<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------------
FORM 10-K/A
Amendment No. 1 to
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 1997
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period From ______ to ______
----------------------
Commission File Number 001-13533
NOVASTAR FINANCIAL, INC.
(Exact name of registrant as specified in its charter)
Maryland 74-2830661
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1901 W. 47/th/ Place, Suite 105, Westwood, KS 66205
(Address of principal executive office) (Zip Code)
Registrant's telephone number, including area code: (913) 362-1090
----------------------
Securities registered pursuant to Section 12(b) of the Act:
Name of Each Exchange on
Title of Each Class Which Registered
Common Stock, $0.01 par value New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
The aggregate market value of voting stock held by non-affiliates of the
registrant as of March 16, 1998 was approximately $135,363,000 as reported by
the New York Stock Exchange Composite Transactions on such date.
The number of shares of the Registrant's Common Stock outstanding on March 16,
1998 was 7,828,665.
Documents incorporated by reference
Items 10, 11 12, and 13 of Part III are incorporated by reference to the
NovaStar Financial, Inc. definitive proxy statement to shareholders, which will
be filed with the Commission no later than 120 days after December 31, 1997.
<PAGE>
NOVASTAR FINANCIAL, INC.
FORM 10-K
For the Fiscal Year Ended December 31, 1997
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TABLE OF CONTENTS
<TABLE>
<CAPTION>
PART I
<S> <C> <C>
Item 1. Business............................................................................. 1
Item 2. Properties........................................................................... 16
Item 3. Legal Proceedings.................................................................... 16
Item 4. Submission of Matters to a Vote of Security Holders.................................. 16
PART II
Item 5. Market For Registrant's Common Equity and Related Stockholder Matters................ 17
Item 6. Selected Consolidated Financial Data................................................. 18
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 19
Item 8. Financial Statements and Supplementary Data.......................................... 29
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. 43
PART III
Item 10. Directors and Executive officers of the Registrant................................... 43
Item 11. Executive Compensation............................................................... 43
Item 12. Security Ownership of Certain Beneficial Owners and Management....................... 43
Item 13. Certain Relationships and Related Transactions....................................... 43
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K..................... 44
GLOSSARY......................................................................................... 46
</TABLE>
<PAGE>
PART I
Item 1. Business
Overview
NovaStar Financial, Inc. (NovaStar or 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. A
primary source of mortgage assets for the Company is the subprime loans
originated by NovaStar Mortgage, Inc., an affiliate of the Company.
Management believes the tax-advantaged structure of a Real Estate Investment
Trust (REIT) is the most efficient method of owning the cash flows associated
with mortgage assets owned by the Company. The Company must meet numerous rules
established by the Internal Revenue Service to retain its status as a REIT. The
rules are extensive and complicated. In short, they require NovaStar to:
1) Restrict its investing to certain real estate related assets,
2) Avoid certain investment trading and hedging activities, and
3) Distribute taxable income to stockholders.
As long as NovaStar maintains its REIT status, distributions to stockholders
will generally be deductible for income tax purposes. This deduction
effectively eliminates corporate level income taxes. Management believes it has
and will continue to meet the requirements to maintain its REIT status.
A primary source of assets for the Company is the loans originated by
NovaStar Mortgage, which shares common management with the Company. NovaStar
Mortgage lends to subprime borrowers -- individuals that do not qualify for
agency/conventional lending programs because of a lack of available
documentation or previous credit difficulties, but generally have substantial
equity in their homes. Often, these are individuals or families who have built
high-rate consumer debt and are attempting to use the equity in their home to
consolidate debt and lower their total monthly payments.
During 1997, NovaStar purchased 100 percent of the mortgage loans originated
by NovaStar Mortgage through its wholesale lending operation. The sales force
of NovaStar Mortgage -- consisting of commissioned employees (account
executives) -- maintains and develops relationships with a nationwide network of
independent retail brokers. As of December 31, 1997, NovaStar Mortgage had 36
account executives in 24 states.
NovaStar's principal customers are retail brokers. Retail brokers seek a
wholesale lender or end investor to fund the loans they originate. Once the
loan is originated, a wholesaler warehouses loans and sells a bulk pool of
product to an end investor. In this process, the retail broker earns a fee
(from the wholesaler) and the wholesaler earns a fee (from the end investor).
The end investor may or may not outsource the servicing of loans.
As a fully integrated investor, NovaStar owns the loan from cradle to grave.
It underwrites, processes, funds and services mortgage loans. In this role,
NovaStar is both the wholesaler and the end investor. By eliminating one phase
of the loan process, loans are added to the Company's portfolio at an "all-in"
lower cost than those mortgage loans purchased by the end investor through
wholesalers. All-in costs include premiums paid to the broker and expenses
incurred in the origination operation.
NovaStar strives to provide a competitive menu of mortgage loan products. The
marketing personnel of NovaStar Mortgage constantly monitor "main street" to
ensure we are maintaining competitive interest rates and product pricing that
are attractive for the broker to offer borrowers. However, quality customer
service maintains and retains relationships with brokers to gain repeat
business. A key focus for the origination operation is underwriting turnaround
time.
Further details regarding the loans originated by NovaStar Mortgage and
purchased by the Company are provided in Business--Risk Management--Credit Risk,
- --Prepayment Risk, Management's Discussion and Analysis of Consolidated
Financial Condition and Results of Operations and Note 3 to the Company's
consolidated financial statements.
On a short-term basis, NovaStar finances its mortgage loans through a bank
warehouse line of credit and repurchase agreements with several nationally
recognized investment bankers. Details regarding available financing
arrangements and amounts outstanding under those arrangements are included in
Management's
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Discussion and Analysis of Consolidated Financial Condition and
Results of Operations and Note 4 to the Company's consolidated financial
statements.
For long-term financing, NovaStar securitizes its loans by issuing
collateralized mortgage obligations (CMOs). CMOs are debt arrangements whereby
the investor in the CMO is paid based on the performance of the mortgage loans
collateralizing the debt. As NovaStar borrowers repay principal and pay
interest on their mortgages, the funds are segregated to repay the investors in
the NovaStar CMO.
Although these CMOs are non-recourse debt, NovaStar retains the credit,
prepayment and interest rate risks associated with the loans. Under its CMOs,
NovaStar retains the mortgage loans and incurs the obligation to pay the CMO
bondholders. NovaStar earns the net spread between the interest income on the
loans and the interest expense on the bonds. The spread earned by NovaStar also
is reduced by credit losses on the portfolio. Prepayments on the mortgage loans
serve to reduce the term over which NovaStar earns its spread. The longer the
mortgage collateral is outstanding, the longer the period for which NovaStar
will receive cash flow. To the extent the borrowers prepay, it shortens the life
of the CMO and the period over which NovaStar receives cash flow. The cash flow
to NovaStar will change when interest rates on the bonds fluctuate at amounts or
times that are different from the mortgage loan collateral, thereby subjecting
NovaStar to interest rate risk. NovaStar addresses these risks as discussed in
the Risk Management portion of this Annual Report.
Securitization is a common method used to finance loans by large mortgage
lenders. Many lenders structure securitizations to allow the transaction to be
treated as a sale of the loans for financial reporting purposes. The loans are
removed from the lenders' balance sheets, the securities issued are not recorded
as an obligation of the lender and a non-cash gain is recorded on this "sale."
In structuring their transactions, these companies must estimate the future
value of loan spread using prepayment, loss and discount rate assumptions deemed
reasonable by management. The present value of the estimated long-term value of
the loans is immediately recognized in income as a gain. In effect, the gain
and the related expenses incurred to originate the loans are matched in the same
period. In addition, the seller retains a "residual value" on its balance sheet
that represents the estimated long-term value of the "spread" to their
financing. Spread is the difference between the income from the mortgage and
the related long-term funding. However, if the assumptions made by management
are proven wrong, the entity will be required to subsequently adjust the value
of its residual.
CMO transactions executed by NovaStar are designed to meet accounting rules
that result in securitizations being treated as financing transactions. The
mortgage loans and related debt continue to be presented on the Company's
balance sheet, and no gain is recorded. This accounting is similar to that of a
bank -- expenses are recognized when the loan is originated and income is earned
over time as loan payments are made. For a bank, customer deposits provide
long-term funding. For NovaStar, it is CMO debt.
Details regarding CMOs issued by the Company can be found in Business--Risk
Management--Credit Risk, Management's Discussion and Analysis of Consolidated
Financial Condition and Results of Operations and Note 4 to the Company's
consolidated financial statements.
As a portfolio lender, NovaStar must create a loan portfolio large enough to
cover operating expenses, and still provide good returns to shareholders. While
management is focused on earnings, it views the net interest margin as the first
measure of profitability. It represents the current income from previous
investments in mortgage loans. Current loan origination expenses are part of
the Company's investment in current production that will provide returns to
stockholders in future periods. GAAP requires the Company to expense most of
the origination costs as loans are funded, while the economic benefit will be
received over the life of the loans.
In the opinion of management of the Company, maintaining contact with
NovaStar's customers is critical in managing credit risk and in borrower
retention. Subprime borrowers are prone to late payments and are more likely to
default on their obligations than conventional borrowers. By servicing loans
"in-house", NovaStar strives to identify problems with borrowers early and take
quick action to address problems. Borrowers may be able to improve their
personal credit and thereby seek to refinance their loan to obtain a lower
interest rate and payment. By keeping in close touch with borrowers, the
Company can provide them with information about Company products to entice them
to refinance with NovaStar.
The Company's business requires capital to fund loan production. Ideally,
that capital would be raised in small pieces to minimize dilution and create
"just in time" capital. However, capital typically comes in larger chunks.
These large infusions of capital cannot be immediately absorbed and invested in
wholesale loan originations. As a result, the Company temporarily invests in
high-quality investment securities as a means of "warehousing" capital. These
securities are liquid assets and can be sold to generate cash to fund loan
origination. Information regarding the Company's investment securities can be
found in Business--Risk Management--Credit Risk, --Prepayment Risk, Management's
Discussion and Analysis of Consolidated Financial Condition and Results of
Operations and Note 2 to the Company's consolidated financial statements.
Market in Which the Company Operates and Competition
Over the last three years, the residential mortgage market generated annual
volume in excess of $600 billion per year. The majority of these originations
(approximately 80 to 90 percent) were classified as "prime" mortgages which
generally means they have credit quality and documentation sufficient to qualify
for guarantee by GNMA, FNMA or FHLMC. The remaining 10 to 20 percent
(approximately $85 to $150 billion) of the originations were classified as
"subprime."
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<PAGE>
The Company believes 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 that
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 1995. While the
prime market experienced a decline in originations of more than 40 percent due
primarily to an increase in interest rates, loan originations in the subprime
market continued to grow at an annual rate of 10 to 15 percent over the same
three-year period.
Based on industry sources, the estimated 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, the
Company believes the subprime mortgage market is still highly fragmented. 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 loan volume at traditional financial institutions have
together drawn new participants and capital to the subprime mortgage loan
market. Management believes 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 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.
The Company believes 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: (i) growth in the number of existing
homeowners with negative entries on their credit reports; (ii) growth in the
number of immigrants with limited credit histories who are in the prime home
buying ages of 25 to 34; (iii) growth in the number of self-employed individuals
who have sources of income which are inconsistent and difficult to document;
(iv) growth in consumer debt levels which are causing many borrowers to have
higher debt/income ratios; and (v) growth in consumer bankruptcy filings which
cause borrowers to be classified as subprime.
The Company believes that more competitors may attempt to enter the market.
While this may cause profit margins to narrow, the Company believes that the
subprime mortgage market will be able to sustain attractive profit margins due
to certain barriers to entry which include (i) 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; (ii) the higher level of
expertise required to underwrite the mortgage loans; (iii) the higher cost to
service the mortgage loans due to the additional emphasis required on
collections and loss mitigation; and (iv) the highly fragmented nature of
business due to the difficulty of sourcing the mortgage loans. Principal
competition in the business of originating, acquiring and servicing subprime
mortgage loans are financial institutions such as banks, thrifts and other
independent wholesale mortgage lenders, and certain other mortgage acquisition
companies structured as REITs.
The Company faces intense competition in the business of originating,
purchasing, selling and securitizing sub-prime mortgage loans. The number of
participants is believed to be well in excess of 100 companies and no single
participant holds a dominant share of the sub-prime market. In addition to other
residential mortgage REIT's, the Company is in competition for sub-prime
borrowers with consumer finance companies, conventional mortgage bankers,
commercial banks, credit unions and thrift institutions. The Company competes
for holding mortgage loans with life insurance companies, institutional
investors and other well-capitalized publicly-owned mortgage lenders. Many of
these competitors are substantially larger and have considerably greater
financial, technical and marketing resources than the Company.
Competition among industry participants can take many forms, including
convenience in obtaining a loan, amount and term of the loan, customer service,
marketing/distribution channels, loan origination fees and interest rates. To
the extent any of the Company's competitors significantly expand their
activities in the Company's market, the Company could be materially adversely
affected.
The Company believes that one of its key competitive strengths is its
employees and the level of service they are able to provide its borrowers. By
servicing its loan portfolio directly, the Company is able to stay in close
contact with its borrowers and identify potential problems early. The Company's
servicing staff is comprised of seasoned mortgage professionals with significant
experience in the sub-prime marketplace.
Significant external competitive factors include interest rate fluctuations
and general economic conditions. Changing interest rates have a direct affect on
the spread the Company earns on its loan portfolio. In general, the interest
income the Company receives from its borrowers does not reset as fast as the
interest expense the Company must pay on its financing lines. Therefore, when
interest rates are rising the Company spread decreases and when they are falling
the Company's spread increases. Other economic factors may also affect the
Company's competitive position. Certain market conditions might exist which
could adversely affect the Company's liquidity, as well as its ability to raise
capital and securitized portions of its mortgage holdings. To the extent the
Company is able to endure such market conditions, the Company could be
materially adversely affected.
The Company anticipates that it will be able to effectively compete due to
its:
(i) experienced management team;
(ii) tax advantaged status as a REIT;
(iii) vertical integration through its relationship with NovaStar
Mortgage, which originates and services mortgage loans;
(iv) freedom from certain regulatory-related administrative and oversight
costs;
(v) direct access to capital markets to securitize its assets; and
(vi) cost-efficient operations.
Regulated mortgage lenders, such as savings and loans and banks, are
subject to regulatory review and must pay for the costs incurred by the
regulator in their examinations. NovaStar incurs no such regulation fees or
costs and is, therefore, competitively advantaged.
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<PAGE>
Risk Management
The Company's management recognizes the following primary risks associated
with the business and industry in which it operates.
-- Credit
-- Prepayment
-- Market
-- Liquidity
Credit Risk
Credit risk is the risk that NovaStar will not fully collect the principal it
has invested in mortgage loans or securities. Subprime mortgage loans compose
51 percent of the mortgage assets owned by the Company as of December 31, 1997.
Our subprime borrowers include individuals that do not qualify for
agency/conventional lending programs because of a lack of available
documentation or previous credit difficulties, but have substantial equity in
their homes. Often, they are individuals or families who have built up high-
rate consumer debt and are attempting to use the equity in their home to
consolidate debt and lower their monthly payments. The worse their credit has
been or the fewer documents the borrower can produce to support income, the
lower a credit grade is assigned to the borrower.
NovaStar Mortgage underwrites the loans acquired by the Company using
guidelines that have been approved by the Company. The underwriting guidelines
are intended to evaluate the credit history of the potential borrower, the
capacity and willingness of the borrower to repay the loan and the adequacy of
the collateral securing the loan.
Loans acquired by the Company in bulk pools were subject to the same
underwriting guidelines as established for NovaStar Mortgage production.
NovaStar Mortgage employs an experienced underwriting staff who works under the
supervision of their Chief Credit Officer. The underwriters hired by NovaStar
Mortgage all have substantial experience in the underwriting of subprime
mortgage loans.
Underwriters are given approval authority only after the Chief Credit Officer
has reviewed their work for a period of at least two weeks. Thereafter, the
Chief Credit Officer re-evaluates the authority levels of all underwriting
personnel on an ongoing basis. All loans in excess of $350,000 currently
require the approval of the Chief Credit Officer. In addition, the President
approves all loans in excess of $750,000.
The Company's underwriting guidelines take into consideration the number of
times the potential borrower has recently been late on a mortgage payment and
whether the late payment was 30, 60 or 90 days late. Lateness on other debt is
also considered. Discharged bankruptcy filings are allowed under all credit
ratings. However, to obtain an "A" or "B" rating, the borrower must have a
one-year seasoning on its discharged Chapter 13 filing and two years for a
Chapter 7 filing.
Maximum loan-to-value ratios for each credit rating depend on the level of
income documentation provided by the potential borrower. In no cases do the
guidelines allow a loan-to-value ratio greater than 95 percent.
Depending on circumstances, exceptions to the underwriting guidelines are
approved by underwriting supervisors, the Chief Credit Officer or the President
of NovaStar Mortgage.
Table I is a presentation of loans as of December 31, 1997 and their credit
grades.
-4-
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Table I
Mortgage Loans by Credit Grade
December 31, 1997 (dollars in thousands)
<TABLE>
<CAPTION>
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Maximum Weighted Weighted
Allowed Loan-to Average Average
Credit Rating Mortgage Lates(A) value Principal Coupon Loan-to-value
- --------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
AA.................. 0 x 30 95% $ 16,654 9.61% 85%
A................... 1 x 30 90 251,751 9.91 77
A- ................. 2 x 30 90 145,314 10.20 78
B................... 3 x 30, 1 x 60 85 99,317 10.50 76
C................... 5 x 30, 2 x 60,
1 x 90 80 35,483 11.09 71
D................... 6 x 30, 3 x 60,
2 x 90 65 10,917 12.05 63
-------- ----- --
Total............. $559,436 10.20% 77%
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</TABLE>
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(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.
The Company's credit risk is currently concentrated geographically.
Initially, a disproportionate number of loans generated by NovaStar Mortgage
were originated in California. As the sales force has been established
throughout the United States, the geographic credit risk has and will continue
to become less concentrated.
Table II is a summary of loans originated by NovaStar Mortgage (and
subsequently acquired by the Company) by state. Table III is a summary of all
mortgage loans owned by the Company as of December 31, 1997 by state.
<TABLE>
<CAPTION>
Table II Table III
Mortgage Loan Originations by State Collateral Location
Year Ended December 31, 1997 December 31, 1997
- ------------------------------------------------------------------------------ ----------------------------------------
Percent of Total Percent of
Originations during Quarter Portfolio
------------------------------------------- ----------------------------------------
Collateral Location First Second Third Fourth Collateral Location
<S> <C> <C> <C> <C> <C> <C>
California.................. 40% 26% 24% 19% California............ 27%
Washington.................. 15 16 11 8 Washington............ 9
Utah........................ 13 9 6 6 Florida............... 8
Maryland.................... 13 5 6 5 Utah.................. 6
Oregon...................... 7 9 6 6 Oregon................ 6
Oklahoma.................... 5 2 1 1 Texas................. 5
Florida..................... 1 8 10 9 All other states...... 39
Virginia.................... - 2 6 5
Michigan.................... - - 3 5
Texas....................... 2 7 4 3
All other states............ 4 16 23 33
</TABLE>
All mortgage securities owned by the Company since inception were issued by
agencies of the United States Government. Management considers their credit risk
to be nominal. Securities issued by FHLMC and FNMA are not guaranteed by the
full faith and credit of the U.S. Government. The Company's investment policy
also allows for the purchase of privately issued mortgage securities. The policy
provides that Standard & Poor's must rate privately issued mortgage securities.
Detail regarding loan delinquencies and loans charged off during 1997 are
disclosed in Management's Discussion and Analysis of Financial Condition and
Results of Operations under the heading Provision for Credit Losses.
Prepayment Risk
The Company acquired substantially all of its mortgage assets at a premium.
When mortgage loans are originated, a premium of 1.5 to 3.0 percent is generally
paid to the retail brokers. For the most part, mortgage securities acquired by
the Company have also been acquired with premiums. Premiums are amortized over
the life of the asset as an adjustment of the coupon received. For example,
assume a $100,000 loan with a coupon fixed at 10 percent was acquired with a
$3,000 premium. The Company would record approximately $10,000 in coupon
interest. Based on management's expectations of when the loan will be repaid,
the loan is expected to yield 9.25 percent, when considering the effect of
premium amortization. Amortization of the premium in
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<PAGE>
the amount of $750 in the year would result in net interest income of $9,250 on
this loan -- a 9.25 percent yield. Although this example is simplified to
exclude the effect of principal repayment, it demonstrates the effect of
amortization on interest income.
When borrowers repay the principal on their mortgage loans early, the effect
is to shorten the period over which premiums are amortized. The shorter this
period the lower the overall yield on the mortgage asset.
Management attempts to mitigate prepayment risk by acquiring loans that are
originated with a penalty if the borrower repays the loan in the early months of
the loan's life. Table XIV of Part II, Management, Discussion, and Analysis
section of this report is a summary of the loans originated by NovaStar Mortgage
(and subsequently acquired by the Company) demonstrating the nature of
prepayment penalties. As of December 31, 1997, 68 percent of all loans owned by
the Company had a prepayment penalty. The weighted-average years that the
prepayment period applies to was 1.6. Management cannot control the prepayment
speeds of the mortgage loans securitizing mortgage securities.
In periods of decreasing interest rates, borrowers are more likely to
refinance their mortgages to obtain a better interest rate. Even in rising rate
environments, borrowers tend to collectively repay their mortgage principal
balances earlier than is required by the terms of their mortgages. This is
particularly true for subprime borrowers who are seeking to upgrade their credit
rating to obtain a lower interest rate. During 1997, $55,062,000 of the
Company's loans fully prepaid. The prepayments represent 8.9 percent of the
principal of mortgage loans ($617.2 million) acquired during 1997.
Table IV displays the historical prepayment speeds for mortgage loans
collateralizing the Company's CMOs. Prepayment rates in the table represent the
percent of loan principal that pre-pays in the most recent one, three and twelve
month periods and over the life of the pool of loans. Percents are presented on
an annual basis. For instance, 18.6 percent, on an annual basis, of the
principal of the loans collateralizing CMO issue 1997-1 prepaid during December
1998. Percentages for the life of the pool represent the percent that has paid
off since the loans were pooled as collateral for the CMO. Virtually all loans
are used as collateral for CMOs and NovaStar does not monitor prepayment speeds
for loans not financing CMOs.
Table IV
Prepayment Speed
December 31, 1997
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------
Constant Prepayment Rate (Annual Percent)
---------------------------------------------------
One-month Three-month Twelve-month Life
<S> <C> <C> <C> <C>
NovaStar Home Equity Series:
1997-1........................... 18.6 15.7 -- 15.7
1997-2........................... 10.5 -- -- 10.5
</TABLE>
Tables V summarizes mortgage assets showing the amount of amortization during
1997 and remaining balances as of December 31, 1997.
Table V
Mortgage Assets Activity
As of and for the Year Ended December 31, 1997
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------------
Mortgage Loans Mortgage Securities Total
------------------------- ------------------------- -------------------------
Principal Premium Principal Premium Principal Premium
<S> <C> <C> <C> <C> <C> <C>
Balance, January 1, 1997....... $ -- $ -- $ 12,821 $ 434 $ 12,821 $ 434
Acquisitions................... 170,120 10,530 16,422 405 186,542 10,935
Principal repayments and
amortization.................. (338) (53) (977) (28) (1,315) (81)
-------- ------- -------- ------- ---------- -------
Balance, March 31, 1997........ 169,782 10,477 28,266 811 198,048 11,288
Acquisitions................... 127,500 4,100 349,302 7,624 476,802 11,724
Principal repayments and
amortization.................. (6,989) (420) (2,332) (133) (9,321) (553)
Disposals...................... -- -- (98,267) (2,309) (98,267) (2,309)
-------- ------- -------- ------- ---------- -------
Balance, June 30, 1997......... 290,293 14,157 276,969 5,993 567,233 20,150
Acquisitions................... 136,582 2,449 2,202 87 138,784 2,536
Principal repayments and
amortization.................. (22,227) (913) (19,291) (383) (41,151) (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)
Disposals...................... -- -- (9,263) (177) (9,263) (177)
-------- ------- -------- ------- ---------- -------
Balance, December 31, 1997..... $559,436 $17,861 $504,847 $ 8,205 $1,064,283 $26,066
======== ======= ======== ======= ========== =======
</TABLE>
Market Risk
The primary component of market risk for the Company is interest rate risk --
the risk that the market value of the Company's assets will increase or decrease
at different rates than that of the Company's liabilities.
-6-
<PAGE>
Expressed another way, this is the risk that NovaStar's net asset value will
experience an adverse change when interest rates change. When interest rates on
the Company's assets do not adjust at the same rates as liabilities or when the
Company's assets have fixed rates and the liabilities are adjusting, future
earnings potential is affected. Management primarily uses financing sources
where the price (interest rate) resets frequently. As of December 31, 1997,
borrowings under all of the Company's financing arrangements adjust monthly or
daily. On the other hand, very few of the Company's mortgage assets, as of
December 31, 1997, adjust on a monthly basis and none adjust daily. Most of the
mortgage loans contain features where their rates are fixed for some period of
time and then adjust frequently thereafter. For example, the most popular loan
product during 1997 was the "2/28" loan. This loan is fixed for its first two
years and then adjusts every six months thereafter. Many of the mortgage
securities owned by the Company are fixed for at least a year, and then adjust
annually thereafter.
While short-term borrowing rates are low and long-term asset rates are high,
this portfolio structure produces good results. However, if short-term interest
rates rise rapidly, the Company's earning potential could be significantly
effected as the asset rate resets would "lag" borrowing rate resets.
In its assessment of the interest sensitivity and as an indication of the
Company's exposure to interest rate risk, management relies on models of
financial information in a variety of interest rate scenarios. Using these
models, the fair value and interest rate sensitivity of each financial
instrument (or groups of similar instruments) is estimated, and then aggregated
to form a comprehensive picture of the risk characteristics of the balance
sheet. These amounts contain estimates and assumptions regarding prepayments and
future interest rates. Actual economic conditions may produce results
significantly different from the results depicted below. However, management
believes the interest sensitivity model used is a valuable tool to manage the
Company's exposure to interest rate risk.
Table VI is a summary of the analysis as of December 31, 1997.
<TABLE>
<CAPTION>
Table VI
Interest Rate Sensitivity (A)
December 31, 1997 (dollars in thousands)
- -----------------------------------------------------------------------------------------------------------
Basis Point Increase (Decrease) in Interest Rates(B)
----------------------------------------------------
<S> <C> <C> <C> <C>
(100) Base(C) 100 Elasticity(F)
Market value of:
Assets ............................ $1,222,869 $1,211,591 $1,194,896 1.15%
Liabilities ....................... 1,066,611 1,064,944 1,063,290 0.68
Interest rate agreements .......... (6,517) (178) 8,268 1.35
---------- ---------- ----------
Net market value ................... $ 151,406 $ 148,134 $ 141,539
========== ========== ==========
Cumulative change in value (C) ..... $ 3,272 $ -- $ (6,595)
========== ========== ==========
Percent change from base assets(D)... 0.27% --% (0.54)% 0.42%
========== ========== ========== ====
Percent change of capital (E) ...... 2.81% --% (5.66)% 4.23%
========== ========== ========== ====
</TABLE>
- -------------------
(A) Management analyzes the interest sensitivity of the Company and NovaStar
Mortgage on a combined basis. The assets and liabilities of NovaStar
Mortgage consist primarily of mortgage securities with a current face of
$54.2 million and their related repurchase agreement financing.
(B) Value of asset, liability or interest rate agreement in a parallel shift
in the yield curve, up and down one percent.
(C) Total change in estimated market value, in dollars, from "base." "Base" is
the estimated market value at December 31, 1997.
(D) Total change in estimated market value, as a percent, from base.
(E) Total change in estimated market value as a percent of total stockholders'
equity at December 31, 1997.
(F) Elasticity is the average percentage change in estimated market value from
base over a range of up and down interest rate scenarios.
Interest Rate Sensitivity Analysis. The values under the heading "Base" are
management's estimates of market values of the Company's assets, liabilities and
interest rate agreements on December 31, 1997. The values under the headings
"100" and "(100)" are management's estimates of the market value of those same
assets, liabilities and interest rate agreements assuming that interest rates
were 100 basis points (1 percent) higher and lower. The cumulative change in
value represents the change in value of assets from base, net of the change in
value of liabilities and interest rate agreements from base.
-7-
<PAGE>
The interest sensitivity analysis is prepared regularly. If the analysis
demonstrates that a 100 basis point shift (up or down) in interest rates would
result in 10 percent or more cumulative change in value from base, management
will modify the Company's portfolio by adding or removing interest rate cap or
swap agreements.
Assumption Used in Interest Rate Sensitivity Analysis. Management uses
estimates in determining the market (or fair) value of assets, liabilities and
interest rate agreements. The estimation process is dependent upon a variety of
assumptions, especially in determining the fair value of its subprime mortgage
loan holdings. The estimates and assumptions have a significant impact on the
results of the interest rate sensitivity analysis, the results of which are
shown as of December 31, 1997.
The Company's analysis for assessing interest rate sensitivity on its
subprime mortgage loans relies significantly on estimates for prepayment speeds.
A prepayment model has been internally developed based upon four main factors:
. Refinancing incentives (the interest rate of the mortgage compared with the
current mortgage rates available to the borrower)
. Borrower credit grades
. Loan-to-value ratios
. Prepayment penalties, if any
Generally speaking, when market interest rates decline, borrowers are more
likely to refinance their mortgages. The higher the interest rate a borrower
currently has on his or her mortgage, the more incentive he or she has to
refinance the mortgage when rates decline. In addition, the higher a credit
grades, 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 make
a "cash-out" refinance. Each of these factors presumably increases the chance
for higher prepayment speeds during the term of the loan. On the other hand,
prepayment penalties serve to mitigate the risk that loans will prepay, under
the assumption that the penalty is a deterrent to refinancing.
These factors are weighted based on management's experience and an evaluation
of the important trends observed in the subprime mortgage origination industry.
Actual results may differ from the estimates and assumptions used in the
Company's model and the projected results as shown in the above table.
NovaStar's projected prepayment rates in each interest scenario start at a
prepayment speed less than 5% in month one and increase to a long-term
prepayment speed in nine to 18 months, to account for the seasoning of the
loans. The long-term prepayment speed ranges from 20% to 40% and depends on the
characteristics of the loan which include type of product (ARM or fixed rate),
note rate, credit grade, LTV, gross margin, weighted average maturity and
lifetime and periodic caps and floors. This prepayment curve is also multiplied
by a factor of 60% on average for periods when a prepayment penalty is in effect
on the loan. These assumptions change with levels of interest rates. The actual
historical speeds shown for our loans in Table IV are weighted average speeds of
all loans in each deal and are shown only for the short period of time that the
deal has been outstanding.
The Company's 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 the Company's assets.
Although management evaluates the portfolio using interest rate increases and
decreases greater than one percent, management focuses on the one percent
increase as any further increase in interest rates would require action to
adjust the portfolio to adapt to changing rates. The Company's 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.
Sensitivity as of December 31, 1997. As shown in Table VI, if interest rates
were to decrease one percent (-100 basis points), the value of the Company's
capital would increase by an estimated 2.81 percent. If interest rates rise by
one percent (+100 basis points), the value of the Company's capital would
decrease by an estimated 5.66 percent.
Elasticity. 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 a falling rate environment. Management's dynamic hedging strategies allow the
Company to match the elasticity of its assets with the elasticity of its
liabilities.
Hedging with Off-balance-sheet Financial Instruments In order to address a
mismatch of assets and liabilities, the Company follows the hedging section of
its investment policy, as approved by the Board. Specifically, the Company's
interest rate risk management program is formulated with the intent to offset
the potential adverse effects resulting from rate adjustment limitations on its
mortgage assets and the differences
-8-
<PAGE>
between interest rate adjustment indices and interest rate adjustment periods of
its adjustable-rate mortgage loans and related borrowings.
The Company uses interest rate cap and swap agreements and financial futures
contracts to mitigate the risk of the cost of its variable rate liabilities
increasing at a faster rate than the earnings on its assets during a period of
rising rates. In this way, the Company intends generally to "hedge" as much of
the interest rate risk as management determines is in the best interest of the
Company, given the cost of hedging transactions and the need to maintain the
Company's status as a REIT.
The Company seeks to build a balance sheet and undertake an interest rate
risk management program that is likely, in management's view, to enable the
Company to maintain an equity liquidation value sufficient to maintain
operations given a variety of potentially adverse circumstances. Accordingly,
the hedging program addresses both income preservation, as discussed in the
first part of this section, and capital preservation concerns.
Interest rate cap agreements are legal contracts between the Company and a
third party firms (the "counter-party"). The counter-party agrees to make
payments to the Company in the future should the one- or three-month LIBOR
interest rate rise above the "strike" rate specified in the contract. The
Company makes monthly premium payments to the counterparty under the contract.
Each contract has a fixed "notional face" amount, on which the interest is
computed, and a set term to maturity. Should the reference LIBOR interest rate
rise above the contractual strike rate, the Company will earn cap income.
Payments on an annualized basis equal the contractual notional face amount times
the difference between actual LIBOR and the strike rate.
Interest rate swap agreements entered into by the Company through December
31, 1997 stipulate that the Company will pay a fixed rate of interest to the
counterparty. In return, the counterparty pays the Company 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.
A futures contract is a standardized, transferable agreement to buy or sell
a given financial instrument on a specific future date at a set price. The
futures contracts entered into by NovaStar are interest rate futures, under
which settlements are made in cash rather physical delivery of the underlying
security. The value of the cash settlement depends on how the interest rates,
therefore market prices fluctuate during the term of the contract. Depending on
market prices, NovaStar may be in a gain or loss position. Futures contracts are
exchange traded, which means the exchange accepts counterparty credit risk and
generally requires cash deposits as collateral.
NovaStar is subject to credit risk under its interest rate agreements
because the counterparty may fail on its obligation to NovaStar. To limit
counterparty credit risk NovaStar:
1) enters into ISDA Master Agreements with each counterparty,
2) deals with counterparties with BBB/Baa ratings or higher from S&P and
Moody's, respectively,
3) measures the risk on at least a monthly basis,
4) obtains bilateral cross collateralization agreements on each agreement, and
5) obtains the right for margin calls when hedges are in loss positions.
The net market value of all agreements with each counterparty is in a loss
position as of December 31, 1997, exposing NovaStar to no credit risk at that
date.
All interest rate agreements are tied to either one- or three-month LIBOR.
All financing agreements reset based on one-month LIBOR or short-term repurchase
agreement rates. Therefore, the extent of the basis risk of the company lies in
the differences in movements between one- and three-month LIBOR and short-term
repurchase agreements rates versus one- and three-month LIBOR. Historically, the
basis movements between these rates have been minimal.
ISDA Master Agreements set the legal framework for transactions with
counterparties in over-the-counter derivative markets. Corporate counsel reviews
legal documents at the discretion of management. NovaStar considers its exposure
to legal enforcement risk to be minimal.
When analyzed in isolation, the cost of a hedging transaction over the life
of the agreement may exceed the benefit of the transaction if market interest
rates move against the hedge. However, if analyzed in the context of the entire
portfolio, losses on hedging transactions in downward interest rate movements
will be offset by gains on the asset side of the balance sheet.
In order to retain REIT status, NovaStar Financial must meet requirements
established by the Internal Revenue Code. Income from hedges that reduce the
interest rate risk of REIT liabilities is treated as qualifying income under the
Internal Revenue Code. All hedging instruments owned by NovaStar are REIT-
qualifying. Further details regarding qualification as a REIT and income
restrictions is provided under the heading "Federal Income Tax Considerations."
Note 5 to the Company's consolidated financial statements provides
additional information regarding the Company's hedging instruments.
Liquidity Risk
See Management's Discussion and Analysis of Financial Condition--Liquidity
and Capital resources for a discussion of liquidity resources available to the
Company as of December 31, 1997.
Capital Allocation Guidelines (CAG). The Company's goal is to strike a
balance between the under-utilization of leverage, which reduces returns to
stockholders, and the over-utilization of leverage, which could reduce the
Company's ability to meet its obligations during adverse market conditions. The
Company's CAG have been approved by the Board of Directors. The CAG are intended
to keep the Company properly leveraged by (i) matching the amount of leverage
allowed to the riskiness (return and liquidity) of an asset and (ii) monitoring
the credit and prepayment performance of each investment to adjust the required
capital. This analysis takes into account the Company's various hedges and other
risk programs discussed below. In this way, the use of balance sheet leverage
will be controlled. Following presents a summary of the Company's CAG for the
following levels of capital for the types of assets it owns.
-9-
<PAGE>
<TABLE>
<CAPTION>
Table VII
Capital Allocation Guidelines
December 31, 1997
- ------------------------------------------------------------------------------------------------------------------------
(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
Mortgage loans........... 3.00 3.00 100 50 150 4.50 7.50
- --------------------------------
</TABLE>
(A) Indicates the minimum amount of equity a typical lender would require with
an asset from the applicable asset category. There is some variation in
haircut levels among lenders. From the lender perspective, this is a
"cushion" to protect capital in case the borrower is unable to meet a
margin call. The size of the haircut depends on the liquidity and price
volatility of the asset. Agency securities are very liquid, with price
volatility in line with the fixed income markets, which means a lender
requires a smaller haircut. On the other extreme, "B" rated securities and
securities not registered with the Securities and Exchange Commission (the
"Commission") are substantially less liquid, and have more price volatility
than Agency securities, which results in a lender requiring a larger
haircut. Particular securities that are performing below expectations would
also typically require a larger haircut.
(B) Duration is the price-weighted average term to maturity of financial
instruments' cash flows.
(C) Estimated cushion need to protect against investors requiring a higher
return compared to Treasury securities, assuming constant interest rates.
(D) Estimated cushion required due to a potential imbalance of supply and
demand resulting in a wider bid/ask spread.
(E) Sum of duration (C) and liquidity (D) spread cushions.
(F) Product of estimated price duration (B) and total spread cushion. The
additional equity, as determined by management, to reasonably protect the
Company from lender margin calls. The size of each cushion is based on
management's experience with the price volatility and liquidity in the
various asset categories. Individual assets that have exposure to
substantial credit risk will be measured individually and the leverage
adjusted as actual delinquencies, defaults and losses differ with
management's expectations.
(G) The sum of the minimum lender haircut (A) and the Company's equity cushion
(F).
Implementation of the CAG--Mark to Market. Each month, the Company marks its
assets to market. This process consists of two steps: (i) valuing the Company's
mortgage securities and (ii) valuing the Company's mortgage loans. For the
portfolio, the Company obtains market quotes from traders that make markets in
securities similar to those in the Company's portfolio. Market values for the
Company's 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 the Company's assets (and hedges).
This is the current market value of the Company's equity. This number is
compared to the required capital as determined by the CAG. If the actual equity
of the Company falls below the capital required by the CAG, the Company must
prepare a plan to bring the actual capital above the level required by the CAG.
Each quarter, management presents to the Board of Directors the results of
the CAG compared to actual equity. Management may propose changing the capital
required for a class of investments or for an individual investment based on its
prepayment and credit performance relative to the market and the ability of the
Company to predict or hedge the risk of the asset.
Table VIII is a summary of the capital allocation for NovaStar as they apply
to the Company's mortgage assets and hedging instruments during December 31,
1997.
-10-
<PAGE>
<TABLE>
<CAPTION>
Table VIII
Required Equity
As of and For the Year Ended December 31, 1997
- ----------------------------------------------------------------------------------------
Category December 31 September 30 June 30 March 31
Mortgage loans:
<S> <C> <C> <C> <C>
Current.................. $ 6,675 $ 33,832 $22,780 $15,958
Delinquent............... 1,600 2,376
Mortgage securities....... 36,170 12,763 13,549 1,646
Excess cash flows......... 22,500
Hedging instruments....... 5,500 427 1,787 2,804
-------- --------- ------- -------
Required equity........... 72,445 49,398 38,116 20,408
Stockholders' equity...... 116,489 47,036 46,337 46,202
-------- --------- ------- -------
Excess equity............. $ 44,044 ($ 2,362) $ 8,221 $25,794
======== ========= ======= =======
</TABLE>
During November 1997, the Company received net proceeds of $67 million from
its initial public offering of common stock. This capital was not fully employed
as of December 31, 1997, as demonstrated by the excess equity on that date.
During 1998, the Company intents to employ the capital within it's CAG.
Other Risk Factors
Although the Company's management considers the above risk components to be
its primary business risks, the following are other risks that should be
considered by the Company's investors. Further information regarding these
risks is included in the Company's registration statements filed with the
Commission on Form S-11.
Limited Operating History of the Company and Net Losses Incurred. The Company
has not yet developed an extensive earnings history or experienced a wide
variety of interest rate or market conditions. Historical operating performance
may be of limited relevance in predicting future performance. For the period
since inception to December 31, 1996 and for the year ended December 31, 1997,
the Company has incurred net losses.
Forgivable Notes May Adversely Affect Results of Operations. In the
Company's Private Placement, the Company's founders - Scott Hartman and Lance
Anderson - each acquired Units paid for by delivering to the Company promissory
notes. The Company will forgive principal due on the notes if the return to
Private Placement investors meets certain benchmarks. For the period from the
closing of the private placement through December 31, 1997, the Company exceeded
the benchmark return to Private Placement investors, therefore, the first
tranche of the founders' notes was forgiven resulting in a non-cash charge of
$1,083,000. The non-cash charge against earnings resulting from forgiveness of
the notes had a material adverse effect on the Company's results of operations
during 1997 and could have a material impact on future periods when the notes
are forgiven. See Management's Discussion and Analysis of Consolidated Financial
Condition and Results of Operation.
Dependence on Key Personnel for Successful Operations. Operations of the
Company and 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 those
Companies' businesses and results of operations. The Company has entered into
employment agreements with these individuals which provide for initial terms
through December 31, 2001. The employment agreements contain compensation
arrangements including base salaries, incentive bonuses and severance
arrangements. Each employment agreement also provides that if the employee
terminates his employment without "good reason" prior to expiration of the term
of the agreement, certain incentive and severance benefits will be forfeited and
a restriction against competing with the Company will become effective. Although
the Company 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
the Company's employ. See "Management--Executive Compensation."
-11-
<PAGE>
Consequence of Failure to Retain REIT Status: Company Subject to Tax as a
Regular Corporation. If the Company fails to maintain its qualification as a
REIT, the Company will be subject to federal income tax as a regular
corporation. The Company intends to conduct its business at all times in a
manner consistent with the REIT provisions of the Code.
The President's tax proposal contained in the 1999 Budget Plan released by
the Treasury Department on February 2, 1998 includes a provision that could
adversely affect REITs in general and the Company's actual and proposed
operations in particular. That provision would prohibit a REIT from owning, by
vote or value, more than 10% of the capital stock of any corporation. (The
current 10% asset test relates only to voting stock.) That proposal is intended
to prevent REITs from conducting through a taxable subsidiary any business that
would be prohibited to the REIT itself. The Company currently conducts its
mortgage loan origination and servicing business through a taxable subsidiary.
While implementation of this tax proposal or any other proposal with similar
effect is uncertain, its enactment could adversely affect the Company's ability
to establish and maintain the kind of taxable subsidiaries currently being used
in the Company's operations. Further, the Company may be unable to continue
certain activities presently being conducted through such subsidiaries. See
"Federal Income Tax Considerations--Proposed Tax Legislation."
Changes in Interest Rates May Adversely Affect Results of Operation. The
Company's results of operations are likely to be adversely affected during any
period of unexpected or rapid changes in interest rates. For example, a
substantial or sustained increase in interest rates could adversely affect the
ability of the Company to acquire mortgage loans in expected volumes necessary
to support fixed overhead expense levels.
Declines and increases in interest rates will cause the value of a loan to
rise and fall respectively if the yield spread, or basis, between the loan and
the duration-matched treasury remains the same. The basis does fluctuate over
time, however, and NovaStar may experience mark-to-market gains and losses on
its unsecuritized portfolio even though interest rates may have remained stable.
This may effect the value of future securitizations to the company if the
decrease in market value on loans was caused by basis widening in the
securitization market, which would make long-term, non-recourse financing more
expensive. Basis changes may not have an effect on future securitizations if,
for example, there was simply an over supply in the whole loan market and
securitization spreads had remained constant.
Intense Competition in the Subprime Mortgage Industry. The Company and
NovaStar Mortgage will face intense competition, primarily from commercial
banks, savings and loans, other independent mortgage lenders, and certain other
mortgage REITs. The increasing level of capital resources being devoted to
subprime mortgage lending may increase the competition among lenders to
originate or purchase subprime mortgage loans and 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.
Higher Delinquency and Loss Rates with Subprime Mortgage Borrowers. Lenders
in the subprime mortgage banking industry make loans to borrowers who have
impaired or limited credit histories, limited documentation of income and higher
debt-to-income ratios than traditional mortgage lenders allow. Loans made to
subprime mortgage borrowers generally entail a higher risk of delinquency and
foreclosure than loans made to borrowers with better credit and may result in
higher levels of realized losses. The failure of the Company to adequately
address the risks of subprime lending would have a material adverse impact on
the Company's results of operations, financial condition and business prospects.
Lack of Loan Performance Data. The mortgage loans purchased by the Company
have been outstanding for a relatively short period of time. Consequently, the
delinquency, foreclosure and loss experience of these loans to date may not be
indicative of future results. It is unlikely that the Company will be able to
sustain delinquency, foreclosure and loan loss rates at their present levels as
the portfolio becomes more seasoned.
Availability of Funding Sources. The Company and NovaStar Mortgage are
currently dependent upon a few lenders to provide the primary credit facilities
for its funding of mortgage loan originations and acquisitions. Any failure to
renew or obtain adequate funding under these financing arrangements could have a
material adverse effect on the Company's lending operations.
Financing with Repurchase Agreements. NovaStar uses repurchase agreements to
finance acquisition of mortgage loans and securities. In a repurchase agreement,
NovaStar purchases an asset and then sells the asset under an agreement to
repurchase the same asset at some period in the future. Generally, the
repurchase agreements entered into by NovaStar stipulate that NovaStar must
repurchase the asset in 30 days. For financial accounting purposes, these
arrangements are treated as secured financing arrangements. NovaStar retains the
assets on its balance sheet and records an obligation to repurchase the asset.
The amount NovaStar can "borrow" under these arrangements is generally 96 to 98
percent of the asset market value. When asset values decrease, NovaStar is
required to repay the margin, or difference in fair value. To the extent the
market values of assets financed with repurchase agreements decline rapidly,
NovaStar will be required to meet cash margin calls. If cash is unavailable,
NovaStar may be forced to default under the terms of the repurchase agreement.
In that event, the lender retains the right to liquidate the collateral to
settle the amount due from NovaStar.
Decrease in Net Interest Income Due to Interest Rate Fluctuations. Interest
rate fluctuations may affect the Company's earnings as a result of potential
changes in the spread between the interest rates on its borrowings and the
interest rates on its Mortgage Assets. In addition, mortgage prepayment rates
vary depending on such factors as mortgage interest rates and market conditions.
Changes in anticipated prepayment rates may adversely affect the Company's
earnings.
Failure to Effectively Hedge Against Interest Rate Changes May Adversely
Affect Results of Operations. Asset/liability management hedging strategies
involve risk and may not be effective in reducing the Company's exposure to
interest rate changes. Moreover, compliance with the REIT provisions of the Code
may prevent the Company from effectively implementing the strategies that the
Company determines, absent such compliance, would best insulate the Company from
the risks associated with changing interest rates.
-12-
<PAGE>
Loss Exposure on Single Family Mortgage Assets. A substantial portion of the
Mortgage Assets of the Company consists of (i) single family mortgage loans or
(ii) pass-through certificates and CMOs ("Mortgage Securities") evidencing
interests in single family mortgage loans. The Company 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 the Company's Ability to Acquire Mortgage Assets at
Yields Which are Favorable Relative to Borrowing Costs. Despite management's
experience in the acquisition of Mortgage Assets and its relationships with
various mortgage suppliers, there can be no assurance that the Company will be
able to acquire sufficient Mortgage Assets from mortgage suppliers at spreads
above the Company's cost of funds.
Federal Income Tax Considerations
General
The Company believes it has complied and, intends to comply in the future,
with the requirements for qualification as a REIT under the Internal Revenue
Code ("the Code"). To the extent that the Company qualifies as a REIT for
federal income tax purposes, it generally will not be subject to federal income
tax on the amount of its income or gain that is distributed to shareholders.
However, NMI conducts the production operations and is not a qualified REIT
subsidiary. Consequently, all of the taxable income of NMI is subject to federal
and state income taxes.
The REIT rules generally require that a REIT invest primarily in real estate-
related assets, its activities be passive rather than active and it distribute
annually to its shareholders substantially all of its taxable income. The
Company could be subject to a number of taxes if it failed to satisfy those
rules or if it acquired certain types of income-producing real property through
foreclosure. Although no complete assurance can be given, the Company does not
expect that it will be subject to material amounts of such taxes.
The Company's failure to satisfy certain Code requirements could cause the
Company to lose its status as a REIT. If the Company failed to qualify as a REIT
for any taxable year, it would be subject to federal income tax (including any
applicable minimum tax) at regular corporate rates and would not receive
deductions for dividends paid to shareholders. As a result, the amount of after-
tax earnings available for distribution to shareholders would decrease
substantially. While the Company intends to operate in a manner that will enable
it to qualify as a REIT in future taxable years, there can be no certainty that
such intention will be realized.
Qualification of the Company as a REIT
Qualification as a REIT requires that the Company satisfy a variety of tests
relating to its income, assets, distributions and ownership. The significant
tests are summarized below.
Sources of Income
To qualify as a REIT in 1998 and thereafter, the Company must satisfy two
tests with respect to the sources of its income: the "75 percent income test,"
and the "95 percent income test". The 75 percent income test requires that the
Company derive at least 75 percent of its gross income (excluding gross income
from prohibited transactions) from certain real estate-related sources.
In order to satisfy the 95 percent income test, at least an additional 20
percent of the Company gross income for the taxable year must consist either of
income that qualifies under the 75 percent income test or certain other types of
passive income.
For 1996 and 1997, the Company was also required to satisfy the 30 percent
income test, which unlike the other income tests, prescribed a ceiling for
certain types of income. Under the test a REIT could not derive more than 30
percent of its gross income from the sale or other disposition of (i) stock or
securities held for less than one year, (ii) dealer property that is not
foreclosure property or (iii) certain real estate property held for less than
four years.
If the Company fails to meet either the 75 percent income test or the 95
percent income test, or both, in a taxable year, it might nonetheless continue
to qualify as a REIT, if its failure was due to reasonable cause and not willful
neglect and the nature and amounts of its items of gross income were properly
disclosed to the Internal Revenue Service. However, in such a case the Company
would be required to pay a tax equal to 100 percent of any excess non-qualifying
income. No analogous relief was available to REITs that failed to satisfy the 30
percent income test.
-13-
<PAGE>
Nature and Diversification of Assets
As of the last day of each calendar quarter, three asset tests must be met by
the Company. Under the "75 percent asset test," at least 75 percent of the value
of the Company's total assets must represent cash or cash items (including
receivables), government securities or real estate assets. Under the "10 percent
asset test", the Company may not own more than 10 percent of the outstanding
voting securities of any single non-governmental issuer, if such securities do
not qualify under the 75 percent asset test. Under the "5 percent asset test,"
ownership of any stocks or securities that do not qualify under the 75 percent
asset test must be limited, in respect of any single non-governmental issuer, to
an amount not greater than 5 percent of the value of the total assets of the
Company. The definition of security for this purpose includes financial
contracts and instruments that the Company acquires in the normal course of
business.
If the Company inadvertently fails to satisfy one or more of the asset tests
at the end of a calendar quarter, such failure would not cause it to lose its
REIT status, the Company still could avoid disqualification by eliminating any
discrepancy within 30 days after the close of the calendar quarter in which the
discrepancy arose.
Ownership of Common Stock
For all taxable years after the first taxable year for which a REIT election
is made, the Company's shares of capital stock 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). In addition, at all times during the second half of each
taxable year, no more than 50 percent in value of the capital stock of the
Company may be owned directly or indirectly by five or fewer individuals. The
Company is required to maintain records regarding the actual and constructive
ownership of its shares, and other information, and to demand statements from
persons owning above a specified level of REIT's shares (as long as the Company
has over 200 or more shareholders, only persons holding 1 percent or more of the
Company's outstanding shares of common stock) regarding their ownership of
shares. The Company must keep a list of those shareholders that fail to reply to
such a demand. The Company uses the calendar year as its taxable year for income
tax purposes.
Distributions
The Company generally must distribute to its shareholders an amount equal to
at least 95 percent of the sum of its "REIT taxable income" (determined without
regard to the deduction for dividends paid and by excluding any net capital
gain) and any after-tax net income from certain types of foreclosure property
minus any "excess non-cash income." The Code provides that distributions
relating to a particular year may be made early in the following year, under
certain circumstances.
The Service has ruled that if a REIT's dividend reinvestment plan ("DRP")
allows shareholders of the REIT to elect to have cash distributions reinvested
in shares of the REIT at a purchase price equal to at least 95 percent of fair
market value on the distribution date, then such cash distributions qualify
under the 95 percent distribution test. The Company is developing a DRP and
believes it will comply with this ruling.
Taxation of Distributions by the Company
Assuming that the Company maintains its status as a REIT, any distributions
that are properly designated as "capital gain dividends" will generally be taxed
to shareholders as long-term capital gains, regardless of how long a shareholder
has owned his shares. Any loss on the sale or exchange of shares of the common
stock of the Company held by a shareholder 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 common stock held by such shareholders. Any other distributions
out of the Company's current or accumulated earnings and profits will be
dividends taxable as ordinary income. Corporate shareholders will not be
entitled to dividends-received deductions with respect to any dividends paid by
the Company. Distributions in excess of the Company's current or accumulated
earnings and profits will be treated as tax-free returns of capital, to the
extent of the shareholder's basis in his shares and, as gain from the
disposition of shares, to the extent they exceed such basis. Shareholders may
not include on their own tax returns any of the Company's ordinary or capital
losses.
Dividends paid by the Company to organizations that generally are exempt from
federal income tax under Section 501(a) of the Code should not be taxable to
them as UBTI except to the extent that purchase of shares of the Company was
financed by "acquisition indebtedness."
-14-
<PAGE>
Taxable Income
The Company uses the calendar year for both tax and financial reporting
purposes. However, there may be differences between taxable income and income
computed in accordance with generally accepted accounting principles (GAAP).
These differences primarily arise from timing differences in the recognition of
revenue and expense for tax and GAAP purposes. Additionally, the Company's
taxable income does not include the taxable income of its taxable affiliate,
although the affiliate is included in the Company's GAAP consolidated financial
statements.
Proposed Tax Legislation
The President's tax proposals contained in the 1999 Budget Plan released by
the Treasury Department on February 2, 1998 (the "1999 Budget Plan") include a
provision that could adversely affect REITs in general and the Company's actual
and proposed operations in particular. The 1999 Budget Plan has been submitted
to the Ways and Means Committee of the U.S. House of Representatives (the "Ways
and Means Committee") for review, which held its first hearing on February 25,
1998, but has not taken any action to date.
That provision would prohibit a REIT from owning, by vote or value, more than
10 percent of the capital stock of any corporation. (The current 10 percent
asset test relates only to voting stock.) That proposal is intended to prevent
REITs from conducting through a taxable subsidiary any business that would be
prohibited to the REIT itself. If adopted, this proposal would require the
Company to change the nature of its ownership in its taxable subsidiaries.
The Company conducts its active mortgage origination business through taxable
subsidiaries. The Company owns all of the preferred stock of the taxable
subsidiary, which stock entitles the Company to 95 percent of the economic value
of the taxable subsidiary. The Service has previously issued private letter
rulings (which do not constitute binding precedent) approving of arrangements
whereby REITs benefit by receiving dividends from affiliated taxable
corporations. Although the Company has not requested a private letter ruling
from the Service, the Company has relied on the reasoning of those letter
rulings in structuring the proposed arrangements between itself and its taxable
subsidiaries.
While the active origination of Mortgage Loans in itself does not violate any
of the income or asset tests for maintaining REIT status, the Service could
attempt to treat the income from frequent sales of Mortgage Loans as subject to
the 100 percent tax on income from prohibited transactions. "Prohibited
transactions" are defined as sales of property held by the REIT primarily for
sale to customers in the ordinary course of the REIT's business (other than
income from sales of foreclosure property). The regular sale of Mortgage Loans
by the Company or its subsidiaries may be treated as prohibited transactions,
subjecting the Company to the 100 percent tax.
The Treasury Department has proposed that this new stock ownership limitation
for REITs would first be effective with respect "to stock acquired on or after
the date of first committee action." The 1999 Budget Plan limits the effective
date provision as follows: "To the extent that a REIT's stock ownership is
grandfathered by virtue of this effective date, that grandfathered status will
terminate if the subsidiary corporation engages in a trade or business that it
is not engaged in on the date of first committee action or acquires substantial
new assets on or after that date." If the purchase and sale of Mortgage Loans by
the taxable subsidiary were deemed to be engaging in a new trade or business or
the acquisition of new assets, then the activities of the taxable subsidiary
would not be "grandfathered."
The provisions of the Code are highly technical and complex. This summary is
not intended to be a detailed discussion of all applicable provisions of the
Code, the rules and regulations promulgated thereunder, or the administrative
and judicial interpretations thereof. The Company has not obtained a ruling from
the Internal Revenue Service with respect to tax considerations relevant to its
organization or operation, or to an acquisition of its common stock. This
summary is not intended to be a substitute for prudent tax planning, and each
shareholder of the Company is urged to consult its own tax advisor with respect
to these and other federal, state and local tax consequences of the acquisition,
ownership and disposition of shares of the common stock of the Company and any
potential changes in applicable law.
Personnel
As of December 31, 1997, the Company employed 15 people. NovaStar Mortgage
employed 160 people on December 31, 1997.
-15-
<PAGE>
Item 2. Properties
The Company's executive and administrative offices are located in Westwood,
Kansas, and consist of approximately 6,000 square feet. The lease on the
premises expires February 2000. The current annual rent for these offices is
approximately $116,000.
NovaStar Mortgage leases space for its mortgage lending operations in Irvine,
California. These offices consist of approximately 24,000 square feet. The lease
on the premises expires November 2001, and the current annual rent is
approximately $480,000.
Item 3. Legal Proceedings
The Company occasionally becomes involved in litigation arising in the normal
course of business. Management believes that any liability with respect to such
legal actions, individually or in the aggregate, will not have a material
adverse effect on the Company's financial position or results of operations.
Item 4. Submission of Matters to a Vote of Security Holders
None
-16-
<PAGE>
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
The Common Stock of the Company is traded on the NYSE under the symbol "NFI".
The Company has applied to list the Warrants on the Nasdaq small cap 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 Capital Stock.
<TABLE>
<CAPTION>
Common Stock Prices Cash Dividends
- ----------------------------------------- --------------------------------------------------
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(A) 18 13/16 14 1/2 Preferred Stock 3/13/97 4/30/97 $0.05
6/18/97 7/30/97 0.05
9/18/97 10/20/97 0.08
Common Stock 12/19/97 1/27/98 0.10
</TABLE>
- -----------
(A) The Company's Common Stock began trading on October 31, 1997. There has not
yet been a full quarter of trading information that may be reported.
As of March 16, 1998, approximately 2,900 stockholders held the Company's
7,828,665 shares of Common Stock.
The Company intends to pay quarterly dividends. The Company intends to make
distributions to its stockholders of all or substantially all of its taxable
income in each year (subject to certain adjustments) so as to qualify for the
tax benefits accorded to a REIT under the Code. All distributions will be made
by the Company at the discretion of the Board of Directors and will depend on
the earnings of the Company, financial condition of the Company, maintenance of
REIT status and such other factors as the Board of Directors may deem relevant
from time to time.
Recent Sales of Securities
On December 1, 1997, the Company completed the sale of its $0.01 par, common
stock in an initial public offering of 4,059,500 shares at an aggregate offering
price of $73,071,000. Underwriting fees associated with this offering aggregated
$5,114,970. The principal underwriters associated with this offering were
Stifel, Nicolaus & Company and NationsBanc Montgomery Securities, Inc. Under the
provisions of the Company's 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 additional shares of preferred stock converted
into common stock on November 4, 1997.
Approximately 50 percent of the proceeds from the initial public offering of
common stock has been used to acquire mortgage securities, 50 percent has been
used to acquire subprime mortgage loans or to repay borrowings financing
mortgage loans and securities in approximately the same proportion.
-17-
<PAGE>
Item 6. Selected Consolidated Financial Data
The following selected consolidated financial data are derived from the
audited consolidated financial statements of the Company 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 Report. Operating results for
the twelve months ended December 31, 1997 are not necessarily indicative of
future results. Dollars are presented in thousands.
<TABLE>
<CAPTION>
For the Year Ended For the Period Ended
December 31, 1997 December 31, 1996
<S> <C> <C>
Consolidated Statement of Operations Data
Interest income.............................................. $ 36,961 $ 155
Interest expense............................................. 28,185 -
Net interest income.......................................... 8,776 155
Provision for credit losses.................................. 2,453 -
Net interest income after provision for credit losses........ 6,323 155
Other income................................................. 755 -
Equity in net income of NFI Holding Corporation.............. 28 -
General and administrative expenses.......................... 7,158 457
Forgiveness of notes receivable from founders................ 1,083 -
Net loss..................................................... (1,135) (302)
Basic and diluted loss per share (A)......................... (0.26) (0.08)
As of As of
December 31, 1997 December 31, 1996
Consolidated Balance Sheet Data
Mortgage Assets:
Mortgage loans............................................... $ 574,984 $ -
Mortgage securities.......................................... 517,246 13,239
Total assets................................................... 1,126,252 59,811
Short-term borrowings.......................................... 596,693 -
Collateralized mortgage obligations............................ 408,867 -
Stockholders' equity........................................... 116,489 46,380
As of or for the As of or for the
Year Ended Period Ended
December 31, 1997 December 31, 1996
Other Data:
Acquisition of wholesale loan production of NovaStar Mortgage:
Principal at purchase.......................................... $ 409,974 $ -
Average principal balance per loan............................. 128 -
Weighted average interest rate:
Adjustable rate mortgage loans............................... 10.1% -
Fixed rate mortgage loans.................................... 10.5% -
Loans with prepayment penalties................................ 73% -
Weighted average prepayment period (in years).................. 2.4 -
Loans purchased in bulk:
Principal at purchase.......................................... $ 207,240 -
Average principal balance per loan............................. 102 -
Weighted average interest rate:
Adjustable rate mortgage loans............................... 10.4% -
Fixed rate mortgage loans.................................... 10.5% -
Loans with prepayment penalties................................ 57% -
Weighted average prepayment period (in years).................. 2.1 -
Delinquent loans (60 days or greater), as percent of total):
Loans as collateral for NovaStar Home Equity Series:
1997-1...................................................... 3.91% -
1997-2...................................................... 1.03% -
All loans..................................................... 2.62% -
Net interest rate spread........................................ 1.30% -
Net yield....................................................... 1.84% -
Annualized return on assets..................................... (0.10)% (1.69)%
Annualized return on equity..................................... (0.97)% (2.18)%
Taxable income (loss)........................................... $ 1,434 $ (173)
Taxable income (loss) per share................................. $ 0.18 $ (0.05)
Dividends declared per share.................................... $ 0.28 -
Dividends declared.............................................. $ 1,423 -
Number of account executives.................................... 36 -
</TABLE>
- ----------------------------------------------------------------
(A) Prior periods restated to reflect adoption of SFAS No. 128.
-18-
<PAGE>
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion should be read in conjunction with the preceding
Selected Consolidated Financial and Other Data and the Consolidated Financial
Statements of the Company and the Notes thereto, included elsewhere in this
Report.
Safe Harbor Statement
"Safe Harbor" statement under the Private Securities Litigation Reform Act of
1995: Statements in this discussion regarding NovaStar Financial, Inc. (the
Company) and its business, which are not historical facts, are "forward-looking
statements" that involve risks and uncertainties. For a discussion of these
risks and uncertainties, refer to the "Risk Factors" section of this Report.
Information
NovaStar's management intends to provide extensive information about the
Company's financial position and results of operations in a format that is clear
and easy to understand. This report and other published documents are designed
to provide a framework for understanding the Company's business and the
associated risks. The manner in which management conducts business and assesses
risks will determine the Company's future performance. By providing detailed
information to this extent, investors will be able to evaluate NovaStar as an
investment option and to compare it with its competition.
Basis of Presentation
The Company owns 100 percent of the common stock of NovaStar Assets
Corporation and NovaStar Certificates Financing Corporation. These entities were
established as special purpose entities used in the Company's issuance of
collateralized mortgage obligations. The consolidated financial statements of
the Company include the financial condition and results of operations of these
two entities.
The Company owns 100 percent of the non-voting preferred stock of NFI Holding
Corporation (Holding) for which it receives 99 percent of any dividends paid by
Holding. The founders of the Company own the voting common stock of Holding and
receive one percent of any dividends paid by Holding. NovaStar Mortgage is a
wholly owned subsidiary of Holding. Certain key officers of the Company serve as
officers of Holding and NovaStar Mortgage and the founders are the only members
of the Board of Directors of Holding and NovaStar Mortgage. The Company accounts
for its investment in Holding using the equity method.
Financial Condition and Results of Operations as of and for the Period Ended
December 31, 1996
The Company 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. Those operating results are not meaningful to the on-going
operations of the Company.
Forgivable Notes Receivable from Founders
The Company's founders received 216,666 units upon closing of the 1996
private placement. A unit consisted of one share of convertible preferred stock
and one common stock warrant. The founders delivering forgivable promissory
notes made payment for these units. Principal on these notes will be forgiven if
certain incentive performance targets are achieved. The incentive tests relate
to the return generated to investors in the private placement. Return includes
the appreciation in the Company's stock price, the value of the warrants, and
dividends paid. One tranche will be forgiven for each fiscal period that the
Company generates a return of 15 percent to investors in the private placement.
All three tranches will be forgiven if the Company generates a 100 percent
return. During the period from the closing of the private placement through
December 31, 1997, the Company'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 percent. As a result, the first tranche of these notes was forgiven
resulting in a non-cash charge of $1,083,000.
Financial Condition as of December 31, 1997
NovaStar Mortgage began originating loans in February 1997. From February 1,
1997 through December 31, 1997, NovaStar Mortgage originated 3,154 wholesale
loans with an aggregate principal amount of $410 million. The Company purchased
all loans originated by NovaStar Mortgage during 1997. During the first five
months of 1997, the Company also acquired several bulk pools of subprime
mortgage loans. Table IX is a summary of wholesale loan originations and bulk
acquisitions. Table X is a detailed analysis of wholesale loan originations.
-19-
<PAGE>
Table IX
Wholesale Loan Originations (A) and Bulk Acquisitions
Year Ended December 31, 1997 (dollars in thousands)
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------
Wholesale Originatons(A) Bulk Acquisitions Total
----------------------------------------------------------------------------------
Number Principal Number Principal Number Principal
of Loans Amount of Loans Amount of Loans Amount
<S> <C> <C> <C> <C> <C> <C>
Quarter:
First.......... 68 $ 12,688 1,422 $157,432 1,490 $170,120
Second......... 509 77,692 530 49,808 1,039 127,500
Third.......... 1,025 136,582 - - 1,025 136,582
Fourth......... 1,552 183,012 - - 1,552 183,012
----- -------- ----- -------- ----- --------
Total.......... 3,154 $409,974 1,952 $207,240 5,106 $617,214
===== ======== ===== ======== ===== ========
</TABLE>
- ----------
(A) Loans originated by NovaStar Mortgage and purchased by the Company.
Table X
Wholesale Loan Originations (A)
Year Ended December 31, 1997 (dollars in thousands)
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------
Weighted Average
-----------------
Average Percent with
Number Loan Price Paid Loan-to Credit Prepayment
of Loans Principal Balance to Broker value Rating Coupon Penalty
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Quarter:
First....... 68 $ 12,688 $187 102.3 75% 4.22 9.64% 78%
Second...... 509 77,692 153 102.1 77 4.23 10.17 84
Third....... 1,025 136,582 133 101.6 79 4.21 10.12 66
Fourth...... 1,552 183,012 118 101.6 81 4.32 10.09 71
----- -------- ----
Total....... 3,154 $409,974 $130 101.7 79 4.26 10.10 73
===== ======== ====
</TABLE>
- --------------
(A) Loans originated by NovaStar Mortgage and purchased by the Company.
Further details regarding mortgage loans outstanding as of December 31, 1997
are given in various sections of "Business-Risk Management" of this report.
The Company has been an active investor in mortgage securities issued by
Government-sponsored entities. During 1997, the Company acquired mortgage
securities with an aggregate cost of $659.4 million and sold securities
generating proceeds of $110.1 million. As of December 31, 1997, the carrying
value of mortgage securities totaled $517.2 million. Tables XI and XII are
summaries of the securities acquired during 1997 by quarter and the portfolio as
of December 31, 1997.
-20-
<PAGE>
Table XI
Mortgage Security Acquisitions
Year Ended December 31, 1997 (dollars in thousands)
- -------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Net Weighted
Price to Average
Principal Premium Discount Par Coupon
First quarter:
<S> <C> <C> <C> <C> <C>
Federal National Mortgage Association....... $ 7,491 $ 231 -- 103.1 7.57%
Government National Mortgage Association.... 8,931 174 -- 101.9 7.13
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
Third quarter:
Federal Home Loan Mortgage Corporation...... 2,202 87 -- 104.0 7.40
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
</TABLE>
Table XII
Mortgage Security Portfolio
Year Ended December 31, 1997 (in thousands)
- -------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Gross
Unamoritized Unaccreted Amortized
Principal Premium Discount Cost
<S> <C> <C> <C> <C>
Federal National Mortgage Association.......... $266,083 $6,690 $ -- $272,773
Government National Mortgage Association....... 233,407 2,640 1,302 234,745
Federal Home Loan Mortgage Corporation......... 5,357 177 -- 5,534
-------- ------ ------ --------
$504,847 $9,507 $1,302 $513,052
======== ====== ====== ========
</TABLE>
Loans originated through the lending operations of NovaStar Mortgage have
typically been funded through a $50 million warehouse line with First Union
National Bank under which the Company and NovaStar Mortgage are co-borrowers.
The Company also has a $300 million master repurchase line with Merrill Lynch
Mortgage Capital, Inc. and Merrill Lynch Credit Corporation to finance mortgage
loans prior to securitization. The Company is negotiating mortgage loan
repurchase agreements with other national mortgage and investment dealers.
During 1997, funds borrowed under this agreement were used to acquire some of
the largest pools of mortgage loans acquired by the Company. Funds borrowed
against the master repurchase agreement are also used to buy loans from NovaStar
Mortgage, which in turn pays down advances under its warehouse line of credit to
free its use for further wholesale production. Management expects to continue
using this method for the short-term financing of its mortgage lending
operation.
On a long-term basis, the Company finances its mortgage loans using
collateralized mortgage obligations (CMOs). Investors in CMOs are repaid based
on the performance of the mortgage loans collateralizing the CMOs. Under the
terms of its CMOs, NovaStar Financial is entitled to repurchase the mortgage
loan collateral when their aggregate principal balance falls below 35 percent
for issue 97-01 and 25 percent for issue 97-02. Subprime mortgage loans are not
readily obtainable financial assets. As a result, NovaStar Financial retains
effective control over the transferred assets as defined in paragraph 9c. of
Statement of Financial Accounting Standards (SFAS) No. 125, Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities
and further clarified by paragraph 30 of SFAS No. 125. Accordingly, NovaStar
Financial records its CMO transactions as secured borrowings, rather than sales
of the transferred loans. These non-recourse financing arrangements match the
loans with the financing arrangement for long periods of time, as compared to
repurchase agreements that mature frequently with interest rates that reset
frequently.
Using individual assets as collateral for repurchase agreements, the Company
has financed acquisitions of agency-issued mortgage securities. These agreements
have been executed with a number of reputable securities dealers. Management
expects to continue using this method to finance its acquisition of mortgage
securities. During 1997, the Company issued CMOs totaling $474.7 million, which
includes a $50 million prefunded amount, in two separate transactions. Proceeds
from the issuance of these CMOs were used to repay amounts borrowed under the
Company's master repurchase agreement.
-21-
<PAGE>
Under the terms of all financing arrangements, lending institutions require
"over-collateralization" from the Company. The value of the collateral generally
must exceed the allowable borrowing by two to five percent. As a result, the
Company must have capital available to cover this "haircut."
Amounts outstanding under borrowing arrangements aggregated $1.0 billion as
of December 31, 1997 and are further detailed in note 4 to the consolidated
financial statements.
Results of Operations--Year Ended December 31, 1997
Net Loss
During 1997, the Company recorded a net loss of $1,135,000, or $0.26 per
share. Excluding the forgiveness of the notes receivable from founders, the
Company incurred a loss of $52,000, or $0.01 per share. During much of 1997, the
Company focused on the hiring of key employees and the development of policies
and procedures. The results for the year ended December 31, 1997 also reflect
the significant cost of developing operations.
Net Interest Income
Interest Income. The Company had average interest-earning assets of $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 percent, while mortgage securities earned $11.8
million, or a yield of 6.5 percent. In total, assets earned $37.0 million, or a
7.8 percent yield.
A substantial portion of the mortgage assets owned by the Company has
interest rates that fluctuate with short-term market interest rates. However,
many of these assets have initial coupons lower than current market rates
("teaser" rates). As a result, during 1997 these assets, collectively, have not
adjusted upward to their potential coupon rate. This results in a temporarily
lower rate and lower interest yield to the Company. As these assets "season,"
they should increase to their higher rates and result in higher yields to the
Company. Table XIII is a summary of the Company's mortgage assets by type,
presenting their current and fully indexed weighted-average coupons.
Table XIII
Mortgage Assets by Product/Type and Weighted Average Coupon
December 31, 1997 (dollars in thousands)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Weighted Average
Coupon
------------------------
Outstanding Fully
Product/Type Principal Current Indexed
Mortgage loans:
<S> <C> <C> <C>
Two and three year fixed/adjustable
thereafter............................. $ 314,918 10.19% 11.51%
Fixed rate (30 Yr, 15 Yr, 30/15)....... 124,135 10.50 10.50
Other (1 year CMT, 6 month LIBOR)...... 120,383 10.02 11.41
----------
Total mortgage loans.......... 559,436
Mortgage securities issued by:
Federal National Mortgage Association.. 266,083 7.55 7.55
Government National Mortgage
Association............................ 233,407 5.74 6.57
Federal Home Loan Mortgage Corporation. 5,357 7.71 7.71
----------
Total mortgage securities..... 504,847
----------
Total..................................... $1,064,283
==========
</TABLE>
The Company acquires substantially all of its mortgage loans at a premium.
Premiums are amortized as a reduction of interest income over the estimated
lives of the assets. If mortgage principal repayment rates accelerate, the
Company will recognize more premium amortization, thereby reducing the effective
yield on the assets. Decelerating repayment rates will have the opposite effect
on asset yields. To mitigate the effect of prepayments, the Company generally
strives to acquire mortgage loans that have some form of prepayment penalty.
Table XIV is an analysis of mortgage loans and prepayment penalties.
-22-
<PAGE>
<TABLE>
<CAPTION>
Table XIV
Mortgage Loan Prepayment Penalties
December 31, 1997 (dollars in thousands)
- ------------------------------------------------------------------------------------------------------------------
Weighted Average
----------------------------------------
Prepayment Penalty
Period (in years)
-------------------
Percent with Loans with
Original Prepayment Loan-to- All Prepayment
Principal Premium Penalty Coupon value Loans Penalty
<S> <C> <C> <C> <C> <C> <C> <C>
Loans collateralizing NovaStar
Home Equity Series (CMO):
1997-1....................... $252,166 $12,365 69% 10.28% 75% 1.4 2.1
1997-2(A).................... 168,712 2,553 66 10.20 78 1.6 2.4
All other loans................ 138,558 2,943 71 10.06 81 2.0 2.8
-------- --------
Total.......................... $559,436 $17,861 68 10.20 77 1.6 2.4
======== ========
</TABLE>
- -------------------
(A) Excludes $50 million in loans added during second closing for the
transaction on January 20, 1998.
As noted above, interest income is a function of volume and rates.
Management expects its mortgage asset portfolio to continue to increase through
wholesale loan originations. Management will continue to monitor the market
for mortgage securities and whole loan mortgage pools and will acquire mortgage
assets that are appropriate for its overall asset/liability strategy.
Increasing the volume of assets will cause future increases in interest income,
while declining balances will reduce interest income. Market interest rates
will also affect future interest income.
Interest Expense. The cost of borrowed funds for the Company was $28.2
million during the year ended December 31, 1997, or 6.5 percent of average
borrowings. Advances under the master repurchase agreement bear interest at
rates based on LIBOR, plus a spread. During the year ended December 31, 1997,
the one-month LIBOR averaged 5.6 percent. As with interest income, the
Company's cost of funds in the future will largely depend on market conditions,
most notably levels of short-term interest rates. Rates on other borrowings
generally fluctuate with short-term market interest rates, such as LIBOR or the
Federal Funds rate.
Table XV 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>
<CAPTION>
Table XV
Interest Analysis
Year Ended December 31, 1997 (dollars in thousands)
- -------------------------------------------------------------------------------------------------------------
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
Repurchase agreements.................. $170,344 11,972 7.03 172,829 10,336 5.98
Collateralized mortgage obligations.... 74,511 4,736 6.36 -- -- --
Other borrowings (A)................... 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>
- -----------
(A) Represents borrowings of NovaStar Mortgage and interest paid thereon. The
Company reimburses interest expense incurred by NovaStar Mortgage under the
terms of an Administrative Services Outsourcing Agreement. See Note 9 to
the Company's financial statements.
Net Interest Income and Spread. Net interest income during 1997 was $8.8
million, or 1.8 percent of average interest-earning assets. Net interest spread
for the Company was 1.3 percent during the year ended December 31, 1997. Net
interest income and the spread are functions of the yield of the Company's
assets relative to its costs of funds. During
-23-
<PAGE>
1997, the cost of funds was relatively low and stable. This lower cost of funds
offsets, to some degree, the lower yield on "teased" assets as previously
discussed. In addition, the Company has entered into interest rate agreements to
mitigate the exposure to variations in interest rates on interest-earning assets
that are different from the variations in interest incurred on borrowings. The
volume of assets and liabilities and how well the Company manages the spread
between earnings on assets and the cost of funds will dictate future net
interest income.
Impact of Interest Rate Agreements. During 1997, the Company entered into
certain interest rate agreements and financial futures contracts designed to
mitigate exposure to interest rate risk. Interest rate cap agreements, with a
combined notional amount of $270 million, require the Company to pay a monthly
fixed premium while allowing it to receive a rate that adjusts with LIBOR, when
rates rise above a certain agreed-upon rate. Other agreements executed by the
Company are simple fixed to floating interest rate swaps with an aggregate
notional amount of $276 million. These agreements are used to alter, in effect,
the interest rates on funding costs to more closely match the yield on interest-
earning assets. During 1997, the Company incurred net interest expense on these
agreements of $1.0 million, which is included as a component of interest
expense.
Gains and Losses on Securities Sales
The Company classifies its mortgage securities as available-for-sale because
management may deem it appropriate to sell securities, from time to time, to
reallocate the Company's capital. Since inception, the Company has not sold any
mortgage loans. The Company's principal strategy is to hold and service mortgage
loans in order to earn the spread over the life of the loans.
Provisions for Credit Losses
The Company provides regular reserves for credit losses on its mortgage
loans. Management continuously evaluates the potential for credit losses for
mortgage loans held in its portfolio. Since the Company has limited actual
performance history for its loan portfolio, losses have been provided for
primarily based on general industry trends and on the judgement of management.
The Company believes that loan defaults occur throughout the life of a loan or
group of loans. As a result, provisions for credit losses are recorded against
income over the estimated life of the loans, rather than immediately upon
acquisition of the loan. During the year ended December 31, 1997, the Company
provided $2.5 million for credit losses.
The Company charged off loans in the amount of $140,000 during 1997. As the
portfolio seasons, management expects the actual loss rate to increase.
Table XVI is a summary of delinquent loans as of December 31, 1997. The low
level of delinquencies is reflective of the short amount of time loans
originated or acquired by the Company have been outstanding. Higher rates of
delinquency are expected in the future and management has established, in its
opinion, the appropriate staff and policies to monitor delinquencies.
Table XVI
Loan Delinquencies (60 days and greater)
Year Ended December 31, 1997
<TABLE>
<CAPTION>
=========================================================================================================
December 31 September 30 June 30 March 31
<S> <C> <C> <C> <C>
Mortgage loans collateralizing
NovaStar Home Equity series (CMO):
1997-1 (A)............................ 3.91% -- -- --
1997-2 (B)............................ 1.03 -- -- --
All other mortgage loans............... 2.62 1.73% 1.04% --
</TABLE>
- -----------
(A) Issued October 1, 1997
(B) Issued December 11, 1997
General and Administrative Expenses
General and administrative expenses for the year ended December 31, 1997 are
provided in table XVII. Table XVIII displays the relationship of portfolio
expenses to net interest income during the four quarters of 1997.
-24-
<PAGE>
Table XVII
General and Administrative Expenses
Year Ended December 31, 1997 (dollars in thousands)
- -------------------------------------------------------------------
<TABLE>
<CAPTION>
Percent of
Net Interest
Income
<S> <C> <C>
Loan servicing....................... $1,246 14.2%
Compensation and benefits............ 839 9.6
Professional and outside services.... 676 7.7
Office administration................ 299 3.4
Other................................ 448 5.1
------ ----
Total portfolio-related expenses 3,508 40.0%
====
Forgiveness of notes receivable from
Founders........................ 1,083
Administrative services provided by
NovaStar Mortgage................ 3,650
------
Total.............................. $8,241
======
</TABLE>
Table XVIII
Portfolio Related Expenses as a
Percent of Net Interest Income
Year Ended December 31, 1997 (dollars in thousands)
<TABLE>
<CAPTION>
Percent of
Net
Interest
Income
<S> <C>
First quarter................................ 33.1%
Second quarter............................... 62.1
Third quarter................................ 36.3
Fourth quarter............................... 65.9
</TABLE>
The largest component of general and administrative expenses is the
administrative service fee paid to NovaStar Mortgage. NovaStar Mortgage provides
mortgage loan marketing, underwriting, funding, quality control and servicing on
behalf of the Company. During the year ended December 31, 1997, the fee paid for
these services was $3,650,000. Management expects to continue to incur
increasing administrative costs in future periods as NovaStar Mortgage further
develops and expands its mortgage production operation.
Compensation and benefits include employee base salaries, benefit costs and
incentive bonus awards. The number of employees and the related compensation
costs have increased throughout 1997 as the Company has continued to hire staff.
In general, the Company expects compensation and benefits to increase as the
Company grows.
Loan servicing consists of direct costs associated with the mortgage loan
servicing operation, which the Company outsourced until July 15, 1997. Effective
July 15, 1997, the Company engaged NovaStar Mortgage to service its mortgage
loans. Management believes that by servicing its own mortgage loans (through
NovaStar Mortgage), the Company will be able to better manage credit risk by
controlling delinquencies and defaults as well as improving its opportunities of
refinancing borrowers. Management believes this is particularly important in the
subprime sector of the mortgage industry. On a go-forward basis, loan servicing
costs will consist of direct costs (other than compensation and benefits)
incurred by the Company in servicing loans. These costs will vary depending on
overall volume of loans and the number of delinquencies and foreclosures.
Professional and outside services include the cost of contract labor, as well
as fees for legal and accounting services. Management used contract labor
services extensively during 1997, particularly in the area of systems
development. As permanent employees are hired, management anticipates using
contract labor to a lesser extent.
Office administration includes items such as rent, depreciation, telephone,
office supplies, postage, delivery, maintenance and repairs. Certain of these
items have been necessarily high during the start up phase of the Company.
However, management expects many of these expenses to continue to increase
relative to increasing personnel.
-25-
<PAGE>
Earnings of NFI Holding Corporation
For the year ended December 31, 1997, Holding recorded net income of $28,000,
of which the Company recorded its portion. Income generated by Holding is a
function of the fees earned by NovaStar Mortgage relating to the origination of
loans for the Company. General and administrative expenses consist largely of
compensation and benefits for the marketing, underwriting, funding and servicing
staffs. NovaStar Mortgage incurs significant general and administrative expenses
in generating loan production and servicing loans. Going forward, management
expects that the general and administrative expenses of NovaStar Mortgage will
vary and increase, as a general rule, with loan production. Fees received from
the Company will also generally vary dependent upon the volume of loans acquired
from NovaStar Mortgage relative to the extent of services provided. Condensed
consolidated financial statements for Holding are presented in Note 12 to the
Company's consolidated financial statements.
Table XIX is a summary of loan costs for NovaStar Mortgage relative to its
wholesale loan originations.
Table XIX
Cost of Loan Production NovaStar Mortgage, Inc.
Year Ended December 31, 1997 (dollars in thousands)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Quarter
-------------------------------------------------------------------
First Second Third Fourth 1997
<S> <C> <C> <C> <C> <C>
Total costs of loan production...................... $ 410 $ 1,401 $ 1,938 $ 2,096 $ 5,845
Wholesale loan origination--principal............... 12,688 77,692 136,582 183,012 $409,974
Premium paid to broker.............................. 295 1,618 2,119 2,896 6,928
------- ------- -------- -------- --------
Total acquisition cost (A).......................... $13,393 $80,711 $140,639 $188,004 $422,747
======= ======= ======== ======== ========
Costs of loan production and principal as a percent
of principal....................................... 103.2% 101.8% 101.4% 101.1% 101.4%
======= ======= ======== ======== ========
Premium paid to broker and principal as a percent
of principal....................................... 102.3% 102.1% 101.6% 101.6% 101.7%
======= ======= ======== ======== ========
Total acquisition cost as a percent of principal.... 105.6% 103.9% 103.0% 102.7% 103.1%
======= ======= ======== ======== ========
</TABLE>
- -------------
(A) Principal, premium and general administrative expenses associated with loan
production.
Value of Mortgages Added through Wholesale Operations
By establishing a wholesale lending operation to originate loans, NovaStar
has developed a process to add mortgage assets to its balance sheet at amounts
below what it would cost to acquire the same assets in the open market. In
effect, the value created by generating assets at this lower cost is creating
future economic benefit, or value, for stockholders. This added value is
demonstrated in the estimated fair value of its loans. For example, Table XIX
indicates the loans added to its balance sheet in 1997 had an average total cost
to par of 103 percent, including the operating expenses that NovaStar has
already recognized as expense. Excluding the costs expensed, the average price
of loans as reflected on the Company's balance sheet (principal plus broker
premium) was 102 percent.
Table XX provides management's estimates of the market price of its loan
portfolio as of December 31, 1997, by product, given the assumptions presented.
Based upon these assumptions, the Company estimates the value of its loans (in
terms of price to par) ranges from 105 percent to 109 percent, depending on the
product type and the assumptions made. An average value in the open market is
estimated for all loans to be more than 106 percent. If management had purchased
these loans at a price of 106, the additional four percent of price would result
in a reduction of yield over the life of the loan. NovaStar's stockholders will
realize this added value over the lives of the loans through interest income.
Management estimates the total fair value of its loan portfolio as of December
31, 1997 to be $609 million a $34 million premium to book value.
-26-
<PAGE>
Table XX
Estimated Market Price of Loans
Year Ended December 31, 1997
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------
Estimated Market Price
-------------------------------------------------------------------
Two- and Three-year
Fixed Loan Products Six-month LIBOR Loan
(Six-month LIBOR) Products
----------------------------- ----------------------------
<S> <C> <C> <C> <C> <C> <C>
Bond Equivalent Yield............ 8.34% 8.59% 8.84% 8.34% 8.59% 8.84%
Spread to Index.................. 2.50% 2.75% 3.00% 2.75% 3.00% 3.25%
Assumed Prepayment Speed (CPR)...
20............................... 108.9% 108.1% 107.2% 108.9% 108.2% 107.5%
25............................... 107.2% 106.5% 105.8% 107.4% 106.9% 106.3%
30............................... 105.9% 105.4% 104.8% 106.3% 105.8% 105.3%
30/15-year Fixed and Balloon
One-year CMT Loan Loan Products
Products (Three-year Treasury)
----------------------------- ----------------------------
Bond Equivalent Yield............ 7.98% 8.23% 8.48% 7.92% 8.17% 8.42%
Spread to Index.................. 2.50% 2.75% 3.00% 2.25% 2.50% 2.75%
Assumed Prepayment Speed (CPR)...
20............................... 109.1% 108.3% 107.4% 108.3% 107.5% 107.9%
25............................... 107.4% 106.7% 106.0% 107.0% 106.4% 105.7%
30............................... 106.1% 105.5% 104.9% 106.0% 105.4% 104.9%
</TABLE>
Taxable Income (Loss)
Income reported for financial reporting purposes as calculated in accordance
with generally accepted accounting principles (GAAP) differs from income
computed for income tax purposes. This distinction is important as dividends
paid are based on taxable income. Table XXI is a summary of the differences
between the Company's net income or loss reported for GAAP in 1997 and its
taxable income.
Table XXI
Taxable Income
Year Ended December 31, 1997 (in thousands)
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------
Quarter
First Second Third Fourth 1997
<S> <C> <C> <C> <C> <C>
Net income (loss).................... $194 $(1,073) $ 177 $ (433) $(1,135)
Results of Holding and subsidiary.... 408 126 (393) (169) (28)
Provision for credit losses.......... 171 547 726 1,009 2,453
Loans charged-off.................... - - - (140) (140)
Other, net........................... - (8) (4) 296 284
---- ------- ----- ------ -------
Taxable income....................... $773 $ (408) $ 506 $ 563 $ 1,434
==== ======= ===== ====== =======
</TABLE>
Liquidity and Capital Resources
Liquidity, as used herein, means the need for, access to and uses of cash.
During 1997, the Company's financing activities generated cash of $1.1 billion.
Cash was used during 1997 in investing activities ($1.1 billion) and in
operating activities ($2.3 million). The Company's primary needs for cash
include the acquisition of mortgage assets, principal repayment and interest on
borrowings, operating expenses and dividend payments. The Company's business
requires
-27-
<PAGE>
substantial cash to support its operating activities and growth plans. The
Company has a certain amount of cash on hand to fund operations. The Company
requires access to short-term credit facilities to fund its acquisition of
wholesale loan originations and mortgage securities. Also, principal, interest
and fees received on mortgage assets will serve to support the cash needs of the
Company. Drawing upon various borrowing arrangements typically satisfies major
cash requirements. The Company has demonstrated the ability to access public
markets as a source of long-term cash resources.
The Company has available borrowing capacity of $300 million under a master
repurchase agreement to acquire mortgage loans. Management is negotiating with
other dealers for additional borrowing capacity. In addition, the Company has
been approved as a borrower from reputable securities dealers for repurchase
agreements to fund the acquisition of mortgage securities. On a long-term basis,
the Company will pool its mortgage loans to serve as collateral for its CMOs. By
doing so, the loans will be cleared as collateral from the master repurchase
agreement and the warehouse line of credit, freeing those arrangements to fund
further loan originations. In addition, all mortgage securities are classified
as available-for-sale and could be sold in the open market to provide additional
cash for liquidity needs. Table XXII is a summary of financing arrangements and
available borrowing capacity under those arrangements as of December 31, 1997.
Table XXII
Liquidity Resources
December 31, 1997 (dollars in thousands)
<TABLE>
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------------------
Availability as a
Percent of
-----------------------
Value of Stockholders' Total
Collateral Collateral Borrowings Availability Equity Assets
<S> <C> <C> <C> <C> <C>
First Union National Bank.................. $45,600 $40,250 $ 5,350 4.6% 0.5%
Merrill Lynch Mortgage Capital, Inc........ 79,743 55,013 24,730 21.2 2.2
Residual financing available under CMOs.... 45,662 - 29,680 25.5 2.6
</TABLE>
On December 1, 1997, the Company successfully completed its initial public
offering of 4,059,500 shares of common stock at $18 per share. Net proceeds of
the offering were $67 million. Management believes that resources available for
liquidity, including potential future equity offerings, will be sufficient to
fund its operations for the next twelve months, if future operations are
consistent with management's expectations.
The Year 2000
Management is aware of potential Year 2000 system issues. The Company has
focused its internal system resources to ensure that Year 2000 software issues
will not adversely affect its operational and financial systems. Primarily as a
result of recently developing or purchasing all software used by the Company,
management expects to incur no significant costs in conjunction with becoming
Year 2000 compliant. The Company is requiring outside vendors to be Year 2000
compliant, and has a planned program for compliance testing.
Inflation
Virtually all of the Company's assets and liabilities are financial in
nature. As a result, interest rates and other factors drive the Company's
performance far more than does inflation. Changes in interest rates do not
necessarily correlate with inflation rates or changes in inflation rates. The
Company's financial statements are prepared in accordance with generally
accepted accounting principles and the Company's dividends are based upon the
Company's taxable income. In each case, the Company's activities and balance
sheet are measured with reference to historical cost or fair market value
without considering inflation.
Impact of Recently Issued Accounting Pronouncements
Note 1 to the consolidated financial statements describes certain recently
issued accounting pronouncements. Management believes the implementation of
these pronouncements will not have a material impact on the Company's
consolidated financial condition or results of operations.
-28-
<PAGE>
Item 8. Financial Statements and Supplementary Data
NOVASTAR FINANCIAL, INC.
CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share amounts)
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------
December 31,
-------------------------
1997 1996
<S> <C> <C>
Assets
Cash and cash equivalents..................................................... $ - $46,434
Restricted cash............................................................... 20,424 -
Mortgage securities--available-for-sale....................................... 517,246 13,239
Mortgage loans, net........................................................... 574,984 -
Accrued interest receivable................................................... 7,088 29
Investment in NFI Holding Corporation......................................... 2,188 -
Other assets.................................................................. 4,322 109
---------- -------
Total assets............................................................ $1,126,252 $59,811
========== =======
Liabilities and Stockholders' Equity
Liabilities:
Repurchase agreements....................................................... $ 556,443 $ -
Collateralized mortgage obligations......................................... 408,867 -
Warehouse line of credit.................................................... 40,250 -
Amounts due to brokers and dealers for unsettled securities
Purchases.................................................................. - 13,255
Accounts payable and other liabilities...................................... 4,203 176
---------- -------
Total liabilities........................................................ 1,009,763 13,431
Commitments and contingencies
Stockholders' equity:
Capital stock, $0.01 par value, 50,000,000 shares authorized:
Convertible preferred stock, 3,549,999 shares issued and
outstanding as of December 31, 1996....................................... - 36
Common stock, 7,828,665 and 216,666 shares issued and
outstanding, respectively................................................. 78 2
Additional paid-in capital................................................. 117,084 49,910
Accumulated deficit........................................................ (2,859) (302)
Net unrealized gain (loss) on available-for-sale securities................ 4,353 (16)
Forgivable notes receivable from founders.................................. (2,167) (3,250)
---------- -------
Total stockholders' equity............................................... 116,489 46,380
---------- -------
Total liabilities and stockholders' equity.............................. $1,126,252 $59,811
========== =======
</TABLE>
See notes to consolidated financial statements.
-29-
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------------------
For the Year For the period from
Ended September 13, 1996
December 31, (inception) to
1997 December 31, 1996
<S> <C> <C>
Interest income:
Mortgage loans........................................................... $25,154 $ -
Mortgage securities...................................................... 11,807 155
------- -------
Total interest income...................................................... 36,961 155
Interest expense........................................................... 28,185 -
------- -------
Net interest income........................................................ 8,776 155
Provision for credit losses................................................ 2,453 -
------- -------
Net interest income after provision for credit losses...................... 6,323 155
Other income............................................................... 755 -
Equity in net income of NFI Holding Corporation............................ 28 -
General and administrative expenses:
Administrative services provided by NovaStar Mortgage, Inc............... 3,650 -
Loan servicing........................................................... 1,246 -
Forgiveness of notes receivable from founders............................ 1,083 -
Compensation and benefits................................................ 839 199
Professional and outside services........................................ 676 200
Office administration.................................................... 299 -
Other.................................................................... 448 58
------- -------
Total general and administrative expenses................................ 8,241 457
------- -------
Net loss................................................................... $(1,135) $ (302)
======= =======
Basic and diluted loss per share........................................... $ (0.26) $ (0.08)
======= =======
Weighted average shares outstanding........................................ 4,430 3,767
======= =======
</TABLE>
See notes to consolidated financial statements.
-30-
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(dollars in thousands, except share amounts)
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------------------
Net
Unrealized
Gain Forgivable
(Loss) on Notes
Convertible Additional Available- Receivable Total
Preferred Common Paid-in Accumulated for-sale from Stockholders'
Stock Stock Capital Deficit Securities 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) --
Net loss................................. -- -- -- (302) -- -- (302)
Net change in unrealized gain
(loss) on available-for-sale
securities.............................. -- -- -- -- (16) -- (16)
---- --- -------- ------- ------ ------- --------
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
Net loss................................. -- -- -- (1,135) -- -- (1,135)
Net change in unrealized gain
(loss) on available-for-sale
securities.............................. -- -- -- -- 4,369 -- 4,369
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
---- --- -------- ------- ------ ------- --------
Balance, December 31, 1997............... $ -- $78 $117,084 $(2,859) $4,353 $(2,167) $116,489
==== === ======== ======= ====== ======= ========
</TABLE>
See notes to consolidated financial statements.
-31-
<PAGE>
NOVASTAR FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
For the period from
September 13, 1996
For the Year Ended (inception) to
December 31, 1997 December 31, 1996
Cash flow from operating activities:
<S> <C> <C>
Net loss............................................................... $ (1,135) $ (302)
Adjustments to reconcile net loss to cash used in operating activities:
Amortization of premiums on mortgage loans........................... 2,532 --
Amortization of premiums on mortgage securities...................... 908 --
Provision for credit losses.......................................... 2,453 --
Forgiveness of notes receivable from founders........................ 1,083 --
Equity in net income of NFI Holding Corporation...................... (28) --
Gains on sales of mortgage securities................................ (51) --
Change in:
Accrued interest receivable....................................... (7,059) (29)
Other assets...................................................... (4,213) (109)
Other liabilities................................................. 3,223 176
----------- -------
Net cash used in operating activities.......................... (2,287) (264)
Cash flow from investing activities:
Purchases of available-for-sale securities............................ (659,415) --
Settlement of amounts due to brokers.................................. (13,255) --
Proceeds from sales of available-for-sale securities.................. 110,067 --
Proceeds from paydowns on available-for-sale securities............... 48,694 --
Investment in NFI Holding Corporation................................. (1,980) --
Mortgage loans purchased from NovaStar Mortgage, Inc.................. (417,752) --
Mortgage loans purchased from others.................................. (219,995) --
Mortgage loan repayments.............................................. 57,778 --
----------- -------
Net cash used in investing activities.......................... (1,095,858) --
Cash flow from financing activities:
Proceeds from issuance of common stock, net of offering costs......... 67,256 2
Exercise of stock options............................................. 6 --
Net borrowings under repurchase agreements and warehouse line......... 596,693 --
Net change in restricted cash......................................... (20,424) --
Proceeds from issuance in collateralized mortgage obligations......... 424,674 --
Payments on collateralized mortgage obligations....................... (15,807) --
Proceeds from private placement, net of offering costs................ (48) 46,696
Dividends paid........................................................ (639) --
----------- -------
Net cash provided by financing activities...................... 1,051,711 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................................................ $ 27,436 $ --
=========== =======
Issuance of units acquired with forgivable debt....................... $ -- $ 3,250
=========== =======
Dividends payable..................................................... $ 783 $ --
=========== =======
</TABLE>
See notes to consolidated financial statements.
-32-
<PAGE>
NOVASTAR FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1997
- -------------------------------------------------------------------------------
Note 1. Summary of Significant Accounting Policies
NovaStar Financial, Inc. (NovaStar or 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 reserve 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 ore
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 two special purpose
entities--NovaStar Assets 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 (Holding)
using the equity method. NovaStar owns 100 percent of the nonvoting preferred
stock of Holding, for which it receives 99 percent of any dividends paid by
Holding. The preferred stock was purchased in February 1997 for $1,980,000.
Holding owns 100 percent of the outstanding common stock of NovaStar Mortgage,
Inc. (NMI), a mortgage loan originator and servicer. NMI serves as NovaStar's
principal source of subprime residential mortgage loans. The founders of
NovaStar own 100 percent of the common stock of Holding and serve as officers
and directors of Holding and NMI.
Cash and Cash Equivalents The Company considers investments with maturities
of three months or less at the date of purchase to be cash equivalents. As of
December 31, 1996, cash equivalents include $35 million in commercial paper.
Restricted Cash--Restricted cash of the Company includes cash held in escrow
for payment of borrowers' taxes and insurance, principal and interest payments
of loans held in trust as required under the Company's collateralized mortgage
obligations, and cash pledged as collateral on certain interest rate agreements.
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.
Mortgage Loans Mortgage loans include loans originated through NMI's
wholesale production operation and those acquired in bulk pools from other
originators and securities dealers. Loans are generally purchased at a premium
over the outstanding principal balance. Mortgage loans 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 will not be collectible in the normal course of business, but in no
case beyond ninety days. The Company charges off any accrued interest receivable
on loans greater than 90 days delinquent. Interest collected on non-accrual
loans is recognized as income upon receipt.
NovaStar maintains a reserve for credit losses at a level deemed appropriate
by management. The reserve for credit losses 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, overall loan to value, delinquency status and other factors deemed
to warrant consideration. The reserve is maintained through ongoing provisions
charged to operating income, reduced by loans that are charged off.
Included in other assets are properties acquired through foreclosure. These
properties are transferred from loans at their fair value at date of
foreclosure.
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
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<PAGE>
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.
Earnings (Loss) Per Share The Company has adopted the provisions of
Statement of Financial Accounting Standards 128, "Earnings Per Share" (SFAS No.
128), which requires the presentation of basic and diluted earnings (loss) per
share (EPS). Basic 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. EPS for all periods have been restated to
conform to the requirements of SFAS No. 128.
Income Taxes NovaStar intends to operate and qualify as a Real Estate
Investment Trust (REIT) under the requirements of the Internal Revenue Code. As
a result, NovaStar, 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, NovaStar 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 NovaStar
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 the reserve for credit losses in that
only actual amounts charged off are deductible for income tax purposes.
NovaStar's non-REIT affiliate, Holding files a consolidated federal income tax
return with NMI.
New Accounting Pronouncements SFAS No. 125, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities," as amended by
SFAS No. 127, is effective for all transfers and servicing of financial assets
and extinguishments of liabilities occurring after December 31, 1996, except for
secured borrowings and collateral, repurchase agreements, dollar rolls,
securities lending and similar transactions, which transfers will be effective
for transactions occurring after December 31, 1997. This statement provides
accounting and reporting standards for transfers and servicing of financial
assets and extinguishments of liabilities based on consistent application of
financial-components approach that focuses on control. It distinguishes
transfers of financial assets that are sales from transfers that are secured
borrowings.
Under the financial-components approach, after a transfer occurs, an entity
recognizes all financial and servicing assets it controls and liabilities it has
incurred and derecognizes financial assets it no longer controls and liabilities
that have been extinguished. Many of these assets and liabilities are components
of financial assets that existed prior to the transfer. If a transfer does not
meet the criteria for a sale, the transfer is accounted for as a secured
borrowing with a pledge of collateral. Management believes adoption of SFAS No.
125, as amended by SFAS No. 127, did not and will not have a material effect on
the financial position or results of operations, nor did or will adoption
require any significant additional capital resources.
SFAS No. 130, "Reporting Comprehensive Income" requires companies to classify
items of other comprehensive income by their nature in a financial statement and
display the accumulated balance of other comprehensive income separately from
retained earnings and additional paid-in capital in the equity section of a
statement of financial position. This statement is effective for financial
statements issued for fiscal years beginning after December 15, 1997.
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<PAGE>
Note 2. Mortgage 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>
As of December 31, 1996, mortgage securities consisted of obligations of the
Federal National Mortgage Association with a weighted-average coupon of 7.77
percent. These securities had gross unrealized losses of $16,000.
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.
Proceeds from the sales of mortgage securities during the year ended December
31, 1997 were $110 million. Gross gains of $51,000, included in other income,
were realized on these sales.
All mortgage securities are 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 includes $159,000 in net unrealized
gains on the investments of Holding.
Note 3. Mortgage Loans
Mortgage loans, all of which are secured by residential properties, consisted
of the following as of December 31, 1997 (in thousands):
<TABLE>
<S> <C>
Outstanding principal...................................... $559,436
Net unamortized premium.................................... 17,861
--------
Amortized cost............................................. 577,297
Reserve for credit losses:
Provision for credit losses....................... (2,453)
Amounts charged off............................... 140
--------
Reserve for credit losses.................................. (2,313)
--------
$574,984
========
</TABLE>
All the 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, 1997 was 10.20%.
Collateral for 27 percent of mortgage loans outstanding as of December 31,
1997 was located in California. The Company has no other significant
concentration of credit risk.
The following table presents certain information regarding impaired loans as
of December 31, 1997 (in thousands):
<TABLE>
<S> <C>
Total recorded investment in impaired loans........................ $11,595
=======
Allowance for loan losses allocated to impaired loans.............. $ 1,710
=======
</TABLE>
The average balance of impaired loans for 1997 was $4,100,000. The net amount
of interest income recorded on these loans during their impairment period
aggregated $385,000 in 1997, all of which was recorded on a cash basis.
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<PAGE>
Note 4. Borrowings
Short-term Financing Arrangements The Company has a $300 million master
repurchase agreement with Merrill Lynch Mortgage Capital, Inc. and Merrill Lynch
Credit Corporation. Borrowings under the master repurchase agreement bear
interest at various rates priced in connection with respective purchases of
mortgage assets. The Company is a co-borrower with NMI under a warehouse line of
credit agreement with First Union National Bank of Charlotte with a maximum
borrowing amount of $50 million. Advances under the line bear interest based on
the Federal Funds rate. These agreements expire in the first quarter of 1998. As
of December 31, 1997, the Company was in compliance with all covenants and
expects the agreements to be renewed at maturity.
Other repurchase agreements used to finance mortgage securities bear interest
at market rates and mature in 30 days to one year.
The following tables present a summaries of the Company's short-term
borrowings (dollars in thousands):
<TABLE>
<CAPTION>
As of December 31, 1997
-----------------------------------------
Weighted Average Daily
Weighted Days to Balance During the
Average Reset or Year Ended
Rate Maturity Balance December 31, 1997
<S> <C> <C> <C> <C>
Repurchase agreements secured by mortgage securities....... 5.92% 87 $501,430 $172,829
Master repurchase agreement secured by mortgage loans...... 6.69 31 55,013 170,344
---------
Total repurchase agreements.............................. 556,443
Warehouse line of credit................................... 7.09 Demand 40,250 18,402
---------
Total borrowings......................................... $596,693
=========
</TABLE>
<TABLE>
<CAPTION>
Days to Reset or Maturity
------------------------------------------------------------
90 and
Daily 0 to 30 30 to 90 greater Total
<S> <C> <C> <C> <C> <C>
Repurchase agreements secured by mortgage securities........ $ -- $299,120 $ -- $202,310 $501,430
Master repurchase agreement secured by mortgage loans....... -- -- 55,013 -- 55,013
Warehouse line of credit.................................... 40,250 -- -- -- 40,250
------- -------- ------- -------- --------
Total borrowings.......................................... $40,250 $299,120 $55,013 $202,310 $596,693
======= ======== ======= ======== ========
</TABLE>
Following is a summary of counterparties that are considered concentrations
of risk under various repurchase agreements as of December 31, 1997 (in
thousands):
<TABLE>
<CAPTION>
Weighted
Amount at Risk Days to
Under Repurchase Reset or
Counterparty Agreements Maturity
<S> <C> <C>
Merrill Lynch Mortgage Capital, Inc.......................... $25,161 31
Societe Generale Securities Corporation...................... 11,029 27
Donaldson, Lufkin and Jenrette Securities Corporation........ 7,505 175
-------
$43,695
=======
</TABLE>
The amount considered at risk is the fair value of the collateral under
repurchase agreements plus accrued interest receivable less the Company's
obligation to the counterparty.
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. In a CMO
transaction, the Company sells the loans to its wholly owned qualified-REIT
subsidiary, NovaStar Assets Corporation (NAC). NAC, in turn, transfers the loans
to a trustee who administers the CMO. Interest and principal on each CMO issue
is payable only from principal and interest on the underlying mortgage loans
collateralizing the CMO. Following is a summary of outstanding CMOs as of
December 31, 1997 (dollars in thousands):
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<PAGE>
<TABLE>
<CAPTION>
Collateralized
Mortgage Obligation Underlying Mortgage Loans
----------------------------- ------------------------------------------------------
Estimated Weighted
Remaining Interest Carrying Weighted Average Months to
Principal Rate Value Average Coupon Maturity
<S> <C> <C> <C> <C> <C>
NovaStar Home Equity Series:
Issue 1997-1....................... $250,262 5.95% $263,468 10.28% 35
Issue 1997-2 (A)................... 160,376 6.25 170,298 10.20 36
Debt issuance costs, net........... (1,771) -
-------- --------
$408,867 $433,766
======== ========
</TABLE>
A) Excludes $50 million in loans added during second closing for the
transaction on January 20, 1998.
Interest rates reset monthly based on one-month LIBOR plus 25 basis points.
The weighted-average months to maturity are when management expects the
underlying pool of mortgage loans to repay. This expectation is based on
estimates and assumptions made by management. The actual maturity may differ
from expectations.
Under the terms of supplemental financing agreements with Merrill Lynch
Mortgage Capital, Inc., the Company may borrow 65 percent of the estimated value
of the residual interests in its CMOs. Availability under these agreements was
$29.7 million as of December 31, 1997. Borrowings under these agreements bear
interest at one-month LIBOR plus 250 basis points and are due upon demand. No
amounts were borrowed under these arrangements as of December 31, 1997.
Note 5. Financial Instruments with Off-balance-sheet Risk
NovaStar'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 NovaStar's exposure to credit risk on interest rate swap and cap
agreements is limited to the cost of replacing contracts should the counterparty
fail. NovaStar 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, NovaStar has in
place fully executed written agreements. Agreements with counterparties also
call for full two-way netting of payments. Under such agreements, on each
payment exchange date all gains and losses of a counterparty are netted into a
single amount, limiting exposure to the counterparty to any net positive value.
Financial futures contracts are exchange-traded, and, as such, credit risk is
considered nominal.
Market Risk The potential for financial loss due to adverse changes in
market interest rates is a function of the sensitivity of each position to
changes in interest rates, the degree to which each position can affect future
earnings under adverse market conditions, the source and nature of funding for
the position, and the net effect due to offsetting positions. The synthetic
product of these transactions is a "matched" position for NovaStar. The
combination of off-balance-sheet instruments with on-balance-sheet liabilities
leaves NovaStar 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,
1997 and December 31, 1996.
Other Risk Considerations NovaStar 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.
The Company did not enter into any interest rate agreements during 1996.
Derivatives held for purposes other than trading consisted of the following as
of December 31, 1997 (dollars in thousands):
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<PAGE>
<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>
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, 1997, the Company recognized $1,047,000 in
interest expense relating to off-balance-sheet financial instruments.
Note 6. Fair Value of Financial Instruments
The following disclosure of the estimated fair value of financial instruments
is made using 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.
The estimated fair values of the Company's financial instruments as of
December 31, 1997 are as follows (in thousands):
<TABLE>
<CAPTION>
Carrying Fair
Value Value
<S> <C> <C>
Financial assets:
Mortgage securities................................ $517,246 $517,246
Mortgage loans..................................... 574,984 608,550
Financial liabilities:
Repurchase agreements.............................. 556,443 556,783
Collateralized mortgage obligations................ 408,867 409,322
Warehouse line of credit........................... 40,250 40,250
Off-balance-sheet financial instruments............. -- (178)
</TABLE>
Market quotations are received for estimating 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.
As of December 31, 1996, fair values of financial instruments approximated
carrying values.
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 become exercisable
in February 1998 and remain exercisable until February 2001 at an exercise price
of $15.00 per share.
In addition, 216,666 units were issued in equal amounts to the two founders
at a price of $15.00 per unit upon the closing of the private placement
offering. Payment for these units 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. The principal
amount of the notes will be 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.
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<PAGE>
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 additional shares of preferred stock converted
into common stock on November 4, 1997. At December 31, 1997, 3,649,000 warrants
were outstanding.
Note 8. Stock Option Plan
The Company's 1996 Stock Option Plan (the Plan) provides for the grant of
qualified incentive stock options (ISOs), stock options not so qualified
(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. Unless previously terminated by
the Board of Directors, the Plan will terminate on September 1, 2006.
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 the Company's initial public
offering in October 1997. The following table summarizes option grants to date:
<TABLE>
<CAPTION>
Grant Exercise
Recipient Date Quantity Price
<S> <C> <C> <C>
Non-officer directors......................... 09/96 10,000 $ 0.01
Founders...................................... 12/96 289,332 15.00
Employees..................................... 12/96 35,000 2.50
Non-officer directors and employees........... 10/97 215,640 18.00
-------
549,972
=======
</TABLE>
The 10,000 options granted in September 1996, the 35,000 options granted in
December 1996, and the 10,000 options granted to non-officer directors in
October 1997 were granted with dividend equivalent rights (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. Compensation expense relating to the DERs during the
year ended December 31, 1997 aggregated $14,000, representing 881 shares of
common stock.
Options to exercise 2,500 options at $2.50 per share were exercised by an
officer in December 1997. At December 31, 1997 and December 31, 1996, total
options outstanding aggregated 547,472 and 334,332, respectively. These options
had a weighted-average exercise prices of $15.17 and $13.24, respectively. As of
December 31, 1997, 298,082 options were exercisable. No options were exercisable
as of December 31, 1996.
The Company has chosen not to adopt the optional accounting provisions of
SFAS 123, "Accounting for Stock-Based Compensation," and, accordingly, there has
been no expense recognized in the accompanying financial statements. If the
Company had recorded expense based on the fair value of the stock options at the
grant date under SFAS No. 123, the Company would have recognized $34,000 as
compensation expense in 1997, and the resulting pro forma basic and diluted loss
per share would have been $0.26 in 1997.
The following table summarizes the weighted average fair value of the options
granted during 1997 and 1996 and the assumptions used in their determination.
The fair value was determined using the Black-Scholes option pricing model.
<TABLE>
<CAPTION>
1997 1996
<S> <C> <C>
Weighted average fair value................... $ -- $0.18
Expected life in years........................ 7 5
Annual risk-free interest rate................ 6.5% 7.0%
Volatility.................................... -- --
Dividend yield................................ 8.0% --
</TABLE>
Note 9. Related Party Transactions
NovaStar and NMI are parties to a Mortgage Loan Purchase and Sale Agreement,
an Administrative Services Outsourcing Agreement and a Loan Servicing Agreement.
Under the terms of the Mortgage Loan Purchase and Sale Agreement, mortgage loans
originated by NMI are purchased by the Company at prices that vary with the
nature and terms of the underlying mortgage loans. Through December 31, 1997,
the Company acquired all mortgage loans originated by NMI. In that regard,
NovaStar reimbursed NMI $1,030,000 of interest during 1997. The Company has
reflected such cost as interest expense in the accompanying statement of
operations. Under the Outsourcing Services Agreement, the Company
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<PAGE>
pays NMI a monthly fee for providing certain services, including the development
of loan products, underwriting, funding, and quality control, as well as for any
interest costs incurred related to borrowings obtained by NMI to originate loans
that are purchased by NovaStar. The Company paid NMI $4,155,000 during the
twelve months ended December 31, 1997, of which $505,000 is included in loan
servicing expenses in the accompanying financial statements. In addition,
through December 31, 1997, NovaStar had purchased 100 percent of the mortgage
loans originated by NMI, which was $418 million.
Note 10. Income Taxes
NovaStar 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 NovaStar has paid or will pay dividends in amounts approximating its
taxable income for the year ended December 31, 1997, no provision for income
taxes has been provided in the accompanying financial statements.
Note 11. Commitments and Contingencies
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.
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<PAGE>
Note 12. Condensed financial statements of NFI Holding Corporation
NFI Holding Corporation and its subsidiary, NMI had no operations, revenues
or expenses prior to February 1997, when NMI began originating subprime mortgage
loans through a network of wholesale brokers and correspondents. NMI generally
intends to sell the mortgage loans it originates to the Company. Effective July
15, 1997, NMI began servicing mortgage loans on behalf of NovaStar. Holding has
no operations of its own and, therefore, its consolidated financial statements
generally reflect the operations of NMI. Following are the condensed
consolidated balance sheet and statement of operations of NFI Holding
Corporation for 1997(in thousands):
<TABLE>
<CAPTION>
NFI Holding Corporation
Condensed Consolidated Balance Sheet
December 31, 1997
- ----------------------------------------------------------
Assets
<S> <C>
Mortgage securities available-for-sale........ $55,195
Other assets.................................. 1,675
-------
Total assets............................... $56,870
=======
Liabilities and Stockholders' Equity
Liabilities:
Repurchase agreements........................ $53,490
Accounts payable and other liabilities....... 1,192
Stockholders' equity......................... 2,188
-------
Total liabilities and stockholders' equity. $56,870
=======
</TABLE>
<TABLE>
<CAPTION>
NFI Holding Corporation
Condensed Consolidated Statement of Operations
For the period from February 6, 1997 (inception) to
December 31, 1997
- --------------------------------------------------------------------
<S> <C>
Interest income - mortgage securities.................... $1,136
Interest expense......................................... 945
------
Net interest income.................................. 191
Fee income:
Administrative and service fees received from 4,155
NovaStar Financial, Inc................................
Other................................................... 1,271
------
Total Fee Income................................. 5,426
General and administrative expenses...................... 5,569
------
Net income before taxes.................................. 48
Income tax expense....................................... 20
------
Net income............................................... $ 28
======
</TABLE>
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<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, 1997 and 1996 and the
related consolidated statements of operations, stockholders' equity and cash
flows for the year ended December 31, 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, 1997 and 1996 and the
results of their operations and their cash flows for the year ended December 31,
1997 and the period from September 13, 1996 (inception) to December 31, 1996, in
conformity with generally accepted accounting principles.
/s/ KPMG Peat Marwick LLP
Kansas City, Missouri
January 30, 1998
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<PAGE>
Item 9. Changes in and Disagreements With Accountants on Accounting and
Financial Disclosure
None
PART III
Item 10. Directors and Executive Officers of the Registrant
Information with respect to Item 401 of Regulation S-K is incorporated by
reference to the information included on the Company's Proxy Statement dated
March 30, 1998, for the Annual Meeting of Shareholders to be held at 3 p.m., May
13, 1998, Crowne Plaza, 4445 Main Street, Kansas City, Missouri, 64111.
Item 11. Executive Compensation
Information with respect to Item 402 of Regulation S-K is incorporated by
reference to the information included on the Company's Proxy Statement dated
March 30, 1998, for the Annual Meeting of Shareholders to be held at 3 p.m., May
13, 1998, Crowne Plaza, 4445 Main Street, Kansas City, Missouri, 64111.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Information with respect to Item 403 of Regulation S-K is incorporated by
reference to the information included on the Company's Proxy Statement dated
March 30, 1998, for the Annual Meeting of Shareholders to be held at 3 p.m., May
13, 1998, Crowne Plaza, 4445 Main Street, Kansas City, Missouri, 64111.
Item 13. Certain Relationships and Related Transactions.
Information with respect to Item 404 of Regulation S-K is incorporated by
reference to the information included on the Company's Proxy Statement dated
March 30, 1998, for the Annual Meeting of Shareholders to be held at 3 p.m.,
May 13, 1998, Crowne Plaza, 4445 Main Street, Kansas City, Missouri, 64111.
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<PAGE>
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) Financial Statements and Schedules
(1) The financial statements as set forth under Item 8 of this report on
Form 10-K are included herein.
(2) The required financial statement schedules are omitted because they
are not applicable to the Company.
(b) Reports on Form 8K
No reports on Form 8-K were filed during the last quarter of fiscal 1997.
(c) Exhibit Listing
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<CAPTION>
Exhibit
No. Description of Document
--- -----------------------
<S> <C>
3.1* Articles of Amendment and Restatement of the Registrant
3.2* Articles Supplementary of the Registrant
3.3* Bylaws of the Registrant
4.1* Specimen Common Stock Certificate
4.2* Specimen Warrant Certificate
10.1* Purchase Terms Agreement, dated December 6, 1996, between the
Registrant and the Placement Agent.
10.2* Registration Rights Agreement, dated December 9, 1996, between the
Registrant and the Placement Agent.
10.3* Warrant Agreement, dated December 9, 1996, between the Registrant
and the Holders of the Warrants Acting Through the Registrant as
the Initial Warrant Agent.
10.4* Founders Registration Rights Agreement, dated December 9, 1996,
between the Registrant and the original holders of Common Stock of
the Registrant.
10.5* Commitment Letter dated October 3, 1996 from General Electric
Capital Group accepted by the Registrant.
10.6* Form of Master Repurchase Agreement for mortgage loan financing
10.7* Mortgage Loan Warehousing Agreement dated as of November 24, 1997
between First Union National Bank of North Carolina, NovaStar
Mortgage, Inc. and the Registrant.
10.8* Employment Agreement, dated September 30, 1996, between the
Registrant and Scott F. Hartman.
</TABLE>
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<PAGE>
<TABLE>
<CAPTION>
<S> <C>
10.9* Employment Agreement, dated September 30, 1996, between the Registrant and W. Lance
Anderson.
10.10* Promissory Note by Scott F. Hartman to the Registrant, dated December 9, 1996.
10.11* Promissory Note by W. Lance Anderson to the Registrant, dated December 9, 1996.
10.12* Stock Pledge Agreement between Scott F. Hartman and the Registrant, dated
December 9, 1996.
10.13* Stock Pledge Agreement between W. Lance Anderson and the Registrant, dated
December 9, 1996.
10.14* 1996 Executive and Non-Employee Director Stock Option Plan, as last amended
December 6, 1996.
10.15* Administrative Services Outsourcing Agreement, dated June 30, 1997, between the
Registrant and NovaStar Mortgage, Inc.
10.16* Mortgage Loan Sale and Purchase Agreement, dated as of June 30, 1997, between the
Registrant and NovaStar Mortgage, Inc.
10.17* Flow Loan Subservicing Agreement, dated as of June 30, 1997, between the Registrant and
NovaStar Mortgage, Inc.
10.18* Certificate of Incorporation of NFI Holding Corporation.
10.19* Agreement of Shareholders of Common Stock NFI Holding Corporation.
11.1 Statement regarding computation of per share earnings.
21.1* Subsidiaries of the Registrant (set forth in "Prospectus Summary," "The Company" and
"Certain Transactions" in the Prospectus).
23.1* Consent of Tobin & Tobin, a professional corporation.
23.2* Consent of Piper & Marbury, LLP
23.3* Consent of Jeffers, Wilson, Shaff & Falk, LLP
23.4 Consent of KPMG Peat Marwick, LLP
27.1 Financial Data Schedule
</TABLE>
* Previously filed.
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<PAGE>
GLOSSARY
As used in this Prospectus, the capitalized and other terms listed below have
the meanings indicated.
"Agency" means FNMA, FHLMC or GNMA.
"CAG" means Capital Allocation Guidelines adopted by the Company's Board of
Directors.
"CMO" or "Collateralized Mortgage Obligations" means adjustable or short-term
fixed-rate debt obligations (bonds) that are collateralized by mortgage loans or
Pass-Through Certificates and issued by private institutions or issued or
guaranteed by GNMA, FNMA or FHLMC.
"Company" means NovaStar Financial, Inc., a Maryland corporation.
"DER" means dividend equivalent rights, an element of the Company's stock
option plan, which are granted together with certain stock options.
"FHLMC" means the Federal Home Loan Mortgage Corporation.
"founders" means Scott F. Hartman and W. Lance Anderson.
"FNMA" means the Federal National Mortgage Association.
"GNMA" means the Government National Mortgage Association.
"Holding" means NFI Holding Corporation, a taxable affiliate of the Company.
"ISOs" means qualified incentive stock options granted under the Stock Option
Plan which meet the requirements of Section 422 of the Code.
"Net interest spread" means the difference between the annual yield earned on
interest-earning assets and the rate paid on borrowings.
"NovaStar Mortgage" means NovaStar Mortgage, Inc., a taxable affiliate of the
Company.
"NQSOs" means Non-Qualified Stock Options, an element of the Company's stock
option plan regulated by Section 422 of the Code.
"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 the Company's private placement of Units, which
closed December 9, 1996. Each Unit consists of one share of Convertible
Preferred Stock and one Warrant to purchase one share of Common Stock.
"REIT" means Real Estate Investment Trust as defined under Section 856 of the
Code.
"single family" means, with respect to mortgage loans, loans secured by one-
to four-unit residential property.
"taxable income" means for any year the taxable income of the Company 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.
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<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
NOVASTAR FINANCIAL, INC.
(Registrant)
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Date: FEBRUARY 12, 1999 By: /s/ SCOTT F. HARTMAN
----------------- ----------------------------------------
Scott F. Hartman, Chairman of the Board
of Directors and Chief Executive Officer
Date: FEBRUARY 12, 1999 By: /s/ W. LANCE ANDERSON
----------------- ----------------------------------------
W. Lance Anderson, President,
Chief Operating Officer and Director
Date: FEBRUARY 12, 1999 By: /s/ MARK J. KOHLRUS
----------------- ----------------------------------------
Senior Vice President
and Chief Financial Officer
Date: FEBRUARY 12, 1999 By: /s/ RODNEY E. SCHWATKEN
----------------- ----------------------------------------
Rodney E. Schwatken, Vice President,
Controller and Assistant Treasurer
(Chief Accounting Officer)
Date: FEBRUARY 12, 1999 By: /s/ EDWARD W. MEHRER
----------------- ----------------------------------------
Edward W. Mehrer, Director
Date: FEBRUARY 12, 1999 By: /s/ GREGORY T. BARMORE
----------------- ----------------------------------------
Gregory T. Barmore, Director
Date: FEBRUARY 12, 1999 By: /s/ JENNE K. BRITTELL
----------------- ----------------------------------------
Jenne K. Britell, Director
</TABLE>
