A)  All Loans
                          --------  --------  --------  --------  --------  ----------
<S>                       <C>       <C>       <C>       <C>       <C>       <C>
Loan servicing
 portfolio..............  $168,255  $167,685  $273,583  $301,857  $268,587  $1,179,967
                          ========  ========  ========  ========  ========  ==========
Allowance for Credit
 Losses:
  Balance, January 1,
   1998.................  $  1,063  $    967  $    --   $    --   $    283  $    2,313
  Provision for credit
   losses...............     1,895     2,257     1,878       222     1,178       7,430
  Amounts charged off,
   net of recoveries....    (2,142)   (2,175)     (715)      124    (1,262)     (6,170)
                          --------  --------  --------  --------  --------  ----------
  Balance, December 31,
   1998.................  $    816  $  1,049  $  1,163  $    346  $    199  $    3,573
                          ========  ========  ========  ========  ========  ==========
Defaults as a percent of
 loan servicing
 portfolio, December 31,
  1998:
  Delinquent loans......      6.45%     5.95%     4.89%     4.06%     2.01%       4.40%
                          ========  ========  ========  ========  ========  ==========
  Loans in foreclosure..      2.63      2.96      3.60      2.06      0.40        2.25
                          ========  ========  ========  ========  ========  ==========
  Real estate owned.....      3.54      2.76      1.01      0.09      0.23        3.55
                          ========  ========  ========  ========  ========  ==========
</TABLE>

<TABLE>
<CAPTION>
                                       1998                          1997
                         --------------------------------- ------------------------
                         Dec. 31 Sept. 30 June 30 March 31 Dec. 31 Sept. 30 June 30
                         ------- -------- ------- -------- ------- -------- -------
<S>                      <C>     <C>      <C>     <C>      <C>     <C>      <C>
Total defaults:
  Delinquent loans......  4.40%    2.95%   1.95%    1.92%   1.76%    4.44%   3.09%
                          ====     ====    ====     ====    ====     ====    ====
  Loans in foreclosure..  2.25     2.02    2.28     2.29    2.05     0.47    0.01
                          ====     ====    ====     ====    ====     ====    ====
  Real estate owned.....  3.55     0.81    0.52     0.24    0.05      --      --
                          ====     ====    ====     ====    ====     ====    ====
</TABLE>
- --------
(A) Primarily loans owned by NovaStar Mortgage, Inc.

                                       45
<PAGE>

General and Administrative Expenses

  General and administrative expenses for the years ended December 31, 1998 and
1997 are provided in Table 19. Table 20 displays the relationship of portfolio
expenses to net interest income during the 1998 and 1997 by quarter.

                                    Table 19
                      General and Administrative Expenses
         Years Ended December 31, 1998 and 1997 (dollars in thousands)

<TABLE>
<CAPTION>
                                           Year Ended      Year Ended December
                                       December 31, 1998        31, 1997
                                      -------------------- -------------------
                                               Percent of          Percent of
                                              Net Interest        Net Interest
                                                 Income              Income
                                              ------------        ------------
<S>                                   <C>     <C>          <C>    <C>
Compensation and benefits............ $ 1,785      8.9%    $  839      9.6%
Professional and outside services....   1,117      5.6        676      7.7
Other loan servicing.................   1,071      5.4        741      8.4
Office administration................     903      4.5        299      3.4
Other................................     247      1.2        448      5.1
                                      -------     ----     ------     ----
Total portfolio-related expenses.....   5,123     25.6%     3,003     34.2%
                                                  ====                ====
Forgiveness of notes receivable from
 founders............................     --                1,083
Fees for services provided by
 NovaStar Mortgage, Inc..............   6,486               4,155
                                      -------              ------
  Total.............................. $11,609              $8,241
                                      =======              ======
</TABLE>

                                    Table 20
                        Portfolio Related Expenses as a
                         Percent of Net Interest Income
                     Years Ended December 31, 1998 and 1997

<TABLE>
<CAPTION>
                                                                 Percent of Net
                                                                 Interest Income
                                                                 ---------------
     <S>                                                         <C>
     1998.......................................................      25.6%
     Fourth quarter.............................................      89.7
     Third quarter..............................................      22.3
     Second quarter.............................................      20.1
     First quarter..............................................      15.6
     1997.......................................................      34.2%
     Fourth quarter.............................................      37.1
     Third quarter..............................................      38.8
     Second quarter.............................................      33.9
     First quarter..............................................      31.2
</TABLE>

  The fees for services provided by NovaStar Mortgage, Inc. represent
compensation for services, including the development of mortgage loan products,
underwriting, funding, quality control, and servicing. NovaStar Mortgage pays a
commitment fee to NovaStar Financial when originated mortgage loans are not
sold to NovaStar Financial. No fee is paid if NovaStar Financial is unable or
unwilling to purchase the mortgage loans originated by NovaStar Mortgage. The
increase in this fee for 1998 compared with 1997 is primarily a result of an
increase in the extent of services required and the increase in mortgage loan
volume. These fees are discussed in greater detail in Note 9 to consolidated
financial statements.

                                       46
<PAGE>

  Compensation and benefits include employee base salaries, benefit costs and
incentive compensation awards. The increase in compensation and benefits for
the year ended December 31, 1998 compared with the year ended December 31, 1997
is due to adding portfolio and finance staff and management.

  Other mortgage loan servicing in 1998 consists primarily of the fees paid to
Commonwealth Mortgage Acceptance Corporation as discussed under the "Provisions
for Credit Losses." Also included as a component of mortgage loan servicing are
the direct costs associated with the mortgage loan servicing operation that are
paid directly to independent third parties for such things as property
appraisals and borrower location services. These fees vary based on mortgage
loan volume as well as the number of delinquencies and foreclosures. However,
mortgage loan servicing fees recognized in 1997 were primarily the fees paid
during the first half of 1997 to an independent third party for servicing its
portfolio while NovaStar Mortgage's servicing operation was being developed.

  Professional and outside services include fees for legal and accounting
services. In the normal course of business, fees are incurred for professional
services related to general corporate matters and specific transactions. Office
administration includes items such as rent, depreciation, telephone, office
supplies, postage, delivery, maintenance and repairs. The increases in both
these financial statement captions can be attributable to additional personnel
and general company growth.

Equity in Earnings or Loss of NFI Holding Corporation

  For the year ended December 31, 1998, NFI Holding Corporation recorded a net
loss of $3.0 million compared with net income of $28,000 for the year ended
December 31, 1997. NovaStar Financial records its portion of the income or loss
as equity in net earnings or loss of NFI Holding in its income statement, which
includes the net earnings or loss of NovaStar Mortgage and NovaStar Capital,
Inc., subsidiaries of NFI Holding. Net income generated by NFI Holding is
primarily a function of the fees earned by NovaStar Mortgage relating to the
origination and servicing of loans for NovaStar Financial and the costs of
these activities. During 1998 the loan production volume of NovaStar Mortgage
increased dramatically compared to 1997. The cost of producing loans increased
more than its fee and interest income, which primarily consists of the
administrative fees received from NovaStar Financial as discussed above and in
Note 9 of the consolidated financial statements. Also, during the last half of
1998, NovaStar Mortgage retained its mortgage loans versus selling them to
NovaStar Financial. As discussed above and in Note 9 of the consolidated
financial statements, NovaStar Mortgage pays NovaStar Financial a fee when it
does not sell its mortgage loan production to NovaStar Financial. NovaStar
Mortgage did not pay this fee in 1997, as NovaStar Financial acquired all of
NovaStar Mortgage's loan production.  The additional expense incurred by
NovaStar Mortgage in 1998 was offset to a degree by net gains of $3.0 million
on the sale of $134 million of subprime residential mortgage loans to third
parties. For these reasons, NovaStar Mortgage, and therefore, NFI Holding,
incurred a larger net loss during 1998 when compared to the same period in
1997.

  Condensed consolidated financial statements for NFI Holding are presented in
Note 12 to the consolidated financial statements.

Value of Mortgages Added through Wholesale Operations

  By establishing a wholesale lending operation to originate subprime
residential mortgage loans, NovaStar has developed a process to add mortgage
assets to its balance sheet at amounts we believe are below what it would
generally cost, in most market environments, to acquire the same assets in bulk
through open market purchases. In effect, the value created by generating
assets at this lower cost is creating future economic benefit, or value, for
our stockholders. This added value is demonstrated in the estimated fair value
of our loan portfolio. The values presented in Tables 21 and 22 are our
estimates based on market conditions as of December 31, 1998.

  We estimate the weighted-average value of its mortgage loan portfolio as of
December 31, 1998 to be between 103 and 105 in terms of price to par, based
upon return assumptions and secondary market prices. We

                                       47
<PAGE>

believe 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 December 31,
1998 loans should take into consideration at what value the loans could be sold
in the open market. During the 1998 fourth quarter, NovaStar Financial sold a
number of whole loan packages at prices that averaged between 103.5 and 104.0.
Tables 21 and 22 provide our estimates of the value of the mortgage loans in
its portfolio and 1998 fourth quarter production and the assumptions used for
estimating fair value. Because any estimated value can vary dramatically based
upon the assumptions used, a range of assumptions is used to determine the
estimated value.

  During 1998, NovaStar originated mortgage loans at an all-in cost of 103.4%
of principal, including direct costs of acquisition, such as broker premiums,
and general overhead expenses. Table 3 displays costs of production for each
quarter. The cost of production during the 1998 third and fourth quarters is
higher than previous quarters as a result of lower production levels. NovaStar
Mortgage operated 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.

  The weighted-average premium on mortgage loans outstanding at December 31,
1998 represented 2.3% of principal. Using the estimated fair values from above,
this implies an estimated unrealized gain, or additional value in the mortgage
loan portfolio at December 31, 1998 of between 1.0 and 3.0%. Applying this
percent to the balance of mortgage loans outstanding of $921 million results in
an estimated unrealized gain of between $9 and $28 million. This additional
value results in an estimated mark-to-market equity at December 31, 1998 of
$96-$115 million, or $11.81-14.15 per outstanding share, compared with a book
value per outstanding share of $10.74. On a diluted basis, book value per share
at December 31, 1998 is $10.14, while a mark-to-market value is $10.69-12.81.

                                    Table 21
            Estimated Market Price on Entire Mortgage Loan Portfolio
                            As of December 31, 1998

<TABLE>
<CAPTION>
                         Estimated Market                             Estimated Market
                               Price                                        Price
                         -------------------                          -------------------
                          Two- and Three-
                          year Fixed Loan                              Six-month LIBOR
                             Products                                   Loan Products
                         -------------------                          -------------------
<S>                      <C>    <C>    <C>    <C>                     <C>    <C>    <C>
Bond Equivalent Yield...  8.31%  8.56%  8.81% Bond Equivalent Yield..  9.06%  9.31%  9.56%
Spread to Index.........  3.25%  3.50%  3.75% Spread to Index........  4.00%  4.25%  4.50%
Assumed Prepayment                            Assumed Prepayment
Speed (CPR)                                   Speed (CPR)
30...................... 105.3% 104.7% 104.1% 35..................... 104.1% 103.6% 103.1%
35...................... 104.5% 104.0% 103.5% 40..................... 103.6% 103.1% 102.7%
40...................... 103.9% 103.4% 103.0% 45..................... 103.1% 102.8% 102.4%
<CAPTION>
                                                                      30/15-year Fixed
                                                                      and Balloon Loan
                           One-year CMT                               Products (Three-
                           Loan Products                               year Treasury)
                         -------------------                          -------------------
<S>                      <C>    <C>    <C>    <C>                     <C>    <C>    <C>
Bond Equivalent Yield...  8.02%  8.27%  8.52% Bond Equivalent Yield..  8.03%  8.28%  8.53%
Spread to Index.........  3.50%  3.75%  4.00% Spread to Index........  3.50%  3.75%  4.00%
Assumed Prepayment                            Assumed Prepayment
Speed (CPR)                                   Speed (CPR)
30...................... 104.2% 103.6% 103.0% 25..................... 105.4% 104.7% 104.1%
35...................... 103.6% 103.1% 102.6% 30..................... 104.6% 104.1% 103.5%
40...................... 103.1% 102.7% 102.2% 35..................... 104.0% 103.5% 103.1%
</TABLE>


                                       48
<PAGE>

                                    Table 22
 Estimated Market Price of Mortgage Loans Originated in Fourth Quarter of 1998

<TABLE>
<CAPTION>
                         Estimated Market                             Estimated Market
                               Price                                        Price
                         -------------------                          -------------------
                          Two- and Three-
                          year Fixed Loan                              Six-month LIBOR
                             Products                                   Loan Products
                         -------------------                          -------------------
<S>                      <C>    <C>    <C>    <C>                     <C>    <C>    <C>
Bond Equivalent Yield...  8.06%  8.31%  8.56% Bond Equivalent Yield..  8.31%  8.56%  8.81%
Spread to Index.........  3.00%  3.25%  3.50% Spread to Index........  3.25%  3.50%  3.75%
Assumed Prepayment                            Assumed Prepayment
Speed (CPR)                                   Speed (CPR)
30...................... 105.1% 104.5% 103.9% 35..................... 103.9% 103.4% 102.9%
35...................... 104.3% 103.8% 103.3% 40..................... 103.4% 102.9% 102.5%
40...................... 103.7% 103.3% 102.8% 45..................... 102.9% 102.5% 102.2%
<CAPTION>
                                                                      30/15-year Fixed
                           One-year CMT                               and Balloon Loan
                           Loan Products                                  Products
                         -------------------                          -------------------
<S>                      <C>    <C>    <C>    <C>                     <C>    <C>    <C>
Bond Equivalent Yield...  7.52%  7.77%  8.02% Bond Equivalent Yield..  7.78%  8.03%  8.28%
Spread to Index.........  3.00%  3.25%  3.50% Spread to Index........  3.25%  3.50%  3.75%
Assumed Prepayment                            Assumed Prepayment
Speed (CPR)                                   Speed (CPR)
30...................... 104.0% 103.4% 102.8% 25..................... 105.3% 104.6% 104.0%
35...................... 103.3% 102.8% 102.3% 30..................... 104.5% 104.0% 103.4%
40...................... 102.8% 102.4% 102.0% 35..................... 103.9% 103.4% 103.0%
</TABLE>

                                    Table 23
                Carrying Value of Mortgage Loans by Product/Type
                        December 31, 1998 (in thousands)

<TABLE>
<CAPTION>
      Product/Type                                                      Amount
      ------------                                                     --------
      <S>                                                              <C>
      Two- and three-year fixed....................................... $511,824
      Six-month LIBOR.................................................   54,158
      One-year CMT....................................................   34,800
      30/15-year fixed and balloon....................................  302,620
                                                                       --------
        Outstanding principal.........................................  903,402
      Premium.........................................................   20,868
      Allowance for credit losses.....................................   (3,573)
                                                                       --------
        Carrying Value................................................ $920,697
                                                                       ========
      Carrying value as a percent of principal........................   101.91%
                                                                       ========
</TABLE>

Results of Operations--Year Ended December 31, 1997

 Net Loss

  During 1997, NovaStar Financial recorded a net loss of $1,135,000, or $0.26
per share. Excluding the forgiveness of the notes receivable from founders,
NovaStar Financial incurred a loss of $52,000, or $0.01 per share. During much
of 1997, NovaStar Financial focus was placed on hiring key employees and
development of policies and procedures. The results for the year ended December
31, 1997 also reflect the significant cost of developing operations.

                                       49
<PAGE>

 Net Interest Income

  Table 24 presents a summary of the average interest-earning assets, average
interest-bearing liabilities and the related yields and rates thereon for the
year ended December 31, 1997.

                                    Table 24
                               Interest Analysis
           Year Ended December 31, 1997 (dollar amounts in thousands)

<TABLE>
<CAPTION>
                                   Mortgage Loans        Mortgage Securities
                              ------------------------ ------------------------
                                       Interest Annual          Interest Annual
                              Average  Income/  Yield/ Average  Income/  Yield/
                              Balance  Expense   Rate  Balance  Expense   Rate
                              -------- -------- ------ -------- -------- ------
<S>                           <C>      <C>      <C>    <C>      <C>      <C>
Mortgage Assets.............. $294,111 $25,154   8.56% $182,140 $11,807   6.48%
                              ========                 ========
Liabilities
  Master repurchase
   agreement................. $170,344  11,972   7.03       --      --     --
  Other repurchase
   agreements................                           172,829  10,336   5.98
  Collateralized mortgage
   obligations...............   74,511   4,736   6.36       --      --     --
  Other borrowings...........   18,402   1,141   6.20       --      --     --
                              -------- -------         -------- -------
    Total borrowings......... $263,257  17,849   6.49  $172,829  10,336   5.98
                              ======== -------         ======== -------
Net interest income..........          $ 7,305                  $ 1,471
                                       =======                  =======
Net interest spread..........                    2.07%                    0.50%
                                                 ====                     ====
Net yield....................                    2.48%                    0.81%
                                                 ====                     ====
</TABLE>

  Interest Income. Interest-earning assets averaged $476.3 million during 1997,
including $294.1 million of mortgage loans and $182.1 million of mortgage
securities. During the year, mortgage loans earned $25.2 million, or a yield of
8.6%, while mortgage securities earned $11.8 million, or a yield of 6.5%. In
total, assets earned $37.0 million, or a 7.8% yield.

  Interest Expense. The cost of borrowed funds was $28.2 million during the
year ended December 31, 1997, or 6.5% of average borrowings. During the year
ended December 31, 1997, the one-month LIBOR averaged 5.6%. As with interest
income, cost of funds in the future will largely depend on market conditions,
most notably levels of short-term interest rates.

  Net Interest Income and Spread. Net interest income during 1997 was $8.8
million, or 1.8% of average interest-earning assets. Net interest spread was
1.3% during the year ended December 31, 1997. Net interest income and the
spread are functions of the asset yield relative to its costs of funds. During
1997, the cost of funds was relatively low and stable. This lower cost of funds
offsets, to some degree, the lower yield on "teaser" rate mortgage loans. In
addition, interest rate agreements are used to mitigate the exposure to
variations in interest rates on interest-earning assets that are different from
the variations in interest incurred on borrowings.

  Impact of Interest Rate Agreements. As of December 31, 1997, NovaStar
Financial had interest rate cap agreements, with a combined notional amount of
$270 million and interest rate swap agreements with an aggregate notional
amount of $276 million. During 1997, net interest expense on these agreements
was $1.0 million, which is included in interest expense.

 Other Income

  During the year ended December 31, 1997, $51,000 in net gains was recognized
on sales of mortgage securities with a principal balance of $107,530. No
mortgage loans were sold during this same period of 1997. Prepayment penalty
income and interest earned on notes receivable from founders during the year
ended December 31, 1997 was $425,000 and $195,000, respectively.

                                       50
<PAGE>

 Provisions for Credit Losses

  During the year ended December 31, 1997, $2.5 million for credit losses was
provided while credit losses for this same period of 1997 were $140,000. As
mentioned earlier, allowances are maintained for losses management expects to
incur on the mortgage loans in the portfolio.

 General and Administrative Expenses

  General and administrative expenses for the year ended December 31, 1997 are
provided in Table 25.

                                    Table 25
                      General and Administrative Expenses
              Year Ended December 31, 1997 (dollars in thousands)

<TABLE>
<CAPTION>
                                                                    Percent of
                                                                   Net Interest
                                                                      Income
                                                                   ------------
      <S>                                                   <C>    <C>
      Compensation and benefits............................ $  839      9.6%
      Loan servicing.......................................    741      8.4%
      Professional and outside services....................    676      7.7%
      Office administration................................    299      3.4%
      Other................................................    448      5.1%
                                                            ------     ----
      Total portfolio-related expenses.....................  3,003     34.2%
                                                                       ====
      Forgiveness of notes receivable from founders........  1,083
      Fees for services provided by NovaStar Mortgage......  4,155
                                                            ------
        Total.............................................. $8,241
                                                            ======
</TABLE>

  Fees for services provided by NovaStar Mortgage during the year ended
December 31, 1997 totaled $4,155,000 and the components of these are further
detailed in Note 9 of the consolidated financial statements. Compensation and
benefits totaled $839,000 during the year ended 1997. The number of employees
and the related compensation costs increased throughout 1997 as staff was
hired.

  Loan servicing costs were $741,000 for the year ended December 31, 1997 and
consist primarily of the fees paid to an outside servicer while NovaStar
Mortgage developed its servicing operation during the first half of the year.
NovaStar Mortgage did not begin servicing NovaStar Financial's mortgage loans
until July 15, 1997. The servicing fee that NovaStar Mortgage charges NovaStar
Financial is based on 50 basis points on the outstanding principal when
mortgage loans are securitized and a flat fee per mortgage loan prior to
securitization. These fees are included as a component of the fees for services
provided by NovaStar Mortgage.

  Professional and outside services include contract labor as well as fees for
legal and accounting services. We used contract labor services fairly
extensively during 1997, particularly in the area of systems development.
During the year ended December 31, 1997, these expenses totaled $676,000.

  Office administration during the twelve months ended December 31, 1997 were
$299,000. These items were relatively high during the NovaStar start-up phase.
However, we expect many of these expenses to continue to increase relative to
increasing personnel.

Earnings of NFI Holding Corporation

  For the year ended December 31, 1997, NFI Holding recorded net income of
$28,000, of which NovaStar Financial recorded its portion $28,000. Condensed
consolidated financial statements for NFI Holding are presented in Note 12 to
the consolidated financial statements.


                                       51
<PAGE>

Taxable Income or Loss

  Income reported for financial reporting purposes as calculated in accordance
with generally accepted accounting principles differs from income computed for
income tax purposes. This distinction is important as dividends paid are based
on taxable income. Table 26 is a summary of the differences between net income
or loss reported for generally accepted accounting principles during 1998 and
1997 by quarter and its taxable income.

                                    Table 26
                             Taxable Income (Loss)
             Years Ended December 31, 1998 and 1997 (in thousands)

<TABLE>
<CAPTION>
                                       1998                                1997
                         -----------------------------------  ---------------------------------
                          Fourth    Third   Second    First   Fourth    Third  Second    First
                         Quarter   Quarter  Quarter  Quarter  Quarter  Quarter Quarter  Quarter
                         --------  -------  -------  -------  -------  ------- -------  -------
<S>                      <C>       <C>      <C>      <C>      <C>      <C>     <C>      <C>
Net income (loss)....... $(27,388) $ 2,394  $1,894   $1,279   $ (433)   $ 177  $(1,073)  $194
Results of Holding and
 subsidiary.............      529    2,447     --       273     (169)    (393)     126    408
Provision for credit
 losses.................    4,030    1,179   1,145    1,076    1,009      726      547    171
Loans charged-off.......   (3,214)  (1,762)   (675)    (518)    (140)     --       --     --
Capital losses..........   15,450      --      --       --       --       --       --     --
Other, net..............      351       95     208       (4)     296       (4)      (8)   --
                         --------  -------  ------   ------   ------    -----  -------   ----
  Taxable income
   (loss)............... $(10,242) $ 4,353  $2,572   $2,106   $  563    $ 506  $  (408)  $773
                         ========  =======  ======   ======   ======    =====  =======   ====
</TABLE>

  As discussed under "Events Subsequent of the Fourth Quarter 1998," several
transactions were executed during October 1998 that included the sale of
mortgage assets and termination of hedging arrangements, which eliminates
taxable income for 1998.

Interest Rate Sensitivity

  Table 27 details Interest Rate Sensitivity for NovaStar Financial as of
December 31, 1998.

                                    Table 27
                           Interest Rate Sensitivity
                               December 31, 1998

<TABLE>
<CAPTION>
                                     Basis Point Increase
                                    (Decrease) in Interest
                                           Rate(B)
                                  ----------------------------
     As of December 31, 1998(A)    (100)    Base(C)     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(C)......   $  5,910       --   $ (3,967)
                                  ========  ========  ========
     Percent change from base
      spread income(D).........       23.8%      --      (16.0)%
                                  ========  ========  ========
     Percent change of
      capital(E)...............       6.77%      --      (4.54)%
                                  ========  ========  ========
</TABLE>
- --------
(A) The securitized mortgage assets of NovaStar Financial are managed on a
    spread income basis.
(B) Income of asset, liability or interest rate agreement in a parallel shift
    in the yield curve, up and down 1%.
(C) Total change in estimated spread income, in dollars, from "base." "Base" is
    the estimated spread income at December 31, 1998.
(D) Total change in estimated spread income, as a percent, from base.
(E) Total change in estimated spread income as a percent of total stockholders'
    equity at December 31, 1998.

                                       52
<PAGE>

  Interest Rate Sensitivity Analysis. The values under the heading "Base" are
our estimates of spread income for assets, liabilities and interest rate
agreements on December 31, 1998. The values under the headings "100" and
"(100)" are our estimates of the income value of those same assets, liabilities
and interest rate agreements assuming that interest rates were 100 basis point,
1%, higher and lower. The cumulative change in income represents the change in
income of assets from base, net of the change in income of liabilities and
interest rate agreements from base.

  Sensitivity as of December 31, 1998. As shown in the table above, if interest
rates were to decrease one percent, -100 basis points, the spread income of
capital would increase by an estimated 6.77% as of December 31, 1998. If
interest rates rise by one percent, +100 basis points, the spread income of
capital would decrease by an estimated 4.54% as of December 31, 1998.

  A discussion of the assumptions used by management in preparing this analysis
is provided in "Business--Interest Rate Risk Management."

Capital Allocation Guidelines

  Each quarter, we present to the Board of Directors the results of the capital
allocation guidelines compared to actual equity. We 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 Novastar to predict or hedge the risk of the asset.

  Table 28 is a summary of the capital allocation for NovaStar as they apply to
mortgage assets and hedging instruments owned by NovaStar during 1998 and 1997.

                                    Table 28
                                Required Equity

<TABLE>
<CAPTION>
                                         1998                                   1997
                          -------------------------------------  -----------------------------------
Category                  Dec. 31  Sept. 30  June 30   March 31  Dec. 31  Sept. 30  June 30 March 31
- --------                  -------  --------  --------  --------  -------- --------  ------- --------
<S>                       <C>      <C>       <C>       <C>       <C>      <C>       <C>     <C>
Mortgage loans:
 Current................  $12,648  $ 14,567  $ 21,566  $ 23,628  $  6,675 $33,832   $22,780 $15,958
 Delinquent.............    3,918       452       601     1,200     1,600   2,376       --      --
 Securitized loans......   62,315    55,822    37,766    23,478    22,500     --        --      --
Mortgage securities.....      --     19,514    24,904    27,426    36,170  12,763    13,549   1,646
Other assets............   12,536    20,682    13,782    10,733       --      --        --      --
Hedging instruments.....     (179)     (688)     (232)     (203)    5,500     427     1,787   2,804
                          -------  --------  --------  --------  -------- -------   ------- -------
Required equity.........   91,238   110,349    98,387    86,262    72,445  49,398    38,116  20,408
Stockholders' equity....   87,204   109,848   114,875   115,798   116,489  47,036    46,337  46,202
Market value in excess
 of the carrying value
 of assets and
 hedges(A)..............    5,961     2,331    31,999    20,685       --      --        --      --
                          -------  --------  --------  --------  -------- -------   ------- -------
Excess equity...........  $ 1,927  $  1,830  $ 48,487  $ 50,221  $ 44,044 $(2,362)  $ 8,221 $25,794
                          =======  ========  ========  ========  ======== =======   ======= =======
</TABLE>
- --------
(A) The capital allocation guideline model was revised during the first quarter
    of 1998 to include the market value in excess of the carrying value of
    assets and hedges as NovaStar Financial has the ability to borrow against
    this residual.

                                       53
<PAGE>

Inflation

  Virtually all assets and liabilities of NovaStar Financial are financial in
nature. As a result, interest rates and other factors drive company performance
far more than does inflation. Changes in interest rates do not necessarily
correlate with inflation rates or changes in inflation rates. The financial
statements of NovaStar Financial are prepared in accordance with generally
accepted accounting principles and dividends declared by NovaStar Financial are
based upon taxable income. In each case, company activities and the 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 describes two recently issued
accounting pronouncements. We believe the implementation of these
pronouncements did not or will not have a material impact on the consolidated
financial condition or results of operations. We are currently evaluating the
impact of SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities."

The Year 2000

  NovaStar Financial is highly dependent on purchased and leased computer
software to conduct business. In addition, NovaStar Financial is highly
dependent on computer software used by market counterparties and vendors,
including banks, in conducting business. We recognize that some computer
software may not have the ability to correctly identify dates beyond December
31, 1999. Successful modification of computer software, or the vendors'
successful modification of their programs, to be year 2000 compliant is
critical to the viability of NovaStar Financial.

  NovaStar uses three major, and a number of smaller, internal automation
solutions to conduct its 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 integrates with a number of outside entities in normal
business transactions. Interfaces with other businesses and third party
solution providers are used to conduct some of NovaStar's business processes.
Other processes are supported by systems created internally.

  NovaStar is using the Federal Financial Institutions Examination Council's
"Year 2000 Project Management Awareness" document to guide NovaStar's year 2000
readiness effort. Each program/system interface used is being reviewed and
tested for year 2000 compliance. The guidelines call for a three-phase approach
to assess year 2000 compliance.

                                       54
<PAGE>

  Based on this three-phase approach our projected timeline is as follows:

                              [GRAPH APPEARS HERE]

  In the assessment phase, we have determined which business
processes/interfaces rely on dates and date arithmetic. Most business
processes/interfaces of NovaStar rely on dates and date arithmetic. These
business processes/interfaces are being tested internally for compliance. We
have asked our market counterparties and vendors to document that they have
assessed software for year 2000 compliance.

  Solution updates to non-compliant Year 2000 software should be made in the
correction phase. Corrections on company developed software will be made
internally and are expected to be insignificant. Management is requiring all
market counterparties and vendors to document they have made all corrections.

  NovaStar will conduct "mock" business as if it is in the year 2000 during the
validation phase. During this phase, NovaStar will test all internally
developed software as well as vendor software.

  NovaStar has contacted all of its significant outside market counterparties
and vendors to obtain documentation regarding their process and status for
assuring year 2000 compliance. We have asked that each party adhere to the same
Federal Financial Institutions Examination Council guidelines and to provide
documents of progress during each phase. NovaStar has received written
confirmation from Alltel Residential Lending Solutions, vendor of NovaStar's
servicing system, and Baan/CODA, vendor of NovaStar's accounting system,
stating that the versions currently used by NovaStar are fully year 2000
compliant.

  All internally developed software was designed to be year 2000 compliant. In
addition, we have contacted our significant financial counterparty, First Union
National Bank, who is completing its internal review of year 2000 compliance.

  We believe that its greatest risk in regards to year 2000 compliance is the
software and systems used to service its subprime mortgage loans. NovaStar
Mortgage services the mortgage loans owned by NovaStar Financial. NovaStar
Mortgage uses systems developed by Alltel for mortgage loan servicing. If these
systems fail, NovaStar Mortgage will not be able to continue on a manual basis.
In this worst case scenario, mortgage loans would not be serviced until the
failed system could be remedied. If the mortgage loans go "unserviced" for an
extended period of time--several weeks--the result could have a material
adverse impact on NovaStar Financial.

  NovaStar is also at significant risk in the event the systems of financial
institutions, on which it is relying for financing and cash management, fail.
In a worst case scenario, NovaStar Financial and NovaStar Mortgage may not be
able to meet financial obligations during the period of failure--an unknown
timeframe. The result could have a material adverse impact on NovaStar
Financial.

                                       55
<PAGE>

  NovaStar is exposed to smaller risks in the event other systems, including
those developed internally, fail to perform beyond December 31, 1999. However,
we believe 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 for these systems failures is
expected to be minimal.

  We expect, through the completion of our year 2000 plan, the likelihood of a
material business disruption is not significant. The major risks presented
above involve year 2000 remediation efforts of third party vendors used by
NovaStar. Based on the information provided, we believe these vendors will meet
their obligation for resolution of year 2000 issues.

  We estimate we have 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 any market counterparty determines it will not be year 2000 compliant.

                                       56
<PAGE>
                                    BUSINESS

  Generally, we acquire and manage a portfolio of mortgage loans, primarily
subprime, and mortgage securities. Through June 30, 1998, a substantial portion
of the mortgage loans we acquired was originated by our affiliate, NovaStar
Mortgage, Inc. Mortgage securities were acquired in the open marketplace. As
our capital was depleted and liquidity tightened, we ceased acquiring mortgage
assets and sold certain of our mortgage assets as discussed in "Management's
Discussion and Analysis of Financial Condition and Results of Operation."

  NovaStar Mortgage continues to originate loans for sale to third parties and
we consider that function integral to our business. As additional capital is
raised, we expect to resume acquiring mortgage loans originated by NovaStar
Mortgage. We continue to own and manage a portfolio of mortgage loans that are,
substantially, financed with long-term, non-recourse asset-backed bonds.
Following are summaries of the lending operation and our portfolio management
strategy.

Mortgage Lending Operation

 Market Overview

  During 1997, total mortgage loan originations were approximately $875
billion. Approximately 90% of these loans were classified as "prime" mortgages
which generally means they have credit quality and documentation sufficient to
qualify for a guarantee by GNMA, FNMA or FHLMC. More than $100 billion of the
total mortgage loans originated in 1997 were classified as "subprime" as
published in National Mortgage News on March 23, 1998. Overall loan origination
volume in 1998 was similar to the volume in 1997.

  We believe there is strong national demand by borrowers for subprime mortgage
loans. Across the country, many borrowers have suffered dislocation and
temporary unemployment, resulting in negative entries on their credit reports.
Erratic market and economic conditions and other factors have resulted in high
ratios of debts to assets and high levels of credit card and other installment
debt for these individuals. In addition, more borrowers are choosing to become
self-employed. These are some of the circumstances, which create the market for
subprime mortgage loans.

  One of the significant differences between the prime and subprime mortgage
loan markets has been the comparative dependence upon the overall level of
interest rates. Generally, the subprime mortgage loan market's historical
performance has been more consistent without regard to interest rates. This is
evident by the growth in subprime originations from 1993 through 1997. While
the prime market experienced a decline in originations due primarily to an
increase in interest rates, mortgage loan originations in the subprime market
continued to grow.

  The size of the subprime mortgage loan market in 1997 was approximately $100
billion in annual originations. Historically, the subprime mortgage loan market
has been a highly fragmented niche market dominated by local brokers with
direct ties to investors who owned and serviced this relatively higher margin,
riskier product. Although there have recently been several new entrants into
the subprime mortgage business, we believe the subprime mortgage market is
still highly fragmented, with no single competitor having more than a 6% market
share. The growth and profitability of the subprime mortgage loan market, the
demise of numerous financial institutions in the late 1980s which had served
this market, and reduced profits and mortgage loan volume at traditional
financial institutions have together drawn new participants and capital to the
subprime mortgage loan market. We believe the subprime mortgage loan market
requires more business judgement from underwriters in evaluating borrowers with
previous credit problems. Subprime lending is also generally a lower
volume/higher profit margin business rather than the generally higher
volume/lower profit margin prime mortgage loan business to which traditional
mortgage bankers have become accustomed. Subprime mortgage lending is also more
capital intensive than the prime mortgage market due to the fact that the
securitization function requires a higher level of credit enhancement which
must be provided by the issuer in the form of over-collateralization or
subordination.


                                       57
<PAGE>

  We believe that the subprime mortgage market will continue to grow and to
generate relatively attractive risk-adjusted returns over the long term due in
part to the following reasons:

  . growth in the number of existing homeowners with negative entries on
    their credit reports;

  . growth in the number of immigrants with limited credit histories who are
    in the prime home buying ages of 25 to 34;

  . growth in the number of self-employed individuals who have sources of
    income which are inconsistent and difficult to document;

  . growth in consumer debt levels which are causing many borrowers to have
    higher debt/income ratios; and

  . growth in consumer bankruptcy filings which cause borrowers to be
    classified as subprime.

  We expect more competitors to attempt to enter the market. While this may
cause profit margins to narrow, we believe that the subprime mortgage market
will be able to sustain relatively attractive profit margins due to certain
barriers to entry which include:

  . the capital intensive nature of the business as issuers of securities
    backed by subprime mortgage loans are required to retain the credit and
    prepayment risks;

  . the higher level of expertise required to underwrite the mortgage loans;

  . the higher cost to service the mortgage loans due to the additional
    emphasis required on collections and loss mitigation; and

  . the highly fragmented nature of business due to the difficulty of
    sourcing the mortgage loans.

 Competition

  In the November 16, 1998 issue of National Mortgage News, NovaStar Mortgage
was ranked number 15 of 60 in subprime mortgage lenders based on mortgage
lending volume for the nine months ended September 30, 1998. Based on market
capitalization, as published in National Mortgage News, NovaStar Financial
ranked number 16 of 24 publicly traded subprime lenders. Management's research
of the asset size of these companies indicated NovaStar Financial ranks number
11 of the 24.

  We face intense competition in the business of originating, purchasing,
selling and securitizing subprime mortgage loans. The number of participants is
believed to be well in excess of 100 companies and no single participant holds
a dominant share of the subprime market. In addition to other residential
mortgage REITs, we are in competition for subprime borrowers with consumer
finance companies, conventional mortgage bankers, commercial banks, credit
unions and thrift institutions. We compete for holding mortgage loans with life
insurance companies, institutional investors and other well-capitalized
publicly-owned mortgage lenders. Many of these competitors are substantially
larger than we are and have considerably greater financial, technical and
marketing resources than we do.

  Competition among industry participants can take many forms, including
convenience in obtaining a mortgage loan, amount and term of the loan, customer
service, marketing/distribution channels, loan origination fees and interest
rates. To the extent any competitor significantly expands its activities in the
subprime mortgage loan market, we could be materially adversely affected.

  We believe that one of our key competitive strengths is our employees and the
level of service they are able to provide our borrowers. By servicing our loan
portfolio directly, we are able to stay in close contact with our borrowers and
identify potential problems early. NovaStar Mortgage's servicing staff is
comprised of seasoned mortgage professionals with significant experience in the
subprime mortgage loan marketplace.

                                       58
<PAGE>

  We effectively compete due to our:

  . experienced management team;

  . tax advantaged status as a REIT;

  . vertical integration through our relationship with NovaStar Mortgage,
    which originates and services mortgage loans;

  . direct access to capital markets to securitize our assets; and

  . cost-efficient operations.

  Generally, we do not intend to sell our mortgage loans in order to realize
gain on sale for financial accounting or tax reporting purposes. Rather, we
intend to finance our mortgages through structured debt vehicles where the
emphasis is on earning net interest income and not taking gain on the sale of
assets. The strategy is to build and hold a portfolio of mortgage loans and
securities for investment that generates a net interest margin over time and
allows us to take full advantage of our REIT status. While selling mortgage
loans presents greater earnings and taxable income during the period of
production, using constant portfolio assumptions, due to the current income
recognition of the present value of future cash flows, we believe that over the
long term we will produce a tax-advantaged stream of income and a more stable
dividend flow to stockholders because our earnings will be dependent on the
size of the portfolio of mortgage loans and securities, rather than on our
quarterly mortgage loan production level. The accounting for gain on sale
presents, as current income, the present value of expected future cash flows
from the mortgage loans sold. Future performance expectations are subject to
revision should actual losses, interest rates and prepayment experience differ
from the assumed levels. Holding the mortgage loans as investments allows us to
record income as interest is earned. While management intends to aggressively
manage costs in all production cycles, holding the mortgage loans and recording
income as interest is earned provides us the flexibility to reduce our mortgage
loan production rate during periods in which we believe the market conditions
for subprime mortgage loans are unattractive without necessarily experiencing
an immediate decline in net income. Companies utilizing gain on sale accounting
will typically experience a decline in net income during periods of declining
mortgage loan origination volume.

  While the above is the optimal strategy for us, that strategy is dependent
upon our having sufficient capital to increase our mortgage loan and security
portfolio. During periods where market conditions do not allow us to increase
our capital base, we can sell mortgage loans in the open market to sustain
mortgage loan production.

  We believe we have an advantage over other mortgage REITs through our
infrastructure that allows us to acquire wholesale loan production through our
taxable affiliate, NovaStar Mortgage, at a total cost lower than purchasing
those mortgage loans in the secondary market. Moreover, the relationship we
have with NovaStar Mortgage results in a vertically integrated organization.
Because of this integration, there are no material conflicts between the
interests of the mortgage lending operation and the portfolio management
operation. Conflicts may arise in REITs where the incentives and interest of
management are dependent on asset size rather than return on equity or
stockholder returns. Conflict may arise in entities that have external
management contracts or situations where management's compensation is not
directly related to the company's performance or return to stockholders. Our
primary management incentive programs are dependent on return on equity, in the
annual bonus plan, and stock price appreciation for forgivable loans to
founders and the stock option plan.

  We file our own income tax return, while NFI Holding files consolidated
income tax returns that include NovaStar Mortgage. This structure is designed
to legally separate the mortgage loan origination operation from our
operations, i.e., the REIT entity. This structure also allows for activities
and transactions to be entered into by NovaStar Mortgage, while preserving our
REIT status. These activities include such items as the sale of assets, hedging
techniques and forms of indebtedness. NFI Holding was formed in order to
provide an efficient means of adding additional taxable affiliates to the
organization.


                                       59
<PAGE>

  NovaStar is competitively disadvantaged because of its youth and relatively
low production volume. NovaStar Mortgage has been in the business of
originating subprime mortgage loans for two years and is still developing its
lending network. Until the infrastructure is completely refined and developed,
NovaStar Mortgage will not have the high volume/low cost per loan production
experienced by its competition. In addition, NovaStar Financial requires
significant capital to acquire assets and maximize earnings potential. Many
competitors of NovaStar Financial have larger market capitalization. A larger
market capitalization generally affords larger trading volume, more recognition
in the marketplace and, therefore, greater ability to raise capital.

 Loan Origination

  As discussed in the following sections, NovaStar Mortgage originates and
services subprime mortgage loans. Under the terms of a Loan Purchase and Sale
Agreement, NovaStar Financial may purchase the mortgage loans originated by
NovaStar Mortgage. When NovaStar Mortgage chooses to retain the mortgage loans
it originates, it pays a commitment fee to NovaStar Financial based on the
mortgage loans it has retained. No fee is paid when NovaStar Financial is
unwilling or unable to acquire the mortgage loans offered by NovaStar Mortgage.
NovaStar Mortgage has agreed to service the mortgage loans owned by NovaStar
Financial. NovaStar Financial pays an administrative outsourcing fee to
NovaStar Mortgage as compensation for mortgage loan development, underwriting,
funding and quality control services.

  The historical amounts and nature of these intercompany fees are further
described under the "Fees from NovaStar Mortgage, Inc." and "General and
Administrative Expenses" categories in "Management's Discussion and Analysis of
Financial Condition and Results of Operations". Intercompany fees are also
disclosed in the consolidated financial statements of NovaStar Financial and
the notes thereto.

  Loans originated by NovaStar Mortgage are primarily subprime mortgage loans,
generally secured by first liens on single family residential properties.
Subprime mortgage lending involves lending to individuals whose borrowing needs
are generally not being served by traditional financial institutions due to
poor credit history and/or other factors which make it difficult for them to
meet prime mortgage loan underwriting criteria. NovaStar Mortgage targets as
potential customers individuals with relatively significant equity value in
their homes, but who have impaired credit profiles, are self-employed, tend to
experience some volatility in their income or have difficult-to-document
sources of income, or are otherwise unable to qualify for traditional prime
mortgage loans. Mortgage loan proceeds are used by borrowers for a variety of
purposes such as to consolidate consumer credit card and other installment
debt, to finance home improvements and to pay educational expenses. These
borrowers are often seeking to lower their monthly payments by reducing the
rate of interest they would otherwise pay or extending their debt amortization
period or doing both. Customer service is emphasized by providing prompt
responses and flexible terms to broker-initiated customer borrowing requests.
Through this approach, NovaStar Mortgage expects to originate new mortgage
loans and purchase closed mortgage loans with relatively higher interest rates
than are typically charged by lenders for prime mortgage loans while having
comparable or lower loan-to-value ratios. The pricing differential between
typical prime non-conforming mortgage loans and subprime mortgage loans is
often as much as 300 basis points. With proper management of the credit risk,
most of this additional spread may become additional profit for the owner of
these mortgage loans.

  Originations have primarily been made for debt consolidation purposes, with
the remainder of our origination either rate/term refinances or purchase money
loans. Given the borrowers needs, subprime mortgage lending tends to be less
interest rate sensitive than the prime mortgage purchase market or rate/term
refinance market, since borrowings secured by real estate are generally less
expensive than credit card or installment debt. Subprime borrowers are also
generally more willing to accept a prepayment penalty since they have fewer
options for obtaining financing then the typical prime mortgage loan borrower.
During 1998, 74% of the mortgage loans originated by NovaStar Mortgage had a
prepayment penalty.

                                       60
<PAGE>

 Marketing and Production Strategy

  General. NovaStar Mortgage's competitive strategy is to build efficient
channels of production for originating subprime mortgage loans. NovaStar
Mortgage has generated mortgage product through two distinctive production
channels:

  . direct origination through a wholesale broker network; and

  . bulk acquisitions from originators.

  NovaStar Mortgage's long-term strategy is to emphasize production through the
wholesale broker network. We believe that production channels that allow us to
get closer to the customer and eliminate as many intermediaries as possible
will generally be the most efficient over the long-term and that by developing
the direct origination channel through a mortgage broker network, we will be
able to differentiate ourselves from other end investors who purchase their
production in bulk from other originators. From time to time, we may
participate in the bulk acquisition market depending on market conditions and
the availability of capital.

  We believe that subprime mortgage loans provide a relatively attractive net
earnings profile, producing higher yields without commensurately higher credit
risks when compared to prime mortgage loans. With the proper focus on
underwriting, appraisal, management and servicing of subprime mortgage loans,
we believe we can be successful in developing a profitable business in this
segment of the market. While many new competitors have recently entered the
subprime mortgage loan market, We believe that the experience of our management
in this industry and the infrastructure, which has been established, allows it
to effectively compete in this segment.

  Mortgage Products. NovaStar Mortgage offers a broad menu of products in order
to serve our customers. These products are comprised of both fixed rate and
adjustable-rate mortgages. During 1998, the percentage of fixed rate and
adjustable rate loans originated by NovaStar Mortgage is 31% and 69%,
respectively. NovaStar Mortgage categorizes the mortgage loans that it
originates into one of six different credit risk classifications. Mortgage
loans are assigned a credit classification based on several factors consisting
of such things as loan-to-value ratios, the credit history of the borrower,
debt ratios of the borrower and other characteristics. NovaStar Mortgage
provides loans up to a maximum loan-to-value ratio of 95% based on the credit
risk classification and the loan amount. For loans originated since inception
the average loan-to-value ratio is 80% and the average loan amount is $106,000.

  Wholesale Channel. NovaStar Mortgage's wholesale origination consists of a
network of brokers and mortgage lenders that offer our line of mortgage
products. We believe that our wholesale channel allows NovaStar Mortgage to
originate mortgage loans at a lower cost, including the cost to originate the
loan, than it could purchase the loan in the market. For example, assume the
price to purchase a loan in bulk is 105% of the face amount. If NovaStar
Mortgage can originate the same loan at 101% of face amount and incurs
origination costs of 2% of par, the wholesale loan would be 2% less expensive
than the mortgage loan purchased in bulk.

  The wholesale origination infrastructure consists of a sales force to call on
mortgage loan brokers, two underwriting and processing centers to underwrite,
close and fund mortgage loans and systems to process data. As of December 31,
1998, we had a staff of 63 account executives, located in offices nationwide,
whose job is to call on brokers. Supporting the sales force is a staff of 100
in Orange County, California. We believe we can originate loans through the
wholesale channel at a price 1.5 to 2.0% lower than the cost of acquiring
mortgage loans in bulk when our mortgage lending operation is running at full
capacity.

  We believe we have been, and will continue to be, successful in competing in
the wholesale business for several reasons. First, we are vertically integrated
with our wholesale originator. Management believes this approach will provide a
competitive advantage over many competitors who either only originate loans or
only act as end investors because of the elimination of redundancy in
separating the two functions. Second, we believe our REIT status gives us a
pricing advantage over non-REIT mortgage investors.

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<PAGE>

Third, NovaStar Mortgage assembled a mortgage loan production staff with
extensive experience and contacts in the subprime mortgage loan market. We
believe that important factors influencing success or failure in the wholesale
channel are offering competitive prices, consistent application of underwriting
guidelines, and responsive service.

  Bulk Acquisitions. The bulk acquisition channel was the first channel
developed by us as it required the least infrastructure to operate and it
allowed us to acquire subprime mortgage loans very quickly. Although it
generally carries a lower margin than the wholesale channel, from time to time
we may still acquire mortgage loans through this channel. In bulk acquisitions,
pools of mortgage loans ranging in size from $2 million to in excess of $25
million are acquired from large originators of mortgage loans.

  Due diligence with respect to bulk acquisitions may be performed from time to
time by contract underwriters under the guidance of our Chief Credit Officer.
The Chief Credit Officer personally reviews the resumes of each contract
underwriter prior to the performance of the due diligence process. Any
exceptions to our underwriting guidelines must be approved by the Chief Credit
Officer. Only the Chief Credit Officer and the President can make the ultimate
decision to approve a loan when the borrower has an open bankruptcy. Personnel
for this channel are centralized in the mortgage operations headquarters with
the only field personnel consisting of the sales force strategically located in
select markets. Through this production channel, capital quickly invested in
pools of subprime mortgage loans.

  Retail Channel. Neither NovaStar Mortgage nor NovaStar Financial has yet
established a retail or direct origination channel to the consumer. This is the
typical finance company model with a local office in a strip center and
commissioned loan originators. Retail origination is the most expensive and
potentially the most profitable origination channel. The overhead cost to
originate retail mortgage loans can be as high as four to 6% of the face amount
of the loan. However, the gross profit on such a mortgage loan can be as high
as 10% of the face amount of the mortgage loan and the prepayment risk is
mitigated due to the loan being funded at a discount to par. Success in retail
origination often times depends on the branch's ability to generate leads,
access to an outlet to sell mortgage loan products which are attractive to
borrowers, and flexible, common sense underwriting. This segment of the
mortgage industry remains highly fragmented and dominated by local brokers.
While NovaStar Mortgage or NovaStar Financial do not have plans to implement a
retail production channel initially, it may test a variety of direct consumer
marketing strategies in the future.

  Profitability and Capital Allocation by Production Channel. In general, we
believe that the closer it gets to the consumer in the mortgage process chain,
the more profitable the production channel will be due to the elimination of
unnecessary intermediaries. While over the long term we believe this to be
true, there may be times when market conditions are such that the bulk
acquisition channel, the furthest from the customer, is the most profitable. In
order to properly manage the allocation of capital, we will measure the
profitability of each channel on a stand-alone basis. Direct expenses will be
tracked by channel and measured against mortgage loans originated via each
channel.

  By measuring each channel independently, we intend to avoid supporting a
channel, which has been unprofitable over time. In addition, by knowing the
profitability of each channel at any given point in time, as well as on average
over a specified time period, we can make the proper decisions in deciding
where to invest our capital to obtain the best return for stockholders.

 Underwriting and Quality Control Strategy

  Underwriting Guidelines. We purchase loans in accordance with its
underwriting guidelines. These underwriting guidelines were developed by our
senior management utilizing their experience in the industry. The underwriting
guidelines are intended to evaluate the credit history of the potential
borrower, the capacity and willingness of the borrower to repay the loan and
the adequacy of the collateral securing the loan. NovaStar Mortgage originates
loans only in compliance with NovaStar Financial's underwriting guidelines.


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<PAGE>

  NovaStar Mortgage underwrites all mortgage loans it originates through its
wholesale channel. Loans acquired by the Company in bulk pools are subject to
the same underwriting guidelines as established for NovaStar Mortgage
production. NovaStar Mortgage has hired experienced underwriters who work under
the supervision of the Chief Credit Officer. The underwriters hired by NovaStar
Mortgage all have substantial experience in the underwriting of subprime
mortgage loans.

  Underwriters are given approval authority only after their work has been
reviewed by the Chief Credit Officer for a period of at least two weeks.
Thereafter, the Chief Credit Officer re-evaluates the authority levels of all
underwriting personnel on an ongoing basis. All mortgage loans in excess of
$350,000 currently require the approval of the Chief Credit Officer. In
addition, the President approves all mortgage loans in excess of $600,000.

  On a case-by-case basis, exceptions to the underwriting guidelines are made
where compensating factors exist. Compensating factors may consist of factors
like length of time in residence, lowering of the borrower's monthly debt
service payments, the loan to value ratio on the mortgage loan or other
criteria that in the judgment of the underwriter warrants an exception. The
Chief Credit Officer and the President have the authority to approve a mortgage
loan when the potential borrower has an open bankruptcy.

  Each loan applicant completes an application that includes information with
respect to the applicant's income, assets, liabilities and employment history.
A credit report is also submitted by the broker along with the loan application
which provides detailed information concerning the payment history of the
borrower on all of their debts. Prior to issuing an approval on the mortgage
loan, the underwriter runs an independent credit report to verify that the
information submitted by the broker is still accurate and up-to-date. An
appraisal is also required on all mortgage loans and in many cases a review
appraisal or second appraisal may be required depending on the value of the
property and the underwriters comfort with the original valuation. All
appraisals are required to conform to the Uniform Standards of Professional
Appraisal Practice adopted by the Appraisal Standards Board of the Appraisal
Foundation and are generally on forms acceptable to FNMA and FHLMC.

  The underwriting guidelines include three levels of applicant documentation
requirements, referred to as "full documentation", "limited documentation", and
"stated income". Under the full documentation program applicants generally are
required to submit two written forms of verification of stable income for at
least 12 months. Under the limited documentation program, verification of
income is not required. However, personal or business bank statements for the
most recent 12 months are required as evidence of cash flows. Under the stated
income documentation program, an applicant may be qualified based on monthly
income as stated in the loan application.

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<PAGE>

  Our categories and criteria for grading the credit history of potential and
the maximum loan to value ratios allowed for each category are shown below.

<TABLE>
<CAPTION>
                         AA Risk        A Risk         A- Risk        B Risk         C Risk        D Risk
                      -------------  -------------  -------------  -------------  ------------ ---------------
<S>                   <C>            <C>            <C>            <C>            <C>          <C>
Mortgage History....  No mortgage    Maximum one    Maximum two    Maximum three  Maximum five  Maximum six
                      lates allowed  30-day late    30-day lates   30 day lates   30 day        30 day lates,
                      within the     and no 60-day  and no 60-day  and one 60     lates, and    and three 60
                      last 24        lates within   lates within   day late       two 60 day    day lates and
                      months         the last       the last       within the     lates, and    two 90 day
                                     12 months      12 months      last           one 90 day    lates within
                                                                   12 months      late within   the last 12
                                                                                  the last      months. Must be
                                                                                  12 months     current at time
                                                                                                of origination


Other Credit........  Limited 30     Limited 30     Limited 30     Limited 60     Limited 90    Discretionary--
                      day lates      day lates      day lates      day lates      day lates     credit is
                      within the     within the     within the     within the     within the    generally
                      last 24        last 12        last 12        last 12        last 12       expected to be
                      months.        months.        months         months         months        late pay
                      Generally      Generally
                      paid as        paid
                      agreed         as agreed


Bankruptcy Filings..  Chapter 13     Chapter 13     Chapter 13     Chapter 13     Chapter 13    Chapter 13 and
                      must be        must be        must be        must be        no seasoning  7 no seasoning
                      discharged     discharged     discharged     discharged     required on   required on
                      minimum of     minimum of     minimum of     minimum of     discharge     discharge with
                      2 years with   2 years with   1 year with    1 year with    with          evidence of
                      reestablished  reestablished  reestablished  reestablished  evidence of   satisfactory
                      credit;        credit;        credit;        credit;        satisfactory  discharge
                      Chapter 7      Chapter 7      Chapter 7      Chapter 7      discharge;
                      must           must           must           must           Chapter 7
                      be discharged  be discharged  be discharged  be discharged  minimum
                      minimum of     minimum of     minimum of     minimum of     discharge of
                      3 years with   3 years with   2 years with   2 years with   1 year
                      reestablished  reestablished  reestablished  reestablished
                      credit         credit         credit         credit


Debt Service Ratio..  45%            45%            80%            50%            55%           55%
Maximum Loan-to-
 Value Ratio:
Full documentation..  95%            90%            80%            85%            75%           65%
Limited
 documentation......  90%            85%            80%            80%            70%           60%
Stated income.......  85%            80%            80%            75%            65%           NA
</TABLE>

  Loan Portfolio by Credit Risk Category. Table 5 of the Management's
Discussion and Analysis of Financial Condition and Results of Operations sets
forth our mortgage loan portfolio by credit grade as of December 31, 1998 and
1997, all of which are non-conforming.

  Geographic Diversification. Close attention is paid to geographic
diversification in managing our credit risk. We believe one of the best tools
for managing credit risk is to diversify the markets in which we originate and
purchase mortgage loans. We have established a diversification policy to be
followed in managing this credit risk which states that no one market can
represent a percentage of total mortgage loans we own higher than twice that
market's percentage of the total national market share. While there generally
is some geographic concentration in mortgage loans originated through the bulk
acquisition channel, over time our mortgage lending operation plans to
diversify our credit risk by selecting target markets through the wholesale
channel. Presented in Table 7 of the "Management's Discussion and Analysis of
Financial Condition and Results of Operations" section of this prospectus is a
breakdown of our current geographic diversification as of December 31, 1998 and
1997.

  Collateral Valuation. Collateral valuation also receives close attention in
our underwriting of our mortgage loans. Given that we primarily lend to
subprime borrowers, we place great emphasis on the ability of collateral to
protect against losses in the event of default by borrowers. We have
established an appraisal policy as part of our underwriting guidelines. This
policy includes requiring second and/or review appraisals on properties in
order to verify the value of the property.

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<PAGE>

  Quality Control. Quality control reviews are conducted to ensure that all
mortgage loans, whether originated or purchased, meet established quality
standards. The type and extent of the reviews depend on the production channel
through which the mortgage loan was obtained and the characteristics of the
mortgage loan. Reviews are performed on a high percentage of mortgage loans
with principal balances in excess of $450,000, high loan to value, limited
documentation, or those made for "cash out" refinance purposes. Appraisal
reviews and compliance reviews are also performed as part of the quality
control process to ensure adherence to appraisal policies and state and federal
regulations.

  Regulation. We are regulated with respect to mortgage loan origination
marketing efforts, credit application and underwriting activities, maximum
finance and other charges, disclosure to customers, rights of rescission on
mortgage loans, closing and servicing mortgage loans, collection and
foreclosure procedures, qualification and licensing requirements for doing
business in various jurisdictions and other trade practices. Mortgage loan
origination activities are subject to the laws and regulations in each of the
states in which those activities are conducted. Activities as a lender are also
subject to various federal laws. The Truth in Lending Act, and Regulation Z
promulgated thereunder, contain disclosure requirements designed to provide
consumers with uniform, understandable information with respect to the terms
and conditions of loans and credit transactions so consumers have the ability
to compare credit terms. The Truth in Lending Act also guarantees consumers a
three-day right to cancel credit transactions. The Truth in Lending Act also
imposes disclosure, underwriting and documentation requirements on mortgage
loans with (1) total points and fees upon origination in excess of eight
percent of the mortgage loan amount or (2) an annual percentage rate of more
than ten percentage points higher than comparably maturing U.S. treasury
securities. We are also required to comply with the Equal Credit Opportunity
Act of 1974, as amended, which prohibits creditors from discriminating against
applicants on the basis of race, color, sex, age or marital status. Regulation
B promulgated under the Equal Credit Opportunity Act restricts creditors from
obtaining information from loan applicants. It also requires certain
disclosures by the lender regarding consumer rights and requires lenders to
advise applicants of the reasons for any credit denial. In instances where the
applicant is denied credit or the rate or charge for a loan increases as a
result of information obtained from a consumer credit agency, the Fair Credit
Reporting Act of 1970, as amended, requires the lender to supply the applicant
with a name and address of the reporting agency. We will also be subject to the
Real Estate Settlement Procedures Act and the Debt Collection Practices Act
pursuant to the Home Mortgage Disclosure Act. We will also be subject to the
rules and regulations of, and examinations by, the Government National Mortgage
Association, HUD and state regulatory authorities with respect to originating,
processing, underwriting, selling and servicing loans.

 Mortgage Loan Servicing Strategy

  Overview. We plan to acquire the large majority of mortgage loans we purchase
on a servicing released basis and thereby acquire the servicing rights. Through
July 14, 1997, Advanta Mortgage Corp. USA was acting as sub-servicer for the
mortgage loans we acquired. Effective, July 15, 1997, NovaStar Mortgage began
servicing our mortgage loans. The servicing operation is located in the
Westwood, Kansas office and is currently staffed with 70 employees. Servicing
includes collecting and remitting loan payments, making required advances,
accounting for principal and interest, holding escrow or impound funds for
payment of taxes and insurance, making required inspections of the property,
contacting delinquent borrowers and supervising foreclosures and property
disposition in the event of unremedied defaults in accordance with company
guidelines.

  NovaStar Mortgage's focus for the servicing of our subprime mortgage loans is
based on effective credit risk. NovaStar Mortgage intends to employ the proper
resources to mitigate the losses on the mortgage loans serviced. We also
believe we can better manage prepayment risk by servicing our mortgage loans
through our affiliate. Through our servicing function, we intend to pre-select
borrowers that have an incentive to refinance and retain those mortgage loans
by soliciting the borrowers directly rather than losing them to another
mortgage lender. Although it is not a primary focus, we estimate that NovaStar
Mortgage will be able to effectively service our loans at a cost less than the
cost to outsource this to an unrelated company.

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<PAGE>

  Procedures. We have prescribed procedures for servicing our mortgage loans
which are to be followed by NovaStar Mortgage. In servicing subprime mortgage
loans, NovaStar Mortgage uses collection procedures that are generally more
stringent than those typically employed by a servicer of prime mortgage loans
consistent with applicable laws. We believe one of the first steps in
effectively servicing subprime mortgage loans is to establish contact with the
borrower prior to any delinquency problems. To achieve this objective, each
borrower is telephoned ten days prior to the first payment due date on the
mortgage loan. With this telephone call,

  . NovaStar Mortgage ensures it has the proper telephone number for the
    borrower;

  . the borrower will be aware of who is servicing the loan, where payment is
    to be made, and has a contact to call in the event of any questions; and

  . NovaStar Mortgage is able to stress to the borrower the importance of
    making payments in a complete and timely manner.

  The first 30 days of a delinquency are, in our view, the crucial period for
resolving the delinquency. At a minimum, all borrowers who have not made their
mortgage payment by the 10th day of the month in which it is due receive a call
from a collector. Borrowers whose payment history exhibits signs that the
borrower may be having financial difficulty receive more attention. For
example, any borrowers who made their previous months payment after the late
charge date, generally the 15th of the month, receive a call from a collector
no later than the second business day of the current month if their payment has
not yet been received. This allows NovaStar Mortgage to be more aggressive with
those borrowers who need the most attention and also focuses the efforts of the
collection staff of NovaStar Mortgage on the higher risk borrowers.

  For accounts that have become 60 days or more delinquent, the collection
follow-up is increased and a full financial analysis of the borrower is
performed, a Notice of Intent to Foreclose is filed, and efforts to establish a
work out plan with the borrower are instituted.

  Our policy allows for reasonable discretion to extend appropriate relief to
borrowers who encounter hardship and who are cooperative and demonstrate proper
regard for their obligation. NovaStar Mortgage is available to offer some
guidance and make personal contact with delinquent borrowers as often as
possible to seek to achieve a solution that will bring the mortgage loan
current. However, no relief will be granted unless there is reasonable
expectation that the borrower can bring the mortgage loan current within 180
days following the initial default.

  If properly managed from both an underwriting and a servicing standpoint,
management believes it will be able to keep the level of delinquencies and
losses in our mortgage loans in line with industry standards.

Portfolio Management

  We build our mortgage asset portfolio from two sources--loans originated in
the mortgage lending operation of NovaStar Mortgage and purchases in the
mortgage and securities markets. Initially, the portfolio was comprised of
purchased mortgage assets. As NovaStar Mortgage has developed its
infrastructure of subprime mortgage lending, we have relied less on purchasing
mortgage loans in bulk and more on wholesale origination. Ultimately,
management expects a substantial portion of our portfolio to consist of
retained interests in wholesale loans originated by NovaStar Mortgage
collateralizing our structured debt instruments.

 Types of Mortgage Assets

  The mortgage assets we purchased are principally single family mortgage loans
and mortgage securities backed by single family mortgage loans, as well as from
time to time multifamily mortgage loans and mortgage securities backed by
multifamily mortgage loans and commercial mortgage loans and mortgage
securities backed by commercial mortgage loans. Single family mortgage loans
are mortgage loans secured solely by first mortgages or deeds of trust on
residences with one-to-four units. Multifamily mortgage loans are mortgage
loans

                                       66
<PAGE>

secured solely by first mortgages or deeds of trust on residential properties
with more than four units. Commercial mortgage loans are secured by commercial
properties. Substantially all of our mortgage assets bear adjustable interest
rates or have a fixed-rate coupon that has been paired with an interest rate
cap, so that we have the proper matching of assets and liabilities.

  We have not and generally will not acquire residuals, first loss subordinated
bonds rated below BBB, or mortgage securities rated below B. We could retain
the subordinate class from mortgage loans securitized through our taxable
affiliate. We may acquire interest-only or principal-only mortgage strips to
assist in the hedging of prepayment or other risks. In addition, as discussed
above we may create a variety of different types of assets, including the types
mentioned in this paragraph, through the normal process of securitization of
our own mortgage assets. Other than our taxable affiliates, we will not acquire
or retain any REMIC residual interest that may give rise to excess inclusion
income as defined under Section 860E of the Code. Excess inclusion income
realized by a taxable affiliate is not passed through to our stockholders.

  Single Family Mortgage Loans. In future periods, we may acquire conforming
mortgage loans--those that comply with the requirements for inclusion in a loan
guarantee program sponsored by other FHLMC or FNMA. To date, we have acquired
only nonconforming mortgage loans. We also may acquire FHA Loans or VA Loans,
which qualify for inclusion in a pool of mortgage loans guaranteed by GNMA. To
date, no loans insured by FHA or VA have been originated or owned. Under
current regulations, the maximum principal balance allowed on conforming
mortgage loans ranges from $240,000 for one-unit to $461,300 for four-unit
residential loans. For properties located in either Alaska or Hawaii, the
maximum principal balance allowed ranges from $360,000 for one-unit to $691,950
for four-unit residential loans. Nonconforming single family mortgage loans are
single family mortgage loans that do not qualify in one or more respects for
purchase by FNMA or FHLMC. We expect that a majority of the nonconforming
mortgage loans it purchases will be nonconforming because they have original
principal balances which exceed the requirements for FHLMC or FNMA programs or
generally because they vary in certain other respects from the requirements of
such programs including the requirements relating to creditworthiness of the
mortgagors. A substantial portion of our nonconforming mortgage loans meet the
requirements for sale to national private mortgage conduit programs which focus
upon the subprime mortgage lending market. As of December 31, 1998, 83.7% of
our mortgage loans were collateralized by single family residential properties.

  Multifamily Mortgage Loans. We have not, to date, acquired multifamily
mortgage loans. However, these types of loans may be acquired in future
periods. Multifamily mortgage loans generally involve larger principal amounts
per loan than single family mortgage loans and require more complex credit and
property evaluation analysis. Multifamily mortgage loans share many of the
characteristics and risks associated with commercial mortgage loans and are
often categorized as commercial loans rather than residential loans. For
example, the credit quality of a multifamily mortgage loan typically depends
upon the existence and terms of underlying leases, tenant credit quality and
the historical and anticipated level of vacancies and rents on the mortgaged
property and on the competitive market condition of the mortgaged property
relative to other competitive properties in the same region, among other
factors. Multifamily mortgage loans, however, constitute "qualified mortgages"
for purposes of the REMIC regulations and the favorable tax treatment
associated therewith and, when securitized, certain of the resulting rated
classes of multifamily mortgage securities qualify as "mortgage-related
securities" and for the favorable treatment accorded such securities under the
Secondary Mortgage Market Enhancement Act of 1984. As of December 31, 1998,
3.6% of our mortgage loans were collateralized by multifamily residential
property.

  Mortgage Securities. Mortgage securities we owned as of and during the period
since inception and through December 31, 1998, have consisted of mortgage
securities issued by corporations sponsored by the United States government,
including FNMA, GNMA and FHLMC. Securities issued by FHLMC and FNMA are not
guaranteed by the full faith and credit of the U.S. Government. As discussed in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Events of the Fourth Quarter 1998," of this prospectus, in October
1998, we sold all securities owned by NovaStar Financial and NovaStar Mortgage
and paid off the related repurchase agreement financing, recognizing an
aggregate loss of $15.4 million.

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<PAGE>

  Mortgage assets purchased by us in the future may include mortgage securities
as follows:

    (1) Single Family and Multifamily Privately Issued Certificates. Single
  family and multifamily privately issued certificates are issued by
  originators of, investors in, and other owners of mortgage loans, including
  savings and loan associations, savings banks, commercial banks, mortgage
  banks, investment banks and special purpose "conduit" subsidiaries of such
  institutions. Single family and multifamily privately issued certificates
  are generally covered by one or more forms of private, i.e., non-
  governmental, credit enhancements. Forms of credit enhancements include,
  but are not limited to, surety bonds, limited issuer guarantees, reserve
  funds, private mortgage guaranty pool insurance, over-collateralization and
  subordination.

    (2) Agency Certificates. At present, all GNMA certificates are backed by
  single family mortgage loans. FNMA certificates and FHLMC certificates may
  be backed by pools of single family or multifamily mortgage loans. The
  interest rate paid on agency certificates may be fixed rate or adjustable
  rate.

    (3) Commercial Mortgage Securities. To the extent we will seek to acquire
  any mortgage assets either backed by or secured by commercial property, we
  intend to favor the acquisition of mortgage securities backed by commercial
  mortgage loans rather than direct acquisition of commercial mortgage loans.
  These mortgage securities generally have been structured as pass-through
  certificates with private, i.e., non-governmental, credit enhancements or
  as collateralized mortgage obligations. Because of the great diversity in
  characteristics of the commercial mortgage loans that secure or underlie
  these mortgage securities, such securities will also have diverse
  characteristics. Although many are backed by large pools of commercial
  mortgage loans with relatively small individual principal balances, these
  mortgage securities may be backed by commercial mortgage loans
  collateralized by only a few commercial properties or a single commercial
  property. Because the risk involved in single commercial property financing
  is highly concentrated, single commercial property mortgage securities to
  date have tended to be limited to extremely desirable commercial properties
  with excellent values and/or lease agreements with extremely creditworthy
  and reliable tenants, such as major corporations.

  Commercial Mortgage Loans. We will only acquire commercial mortgage loans
when we believe we have the necessary expertise to evaluate and manage them and
only if they are consistent with our capital asset guidelines. Commercial
mortgage loans are secured by commercial properties, such as industrial and
warehouse properties, office buildings, retail space and shopping malls, hotels
and motels, hospitals, nursing homes and senior living centers. Commercial
mortgage loans have certain distinct risk characteristics: commercial mortgage
loans generally lack standardized terms, which may complicate their structure,
although some of the new conduits are introducing standard form documents for
use in their programs; commercial mortgage loans tend to have shorter
maturities than single family mortgage loans; they may not be fully amortizing,
meaning that they may have a significant principal balance or "balloon" due on
maturity; and commercial properties, particularly industrial and warehouse
properties, are generally subject to relatively greater environmental risks
than non-commercial properties and the corresponding burdens and costs of
compliance with environmental laws and regulations. To date, we have not
acquired commercial mortgage loans. As of December 31, 1998, we had no loans
collateralized by commercial property.

 Asset Acquisition Policies

  We acquire only those mortgage assets that we believe we have the necessary
expertise to evaluate and manage and which are consistent with our risk
management objectives. Our strategy is to focus primarily on the acquisition of
single family mortgage loans, single family mortgage securities, multifamily
mortgage loans and multifamily mortgage securities. We focus primarily on the
acquisition of floating-rate and adjustable-rate assets, so that assets and
liabilities remain matched. Our asset acquisition strategy will change over
time as market conditions change and as we evolve.

  Our investment policy allows for the acquisition of mortgage assets and
certain other liquid investments, such as federal agency securities and
commercial paper. We do not presently intend to invest in real estate,
interests in real estate, or interests in persons primarily engaged in real
estate activities.


                                       68
<PAGE>

  We may also purchase the stock of other mortgage REITs or similar companies
when we believe that such purchases will yield attractive returns on capital
employed. We have not, nor do we presently intend to invest in the securities
of other issuers for the purpose of exercising control or to underwrite
securities of other issuers. We have not and we presently have no intention to
repurchase or otherwise reacquire our shares or other securities. Although we
have not, we may in the future acquire mortgage assets by offering our debt or
equity securities in exchange for mortgage assets.

  We generally intend to hold mortgage assets to maturity. In addition, the
REIT provisions of the Code limit our ability to sell mortgage assets. We may
decide to sell assets from time to time, however, for a number of reasons,
including, without limitation, to dispose of a mortgage asset as to which
credit risk concerns have arisen, to reduce interest rate risk, to substitute
one type of mortgage asset for another to improve yield or to maintain
compliance with the 55% requirement under the Investment Company Act, and
generally to restructure the balance sheet when we deem such action advisable.
We will select any mortgage assets to be sold according to the particular
purpose such sale will serve. The Board of Directors has not adopted a policy
that would restrict our authority to determine the timing of sales or the
selection of mortgage assets to be sold.

 Financing for Mortgage Lending Operations and Mortgage Security Acquisitions

  We finance our mortgage loan purchases through interim financing facilities
such as repurchase agreements. A repurchase agreement is a borrowing device
evidenced by an agreement to sell securities or other assets to a third-party
and a simultaneous agreement to repurchase them at a specified future date and
price, the price differential constituting interest on the borrowing.

  A subprime mortgage lending operation is a capital intensive business.
Depending on the type of product originated and the production channel, the
amount of capital required as a percentage of the balance of mortgage loans
originated may range from 6% to 12%. For illustration purposes only, based on a
hypothetical monthly volume of $25 million, this will equate to a capital
requirement of $1.5 to $3 million per month, and on a hypothetical volume of
$50 million, this requirement doubles to $3 to $6 million per month. Our
subprime mortgage lending operation is managed through a taxable affiliate,
which provides us the flexibility to sell our mortgage loan production as whole
loans or in the form of pass-through securities in the event it encounters
restrictions in accessing the capital markets.

  To mitigate interest rate risk, we enter into transactions designed to hedge
interest rate risk, which may include mandatory and optional forward selling of
mortgage loans or mortgage assets, interest rate caps, floors and swaps, buying
and selling of futures and options on futures, and acquisition of interest-only
REMIC regular interests. The nature and quantity of these hedging transactions
will be determined by us based on various factors, including market conditions
and the expected volume of mortgage loan purchases. We believe our strategy of
issuing long-term structured debt securities will also assist us in managing
interest rate risk.

  Acquisitions of mortgage securities are generally financed using repurchase
agreements.

 Mortgage Loans Held as Collateral for Structured Debt

  We intend to securitize the subprime mortgage loans produced by the mortgage
lending operation as part of our overall asset/liability strategy.
Securitization is the process of pooling mortgage loans and issuing equity
securities, such as mortgage pass throughs, or debt securities, such as
collateralized mortgage obligations. We intend to securitize by issuing
structured debt. Under this approach, for accounting purposes the mortgage
loans securitized remain on the balance sheet as assets and the collateralized
mortgage debt obligations appear as liabilities. A securitization results only
in rearranging our borrowings, as proceeds from the structured debt issuance
are applied against preexisting borrowings. The proceeds repay advances under
the warehouse line of credit or borrowings under repurchase agreements. Issuing
structured debt in this matter serves to lock in less expensive, non-recourse
long-term financing that better matches the terms of the loans serving as
collateral for the debt.

                                       69
<PAGE>

  Proceeds from securitizations have been used to support new mortgage loan
originations. Securitizations are long-term financing and are not subject to a
margin call if a rapid increase in rates would reduce the value of the
underlying mortgages.

  Our investment in retained interests under securitizations, as discussed
above, reflects the excess of the mortgage loan collateral over the related
liabilities on the balance sheet. The resulting stream of expected "spread"
income will be recognized over time through the tax-advantaged REIT structure.
Other forms of securitizations may also be employed from time to time under
which a "sale" of interests in the mortgage loans occurs and a resulting gain
or loss is reflected for accounting purposes at the time of sale. Under this
form, only the net retained interest in the securitized mortgage loans remains
on the balance sheet. We anticipate such sales will generally be made through
one or more of our taxable affiliates. We may conduct securitization activities
through one or more taxable affiliates or qualified REIT subsidiaries formed
for such purpose.

  We expect our retained interests in our securitizations, regardless of the
form used, will be subordinated to the classes of securities issued to
investors in such securitizations with respect to losses of principal and
interest on the underlying mortgage loans. Accordingly, any such losses
incurred on the underlying mortgage loans will be applied first to reduce the
remaining amount of our retained interest, until reduced to zero. Thereafter,
any further losses would be borne by the investors or, if used, the monoline
insurers in such securitizations rather than us.

  We will structure our securitizations so as to avoid the attribution of any
excess inclusion income to our stockholders. NovaStar management is experienced
in the securitization of subprime and other single family residential mortgage
loans.

  We have financed our retained interests in our securitizations through a
combination of equity and secured debt financings.

 Credit Risk Management Policies

  Mortgage Loans. With respect to our mortgage loan portfolio, we attempt to
control and mitigate credit risk through:

  . ensuring that established underwriting guidelines are followed;

  . geographic diversification of our loan portfolio;

  . the use of early intervention, aggressive collection and loss mitigation
    techniques in servicing our mortgage loans;

  . the use of insurance and the securitization process to limit the amount
    of credit risk that it is exposed to on our retained interests in
    securitizations; and

  . maintenance of appropriate capital reserve levels.

  A summary of the credit quality and diversification of our loan portfolio as
of December 31, 1998 and 1997 is presented in Table 5 of "Management's
Discussion and Analysis of Financial Condition and Results of Operations."

  Acquisitions. With respect to the mortgage assets we purchase, we review the
credit risk associated with each investment and determine the appropriate
allocation of capital to apply to such investment under our capital allocation
guidelines. Because the risks presented by single family, multifamily and
commercial mortgage assets are different, we analyze the risk of loss
associated with such mortgage assets separately. In addition, we attempt to
diversify our portfolio to avoid undue geographic, issuer, industry and certain
other types of concentrations. We attempt to obtain protection against some
risks from sellers and servicers through representations and warranties and
other appropriate documentation. The Board of Directors will monitor the
overall portfolio risk and determine appropriate levels of provision for
losses.


                                       70
<PAGE>

  With respect to our purchased mortgage assets, we are exposed to various
levels of credit and special hazard risk, depending on the nature of the
underlying mortgage assets and the nature and level of credit enhancements
supporting such securities. Each of the mortgage assets acquired by us will
have some degree of. Credit loss protection for privately issued certificates
is achieved through the subordination of other interests in the pool to the
interest held by us and/or through pool insurance. The degree of credit
protection varies substantially among the privately issued certificates held by
us. While privately issued certificates held by us will have some degree of
credit enhancement, the majority of such assets are, in turn, subordinated to
other interests. Thus, should such a privately issued certificate experience
credit losses, such losses could be greater than our pro rata share of the
remaining mortgage pool, but in no event could exceed our investment in such
privately issued certificate.

  With respect to purchases of mortgage assets in the form of mortgage loans,
we have developed a quality control program to monitor the quality of loan
underwriting at the time of acquisition and on an ongoing basis. We will
conduct a legal document review of each mortgage loan acquired to verify the
accuracy and completeness of the information contained in the mortgage notes,
security instruments and other pertinent documents in the file. As a condition
of purchase, we will select a sample of mortgage loans targeted to be acquired,
focusing on those mortgage loans with higher risk characteristics, and submit
them to a third party, nationally recognized underwriting review firm for a
compliance check of underwriting and review of income, asset and appraisal
information. In addition, we or our agents will underwrite all multifamily and
commercial mortgage loans. During the time it holds mortgage loans, we will be
subject to risks of borrower defaults and bankruptcies and special hazard
losses, such as those occurring from earthquakes or floods, that are not
covered by standard hazard insurance. We will generally not obtain credit
enhancements such as mortgage pool or special hazard insurance for our mortgage
loans, although individual loans may be covered by FHA insurance, VA guarantees
or private mortgage insurance and, to the extent securitized into agency
certificates, by such government sponsored entity obligations or guarantees.

                                       71
<PAGE>

 Capital and Leverage Policies

  Capital allocation guidelines. Our goal is to strike a balance between the
under-utilization of leverage, which reduces returns to stockholders, and the
over-utilization of leverage, which could reduce the ability of NovaStar to
meet its obligations during adverse market conditions. The capital allocation
guidelines have been approved by the Board of Directors. The capital allocation
guidelines are intended to keep NovaStar Financial properly leveraged by (1)
matching the amount of leverage allowed to the riskiness on return and
liquidity of an asset and (2) monitoring the credit and prepayment performance
of each investment to adjust the required capital. This analysis takes into
account various hedges and other risk programs discussed below. In this way,
the use of balance sheet leverage will be controlled. Following presents a
summary of the capital allocation guidelines for the following levels of
capital for the types of assets it owns.

<TABLE>
<CAPTION>
                           (A)       (B)      (C)       (D)        (E)           (F)          (F)
                         Minimum  Estimated Duration Liquidity   (c + d)       (b x e)      (a + f)
                         Lender     Price    Spread   Spread   Total Spread Equity Cushion CAG Equity
     Asset Category      Haircut  Duration  Cushion   Cushion    Cushion      (% of MV)     Required
     --------------      -------  --------- -------- --------- ------------ -------------- ----------
<S>                      <C>      <C>       <C>      <C>       <C>          <C>            <C>
Agency-issued:
 Conventional ARMs......   3.00%    3.50%      50        --         50           1.75%         4.75%
 GNMA ARMs..............   3.00     4.50       50        --         50           2.25          5.25
 GNMA Fixed Rates.......   3.00     5.00       50        --         50           2.50          5.50
 Corporate Bonds........  10.00     3.50      225        25        250           8.75         18.75
Mortgage loans:
 Collateral for
  warehouse financing...   2.00     3.00      100        50        150           4.50          7.50
 Collateral for CMO.....   5.00      --       --         --        --             --           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 SEC are substantially less liquid, and
    have more price volatility than agency securities, which results in a
    lender requiring a larger haircut. Particular securities that are
    performing below expectations would also typically require a larger
    haircut.
(B) Duration is the price-weighted average term to maturity of financial
    instruments' cash flows.
(C) Estimated cushion need to protect against investors requiring a higher
    return compared to U.S. Treasury securities, assuming constant interest
    rates.
(D) Estimated cushion required due to a potential imbalance of supply and
    demand resulting in a wider bid/ask spread.
(E) Sum of duration (C) and liquidity (D) spread cushions.
(F) Product of estimated price duration (B) and total spread cushion. The
    additional equity, as determined by management, to reasonably protect
    NovaStar 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.

                                       72
<PAGE>

  Implementation of the capital allocation guidelines--mark to market. Each
month, we mark our assets to market. This process consists of two steps: (1)
valuing the mortgage assets we acquired and (2) valuing our non-security
investments, such as our mortgage loans. For the purchased mortgage assets
portfolio, we obtain market quotes for our mortgage assets from traders that
make markets in securities similar to those in our portfolio. Market values for
our mortgage loan portfolio are calculated internally using assumptions for
losses, prepayments and discount rates.

  The face amount of all financing used for securities and mortgage loans is
subtracted from the current market value of our assets and hedges. This is the
current market value of our equity. This number is compared to the required
capital as determined by the capital allocation guidelines. If our actual
equity falls below the capital required by the capital allocation guidelines,
we 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 our prepayment and credit performance relative
to the market and our ability to predict or hedge the risk of the asset.
Historical capital allocation is presented in capital allocation guidelines
under "Management's Discussion and Analysis of Financial Condition and Results
of Operations."

 Interest Rate Risk Management

  We address the interest rate risk to which our mortgage portfolio is subject
in part through our securitization strategy, which is designed to provide long-
term financing for our mortgage loan production while maintaining a consistent
spread in a variety of interest rate environments. In order to address any
remaining mismatch of assets and liabilities, we follow the hedging section of
our investment policy, as approved by the Board. Specifically our interest rate
risk management program is formulated with the intent to offset the potential
adverse effects resulting from rate adjustment limitations on our mortgage
loans and mortgage assets and the differences between interest rate adjustment
indices and interest rate adjustment periods of our adjustable-rate mortgage
loans and related borrowings.

  We currently use interest rate caps and may, from time to time, purchase
interest rate swaps, interest-only REMICs and similar instruments to attempt to
mitigate the risk of the cost of our variable rate liabilities increasing at a
faster rate than the earnings on our assets during a period of rising rates. In
this way, we intend generally to hedge as much of the interest rate risk as
management determines is in the best interests of our stockholders, given the
cost of such hedging transactions and the need to maintain our status as a
REIT. This determination may result in management electing to have us bear a
level of interest rate risk that could otherwise be hedged when management
believes, based on all relevant facts, that bearing such risk is advisable. We
may also, to the extent consistent with our compliance with the REIT gross
income tests and applicable law, utilize financial futures contracts, options
and forward contracts as a hedge against future interest rate changes.

  We seek to build a balance sheet and undertake an interest rate risk
management program which is likely, in management's view, to generate positive
earnings and maintain an equity liquidation value sufficient to maintain
operations given a variety of potentially adverse circumstances. Accordingly,
the hedging program addresses both income preservation, as discussed in the
first part of this section, and capital preservation concerns.

  Interest rate cap agreements are legal contracts between us and a third party
firm, called the counter-party. The counter-party agrees to make payments to us
in the future should the one or three month LIBOR interest rate rise above the
"strike" rate specified in the contract. Under some of the contracts, we make
quarterly premium payments to the counterparty under the contract. Under other
interest cap agreements, we have paid the premium upfront. Each contract has a
fixed "notional face" amount and a fixed interest rate, on which the interest
is computed, and a set term to maturity. Should the reference LIBOR interest
rate rise above the contractual strike rate, we will earn cap income.

                                       73
<PAGE>

  Interest rate swap agreements we have entered into through December 31, 1998
stipulate we will pay a fixed rate of interest to the counterparty. In return,
the counterparty pays us a variable rate of interest based on the notional
amount. The agreements have fixed notional amounts, on which the interest is
computed, and set terms to maturity. As discussed in the "Management's
Discussion and Analysis of Financial Condition and Results of Operations--
Events of the Fourth Quarter 1998", we terminated all swap agreements and paid
off the liabilities pertaining to these hedging instruments in October 1998,
recognizing losses aggregating $8.0 million.

  In all of our interest rate risk management transactions, we follow
procedures designed to limit credit exposure to counterparties, including
dealing only with counterparties whose financial strength meets our
requirements.

  In our assessment of the interest sensitivity and as an indication of our
exposure to interest rate risk, management relies on models of financial
information in a variety of interest rate scenarios. Using these models, the
fair value and interest rate sensitivity of each financial instrument or groups
of similar instruments is estimated, and then aggregated to form a
comprehensive picture of the risk characteristics of the balance sheet. These
amounts contain estimates and assumptions regarding prepayments and future
interest rates. Actual economic conditions may produce results significantly
different from the results depicted. However, management believes the interest
sensitivity model used is a valuable tool to manage our exposure to interest
rate risk. Our interest rate sensitivity analysis as of December 31, 1998 is
presented in the "Management's Discussion and Analysis of Financial Condition
and Results of Operations" section of this prospectus.

  Interest Rate Sensitivity Analysis. The sensitivity table is a tool used by
management in assessing the impact of changing interest rates on our assets,
liabilities and interest rate agreements. The values under the heading "Base"
are management's estimates of the spread income for our assets, liabilities and
interest rate agreements as of a specific point in time. The values under the
headings "100" and "(100)" are management's estimates of the spread income of
those same assets, liabilities and interest rate agreements assuming that
interest rates were 100 basis points, 1%, higher and lower. The cumulative
change in spread income represents the change in spread income of assets from
base, net of the change in spread income of liabilities and interest rate
agreements from base.

  The interest sensitivity analysis is prepared at least monthly. If the
analysis demonstrates that a 100 basis point shift up or down in interest rates
would result in 10% or more cumulative change in spread income from base,
management will modify our portfolio by adding or removing interest rate cap or
swap agreements.

  Assumption 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 our subprime mortgage loan holdings.
The following paragraphs discuss the nature of the process used in estimating
the income of our assets, liabilities and interest rate agreements that are
used in the interest rate sensitivity analysis. The estimates and assumptions
have a significant impact on the results of this sensitivity analysis.

  Our analysis for assessing interest rate sensitivity on our subprime mortgage
loans relies significantly on estimates for prepayment speeds. A prepayment
model has been internally developed based upon four main factors:

  . Refinancing incentives, the interest rate of the mortgage compared with
    the current mortgage rates available to the borrower;

  . Borrower credit grades, a higher letter means a higher grade;

  . Loan-to-value ratios; and

  . Prepayment penalties, if any.

                                       74
<PAGE>

  Generally speaking, when market interest rates decline, borrowers are more
likely to refinance their mortgages. The higher the interest rate a borrower
currently has on his or her mortgage, the more incentive he or she has to
refinance the mortgage when rates decline. In addition, the higher the credit
grade, the more incentive there is to refinance when credit ratings improve.
When a borrower has a low loan-to-value ratio, he or she is more likely to do a
"cash-out" refinance. Each of these factors presumably increases the chance for
higher prepayment speeds during the term of the loan. On the other hand,
prepayment penalties serve to mitigate the risk that loans will prepay, under
the assumption that the penalty is a deterrent to refinancing.

  These factors are weighted based on management's experience and an evaluation
of the important trends observed in the subprime mortgage origination industry.
The following table is designed to display the impact of a change in each of
the factors on prepayment speeds within our model.

<TABLE>
<CAPTION>
   Prepayment Factor    Increase Prepayments          Decrease Prepayments
   -----------------    --------------------          --------------------
   <S>                  <C>                           <C>
   refinancing
    incentives/current
    mortgage rates      lower mortgage rates          higher mortgage rates
   credit grade         better credit                 worse credit
   loan-to-value        lower loan-to-value           higher loan-to-value
   prepayment penalty   lower prepayment penalty cost higher prepayment penalty cost
</TABLE>

  NovaStar's projected prepayment rates in each interest rate scenario start at
a prepayment speed less than 5% in month one and increase to a long-term
prepayment speed in nine to 18 months, to account for the seasoning of the
loans. The long-term prepayment speed range from 20% to 40% and depends on the
characteristics of the loan which include type of product, adjustable or fixed
rate, note rate, credit grade, loan-to-value, gross margin, weighted average
maturity and lifetime and periodic caps and floors. This prepayment curve is
also multiplied by a factor of 60% on average for periods when a prepayment
penalty is in effect on the loan. These assumptions change with levels of
interest rates.

  Historical rates of prepayment experienced on the loans owned by NovaStar
Financial are shown in Table 10 of "Management's Discussion and Analysis of
Financial Condition and Results of Operations." These speeds represent the
actual weighted average rate of prepayment for all loans in each securitized
pool. As shown in Table 10, the historical prepayment rates on loans that have
been held in portfolio for shorter periods are slower than the estimated
prepayment rates projected in the interest rate sensitivity analysis which is
in the preceding paragraph. However, this table also indicates that as pools of
loans held in portfolio season, the actual prepayment rates are more consistent
with the long term prepayment rates used in the interest sensitivity analysis.

  The refinancing incentive measures the gain the borrower realizes from
refinancing at current mortgage rates. The greater the incentive to refinance,
interest rates lower than when the mortgage was originated, the higher the
prepayment speeds. Conversely, if interest rates rise, the borrower is less
likely to payoff their loan.

  A borrower's credit grade impacts projected prepayment due to the
availability of refinancing options. "A" credit borrowers have more lenders
willing to make mortgage loans to them than do "D" credit borrowers. Our
prepayment model takes this fact into account over a continuum of credit
grades.

  The loan-to-value ratio is another important factor in our prepayment model.
Loans with a low loan-to-value ratio have more equity in their property and are
more likely to take equity out of the homes through a cash-out refinancing.
Borrowers with high loan-to-value ratios have fewer options and little equity
to be taken out of the property, presumably resulting in lower prepayment
speeds.

  The length and amounts of the prepayment penalty is another factor that
drives the level of projected mortgage prepayments. A borrower with a
significant prepayment penalty effectively increases the current mortgage rate,
which reduces the refinancing incentive. Conversely, a borrower without a
prepayment penalty has fewer financial barriers to realize the gains from
refinancing an existing mortgage into a lower rate mortgage loan.

                                       75
<PAGE>

  The prepayment projections have limits on how fast or how slow a pool of
loans prepay. If interest rates rise, some borrowers still prepay their
mortgages due to factors such as relocation or the purchase of a new home. If
interest rates fall, some borrowers will not refinance their mortgage,
regardless of their economic incentives to do so.

  We attempt to model the interrelation of these factors. The prepayment
projections are estimates intended to provide management an indication of the
change in cash flow in different interest rate scenarios. These estimates are
used in preparing interest sensitivity analyses used by management in
portfolio management. Actual results may differ from the estimates and
assumptions used in our model and the projected results as shown in the
interest rate sensitivity analysis as of December 31, 1998 as presented in the
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" section of this prospectus.

  Our investment policy sets the following general goals:

    (1) Maintain the net interest margin between assets and liabilities, and

    (2) Diminish the effect of changes in interest rate levels on the market
  value of our assets.

  The interest rate sensitivity analysis as presented in the "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
section of this prospectus displays an estimate of the spread income of our
assets, liabilities and interest rate agreements as of December 31, 1998. The
analysis also shows the estimated changes in the spread income of financial
instruments should interest rates increase or decrease 1% (100 basis points).
Management uses this information to determine the impact on stockholders'
equity of changing interest rates and to monitor the effectiveness of the
interest rate risk management techniques discussed above. Although management
evaluates the portfolio using interest rate increases and decreases greater
than one percent, management focuses on the one percent increase as any
further increase in interest rates would require action to adjust the
portfolio to adapt to changing rates. Our investment policy allows for no more
than a ten percent change in the net fair value of assets when interest rates
rise or fall by one percent.

  Another measure of interest risk is elasticity, a refinement of duration.
Duration is the price-weighted average term to maturity of financial
instruments' cash flows. Elasticity is the change, expressed as a percent, in
market value of a financial instrument, given a 100 basis point change in
interest rates. Financial companies with relatively long duration assets
financed by shorter duration liabilities generally experience market value
losses when rates increase and market value gains when rates decrease. This
pattern is complicated because many mortgages have prepayment options which
result in shorter mortgage durations as these prepayment options are exercised
in falling rate environment. Management's dynamic hedging strategies allow us
to match the elasticity of our assets with the elasticity of our liabilities.

 Prepayment Risk Management

  We seek to minimize the effects of faster or slower than anticipated
prepayment rates in our mortgage assets portfolio by acquiring mortgage loans
with prepayment penalties, utilizing various financial instruments and the
production of new mortgage loans as a hedge against prepayment risk, and
capturing through our servicing of the mortgage loans and our portfolio
retention department a large portion of those loans which are refinanced.
Under certain state laws, prepayment charges may not be imposed or may be
limited as to amount or period of time they can be imposed. Prepayment risk is
monitored by management and through periodic review of the impact of a variety
of prepayment scenarios on our revenues, net earnings, dividends, cash flow
and net balance sheet market value.

  Although we believe we have developed a cost-effective asset/liability
management program to provide a level of protection against interest rate and
prepayment risks, no strategy can completely insulate us from the effects of
interest rate changes, prepayments and defaults by counterparties. Further,
certain of the federal income tax requirements that we must satisfy to qualify
as a REIT limit our ability to fully hedge our interest rate and prepayment
risks.

                                      76
<PAGE>

 Taxable Affiliates

  We have implemented, and will continue to implement, portions of our business
strategy from time to time through one of our taxable affiliates. Other taxable
affiliates may be used to implement future business strategies. The REIT is
entitled to up to 99% of dividends distributed by such taxable affiliate. The
voting common stock of such corporation, however, is owned by persons other
than the REIT due to the provisions of the Code limiting ownership by REITs of
the voting stock of non-REIT qualifying entities. In our case, the voting
common stock of NFI Holding, our taxable affiliate holding company, is held by
Messrs. Hartman and Anderson. Such common stock will at all times have at least
one percent of the dividends and liquidation rights of NFI Holding. We hold a
class of preferred stock of the taxable affiliate holding company, which
preferred stock is entitled to up to 99% of the dividends and liquidation
proceeds distributable from NFI Holding.

  Taxable affiliates are not qualified REIT subsidiaries and would be subject
to federal and state income taxes. In order to comply with the nature of asset
tests applicable to us as a REIT, as of the last day of each calendar quarter,
the value of the securities of any such affiliate held by us must be limited to
less than five percent of the value of our total assets and no more than ten
percent of the voting securities of any such affiliate may be owned by us.
Taxable affiliates have not elected REIT status and distribute any net profit
after taxes to us and our other stockholders. Any dividend income received by
us from any such taxable affiliate, combined with all other income generated
from our assets, other than qualified REIT assets, must not exceed 25% of our
gross income. Before we form any additional taxable affiliate corporations, we
will obtain an opinion of counsel to the effect that the formation and
contemplated method of operation of such corporation will not cause us to fail
to satisfy the nature of assets and sources of income tests applicable to it as
a REIT.

  The Clinton Administration's fiscal year 2000 budget would place several
constraints on the activities and ownership by a REIT of a taxable subsidiary
corporation. If the proposal is enacted in the form introduced, we could be
required to modify certain business activities or the capital structure of
NovaStar Mortgage. We do not anticipate that the Administration's budget
proposal would have an adverse effect on our operations, including those of
NovaStar Mortgage.

 Properties

  Our executive and administrative offices are located in Westwood, Kansas, and
consist of approximately 6,000 square feet. The lease on the premises expires
December 2002. The current annual rent for these offices is approximately
$116,000.

  NovaStar Mortgage leases space for its mortgage lending operations in Orange
County, California. Currently, these offices consist of approximately 35,000
and 15,000 square feet, respectively. The lease on the Orange County premises
expires January 2005, and the current annual rent is approximately $917,000.

  NovaStar Mortgage also leases space for its mortgage servicing operation in
Westwood, Kansas. The square footage on these premises is approximately 28,000,
with annual rent of approximately $382,000, and a lease scheduled to expire in
January 2007.

 Legal Proceedings

  We occasionally become involved in litigation arising in the normal course of
business. We believe that any liability with respect to such legal actions,
individually or in the aggregate, will not have a material adverse effect on
our financial position or results of operations.

                                       77
<PAGE>

                                   MANAGEMENT

Directors and Executive Officers

  Our directors and executive officers and their positions are as follows:

<TABLE>
<CAPTION>
                 Name              Position
                 ----              --------
      <S>                          <C>
      Scott F. Hartman(1)........  Chairman of the Board, Secretary and
                                   Chief Executive Officer
      W. Lance Anderson(1).......  Director, President and Chief Operating Officer
      Mark J. Kohlrus............  Senior Vice President, Treasurer and
                                   Chief Financial Officer
      Michael L. Bamburg.........  Senior Vice President and Chief Investment Officer
      Edward W. Mehrer(2)(3)(4)..  Director
      Gregory T. Barmore(2)(4)...  Director
      Bart Johnson(2)(3).........  Director
</TABLE>
- --------
(1) Founder of the Company.
(2) Independent director.
(3) Member of the Audit Committee.
(4) Member of the Compensation Committee.

  Information regarding the background and experience of our directors and
officers follows:

 Directors and Executive Officers

  Scott F. Hartman, age 39, is our co-founder, Chairman of the Board of
Directors and Chief Executive Officer and has been a member of the Board of
Directors since 1996. His main responsibilities are to manage our portfolio of
investments, interact with the capital markets and oversee the securitization
of our mortgage loan production. Mr. Hartman most recently served as Executive
Vice President of Dynex Capital, Inc., (Dynex) formerly Resource Mortgage
Capital, Inc., a New York Stock Exchange listed REIT. His responsibilities
while at Dynex included managing the investment portfolio, overseeing the
securitization of mortgage loans originated through Dynex's mortgage operation
and the administration of the securities issued by Dynex. Mr. Hartman left
Dynex in June 1996 to pursue this opportunity. Prior to joining Dynex in
February 1995, Mr. Hartman served as a consultant to Dynex for three years
during which time he was involved in designing and overseeing the development
of Dynex's analytical and securities structuring system. Mr. Hartman also
serves as a director and Vice Chairman of NovaStar Mortgage.

  W. Lance Anderson, age 39, is our co-founder, President and Chief Operating
Officer and has been a member of the Board of Directors since 1996. His main
responsibility is to manage our mortgage origination and servicing operations.
Mr. Anderson most recently served as Executive Vice President of Dynex Capital,
Inc., formerly Resource Mortgage Capital, Inc., a NYSE-listed REIT. In
addition, Mr. Anderson was President and Chief Executive Officer of Dynex's
single family mortgage operation, Saxon Mortgage. In this role he was
responsible for the origination, underwriting, servicing, quality control and
pricing functions for Saxon. He served in this capacity for two years prior to
which he was Executive Vice President in charge of production for the single
family operation. Mr. Anderson served from October 1989 at Dynex where he was
responsible for the startup of the single family operation. Mr. Anderson was
also responsible for re-focusing the conduit on the subprime mortgage market in
late 1993. Mr. Anderson also serves as Chairman of the Board of Directors,
President and Chief Executive Officer of NovaStar Mortgage.

  Mark J. Kohlrus, age 39, is Senior Vice President, Treasurer and Chief
Financial Officer of NovaStar Financial and NovaStar Mortgage. In that role,
Mr. Kohlrus is responsible for all accounting and finance functions, including
external reporting and compliance with REIT regulations. Prior to his joining
us in December

                                       78
<PAGE>

1996, Mr. Kohlrus was employed by the public accounting firm of KPMG Peat
Marwick LLP, a predecessor firm to KPMG LLP, in Kansas City, Missouri for
nearly 15 years. During his tenure with KPMG, Mr. Kohlrus worked extensively in
the firm's financial services practice and was involved in several public stock
and debt offerings.

  Michael L. Bamburg, age 36, is Senior Vice President and Chief Investment
Officer of NovaStar Financial and NovaStar Mortgage. Mr. Bamburg is responsible
for managing our portfolio of investments, interacting with the capital
markets, overseeing the securitization of our mortgage loan production, and
developing new business lines for us. Mr. Bamburg most recently served as a
Principal of Smith Breeden Associates, a financial institution consulting and
money management firm specializing in the evaluation and hedging of mortgage
backed securities. Mr. Bamburg spent over 11 years with Smith Breeden where he
analyzed and traded hundreds of millions of dollars of mortgage backed
securities and consulted with various financial institutions regarding
investments and asset/liability management issues. During the last 3 years with
Smith Breeden, Mr. Bamburg spent most of his time marketing Smith Breeden's
money management products.

  Edward W. Mehrer, age 59, has been a member of the Board of Directors since
1996. He is presently Chief Financial Officer of Cydex, a pharmaceutical
company based in Overland Park, Kansas. Mr. Mehrer was previously associated
with Hoechst Marion Roussel, formerly Marion Merrell Dow, Inc., an
international pharmaceutical company, for approximately ten years until his
retirement in December 1995. From December 1991, he served as Executive Vice
President, Chief Financial Officer and a director of Marion. Prior to that
position, he served in a number of financial and administrative positions.
Prior to joining Marion, Mr. Mehrer was a partner with the public accounting
firm of Peat Marwick Mitchell & Co., a predecessor firm to KPMG LLP, in Kansas
City, Missouri.

  Gregory T. Barmore, age 57, was most recently Chairman of the Board of GE
Capital Mortgage Corporation, a subsidiary of GE Capital Corporation
headquartered in Raleigh, North Carolina. He has served on the Board of
Directors since 1996. He was responsible for overseeing the strategic
development of GE Capital Mortgage Corporation's residential real estate-
affiliated financial businesses, including mortgage insurance, mortgage
services and mortgage funding. Prior to joining GE Capital Mortgage Corporation
in 1986, Mr. Barmore was Chief Financial Officer of Employers Reinsurance
Corporation, one of the nation's largest property and casualty reinsurance
companies and also a subsidiary of GE Capital Corporation. Prior to his
appointment at Employers Reinsurance Corporation, he held a number of financial
and general management positions within GE. Mr. Barmore was selected to serve
on our Board as an independent director without regard to the GE Capital
Corporation investment and accordingly there are no arrangements with GE
Capital Corporation or our affiliates regarding his term of office or other
aspects of his service on the Board.

  Bart Johnson, age 50, has been a member of the Board since 1998 and is the GE
Capital Corporation nominee. He is currently President of GE Capital
Residential Connections, a division of GE Capital Mortgage Corporation, and is
a 25-year mortgage industry veteran. Immediately prior to joining GE in 1997,
Mr. Johnson served as Chief Financial Officer and National Residential
Production Manager at Mellon Bank's Mortgage Banking Group beginning in 1989.

 Other Senior Officers

  James H. Anderson, age 35, is Senior Vice President and National Sales
Manager of NovaStar Mortgage. His primary responsibilities include overseeing
the overall marketing efforts of NovaStar Mortgage, including managing the
sales force of account executives. Prior to joining NovaStar in November 1996,
Mr. Anderson was President of his own marketing consulting business. From
August 1992 through September 1996, Mr. Anderson was employed by Saxon, where
he served as Vice President of Marketing, in charge of the Western Region of
the United States. In addition, Mr. Anderson was in charge of Saxon's national
sales force for correspondent lending.

  Manual X. Palazzo, age 48, is Senior Vice President and Chief Credit Officer
of NovaStar Financial and NovaStar Mortgage. His primary responsibility is to
manage the underwriting and funding functions. Prior to

                                       79
<PAGE>

joining NovaStar in December 1996, Mr. Palazzo was Senior Vice President of
Credit and Administration of Long Beach Mortgage Company since October 1995.
From May 1994 Mr. Palazzo was with Household Financial as Director of
Underwriting. Prior to his tenure at Household, Mr. Palazzo spent eight years
as manager of the wholesale lending business for Novus Financial. Mr. Palazzo
has been involved in the consumer finance industry since 1972.

  Christopher S. Miller, age 33, is Senior Vice President and Servicing Manager
of NovaStar Mortgage. Mr. Miller is a former Vice President of Option One
Mortgage Corporation, a subsidiary of Fleet Mortgage Corporation. From July
1995 to March 1997, Mr. Miller's responsibilities included managing the
Collections Department, Customer Service Department, Escrow Analysis, Payoff
Department, and Reconveyance. Prior to his tenure at Option One Mortgage in
1995, Mr. Miller spent over seven years at Novus Financial Corporation, a
subsidiary of Dean Witter Financial Services, where he managed multiple
servicing departments. Mr. Miller brings to NovaStar a diverse servicing
background with an emphasis on default management.

Terms of Directors and Officers

  Our Board of Directors consists of such number of persons as shall be fixed
by the Board of Directors from time to time by resolution to be divided into
three classes, designated Class I, Class II and Class III, with each class to
be as nearly equal in number of directors as possible. Currently there are five
directors. Mr. Mehrer is a Class I director, Mr. Anderson and Mr. Barmore are
Class II directors and Mr. Hartman and Mr. Johnson are Class III directors.
Class I, Class II and Class III directors will stand for reelection at the
annual meetings of stockholders held in 2000, 1998 and 1999, respectively. At
each annual meeting, the successors to the class of directors whose term
expires at that time are to be elected to hold office for a term of three
years, and until their respective successors are elected and qualified, so that
the term of one class of directors expires at each such annual meeting. We
intend to maintain the composition of the Board so that there will be no more
than six directors, with a majority of independent directors at all times, each
of whom shall serve on the Audit and/or Compensation Committees. Mr. Johnson is
the GE Capital Corporation nominee. Such nominee will serve as a Class III
director with a term running until the 1999 annual meeting of stockholders. In
the case of any vacancy on the Board of Directors, including a vacancy created
by an increase in the number of directors, the vacancy may be filled by
election of the Board of Directors or the stockholders, with the director so
elected to serve until the next annual meeting of stockholders, if elected by
the Board of Directors, or for the remainder of the term of the director being
replaced, if elected by the stockholders; any newly-created directorships or
decreases in directorships are to be assigned by the Board of Directors so as
to make all classes as nearly equal in number as possible. Directors may be
removed only for cause and then only by vote of a majority of the combined
voting power of stockholders entitled to vote in the election for directors.
Subject to the voting rights of the holders of preferred stock, our charter may
be amended by the vote of a majority of the combined voting power of
stockholders, provided that amendments to the article dealing with directors
may only be amended if it is advised by at least two-thirds of the Board of
Directors and approved by vote of at least two-thirds of the combined voting
power of stockholders. The effect of the foregoing as well as other provisions
of our charter and bylaws may discourage takeover attempts and make more
difficult attempts by stockholders to change management. Prospective investors
are encouraged to review our charter and bylaws in their entirety.

  Our bylaws provide that, except in the case of a vacancy, a majority of the
members of the Board of Directors will at all times be independent directors.
Independent directors are defined as directors who are not officers or our
employees or any affiliate or our subsidiary. GE Capital Corporation and our
affiliates are expressly deemed not to be our affiliates for this purpose.
Vacancies occurring on the Board of Directors among the independent directors
may be filled by a vote of a majority of the remaining directors, including a
majority of the remaining independent directors. Officers are elected annually
and serve at the discretion of the Board of Directors. There are no family
relationships between the executive officers or directors.


                                       80
<PAGE>

Committees of the Board

  Audit Committee. We have established an Audit Committee composed of two
independent directors. The Audit Committee makes recommendations concerning the
engagement of independent public accountants, reviews with the independent
public accountants, the plans and results of any audits, reviews other
professional services provided by the independent public accountants, reviews
the independence of the independent public accountants, considers the range of
audit and non-audit fees and reviews the adequacy of our internal accounting
controls.

  Compensation Committee. We have established a Compensation Committee composed
of two independent directors. The Compensation Committee determines the
compensation of our executive officers.

  Other Committees. The Board of Directors may establish other committees as
deemed necessary or appropriate from time to time, including, but not limited
to, an Executive Committee of the Board of Directors.

Compensation of Directors

  We pay independent directors $10,000 per year plus $500 for each meeting
attended in person. Independent directors also receive automatic stock options
pursuant to our Stock Option Plan. However, as the GE Capital Corporation
nominee and pursuant to GE Capital Corporation's internal policy, Mr. Johnson
does not receive any compensation, whether fees or stock options, for his
service on the Board of Directors. None of our directors have received any
separate compensation for service on the Board of Directors or on any
committee. In addition, each independent director has been granted options to
purchase 5,000 shares of common stock at the fair market value of the common
stock upon becoming a director and options to purchase 2,500 shares at the fair
market value of the common stock on the day after each annual meeting of
stockholders. All directors receive reimbursement of reasonable out-of-pocket
expenses incurred in connection with meetings of the Board of Directors. No
director who is our employee will receive separate compensation for services
rendered as a director.

Compensation Committee Interlocks

  No interlocking relationship exists between our Board of Directors or
officers responsible for compensation decisions and the board of directors or
compensation committee of any other company, nor has any such interlocking
relationship existed in the past.

                                       81
<PAGE>

Executive Compensation

  The objective of senior management in constructing our own compensation
packages as well as those of all our managers is to align the interests of
management as closely as possible with those of the stockholders. This is
accomplished by basing a large percentage of key managers' compensation on our
profitability, measured by return on stockholders' equity, and the stock price.

                  Executive Officer Summary Compensation Table

<TABLE>
<CAPTION>
                                                                    Long-term
                                                                  Compensation
                                                               -------------------
                                                               Securities
                                                 Other Annual  Underlying           All Other
Name and Position          Year  Salary   Bonus  Compensation  Options(#) DER's(5) Compensation
- -----------------          ---- -------- ------- ------------  ---------- -------- ------------
<S>                        <C>  <C>      <C>     <C>           <C>        <C>      <C>
Scott F. Hartman(1)....... 1998 $185,000     --         --          --       --        --
 Chairman of the Board,    1997  130,833     --    $549,635(4)   40,000      --        --
 Secretary and Chief       1996   70,000     --         --      144,666                --
 Executive Officer


W. Lance Anderson(1)...... 1998  185,000     --         --          --       --        --
 President and Chief       1997  130,833     --     549,635(4)   40,000      --        --
 Operating Officer         1996   70,000     --         --      144,666      --        --


Mark J. Kohlrus(2)........ 1998  120,000 $86,000        --       10,000    3,300       --
 Senior Vice President,    1997  100,000  90,000        --       20,000      700       --
 Treasurer and Chief       1996    4,000     --         --       10,000      --        --
 Financial Officer


Michael L. Bamburg(3)..... 1998  128,333 105,000        --       50,000      --        --
 Senior Vice President and 1997      --      --         --          --       --        --
 Chief Investment Officer  1996      --      --         --          --       --        --
</TABLE>
- --------
(1) Mr. Hartman and Mr. Anderson were reimbursed by us for services provided by
    them that were necessary and prudent in connection with our formation and
    our private placement in 1996, including payments in lieu of salary and for
    expenses directly attributable to our formation. Mr. Hartman and Mr.
    Anderson are employed by us at a base salary of $185,000 per year.
(2) Mr. Kohlrus' employment with us began on December 16, 1996. He has an
    annual base salary of $120,000 per year. Mr. Kohlrus is eligible to receive
    an annual bonus of up to 75 percent of his annual salary. After our initial
    public offering in October 1997, Mr. Kohlrus's annual salary increased to
    $120,000. This was the base salary used in determining Mr. Kohlrus's 1997
    bonus.
(3) Mr. Bamburg's employment with us began in February 1998 and provided for an
    annual salary of $140,000 through December 31, 1998. Mr Bamburg is eligible
    to receive an annual bonus of up to 75% of his annual salary.
(4) Represents forgiveness of one tranche of founders' forgivable debt.
(5) 1996 options granted to Mr. Hartman and Mr. Anderson which vested on the
    closing of the initial public offering were granted without dividend
    equivalent rights. Options granted to Mr. Kohlrus which began to vest in
    December 1997 were granted with dividend equivalent rights. None of the
    1997 and 1998 options were granted with dividend equivalent rights.

                                       82
<PAGE>

  Bonus Incentive Compensation Plan. A bonus incentive compensation plan has
been established for certain executive and key officers of us and our
affiliates, and was effective commencing with the fiscal year beginning January
1, 1998. The annual bonus pursuant to the bonus incentive compensation plan
will be paid one-half in cash and one-half in shares of our common stock,
annually, following receipt of the audit for the related fiscal year. This
program will award bonuses annually to those officers out of a total pool
determined by stockholder return on equity as follows:

<TABLE>
<CAPTION>
           Return on Equity(1)                               Bonus as percent of
      in Excess of Base Rate(2) By:                    Average Net Worth(3) Outstanding
      -----------------------------                    --------------------------------
   <S>                                       <C>
       zero or less                                   0%
       greater than 0% but less than 6%               10% x (actual return on equity - Base Rate)
       Greater than 6%                                (10% x 6%) + 15% x (actual return
                                                       on equity - (Base Rate + 6%))
</TABLE>

Of the amount so determined, one-half will be deemed contributed to the total
pool in cash and the other half deemed contributed to the total pool in the
form of shares of our common stock, with the number of shares to be calculated
based on the average price per share during the preceding year. The total pool
may not exceed $1 million for fiscal years ending December 31, 1998, and
December 31, 1999.
- --------
(1) Return on equity is determined for the fiscal year by averaging the monthly
    ratios calculated each month by dividing our monthly net income adjusted to
    an annual rate, by our average net worth for such month. For such
    calculations, our "net income" means our net income or net loss determined
    according to generally accepted accounting principles, but after deducting
    any dividends paid or payable on preferred stock that may be issued before
    giving effect to the bonus incentive compensation or any valuation
    allowance adjustment to stockholders' equity. The definition "return on
    equity" is used only for purposes of calculating the bonus incentive
    compensation payable pursuant to the bonus incentive compensation plan and
    is not related to the actual distributions received by stockholders. The
    bonus payments will be an operating expense of us.
(2) "Base rate" is the average for each month of the ten-year U.S. Treasury
    rate, plus four percent.
(3) "Average net worth" for any month means the arithmetic average of the sum
    of (1) the net proceeds from all offerings of equity securities since
    formation including exercise of Warrants and stock options and pursuant to
    the proposed dividend reinvestment plan, but excluding any offerings of
    preferred stock in the future, after deducting any underwriting discounts
    and commissions and other expenses and costs relating to the offerings,
    plus (2) our retained earnings without taking into account any losses
    incurred in prior fiscal years, after deducting any amounts reflecting
    taxable income to be distributed as dividends and without giving effect to
    any valuation allowance adjustment to stockholders' equity, computed by
    taking the daily average of such values during such period.

                                       83
<PAGE>

Stock Option Grants

  Options have been granted at exercise prices greater than or equal to the
estimated fair value of the underlying stock at the date of grant. Options vest
over four years and expire ten years after the date of grant, except for the
founders' options, which vested upon the closing of our initial public offering
in October 1997. Options to acquire 383,820 shares of common stock are
outstanding to the date of this prospectus under our 1996 Stock Option Plan.

  The following table sets forth information concerning stock options granted
during 1998 to each of the directors and executive officers.
<TABLE>
<CAPTION>
                                                                                    Potential
                                                                                Realizable Value
                                                                                at Assumed Annual
                                                                                      Rates
                                                                                    of Stock
                                                                               Price Appreciation
                                           Individual Grants                     for Option Term
                         ----------------------------------------------------- -------------------
                                    Percent of Total
                                    Options Granted  Exercise Price
                            No.       to Employees   or Base Price  Expiration
Name                     Granted(1) During the Year    ($/Share)       Date     5% ($)   10% ($)
- ----                     ---------- ---------------- -------------- ---------- -------- ----------
<S>                      <C>        <C>              <C>            <C>        <C>      <C>
Michael L. Bamburg......   30,000        20.27%          $17.01       1/28/08  $831,225 $1,323,587
Michael L. Bamburg......   20,000        13.51%          $ 6.38      12/30/08  $207,847 $  330,962
Gregory T. Barmore......    2,500         1.69%          $20.81       5/14/08  $ 84,753 $  134,956
Edward W. Mehrer........    2,500         1.69%          $20.81       5/14/08  $ 84,753 $  134,956
Mark J. Kohlrus.........   10,000         6.76%          $ 6.38      12/30/08  $103,923 $  165,481
                          -------        ------
Total to Directors and
 Executive Officers.....   65,000        43.92%
                          =======        ======
Total shares granted
 under SOP..............  148,000
                          =======
</TABLE>
- --------
(1) Twenty-five percent of the options granted will vest in 1999 and 25% in
    each year thereafter. Options do not include dividend equivalent rights.

  The following table sets forth information with respect to the value of the
options as of December 31, 1998 held by the named directors and executive
officers.

                          Fiscal Year End Option Value

<TABLE>
<CAPTION>
                                                       Number of Securities      Value of Unexercised
                                                      Underlying Unexercised         In-the-Money
                                                           Options as of             Options as of
                         Shares Acquired    Value        December 31, 1998      December 31, 1998(1)(3)
                           on Exercise   Realized(2) ------------------------- -------------------------
Name                     (No. of Shares)     ($)     Exercisable Unexercisable Exercisable Unexercisable
- ----                     --------------- ----------- ----------- ------------- ----------- -------------
<S>                      <C>             <C>         <C>         <C>           <C>         <C>
Scott F. Hartman(4).....     144,666      $759,497     10,000       30,000           --           --
W. Lance Anderson(4)....     144,666       759,497     10,000       30,000           --           --
Gregory T. Barmore......       2,500        39,350      1,250        8,750           --       $15,450
Edward W. Mehrer........         --            --       3,750        8,750       $15,450       15,450
Michael L. Bamburg......         --            --         --        50,000           --           --
Mark J. Kohlrus.........       2,500         9,075      5,000       30,000           --        18,450
</TABLE>
- --------
(1) "In-the-money" options whose exercise was less than the market price of
    common stock at December 31, 1998.
(2) The "value realized" represents the difference between the exercise price
    of the option shares and the market price of the option shares on the date
    the option was exercised. The value realized was determined without
    considering any taxes which may have been owed.
(3) Assuming a stock price of $6.19 per share, which was the closing price of a
    share of common stock reported for the New York Stock Exchange on December
    31, 1998.
(4) During 1998, the founders exercised options to acquire 289,332 shares of
    common stock at $15.00 per share. In payment for the acquired common stock,
    the founders issued notes payable to NovaStar Financial. Unpaid principal
    on the notes was $4,340,000 as of December 31, 1998. During 1998, NovaStar
    Financial accrued interest of $220,000 and the founders paid $78,000 in
    interest.

                                       84
<PAGE>

  Units Acquired with Forgivable Debt. Messrs. Hartman and Anderson have each
acquired 108,333 units, each unit consisting of one share of preferred stock
which converted to common stock at the closing of the initial public offering
and one warrant, which were acquired at the price of $15 per unit on December
9, 1996. Payment for such units was made by delivering promissory notes,
bearing interest at eight percent per annum compounded annually and secured by
the units being acquired. Interest began accruing during the first year and was
added to principal due under the note. Thereafter, interest became payable
quarterly and upon forgiveness or at maturity of the notes, which is at the end
of the fifth fiscal period.

  The principal amount of the notes is divided into three equal parts which we
refer to as "tranches." Payment of principal on each tranche will be forgiven,
if the following incentive performance tests are achieved:

  . During the first five fiscal periods after issuance of the notes:

    --One tranche will be forgiven for each fiscal period as to which we
     generate a total return to investors in units equal to or greater than
     15%. The debt on the first tranche was forgiven and we recognized a
     non-cash charge against earnings of $1,083,330 for the fiscal period
     ending December 31, 1997. No debt was forgiven during 1998.

    --At the end of each of the five fiscal periods, all remaining tranches
     will be forgiven if we have generated a total cumulative return to
     investors in units, from date of initial issuance of the notes, equal
     to or greater than 100%.

  . For purposes of calculating the returns to such investors:

    --The term "fiscal period" will refer to each of five periods. The
     first period commenced with the closing of the private placement on
     December 9, 1996, and ends on December 31, 1997, and, thereafter, each
     succeeding fiscal period extends for twelve months and ends on each
     December 31.

  . The term "return" for each fiscal period will mean the sum of, on a per
    unit basis,

    (1) all cash dividends paid during, or declared with respect to, such
        fiscal period per share of preferred stock, or per share of common
        stock following conversion of the preferred stock upon completion
        of the initial public offering;

    (2) any increase or decrease in the price per share of preferred stock,
        or resulting common stock, during such fiscal period, measured by
        using the price per unit to investors in the private placement as
        the starting price ($15.00), and using the average public trading
        price during the last 90 days of each succeeding fiscal period for
        such succeeding periods, except such shorter period as the common
        stock was traded in 1997; and

    (3) any increase or decrease in the price per warrant during such
        fiscal period, determined in the same manner as in (2).

    For purposes of the fiscal period 15% return test, the total return for a
  given period will be equal to the sum of (1), (2) and (3) during the
  period, and for purposes of the cumulative 100% return test, the amounts in
  (1), (2) and (3) will all be measured from the beginning of the first
  fiscal period. The amount of that "return" will then be measured as a
  percentage of the investor's investment in the units on a per unit basis
  without regard to timing of receipt of dividends or timing of increases in
  per share or per warrant prices.

  . If one of the incentive tests is met, the amount of loan forgiveness for
    each tranche will be the principal amount of such tranche of the note. In
    addition, a loan will be made by us to Messrs. Hartman and Anderson in
    the amount of (1) personal tax liability resulting from the forgiveness
    of debt, and (2) interest accrued during the first year of the forgiven
    tranches. These notes are secured by the proportionate number of shares
    of common stock that had secured the forgiven tranche of the notes and
    will mature upon the earlier of the sale of these common shares or the
    termination of the officer's employment with us. Messrs. Hartman and
    Anderson have issued notes payable to NovaStar Financial

                                       85
<PAGE>

   for the repayment of the tax liability and interest accrued on forgivable
   notes through December 31, 1997. Unpaid principal on the notes was
   $843,000 and $763,000 as of December 31, 1998 and 1997, respectively.
   Interest accrues monthly at one-month LIBOR plus 1%, which was 6.54% as of
   December 31, 1998, and is payable quarterly. During 1998, NovaStar
   Financial accrued interest on these amounts totaling $47,000 and the
   founders paid interest totaling $18,000.

  Employment Agreements. We have entered into employment agreements with the
founders, Mr. Hartman and Mr. Anderson. Each employment agreement provides for
a term through December 31, 2001, and will be automatically extended for an
additional year at the end of each year of the agreement, unless either party
provides a prescribed prior written notice to the contrary. Each employment
agreement provides for the annual base salary set forth in the compensation
table above and for participation by the subject officer in the Bonus Incentive
Compensation Plan. Each employment agreement provides for the subject officer
to receive his annual base salary and bonus compensation to the date of the
termination of employment by reason of death, disability or resignation and to
receive base compensation to the date of the termination of employment by
reason of a termination of employment for cause as defined in the agreement.
Each employment agreement also provides for the subject officer to receive, if
the subject officer resigns for "good reason" or is terminated without cause
after a "change in control" as those terms are defined in the agreement, an
amount, 50% payable immediately and 50% payable in monthly installments over
the succeeding twelve months, equal to three times such officer's combined
maximum base salary and actual bonus compensation for the preceding year,
subject in each case to a maximum amount of one percent of our book equity
value, exclusive of valuation adjustments, and a minimum of $360,000. In that
instance, the subject officer is prohibited from competing with us for a period
of one year. In addition, all outstanding options granted to the subject
officer under the 1996 Stock Option Plan shall immediately vest. Section 280G
of the Code may limit the deductibility of the payments to such officer by us
for federal income tax purposes. "Change of control" for purposes of the
agreements would include a merger or consolidation of NovaStar Financial, a
sale of all or substantially all of our assets, changes in the identity of a
majority of the members of our Board of Directors, other than due to the death,
disability or age of a director, or acquisitions of more than 25% of the
combined voting power of our capital stock, subject to certain limitations.
Absent a "change in control," if we terminate the officer's employment without
cause, or if the officer resigns for "good reason," the officer receives an
amount, payable immediately, equal to such officer's combined maximum base
salary and actual bonus compensation for the preceding year, subject in each
case to a maximum amount of one percent of our book value, exclusive of
valuation adjustments, and a minimum of $120,000. If the officer resigns for
any other reason, there is no severance payment and the officer is prohibited
from competing with us for a period of one year following the resignation.
Although we believes these forfeiture and non-compete provisions would
generally be enforceable, there can be no assurance that the employee will not
elect to terminate the agreement early despite these provisions and no longer
remain in our employ.

 Stock Option Plan

  General. Our 1996 Executive and Non-Employee Director Stock Option Plan
provides for the grant of qualified incentive stock options which meet the
requirements of Section 422 of the Code, stock options not so qualified,
deferred stock, restricted stock, performance shares, stock appreciation and
limited stock awards and dividend equivalent rights.

  Purpose. The 1996 Stock Option Plan is intended to provide a means of
performance-based compensation in order to attract and retain qualified
personnel and to afford additional incentive to others to increase their
efforts in providing significant services to us.

  Administration. The 1996 Stock Option Plan is administered by the
Compensation Committee of the Board of Directors, which shall at all times be
composed solely of non-employee directors as required by Rule 16b-3 under the
Securities Exchange Act of 1934, as amended. Members of the Compensation
Committee are eligible to receive only non-qualified stock options pursuant to
automatic grants of stock options discussed below.

                                       86
<PAGE>

  Options and Awards. Options granted under the 1996 Stock Option Plan will
become exercisable in accordance with the terms of the grants made by the
Compensation Committee. Awards will be subject to the terms and restrictions of
the awards made by the Compensation Committee. Option and award recipients
shall enter into a written stock option agreement with us. The Compensation
Committee has discretionary authority to select participants from among
eligible persons and to determine at the time an option or award is granted
when and in what increments shares covered by the option or award may be
purchased or will vest and, in the case of options, whether it is intended to
be an incentive stock option or a non-qualified stock option provided, however,
that certain restrictions applicable to incentive stock options are mandatory,
including a requirement that incentive stock options not be issued for less
than 100% of the then fair market value of our common stock, 110% in the case
of a grantee who holds more than ten percent of the outstanding common stock,
and a maximum term of ten years, five years in the case of a grantee who holds
more than 10% of the outstanding common stock. Fair market value means as of
any given date, with respect to any option or Award granted, at the discretion
of the Board of Directors or the Compensation Committee,

  . the closing sale price of the common stock on such date as reported in
    the Western Edition of the Wall Street Journal; or

  . the average of the closing price of the common stock on each day of which
    it was traded over a period of up to twenty trading days immediately
    prior to such date; or

  . if the common stock is not publicly traded, the fair market value of the
    common stock as otherwise determined by the Board of Directors or the
    Compensation Committee in the good faith exercise of their discretion.

  Eligible Persons. Our officers and directors and employees and other persons
expected to provide significant services to us are eligible to participate in
the 1996 Stock Option Plan. Incentive stock options may be granted to the
officers and our key employees. Non-qualified stock options and awards may be
granted to our directors, officers, key employees, agents and consultants or
any of subsidiaries.

  Under current law, incentive stock options may not be granted to any of our
directors who are not also an employee, or to directors, officers and other
employees of entities unrelated to us. No options or awards may be granted
under the 1996 Stock Option Plan to any person who, assuming exercise of all
options held by such person, would own or be deemed to own more than 25% of the
outstanding shares of our equity stock.

  Shares Subject to the Plan. The 1996 Stock Option Plan authorizes the grant
of options to purchase, and Awards of, an aggregate of up to 10% of our total
outstanding shares at any time, provided that no more than 339,332 shares of
common stock shall be cumulatively available for grant as incentive stock
options. If an option granted under the 1996 Stock Option Plan expires or
terminates, or an Award is forfeited, the shares subject to any unexercised
portion of such option or award will again become available for the issuance of
further options or awards under the 1996 Stock Option Plan. In connection with
any reorganization, merger, consolidation, recapitalization, stock split or
similar transaction, the Compensation Committee shall appropriately adjust the
number of shares of common stock subject to outstanding options, awards and
dividend equivalent rights and the total number of shares for which options,
awards or dividend equivalent rights may be granted under the Plan.

  Term of the Plan. Unless previously terminated by the Board of Directors, the
1996 Stock Option Plan will terminate on September 1, 2006, and no options or
awards may be granted under the 1996 Stock Option Plan thereafter, but existing
options or awards will remain in effect until the options are exercised or the
options or awards are terminated by their terms.

  Term of Options. Each option must terminate no more than ten years from the
date it is granted, or five years in the case of incentive stock options
granted to an employee who is deemed to own an excess of 10% of the combined
voting power of our outstanding equity stock. Options may be granted on terms
providing for exercise either in whole or in part at any time or times during
their restrictive terms, or only in specified percentages at stated time
periods or intervals during the term of the option.

                                       87
<PAGE>

  Dividend equivalent rights. The Plan provides for granting of dividend
equivalent rights in tandem with any options granted under the Plan. Such
dividend equivalent rights accrue for the account of the optionee shares of
common stock upon the payment of dividends on outstanding shares of common
stock. The number of shares accrued is determined by a formula and such shares
may be made transferable to the optionee either upon exercise of the related
option or on a "current-pay" basis so that payments would be made to the
optionee at the same time as dividends are paid to holders of outstanding
common stock. Holders of dividend equivalent rights may be made eligible to
participate not only in cash distributions but also in distributions of stock
or other property made to holders of outstanding common stock. Shares of common
stock accrued for the account of the optionee are eligible to receive dividends
and distributions. dividend equivalent rights may also be made "performance
based" by conditioning the right of the holder of the dividend equivalent
rights to receive any dividend equivalent payment or accrual upon the
satisfaction of specified performance objectives.

  Option Exercise. The exercise price of any option granted under the 1996
Stock Option Plan is payable in full in cash, or our equivalent as determined
by the Compensation Committee. We may make loans available to option holders to
exercise options evidenced by a promissory note executed by the option holder
and secured by a pledge of common stock with fair value at least equal to the
principal of the promissory note unless otherwise determined by the
Compensation Committee.

  Automatic Grants to Non-Employee Directors. Each of our non-employee
directors are automatically granted non-qualified stock options to purchase
5,000 shares of common stock with dividend equivalent rights upon becoming a
director, and is also automatically granted non-qualified stock options to
purchase 2,500 shares of common stock, with dividend equivalent rights the day
after each annual meeting of stockholders upon re-election to or continuation
on the Board. Such automatic grants of stock options vest 25% on the
anniversary date in the year following the date of the grant and 25% on each
anniversary date thereafter. The exercise price for such automatic grants of
stock options is the fair market value of the common stock on the date of
grant, and is required to be paid in cash.

  Amendment and Termination of Stock Option Plan. The Board of Directors may,
without affecting any outstanding options or awards, from time to time revise
or amend the 1996 Stock Option Plan, and may suspend or discontinue it at any
time without stockholder approval, increase the number of shares subject to the
1996 Stock Option Plan, modify the class of participants eligible to receive
options or awards granted under the 1996 Stock Option Plan or extend the
maximum option term under the 1996 Stock Option Plan.

                                       88
<PAGE>

                           PRINCIPAL SECURITYHOLDERS

Beneficial Ownership of Common Stock by Large Securityholders

  The following table sets forth the information we have with respect to
beneficial ownership of our common stock as of April 1, 1999, by each person
other than members of management known to us to beneficially own more than 5%
of our common stock. Unless otherwise indicated in the footnotes to the table,
the beneficial owners named have, to our knowledge, sole voting and investment
power with respect to the shares beneficially owned, subject to community
property laws where applicable.

<TABLE>
<CAPTION>
                                                          Beneficial Ownership
                                                           of Common Stock(1)
                                                          ----------------------
Name and Address of Beneficial Owner                        Shares     Percent
- ------------------------------------                      ----------- ----------
<S>                                                       <C>         <C>
Wallace R. Weitz & Company(2)............................   6,372,262   48.99%
 1125 South 103rd Street, Suite 600
 Omaha, NE 68124-6008
General Electric Capital Corporation(3)..................   1,333,332   15.16%
 260 Long Ridge Road
 Stamford, CT 06927
Lindner Dividend Fund(4).................................   1,216,567   13.83%
 7711 Carondolet Avenue, Suite 700
 St. Louis, MO 63104
GMAC/Residential Funding Corporation(5)..................   1,177,713   12.65%
 8400 Normandale Lake Blvd., Suite 600
 Minneapolis, MN 55437
McCarthy Group, Inc.(6)..................................     814,285    9.21%
 1125 South 103rd Street, Suite 450
 Omaha, NE 68124
First Union Corporation(7)...............................     536,667    6.33%
 One First Union Center, TW9
 Charlotte, NC 28288-0610
First Financial Fund(8)..................................     450,700    5.54%
 c/o Wellington Management Company
 75 State Street
 Boston, MA 02109
</TABLE>

- --------
(1) Assuming no exercise of warrants or conversion of preferred stock except by
    the securityholder named, separately, and no purchases by any of the listed
    securityholders in this offering.
(2) Includes 1,305,000 shares of common stock issuable upon the exercise of
    warrants and 3,571,429 shares of common stock issuable upon conversion of
    preferred stock.
(3) Includes 666,666 shares of common stock issuable upon the exercise of
    warrants.
(4) Includes 666,667 shares of common stock issuable upon the exercise of
    warrants.
(5) Includes 1,177,713 shares of common stock issuable upon the exercise of
    warrants.
(6) Includes 714,285 shares of common stock issuable upon conversion of
    preferred stock.
(7) Includes 350,000 shares of common stock issuable upon the exercise of
    warrants.
(8) Consists of shares of common stock currently outstanding.

                                       89
<PAGE>

Beneficial Ownership of Common Stock by Directors and Management

  The following table sets forth information we have with respect to beneficial
ownership of our common stock as of April 1, 1999, by (1) each director, (2)
our executive officers, and (3) all directors and executive officers as a
group. Unless otherwise indicated in the footnotes to the table, the beneficial
owners named have, to our knowledge, sole voting and investment power with
respect to the shares beneficially owned, subject to community property laws
where applicable.

<TABLE>
<CAPTION>
                                                                              Beneficial
                                                                               Ownership
                                                                               of Common
                                                                               Stock(1)
                                                                           -----------------
Name of Beneficial Owner                                                    Number   Percent
- ------------------------                                                   --------- -------
<S>                                                                        <C>       <C>
Scott F. Hartman(2)......................................................    529,065   6.40
W. Lance Anderson(3).....................................................    539,465   6.52
Edward W. Mehrer(4)......................................................     39,750      *
Gregory T. Barmore(5)....................................................      1,250      *
Bart O. Johnson..........................................................        --     --
Michael L. Bamburg(6)....................................................     76,988      *
Mark J. Kohlrus(7).......................................................     16,305      *
All Directors and Executive Officers as a Group (7 persons)..............  1,202,823  14.57
</TABLE>
- --------
 * Less than one percent.
(1) Assuming no exercise of the warrants and exercisable options, except by the
    listed securityholder named separately.
(2) Consists of 390,732 shares of common stock and 128,333 warrants, including
    224,066 of common stock and 20,000 of warrants owned jointly with his wife,
    and 10,000 shares of common stock issuable upon the exercise of options.
(3) Consists of 395,932 shares of common stock and 133,533 warrants, including
    287,599 of common stock and 25,200 of warrants owned jointly with his wife,
    and 10,000 shares of common stock issuable upon the exercise of options.
(4) Consists of 24,000 shares of common stock and 12,000 of warrants, including
    2,000 of each owned by his wife, and 3,750 shares of common stock issuable
    upon the exercise of options.
(5) Consists of 1,250 shares of common stock issuable upon the exercise of
    options.
(6) Consists of 46,188 shares of common stock and 23,300 warrants, including
    1,228 shares of common stock owned by his wife, 300 warrants owned by his
    wife, 20,110 warrants owned jointly with his wife, and 7,500 shares of
    common stock issuable upon the exercise of options.
(7) Includes 9,805 shares of common stock and 1,500 warrants, all of which are
    owned jointly with his wife, except for 550 shares of common stock which
    are controlled by Mr. Kohlrus as custodian for his children, and 5,000
    shares of common stock issuable upon the exercise of options.

                                       90
<PAGE>

                              CERTAIN TRANSACTIONS

Transactions with Management

  In May 1996, Messrs. Hartman and Anderson formed NovaStar Mortgage for the
purpose of engaging in the subprime lending business. Following our private
placement, NovaStar Mortgage began obtaining required licenses and permits,
developing guidelines for the origination of mortgage loans through our
wholesale lending channel and hiring critical senior personnel to put in place
the infrastructure for our mortgage lending and servicing operations.

  Following the close of the private placement in December 1996, we moved to
implement the portion of our business strategy to be conducted through taxable
affiliates. In February 1997, NFI Holding was formed to serve as a holding
company for such taxable affiliates. In March 1997, Messrs. Hartman and
Anderson acquired all of the outstanding voting common stock of NFI Holding for
a total price of $20,000 and we acquired all of the outstanding non-voting
preferred stock of NFI Holding for a total price of $1,980,000. The voting
common stock is entitled to one percent of the dividend distributions of NFI
Holding and the preferred stock is entitled to 99% of such distributions. At
the time of acquisition of the common stock, Messrs. Hartman and Anderson
entered into an agreement of shareholders, to which we are a party, which
contains certain management and control provisions and restrictions on transfer
of the common stock. The obligations of Messrs. Hartman and Anderson under the
agreement of shareholders are secured by the pledge of their common stock in
NFI Holding.

  In February 1997, NFI Holding acquired all of the outstanding common stock of
NovaStar Mortgage from Messrs. Hartman and Anderson. NovaStar Mortgage thereby
became a wholly-owned subsidiary of NFI Holding. Through NFI Holding, we thus
own a beneficial interest in 99% of the future dividend distributions
attributable to NovaStar Mortgage.

  We have entered into a loan sale and purchase agreement with NovaStar
Mortgage pursuant to which we agree to buy from time to time and NovaStar
Mortgage agrees to sell to us mortgage loans originated or acquired by NovaStar
Mortgage. The loan purchase agreement is non-exclusive as to both parties and
provides for a fair market value transfer of mortgage loans, generally on a
servicing-released basis which means ownership of the loan servicing is
transferred with the mortgage loan. Also, under the terms of this agreement, if
NovaStar Mortgage chooses to sell its loan originations to other parties, it
pays a fee to us for not delivering production under the purchase commitment.
The fee is 1% of the principal balance of the loans originated but not sold to
us.

  NovaStar Mortgage and NovaStar Financial also entered into a flow
subservicing agreement under which NovaStar Mortgage agrees to service our
mortgage loans initially for a fixed dollar fee per loan based on the fee in
comparable subservicing arrangements. The subservicing agreement became
effective with the commencement of NovaStar Mortgage's servicing operation in
July 1997. Separate agreements have been executed for each pool of loans
serving as collateral for NovaStar Financial's collateralized mortgage
obligations.

  NovaStar Mortgage and NovaStar Financial further entered into an
Administrative Services Outsourcing Agreement, dated as of January 30, 1998,
pursuant to which NovaStar Mortgage will provide to us on a fee basis certain
administrative services, including consulting with respect to the development
of mortgage loan products, loan underwriting, loan funding and quality control.

                                       91
<PAGE>

  Following is a summary of the fees, in thousands, which NovaStar Financial
paid to and received from NovaStar Mortgage:

<TABLE>
<CAPTION>
                                                                   Year Ended
                                                                  December 31,
                                                                 ---------------
                                                                  1998     1997
                                                                 -------  ------
   <S>                                                           <C>      <C>
   Amounts paid to NovaStar Mortgage
     Administrative fees........................................ $ 7,800  $3,650
     Loan servicing fees........................................   3,803     505
   Amounts received from NovaStar Mortgage:
     Purchase commitment fee....................................  (5,117)    --
                                                                 -------  ------
       Total.................................................... $ 6,486  $4,155
                                                                 =======  ======
</TABLE>

Indebtedness of Management

  Messrs. Hartman and Anderson are indebted to us pursuant to forgivable
promissory notes, notes covering the related tax liability and notes issued to
cover the exercise of options, each as described under "Management--Executive
Compensation." The aggregate amount due on these notes as of December 31, 1998
was $7,608,000 which is included as amounts due from founders in the
consolidated financial statement.

Certain Business Relationships

  In connection with a commitment from General Electric Capital Corporation to
purchase units in our private placement of units in 1996, we agreed that so
long as GE Capital Corporation owns at least 10% of the outstanding common
stock, assuming full exercise of all warrants, GE Capital Corporation will
have the right to appoint one director, of up to six authorized directors, or,
alternatively, to have board observation rights so long as it maintains more
than 20% of its initial investment in us. The current director serving
pursuant to these provisions is Bart Johnson, who replaced Jenne Britell in
1998. He will stand for election as an independent director at the 1999 annual
meeting of stockholders.

  We also agreed, unless GE Capital Corporation waives our compliance,

  . to give GE Capital Corporation's insurance affiliate FGIC three years'
    right of first offer to issue credit enhancements on our securitizations;

  . to permit GE Capital Corporation's mortgage company affiliate GE Capital
    Mortgage Corporation to sell subprime mortgage loans, conforming to
    underwriting guidelines, to us on an arm's-length basis; and

  . to pay, subject to the subsequent closing of the private placement, GE
    Capital Corporation's reasonable legal and consulting fees up to $40,000
    incurred in the private placement.

  To ensure that any purchases of subprime mortgage loans from GE Capital
Mortgage Corporation are executed at arms-length, we will obtain two
independent prices related to any such transaction.

  On October 13, 1998, NovaStar Financial executed a 90-day financing
agreement with GMAC/Residential Funding Corporation, secured by certain
mortgage assets. Under the terms of the agreement, NovaStar Financial borrowed
$15 million to support immediate cash needs. In addition, NovaStar Financial
agreed to pay a $3 million commitment fee at maturity of the note. The
resulting $18 million obligation accrued interest at one-month LIBOR plus 5%
and has been repaid in full. Additionally, GMAC/Residential Funding
Corporation acquired 812,731 warrants for the purchase of common stock at a
price of $4.5625, the closing price of the common stock on October 12, 1998,
and 364,982 warrants for the purchase of common stock at a price of $15.00,
the price in effect on our December 9, 1996 warrants. Pursuant to anti-
dilution provisions, each warrant exercised at $15.00 per share will currently
purchase 1.29 shares of our common stock, which represents an effective
exercise price of $11.62 per share.

                                      92
<PAGE>

  On February 12, 1999, NovaStar Financial entered into several lending
arrangements with First Union National Bank for one year. The warehouse line of
credit and master repurchase agreements with First Union allow NovaStar
Financial to borrow up to $75 million and $300 million, respectively, and are
secured by mortgage loans. At the same time, two additional lending
arrangements were executed with First Union whereby NovaStar Financial can
borrow up to $20 million secured by the residual interests of asset-backed
bonds. NovaStar Financial will issue First Union 350,000 warrants to purchase
common stock at $6.9375 per share, the closing price on February 11, 1999, in
exchange for 186,667 existing warrants at $15.00 per share.

  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. Weitz's present beneficial ownership of NovaStar
Financial is 49% which includes 1.5 million shares of common stock outstanding,
1.3 million of the 1996 Warrants and over 3.5 million shares of convertible
preferred stock. 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.

Conflict of Interest Policy

  On January 27, 1999, the Board of Directors of NovaStar Financial adopted a
conflict of interest policy which includes, among others, the following
provisions:

  If a director or officer has an interest that may conflict with those of
NovaStar Financial, he or she must immediately disclose the matters and discuss
them fully and frankly with the Board of Directors. An interested director or
officer may participate in the discussion of the transaction and his or her
presence may be counted for purposes of determining a quorum. However, he or
she must not vote on any resolution or motion that authorizes, approves or
ratifies a contract or transaction in which that director or officer may have a
conflict of interest.

  Specifically, no director or officer shall:

  . Accept or seek on behalf of himself/herself, or any immediate family
    member, any financial advantage or gain of other than nominal value
    offered as a result of the individual's affiliation with NovaStar
    Financial;

  . Disclose any confidential information that is available solely as a
    result of the director or officer's affiliation with NovaStar Financial
    to any person not authorized to receive such information, or use to the
    disadvantage of NovaStar Financial any such confidential information,
    without the express authorization of NovaStar Financial; or

  . Knowingly take any action or make any statement intended to influence the
    conduct of NovaStar Financial in such a way to confer any financial
    benefit on such person or on any corporation or entity in which the
    individual has a significant interest or affiliation.

                                       93
<PAGE>

                            SELLING SECURITYHOLDERS

  At the date of this prospectus, the number of shares of common stock,
preferred stock and warrants which may be offered pursuant to this prospectus
by the selling securityholders is as set forth below. In addition, at the date
of this prospectus, none of the underlying common stock is currently held by
the selling securityholders but may be issued to them pursuant to the
conversion of the preferred stock or the exercise of warrants, all of which
underlying common stock, to the extent acquired by such selling
securityholders, may be offered pursuant to this prospectus.

<TABLE>
<CAPTION>
                              Beneficial       Securities Covered by       Beneficial
                           Ownership Before      Shelf Registration      Ownership After
                               Offering              Statement              Offering
                          ------------------- ------------------------ -------------------
                                              No. Shares
                          No. Shares          Outstanding              No. Shares
                          Outstanding          Preferred  No. Warrants Outstanding
                            Common             or Common   or Common     Common
Name                         Stock    Percent  Stock(1)     Stock(1)      Stock    Percent
- ----                      ----------- ------- ----------- ------------ ----------- -------
<S>                       <C>         <C>     <C>         <C>          <C>         <C>
Wallace R. Weitz &
 Company (2)............   1,495,833    18.4   3,571,429         --     1,495,833    18.4
McCarthy Group, Inc.
 (3)....................     100,000     1.2     714,285         --       100,000     1.2
First Union Corporation
 (4)....................     186,667     2.3         --      350,000      186,667     2.3
GMAC/Residential Funding
 Corporation............         --      --          --    1,177,713          --      --
                           ---------   -----   ---------   ---------    ---------   -----
 Subtotal...............   1,782,500    21.9   4,285,714   1,527,713    1,782,500    21.9
 Shareholders not
  subject to this
  filing................   6,347,569    78.1         --          --     6,347,569    78.1
                           ---------   -----   ---------   ---------    ---------   -----
  Total.................   8,130,069   100.0   4,285,714   1,527,713    8,130,069   100.0
                           =========   =====   =========   =========    =========   =====
</TABLE>
- --------
(1) Reflects shares of common stock issuable to the holder upon the conversion
    of preferred stock or the exercise of warrants.
(2) Includes securities owned by funds managed by Wallace R. Weitz & Company,
    including Weitz Series Fund, Inc.--Value Portfolio, Weitz Series Fund,
    Inc.--Hickory Portfolio, Weitz Series Fund, Inc.--Partners Value Fund and
    Weitz Partners III--Limited Partnership.
(3) Includes securities owned by funds managed by McCarthy Group, Inc.,
    including Fulcrum Capital Partners, LLC and McCarthy Group Asset
    Management, Inc.
(4) Includes securities owned by First Union Corporation and its subsidiary,
    First Fidelity Incorporated.

                                       94
<PAGE>

                        FEDERAL INCOME TAX CONSEQUENCES

  The following discussion summarizes the material federal income tax
consequences that may be relevant to a prospective purchaser of securities.
This discussion is based on current law. The following discussion is not
exhaustive of all possible tax consequences. It does not give a detailed
discussion of any state, local or foreign tax consequences, nor does it discuss
all of the aspects of federal income taxation that may be relevant to a
prospective investor in light of such investor's particular circumstances or to
special classes of investors, including insurance companies, tax-exempt
entities, financial institutions, broker/dealers, foreign corporations and
persons who are not citizens or residents of the United States, subject to
particular treatment under federal income tax laws.

  Each prospective purchaser of the securities is urged to consult with his or
her own tax advisor regarding the specific consequences to him or her of the
purchase, ownership and sale of the securities, including the federal, state,
local, foreign and other tax consequences of such purchase, ownership and sale
and the potential changes in applicable tax laws.

General

  The Code provides special tax treatment for organizations that qualify and
elect to be taxed as REITs. The discussion below summarizes the material
provisions applicable to NovaStar Financial as a REIT for federal income tax
purposes and to its stockholders in connection with their ownership of shares
of stock of NovaStar Financial. However, it is impractical to set forth in this
prospectus all aspects of federal, state, local and foreign tax law that may
have tax consequences with respect to an investor's purchase of the common
stock. The discussion of various aspects of federal taxation contained herein
is based on the Code, administrative regulations, judicial decisions,
administrative rulings and practice, all of which are subject to change. In
brief, if detailed conditions imposed by the Code are met, entities that invest
primarily in real estate assets, including mortgage loans, and that otherwise
would be taxed as corporations are, with limited exceptions, not taxed at the
corporate level on their taxable income that is currently distributed to their
stockholders. This treatment eliminates most of the "double taxation", at the
corporate level and then again at the stockholder level when the income is
distributed, that typically results from the use of corporate investment
vehicles. A qualifying REIT, however, may be subject to certain excise and
other taxes, as well as normal corporate tax, on taxable income that is not
currently distributed to its stockholders.

  NovaStar Financial elected to be taxed as a REIT under the Code commencing
with its taxable year ended December 31, 1996.

Opinion of tax counsel

  Jeffers, Wilson, Shaff & Falk, LLP, tax and ERISA counsel to NovaStar
Financial, has advised NovaStar Financial in connection with the formation of
NovaStar Financial, the private placement, our initial public offering, this
offering and NovaStar Financial's election to be taxed as a REIT. Based on
existing law and factual representations made to tax counsel by NovaStar
Financial, tax counsel is of the opinion that NovaStar Financial, exclusive of
any taxable affiliates, operated in a manner consistent with its qualifying as
a REIT under the Code since the beginning of its taxable year ended December
31, 1996 through December 31, 1998, the date of the unaudited balance sheet and
income statement made available to tax counsel, and the organization and
contemplated method of operation of NovaStar Financial are such as to enable it
to continue to so qualify throughout the balance of 1998 and in subsequent
years. However, whether NovaStar Financial will in fact so qualify will depend
on actual operating results and compliance with the various tests for
qualification as a REIT relating to its income, assets, distributions,
ownership and administrative matters, the results of which may not be reviewed
by tax counsel. Moreover, some aspects of operations have not been considered
by the courts or the Internal Revenue Service. There can be no assurance that
the courts or the Internal Revenue Service will agree with this opinion. In
addition, qualification as a REIT depends on future transactions and events
that cannot be known at this time. In the opinion of tax counsel, this section
of the

                                       95
<PAGE>

prospectus identifies and fairly summarizes the federal income tax consequences
that are likely to be material to a holder of the common stock and to the
extent such summaries involve matters of law, such statements of law are
correct under the Code. Tax counsel's opinions are based on various assumptions
and on the factual representations of NovaStar Financial concerning its
business and assets.

  The opinions of tax counsel are also based upon existing law including the
Code, existing Treasury Regulations, Revenue Rulings, Revenue Procedures,
proposed regulations and case law, all of which is subject to change either
prospectively or retroactively. Moreover, relevant laws or other legal
authorities may change in a manner that could adversely affect NovaStar
Financial or its stockholders.

  In the event NovaStar Financial does not qualify as a REIT in any year, it
will be subject to federal income tax as a domestic corporation and its
stockholders will be taxed in the same manner as stockholders of ordinary
corporations. To the extent NovaStar Financial would, as a consequence, be
subject to potentially significant tax liabilities, the amount of earnings and
cash available for distribution to its stockholders would be reduced.

Qualification as a REIT

  To qualify for tax treatment as a REIT under the Code, NovaStar Financial
must meet certain tests which are described immediately below.

  Ownership of Stock. For all taxable years after the first taxable year for
which a REIT election is made, NovaStar Financial shares of stock must be
transferable and must be held by a minimum of 100 persons for at least 335 days
of a 12 month year or a proportionate part of a short tax year. Since the
closing of its private placement, NovaStar Financial has had more than 100
shareholders of record. NovaStar Financial must, and does, use the calendar
year as its taxable year. In addition, at all times during the second half of
each taxable year, no more than 50% in value of the shares of any class of the
stock of NovaStar Financial may be owned directly or indirectly by five or
fewer individuals. In determining whether NovaStar Financial shares are held by
five or fewer individuals, the attribution rules apply. NovaStar Financial's
charter imposes certain repurchase provisions and transfer restrictions to
avoid more than 50% by value of any class of stock being held by five or fewer
individuals, directly or constructively, at any time during the last half of
any taxable year. Such repurchase and transfer restrictions will not cause the
stock not to be treated as "transferable" for purposes of qualification as a
REIT. NovaStar Financial has satisfied and intends to continue satisfying both
the 100 stockholder and 50%/5 stockholder individual ownership limitations
described above for as long as it seeks qualification as a REIT.

  Nature of Assets. On the last day of each calendar quarter at least 75% of
the value of assets owned by NovaStar Financial must consist of qualified REIT
assets, government securities, cash and cash items, the "75% of assets test".
NovaStar Financial expects that substantially all of its assets, other than
qualified hedges and the preferred stock of NFI Holding, will be "qualified
REIT assets." Qualified REIT assets include interests in real property,
interests in mortgage loans secured by real property and interests in REMICs.
NovaStar Financial has complied with the 75% of assets test for each quarter
since inception of its REIT election. Qualified hedges generally are financial
instruments that a REIT enters into or acquires to protect against interest
rate risks on debt incurred to acquire qualified REIT assets.

  On the last day of each calendar quarter, of the investments in securities
not included in the 75% of assets test, the value of any one issuer's
securities may not exceed 5% by value of total assets and NovaStar Financial
may not own more than 10% of any one issuer's outstanding voting securities.
Pursuant to its compliance guidelines, NovaStar Financial intends to monitor
closely, on not less than a quarterly basis, the purchase and holding of assets
in order to comply with the above assets tests. In particular, as of the end of
each calendar quarter NovaStar Financial intends to limit and diversify its
ownership of securities of any taxable affiliate, hedging contracts and other
mortgage securities that do not constitute qualified REIT assets to less than
25%, in the aggregate, by value of its portfolio, to less than 5% by value as
to any single issuer, including the stock of

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any taxable affiliate, and to less than 10% of the voting stock of any single
issuer, collectively the "25% of assets limits". If such limits are ever
exceeded, NovaStar Financial intends to take appropriate remedial action to
dispose of such excess assets within the 30 day period after the end of the
calendar quarter, as permitted under the Code. As of December 31, 1998,
NovaStar Financial complied with the tests described in this paragraph.

  When purchasing mortgage-related securities, NovaStar Financial may rely on
opinions of counsel for the issuer or sponsor of such securities given in
connection with the offering of such securities, or statements made in related
offering documents, for purposes of determining whether and to what extent
those securities and the income therefrom constitute qualified REIT assets and
income for purposes of the 75% of assets test and the source of income tests.
If NovaStar Financial invests in a partnership, NovaStar Financial will be
treated as receiving its share of the income and loss of the partnership and
owning a proportionate share of the assets of the partnership and any income
from the partnership will retain the character that it had in the hands of the
partnership.

  Sources of Income. NovaStar Financial must meet two separate income-based
tests each year in order to qualify as a REIT.

  1. The 75% Test. At least 75% of gross income, the "75% of income test" for
the taxable year must be derived from the following sources among others:

  . interest on, other than interest based in whole or in part on the income
    or profits of any person, and commitment fees to enter into obligations
    secured by mortgages on real property;

  . gains from the sale or other disposition of interests in real property
    and real estate mortgages, other than gain from property held primarily
    for sale to customers in the ordinary course of business; and

  . income from the operation, and gain from the sale, of property acquired
    at or in lieu of a foreclosure of the mortgage secured by such property
    or as a result of a default under a lease of such property.

  The investments that NovaStar Financial intends to make will give rise
primarily to mortgage interest qualifying under the 75% of income test. As of
December 31, 1998, NovaStar Financial complied with the 75% income test on an
annualized basis.

  2. The 95% Test. In addition to deriving 75% of its gross income from the
sources listed above, at least an additional 20% of gross income for the
taxable year must be derived from those sources, or from dividends, interest or
gains from the sale or disposition of stock or other securities that are not
dealer property, the "95% of income test". Income attributable to assets other
than qualified REIT assets, such as income from or gain on the disposition of
qualified hedges, dividends on stock including any dividends from a taxable
affiliate, interest on any other obligations not secured by real property, and
gains from the sale or disposition of stock or other securities that are not
qualified REIT assets will constitute qualified income for purposes of the 95%
of income test only, and will not be qualified income for purposes of the 75%
of income test. Income from mortgage servicing, loan guarantee fees or other
contracts under which NovaStar Financial would earn fees for performing
services and hedging other than from qualified REIT assets will not qualify for
either the 95% or 75% of income tests. NovaStar Financial intends to severely
limit its acquisition of any assets or investments the income from which does
not qualify for purposes of the 95% of income test. Moreover, in order to help
ensure compliance with the 95% of income test and the 75% of income test,
NovaStar Financial intends to limit substantially all of the assets that it
acquires, other than the shares of the preferred stock of any taxable affiliate
and qualified hedges, to qualified REIT assets. The policy of NovaStar
Financial to maintain REIT status may limit the type of assets, including
hedging contracts, that NovaStar Financial otherwise might acquire. As of
December 31, 1998, NovaStar Financial complied with the 95% income test on an
annualized basis.

  For purposes of determining whether NovaStar Financial complies with the 75%
of income test and the 95% of income test detailed above, gross income does not
include gross income from "prohibited

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transactions." A "prohibited transaction" is one involving a sale of dealer
property, other than foreclosure property. Net income from "prohibited
transactions" is subject to a 100% tax.

  NovaStar Financial intends to maintain its REIT status by carefully
monitoring its income, including income from hedging transactions, futures
contracts and sales of Mortgage Assets to comply with the 75% of income test
and the 95% of income test. In order to help insure its compliance with the
REIT requirements of the Code, NovaStar Financial has adopted guidelines the
effect of which will be to limit its ability to earn certain types of income,
including income from hedging, other than hedging income from qualified REIT
assets and from qualified hedges.

  Failure to satisfy one or both of the 75% or 95% of income tests for any year
may result in either (a) a 100% tax on the greater of the amounts of income by
which it failed to comply with the 75% test of income or the 95% of income
test, reduced by estimated related expenses, assuming such failure was for
reasonable cause and not willful neglect, or (b) loss of REIT status. There can
be no assurance that NovaStar Financial will always be able to maintain
compliance with the gross income tests for REIT qualification despite periodic
monitoring procedures. Moreover, there is no assurance that the relief
provisions for a failure to satisfy either the 95% or the 75% of income tests
will be available in any particular circumstance.

  Distributions. NovaStar Financial must distribute to its stockholders on a
pro rata basis each year an amount equal to

  . 95% of its taxable income before deduction of dividends paid and
    excluding net capital gain, plus

  . 95% of the excess of the net income from foreclosure property over the
    tax imposed on such income by the Code, less

  . any "excess noncash income."

  NovaStar Financial intends to make distributions to its stockholders in
amounts sufficient to meet this 95% distribution requirement. Such
distributions must be made in the taxable year to which they relate or, if
declared before the timely filing of the tax return for such year and paid not
later than the first regular dividend payment after such declaration, in the
following taxable year. A nondeductible excise tax, equal to 4% of the excess
of such required distributions over the amounts actually distributed will be
imposed for each calendar year to the extent that dividends paid during the
year, or declared during the last quarter of the year and paid during January
of the succeeding year, are less than the sum of

  . 85% of NovaStar Financial's "ordinary income,"

  . 95% of NovaStar Financial's capital gain net income, and

  . income not distributed in earlier years.

  If NovaStar Financial fails to meet the 95% distribution test as a result of
an adjustment to tax returns by the Internal Revenue Service, NovaStar
Financial by following certain requirements set forth in the Code may pay a
deficiency dividend within a specified period which will be permitted as a
deduction in the taxable year to which the adjustment is made. NovaStar
Financial would be liable for interest based on the amount of the deficiency
dividend. A deficiency dividend is not permitted if the deficiency is due to
fraud with intent to evade tax or to a willful failure to file a timely tax
return. NovaStar Financial generally distributes dividends equal to 100% of its
taxable income to eliminate corporate level tax.

Taxation of NovaStar Financial

  In any year in which NovaStar Financial qualifies as a REIT, it generally
will not be subject to federal income tax on that portion of its taxable income
or net capital gain which is distributed to its stockholders. NovaStar
Financial will, however, be subject to tax at normal corporate rates upon any
net income or net capital gain not distributed. NovaStar Financial intends to
distribute substantially all of its taxable income to its stockholders on a pro
rata basis in each year.

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  In addition, NovaStar Financial will also be subject to a tax of 100% of net
income from any prohibited transaction and will be subject to a 100% tax on the
greater of the amount by which it fails either the 75% or 95% of income tests,
reduced by approximated expenses, if the failure to satisfy such tests is due
to reasonable cause and not willful neglect and if certain other requirements
are met. NovaStar Financial may be subject to the alternative minimum tax on
certain items of tax preference.

  If NovaStar Financial acquires any real property as a result of foreclosure,
or by a deed in lieu of foreclosure, it may elect to treat such real property
as foreclosure property. Net income from the sale of foreclosure property is
taxable at the maximum federal corporate rate, currently 35%. Income from
foreclosure property will not be subject to the 100% tax on prohibited
transactions. NovaStar Financial will determine whether to treat such real
property as foreclosure property on the tax return for the fiscal year in which
such property is acquired. NovaStar Financial expects to so elect.

  NovaStar Financial securitizes mortgage loans and sells such mortgage loans
through one or more taxable affiliates. However, if NovaStar Financial itself
were to sell such mortgage assets on a regular basis, there is a substantial
risk that it would be deemed "dealer property" and that all of the profits from
such sales would be subject to tax at the rate of 100% as income from
prohibited transactions. Such taxable affiliate will not be subject to this
100% tax on income from prohibited transactions, which is only applicable to
REITs.

  NovaStar Financial will also be subject to the nondeductible four percent
excise tax discussed above if it fails to make timely dividend distributions
for each calendar year. NovaStar Financial generally will declare its fourth
regular annual dividend during the final quarter of the year and make such
dividend distribution no later than thirty-one (31) days after the end of the
year in order to avoid imposition of the excise tax. Such a distribution would
be taxed to the stockholders in the year that the distribution was declared,
not in the year paid. Imposition of the excise tax on NovaStar Financial would
reduce the amount of cash available for distribution to stockholders.

  As a publicly held corporation, NovaStar Financial will not be allowed a
deduction for applicable employee remuneration with respect to any covered
employee in excess of $1 million per year. The million dollar limit on
deductibility is subject to certain exceptions, including the exception for
"performance based compensation" meeting each of the following criteria:

  . the agreement must have been approved by the corporation's stockholders;

  . the agreement must have been approved by a compensation committee
    consisting solely of two or more non-employee directors of the
    corporation; and

  . the performance based compensation payable to the employee must be based
    on objective performance criteria and the meeting of these criteria must
    have been certified by the compensation committee.

  Based on certain representations of NovaStar Financial, counsel is of the
opinion that it is more likely than not that the deduction for compensation to
the officers under the agreements would not be disallowed under the million
dollar limit.

Taxation of Taxable Affiliates

  NovaStar Financial has caused, and will continue to cause, the creation and
sale of mortgage assets or conduct certain hedging activities through one or
more taxable affiliates. To date, NovaStar Financial has caused the formation
of NFI Holding and NovaStar Mortgage, the wholly owned subsidiary of NFI
Holding. NovaStar Financial owns all of the preferred stock issued by NFI
Holding. The common stock is the sole class of voting stock of NFI Holding,
although NovaStar Financial would be entitled to vote on any matter that could
adversely affect the rights of its preferred stock in NFI Holding. The assets
of NFI Holding consist of the issued capital stock of NovaStar Mortgage and a
nominal amount of cash.


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  In order to ensure that NovaStar Financial will not violate the prohibition
on ownership of more than 10% of the voting stock of a single issuer and the
prohibition on investing more than 5% of the value of its assets in the stock
or securities of a single issuer, NovaStar Financial will primarily own only
shares of nonvoting preferred stock of NFI Holding and will not own any of the
NFI Holding's common stock. NovaStar Financial will monitor the value of its
investment in NFI Holding on a quarterly basis to limit the risk of violating
any of the tests that comprise the 25% of assets limits. In addition, the
dividends that NFI Holding pays to NovaStar Financial will not qualify as
income from qualified REIT assets for purposes of the 75% of income test, and
in all events would have to be limited, along with other interest, dividends,
gains on the sale of securities, hedging income, and other income not derived
from qualified REIT assets to less than 25% of gross revenues in each year. NFI
Holding will not elect REIT status, will be subject to income taxation on its
net earnings and will generally be able to distribute only its net earnings to
its stockholders, including NovaStar Financial, as dividend distributions. If
NFI Holding creates a taxable mortgage pool, such pool itself will constitute a
separate taxable subsidiary of NFI Holding. NFI Holding would be unable to
offset the income derived from such a taxable mortgage pool with losses derived
from any other activities.

Termination or Revocation of REIT Status

  The election to be treated as a REIT will be terminated automatically if
NovaStar Financial fails to meet the requirements described above. In that
event, NovaStar Financial will not be eligible again to elect REIT status until
the fifth taxable year which begins after the year for which the election was
terminated unless all of the following relief provisions apply:

  . NovaStar Financial did not willfully fail to file a timely return with
    respect to the termination taxable year;

  . inclusion of incorrect information in such return was not due to fraud
    with intent to evade tax; and

  . NovaStar Financial establishes that failure to meet requirements was due
    to reasonable cause and not willful neglect.

  NovaStar Financial may also voluntarily revoke its election, although it has
no intention of doing so, in which event NovaStar Financial will be prohibited,
without exception, from electing REIT status for the year to which the
revocation relates and the following four taxable years.

  Failure to qualify for taxation as a REIT in any taxable year, and the relief
provisions do not apply, NovaStar Financial would be subject to tax, including
any applicable alternative minimum tax, on its taxable income at regular
corporate rates. Distributions to stockholders with respect to any year in
which NovaStar Financial fails to qualify as a REIT would not be deductible by
NovaStar Financial nor would they be required to be made. Failure to qualify as
a REIT would result in a reduction of its distributions to stockholders in
order to pay the resulting taxes. If, after forfeiting REIT status, NovaStar
Financial later qualifies and elects to be taxed as a REIT again, NovaStar
Financial could face significant adverse tax consequences.

Taxation of the Company's Stockholders

  General. For any taxable year in which NovaStar Financial is treated as a
REIT for federal income purposes, amounts distributed by NovaStar Financial to
its stockholders out of current or accumulated earnings and profits will be
includible by the stockholders as ordinary income for federal income tax
purposes unless properly designated by NovaStar Financial as capital gain
dividends. In the latter case, the distributions will be taxable to the
stockholders as long-term capital gains.

  Distributions will not be eligible for the dividends received deduction
available for non-REIT corporations. Stockholders may not deduct any net
operating losses or capital losses of NovaStar Financial.

  Any loss on the sale or exchange of shares of the stock held by a stockholder
for six months or less will be treated as a long-term capital loss to the
extent of any capital gain dividend received on the stock held by such
stockholders.

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  If NovaStar Financial makes distributions to its stockholders in excess of
its current and accumulated earnings and profits, those distributions will be
considered first a tax-free return of capital, reducing the tax basis of a
stockholder's shares until the tax basis is zero. Such distributions in excess
of the tax basis will be taxable as gain realized from the sale of shares.

  NovaStar Financial, exclusive of its taxable affiliates, does not expect to
acquire or retain residual interests issued by REMICs. Such residual interests,
if acquired by a REIT, would generate excess inclusion income to shareholders
of the REIT. Excess inclusion income cannot be offset by net operating losses
of a stockholder. If the stockholder is a tax-exempt entity, the excess
inclusion income is fully taxable as unrelated trade or business income as
defined in Section 512 of the Code. If allocated to a foreign stockholder, the
excess inclusion income is subject to Federal income tax withholding without
reduction pursuant to any otherwise applicable tax treaty. Excess inclusion
income realized by a taxable affiliate is not passed through to stockholders.
Potential investors, and in particular tax exempt entities, are urged to
consult with their tax advisors concerning this issue.

  NovaStar Financial will notify stockholders after the close of the taxable
year as to the portions of the distributions which constitute ordinary income,
return of capital and capital gain. Dividends and distributions declared in the
last quarter of any year payable to stockholders of record on a specified date
in such month will be deemed to have been received by the stockholders and paid
on December 31 of the record year, provided that such dividends are paid before
February 1 of the following year.

Redemption and Conversion of Preferred Stock

  Cash Redemption of Preferred Stock. A cash redemption of shares of the
preferred stock will be treated under section 302 of the Code as a distribution
taxable as a dividend, to the extent of NovaStar's current and accumulated
earnings and profits, at ordinary income rates unless the redemption satisfies
one of the tests set forth in the Code for treatment as a sale or exchange of
the redeemed shares. The cash redemption will be treated as a sale or exchange
if it (1) is "substantially disproportionate" with respect to the holder, (2)
results in a "complete termination" of the holder's stock interest in NovaStar,
or (3) is "not essentially equivalent to a dividend" with respect to the
holder. In determining whether any of these tests have been met, shares of
capital stock, including common stock and other equity interests in NovaStar,
considered to be owned by the holder by reason of certain constructive
ownership rules set forth in the Code, as well as shares of capital stock
actually owned by the holder, must generally be taken into account. In general,
a non-prorata redemption of preferred stock from a shareholder who owns only
preferred stock is treated as a sale or exchange and not a dividend.
Nevertheless, because the determination as to whether any of the alternative
tests for capital gain treatment as a redemption will be satisfied with respect
to any particular holder of the preferred stock depends upon the facts and
circumstances at the time that the determination must be made, prospective
holders of the preferred stock are advised to consult their own tax advisors to
determine such tax treatment.

  If a cash redemption of shares of the preferred stock is not treated as a
distribution taxable as a dividend to a particular holder, it will be treated,
as to that holder, as a taxable sale or exchange. As a result, such holder will
recognize gain or loss for federal income tax purposes in an amount equal to
the difference between (1) the amount of cash and the fair market value of any
property received, less any portion thereof attributable to accumulated and
declared but unpaid dividends, which will be able as a dividend to the extent
of NovaStar's current and accumulated earnings and profits, and (2) the
holder's adjusted basis in the shares of the preferred stock for tax purposes.
Such gain or loss will be capital gain or loss if the shares of the preferred
stock have been held as a capital asset, and will be long-term gain or loss if
such shares have been held for more than one year.

  If a redemption of shares of the preferred stock is treated as a distribution
taxable as a dividend, the amount of the distribution will be measured by the
amount of cash and the fair market value of any property received by the
holder. The holder's adjusted basis in the redeemed shares of the preferred
stock for tax purposes will be transferred to the holder's remaining shares of
capital stock in NovaStar, if any. A redemption of shares of the preferred
stock for shares of common stock will be treated as a conversion of the
preferred stock into common stock.

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  Conversion of Preferred Stock into Common Stock. In general, no gain or loss
will be recognized for federal income tax purposes upon conversion of the
preferred stock solely into shares of common stock. The basis that a holder
will have for tax purposes in the shares of common stock received upon
conversion will be equal to the adjusted basis for the holder in the shares of
preferred stock so converted, and provided that the shares of preferred stock
were held as a capital asset, the holding period for the shares of common stock
received would include the holding period for the shares of preferred stock
converted. A holder will, however, generally recognize gain or loss on the
receipt of cash in lieu of fractional shares of common stock in an amount equal
to the difference between the amount of cash received and the holder's adjusted
basis for tax purposes in the preferred stock for which cash was received.
Furthermore, under certain circumstances, a holder of shares of preferred stock
may recognize gain or dividend income to the extent that there are dividends in
arrears on the shares at the time of conversion into common stock.

  Adjustments to Conversion Price. Adjustments in the conversion price, or the
failure to make such adjustments, pursuant to the anti-dilution provisions of
the preferred stock or otherwise may result in constructive distributions to
the holders of preferred stock that could, under certain circumstances, be
taxable to them as dividends pursuant to section 305 of the Code, If such a
constructive distribution were to occur, a holder of preferred stock could be
required to recognize ordinary income for tax purposes without receiving a
corresponding distribution of cash.

Warrants

  Upon the exercise of a warrant, a holder will not recognize gain or loss and
will have a tax basis in the common stock received equal to the tax basis in
such holder's warrant plus the exercise price of the warrant. The holding
period for the common stock purchased pursuant to the exercise of a warrant
will begin on the day following the date of exercise and will not include the
period that the holder held the warrant.

  Upon a sale or other disposition of a warrant, a holder will recognize
capital gain or loss in an amount equal to the difference between the amount
realized and the holder's tax basis in the warrant. Such a gain or loss will be
long-term if the holding period is more than one year. In the event that a
warrant lapses unexercised, a holder will recognize a capital loss in an amount
equal to his tax basis in the warrant. Such loss will be long-term if the
warrant has been held for more than one year.

Taxation of Tax-Exempt Entities

  In general, a tax-exempt entity that is a stockholder of NovaStar Financial
is not subject to tax on distributions. The Internal Revenue Service has ruled
that amounts distributed by a REIT to an exempt employees' pension trust do not
constitute unrelated trade or business income and thus should be nontaxable to
such a tax-exempt entity. Tax counsel is of the opinion that indebtedness
incurred by NovaStar Financial in connection with the acquisition of real
estate assets such as mortgage loans will not cause dividends paid to a
stockholder that is a tax-exempt entity to be unrelated trade or business
income, provided that the tax-exempt entity has not financed the acquisition of
its stock with "acquisition indebtedness" within the meaning of the Code. Under
some conditions, if a tax-exempt employee pension or profit sharing trust were
to acquire more than 10% of the stock of NovaStar Financial, a portion of the
dividends on such stock could be treated as unrelated trade or business income.

  For social clubs, voluntary employee benefit associations, supplemental
unemployment benefit trusts, and qualified group legal services plans exempt
from federal income taxation under Code Sections 501(c)(7), (c)(9), (c)(17) and
(c)(20), respectively, income from an investment in NovaStar Financial will
constitute unrelated trade or business income unless the organization is able
to properly deduct amounts set aside or placed in reserve for certain purposes
so as to offset the unrelated trade or business income generated by its
investment. Such entities should review Code Section 512(a)(3) and should
consult their own tax advisors concerning these "set aside" and reserve
requirements.

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Foreign Investors

  The preceding discussion does not address the federal income tax consequences
to foreign investors, non-resident aliens and foreign corporations as defined
in the Code, of an investment in NovaStar Financial. In general, foreign
investors will be subject to special withholding tax requirements on income and
capital gains distributions attributable to their ownership of NovaStar
Financial stock. Foreign investors should consult their own tax advisors
concerning the federal income tax consequences to them of a purchase of shares
of NovaStar Financial stock including the federal income tax treatment of
dispositions of interests in, and the receipt of distributions from, REITs by
foreign investors. In addition, federal income taxes must be withheld on
certain distributions by a REIT to foreign investors unless reduced or
eliminated by an income tax treaty between the United States and the foreign
investor's country. A foreign investor eligible for reduction or elimination of
withholding must file an appropriate form with NovaStar Financial in order to
claim such treatment.

Recordkeeping Requirement

  A REIT is required to maintain records regarding the actual and constructive
ownership of its shares, and other information, and within 30 days after the
end of its taxable year, to demand statements from persons owning above a
specified level of the REIT's shares, e.g., if NovaStar Financial has over 200
but fewer than 2,000 stockholders of record, from persons holding 1% or more of
outstanding shares of stock and if NovaStar Financial has 200 or fewer
stockholders of record, from persons holding 1/2% or more of the stock,
regarding their ownership of shares. NovaStar Financial must maintain, as part
of its records, a list of those persons failing or refusing to comply with this
demand. Stockholders who fail or refuse to comply with the demand must submit a
statement with their tax returns setting forth the actual stock ownership and
other information. NovaStar Financial maintains the records and demand
statements as required by these regulations.

Backup Withholding

  The Code imposes a modified form of "backup withholding" for payments of
interest and dividends. This withholding applies only if a stockholder, among
other things,

  . fails to furnish NovaStar Financial with a properly certified taxpayer
    identification number;

  . fails properly to report interest or dividends from any source; or

  . under certain circumstances fails to provide NovaStar Financial or the
    stockholder's securities broker with a certified statement, under penalty
    of perjury, that he or she is not subject to backup withholding.

  The backup withholding rate is 31% of "reportable payments," which include
dividends. Stockholders should consult their tax advisors as to the procedure
for insuring that distributions to them will not be subject to backup
withholding.

  NovaStar Financial will report to its stockholders and the Internal Revenue
Service the amount of dividends paid during each calendar year and the amount
of tax withheld, if any.

State and Local Taxes

  State and local tax laws may not correspond to the federal income tax
principles discussed in this section. Accordingly, prospective stockholders
should consult their tax advisers concerning the state and local tax
consequences of an investment in NovaStar Financial's stock.

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ERISA Investors

  A fiduciary of a pension, profit-sharing plan, stock bonus plan or individual
retirement account, including a plan for self-employed individuals and their
employees or any other employee benefit plan subject to the prohibited
transaction provisions of the Code or the fiduciary responsibility provisions
of the Employee Retirement Income Security Act of 1974, commonly called
"ERISA," should consider

  . whether the ownership of NovaStar Financial's stock is in accordance with
    the documents and instruments governing the plan;

  . whether the ownership of NovaStar Financial's stock is consistent with
    the fiduciary's responsibilities and satisfies the requirements of Part 4
    of Subtitle A of Title I of ERISA, if applicable, and, in particular, the
    diversification, prudence and liquidity requirements of Section 404 of
    ERISA;

  . the prohibitions under ERISA on improper delegation of control over, or
    responsibility for, "plan assets" and ERISA's imposition of co-fiduciary
    liability on a fiduciary who participates in, or permits, by action or
    inaction, the occurrence of, or fails to remedy, a known breach of duty
    by another fiduciary with respect to plan assets; and

  . the need to value the assets of the plan annually.

  As to the "plan assets" issue noted in the third bullet point above in
connection with the Class B preferred stock, the responsibility for "plan
assets," in the case of a plan's investment in an equity interest of an entity,
such as the preferred stock, which is a class of securities that are not
publicly-offered securities, the plan's assets include both the equity interest
and an undividend interest in each of the underlying assets of the entity,
unless it is established that, in the context of NovaStar Financial, that
equity participation in the preferred stock by plan investors is not
"significant." Equity participation is not "significant" if the aggregate
ownership by plans of any class of equity interests issued by NovaStar
Financial is at all times less than 25%. NovaStar Financial has represented
that it will not permit any of its Class B preferred stock to be sold to a plan
if such sale would cause ownership by plans of such class of preferred stock to
equal or exceed 25% until such time as such class of preferred stock is, in the
opinion of tax counsel, a publicly offered security under ERISA. NovaStar
Financial will use reasonable efforts to maintain the ownership interest in the
preferred stock held by plan investors at a level below the 25% limit. NovaStar
Financial will be able to reject a potential investor that would cause
aggregate ownership by plans to equal or exceed 25% of any class of stock that
is not a publicly-offered security, excluding from such class any shares held
by certain affiliates of NovaStar. Based on such representations, tax and ERISA
counsel believes that NovaStar Financial's Class B preferred stock, and not the
underlying assets of NovaStar Financial, will be considered the assets of a
plan investing in the Class B preferred stock of NovaStar Financial.

  Based on certain representations of NovaStar Financial, tax and ERISA counsel
is of the opinion that the common stock will qualify as "publicly offered
securities" within the meaning of the regulations defining "plan assets" and
therefore, in most circumstances, the common stock, and not the underlying
assets of NovaStar Financial, will be considered the assets of a plan investing
in the common stock.

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                          DESCRIPTION OF CAPITAL STOCK

General

  Our authorized capital stock will consist of 46,450,000 shares of common
stock, of which 12,430,069 shares will be outstanding, and 3,550,000 shares of
unclassified capital stock, none of which will be outstanding.

Historical Capital Structure

  Our authorized capital stock consists of 50,000,000 shares of capital stock,
$0.01 par value. These shares of capital stock were initially classified as
common stock. Our charter authorizes the Board of Directors to reclassify any
of the unissued shares of authorized capital stock into other classes or series
of capital stock, including classes or series of preferred stock. On December
6, 1996, we supplemented our charter to divide and classify 3,550,000 shares of
our capital stock into a class of preferred stock. The Class A preferred stock
had the rights and privileges of, and was subject to the conditions and terms
set forth in, articles supplementary. On December 9, 1996, we issued (1)
3,333,333 shares of preferred stock as part of the units sold in our private
placement, each unit consisting of one share of preferred stock and one
warrant; and (2) 216,666 shares of preferred stock as part of the units
acquired by the founders with forgivable debt. Effective on the closing of our
initial public offering in December 1997, such shares of outstanding Class A
preferred stock automatically converted to common stock. Shares of the
preferred stock which we received upon the conversion and all remaining
authorized shares of preferred stock were restored to the status of authorized
but unissued shares of capital stock, without designation as to class.

Preferred Stock

  On March 24, 1999, articles supplementary were filed to divide and classify
4,300,000 shares of our capital stock into shares of the Class B preferred
stock. Additional preferred stock may be issued from time to time in one or
more classes or series, with such distinctive designations, rights and
preferences as shall be determined by the Board of Directors. Additional
preferred stock would be available for possible future financing of, or
acquisitions by, NovaStar Financial and for general corporate purposes without
any legal requirement that further stockholder authorization for issuance be
obtained. The issuance of preferred stock could have the effect of making more
difficult any attempt to gain control of NovaStar Financial by means of a
merger, tender offer, proxy contest or otherwise. Additional preferred stock,
if issued, could have a preference on dividend payments. This would affect our
ability to make dividend distributions to the holders of our common stock or
our Class B preferred stock.

  The rights and preferences of the Class B 7% Cumulative Convertible Preferred
Stock, including the priority of cumulative dividends, conversion rights,
liquidation preference, redemption options, voting rights and ranking, as set
forth in articles supplementary are as follows:

  Dividends. The holders of Class B preferred stock shall be entitled to
receive, when and as declared by the Board of Directors out of funds legally
available for that purpose, cumulative dividends payable in cash in an amount
per share equal to the greater of (1) the base dividend of $0.1225 per quarter
or (2) the cash dividends declared on the number of shares of common stock, or
portion thereof, into which a share of preferred stock is convertible.
Dividends are payable, with respect to each calendar quarter in arrears on the
same basis as the common stock on the following January 10, May 10, August 10
and November 10 of each year, commencing May 10, 1999. Holders of preferred
stock shall not be entitled to any dividends, whether payable in cash, property
or stock, in excess of cumulative dividends, as herein provided, on the
preferred stock. No interest, or sum of money in lieu of interest, shall be
payable in respect of any dividend payment or payments on the preferred stock
that may be in arrears. No dividends will be paid or set apart for payment on
shares of common stock unless full cumulative dividends have been paid on the
preferred stock.

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  Conversion. Holders of shares of preferred stock shall have the right to
convert all or a portion of such shares into shares of common stock, at such
holder's option, at any time, in whole or in part, into the number of fully
paid and non-assessable shares of authorized but previously unissued shares of
common stock per each share of preferred stock obtained by dividing the
liquidation preference, excluding any accumulated, accrued and unpaid
dividends, per share by the conversion price, by surrendering such shares to be
converted; provided, however, that the right to convert shares of preferred
stock called for redemption shall terminate at the close of business on the
call date fixed for redemption, unless NovaStar Financial shall default in
making payment of cash upon such redemption. Holders of shares of preferred
stock at the close of business on a dividend payment record date shall be
entitled to receive the dividend payable on such shares on the corresponding
dividend payment date notwithstanding the conversion thereof following such
dividend payment record date and prior to such dividend payment date. Except as
provided above, NovaStar Financial shall make no payment or allowance for
unpaid dividends, whether or not in arrears, on converted shares or for
dividends on the shares of common stock issued upon such conversion. Each
conversion shall be deemed to have been effected immediately prior to the close
of business on the date on which the certificates for shares of preferred stock
shall have been surrendered and such notice received by NovaStar Financial. If
more than one share shall be surrendered for conversion at one time by the same
holder, the number of full shares of common stock issuable upon conversion
thereof shall be computed on the basis of the aggregate number of shares of
preferred stock so surrendered. The conversion price shall be adjusted from
time to time if NovaStar:

  . shall after the issue date pay a dividend or make a distribution on its
    capital stock in shares of common stock, subdivide its outstanding common
    stock into a greater number of shares; combine its outstanding common
    stock into a smaller number of shares or issue any shares of capital
    stock by reclassification of its outstanding common stock;

  . shall issue after the issue date rights, options or warrants to all
    holders of common stock entitling them, for a period expiring within 45
    days after the record date, to subscribe for or purchase common stock at
    a price per share less than the fair market value per share of the common
    stock on the record date for the determination of stockholders entitled
    to receive such rights, options or warrants;

  . shall after the issue date make a distribution on its common stock other
    than in cash or shares of common stock, including any distribution in
    securities other than rights, options or warrants.

  No adjustment in the conversion price shall generally be required unless such
adjustment would require a cumulative increase or decrease of at least 1% in
such price.

  If NovaStar Financial shall be a party to any transaction, including without
limitation a merger, consolidation, statutory share exchange, issuer or self
tender offer for all or a substantial portion of the shares of common stock
outstanding, sale of all or substantially all of NovaStar Financial's assets or
recapitalization of the common stock, in each case as a result of which shares
of common stock shall be converted into the right to receive stock, securities
or other property, including cash or any combination thereof, each share of
preferred stock which is not converted into the right to receive stock,
securities or other property in connection with such transaction shall
thereupon be convertible into the kind and amount of shares of stock,
securities and other property, including cash or any combination thereof,
receivable upon such consummation by a holder of that number of shares of
common stock into which one share of preferred stock was convertible
immediately prior to such transaction.

  There shall be no adjustment of the conversion price in case of the issuance
of any capital stock of NovaStar Financial in a reorganization, acquisition or
other similar transaction except as specifically set forth in this section. If
NovaStar Financial shall take any action affecting the common stock, other than
action described in this section, that in the opinion of the Board of Directors
would materially adversely affect the conversion rights of the holders of
preferred stock, the conversion price for the preferred stock may be adjusted,
to the extent permitted by law, in such manner, if any, and at such time as the
Board of Directors, in its sole discretion, may determine to be equitable under
the circumstances. NovaStar Financial covenants that any shares of common stock
issued upon conversion of the shares of preferred stock shall be validly
issued,

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fully paid and nonassessable. NovaStar Financial shall use its best efforts to
list the shares of common stock required to be delivered upon conversion of the
shares of preferred stock, prior to such delivery, upon each national
securities exchange, if any, upon which the outstanding shares of common stock
are listed at the time of such delivery.

  Liquidation Preference. In the event of any liquidation, dissolution or
winding up of NovaStar Financial, whether voluntary or involuntary, before any
payment or distribution of NovaStar Financial, whether capital or surplus,
shall be made to or set apart for the holders of junior stock, the holders of
shares Class B Preferred Stock shall be entitled to receive $7.00 per share,
plus an amount equal to all dividends, whether or not earned or declared,
accumulated, accrued and unpaid thereon to the date of final distribution to
such holders; but such holders shall not be entitled to any further payment.
Until the holders of the preferred stock have been paid in full, plus an amount
equal to all dividends, whether or not earned or declared, accumulated, accrued
and unpaid thereon to the date of final distribution to such holders, no
payment will be made to any holder of junior stock upon the liquidation,
dissolution or winding up of NovaStar Financial. If, upon any liquidation,
dissolution or winding up of NovaStar Financial, the assets of NovaStar
Financial, or proceeds thereof, distributable among the holders of preferred
stock and any class or series of parity stock shall be insufficient to pay in
full the preferential amount aforesaid and liquidating payments on any other
shares of any class or series of parity stock, then such assets, or the
proceeds thereof, shall be distributed among the holders of preferred stock and
any such other parity stock ratably in the same proportion as the respective
amounts that would be payable on such preferred stock and any such other parity
stock if all amounts payable thereon were paid in full.

  Redemption at the Option of NovaStar Financial. Shares of Class B Preferred
Stock shall not be redeemable by NovaStar Financial prior to March 31, 2002.
The shares may be redeemed, in whole or in part, at the option of NovaStar
Financial at any time on or after March 31, 2002 out of funds legally available
therefor at a redemption price payable in cash equal to $7.00 per share, plus
all accumulated, accrued and unpaid dividends as provided below. NovaStar
Financial shall pay in cash all cumulative, accrued and unpaid dividends for
all dividend periods ending prior to the dividend period in which the
redemption occurs, plus the dividend, determined by reference to the base rate
if the call date precedes the date on which the dividend on the common stock is
declared for such dividend period, accrued from the beginning of the dividend
period in which the redemption occurs and ending on the call date; provided,
however, that if such call date is on or after the record date for such
dividend period, each holder of preferred stock at the close of business on
such dividend record date shall be entitled to the dividend payable on such
shares on the corresponding dividend payment date notwithstanding the
redemption of such shares prior to such dividend payment date. Except as
provided above, NovaStar Financial shall make no payment or allowance for
accumulated or accrued dividends on shares of preferred stock called for
redemption or on the shares of common stock issued upon such redemption. The
call date shall be selected by NovaStar Financial, shall be specified in the
notice of redemption and shall be not less than 30 days nor more than 60 days
after the date notice of redemption is sent by NovaStar Financial.

  Stock To Be Retired. All shares of Class B Preferred Stock which shall have
been issued and reacquired in any manner by NovaStar Financial shall be
restored to the status of authorized, but unissued shares of common stock, par
value $.01 per share. NovaStar Financial may also retire any unissued shares of
preferred stock, and such shares shall then be restored to the status of
authorized but unissued shares of common stock, par value $.01 per share.

  Ranking. Any class or series of capital stock of NovaStar Financial shall be
deemed to rank:

  . prior or senior to the preferred stock, as to the payment of dividends
    and as to distribution of assets upon liquidation, dissolution or winding
    up, if the holders of such class or series shall be entitled to the
    receipt of dividends or of amounts distributable upon liquidation,
    dissolution or winding up, as the case may be, in preference or priority
    to the holders of preferred stock;

  . on a parity with the preferred stock, as to the payment of dividends and
    as to distribution of assets upon liquidation, dissolution or winding up,
    whether or not the dividend rates, dividend payment dates or

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    redemption or liquidation prices per share thereof be different from
    those of the preferred stock, if the holders of such class of stock or
    series and the preferred stock shall be entitled to the receipt of
    dividends and of amounts distributable upon liquidation, dissolution or
    winding up in proportion to their respective amounts of accrued and
    unpaid dividends per share or liquidation preferences, without preference
    or priority one over the other or parity stock; and

  . junior to the preferred stock, as to the payment of dividends or as to
    the distribution of assets upon liquidation, dissolution or winding up,
    if such stock or series shall be common stock or if the holders of
    preferred stock shall be entitled to receipt of dividends or of amounts
    distributable upon liquidation, dissolution or winding up, as the case
    may be, in preference or priority to the holders of shares of such class
    or series or junior stock.

  Voting. Except as otherwise expressly required by applicable law or NovaStar
Financial's Articles of Incorporation or as described below, the holders of
the preferred stock will not be entitled to vote on any matter and will not be
entitled to notice of any meeting of shareholders of NovaStar Financial. If at
any time NovaStar Financial falls in arrears in the payment of dividends on
the preferred stock in an aggregate amount equal to the full accrued dividends
for six quarterly dividend periods, or upon failure of NovaStar Financial to
maintain consolidated shareholders' equity, determined in accordance with
generally accepted accounting principles and giving any effect to any
adjustment for the net unrealized gain or loss on assets available for sale,
of at least 150 % of the sum of (a) the aggregate issue price of the then
outstanding preferred stock and (b) the aggregate original issue price of any
then outstanding parity stock, as defined below, the number of NovaStar
Financial's directors will be increased, if not already increased by reason of
similar types of provisions with respect to any parity stock, by two and the
holders of the preferred stock, together with holders of all classes of parity
stock, voting together as a single class, will have the right to elect two
directors to fill the positions created, and such right will continue until
all dividends in arrears shall have been paid, or such shareholders' equity
has been restored to at least 150% of the sum of (a) the aggregate issue price
of the then outstanding preferred stock and (b) the aggregate original issue
price of any then outstanding parity stock, as the case may be. If any other
class of parity stock with which the preferred is entitled to vote as a single
class is entitled to elect two directors as a result of a failure to maintain
a specified level of consolidated shareholders' equity, then, when such
entitlement to vote is triggered, the separate entitlement of the preferred
stock to vote for directors described in this paragraph shall be suspended.

  For purposes of the foregoing provisions and all other voting rights, each
share of preferred stock shall have one (1) vote per share, except that when
any class or series of parity stock shall have the right to vote with the
preferred stock as a single class on any matter, then the preferred stock and
such other class or series shall have with respect to such matters one (1)
vote per $7.00 of stated liquidation preference. Except as otherwise required
by applicable law or as set forth in this prospectus, the preferred stock
shall not have any relative, participating, optional or other special voting
rights and powers other than as set forth in this prospectus, and the consent
of the holders thereof shall not be required for the taking of any corporate
action.

Common Stock

  The following summary of the rights of the common stock is qualified in its
entirety by reference to our charter. A copy of our charter has been filed
with the SEC as an exhibit to the shelf registration statement of which this
prospectus is a part.

  Voting. Each holder of common stock is entitled to one vote for each share
of record on each matter submitted to a vote of holders of our capital stock.
Our charter does not provide for cumulative voting. Accordingly, the holders
of a majority of the outstanding shares of capital stock have the power to
elect all directors to be elected each year.

  We hold annual meetings of our stockholders. Special meetings may be called
by any member of the Board of Directors, by the President or generally by
stockholders holding at least 20% of the outstanding shares

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of capital stock entitled to be voted at the meeting. Our charter may be
amended in accordance with Maryland law, subject to limitations set forth in
the charter.

  Dividends; Liquidation; Other Rights. The holders of shares of our common
stock are entitled to receive dividends when, as, and if declared by the Board
of Directors out of funds that are legally available, subject to the rights of
the holders of the preferred stock or any other class or series of preferred
stock that may be issued in the future. In the event of liquidation,
dissolution or winding up of NovaStar Financial, the holders of our common
stock will share ratably in all the assets of NovaStar Financial remaining
after the payment of liabilities and after payment of the liquidation
preference of any shares, classes or series of preferred stock that may be
issued and outstanding. There are no preemptive or other subscription rights,
conversion rights or redemption or sinking fund provisions with respect to
shares of common stock. The common stock is nonassessable.

Registration Rights

  Each purchaser of units in our 1996 private placement is entitled to rights
with respect to registration under the Securities Act. With respect to the
shares of our common stock into which the shares of our Class A preferred stock
have been converted, the 1996 warrants and the shares of underlying common
stock, there is a registration rights agreement. In accordance with the 1996
registration rights agreement, we have filed with the Commission, within six
months after the closing of our initial public offering, and then used our best
efforts to effectuate, a shelf registration statement. We also agreed to use
our best efforts to have the shares of common stock, upon the effectiveness of
the initial public offering, and the 1996 warrants, upon the effectiveness of
the shelf registration agreement, approved for quotation on the NYSE. We are
required to keep the shelf registration statement effective until the sooner of
three years or such time as, in the written opinion of our counsel, such
registration is not required for the unrestricted resale of shares of common
stock or warrants entitled to registration rights under the registration rights
agreement. In addition, with respect to each investor who purchased 5% or more
of the units sold in the private placement, a "5% purchaser", we have agreed to
include with each registration statement we file that relates to a new issuance
of common stock during the term of the registration rights agreement, shares of
common stock of such 5% purchaser resulting from the conversion of the
preferred stock or the exercise of warrants, subject to certain conditions.
Such conditions provide, among other things, that the managing underwriter in
any offering being so registered may determine that all of such shares of
common stock proposed to be included in the offering cannot be sold. If this is
the case, the number of such shares included will be reduced pro rata among
such 5% purchasers proposing to participate according to the number of such
shares proposed to be sold. Provided, however, that with respect to our first
two public offerings of common stock exceeding a $50 million threshold, such
purchasers will be entitled to participate pro rata in any amount that can be
sold in excess of $50 million per offering. Following the end of the
effectiveness of the shelf registration statement, each 5% purchaser shall have
two demand registration rights, unless, in a written opinion of our counsel
which is reasonably acceptable to such purchaser, such registration is not
necessary for such 5% purchaser to sell its shares in the manner contemplated
in compliance with applicable securities laws. If requested by any
participating 5% purchaser, our management will conduct road shows to assist
such 5% purchaser in selling its shares under either the shelf registration
statement or the demand registrations.

  Messrs. Hartman and Anderson, as holders of the 216,666 shares of currently
outstanding common stock, are entitled to rights with respect to registration
under the Securities Act of such common stock. Under the terms of a founders
registration rights agreement, such holders are entitled to include shares of
our common stock held by such holders, subject to conditions and limitations,
within any of our proposed registration statements under the Securities Act
with respect to a firm commitment underwritten public offering of common stock,
either for its own account or for the account of other security holders.

  Our warrant agreements with First Union and GMAC/Residential Funding
Corporation contain anti-dilution protections and registration rights for
warrantholders. We have also entered into a registration rights

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agreement for the benefit of the holders of the preferred stock. We have agreed
to file a shelf registration statement with the SEC covering the warrants and
the preferred stock. This prospectus is a part of that shelf registration
statement.

Private Placement Purchase Terms Agreement

  According to a purchase terms agreement between NovaStar Financial and the
placement agent in our private placement, we agreed to a number of provisions
for the benefit of the purchasers of units. The purchase terms agreement
included, among other covenants, the following:

  (1) financial reporting and information requirements prior to our initial
      public offering;

  (2) approval by a majority of independent directors of material increases
      in management compensation;

  (3) restrictions on affiliated transactions, excluding transactions with GE
      Capital Corporation and its affiliates;

  (4) prohibitions on entering unrelated lines of business, including, but
      not limited to, investments in commercial and multifamily mortgage and
      mortgage-backed securities or other REITs;

  (5) maintenance of key man life insurance on Messrs. Hartman and Anderson
      for five years;

  (6) maintenance of our status as a REIT;

  (7) changes in the capital allocation guidelines and hedge policies;

  (8) undertaking to carry out a liquidation of NovaStar Financial upon the
      vote of a majority of the stockholders recommending such action; and

  (9) prohibition on grants of stock options or other awards under our 1996
      Stock Option Plan prior to our initial public offering other than those
      stock options described in "Management--Executive Compensation."

  Since our 1997 initial public offering or, in the case of clauses (4) and (5)
above, for one year following our 1997 initial public offering, the provisions
of clauses (2) through (7) above may be modified or waived by a majority of
independent directors. During such one-year period, clauses (4) and (5) may be
waived by a unanimous vote of the Board of Directors. Clauses (8) and (9)
terminated upon the closing of our 1997 initial public offering.

Repurchase of Shares and Restriction on Transfer

  Two of the requirements of qualification for the tax benefits accorded by the
REIT provisions of the Code are that (1) during the last half of each taxable
year not more than 50% in value of the outstanding shares may be owned directly
or indirectly by five or fewer individuals, which is the "50%/5 stockholder
test", and (2) there must be at least 100 stockholders on 335 days of each
taxable year of 12 months.

  In order that we may meet these requirements at all times, the charter
prohibits any person from acquiring or holding, directly or indirectly, shares
of capital stock in excess of 9.8% in value of the aggregate of the outstanding
shares of capital stock or in excess of 9.8%, in value or in number of shares,
whichever is more restrictive, of the aggregate of the outstanding shares of
our common stock. For this purpose, the term "ownership" is defined in
accordance with the REIT provisions of the Code and the constructive ownership
provisions of Section 544 of the Code, as modified by Section 856(h)(1)(B) of
the Code.

  For purposes of the 50%/5 stockholder test, the constructive ownership
provisions applicable under Section 544 of the Code attribute ownership of
securities owned by a corporation, partnership, estate or trust proportionately
to its stockholders, partners or beneficiaries. These code provisions also
attribute ownership of securities owned by family members and partners to other
members of the same family. Further these code

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provisions treat securities with respect to which a person has an option to
purchase as actually owned by that person. Finally, the code provisions set
forth rules as to when securities constructively owned by a person are
considered to be actually owned for the application of such attribution
provisions i.e., "reattribution". Thus, for purposes of determining whether a
person holds shares of capital stock in violation of the ownership limitations
set forth in our charter, many types of entities may own directly more than the
9.8% limit because such entities shares are attributed to its individual
stockholders. On the other hand, a person will be treated as owning not only
shares of capital stock actually or beneficially owned, but also any shares of
capital stock attributed to such person under the attribution rules.
Accordingly, under some circumstances, shares of capital stock owned by a
person who individually owns less than 9.8% of the shares outstanding may
nevertheless be in violation of the ownership limitations set forth in our
charter. Ownership of shares of our capital stock through such attribution is
generally referred to as constructive ownership. The 100 stockholder test is
determined by actual, and not constructive, ownership. We have greater than 100
shareholders of record.

  Under the constructive ownership provisions of Section 544 of the Code, a
holder of a warrant will be treated as owning the number of shares of capital
stock into which such warrant may be converted.

  Our charter further provides that if any transfer of shares of capital stock
occurs which, if effective, would result in any person beneficially or
constructively owning shares of capital stock in excess or in violation of the
above transfer or ownership limitations, then that number of shares of capital
stock the beneficial or constructive ownership of which otherwise would cause
such person to violate such limitations, rounded to the nearest whole shares,
shall be automatically transferred to the trustee of a trust for the exclusive
benefit of one or more charitable beneficiaries, and the intended transferee
shall not acquire any rights in such shares. Shares held by the trustee shall
be issued and outstanding shares of capital stock. The intended transferee
shall not benefit economically from ownership of any shares held in the trust,
shall have no rights to dividends, and shall not possess any rights to vote or
other rights attributable to the shares held in the trust. The trustee shall
have all voting rights and rights to dividends or other distributions with
respect to shares held in the trust, which rights shall be exercised for the
exclusive benefit of the charitable beneficiary. Any dividend or other
distribution paid to the intended transferee prior to our discovery that shares
of common stock have been transferred to the trustee shall be paid with respect
to such shares to the trustee by the intended transferee upon demand and any
dividend or other distribution authorized but unpaid shall be paid when due to
the trustee. Our Board of Directors, in their discretion, may waive these
requirements on owning shares in excess of the ownership limitations.

  Within 20 days of receiving notice from us that shares of capital stock have
been transferred to the trust, the trustee shall sell the shares held in the
trust to a person, designated by the trustee, whose ownership of the shares
will not violate the ownership limitations set forth in the charter. Upon such
sale, the interest of the charitable beneficiary in the shares sold shall
terminate and the trustee shall distribute the net proceeds of the sale to the
intended transferee and to the charitable beneficiary as follows. The intended
transferee shall receive the lesser of (1) the price paid by the intended
transferee for the shares or, if the intended transferee did not give value for
the shares in connection with the event causing the shares to be held in the
trust, e.g., in the case of a gift, devise or other such transaction, the
market price of the shares on the day of the event causing the shares to be
held in the trust and (2) the price per share received by the trustee from the
sale or other disposition of the shares held in the trust. Any net sales
proceeds in excess of the amount payable to the intended transferee shall be
immediately paid to the charitable beneficiary. In addition, shares of capital
stock transferred to the trustee shall be deemed to have been offered for sale
to NovaStar Financial, or our designee, at a price per share equal to the
lesser of (1) the price per share in the transaction that resulted in such
transfer to the trust, or, in the case of a devise or gift, the market price at
the time of such devise or gift and (2) the market price on the date we, or our
designee, accept such offer. We shall have the right to accept such offer until
the trustee has sold shares held in the trust. Upon such a sale to NovaStar
Financial, the interest of the charitable beneficiary in the shares sold shall
terminate and the trustee shall distribute the net proceeds of the sale to the
intended transferee.

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  The term "market price" on any date shall mean, with respect to any class or
series of outstanding shares of our stock, the closing price for such shares on
such date. The "closing price" on any date shall mean the last sale price for
such shares, regular way, or, in case no such sale takes place on such day, the
average of the closing bid and asked prices, regular way, for such shares. In
either case as reported in the principal consolidated transaction reporting
system with respect to securities listed or admitted to trading on the NYSE or,
if such shares are not listed or admitted to trading on the NYSE, as reported
on the principal consolidated transaction reporting system with respect to
securities listed on the principal national securities exchange on which such
shares are listed or admitted to trading or, if such shares are not listed or
admitted to trading on any national securities exchange, the last quoted price,
or, if not so quoted, the average of the high bid and low asked prices in the
over-the-counter market, as reported by the National Association of Securities
Dealers, Inc. Automated Quotation System or, if such system is no longer in
use, the principal other automated quotation system that may then be in use or,
if such shares are not quoted by any such organization, the average of the
closing bid and asked prices as furnished by a professional market maker making
a market in such shares selected by the Board of Directors or, in the event
that no trading price is available for such shares, the fair market value of
the shares, as determined in good faith by the Board of Directors.

  Every owner of more than 5% or such lower percentage as required by the Code
or the regulations promulgated thereunder of all classes or series of our
stock, within 30 days after the end of each taxable year, is required to give
us written notice stating the name and address of such owner, the number of
shares of each class and series of our stock beneficially owned and a
description of the manner in which such shares are held. Each such owner shall
provide us with such additional information as we may request in order to
determine the effect, if any, of such beneficial ownership on our status as a
REIT and to ensure compliance with the ownership limitations.

  Subject to some limitations, our Board of Directors may increase or decrease
the ownership limitations. In addition, to the extent consistent with the REIT
provisions of the Code, our Board of Directors may waive the ownership
limitations for and at the request of purchasers in this offering or subsequent
purchasers.

  The provisions described above may inhibit market activity and the resulting
opportunity for the holders of our capital stock and warrants to receive a
premium for their shares or warrants that might otherwise exist in the absence
of such provisions. Such provisions also may make us an unsuitable investment
vehicle for any person seeking to obtain ownership of more than 9.8% of the
outstanding shares of capital stock.

Indemnification

  Our charter obligates us to indemnify our directors and officers and to pay
or reimburse expenses for such individuals in advance of the final disposition
of a proceeding to the maximum extent permitted from time to time by Maryland
law. Maryland law permits a corporation to indemnify its present and former
directors and officers, among others, against judgments, penalties, fines,
settlements and reasonable expenses actually incurred by them in connection
with any proceeding to which they may be made a party by reason of their
service in those or other capacities, unless it is established that

  . the act or omission of the director or officer was material to the matter
    giving rise to the proceeding and (1) was committed in bad faith, or (2)
    was a result of active and deliberate dishonesty;

  . the director or officer actually received an improper personal benefit in
    money, property or services; or

  . in the case of any criminal proceeding, the director or officer had
    reasonable cause to believe that the act or omission was unlawful.

Limitation of Liability

  Maryland law permits the charter of a Maryland corporation to include a
provision limiting the liability of its directors and officers to the
corporation and its stockholder for money damages, except to the extent that

                                      112
<PAGE>

(1) it is proved that the person actually received an improper benefit or
profit in money, property or services, or (2) a judgment or other final
adjudication adverse to the person is entered in a proceeding based on a
finding that the person's action, or failure to act, was the result of active
and deliberate dishonesty and was material to the cause of action adjudicated
in the proceeding. Our charter contains a provision providing for elimination
of the liability of our directors and officers to NovaStar Financial or our
stockholders for money damages to the maximum extent permitted by Maryland law
as amended or interpreted.

Business Acquisitions Statutes

  Under Maryland law, "business combinations", including a merger,
consolidation, share exchange, or, in circumstances, an asset transfer or
issuance or reclassification of equity securities, between a Maryland
corporation and any person who beneficially owns 10% or more of the voting
power of the corporations shares or an affiliate of the corporation which, at
any time within the two-year period prior to the date in question, was the
beneficial owner of 10% or more of the voting power of the then-outstanding
voting stock of the corporation, an "interested stockholder", or an affiliate
thereof, are prohibited for five years after the most recent date on which the
interested stockholder became an interested stockholder. Thereafter, any such
business combination must be recommended by the board of directors of such
corporation and approved by the affirmative vote of at least (a) 80% of the
votes entitled to be cast by holders of outstanding voting shares of the
corporation and (b) two-thirds of the votes entitled to be cast by holders of
outstanding voting shares of the corporation other than shares held by the
interested stockholder with whom the business combination is to be effected,
unless, among other things, the corporation's stockholders receive a minimum
price, as defined by Maryland law, for their shares and the consideration is
received in cash or in the same form as previously paid by the interested
stockholder for its shares. These provisions of Maryland law do not apply,
however, to business combinations that are approved or exempted by the board of
directors of the corporation prior to the time that the interested stockholder
becomes an interested stockholder. Our Board of Directors has adopted a
resolution to the effect that the foregoing provisions of Maryland law shall
not apply to any future business combination with any purchaser of units in the
private placement, or an affiliate thereof, or to any other future business
combination with NovaStar Financial. No assurance can be given that such
provision will not be amended or eliminated at any point in the future with
respect to business combinations not involving a purchaser of units.

Control Share Acquisitions

  Maryland law provides that "control shares" of a Maryland corporation
acquired in a "control share acquisition" have no voting rights except to the
extent approved by a vote of two-thirds of the votes entitled to be cast on the
matter, excluding shares of stock owned by the acquiror or by officers or
directors who are employees of the corporation. "Control shares" are voting
shares of stock which, if aggregated with all other shares of stock owned by
such a person, would entitle the acquiror to exercise voting power in electing
directors within one of the following ranges of voting power:

  . one-fifth or more but less than one third;

  . one-third or more but less than a majority; or

  . a majority or more of all voting power.

  "Control shares" do not include shares of stock the acquiring person is then
entitled to vote as a result of having owned stockholder approval. A "control
share acquisition" means, subject to exceptions, the acquisition of, ownership
of, or the power to direct the exercise of voting power with respect to,
control shares.

  A person who has made or proposes to make a "control share acquisition," upon
satisfaction of conditions including an undertaking to pay expenses, may compel
the Board of Directors to call a special meeting of stockholders to be held
within 50 days of demand to consider the voting rights of the shares. If no
request for a meeting is made, the corporation may itself present the question
at any stockholders' meeting. If

                                      113
<PAGE>

voting rights are not approved at the meeting or if the acquiring person does
not deliver an acquiring person statement as permitted by the statute, then,
subject to conditions and limitations, the corporation may redeem any or all of
the "control shares," except those for which voting rights have previously been
approved, for fair value determined, without regard to absence of voting
rights, as of the date of the last control share acquisition or of any meeting
of stockholders at which the voting rights of such shares are considered and
not approved. If voting rights for "control shares" are approved at a
stockholders meeting and the acquiror becomes entitled to vote a majority of
the shares entitled to vote, all other stockholders may exercise appraisal
rights. The fair value of the stock, as determined for purposes of such
appraisal rights may not be less than the highest price per share paid in the
control share acquisition, and certain limitations and restrictions otherwise
applicable to the exercise of dissenters rights do not apply in the context of
"control share acquisitions."

  The "control share acquisition" statute does not apply to stock acquired in a
merger, consolidation or share exchange if the corporation is a party to the
transaction, or to acquisitions approved or exempted by a provision of the
articles of incorporation or bylaws of the corporation adopted prior to the
acquisition of the shares. We have adopted a provision in our bylaws that
exempts our shares of capital stock from application of the control share
acquisition statute. No assurance can be given, however, that such bylaw
provision may not be removed at any time by amendment of the bylaws.

Transfer Agent and Registrar

  We have appointed UMB Bank N.A. as transfer agent and registrar with respect
to the common stock and the warrants.

                                      114
<PAGE>

                            DESCRIPTION OF WARRANTS

  The warrants were issued pursuant to two warrant agreements. The following
summary of the warrant agreements is not complete and is qualified in its
entirety by reference to the warrant agreements including the definitions
therein of terms used below. A copy of each warrant agreement is filed with the
SEC.

  On February 12, 1999, we entered into a warrant agreement with First Union
Corporation whereby we agreed to issue to First Union Corporation 350,000
warrants by two separate warrant certificates, one warrant certificate in the
amount of 230,000 warrants and the other warrant certificate in the amount of
120,000 warrants, to purchase common stock at $6.9375 per share, the closing
price on February 11, 1999, in exchange for 186,667 existing 1996 warrants at
$15.00 per share. The registered holder of the warrant certificates may
exercise, in whole or in part, but not as to a fractional share of common
stock, the purchase rights represented by the warrant at any time prior to
February 12, 2002.

  On March 10, 1999, we entered into a warrant agreement with GMAC/Residential
Funding Corporation whereby we agreed to issue to GMAC/Residential Funding
Corporation (1) a guaranty warrant to acquire 812,731 warrants for the purchase
of our common stock at a price of $4.5625 per share, the closing price of the
common stock on October 12, 1998 and (2) a tag along warrant to acquire 364,982
shares of our common stock at $15.00 per share, the price in effect on our
December 9, 1996 warrants. Pursuant to anti-dilution provisions, each warrant
exercised at $15.00 will currently purchase 1.29 shares of common stock, which
represents an effective exercise price of $11.62 per share. The registered
holder of the guaranty warrant may exercise, in whole or in part, but not as to
a fractional share of common stock, the purchase rights represented by the
warrant at any time prior to October 13, 2003. The registered holder of the tag
along warrant may exercise, in whole or in part, but not as to a fractional
share of common stock, the purchase rights represented by the warrant at any
time and from time to time after March 10, 1999 up to and including the
expiration date of the 1996 warrants, which is February 3, 2001.

  The warrants will be deemed to be exercised when NovaStar Financial has
received:

  . a completed exercise agreement, executed by the person exercising all or
    part of the purchase rights represented by the warrant;

  . the warrant;

  . if the warrant is not registered in the name of the purchaser, an
    assignment or assignments evidencing the assignment of the warrant to the
    purchaser; and

  . either (1) a check payable to the NovaStar Financial in an amount equal
    to the product of the exercise price multiplied by the number of shares
    of common stock being purchased upon such exercise, (2) the surrender to
    NovaStar Financial of debt or equity securities of NovaStar Financial or
    any of its wholly owned subsidiaries having a market price equal to the
    aggregate exercise price of the common stock being purchased upon such
    exercise, provided that the market price of any note or other debt
    security or any preferred stock shall be deemed to be equal to the
    aggregate outstanding principal amount or liquidation value thereof plus
    all accrued and unpaid interest thereon or accrued or declared and unpaid
    dividends thereon or (3) a written notice to NovaStar Financial that the
    purchaser is exercising the warrant, or a portion thereof, by authorizing
    NovaStar Financial to withhold from issuance a number of shares of common
    stock issuable upon such exercise of the warrant which when multiplied by
    the market price of the common stock is equal to the aggregate exercise
    price and such withheld shares shall no longer be issuable under the
    warrant.

  NovaStar Financial will deliver certificates for shares of common stock
purchased upon exercise of the warrant to the purchaser within three business
days, or five business days in the case of warrants exercised under the First
Union warrant agreement. Unless the warrant has expired or all of the purchase
rights represented have been exercised, NovaStar Financial shall prepare a new
warrant, representing the rights which

                                      115
<PAGE>

have not been exercised and shall within such three or five day period deliver
such new warrant to the person designated in the exercise agreement.

  The common stock issuable upon the exercise of the warrant shall be deemed to
have been issued to the purchaser at the opening of business on the date on
which the exercise time occurs, and the purchaser shall be deemed for all
purposes to have become the record holder of such common stock at the exercise
time. The issuance of certificates for shares of common stock upon exercise of
the warrant shall be made without charge to the registered holder or the
purchaser for any issuance tax or other cost incurred by NovaStar Financial in
connection with exercise and the related issuance of shares of common stock.

  NovaStar Financial will at all times reserve and keep available out of its
authorized but unissued shares of common stock, solely for the purpose of
issuance upon the exercise of the warrants, the number of shares of common
stock then issuable upon the exercise of all outstanding warrants. All shares
of common stock which are so issuable shall, when issued upon payment of the
exercise price, be duly and validly issued, fully paid and nonassessable and
free from all taxes, liens and charges. NovaStar Financial shall take all
actions as may be necessary to assure that all shares of common stock may be so
issued without violation of any applicable law or governmental regulation or
any requirements of any domestic securities exchange upon which shares of
common stock may be listed. NovaStar Financial shall not take any action which
would cause the number of authorized but unissued shares of common stock to be
less than the number of shares required to be reserved for issuance upon
exercise of the warrants.

  No fractional shares will be issued upon exercise of the warrants. The
holders of the warrants have no right to vote on matters submitted to our
stockholders and no right to receive dividends. The holders of warrants not yet
exercised are not entitled to share in the assets of NovaStar Financial in the
event of our liquidation, dissolution or the winding up of our affairs. There
are no statutory, or to the best of NovaStar's knowledge, contractual
stockholder preemptive rights or rights of first refusal with respect to the
issuance of the warrants or the issuance of the common stock upon exercise of
the warrants or any other issuance of common stock.

  In order to prevent dilution of the rights granted under the guaranty
warrant, the exercise price of the guaranty warrants will be subject to
adjustment from time to time and the number of shares of common stock
obtainable upon exercise of the guaranty warrant will be subject to adjustment
from time to time. If and whenever on or after the date of issuance NovaStar
Financial issues or sells, or is deemed to have issued or sold, any share of
common stock for a consideration per share less than the greater of (1) $4.5625
and (2) the market price per share of such common stock, then immediately upon
such issue or sale the exercise price shall be reduced to the exercise price
determined by multiplying (A) the exercise price in effect immediately prior to
such issue or sale by (B) a fraction, the numerator of which shall be the sum
of (x) the number of shares of common stock deemed outstanding immediately
prior to such issue or sale and (y) the number of shares that could be
purchased at the base rate from the aggregate proceeds to NovaStar Financial
from the issuance of such new shares of common stock, and the denominator of
which shall be the number of shares of common stock deemed outstanding
immediately after such issue or sale. Upon each adjustment of the exercise
price, the number of shares of common stock acquirable upon exercise of the
warrant shall be adjusted to the number of shares determined by multiplying the
exercise price in effect immediately prior to the adjustment by the number of
shares of common stock acquirable upon exercise of the warrant immediately
prior to the adjustment and dividing the product thereof by the exercise price
resulting from the adjustment.

  So long as they are outstanding, if NovaStar Financial reprices, adjusts or
amends in any manner the warrants issued pursuant to the warrant agreement
dated as of December 9, 1996 between NovaStar Financial and the holders of such
warrants, NovaStar Financial shall offer to make an identical change to the tag
along warrant.

                                      116
<PAGE>

  Pursuant to the warrant agreement with First Union the exercise price will be
appropriately adjusted if we:

  . Pay a dividend or make a distribution on our common stock in shares of
    our common stock;

  . Subdivide our outstanding shares of our common stock into a greater
    number of shares;

  . Combine our outstanding shares of our common stock into a smaller number
    of shares;

  . Issue by reclassification of our common stock any shares of our capital
    stock; or

  . Issue shares of capital stock, as to the First Union warrants, at a price
    below the greater of (a) 6.9375 or (b) fair market value.

  In case of consolidations or mergers of NovaStar Financial, or our
liquidation or the sale of all or substantially all of our assets to another
corporation, each warrant will thereafter be deemed exercised for the right to
receive the kind and amount of shares of stock or other securities or property
to which such holder would have been entitled as a result of such
consolidation, merger or sale had the warrants been exercised immediately prior
thereto and into shares of our common stock, less the exercise price.

                                      117
<PAGE>

                              PLAN OF DISTRIBUTION

  The offered preferred stock, the warrants and the underlying common stock
subsequently acquired by the selling securityholders pursuant to the exercise
of outstanding warrants or conversion of preferred stock, may be offered for
sale from time to time by the selling securityholders named in this prospectus,
or by their pledgees, donees, transferees or other successors in interest, to
or through underwriters or directly to other purchasers or through agents in
one or more transactions in the over-the-counter market, in one or more private
transactions, or in a combination of such methods of sale, at prices and on
terms then prevailing, at prices related to such prices, or at negotiated
prices. Under some circumstances, the selling securityholders and any broker-
dealers that act in connection with the sale of such securities may be deemed
to be "underwriters" within the meaning of Section 2(11) of the Securities Act,
and any commissions or discounts and other compensation paid to such persons
may be deemed to be underwriting discounts and commissions under the Securities
Act. At any time a particular offer of offered common stock, warrants or
underlying common stock is made, if required, a prospectus supplement will be
distributed that will set forth the aggregate amount of such securities being
offered and the terms of the offering, including the name or names of any
underwriters, dealers or agents, any discounts, commissions and other items
constituting compensation from the selling securityholders and any discounts,
commissions or concessions allowed or reallowed or paid to dealers. Such
prospectus supplement and, if necessary, a post-effective amendment to the
shelf registration statement of which this prospectus is a part, will be filed
with the SEC to reflect the disclosure of additional information with respect
to the distribution of such securities.

  The underlying common stock offered hereby will be sold directly by us to the
warrantholder at the exercise price of the warrants and pursuant to the terms
and conditions of the warrant agreement governing the warrants, a copy of which
has been filed as an exhibit to the shelf registration statement of which this
prospectus is a part.

  To comply with the securities laws of different jurisdictions, the securities
offered hereby may be offered or sold in such jurisdictions only through
registered or licensed brokers or dealers. In addition, in different
jurisdictions the securities offered hereby may not be offered or sold unless
they have been registered or qualified for sale in such jurisdictions or an
exemption from registration or qualification is available and is complied with.

  The holders of the securities covered by this prospectus have agreed not to
effect any public sale or distribution of our securities in periods surrounding
underwritten public offerings by NovaStar Financial.

                                      118
<PAGE>

                                 LEGAL MATTERS

  The validity of the common stock offered hereby and legal matters will be
passed upon by Tobin & Tobin, a professional corporation, San Francisco,
California. Tax matters will be passed on by Jeffers, Wilson, Shaff & Falk,
LLP, Irvine, California.

                                    EXPERTS

  Our balance sheets as of December 31, 1998 and 1997 and our statements of
operations, stockholders' equity and cash flows for the years ended December
31, 1998 and 1997 and for the period from September 13, 1996 (inception) to
December 31, 1996 have been incorporated by reference in this prospectus, in
reliance on the report of KPMG LLP, independent accountants, given on the
authority of that firm as experts in accounting and auditing.

                      WHERE YOU CAN FIND MORE INFORMATION

  We file annual, quarterly and special reports, proxy statements and other
information with the SEC. Our SEC filings are available to the public over the
Internet at the SEC's web site at http://www.sec.gov. You may also read and
copy any document we file at the SEC's public reference rooms in Washington,
D.C., New York, New York and Chicago, Illinois. Please call the SEC at 1-800-
SEC-0300 for further information on the public reference rooms.

  The SEC allows us to "incorporate by reference" the information we file with
them, which means that we can disclose important information to you by
referring you to those documents. The information incorporated by reference is
an important part of this prospectus, and information that we file later with
the SEC will automatically update and supersede this information. We
incorporate by reference the documents listed below and any future filings made
with the SEC under Sections 13(a), 13(c), 14 and 15(d) of the Securities
Exchange Act of 1934 until we sell all of the securities.

  . Annual Report on Form 10-K for the year ended December 31, 1998; and

  . Current Reports on Form 8-K, filed July 6, 1998, October 12, 1998,
    October 13, 1998, October 15, 1998, December 22, 1998, February 23, 1999,
    and April 6, 1999.

  You may request a copy of these filings at no cost, by writing or telephoning
us at the following address:

    Corporate Secretary
    NovaStar Financial, Inc.
    1901 West 47th Place, Suite 105
    Westwood, Kansas 66205
    (913) 362-1090

  You should rely only on the information incorporated by reference or provided
in this prospectus. We have not authorized anyone else to provide you with
different information. We are not making an offer of these securities in any
state where the offer is not permitted. You should not assume that the
information in this prospectus is accurate as of any date other than the date
on the front of the document.

                                      119
<PAGE>

                                    GLOSSARY

  As used in this Prospectus, the capitalized and other terms listed below have
the meanings indicated.

  "agency" means FNMA, FHLMC or GNMA.

  "agency certificates" means pass-through certificates guaranteed by FNMA,
FHLMC or GNMA.

  "agency securities" means securities issued or guaranteed by FNMA, FHLMC or
GNMA.

  "adjustable-rate mortgage" or "ARM" means a mortgage loan (including any
mortgage loan underlying a mortgage security) that features adjustments of the
underlying interest rate at predetermined times based on an agreed margin to an
established index. An ARM is usually subject to periodic interest rate and/or
payment caps and a lifetime interest rate cap.

  "capital stock" means the shares of capital stock issuable by NovaStar
Financial under its charter, and includes common stock and preferred stock.

  "collateralized mortgage obligations" or "CMOs" means adjustable or short-
term fixed-rate debt obligations or bonds, that are collateralized by mortgage
loans or pass-through certificates issued by private institutions or issued or
guaranteed by GNMA, FNMA or FHLMC.

  "Code" means the Internal Revenue Code of 1986, as amended.

  "conforming mortgage loans" means mortgage loans that either comply with
requirements for inclusion in credit support programs sponsored by FHLMC or
FNMA or are FHA or VA Loans, all of which are secured by first mortgages or
deeds of trust on single family (one to four units) residences.

  "dividend equivalent rights" or "DERs" means an element of our 1996 stock
option plan, which are granted together with certain stock options.

  "ERISA" means the Employee Retirement Income Security Act of 1974.

  "Exchange Act" means the Securities Exchange Act of 1934, as amended.

  "FHA" means the United States Federal Housing Administration.

  "FHLMC" means Freddie Mac, previously the Federal Home Loan Mortgage
Corporation.

  "founders" means Scott F. Hartman and W. Lance Anderson.

  "FNMA" means Fannie Mae, previously the Federal National Mortgage
Association.

  "GAAP" means generally accepted accounting principles.

  "GNMA" means Ginnie Mae, previously the Government National Mortgage
Association.

  "independent directors" means a director of NovaStar Financial who is not an
officer or employee of NovaStar Financial or any affiliate (excluding GE
Capital and its affiliates) or subsidiary of NovaStar Financial.

  "IPO" means NovaStar Financial's initial public offering, which closed on
December 1, 1997.

  "incentive stock options" or "ISOs" means stock options granted under our
1996 stock option plan which meet the requirements of Section 422 of the Code.

                                      120
<PAGE>

  "loan-to-value" or "LTV" ratio is the percentage obtained by dividing the
principal amount of a loan by the lower of the sales price or appraised value
of the mortgaged property when the loan is originated.

  "Maryland GCL" means the general corporation laws of the State of Maryland,
the state in which NovaStar Financial, Inc. is incorporated.

  "mortgage assets" means (1) mortgage loans, and (2) mortgage securities, and
(3) other qualified REIT assets.

  "mortgage securities" means (1) pass-through certificates and (2) CMOs.

  "net interest spread" means the difference between the annual yield earned on
interest-earning assets and the rate paid on borrowings.

  "NFI Holding" means NFI Holding Corporation, a taxable affiliate of NovaStar
Financial.

  "NovaStar Mortgage" means NovaStar Mortgage, Inc., a taxable affiliate of
NovaStar Financial, Inc.

  "non-qualified stock options" or "NQSOs", are an element of our 1996 Stock
Option Plan, which are not treated as ISOs pursuant to Section 422 of the Code.

  "NYSE" means the New York Stock Exchange.

  "pass-through certificates" means securities (or interests therein) which are
qualified REIT assets evidencing undivided ownership interests in a pool of
mortgage loans, the holders of which receive a "pass-through" of the principal
and interest paid in connection with the underlying mortgage loans in
accordance with the holders' respective undivided interests in the pool.

  "private placement" means NovaStar Financial's private placement of units
which closed December 9, 1996. Each unit consisted of one share of convertible
preferred stock and one warrant to purchase one share of common stock.

  "qualified hedge" means any interest rate swap or cap agreement, option,
futures contract, forward rate agreement, or any similar financial instrument,
entered into by NovaStar Financial in a transaction to reduce NovaStar
Financial's interest rate risk with respect to indebtedness (including NovaStar
Financial's reverse repurchase obligations) incurred or to be incurred by
NovaStar Financial to acquire and carry mortgage assets or other real estate
assets.

  "qualified REIT assets" means pass-through certificates, mortgage loans,
agency certificates and other assets of the type described in Code Section
856(c)(6)(B).

  "real estate asset" means interests in real property, interests in mortgages
on real property, and regular or residual interests in REMICs.

  "REIT" means real estate investment trust as defined under Section 856 of the
Code.

  "REMIC" means real estate mortgage investment conduit as defined under
Section 860D of the Code.

  "reverse repurchase agreement" means a secured borrowing device evidenced by
an agreement to sell securities or other assets to a third party and a
simultaneous agreement to repurchase them at a specified future date and price,
the price difference constituting the interest on the borrowing.

  "SMMEA" means the Secondary Mortgage Market Enhancement Act of 1984.

  "Securities Act" means the Securities Act of 1933, as amended.

                                      121
<PAGE>

  "single family" means, with respect to mortgage loans, loans secured by one-
to four-unit residential property.

  "tax-exempt entity" means a qualified pension, profit-sharing or other
employee retirement benefit plan, Keogh Plans, bank commingled trust funds for
such plans, IRAs and other similar entities intended to be exempt from federal
income taxation.

  "taxable income" means for any year the taxable income of NovaStar Financial
for such year (excluding any net income derived either from property held
primarily for sale to customers or from foreclosure property) subject to
certain adjustments provided in Section 857 of the Code.

  "tranches" means one of three equal parts that the principal amount of
forgivable notes are divided into.

  "VA" means the United States Department of Veterans Affairs.

                                      122
<PAGE>

                         INDEX TO FINANCIAL STATEMENTS

<TABLE>
<CAPTION>
                                                                            Page
                                                                            ----
<S>                                                                         <C>
December 31, 1998
NOVASTAR FINANCIAL, INC.
Audited Financial Statements:
  Consolidated Balance Sheets..............................................  F-2
  Consolidated Statements of Operations....................................  F-3
  Consolidated Statements of Stockholders' Equity..........................  F-4
  Consolidated Statements of Cash Flows....................................  F-5
  Notes to Consolidated Financial Statements...............................  F-6
Independent Auditors' Report............................................... F-20
</TABLE>


                                      F-1
<PAGE>

                            NOVASTAR FINANCIAL, INC.

                          CONSOLIDATED BALANCE SHEETS
                  (dollars in thousands, except share amounts)

<TABLE>
<CAPTION>
                                                            December 31,
                                                        ----------------------
                                                           1998        1997
                                                        ----------  ----------
<S>                                                     <C>         <C>
Assets
  Mortgage loans, net.................................. $  920,697  $  574,984
  Mortgage securities--available-for-sale..............        --      517,246
  Accrued interest receivable..........................      9,702       7,088
  Due from affiliates..................................     51,528      20,701
  Investment in NFI Holding Corporation................         13       2,188
  Amounts due from founders............................      5,354         763
  Assets acquired through foreclosure..................     10,583         156
  Other assets.........................................      4,359       3,126
                                                        ----------  ----------
      Total assets..................................... $1,002,236  $1,126,252
                                                        ==========  ==========
Liabilities and Stockholders' Equity
  Liabilities:
    Borrowings......................................... $  909,944  $1,005,560
    Dividends payable..................................      2,845         783
    Accounts payable and other liabilities.............      2,157       3,420
                                                        ----------  ----------
      Total liabilities................................    914,946   1,009,763
  Commitments and contingencies
  Stockholders' equity:
    Capital stock, $0.01 par value, 50,000,000 shares
     authorized:
     Common stock, 8,130,069 and 7,828,665 shares
      issued and outstanding, respectively.............         81          78
    Additional paid-in capital.........................    122,180     117,084
    Accumulated deficit................................    (32,804)     (2,859)
    Accumulated other comprehensive income.............        --        4,353
    Forgivable notes receivable from founders..........     (2,167)     (2,167)
                                                        ----------  ----------
      Total stockholders' equity.......................     87,290     116,489
                                                        ----------  ----------
      Total liabilities and stockholders' equity....... $1,002,236  $1,126,252
                                                        ==========  ==========
</TABLE>

                See notes to consolidated financial statements.

                                      F-2
<PAGE>

                            NOVASTAR FINANCIAL, INC.

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                    (in thousands, except per share amounts)

<TABLE>
<CAPTION>
                                                                       For the
                                                                     period from
                                                   For the Year     September 13,
                                                  Ended December        1996
                                                       31,           (inception)
                                                 -----------------   to December
                                                   1998     1997      31, 1996
                                                 --------  -------  -------------
<S>                                              <C>       <C>      <C>
Interest income:
  Mortgage loans...............................  $ 76,751  $25,154     $  --
  Mortgage securities..........................    23,996   11,807        155
                                                 --------  -------     ------
Total interest income..........................   100,747   36,961        155
Interest expense...............................    80,794   28,185        --
                                                 --------  -------     ------
Net interest income............................    19,953    8,776        155
Provision for credit losses....................     7,430    2,453        --
                                                 --------  -------     ------
Net interest income after provision for credit
 losses........................................    12,523    6,323        155
Gain (loss) on sales of securities and mortgage
 loans.........................................   (14,962)      51        --
Loss on termination of interest rate
 agreements....................................    (7,977)     --
Equity in net income (loss) of NFI Holding
 Corporation...................................    (2,984)      28        --
Other income...................................     3,188      704        --
General and administrative expenses:
  Loan servicing fees paid to NovaStar
   Mortgage, Inc...............................     3,803      505        --
  Fees for other services provided by NovaStar
   Mortgage, Inc. .............................     2,683    3,650        --
  Compensation and benefits....................     1,785      839        199
  Professional and outside services............     1,117      676        200
  Other loan servicing expenses................     1,071      741        --
  Office administration........................       903      299        --
  Forgiveness of notes receivable from
   founders....................................       --     1,083        --
  Other........................................       247      448         58
                                                 --------  -------     ------
    Total general and administrative expenses..    11,609    8,241        457
                                                 --------  -------     ------
Net loss.......................................  $(21,821) $(1,135)    $( 302)
                                                 ========  =======     ======
Basic and diluted loss per share...............  $  (2.71) $ (0.26)    $(0.08)
                                                 ========  =======     ======
Weighted average shares outstanding............     8,057    4,430      3,767
                                                 ========  =======     ======
</TABLE>

                See notes to consolidated financial statements.

                                      F-3
<PAGE>

                            NOVASTAR FINANCIAL, INC.

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                  (dollars in thousands, except share amounts)

<TABLE>
<CAPTION>
                                                                                  Forgivable
                                                                     Accumulated    Notes
                          Convertible        Additional                 Other     Receivable     Total
                           Preferred  Common  Paid-in   Accumulated Comprehensive    from    Stockholders'
                             Stock    Stock   Capital     Deficit      Income      Founders     Equity
                          ----------- ------ ---------- ----------- ------------- ---------- -------------
<S>                       <C>         <C>    <C>        <C>         <C>           <C>        <C>
Balance, September 13,
 1996 (inception).......     $ --     $ --    $    --    $    --       $   --      $   --      $    --
Issuance of 216,666
 shares of Common
 stock..................       --         2        --         --           --          --             2
Proceeds from private
 placement of 3,333,333
 units, net of costs of
 $3,304.................        34      --      46,662        --           --          --        46,696
Units (216,666) acquired
 with forgivable debt...         2      --       3,248        --           --       (3,250)         --
                             -----    -----   --------   --------      -------     -------     --------
Comprehensive loss:
 Net loss...............                                     (302)         --                      (302)
 Other comprehensive
  loss--change in
  unrealized gain
  (loss) on available-
  for-sale securities...                                      --           (16)                     (16)
                                                         --------      -------                 --------
   Total comprehensive
    loss................                                     (302)         (16)                    (318)
                                                         --------      -------                 --------
Balance, December 31,
 1996...................        36        2     49,910       (302)         (16)     (3,250)      46,380
Private placement
 issuance costs.........       --       --         (48)       --           --          --           (48)
Proceeds from initial
 public offering of
 common stock, net of
 issuance costs of
 $5,848.................       (36)      76     67,216        --           --          --        67,256
Exercise of stock
 options................       --       --           6        --           --          --             6
Dividends on convertible
 preferred stock
 ($0.18 per share)......       --       --         --        (639)         --          --          (639)
Dividends on common
 stock ($0.10 per
 share).................       --       --         --        (783)         --          --          (783)
Forgiveness of founders'
 notes receivable.......       --       --         --         --           --        1,083        1,083
                             -----    -----   --------   --------      -------     -------     --------
Comprehensive income
 (loss):
 Net loss...............                                   (1,135)         --                    (1,135)
 Other comprehensive
  income (loss)--change
  in unrealized gain
  (loss) on available-
  for-sale securities,
  net of
  reclassification
  adjustments of $51
  for gains included in
  net loss..............                                      --         4,369                    4,369
                                                         --------      -------                 --------
   Total comprehensive
    income (loss).......                                   (1,135)       4,369                    3,234
                                                         --------      -------                 --------
Balance, December 31,
 1997...................       --        78    117,084     (2,859)       4,353      (2,167)     116,489
Initial public offering
 of common stock
 issuance costs.........       --       --         (88)       --           --          --           (88)
Exercise of stock
 options and warrants...       --         3      5,184        --           --          --         5,187
Dividends on common
 stock ($1.00 per
 share).................       --       --         --      (8,124)         --          --        (8,124)
                             -----    -----   --------   --------      -------     -------     --------
Comprehensive loss:
 Net loss...............                                  (21,821)         --                   (21,821)
 Other comprehensive
  loss--change in
  unrealized gain
  (loss) on available-
  for-sales securities,
  net of
  reclassification
  adjustments of
  $15,268 for losses
  included in net
  loss..................                                      --        (4,353)                  (4,353)
                                                         --------      -------                 --------
   Total comprehensive
    loss................                                  (21,821)      (4,353)                 (26,174)
                                                         --------      -------                 --------
Balance, December 31,
 1998...................     $ --     $  81   $122,180   $(32,804)     $   --      $(2,167)    $ 87,290
                             =====    =====   ========   ========      =======     =======     ========
</TABLE>

                See notes to consolidated financial statements.

                                      F-4
<PAGE>

                            NOVASTAR FINANCIAL, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                 (in thousands)

<TABLE>
<CAPTION>
                                       For the Year Ended     For the period from
                                          December 31,        September 13, 1996
                                      ----------------------    (inception) to
                                        1998        1997       December 31, 1996
                                      ---------  -----------  -------------------
<S>                                   <C>        <C>          <C>
Cash flow from operating activities:
  Net loss..........................  $ (21,821) $    (1,135)       $  (302)
  Adjustments to reconcile net loss
   to cash provided by (used in)
   operating activities:
    Amortization of premiums on
     mortgage loans.................      5,768        2,532            --
    Amortization of premiums on
     mortgage securities............      1,852          908            --
    Amortization of deferred debt
     costs..........................      4,562           93            --
    Provision for credit losses.....      7,430        2,453            --
    Forgiveness of notes receivable
     from founders..................        --         1,083            --
    Equity in net loss (income) of
     NFI Holding Corporation........      2,984          (28)           --
    Losses (gains) on sales of
     mortgage loans and securities..     14,962          (51)           --
    Loss on terminations of interest
     rate agreements................      7,977          --
    Change in:
      Accrued interest receivable...     (2,614)      (7,059)           (29)
      Other assets..................     (1,638)      (3,780)          (109)
      Other liabilities.............     (9,219)       3,223            176
                                      ---------  -----------        -------
        Net cash provided by (used
         in) operating activities...     10,243       (1,761)          (264)
Cash flow from investing activities:
  Mortgage loans purchased from
   NovaStar Mortgage, Inc. .........   (556,158)    (417,752)           --
  Mortgage loans purchased from
   others...........................        --      (219,995)           --
  Mortgage loans sold to others.....      8,307          --             --
  Mortgage loan repayments..........    178,818       57,622            --
  Purchases of available-for-sale
   securities.......................   (375,051)    (659,415)           --
  Settlement of amounts due to
   brokers..........................        --       (13,255)           --
  Proceeds from sales of available-
   for-sale securities..............    705,906      110,067            --
  Proceeds from paydowns on
   available-for-sale securities....    165,233       48,694            --
  Investment in NFI Holding
   Corporation......................       (990)      (1,980)           --
  Net change in amounts due from NFI
   Holding Corporation..............    (30,827)     (20,701)           --
                                      ---------  -----------        -------
        Net cash provided by (used
         in) investing activities...     95,238   (1,116,715)           --
Cash flow from financing activities:
  Proceeds from issuance of
   collateralized mortgage
   obligations......................    665,000      424,674            --
  Payments on collateralized
   mortgage obligations.............   (179,851)     (13,596)           --
  Debt issuance costs paid on
   collateralized mortgage
   obligations......................     (2,821)      (2,304)           --
  Change in short-term borrowings...   (581,693)     596,693            --
  Proceeds from issuance of capital
   stock and exercise of equity
   instruments, net of offering
   costs............................        (54)      67,214         46,698
  Dividends paid....................     (6,062)        (639)           --
                                      ---------  -----------        -------
        Net cash provided by (used
         in) financing activities...   (105,481)   1,072,042         46,698
                                      ---------  -----------        -------
  Net increase (decrease) in cash
   and cash equivalents.............        --       (46,434)        46,434
  Cash and cash equivalents,
   beginning of period..............        --        46,434            --
                                      ---------  -----------        -------
  Cash and cash equivalents, end of
   period...........................  $     --   $       --         $46,434
                                      =========  ===========        =======
Supplemental disclosure of cash flow
 information:
  Cash paid for interest............  $  80,604  $    27,436        $   --
                                      =========  ===========        =======
  Note received in exchange for
   options exercised by founders....  $   4,591  $       --         $   --
                                      =========  ===========        =======
  Dividends payable.................  $   2,845  $       783        $   --
                                      =========  ===========        =======
  Assets acquired through
   foreclosure......................  $  17,242  $       156        $   --
                                      =========  ===========        =======
  Issuance of units acquired with
   forgivable debt..................  $     --   $       --         $ 3,250
                                      =========  ===========        =======
</TABLE>
                See notes to consolidated financial statements.

                                      F-5
<PAGE>

                            NOVASTAR FINANCIAL, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                               December 31, 1998

Note 1. Summary of Significant Accounting Policies

  NovaStar Financial, Inc. (the Company) is a Maryland corporation formed on
September 13, 1996. The Company acquires subprime mortgage loans and mortgage
securities and manages the resulting portfolio of mortgage assets.

  Financial Statement Presentation The Company's financial statements have been
prepared in conformity with generally accepted accounting principles and
prevailing practices within the financial services industry. The preparation of
financial statements requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities at the date of the
financial statements and the reported amounts of income and expense during the
period. The Company uses estimates and employs the judgements of management in
determining the amount of its allowance for credit losses, amortizing premiums
or accreting discounts on its mortgage assets, and establishing the fair value
of its mortgage securities. While the financial statements and footnotes
reflect the best estimates and judgments of management at the time, actual
results could differ from those estimates. For example, it is possible that
credit losses or prepayments could rise to levels that would adversely affect
profitability if such levels were sustained for more than brief periods of
time.

  The Company owns 100 percent of the common stock of three special purpose
entities--NovaStar Assets Corporation, NovaStar Mortgage Funding Corporation
and NovaStar Certificates Financial Corporation. The Company formed these
entities in connection with the issuance of collateralized mortgage
obligations. The consolidated financial statements of the Company include the
accounts of these entities. Significant intercompany accounts and transactions
have been eliminated in consolidation.

  The Company accounts for its investment in NFI Holding Corporation using the
equity method. NovaStar Financial, Inc. owns 100 percent of the nonvoting
preferred stock of NFI Holding Corporation, for which it receives 99 percent of
any dividends paid by NFI Holding Corporation. The preferred stock was
purchased in February 1997 for $1,980,000 and the Company contributed another
$990,000 of capital to NFI Holding Corporation during 1998. NFI Holding
Corporation owns 100 percent of the outstanding common stock of NovaStar
Mortgage, Inc., a mortgage loan originator and servicer. NovaStar Mortgage
originated a substantial portion of the subprime residential mortgage loans
owned by the Company. The founders of the Company own 100 percent of the common
stock of NFI Holding Corporation and serve as officers and directors of NFI
Holding Corporation and NovaStar Mortgage. NFI Holding Corporation also owns
100 percent of the outstanding common stock of NovaStar Capital, Inc., which
was formed to trade whole loans.

  Cash and Cash Equivalents The Company considers investments with maturities
of three months or less at the date of purchase to be cash equivalents.

  Mortgage Loans Mortgage loans include loans acquired from NovaStar Mortgage
and in bulk pools from other originators and securities dealers. Mortgage loans
are generally purchased at a premium over the outstanding principal balance and
are stated at amortized cost. Premiums are amortized and discounts accreted as
yield adjustments over the estimated lives of the loans using a method that
approximates the interest method. Amortization includes the effect of
prepayments.

  Interest is recognized as revenue when earned according to the terms of the
mortgage loans and when, in the opinion of management, it is collectible. The
accrual of interest on loans is discontinued when, in management's opinion, the
interest is not collectible in the normal course of business, but in no case
beyond when a loan becomes ninety days delinquent. Interest collected on non-
accrual loans is recognized as income upon receipt.


                                      F-6
<PAGE>

                            NOVASTAR FINANCIAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

  The Company maintains an allowance for credit losses at a level deemed
appropriate by management. The allowance is based upon the assessment by
management of various factors affecting its mortgage loan portfolio, including
current and projected economic conditions, the makeup of the portfolio based on
credit grade, loan to value, delinquency status and other factors deemed to
warrant consideration. The allowance is maintained through ongoing provisions
charged to operating income and is reduced by loans that are charged off.

  Mortgage Securities The Company classifies all of its mortgage securities as
available-for-sale and, therefore, reports them at their estimated fair value
with unrealized gains and losses reported as a separate component of
stockholders' equity. Premiums are amortized and discounts are accreted as
yield adjustments over the estimated lives of the securities using a method
that approximates the interest method. Amortization includes the effect of
prepayments. Gains or losses on sales of securities are recognized using the
specific identification method.

  Assets Acquired Through Foreclosure Real estate owned, which consists of
residential real estate acquired in satisfaction of loans, is carried at the
lower of cost or estimated fair value less estimated selling costs. Adjustments
to the loan carrying value required at time of acquisition are charged to the
allowance for credit losses. Losses or gains from the ultimate disposition of
real estate owned are charged or credited to income.

  Transfers of Assets The Company uses the financial components approach when
accounting for transfers of mortgage loans in repurchase and securitization
transactions. Because the Company retains control over the loans, repurchase
and securitization transactions are accounted for as secured borrowings rather
than as sales. The borrowings under repurchase agreements and collateralized
mortgage obligations included in the accompanying consolidated balance sheets
represent the remaining principal amount of funds received in the transfer.

  Stock-based Compensation Compensation expense for services the Company
receives as consideration for stock issued through its employee stock option
plans is measured by the quoted market price of the stock at the measurement
date less the amount, if any, that the employee is required to pay.

  Income Taxes The Company intends to operate and qualify as a Real Estate
Investment Trust (REIT) under the requirements of the Internal Revenue Code. As
a result, the Company, and its qualified REIT subsidiaries, will generally not
be subject to federal income taxes at the corporate level on taxable income
distributed to stockholders. Requirements for qualification as a REIT include
various restrictions on common stock ownership and the nature of assets and
sources of income. In addition, a REIT must distribute at least 95 percent of
its annual taxable income to its stockholders. If in any tax year, the Company
does not qualify as a REIT, it will be taxed as a corporation and distributions
to stockholders will not be deductible in computing taxable income. If the
Company fails to qualify as a REIT in any tax year, it will not be permitted to
qualify for the succeeding four years. The most significant difference between
GAAP earnings and taxable income relates to provisions for credit losses, which
are not deductible for income tax purposes. The Company's non-REIT affiliate,
NFI Holding Corporation files a consolidated federal income tax return with
NMI.

  Earnings (Loss) Per Share Basic earnings per share (EPS) excludes dilution
and is computed by dividing income (loss) available to common stockholders by
the weighted-average number of common shares outstanding for the period. For
purposes of computing basic EPS, the Company has treated the convertible
preferred stock, which was converted into common stock on October 31, 1997, as
if it had been converted at inception of the Company. Diluted EPS reflects the
potential dilution that could occur if securities or other contracts to issue
common stock were exercised or converted into common stock or resulted in the
issuance of common stock that then shared in the earnings of the entity.
Diluted EPS is calculated assuming that all options and warrants on the
Company's common stock have been exercised, unless such exercise would be anti-
dilutive.

                                      F-7
<PAGE>

                            NOVASTAR FINANCIAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Financial Instruments with Off-balance-sheet Risk The Company has entered
into interest rate swap and cap agreements and financial futures contracts
designed to, in effect, alter the interest rates on its funding costs to more
closely match the yield on interest-earning assets. Net income earned from or
expense incurred on interest rate swap and cap agreements is accounted for on
the accrual method and is recorded as an adjustment of interest expense. The
gain or loss on early termination, sale or disposition of an interest rate swap
or cap agreement is recognized in current earnings if the matched funding
source is also extinguished. If the matched funding source is not extinguished,
the unrealized gain or loss on the related interest rate swap or cap agreement
is deferred and amortized as a component of interest expense over the remaining
term of the matched funding source. Unmatched swap or cap agreements are
recorded at fair value with changes in the unrealized gains or losses recorded
in current earnings.

  Realized and unrealized gains and losses on futures contracts that meet the
criteria for deferral accounting are deferred and amortized as an adjustment to
interest expense over the remaining life of the underlying financial
instrument. The estimated fair values of futures contracts that do not qualify
for deferral accounting are recorded at fair value, with changes in their fair
value recorded in current operations.

  Comprehensive Income Effective January 1, 1998, the Company adopted the
provisions of Statement of Financial Accounting Standards (SFAS) No. 130,
"Reporting Comprehensive Income." Comprehensive income includes net income and
revenues, expenses, gains and losses that are not included in net income. The
adoption of SFAS No. 130 did not result in an adjustment to assets,
liabilities, stockholders' equity or net loss.

  Segment Information Effective January 1, 1998, the Company adopted the
provisions of SFAS No. 131, "Disclosures about Segments of an Enterprise and
Related Information." SFAS No. 131 requires public business enterprises to
report financial and descriptive information about its reportable operating
segments. Operating segments are components of an enterprise about which
separate financial information is available that is evaluated regularly by the
chief operating decision-maker in deciding how to allocate resources and in
assessing performance. Generally, financial information is required to be
reported on the basis that it is used internally for evaluating segment
performance and deciding how to allocate resources to segments. The Company has
one reportable operating segment. The adoption of SFAS No. 131 did not result
in an adjustment to assets, liabilities, stockholders' equity or net loss.

  New Accounting Pronouncements During 1998, the Financial Accounting Standards
Board (FASB) issued SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities." SFAS No. 133 standardizes the accounting for derivative
instruments, including instruments embedded in other contracts, by requiring
that an entity recognize those items as assets or liabilities in the balance
sheet and measure them at fair value. If specific conditions are met, an entity
may elect to designate a derivative instrument either as a cash flow hedge, a
fair value hedge or a hedge of foreign currency exposure. Generally, SFAS No.
133 provides for matching the timing of gain or loss recognition on the hedging
instrument with the recognition of the changes in the fair value of hedge asset
or liability that is attributable to the hedge risk or 2) the earnings effect
of the hedge forecasted transaction. SFAS No. 133 is effective for fiscal years
beginning after June 15, 1999. Management is evaluating the effect of the
adoption of SFAS No. 133 on the financial statements of the Company.

  SFAS No. 134, "Accounting for Mortgage-Backed Securities Retained after the
Securitization of Mortgage Loans Held for Sale by a Mortgage Banking
Enterprise" was issued by the FASB during October 1998. SFAS No. 134 amends
SFAS No. 65 and 115, and requires entities to classify retained mortgage-backed
securities after the securitization of mortgage loans held for sale in
accordance with SFAS No. 115. However, a mortgage banking enterprise must
classify as trading retained mortgage-backed securities that it commits to sell
before or during the securitization process. This statement is effective for
the first fiscal quarter beginning after

                                      F-8
<PAGE>

                            NOVASTAR FINANCIAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

December 15, 1998. Management does not expect the adoption of this standard to
have a material impact on the Company's financial position and results of
operations.

Note 2. Mortgage Loans

  Mortgage loans, all of which are secured by residential properties, consisted
of the following as of December 31 (in thousands):

<TABLE>
<CAPTION>
                                                               1998      1997
                                                             --------  --------
     <S>                                                     <C>       <C>
     Outstanding principal.................................. $903,402  $559,436
     Net unamortized premium................................   20,868    17,861
                                                             --------  --------
     Amortized cost.........................................  924,270   577,297
     Allowance for credit losses............................   (3,573)   (2,313)
                                                             --------  --------
                                                             $920,697  $574,984
                                                             ========  ========
</TABLE>

  Activity in the allowance for credit losses is as follows for the years ended
December 31, 1998 and 1997 (in thousands):

<TABLE>
<CAPTION>
                                                                  1998    1997
                                                                 ------  ------
     <S>                                                         <C>     <C>
     Balance, January 1......................................... $2,313  $  --
     Provision for credit losses................................  7,430   2,453
     Amounts charged off, net of recoveries..................... (6,170)   (140)
                                                                 ------  ------
     Balance, December 31....................................... $3,573  $2,313
                                                                 ======  ======
</TABLE>

  All mortgage loans serve as collateral for various borrowing arrangements as
discussed in Note 4. The weighted-average interest rate on these loans at
December 31, 1998 and 1997 was 10.2%.

  Collateral for 16, 14 and 7 percent of the mortgage loans outstanding as of
December 31, 1998 was located in California, Florida and Washington,
respectively. The Company has no other significant concentration of credit
risk.

Note 3. Mortgage and Other Securities

  Mortgage securities, all classified as available-for-sale, consisted of the
following as of December 31, 1997 (dollars in thousands):

<TABLE>
<CAPTION>
                                      Weighted           Unrealized
                                      Average  Amortized -----------  Carrying
                                       Coupon    Cost     Gain  Loss   Value
                                      -------- --------- ------ ----  --------
     <S>                              <C>      <C>       <C>    <C>   <C>
     Mortgage securities issued by:
       Federal National Mortgage
        Association..................   7.55%  $272,773  $3,394 $(32) $276,135
       Government National Mortgage
        Association..................   5.74    234,745     845  (26)  235,564
       Federal Home Loan Mortgage
        Corporation..................   7.71      5,534      13   --     5,547
                                               --------  ------ ----  --------
                                               $513,052  $4,252 $(58) $517,246
                                               ========  ====== ====  ========
</TABLE>


                                      F-9
<PAGE>

                            NOVASTAR FINANCIAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

  The contractual maturities of mortgage securities were approximately 28 years
as of December 31, 1997. The expected maturities of mortgage securities may
differ from contractual maturities since borrowers have the right to prepay the
obligations.

  Gross gains and losses on sales of securities were as follows (in thousands):

<TABLE>
<CAPTION>
                                                                  For the
                                                                period from
                                                Year Ended     September 13,
                                               December 31,   1996 (inception)
                                               -------------- to December 31,
                                                 1998    1997      1996
                                               --------  ---- ---------------
     <S>                                       <C>       <C>  <C>
     Gross gains.............................. $    222  $51       $ --
     Gross losses.............................   15,490   --       $ --
                                               --------  ---       ----
     Gains (losses) on the sale of mortgage
      and other securities.................... $(15,268) $51       $ --
                                               ========  ===       ====
</TABLE>

  All mortgage securities were pledged as collateral under various borrowing
arrangements as described in Note 4. As of December 31, 1997, the unrealized
gain on available-for-sale securities as reported on the Company's balance
sheet included $159,000 in net unrealized gains on the investments of NFI
Holding Corporation.

Note 4. Borrowings

  Collateralized Mortgage Obligations (CMOs) The Company issues CMOs secured by
its mortgage loans as a means for long-term financing. For financial reporting
and tax purposes, the mortgage loans held as collateral for CMOs are recorded
as assets of the Company and the CMOs are recorded as debt. Interest and
principal on each CMO is payable only from principal and interest on the
underlying mortgage loans collateralizing the CMO. Interest rates reset monthly
and are indexed to one-month LIBOR. The estimated weighted-average months to
maturity is based on estimates and assumptions made by management. The actual
maturity may differ from expectations. However, the Company retains the option
to repay the CMO, and reacquire the mortgage loans, when the remaining unpaid
principal balance of the underlying mortgage loans falls below 35 percent of
their original amounts for issue 97-01 and 25 percent on 97-02, 98-01 and 98-
02.

                                      F-10
<PAGE>

                            NOVASTAR FINANCIAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Following is a summary of outstanding CMOs (dollars in thousands):

<TABLE>
<CAPTION>
                                                         Mortgage Loans
                                                 ------------------------------
                               Collateralized
                                  Mortgage                           Estimated
                                 Obligation                          Weighted
                             -------------------           Weighted   Average
                             Remaining  Interest Remaining Average    Months
                             Principal    Rate   Principal  Coupon  to Maturity
                             ---------  -------- --------- -------- -----------
   <S>                       <C>        <C>      <C>       <C>      <C>
   As of December 31, 1998:
   NovaStar Home Equity
    Series:
     Issue 1997-1..........  $163,419     5.88%  $166,821   10.56%       29
     Issue 1997-2..........   164,496     5.88    166,544   10.37        31
     Issue 1998-1..........   268,152     5.69    272,742   10.01        35
     Issue 1998-2..........   300,161     5.74    301,749    9.95        38
     Unamortized debt
      issuance costs, net..    (4,284)
                             --------
                             $891,944
                             ========
   As of December 31, 1997:
   NovaStar Home Equity
    Series:
     Issue 1997-1..........  $250,262     5.95%  $252,166   10.28%       35
     Issue 1997-2(A).......   160,376     6.25    168,712   10.20        36
     Unamortized debt
      issuance costs, net..    (1,771)
                             --------
                             $408,867
                             ========
</TABLE>
- --------
(A) Excludes $50 million of additional borrowings and mortgage loans added
    during second closing for the transaction on January 20, 1998.

  Short-term Financing Arrangements As of December 31, 1998, the Company has a
short-term financing arrangement with GMAC/Residential Funding Corporation
(GMAC/RFC) secured by residual interests in the Company's CMOs. In 1998, the
Company borrowed $15 million from GMAC/RFC. Under the terms of the agreement,
at maturity the Company will pay principal and a $3 million financing fee. The
$15 million in principal and the $3 million fee are included in borrowings in
the accompanying December 31, 1998 consolidated balance sheet. In connection
with the agreement, the Company issued 812,731 warrants to GMAC/RFC for the
purchase of the Company's stock at $4.63 per share. Originally, the agreement
matured on January 15, 1999 but was extended to February 28, 1999. Interest is
payable monthly at one-month LIBOR plus five percent (10.63 percent as of
December 31, 1998). The financing fee and the estimated value of the warrants
($813,000) were recognized as additional interest expense in 1998. The Company
had no other short-term borrowings outstanding as of December 31, 1998.

  During 1998, the average daily balance for repurchase agreements secured by
mortgage securities, repurchase agreements secured by mortgage loans,
borrowings under the warehouse line of credit and other short-term borrowings
were $392,859,000, $118,380,000, $14,991,000, and $3,945,000, respectively.

  As of December 31, 1997, the Company had a $300 million master repurchase
agreement with Merrill Lynch Mortgage Capital, Inc. and Merrill Lynch Credit
Corporation. Interest on borrowings under the master repurchase agreement was
paid at various rates priced in connection with respective purchases of
mortgage assets. The Company also had a $75 million warehouse line of credit
agreement with First Union National Bank. Interest on advances under the line
were based on the Federal Funds rate. Other repurchase agreements

                                      F-11
<PAGE>

                            NOVASTAR FINANCIAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

were used to finance mortgage securities bear interest at market rates and
mature in 30 days to one year. The following tables summarize the Company's
short-term borrowings as of December 31, 1997 (dollars in thousands):

<TABLE>
<CAPTION>
                                                                     Average
                                                                      Daily
                                                                     Balance
                                                 Weighted           During the
                                        Weighted Days to            Year Ended
                                        Average  Reset or          December 31,
                                          Rate   Maturity Balance      1997
                                        -------- -------- -------- ------------
<S>                                     <C>      <C>      <C>      <C>
Repurchase agreements secured by
 mortgage securities..................    5.92%       87  $501,430   $172,829
Master repurchase agreement secured by
 mortgage loans.......................    6.69        31    55,013    170,344
                                                          --------
  Total repurchase agreements.........                     556,443
Warehouse line of credit..............    7.09    Demand    40,250     18,402
                                                          --------
  Total borrowings....................                    $596,693
                                                          ========
</TABLE>

  The Company is a co-borrower with NovaStar Mortgage under warehouse lending
and master repurchase agreements with First Union National Bank. As of December
31, 1998, the Company and NovaStar Mortgage can borrow up to $75 million under
the warehouse lending agreement and $200 million under the master repurchase
agreement. As of December 31, 1998, the Company had no borrowings outstanding
and NovaStar Mortgage had borrowings of $203,341,000 outstanding under these
arrangements. Borrowings under these arrangements are secured by mortgage loans
owned by the Company or NovaStar Mortgage. The interest rate on borrowings
under the warehouse lending arrangement is indexed to the Federal funds rate.
Under the master repurchase agreement, borrowings are indexed to one-month
LIBOR.

  On February 12, 1999, the lending agreements with First Union National Bank
were renewed for a one-year term. The borrowing limit for the master repurchase
agreement was increased to $300 million. Interest rate structures for
borrowings under the agreements did not change. At the same time, two
additional one-year agreements were executed with First Union whereby the
Company and/or NovaStar Mortgage can borrow up to $20 million secured by
residual interests in CMOs issued by the Company, its affiliates or
subsidiaries. Borrowings under these arrangements bear interest at one-month
LIBOR plus five percent. All arrangements with First Union require NovaStar to
maintain minimum tangible net worth, meet equity ratio tests and comply with
other customary debt covenants. The Company was in compliance with the
covenants as of February 12, 1999.

Note 5. Financial Instruments with Off-balance-sheet Risk

  The Company's interest rate swap and cap agreements and financial futures
contracts result in off-balance-sheet risk. These instruments involve, to
varying degrees, elements of credit and market risk in addition to the amount
recognized in the financial statements.

  Credit Risk The Company's exposure to credit risk on interest rate swap and
cap agreements is limited to the cost of replacing contracts should the
counterparty fail. The Company seeks to minimize credit risk through the use of
credit approval and review processes, the selection of only the most
creditworthy counterparties, continuing review and monitoring of all
counterparties, exposure reduction techniques and through legal scrutiny of
agreements. Prior to engaging in negotiated derivative transactions with any
counterparty, the Company has in place fully executed written agreements.
Agreements with counterparties also call for full two-way netting of payments.
Under such agreements, on each payment exchange date all gains and losses of a
counterparty are netted into a single amount, limiting exposure to the
counterparty to any net positive value.

  Financial futures contracts are exchange-traded, and, as such, credit risk is
considered nominal.

                                      F-12
<PAGE>

                            NOVASTAR FINANCIAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  Market Risk The potential for financial loss due to adverse changes in market
interest rates is a function of the sensitivity of each position to changes in
interest rates, the degree to which each position can affect future earnings
under adverse market conditions, the source and nature of funding for the
position, and the net effect due to offsetting positions. The synthetic product
of these transactions is a "matched" position for the Company. The combination
of off-balance-sheet instruments with on-balance-sheet liabilities leaves the
Company in a market risk position that is designed to be a better position than
if the derivative had not been used in interest rate risk management.
Derivatives instruments used in matched transactions as described above are
classified as derivatives held for purposes other than trading. No derivatives
were held for trading purposes during the periods ended December 31, 1998, 1997
and 1996.

  Other Risk Considerations The Company is cognizant of the risks involved with
financial derivatives. The Company's policies and procedures seek to mitigate
risk associated with the use of financial derivatives in ways appropriate to
its business activities, considering its risk profile as a limited end-user.

  Information regarding the Company's financial instruments with off-balance-
sheet risk is as follows.

<TABLE>
<CAPTION>
                                                                 Weighted Average
                                    Unrealized   Weighted         Interest Rate     Accrued Interest
                          Notional ------------- Days to  Cap   ------------------ ------------------
                           Value   Gains  Losses Maturity Rate  Receivable Payable Receivable Payable
                          -------- ------ ------ -------- ----  ---------- ------- ---------- -------
<S>                       <C>      <C>    <C>    <C>      <C>   <C>        <C>     <C>        <C>
As of December 31, 1998:
  Interest rate cap
   agreements...........  $625,000 $1,194 $   --   709    6.27%      NA       NA        --       --
                          ======== ====== ======
As of December 31, 1997:
  Interest rate swap
   agreements--fixed
   rate pay.............  $276,000 $  --  $1,380   670      NA     5.91%    6.27%    $2,157   $2,291
  Interest rate cap
   agreements...........   270,000  1,268    --    770    5.99%      NA       NA        --       --
  Financial futures
   contracts:
   Eurodollar March
    1998................   200,000    --      20    77      NA       NA       NA         NA       NA
   Eurodollar June
    1998................   200,000    --      46   168      NA       NA       NA         NA       NA
                          -------- ------ ------
                          $946,000 $1,268 $1,446
                          ======== ====== ======
</TABLE>

  During the year ended December 31, 1998 and 1997, the Company recognized
$2,891,000 and $1,047,000, respectively, in interest expense relating to off-
balance-sheet financial instruments. The Company terminated interest rate
agreements with an aggregate notional value of $469 million as a result of the
sale of the Company's portfolio of mortgage securities and repayment of the
related financing under repurchase agreements in 1998, incurring net losses of
$7,977,000.

Note 6. Fair Value of Financial Instruments

  The following disclosure of the estimated fair value of financial instruments
presents amounts that have been determined using available market information
and appropriate valuation methodologies. However, considerable judgment is
required to interpret market data to develop the estimates of fair value.
Accordingly, the estimates presented herein are not necessarily indicative of
the amounts that could be realized in a current market exchange. The use of
different market assumptions or estimation methodologies could have a material
impact on the estimated fair value amounts.


                                      F-13
<PAGE>

                            NOVASTAR FINANCIAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

  The estimated fair values of the Company's financial instruments are as
follows as of December 31 (in thousands):

<TABLE>
<CAPTION>
                                                 1998              1997
                                           ----------------- -----------------
                                           Carrying   Fair   Carrying   Fair
                                            Value    Value    Value    Value
                                           -------- -------- -------- --------
<S>                                        <C>      <C>      <C>      <C>
Financial assets:
  Mortgage loans.......................... $920,697 $925,800 $574,984 $608,600
  Mortgage securities.....................      --       --   517,246  517,200
  Financial liabilities:
    Collateralized mortgage obligations...  891,944  883,000  408,867  409,300
    Other borrowings......................   18,000   18,000      --       --
    Repurchase agreements.................      --       --   556,443  556,800
    Warehouse line of credit..............      --       --    40,250   40,200
    Off-balance-sheet financial
     instruments..........................    1,157    1,200      --      (200)
</TABLE>

  Market quotations were used to estimate the fair value of mortgage
securities. The fair value of all other financial instruments is estimated by
discounting projected future cash flows, including projected prepayments for
mortgage assets, at current market rates. The fair value of cash and cash
equivalents and accrued interest receivable and payable approximates its
carrying value.

Note 7. Stockholders' Equity

  The Company was formed and capitalized by its founders in September 1996. In
December 1996, the Company successfully completed a private placement offering
of 3,549,999 units. Each unit consisted of one share of convertible preferred
stock and one warrant, which entitled the holder to purchase one share of
common stock for $15.00 per share. The underwriter received 100,000 warrants in
addition to underwriting discounts. The Company raised $47 million in the
offering, net of $3 million of offering costs. The warrants became exercisable
in February 1998 and remain exercisable until February 2001 at an exercise
price of $15.00 per share. During 1998, warrants to acquire 181 shares were
exercised. As of December 31, 1998, 3,649,818 warrants remained outstanding and
exercisable.

  Included in the units issued in the Company private placement were 108,333
units acquired by each of the two founders at a price of $15.00 per unit.
Payment was made by the founders delivering to the Company forgivable
promissory notes, bearing interest at eight percent per annum and secured by
the units acquired. Thereafter, interest is payable quarterly, upon forgiveness
or at maturity of the notes on December 31, 2001. During 1998, the Company
accrued interest on these notes totaling $189,000, of which the founders paid
$103,000. The principal amount of the notes is divided into three equal
tranches. Payment of principal on each tranche will be forgiven if certain
incentive targets are achieved. These notes have been reflected as a reduction
of stockholders' equity in the accompanying consolidated balance sheets. During
1997, the Company surpassed its first incentive target resulting in the
forgiveness of one-third of the notes and the recognition of compensation
expense in December 1997 of $1,083,000. The Company did not meet the incentive
targets in 1998 and, accordingly, no debt forgiveness occurred.

  On December 1, 1997, the Company completed the sale of its common stock in an
initial public offering of 4,059,500 shares at a price of $18.00 per share. The
Company raised $67 million in net proceeds from this offering. Under the
provisions of the private placement agreements, the preferred stock
automatically converted to common stock at the closing of the initial public
offering. As a result, 3,549,999 shares of preferred stock were converted into
common stock on November 4, 1997.

                                      F-14
<PAGE>

                            NOVASTAR FINANCIAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


Note 8. Stock Option Plan

  The Company's 1996 Stock Option Plan (the Plan) provides for the grant of
qualified incentive stock options (ISOs), non-qualified stock options (NQSOs),
deferred stock, restricted stock, performance shares, stock appreciation and
limited stock awards, and dividend equivalent rights (DERs). ISOs may be
granted to the officers and employees of the Company. NQSOs and awards may be
granted to the directors, officers, employees, agents and consultants of the
Company or any subsidiaries. Under the terms of the Plan the number of shares
available for issuance is equal to 10 percent of the Company's outstanding
common stock with a current cap on ISO grants at 339,332. Unless previously
terminated by the Board of Directors, the Plan will terminate on September 1,
2006.

  All options have been granted at exercise prices greater than or equal to the
estimated fair value of the underlying stock at the date of grant. Outstanding
options vest over four years and expire ten years after the date of grant. The
following table summarizes option activity under the 1996 Plan for 1998, 1997
and 1996, respectively:

<TABLE>
<CAPTION>
                                  1998               1997              1996
                            ------------------ ----------------- ----------------
                                      Weighted          Weighted         Weighted
                                      Average           Average          Average
                             Shares    Price   Shares    Price   Shares   Price
                            --------  -------- -------  -------- ------- --------
   <S>                      <C>       <C>      <C>      <C>      <C>     <C>
   Outstanding at the
    beginning of year......  557,472   $15.22  334,332   $13.24      --   $  --
   Granted.................  148,000     9.38  225,640    18.00  334,332   13.24
   Exercised............... (300,582)   14.51   (2,500)    2.50      --      --
   Canceled................  (21,070)   18.00      --       --       --      --
                            --------           -------           -------
   Outstanding at the end
    of year................  383,820   $13.37  557,472   $15.22  334,332  $13.24
                            ========   ======  =======   ======  =======  ======
   Exercisable at the end
    of year................   61,625   $15.70  298,082   $14.61      --   $  --
                            ========   ======  =======   ======  =======  ======
</TABLE>

  Certain options granted during 1998, 1997, and 1996 were granted with DERs.
Under the terms of the DERs, a recipient is entitled to receive additional
shares of stock upon the exercise of options. The DERs accrue at a rate equal
to the number of options outstanding times the dividends per share amount at
each dividend date. The accrued DERs convert to shares based on the stock's
fair value on the dividend declaration date. Certain of the options exercised
in 1998 had DERs attached to them. As a result of these exercises, an
additional 641 shares of common stock were issued in 1998. No DERs were
converted to common stock upon the exercise of options in 1997 and 1996. As
discussed in Note 9, the Company's two founders exercised options to acquire
289,332 shares of common stock in 1998.

  The following table presents information on stock options outstanding as of
December 31, 1998.

<TABLE>
<CAPTION>
                                       Outstanding              Exercisable
                              ------------------------------ -----------------
                                        Weighted
                                         Average    Weighted          Weighted
                                        Remaining   Average           Average
                                       Contractual  Exercise          Exercise
                              Quantity Life (years)  Price   Quantity  Price
                              -------- -----------  -------- -------- --------
   <S>                        <C>      <C>          <C>      <C>      <C>
   $0.01-$2.50...............  31,250      7.9       $ 1.90    8,750   $ 1.79
   $6.38..................... 108,000     10.0         6.38      --       --
   $17.01-$20.81............. 244,570      8.9        17.92   52,875    18.00
                              -------                         ------
   Outstanding at the end of
    year..................... 383,820      9.1       $13.37   61,625   $15.70
                              =======     ====       ======   ======   ======
</TABLE>

                                      F-15
<PAGE>

                            NOVASTAR FINANCIAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  In accordance with generally accepted accounting principles, the Company has
chosen to not record the fair value of stock options at their grant date. If
recorded the expense would not have been material and the Company's diluted
loss per share for 1998, 1997 and 1996 would have been unchanged. The following
table summarizes the weighted average fair value of the options granted during
1998, 1997 and 1996, determined using the Black-Scholes option pricing model
and the assumptions used in their determination.

<TABLE>
<CAPTION>
                                                             1998   1997  1996
                                                             -----  ----  -----
     <S>                                                     <C>    <C>   <C>
     Weighted average:
       Fair value........................................... $4.59  $--   $0.18
       Expected life in years...............................     5     7      5
       Annual risk-free interest rate.......................   5.1%  6.5%   7.0%
       Volatility...........................................   4.0   --     --
       Dividend yield.......................................   5.0%  8.0%   --
</TABLE>

Note 9. Related Party Transactions

  The Company and NovaStar Mortgage, Inc. are parties to a mortgage loan
purchase and sale agreement, an administrative services outsourcing agreement
and loan servicing agreements. Under the terms of the mortgage loan purchase
and sale agreement, the Company purchases mortgage loans originated by NovaStar
Mortgage at prices that vary with the nature and terms of the underlying
mortgage loans. The agreement was modified effective January 1, 1998 to include
a purchase commitment fee. If NovaStar Mortgage chooses to retain the mortgage
loans it originates or sell them to third parties, it pays a fee to the Company
for not delivering its loan production under the purchase commitment. During
1998, NovaStar Mortgage originated $877 million, of which the Company acquired
approximately $500 million. During 1997, NovaStar Mortgage originated $735
million in subprime mortgage loans, all acquired by the Company.

  Under the outsourcing services agreement, the Company pays NovaStar Mortgage
a fee for providing certain services, including the development of loan
products, underwriting, funding, and quality control. Under the terms of loan
servicing agreements, NovaStar Mortgage services loans owned by the Company.
Individual agreements have been executed for each pool of loans serving as
collateral for the Company's CMOs. A separate agreement exists between the
Company and NovaStar Mortgage for those loans that do not serve as collateral
for CMOs.

  Following is a summary of the fees, in thousands, paid to and received from
NovaStar Mortgage.

<TABLE>
<CAPTION>
                                                                 Year Ended
                                                                December 31,
                                                                --------------
                                                                 1998    1997
                                                                ------  ------
       <S>                                                      <C>     <C>
       Amounts paid to NovaStar Mortgage:
         Administrative fees................................... $7,800  $3,650
         Loan servicing fees...................................  3,803     505
       Amounts received from NovaStar Mortgage--purchase
        commitment fee......................................... (5,117)    --
                                                                ------  ------
                                                                $6,486  $4,155
                                                                ======  ======
</TABLE>

  As discussed in note 8, during 1998 the founders of the Company exercised
options to acquire 289,332 shares of common stock. In payment for the acquired
common stock, the founders issued notes payable to the Company. Unpaid
principal on the notes was $4,340,000 as of December 31, 1998. During 1998, the
Company accrued interest income of $220,000 and the founders paid $78,000 in
interest on these notes.

                                      F-16
<PAGE>

                            NOVASTAR FINANCIAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


  As discussed in Note 7, during 1997 the founders issued notes payable to the
Company for the units acquired in the Company's private placement offering of
capital stock. In accordance with the terms of the private placement, the
Company agreed to advance funds for the payment of the founders' personal tax
liability arising from the forgiveness of the private placement notes
receivable. The founders have issued notes payable to the Company for the
repayment of the tax liability and interest accrued on forgivable notes through
December 31, 1997. Unpaid principal on the notes was $843,000 and $763,000 as
of December 31, 1998 and 1997, respectively. During 1998, the Company accrued
interest interest on these amounts totaling $47,000 and the founders paid
interest totaling $18,000 on these notes.

  Interest on the foregoing notes due from founders accrues monthly at one-
month LIBOR plus one percent (6.54 percent as of December 31, 1998) and is
payable quarterly. The notes mature on the earlier of the founder's employment
termination or their sale of the common stock. Common stock of the Company
owned by the founders serves as collateral for the notes. The aggregate amounts
due under these arrangements was $5,354,000 and $763,000 as of December 31,
1998 and 1987, respectively, and are included as amounts due from founders in
the Company's consolidated balance sheets.

Note 10. Income Taxes

  The Company has elected to be taxed as a REIT and accordingly has deducted
for income tax purposes, all dividends paid on its common and preferred stock.
Because the Company has paid or will pay dividends in amounts approximating its
taxable income or has a taxable loss, no provision for income taxes has been
provided in the accompanying financial statements for the years ended December
31, 1998 and 1997.

Note 11. Commitments and Contingencies

  A dividend of $0.35 per share was declared by the Board of Directors during
September 1998 to be paid to stockholders of record on October 15, 1998.
Subsequently, the dividend was deferred and is scheduled for payment on April
15, 1999.

  In the normal course of its business, the Company is subject to various legal
proceedings and claims, the resolution of which, in the opinion of management,
will not have a material adverse effect on the Company's financial condition or
results of operations.

  The Company leases facilities and equipment under operating leases. Rent
expense and future obligations under these leases are not material to the
financial statements.

                                      F-17
<PAGE>

                            NOVASTAR FINANCIAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


Note 12. Condensed Financial Statements of NFI Holding Corporation

  NFI Holding Corporation and its subsidiary, NovaStar Mortgage had no
operations, revenues or expenses prior to February 1997, when NovaStar Mortgage
began originating subprime mortgage loans through a network of wholesale
brokers and correspondents. Effective July 15, 1997, NovaStar Mortgage began
servicing mortgage loans on behalf of the Company. NFI Holding Corporation has
no operations of its own and, therefore, its consolidated financial statements
generally reflect the operations of NovaStar Mortgage. Following are the
condensed consolidated balance sheet and statement of operations of NFI Holding
Corporation for 1998 and 1997 (in thousands):

                            NFI Holding Corporation

                     Condensed Consolidated Balances Sheets

<TABLE>
<CAPTION>
                                                                 December 31,
                                                               ----------------
                                                                 1998    1997
                                                               -------- -------
<S>                                                            <C>      <C>
Assets
Cash and cash equivalents..................................... $  5,759 $   --
Restricted cash...............................................   33,007  20,424
Mortgage loans................................................  216,839     --
Mortgage securities...........................................      --   55,195
Other assets..................................................    4,492   1,675
                                                               -------- -------
      Total assets............................................ $260,097 $77,294
                                                               ======== =======
Liabilities and Stockholders' Equity
  Liabilities:
    Borrowings................................................ $203,341 $53,490
    Due to NovaStar Financial, Inc............................   51,528  20,701
    Accounts payable and other liabilities....................    5,215     915
    Stockholders' equity......................................       13   2,188
                                                               -------- -------
      Total liabilities and stockholders' equity.............. $260,097 $77,294
                                                               ======== =======
</TABLE>

                                      F-18
<PAGE>

                            NOVASTAR FINANCIAL, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

                            NFI Holding Corporation

                Condensed Consolidated Statements of Operations

<TABLE>
<CAPTION>
                                                            For the period from
                                                Year Ended   February 6, 1997
                                               December 31,   (inception) to
                                                   1998      December 31, 1997
                                               ------------ -------------------
<S>                                            <C>          <C>
Interest income...............................   $11,812          $1,136
Interest expense..............................     7,501             945
                                                 -------          ------
  Net interest income.........................     4,311             191
Other income:
  Fees from third parties.....................     2,829           1,271
  Fees received from, net of paid to, NovaStar
   Financial, Inc.............................     6,486           4,155
  Net gain on sales of mortgage assets........     3,148             --
                                                 -------          ------
    Total other income........................    12,463           5,426
General and administrative expenses...........    19,789           5,569
                                                 -------          ------
Net income (loss) before taxes................    (3,015)             48
Income tax expense............................       --               20
                                                 -------          ------
Net income (loss).............................   $(3,015)         $   28
                                                 =======          ======
</TABLE>

                                      F-19
<PAGE>

                          INDEPENDENT AUDITORS' REPORT

The Board of Directors
NovaStar Financial, Inc.:

  We have audited the accompanying consolidated balance sheets of NovaStar
Financial, Inc. and subsidiaries as of December 31, 1998 and 1997 and the
related consolidated statements of operations, stockholders' equity and cash
flows for the years ended December 31, 1998 and 1997 and the period from
September 13, 1996 (inception) to December 31, 1996. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.

  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.

  In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of NovaStar
Financial, Inc. and subsidiaries as of December 31, 1998 and 1997 and the
results of their operations and their cash flows for the years ended December
31, 1998 and 1997 and the period from September 13, 1996 (inception) to
December 31, 1996, in conformity with generally accepted accounting principles.

                                          KPMG LLP

Kansas City, Missouri
January 29, 1999
except for the last paragraph
of Note 4, as to which the
date is February 12, 1999

                                      F-20
<PAGE>

- --------------------------------------------------------------------------------

    You should rely only on
  the information contained
  or incorporated by
  reference in this
  prospectus. We have not
  authorized anyone to
  provide you with different
  information.

    We are not offering the
  securities in any state
  where the offer is not
  permitted.

    We do not claim that the
  information in this
  prospectus is accurate as
  of any date other than the
  date stated on the cover.


- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------

                                4,285,714 Shares

                            NovaStar Financial, Inc.

                          Convertible Preferred Stock

                                5,813,427 Shares

                            NovaStar Financial, Inc.

                                  Common Stock

                                   1,527,713

                            NovaStar Financial Inc.

                            Stock Purchase Warrants


                       [LOGO OF NOVASTAR FINANCIAL, INC.]


                                ---------------
                                   Prospectus
                                  May 12, 1999

                                ---------------

- --------------------------------------------------------------------------------


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